The Medley Judgment

How hedge fund law is developing in the Caymans

CHRISTOPHER RUSSELL and DAVID BUTLER, APPLEBY

In the case of Medley Opportunity Fund Ltd v Fintan Master Fund Ltd and Nautical Nominees Ltd (judgment 21 June 2012), the question of the effect of hedge fund restructuring arrangements on pre-existing rights under the fund’s articles of association and the enforcement by nominee investors of rights given to their underlying principals in side letters to which the nominee is not a party, was considered by the Cayman Islands Court.

The global liquidity crisis which began in 2008 continues to produce such disputes that are developing the law of the Cayman Islands in relation to hedge funds. The Medley decision is the most recent of a growing line of Cayman cases which consider the legal ramifications of protective steps that funds took in the wake of the financial tsunami.

The Medley Case: the facts
The investor (Fintan) proposed to invest in the Medley Opportunity Fund (“Medley”), a Cayman fund, offering returns from predominantly credit and asset based investments in Asia, North and Latin America and Western Europe. Fintan sought terms in return for its investment more favourable than those generally offered by Medley, and prior to subscribing, entered into a side letter with Medley and its investment manager, which included, in particular, the following clause in respect of redemptions:

“All distributions from the Fund to Fintan upon redemption, liquidation or otherwise shall be paid in cash. If it is not possible for a distribution to be paid immediately in cash, securities equal in value to the amount that would otherwise be distributed will be deposited by the Fund into a separate liquidation account on Fintan’s behalf, with the proceeds therefrom to be distributed to Fintan in cash as such securities are liquidated. Any and all expenses in connection with such liquidation account will be paid by the Fund.”

The underlying purpose was not expressly stated, but it may be that Fintan, in addition to seeking assurance that it be paid redemptions immediately in cash or in assets sought to establish proprietary rights over assets paid into the segregated account, so to give it priority over other creditors or shareholders in the event that Medley went into liquidation; establishing propriety rights in this way, is complex in principle, and might in any event amount to a voidable preference in the event of liquidation.

The side letter also contained a provision that Medley would not suspend redemptions of Fintan’s investments for more than 12 months, unless the suspension was caused by matters beyond Medley’s control.

Having entered into the side letter, Fintan did not then make its investment into Medley directly; it made a series of investments totalling some $45 million through a nominee, Nautical Nominees Ltd, the second defendant in the Cayman litigation (“Nautical”). Nautical, not Fintan, became the registered shareholder in Medley. Nautical was not a party to the side letter, nor was any other agreement entered into between Medley and Nautical to afford to Nautical the rights conferred on Fintan under the side letter.

A year later the financial tsunami struck and Medley, as did many other funds, embarked on a restructuring plan. A restructuring proposal, circulated to investors on 24 November 2008, proposed a way forward which was designed to address the liquidity needs of some of its investors, while affording opportunities for those who were not so affected by liquidity issues.

There were two options: option 1 comprised the transfer of shares from the existing class A to new classes of shares to be created within class C, those new shares having as their next redemption date 31 December 2009; option 2 was to remain in class A and to receive quarterly cash distributions. Investors were not obliged to elect either option, but by electing for either option the investor expressly agreed to withdraw any outstanding redemption requests.  

Nautical elected to leave $10 million in class A and move the balance of its investment (then valued at some $39 million) into class C. As part of the process, Nautical signed a document which recorded that it approved the terms of the 2008 plan. In 2009 a further restructuring plan was proposed. This plan (offered only to class C shareholders) again provided two options: option 1 provided for a new D class of shares to be created into which the investor could elect to move. Class D had a 1.5%/10% fee structure with quarterly redemptions and a one year notice period, with the next redemption date being four years thereafter on 31 December 2013. Option 2 provided that the investor would remain in class C, but class C would be subject to a soft wind-down, with excess cash generated by (and presumably from the realisation of) existing assets being paid quarterly pro rata the member’s interest in class C by way of partial redemption. Again, by agreeing to either option, the investor agreed to withdraw any outstanding redemption requests. Nautical opted for option 2, and again Nautical signed a document stating that it approved the terms of the 2009 plan.

Perhaps surprisingly in the circumstances, Nautical submitted a redemption request in respect of all its shares in Medley in December 2011.

The dispute
On 17 February 2012 Medley commenced proceedings in the Cayman court seeking the following declarations:

(1) A declaration that the rights of Nautical, as shareholder in Medley as nominee for and on behalf of Fintan, to redeem, and/or to receive from Medley distributions or payments in respect of, the shares that it holds in Medley and are the subject of Option 2 of the 2008 Plan and/or Option 2 of the 2009 Plan … elected for by Nautical (for and on behalf of Fintan), are those rights conferred by the 2008 and/or the 2009 Options, to the exclusion of any rights of redemption or distribution or payment or other rights conferred by the side letter.

(2) A declaration that the Defendants, having elected the 2008 and/or the 2009 plans, are estopped from relying on the terms of the side letter, insofar as those terms are inconsistent with the provisions of the 2008 and/or the 2009 plans.

