Following the unprecedented events of last year, not least the stunning Madoff fraud, funds have come under far greater scrutiny. Litigation looks set to soar, and in this feature WealthBriefing asks leading Guernsey lawyers what the future may hold for the jurisdiction’s funds sector.

“If you are going to make a million quid tomorrow, you don’t have to worry about the half a million you lost yesterday. But if you’re not making that million you are more likely to go after the half you’ve lost” - Robert Shepherd, Managing Partner, Ozannes, Guernsey.

High-profile cases such as the collapse of Lehman Brothers and the Madoff fraud case have started ripple effects that some say will build to a tsunami across the financial world. Offshore is not immune. Guernsey, which has seen a funds boom in recent years, is feeling the waves.

The total value of funds under management and administration in the island has fallen to £175.9 billion ($281 billion) as at March 2009 – a drop of £27.9 billion (13.7 per cent) year on year (source: GuernseyFinance).

Not surprisingly however, as the amount of funds formation work declines for Guernsey lawyers, the amount of litigation is on the rise.

Funds under scrutiny

Advocate Robert Shepherd, managing partner and litigator at Guernsey law firm Ozannes, puts this down to a number of factors – all stemming from the economic downturn.

“Funds formation in the last ten years has been extraordinary. Everyone has been so focused on getting the job done that it would be naïve to think that, during that time, corners were not cut.”

Mr Shepherd said it has really only been in the last 18 months that funds-related litigation has been explored - bringing the formation, management and administration of funds under scrutiny as never before.

Mr Shepherd said there were three main areas of litigation either being considered or underway in Guernsey: redemption, gating and investment disputes.

Redemption issues are critical with a fund that is falling in value or has collapsed altogether. If there has been a delay in redemption, fund investors are looking to recoup any reduction in value during such delay. In good times, this was not an issue. Now, significant amounts have been sliced off the value of the investment in the intervening period and investors want to hold funds or their administrators or managers responsible for those losses.

Common Law precedent

A case in the Cayman Islands could have ramifications for Guernsey and other common law jurisdictions.

An investor in the Strategic Turnaround Master Partnership Fund, Culross, was seeking for the fund to be compulsorily wound up as a result of the fund suspending payments after Culross made a redemption request. In layman’s terms, the investor wanted to be considered a creditor; with more power and more chance of getting his money back, rather than a shareholder who would be unlikely to see much if any return of his investment.

In essence, the Court of Appeal held that the terms of the Articles of Association and Confidential Explanatory Memorandum (CEM) meant that the fund directors had the power to suspend the actual payment of redemption proceeds to a redeeming shareholder even though the relevant redemption date had already passed and the redemption price had been determined.

The Court of Appeal also found that Culross, as a redeeming shareholder, remained a shareholder until the process of redemption of shares was completed. That meant Culross’ rights remained governed by the Articles and CEM.

Culross’ application for leave to appeal to the Privy Council was refused by the Court of Appeal. It is not clear if Culross will seek, and be given, leave to appeal directly to the Privy Council.

“This is something that could definitely happen in Guernsey,” Mr Shepherd said.

Gating issues

Another source of dispute is gating issues where, in order to prevent a run on the investments, funds put conditions on how and when investors can redeem their investments.

Mr Shepherd said gating did not always work as there could be inconsistencies in the documentation, in particular between the Articles of Association and Scheme Particulars.

“When money is lost the investor looks at the fine detail of the documentation in an effort to find a way to get their money back,” he said.

The third area of potential legal disputes is breach of investment criteria where the investment managers may have gone beyond the investment parameters.

 “A lot of people have lost a lot of money in the past 18 months and they are looking for someone to blame,” said Mr Shepherd.

“The tyranny of the funds sector is that even a £50,000 investor can have a huge amount of power in litigation because they join with other significant investors and sue as a group, becoming part of an action that’s worth millions of pounds.”

Scattergun approach

For Carey Olsen, another prominent Guernsey law firm, the floodgates have not opened yet in terms of cases coming to court but Advocate Karen Le Cras said the firm’s litigators are being kept extremely busy with clients who are increasingly seeking litigation related to funds.

Ms Le Cras said there was an escalating amount of investigation into possible claims on behalf of clients but this was not necessarily translating into actual cases coming before the Guernsey court.

She said there was a broad range of clients coming to Carey Olsen from funds and fund managers and administrators, to individual investors and she anticipated many of these claims would solidify in the coming months resulting in litigation, particularly as the fallout from the Madoff case continues.

 “There is a scattergun approach as to who is blaming who and many issues are being discussed and investigated,” she said.

“Essentially those who are angry are going for those with the deepest pockets and we might see an increase in litigation, but it is early days for the fallout to have a deep impact.”

New opportunities

Ian Swan, a partner at Babbé, which has a niche funds practice in Guernsey, believes that the current climate presents new opportunities for the island’s lawyers.

“No new big retail funds have been created in Guernsey this year but those working more cleverly in the smaller funds are seizing the opportunities,” he said.

“There is still funds work out there, it just isn’t the headline grabbing formations Guernsey has seen in recent years.”

Offshore survival?

All three agree that the political spotlight falling on “offshore”, coupled with more litigation, will result in increased regulation for Guernsey.

Mr Swan said: “Light touch regulation, as we have in Guernsey, has got a bad name in influential quarters and been misinterpreted as allowing financial institutions to run riot. The offshore world is mixed up in that.

“I’m not sure if greater regulation would have mitigated the issues we currently face but I do think more regulation is a likely consequence of it.”

Mr Shepherd of Ozannes believes that there is a great deal of onshore political pressure on offshore centres designed to threaten their existence.

“If offshore financial centres are to survive it will be in places like the Channel Islands where people are prepared to pay for the security of such a respected ‘brand’,” he said.