Preference Shareholder Redemption Rights in Cayman Islands companies

Structure

PRC based businesses seeking to attract institutional venture capital and private equity investment commonly adopt the familiar ‘red chip’ group structure.

A typical structure may comprise:

1. A Cayman Islands holding company which issues redeemable preference shares to raise capital.
2. A Hong Kong subsidiary of the Cayman holding company.
3. A PRC ‘WFOE’ (wholly foreign owned enterprise) subsidiary of the Hong Kong company.
4. Subject to PRC foreign investment regulations, the PRC operating subsidiaries may enter into ‘variable interest entity’ (VIE) contractual arrangements with the WFOE.

This group structure is designed to facilitate the eventual IPO of the business on, typically, the Hong Kong or a US stock exchange using the Cayman holding company. Preference shareholders will receive the return on their investment either via the IPO, or if the IPO does not occur within a specified period, by redeeming their preference shares for a pre-agreed redemption price.

Key Documents and Essential Terms

Key transaction documents will include the Memorandum and Articles of Association of the Cayman holding company (Articles) and a shareholders’ agreement between the Company, the founders, the preference shareholders and subsidiaries (SHA).

Essential terms of the transaction documents will typically include:

1. A provision that the preference shares will be ‘redeemable’ under certain conditions, often including where a qualified IPO does not occur by a specified, future date. This term is usually included in both the Articles and the SHA.
2. An ‘arbitration clause’ in the SHA providing that any dispute, controversy or claim arising out of or relating to the SHA, including the interpretation, validity, invalidity, breach or termination thereof, will be determined in arbitration proceedings, typically in Hong Kong.

Contractual interpretation

As a ‘statutory contract’, the Articles will be governed by Cayman Islands law, while the SHA will be governed by the law nominated therein, often Hong Kong law. In Cayman, the meaning of the words in a written contract are assessed having regard to: (i) the natural and ordinary meaning of the clause; (ii) any other relevant provisions of the document; (iii) the overall purpose of the clause and the document; (iv) the facts and circumstances known or assumed by the parties at the time that the document was executed; and (v) commercial common sense; but, (vi) disregarding subjective evidence of any party’s intentions. When interpreting the Articles, the surrounding circumstances will have limited application. The focus is predominantly on the text itself. Where there are competing interpretations, the Court should adopt the interpretation that is more consistent with business common sense.

Redemption of shares – overview and solvency requirement

The ‘redemption’ of a share involves the surrender of the share to the company, along with all attendant rights as a shareholder, at an agreed time for an agreed price.[1] There may be several steps in the redemption process, including service of a redemption notice by the shareholder, a period of time between service of the notice and the nominated day for payment and, in some cases, an ability on the company’s part to defer or suspend payment for a period of time. At some point in the redemption process, the shareholder will cease to be shareholder and will receive payment of the redemption price, or pending payment, may become an unsecured creditor of the company. The exact process will be governed by the Articles/SHA, so it may differ substantially from company to company.

In contrast to dividends, a company is not restricted to paying redemptions out of ‘profits’ and ‘share premium’.[2] It may pay out of ‘capital’ if authorised to do so by its Articles, but only if immediately following the date on which the payment out of capital is proposed to be made, the company is able to pay its debts as they fall due in the ordinary course of business.[3] Cayman adopts a ‘cash flow’ solvency test, although as well as current debts, debts falling due for payment in the ‘reasonably near future’ should be considered.

Redemption – process and timing

At the conclusion of the redemption process, the prior shareholding interest is extinguished. At this point, the former shareholder will become a paid creditor, or if not paid, an unpaid creditor of the company. The exact moment at which the transformation from shareholder to creditor occurs can be important when determining the respective rights and obligations as between: (i) the shareholder and the company; (ii) shareholders inter se; and (iii) the shareholder and ordinary creditors (creditors excluding redeeming shareholder-creditors).

• In Culross Global SPC Ltd v Strategic Turnaround Master Partnership Ltd [2010] UKPC 33, it was necessary for the Judicial Committee of the Privy Council (being the highest Appellate Court of the Cayman Islands) to ascertain precisely when the redemption occurred in order to determine whether the company had validly exercised its contractual right to suspend redemptions beforehand.
• In Pearson v Primeo Fund [2017] UKPC 19, the Privy Council was required to ascertain whether shares had been redeemed prior the commencement of the winding up, in order for the official liquidator to correctly distribute funds in accordance with the payment waterfall in section 37(7) of the Companies Act.[4]

Based upon these authorities, some preference shareholders and their advisors consider that it is necessary to determine precisely when the ‘redemption’ occurred or was completed, on the basis that until the redemption process is complete, the redeeming shareholder cannot be a creditor of the company for the redemption price. The author disagrees with this approach in most circumstances, where the issue is simply whether the redeeming shareholder should be entitled to enforce its right to payment.

