The majority of investment funds operate without problem and allow investors a convenient approach to invest monies in a chosen manner, taking advantage of all of the beneficial attributes of the investment fund structure. However, when there are problems with an investment fund there are a number of issues that can arise and which can have a marked effect upon how matters are resolved, writes Jeremy Le Tissier, Partner at Ashton Barnes Tee.
This article begins to explore some of the more general issues to be aware of in relation to some problems concerning investment funds and funds in distress. Generally, the article is based on Guernsey law but the principles are likely to be of general application in other common law jurisdictions.
The constitution of the fund
One of the first issues to consider, and which can have a fundamental difference on how matters may develop, is how the fund has been set up and the ‘constitution’ under which it operates. At the most basic level, the fund is likely to be either a corporate structure, a unit trust type of structure or a partnership structure. This article is going to deal mainly with the first two types. They are fundamentally different types of legal entity and which one they are is likely to have a very significant effect on how matters may be approached and also what remedies may be available.
Once the structure of the fund is known there is further information which will help work out how the fund is intended to operate. If it is a corporate structure it will have a memorandum and articles of incorporation which will govern how the company is to operate. For a unit trust type of structure, the trust instrument governs how the trust should operate.
In additional to the above documents, there will also be further documentation which is important to consider, if available. The fund will have scheme particulars which is a further document setting out how the fund is intended to be run. In addition, there are likely to be agreements with service providers, such as the fund manager and also the fund administrator. Given that every fund is inevitably different, the documents and content of them change with each fund.
If there have been breaches of the provisions set out within these documents and there has been loss arising from such a breach. It may well be that this could give rise to a cause of action.
Statutory and other requirements and duties
In addition to the agreement and instruments set out above, there will be statutory requirements which impact on how the fund operates. These may well be set out in primary legislation, in secondary legislation and other rules and documentation issued by the relevant regulator of the fund. A breach of such statutory requirements may be able to be actioned as a breach of statutory duty.
In addition, there will most likely be common law duties imposed on those connected with the fund, such as the directors of a corporate fund or the trustees of a unit trust. Once again, breach of such duties can be actionable where loss has been suffered.
What if losses have been incurred?
If it appears as though there has been some form of breach of duty or a term of an agreement has been breached, or similar, which has caused loss it is important to establish to whom any cause of action has accrued. While investors may feel as though they have suffered loss where something has gone wrong which has caused a drop in the value of their interest in the fund, the reality is likely to be that they are not the party to sue as they are not the ones who have suffered the loss. Often any loss that they experience, such as a drop in the value of their investment in the fund, is what is known as reflective loss, which generally is not actionable.
Often where there has been an actionable loss, the party in whom the action vests is the fund itself. This means that if there is to be an attempt to recover losses, the fund must be the entity which seeks to recover the losses. However, matters become more complicated where the people or entities who are the potential target of an action are also the decision-makers of the fund. For instance, if, in the context of a corporate structure, the directors have breached their duties to the fund and loss has been suffered as a result, then in normal circumstances there should be attempts made to recover the losses from the directors. However, it would normally be the directors who decide whether or not the fund should commence the action for recovery of the loss.
It is not difficult to imagine directors considering they have done nothing wrong and not causing the fund to sue themselves. This does not mean that there are no remedies available to deal with such a situation. It is possible that the shareholders/investors may be able to commence what is known as a derivative action, where they would sue in the name of the fund, and if there were any recoveries then they are paid to the fund (which the shareholders/investors would then, reflectively, benefit from). However, proceedings such as a derivative action are generally subject to a number of requirements in order to ensure that such an action is commenced only in the appropriate circumstances and is not abused.
A similar difficulty can arise in circumstances where, in a fund constituted as a unit trust, there is a breach of duty by the trustee which causes an actionable loss. However, in such circumstances a beneficiary/investor of the trust is generally able to sue the trustee directly.
It is possible that some investment funds may become distressed and possibly need to be wound up or similar. There can be any number of reasons for this, but commonly this may arise from poor or problematic investments, liquidity problems, significant redemptions, allegations of fraud or a combination of a number of these.
How the winding up of a distressed fund is approached will be different when comparing a corporate structure to a unit trust structure. Generally, there are well established statutory provisions for the winding up of corporate structures and these will often involve the appointment of an independent liquidator to undertake the winding up of the fund, ensuring all assets are realised and all liabilities are discharged, with any remaining monies being distributed to shareholders/investors. By contrast, the winding up of a trust is something over which there is little statutory provision. The approach to the winding up of a trust structure may be provided for within the trust instrument or it may be silent. Irrespective of which it is, absent contrary provisions it will generally be the trustee who undertakes the winding up. While the entity winding up the fund is likely to take broadly the same approach as if a corporate fund was being wound up – realising assets and settling liabilities, before returning any surplus to investors – the fact that it is the trustee who is winding up the fund has the potential for there to be conflicts of interest.
If the fund became distressed, depending on the particular cause of this, there is the possibility that the fund has potential claims against its service providers – for example, if they are part of the reason why the fund has become distressed. These potential claims will be assets of the fund. If the trustee has caused loss and there is a good cause of action against the trustee we return to the position where the entity deciding whether steps should be taken to recover that loss is the same entity against whom the steps to recover the loss would be being taken. It is clear to see the conflict of interest in such circumstances, which would not be the case if an independent entity was winding up the fund.
Funds are complex. When there are problems, losses or they get into distress the constitution of the fund and the other documents governing how it operates are likely to be very important in resolving the issues. A careful analysis of the position is needed before deciding what the best course of action may be.
An original version of this article was first published by Financier Worldwide, November 2016.