Vol 5 (2008) - Issue 4

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Offshore Funds Disputes: Practical Issues on Indemnities and Releases

This article discusses a number of the issues facing liquidators of, and investors in, failed Cayman Islands funds who seek to sue the fund’s service providers in circumstances where the service providers claim the benefit of indemnities and releases from the fund.

Whilst the article focuses on the ability of auditors and directors to rely on such protections as a matter of Cayman Islands law, with examples of some common scenarios that arise in practice, many of the principles are generally applicable to such claims from a variety of service providers.

The applicability of such protections and the extent to which the service provider can rely on them can in many cases be a major issue that needs to be litigated to conclusion before an underlying claim, such as for negligence or breach of contract, can be substantively advanced.

Introduction

The Cayman Islands are the world’s leading hedge fund jurisdiction. Whilst hedge funds have been one of the financial success stories of the last few years, there are occasional (and often very high profile) failures, which have been increasing in recent months as the ‘credit crunch’ intensifies.

Such failures can be simply due to market forces or can be caused or intensified by defaults by management or service providers (as in the case of the Bayou funds whose management defrauded the funds’ investors and are now facing jail as a result).

Fund collapses frequently lead to a welter of litigation as those who have lost money seek to recoup their losses from those they perceive to be responsible. This is particularly so where there are allegations of default. Targets for such litigation can include service providers such as the fund’s investment managers, auditors, administrators and directors, and counterparties to financial instruments entered into by the fund.

In the case of a Cayman Islands fund, such litigation will typically be instituted by the fund’s liquidators, who may have been appointed by the voting shareholders, or by the Grand Court of the Cayman Islands (the ‘Court’) on the application of the fund itself or of an interested investor or creditor.

In some cases investors may seek to bring actions directly against third parties related to the fund, arguing that the investor has a direct cause of action against the third party (e.g. tort claims that may be governed other than by Cayman Islands law).

When a liquidator or investor contemplates litigation against a fund’s service providers one of the first questions will be; ‘what are the terms on which the service provider was retained by the fund, and do those affect the ability of the liquidator/investor to sue the service provider?’

The service provider will almost invariably have written engagement terms with the fund and these may contain limitations on, or exclusions of the liability of, and/or indemnities in favour of, the service provider. There is no statutory prohibition in the Cayman Islands against such indemnities or releases. Additionally, the fund’s articles may purport to provide protections of this sort in favour of the potential defendant.

These protections can give rise to immediate and obvious practical issues. For example, there is no point a liquidator suing a third party in respect of a cause of action for which the fund has validly contracted to release that third party. Alternatively, if a fund’s investors sue a third party who has the benefit of valid indemnities from the fund sufficient in scope to extend to the investors’ claim, any damages award in the investors’ favour will simply be recouped by the service provider from the fund (perhaps with added costs), reducing the investors’ recovery from the fund accordingly.

The issues thrown up by indemnities and releases are wide-ranging. In most cases there are complex inter-related questions including the scope of the protections, whether there are any contractual or other exceptions, the circumstances in which the service provider can rely on them, and how such protections affect the relationship between the fund, the liquidators and its investors.