Time to Look Over the Hedge?

Litigation and liquidation strategies

Originally published in the October 2007 issue

For 10 years or so, fund promoters, managers, administrators and – especially – investors have been too busy to look over the hedge and see what lies on the other side of a dynamically expanding industry. During this period, the attraction of hedge funds has spread across the globe and into a broad constituency of investors. The US government acknowledged the benefits of bringing the funds industry back onshore and, through its repeal of the ’10 Commandments’1 in 1997, spawned the rise of fund management and administration businesses from Delaware to New York and Boston. In Europe, increased investor demand spurred the launch of Dublin and Luxembourg, in addition to London, as regional centres of excellence for the funds industry.

At the same time, and rather inevitably on the heels of this meteoric growth, has come greater regulatory scrutiny in both the USA and the EU2, at the behest of influential investor lobbies such as the pension funds who, despite their sophistication, ultimately represent the savings of ordinary people.

There have of course, been a few casualties throughout this period – spectacular collapses such as Long Term Capital or Amaranth and frauds, such as Beacon Hill or Manhattan, but these represent a very small percentage of both number and value of funds in the market, which remained generally robust in line with overall economic conditions.

Changing financial climate

Today however, the conditions are ripe for a spike in liquidation and consequent litigation activity over the course of the next few years. The current turmoil in the US sub-prime mortgage market has led to a spreading credit crunch and nervous behaviour among all types of investors, witness the run on the UK’s Northern Rock Bank. In consequence, funds are struggling to meet redemption requests submitted by investors and at the same time are suffering margin calls on its leveraged investments.

Investors and creditors are taking a harder look, and a much harder line with their service providers. Declining performance always heightens suspicions of malfeasance, while some managers are making increasingly risky plays to cover below-par returns and short positions. In addition, directors are realising that the indemnity offered by their funds may be worthless in the event of a fund meltdown. And of course, in the wings, the global regulators are keen to be seen to make use of their newly enhanced powers, when put on notice by investors of apparent defaults or defalcations.

In the Cayman market we are already seeing the following scenarios on a regular basis, some of which are applied to the same fund at the same time:

  • An investor redeems but does not get paid – he presents a winding up petition in the Cayman Islands which, unless dismissed within 30 days, will trigger an event of default under numerous fund contracts.
  • Another investor files a complaint in the Delaware Chancery Court against the onshore fund and seeks class action certification.
  • The SEC opens an investigation into the fund’s investment adviser under the new anti-fraud rule for allegedly making false or misleading statements to investors.
  • The fund’s administrator receives notification from investors that NAV figures published, based on instructions from the fund’s directors, cannot be supported by independent verification.
  • The investment manager goes outside the strict investment parameters in the fund’s offering memorandum, in order to make up ground in a month of under-performance. The strategy does not succeed, and the fund’s position worsens.
  • A director of the fund notifies his insurer of a potential claim under his D&O or E&O policy, but cover is refused because of fraud allegations which have been made.

Where will all these disputes be played out and where can litigation take place? The obvious answer is the US, particularly Delaware and New York and in the EU particularly London and Dublin.

However, these venues are not necessarily convenient for some of the prospective litigation targets for disgruntled investors, fearless liquidators and zealous regulators. For example, many US courts exercise long-arm jurisdiction. They are more tolerant of unparticularised fraud pleadings, which in turn make it difficult for defendants to rely on indemnity clauses and insurance cover, they may disregard indemnity provisions altogether, offer statutory claims with the prospect of treble or other punitive damages3, and allow for class actions or jury trials.

Those involved in the industry have some ability to position themselves in order to maximise their prospects of dictating the selection of venue for resolution of disputes, in a jurisdiction of their choosing. Many court systems will accept jurisdiction based on grounds other than the domicile of the parties; for example, jurisdiction clauses in the agreements with and between fund service providers will generally be respected. Most common law systems to a greater or lesser degree permit parties to challenge both the venue for lawsuits brought in unsuitable jurisdictions, under the doctrine of forum non conveniens, and the duplication of disputes already before another court, under the doctrine of lis alibi pendens.

