Seven years after Bernie Madoff was sentenced to 150 years in prison for frauds worth an estimated US$65 billion, the legal shockwaves from his disgraced empire continues to reverberate. In a case that was recently decided by the Grand Court of the Cayman Islands, the court determined how the remaining value of a Cayman “feeder fund”, once part of the Madoff empire and now in official liquidation, should be distributed among its investors.
In this case, Herald and Primeo were open-ended investment funds. They both placed funds for investment with a Madoff-related entity called BLMIS.
In 2007, Primeo assigned the credit of its account with BLMIS to Herald in return for subscribing for shares in Herald. The number of Herald shares provided to Primeo was based on the perceived value of Primeo’s account with BLMIS, which at that time was valued at US$466 million.
In 2008, it was discovered that BLMIS was a Madoff run Ponzi scheme, with the consequence that every reported Net Asset Value (“NAV”) had been misstated, including the NAV used to calculate the value of Primeo’s consideration under its subscription with Herald.
Herald was subsequently put into liquidation and its liquidator sought to determine how the remaining value in the fund should be distributed among its shareholders, including Primeo. In particular, the liquidator was tasked with determining whether Primeo’s shareholding in Herald should be adjusted to reflect the fact that it had received a greater number of shares in Herald than it would have otherwise received if the actual value of its account with BLMIS had been known at the time of the subscription.
The issues before the Cayman Court were: (a) whether Herald’s share register should be rectified; and, (b) if so, on what basis should any rectification be performed.
Under the applicable Cayman Islands Companies Law, the concept of rectification implied restoring the shareholder’s register to a position that accurately reflected the relative position of all shareholders as it would be if all subscriptions and redemptions had been transferred at a “true” NAV per share. The court found that since every subscription and redemption of shares in Herald after the initial offering had occurred on the basis of a fraudulently misstated NAV, there could be no clearer case in which the power of the liquidator to rectify should be exercised. The court held that any rectification needed to apply equally to all remaining shareholders.
There were several methods as to what basis rectification should be performed. The liquidator submitted that the register should be rectified so that the net loss of subscription monies in Herald was borne rateably and that the remaining shareholders shared equitably in the pool of funds available for distribution.
Two methods were proposed to achieve this: (a) the net investment method – this method calculates each shareholder's economic interest on the basis of the amount of their total subscriptions, less any redemptions, as a percentage of the total surplus fund available for distribution; and (b) the rising tide method – this method directly takes account of redemptions that have already been paid to investors in addition to the remaining value in the company. It works by distributing remaining funds to shareholders according to the value each shareholder has already realized.
The Cayman Court found that both methods would create a result whereby Herald's shareholders would "share in the common misfortune of Madoff's fraud". However, he concluded that the Companies Law prevented either method from being available.
Instead, the court held that the proper approach was to assign a constant “true” NAV for each and every subscription and redemption throughout Herald’s active life. Since Herald’s NAV had been fraudulently misstated since its inception, the true NAV was held to be the initial offering price of the shares. All NAVs after this date needed to be disregarded despite the value that may have actually been assigned (and paid) for shares at the time.
The court directed the liquidator to recalculate each subscription and redemption of shares in Herald at this constant “true” NAV and rectify the share register accordingly.