On 16 April 2014, the Privy Council delivered judgment in the claim brought by the liquidators of Fairfield Sentry Ltd (“Fairfield”) against a number of redeemed investors.

Background

Fairfield is a company incorporated in the BVI as a mutual fund (the “Fund”). From 1997 to 2008, Fairfield was the largest feeder fund to have invested in Bernard Madoff Investment Securities LLC (“BLMIS”).  In December 2008, it was discovered that Bernard Madoff and his investment company BLMIS operated probably the largest Ponzi scheme in history.

The clients of Fairfield participated indirectly in fund placements by subscribing for shares in Fairfield at a price dependent on Fairfield’s net asset value (“NAV”) per share, and they were entitled to withdraw funds by redeeming their shares under the provisions of Fairfield’s Articles of Association (the “Articles”) at a price dependent on NAV.  Fairfield’s administrator, Citco Fund Services (Europe) BV (the “Fund’s Administrator”), was responsible for the day-to-day administrative services including the calculation of NAV and communication with shareholders.

As with any Ponzi scheme, net withdrawals from funds under management were paid from new money placed with BLMIS for investment.  It is inherent in a Ponzi scheme that those who withdraw their investments before the scheme collapses escape without loss, possibly with substantial fictitious profits.  The loss then falls entirely on those investors whose funds were still invested when the money runs out and the scheme fails.

Fairfield sought to recover the redemption money paid to a number of institutions which redeemed some or all their shares before December 2008, on the ground that the money was paid under the mistaken belief that the assets were as stated by BLMIS, whereas in fact those assets did not exist.  Fairfield argued that former shareholders had been unjustly enriched at Fairfield’s expense and liable to make restitution to Fairfield.  Thus, any recoveries made on this basis could be distributed rateably between all members, irrespective of when or whether they redeemed.

Decision of the High Court

On 20 April 2011, Bannister J in the Commercial Division of the High Court of the BVI decided that the whole dispute should be dealt with on the basis of 4 preliminary issues.

The first 3 issues were concerned with whether or not the contract notes, monthly statements, emails and screen shots issued to members of Fairfield recording the NAV per share or the redemption price (the “Documents”) were binding on the Funds under Article 11 of the Articles.  Article 11 states that any certificate as to the NAV per share or as to the subscription price or redemption price therefore given in good faith by or on behalf of the directors of the Fund shall be binding on all parties.

The last issue focussed on whether the investors had good defence to claims by the liquidators on the ground that the investors had given good consideration for money received upon redemption by their act of surrendering their shares.

Bannister J decided issue of Article 11 of the Articles in favour of Fairfield but decided the last issue of consideration in favour of the redeemed investors.  Thus, the Documents were held not to be “certificates” for the purpose of Article 11 of the Articles but it was held that those redeemed investors had given good consideration by surrendering the shares. On this basis, claims by the liquidators failed.

The Court of Appeal affirmed the judgment of Bannister J that none of the Documents were certificates.  This was because the directors of the Fund had engaged the Fund’s Administrator to calculate the NAV.  There had not been a delegation of the power of the directors of the Fund to issue a certificate of the NAV and the determination of the NAV can be published without it being certified or binding.  The Court of Appeal further concluded that the mere stating of a precise price would not suffice for any document to amount to a certificate and it must be issued either by the directors of the Fund or some agency to whom the power to certify was delegated, neither of which was the case here.

On the defence of good consideration, the Court of Appeal, citing Barclays Bank Ltd v. W. J. Simms [1979] 3 All ER 522, considered that unless the underlying original contract which gave rise to the contractual debt was void or had been avoided prior to payment, the good consideration defence would bar a restitution claim.  Here, there were specified contractual obligations to be fulfilled by Fairfield and the redeemed investors under Article 10 of the Articles.  The redeemed investors had fully performed their obligations under the contract.  Thus, Fairfield was contractually bound to pay the redemption price for the shares upon request.  By paying the redemption price, Fairfield discharged its debt obligations to the redeeming investors according to the Articles.

The Court of Appeal also considered that there was no common mistake for the alleged mistaken calculation of the NAV, as it was solely a mistake of Fairfield’s and there was nothing essentially different about the subscription contract when it became known that BLMIS was operating as a Ponzi Scheme - this was because the subscription contract was for the shares while the redemption payment was for the surrender of the shares. Therefore, the redemption money paid by Fairfield based on the alleged mistaken calculation of the NAV did not nullify its obligation to pay on redemption.

