Cayman Islands: Cayman Islands Court Of Appeal Rules On Limited Partner Derivative Actions

The recent judgment of the Cayman Islands Court of Appeal ("CICA") in Kuwait Ports Authority & Ors v. Port Link GP Ltd & Ors¹ , delivered on 20 January 2023, has clarified the test for limited partners in a Cayman Islands exempted limited partnership ("ELP") to bring derivative claims for and on behalf of the ELP pursuant to section 33(3) of the Exempted Limited Partnership Act (2021 Revision) (the "ELP Act").

The judgment is the first time section 33(3) of the ELP Act has been considered at appellate level and the CICA overruled the Grand Court's earlier decision in a number of important respects.

The CICA's judgment represents the leading jurisprudence on derivative claims by limited partners in an ELP and will therefore be of interest to private equity and other professionals and investors familiar with the widely-used Cayman ELP structure.

Background

Two of the eleven limited partners in The Port Fund, L.P. (the "Fund") had filed direct and derivative claims against the Fund's general partner (the "GP") and three other defendants said to be related to management of the fund or involved in alleged wrongdoing ("D2-D4"). The defendants sought, inter alia, to strike out the derivative claims on the basis these were not permitted under the ELP Act.

Section 33 of the ELP Act provides that legal proceedings by or against an ELP may be instituted by or against a general partner only. Section 33(3) provides an exception to this, permitting a limited partner to bring an action on behalf of an ELP only if the general partner with authority to do so has, "without cause, failed or refused to institute proceedings".

In this case, the GP (under the control of independent directors with no connection to the alleged wrongdoing) had determined, following extensive investigations, that the claims sought to be brought by the limited partners lacked merit and should not be pursued in the interests of the Fund.

At first instance, the Grand Court (Parker J) had the unenviable task of considering the operation of section 33(3) of the Act for the first time (the provision having never been the subject of judicial consideration in the Cayman Islands or in any other commonwealth jurisdiction with equivalent legislation). A more detailed overview of the relevant facts and Campbells' analysis of the first instance decision is accessible here.

The test under section 33(3)

At first instance, Parker J held that:

1. There is no "leave stage" under section 33(3) as in the case of shareholder derivative actions in a company context (per GCR O.15, r.12A).
2. Section 33(3) "occupies the field" and principles of common law and equity for bringing derivative claims in the case of companies, trusts or English limited partnerships are not applicable to derivative claims sought to be brought by limited partners under the ELP Act.
3. A respondent to a derivative claim had the burden of establishing on an application to strike out the derivative claim that the derivative claim failed to meet the statutory test and that it is only if the court is certain that the general partner has not refused or failed to bring the claims "without cause" that the derivative claims must be struck out.
4. It was sufficient for the plaintiffs to show a "good arguable case" that the GP had failed or refused without cause to bring the derivative claims.
5. The test is to be considered on the relevant facts as they were at the time the proceedings were commenced, rather than at the time of the hearing to determine whether the derivative claims should be permitted to continue.

Although Parker J held that common law and equitable principles did not apply, he nonetheless considered that the GP (under the control of independent directors) remained under a relevant inhibition (being a feature of the "special circumstances" test for derivative standing at common law) as (i) the GP's independent directors, acting in the GP's best interests, would not sue the GP, and (ii) the decision not to pursue the claims is insufficiently distinct from the wrongdoing upon which the claims are founded.

The CICA substantially changed the test laid down at first instance and held as follows:

1. Although there is no leave stage, and a limited partner may simply institute proceedings, it must plead the facts and matters relied upon as entitling him to the exceptional relief under section 33(3) (which forms part of the cause of action).
2. It is necessary for the court to decide at an early stage of the proceedings whether the limited partner can indeed bring himself within section 33(3), and this cannot be left to trial. A defendant wishing to challenge the right of a limited partner to have instituted proceedings under section 33(3) should do so either by applying to strike out the proceedings on the ground of a lack of standing (as was done in this case) or by applying for the court to direct the trial of a preliminary issue.
3. The court's approach must be the same regardless of what application is made. The court should not hold a mini-trial but should reach a view on the affidavit evidence before it.
4. The court's task is an evaluative one, and the Grand Court was wrong to hold that the defendants bear the onus of satisfying the strike out threshold. Rather, the CICA held at [118] that:

The court must decide, on the basis of the material before it, whether the likelihood of the general partner having failed or refused to institute proceedings without cause is sufficient to lead the court to conclude that a derivative action should be permitted in the interests of justice. In reaching this evaluative conclusion, the Court will no doubt have regard, inter alia, to the strength of the evidence that the general partner has failed or refuse to institute proceedings without cause, the strength of the underlying claim which is sought to be brought and the likelihood and nature of any injustice if the derivative claim is not permitted.

5. In determining this issue, the court is likely to be assisted by consideration of whether special circumstances exist, but the court's task remains one of applying the statutory test set out in section 33(3).
6. The court is required to consider the test by reference to the facts at the time of the hearing, not at the time of commencement of the action as Parker J had held.
7. Even if the court is satisfied that a plaintiff can bring himself within section 33(3), the court still has a residual discretion whether to permit the derivative claims to continue, and one relevant factor in the exercise of the discretion is whether the plaintiff has an alternative remedy such that the derivative action is not necessary.

Having clarified the test to be applied, the CICA went on to strike out the derivative claims against the GP on the basis that (i) the Fund had suffered no distinct or separate loss from that of its limited partners, and there was no claim held by the Fund which the GP could fail or refuse to bring, and (ii) the limited partners already had an alternative remedy in the form of their direct claims against the GP.

The derivative claims against D2-D4 were permitted to continue on the basis that the GP was under a relevant inhibition because (i) the essential wrongdoing giving rise to the allegations against D2-D4 was that of the GP itself (albeit while under the control of different directors), and (ii) the GP would have to consider whether it should sue itself as a co-conspirator. On the question of discretion and the presence of an alternative remedy, the CICA held there was sufficient uncertainty about whether the plaintiffs had direct claims against D2-D4 and would permit both the direct and derivative claims to continue for practical reasons.

Analysis

While the judgment provides greater clarity concerning the test to be applied under section 33(3), and should ensure that investors cannot abuse the derivative jurisdiction against the interests of other stakeholders in an ELP, some points of concern still remain.

Of potential significance is the finding made in both courts that the GP remains subject to a conflict of interest (and therefore a relevant inhibition for the purposes of the special circumstances test) notwithstanding that, at the time of assessing the claims for the purposes of the section 33(3) the GP was under the control of independent directors. It follows that unless a limited partnership agreement permits a change of the general partner (and such change does not trigger a winding up of the fund or other adverse consequences), the courts' findings tend to suggest that all general partners will always be subject to such a relevant inhibition as soon as its conduct has been at least arguably impugned in a statement of claim; the general partner can never rid itself of the conflict of interest even if there is a complete change of directors. The CICA did not accept D2-D4's submission that the appointment of independent directors to consider the alleged historic wrongdoing of the GP was tantamount to official liquidators investigating the affairs of a company or suing a former director.

Stakeholders may also be concerned by the fact that the CICA permitted the plaintiffs to continue their derivative claims against D2-D4 notwithstanding the existence, on the plaintiffs' own case, of corresponding direct claims. Allowing plaintiffs to 'ride both horses' in this way might be considered contrary to the structure of the ELP Act, the exceptional nature of derivative claims, and the historical approach of permitting such claims to be brought only where no other remedy is available.

Footnote

^{1. Unreported, CICA (Civil) Appeal Nos. 002 and 003 of 2022, 20 January 2023, per Field, Beatson and Birt JJA.}