“I recommend it to the Charity of all good People to look back, and reflect duly upon the Terrors of the Time; and whoever does so will see, that it is not an ordinary Strength that cou’d support it” – Daniel Defoe, A Journal of the Plague Year
Introduction
It is more than ten years since the Global Financial Crisis (“GFC”), but the strains of that time remain fresh in the memory for many. The current COVID-19 pandemic threatens to have a far deeper and longer lasting impact on business alongside the awful health effects which are already being seen in hospitals around the world. While governments grapple with the public health consequences, many businesses have already shut or failed and it seems likely that many more will suffer in the coming months. This briefing note is intended to provide some guidance for fund directors as they deal with the fallout from this pandemic.
Meetings
The first challenge being faced by directors at this time is the ability to function as a board and to ensure that the appropriate business decisions are being taken despite social distancing requirements and the absence or unavailability of key personnel. Cayman fund board members are typically in different locations and so have long experience of using conference and video calls as a means of making decisions remotely and without close contact. Most articles of association also permit unanimous decisions to be recorded in written resolutions. In most cases, boards will simply be able to adopt or adapt existing practices. However, the pandemic will inevitably present fresh challenges in this regard so where any arrangements are made which are outside the norm, board members should consult the articles or other constitutional documents to ascertain whether what is proposed is permitted and the board meeting is quorate and properly constituted.
If fundamental decisions are required to be taken then directors should consider whether these are matters for an extraordinary general meeting (“EGM”). Again, the constitutional documents should be consulted as to whether that is the case and, if so, whether the requirements for an EGM can be complied with given current restrictions. Again, modern Cayman constitutional documents usually offer considerable flexibility, but it should not be assumed that a provision which may be “market standard” is in fact universal.
In crisis situations it is often the case that “the perfect is the enemy of the good”; nevertheless directors will be concerned to avoid situations where steps taken urgently now become open to challenge later. Helpfully, when it comes to matters requiring a shareholders’ resolution, the Cayman courts have recently confirmed the applicability of the Duomatic principle to Cayman investment funds[1]. That is the principle that where a decision is taken with the informal but unanimous assent of the shareholders it will be legally effective notwithstanding any formal deficiencies.
Liquidity and Solvency
Many of the issues which arose during the GFC for fund boards (some of which continue to be litigated) related to the rush for liquidity and the occurrence of a “run” on the fund. Given the sudden and all-embracing nature of the current crisis, similar issues will certainly arise if they have not already. It may be a small comfort in the general scheme of things but there is far greater legal clarity in this area following the GFC and the many cases that came before the courts in the intervening years.
Preferences
The courts have found that Section 145 of the Companies Law (Voidable Preference) applies to redemption payments. Weavering Macro Fixed Income Fund Ltd (“Weavering”) is a case in point. Redemption payments totalling US$138.4 million became due to Weavering redeeming shareholders on 1 December 2008 (the “December Redeemers”). Redeeming shareholders with a 2 January 2009 redemption day (the “January Redeemers”) were owed US$54.7 million. Redeeming shareholders with a 2 February 2009 redemption day (the “February Redeemers”) were owed US$30 million. One redeeming shareholder (“SEB”) was paid just over US$1 million by the company on 19 December 2008, received a second payment of 25% of the balance of the redemption amounts owing to it on 2 January 2009, and a third and final payment of the remaining 75% on 11 February 2009. It was understood that SEB was to invest the redemption proceeds in a related fund. All but three large December Redeemers had been paid their redemption claims in full by the time the company went into liquidation on 19 March 2009, with the balance owed to the unsatisfied December Redeemers being about US$50 million. The January Redeemers and the February Redeemers were never paid.
The Privy Council[2] held last year that the second and third SEB redemption payments had been made with a dominant intention to prefer SEB (as one of the class of December Redeemers). The fact that the second and third SEB redemption payments had fully discharged SEB’s redemption claim, whereas the three largest December Redeemers received only 25% of their claims, was, in the view of the court, itself sufficient to demonstrate a dominant intention to prefer SEB over those partially-paid December Redeemers. Further, the fact that the company had a policy in place designed to allow December Redeemers to be paid before January Redeemers and February Redeemers, all of whom were to the knowledge of the company unlikely to be paid, was also held to be a sufficient indication of the company’s dominant intention to prefer SEB.
