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Comment: Is Chapter 15 now a closed book for hedge funds?

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Jeremy Walton, a partner in the litigation practice group at international law firm Appleby and head of the firm’s fund disputes team, says the ruling by a US court on the liquidation of t

Jeremy Walton, a partner in the litigation practice group at international law firm Appleby and head of the firm’s fund disputes team, says the ruling by a US court on the liquidation of two Bear Stearns hedge funds in the Cayman Islands does not necessary rule out Chapter 15 bankruptcies for offshore hedge funds in the future.

The US District Court for the Southern District of New York has upheld the rejection of a petition by liquidators of the Bear Stearns High Grade Structured Credit funds for recognition of their liquidation proceedings in the Cayman Islands. This decision comes as no surprise to observers of this case, and some might paint a gloomy picture when discussing the future of Chapter 15 bankruptcies for hedge funds in the future. However, a close reading of the Court’s ruling suggests that there is still hope for the well-advised.

The Cayman liquidation did not qualify as a ‘foreign main proceeding’: the statutory presumption that Cayman as a place of incorporation of the funds was their centre of main interests was rebutted by contrary evidence. But the ruling went on to record that the funds did not qualify in part because of a failure or omission to show (a) that the fund directors had any substantial involvement in the business of the funds, or (b) that outside investors knew these were Cayman funds.

The Cayman liquidation also did not qualify as a ‘foreign non-main proceeding’ due to a failure to show that the funds had any place of operations in Cayman where they carried out ‘non-transitory economic activity’. This was based on the same evidentiary failings referred to above, and also on the lack of assets held by the funds in the Cayman Islands (a factor of doubtful relevance to this statutory test).

Significantly, there was no reference to the comments made by the judge in the court below that an exempted company (the type of company routinely used for incorporation of hedge funds) was prohibited by statute from conducting any business in Cayman. This was perhaps because the judge had heard no expert evidence on Cayman law before making these remarks, and the liquidators’ subsequent filings in the appeal showed such a conclusion to be untenable as a matter of Cayman law. It is hoped that we have seen the last of this argument from a US court.

At the same time, some general propositions were stated which might be surprising to some practitioners in the field of cross-border insolvency.

First, it was said that the shift from a ‘subjective comity-based process [under earlier bankruptcy law] to Chapter 15’s more rigid recognition standard is consistent with the general goals of the Model Law’. Supporters of the Model Law may argue that principles of comity should inform a court’s interpretation of its recognition standards as well as its subsequent grant of relief to aid a foreign liquidation.

Second, it was held that ‘principles of comity do not figure in the recognition analysis’, whereas post-recognition ‘conversely the relief is largely discretionary and turns on subjective factors that embody principles of comity’. However, this statement ignores the fact that the recognition of a foreign main proceeding leads automatically to the grant of a list of mandatory items of relief.

What does the future hold for Chapter 15 and possible filings by insolvent hedge funds or other offshore vehicles with substantial onshore dealings, in light of this ruling?

This appeal ruling may effectively be confined to its facts, and can readily be distinguished in another case that does not have such problematic circumstances.

The ruling also provides important lessons to be learned in terms of the evidence that should be submitted (or even generated) for successful recognition. The next Chapter 15 fund case will be presented quite differently.

The statutory term ‘non-transitory economic activity’ remains undefined and unexplained, save to say that certain ancillary functions (such as auditing work) will not qualify. In a case with better facts, foreign liquidators may still persuade the US Bankruptcy Court that an appropriately-structured fund comes within that term.

In particular, it would seem that substantial business activities by Cayman-resident directors and administrators of hedge funds (as long as it is adequately documented and evidenced) should qualify those funds for at least non-main recognition under Chapter 15.

In conclusion, while this ruling confirms the challenges for many distressed hedge funds that are considering bankruptcy, there may still be solutions that allow for a successful Chapter 15 filing.

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