The various powers that a responsible entity has to respond to a liquidity crisis must be clearly understood and communicated to investors.
The last financial crisis in Australia, at the end of the 1980s, produced some important decisions on the rights of investors in illiquid property funds. These focussed mainly on the validity of trustees’ amendments to constitutions to restrict redemption rights.1 They also, however, taught us an important lesson about the need for flexibility in managing redemption rights, the results of which are reflected in the current provisions of Chapter 5C of the Corporations Act (the Act).2
More recently, however, another wave of decisions has been issued by Australian courts considering measures that responsible entities have taken to manage liquidity in the face of underlying assets becoming illiquid and substantial investor redemptions over short periods of time.
In reviewing these decisions, this article considers the options that typically exist for managers to stem the flow of redemptions in special circumstances, and the challenges these decisions produce for investors. In times of financial crisis investors’ rights to redeem investments in funds are, of course, highly valued and may be keenly contested. The issues raised by illiquid schemes are very complex and involve the interaction of Chapter 5C of the Act trust law and insolvency law. In such circumstances, it is necessary to keep clearly in mind some basic principles about the operation of the redemption facilities.
Constitutional powers and liquidity management
There are typically three types of legal powers under the constitution of a scheme that may be resorted to by responsible entities in an attempt to manage liquidity in a crisis. These are:
- A power to extend the time for making redemption payments
- A power to suspend redemptions
- A power to determine that the fund has ceased to be “liquid” within the meaning of s 601KA of the Corporations Act.
To these may be added the power to amend the constitution, noted above, though in urgent situations a manager would generally prefer not to have to rely on this power. In critical circumstances, of course, the power to wind up the fund may also be able to be exercised.
Impact of the exercise of constitutional powers on redemption rights
Unfortunately, in times of market turmoil it may be hoped by a manager that a temporary solution to a liquidity crisis is all that is needed. This may lead to a lack of necessary (or advisable) steps to be taken, a lack of clear understanding as to options and poor communication with investors.
From a manager’s point of view it is necessary to be sure of the consequences of exercising each power, and to be transparent in communicating to investors which of these has been employed. Failure to adhere to these rules is likely to be costly. For example, for a manager incorrectly to believe that it has ‘suspended’ redemptions when the legal steps it has taken have merely extended the time for payment, would be a significant error and may impact investor rights. Once the time for extension of payment has passed, the obligation to meet the redemption request becomes due and there may be no opportunity to exercise further powers. This may leave the manager no alternative but to immediately wind-up the fund, in order to avoid breaching the terms of the constitution.
From an investor’s point of view it can be of equal importance to determine with precision which of these powers have been exercised. This is because they may impact differently on an investor’s redemption application, both in terms of timing of payment and the amount that is ultimately received on the redemption request.
An important point is whether powers can be exercised once the time for payment of a redemption has already fallen due. The problem has been roughly summarised as depending on whether an investor becomes a creditor in relation to the rights to redemption proceeds, or remains simply a member of the scheme. In general, the earlier the member earns the status of creditor, or equivalent status, in relation to his or her redemption proceeds, the more likely the member will be to retain the value of his or her investment unaffected by subsequent events.
The recent cases have considered the whole range of managers’ powers in this context.
In Basis Capital Funds Management Ltd v BT Portfolio Services Ltd  NSWSC 766 (Basis Capital) the members of certain registered schemes had lodged redemption requests which had not been fulfilled by the responsible entity, as a result of the developing financial crisis. Justice Austin determined that in the case of these schemes, the members became creditors from the time of lodgement of their redemption requests. Under the schemes, the time for payment of a creditor’s redemption could be extended even after the time for payment of a redemption request had fallen due. However his Honour did not agree that redemptions could be suspended after the time for payment had fallen due.
In Culross Global SPC Ltd v Strategic Turnaround Master Partnership Ltd  UKPC 33, the Privy Council came to the same conclusion as Austin J about the application of the suspension provisions of the scheme in question. Having regard to the terms of the constitution of the fund, the Privy Council decided that the investor was a creditor in relation to its redemption right, and that right could not be suspended once due.
More generally, both cases suggest that clear words will be required before it will be found that suspension destroys redemption rights.
In Basis Capital, Justice Austin also considered that the event of the fund ceasing to be liquid, did not extinguish the member’s right of redemption. Instead, it nullified the provisions extending the time for payment, so that the member (by then a creditor) was able to demand immediate payment. In contrast, in AvSuper Pty Ltd v Commonwealth Managed Investments Limited  NSWSC 1499, Justice White determined that the member’s redemption rights ceased to exist upon the fund becoming illiquid.
Finally, in ING Funds Management Ltd v ANZ Nominees Ltd  NSWSC 404 (ING Justice Barrett considered that the member’s redemption rights in that scheme, albeit not the rights of a creditor at law, were not destroyed by a decision to wind-up the fund.
Although the beneficiary was not a creditor, the redemption amount owed represented an equitable ‘liability’, as defined in the trust deed, that ranked higher in the distribution upon winding-up. In effect, the beneficiary was treated under this scheme on an equivalent basis to a creditor, due to the specific wording of the wind-up provisions of the scheme.
Claims for damages
The importance of creditor status to a redeeming investor’s chances of payment from a scheme is clear. However, whether an investor holds a fixed right to payment as a creditor may have other important consequences. If the investor is not paid on a winding-up of the scheme the value of the redemption proceeds due, he or she may still have a claim in debt for recovery of the balance as against the responsible entity. A claim against the responsible entity may take the form of an action for damages for loss.
If redeeming investors do not become creditors and, therefore, are vulnerable to the responsible entity’s exercise of powers to eliminate their redemption, it is still possible that an action for breach of s 601FC(1)(f) of the Corporations Act may assist in recovering compensation for loss due to the unfairness of the redemption provisions. In Basis Capital and ING it was suggested that the destruction of redemption rights by the exercise of the suspension or winding-up power would not be consistent with rules compliant with s 601GA of the Corporations Act. Breach of this section is a contravention of an important ongoing duty of the responsible entity, which itself may sound in damages under s 601MA of the Act.
Financial crises have historically produced some key decisions on the redemption rights of investors in collective investment schemes. The latest episode has been no exception. The recent cases demonstrate that the range of powers available to responsible entities in the event of a liquidity crisis, while perhaps more powerful than those previously available, must be clearly understood and communicated to investors. The alternative is likely to result in a range of remedies becoming available to investors, though only after complex legal issues of trust and statutory law are addressed.
1 Graham Australia Pty Ltd v Perpetual Trustees WA Limited (1989) 1 WAR 65; Eagle Star Trustees Ltd v Heine Management Ltd (1990) 3 ACSR 232.
2 Collective Investments: Other People’s Money Australian Law Reform Commission Report No 65, Chapter 7; Part 5C.6 of the Act.