Directors may come under intense pressure to permit or prioritise certain redemptions. Factors to consider in those circumstances may (or will) include (i) the terms of the fund’s constitutional documents, (ii) the fund’s ability to pay its debts (including debts which are presently due and payable and debts which will fall due in the reasonably near future[3]); (iii) the fund’s balance sheet position[4]; and (iv) the directors’ duties to consider the interests of the fund, including their duty to have regard to the interests of its creditors if the fund is insolvent or at risk of becoming so,[5] and potentially their duty to act fairly as between different classes of shareholders.[6]
Unlawful redemptions
It is not just the case that payments which prefer one redeeming shareholder over another may be impugned subsequently. Any payment by a fund out of its capital (which includes payments out of its share premium account) to its shareholders is subject to a cash flow solvency test. Directors who authorize such a payment when the fund is unable to pay its debts will breach their statutory duty and (subject to indemnification rights) may be liable to compensate the fund for any losses which it suffers. It may not be possible to mitigate those losses by recovering the payment from the redeeming shareholder, because doing so requires evidence that the shareholder knew the payment had been made by the fund in breach of its directors’ statutory duties.[7] In addition, and significantly, any director (or company or manager) who “knowingly and wilfully” authorizes or permits a redemption payment in contravention of this prohibition commits an offence and is liable on summary conviction to a fine of US$15,000 and imprisonment for five years[8].
Gates and suspensions
For the reasons noted above, when considering redemption requests in times of financial uncertainty or distress directors must consider carefully whether the fund is able to pay its debts. Following the GFC, the Privy Council clarified in Strategic Turnaround in 2010 [9] that redemption payments are considered to become debts of the fund as of the relevant redemption day. As a result, if the fund is unable to pay all of its redemption requests then it is, by definition, insolvent.
Directors should therefore give careful consideration to powers to gate or suspend redemptions where appropriate. While such steps will never be taken lightly, they can be an effective means for avoiding situations like those described above. Used correctly, they provide the board with valuable breathing space to deal with the challenges confronting the fund in an orderly fashion. If redemptions can be suspended then this might prevent the fund’s insolvency and liquidation; unless there are debts to third parties which the fund is unable to pay. Often, in funds which are not leveraged, the largest prospective creditors are redeeming shareholders, so if redemptions or the payment of redemption proceeds are gated to manageable levels or suspended entirely the fund can focus on protecting creditors, preserving value for investors and avoiding formal liquidation processes.
Service providers
In this context, directors should also ensure that service providers report regularly to the board on routine matters, and escalate substantial issues to the board as appropriate. Key areas of concern include whether investment managers are acting in accordance with relevant regulations and investment restrictions; and whether administrators are applying the fund’s constitutional documents exactly, particularly with respect to redemption requests. Boards should also involve professional advisers in relation to valuation and solvency issues. Demanding proper communication from the service providers (and any other professionals), scrutinizing information carefully and acting on it in a timely and prudent manner is a crucial part of fund directors’ duties at all times, but particularly so in times of crisis.
Personal civil liability
In times of heightened risk, directors should be cognizant of the potential for personal civil liability in respect of decisions and actions taken by them. Cayman fund directors (unlike directors in many onshore jurisdictions where such indemnities are prohibited by statute) typically rely on standard indemnity provisions contained in the articles of association. However, recent case law[10] has served as a reminder that the articles of association are not, in themselves, a contract between the company and the directors. The optimal situation is where the indemnity provisions in the articles are explicitly incorporated into the directors’ services agreement (“DSA”). However, many directors do not have a DSA and the courts in such a case will look at the facts surrounding their appointment and whether they were retained “on the footing of” the articles. That is clearly a much more uncertain situation for directors than having the indemnity in black and white in a DSA, particularly where there is no directors’ and officers’ insurance available. Now may be an opportune time for directors to undertake an urgent review of the contractual protections which are in place in respect of the boards on which they serve.
