The Judicial Committee of the Privy Council in London (JCPC), the highest court of appeal of the Cayman Islands, found that redemption payments to a former shareholder that are made from the share premium account are payments out of capital. It also found that if such payments are made when the company is not solvent then they are unlawful acts by the company.

Case: DD Growth Premium 2X Fund (In Official Liquidation) v RMF Market Neutral Strategies (Master) Limited [2017] UKPC 36

What happened here?

The Liquidators of DD Growth Premium 2X Fund (In Official Liquidation) (‘DD Growth’) sued RMF Market Neutral Strategies (Master) Limited  (‘RMF’) to recover payments made to RMF in partial satisfaction of the sums due to it as a former shareholder that had redeemed shares in DD Growth. The payments were made when the DD Growth was not solvent as it was unable to pay all redemptions due in full.

Does that mean the payments can be recovered?

We don’t know that yet. The JCPC also found that whilst the payments were unlawful the redemptions by RMF as former shareholders were lawful transactions for value, so the payments were not recoverable from RMF under the common law principle of unjust enrichment. It recommended that the matter be returned to the Grand Court for it to consider whether the unlawful redemption payments can be recovered from RMF on the basis that it holds the payment on constructive trust for DD Growth due to RMF being involved in the ‘knowing receipt’ of an unlawful payment (discussed below).

Why are the payments unlawful?

Contrary to the findings of the Grand Court and the Cayman Islands Court of Appeal, the JCPC found that redemption payments made out of the share premiums received when the shares were sold were payments out of capital. The JCPC considered section 37(5)(a), (b) and (f) of the Companies Law (2007 Revision) (‘Co Law’) whereby ‘capital’ for the purpose of s.37(6) is any payment not made out of either profit or the proceeds of a fresh issue of new shares. The redemption payments to RMF were not from either of these sources and so they were a payment from capital.

How did the JCPC disagree with the lower courts?

The JCPC rejected the arguments that the lower courts had accepted that the clear language of section 37(5) and (6) of the Co Law was displaced by language in other sections of the Co Law, taking into account the subject and purpose of those other sections. It also considered the fact that had those drafting the legislation intended that payment out of share premium would not count as a payment from capital then they would have drafted the legislation accordingly, but they did not do so.

What does the Co Law say?

Section 37(6)(a) of the relevant Companies Law (the 2007 Revision) (‘s.37(6)’) provides:

‘A payment out of capital by a company for the redemption or purchase of its own shares is not lawful unless immediately following the date on which the payment out of capital is proposed to be made the company shall be able to pay its debts as they fall due in the ordinary course of business.

How did that apply here?

At the time RMF received the redemption payment, which was made from capital of DD Growth, it (and all the other former shareholders who had redeemed) only received a partial payment of the full sum due to them. The courts at all levels agreed that an inability to pay 100% of redemption payments that are due at any given time means that a company is unable to pay its debts as they fall due in the ordinary course of business. That meant DD Growth was insolvent when it made the partial redemption payment to RMF. On that basis section 37(6)(a) meant the payment was unlawful.

So why couldn’t DD Growth get the unlawful payment back from RMF?

The JCPC found that the payments could not be recovered from RMF under the common law principle of unjust enrichment (i.e. where a person has gained unfairly at the claimant's expense e.g. by chance, by mistake or unfairly but not necessarily wrongdoing) as the redemptions were lawful transactions and RMF had not acted unlawfully in any way. It had simply received payments which were legally and undisputedly due to it in transactions where it had given ‘full consideration’ by redeeming its shares.

The JCPC stated that the fulfilment of the conditions imposed by section 37(6)(a) is a matter of internal administration of a company and that an authorisation of a payment where there is a failure to meet the conditions is a breach of trust on the part of the directors. However, they found it “is fundamental that a payment cannot amount to enrichment if it was made for full consideration; and that it cannot be unjust to receive or retain it if it was made in satisfaction of a legal right.”

What about constructive trusts?

Having rejected the liquidators’ argument that RMF had to repay DD Growth on the basis that the redemption payment was unlawful and that there had been no unjust enrichment of RMF, the JCPC considered  that DD Growth’s alternative argument, that RMF was holding the redemption payments on constructive trust for DD Growth by virtue of knowing receipt, needed to be decided.

So what happens next?

The JCPC stated,

The Board concludes that the Company is not entitled to recover the payments at common law on the ground of unjust enrichment.  The reality of the present case is that a payment has been received from a company for lawful consideration but it has been authorised by its directors in breach of their duties to the Company.  This is the proper domain of the law of constructive trusts [Emphasis added].  Not even in return for good consideration can a person retain assets which he knows to have been paid to him in breach of the statutory duties of the directors.  But knowledge, especially in relation to apparently routine transactions where lawfulness depends on the internal affairs of the Company, may be hard to prove.” 

The lower courts had not needed to make any decision on this point because they decided the payment to RMF was lawful. The JCPC directed that the question be remitted back to the Grand Court for them to decide.

What will the courts look at to decide if RMF have to repay DD Growth ?

If RMF was aware at the time of receipt that the payment being made was unlawful and made in breach of the directors’ duties to DD Growth (i.e. there was ‘knowing receipt’ by RMF) then RMF could be considered to be holding that money on constructive trust for DD Growth. The legal elements for knowing receipt claims are that the recipient of a payment:

(1) knowingly receives trust property in breach of trust but does not deal with it by returning it to the rightful owner(s); or

(2) receives trust property in breach of trust without knowledge of the trust but subsequently deals with it in a manner inconsistent with the trusts of which he has become aware; or

(3) receives trust property knowing it to be such but without breach of trust and subsequently deals with it in a manner inconsistent with the trusts.

What constitutes knowledge?

Knowledge in this context can be actual or constructive knowledge. RMF would be deemed to have knowledge of the Co Law provisions which state when a redemption payment is unlawful. Whether RMF will be deemed to have knowledge of the qualifying conditions (i.e. that the payment it received was out of capital and that DD Growth was insolvent) is likely to be much harder to prove.

What next?

Whether this route will allow the company’s liquidators to recover the payments is now a matter for the Grand Court. It is likely to take 6 – 9 months for a decision to be made. Once it is we will know whether a ‘ knowing receipt’ claim provides a better route to claw back a redemption payment than the more conventional claim for a preference under the Co Law, which requires establishing an intention to prefer one creditor ahead of the others. The difficulty in each type of claim is proving what was known and what was in the mind of a person at the time the payment was made and that is always going to be challenging and uncertain.

Solomon Harris

We at Solomon Harris have many years of experience in all forms of disputes arising from fund liquidations, including repayment of unlawful redemption payments. If you are would like further information on how we can help contact KMcGriele@solomonharris.com.

Disclaimer
The information contained in this article is necessarily brief and general in nature and does not constitute legal advice. Appropriate legal or other professional advice should be sought for any specific matter.

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Redemption payments made when insolvent are unlawful, but so what?...

The Judicial Committee of the Privy Council in London (JCPC), the highest court of appeal ...


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