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NP Private Fund Disputes: Now + Next

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Our attorneys take a look at recent developments in the private fund space and what they mean for your business. FOr more, visit http://www.nixonpeabody.com/private_fund_disputes

Our attorneys take a look at recent developments in the private fund space and what they mean for your business. FOr more, visit http://www.nixonpeabody.com/private_fund_disputes

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  • 1. Private Fund Disputes: Now + Next We’re constantly thinking ahead for clients—getting in front of trends and industry developments. Our alerts smooth the way as you prepare for change in laws, regulations, legislation and market conditions.
  • 2. Table of Contents—2013 Private Fund Disputes Alerts New developments in recovery efforts for Madoff investors December 19, 2013 Private equity firms may be liable for unfunded pension obligations of portfolio companies August 27, 2013 "But I thought we were just negotiating"—Are the good faith provisions in a term sheet or letter of intent enforceable upon the parties? July 24, 2013 Whose claim is it anyway—the investment fund's or the investor's? Askenazy et al., v. KPMG LLP et al., No 12-P-863, Mass. App. Ct., May 23, 2013 May 31, 2013 Second Circuit holds that Madoff feeder fund's "center of main interests" is located in British Virgin Islands May 1, 2013 Recent BVI decisions offer guidance to investors and funds facing redemption disputes April 2, 2013
  • 3. Private Fund Disputes alert | Nixon peabody LLP December 19, 2013 New developments in recovery efforts for Madoff investors By Stephen LaRose and Kathleen Ceglarski Burns Five years after a massive Ponzi scheme unraveled Bernard L. Madoff Investment Securities (“BLMIS”), investors affected by the fraud should be aware that there are several new developments impacting the available avenues for recovery. U.S. District Court Judge Jed Rakoff of the Southern District of New York recently issued a new ruling in the BLMIS liquidation proceedings administered under the Securities Investors Protection Act (“SIPA”). Judge Rakoff’s decision allowed the SIPA Trustee, Irving Picard (the “Trustee”), to move forward with claims on behalf of BLMIS customers that, if successful, could expand the pool of funds to be distributed to BLMIS customers. Additionally, the Madoff Victim Fund administered by the U.S. Attorney’s Office has begun accepting claims from investors who suffered losses, including a broader group of indirect investors who lost money through feeder funds or other funds that pooled customers’ assets for investments with BLMIS. These “indirect” investors were previously precluded from other recovery opportunities. Certain assigned claims may proceed In the BLMIS liquidation proceedings, the Trustee asserted common law claims for money damages against principals and affiliates of feeder funds that invested with BLMIS as well as other service providers that allegedly engaged in conduct that facilitated BLMIS’s fraud. Judge Rakoff issued a decision on December 5, 2013, that allows the Trustee to pursue these common law claims, but only on behalf of BLMIS customers who validly assigned their claims to the Trustee.1 In this recent decision, Judge Rakoff rejected many of the Trustee’s theories that attempt to assert claims on behalf of customers. The court held that neither federal bankruptcy law nor SIPA permitted the Trustee to assert common law claims on behalf of customers against alleged aiders and abettors of BLMIS’s fraud, noting that it is well established that federal bankruptcy law does not empower a trustee to assert claims on behalf of another party. As the court described, “a party 1 Sec. Investor Prot. Corp. v. Bernard L. Madoff Inv. Secs. LLC, 2013 U.S. Dist. LEXIS 172952 (S.D.N.Y. 2013) This newsletter is intended as an information source for the clients and friends of Nixon Peabody LLP. The content should not be construed as legal advice, and readers should not act upon information in the publication without professional counsel. This material may be considered advertising under certain rules of professional conduct. Copyright © 2013 Nixon Peabody LLP. All rights reserved.
