The recent decision of the Cayman Islands Grand Court in RMF Market Neutral Strategies (Master) Limited v DD Growth Premium 2X Fund (unreported, 17 November 2014) is a further reminder of the serious challenges associated with bringing clawback actions against "innocent" third party fund investors who have received redemption proceeds from a Cayman Islands fund in the period leading up to the fund's collapse. It is a decision which should be welcomed by fund investors who are seeking certainty in this area – and in that regard, it is a useful companion-piece to the Privy Council's recent decision inFairfield Sentry v Migani and others.1
DD Growth 2X ("2X Fund") was an open-ended feeder fund incorporated in the Cayman Islands. As with many funds, it encountered serious difficulties in late 2008 and early 2009, and was faced with large redemptions. 2X Fund's difficulties were compounded as a result of the NAV having been massively overstated as a result of a fraud: in order to cover up losses, the manager had acquired certain debt instruments (the "Asseterra bonds") for cents on the dollar, but had then reported them in the NAV at face value (for example, one bloc had been purchased for $5 million, but then marked in the NAV at $190 million). As the Court put it, the result was that the fund in effect became a Ponzi Scheme.
The 2X Fund had a number of investors who redeemed in December 2009. There was no suggestion that any of the redeeming investors knew anything about the fraud. Some of those redeemers, including RMF, were paid in part, while others received nothing. There was no suspension of NAV or of redemptions. The 2X Fund was then wound up in around May 2009 and the full extent of the fraud was uncovered.
The 2X Fund liquidators threatened a clawback action against RMF. RMF sued for a negative declaration and was met with a counterclaim. The 2X Fund liquidators principally claimed:
- The payments were unlawful as they were a breach of s.37(6)(a) of the Companies Law, being payments made out of capital at a time when the company was insolvent, such that they were unlawful and void; and/or
- The payments were voidable preferences under s.168 of the Companies Law.
Chief Justice Smellie comprehensively rejected both of those claims.
Although the Chief Justice readily accepted that the 2X Fund was insolvent (in every sense) at the time of the payments, the Chief Justice dismissed the s.37 claims, essentially on the basis that the payments were not made out of "capital". He rejected as "strained and tortuous" the liquidators' construction of s.37(6), as it then stood, to the effect that "capital" included not just the nominal par value of the shares, but also the share premium (and, as he noted, the statute has since been amended to clarify this point in any event). The Chief Justice confirmed that "payments out of share premium for the redemption of shares when a company has become cash flow insolvent, are not prohibited as being a payment out of capital by s.37(6)(a)".
The Chief Justice further noted that such an interpretation should not be regarded as surprising. He observed that (as is common) the constitutional documents of the fund allowed for redemption on a "first come first served" basis and, further, that it was clear that redemptions of shareholders form part of the ordinary course of business of a Cayman Islands mutual fund. In a particularly robust passage which should give additional comfort to innocent redeemers concerned about clawback risk, the Chief Justice held:
"… the right to payment of redeemed shares was not contingent upon the ability of the 2X Fund to pay other redeemed shareholders, still less other shareholders who had not redeemed their shares.
This does not mean that the 2X Fund should not have taken other steps which might have proven more equitable or contractually fair to all shareholders. Mr Micalizzi [the principal of the manager, key decision maker and fraudster] should certainly have suspended NAV calculations in keeping with the Articles and OM and disclosed the true state of hopeless insolvency, rather than perpetrate the fraudulent use of the Asseterra bonds.
It is also regrettable that by means of that fraud, it appears that late subscribers' funds (ie: the proceeds of fresh issues) became available and were used to pay dividends back to the 2X Fund from the master Fund and those funds used to pay some of the December Redeemers, including RMF."
The Chief Justice went on to acknowledge that the results had been "grossly unfair to the December redeemers who were not paid, and even more so to those shareholders who had not yet sought to redeem their shares in the 2X Fund". However, drawing on the recent dicta of the Privy Council in Fairfield Sentry v Migani, the Chief Justice concluded: "such are the unfortunate consequences when an investment fund becomes a Ponzi Scheme".
The Chief Justice also rejected the preference claim under s.168 of the Companies Law, essentially on the basis that the liquidators were unable to discharge their burden of showing that the 2X Fund's dominant purpose in making the payment was to prefer RMF. Demonstrating such dominant purpose remains a critical (and regularly, the most forensically difficult) aspect of any preference claim under that legislation. The judgment reaffirmed and clarified the following principles:
- The Court must be satisfied that the dominant motive of the payer was to prefer the particular creditor.
- The Court can infer an intention to prefer from the circumstances (although the burden remains on the JOLs).
- It is essential that payer knows or believes that the company is or will become insolvent: there can be no intention to prefer if the payer honestly believes all the creditors will be paid.
- However, and critically, knowledge or belief of the payer that the company is or will become insolvent is not enough: "There is no basis for reading [the authorities] as saying that the very fact of making the payment being aware of the state of insolvency was sufficient to make it a fraudulent preference". In other words, it is not enough to show that the payer knew that the net effect of the payment would be to prefer that creditor, if that was not also the motivation behind the payment. The real question is "whether the dominant intention was to prefer (in the sense of deliberately paying out of turn being aware of the consequences for those other creditors not paid) or whether payment may have been motivated by other concerns typically of the debtor himself, which are not impelled predominantly by an intention to prefer the creditor, even if the preference is the consequence of that payment".
After a careful analysis of the background and chronology, the Chief Justice found the payment was made not with an intention to prefer, but in response to "unrelenting and escalating pressure being applied by RMF and an equally consistent effort at prevarication and evasiveness on the part of [2X Fund]". The Chief Justice found that 2X Fund had paid, in effect, only because it had a gun to its head – that in the absence of payment, RMF would have insisted in regulatory intervention by the FSA and would have taken legal action. That was not a payment made with the intention to prefer. In echoes of what is perhaps not a unique story, the Chief Justice held:
"Apart from hoping to postpone or avoid the evil day, Mr Micalizzi had no demonstrated motive for wishing to pay RMF ahead of any other of the December redeemers. Having papered over the catastrophic losses with the Asseterra bonds, it appears he was stalling for time in the futile hope that the Funds under his management could recover."
Overall, this judgment reflects what we would suggest is an entirely orthodox approach to preference claims under Cayman Islands law. It brings further helpful clarity to the area, and in particular, emphasises the benefits of certainty in the context of funds which permit redemptions on a "first come first served" basis. It is a decision which should rightly give additional comfort to innocent third party redeemers of Cayman Islands funds who may otherwise be concerned about the possibility of being subject to clawback actions many years after they have (through no fault of their own) been caught up in a fraudulent investment scheme.