HQP and Direct Lending: Liquidation Waterfall

In a Nutshell

In settling conflicting first-instance decisions and providing clear distribution rules for Cayman Islands liquidations, the Cayman Islands Court of Appeal (“CICA”) held that the rule in Houldsworth² (which prevents shareholders’ misrepresentation claims after a company enters liquidation) remains good law in the Cayman Islands. The important gloss provided is that once “external creditors” are paid such misrepresentation claims may be admitted, ranking behind ordinary unsecured creditors (and potentially ahead of pure equity claims) subject to the articles of association. This is particularly important in the funds context where shareholder claims of different guises can dwarf external creditor claims.

Background

The CICA resolved two competing judgments from the Court³ considering whether the rule in Houldsworth is still good law in the Cayman Islands.

The rule in Houldsworth originates from 19th-century English law and prevented shareholders’ misrepresentation claims after a company entered liquidation on the basis that such claims would amount to an impermissible return of capital (capital needed to be maintained to protect non-shareholder creditors).

Houldsworth has been criticised and removed by statute in England and other jurisdictions, but its status in the Cayman Islands remained unsettled.

Issues

The CICA addressed two questions:

1. Whether, in the Cayman Islands, after the presentation of a winding up petition, claims for damages for misrepresentation inducing a subscription for shares in a company can be admitted to proof in a liquidation or whether such claims are barred by the decision of the House of Lords in Houldsworth (the “Bar on Proof Question”); and
2. Where, if such claims are provable, they rank in a liquidation in relation to other claims made by members, former members and external unsecured creditors (and specifically, do such claims fall within section 49(g) of the Companies Act (2023 Revision) (“CA”)⁴ so that the claims of members and former members are subordinated to the claims of external unsecured creditors) (the “Priority Question”).

Decision

Bar on Proof Question

1. The rule in Houldsworth remains a part of the common law in Cayman. It bars a shareholder from proving in a winding up for damages for a misrepresentation which induced him to subscribe for shares in the company. However, the CICA held that the purpose of the Houldsworth rule is to protect external creditors and therefore, the rule should only apply to prevent shareholders from competing with external creditors. Once external creditors are paid, Houldsworth serves no practical purpose. This was particularly the case in the Cayman Islands given the prevalence of open-ended funds where external creditor debts are typically small compared to shareholder claims.
2. Following the approach of Segal J in Direct Lending (which the CICA noted to be compelling), the CICA therefore adopted a modified approach and held that shareholders can prove for misrepresentation damages, but only after all external (non-member) creditors have been paid or provided for.

Priority Question

1. The CICA found that section 49(g) CA applies to misrepresentation plaintiffs, which states that no sum due to a member of a company in that person’s character of a member shall be paid in competition with other creditors. This is because a claim for damages for being induced into buying shares is inextricably linked to the plaintiff’s status as a member. It is essentially a claim for the return of capital contributed. Consequently, these claims fall within the scope of section 49(g) and are statutorily subordinated. They rank behind ordinary unsecured external creditors but potentially ahead of other shareholders claiming only for the return of equity (depending on the relevant provisions of a company’s articles of association).
2. The CICA’s judgment also endorsed the approach that Houldsworth is targeted at subscription claims; open market purchase claims stand differently because satisfying them does not undermine capital maintenance. As such, open-market purchase claims are permitted to rank alongside unsecured creditors.

¹ [2025] CICA (Civ) 19
² Houldsworth v City of Glasgow Bank (1880) 5 App Cas 317
³ In re Direct Lending Income Feeder Fund Ltd. [2024(1) CILR 171] and In re HQP Corp. Ltd. [2023(2) CILR 203]
⁴49. In the event of a company being wound up every present and past member of such company shall be liable to contribute to the assets of the company to an amount sufficient for payment of the debts and liabilities of the company, and the costs, charges and expenses of the winding up and for the payment of such sums as may be required for the adjustment of the rights of the contributories amongst themselves:
Provided that …(g) no sum due to any member of a company in that person’s character of a member by way of dividends, profits or otherwise, shall be deemed to be a debt of the company, payable to such member in a case of competition between that person and any other creditor not being a member of the company; but any such sum may be taken into account for the purposes of the final adjustment of the rights of the contributions amongst themselves.