No Loss of Substratum Finding in Case of Liquidating Fund
In a significant decision, the Cayman Islands Grand Court on 10 November 2015 handed down an important judgment in Re Harbinger Class PE Holdings (Cayman) Limited, dismissing a winding-up petition presented on grounds of loss of substratum.
The decision follows the traditional approach applied by the English courts in loss of substratum cases in the case of a fund which is set up as a liquidating vehicle, differing from what has been suggested as a controversial line of authorities in the Cayman Islands, dealing with when an open-ended mutual fund may be said to have lost its substratum.
By a winding-up petition dated 14 May 2015 (Petition) an entity called “NYROY/RBC Acct# 1583 pledged to Royal Bank of Canada” (Petitioner) sought the winding-up of Harbinger Class PE Holdings (Cayman) Limited (Company) on “just and equitable” grounds under section 92(e) of the Companies Law (2013 Revision) (Section 92(e)), alleging in particular that there had been a failure of the Company’s substratum.
The Company was initially incorporated as a subsidiary of Harbinger Capital Partners Offshore Fund I Limited (Offshore Fund). The Offshore Fund operated as a feeder fund to Harbinger Capital Partners Master Fund I Limited (Master Fund). Various investors subscribed for shareholdings in the Offshore Fund and the sole asset of the Offshore Fund was a shareholding in the Master Fund.
Following the onset of the financial crisis in 2008, the Offshore Fund was faced with substantial redemption requests from investors which it and, in turn, the Master Fund, lacked the liquidity to meet. Faced with this situation, the Master Fund restructured: it created a new class of shares (Class PE Shares) to which it allocated certain private equity-type investments (the Private Portfolio). The Class PE Shares were then contributed to the Company by the Offshore Fund and used to satisfy in part the redemption claims of redeeming investors by way of an in specie redemption of shares in the Company.
Section 92(e) provides that a company may be wound up if the court is of the opinion that it is just and equitable to do so. The allegation relied upon in the Petition that there had been a failure of the substratum of the Company was predicated on the basis that:
1. The Company stated in a supplement to the Confidential Offering Memorandum of the Offshore Fund issued in December 2008 that it would use “commercially reasonable efforts” to complete the redemption of Class PE Shares by the end of 2010 but failed to do so; and
2. The Company had not indicated when there might be further compulsory redemptions of the Class PE Shares.
In addition, the Petition and the evidence filed on behalf of the Petitioner raised numerous complaints surrounding the Master Fund’s treatment and management of the investments contained in the Private Portfolio, although it was not alleged in the Petition that the Master Fund or the Private Portfolio had been mismanaged. One of the principal complaints was that the proceeds of some of the realisations of the assets in the Private Portfolio had not been distributed to the Company for onward payment to shareholders but had been used to collateralise or finance other obligations or investments held by the Master Fund outside of the Private Portfolio.
The Company defended the Petition on the basis that there had been no loss of substratum: the Company had fulfilled and continued to fulfil the purpose for which it was established, namely, the holding of the Class PE Shares held by the Company and the distribution of the proceeds of those shares to shareholders in the Company upon the realisation of investments in the Private Portfolio. Evidence filed on behalf of the Company also responded to the complaints made regarding the Master Fund’s management of the Private Portfolio and set out the extensive efforts made by the Master Fund’s investment manager to realise those investments.
At the trial on 5 and 6 October 2015, the Company argued that there was no reason whatsoever why the Company could not continue to fulfil its purpose in holding the Class PE Shares and distributing the proceeds to investors and, as such, the court had no jurisdiction to wind up the Company on the grounds of failure of substratum pursuant to Section 92(e). Further the Company argued, even if the court did have jurisdiction to make a winding up order it should not exercise its discretion to do so as this would be unlikely to have positive benefits for the investors and could have a detrimental impact on the investment manager’s on-going efforts to realise the remaining assets in the Private Portfolio.
