The courts in both the Cayman Islands and the British Virgin Islands have recently handed down a number of judgments focused on the liquidation of hedge funds and the circumstances in which it is just and equitable for funds to be wound up on a petition by one or more shareholders.

The courts’ jurisdiction to wind-up companies on the just and equitable basis is broad based and largely discretionary to allow for requirements of “justice and equity” (per Crossman J in Re Davis and Collett Ltd [1935] Ch 693 at 701).

In the context of applications to wind-up hedge funds, recent cases have focused on the circumstances in which a fund can be said to have "lost its substratum". The basic principle, based on established English authorities, is that where it has become impossible in a practical sense to carry on the business for which a fund was established, it can be wound up on just and equitable grounds even though the petition is opposed by a substantial majority of shareholders. In this context, the key issue for funds is the circumstances in which it can be said that it has become practically impossible to carry on the business for which they were promoted.

Mr Justice Jones of the Cayman Grand Court concentrated on this issue in his recent decision in Re Heriot African Trade Finance Limited (FSD no 87 of 2010, 4 January 2011, unreported ("Heriot")). Most importantly he confirmed his definition of the test for "loss of substratum" for open ended investment funds in the following terms (judgment paragraph 30, originally set out by the same judge in Re Belmont Asset Based Lending Ltd (21 January 2010, unreported)):

“…it can be said that it is just and equitable to make a winding up order in respect of an open ended corporate mutual fund if the circumstances are such that it has become impractical, if not actually impossible, to carry on its investment business in accordance with the reasonable expectations of its participating shareholders, based upon representations contained in its offering document.”

Based on this test, the judge focused on Heriot's constitutional documents and whether they gave active consideration as to how the fund was to be liquidated. Like most hedge funds, Heriot did not set out how it was to be liquidated in its constitutional documentation. As a result, the Court concluded that the liquidation of the fund by its management was not something which the shareholders should have anticipated in the ordinary course of Heriot's business.

Therefore it was held to be just and equitable to make a winding-up order on the basis that the fund was no longer viable, in the sense that it was practically impossible to carry on its business in accordance with the reasonable expectations of its participating shareholders based upon the representations contained in the constitutional documentation. This decision was arrived at despite the majority of investors opposing the petition and giving evidence of their support for the fund's existing manager liquidating the fund's assets. 

Based on this judgment and earlier decisions along similar lines, where a fund's constitutional documentation does not deal with how the fund is to be liquidated, there is a serious risk that the court will decide that the winding down of the fund by its own management was not something which the participating shareholders should have anticipated in the ordinary course of its business. Consequently in these circumstances, an unhappy shareholder may be able to successfully petition the court for a winding-up order on the basis that the fund has "lost its substratum".

Mr Justice Bannister in the BVI has approached the same question in a different way. In recent decisions (for example Aris Multi-Strategy Lending Fund Ltd -v- Quantek Opportunity Ltd, 15 December 2010, unreported) he has set out his view that the underlying principle in applications for just and equitable winding-up based on "loss of sub-stratum" is that minority shareholders seeking a winding-up on the grounds that the business life of a fund has come to an end will only be permitted to overcome the will of the majority shareholders if they can show that further conduct of the fund's business is impossible (as opposed to impractical). In his judgment, simply because a fund seeks to wind down its affairs does not mean that it has ceased to carry on business or that it is impossible for it to carry on business and hence it cannot be said to have lost its substratum, even if the liquidation of the fund is not expressly dealt with in its constitutional documents.  

The decisions of Mr Justice Bannister and Mr Justice Jones are both first instance judgments. Since both the Cayman Islands and BVI base their law on English principles, both should theoretically approach the issues arising in the same way. Unfortunately, these divergent decisions have created a position where there is real uncertainty about an investor's ability to wind-up a fund seeking to liquidate its assets.

It would clearly be helpful if matters could be clarified on appeal. Unfortunately, no appeal appears likely in the short term because there are real practical difficulties for funds in appealing a winding-up order. If a stay of the winding-up order is not obtained, it is likely to be very difficult to unwind the position once the liquidator has been in office for some months.

Further, the Court will only grant a stay where a refusal to stay would operate so as to render a successful appeal nugatory (ie worthless). In practice, proving this to the court's satisfaction is very difficult as both England and the Cayman Islands have case law to the effect that stays of winding-up orders are hardly ever granted (see, for example, Re A & BC Chewing Gum Ltd [1975] 1WLR 579). Even if a winding-up order is stayed, it is likely that the court will order that the fund provide security for the legal costs of the petitioning investor and it is likely to have to persuade other investors to provide this security.  

To deal with the issues raised by Heriot and similar recent decisions, new funds are now including express provisions allowing for the winding down of their affairs by management. Although existing funds are unlikely to have such provisions in their constitutional documents, they are being advised to review and consider amending their constitutional documents to similarly allow existing management to conduct a wind-down of the fund's affairs.

Some funds are going further and specifically excluding the possibility of investors bringing petitions, as permitted by section 95(2) of the Companies Law (2010 Revision). The irony is that the pro-investor approach adopted by Mr Justice Jones is likely to mean that in future investors are deprived of the just and equitable winding-up remedy all together.