The global stage
Today's board members would be forgiven for feeling a little
weary of the regulatory juggernauts that are blasting repeatedly by
and leaving them contemplating yet more new rules or directives. In
the past, the fatigue might have been driven by the rules that
applied in the jurisdiction of incorporation, but not now. Global
financial service providers are no longer solely bound by or
subject to the rules of their home jurisdiction. Participation in
global capital markets has resulted in the extension and
extra-territorial application of home-ground rules of corporate
governance, notwithstanding the jurisdiction of the entity's
formation, primary listing or licensing.
The global regulatory scene over the last half-decade has been
dominated by the anti-money-laundering movement; corporate
governance will monopolize the second half. The ongoing development
of international principles of best practice has placed additional
pressure on governments and regulators to attain the globally
approved benchmark. Failure to do so within a reasonable timeframe
might eventuate in a jurisdiction being labelled (formally or
informally) as non-compliant and higher-risk. Equally, investors
and stakeholders alike now actively assess the corporate governance
practices of the subject entity before investing or transacting.
The level of scrutiny is unrelenting.
The Cayman Islands approach to corporate governance
As a British overseas dependant territory, the Cayman Islands
legal system is founded on English common law and statute.
Sophisticated corporate principles in relation to directors'
duties, shareholder rights and fiduciary responsibilities
necessarily apply. Under a Statement of Guidance on Corporate
Governance issued in October 2003, all licensees must adhere to
fundamental principles of corporate governance, including guidance
in relation to the proper composition and responsibilities of the
board, the conduct and duties of a director and the adoption of a
risk-management strategy and controls. These principles are further
refined under the listing rules of the Cayman Islands Stock
Exchange. The Cayman Islands Monetary Authority undertakes a
thorough assessment of a proposed director's fitness and propriety
before approving their appointment to a licensed entity.
As a leading global offshore financial centre, the Cayman
Islands are home to over 60,000 registered companies. Whereas
jurisdictions such as the British Virgin Islands predominantly
favour personal holding companies, Cayman companies are largely
established by institutional investors for specific transactional
purposes. This is illustrated by the burgeoning investment fund and
captive insurance industries. Historically there has been a
tendency to focus on the actions or inactions of the board and
management of the parent or holding company. But as recent
corporate failures have shown, issues of corporate governance are
not solely the remit or concern of the parent board. For financial
conglomerates, the fundamental principles of corporate governance
should apply distinctly to every subsidiary and most essentially to
off-balance-sheet companies.
Largely on account of the witch-hunt in the US for unpatriotic
corporations making use of legitimate tax advantages, the term
off balance sheet has recently garnered a negative
connotation. To put it simply, the primary objective of an
off-balance-sheet transaction is that on-balance-sheet assets (or
their benefit) are irrevocably sold to the finance vehicle on arm's
length terms for cash (a true sale) and essentially moved off the
balance sheet. But for full value.
The finance vehicle is able to fund the purchase of the assets
by issuing debt or equity interests to investors on the basis of a
more favourable credit rating and limited recourse to the assets,
as they are definitively segregated from the assets and liabilities
of the originator (that is, the investor's recourse is limited
exclusively to the assets of that finance vehicle supporting the
issue of securities and, unless otherwise disclosed or agreed,
there is no comeback against other transaction parties or by their
creditors if the financing party becomes insolvent).
Corporate governance of offshore finance vehicles
Offshore finance vehicles are commonly established in the Cayman
Islands by most of the leading international financial institutions
acting as sponsors, originators and counterparties for the purposes
of accessing the international capital markets. This access
provides highly efficient and lower cost institutional funding for
a variety of enterprises, reducing the cost of many consumer items
including mortgages, car loans, and credit card receivables. For
example, the asset-backed securities market has been actively
supported by government agencies, including the Federal Reserve,
and international authorities as a highly efficient means of
reducing the ultimate costs to consumers by transferring risk
exposure from domestic banks and financial institutions to offshore
finance vehicles.
