Offshore Hedge Fund Disputes: We're Not in New York Anymore

Jonathan Sablone, Nixon Peabody LLP

"Hedge Funds are sophisticated investment vehicles often strict adherence to the fund documents reminiscent of hedgehogs or sea urchins which tend regardless of the sale tactics utilized by the fund, to prick badly if not carefully handled . . . ." ― Judge and the difficulty encountered by onshore Joseph-Olivetti, Matter Between SV Special authorities looking to investigate, prosecute or seize Situations Fund Limited and Headstart Class F the assets of such funds. In many ways, offshore Holdings Limited, In the High Court of Justice, venues provide idyllic upsides to both fund British Virgin Islands (2008). managers and investors alike. These benefits may be outweighed by the downside of litigating a Introduction dispute offshore, however. Fund managers and investors often discount the offshore legal structure There is perhaps no better summation of the until a problem arises. It is only then that they may offshore legal philosophy, borrowed from English come to realize that offshore legal vehicles are not law, than the above statement by Judge Joseph- for everyone, and may provide insurmountable Olivetti in the SV case. Put simply, offshore problems when a loss of capital liquidity or a jurisdictions, following the lead of courts in the freezing of redemptions occurs. United Kingdom, are much more likely to apply a "buyer beware" standard to hedge fund investors Offshore Venues seeking redress in offshore courts. Both fund managers and institutional investors should Although there are many offshore jurisdictions understand the key differences in offshore law which have become havens for hedge funds and before forming, or investing in, an offshore fund. asset management, the two most important (especially with respect to the US financial markets) Over the past decade, there has been an explosion are the Cayman Islands (Cayman), specifically Grand of offshore hedge funds catering primarily to Cayman, and the British Virgin Islands (BVI), investors in the United States (US) and the United specifically Tortola. Cayman has long been the Kingdom (UK), but also the Middle East and Far favored offshore haven for US hedge funds. It is a East. Investors are attracted to such funds because large commercial and banking center (ranked fifth of the promise of tax avoidance, limited regulatory largest in the world). It is easily accessible from the regimes, and the privacy protections that such US mainland, highly developed, and home to many jurisdictions can offer. Fund managers, on the other top-notch banking, accounting, consulting and legal hand, are enamored of the limited liability offered firms principally staffed with US and UK ex-patriots. in such jurisdictions for single purpose funds, the BVI, while less a center of US financial transactions,

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© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P. in the Vol. 4, No. 41 edition of the Bloomberg Law Reports—Securities Law. Reprinted with permission. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P.

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has attracted investors from around the world, and US litigants that offshore legal counsel (as well as has been a growing center for US funds. The Queen’s Counsel often imported from London in investment vehicle of choice in BVI has long been high stakes cases) cannot and will not frame claims the limited liability company (LLC) as opposed to in a manner that is consistent with US legal the limited partnership structure that is more principles. favored in Cayman. While less accessible and less developed than Grand Cayman, BVI is home to Even if a litigant can get past the pleading stage, approximately one million registered companies and commence a lawsuit, a roadblock is often (typically LLCs), most of which are financial funds. quickly encountered in the prosecution of the case. Discovery in Cayman and BVI generally follows the As noted above, while many US-based fund "disclosure" standards in the UK. Disclosure, as a managers and investors choose Cayman or BVI for concept, is much more narrowly defined than their perceived benefits over an onshore domicile, it discovery in the US. Parties are only allowed is only when problems arise that they realize they disclosure on specifically pled items in the need to contend with the offshore legal systems in complaint (on which they already have some both locales. The differences between those legal evidence or they could not have made the systems and that of US jurisdictions can be stark, allegations in the first place). Even then, the scope and vary greatly in both procedural and substantive of disclosure is extremely narrow and limited solely law. to information that is directly relevant to such claims (as opposed to the liberal "likely to lead to Procedural Challenges the discovery of admissible evidence" standard in the US). For US litigants who are used to Both the Eastern Caribbean Supreme Court, High voluminous discovery requests and production of Court of Justice, Commercial Division (Tortola, BVI) millions of pages of documents often encompassing and the Grand Court of the Cayman Islands (Grand terabytes of electronically stored information, it is a Cayman, the Cayman Islands) operate procedurally shock to discover that most "disclosure," even in like UK courts (which can be a shock to anyone very large, high stakes cases, can fit in a few familiar with US style litigation). Judges in both bankers boxes. US litigants are often even more jurisdictions are imported from the UK, or, at the shocked that the use and dissemination of such very least, are UK educated and trained. The disclosure is strictly regulated by the courts. For pleading, evidentiary, and discovery standards of example, court documents and disclosure are the courts are extremely narrow compared to the typically not available to the public or third parties US. Pleading in these systems is based upon (including other investors in a fund that is in personal knowledge and must have a factual basis litigation) without court order, and most offshore that can be supported. If evidence of a fact is not in judges are loath to require the court or the litigants the possession of the pleading party, it may not be to share any information with any third party. In pled, unlike the looser "information and belief" short, the offshore litigant who hopes to prove his standard applicable to most US jurisdictions. From a or her case through the document production of pleading standpoint, litigants often find that they the opposing party will, in almost all cases, fail. are in a "chicken and egg" scenario. They may firmly believe there has been some malfeasance by the Perhaps the biggest impediment to engaging in other side, but they cannot demonstrate it until offshore litigation, however, is the UK concept of they file suit and receive some information through shifting of legal fees. The UK follows a "losing party discovery. The lack of evidence of the claims, pays" standard with respect to legal fees and costs. however, precludes the bringing of the suit in the The same standard applies in Cayman and BVI, and first place. It is a continual source of frustration for often takes on a life of its own with respect to the way litigation is conducted. For example, it is not

