Segregated Portfolios Companies – The SPhinX Lesson
- Published: 05 May 2010 05 May 2010
Georges Boivin provides a case study of a hedge fund collapse of which the offshore hedge fund industry should take note.
A major bankruptcy case in the United States and Cayman courts involving the legal nature of a segregated portfolio company (‘SPC’) was seen by many hedge fund observers as the first occasion for the United States courts to test the statutory integrity of the SPC vehicle, that has found some popularity in the hedge funds industry. Although legal arguments raised a trust theory in relation to the statutory ‘firewall’ that distinguishes SPCs from regular limited liability companies, the United States courts in this case did not in fact test the statutory validity of an SPC. Nevertheless, close attention should be paid to the possibility that an era of judicial oversight could develop certain ground rules for interpreting the corner stone of the SPC.
The SPC offers the unique advantage of being able to ‘ring fence’ the assets and liabilities of several portfolios within the same fund company by using separate segregated portfolios, or cells as they are frequently called. Equivalents of the segregated portfolio company are also being used now in many jurisdictions around the world (including certain states of the US), which suggests that these vehicles are beginning to fall much more within the mainstream these days. Nevertheless, the well-advised founder of an SPC will always be given a health warning that the integrity of the structure has still not been tested by a court in any jurisdiction. They would typically be cautioned that if a challenge came before a foreign court that was unfamiliar with the segregated portfolio concept, the court may be unwilling to respect the structure. By a ‘foreign court’ we mean a court in a jurisdiction other than the jurisdiction in which the SPC is incorporated. If the foreign court is not willing to respect the structure, it is likely that it would treat the segregated portfolio company as a ‘regular’ company and simply allow the petitioning cell creditor to pierce the ‘firewall’ that protects the assets of other cells within the SPC.
The bankruptcy case mentioned above involves a number of Cayman SPCs. This case had the potential to provide some insight into how a foreign court may deal with this type of vehicle. My firm represents an interested party, but the facts set out in this article are derived entirely from publicly available documents. The case involves a group of connected hedge funds known as the SPhinX Funds. There are many strands to this particular bankruptcy, including cross-border issues between the US and the Cayman Islands, allegations of fraudulent preference, co-mingling of assets between cells, the legal nature of SPC cells and problematic valuations issues. A detailed analysis of the facts is beyond the scope of this article. However, a brief summary of the background is essential to an understanding of the SPC aspects.
The SPhinX Funds were established in 2002 as hedge fund trackers marketed to sophisticated investors through a master/feeder structure involving both onshore and offshore vehicles. The structure comprised 22 vehicles of which nine were Cayman SPCs with 68 cells between them. Each cell was operated by a different fund manager. All of the Cayman SPCs were put into liquidation in the summer of 2006 subject to the supervision of the Cayman courts. The collapse of the SPhinX Funds and their investment manager, PlusFunds Group Inc, was precipitated by the spectacular collapse of US commodities broker Refco LLC.
One of the SPCs in the SPhinX platform, SPhinX Managed Futures Funds SPC (SMFF), engaged Refco LLC and Refco Capital Markets Ltd (RCM) as its broker and the excess margin cash of each of the 15 cells of SMFF was deposited with RCM. In October 2005, just a few days before Refco’s petition for Chapter 11 Bankruptcy, RCM transferred US$312 million of excess cash held for the SMFF cells to accounts opened by the cells with Refco LLC. In turn, the same funds were transferred by Refco LLC to accounts held by the cells at other institutions.
In December 2005, the Refco creditors’ committee challenged in the US courts the US$312 million transfer as an unlawful preference. This became known as the Preference Action. The allegation was that in making this payment, the cells of SMFF were preferred over other Refco creditors. The US courts granted a temporary restraining order over SMFF and its cells, which prohibited the use of the funds held by the cells. The effect of this order was to prevent redemptions by investors in SMFF, and there was a knock-on effect in relation to redemptions in other SPhinX Funds.
In April 2006, the Preference Action was settled in a settlement agreement, subsequently approved by the US court, whereby the SPhinX Funds were required to make a payment of US$263 million to the Refco entities. The court approval of the settlement agreement was later appealed by a number of investors in the SPhinX Funds. In the Cayman liquidators’ first interim report to investors and creditors, they stated: “One of the most critical matters facing the joint voluntary liquidators is the Preference Action and the settlement of it.” The liquidators embarked on a strategy to try and unravel the settlement in a number of different legal proceedings, including separate litigation asserting that the settlement was a fraudulent preference under the Cayman Islands Companies Law.
