Custodian Role in the Limelight

By Jonathan Murphy
Cayman Financial Review, Second Quarter 2011

As a result of the bankruptcies of feeders funds and investment vehicles underlying Bernard L Madoff Investment Securities LLC and other recent Ponzi schemes, the authority and culpability of feeder fund shareholders vis-a-vis their own customers in certain situations is being put into the limelight by these shareholders who may try, or are trying, to limit their liabilities to feeder funds and as well as to their own customers.

The issues arise from a number of factors, not least:

1. most articles and memoranda of association for funds structure the capitalisation of the entity on the basis of shareholdings
2. the laws for most commonwealth jurisdictions provide for clear legal distinctions between “creditors” and “shareholders” and the rights and remedies of those classes  in relation to a corporation are distinctly different
3. the role of a purported custodian can be to act as the trustee or agent for its customers in relation to their investment transactions
4. purported custodians sometimes sign the subscription agreements and request redemptions on behalf of their customers and the extent of disclosure often is related  more to the convenience of the custodian  and depends on the arrangements it has  with its customers rather than  on  the  legal  implications  of  the same in relation to the fund transfers  in  connection  with  transactions sometimes are received first by the custodian and then subsequently transferred to its customer, and such customer may withdraw the funds transferred externally from the custodian.

The  above  factors  are  relevant  in  three main scenarios: first, when a customer of a purported custodian wants to petition to wind up a fund; second,  when  a  customer  wants   to lodge a proof of debt in the liquidation of an estate and otherwise participate in the estate (eg attend  creditors  or  investors  meetings), and third, when an insolvency practitioner takes steps to claw back redemptions or fictitious profits for the benefit of the estate. Where a shareholder in a fund believes it has sufficient grounds to petition for the winding up of a fund, the question of whether the shareholder has authority to bring such an application is relatively uncontroversial. The shareholder, given its appearance on the register of members or shareholders (subject to certain provisos), has the authority under the law to make such an application. However, complications may arise for an investor who is a customer of a claimed custodian (or trust). In a recent case in the Grand Court of the Cayman Islands, Hannoun v. R Limited and Banque Syz Company Limited [2009 CILR 124], the Court dismissed a petition to wind up a fund as the petitioner did not have locus standing to petition. In this instance, a customer of the claimed custodian

brought a derivative action to wind up the company in place of its purported custodian who was unwilling to do so for reasons of conflict. The court found that it could not expand the

law to allow a beneficiary of a trust, as their interest was unknown  to  the  directors of the company,

to seek the winding up of the company. The court found that only investors entered into the register of shareholders had proper standing to present a winding up petition.

Issues may arise for purported custodians and their customers upon a fund being placed into liquidation and there is a call for stakeholders to lodge claims in the estate. Liquidators are required to act in accordance with the relevant laws of the jurisdiction in which they are appointed. In most Commonwealth countries, those laws require that the Liquidators recognise only the registered shareholders as the appropriate entity to have standing and make claims relating to members. Where purported custodians are not willing to make claims, either for legal reasons, administrative costs or otherwise, a customer may be unable to have standing or make a claim in its own name in the estate. This may be resolved by having the purported custodian transfer its shareholding to the underlying customer, but this could be made complicated if the relevant laws where is the estate is being wound up requires that the customer seek court approval of the post-appointment transfer. Our experience in such applications is mixed. If such approval is not granted, it may be that the customer will have an economic interest in the transfer but will not otherwise be able to participate in the estate (eg voting at shareholders meetings).

The Liquidator may seek to pursue the clawback of redemptions or other payments made to shareholders prior to the date of liquidation. The grounds for such recoveries will be specific to each case, but the liquidator may have claims arising pursuant to the statutory preference or avoidance provisions in the countries that govern them. In relation to the latter types of claims, commonwealth jurisdictions often deem shareholders to be of a specific class in relation to which the applicable time period for payments which may be clawed back by the liquidator is extended. Accordingly, the structure of a fund and its subsequent liquidation of a fund may pose some surprises for an unwary purported custodian and its customers.

There is an increasing number of cases worldwide, catalysed by the collapse of Madoff and other Ponzi schemes, which will provide guidance that is likely to impact the way in which purported custodians act and the arrangements they enter with their customers in future years.