Redemptions
The power of a hedge fund to suspend redemptions, net asset values and redemption proceeds and its risks and limitations
BY JOHN ORIOGUN, MANAGING PARTNER, ORIOGUN, PLLC
The present economic realities and the wild fluctuations being experienced in the stock markets have ensured that the hedge fund industry has had to confront significant redemption requests in recent times. The massive worldwide declines in stock market values and the risks of depression facing many western and emerging market economies has led many investors in hedge funds to seek to reduce their risks across the board. This article examines whether hedge funds can legitimately suspend redemptions in the face of large scale requests.
The starting point to address this question is a fund’s constitutional documents. The constitutional documents of most hedge funds have anticipated that money may be invested in assets or underlying funds that may be (i) illiquid, (ii) incapable of being valued due to adverse market conditions, or (iii) subject to redemption suspensions in underlying funds. To tackle this situation, many contain provisions that give their directors the power to (x) restrict the proportion of assets under management that can be redeemed on a given redemption date or (y) suspend redemptions altogether. This power has caused some angst with the investor community and (in some cases) legal challenges.
Are suspensions lawful?
The question of the legality of redemption suspensions was considered by the Cayman Island Court of Appeal in the case of Strategic Turnaround Master Partnership (the “Fund”) and Culross Global Limited (the “Turnaround case”) in December 2008. The Court determined that the articles of association, Offering Memorandum and subscription agreement (together the “Constitutional Documents”) contained the contract between the investor and the Fund. Consequently, as a matter of Cayman law and construction, an investor who gives valid notice of redemption becomes a creditor of the Fund on the applicable redemption date. Consequently, a failure by the Fund to pay the redemption proceeds would leave the Fund open to a petition for the winding up of the Fund for failing to pay its debts as and when due.
However, in the Turnaround case, the Constitutional Documents conferred a power on the directors to suspend redemptions, NAV calculations and/or the payment of redemption proceeds. The Fund exercised its power to suspend the payment of redemption proceeds before the proceeds were due to be payable under the Constitutional Documents of the Fund.
• The Court decided that the investor was bound by the power of the Directors to suspend the payment of redemption proceeds because the investor remained a shareholder of the Fund until its redemption proceeds had been paid and its name removed from the Fund’s register.
• The Court decided that the exercise of the Directors’ power to suspend redemption payments was not retrospective because the power to suspend redemptions was exercised before the date on which the Constitutional Documents required that the relevant redemption payments be paid.
Limitations on the power to suspend
The terms of a fund’s Constitutional Documents, taken together, are the single most limiting factor in a fund’s power to suspend redemptions, NAV calculations or the payment of redemption proceeds. It is a matter of the utmost importance that a fund’s Constitutional Documents are drafted in a manner that gives its Directors wide powers to act in the fund’s best interest (which in some instances may warrant the exercise of the power of suspension).
Secondly, the power to suspend a given right must be exercised by the Directors before that right has crystalised. The Turnaround case upheld the power of the Directors to suspend the redemption payments because the resolution to suspend payment was made prior to the date on which the Constitutional Documents required the redemption proceeds be paid.
Thirdly, if the power to authorize suspension of (i) redemptions, (ii) NAV calculations or (iii) redemption proceeds was exercised by the Directors in bad faith, such action is open to being challenged and rendered invalid. The Court in the Turnaround case reinforced the position that the court would not “assume that the powers of the directors had been exercised otherwise than bona fide without clear evidence to that effect”.
Finally, the Directors must be careful to exercise the power in a manner consistent with the terms specified in the Constitutional Documents. It is imperative that the circumstances underlying the power to suspend must exist.
Consequences
• The Cayman Islands Court of Appeal noted that an investor that is locked into a fund as a result of the fund’s exercise of its power of suspension could institute a petition to wind up the fund on just and equitable grounds. The Chief Justice (of the lower court in the Turnaround case) indicated that an investor has a legitimate expectation to be able to redeem its shares in accordance with the fund’s Constitutional Documents. The exercise of the power of suspension effectively exposed the investor “to the risk of the assets declining below the point at which it can be paid in full, without the upside of either an express right to interest or the ability to benefit from an increase in values”, which is a significant risk factor for any potential investor in a fund.
• the reputational fallout from suspensions may cause some angst and annoyance among the investment community. Certain investors may now take the view against investing in those funds that have exercised their right to suspend redemptions. However, this fallout may be mitigated by the fact that the exercise of the power of suspension has been made by a significant number of hedge funds.
The way forward
It seems clear that a significant factor contributing to the exercise of the power of suspension is the mismatch and tension between the short term funding that funds obtain from investors and the long-term investments those funds make. Funds are then left in a situation where they cannot easily divest themselves from otherwise illiquid positions without incurring a big loss for those investors wishing to redeem and a collateral loss for the investors that remain in the fund. The solution may lie in a change in structure whereby funds that provide for redemption at short notice invest in liquid assets, whilst funds that invest in illiquid or “hard-to-sell” assets have lock-up provisions that keep investors in the fund for a given number of years.
Alternatively, the Articles of Association could provide investors with the option to redeem early. The Articles make clear that the exercise of this right would be subject to the imposition of punitive redemption fees.
Conclusion
In conclusion, it is clear that hedge funds have had to consider unpopular options in order to ensure both their continued solvency and to protect all investors from the consequences of a fire sale in a distressed market. Whilst the power of suspension must be contained in the Constitutional Documents in order to be valid and the exercise of that power must be made before suspension has occurred, there are of course reputational risks involved in exercising the power to suspend. The biggest risk however, is the potential risk that a court decides to wind up the fund on the grounds that it would be just and equitable to do so. Funds may have to consider structuring themselves in a way that aligns their investment strategy with applicable long or short term redemption notice periods.