The decisive issue is whether, and if so when, the redemption price became due and payable. It should not matter whether the redemption process is ongoing or complete. A debt that is due and owing may be pursued by a redeeming shareholder, just as it may be pursued by any creditor: for example, by issuing a statutory demand and filing winding up proceedings against the company. By way of analogy, a shareholder may pursue a company as a creditor for a declared but unpaid dividend.

Redemption – funds from which redemptions may be paid

The Articles (and any other relevant transaction documents) will prescribe the mechanics of the redemption process, including the time at which the redemption price becomes due and payable and, in some instances, the source of funds from which any redemption price may be paid. However, certain requirements of the Companies Act must also be observed.

Section 37(6)(a) of the Companies Act prohibits redemption payments out of capital unless the company can pay its other debts as they fall due in the ordinary course of business. The effect of this section is to ensure that a company’s ordinary creditors, who would have priority in an insolvency waterfall, can expect to be paid before a company uses its assets to pay its redeeming shareholders.[5] Possibly in recognition of section 37(6)(a), the Articles of the Cayman holding company in a red chip structure will commonly include a term that the company may only pay the redemption price from ‘assets or funds that are legally available’ (legally available funds). The Articles will invariably not define the meaning of this phrase. It is not defined in the Companies Act either. The author is unaware of the origins of the term, but it might have been designed to import the priority-of-payments and solvency requirements from the Companies Act (outlined above).

Whatever the intended meaning, a practice seems to have developed in which a Cayman holding company faced with a redemption request that it cannot, or wishes not, to pay, may allege that the redemption price itself does not become due and payable until such time as the company has legally available funds to pay it, without due consideration of (or, in some cases, intentional disregard for) the provisions of the Articles / SHA. In other words, the company may contend that the redemption debt should be regarded as a future or contingent debt, payable only if and when the company has funds legally available to pay it.

Adopting this argument, some Cayman holding companies have effectively sought to treat their preference shares as only conditionally redeemable, with the company, in its unilateral assessment, deciding whether or not it has legally available funds to pay. Management might even organise the affairs and finances of the corporate group in a manner intentionally designed to deprive the Cayman holding company of its ability to pay redemptions.[6]

Enforcement of redemption rights

Is it possible for a company’s Articles to be drafted in a way that clearly and expressly renders preference shares effectively ‘irredeemable’ unless the company has legally available funds to pay?

Almost certainly, yes. However, in the experience of the author, in most instances Cayman holding company Articles are not drafted in this way.

Faced with a company that refuses to honour a redemption request, a redeeming shareholder may be forced to commence proceedings in Court, or more commonly, in an arbitral tribunal.[7] As arbitration proceedings are private, the outcome in these cases remain largely unknown to investors and lawyers alike.

Fortunately for preference shareholders, the Cayman Islands Court was recently asked to consider the enforceability of an arbitration Award concerning investor redemption rights. The Cayman Court’s judgment includes several passages from the Award which detail the Tribunal’s construction of the Cayman company’s Articles.[8] As such, there is now a publicly available ruling on this issue.[9]

DE Shaw v Grand State Investments

Essential facts

D.E. Shaw Composite Investments Asia 10 (Cayman) Limited (DE Shaw) held redeemable preference shares in Grand State Investments Limited (Grand State). DE Shaw served a redemption notice on Grand State. Grand State refused to pay on the basis that it did not have legally available funds and thus, the redemption debt was not due and payable.

The relevant redemption clause included a term that if Grand State failed to pay the redemption price on the basis that it had inadequate funds legally available therefor, the shortfall was to be paid from time to time out of legally available funds as such funds became available. As such, this was not a case where the redemption clause provided that, for example, redemption itself was subject to there being legally available funds at the time of the redemption notice or proposed redemption date.[10]

First Cayman judgment

In a judgment dated 28 April 2021, Parker J refused an application by DE Shaw to wind up Grand State. This was on the basis that the ‘legally available funds’ argument was sufficient to qualify as a ‘genuine dispute on substantial grounds’. As such, the dispute should be resolved by arbitration rather than in winding up proceedings.

HKIAC Award

The dispute was heard by a Tribunal of the HKIAC in November 2023. The Tribunal’s ruling was delivered in June 2024. The Tribunal found decisively in favour of the redeeming preference shareholder, DE Shaw.

In the Tribunal’s view, the phrase ‘legally available funds’, “… only impose[s] obligations on the [company] but do[es] not exempt the [company] from the responsibility of making immediate redemption payment.” The Tribunal found that the redeeming shareholder may choose to allow the company a reasonable period of time to pay the redemption price out of legally available funds, “… but the choice rests entirely with [redeeming shareholders]. If the choice does not rest with the [redeeming shareholders], then the [company] may indefinitely postpone the redemption obligation on the grounds of ‘inadequate legally available funds’.”

