“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.

On October 7, 2014, Twitter, Inc. filed a lawsuit in the U.S. District Court for the Northern District of California seeking permission to publicly disclose details about legal requests from the U.S. government regarding its customers. Twitter, Inc. v. Holder, Case No. 14-cv-4480 (N.D. Ca. Oct. 7, 2014). Twitter is seeking declaratory relief in order to publish a Transparency Report detailing information regarding requests Twitter received for customer information related to national security and foreign intelligence.

With the advancement of digital technology, corporations and individuals alike have abandoned traditional forms of file retention in favor of digital retention which provides the ability to store exponentially more data (e.g., documents, pictures and electronic recordings) at a fraction of the cost. In addition, digital storage provides a more reliable and detailed source of information than ever previously available to investigators. Add to this the developing trend of businesses migrating from server/exchange storage to cloud storage and then Twitter’s lawsuit becomes infinitely more relevant. Various provisions of the Stored Communications Act (“SCA”) authorize the federal government to compel providers of electronic communication services (“Providers”), such as Twitter, Yahoo!, Google, Apple and Amazon, to disclose customer information ranging from name, address, length of service and source for payment of service (including credit card or bank account numbers) to actual content of communications—the date and time each email was sent, the destination and source addresses for each email and the size and length of each email.

Seemingly innocuous in the analysis of the statute is the danger to the actual owners of the data emanating from Sections 2705 and 2709 of the SCA. These two provisions allow the government to either delay or completely withhold notification to the end user/customer. Under Section 2705, the federal government can request an order from the court prohibiting the Provider from giving notice to its customer that it has received legal process (e.g., administrative subpoena, grand jury subpoena or warrant) for the customer’s account, many times based solely upon the government’s unchallenged assertion that notice to the customer would jeopardize an investigation or unduly delay trial. Moreover, and as highlighted by Twitter’s lawsuit, Section 2709 allows the FBI to prevent a Provider from disclosing that the FBI requested or obtained information on a customer’s account indefinitely upon the certification of the Director of the FBI that such disclosure would compromise national security or interfere with a criminal investigation.

As reflected in Twitter’s lawsuit and based on current government actions, it is more than probable that business information stored on a third-party cloud could be accessed by the Provider and disclosed to the federal government with the business finding out only when an indictment is issued and discovery of the government’s evidence is provided leading up to trial. In addition, recent government search warrant applications for the content of electronic communications make clear that the Provider may be required to copy and produce large portions, if not all, of a customer’s account with little or no limitation as to what is to be provided to the government. See In the Matter of the Search of Information Associated with [redacted]@mac.com That is Stored at Premises Controlled by Apple, Inc., Case No. 14-228 (D.D.C. Aug. 8, 2014) (holding a search warrant application requiring Apple to disclose all emails and records related to a specific account constitutional because it met the particularity requirement [by identifying a specific email account] and was supported by probable cause stating that fruits of the crime were likely to be found in the specific email account); see also In the Matter of a Warrant for All Content and Other Info. Associated with the Email Account [email protected] Maintained at Premises Controlled by Google, Inc., No. 14 Mag. 309 (S.D.N.Y. July 18, 2014). Unfortunately, the courts have yet to strike a balance between the government’s investigative rights and a customer’s privacy rights. This is partly due to the sealed nature of search warrant applications which has led to a lack of reported opinions on Fourth Amendment standards for warrants seeking electronic communications. Moreover, the SCA itself virtually calls for this lack of direction since it only provides a method for customer challenges to the government’s search and seizure efforts after the customer has been notified—which, in most cases, will be after the government has already obtained and, likely, searched the electronic data.

The use of broadly worded search warrants to Providers also has another unintended side effect which could be problematic in the future. Per the Department of Justice’s manual on seizing electronic data, federal prosecutors are guided to seek warrants requiring Providers to disclose all emails and files to the government. Then, the government segregates data for which it has established probable cause, from the data not relevant to the government’s investigation. The information seized by the government (and supported by probable cause) is turned over to the investigative team. However, the disclosed information for which no probable cause exists, is still retained by the government indefinitely, and with the multiple exceptions to the requirement of a search warrant (e.g., plain view, inevitable discovery, etc.), there is a great risk that the government will take advantage of the windfall of electronic information for an unrelated prosecution. See United States v. Ganias, No. 12-240-cr, 2014 WL 2722618 (2nd Cir. June 17, 2014) (government contractor’s conviction for tax evasion on personal tax returns vacated because the tax evasion case was beyond the scope of the original warrant for a fraud investigation). As Ganias shows, absent a post-conviction appeal, it is reasonable to fear that prosecutors will review non-responsive evidence in the absence of court-imposed safeguards to prevent it.

