Special purpose vehicles
The Cayman Islands continued its successful relationship with
the Japanese structured finance market in 2004. In a year that saw
the chukan hojin structure attempt to obtain wider
acceptance in the market place, the Cayman special purpose vehicle
(SPV) has remained the market leader among off-balance-sheet and
bankruptcy-remote entities in Japanese and global capital
markets.
The Cayman Islands entity most commonly used in the Japanese
structured finance market is the exempted company, which may be
incorporated pursuant to the Companies Law (2004 Revision) of the
Cayman Islands provided its operations will be conducted offshore.
A Cayman SPV used in a structured finance transaction in Japan will
generally satisfy this requirement.
An exempted company requires no government authorization or
licences and is free from any form of income, capital gains or
corporation tax in the Cayman Islands. No withholding taxes are
imposed on any of the company's cash flows and it is able to obtain
an undertaking from the Cayman government that it will remain
tax-free for 20 years (this can be extended to 30 years).
Incorporating a Cayman SPV
One of the advantages of a Cayman SPV over other entities,
including the chukan hojin, is the speed with which it can
be incorporated. Provided the name of the proposed Cayman SPV is
available and the level of authorized share capital has been
agreed, such an SPV can be incorporated and its constituent
documents returned by the Companies Registry within 24 hours of
filing an application.
Roles for a Cayman SPV in Japan
The Japanese structured finance market includes a wide range of
products and transaction types and there is a number of roles for a
Cayman SPV. This ranges from acting as an issuer of limited
recourse notes in an asset-backed securitization, to acting as a
holding company in a single-asset real estate transaction.
A Cayman SPV incorporated for use in this market will generally
issue voting shares to a licensed trust company to hold on trust
for a charity in the Cayman Islands. This shareholding gives the
SPV an orphan status, which is critical for ensuring that the SPV
is bankruptcy remote and off balance sheet to the originator and
other parties to the transaction.
Bankruptcy remoteness and off-balance-sheet status mean that in
the event of an insolvency of the originator or another party to
the transaction, the assets of the Cayman SPV will not form part of
the assets of the insolvent entity because the insolvent party does
not own or control the SPV.
Cayman SPV as a holding company
A Cayman SPV is often used to act as a holding company of a
Japanese yugen kaisha (YK) or tokutei mokuteki kaisha
(TMK). The YK or TMK will be a part of a wider transaction and it
is important to the structure that the YK or TMK be bankruptcy
remote such that its assets will not be included within an
insolvency of the other entities in the structure. This bankruptcy
remoteness is achieved by having the membership units in the YK or
TMK held by a Cayman SPV, which in turn has all of its issued
voting shares held on trust for a charity in the Cayman
Islands.
In a holding company structure the Cayman SPV will be required
to purchase the membership units in the YK or TMK. To finance this
purchase it will need to raise an amount equal to the value of the
membership units by either issuing preference shares to a third
party or entering into a limited recourse loan agreement with a
third party lender. This type of structure is common in real estate
transactions in Japan.
The Cayman SPV is a cost-effective form of holding company and
its position in this type of structure is supported by a
well-established and flexible legal framework. When selecting an
entity for this holding company role it is important that the
entity is legally tested and secure in the role and the parties to
the transaction should look at its cost over the life of the
transaction. It is possible that entities such as the chukan
hojin will be cheaper in the first year of the transaction but
over the life of most deals the ongoing and liquidation costs of
other entities will be higher than the costs of the Cayman SPV.
Cayman SPV as an issuer
In a variety of structured finance transactions the parties are
seeking to convert assets into marketable securities; the Cayman
SPV can fulfil the role of issuer of those securities. For example,
in an asset-backed securitization (diagram 1), the SPV will
purchase a pool of receivables or other assets from an originator,
who will be seeking to remove those assets from its balance sheet
in exchange for funds that are ultimately sourced from the
international capital markets.
The Cayman SPV will issue securities to raise the funds and will
then use these funds to purchase the pool of assets from the
originator. The pool of assets will generate a cash flow to pay
interest on the securities. The arranger will also use part of the
issue of the securities to pay all fees and expenses on behalf of
the SPV, which will receive a small fee to establish it has
generated a corporate benefit for itself. Ultimately, the
redemption proceeds of the underlying assets (or occasionally the
sale proceeds) are used by the SPV to redeem the securities on
maturity.
