The Treatment and Rights of Creditors of Cayman Islands Funds

The Treatment and Rights of Creditors of Cayman Islands Funds

ARISTOS GALATOPOULOS & BEN MAYS, MAPLES AND CALDER

Recent news in the financial press has focused on a potential ‘credit crunch’ amid speculation that recent high market liquidity may be coming to an end. This has been highlighted by the US sub-prime mortgage crisis that has affected a number of hedge funds, including two Bear Stearns sponsored funds domiciled in the Cayman and apparent intervention in the markets by European and US central banks. As such, the treatment and rights of creditors of Cayman Islands funds have come under the spotlight, and in many cases familiar misapprehensions have surfaced about how the Cayman insolvency regime operates and whose interests are protected in a crisis. Thus for example an 8th August Bloomberg article suggested that Bear Stearns’ decision to liquidate its sub-prime funds in the Cayman Islands rather than New York “may limit creditors’ and investors’ ability to get their money back”, that Cayman judges have “a track record of favouring management” and that the Cayman liquidations were simply strategic ploys designed to protect the funds’ management.

Is this an accurate analysis of what happens when times are bad? Are the Cayman Islands a debtor-friendly jurisdiction where fund managers who want to avoid their investors and creditors can run and hide behind the skirts of a bankruptcy filing and a sympathetic judge?

The simple answer is no. One of the principal structural reasons why the Cayman Islands are so popular with the financial markets and with hedge funds in particular is because of their creditor (and investor) friendly insolvency regime. The Cayman Islands have no bankruptcy reorganisation regime comparable to US Chapter 11 or to administration in the UK, each of which provides extensive protection for the debtor by way of moratoria on secured creditor action and a ‘breathing space’ in which the business can re-structure. In the US and UK there are socio-economic reasons – principally employment related – why preservation of the enterprise or business is desirable and why creditors and investors are, for policy reasons, expected to share at least some of the pain. In the Cayman Islands, where exempted limited companies are predominantly structured for use in financial transactions, there is no such dynamic. The legislative and practical focus is on protecting the interests of those with the direct financial interest in a fund, ie its creditors and investors.

Prior to a bankruptcy filing, Cayman Islands exempted companies have considerable flexibility to organise their affairs in the manner that most suits the interests of their financial stakeholders, and there may be a variety of different creditor dynamics. Thus for example many Cayman companies will be set up for single ‘limited recourse’ transactions, where the creditors’ recourse is expressly and contractually limited to a defined pool of assets, over which they will typically have comprehensive security rights, and which limits the exposure of the investors accordingly.

Many Cayman funds, if they are not leveraged and simply hold and manage assets, will owe limited professional and management fees from time to time but will have no ‘financial’ creditors as such, although in a crisis situation there may be arguments as to whether investors who have redeemed (or consider that they have redeemed) have elevated themselves to the status of creditors or rank alongside their (former) fellow investors.

In other cases, such as leveraged funds like the Bear Stearns sub-prime funds and high-profile historic cases such as the MotherRock Energy Master Fund, investors’ risk is explicitly linked to leverage provided by sophisticated creditors under lending arrangements or a variety of complex swaps, repos or other derivative structures. The relevant creditors under these arrangements usually have a variety of contractual security, lien and set-off rights. In many cases these arrangements will not be governed by Cayman Islands law but by the local (onshore) law where the creditor is based.

When the underlying assets in a leveraged fund fail to perform and events of default occur or margin calls are made, those creditors will expect to be able to realise their security and exercise their liens and set-off, close-out and netting rights in accordance with their terms. The reason that such sophisticated creditors are willing and indeed want to have Cayman Islands funds as counterparties to these leveraged transactions is that they know that Cayman Islands law allows them to do precisely that. A creditor with valid security or rights of set-off, close-out and netting can exercise those rights when a crisis occurs without impediment under Cayman Islands law. These rights can be exercised even if the relevant fund is insolvent, and (critically) regardless of whether a bankruptcy filing has taken place in the Cayman Islands.

Thus one news report of the Bear Stearns funds crisis was able to confirm, following the funds’ bankruptcy filings in the Cayman Islands, that “Nearly all secured counterparties have now seized and sold off assets in the fund that has been subject to repurchase agreements. In some cases, this has resulted in a positive asset or cash return to the hedge fund.” (Reuters News, 3rd August). In other words, the secured creditors were able to exercise their security and take action to protect their positions without hindrance.