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The present economic realities and the wild fluctuations being experienced in the stock markets have ensured that the hedge fund industry has had to confront significant redemption requests in recent times. The massive worldwide declines in stock market values and the risks of depression facing many western and emerging market economies has led many investors in hedge funds to seek to reduce their risks across the board. This article examines whether hedge funds can legitimately suspend redemptions in the face of large scale requests.
The starting point to address this question is a fund’s constitutional documents. The constitutional documents of most hedge funds have anticipated that money may be invested in assets or underlying funds that may be (i) illiquid, (ii) incapable of being valued due to adverse market conditions, or (iii) subject to redemption suspensions in underlying funds. To tackle this situation, many contain provisions that give their directors the power to (x) restrict the proportion of assets under management that can be redeemed on a given redemption date or (y) suspend redemptions altogether. This power has caused some angst with the investor community and (in some cases) legal challenges.
Are suspensions lawful?
The question of the legality of redemption suspensions was considered by the Cayman Island Court of Appeal in the case of Strategic Turnaround Master Partnership (the “Fund”) and Culross Global Limited (the “Turnaround case”) in December 2008. The Court determined that the articles of association, Offering Memorandum and subscription agreement (together the “Constitutional Documents”) contained the contract between the investor and the Fund. Consequently, as a matter of Cayman law and construction, an investor who gives valid notice of redemption becomes a creditor of the Fund on the applicable redemption date. Consequently, a failure by the Fund to pay the redemption proceeds would leave the Fund open to a petition for the winding up of the Fund for failing to pay its debts as and when due.
However, in the Turnaround case, the Constitutional Documents conferred a power on the directors to suspend redemptions, NAV calculations and/or the payment of redemption proceeds. The Fund exercised its power to suspend the payment of redemption proceeds before the proceeds were due to be payable under the Constitutional Documents of the Fund.
• The Court decided that the investor was bound by the power of the Directors to suspend the payment of redemption proceeds because the investor remained a shareholder of the Fund until its redemption proceeds had been paid and its name removed from the Fund’s register.
• The Court decided that the exercise of the Directors’ power to suspend redemption payments was not retrospective because the power to suspend redemptions was exercised before the date on which the Constitutional Documents required that the relevant redemption payments be paid.
Limitations on the power to suspend
The terms of a fund’s Constitutional Documents, taken together, are the single most limiting factor in a fund’s power to suspend redemptions, NAV calculations or the payment of redemption proceeds. It is a matter of the utmost importance that a fund’s Constitutional Documents are drafted in a manner that gives its Directors wide powers to act in the fund’s best interest (which in some instances may warrant the exercise of the power of suspension).
Secondly, the power to suspend a given right must be exercised by the Directors before that right has crystalised. The Turnaround case upheld the power of the Directors to suspend the redemption payments because the resolution to suspend payment was made prior to the date on which the Constitutional Documents required the redemption proceeds be paid.
Thirdly, if the power to authorize suspension of (i) redemptions, (ii) NAV calculations or (iii) redemption proceeds was exercised by the Directors in bad faith, such action is open to being challenged and rendered invalid. The Court in the Turnaround case reinforced the position that the court would not “assume that the powers of the directors had been exercised otherwise than bona fide without clear evidence to that effect”.
Finally, the Directors must be careful to exercise the power in a manner consistent with the terms specified in the Constitutional Documents. It is imperative that the circumstances underlying the power to suspend must exist.
Consequences
• The Cayman Islands Court of Appeal noted that an investor that is locked into a fund as a result of the fund’s exercise of its power of suspension could institute a petition to wind up the fund on just and equitable grounds. The Chief Justice (of the lower court in the Turnaround case) indicated that an investor has a legitimate expectation to be able to redeem its shares in accordance with the fund’s Constitutional Documents. The exercise of the power of suspension effectively exposed the investor “to the risk of the assets declining below the point at which it can be paid in full, without the upside of either an express right to interest or the ability to benefit from an increase in values”, which is a significant risk factor for any potential investor in a fund.
• the reputational fallout from suspensions may cause some angst and annoyance among the investment community. Certain investors may now take the view against investing in those funds that have exercised their right to suspend redemptions. However, this fallout may be mitigated by the fact that the exercise of the power of suspension has been made by a significant number of hedge funds.
The way forward
It seems clear that a significant factor contributing to the exercise of the power of suspension is the mismatch and tension between the short term funding that funds obtain from investors and the long-term investments those funds make. Funds are then left in a situation where they cannot easily divest themselves from otherwise illiquid positions without incurring a big loss for those investors wishing to redeem and a collateral loss for the investors that remain in the fund. The solution may lie in a change in structure whereby funds that provide for redemption at short notice invest in liquid assets, whilst funds that invest in illiquid or “hard-to-sell” assets have lock-up provisions that keep investors in the fund for a given number of years.
Alternatively, the Articles of Association could provide investors with the option to redeem early. The Articles make clear that the exercise of this right would be subject to the imposition of punitive redemption fees.
Conclusion
In conclusion, it is clear that hedge funds have had to consider unpopular options in order to ensure both their continued solvency and to protect all investors from the consequences of a fire sale in a distressed market. Whilst the power of suspension must be contained in the Constitutional Documents in order to be valid and the exercise of that power must be made before suspension has occurred, there are of course reputational risks involved in exercising the power to suspend. The biggest risk however, is the potential risk that a court decides to wind up the fund on the grounds that it would be just and equitable to do so. Funds may have to consider structuring themselves in a way that aligns their investment strategy with applicable long or short term redemption notice periods.
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