Since many fund disputes and blow-ups will involve parties domiciled in EU states, defendants should give particular consideration to the effect of a recent decision by the European Court of Justice in Owusu v. Jackson4 which restricts the power of EU courts to decline jurisdiction in international disputes involving non-EU courts, and has a significant impact on the traditional common law doctrines concerning choice of forum issues.

The Owusu Case

In Owusu, the ECJ held that courts in EU jurisdictions could no longer apply the forum non conveniens doctrine to decline jurisdiction against a party domiciled in the EU state where the proceedings have been brought in favour of a non-EUjurisdiction. The effect of this is to give primacy to the court first seized of a dispute, even if an alternative forum in another country might be more suitable or appropriate for the defendant. Owusu has therefore reduced the scope of EU courts to stay proceedings which have been brought before them in favour of non-EU jurisdictions, even where there are parallel ongoing proceedings.

This is particularly important given the increased acceptance, both in ECJ jurisprudence and English domestic case law, of proceedings in which parties seek to establish that they are not liable to another party (known as actions for negative declarations). These are being used as a way to bring disputes before a particular jurisdiction, and also to reverse the traditional positions of plaintiff and defendant. Parties wishing to keep disputes out of non-EU jurisdictions may use this development to their advantage, by serving proceedings in a defendant’s domiciled EU state and then relying upon the doctrines of forum non conveniens and lis alibi pendens to fend off parallel proceedings in jurisdictions like Cayman which are still governed by common law conflict of laws principles, by creating a critical mass of litigation which has to be determined within the EU.

This leverage can be increased by using the Brussels Regulations to bring other parties domiciled in other EU jurisdictions before the court in which proceedings have been issued for example, adding parties domiciled in Ireland or Luxembourg to English proceedings.

The extension of the Owusu principles to jurisdiction based on factors other than domicile is not settled, although post-Owusu it has been argued that EU Courts may be able to apply Brussels Regulation lis alibi principles to litigation in non-EU states. One thing is certain, the EU regime only allows matters to be stayed in favour of litigation in another state which was ongoing prior to the proceedings in the EU. This is an important factor and, in the event of a fund collapse, is likely to lead to a tactical race by those involved to issue and serve proceedings in order to strengthen each party’s arguments in favour of its preferred jurisdiction.

Fund collapses are often swift and terminal, with the result that much of the ensuing litigation between and against the parties who may be to blame takes place within the realm of a liquidation process. They will be impacted by the widely-implemented UNCITRAL Model Law on Cross-Border Insolvency5, a protocol system which is designed to facilitate cooperation between national courts, their office-holders and debtors, so as to maximise assets and recoveries and to protect the interests of creditors and other stakeholders.

Where a collapse involves companies or assets in more than one country, and thus multiple insolvency proceedings, the Model Law allows for one jurisdiction to be recognised as the ‘main’ proceeding on the basis that the fund’s Centre of Main Interests (COMI) is located there, to which the courts of other jurisdictions will then provide supporting assistance. This is ideal for insolvent hedge funds, where the typical master/feeder structure requires one or more onshore and offshore companies to be liquidated simultaneously, particularly if a foreign liquidator can invoke the benefits of the US insolvency regime which favours a ‘debtor-in-possession’ approach, and affords interim protection from third party suits and attachments of assets.

It will also give rise to a power struggle between those who have opposing interests in the availability and location of such relief. Establishing a foreign COMI for funds, whether from the outset or during the course of business or possibly even in the future, may both shield fund service providers from claims in their home jurisdictions and force primary activity in another country where they may obtain more favourable treatment. Equally, manoeuvres by a fund to move its COMI too late when facing liquidation and/or litigation claims will likely be challenged bythose who would stand to be disadvantaged.

In this context, there has been much coverage of the Bear Stearns sub-prime funds6, which recently went into provisional liquidation in the Cayman Islands and then sought recognition and protection from a court in New York under Chapter 15 of the US Bankruptcy Code. Such recognition was initially obtained, but was later reversed on the basis that the funds’ COMI was in New York and they did not qualify for discretionary protection on the basis that they did not even have what the court considered to be a “local place of business” in the Cayman Islands.