uncommon that every motion, and every move by might find an offshore court distinctly uninterested an opposing litigant, is met with a cost-shifting in his or her plight. Rather, an offshore court is petition as parties tally the ongoing costs associated more likely to credit language in the fund with winning or losing during the life of a case. The agreements that states the fund manager may fee shifting standard also makes for extremely invest in any asset class he or she desires, as well as cautious litigation because the costs associated with language that the fund manager does not owe the bringing a case to fruition and losing can be investor any transparency into the fund’s enormous. A typical large case offshore will often investments (i.e., a black box trading strategy). involve Queen’s Counsel whose rates are in the While such a construction might offend traditional $1,500 per hour range, as well as numerous local notions of justice and equity in the US, it would counsel whose rates exceed those charged in New likely not arouse such passions with an offshore York (typically getting close to or exceeding $1,000 judge. Furthermore, litigants who think they can per hour). Coupled with the need for onshore legal simply bring suit in the US to avoid such legal advice, experts, consultants and financial advisors, constructs are likely to find that the same the cost of litigating offshore can be enormous. protections they sought through investment in an Given the risk that a litigant will have to cover not offshore fund (e.g., lack of oversight by US tax and only his or her own costs, but those of the other regulatory authorities) act against them in a dispute side as well, the cost-benefit equation often tips in as the offshore fund and manager are often not favor of avoiding redress in the court system. subject to jurisdiction in the US, and the assets of the fund may not be reached by US courts. Substantive Law Given the above, most readers would conclude that While the procedural, logistical and financial the offshore structure is an excellent choice for hurdles can sometimes seem insurmountable to fund managers in a time of crisis and not very litigants, the substantive law applied offshore can friendly to investors. The statutory and common be an equal discouragement to certain types of law options available to litigants offshore, however, litigation. The most important substantive while more narrow, are very different than those distinction is the weight to which offshore judges available in the US, and can sometimes be more will give fund documents. In general, such judges beneficial to investors. As an example, it is helpful will apply what is considered in the US to be an to look at a situation that has become all too ultra-strict contract construction to such common in the hedge fund industry since 2008. A agreements. For example, many fund documents fund has invested in an asset class that is now have provisions that allow the fund manager to illiquid, meaning that it cannot be sold except at a invest in any manner he or she sees fit regardless of steep discount. Rather than discount the net asset the type of fund, investment strategy, or sales pitch value (NAV) of the fund to approximate actual made by the fund to investors. In the US, it might be market value, understood by lawyers as what a relatively easy to avoid such provisions by pointing willing buyer will pay to a willing seller under no to evidence outside the four corners of the compulsion to buy or sell, the fund manager contract, or by bringing extra-contractual claims, decides to maintain the NAV and simply freeze such as fraud, negligent misrepresentation, breach redemptions by investors consistent with his or her of fiduciary duty, etc. Such claims are virtually right in the fund documents. The fund manager, unheard of offshore, however, and most judges will thus, takes the position that there has been no loss strictly apply the language found in the fund in the fund, only a temporary illiquidity event and documents. Thus, an investor who wishes to bring that the NAV represents market value once liquidity suit against a fund manager who sold the fund as a returns to the market. Redemptions have now been global equity investment and then invested (and frozen for two years so as to address the lost) investor funds trading in credit default swaps

