All posts by Ian Huskisson

About Ian Huskisson

Email: [email protected]
Tel: +1 345 949 0699
Ian is a partner in Travers Thorp Alberga’s litigation department and is based in the Cayman Islands. The firm has been involved in many of the most significant cases to come before the courts in recent times and was named alternative dispute resolution of the year for 2014 in the Cayman Islands.”

Offshore Roadblocks in Investor Claw Back Claims

“It is inherent in a Ponzi scheme that those clients who withdraw their funds before the scheme collapses escape without loss, and the loss falls on clients whose funds are still invested when the scheme fails”

Introduction/Summary

This statement is taken from the Press Summary issued by the Judicial Committee of the Privy Council, the highest appellate court for several offshore jurisdictions including the Cayman and the British Virgin Islands. The case was one of several investor claw back claims that have emerged following the Madoff fraud (Fairfield Sentry Limited (In Liquidation) v Alfredo Migani and others [2014] UKPC 9).

The strong trend emerging in the offshore cases is reflected in the quote: investors who cash in prior the discovery of the fraud may keep their payments even if based on fraudulent accounting and will do so at the expense of the remaining investors. This approach is justified in part on the need for commercial certainty in order for mutual funds to operate efficiently. As the London based Judges of the Privy Council explained in Fairfield Sentry, it would be unfortunate if every time an investor redeemed its share there was the potential for it to be set aside or declared unlawful at some later date.

This approach does contrast with that taken in the United States, where courts will generally allow claw back of payments made to investors who redeem their investments before the fraud is discovered. The approach in the United States is to ensure the gain made by the early redeemers or “net winners” is fairly distributed amongst those that were not so fortunate as to redeem out in time, the “net losers”. This approach is adopted in some European countries, including Italy where there were numerous successful claw back claims made against the administrators of Parmalat.

The tension between the different approaches shows no sign of easing. This article will review the Fairfield Sentry case and a more recent Cayman Islands claw back case which produced the same result but through a different route.

Fairfield Sentry

Fairfield Sentry is one of the leading cases arising out of the Madoff fraud. It was an appeal from the British Virgin Islands, but involves fundamental legal principles that should apply in England and Wales and offshore jurisdictions including the Cayman Islands. The Cayman and British Virgin Islands share the London based Privy Council as their highest appellate court.

Fairfield involved the liquidators of one of Mr Madoff’s funds seeking to set aside early redemption payments made by the fund before the discovery of the fraud. The liquidators argued that it should be possible to revisit and rectify what has emerged to be a flawed redemption process because the valuation process was tainted by fraud. The early redeemers had been unjustly enriched at the expense of the other investors or creditors because their redemptions were calculated at highly inflated valuations based on Madoff’s fraudulent accounting. It was argued that at the time of the early redemptions, no certificate had been issued by the fund’s directors and that accordingly the valuation used for the early redemptions was not definitive.

This argument was rejected. The court pointed out that the fund’s constitutional documents envisaged the redemption prices being definitively ascertained at the time of the redemption and not afterwards. The provisions for certification were included as part of that process and had to be interpreted in a commercial and “workable” manner. Since there was reliance on the redemption price being definitively determined on the relevant dealing day, any other interpretation would be rejected as unworkable. The judgment of the court described the liquidators’ argument (that the flawed valuation should be revisited) in the following terms:

“In the Board’s opinion, this is an impossible construction. If it were correct, an essential term of both the subscription for shares and their redemption, namely the price, would not be definitively ascertained at the time when the transaction took effect, nor at the time when the price fell to be paid. Indeed, it would not be definitively ascertained for an indefinite period after the transaction had ostensibly been completed, because unless a certificate was issued it would always be possible to vary the determination of the NAV per share made by the Directors at the time and substitute a different one based on information acquired long afterwards about the existence or value of the assets…”

In short, the requirement to interpret the fund’s constitutional documents in a workable commercial manner was paramount. The determination by the fund of the price to be paid to the early redeemers was accordingly binding on all parties notwithstanding the fact that it was based on fictitious accounting. The early redeemers would be allowed to keep their redemption payments even though this was to the detriment of the fund’s creditors and other investors.