  • 4. must assert his own legal rights and interests, and cannot rest his claim to relief on the legal rights or interests of third parties.” Further, the court found that the Trustee could not assert on behalf of BLMIS itself the common law claims for aiding and abetting, because of the well-known doctrine of in pari delicto—the legal notion that “one wrongdoer may not recover against another.” However, Judge Rakoff did accept one theory argued by the Trustee in support of aiding and abetting common law claims, holding that the Trustee has standing to assert claims assigned to it by BLMIS customers. In court filings, the Trustee alleged that he received multiple express assignments of certain claims from BLMIS customers. While it is not clear exactly which claims have been assigned to the Trustee, it is suspected that the Trustee is relying on the “Assignment and Release” forms that BLMIS direct customers executed prior to receiving their payments under SIPA. Defendants in the proceedings question the validity of these assignments, but Judge Rakoff found that the issue was a fact-specific inquiry to be addressed at a later stage in the proceedings and not ripe for dismissal. It should be noted that Judge Rakoff’s decision left open the question of whether the federal securities class-action statute (SLUSA) precludes the Trustee’s pursuit of these validly assigned common law claims and remanded that issue to the Bankruptcy Court. Thus, while the Trustee’s pursuit of common law claims against third parties for aiding and abetting Madoff’s fraud has several additional hurdles to go, Judge Rakoff’s decision potentially opens a door to claims against feeder funds, banks and service providers, allowing BLMIS direct customers with another source of funds to be recovered. Madoff Victim Fund—a possible recovery for indirect investors As those who have been following the Madoff proceedings are well aware, the Trustee’s mandate is to recover assets stolen in the Madoff fraud so that BLMIS customers and creditors can receive compensation for their losses. Importantly, monies recovered by the Trustee are distributed only to allowed claimants who were direct customers of BLMIS as of December 11, 2008, when the fraud was uncovered. “Direct Customers” have been previously described as those who had entrusted deposits of principal with BLMIS. The Second Circuit Court of Appeals affirmed this narrow interpretation of the term “customer” earlier this year, which means that indirect investors—those who lost money by investing in feeder funds that then opened accounts with BLMIS—were not “customers” entitled to SIPA protection or distribution of funds recovered by the Trustee in proceedings such as those described above. The Madoff Victim Fund is separate from the SIPA proceedings and contains approximately $2.35 billion of forfeitures that have been obtained by the United States Attorney’s Office for the Southern District of New York. The Madoff Victim Fund began accepting claims in November 2013, and unlike the Trustee under the SIPA proceedings, will offer recoveries to investors who lost assets that came into BLMIS indirectly through feeder funds, investment partnerships, bank commingled funds, family trusts or other pooled investment accounts. If you have any questions about the Madoff Trustee’s claims against third parties under the SIPA proceeding, or filing claims with the Madoff Victim Fund, please contact your Nixon Peabody attorney or: — Stephen LaRose at slarose@nixonpeabody.com or 617-345-1119 — Kathleen Ceglarski Burns at kburns@nixonpeabody.com or 617-345-1109 — Jonathan Sablone at jsablone@nixonpeabody.com or 617-345-1342
  • 5. Private Fund Disputes alert | Nixon peabody LLP August 27, 2013 Private equity firms may be liable for unfunded pension obligations of portfolio companies By Jonathan Sablone and Matthew T. McLaughlin Private equity firms may be responsible for pension fund payments of the portfolio companies they acquire, according to a recent ruling by the U.S. Court of Appeals for the First Circuit. When firms are actively involved with the management and operations of a portfolio company, they cannot escape such pension liability by claiming to be merely passive investors in the companies. Background The decision in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund1 stemmed from Sun Capital Advisors, Inc.’s (“SCAI”) investment in a portfolio company. In 2007, two of SCAI’s private equity funds (the “Sun Funds”) invested in Scott Brass, Inc. (“SBI”), a producer of brass, copper, and other metals. SBI contributed to the Trucking Industry Pension Fund on behalf of its employees pursuant to a collective bargaining agreement. However, in 2008 due to declining copper prices, SBI breached its loan obligations, was unable to pay its bills, and stopped contributing to the pension fund. An involuntary Chapter 11 bankruptcy proceeding was brought against SBI, and the Sun Funds lost the entire value of their investment in SBI. The pension fund demanded payment from the Sun Funds of SBI’s withdrawal liability from the pension fund, estimated at approximately $4.5 million. In response, the Sun Funds sought a declaratory judgment from the U.S. District Court in Massachusetts that they were not subject to withdrawal liability under the Employee Retirement Income Security Act of 1974 (“ERISA”) as amended by the Multiemployer Pension Plan Amendment Act of 1980 (“MPPAA”). The district court granted summary judgment to the Sun Funds, finding, inter alia, that they were not “trades or businesses” under the MPPAA but instead “passive” investors in SBI. The First Circuit’s decision On appeal, the First Circuit reversed, finding that at least one of the Sun Funds was not merely a “passive” investor but instead “through layers of fund-related entities . . . sufficiently operated, 1 No. 12-2312, 2013 U.S. App. LEXIS 15190 (1st Cir. July 24, 2013). This newsletter is intended as an information source for the clients and friends of Nixon Peabody LLP. The content should not be construed as legal advice, and readers should not act upon information in the publication without professional counsel. This material may be considered advertising under certain rules of professional conduct. Copyright © 2013 Nixon Peabody LLP. All rights reserved.
