The establishment of offshore investment funds to invest into cryptocurrency has been a very active area over the last couple of years, and there are now many offshore funds operating in this space. The US bankruptcy filings in respect of FTX, made on 11 November 2022, have resulted in the assets of one of the largest crypto exchanges by volume, with possibly over one million users, being frozen.
The directors of funds that were utilizing this exchange, and their investment managers, now have to rapidly consider the implications.
The possibility that other exchanges and/or counterparties in the digital assets space may become subject to a contagion effect may mean that the requirement to undertake such considerations may soon spread to an even broader number of investment funds.
When considering a fund’s options, it will be necessary to ensure a complete understanding of the fund’s powers under its offering document and in its articles of association (or other constitutional documents). In addition, it will be necessary to be fully cognizant of any side letters purporting to provide differential rights to any particular investors.
Depending on the percentage of the fund’s overall assets that have become illiquid, various paths forward may be applicable.
If the fund should be able to survive, consideration would still need to be given to whether it remains possible for the fund to reliably undertake the valuation of its assets (i.e. determine the net asset value or “NAV”) and also to managing the liquidity rights of investors in the face of potentially significant redemption requests.
As noted above, the provisions of the fund’s documentation will become critical to determine whether mechanics for various mitigation strategies are drafted in. Some examples of the possible mechanics that might be used to limit investors ability to redeem from the fund include the suspension of the determination of NAV and/or redemptions, the suspension of the payment of redemption proceeds or the use of redemption “gates”.
Another approach that may be available for consideration is the use of “side pockets”, if the fund’s documentation provides for this. If the documents do not expressly allow for such side pockets then a similar outcome can be achieved by utilizing an ability to make distribution of assets in kind. This ability can be utilized to undertake a “synthetic side pocket” strategy which involves the creation of a newly formed special-purpose vehicle (SPV) by the fund, the contribution of assets to that SPV by the fund, and distribution of the SPV shares to the fund’s investors.
If it is determined that the fund is not going to survive, but remains solvent, the method of implementing an orderly winding down needs to be considered. This could be implemented merely by the compulsory redemption of all investors, whilst the fund’s board of directors remain in control, or it could be implemented by placing the fund into voluntary liquidation and appointing a third-party liquidator to conduct the winding down. There are advantages and disadvantages to each approach and the most appropriate course will be dependent on the specific facts in any instance.
If the fund is potentially insolvent, the approaches that need to be contemplated become a little more specific to the offshore jurisdiction in which the fund is domiciled but, broadly speaking, the winding up will become a Court supervised process, requiring specialist litigation and insolvency expertise. These various Court processes generally give the fund the benefit of a statutory moratorium against legal claims.
Throughout all of this, it will be necessary to ensure appropriate communication of relevant information between the fund’s directors, the investment manager and the fund’s investors.
As can be seen, there is a lot to consider and sometimes all of this must be done under stress and on an expedited timeline. Fund directors and investor managers facing the sorts of issues contemplated by this memorandum should be proactive, and seek professional advice as soon as possible.