Most open ended funds in Asia are structured using a Cayman Islands company as the fund vehicle. The principal documents governing the contractual relationships between the investor and the fund are the offering memorandum, the subscription agreement and the memorandum and articles of association of the fund.
Generally managers and investors tend to focus much of their review time on the offering memorandum and regard the articles of association as less important. Unfortunately, this practice is the result of a misunderstanding of the relationship between the offering memorandum and the articles of association. The articles of association are the dominant document, and it is always sensible to include in the offering memorandum a qualification that the offering terms are subject to the articles of association and in the event of a discrepancy, the articles of association prevail. This is a useful provision but it does not replace the need for a careful review of the fund documentation particularly to ensure that the documents are consistent and the relevant terms have been included in the right place.
The reality is that the fund documents create two separate contracts.
1. The economic contract
The economic contract is the product of the offering memorandum and the subscription agreement, and contains the economic and commercial terms of the investment. These terms include the fund’s investment objective and strategies, the identity of the directors, investment manager and other service providers, the fees to be paid to the fund’s service providers and other material offering terms. It also contains certain disclosure of the material contracts, including the articles of association. The economic contract is an individual contract between each investor and the fund. As a result, any change requires the consent of each investor. Accordingly, in order to avoid having to obtain unanimous investor consent for any proposed change, it is important to ensure that the offering memorandum includes an express provision allowing the fund to vary the offering terms in the manner desired.
2. The articles contract
The articles of association are the constitution of the fund and provide the internal rules governing the operation of the fund. The articles of association contain the powers of the fund which are usually exercised by the directors, the rights attaching to the shares and the rules for the management of the fund, including dealings in shares and the provisions for the holding of director and shareholder meetings. They constitute a contract between the fund and its shareholders, and between the shareholders themselves. The threshold for amending the articles of association is set out in the statute and is a two thirds majority of the shareholders entitled to vote unless a greater number is specified in the articles of association.
Although separate, these two contracts must be consistent in order to avoid disputes that may arise when for example, the economic contract refers to shareholders’ rights and directors’ powers which are inconsistent with, or do not appear in, the articles of association. If there is a conflict, the generally accepted view in the Cayman Islands was that any term of the offering memorandum which purports to confer powers on a fund which are not contained in the articles of association, will not be legally valid. This view has largely been confirmed and clarified by the recent decision of the UK Privy Council (the highest court of appeal for the Cayman Islands) in the case of Culross Global SPC Limited v Strategic Turnaround Master Fund Partnership Limited.
Here are two examples to illustrate the differences.
Example 1 - economic contract
Let’s assume that the fund’s offering memorandum states that the investment strategy of the fund is to invest solely in ships, but the fund adopts a change in such strategy and invests the fund’s assets wholly in securities, without the consent of the shareholders. This would not be a breach of the fund’s articles of association but would be a breach of the economic contract.
It is common for the offering memorandum to cover a medley of provisions which are generally not replicated in the articles of association, but the Strategic Turnaround decision does not expressly address the effect of such provisions. However, if the above analysis is correct and the offering memorandum constitutes a separate economic contract between the fund and the shareholders, then a breach of the offering terms should clearly be actionable, and shareholders should have a remedy for damages for any losses caused by a change in the offering terms to which they have not consented.
Example 2 - articles of association contract
Rather than make up an example, we can simply look at what happened in Strategic Turnaround. In that case, the offering memorandum purported to provide a power for the fund to suspend the payment of redemption proceeds even though no such provision was included in the articles of association. The Privy Council held that “any power to withhold payment of the redemption proceeds must be authorised by or pursuant to the articles of association.” The Privy Council held that none of the provisions of the articles of association extended to permit suspension of payment of redemption proceeds after the redemption date had passed. The Privy Council stated: “Quite how it came about that the CEM [the confidential explanatory offering memorandum] contained terms so very different to the those in the articles, whose effects it purports to summarise is a matter of conjecture . . . but in so far as the description [in the CEM] embraced powers going beyond those in the articles, the description was and is, in the [Privy Council’s] view, of no legal effect as against investors…”.
The decision in Strategic Turnaround confirms the generally accepted view that the articles of association of a fund will be determinative of the rights of shareholders and the powers of the fund and it illustrates the need for consistency within the fund’s documentation. Whether in fact there is a discrepancy between the two documents will of course turn on the wording of the particular provisions in question. Frequently what appears to be a discrepancy is, on analysis, merely an expression in the offering documentation which represents the result of an exercise, by the directors, of a more generally worded discretion contained in the articles of association.
Legal counsel acting for managers establishing new funds, or acting for potential investors contemplating an investment in a fund, should pay particular attention to ensure that the principal documents are consistent and interrelate correctly as well as providing the necessary consent language so that the fund can amend its terms as needed to react to changes in the market.