Cayman Islands counterparty insolvency risks - general
A particular feature of the official liquidation process in the Cayman Islands can lead to uncertainty for those facing a Cayman Islands counterparty in an insolvency scenario. Official liquidation of a Cayman Islands company is commenced by the court making a winding up order. The court process is initiated by the filing of a winding up petition. If a winding up order is made, the liquidation is deemed to have commenced on the date the winding up petition was filed. This is important because any disposition of the company’s property, any transfer of shares and any alteration in the status of the company’s shareholders purportedly made after the deemed commencement of winding up is void unless the court orders otherwise. This means that there will be uncertainty between the date upon which a winding up petition is filed and the date of the hearing at which the court will determine whether the company is to be wound up. It would be possible to apply to court for an order to validate any transaction that involves the disposition of the Cayman Islands company’s property or, where it is also the issuer, any transfer of shares in the counterparty issuer or alteration in the status of its shareholders. However, there can be no guarantee that the court would validate a particular transaction, as there would be a number of factors to be considered (eg, the solvency of the company). Of course, if no winding up order were to be made, then the company would be able to perform the transaction as contemplated by its terms.
When a liquidator has been appointed in respect of a Cayman Islands company, there are different proceedings that the liquidator may bring to challenge transactions of the company, which are outlined below.
A transaction that constitutes a voidable preference is invalid and will be reversed such that the parties will, to the extent able, be put back into the position they were in prior to entry into the transaction. A transaction that involves or consists of a transfer of property or payment obligation will be a voidable preference where the transaction was made:
- by a Cayman Islands company in favour of a creditor within six months immediately preceding the commencement of the liquidation of the company;
- at a time when the company was unable to pay its debts on a cash-flow basis; and
- with a view to giving the creditor a preference over other creditors. English judicial authority (which is persuasive although not technically binding in the Cayman Islands) indicates that acting ‘with a view’ to preferring one creditor over another means that it is the company’s dominant intention to do so.
Fraudulent disposition or disposition at an undervalue
Any disposition of property made at an undervalue (which means for no consideration or for consideration the value of which is significantly less than the value of the property disposed of) by or on behalf of a company with the intention of defrauding its creditors (which means an intention wilfully to defeat an obligation owed to a creditor that existed on or prior to the date of the disposition) is voidable at the instance of the company’s official liquidator. If these elements are present, the transaction is also voidable at the instance of a creditor that is prejudiced by it (although such a claim can be made outside of the company’s liquidation). However, such action by a liquidator or creditor cannot be commenced more than six years after the relevant disposition. If a transaction is set aside on this ground then if the court is satisfied that the transferee has not acted in bad faith, the transferee will have a first and paramount charge over the property that is the subject of the disposition in an amount equal to the costs properly incurred by the transferee in defending the proceedings, and the disposition will be set aside subject to the proper fees, costs, pre-existing rights, claims and interests of the transferee.
This statutory cause of action requires the liquidator to establish that certain business of the company has been carried on with intent to defraud creditors of the company or of any other person or for any fraudulent purpose. The court may declare that any person who was knowingly party to carrying on the company’s business in such manner is liable to make such contributions to the company’s assets as the court deems proper. This power is very wide, allowing a liquidator to seek redress from any such knowing party to the fraudulent trading. There is no limitation period for fraudulent trading actions brought by a liquidator.
A liquidator may bring proceedings against the directors of the company in liquidation for breach of their fiduciary duties owed to the company, for example, where the company (by its directors) knowingly divests itself of an asset at an undervalue in breach of the directors’ duty to act in the best interests of the company. If the recipient of the property ‘knew’ that it was receiving the property as a result of a breach of fiduciary duty, the liquidator may seek, as part of its relief, a declaration that the recipient is holding the property on constructive trust for the company. Based on English judicial authority (which is persuasive although not technically binding in the Cayman Islands), the test for the required level of knowledge is whether the recipient knew enough of the facts surrounding the breach of fiduciary duty to make it unconscionable for it to retain the benefit received.
It should be noted that constructive trust claims are not exclusively available to a liquidator and may arise pre-insolvency. However, a claim based on a breach of fiduciary duty is a claim of the company. As a practical matter, it may be unlikely that the company’s directors would cause the company to commence proceedings against themselves. A shareholder derivative action may be possible with the leave of the court, but dissatisfied creditors would have no standing to make a claim of this kind. The creditors’ remedy in that situation, if the company is on the brink of insolvency or is insolvent, would be to petition for the winding up of the company and to seek the company’s liquidator to pursue any claims against the directors.
Insolvency risks - where the counterparty is the issuer
Where the counterparty is the issuer of shares that are the subject of an OTC equity derivatives transaction, the transaction is one that is in respect of the counterparty’s shares rather than its assets.
As noted in the first paragraph above, any transfer of shares in a Cayman Islands company and any alteration in the status of the company’s shareholders purportedly made after the commencement of a winding up of the company is void unless the court orders otherwise.
To the extent that the issuer will, or may, acquire its own shares under an OTC equity derivatives transaction, the share purchase regime under the Companies Law would apply in respect of the transaction. As indicated in question 7, it is important that the issuer is solvent at the time that it makes any payment to acquire its own shares and continues to be solvent immediately following any such payment.
Under the share purchase regime of the Companies Law, if at the commencement of the winding up of a Cayman Islands company any of its shares that it agreed to purchase have not been purchased, the purchase agreement may be enforced against the company unless either:
- the purchase was to take place on a date later than the commencement of the winding up; or
- in the period from the agreed purchase date to the commencement of the winding up, the company could not, at any time, have made a distribution equal to the purchase price because immediately following the date of such distribution it would not have been able to pay its debts in the ordinary course of business.
Another important consequence of the liquidation of the counterparty issuer is that any claim for the payment of share purchase monies would be subordinated. If a shareholder is able to enforce the share purchase agreement with the issuer (as described in the previous paragraph), such amount would be subordinated to all other debts and liabilities of the company (other than any due to shareholders in their character as such), and any amount due to satisfy any preferential rights of other classes of shares of the issuer. More generally, in a liquidation of a Cayman Islands company, the claims of shareholders against the company are subordinated to the claims of unsecured creditors.
In the context of an OTC equity derivatives transaction, the risk of not being able to enforce the obligations of an issuer to pay for its shares when that issuer is in liquidation may be mitigated if certain termination or settlement provisions are structured into the transactions, the effect of which may be to change the overall nature of the characterisation of the transaction.
Many OTC equity derivatives transactions are structured so that the only payments to be made by the issuer are at inception, in circumstances where the issuer’s solvency at such time can be determined, so as to reduce further the potentially adverse consequences.
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