The voidable preference claim, as it is construed under Cayman Islands law, enables liquidators to have the court invalidate a payment that was made to a creditor within the six months preceding the commencement of a liquidation, where they can establish that the payment was made while the company was unable to pay its debts as they fell due (ie, that it was cash flow insolvent) and with the dominant intention of preferring the paid creditor over other creditors.
The position prior to Weavering v SEB
The voidable preference provision has long been a part of the insolvency regime in the Cayman Islands. Notwithstanding its antiquity, there had been only two known instances prior to the Weavering liquidation where liquidators had pursued such a claim through to final judgment: Segoes Services Ltd v Ueoka (2005); and RMF Market Neutral Strategies v DD Growth (2014).
The distinct lack of appetite for pursuing such claims, at least prior to Weavering, has lain in the need for the liquidator to establish, either by direct evidence or as a matter of inference, that the company made the payment with the dominant intention of preferring the receiving creditor over others.
That was generally believed to be very difficult to do in all but the most extreme cases of preferential treatment. Indeed, in England and Wales, the corresponding statutory provision was amended to replace the dominant intention requirement with the less onerous requirement to prove that the decision to make the payment was “influenced by a desire” to put the receiving creditor in a better position than it would be following the liquidation of the company. Liquidators are often faced with limited evidence and the only testimony as to the intention of the company rests with those who have been discredited owing to their fraudulent management of the company.
Segoes was an extreme case: a director had preferred his wife over other creditors while knowing that the company was insolvent and that other creditors had demanded payment. In those circumstances, the court found irresistible the inference of a dominant intention to prefer. The insolvency regime in fact provides that payments to parties related to the debtor company are deemed to have been made with the necessary dominant intention to prefer.
However, the judgment in DD Growth seemed to affirm the prevailing view that claims against unrelated creditors were considerably more difficult to prove. DD Growth Premium 2X Fund (DD2X) was an open-ended investment fund established by Italian academic Alberto Micalizzi as part of a typical master-feeder structure. Investors in DD2X subscribed for redeemable participating shares, and DD2X then invested substantially all of its capital, purportedly on a leveraged basis, alongside other feeder funds in its master fund (DD Master), of which Micalizzi was also a director. As a result, DD2X was reliant upon DD Master for cash to satisfy redemption requests from DD2X’s own investors.
DD Master suffered catastrophic losses in its investments when the derivatives market collapsed in October 2008, which rendered it cash flow insolvent. Micalizzi sought to conceal those losses by purchasing bonds that were then recorded at an inflated value in the books of DD Master, creating false profits that artificially inflated the net asset value upon which redemptions and subscriptions were based. These bonds were actually worthless, such that when significant redemption requests were received in the midst of the financial crisis, DD Master was unable to provide DD2X with sufficient cash and both were unable to pay their debts as they fell due.
During that time, investor RMF Market Neutral Strategies (RMF) submitted redemption requests totalling US$62.2 million. Over the course of January and February 2009, RMF received partial payments, which had the effect of putting it in a better position than various other creditors of DD2X. Despite Micalizzi’s efforts, DD2X was put into liquidation, and its liquidators sought to recover the payments which had been made while DD2X was insolvent, including those made to RMF.
In addressing the claim that the payments to RMF were voidable preferences, the Chief Justice confirmed that the intention to prefer must be the principal or dominant intention. The Chief Justice also confirmed that the court was obliged to discern whether the dominant intention behind making the payment was to prefer in the sense of deliberately paying out of turn while being aware of the consequences for the unpaid creditors; or whether the payment may have been motivated by other concerns such as to avoid the detection of a criminal act or relieve threats being made by the creditor. The latter motivations are not impelled predominantly by an intention to prefer the creditor, even if preference is the consequence of payment.
The Chief Justice inferred that Micalizzi had directed that RMF be paid because he was seeking to postpone the inevitable revelation of the true state of affairs; not because he had intended in these circumstances to prefer RMF over other creditors in the hope of keeping it as a client.
In reaching that conclusion, the Chief Justice cited the observation made in the judgment of the Privy Council in Fairfield Sentry v Migani that it is “inherent in a Ponzi scheme that those who withdraw their funds before the scheme collapses escape without loss, and quite possibly with substantial fictitious profits. The loss falls entirely on those investors whose funds are still invested when the money runs out and the scheme fails”.