  • 6. managed, and was advantaged by its relationship with” SBI.2 The court noted that the Sun Funds’ limited partnership agreements and private placement memoranda provided that they, like many private equity firms, were directly involved in the management and operation of their portfolio companies and that the general partners of the Sun Funds were empowered to make decisions regarding the employees of the Sun Funds and their portfolio companies. Specifically, the court noted that employees of the Sun Funds or their affiliates were involved in decisions regarding the hiring of employees and consultants, possible acquisitions, and capital expenditures and were able to place SCAI employees as directors of SBI who controlled the board. In sum, the court found that “[n]umerous individuals with affiliations to various Sun Capital entities . . . exerted substantial operational and managerial control over SBI” and therefore that at least one of the Sun Funds was a “trades or business” for purposes of withdrawal liability. In reaching its conclusion, the court rejected the Sun Funds’ argument that they cannot be “trades or businesses” as that phrase is used in the Internal Revenue Code and because they earned no income other than dividends and capital gains. The court further rejected the Sun Funds’ argument that the funds themselves were not involved in the business activities of SBI, relying on Delaware partnership law to conclude that the general partner of the fund was acting as an agent of the fund when it acted on behalf of the fund to provide services to SBI. Impact of decision While the court cautioned that its determination was “very fact-specific” that took into account numerous factors about the Sun Funds’ investments, the decision nevertheless will empower pension funds seeking recovery to assert claims against private equity firms involved with the underlying company. As a result, private equity firms should, at a minimum, be aware that even though their principal purpose in investing in portfolio companies is to make a profit, when they take on management and operational responsibilities, as they often do as part of a strategic plan, they may not claim to be simply “passive” investors to avoid liability for unfunded pension obligations of those portfolio companies. While the Sun Funds apparently engaged counsel to draft fund documents in a manner that would avoid withdrawal liability, given the guidance that the First Circuit has provided, private equity firms may want to revisit the language used in their documents. In addition, firms may want to seek legal counsel to find the sliding scale point between operational control and passive investment in a portfolio. For more information on the content of this alert, please contact your regular Nixon Peabody attorney or: — Jonathan Sablone at jsablone@nixonpeabody.com or (212) 224-6395 — Matthew T. McLaughlin at mmclaughlin@nixonpeabody.com or (617) 345-6154 2 Id. at *4. The court remanded the case back to the district court for further factual findings with respect to the other Sun Funds.
  • 7. Private Fund Disputes alert | Nixon peabody LLP July 24, 2013 “But I thought we were just negotiating”—Are the good faith provisions in a term sheet or letter of intent enforceable upon the parties? By Stephen M. LaRose and Kathleen Ceglarski Burns SIGA Technologies Inc. v. PharmAthene Inc., C. A. No. 2627 (Del. 2013) Introduction The Delaware Supreme Court (the “Court”) recently affirmed a lower court decision finding that a good faith negotiation provision in a term sheet or proposed merger agreement is breached where a party’s later proposed terms are substantially dissimilar to those of the term sheet or merger agreement, and that the party proposed such terms in bad faith. The Court went further in addressing the proper remedy for the breach of such a term sheet, holding that where parties enter into a preliminary agreement pursuant to which they agree on certain major terms and leave other terms open for good faith negotiation, a plaintiff can recover their contract “expectation damages” if the parties would have reached an agreement but for the defendant’s bad faith negotiations. Background on the Court’s decision In SIGA Technologies Inc. v. PharmAthene Inc., C. A. No. 2627 (Del. May 24, 2013) (the “Opinion”), the parties negotiated a license agreement term sheet (“LATS”) for a SIGA antiviral drug. Following agreement on the LATS, the parties’ discussions turned to a possible merger, ultimately culminating in entry into a proposed merger agreement that included and incorporated the LATS. Both the proposed merger agreement and its attached license term sheet stated that the parties agreed to negotiate in good faith. At the time, SIGA’s drug looked promising, but SIGA had encountered difficulties in the development process and sought an infusion of cash from PharmAthene. However, SIGA’s financial position brightened as the negotiations went on, particularly when SIGA received a grant from the National Institutes of Health, and the results of clinical trials proved successful. SIGA ultimately terminated the merger agreement according to a 30-day termination clause, and after announcing its drug’s successes, its stock price skyrocketed. The parties then continued to pursue the license, but SIGA drastically changed the terms on the grounds that the term sheet was merely a jumping off point to negotiations, and ultimately ended the parties’ discussions. PharmAthene filed suit in Delaware Chancery Court and a Vice Chancellor of that trial court eventually presided over an 11-day trial. This newsletter is intended as an information source for the clients and friends of Nixon Peabody LLP. The content should not be construed as legal advice, and readers should not act upon information in the publication without professional counsel. This material may be considered advertising under certain rules of professional conduct. Copyright © 2013 Nixon Peabody LLP. All rights reserved.
