The latest Cayman Islands Court of Appeal (‘CICA’) decision in the Weavering Macro Fixed Income Fund Limited (‘Weavering’) litigation has thrown into focus a thorny issue for those invested in Cayman Islands funds.
At the end of November 2016, the CICA upheld the decision of the Grand Court that Skandinaviska Enskilda Banken AB’s (publ) (‘SEB’) repay back to the liquidation estate the approximately $8 million that it had received by way of redemption payments shortly before the fund went into liquidation.
The case will be welcome news for creditors and shareholders that were not fortunate enough to redeem out of the fund before it entered liquidation, but the case also serves as a stark reminder that redeeming investors cannot rest so easily when they receive payments from a fund that subsequently goes into liquidation.
In this article we provide a quick recap of the law in relation to the so-called ‘clawback’ provisions and discuss the latest developments in this area in light of the CICA’s recent decision.
The Cayman Islands Companies Law empowers a liquidator to apply to the court to have a payment to a creditor declared invalid when that payment was made within six months of the commencement of a liquidation, and when the payment was made with a view to preferring a creditor over other creditors. This type of claim is called a voidable preference or a ‘clawback claim’.
The mischief that the section is designed to prevent is the violation of the principle that all creditors of an insolvent fund should receive distributions on a pari passu basis – in other words, every creditor must share in the losses generated by a fund’s insolvency. If a fund bypasses this principle by preferring one creditor over another then the payment is invalidated, and it therefore must follow that the payment should be paid back, so that it can be distributed equally amongst all of the fund’s creditors.
Of course, if the fund pays a related creditor in preference to other creditors – for example, a subsidiary – it seems only fair that the related creditor should return the money to be distributed equally amongst the creditors (indeed, there is statutory provision that automatically deems that a related party will have received a payment in preference). However, if a third-party investor has innocently redeemed out of the fund (thereby becoming a creditor) and is paid without being aware of the insolvency or potential insolvency of the fund, the fairness of the clawback is a little less obvious.
This is particularly true in circumstances where that shareholder was acting as a nominee or custodian and has passed the proceeds on to a third party by the time the liquidators come calling.
SEB acquired shares in Weavering as custodian for two Swedish mutual funds, and was paid approximately $8 million in redemption proceeds shortly before it was discovered that the investment manager had entered into worthless interest rate swaps with affiliated counterparties to disguise huge losses.
The redemption payments that formed the subject of the dispute were made in December 2008, January 2009 and February 2009, before payment of redemptions was suspended. When the investment manager came to decide to whom the December 2008 redemption payments should be made, he directed that ‘Swedish investors that have switched into [an affiliate] fund’ should be paid immediately.
Ironically, the two investors for whom SEB had been a custodian had shown no interest whatsoever in investing in the affiliate fund, and SEB’s name had seemingly been mistakenly highlighted as one of the Swedish investors investing in the affiliate fund. However, as the result of what appeared to be a mistake, SEB was paid its redemption proceeds.
Weavering subsequently went into liquidation and the liquidators sought to recover the redemption payments from SEB on the basis that they were voidable preferences.
The Investment Manager’s Motivation
SEB defended the claim on a number of grounds. Of note: the CICA determined that there was no requirement that the investment manager should have been dishonest in seeking to prefer a creditor and it did not matter that the investment manager had made a mistake in believing that SEB would re-invest in the affiliate fund – the investment manager’s dominant intention in making the payment was the only matter to take into consideration.
In reaching this conclusion, the CICA cited a previous decision of the Chief Justice – the first Cayman Islands authority to discuss voidable preference claims in detail – in RMF Neutral Growth v DD Finance.
In RMF, the Chief Justice found that before it can be determined that a payment is a voidable preference, a liquidator would have to establish that the dominant intention of the fund was to prefer a particular creditor – the mere fact that the a creditor got paid in preference to other creditors as a consequence of the payment was not enough.
Interestingly, in RMF the investor that had received a redemption payment did so in circumstances in which it had exerted considerable commercial pressure and had threatened to report the fund to the Financial Services Authority. The Chief Justice held that, in making the payment, the fund’s dominant intention was to relieve this pressure – and so the payment was not a voidable preference.
Unfortunately, how the motivation in RMF was distinguishable from the motivation of the investment manager in Weavering was not discussed before the CICA. It remains to be seen how the authorities will develop the law in this area, and what will be held to constitute commercial pressure or other commercial inducement on the one hand, and what will constitute a preference, on the other.
The Innocent Investor
Perhaps of greatest concern to SEB was that, in acting as custodian, it had paid the redemption proceeds to the two Swedish mutual funds before the liquidators commenced their claim. With the money paid to the mutual funds having long since gone, and as the CICA noted in its judgment, the contractual indemnities that SEB had received from the mutual funds being ‘worthless’, SEB faced the possibility of having to reimburse the liquidation estate itself.
It was in these circumstances that SEB sought to argue that a ‘change of position’ defence was available.
A change of position defence is a defence to a restitutionary claim for the return of funds. The defence is premised on the inequity of a recipient having to returnfunds which have been spent or passed on in reliance on the payment.
Key to SEB’s defence was the contention that, because section 145 of the Companies Law did not expressly provide a remedy in the event that a payment was found to be a voidable preference, Weavering’s claim was founded in restitution.
The CICA rejected SEB’s argument. It held that the remedy for a voidable preference was that the payment is avoided and the recipient must return the funds irrespective of their change of position in reliance on the payment.
It further held that a change of position defence would not have been available in any event. The fact that SEB’s position had deteriorated as a result of the payment to the mutual funds stemmed from the fact that it had failed to procure a valuable indemnity or otherwise protect its position – not from having made the payment.
The remaining creditors and shareholders of SEB will take significant comfort from this decision, given that the liquidation estate will now be increased and the remaining funds distributed more evenly amongst the creditors and shareholders.
However, this case is a reminder that investors should carefully consider how they deal with a non-payment of their redemption. It might be said that exerting commercial pressure to be paid ahead of others may now be the best way to get paid while reducing the risk of clawback.
Furthermore, nominee and custodian shareholders should take particular care that they have safeguards in place to guard against the eventuality that a clawback claim is brought against them after funds have been distributed.