Directors and managers of closed-ended funds may find a recent Royal Court judgment of interest.
The Jersey courts, in line with other common law jurisdictions, have a wide discretion to order a just and equitable winding-up pursuant to the Companies Law. However, of most relevance to investment funds is the ordering of a just and equitable winding-up on the basis that the company has lost its substratum.
The traditional basis for a loss of substratum is a case in which a company finds it impossible to carry on the business for which it was established and must be wound up, even if the directors or a majority of the shareholders wish for the company to continue in business.
For these purposes, the identification of the business for which the company was established has traditionally included the sector of commerce in which it operates, as well as particular features of the manner in which the business was to be carried on. However, the focus in EVIC v Greater Europe was on the closed ended nature of the company.
The prospectus for the Greater Europe Deep Value Fund II Limited provided for the fund to last five years (unless extended), divided into two periods:
- the 'investment period' - that is, the first three years; and
- the 'wind-down period' - that is, the two years immediately following, during which the investments were to be realised and distributions made to shareholders.
The prospectus provided that the wind-down period could be extended with the consent of 75% of the shareholders. However, the plaintiff, Euro Value Investment Company (EVIC), was the largest single shareholder (holding 27% of the shares) and it refused to support an extension of the wind-down period.
The fund's manager accordingly presented an alternative solution - namely, a choice for shareholders to take a redemption either by way of cash or in kind by way of shares in a new special purpose vehicle (Phoenix SPV) into which the fund's real estate assets, plus cash, would be transferred. This was described as a "wind-down with choice". After taking legal advice, the fund indicated that a redemption in kind of the shares in the special purpose vehicle required an ordinary resolution of the shareholders and not 75% approval.
The court noted that Phoenix SPV would differ little from how the fund would have been if the wind-down period had been extended on the conditions put forward by the fund - it would have:
- broadly the same constitution;
- the same real estate assets;
- the same cash of $10 million;
- the same management and investment adviser; and
- the same fee structure.
Depending on how the shareholders exercised their options, those who elected for cash only could be forced to accept shares in Phoenix SPV.
As the investment was fundamentally a closed-ended fund and the provisions to this effect were contained in the prospectus, the parties were taken as having intended the provisions of the prospectus to have contractual effect.
The plaintiff submitted that there was an express or implied term in the agreement that the fund would take no step with the object or effect of prolonging the winding down of the fund's affairs beyond the expiry of the wind-down period, unless the holders of 75% of the participating shares approved. The fund's counsel contended that Phoenix SPV was an asset of the fund created in order to preserve as much value as possible for the purposes of redemption in kind. Accordingly, the solution proposed was permitted and contemplated by the articles and the prospectus and was not, as contended by EVIC, an artificial way of extending the life of the fund.
The court concluded that the wind-down period was established in order to create a timeframe during which risk would be reduced by realisation and distribution. The fund was contractually bound not to make new investments during the wind-down period. Moneys received from the realisation of investments during the wind-down period were, subject to the requirements of the fund, to be made available for distribution pro rata to the shareholders and were not available for making new investments. In particular, the court found that the transfer of cash of $10 million to Phoenix SPV constituted a new investment, not a follow-on investment made with a view to realisation during the wind-down period.
The court was persuaded by EVIC's argument that the creation of Phoenix SPV amounted to a rolling over into a new fund (with an extended life) with the approval of an ordinary resolution; the extension of the life of the existing fund would require the approval of 75% of the participating shareholders.
Just and equitable winding-up is a discretionary remedy and the courts will consider the terms on which investors have invested in a fund, including any provisions as to the closed-ended nature of the fund set out in its prospectus. The court's finding that the creation of Phoenix SPV amounted to an attempt to circumvent the fund's extension provisions serves as a timely reminder that directors are constrained by the contractual provisions of a fund's constitutive documents and must give such provisions careful consideration, particularly when proposing innovative strategies and solutions.
The court declined to state that follow-on investments were prohibited during a fund's wind-down period. Furthermore, the courts will be slow to criticise directors for seeking to protect, preserve and enhance existing investments with a view to realising those investments during the wind-down period, provided that such behaviour occurs honestly and in good faith for the benefit of the shareholders. The court may imply terms into a fund's articles or prospectus to give effect to the fund's closed ended nature.
The fund declined EVIC's request to circulate to all shareholders a letter that EVIC had prepared setting out its concerns in relation to the proposals. Although the court noted that there is no legal duty on a fund to circulate letters received from shareholders to other shareholders, it questioned the decision not to do so. The letter raised a number of concerns that the court noted were perfectly proper and (as it transpired) correct as to the proposals. Fund boards and managers should take note of this in the context of discussions with aggrieved shareholders.
Given the large number of investors who approved the extension (some 62%), the court declined to hold that the investors as a whole had lost confidence in the directors and initially declined to appoint liquidators to conduct the winding-up of the fund, taking judicial notice of the substantial costs likely to be accrued by such action. It adjourned the application to ascertain the views of shareholders on whether the directors or the liquidators should conduct the winding-up.
It is crucial that the views of shareholders be sought before instituting any such action. Furthermore, following that adjournment, the court ordered the winding-up of the fund and the appointment of independent liquidators.
For further information on this topic please contact Niamh Lalor at Ogier by telephone (+44 1534 504 000), fax (+44 1534 504 444) or email ([email protected]).
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