Prevention or cure – the use of segregated portfolios and side pockets
May 2013 | LEGAL & REGULATORY | BANKRUPTCY & RESTRUCTURING
Financier Worldwide Magazine
In the dying days of the post-Lehman financial crisis, a number of cases have reached the courts of the Cayman Islands concerning the ‘orderly’ wind down of hedge funds by their managers. It seems that these cases emphasise the importance of forward planning in considering whether to hold different classes of assets separately. If the fund is not structured with segregated portfolios, it may not be possible to validly hive illiquid assets into a side pocket at a later stage.
A segregated portfolio company is a single legal entity comprised of distinct portfolios in which assets and liabilities may be held separately. An investor or creditor may generally only look to the assets in a particular portfolio to satisfy any claims against that portfolio, and so the assets in one portfolio are insulated against claims arising in respect of another portfolio.
The case of ABC Company (SPC) v J & Co. Ltd (CICA Unreported, May 2012) concerned the collapse of a segregated portfolio in a large fund composed of many portfolios, which the investment manager was seeking to liquidate in an orderly fashion over an extended period. The main issue was whether, under the Cayman Islands’ Companies Law, the members of a particular segregated portfolio could cause the entire fund to be wound up on the basis of loss of substratum.
The Court of Appeal, overturning the decision at first instance, held that the petitioner could not contend that it was appropriate for the court to order the winding up of the company on just and equitable grounds based on a loss of substratum in circumstances where: (i) the company’s offering documents (as refined by shareholders’ resolutions) contemplated the suspension of redemptions; (ii) the decision to suspend was made bona fide in the interests of the company as a whole; and (iii) a substantial majority of the portfolios were operating normally.
The company was therefore able to rely on the segregated portfolio structure to ensure that illiquid assets, in this case various real estate investments, could be realised over time without the other viable portfolios being compromised.
The Cayman Islands’ Court of Appeal addressed the question of the use of side pockets in the case of FIA Leveraged Fund v Firefighters’ Retirement System (CICA Unreported, February 2013).
In that case, investment managers sought to satisfy a redemption request by hiving off highly illiquid assets of the fund into a new specially incorporated company, and then issuing shares in the new company to the redemption creditors. It was argued that this side pocket arrangement was technically permitted by the Articles of Association of the fund, but the manner in which the investment manager arranged the side pocket was highly controversial. The redemption creditors sought to wind up the fund on the grounds that the distribution of shares in the special purpose company was illegitimate and, accordingly, that it was able to demonstrate that the fund was unable to pay its debts. The redemption creditors succeeded in obtaining an order for the winding up of the fund at first instance and in the Court of Appeal.
The Court of Appeal rejected the argument that the creation of the side pocket and the distribution of the shares in the special purpose company was a valid in specieredemption, because the shares in the new company were not an asset of the fund at the redemption date. On a proper construction of the Articles, in order to be effective an in specie distribution required the fund to distribute assets held in its portfolio on the redemption date. However, the shares in the special purpose company did not exist as an asset of the fund on the redemption date. The Court of Appeal commented that the arrangement was analogous to the fund going out into the market and purchasing some other asset which was then used for the purpose of making an in specie distribution to the redemption creditors.
Additionally, the Court of Appeal held that the directors of the fund had not applied their minds to the proper valuation of the assets which they sought to distribute, and that it was no answer for them to say that they had a complete discretion to value the fund as they saw fit. The Court of Appeal emphasised that it was concerned to see that the directors’ discretion was not abused; that discretion was limited as a matter of necessary implication by concepts of honesty, good faith and genuineness and a need for the absence of arbitrariness, capriciousness, perversity and irrationality.
The attempt to create a side pocket to satisfy the redemption creditors failed to prevent the winding up of the fund as a whole.
When considering an in specie distribution of assets held by a distressed fund, directors and investment managers should carefully consider not only the constitutional documents of the fund, but also that the distribution is an appropriate use of their discretion. In any event, the Firefighters case casts doubt as to whether an in specie distribution may be achieved through a side pocket arrangement.
Given the Court of Appeal’s acknowledgement of the protection achieved through the use of a segregated portfolio company, directors and investment managers should give careful consideration to the extent to which a segregated portfolio company might be a preferable vehicle to manage different asset classes within a fund, which may avoid the need to rely on reactive measures, such as side pockets, in the event of distress.
Fund directors and investment managers should seek advice before tackling any sort of unusual or unorthodox distribution.
Ross McDonough is a partner, and Mark Goodman and Kirsten Houghton are senior associates, at Campbells. Mr McDonough can be contacted by email: firstname.lastname@example.org. Mr Goodman can be contacted by email: email@example.com. Ms Houghton can be contacted by email: firstname.lastname@example.org.
© Financier Worldwide
Ross McDonough, Mark Goodman and Kirsten Houghton