Home and dry: When can investors be confident that distributions will not be clawed back?
By Ulrich Payne, Partner, Giorgio Subiotto, Partner, and Paul Murphy, Senior Associate, Ogier
Published: 27 January 2017
Home and dry: When can investors be confident that distributions will not be clawed back?
When an investor secures a redemption payment from a fund that subsequently goes into liquidation, the investor - understandably - derives an enormous sense of relief that he managed to abandon a sinking ship in time. However, the recent Cayman Islands Court of Appeal ("CICA") decision in the Weavering Macro Fixed Income Fund Limited ("Weavering") litigation serves as a stark reminder that redeeming investors cannot rest so easily.
Those funds may have to be returned and distributed amongst the remaining investors.
In this article we will take you through a quick recap of the law in relation to the so called "clawback" provisions and discuss the latest developments in this area in light of the CICA's recent decision.
The Cayman Islands Companies Law empowers a liquidator to apply to the court to have a payment to a creditor declared invalid when that payment was made within six months of the commencement of a liquidation and the payment was made with a view to preferring a creditor over other creditors. This type of claim is called a voidable preference.
The mischief that the section is designed to prevent is a violation of the principle that all creditors of an insolvent fund should receive distributions on a pari passu basis – in other words, every creditor must share in the misery generated by a fund's insolvency. If a fund bypasses this principle by preferring one creditor over another then the payment is invalidated, and it must therefore follow that the payment should be paid back, so that it can be distributed equally amongst all of the fund's creditors.
Of course, if the fund pays a related creditor in preference to other creditors - for example, a subsidiary - it seems only fair that the related creditor should return the money to be distributed equally amongst the creditors (indeed, there is statutory provision that automatically deems that a related party will have received a payment in preference). However, if a third party investor has the foresight to redeem out of the fund (thereby becoming a creditor) and is paid without being aware of the insolvency or potential insolvency of the fund, it might appear unfair that they would be subjected to a clawback action.
It is this tension that lies at the heart of two recent Cayman Islands decisions…
A tale of two cases: RMF and Weavering
Before the CICA's latest decision in Weavering, the leading authority on clawback claims was the Chief Justice's decision in RMF Neutral Growth v DD Finance. After a comprehensive review of Cayman and English case law the Chief Justice held that before a payment could be declared invalid the liquidators of a fund would have to show that the dominant intention of the fund was to prefer a particular creditor – the mere fact that the consequences of the payment were that a creditor got paid in preference to other creditors was not enough.
In other words, a liquidator must establish the fund's motive in making the payment.
This concept is perhaps a little confusing and it stems from the fact that there a number of ways that the word "preference" can be used. A "preference" can be defined as "one that is preferred" – in other words an investor who, as a matter of fact, receives a payment ahead of all other creditors is an investor that has been preferred.
However, "preference" can also be defined as intentionally giving an advantage to some over others. It is this second usage that the court is seeking to employ when it states that the dominant intention or dominant motive of the fund must be to prefer a creditor before a payment can be called a preference.
By way of illustration, where a director pays his best friend before all other creditors it can be readily inferred that he is intending to give his best friend an advantage over all other creditors. However, where a director pays a creditor that is threatening the fund with legal action, the director's dominant intention is to relieve the threat rather than to give the investor an advantage over other creditors, even if this is a natural consequence of his actions.
This principle was expounded in the 1956 English decision of In re Cutts and was citied with approval in RMF. In In re Cutts the judge cited examples of payments to oldest friends or closest relatives being clear examples of preferential payments. The payment in In re Cutts was held to be a preferential payment on the basis that it was made to the debtor's most important client.
Conversely, the Judge in In re Cutts went on to say that if a debtor steals from his employers till and elects to reimburse the till over other creditors in order to avoid detection this would not be a preferential payment. He went further and said that if a debtor pays a particular creditor because of some pressure or a threat or to obtain some immediate and material benefit or to fulfil some particular obligation then the dominant or real intention will not be to prefer (i.e. pay out of turn) but to achieve some other goal. In these circumstances the inference that there has been a preferential payment may be displaced.
In RMF the Chief Justice found that, in making payments to a redeemed investor, the director was responding to pressure and concern that, absent the payments, the redeemed investor would insist on regulatory intervention by the Financial Services Authority and take legal action against the fund. And so, although a consequence of this payment was that the redeemed investor was preferred, the dominant intention in making the payment was to relieve the threat. The dominant intention was not to give an advantage to that redeemed investor over other investors.
This brings us to the recent decision in Weavering.
Weavering and where next?
