Introduction

A recent judgment of Jersey's Royal Court will be of interest to directors and managers of closed ended funds.The Jersey courts, in line with other common law jurisdictions, have a wide discretion to order a just and equitable winding up pursuant to the Companies Law. Perhaps of most relevance to investment funds is the ordering of a just & equitable winding up on the basis that the company has lost its substratum.

The traditional basis for a loss of substratum is that where it is impossible for a company to carry on the business for which it was established, then it must be wound up, even if the directors or a majority of the shareholders wish the company to continue in business. For these purposes the identification of the business for which the company was established has traditionally included the sector of commerce and also particular features of the manner in which the business was to be carried on.  However, the focus in EVIC v Greater Europe was on the closed-ended nature of the company.

Facts

The Prospectus for Greater Europe Deep Value Fund II Limited (the Fund) provided for a life of the Fund of five years (unless extended) which was divided into two periods, the first, defined as the “Investment Period”, meaning the first three years and the second, defined as the “Wind-Down Period”, meaning the two years immediately following, during which the investments were to be realised and distributions made to shareholders.  The Prospectus provided that the Wind-Down Period could be extended with the consent of 75% of the shareholders. The plaintiff, Euro Value Investment Company (EVIC) was the largest single shareholder, with 27% and it refused to support an extension of the Wind-Down Period.

The Fund's manager accordingly presented an alternative solution, namely a choice for shareholders to either take a redemption by way of cash or in kind by way of shares in a new special purpose vehicle (Phoenix SPV) into which the Fund's real estate assets plus cash would have been transferred.  This was described as “wind-down with choice” and, after taking legal advice, the Fund indicated that a redemption in kind of the shares in the SPV required an ordinary resolution of the shareholders, and not 75% approval.

The court noted that the Phoenix SPV would be little different to the Fund than if the Wind-Down Period had been extended on the conditions put forward by the Fund, namely it would have broadly the same constitution, the same real estate assets, the same cash of $10m, the same management and investment adviser and the same fee structure.  Depending on how shareholders exercised their options, shareholders who elected for cash only could be forced to accept shares in Phoenix SPV.

Because the fundamental nature of the investment was that it was a closed ended fund and the provisions to this effect were contained in the Prospectus, the parties were taken as having intended the provisions of the Prospectus to have contractual effect.

EVIC's counsel submitted that there was an express or implied term that the Fund would not take any step with the object or effect of prolonging the winding down of the Fund’s affairs beyond the expiry of the Wind-Down Period unless with the approval of holders of 75% of the participating shares. The Fund's counsel contended that the Phoenix SPV was an asset of the Fund created in order to preserve value as much as possible for the purposes of redemption in specie and, accordingly, the solution proposed was permitted and contemplated by the Articles and the Prospectus and was not, as contended by EVIC, an artificial way of extending the life of the Fund.

The court concluded that the Wind-Down Period was established in order to be a time when risk would be reduced by realisation and distribution and that the Fund was contractually bound not to make new investments during the Wind-Down Period.  Monies received from the realisation of investments during the Wind-Down Period were, subject to the requirements of the Fund, to be made available for distribution pro rata to the shareholders and were not available to make new investments. In particular, the court found that the transfer of cash of $10m to the Phoenix SPV constituted a new investment, which was not a follow-on investment made with a view to realisation during the Wind-Down Period.

The court was persuaded by EVIC's argument that the creation of Phoenix SPV amounted to a rolling over into a new fund with an extended life with the approval of an ordinary resolution, when the extension of the life of the existing Fund would require the approval of 75% of the participating Shareholders.

Lessons learned

  • Just & equitable winding up is a discretionary remedy and the courts will have regard to the terms on which investors have invested in a fund, in particular any provisions as to the closed-ended nature of the fund set out in its prospectus.
  • The court's finding that the creation of the Phoenix SPV amounted to an attempt to circumvent the Fund's extension provisions serves as a timely reminder that directors are constrained by the contractual provisions of a fund's constitutive documents and must give such provisions careful consideration, particularly when proposing innovative strategies and solutions.
  • The court declined to say that follow-on investments were prohibited during a fund's Wind-Down Period. In particular, the Court will be slow to criticise directors for seeking to protect, preserve and enhance existing investments with a view to realising those investments during the Wind-Down Period honestly and in good faith for the benefit of the shareholders.
  • The court may imply terms into a fund's articles and/or prospectus to give effect to the fund's closed-ended nature.
  • The Fund declined EVIC's request to circulate to all shareholders a letter EVIC had prepared setting out its concerns in relation to the proposals. Although the Court noted that there is no legal duty on a fund to circulate letters received from shareholders to other shareholders, it questioned the decision not to. The letter raised what the court noted were perfectly proper and, as it transpires, correct concerns as to the proposals. Fund boards and managers should take note of this in the context of discussions with aggrieved shareholders.
  • Given the large number of investors who approved the extension (some 62%), the court declined to hold that the investors as a whole had lost confidence in the directors and initially declined to appoint liquidators to conduct the winding up of the Fund, taking judicial notice of the substantial costs likely to accrue. It adjourned the application to ascertain the views of shareholders on whether the directors or liquidators should conduct the winding up. It is, therefore, crucial, for the views of shareholders to be sought before instituting any such action. It should be noted that, following that adjournment, the court ordered the winding up of the Fund and the appointment of independent liquidators.