Companies migrating to clouds, and particularly those with international offices, should pay special attention to the policies of their Provider in relation not only to reporting but also responding to service of legal process.

Andrews Kurth is currently challenging the federal government’s power to request such a search warrant, served on a third-party provider, which was argued to be overly broad in scope and in violation of the Fourth Amendment. If you would like more information about this subject or other litigation-related topics, please contact your Andrews Kurth representative in the Litigation Practice Section.

Background to the offence

The Corporate Manslaughter and Corporate Homicide Act 2007 (the “Act”) has been in force since 6 April 2008.  It was introduced to make it easier for the authorities to prosecute organisations where a corporate management failing has caused a fatality.  It replaces the old law of corporate manslaughter but sits alongside existing Health and Safety at Work Act offences.  Safety related prosecutions are therefore typically brought under Health and Safety at Work Act as well as under the Act.

It is an offence under the Act if the management or organisation of a company, partnership or other organisation is grossly negligent, the senior management are substantially to blame for that failure and the failure has caused someone’s death.  “Gross negligence” means conduct which falls far below what can reasonably be expected of the organisation in the circumstances.  If convicted, the penalty is an unlimited fine, in addition to which the court has powers to make publicity, compensation and certain other orders.

The Act applies to harm resulting in death within the UK, within the UK’s territorial waters, on a British ship, aircraft or hovercraft or on an oil rig or other offshore installation already covered by UK criminal law.

The Act does not apply to individuals, who continue to be liable under the common law offence of gross negligence manslaughter and under existing health and safety legislation.

Corporate manslaughter cases in 2014 to date

To date 2014 has seen two convictions and two acquittals under the Act, details of which are set out below.

PS and JE Ward Ltd – Not guilty

Tractor driver Grzegorz Krystian Pieton was electrocuted when the hydraulic lift trailer he was towing hit an overhead power cable in Norfolk in July 2010.  He subsequently died.

Mr Pieton’s employer, PS and JE Ward Ltd, was acquitted of the charge of corporate manslaughter in April 2014.  This was the first case of an organisation being acquitted of such a charge.  During the hearing it emerged that Mr Pieton had attended a training course for forklift truck  drivers that covered working under live cables and it appeared that Mr Pieton was acting under his own initiative in carrying out the task in hand rather than following instructions from a director, both factors which are believed to have contributed to the outcome of the case.

The company was however convicted and fined under section 2(1) of the  Health and Safety at Work Act 1974 which states that “It shall be the duty of every employer to ensure, so far as is reasonably practicable, the health, safety and welfare at work of all his employees”.  The company was fined £50,000 and ordered to pay costs of £47,932.

Cavendish Masonry Limited – Guilty

In May this year Cavendish Masonry was found guilty of corporate manslaughter following the death of its employee David Evans during the refurbishment of a large Oxfordshire estate in February 2010.  A two-tonne limestone block fell off a concrete lintel and crushed the 23 year old.  The company had previously pleaded guilty to an offence under section 2(1) of the  Health and Safety at Work Act 1974.

Cavendish Masonry were found to have committed a gross breach of their duty of care in their management and organisation of work on the estate, by failing to take reasonable care in the planning and execution of those activities.  As at the time of writing, details of the sentence were not available.

MNS Mining Limited – Not guilty

In June 2014 MNS Mining Limited was acquitted of four counts of corporate manslaughter following the drowning of four individuals trapped in the Gleision drift mine in 2011 when 650,000 gallons of water flooded the Swansea Valley mine following a controlled explosion.

The prosecution claimed the mine manager, charged with four counts of gross negligence manslaughter, had not carried out adequate inspections the day before the incident, but evidence from an expert geologist confirmed that the water could have gathered following the explosion.  The mine manager was also acquitted.

Mobile Sweepers (Reading) Limited – Guilty

This case involved the death of Malcolm Hinton, who was crushed to death whilst he carried out repairs to a road sweeper.  The company pleaded guilty to corporate manslaughter and was fined £8,000 and ordered to pay £4,000 in costs.  The company was also ordered to publicise its wrongdoing.  The company’s sole director, Mervyn Owens, was fined £183,000 after he admitted breaches of health and safety legislation and was disqualified from being a company director for 5 years.