"temporary" illiquidity event, causing investors to date the petition is filed until the date the court clamor for redress. rules. This timeframe can only be extended if the court makes a determination that the case involves Strategic Options "extraordinary circumstances." Given the conservative nature of most UK trained judges, it In such a situation, investors have two primary can be very difficult to obtain a ruling that such options in both Cayman and BVI. The first, and by extraordinary circumstances exist. These statutes far more traditional option, is to file a "just and intended for vendor creditors have, recently, been equitable" petition to wind-up a fund. Such co-opted by investors in the fund context. To use petitions are authorized by the statutory the example above, an investor (or group of "Companies Act" in both Cayman and BVI, and, as investors) would file an insolvency petition and the name implies, empowers a court to liquidate a argue that, due to the illiquid nature of a fund’s company if such a result would be just and holdings, the fund is actually insolvent. Moreover, equitable. While this traditional path to liquidation they would argue, that when they submitted is somewhat analogous to US bankruptcy redemption requests and the fund froze proceedings, it is much more flexible, contains redemptions, they became "creditors" of the fund much less court oversight, and is investor friendly. for purposes of the statutes. If a court were to Such proceedings allow for the appointment of a determine that this is the case, it could order a liquidator to take control of the fund and oversee liquidation of the fund and a payout to investors an orderly disposition of assets. Savvy institutional who attempted to redeem from the fund. There is investors typically line up as much invested capital scant caselaw applying these petitions to hedge as possible to back such a petition, choose, in funds, however, and more questions than answers: advance, a friendly liquidator, and file a just and Is an investor who had redemptions suspended a equitable petition to liquidate the fund. If "creditor" under the acts, and when does such successful, this maneuver effectively removes the status attach? Is an illiquid fund that nevertheless fund manager, gives investors control over the reports significant NAV "insolvent" under the acts? fund, and allows for a controlled liquidation of the If a liquidation is ordered, does a liquidator have a fund assets over time with a commensurate payout duty to payout redeemers (creditors) ahead of non- to investors. redeeming investors? Despite the unsettled nature of the law on these points, such a petition may offer The second, and less tested, option for investors in investors another avenue of redress against fund such a scenario is to file an insolvency petition managers in an offshore fund. under the Cayman Companies Act or the BVI Insolvency Act. Such statutes were designed to Conclusion allow creditors to liquidate a company if a court determines that the company is "insolvent." Such The takeaway for investors trapped in an offshore statutes were traditionally used by vendors to fund is that while there are high procedural, quickly liquidate a company that owed them money logistical, substantive and financial hurdles to for services but could not pay. The statutes assume litigating offshore, there are ways in which investors that it will be a straightforward analysis to can use the offshore legal system to their determine if a company is insolvent and cannot pay advantage. Such investors should consider using the a creditor (e.g., a business that cannot pay a local jurisdiction’s procedural and substantive rules contractor for renovations on a building), and, thus, to initiate liquidation actions; they should consult provide for a speedy resolution of such petitions. with US counsel to quarterback a team of For example, the BVI Insolvency Act imposes a six- professionals that includes Queens Counsel, local month maximum time-frame on litigation from the counsel, and various onshore and offshore consultants and experts; and they should use the

leverage inherent in a possible fund takeover and liquidation to negotiate with a fund manager for either removal or a phased liquidation plan acceptable to the investors. At a minimum, they should understand from the beginning that by investing in an offshore fund, they submitted themselves to the offshore jurisdiction’s laws, regulations and procedures, and should be aware of how such local rules impact their claims both positively and negatively.

Jonathan Sablone is an "AV Rated" trial attorney and Partner in the New York City and Boston offices of Nixon Peabody LLP, an international "Global 100" law firm. Mr. Sablone is the founder and Co-Chair of Nixon Peabody’s Alternative Investment Litigation Team, and regularly speaks, writes and provides media commentary on litigation topics in the alternative investment industry. Mr. Sablone represents hedge funds, institutional investors and liquidators in domestic and international disputes, including in the Cayman Islands and British Virgin Islands.