Rectification of the Members Register and Restitution Claims: Powers of a Liquidator in the Cayman Islands

By Alyson Reilly and Andrea Harris
IWIRC Connection (Spring 2012)

A Liquidator appointed over a fund that has been the subject of a substantial loss and possi- bly fraud must consider the possible avenues for recovery. In such circumstances, a Liquidator will seek ways to address the inequities that exist between those shareholders who remain in the fund and have suffered from the loss, and those who have benefitted from redeeming out of the fund prior to the date of liquidation.

The Articles of Association (“Articles”) of a fund represent the contractual relationship between the fund and its shareholders and contain provisions stipulating the basis on which that   fund’s Net Asset Value (“NAV”) is to be calculated. The Articles set out who should calculate the NAV and govern the mechanisms for subscriptions into, and redemptions out of, the fund. In situations where a fund has fallen victim to fraudulent activity, and the solvency of the fund is affected, a Liquidator will investigate the circumstances surrounding the calculation of the NAV to consider whether there has been a mistake and accordingly, to determine whether it has been overstated at any point.

Once a liquidator has undertaken investigations into a fund’s affairs and it appears that the NAV has been misstated, consideration is given to rectification of the members’ register of   the fund, and to restating the NAV. Rectification and restatement are mechanisms by which a liquidator may provide recoveries to the estate and address the inequities arising within the fund where some investors are suffering at the hand of other investors as a result of, for ex- ample, fraud. In any event, changes introduced into the Cayman Islands Companies Winding Up (Amendment) Rules (“CWR”) in 2010 include a positive obligation on the liquidator to use their powers to rectify the register of members and to restate the NAV, which supplement the powers in Section 112 of the Companies Law (2010 Revision) (“the Law”). Since the enactment of this rule, there is yet to be a reported case in the Cayman Islands in relation to this matter.

CWR Order 12 Rule 2(1) imposes an obligation on a liquidator to exercise their power to rectify the fund’s register of members under Section 112(2) if satisfied that the fund:-

• is, or will become, solvent; or
• has issued or redeemed shares at prices based on a misstated NAV which is not binding on the fund and its members by reason or fraud or default and has resulted in the issuance of an excessive or inadequate number of shares in consideration for prices paid, or has resulted in excessive or inadequate amounts being paid out to former members in consideration for the redemption of shares.

For the purposes of rectifying the register, the liquidator is required to determine the true NAV of the fund at each relevant redemption date in accordance with the accounting principles specified in the Articles, or as adopted by the liquidator (CWR Order 12 Rule 2(2) and (3)). Sub- sequent to this, the liquidator must follow a 4-stage process to rectify the register as set out in CWR Order 12 Rule 3.

If an investor (or former investor) is dissatisfied with the liquidator’s decision to exercise their powers of rectification, that party may issue a summons to appeal to the Court within 90 days of being served notification of the rectification. The liquidator must serve the appeal sum- mons on other investors (or former investors) affected by rectification, and then reply to the appeal summons to set out his/her position on the same.

There is no discretion given to the liquidator to make a definitive decision against rectifying the register. However, the liquidator may do so in an alternative manner to what is specified in the Articles based on cost considerations or the impracticalities of rectification in that manner. Given the recent introduction of these powers, there are no reported cases to date where   a liquidator has utilised an alternative method to rectify the register of a fund. One possible approach could be to apply the de minimis rule such that the rectification only applies to those parties with a shareholding, or a level of unjust enrichment, above a certain threshold. The liquidator is therefore in a position to exercise powers which the directors of the fund  did not and could not possess. A further consideration for a liquidator is that, unlike other ac- tions which may adjust the rights of contributories for a misstated NAV, such as restitutionary claims, there is no prescribed time limit within which rectification must be carried out.

Determining Fraud or Default

So how does a liquidator determine that there was a misstatement or fraud, and what needs to be done subsequent to this determination? Various financial analyses would need to be undertaken to recalculate the NAV, which may also include obtaining expert evidence to support the assumptions and conclusions made in respect of application of the provisions of the Articles, together with the relevant accounting principles. A liquidator will likely seek legal advice on the most appropriate approach.

Neither the CWR nor the Law stipulate when a misstated NAV will not be binding on a fund or its members due to fraud or default. Further, the Court is yet to provide a decision on this point. Such matters need to be considered on a case by case basis.

Restitutionary Claims

Whilst rectification will enable the liquidator to adjust the shareholdings of past and present members of the fund, it does not provide that former investors are required to repay sums which have been overpaid due to the overstated NAV. For example, if a shareholder that has benefited from an overstated NAV now has no shares left on the register, rectification is of no assistance. Alternatively, recoveries against overpaid investors (or former investors) can proceed by way of a common law restitutionary claim based upon there having been a mistake of fact resulting in the investors’ unjust enrichment at the expense of the fund.

Restitutionary claims of this type are premised upon there being a mistake regarding the NAV, in the same way as required for rectification. The burden of proof for establishing a mistake  lies with the liquidator. To pursue restitutionary claims, the liquidator must issue a writ against those shareholders or former shareholders that have been overpaid as a result of the inflated NAV. The writ must be issued within 6 years of the shareholder receiving such over-payments, otherwise the applicable limitation period will have expired and the claim will be time-barred.

Conclusion

Restating the NAV of a fund and rectifying its register provides an opportunity, where appropriate, for a liquidator to bridge the gap between investors who remain within the fund at the date of liquidation and have suffered from maintaining their position as an investor, and those who have benefited from redeeming out of the fund prior to the date of liquidation. In any event, a liquidator of a Cayman Islands fund has a positive obligation to restate its NAV and rectify the register of members if one of the criteria set out in Order 12, Rule 2(1) of the CWR applies. If satisfied that the fund was operating on the basis of an overstated NAV, the liquidator should also consider whether there is merit in pursuing a restitutionary claim against shareholders that received inflated redemptions prior to liquidation. Rectification can be used by the liquidator in conjunction with restitution, provided that there is no double recovery from shareholders. Given the recent introduction of the power of rectification to the Cayman Islands, it is no doubt an area which insolvency practitioners and lawyers will watch for development with great interest.