According to the Tribunal, the agreement, “… clearly grants an absolute redemption right …” to the preference shareholders. The Tribunal said that if a company claims that its, “… ‘legally available funds’ are inadequate to pay the redemption price, the [company] must fully and comprehensively disclose the company’s overall financial situation so as to inform all parties of the gap between the ‘legally available funds’ and the redemption price and when the full redemption price can be paid …”.

Second Cayman judgment

DE Shaw sought to enforce the Award in Cayman. Grand State applied to prevent enforcement, arguing, amongst other things, that enforcement would contravene section 37(6)(a) of the Companies Act, because it would involve a payment out of capital at a time when the company cannot pay its other debts as they fall due in the ordinary course of business. In a detailed judgment delivered on 20 May 2025 Justice Parker rejected the argument. He said:

“[i]n this case there is a final foreign arbitral award, which has not been appealed, which has comprehensively determined the contractual rights and obligations of the parties and which has ordered one party to immediately redeem its shares and immediately pay a sum of money to another.”

“The Tribunal decided that [the company] was unable to rely on the argument that it did not have legally available funds in order to excuse non-payment; and that it had failed to disclose its financial situation fully.”

“The enforcement of the Final Award would not in the Court’s view be contrary to Cayman Islands public policy or the integrity of the Cayman Island’s legal system.”

Implications of the Grand State case – enforcement in winding up proceedings

In situations where a Cayman holding company has the same or similar Articles to those in Grand State, a redeeming preference shareholder should feel justified in demanding payment of the redemption price on the due date for payment. The company, on the other hand, should not feel completely secure that by simply alleging a lack of legally available funds, the Cayman Court will find there is a ‘genuine dispute on substantial grounds’, such that the dispute must be arbitrated.

Thus, if a redemption debt is not paid in similar circumstances, the shareholder should consider issuing a statutory demand for payment under the Companies Act. Depending on the company’s response, it may be appropriate to commence winding up proceedings, seeking the Cayman court to apply the HKIAC Tribunal’s reasoning in the Grand State case.[11]

With this approach, the multi-year enforcement process seen in Grand State might be avoided and enforcement costs significantly reduced. Success in winding up proceedings will result in the appointment of an official liquidator to the Cayman holding company. The liquidator would then commonly take control of the group to protect and preserve its assets and operations, and ultimately, may restructure the group and/or distribute funds to creditors and shareholders.

[1] Redemption rights have traditionally been available to shareholders in open-ended investment funds, allowing investors to redeem on periodic redemption days at the net asset value of the fund. In contrast, redemption under the ‘red chip’ structure is often available only after certain ‘trigger’ events, and at a pre-agreed price.

[2] The term ‘profit’ is not defined in the Companies Act. It should be determined applying relevant accounting principles. The term ‘share premium’ is the difference (if any) between the nominal or par value of a share (commonly US$0.0001) and the price at which the share was issued to an investor. The share premium (if any) should be held in a share premium account.

[3] Section 37(6)(a) of the Companies Act.

[4] Essentially, ordinary creditors should be paid in full prior to distributions to redeeming shareholder-creditors.

[5] Similarly, in the period following the commencement of the winding up of a company section 37(7) of the Companies Act authorises a redeeming shareholder to enforce the redemption against the company (i.e. to claim as a creditor in the liquidation), provided that: (i) the company could have lawfully paid the redemption prior to the commencement of the winding up (this imports the requirements in section 37(6)(a)); and (ii) the company’s ordinary creditors are paid in full in the liquidation before redeeming shareholders receive payment (section 37(7)).

[6] Management might also purport to confine their assessment of legally available funds solely to those available at the holding company level, ignoring assets, or even freely distributable cash, at the operating subsidiary level which could otherwise be distributed to the Cayman holding company to help satisfy redemptions.

[7] As most SHA’s include an arbitration clause, it is usually an arbitration tribunal, such as the HKIAC, that will decide the issue.

[8] The Tribunal construed the SHA but noted that the relevant provisions of the SHA were virtually identical to the Articles.

[9] In each case a Cayman company’s Articles/SHA are likely to contain differences, which may have a bearing on construction.

[10] In the author’s view, very clear language would be needed if the right of redemption itself is to be conditional upon the company having legally available funds to pay it.

[11] It should be observed that the second Cayman judgment in DE Shaw v Grand State does not constitute binding caselaw precedent on the meaning of the phrase ‘legally available funds’ and the implications of inclusion of that phrase in a Cayman holding company’s Articles. The HKIAC Tribunal ruled on the construction of the agreement, not the Cayman Court. Nevertheless, the Tribunal rendered a comprehensive ruling and that ruling was carefully considered and held to be enforceable in Cayman.