  • 8. The Delaware Supreme Court affirmed the trial court’s decision that SIGA breached the LATS’ and merger agreement’s requirements to negotiate in good faith. Critical to the Court was the finding that while the “economic terms [SIGA] proposed in the Draft LLC Agreement may not have directly contradict[ed] the LATS . . . they differed dramatically from the LATS in favor of SIGA to the extent that they virtually disregarded the economic terms of the LATS other than using them as a skeletal framework.” Opinion at 38. As the Court described the situation, “SIGA began experiencing seller’s remorse during the merger negotiations for having given up control of what was looking more and more like a multi-billion dollar drug.” Opinion at 41. What does this mean for you? In our view, this decision can add to the level of uncertainty and risk for parties negotiating a transaction. The Delaware Court addressed this concern head-on and found it overstated, explaining that “a trial judge must find both that a party’s proposed terms are substantially dissimilar and that the party proposed those terms in bad faith.” Opinion at 39. We are not as convinced as the Court on this point, particularly because one person’s “bad faith” may be another’s tough negotiating style. While the facts in SIGA Technologies may illustrate a level of bad faith— what the Court referred to as “seller’s remorse”—the definition of bad faith is far from cut and dry. Under Delaware law, bad faith is defined using ambiguous terms such as “dishonest purpose or moral obliquity” and “furtive design or ill will.”1 Following this decision, parties must beware that even in the absence of a signed definitive agreement, one party may be required to pay the other the full benefit of the bargain for a deal that was contemplated but ultimately did not reach finality if they agree in a term sheet or letter of intent to negotiate in good faith. Clients should also be aware that state laws vary widely in their treatment of term sheets, letters of intent, and agreements to negotiate in good faith, as do the available remedies for breach of those agreements. Parties should carefully consider the choice of law clause when entering into such agreements, and draft the agreements with precision to make clear whether the parties intend to enter into a binding agreement to negotiate, an exclusivity agreement, or another type of preliminary agreement. With this decision, the Delaware Supreme Court made clear that so-called non-binding “agreements to agree” can in fact be interpreted as enforceable contracts and the breach of those contracts can have substantial financial ramifications if they previously agreed to negotiate in good faith. For more information on the content of this alert, please contact your regular Nixon Peabody attorney or: — Stephen M. LaRose at slarose@nixonpeabody.com or (617) 345-1119 — Kathleen Burns at kburns@nixonpeabody.com or (617) 345-1109 1 Opinion at 39; citing CNL-AB LLC v. E. Prop. Fund I SPE (MS REF) LLC, 2011 WL 35319 at *9 (Del. Ch. Jan. 28, 2011).
  • 9. Private Fund Disputes alert | Nixon peabody LLP May 31, 2013 Whose claim is it anyway—the investment fund's or the investor's? By Danielle M. McLaughlin and Stephen M. LaRose Askenazy et al., v. KPMG LLP et al., No 12-P-863, Mass. App. Ct., May 23, 2013 Introduction The Massachusetts Appeals Court decided on May 23, 2013, that investors in a pair of hedge funds cannot be forced to arbitrate a dispute with the funds’ auditor over the alleged failure to alert the investors to various “red flags” from the Bernard L. Madoff (“Madoff”) Ponzi scheme. Applying Delaware law to the dispute, the Appeals Court found that because the claims asserted were “direct claims” that separately belong to the limited partner investors, and are not “derivative claims” that belong more broadly to the funds, the funds’ contractual agreement to arbitrate disputes with KPMG did not apply to the investors’ claims. Background: Askenazy et al., v. KPMG LLP et al., Mass. App. Ct., May 23, 2013 (“Askenazy v. KPMG”) The Investor Plaintiffs (the “Plaintiffs”) in Askenazy v. KPMG are limited partners of two hedge funds, the Rye Select Broad Market Prime Fund, L.P. and the Rye Select Broad Market XL Fund, L.P. (the “Rye Funds”), that functioned as so-called “feeder funds” to Madoff’s investment house. In 2008, after the Madoff fraud was uncovered, it was determined that the Rye Funds, like many other feeder funds, had no value, leaving its investors in great distress and without a source of recovery. The Investor Plaintiffs brought suit in 2010 against the investment manager and several affiliates, as well as the Rye Funds’ auditor, KPMG. Over a period of years, KPMG performed various audit and tax services for the Rye Funds. In general, the Investor Plaintiffs alleged that KPMG did not adequately perform its auditing and tax functions and, essentially, by certifying its auditing results and failing to bring to the Plaintiffs’ attention various “red flags” regarding irregularities in the investments and operation managed by Madoff, KPMG aided and abetted the scheme, and harmed the Plaintiffs. In their suit, Plaintiffs brought claims for fraud in the inducement, negligent misrepresentation, Mass. General Law c. 93A violations for unfair business practices, aiding and abetting fraud, and professional malpractice. KPMG defended on the basis that it was not employed by any of the Plaintiffs and did not provide This newsletter is intended as an information source for the clients and friends of Nixon Peabody LLP. The content should not be construed as legal advice, and readers should not act upon information in the publication without professional counsel. This material may be considered advertising under certain rules of professional conduct. Copyright © 2013 Nixon Peabody LLP. All rights reserved.