RMF Market Neutral Strategies v DD Growth

RMF Neutral Strategies v DD Growth [17 November 2014] is a decision of the Chief Justice of the Cayman Islands in a similar claw back type claim arising out of a fraud. In contrast to Fairlfied Sentry, the argument in RMF was that the payments made to the redeeming investor represented an unlawful distribution of capital to shareholders at a time when the fund was insolvent. It is a cardinal principle of English and Cayman Islands company law that the share capital of a limited company belongs to the company and not its shareholders. This principle exists primarily for the benefit of the company’s creditors: while creditors have little or no protection against a solvent company incurring trading losses, they should be entitled to rely on the existence of the share capital to satisfy the company’s debts.

The English Supreme Court revisited the principle recently in Progress Property Company Ltd v Moorgarth Group Ltd [2010] UKSC 55. In this case the court rejected a submission that there was an unlawful return of capital whenever a company entered into a transaction with a shareholder, regardless of the purpose of the transaction. It considered that a relentlessly objective rule of that sort would be oppressive and unworkable, and would tend to cast doubt on any transaction between a company and a shareholder, even if negotiated at arm’s length and in perfect good faith, whenever the company proved, with hindsight, to have got significantly the worse of the transaction. The court’s real task in such cases was to inquire into the true purpose and substance of the impugned transaction.

In RMF, the Chief Justice was quick to point out that process of redeeming investments goes to the very heart of the ordinary business of a mutual fund. Any restrictions imposed on the process of redeeming shares in a mutual fund could have serious implications for the fund industry. He went on to make a distinction between the par value of the fund’s shares and the share premium at which they were traded or redeemed. As is common, the fund’s shares were issued at a nominal par value of one thousandth of a dollar, but were traded or redeemed at a significant premium over par. For the purposes of the capital preservation rule, the fund was prevented from distributing par, but not premium. He explained:

“In reality though as I am satisfied and as already noted, the treatment of share premium as available for the redemption of shares in the ordinary course of business, was (and is) what investors and third party creditors would expect in the case of a fund like the 2X fund whose ordinary course of business would involve not only the sale, but also the redemption of shares to take place at a premium on the ongoing basis”

The Chief Justice went on to point out that funds normally retain the right to suspend redemptions where the circumstances demand it. This is of course a valuable tool to enable a properly managed fund some breathing space during turbulent market conditions or to manage large redemptions. A valid suspension of redemptions will also prevent possible injustice to creditors or other investors where there are potential early redeemers. It is unlikely to be relied on by the fraudster though, who will be keen to encourage new investment and to project an image of “business as usual” so that the fraud is not uncovered.

There was a further argument put forward in support of the claw back claim, namely that the payment to the redeeming investors was an unlawful preference and accordingly should be set aside. Preference claims are rare in the Cayman Islands, not least because the applicable statutory test is based on the English Bankruptcy Law of 1914 (which has since been relaxed there) which requires a claiming party to show that the payment was made with the dominant intention to prefer the early redeemer over other creditors. In practice, this test had proved extremely difficult to overcome. This is especially so in claw back cases, since the early redemptions are usually motivated by the desire to keep the scheme going as long as possible rather than to prefer the early redeemer over other creditors.

Conclusion

There is unlikely to be much consistency of approach across different jurisdictions to investor claw back claims. The best advice for investors and funds alike normally remains to act early when there are signs of trouble. Although it could be said to be harsh on investors that fail to get out in time, the approach prevalent in the BVI and Cayman cases attaches much importance to the “workability” of the structures used in the fund industry. At the heart of this is the ability for the investor to know and trust that the redemption process works and will not be unpicked years down the line.