For most of these financing transactions, the makeup and conduct
of the board will be assessed by the rating agencies when
considering the significance attributed to corporate governance and
the integrity of the entity issuing the interests.
Standard & Poor's has applied qualitative processes to
assess corporate governance principles of subject entities since
2000. Under the criteria employed, the rating agency defines
corporate governance to mean: "The interaction of managers,
directors, and shareholders to direct and control the company, and
to ensure that all financial stakeholders receive their fair share
of the company's earnings and assets."
For offshore corporate vehicles to achieve their intended
purpose they must show both financial integrity and legal
independence. As mentioned above, the motives of offshore financing
vehicles have been stigmatized in political and media circles, and
a number of the critical features are misconstrued. It is usually a
key factor that an offshore vehicle is treated as being resident in
the offshore jurisdiction of incorporation or administration to
achieve fiscal or tax neutrality. The investments of the offshore
vehicle will still be taxed in the jurisdiction of the investment
and the ultimate investors will remain taxable in accordance with
the laws of their respective home jurisdictions.
The offshore adviser, establishing a financing vehicle for an
onshore originator or arranger, will need to ensure that the
vehicle has the essential integrity to withstand scrutiny for tax
purposes. The intended tax and regulatory treatment and benefit of
the offshore finance vehicle will only be obtained if the
fundamental principles are observed.
Corporate integrity, bankruptcy remoteness, non-consolidation
and tax residence
To maintain the integrity of its transactions and the benefit of
independent personality, the company must be treated as a separate
legal entity. Failure to recognize the independence could result in
the piercing of the corporate veil or a risk of substantive
consolidation (for accounting purposes). If structured correctly
(for example, by appointing an independent board and placing the
shares of the finance vehicle under a charitable trust), the
bankruptcy of other transaction parties, including the originator
or arranger, should also have no bearing on the finance
vehicle.
For off-balance-sheet vehicles, the certainty of
non-consolidation of the assets and liabilities on the financial
statement of the originator (or a related party) is crucial in the
context of the company being able to obtain a credit rating as a
separate legal entity, distinct and superior to that of the
originator, which consequently facilitates access to capital at
more competitive rates. Similarly, onshore revenue authorities will
often apply a mind-and-management or management-and-control test to
ensure that real control of the vehicle is shown by the board
members charged with that responsibility.
Independent corporate control and transparency
For the above-mentioned purposes and to avoid possible
allegations of consolidation or sham, it is important that the
governance and management of the finance vehicle be sufficiently
independent of the governance and management of the transactional
parties, especially the originator and the arranger. This is often
not recognized by arrangers and might be difficult to explain to
parties (with vested interests in the company) who might be
unfamiliar with the rationale behind the principles of
independence. This is particularly so when greater time and cost in
the initial structuring is required. But it should be
understandable that all interested parties will need to consider,
understand and approve information explaining the nature of the
relevant transactions, their commercial consequences and the risks
involved.
More importantly, any business transacted should be carefully
considered and appropriately documented by the board. It is
essential that the offshore directors have adequate opportunity to
review any business proposal and relevant deal documentation to
assess the benefit (or otherwise) of the company agreeing to
proceed. Inadequate time constraints for the development or
consideration of such documentation by board members can be used to
undermine the credibility of the board's authority.
Offshore directors will be ideally placed to determine whether
any local legal or regulatory factors should be considered and
disclosed or whether any further controls should be implemented
before approving the transaction. They must be allowed to apply
their skill independently in the best interests of the offshore
company. Any risks must be reasonably calculated against the
likelihood and quantum of expected profit or benefit. Simple
rubber-stamping by the directors and officers without the exercise
of informed discretion or at the authorized direction of others
will be used to challenge independence and might emasculate the
integrity of the company. If necessary, the board may rely on the
records of their decision-making to defend themselves against
allegations of impropriety or to assist with an investigation.
The impact of recent onshore measures
It is evident that many of these principles can be equally
attributable to the common onshore listed private company and their
importance does not appear to have been lost on the US
regulators.