So, secured creditors have nothing to fear from a Cayman Islands incorporation or bankruptcy proceeding and will face none of the restrictions on enforcing their rights that they might do under onshore ‘restructuring’ bankruptcy regimes. What of unsecured creditors, who do not have access to secured assets over which they can exercise self-help remedies? Do their interests suffer, at the hands or to the benefit of ‘management’ or the debtor, as a result of a Cayman Islands filing? Again the answer is no.

The liquidators of a Cayman Islands company, whether appointed out of Court by the company’s shareholders or by the Court itself on the application of investors, creditors or ‘management’, are independent. The liquidators displace the fund’s management and directors for all purposes. The liquidators owe their duties to those with the financial interest in the fund, i.e. its creditors and, if the fund is or may be solvent, its investors. Liquidators who are appointed by the Court are also officers of the Court and as such owe duties to the Court. As such, management cannot hope to favour their own interests by appointing liquidators and expecting them to follow their instructions. Members of management are subject to the same scrutiny in the liquidators’ investigations as any third parties.

The principal duty of a liquidator of a Cayman Islands fund is his statutory obligation to realise the (unsecured) assets of the company so that they can be distributed to creditors and thereafter, if and to the extent the company is solvent, to its investors. The liquidator will also have an obligation to investigate the affairs of the fund in appropriate circumstances. If that investigation reveals wrongdoing or claims against third parties, then the liquidators will consider taking appropriate action with the ultimate aim of swelling the assets available for creditors and investors. A Cayman liquidation does not necessarily mean that all related litigation will take place in the Cayman Courts’ or be governed by Cayman law. If the fund has causes of action against third parties, it will have the power to bring those causes of action in whichever courts have jurisdiction to hear the dispute. The usual factors – such as contractual governing law and jurisdiction clauses, location of the defendant and its assets – will influence the decision making process of the liquidators, as will the views of the creditors and investors, through a committee where one is appointed. By way of example the liquidators of the SPhinX group of companies are, with the support of creditors and investors, currently involved in high profile litigation in the New York courts seeking to overturn the funds’ pre-liquidation preference settlement with Refco Capital Markets.

Nor is the appointment of Cayman Islands liquidators solely the preserve of management. More often than not a Cayman bankruptcy filing will be as a direct result of an application to Court by or pressure from creditors or investors concerned to protect their positions. In occasional circumstances it may be the outcome of action from the Cayman Islands Monetary Authority if the fund or company in question is regulated. The ability to apply for the appointment of liquidators is a specific remedy available to unpaid creditors or to the investors of a solvent fund so as to enable the fund’s assets to be protected and realised independently rather than continuing in the control of its management. The bankruptcy regime is flexible enough to allow for emergency protection of a fund’s assets by the appointment of provisional liquidators if, for example, there is a clear risk of the assets being dissipated pending a full hearing.

The fundamental principle underpinning Cayman Islands bankruptcy law is the pari passu principle, i.e. the equal treatment of creditors. This principle does not affect rights of set-off, close-out or netting, other contractual subordination arrangements or ‘waterfalls’. As such a Cayman Islands liquidation, however instituted, is a collective procedure for the benefit of all unsecured creditors (and, if the fund is solvent, the investors in accordance with the terms of their investments). Accordingly once liquidators have been appointed by the Court there is a moratorium on any proceedings against the company so as to ensure that all creditors’ claims are dealt with through the liquidation and no creditor can unfairly improve its position as against the others by taking unilateral action. This is a feature in common with many onshore liquidation regimes. As explained above, and unlike many onshore restructuring regimes, this moratorium does not prohibit the enforcement of valid security, set-off, close-out or netting rights, which will remain unaffected by the bankruptcy filing.

It should also be borne in mind that events that make life harder for creditors of a Cayman fund typically happen by virtue of laws other than those of the Cayman Islands. For example, if a Cayman fund (whether or not it is in liquidation in the Cayman Islands) goes into Chapter 11 in the US or administration in England, rights of creditors may nonetheless be adversely affected by the scope of the stay imposed by US or English law.