(3) A declaration that, in respect of the shares, Nautical is entitled to pro-rata quarterly distributions by Medley in accordance with the 2008 and/or the 2009 Options and to no other rights of distribution or payment relating to the shares, whether in respect of redemption or otherwise.

(4) A declaration that the redemption request dated the 31st December 2011 served on Medley by Nautical for and on behalf of Fintan (the “Redemption Request”) is invalid and of no effect.

On 6 March 2012, Fintan instituted proceedings in the New York state court against Medley, claiming breach of contract and seeking declarations that the side letter governed the terms of redemption of the Nautical shares from Medley. At the instance of Medley, Fintan’s New York proceedings were anti-suited by injunction by the Cayman court and Fintan was restrained from prosecuting its New York case seeking the opposite declaratory relief pending the outcome of Cayman proceedings which Medley had already commenced.

For hedge funds to whom judicial efficiency is a factor in determining jurisdictions in which to establish themselves, the Financial Services Division of Cayman’s Grand Court was specifically created to deal principally with disputes concerning Cayman’s fund and trust industries, and the court heard the Medley matter in a little under four months from the date proceedings were commenced. Given the events that have taken place in the financial services industry in recent years and the complex and high value disputes to which those events have given rise, it may be increasingly important to hedge funds and their managers to have the assurance of high quality dispute resolution, which is capable of operating at the speed appropriate for the dispute and which can offer a broad range of relief to litigants.

The Issues in the Medley Case
There were two main issues : (1) given the restructuring plans to which Nautical had signed up, was Medley still bound by the terms of its articles of association relating to redemptions so that it had to honour Nautical’s redemption request? (2) could Nautical enforce the terms of the side letter in respect of its redemption requests?

Issue 1: was Medley still bound to honour Nautical’s redemption requests post-restructuring?
Among its arguments deployed on this issue, Medley contended that by signing up to the 2008 and 2009 plans Nautical (as the shareholder of record) had agreed to substitute its right to redeem under the terms of the articles, for quarterly cash payments by way of partial redemptions. Medley argued that it was entitled, under its articles of association, to enter into such bilateral agreements with its shareholders, and by entering into such an agreement with Medley, Nautical was estopped (i.e. prevented in law) from relying on the terms of the articles relating to redemption. Medley argued that any interpretation of the 2008 and 2009 plans which meant that investors could elect to enter the plans but nevertheless still maintain their pre-existing rights to redeem, would be a commercial nonsense and make the 2008 and 2009 plans pointless. Medley contended that by signing up by each plan to receive quarterly cash distributions, Nautical had waived whatever redemption rights it had previously held under the articles.

Fintan and Nautical argued that the language of the 2008 and 2009 plans did not clearly spell out that approving and entering into them would restrict future redemption rights and that the terms of the articles of association should prevail over any document or agreement which conflicted with them. Fintan and Nautical also contended that the terms of the 2008 and 2009 plans were ambiguous and in consequence they fell to be construed against Medley (as the plans were promulgated by Medley).

The judge (Quin J.) accepted Medley’s arguments. He held that Medley had the requisite authority to enter into the plans with its investors and that Nautical had, by the terms of the documents it had signed approving the plans, agreed to “all the terms described in [Medley’s] letter in respect of the [plans].” The question then was the correct interpretation of the terms and purpose of the plans. In arriving at his decision on this issue, the judge relied heavily on, and quoted extensively from, the recent decision of the UK Supreme Court in Rainy Sky SA v Kookmin Bank [2011] UKSC 50 in which Lord Clarke JSC considered the leading authorities concerning the interpretation of commercial documents, and concluded that the essence of the judge’s task when interpreting a commercial document which was capable of having more than one meaning, was to adopt the interpretation which was most consistent with business common sense (not, one might hope, a surprising or difficult conclusion).

Quin J. concluded his analysis on this issue by holding, at para 93 of the Judgment: “Upon reviewing the letters sent on behalf of the [Medley] setting out the purpose and proposed terms of the 2008 and 2009 variations, and in light of the Rainy Sky principles comprehensively set out by Lord Clarke, I find that the plain commercial purpose of Option 2 in both variation agreements was to require [Nautical] to exchange its existing redemption rights for periodic cash distributions effected pro rata with all other investors accepting this Option. This allowed [Medley] to have the advantage of minimizing a liquidity squeeze and avoiding a fire sale of assets. The benefit to [Nautical] and all the members was to allow [Nautical] to benefit from the expected recovery in asset prices, to avoid a disorderly scramble for assets under liquidation, and to be treated equally and fairly, with the other members.”

And at para 97 he indicated in trenchant terms his view of the position taken by Fintan and Nautical: “It would cause great confusion and make no sensible commercial business sense if members such as [Nautical] were allowed to enter into these agreements [i.e. the restructuring plans] only to then try and redeem and enforce a redemption right by a different route.”

