Consider the following: a Bermuda limited-partnership hedge fund and an investment bank are parties to an interest-rate swap under a master agreement. The fund's general partner subsequently resigns and is replaced. After the change, the fund enters into an equity option with the bank. During the ensuing months, the businesses of the fund and its new general partner deteriorate to the point both become insolvent. At that time, with the swap USD2 million in the money to the bank and the equity option USD5 million in the money to the fund, the bank exercises its right under the master agreement to terminate both transactions and, believing that close-out netting is enforceable in Bermuda, pays the USD3 million net close-out amount. Weeks later, the bank learns the fund has filed a claim in its insolvency proceeding for the additional USD2 million owed to it under the equity option.
The hedge fund's obligation under the swap could not be netted against the bank's obligation to the fund under the equity option. This is because at the time the fund entered into the swap and the equity option, Bermuda law did not permit a partnership to take on legal personality. In addition, although a change in law effective August 28 now permits Bermuda partnerships to acquire legal personality at the time of formation (and for partnerships in existence when the new law took effect, subsequent to formation if certain steps are taken) the fund was formed prior to this year and did not take the steps necessary to acquire legal status.
Accordingly, at the relevant time, the fund did not have a legal identity separate from that of its partners. Because the original general partner at the time of the swap was replaced prior to the option, there was a lack of "mutuality of obligation" i.e. the bank's two transactions were with different groups of partners. Consequently, the bank owes the additional USD2 million to the fund.
Identity and Mutuality
In recent years, growth in the number of partnerships registered in Bermuda has been fuelled by hedge funds organized as limited partnerships. Given the increasing number of hedge funds organized as partnerships in Bermuda, it was recognized that the traditional position, that partnerships lack legal identity separate from their individual partners, was obsolete. Although this still holds in certain other jurisdictions, such as the Cayman Islands and the British Virgin Islands, in Bermuda this realization led to the enactment of The Partnership Amendment Act 2006, which for the first time extends an option for Bermuda partnerships to obtain legal personality.
Because derivatives market participants enter into transactions with partnerships relying on the netting and set-off rights in the standard ISDA master agreement documentation, lack of separate legal status for both general and limited partnerships represents a significant detraction. The advent of an election for partnerships to take on legal personality is a desirable advance in Bermuda's commercial law.
Although Bermuda law and regulatory provisions permit a Bermuda-registered partnership to enter into a contract that contains close-out netting and set-off provisions, enforcement of such provisions can be rendered difficult or even impossible where there have been changes to the members of a partnership that lacks a legal identity separate from its members. The close-out netting provisions in ISDA Master Agreements, for example, assume mutuality between the parties, with both parties liable as a principal for, and beneficially entitled to, all debits and credits arising from the transactions to be netted.
Transactions With Bermuda-Registered Partnerships
In the case of a Bermuda-registered partnership, this assumption may be false. When a party enters into a trade with a Bermuda-registered partnership that lacks legal personality, its counterparty actually is each partner of the general partnership. In the case of a limited partnership, its counterparty would be each general partner. For partnerships with no legal personality, mutuality is affected by changes in the partnership's members. Consequently, obligations resulting from transactions arranged before any membership change will not be netted against obligations from transactions agreed after the change, unless and until mutuality is restored.
Mutuality And Insolvency
For a Bermuda registered partnership that lacks legal personality, the preservation of mutuality is particularly significant if the partnership becomes insolvent or otherwise goes out of business. In such circumstances, partnership obligations must be borne by the partners or general partners, as the case may be. If the partners or general partners are also insolvent, the ability of the partnership's counterparty to net amounts due under open transactions will depend on the extent to which such transactions meet the mutuality requirement. There is no guarantee the counterparty will be allowed to set off claims from transactions entered before the change in partners against claims for transactions entered after such a change. Where there is no legal personality, the mutuality test is applied separately to each partner or group of partners.
Even a Bermuda partnership that has elected to acquire legal personality cannot become the subject of bankruptcy proceedings, nor is there a statutory procedure for winding-up a Bermuda registered partnership. Bermuda-registered partnerships can, however, become insolvent and individual partners--whether legal entities or natural persons--may become bankrupt under the respective laws that apply to them individually. A receiving order may be made against a partnership under the Bermuda Supreme Court Rules, but any order of adjudication of bankruptcy must be made against the individual partners. This should be taken into consideration in structuring the partnership and in drafting appropriate termination events.
Where the general partners of a Bermuda partnership are bankrupt, the successful enforcement of netting provisions will turn upon the survival of these provisions under the applicable bankruptcy laws of the relevant jurisdiction. The focus is on the general partners. Generally speaking, limited partners are not liable under Bermuda law for partnership obligations and suits regarding the partnership's business cannot be maintained against them.
Practical Steps to Preserve Mutuality
An election and registration to assume legal personality under the Partnership Amendment Act 2006 will remove all concerns over a potential loss of mutuality in transactions entered into with a Bermuda-registered partnership. Under this legislation, a partnership (general or limited) may register to acquire legal personality at the time of its formation. Pre-existing Bermuda partnerships may register to acquire legal personality within 12 months of the new law's August 28 effective date. Registration creates an entity that is separate from the partnership members, possessing unlimited capacity and the power to own and deal with its separate property, thus preserving mutuality as between the partnership and its counterparty.
Where a partnership decides not to take on legal personality, the partnership and its counterparty may include provisions in their master agreement documentation to preserve mutuality in the event the partnership is reconstituted. For example, the agreement can require that, upon any change in membership, the partnership's pre-existing transactions are assigned automatically to, or novated by, the reconstituted partnership. In addition, the agreement can require timely prior notice of such a change to the counterparty and may set out that the failure to provide such notice or effect a novation is an additional termination events. With a view to facilitating such assignments or novations, the partnership agreement and any related agreements with limited partners--including prospective partners--should give general partners the authority to execute all instruments and agreements and to make necessary filings to bring about an effective novation of transactions under the relevant master agreements, in the event of changes in the partnership's members.
This week's Learning Curve was written by Kenneth Robinson, senior counsel at Appleby Hunter Bailhache, and Sherri Venokur, special counsel at Stroock & Stroock & Lavan.