Another misconception about the Cayman bankruptcy process is that it is somehow remote or inaccessible for or not transparent to onshore creditors and investors. Ignoring again the fact that such creditors and investors chose to do business with a Cayman company and are entitled to expect that Cayman Islands liquidation principles will apply when things go wrong, this is also inaccurate. In terms of transparency and practical access to justice and information, a Cayman Islands liquidation is extremely accessible. By way of example:

  • The Cayman Islands have a very well developed, stable and largely predictable legal system based in large part on English law principles;
  • There is an extremely well-developed corporate and commercial market-place in which the practitioners are sophisticated and understand the needs of global finance;
  • A Cayman fund’s liquidators will invariably be professionals from one of the major international firms of accountants, each of which has a large presence in the Cayman Islands and the global reach to handle a major bankruptcy in a seamless and efficient manner. For example, partners from KPMG were appointed as provisional liquidators of the Bear Stearns sub-prime funds. In some cases joint liquidators may be appointed from firms in the jurisdictions in which the company operated, so as to maximise these efficiencies. For example the Court-appointed liquidators of the Beacon Hill Master Fund are a partner of KPMG in the Cayman Islands and a US based attorney.
  • The judiciary in the Cayman Islands has a firm grasp of the importance and nature of the Cayman Islands’ role as a centre of international finance, and of the rights and needs of creditors and investors. There is certainly no judicial practice of ‘favouring management’;
  • The rules and practice of Cayman bankruptcies require and encourage transparency. One of a liquidator’s first tasks after his appointment will be to communicate with investors and creditors. The liquidators will establish a creditors’ and/or investors’ committee with whom the liquidators typically will work closely in formulating strategy and running the liquidation, or where the creditor/investor body is smaller the liquidators will simply work directly with all of them. For example the liquidation committee on the SPhinX group of companies is extremely pro-active and heavily involved with liquidation strategy. The SPhinX liquidations demonstrate the flexibility of such committees in that a single committee can be appointed by the Court representing creditors and investors of a group of companies in complex fund structures with numerous corporate entities. There are specific statutory provisions enabling liquidation committees to appoint independent attorneys and to have expenses met out of the assets of the fund for their work in assisting the liquidators and acting as a representative body of the stakeholders;
  • Financially interested parties have the right to apply to Court if they consider that the Court needs to address a question arising in the liquidation process; and
  • Distressed Cayman incorporated funds routinely become subject to a Cayman liquidation proceeding which may (if necessary) be subsequently exported into the jurisdiction where assets/management are located, although the extent to which the Cayman liquidation proceeding can be so exported is a matter for the laws of that jurisdiction rather than Cayman Islands law. The US Bankruptcy Court’s recent decision in relation to two Bear Stearns funds indicates that formal US Court recognition of Cayman Islands liquidation proceedings will not generally be available pursuant to Chapter 15 of the US Bankruptcy code. This is a question of US law. Nevertheless the US Bankruptcy Court has historically looked favourably on the provisions of Cayman Islands insolvency law when it has had cause to review or interpret it.
  • In cross-border cases the liquidator will generally expect there to be some sort of parallel proceedings in another jurisdiction where appropriate.

Occasionally, a regulatory receivership or other principal onshore filing that is instituted by others may result in preliminary jurisdictional issues as between the Cayman liquidation and the onshore proceeding. This is thankfully rare as the costs of such a dispute are ultimately borne by the investors/creditors. In any event the Cayman Courts are used to giving effect to detailed cross-border protocols to enablewhatever parallel procedures are in place to work to the ultimate advantage of the creditors and investors. The Cayman Court reaffirmed its commitment to and the importance of such protocols as recently as May 2007 in the case of PFA Assurance Group Ltd, whose Cayman liquidators entered into a protocol with a receiver appointed over the assets of the company by the US District Court for the Southern District of Florida.

The bottom line is that it is difficult to see how one can sensibly avoid having a liquidation in the fund’s country of incorporation which complements a parallel or ancillary bankruptcy proceeding in the relevant onshore jurisdiction(s). The liquidations of the Bear Stearns funds are not the out of the ordinary, ground-breaking tactical device that some have suggested, but are the natural outcome for Cayman Islands incorporated funds in distress and follow a well-worn path in which investors’ and creditors’ interests have typically been well-served. In our experience it would be highly unusual for any Cayman domiciled fund to be subject to an onshore bankruptcy proceeding without there being a liquidation in the Cayman Islands. In that context the Cayman regime is designed to and does put the interests of creditors and investors first.