Building on what is now a consistent theme in Cayman Islands law; the Privy Council's decision in DD Growth1 has further reinforced the serious challenges faced by liquidators of investment funds looking to clawback redemption payments from third party redeemers.
Importantly, the Privy Council has held that redemption payments made by an investment fund in breach of the applicable statutory provisions are not automatically void or repayable.
DD Growth Premium 2X Fund ("DD Growth") was an open-ended mutual fund. In 2009, shortly before the fund was placed into liquidation, DD Growth paid US$23 million in redemption payments to RMF Market Neutral Strategies (Master) Limited ("RMF") (the "Redemption Payments"). DD Growth's NAV (on which the Redemption Payments had been calculated) had been massively overstated as a result of fraud and other redeemers received nothing. DD Growth was insolvent at the time of the Redemption Payments. The liquidators sought to claim the Redemption Payments back from RMF. The claim failed in both the Grand Court and the Cayman Islands Court of Appeal.
The DD Growth clawback saga initially included a voidable preference action. This claim was unsuccessful, largely because DD Growth's liquidators were unable to show that DD Growth's dominant intention in making the Redemption Payments was to prefer RMF over other creditors of the fund (a necessary element of a voidable preference).2
In their appeals, ultimately to the Privy Council, the liquidators focused their attention on another strand of their arguments. This was whether the Redemption Payments were unlawful as being made in breach of the old legislative provisions governing redemptions of shares and, if so, what did that mean for RMF? As the first aspect is now largely academic due to changes to the Companies Law made in 2011, it is the second aspect that is of key importance.
Were the Redemption Payments unlawful?
The Redemption Payments were unlawful having been made in breach of section 37(6)(a) of the Companies Law (2007 Revision), which, in short, prohibits payments out of capital by a company that is insolvent.
There were two aspects to this part of the Privy Council's decision. First, the Redemption Payments were payments "out of capital" for the purposes of sections 34 and 37 of the Companies Law (2007 Revision) (a payment "out of capital" including payments from share premium as well as par value).
Secondly, having held that the Redemption Payments were a payment out of capital, this meant that the solvency test in section 37(6)(a) of the Companies Law (2007 Revision) applied to the Redemption Payments (whether DD Growth was able to pay its debts as they fall due in the ordinary course of business). This required DD Growth to take into account the unpaid redeemed investors; redemption debts being debts that fall due "in the ordinary course of business". DD Growth could therefore not satisfy this commercial cash flow test of solvency at the time the Redemption Payments were made; making those payments unlawful.
The Privy Council was clear that reforms to the Companies Law in 2011 to exclude the share premium account from the definition of capital payments meant that, if made today, the Redemption Payments would not be in breach of section 37(6)(a). On its face, this means that redemption payments can now be made from the share premium account, without the fund needing to satisfy the test of commercial solvency in section 37(6)(a). However, this is not a green light for funds to make redemption payments without having regard to solvency of the company. Directors' fiduciary duties mean that where a fund is potentially insolvent directors should take great care in taking any steps that do not treat redeemed investors fairly as between each other.
If the Redemption Payments were unlawful, how could they be recovered?
Although it was held that the Redemption Payments were unlawful, this did not mean that such payments were void and that RMF automatically had to repay the sums received to the liquidator. The redemption itself was lawful and effective and created a valid debt owed by DD Growth to RMF. Therefore, although DD Growth acted unlawfully in making the payment, receipt of the payment by RMF discharged a valid legal entitlement (the entitlement to be paid in exchange for the surrendered shares). This meant that RMF had not been unjustly enriched (which would have given rise to an obligation on RMF in restitution to repay the money to the liquidators).
The correct analysis was that the Redemption Payments had been received for lawful consideration, but that the Redemption Payments were authorised by DD Growth's directors in breach of their duties. The question was, therefore, whether there was a claim against RMF for knowing receipt – this required RMF to have knowledge of the directors' breach of duty. According to the Privy Council, "…knowledge, especially in relation to apparently routine transactions where lawfulness depends on the internal affairs of the company, may be hard to prove".
The Privy Council remitted the matter back to the Grand Court to determine whether there was a knowing receipt claim against RMF. Given that the law on knowing receipt (in particular what amounts to the recipient's knowledge of the breach) is complex, this may mean another trip to the Privy Council for DD Growth's liquidators.
What remains clear is that clawback actions by liquidators against arm's length third party redeemers remain difficult for liquidators to successfully see to fruition.
Impact of DD Growth
The Privy Council has provided important clarification that an unlawful payment received for good consideration is not void and there is not necessarily an obligation on the recipient to return the payment. This does not change the investor friendly landscape in respect of clawback claims against redeemed investors of hedge funds in Cayman Islands funds. Far from it, the suggestion that, if somebody receives money from a company where they know the payment was made in breach of law or duty, then they may later have to repay that money, is not novel.
Whether or not RMF had a level of knowledge that will require them to repay the Redemption Payments will now need to be decided by the Cayman Islands courts. However, and regardless of the end result of the DD Growth odyssey, this decision is a welcome one, and provides yet further comfort to arm's length investors who receive redemption proceeds with no knowledge of any wrongdoing.
A copy of the Privy Council's decision can be found here.