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Private Fund Disputes: Now + Next

Table of Contents—2013 Private Fund Disputes Alerts

New developments in recovery efforts for Madoff investorsDecember 19, 2013

Private equity firms may be liable for unfunded pension obligations of portfoliocompaniesAugust 27, 2013

"But I thought we were just negotiating"—Are the good faith provisions in a termsheet 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, 2013May 31, 2013

Second Circuit holds that Madoff feeder fund's "center of main interests" is located inBritish Virgin IslandsMay 1, 2013

Recent BVI decisions offer guidance to investors and funds facing redemption disputesApril 2, 2013

This newsletter is intended as an information source for the clients and friends of Nixon Peabody LLP. The content should not be construedas legal advice, and readers should not act upon information in the publication without professional counsel. This material may be consideredadvertising under certain rules of professional conduct. Copyright © 2013 Nixon Peabody LLP. All rights reserved.

New developments in recovery efforts for Madoffinvestors

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

1Sec. Investor Prot. Corp. v. Bernard L. Madoff Inv. Secs. LLC, 2013 U.S. Dist. LEXIS 172952 (S.D.N.Y. 2013)

Private Fund Disputes alert | Nixon peabody LLP

December 19, 2013

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 [email protected] or 617-345-1119

— Kathleen Ceglarski Burns at [email protected] or 617-345-1109

— Jonathan Sablone at [email protected] or 617-345-1342


Private equity firms may be liable for unfundedpension 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,

1No. 12-2312, 2013 U.S. App. LEXIS 15190 (1st Cir. July 24, 2013).


August 27, 2013

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 [email protected] or (212) 224-6395

— Matthew T. McLaughlin at [email protected] or (617) 345-6154

2Id. at *4. The court remanded the case back to the district court for further factual findings with respect to the

other Sun Funds.


“But I thought we were just negotiating”—Are thegood faith provisions in a term sheet or letter ofintent 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.


July 24, 2013

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.


attorney or:

— Stephen M. LaRose at [email protected] or (617) 345-1119

— Kathleen Burns at [email protected] or (617) 345-1109

1Opinion 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).


Whose claim is it anyway—the investment fund's orthe 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


May 31, 2013

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

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.


attorney or:

— Stephen LaRose at [email protected] or (617) 345-1119

— Danielle McLaughlin at [email protected] or (617) 345-1068


Second Circuit holds that Madoff feeder fund's"center of main interests" is located in British VirginIslands

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


May 1, 2013

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

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.”


attorney or:


— Anthony J. Galdieri at [email protected] or (603) 628-4046


Recent BVI decisions offer guidance to investors andfunds 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.


April 2, 2013

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,

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.


attorney or:


— Kathleen Ceglarski Burns at [email protected] or (617) 345-1109

np private fund disputes: now + next

Business

madoff investors

behalf of blmis customers

common law claims

behalf of customers

sipa trustee

pool of funds

blmis liquidation proceedings

certain assigned claims