Issue 2: could Nautical claim the benefit of the enhanced terms of the side letter?
As Nautical had given up its redemption rights through its election to enter into option 2 in each of the 2008 and 2009 plans, this issue did not, strictly speaking, arise for decision as the terms of the side letter only applied to the proceeds of redemption requests and periods of suspension. The judge did however consider this second issue and again accepted Medley’s arguments.

Nautical was not a party to the side letter and under current Cayman law – which has the same common law doctrine of privity of contract as existed in English law before its partial abolition by statute at the end of 1999 – a person who is not a party to a contract cannot (subject to certain exceptions which did not apply in the Medley case) claim the benefit conferred by that contract. The judge rejected the argument advanced by Fintan and Nautical that despite investing through a nominee, Medley knew that Fintan was the true party in interest, that Medley drew no distinction between Fintan and Nautical in relation to the investment and treated them as one and the same, so that Medley was estopped from denying the application to the shares of the rights contained in the side letter.

Accordingly, the Judge held, on the proper construction of the 2008 and 2009 plans, Nautical’s redemption rights were given up in favour of a quarterly cash payout which constituted partial redemptions from Medley, and there was no legal or factual basis to give rise to the estoppel for which Fintan and Nautical contended in relation to the more favourable terms negotiated by Fintan in the side letter. In consequence, Medley was entitled to the declarations it sought that Nautical’s redemption request was invalid and of no effect and that Nautical’s redemption and other rights were exclusively those specified in the 2008 and 2009 plans.

Comment
The decision in Medley should be welcomed by funds and investors alike for its sound application of the “business common sense” interpretation it adopted in relation to the restructuring plans and its emphasis on certainty in commercial transactions. Whether a fund is preparing, or investors are being presented with, a restructuring proposal, it should be reassuring to know that in the event that it is subsequently challenged by a disgruntled investor who would, in retrospect, have preferred to have adopted a different course, the effect of the restructuring will be approached by the Cayman court from a common sense business perspective, rather than a pedantic adherence to language and syntactical analysis which might suggest a different conclusion. It is also a timely decision, as write downs and write offs continue in 2012 in worsening economic conditions globally: if there is uncertainty about the validity of restructuring plans, funds may be less willing to promote them, and investors less willing to accept them.

The finding that nominees cannot enforce side letters to which their underlying principals are parties, but the nominee shareholder is not, will come as no surprise to legal practitioners. But there is likely to be significant fallout, for Fintan is but one of a myriad of investors in Cayman funds who have negotiated for themselves side letters conferring favourable terms in respect of their investment only then to invest through a nominee without also making the nominee a party to the side letter agreement, and in consequence able to rely on and enforce the rights it creates.

In light of the Medley decision, such investors may be asking themselves whether there is now anything they can do to correct the position and merge the enhanced side letter terms with the share rights. Three possible solutions present themselves and are discussed below, although it is suggested that it is only the third possibility, novation, which is likely to afford certainty.

First, it might be said that the underlying investor in effect constitutes itself as trustee for the nominee of the provisions and rights contained in the side letter. Establishing a trust relationship in a commercial situation of this type will always be difficult, if not impossible in practice.

Secondly, it might be argued that the benefit of the rights conferred by the side letter could be assigned by the underlying investor to its nominee. On ordinary principles of assignment, it should be possible to assign the benefit – but where the underlying investor never held the legal title to the shares to which the benefits conferred in the side letter attached, the validity of any assignment might well be challenged on the basis that the underlying investor was not assigning rights which it could then presently enforce (because it owned only the beneficial and not also the legal title to the shares) and was in effect seeking to graft on to someone else’s property (the shares held by the nominee) rights which it had contracted for but could not itself exercise.

Thirdly, and it is suggested this is the most effective course, the underlying investor may seek the agreement of the fund to a novation of the side letter at the time of investment so that the nominee becomes a party to, and entitled to the rights contained in, the side letter. Questions of the consideration provided for the novation would require careful analysis, but at the commercial level it is unlikely that a fund would object to a novation which added a nominee as a party and a valid novation would be legally effective to confer both the benefit and burden of the terms of the side letter to the nominee. Investors contemplating investments into funds through a nominee should take care to ensure that any enhanced rights they are able to negotiate in return for their subscription are conferred on the nominee who will be registered as the shareholder, and so able to enforce them, which the investor can not do.

Post-script: legislative reform
The Cayman Islands government recently announced that it is consulting on the introduction of a Contracts (Rights of Third Parties) Bill which, if enacted, will give rights of enforcement to those who are not party to contracts but upon whom the contracting parties expressly agree to confer rights. This is likely to come into law, but the draft Bill lays down certain pre-conditions to enforcement by the non-party with which investors will wish to ensure they comply, if they intend to rely on the Law once enacted (for example the Bill envisages that the third party upon whom it is intended to confer the benefit be expressly named, or identified by class or description in the contract).

Pending legislative reform, investors proposing to invest through a nominee in a fund with whom they have entered into a side letter agreement should investigate whether the fund into which they are invested or are about to invest will agree to novate existing side letter agreements in order to confer the rights contained in them on their nominee.