Loss Of Substratum: ‘A Modern Context'

Introduction

The recent decision of Mr Justice Nigel Clifford in Re Harbinger Class PE Holdings (Cayman) Ltd1 has revisited a line of local authority developed over the past 6 years. Although the case was found to be distinguishable on its facts, Clifford J's analysis has recast the spotlight on an issue that has enlivened debate amongst practitioners in the jurisdiction, leading to calls for clarification on the appropriate test to be applied in the context of just and equitable winding up petitions presented on the basis of a claimed loss of substratum.

The facts in Re Harbinger were straightforward: the Court heard a winding up petition presented by a shareholder whose participating shares in the subject company were received in partial satisfaction of that shareholder's redemption request from a related master-feeder fund structure, where investors subscribed into an offshore feeder which was the sole shareholder in the master fund, through which the investments were made. The company was incorporated in 2008 as a subsidiary of the feeder fund. Although having a general objects clause, the subsidiary company was established as a result of the feeder fund receiving substantial redemption requests which it, and the master fund, had insufficient liquidity to meet. Following a restructuring, the master fund issued a new class of shares, Class PE shares, with various assets allocated to the Class PE shares by the master fund, largely comprising illiquid investments held in a Private Portfolio. The Class PE shares were issued to the feeder fund which in turn transferred the Class PE shares to the subsidiary which issued shares to redeeming shareholders in the feeder fund as partial, in-kind, redemptions. As set out in a supplement to the Confidential Operating Memorandum (COM) of the feeder fund explaining the restructuring, the master fund's investment manager would use 'commercially reasonable' efforts to dispose or otherwise realise assets of the Private Portfolio by the end of 2010, subject to market conditions. Shareholders in the subsidiary would have no right of redemption from the subsidiary, such that it was therefore not considered to be an 'open-ended' mutual fund. Ultimately, this distinction was held to be significant.

Substantial distributions to the subsidiary's shareholders were subsequently made as a result of the master fund realising all but one of the seventeen groups of assets previously held in the Private Portfolio and then making distributions to the subsidiary which was passed through to the subsidiary's shareholders. However, a decision was subsequently taken by the master fund, by way of its investment manager, to reinvest in the remaining illiquid asset in the Private Portfolio to support and protect the investment. The petitioner, one of the subsidiary's shareholders, was dissatisfied with the investment manager's decision to reinvest and presented a winding up petition on the basis that it was 'just and equitable' to do so, the grounds being an alleged loss of substratum, principally on the basis that the master fund's reinvestment in the illiquid asset of the Private Portfolio was said to be contrary to the terms of the COM.

In opposing the petition, the subsidiary countered that its own separate and distinct purpose was simply to hold the Class PE shares in the master fund corresponding to the Private Portfolio and to distribute income attributable to the Private Portfolio assets to the subsidiary as and when they were available. As the subsidiary played no role in managing and/or realising the underlying investments held by the master fund, it argued that it continued to fulfill its purpose and that, accordingly, there had been no loss of substratum. The subsidiary also relied upon supporting conclusions reached by an Independent Monitor, who had been previously appointed by a US bankruptcy court in unrelated proceedings brought against the investment manager by the US Securities Exchange Commission, that actions were being taken to satisfy all outstanding redemption requests and that the relief sought by the petitioner would disrupt the orderly disposition of assets.

Justice Clifford was faced with a choice: apply the modern test for loss of substratum based on a series of first instance decisions in the Grand Court which, although initially the subject of some debate as to its correctness by practitioners in the jurisdiction, was arguably now settled law in the Cayman Islands (at least in the context of open-ended mutual funds), or, follow the centuries-old classic English test for loss of substratum petitions which had in contrast been adopted and followed in another, broadly comparable, offshore jurisdiction. In this regard, the absence of guidance from the Cayman Islands Court of Appeal (CICA) and strongly contrasting judgments from the Commercial Court of...