  • 10. them with any particularized information, but rather, pursuant to contract, KPMG provided auditing and tax service to the Funds themselves. In addition, KPMG’s engagement letter agreement with the Rye Funds contained broad-form arbitration provisions. According to KPMG, all of the Plaintiffs’ claims against KPMG were subject to these engagement letters because the claims were derivative of the company and not direct claims of the investors, therefore belonging solely to the Rye Funds that are bound by the arbitration provisions. Consequently, according to KPMG, the Rye Funds’ limited partners lacked standing to assert their claims directly, or alternatively must arbitrate the claims outside of a court. The trial court disagreed with KPMG, and allowed most of the Plaintiffs’ claims to proceed in court and not arbitration, on the basis that the claims were direct claims belonging to the investors, and not derivative claims of the Funds. KPMG appealed that decision. The appeals court’s decision that the claims are direct and belong to the investors Applying Delaware law, the appeals court agreed with the trial judge, and held that the Plaintiffs’ claims—that they were “induced” by the auditor’s statements to invest in the Rye Funds, to stay invested, and in some cases to make additional investments—describe individualized harm independent of harm to the Rye Funds. The standard to determine whether a claim is derivative or direct was described by the court as turning upon: (1) who suffered the alleged harm described by the claim (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or remedy. Citing Tolley v. Donaldson Lufkin & Jenrette, Inc., 845 A. 2d 1031 (Del. 2004). Here the appeals court explained that the claims made by the investors rested upon a duty to each Plaintiff that did not arise from KPMG’s fiduciary duties to its audit client, the Rye Funds, but rather arose from KPMG’s alleged misstatements and errors. In addition, the appellate panel ruled that Plaintiffs’ claims against KPMG for losses sustained as a result of paying taxes on non-existent income were also direct (and not derivative), because as a limited partnership the Rye Funds were pass-through tax entities, so the profits and losses of the Funds were passed to the limited partners. The appeals court was also not persuaded by KPMG’s alternative contention that even if the Plaintiffs’ claims were direct and not derivative, the claims arise from the engagement of KPMG, such that Plaintiffs remain bound by the arbitration provisions arising from the engagement contracts. On that point, the panel held to the often stated principal that a party cannot be compelled to arbitrate unless it has clearly and unequivocally agreed to do so. As the court found, “[w]e see neither an intent by the Plaintiffs to be bound by the engagement letters nor any effort by them to selectively enforce a portion of the letters while avoiding the arbitration provisions.” What does this decision mean? This decision has many implications for investors, private investment funds, and other similar business organizations, but in particular is a sign that investors likely have significant latitude to bring their own direct claims against fund managers or third-party service providers, and will not always be barred by the requirements of a derivative lawsuit. In the investment fund context, the court made a clear distinction that where an investor was induced by some conduct to take a certain action, claims arising from that conduct are direct claims that may be maintained by the investor. In addition, this decision should make funds and other professional organizations cognizant of the fact that efforts to ensure that their disputes are determined only in a more restrictive arbitration
  • 11. forum will not always be fulfilled if a litigating party can show that it wasn’t party to an agreement to arbitrate. Access to the U.S. courts, of course, provides litigants more sweeping fact discovery rights, the right to a jury, and other rights not found in arbitration. For more information on the content of this alert, please contact your regular Nixon Peabody attorney or: — Stephen LaRose at slarose@nixonpeabody.com or (617) 345-1119 — Danielle McLaughlin at dmclaughlin@nixonpeabody.com or (617) 345-1068
  • 12. Private Fund Disputes alert | Nixon peabody LLP May 1, 2013 Second Circuit holds that Madoff feeder fund's "center of main interests" is located in British Virgin Islands By Jonathan Sablone and Anthony J. Galdieri In Morning Mist Holdings Limited v. Krys (In re Fairfield Sentry Limited), Docket No. 11-4376, 2013 U.S. App. LEXIS 7608 (2d Cir. April 16, 2013), the Second Circuit held that Fairfield Sentry Limited (“Sentry”), the largest “feeder fund” to invest with Bernard L. Madoff Investment Securities LLC, had its “center of main interests” within the meaning Chapter 15 of the Bankruptcy Code in the British Virgin Islands (“BVI”). The Second Circuit concluded that, absent allegations of bad faith manipulation, an entity’s “center of main interests” is determined at the time it files its Chapter 15 bankruptcy petition by examining all of the entity’s internal and external operations and activities and any other relevant circumstances. The Second Circuit’s opinion provides a clear roadmap for courts to follow when determining an entity’s “center of main interests” and provides useful guidance to United States creditors as to which nation’s insolvency laws may bind them in the future. Sentry was organized in 1990 as an International Business Company under the laws of the BVI. From 1990 until Bernie Madoff’s arrest on December 11, 2008, Sentry was the largest feeder fund to invest with Bernard L. Madoff Investment Securities LLC (“BLMIS”). Roughly 95% of Sentry’s assets were invested with BLMIS. Sentry administered its business interests and had its registered office, registered agent, registered secretary, and kept its corporate documents in the BVI. Sentry’s Board of Directors oversaw the management of Sentry, which was handled by Fairfield Greenwich Group in New York. Sentry’s three directors resided in New York, Oslo, and Geneva. After Madoff was arrested, Sentry’s two independent directors suspended all share redemptions and began winding down Sentry’s business to preserve its assets in anticipation of litigation and bankruptcy. From December 2008 to July 2009, those directors participated in approximately 44 teleconference board meetings initiated by Sentry’s registered agent in the BVI. During this time, Sentry also advised its shareholders about its response to the Madoff scandal in correspondence issued from Sentry’s BVI address. In 2009, Morning Mist Holdings Limited (“Morning Mist”), a Sentry shareholder, filed a derivative action against Sentry in New York state court. Meanwhile, in the BVI, ten Sentry shareholders applied for the appointment of a liquidator. On July 21, 2009, the High Court of Justice of the This newsletter is intended as an information source for the clients and friends of Nixon Peabody LLP. The content should not be construed as legal advice, and readers should not act upon information in the publication without professional counsel. This material may be considered advertising under certain rules of professional conduct. Copyright © 2013 Nixon Peabody LLP. All rights reserved.