The case provoked vehement criticism, particularly in the US media, with allegations that Bear Stearns Asset Management had just pulled a stunt to protect their own position and claims that the Cayman courts make it difficult for interested parties to take legal action, being allegedly “much less transparent than American courts” and “attractive to management”. These and other comments led to the Cayman Islands authorities issuing a ‘fact sheet’ outlining the Cayman Islands’ insolvency regime, stressing its friendliness to creditors and investors and highlighting the transparency of its legal processes. Bear Stearns has also filed an appeal against the New York court’s decision.

The Basis Yield Alpha Fund has provided an even more interesting example of the international complexities caused by hedge fund collapses. Casually described as an Australian fund, although the master fund was incorporated in Cayman, it actually had beneficial investors7 in 20 countries, and used managers and administrators with offices variously in Cayman, Hong Kong and the Isle of Man. The provisional liquidators in Cayman have obtained recognition in and assistance from the courts in England and Australia, but not yet in the USA; it seems they may be opposed by Citigroup Global Markets Ltd, a major creditor of the funds. Judge Gerber in the New York Bankruptcy Court has issued a list of 21 factual issues on which he requires evidence, including the degree of ‘back-office’ work that was in fact conducted by managers or administrators outside the Cayman Islands, and the timing of any transfer of records and assets to or from Cayman before and after the liquidation, before he will consider granting Chapter 15 relief at the next hearing of the case in November. This case is shaping up to be the first serious judicial examination of the way in which offshore funds actually operate.

Whatever the outcome of these particular cases, the disputes over COMI and the consequences in terms of identifying battlegrounds are already forcing fund promoters and organisers to rethink the way and the locations in which their funds are managed and administered, in order to be best placed to deal with an end-game that may come sooner than they would like: many are now taking steps to improve their prospects of establishing Cayman as their COMI, not only in the event of outright insolvency, but even if the fund just needs a moratorium on enforcement of secured party rights during a liquidity crisis or a plunge in NAV.

The UNCITRAL Model Law on Cross-Border Insolvency is ultimately a good thing for everyone involved: the funds, in that it provides breathing room for management and an environment for any turnaround efforts; their service providers, in as much as it shields them from an immediate multiplicity of suits and class actions; but ultimately hedge fund investors too: liquidators of offshore funds can utilise these cross-border protocols to cherry-pick the most favourable jurisdiction to bring claims against targets who can provide compensation to restore value to an insolvent estate. Funds which will not have recourse to such protocols, because their country of incorporation has not enacted the necessary legislation, may find themselves less attractive to investors. It is therefore not surprising that the Companies Law of the Cayman Islands has just been amended to adopt relevant aspects of the UNCITRAL Model Law8.

Investors and their advisers will now be scrutinising the overall structures of hedge funds much more closely, to determine where any end-game may be played out, and they may well demand that promoters make changes for the purpose of locating a fund’s COMI in a different jurisdiction. Those with European interests and counterparts also need to have their litigation strategies planned well in advance, since the Owusu rule will give an advantage to the first person to reach their preferred courthouse. This is not to say by any means that the end is nigh for the hedge fund industry, but all involved in the servicing of that industry must take account of the reality that litigation and liquidation strategies now form one of the tools by which people will try to make a return on their investments.

  1. Income Tax Regulations §1.864-2(c)(2)(iii), repealed by the Taxpayer Relief Act 1997
  2. Resulting in initiatives ranging from MiFID in the EU, and the FSA’s Feedback Statement on Side Letters in the UK, to the new Antifraud Rule 206(4)-8 under the Investment Advisers Act in the US
  3. Including civil claims under the infamous Racketeer Influenced and Corrupt Organizations Act (“RICO”)
  4. [2005] ECR I-1383
  5. Implemented in the USA in 2005 by Chapter 15 of the US Bankruptcy Code, and in England by the Cross-Border Regulations 2006
  6. Their full names are Bear Stearns High-Grade Structured Credit Strategies Master Fund and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund
  7. Being a master fund, its only registered investors were two Cayman-incorporated feeder funds
  8. Part XVI of the Companies Law (2007 Second Revision)