Most investment funds that issue redeemable shares will do so with a regular redemption date, and there is therefore a natural priority among creditors as a result of this regular process. In a properly run fund, this is not problematic: the investors who remain have signed up to a risk that investments may go down in value, but in a fund that is exposed to fraud, the loss then falls on the last investors present when the money runs out. The primary rationale of insolvency law is to remove unfair preferences to which creditors have been subjected against their will; not to subvert those inherent priorities to which the investors have agreed.
The judgment of the Chief Justice sent a strong signal that the court would not lightly infer that a company held the dominant intention to prefer a particular creditor to facilitate recovery just because the wrongdoing that led to its insolvency was egregious and other creditors had lost out considerably.
Weavering v SEB
However, the recent Court of Appeal judgment in Weavering Macro Fixed Income Fund Ltd v Skandinaviska Enskilda Banken has given impetus – perhaps falsely – to voidable preference claims more generally. In that case, the liquidators succeeded with their voidable preference claims against a redeemed investor, although an appeal to the Privy Council is pending.
Weavering Macro was established as an open-ended investment fund, in which investors were able to subscribe for redeemable participating shares. It was controlled by Magnus Peterson, who was the CEO and a director of its investment manager; he was also the brother and stepson of its de jure directors, who played a negligible role in its management and merely approved his decisions.
Weavering Macro had entered into a number of interest rate swaps with a related company within the Weavering group, which had the same investment manager controlled by Peterson. The swaps were fictitious: the counterparty was never in a position to honour its obligations under them, having had no realisable assets. Peterson simply used the swaps to give the impression that Weavering Macro was consistently making gains for its investors, while the reality was that he was operating Weavering Macro as a Ponzi scheme.
Following the collapse of Lehman Brothers in September 2008, a large number of the Weavering Macro shareholders, including the defendant SEB, submitted redemption requests. Weavering Macro became cash flow – and indeed balance sheet – insolvent shortly thereafter, as a result of those redemption liabilities arising. Notwithstanding this, and the fact that Peterson was aware of the position, a large proportion of the redemption requests were ultimately paid: SEB itself received redemption payments of US$1.1 million in December 2008, US$1.8 million in January 2009 and US$5.3 million in February 2009.
The trial judge found that there was direct evidence that Peterson had intended to prefer SEB and other Swedish redeemers when he instructed Weavering Macro’s administrator to make the redemption payments to them, which they received in December 2008. The evidence showed that he had intended to prefer SEB and other Swedish redeemers by making those payments for the purpose of them reinvesting the redemption proceeds in another Swedish-based fund, Rantehedge, which he managed.
There was no such evidence with respect to the January and February 2009 redemption payments that SEB received, but the trial judge nevertheless inferred that Peterson had held a continuing dominant intention to prefer SEB, effectively as a member of the previously preferred class of Swedish redeemers. The trial judge therefore held that those further payments were also voidable preferences.
On appeal, the Court of Appeal agreed that the necessary dominant intention was established with respect to the December 2008 redemption payment. However, it did not agree that the trial judge could properly infer that Peterson had continued to prefer SEB in the hope or belief that it would reinvest the proceeds in Rantehedge when the January and February 2009 redemption payments were made: while the evidence showed that Peterson clearly understood SEB held the shares as the nominee for two separate Swedish mutual funds, and that the December 2008 redemption payment had been made to SEB as the nominee for one (Catella), there was nothing to show that Peterson believed SEB would also reinvest the January and February 2009 redemption proceeds in Rantehedge, as the nominee for the other fund (HQ Solid).
Despite having reached that conclusion, the Court of Appeal went on to find that it would have been permissible for the trial judge to infer Peterson held the necessary dominant intention to prefer SEB when the January and February 2009 payments were made, because the trial judge had also found that Peterson knew Weavering Macro was cash flow insolvent at the material times and nevertheless caused it to adopt a policy that was “designed” and “intended” to allow the investors who had submitted redemption requests, which fell due in December 2008, to be paid ahead of later redeemers. The Court of Appeal accordingly held that the January and February 2009 payments were also voidable preferences.
Court of Appeal
What is most interesting about the conclusion that the Court of Appeal ultimately reached in Weavering v SEB regarding the January and February 2009 payments, is that it was largely based upon Peterson having implemented a policy pursuant to which redeeming investors were paid, while knowing full well that Weavering Macro was cash flow insolvent.