Decision of the Privy Council

Reformulating the 4 issues as laid down before the High Court, the Privy Council formulated the 4 issues into the following 2 key issues:

1^st Issue: Certification

The first issue was whether the Documents issued by the Fund’s Administrator recording the NAV per share or the redemption price were binding in accordance to Article 11 of the Articles which deals with the determination of the NAV per share for the purpose of both subscriptions and redemptions.

2^nd Issue: Good Consideration

The second issue was whether the redeemers in surrendering their shares gave good consideration for the payment by the Fund.

The Privy Council decided that Fairfield’s appeal on the first issue of certification should be allowed, whereas the second issue should be dismissed.  In other words, the Documents issued by the Fund’s Administrator constituted “certificates” and had binding effect on Fairfield.

With regard to the first issue, which is closely linked with the second issue, “certificate” had no standard meaning. The question of what constitutes a certificate depends on the commercial or legal context the clause appears in.  In the context of language, “certificate” means (i) a statement in writing; (ii) issued by an authoritative source; (iii) communicated by whatever method to a recipient or class or recipients intended to be relied upon; (iv) conveys information; and (v) in a form or context which shows that it is intended to be definitive.

Thus, the Privy Council considered that the Documents (except screenshots) constituted “certificates” as they were issued by the Fund’s Administrator under the authority of the directors of the Fund (i.e. an authoritative source) and the context shows that they were intended to be definitive.

Throughout the whole dispute, the Privy Council laid down clear principles that the recipient of money “cannot be said to have been unjustly enriched if he was entitled to receive the sum paid to him”.  In other words, if the recipient was entitled to the payment, either through valid contractual obligation or other legal obligation, such a case cannot be a valid one for unjust enrichment.

In light of such issue, the focus of the dispute was whether Fairfield was contractually or otherwise obliged to make the payments paid out to the redeemed members.  Having said that, proper construction of the Articles was the solution to the dispute to determine whether Fairfield was obliged to pay either “true value of the NAV upon redemption” or “NAV per share” determined by directors of the Fund at time of redemption.  Considering commercial interests and conceptual possibility, the Privy Council held in favour of the latter construction (ie. NAV per share).  If the former interpretation was adopted, this implies that investors would be exposed to “open-ended liability” to repay partially the money received if subsequently the assets were discovered to be worth less and they may gain unanticipated windfall if later such assets were found to be worth more.

The determination by directors of the Fund at redemption date must be considered to be conclusive by reference to “certificate” in Article 11(1) of the Articles and must be read referring to ordinary commercial transaction documents recording the NAV per share. Such documents should be considered to constitute certificates.

Key Points to Note for Liquidators

As highlighted in Fairfield’s case, liquidators would not be able to recover redemption payments following the discovery of fraud on the ground of “mistaken” NAV.  The redemption process was held to be part of the contractual relationship between the shareholders and Fairfield under its Articles.  In other words, the redemption of shares constituted good consideration under contract of the Articles.  On the other hand, triggering the redemption process would create a debt owed by the fund to the redeeming investors.  Such debt created by the redemption of shares could be satisfied through payment of redemption money by the Fund.

Fairfield’s case confirmed the law relating to mistake that there would be no mistake where an obligation to pay contractually, statutorily or otherwise, exists.  To recover payment, it would require the contract to be voided.  In order to void a contract by mistake, the mistake must be a common mistake which was held by both parties such as to make performance of the contract impossible.  Finally, the determination of the NAV is solely an issue of the Fund which cannot give rise to a common mistake.

Relating to the “certificate” illustrated under the Articles, the Privy Council confirmed that the wording of the Articles would be determinative and no special kind of document would be required other than the normal fund transactional documents.

The Way Forward

In delivering its decision, the Privy Council recognised that contemporary funds may communicate important information to investors through various kinds of formats, not necessarily limited to the types in the present case.  Therefore, the particular formats have to be made known to the investors so that they may be relied upon for the purposes of making their commercial decisions or protecting their own interests.

This decision provided the necessary certainty for investment funds to resolve their disputes with investors in event of liquidation of the funds.  Commercial reality was at the heart of the Privy Council’s decision in recognising that determination by directors of the Fund at redemption date constitutes conclusive determination of the obligation of the investment funds.  Such interpretation was certainly a favoured approach for conducting commercial affairs and for the operation of investment funds.  If interpreted otherwise, it would mean that investors have to bear “unexpected” further losses or repayment of money already received (although at the same time they may get the chance to earn more than expected).