However, the interesting feature for observers of SPCs arises from the legal advice that the Cayman liquidators sought from UK counsel regarding the SPCs, the cells and the impact of the SPC structure on the liquidation, including distributions to creditors and investors. As far as I am aware, this legal opinion has not been made public by the liquidators. However, the thrust of the advice is summarised in the third interim report of the liquidators, and it has aroused some strong feelings in some legal circles because of the so-called ‘trust theory’ expounded by the UK counsel.
According to the liquidators, UK counsel advised that an SPC is effectively a trust company with each cell having the characteristics of a separate and discreet trust managed by the SPC as trustee. The beneficiaries of each ‘trust’ are not just the shareholders (investors) of the cell but also the creditors of the cell. Further, the liquidation of an SPC does not alter the status of the SPC and its cells, and the liquidators are required to manage cell assets as trust property. If UK counsel’s advice is correct, the liquidators will find themselves in the unexpected position of having stepped into the shoes of the board of directors of a trust company!
As pointed out by the liquidators in their third interim report, this analysis gives rise to a number of implications. First, since there are unique trust rules to deal with situations where trust assets have been co-mingled, before any distribution can be made to creditors and/or investors, it is necessary to establish whether those rules apply. Second, because the core of the SPC has no assets to meet the costs and expenses of the liquidators, the liquidators have no option but to look to the assets of the cells. However, if cell assets are indeed trust assets and the liquidators are trustees, then there are specific trust rules that govern the right of a trustee to seek costs and expenses under the trustee’s indemnity. As is not uncommon, the liquidators are managing the liquidation of the SPhinX Funds with the assistance of a liquidation committee representing a majority of the creditors. However, if cell assets are trust assets, there is at least a question mark over whether the estate can continue to be managed in this way and whether more regular recourse to the courts and other interested parties is required.
In short, the legal advice obtained from UK counsel somewhat placed “a spanner in the works”, adding the potential for even greater complexity to this already difficult liquidation. It should be noted that the trust theory also cast doubt on the authority of the directors of SMMF to enter into the settlement agreement that concluded the Preference Action, and the liquidators added this point to the challenge to the settlement agreement in the US courts.
The liquidation committee disagreed with the trust theory of the liquidators’ UK counsel and obtained its own opinion from another UK counsel. The conclusion reached in this subsequent opinion was to reject the trust theory. This was essentially on the ground that the SPC provisions in the Cayman Islands Companies Law provided a comprehensive statutory scheme for the operation of an SPC, both pre-liquidation and post-liquidation, and it was not appropriate to overlay this framework with principles of trust law. RCM also obtained an opinion from a UK counsel which disagreed with the trust theory of the liquidators’ UK counsel.
An important question for those concerned with SPCs is which legal counsel is correct? The liquidators have sought to address the contradiction between the counsels by distinguishing the opinions on the grounds that their counsel’s trust theory only applies in circumstances where there is a co-mingling of funds between different cells of an SPC contrary to Cayman Islands Companies Law. In the case of a properly run SPC, it would appear that they do not disagree with the liquidation committee’s counsel. It would have been fascinating to have seen how the Cayman courts would have determined these issues, which go to the very fundamentals of the nature of an SPC.
Hearings before the Cayman courts expected during 2007 have still not taken place at the time of writing this article, but the trust theory issue has been adjourned indefinitely whilst the liquidators and the liquidation committee seek a practical solution in trying to agree a scheme of arrangement to resolve investor and creditor claims. The October 2007 judgment in the US Court of Appeals upheld the settlement agreement but took no regard of the fact that SMMF was an SPC. The judgment states that “bankruptcy court is not the appropriate forum in which to resolve investor disputes with the Sphinx board”. It therefore seems likely that SPC observers will be deprived of judicial insight into this important issue, but no one can fault the liquidators and the liquidation committee for seeking a sensible, practical solution rather than incurring fees on complex jurisprudence.
The task for the owners and operators of SPCs is to determine the effect of the SPhinX case. It is not the case that gives clear insight into how a foreign court will deal with the unique features of an SPC. For that we will need to await another case and that time will surely come. Whilst the trust theory outlined above does not, with all due respect to the legal counsel, appear to carry a great deal of merit, it clearly cannot be ignored as a theory that a court might be persuaded to follow where segregated portfolios assets have been co-mingled. Directors of SPCs should therefore take note that they might be regarded as directors of a trust company in such circumstances. The lesson to take from the SPhinX case is the fundamental importance in ensuring that segregation of assets and liabilities of all segregated portfolios is maintained on a permanent basis after the set-up of the SPC legal structure.