The Court of Appeal described the policy as having been designed to prefer the redeemers who would be paid in accordance with it. However, it is clear from the judgment below that the policy did not actually disclose or even suggest any preferential reason for paying the redeeming investors: it only explained how much and when the redeeming investors could expect to be paid, and that the intended approach to payment, which involved potentially paying all smaller redeemers ahead of larger contemporaneous redeemers, was being taken in order to protect the net asset value of the fund and the interests of remaining shareholders. The trial judge made no finding that the policy had been crafted predominantly to ensure that the redeemers to whom it applied would be paid ahead of the rest, beyond the natural priority established by the monthly redemption process itself. Yet the Court of Appeal went on to hold that its implementation in the circumstances was sufficient to support the inference of a dominant intention to prefer.
It is well settled that the court should not, in the absence of direct evidence, infer a dominant intention to prefer if the inference to be drawn from the facts is equivocal. Where there is room for more than one explanation, such inferences cannot properly be drawn.
In Weavering v SEB it must have been at least equally plausible that Peterson had implemented the payment policy with a view to postponing discovery of the fraud, as the court in DD Growth inferred that Micalizzi had intended when making redemption payments to RMF. There was no direct evidence in Weavering v SEB to suggest otherwise.
Unfortunately, it appears that in Weavering v SEB, one impermissible inference was simply replaced by another on appeal, both inferences perhaps having been driven by findings that the wrongdoing, which led to the insolvency, was egregious.
The apparent readiness of the trial judge and the Court of Appeal in Weavering v SEB to infer the necessary dominant intention should nevertheless be concerning for custodians in the investment fund context: although they typically hold the shares and receive redemption payments only on behalf of underlying investors, they are first in the line of fire for this kind of claim.
Open-ended investment funds such as Weavering Macro and DD2X will issue participating shares that are redeemable on demand at specified intervals, usually monthly. Even where the insolvency has been brought on by fraud and those in control are doubtless motivated to delay its discovery by keeping up impressions of normality for as long as possible, it is typical for earlier redeemers to be paid ahead of the later ones in the usual way. Although it remains the law that this only amounts to a creditor having in fact been preferred and the dominant intention to prefer still needs to be proved, the judgment of the Court of Appeal in Weavering v SEB may encourage liquidators to take a “hit and hope” approach in such circumstances, simply because of the manner in which the redeeming shareholders were paid.
A separate, even more troubling issue for custodians is the decision by the Court of Appeal that restitutionary defences, such as change of position and ministerial receipt, cannot be raised to defeat voidable preference claims. This means that that it will be immaterial to the question of liability whether a redeemed shareholder has already made use of the redemption proceeds in the honest belief that the payment was valid, or, by parity of reasoning, has already paid the proceeds over to its client pursuant to its obligations as custodian. Since liquidators are entitled to launch voidable preference claims up to six years after the relevant payments were made, and may wait until the end of that period to bring such claims because of their anticipated difficulties on the facts, it will almost invariably be the case that any custodian who is sued will have paid the redemption proceeds to its client, and by then might encounter practical difficulties in obtaining indemnification.
The decision conflicts with analogous English authority. It is perhaps unfortunate that the availability of such defences was left undecided in DD Growth – although both parties had proceeded on the assumption that restitutionary defences would apply if supported by the facts. It now represents the position under Cayman Islands law, unless or until it is overturned by the Privy Council on the further appeal, with the result that custodians are presently at risk of being left considerably out of pocket, often with no recourse to their own clients so long after the event.
Weavering v SEB does not, by its reasoning, purport to alter the law with respect to the dominant intention requirement, nor the law of evidence as to the circumstances in which particular facts may properly be inferred. However, the mere fact the Court of Appeal was prepared to infer a dominant intention to prefer based on Peterson’s knowledge that the fund was insolvent and his implementation of a payment policy, is apt to have precedential impact: first instance judges may feel compelled to reach the same conclusion in other cases where, even without fraud, redemption payments continued while those in control knew or should have known that the fund was insolvent.
If the judgment turns out to have that effect, the Court of Appeal will have emasculated the standard set by statute and removed the need to establish that any apparent intention to prefer was actually the dominant intention – a major policy decision that should only be taken by the legislature, as was done in England. Weavering has certainly been taken by some to signal a resurgence of voidable preference claims by liquidators of insolvent hedge funds. Whether this becomes a mainstay in Cayman liquidators’ armouries will depend on the decision of the Privy Council later this year.
Originally published in Global Restructuring Review, April 2017