The U.S. Court of Appeals for the Second Circuit recently issued an opinion that denied investors of a Cayman investment fund, Sphinx SPC, the right to appeal a settlement reached in an adversary proceeding in the Refco Chapter 11 case between Sphinx and Refco. The decision underscores the vulnerability of hedge fund investors in distressed situations and the extent to which they may be foreclosed from taking steps to protect their interests.
The Refco meltdown was both sudden and shocking. Shortly after news of the undisclosed liabilities that would precipitate Refco’s collapse became known, a Refco affiliate made a transfer of over $300 million to accounts controlled by Sphinx. Less than a week later, Refco and its affiliates filed for protection under Chapter 11. The official Refco creditors’ committee, on behalf of the Refco bankruptcy estate, soon afterwards commenced an adversary proceeding seeking the avoidance and recovery of the $300 million transfer. After several months of discovery and procedural maneuvering, the Refco creditors and Sphinx announced a settlement, whereby Sphinx agreed to return $263 million to the Refco estate and waive any further claims against Refco and its affiliates. Sphinx subsequently went into liquidation proceedings in the Cayman Islands.
Certain Sphinx investors sought to object to the settlement in the U.S. bankruptcy court, contending, among other things, that the agreement was the result of fraud and reflected collusion between Refco and Sphinx’s managers and directors. The bankruptcy court, however, declined to consider the merits of the investors’ objections, ruling that the investors lacked standing to be heard in the Refco chapter 11 case. The investors were not creditors of Refco and had no privity with Refco, contractual or otherwise. The bankruptcy court stated that its inquiry with respect to the settlement was limited to whether the Refco creditors’ committee had acted in good faith, and whether the settlement was in the best interests of the Refco estates.
Following district court affirmance, the Second Circuit considered the case and similarly affirmed. In the court’s view, the investors, if their claims of fraud and collusion were correct, had causes of action which they could assert against the Sphinx managers and directors in a court of appropriate jurisdiction. They had no right, however, to assert those issues in the Refco chapter 11 case. The court stated:
By investing in Sphinx, Investors placed control of their funds entirely within the hands of the Sphinx directors (or managers acting on behalf of the directors). Only Sphinx, not individual Investors, or even Investors as a group, could assert a claim against the Refco estate, and only Sphinx was permitted to negotiate a settlement with the Committee. Investors maintain a financial “interest” in Sphinx, but they are not a “party in interest” [against Refco] within the meaning of the Bankruptcy Code. The party in interest in the bankruptcy sense, representing the Investors’ financial interest, is Sphinx.
The court similarly denied the Joint Official Liquidators appointed in Sphinx’s Cayman liquidation the right to appeal, holding that the Liquidators were bound by Sphinx’s agreement in precisely the same way as Sphinx itself would have been had it not gone into liquidation.
In today’s volatile environment, hedge fund investors need to be extra vigilant regarding the contractual relationships and brokerage arrangements that their funds have. The Refco decision makes clear that if one of these relationship parties winds up in bankruptcy, investors will have virtually no ability to protect their interests after the fact.