In certain circumstances, income from the underlying assets may
be paid to a swap counterparty (usually the arranger) under an
International Swaps and Derivatives Association (Isda) master
agreement. The swap counterparty makes payments to the SPV,
allowing it to meet any payments it is due to make under the terms
of the issued securities. The swap counterparty will make its final
payment on or immediately before the maturity of the securities,
its final payment financing their redemption.
This structure will deliver funds to the originator, which it
can use to generate new receivables, fund its operations or reduce
its regulatory capital requirements. (See diagram 1)
| Diagram 1 |
 |
Rating a Cayman SPV
In a number of transactions the securities that the SPV issues
will need to be rated by the international rating agencies.
Following its extensive use in the global capital markets, the
Cayman SPV is well known to these agencies. Provided certain
features are included in the transaction the relevant securities
will be given suitable ratings. These features will include:
The SPV must be insulated as far as possible from the insolvency
of the other transaction parties, particularly the originator. The
SPV's business must also be restricted to activities that ensure
enough cash flow to pay the rated securities. And non-petition
language must be included in agreements between the SPV and its
creditors, together with limited recourse language that is
effective under Cayman Islands law in limiting a creditor's right
to petition as an unpaid creditor.
All of the above rating agency requirements can be easily
satisfied under Cayman Islands law and using a Cayman SPV. All of
the main rating agencies have rated numerous structures that
involve Cayman SPVs.
Cayman Islands legal environment
The Cayman Islands has a user-friendly and flexible legal
system. Its English law foundations underpin a modern and proactive
statutory regime capable of adapting to the needs of the global
markets that use the Cayman SPV. Elements of this legal system that
make such an SPV more attractive for the roles referred to above
include:
- statutory enforcement of contractual subordination, setting
off and netting arrangements;
- no restrictions on the provision of financial assistance to
a Cayman SPV;
- the ability to pay dividends out of share premium and
redeem shares out of capital and share premium accounts;
- a creditor-friendly insolvency regime with no provisions
for corporate rehabilitation such as the English administrative
precedent or US Chapter 11 proceedings;
- in the absence of fraud, the Cayman courts will not
generally re-characterize transactions by declaring heavily
subordinated debt to be equity where it exhibits equity-like
characteristics; and
- no restrictions on a Cayman SPV lending, borrowing and
issuing debt securities.
Market leader
The Cayman SPV continues to be the market leader for fulfilling
a number of important roles in the Japanese structured finance
market. The SPV has always been more cost-effective than the
chukan hojin over the life of the transaction, particularly
when taking ongoing and liquidation costs into account. Now,
flexible cost structures being adopted are consolidating the
position of the Cayman SPV as the special purpose vehicle of
choice.
Investment funds
The Cayman Islands continues to be at the centre of offshore
funds activity, with nearly 7,000 registered mutual funds. Apart
from the independent legal and judicial system, the jurisdiction
benefits from advanced telecommunications, infrastructure and
support services, and an educated and well-trained workforce.
Fund structures
Cayman funds may be formed as companies, partnerships or unit
trusts. Unit trusts continue to be the most common Cayman vehicle
in the Japanese market.
Under a unit trust structure, legal ownership of all assets is
vested in a trustee under a trust deed or declaration of trust. The
trust deed provides for the trustee to issue units representing an
interest in the beneficial ownership of the trust assets. The units
are usually (but not necessarily) redeemable at the option of the
holder. The powers, duties and discretions of the trustee, together
with the terms of issues of units, redemption and valuation, are
all set out in the trust deed. The fund manager may also be a party
to the trust deed but care must be taken to ensure that the fund
manager will not be construed as a quasi trustee, because
the fund manager would then become subject to the attendant
fiduciary duties. Alternatively (and more usually) the trustee can
delegate fund management responsibility to the fund manager through
a management agreement between the trustee and the fund
manager.
If the unit trust is registrable with the Cayman Islands
Monetary Authority (CIMA), the fund will require an offering
document. The offering document and accompanying subscription
agreement will contain the contractual provisions between the
trustee and the unitholders. The provisions governing the
relationship between the trustee and other advisers to the trustee
(for example, the administrator and prime broker) will be set out
in agreements between the trustee and the service providers.
There are no restrictions on the investment policies and
strategies of a mutual fund in the Cayman Islands and no legal
restrictions on its power to borrow, other than those specifically
contained in the fund's offering document or its constitutional
documents. Provided the trustee is permitted to do so by the trust
deed, investments of any type may be made anywhere in the world,
subject always to the restrictions of local laws of any applicable
jurisdiction. There are no exchange controls in the Cayman Islands
and investments may be made and realized in unit trusts without
government consent.
