In late February 2008, investors in the now infamous Bear Stearns structured credit funds won a significant victory in the Grand Court of the Cayman Islands, wresting control of the funds from liquidators appointed by their management and voting shareholder, and installing their preferred appointees. Until late April, the Court's ruling in this case was embargoed , although in the meantime the new liquidators (Kinetic Partners) launched a lawsuit in New York against Bear Stearns Asset Management Inc (BSAM) and others, seeking over US$1 billion in damages to make those investors whole.
Now that details of the ruling may be publicly discussed, following the withdrawal of a challenge by one of the losing parties, the funds industry can consider the lessons to be learned from this case.
Of all the litigation that has erupted in the aftermath of the sub-prime mortgage meltdown and ensuing credit crunch, none has been more prevalent or more emotive than complaints about the use of powers by fund managers, directors and voting shareholders to restrict the rights of investors who have different views on the best way out of the crisis. Often such powers are deployed to prevent mass redemptions which can bring about a vicious circle of downward pressure on a fund's assets, but equally often managers and directors find that the fund's constitutional documents do not confer the powers they want to deal with their particular crisis: this can give rise to an imaginative and aggressiveinterpretation of the powers they do have or an attempt to amend the fund's constitution; which in turn invites challenges by the investors whose attempts at redemption end up thereby thwarted.
With the right facts and circumstances, parties can successfully harness the judicial system to achieve a swift determination of their grievances. The Bear case went from a challenge filed by investors on 7 December 2007, via a preliminary hearing on 14 December, to an expedited trial on 19-21 February 2008 including cross-examination of the parties' key witnesses, with judgment delivered by the Chief Justice the next day on 22 February.
This was an exceptional case on a number of levels. The length of the traditional litigation process, even a process which envisages a summary judgment procedure, is often too long for potential litigants; a recalcitrant defendant can deploy delaying tactics that effectively discourage their opponents: with the NAV of many troubled funds declining at the rates we have seen, there may be nothing left to argue over by the time parties get to trial.
At the same time, many institutional and fund of hedge fund investors just want an answer to their questions, no matter how hotly debated; if necessary they will take their haircut and move on. For this reason, parties are increasingly looking to ad hoc arbitration procedures to resolve disputes involving hedge funds.
The investors in Bear were able to present a suite of cumulative and alternative remedies, which enabled the Court to engineer a pragmatic result in their best interests.
'Improper purpose' challenges are notoriously difficult and not often attempted, although it is potentially a very powerful remedy: it can serve to unscramble entire transactions and expose those culpable to personal liability. However, such challenges may be investors' only recourse when fund documents give management apparently untrammelled latitude to make radical decisions about a fund's operations (including liquidation steps). The Bear case had extreme facts, so the remedy was viable for those investors. This case also illustrates the converse: absent 'bad' facts, the average investor cased with tightly-drafted fund documentation will have little recourse.
In the current climate, those with free capital to invest may find they have greater bargaining power than before: the pendulum may start to swing towards the investor body in terms of respective rights between investors and management. In the future, potential seed investors for new funds will review the documentation more carefully to determine what rights they have in the event of trouble. They can seek to negotiate changes from the outset, as a condition of their investment, or else they may go elsewhere. This in turn may force fund promoters to be more competitive in the terms they offer, and the concessions that they are prepared to make in terms of voting power for investors.
The role of an independent director is key to the effective handling of fund crises, where investors start to lose confidence in management (and thus the management-appointed directors). Transparency in a board's decision-making process will do much to assuage concerns of investors who have never been through such economic turmoil, and independent directors can ensure that decisions and even prospective decisions are appropriately communicated to their constituents. In Bear, the investors were presented with a fait accompli, which merely inflamed the situation.
The Bear case represents the second major threat to those offering such services as an ancillary function to fund formation (the first being the Parmalat case, specifically the independent directors provided by Maples Finance to Food & Dairy Holdings Ltd, the Cayman companies which issued US$300 million in notes and ultimately brought the whole house of cards crashing down). Such casesthrow real doubt on the propriety and viability of the one-stop-shop model adopted to a greater or lesser extent by a number of law firms.
It should now be clear that the provision of independent director services is not a scalable business. A company with dozens of employees, purporting to act as directors on 200 or even 100 funds, will become a thing of the past. Investors (and even the more prudent fund promoters) will require smaller operations, which can deliver dedicated director services at perhaps higher cost but delivering higher value.
Although some lawyers may not be happy to endorse this view, extensive and widespread litigation is not looming for the fund industry. There are a number of reasons for this, some referred to above, but chief amongst these is the reality that pragmatism rules for many fund players. Another reason, often unexpressed but no less real, is industry players' fear of setting precedents which may come back to haunt them: many potential litigants (eg. funds of hedge funds) find themselves on opposite sides of the same issue in different cases, potentially giving them a conflict of interest in advancing one argument for the benefit of their investors who may end up using the same argument against them in relation to their own fund products and services. Finally, the general economic situation (namely a slow and extended downturn with no immediate prospect of either a real recession or an upturn) is such that litigation remains a luxury purchase for many, and a necessary evil for only a desperate few who have no other choice.
This conclusion also means that some of the uncertainties and inconsistencies exposed by a critical review of fund documentation are not going to be confirmed as such by judicial interpretation, still less by appellate court rulings which would bind lower courts and create real certainties for the profession when facing incorporation instructions in the future.
In the cases to date, we have seen many instances of boilerplate documentation produced separately by onshore and offshore firms, welded together in a hurry at a time when business was booming and with little thought to the future: fertile ground for litigation lawyers, but still unappealing to any players who have the wherewithal to negotiate a commercial settlement.
Jeremy Walton is a partner at the Cayman-based Head of the Fund Disputes Team at international offshore law firm Appleby