The market standard language in Cayman Islands articles of association excludes liability for conduct falling short of willful default (or some variation on that terminology). What that means in practice is that in order to establish liability on the part of a director, a company (often acting through a liquidator) will need to prove on the balance of probabilities that the director acted in breach of duty either intentionally or recklessly (i.e. that they were conscious that they might be acting in breach but did so regardless). A finding of negligence against a director who is able to rely on an indemnity from the company will not result in personal liability; nevertheless, it goes without saying that any such finding by the Cayman courts would likely cause severe reputational damage to any professional director. It also remains the case that there can be no exculpation of a director[11] who has breached the irreducible core obligations to act honestly and in good faith.
In times of crisis, directors are often placed in a position where there are no easy decisions or good outcomes. They may have to choose between the lesser of two evils and the courts will consider all of the surrounding circumstances in determining whether there has been any breach of duty. Whether a director has acted in breach of duty will involve a factual inquiry in each case. The Cayman courts have in the past had regard to whether, for example, the directors had read administration reports carefully or whether they had complied with stated objectives of the fund recorded in offering documentation, board minutes or elsewhere. The courts have tended to take the view that delegating the functions of a fund to reputable professional service providers is not sufficient to discharge the directors’ duties, and that systems for proper supervision must be in place and followed assiduously.
It should also be noted that the same indemnities generally extend to any costs or expenses which directors might incur arising from their positions (subject to the exclusions outlined above), including the need for independent advice where it is not appropriate or desirable for the fund’s own counsel to provide that advice. Unless there is a breach of the exclusion (which breach often has to be proven in court before the company can rely on it) directors should be able to submit invoices from outside counsel to the relevant fund for payment. Directors can often be concerned about doing so in circumstances where there is a potential issue as between the director personally and the company which is evident from narrative invoices. However, those concerns can often be allayed since in most cases the advice is privileged and can be redacted or otherwise withheld from the company when payment is sought.
Conclusion
Neither governments nor health professionals can say with any certainty what the human cost of this pandemic will be. Equally, business people and lawyers can only guess at the severity of the economic impact. While the primary focus remains the safety and well-being of family, staff members and others, many difficult board decisions will be faced in the coming days and weeks by fund directors. Taking and acting on appropriate financial and legal advice will be crucially important as they navigate through these trying times.
Please contact Campbells if you require more detailed guidance on any of the issues raised in this briefing note. Campbells has adopted a remote working policy as part of our crisis management protocol but remains fully operational. We provide a Directors’ Hotline service which allows directors to contact us on a confidential, no charge basis to discuss issues which arise in the discharge of their duties. Further details and terms and conditions can be found here.
[1] Palladyne v Upper Brook & Ors, Segal J, Unreported, 30 January 2019.
[2] Skandinaviska Enskilda Banken AB v Conway and another (as Joint Official Liquidators of Weavering Macro Fixed Income Fund Ltd) [2019] UKPC 36.
[3] Skandinaviska Enskilda Banken AB v Conway and another (as Joint Official Liquidators of Weavering Macro Fixed Income Fund Ltd) [2016 (2) CILR 514] confirmed that the cash flow test in the Cayman Islands is not confined to consideration of debts which are presently due and payable. It also permits consideration of debts falling due in the reasonably near future. What constitutes the reasonably near future will be a fact specific question in each case.
[4] The cash flow test is the principal test of insolvency under the Companies Law, including for the purposes of voidable preferences (Section 145), winding up petitions presented on the ground of inability to pay debts (Section 92(d)), and unlawful payments out of capital (Section 37(6)). This does not however obviate the need for directors to have regard to a Cayman company’s balance sheet position for a variety of reasons in circumstances of financial distress.
[5] See, for example, Prospect Properties Limited (in liquidation) v McNeill and J.M. Bodden II [1990-91 CILR 171].
[6] See, for example, Howard Smith Limited v Ampol Petroleum Limited [1974] UKPC 3.
[7] DD Growth Premium 2X Fund (in official liquidation) v RMF Market Neutral Strategies (Master) Limited [2017 (2) CILR 739].
[8] Companies Law, Section 37(6).
[9] Culross Global SPC Limited v Strategic Turnaround Master Partnership Limited [2010] UKPC 33
[10] See for example Goodman v Cummings and Anor, Unreported, 13 September 2018.
[11] Actions which are fraudulent, dishonest or conduct evidencing wilful neglect or default would be inconsistent with the core duties to act honestly and in good faith. See Re Bristol Fund [2008] CILR 317 and Renova v Gilbertson [2009] CILR 268.