A trust that is registered as an exempted trust is entitled to
apply for an undertaking that no law enacted in the Cayman Islands
for a period of up to 50 years after the trust is created that
imposes any tax or duty on income or on capital assets, gains or
appreciation, or any tax in the nature of estate duty or
inheritance tax, will apply to the assets or income arising under
that unit trust or to its trustee or unitholders on such
property.
To register a unit trust as an exempted trust, the Registrar of
Trusts has to be satisfied that the unitholders under the trust do
not and are not likely to include any person (which for this
purpose includes a company) at any time resident or domiciled in
the Cayman Islands. A company incorporated in the Cayman Islands as
an exempted company (the most common form of Cayman investment
company) is statutorily deemed not domiciled in the Cayman Islands.
Such a company would also not be considered resident in the Cayman
Islands provided that it did not conduct business in the Cayman
Islands, nor was its central management and control in the Cayman
Islands, and was not owned by Cayman residents.
Consequently, it is possible for a Cayman exempted company to
own units in an exempted unit trust. Once a unit trust is
registered as exempted, it does not cease to be an exempted trust
if any unitholder is at any time resident or domiciled in the
Cayman Islands, but any unitholder who is so resident or domiciled
loses the benefit of the tax undertaking referred to above in
respect of their interest in the unit trust.
Mutual Funds Law (2003 Revision)
The Mutual Funds Law (2003 Revision) (MFL) regulates all mutual
funds established in or operating from the Cayman Islands.
With one exception, the Law requires all open-ended mutual funds
with more than one investor to be regulated and therefore
registered with CIMA. (An open-ended fund is one that issues
interests that are redeemable or repurchasable at the option of the
investor.) The exception is a mutual fund in which the equity
interests are held by not more than 15 investors, the majority of
whom can appoint or remove the operator of the fund. The operator
of a unit trust is the trustee.
Types of mutual funds
Mutual funds that are required to be regulated under the MFL
must either:
- apply for and hold a licence under the MFL (Section
4(1)(a));
- have a licensed mutual fund administrator provide its
principal office in the Cayman Islands (Section 4(1)(b));
or
- register as a mutual fund on the basis that: (i) the fund's
minimum equity interest purchasable by a prospective investor
is $50,000 (or its equivalent in another currency); or (ii) the
fund's equity interests are listed on an approved stock
exchange or over-the-counter market (Section 4(3)).
Regulation under the third category is designed for mutual funds
with sophisticated investors that are assumed to be better able to
afford professional advice in the management of their affairs. It
is the simplest and by far the most commonly used approach.
Retail Mutual Funds (Japan) Regulations
The Cayman government introduced the Retail Mutual Funds (Japan)
Regulations 2003 (the Regulations) in 2003. They apply to Cayman
mutual funds marketed to the Japanese public and were designed to
address specific concerns expressed by some Japanese distributors
and regulatory bodies. The Regulations do not apply to a fund that
existed before November 17 2003 (unless an election is made to fall
under the Regulations).
If the Regulations apply to a fund, in addition to the
requirements of the MFL, CIMA must be provided with additional
reports and information. The Regulations provide that the offering
document for retail mutual funds must contain certain information.
They also require that specific service providers be appointed for
the funds and provide for certain duties and responsibilities to be
carried out by service providers. It is extremely important that
service providers understand their new obligations with respect to
these retail mutual funds. The requirements for administrators, in
particular, are onerous and some administrators will not act in
relation to funds where the Regulations apply.
In response to dissatisfaction with the Regulations expressed by
certain service providers and fund managers, Walkers entered into
dialogue with CIMA to examine the application of the Regulations in
practice. CIMA confirmed that, as the Cayman regulator, it was
concerned with Cayman Islands issues and that the Regulations were
not an attempt to legislate in relation to matters of Japanese law
and regulation.
CIMA also confirmed that, in practice, a retail mutual fund may
be structured so that the Regulations do not apply, saving the fund
legal and regulatory fees. The definition of a retail mutual fund
in the Regulations is a mutual fund licensed under section 4(1)(a)
of the MFL whose units have been or are intended to be offered to
the public in Japan. Falling outside this definition would be: any
fund (including a retail mutual fund offering interests to the
public in Japan) that registers under section 4(1)(b) of the Mutual
Funds Law; and any fund (including a retail fund offering interests
to the public in Japan) that requires a minimum subscription of
$50,000 and that registers under section 4(3) of the Mutual Funds
Law.