  • 13. Eastern Caribbean Supreme Court entered an order that commenced Sentry’s liquidation proceedings under the Virgin Islands Insolvency Act of 2003. The order appointed a liquidator, who subsequently petitioned the United States Bankruptcy Court for the Southern District of New York for recognition of the BVI liquidation proceedings under Chapter 15 of the United States Bankruptcy Code (“Chapter 15”). When the Chapter 15 petition was filed, Sentry had approximately $17 million in liquid assets and $150 million in redemption claims in the BVI. On July 22, 2010, the bankruptcy court granted the liquidator’s Chapter 15 petition. In doing so, the bankruptcy court found that Sentry had its “center of main interests” in the BVI after examining the time period between December 2008, when Sentry stopped doing business, and June 2010, when the Chapter 15 petition was filed. The bankruptcy court therefore recognized the BVI liquidation as a “foreign main proceeding” under Chapter 15. This ruling imposed an automatic stay in all other proceedings against Sentry in the United States, including the derivative action filed by Morning Mist. Morning Mist appealed the bankruptcy court’s order to the federal district court, which affirmed. Morning Mist subsequently appealed to the Second Circuit. The Second Circuit examined the plain language and purpose of Chapter 15 and observed that the only requirement at issue was “whether the BVI liquidation qualifie[d] as a foreign main or nonmain proceeding” under 11 U.S.C. § 1517. Chapter 15 defines “foreign main proceeding” as a “foreign proceeding pending in a country where the debtor has the center of its main interests.” 11 U.S.C. § 1502. Chapter 15 does not define the term “center of main interests.” Accordingly, the Second Circuit had to determine: (1) how an entity’s “center of main interests” should be determined; and (2) where Sentry’s “center of main interests” was located. In deciding how an entity’s “center of main interests” should be determined, the Second Circuit examined the statutory text, other federal court opinions, and international interpretations of the term. The Second Circuit observed that the use of “[t]he present tense [in the statute itself] suggests that a court should examine a debtor’s [center of main interests] at the time the Chapter 15 petition is filed.” The Second Circuit further observed that “[n]early every federal court to address this question has determined that [center of main interests] should be considered as of the time the Chapter 15 petition is filed.” In considering international sources, the Second Circuit found them “of limited use in resolving whether U.S. courts should determine [center of main interests] at the time of the Chapter 15 petition or in some other way,” but acknowledged concern among international authorities that an entity could purposefully manipulate its center of main interests if such a determination was made at the time the Chapter 15 petition was filed. Synthesizing these authorities, the Second Circuit held that an entity’s center of main interests “should be determined based on its activities at or around the time the Chapter 15 petition is filed,” but that “a court may consider the period between the commencement of the foreign insolvency proceeding and the filing of the Chapter 15 petition to ensure that a debtor has not manipulated its [center of main interests] in bad faith.” The Second Circuit then had to decide what factors a court could rely upon to determine an entity’s center of main interests. The Second Circuit observed that “Chapter 15 creates a rebuttable presumption that the country where a debtor has its registered office will be its [center of main interests] . . . .” 11 U.S.C. § 1516(c). The Second Circuit also noted that federal courts have considered a variety of other factors as well, including: (1) the location of the entity’s headquarters, (2) the location of those who actually manage the entity, (3) the location of the entity’s primary assets, (4) the location of a majority of the entity’s creditors, and (5) the jurisdiction that would apply to most disputes. The Second Circuit reviewed these factors and concluded that the text of
  • 14. the statute is “open-ended, and invites development by courts, depending on facts presented, without prescription or limitation.” Accordingly, the Second Circuit held that “[t]he factors that a court may consider in this analysis are not limited and may include the debtor’s liquidation activities.” Applying the above legal principles, the Second Circuit held that the factual record supported a finding that Sentry’s center of main interests was located in the BVI at the time Sentry filed its Chapter 15 petition. The Second Circuit observed that Sentry had no place of business, no management, and no tangible assets located in the United States at that time. Rather, in and around the time the Chapter 15 petition was filed, Sentry’s activities had been centered primarily on winding down its business in the BVI. The Second Circuit further observed that there was no finding of bad-faith manipulation of Sentry’s center of main interests. Accordingly, the Second Circuit affirmed the lower courts’ decisions that Sentry’s center of main interests was located in the BVI. Finally, the Second Circuit held that the bankruptcy court did not err in deciding not to apply the public policy exception available under Chapter 15. 11 U.S.C. § 1506. Morning Mist argued that the bankruptcy court should have refused to recognize the BVI liquidation proceeding under 11 U.S.C. § 1506 because the BVI liquidation proceedings were “cloaked in secrecy.” The Second Circuit disagreed, holding that 11 U.S.C. § 1506 should be construed narrowly and only creates an exception where an action is “manifestly contrary” to public policy. The Second Circuit held that “[t]he confidentiality of BVI bankruptcy proceedings does not offend U.S. public policy” and stated that Morning Mist’s concerns were “overwrought.” The Second Circuit observed that, even in the United States, “[t]he right to access court documents is not absolute and can easily give way to ‘privacy interests’ or other considerations.” Accordingly, the Second Circuit concluded that “[t]here is no basis on which to hold that recognition of the BVI liquidation is manifestly contrary to U.S. public policy.” For more information on the content of this alert, please contact your regular Nixon Peabody attorney or: — Jonathan Sablone at jsablone@nixonpeabody.com or (212) 224-6395 — Anthony J. Galdieri at agaldieri@nixonpeabody.com or (603) 628-4046
