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How To Best Protect Your Investment In A Cayman Islands Based Crypto Hedge Fund

The Cayman Islands is one of the top offshore jurisdictions for hedge funds, with an investor friendly tax regime, an established and reliable legal system and experienced professionals familiar with every aspect of an investment fund’s life-cycle.  It is therefore little surprise that many crypto-currency funds are choosing the Cayman Islands as their place of incorporation.

Crypto-currency offers an opportunity for impressive returns, and an investment fund gives investors access to opportunities that they may not otherwise be able to attain individually.  However, as with all types of investments, crypto-currency funds are not without risk and there are steps that prudent investors should take to best position themselves in the event that the fund hits difficulties.

Whilst hoping for the best, investors should bear in mind that in a worst case scenario, a liquidator’s primary objective is to realise and distribute the fund’s assets, in the following order of priority[1]: expenses of the liquidation, general unsecured creditors (service providers, liquidity providers etc), investor creditors (investors who are owed payments from the fund in relation to their character as member, such as in respect of redemptions or dividends) and investors (those who remain and participate only if there are surplus assets after payment of creditors and expenses). 

There are three stages of a fund’s lifecycle at which investors can take steps to seek to improve their standing in the ultimate event that the fund runs into troubled times.  It is generally the least proactive investor that is left bearing any losses.

During the initial investment

The liquidity of crypto-currency investments can be ideal for open ended investment funds (which allow investors to subscribe or redeem periodically based on a defined net asset value (NAV)) whilst specific investments in the underlying technology may be more suited to closed-ended funds (usually raising an initial amount of capital tailored towards an investment strategy, with the opportunity to increase or realise the investment only at limited points in time).  The Investment Manager’s (IMs) broad strategy will be set out in the fund’s offering documents, including key risk factors which should be reviewed in detail by potential investors.  As an emerging asset class, crypto-currency funds will need to maintain the flexibility to respond to regulatory change and market trends that may develop more quickly than traditional asset classes.

Considerations relevant to both types of fund will include:

  • The structure of the board: specific experience with crypto-currencies both amongst the operational board members but also whether the independent directors are providing genuine oversight and specific value/knowledge.   
  • What information is periodically provided or can be requested by investors to ensure compliance with investment criteria and responses to emerging risks.  Investors may be able to negotiate enhanced access to information or circulation of investment data. 
  • The basis upon which the fund values its investments and calculates the NAV.
  • Steps the fund proposes to protect its asset holding.
  • Whether investors are prevented from petitioning for the winding up of the fund.
  • Whether the fund will accept subscriptions and make redemptions utilising crypto-currency and the valuation interaction between NAV and that mechanism.

Investors in open ended funds should also consider:

  • The regularity with which NAV is calculated and the redemption period.  Whether the investor can negotiate shorter redemption periods, or whether other investors are getting favourable terms. 
  • The fund’s liquidity provision enabling it to reduce underlying asset turnover and align redemptions and subscriptions.
  • Whether the fund’s investment strategy would be adversely affected by withdrawals and accommodate new subscriptions.

Investors in closed-ended funds should also consider:

  • The ultimate expiration date and strategy, together with the rights to extend the life of the fund.
  • Whether there are any ongoing capital call commitments.

During the course of the investment

Much of this will involve continuous checks against the criteria established at the investment stage: an investor should not allow the IM to rest on its laurels. Pay particular attention for:

  • Over concentration in excess of the fund’s stated investment parameters.
  • Delays in reported NAV.
  • Lack of clear strategy in dealing with significant market developments.
  • Unexpected and unexplained changes in the board or service providers.
  • Suspension or gating of redemptions and redemption payments.
  • Consistent returns despite varying or volatile market conditions.

An investor who has submitted a valid redemption request is paid in priority to an investor who has not, and so acting upon red flags can be the difference between getting paid or losing an investment.  If the fund fails to pay redemption requests promptly, investors should consider taking legal action for an unpaid debt, including issuing a statutory demand or a petition that the fund be wound up.  Whilst many jurisdictions contain provisions clawing back payments made to some creditors in favour of others when a fund is on the brink of insolvency, the Cayman Islands courts do not currently permit liquidators to clawback payments if they were made to stave off legal or regulatory action, and so the threat of such may be sufficient to procure payment or favourable treatment, rather than relying upon a distribution through the liquidation of the fund.

Wind down

If the fund is unable to pay its creditors as they fall due (the Cayman Islands has a cash-flow insolvency test), then it may end up in an involuntary court supervised liquidation.  Even in this situation, investors may take steps to protect their position by:

  • Notifying the liquidator of their interest, including any claim to creditor status arising from redemption requests or side-letters, the liquidators must report to stakeholders and distributions will be determined by the investor’s status as creditor or investor;
  • Seeking to join the liquidation committee of the fund, which will act as a steering board to the liquidation and could provide useful information;
  • Entering into funding arrangements with the liquidator, in exchange for a share in the upside of any recovery actions as well as increasing the pool available for general distribution;
  • Bidding in any asset realization process conducted by the liquidators;
  • Trading in any secondary market in distressed shares to crystallise current value and remove ongoing uncertainty.

At each stage of a fund’s life-cycle information is key: procuring access to information will enable the investor to seek to maximise its returns and react to underlying developments in crypto-currency.

Jeremy Snead is a senior associate in Appleby’s dispute resolution practice. Sailaja Alla is a partner and Peter Colegate is a senior associate in the firm’s corporate practice group.

[1] In Cayman liquidations secured creditors can continue to enforce their security, but secured creditors are rare in fund contexts.  Cayman law also recognises certain categories of preferential creditor, but again these are normally de minimis in a hedge fund context.