A US bankruptcy court ruling last week concerning two failed hedge funds incorporated in the Cayman Islands could have implications for other troubled hedge funds incorporated off-shore.
The court ruled the two hedge funds could not protect themselves from claims by US creditors by liquidating in the Cayman Islands.
But according to finance experts on Grand Cayman, the ruling will not make the Cayman Islands any less attractive as an investment location for fund managers.
The two Bear Stearns' funds at the center of the proceedings - estimated to have had more than US$1.5 billion of capital as recently as March - filed for bankruptcy on 31 July after suffering large losses on the US subprime mortgage market.
Provisional liquidators now think recoveries for the two funds will amount to US$25 million and US$50 million respectively.
A stay of proceedings against lawsuits was applied for with respect to the two funds in the US, arguing that they had a liquidation proceeding pending in the Cayman Islands.
To have the application granted, the funds needed to satisfy the court that their 'center of main interests' was located in the Cayman Islands, or that they had an 'establishment' here even though the Cayman Islands was not their center of main interests.
US Bankruptcy court Judge Burton Lifland refused the application " but granted 30 days temporary protection from US lawsuits - saying the only connection the funds had with the Cayman Islands was that they were registered here.
"There are no employees or managers in the Cayman Islands. The investment manager for the funds is in New York. The administrator that runs the back-office operation of the funds is in the United States along with the funds' books and records, and prior to the commencement of the foreign proceeding, all of the funds' liquid assets were located in the United States," Judge Lifland wrote in his judgment.
Kurt Mayer, a US bankruptcy law expert with Bracewell and Giuliani in Connecticut said the decision came as a surprise and would set a strong precedent for other troubled hedge funds that are incorporated outside of the US, but whose assets and operations are truly based in the US.
Some commentators in the US have said the decision will make it easier for creditors to recoup losses from failed hedge funds, sighting an alleged tendency of courts in the Cayman Islands to favour management.
But according to Ben Mays, a Senior Associate in Maples and Calder's Litigation and Insolvency team, that perception is unwarranted.
"It is simply misinformed to suggest that liquidating in the Cayman Islands benefits management to the detriment of creditors or investors," he said Monday.
"The Judiciary in the Cayman Islands has a firm grasp of the importance and nature of the Cayman Islands' role as a centre of international finance, and of the rights and needs of creditors and investors.
"There is no judicial practice of 'favouring management'," he said.
Mr. Mays said it is important to remember the decision is not a ruling on the Cayman Islands but on how US rules apply, as a matter of US law, to specific sets of facts rather than jurisdictions.
"No other jurisdiction has gained a competitive edge against the Cayman Islands as a result of this decision because the US rules in question apply to everyone, and not just the Cayman Islands."
Ridley said the decision was unlikely to change the attractiveness of the Cayman Islands as an incorporation location for hedge funds.
"I seriously doubt that the likely suits of any liquidation or insolvency or bankruptcy proceeding for the fund entered the minds of the various professionals when setting up the fund in Cayman," he said.
"I also seriously doubt that fund promoters decided to domicile funds in Cayman in order to protect themselves against lawsuits from US investors or creditors."
Mr. Ridley said Cayman is chosen as a preferred domicile for hedge funds because of a mix of regulatory, tax, speed, efficiency and cost considerations, and that the jurisdiction has a mature and well tested regime for bankruptcies, insolvencies and liquidations.
"The courts have shown themselves well able to handle complex cross-border proceedings and to handle the claims of creditors and investors."
Mr. Ridley said the key issue is not lawsuits, but finding the best way of dealing fairly, efficiently and promptly with the claims of creditors and investors in such cases.
"In some cases, the US courts may be best placed to take the lead in handling these matters; in other cases the Cayman courts may be the most appropriate."
If fund promoters want to ensure that Cayman courts have primacy in future liquidation proceedings, they can ensure this by conducting more real activities in Cayman, Mr. Ridley explained.
The ruling comes at a time when the number of hedge funds incorporated in the Cayman Islands is proliferating.
According to CIMA Managing Director Cindy Scotland, there were 8,300 registered funds in the Cayman Islands as of 30 June 2007. 90 per cent of these could be characterized as hedge funds, she said.
The two Bear Stearns' funds are just another casualty in a subprime mortgage lending crisis that some analysts predict could foreshadow a recession in the US.
The subprime market is geared towards borrowers with tainted credit histories, who are charged high interest rates. A recent spike in early payment defaults has precipitated the crisis and caused panic in markets. Some are now questioning whether those loans, to people with weak credit histories, were prudent at all.
Last week an Australian managed fund incorporated in the Cayman Islands, Capital Fund Management Ltd., filed for bankruptcy, saying losses in its Basis Yield Alpha Fund - worth US $1 billion as recently as May -could exceed 80 per cent due to defaults in US subprime mortgages.
Like the Bear Stearns' funds, it has also applied for protection from the US Bankruptcy Court, asking for a bar on US lawsuits while it liquidates here. That application must now be in doubt after Judge Lifland's ruling last week.