Practical steps

There are a number of practical steps which organisations can take to minimise the risk of prosecution under the Act and under general health and safety legislation.  In particular, ensuring the following:

• The formulation and regular review of a written health and safety policy.
• Regular risk assessments to identify and manage the source of risks to employees and members of the public.
• Clearly defined roles and responsibilities for safety matters – from the board down.
• Proper and adequate training.
• The appointment of a member of the board with overall responsibility for health and safety.
• Regular reports to the board on matters concerning health and safety.
• A process for monitoring the effectiveness of the health and safety system and reviewing and amending it as appropriate.

The Supreme Court of Canada has held that a party in a civil proceeding can request disclosure of wiretap communications intercepted by the state during a criminal investigation.

In Imperial Oil v. Jacques, 2014 SCC 66, the Competition Bureau of Canada (the “Bureau”) started an investigation into allegations of a conspiracy to fix gasoline pump prices in Québec. As part of its investigation, the Bureau obtained judicial authorizations under the Criminal Code from the Court of Québec to intercept and record over 220,000 private communications. A series of charges were laid as a result of the Bureau’s investigation, alleging that the accused conspired to fix gas pump prices.

At the same time that criminal proceedings took place, the respondents brought a civil class action in the Québec Superior Court alleging that a number of persons, including the appellants, had engaged in anti-competitive practices as set out in the Civil Code of Québec and the federal Competition Act. As part of their civil action, the respondents brought a motion for disclosure of all the private communications that had been intercepted by the Bureau in the course of its investigation. The scope of the motion was eventually narrowed to limit it to recordings that had already been disclosed to the accused in parallel criminal proceedings.

The majority of the Supreme Court of Canada, per LeBel and Wagner JJ., held that a party to a civil action can request the disclosure of recordings of private communications intercepted by the State during a criminal investigation.

The Court recognized that while the right to disclosure in civil litigation had to be given a broad interpretation, it was not unlimited. The scope of disclosure had to be limited at times to avoid harming the interests of third parties. Moreover, in exercising its discretion, the Court could consider the relevance of the documents to the issues between the parties, the extent to which the privacy of a party or of a third party to the proceedings is invaded, and the importance of remaining sensitive to the duty to protect a person’s privacy. In the instant case, the Court upheld the finding that the evidence requested by the respondents was relevant.

The Court devoted much of its analysis to whether the appellant’s objection to disclosure could be upheld by an immunity from disclosure set out in the Criminal Code. In particular, section 193 of the Criminal Code makes it an offence to disclose or use an intercepted private communication without the consent of the originator or the intended recipient of the communication. At first glance, section 193 appears to prevent the disclosure of documents resulting from electronic surveillance. However, because the right to privacy is not absolute, section 193 is “tempered by a series of exemptions”. Specifically, under section 193(2)(a) of the Criminal Code, the prohibition in section 193 does not apply to a person who discloses a private communication “in the course of or for the purpose of giving evidence in any civil or criminal proceedings…”.

The Court held that the words “for the purpose of giving evidence in any civil proceeding” under section 193(2)(a) must include an intention to give the exemption “a generous scope that encompasses the exploratory stage of civil proceedings”. Accordingly, wiretap information may be disclosed at the exploratory stage of a civil proceeding. The documents requested at this stage of the proceeding, in the words of the Court, “may very well be requested for the purpose of testifying at the hearing”. The object of the exception set out in section 193(2)(a) was to ensure that Courts will have access to all information relevant to the proceedings. On this basis, the Court concluded that s.193(2) (a) applied in this case. Litigants are allowed to obtain disclosure of wiretap information for the purpose of a civil proceeding.

The Court further held that in allowing such disclosure, the judge could establish limits, i.e. the judge can limit the number of persons authorized to consult the requested documents and specify in what capacity and for how long they may do so. The judge can also establish the circumstances of access, for example, by ordering that disclosure be made in a specific manner and, if necessary, at a specific time and place. The judge can also order that the information in a requested document be “screened”.

While this case was decided under the Civil Code of Québec, it arguably has significant implications for the common law in other provinces, including Ontario. In its analysis, the Court relied on an Ontario case which recognized that s.193(2)(a) of the Criminal Code provided for the introduction of wiretap information obtained in a criminal investigation in a civil proceeding under the Rules of Civil Procedure, R.R.O. 1990, Reg. 194. Accordingly, Imperial Oil has opened the door to the disclosure of intercepted private communications authorized as part of a criminal investigation in the discovery process of a civil action.