Introduction
The Cayman Islands Court of Appeal (“CICA”) has delivered important and clarifying guidance on the admissibility and ranking of shareholder misrepresentation claims in Cayman Islands liquidations, having regard to the much-maligned rule in Houldsworth v City of Glasgow Bank (1880 5 App Cas 317).
Addressing joint appeals within the liquidations of two Cayman Islands companies – HQP Corporation Ltd and Direct Lending Income Feeder Fund Ltd (each in Official Liquidation) – the CICA was tasked with reconciling conflicting Grand Court judgments which considered for the first and second time in this jurisdiction the troubled rule in Houldsworth which (until its abolishment by English statute in 1989) provided an absolute bar against shareholders proving in a liquidation.
After a detailed trawl through the annals of commonwealth company law, the CICA concluded that the Houldsworth principle, as evolved over more than a century, remains part of Cayman Islands law and prevents subscribers for shares from proving for misrepresentation in a liquidation, but importantly only in competition with non‑member creditors. Giving effect to creditor primacy, the CICA held that once external creditors are paid or suitably provided for in a liquidation, shareholder misrepresentation claims may be admitted, at which point they are subject to statutory subordination of claims under section 49(g) of the Companies Act and, where applicable, the contractual liquidation waterfall in a company’s articles.
Background
The appeals arose from divergent Grand Court decisions pointing in opposite directions. While the facts in each case are materially different, both companies were affected by fraud:
- The Articles of Association in HQP included a “last in, first out” liquidation preference, where the most recent (Series D) investors receive a guaranteed return and uplift on their investment in priority to all earlier share classes, who would receive no return in the liquidation in light of HQP’s cash position. That had arisen because, at each series funding round, existing shareholders of HQP had agreed to amend the company’s Articles and subordinate their dividend rights to those of new investors. Subsequently, however, it transpired that there had been a pervasive and admitted fraud by HQP’s former chairman, who had misrepresented financial data and falsified documents to obtain new investment. Series D investors argued that Houldsworth barred misrepresentation claims, and that the waterfall in the Articles remained determinative of liquidation recoveries. Subscribers for shares in earlier share classes argued that misrepresentation claims should be allowed, and that such claims should rank pari passu with each other (and with other creditors). Notably, no shareholders in HQP had redeemed their shares as at the commencement of HQP’s liquidation and all, therefore, remained shareholders.
At first instance, Mr Justice Doyle declined to follow Houldsworth on the basis that, inter alia, it had been determined to be bad law and was abolished across much of the Commonwealth in recent decades, including in England in 1989. His Lordship held that subscriber misrepresentation claims were provable pari passu with unsecured debts because they were not claims arising within a claimant’s capacity as a member for the purposes of section 49(g). He further determined that the waterfall in the Articles did not apply to the priority of shareholder misrepresentation claims.
- By contrast, the issue in Direct Lending was primarily about the ranking of misrepresentation claims, if allowed, between redemption creditors (who had completed the steps to redeem but had not been paid at the start of the liquidation) and ordinary shareholders. Mr Justice Segal held there was a common law bar against such misrepresentation claims (arising from Houldsworth and related authorities in England), and this was grounded in the maintenance of capital principle which prevented shareholders competing with external creditors over the capital of a company. His Lordship interpreted Houldsworth as permitting shareholder claims to be made once all creditors were paid or provided for, with claims of redemption creditors ranking equally with misrepresentation claims within section 49(g).
The CICA’s Legal Analysis
First, the CICA held (following Segal J) that the rule in Houldsworth remains part of Cayman Islands law and the rule, properly construed, provides that a shareholder who has not rescinded their subscription contract before liquidation cannot, while remaining a member, prove for damages in competition with creditors when doing so would, in substance, amount to a return of capital. The CICA reached that conclusion based on maintenance of capital authorities (Addlestone, Trevor v Whitworth, Ooregum) and after considering the statutory scheme, including section 49(g). The CICA rejected arguments that section 139(1) of the Companies Act (upon which Doyle J had placed emphasis) displaced a Houldsworth‑type restriction.
Secondly, the CICA found shareholder misrepresentation claims are claims made “in [the] character of a member” under section 49(g) of the Companies Act, and thus rank behind creditor claims. Following the House of Lords’ decision in Soden v British & Commonwealth Holdings Plc [1988] AC 298, the CICA held that subscriber claims are functionally claims to refund capital contributed under the statutory contract, which are not permissible (in contrast to claims by a secondary market purchaser, which has not contributed capital to the company). Properly characterised, the CICA held that such claims are subordinated to non‑member creditor claims but become admissible once those creditors are paid.
Thirdly, on priorities the CICA dealt with the two cases differently. In Direct Lending it was held that redemption creditors and misrepresentation claimants rank pari passu once external creditors are satisfied; section 37(7) did not displace that outcome on the facts. In HQP, it was held that once misrepresentation claims become provable, they must still be treated in accordance with the contractual liquidation waterfall within the Articles; claimants therefore rank pari passu with the holders of the same class or classes of share as those to which the relevant misrepresentation claim relates. Misrepresentation claimants cannot claim a greater priority than they agreed to, even if a shareholder agreed to subordinate their rights as a result of fraud. In HQP, this would mean that later shareholders (who may not have been affected by the company’s misrepresentations) would still take priority over victims of fraud who were unlawfully induced to buy earlier share classes and subordinate their rights. The CICA recognised this decision may be thought of as unfair, because it deprives misrepresentation claimants in HQP of any meaningful remedy, but considered that its decision was most consistent with applicable law.
Practical Implications and takeaways
While the judgment confirms the existence of a remedy for shareholders who are the victims of misrepresentation, the reality is that such victims may only have a remedy in solvent liquidations (after the increased costs of adjudication of misrepresentation claims have been provided for). Moreover, even in solvent liquidations, misrepresentation victims will remain bound by any contractual preference, whether or not resulting from fraud or deceit.
Start-up ventures like HQP which rely on new rounds of investment to fund growth will often provide for new subscribers to receive a liquidation preference. Earlier subscribers need to be mindful that they may be left without a remedy by agreeing to subordination, even when such subordination is induced by fraud. Fund-formation attorneys need to be mindful that drafting choices in relation to (i) redemption requirements and timelines; and (ii) class‑based liquidation preferences will drive recoveries and litigation risk. Provisions disapplying liquidation preference provisions in Articles in the event of fraud/misrepresentation may become a necessary work-around to ensure victims of fraud do have a remedy, and that the most recent investors cannot scoop the pot.
Guy Cowan and Harry Shaw of Campbells LLP, together with Robert Levy KC, act for the Respondents in HQP.