Clearly the offering document must not say that the fund is
regulated under the Regulations if it is not. In addition, parties
structuring these trusts should seek the advice of Japanese counsel
in relation to domestic Japanese regulatory requirements. However,
as a matter of Cayman law, these are options open to a fund manager
who does not want a fund to fall within the ambit of the
Regulations.
Partnership
The Cayman Islands should be the first choice for fund managers
in Japan looking to set up offshore funds. Cayman law and
regulation have developed in close partnership with the private
sector to ensure that they meet the needs of the financial
community. Through this partnership, the government has established
sophisticated and efficient supervision and regulation to safeguard
the jurisdiction's integrity, while creating an operating
environment that is highly attractive to private enterprise.
Author
biographies
Ian Ashman
Walkers
Ian Ashman is a law graduate of Newcastle University, England
and trained as a solicitor with Denton Hall in London. After
qualifying in 1991, Ashman moved to the corporate department of
Theodore Goddard and then in 1993 to the role of UK and
international counsel to a large multinational company.
Ashman was admitted as an attorney in the Cayman Islands and
joined Walkers in 1995. He became a partner in 2000.
Ashman specializes in capital markets and structured finance
products, including securitizations, secured note programmes,
CBOs/CLOs and project bonds as well as asset finance and investment
funds. He heads, together with Wayne Panton, the capital markets
and structured finance
team.
John Rogers
Walkers
John Rogers graduated with honours in law from Bond University,
Australia and with a Bachelor of Commerce from the University of
Adelaide, Australia.
In 1996 he joined a leading South Australian commercial law
firm, Fisher Jeffries, as a corporate and commercial lawyer and in
1997 he was admitted as a barrister and solicitor in South
Australia.
In 1998, Rogers moved to London to join Clifford Chance. During
his time in the London office he worked in the asset finance
department specializing in structured and asset finance. In 2001 he
was seconded to the finance department of Clifford Chance's Hong
Kong office where he worked in the areas of project finance and
restructuring. Rogers was also seconded for over six months to the
Hong Kong project finance and advisory team of a large French
bank.
Rogers joined the Hong Kong office of Walkers in 2003, where he
specializes in asset (including aircraft finance) and structured
finance transactions and general corporate
law.
Mark Lewis
Walkers
Mark Lewis graduated from the University of Western Australia in
1981 with an honours degree in law. He completed his articles and
initial training with Freehill, Hollingdale & Page, a large law
firm in Australia, and was admitted to practise there as a
barrister and solicitor in December 1982.
Lewis is also admitted to practise in England and Wales as well
as the Cayman Islands.
Lewis also gained extensive international experience working
with Denton Hall in London and Japan, working in the banking,
corporate finance and entertainment law departments. He
subsequently moved to Theodore Goddard where he worked on
international asset finance and capital markets transactions in
Russia, Poland and Hungary.
Lewis joined Walkers after graduating with a Master of Laws
degree (LLM) in corporate finance and international taxation from
Cambridge University in 1993 and now specializes in all aspects of
mainstream corporate work, particularly investment funds and asset
finance. He is a Notary Public. Lewis is joint head, with Jonathan
Tonge, of the firm's investment funds team and has spoken at
numerous conferences on various aspects of both private equity and
hedge funds.
Lewis is listed as a leading Cayman Islands lawyer in the 2003
edition of the International Who's Who of Private Funds
Lawyers.
Vicki Hazelden
Walkers
After qualifying as an English solicitor in 1996,
Hazelden worked in the securities group at Clifford Chance in
London and then for Cadwalader Wickersham & Taft where, in
addition to advising international clients and governments on
corporate matters, she acted for a number of US and UK investment
banks.
Hazelden was admitted as a Cayman Islands attorney in 2000 and
is also admitted in the British Virgin Islands (BVI). She works
principally on investment funds, structured finance and asset
finance (including aircraft finance) matters. Hazelden also has
extensive experience of listing companies on the Cayman Islands
Stock Exchange.
Hazelden has spoken at a number of conferences on corporate
matters and is a member of the International Bar Association. She
became a partner in 2003 and is now the resident managing partner
of the firm's Hong Kong office.
Walkers, Hong Kong
Tel/Fax: +852 2284 4566 / +852
2284 4560
E-mail:
vhazelden@walkersasia.com
Website:
www.walkers.com.ky
Walkers SPV Limited, Tokyo Branch
Tel/Fax: +81 (0) 3
3560 1321 / +81 (0) 3 3560 1322
E-mail:
skip.hashimoto@wspv.com
Website: www.wspv.com