  • 15. Private Fund Disputes alert | Nixon peabody LLP April 2, 2013 Recent BVI decisions offer guidance to investors and funds facing redemption disputes By Jonathan Sablone and Kathleen Ceglarski Burns Litigation stemming from redemption disputes that arose during the financial crisis continues to impact overseas investors and funds organized under BVI law. Most recently, the Court of Appeal of the Eastern Caribbean Supreme Court issued a significant decision clarifying investors’ rights to receive distributions in liquidation proceedings under BVI law. Previously, two decisions handed down by the Cayman Islands Grand Court in 2012 served as valuable reminders of several key issues to consider when dealing with redemptions and side letters. In the Somers Dublin Ltd. A/C KBCS v. Monarch Pointe Fund Limited (March 11, 2013) case, Monarch Pointe Fund (“Monarch”), a BVI mutual fund, a dispute arose after Monarch suspended redemptions in August 2007. At the time redemptions were suspended, seven redeemed members had yet to receive approximately $18 million of redemption proceeds to which they were entitled. The High Court appointed a liquidator in 2008, and after all of Monarch’s external creditors were paid, the liquidator had $3.5 million available to satisfy the seven redeemed members as well as the other eleven continuing members who were entitled to a total of $47 million in shares. The issue before the court was where the redeemed members’ claims ranked as against continuing members. Initially, the Commercial Court held that the redeemed members ranked pari passu with the continuing members, which was contrary to industry expectations. The Court of Appeal relied on the Westford Special Situations Fund Ltd. v. Barfield Nominees Limited at al. case and the Kenneth M. Krys et al. v. Stichting Shell Pensioenfonds cases, Monarch’s Memorandum and Articles of Association, and Section 197 of the Insolvency Act, 2003, in overturning the trial judge’s decision. The Court of Appeal determined that the redeemed members were deferred creditors, and as such, were entitled to have their claims against Monarch satisfied in priority to any claim by the continuing members. The decision affirms the widely accepted industry view on the priority of redeeming investors, provides certainty to any funds in liquidation that may have been waiting to distribute proceeds, and also provides an important reminder to keep updated on the law and any default positions that may not have been addressed in a company’s organization documents. This newsletter is intended as an information source for the clients and friends of Nixon Peabody LLP. The content should not be construed as legal advice, and readers should not act upon information in the publication without professional counsel. This material may be considered advertising under certain rules of professional conduct. Copyright © 2013 Nixon Peabody LLP. All rights reserved.
  • 16. Two decisions issued by the Cayman Islands Grand Court in 2012 addressed the proper priority of redemptions where side letters were in place. The holding in the case of Medley Opportunity Fund Ltd. v. Fintan Master Fund Ltd. & Nautical Nominees Ltd (June 21, 2012) emphasized the importance of properly documenting and recognizing the distinction between legal and beneficial owners. Here, the investor (Fintan), which was invested through its nominee, Nautical Nominees (Nautical), and the fund (Medley), a Cayman Islands exempted limited company, entered into a side letter, pursuant to which Medley (the “Fund”) agreed to notify Fintan should it enter into a side letter with any comparable investor and provide that other investor with more favorable terms than those offered to Fintan. In November 2008, the Fund notified investors that it was attempting to proactively address the redemption and liquidity issues facing the alternative investment industry, and proposed a restructuring plan. Nautical elected the second of two options that the Fund offered to investors— agreeing to remain in the Fund and receive quarterly cash distributions, rescinding any pending redemption requests that had been previously submitted. Nautical executed the document to enter into the 2008 restructuring plan for the benefit of Fintan, and stated that “[t]he undersigned agrees to all of the terms described in the letter.” In November 2009, the Fund sought the approval of shareholders for a further restructuring plan in order to allow new investors to invest “without the overhang of potential redemption requests.” Nautical again executed the document to enter into the 2009 restructuring plan for the benefit of Fintan, and again agreed to all of the terms in the letter. In December 2011, Nautical submitted a redemption request on behalf of Fintan, signed by the same Nautical authorized signatory who signed the approvals to the 2008 and 2009 restructuring plan. Nautical claimed that the 2007 side letter governed the redemption terms, overriding the agreements to the 2008 and 2009 restructuring plans. The Fund argued that Fintan was bound by the terms of the 2008 and 2009 restructuring plans, which