The Privy Council upheld the decisions of the lower courts that redemption payments to a Swedish bank made shortly prior to the collapse of the Weavering fund were voidable preferences that must be repaid. In doing so, the Privy Council has revisited the question of whether a fund's net asset value ("NAV") calculated in accordance with the fund's constitutional documents can be revised – holding that, in certain limited circumstances, it can. On the whole, though, any erosion to investor certainty will likely be around the margins. This is because it will only be possible to challenge NAV in circumstances where the fund itself has perpetrated a fraud (internal fraud), as opposed to having had a fraud perpetrated on it (external fraud, for example, in the case of the various Madoff feeder funds). Further, there is no automatic adjustment; legal proceedings must be brought to rectify the NAV.

The decision also stands as a reminder to custodians and nominees of claw-back risk. The defendant, SEB, was held to be liable to return the payments, notwithstanding they were a bare trustee and they had paid the redemption proceeds many years ago to their own customers.

Background

The facts are now notorious. A Cayman Islands investment fund (Weavering) defrauded its investors by painting a picture of positive growth using worthless swaps with an affiliated company. This caused NAV to be calculated on fictitious unrealised gains from the swaps. The reality was that Weavering was making huge losses through options trading. The bogus swaps masked the losses. The guiding mind of the fund, and architect of the fraud, was Magnus Peterson (the UK based investment manager) whom the courts also found to be a de-facto director of Weavering. This was therefore internal fraud.

Swedish Bank, SEB, who was acting as custodian investor for third parties, redeemed its shares shortly before the fraud was uncovered and received redemption proceeds based on what turned out to be a fictitious NAV. Other redeeming shareholders were not so fortunate and lost out. Weavering's Cayman Islands liquidators sued SEB for the return of the payments on the basis that they were voidable preferences under the relevant Cayman Islands legislation.

Under such legislation a payment will be a voidable preference if a company transfers property to a creditor when the company is unable to pay its debts (a cash flow insolvency test taking into account future debts) with a view to giving such a creditor a preference over other creditors. Such a payment is invalid. It is settled law that "with a view" requires a dominant intention to prefer.

The Cayman Islands Grand Court and the Cayman Islands Court of Appeal ("CICA") held that the redemption payments to SEB were voidable preferences and ordered SEB to repay the sums received (approximately US$8.5 million). The Privy Council (the highest Cayman Islands Court) upheld these decisions; but, importantly, in some aspects, for different reasons. The Privy Council's reasoning differed both in respect of: (i) whether a contractually binding NAV can ever be revisited; and (ii) how the Cayman Islands voidable preference regime works.

Is NAV Always NAV?

It was held that where NAV has been misstated due to an internal, as opposed to an external, fraud it is possible to challenge the NAV. However, in order to do so legal proceedings will need to be commenced by a party who has suffered loss as a result of the fraud. Without such a successful challenge then the struck NAV remains the NAV and cannot be adjusted. As no proceedings had been brought to rectify NAV and SEB had no standing to do because it had not been defrauded, the Privy Council rejected the argument that: (i) no redemptions had taken place in accordance with Weavering's articles: and (ii) therefore the redeemers were not creditors for the purpose of the voidable preference provisions.

The Privy Council's decision in Fairfield Sentry (that NAV determined in accordance with the articles was binding for all purposes and cannot be revisited) was distinguished. In Fairfield Sentry the fraud was external: the fraud was perpetrated not on the feeder funds, but on the fund those feeder funds invested in. In Weavering the fraud was internal – the fund (through its guiding mind Mr Peterson) knew the NAV was incorrect.

The message is internal fraud unravels all – but, in respect of NAV, it does not do so automatically. This gives rise to a number of questions.

First, when is a fraud internal as opposed to external? For example, where the fraud is initially external to the fund but there are allegations that the fund's directors were complicit in or turned a blind eye to the fraud; is this internal fraud? The lines may not always be bright.

Secondly, if an internal fraud is present, NAV still needs to be rectified. The Privy Council has made it clear that this is not automatic: "the NAV was and is binding on all parties until and unless successful proceedings are before the Grand Court by a party which has suffered loss to have the NAV in a transaction based upon it avoided for fraud". Who has standing to bring such an action is unclear; for example, could a liquidator bring an action? If so, against whom? Indeed, why should it be necessary to bring such a claim at all, in circumstances where (as was the case in Weavering) nobody was denying there had been an internal fraud which had resulted in misstated NAVs.

