The Cayman Islands Court of Appeal decision in In the matter of the Herald Fund SPC (In Official Liquidation)1 has provided some clarity on the ranking of priority in liquidation of amounts owing to shareholders and former shareholders of a company operating as an open ended investment fund. In summary, if a former shareholder has completed the redemption process prescribed by the company's articles, s/he will be treated as a creditor (although ranking behind the general body of outside creditors). If a former shareholder has only "accrued the right to redeem", in that the redemption process prescribed by the company's articles has not been completed, then s/he will be treated as a shareholder.
Herald Fund SPC had been a feeder fund for Bernard L Madoff Investment Securities LLC prior to its collapse following Mr Madoff's revelation that he had been conducting a massive fraud.
The issue before the Court of Appeal was whether a redeemed shareholder, who had completed the redemption process in accordance with the company's articles of association but had not yet been paid because of an intervening winding up, was to be treated as a creditor or a shareholder for the purpose of the redeemed shareholder's claim in the liquidation for the unpaid proceeds of the redemption.
The legislative framework for share redemption and priority ranking in liquidation
Section 37(7)(a) of the Cayman Islands Companies Law (2003 Revision) (the Companies Law)2 deals with redeemable shares in the context of a winding up of the company and materially provides that:
"Where a company is being wound up and, at the commencement of the winding up, any of its shares which are or are liable to be redeemed have not been redeemed or which the company has agreed to purchase have not been purchased, the terms of redemption or purchase may be enforced against the company, and when shares are redeemed or purchased under this subsection they shall be treated as cancelled:
... this paragraph shall not apply if: i. The terms of redemption or purchase provided for the redemption or purchase to take place at a date later than the date of the commencement of the winding up" (our emphasis).
Section 37(7)(b) then sets out the priority ranking of an amount due under sub-section (a). In essence, it provides that these amounts rank behind the company's debts generally but ahead of amounts owing to members in satisfaction of their rights as members.
The Court of Appeal's decision brings some clarity to the question of how amounts owing to former shareholders and existing shareholders are treated in the winding up of a company that operates as an open ended investment fund.
The Court of Appeal's decision has confirmed that section 37(7)(a) applies where a shareholder has merely "accrued the right" to redeem his or her shares, but has not yet completed the redemption process prescribed by the company's articles. Such a shareholder would be still "redeeming" his/her shares and not "redeemed". For those lucky (former) shareholders who have fully redeemed, but have not yet been paid, they are treated as creditors and section 37(7)(a) does not apply to them.
The Court of Appeal accepted the argument that section 37(7)(a) of the Companies Law was enacted to permit a claim by a "redeeming" shareholder in a liquidation where no such claim could be made under the general winding up provisions because (firstly) the purported claimant would still be a shareholder and (secondly) a counterparty is not usually permitted to enforce a contract against a company in liquidation which requires the company to pay out money in order to acquire property.
Conversely, the redeemed but as yet unpaid former shareholder who is not impeded by these two considerations has a provable claim in the liquidation as a creditor for the redemption proceeds under section 139(1) of the Companies Law. In this regard, the Court of Appeal held that the claim of the former shareholder ranked behind the claims of ordinary creditors (pursuant to section 49(g) of the Companies Law), although still ahead of amounts owing to current shareholders. Section 49(g) of the Companies Law provides that no amounts owing to a shareholder "in his character of a member" are deemed a debt of the company payable to the shareholder ahead of any amount owing to an outside creditor.
The Court of Appeal reasoned that a claim for unpaid redemption proceeds, being a claim founded on the statutory contract between a member and the company, was a claim for an amount due in the former shareholder's character as a member and so would fall within the ambit of section 49(g) of the Companies Law.
In coming to its decision, Field JA of the Court of Appeal expressly rejected the reasoning of the Eastern Caribbean Supreme Court in the decision of Western Union International Limited v Reserve International Liquidity Fund Limited  ECSJ No 26 (Western Union) that considered section 197 of the BVI Insolvency Act 2003. In that decision, Bannister J held that a claim for redemption proceeds in liquidation is not founded on the statutory contract between a member and the company because redemption is a surrender of membership and so a claim for the proceeds of redemption, being consideration for the surrender, could not be made in the former shareholder's "character as a member" (being the threshold to triggering the application of section 197 and relevantly the same words used in section 49(g) of the Companies Law).
While Bannister J's decision was not reversed by an appellate court3, the BVI Court of Appeal in Westford Special Situations Fund Ltd v Barfield Nominees Limited HCVAP 2010/014 disapproved Bannister J's conclusions as to the characterisation of redemption proceeds (in the context of whether a redeemed shareholder had standing as a creditor to petition for the appointment of a liquidator to the company) and so it is doubtful whether Western Union remains good law in BVI, let alone of relevance to the Cayman Islands.
Given that over 80 per cent of Cayman Islands open ended investment funds are conducted through a company structure, it is obviously highly desirable that the Companies Law be clear and unambiguous as to how amounts owing to redeemed former shareholders and redeeming existing shareholders be treated in the winding up of a company. It is apparent, however, that section 37(7)(a) of the Companies Law suffers from some unfortunate drafting, including the absence of a definition for the term "redemption".
The Court of Appeal's decision has clarified when section 37(7)(a) of the Companies Law applies and the concomitant priority to be given in a company's winding up.
However, whether a (former) shareholder has been redeemed or merely accrued the right to redeem pursuant to an interpretation of the company's articles may still be something on which reasonable minds may differ.
This is more likely to be an issue for articles of association drafted before 2009. After the Cayman Islands Court of Appeal decision in Re Strategic Turnaround  CILR 447, Cayman Islands funds practitioners tended to draft investment fund articles of association to provide greater clarity that, (subject to any powers to suspend redemptions) shares are automatically deemed to be redeemed on the relevant redemption day and the balance of the steps required before payment of the redemption proceeds could be made (for example, calculation of the net asset value) were not part of a process of "redemption" of the shares. While this decision was reversed on appeal by the Judicial Committee of the Privy Council, the Committee noted that the relevant articles of association were unclear as to the point at which redemption was deemed to have occurred. Accordingly, in order to avoid any doubt, the practice developed as a result of the Court of Appeal's decision in Re Strategic Turnaround has continued.
The authors understand that the liquidator has appealed the Court of Appeal's decision to the Judicial Committee of the Privy Council.