replaced any pre-existing redemption rights. The court first found that the side letter, although it was consistent with the Fund’s Articles of Association, did not govern the parties’ conduct. Importantly, the side letter was executed by Fintan, the Fund, and the investment manager, while the 2008 and 2009 restructuring plans were executed by Nautical. Therefore, the side letter, to which Fintan was a party, did not affect the rights that Nautical had as a shareholder in the Fund. Justice Quin soundly rejected the contention that Fintan and Nautical were one and the same, or that they had single indivisible rights—he emphasized that even though Fintan was the ultimate beneficiary of the arrangement, Fintan and Nautical are both entirely different legal entities incorporated in two different jurisdictions. Accordingly, the court held that the side letter did not provide Nautical with any enhanced rights or favored status as a member of the Fund. While the Medley case serves as an important reminder that the correct entities must be signatories to all investment agreements, it doesn’t necessarily illustrate that a side letter must always be signed by the legal owner, and not the beneficial owner, in order to be enforceable. Rather, investors and managers should be sure that all agreements between the parties are consistent, and recognize that courts are not willing to blur the lines between the rights of legal and beneficial owners. Several months later, Justice Quin again issued a decision involving side letters in the case of Landsdowne Limited & Silex Trust Company Limited v. Matador Investments Limited (In Liquidation) & Ors (August 23, 2012). Again, the court found the side agreement did not alter the parties’ rights,
  • 17. but for different reasons. Close friends Eva Guerrand-Hermes, of the Hermes luxury empire (”EGH”), and Priscilla Waters (“PW”) decided to embark on a joint venture and establish a fund of funds, which came to be known as Matador Investments Limited (the “Fund”). EGH incorporated the Fund, and Lansdowne Limited (“Lansdowne”), of which PW was a shareholder, and Silex Trust Company (“Silex”), of which PW was the beneficial owner, invested in the Fund. EGH and PW allegedly had an oral agreement, which PW alleged amounted to an “oral side letter,” that the Fund’s Articles of Association and other governing documents, including the Fund’s gating and suspension powers, would not apply to PW, and that she should be able to withdraw as much money as she needed from the Fund every quarter. The relationship between EGH and PW deteriorated, and, through Lansdowne and Silex, PW sought to redeem her investments in the Fund. The Fund attempted to impose restrictions on the redemptions pursuant to the Fund’s governing documents, and the Fund subsequently went into liquidation. Justice Quin held that the oral agreement between EGH and PW was not enforceable for several reasons. First, the court relied on the Medley decision in holding that any agreement between EGH and PW would not apply to Silex and Lansdowne, the legal investors in the Fund. The court also held that even if it were to accept PW’s “oral side letter” analogy, it would be unenforceable because the Articles of Association stated exactly the opposite of the alleged agreement. If the parties had intended to modify PW’s redemption rights, they should have ensured that a provision for granting that entitlement was inserted in the Articles. Justice Quin quoted Principles of Modern Company Law 7th Edition: “In order to protect the shareholders whose shares are not to be redeemed, the terms and manner of the redemption must be set out in the company’s Articles.” For example, in the Medley case, although the side letter was found to be unenforceable due to the legal/beneficial owner inconsistency, Justice Quin pointed out that the Fund’s Articles were consistent with the side letter. There, the Articles explicitly provided for side letters and granted the Fund’s directors significant discretion with respect to redemptions. Presumably, had the side letter been executed by the proper parties, or included terms recognizing the effect of the agreement on the legal and beneficial owners, it would have been enforceable. In the Matador case, however, the numerous problems with the parties’ agreements could not have been overcome with such a minor adjustment as the side letter was directly contradictory, rather than complementary, with the Articles of Association. Together, the Medley and Matador decisions illustrate that, when properly documented and in accordance with a fund’s governing documents, side letters can be enforceable. The Grand Court’s recent decisions serve as a reminder that while properly documented and supported side letters are legally binding, strict attention to detail and consistency with the hedge fund’s governing documents are necessary in order for side letter agreements to be enforceable. These three decisions illustrate the deference that BVI courts give to a fund’s organizational documents, and also serve as a reminder that the devil is in the details. In addition to navigating the regulatory waters in the wake of the financial crisis, parties who enter into side letter arrangements must take steps to ensure the enforceability of the agreements from a contractual perspective. Moreover, organizational documents must be well thought out, and revised as necessary in order to ensure that the parties’ intent is enforced. Sponsors and investors must consider both the substance and form of their agreements, as well as the current statutory law, when dealing with redemptions.
  • 18. For more information on the content of this alert, please contact your regular Nixon Peabody attorney or: — Jonathan Sablone at jsablone@nixonpeabody.com or (617) 345-1342 — Kathleen Ceglarski Burns at kburns@nixonpeabody.com or (617) 345-1109