Skandinaviska Enskilda Banken AB's (Publ) ("SEB") acquired shares in Weavering as custodian for two Swedish mutual funds. It was paid approximately US$8 million in redemption proceeds shortly before it was discovered that the investment manager had entered into worthless interest rate swaps with affiliated counterparties to disguise huge losses.
The redemption payments that formed the subject of the dispute were made in December 2008, January 2009 and February 2009 before payment of redemptions was suspended. When the investment manager came to decide who the December 2008 redemption payments should be made to he directed that "Swedish investors that have switched into [an affiliate] Fund" should be paid immediately.
Ironically, SEB was a custodian for two investors that had shown no interest whatsoever in investing in the affiliate fund and SEB's name had seemingly been mistakenly highlighted as one of the Swedish investors investing in the affiliate fund. However, as a result of what appeared to be a mistake, SEB was paid its redemption proceeds in December 2008, January and February 2009.
Weavering subsequently went into liquidation and the liquidators sought to recover the redemption payments from SEB. SEB's defence to the clawback claim was, in essence, that:-
a)There should be some element of dishonesty in the mind of the investment manager decision before a payment is treated as a voidable preference;
b)The fact that the investment manager had made a mistake highlighting SEB as an investor that would invest in an affiliate fund meant that he did not actually intend to prefer SEB over the other creditors; and
c)Even if there was an intention to prefer SEB in relation to the December 2008 payment (on the basis that SEB was preferred in the mistaken belief that they would invest in an affiliate fund), there was no evidence to suggest that this was the case for January and February 2009 payments given that a subsequent email clearly identified the investors that should be paid out -SEB was not one of them.
The dishonesty point was dealt with quickly and decisively by the CICA. The element of dishonesty in a voidable preference claim was the inherent inequity of a payment being made in circumstances that subverted the rule in relation to pari passu distributions amongst creditors of an insolvent company. Therefore, it was not necessary for a liquidator to show that the fund manager had been dishonest according to the definition applied in other contexts, only that his dominant intention was to prefer a creditor.
The CICA also dealt with the "mistake" point in short order. It held that, even where the investment manager mistakenly included SEB in a class of investors that were intended to be preferred on the basis of their investment in an affiliate fund, SEB still fell within that class and had been paid. It was the investment manager's motivation that was important, regardless of whether he had made a mistake or not.
Finally, the CICA agreed that the emails that clearly identified investors other than SEB in relation to the January and February 2009 payments demonstrated that SEB was not intended to be preferred at that time. However, the CICA found instead that a policy implemented by the investment manager in December 2008 to pay out all the December 2008 redeemers was sufficient to ground a finding that SEB had been paid in preference on the basis of the policy instead.
The nuances of the CICA's decision demonstrate the difficulty with clawback claims. For example, an investment manager could decide to pay all investors from the US because he believes (mistakenly) that the all of those investors are related entities. The CICA's decision implies that any payment to a US investor that it is no way related to the investment manager is liable to be clawed back because that investor was mistakenly included in a category of which the investor was never a member.
In the same case the CICA also held that a defence of "change of position" is not available to an investor in these circumstances. A "change of position defence" is premised on the inequity of a recipient having to return funds which have been spent or passed on in reliance on the payment. In the present circumstances SEB argued that it had paid the funds onto the underlying investors and should therefore not be ordered to repay the money because it no longer had it.
The CICA held that no "change of position" defence was available in these circumstances and that a consequence of a payment being found to have been made in preference to a creditor was that the creditor was obliged to return the money regardless of whether it had been paid out to third parties. The primary reason for this finding was that the underlying purpose of the voidable preference section of the Companies Law was to ensure compliance with the basic principle of insolvency law that the distribution of the insolvent estate should be pari passu amongst its creditors.
The decision does leave some points unaddressed.
In RMF it was held that, where the dominant motive of the director was to remove the threat of litigation, the payment was not a preferential payment. But what about the circumstances in Weavering? Arguably, the point could have been taken that the investment manager was making a payment to investors on the basis that they would invest in an affiliate fund. The investment manager's dominant intention or motive was not to pay these investors in preference to other creditors. His dominant intention was to secure their onward investment, which arguably falls within the list of non-preference circumstances set out in In re Cutts. Unfortunately the CICA did not address this issue.
One significant outcome of this line of cases might well be a lack of willingness on the part of investors to politely stand in line and await their payments. Exerting commercial pressure to be paid ahead of others may yield the best chance of avoiding a finding that the payment was a preference, whilst still getting paid.
To contact the authors:
Ulrich Payne, Partner at Ogier: firstname.lastname@example.org
Giorgio Subiotto, Partner at Ogier: email@example.com
Paul Murphy, Senior Associate at Ogier: firstname.lastname@example.org