The answers to the above are likely to be highly fact sensitive; but the settled position that a contractually binding NAV is NAV and cannot be revisited is no longer always the case. However, practically the impact is likely to be small. If there is no internal fraud then NAV remains NAV; so investor certainty remains for properly run funds. Secondly, even if there is internal fraud a party (and it will not always be clear who can do so) needs to bring a successful action to rectify NAV – NAV still remains NAV absent a challenge.

Voidable Preferences

A dominant intention to prefer can be inferred

Upholding the CICA's decision, a dominant intention may be inferred by the court in accordance with the general principles of inference from the available evidence. This does not change the established principle that if a different intention for the payment can be demonstrated (such as to ward off threats of litigation) then the payment will not be a preference. However, SEB had not, after giving notice of redemption, put pressure on Weavering to pay (or even requested payment). Accordingly, there was nothing to displace the inference derived from board minutes and emails that SEB was paid pursuant to an intention to prefer.

It remains the case that proving a dominant intention to prefer will often be a challenge and inferring such intention is not necessarily made easier by Weavering. It is usual for there to be a cogent alternative explanation for payment and in many cases payment will be made to ward off threats of litigation. Accordingly, as has always been the case, generally speaking the more a creditor agitates for payment, the less likely such payment is to be a voidable preference.

Basis for recovery of a voidable preference

The statutory provisions render a payment voidable (not void ab initio). However, as there is no statutory method to recover the payment, it was held that recovery is governed by the common law. Specifically, restitution (based on the concept of a party being unjustly enriched). The usual defences to a restitutionary claim are that the party receiving the payment has: (i) not been enriched; or (ii) that it has changed its position so that it would be inequitable to require repayment.

SEB was a mere custodian – but it was still enriched

SEB had argued that, as custodian, it held the shares as bare trustee for other funds. As trustee, SEB did not have any beneficial interest in the proceeds of redemption and so was not enriched by the receipt of the money. The Privy Council disagreed. SEB dealt with Weavering as principal and not agent and received payments as registered shareholder. It did not matter that SEB was only a custodian for the funds and was obligated to pass them on to the beneficial owners (or that the Weavering knew this). Weavering was entitled and obliged under the articles to deal with SEB as the legal owner of its shares and had no legal relationship with the underlying funds or with the investors in them. SEB, as registered owner of the shares, was entitled to receive, and did in fact receive, the redemption proceeds - it was SEB who was enriched.

"Change of position" defence contrary to public policy in insolvency

In the context of a claim by a liquidator for the restitution of money paid to a preferred creditor, the change of position defence is not available. It was held that the common law should not undermine the operation of the statutory scheme of pari passu distribution, which voidable preferences are intended to support. A contrary conclusion would undermine public policy.

The failure of these two defences, while perhaps not surprising, serves to re-inforce a risk inherent in acting as a custodian investor and the importance of robust and enduring indemnification arrangements with the underlying investors.

Where does this leave investors in Cayman Islands funds?

At its heart Weavering was a battle of conflicting public policy objectives. Certainty of transactions (investor certainty) v. pari passu distribution to unsecured creditors. While pari passu comprehensively trumped; the result in practice is likely to be little actual erosion for investor certainty. While NAV may now, where there is shown to be an internal fraud, be more susceptible to a challenge; without any express challenge NAV remains NAV. Where there is an internal fraud the law will need to develop as to who has standing to bring a challenge to NAV and what matters the court may take into account. Further (and importantly) the bar has not been lowered for a voidable preference action to be successful. This minimises the impact of the change of position defence not being available in the insolvency context to custodian/nominees/trustees (and it is not unusual for the redemption creditor, as was the case here, to be under an obligation as trustee, nominee or custodian to pay on the redemption proceeds to underlying third parties).

This is not the last word on whether NAV really is NAV in all circumstances. In solvent liquidations, where NAV is not binding on the company and its shareholders because of fraud, Cayman Islands law allows the register of shareholders to be rectified. The CICA held in Pearson v Primeo that these provisions grant no power to calculate a correct NAV and substitute it for a misstated NAV, which despite the misstatement has been calculated in accordance with the articles. An appeal to the Privy Council is due to be heard in October 2019 and the decision is keenly awaited.

Skandinaviska Enskilda Banken AB v Conway and another (as Joint Official Liquidators of Weavering Macro Fixed Income Fund Ltd) (Cayman Islands) [2019] UKPC 36.