Dismissing the Petition, the Judge (Clifford J) distinguished the Company, formed specifically as a means to hold and realise illiquid investments, from open-ended corporate mutual funds which are capable of issuing and redeeming shares of investors at any time, investing the net investment proceeds in investments, for the benefit of shareholders. In the present circumstances, the Judge found that the correct test to be applied in establishing whether there had been a failure of substratum was to determine whether it had become impossible for the Company to achieve the purpose for which it was formed, by “ascertaining the principal or main objects of the company and then deciding whether it has become impossible for the company to attain those objects.” In order to ascertain the objects of the company, the Judge was of the view that the court was required to look beyond a wholly general objects clause in the Company’s memorandum of association and to ascertain, on the material evidence, the principal or main object of a company in line with the reasonable expectations of its participating shareholders.
In applying the above test, the Judge endorsed the Company’s case that the principal object for which the Company was formed was limited to holding the Class PE Shares issued by the Master Fund and receiving net available cash flow from the realisation by the Master Fund of the assets in the Private Portfolio, for onward payment to its shareholders. In doing so, the Judge made clear that there could be “no reasonable expectation on the part of its shareholders for the Company to do anything else” and that the evidence demonstrated that the Company was fulfilling this purpose and continued to do so:
“That really is the end of the Petitioner’s case. It cannot possibly be said that the attainment of the Company’s principal or main object has been rendered impossible in some sense resulting in a failure of substratum. Accordingly there is no jurisdiction to make a winding up order.”
The Judge also dismissed the relevance of the complaints raised by the Petitioner regarding the Master Fund’s management of the Private Portfolio, stating that there had been a “fundamental misconception that the purpose of the Company is to realise the Private Portfolio and return proceeds to investors, whereas its actual purpose is to receive proceeds from realisations of the Private Portfolio by the Master Fund.”
The Judge made clear that the court did not have any jurisdiction to make a winding-up order and that he did not therefore need to consider factors going to court’s discretion. However, he nevertheless made clear that such factors were against making a winding-up order in any event. Such factors included the fact that there was very little support for the Petition from other contributories of the Company, notices of support for the Petitioner having been filed which represented only six per cent in value of contributories. In addition, the Judge found it difficult to see how the appointment of a liquidator could serve any useful purpose and was of the view that such an appointment might in fact be counterproductive, introducing an additional layer of costs for no obvious benefit and “could even carry the risk of being detrimental to the interests of shareholders in the Company.”
This case sees the Grand Court apply what might be regarded as the conventional approach adopted by courts in other common law jurisdictions in respect of the question what loss of substratum entails, and marks a departure from a line of first instance decisions in the Cayman Islands in which it has been said that a Company’s substratum has failed when it is no longer “viable”. On first impression it might be thought that this judgment has in some way disapproved that line of Cayman cases based on “viability” and reintroduced the "impossibility" test which applied before that line of cases was decided. That is not so, and the Judge expressly pointed out that this was not the case.
The Cayman cases which have expanded the traditional view of loss of substratum were all decided after the financial crisis in cases which involved open ended mutual funds (ie hedge funds) which, while they had not technically failed, were suffering paralysis and could not make redemptions as investors had expected (indeed when they were wound up there was virtually no prospect that these funds would ever recover from the effects of the financial crisis). It is perhaps not surprising in those circumstances that the court revived and expanded what at the time was a largely dormant doctrine to wind up those companies, although it is certainly debatable whether the “viability” test adopted was sufficiently certain and clear to be the appropriate test. This is similar to the highly publicised line of decisions from the BVI, the other major funds jurisdiction, which relied on a more traditional ”impossibility” test which this case reflects; it is therefore likely that in the case involving a Cayman Islands company which is not an open-ended mutual fund, the courts will follow the decision in Re Harbinger.
David Butler and James Elliott of Harneys’ Cayman Litigation team represented the Company, instructing Tom Smith QC of South Square chambers in London.
A full copy of the judgment can be found here