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Hedge Funds Lose Bid for $200M-Plus Foreign Bankruptcy

In a landmark bankruptcy decision involving foreign-registered companies, a federal judge has ruled that two Bear Stearns hedge funds cannot shield their $200 million in U.S.-based assets by liquidating in the Cayman Islands.

U.S. District Judge Robert W. Sweet upheld a bankruptcy judge's refusal to grant Chapter 15 bankruptcy protection to the funds, which collapsed last year from risky subprime mortgage investments.

The decision could have particularly sweeping ramifications for the hedge fund industry since many funds are based in the Caymans for tax reasons.

Chapter 15, added to the U.S. Bankruptcy Code in 2005 to govern cross-border insolvencies, provides two grounds for recognition of a foreign bankruptcy proceeding.

The proceeding must be either a "foreign main proceeding," filed in a country where the debtor has its main interests, or a "foreign non-main proceeding," filed where the debtor has a place of operations.

Judge Sweet affirmed the bankruptcy judge's findings that the Bear Stearns funds' main interests are in New York and that they carried out insufficient economic activity in the Cayman Islands.

Should the judge's ruling stand, the funds will have to file for bankruptcy in the United States or risk actions against their U.S.-based assets.

The two funds, the High-Grade Structured Credit Strategies Master Fund Ltd. and High-Grade Structured Credit Strategies Enhanced Leverage Master Fund Ltd., were registered in the Cayman Islands.

They declared bankruptcy July 31, 2007, in the Grand Court of the Cayman Islands after suffering large losses from investments in risky securities backed by subprime mortgage loans.

The court-appointed liquidators for each fund then filed petitions in the U.S. Bankruptcy Court for the Southern District of New York to have the foreign bankruptcy proceedings recognized under Chapter 15.

Such recognition would have stayed any actions by U.S.-based creditors against the funds and their remaining assets.

The petitions filed in New York listed combined estimated assets for both funds at more than $200 million.

No party opposed the petitions.

Last September U.S. Bankruptcy Judge Burton R. Lifland refused to recognize the Cayman proceedings on both the "foreign main proceeding" and "foreign non-main proceeding" grounds.

While acknowledging that the Bankruptcy Code presumes a debtor's registered office to be its center of main interests, the judge said the evidence before him rebutted that presumption.

He said the evidence showed that the funds had no employees in the Caymans, the funds' investment manager is in New York, and their administrator, books and records are located in the United States.

Judge Lifland further found that all the funds' liquid assets were in the United States until after the filing of the foreign proceeding, when millions of dollars were transferred into Caymans-based bank accounts.

The funds' liquidators appealed to U.S. District Court for the Southern District of New York, and Judge Sweet affirmed the decision.

He said Judge Lifland correctly rejected the presumption that the funds' registered office in the Caymans was its center of main interests even though no other party stepped forward to rebut it.

The presumption did not relieve the funds from their burden of proof and "may be rebutted by evidence to the contrary, even in the case of an unopposed petition," Judge Sweet said.

He also rejected the liquidators' arguments that Chapter 15 protection is appropriate because most of the funds' remaining assets are in Caymans bank accounts and two of the funds' directors live in the islands.

He said the funds had no assets in the Caymans before the bankruptcy filing and that the two directors had no "substantial involvement with the business of the funds."

Judge Sweet further agreed with the bankruptcy judge's refusal to recognize the Cayman case as a foreign non-main proceeding.

The funds' liquidators failed to show that the funds had a place of operations or carried out economic activity in the Cayman Islands, according to Judge Sweet.

He said that while the funds filed incorporation papers and had auditors perform some pre-bankruptcy work in the islands, such activity is insufficient to meet the requirements of Chapter 15.

To comment, ask questions or contribute articles, contact West.Andrews.Editor@Thomson.com.

Fred S. Hodara of Akin, Gump, Strauss, Hauer & Feld in New York represents the funds' liquidators.