In the US, the introduction of the Sarbanes-Oxley Act of 2001
was heralded as the most influential piece of securities
legislation in the US since the Franklin D Roosevelt
administration. The law was ushered in after several spectacular
corporate collapses, which, aside from the ubiquitous element of
fraud, arose from a lack of adequate commitment and control in the
boardroom, coupled with oversight failure of the auditors,
analysts, rating agencies and, more particularly, the regulators
themselves.
Sarbanes-Oxley is largely a law that prescribes greater
financial reporting and disclosure and promotes greater accuracy
and transparency. It seeks to raise the level of consciousness
within and without the boardroom, to fuel a restoration in investor
confidence and to crystallize fundamental corporate
responsibilities. These are all admirable qualities, but many
commentators rightly regard the law as incapable of preventing the
type of fraud that lay at the core of each of the most recent
collapses. There are also fears that the attention paid to
prescriptive requirements will distract the focus of companies to
create shareholder value and might cause investors to have false
expectations of the board. Over-amplifying and legally formalizing
the aspects of corporate governance might become an end and not the
means.
For foreign participants in the US markets (that is, foreign
issuers), there are greater concerns. Owing to the extraterritorial
affect of the law, foreign issuers must endeavour to marry the
requirements of Sarbanes-Oxley with their own jurisdictional
requirements. Despite certain limited concessions made to foreign
issuers under the law, there will still be inconsistencies in scope
and application. Separate standards of compliance might have to be
introduced and implemented. Exceptions to fundamental practices and
legal obligations might be required (for example, forfeiting the
confidentiality of business undertakings to make certain
certifications and disclosures to US authorities).
Addressing trading abuses in the mutual funds arena, the SEC has
imposed hefty fines and has proposed a raft of new rules in an
attempt to counter the transgressions, which some feel have been
tacitly ignored by fund boards. The SEC recently proposed the
introduction of independent board chairmen and other measures to
strengthen the oversight of the fund from within.
In May 2004, the Federal Reserve, FDIC, Office of the
Comptroller of the Currency, Office of Thrift Supervision and the
SEC issued a joint statement on Sound Practices Concerning Complex
Structured Finance Activities, which recommends that financial
institutions (for example, investment banks, broker-dealers and
investment advisers) should adopt and maintain defined policies and
procedures that provide for the identification, evaluation and
control of risks associated with complex structured finance
transactions. These policies and procedures might include an
approval process for transactions or products, risk identification
and enhanced scrutiny procedures, audit and legal reviews and board
notification.
The considerations under the statement are quite prescriptive
and it will require a great deal of effort for the financial
institution to build them into a risk infrastructure, if they do
not already exist. Although the financial institution will carry
out most of the work, there will need to be a significant amount of
interaction with the board of the offshore vehicle to determine the
accuracy of information and legal or regulatory requirements. The
principles of independence and corporate integrity will need to be
borne in mind by the financial institution, especially when
requesting information from, or providing directives to,
off-balance-sheet vehicles, so that the principles underlying
independent directing mind and corporate personality are not
prejudiced.
Beyond fraud-inspired corporate failures and reactive
over-arching legislation or rule making, there have been a number
of recent challenges within the capital markets that have
reiterated the need for proper corporate governance and specialist
knowledge. The market downturn has caused the restructuring of
certain finance transactions and the re-evaluation of service
providers. Such reorganization could not be properly effected
without experienced board members' valuable input and
understanding.
Vehicles face increased scrutiny
The corporate failures, Sarbanes-Oxley and the joint statement
each reinforce the need to have directors and advisers who
understand the international capital markets and the complexity of
the products now being developed and employed. Like their onshore
listed counterparts, offshore financing vehicles are facing
unprecedented scrutiny from accountancy bodies, tax authorities,
foreign courts, rating agencies and regulators. For those with
vested interests in an offshore financing or investment vehicle,
this should translate into careful consideration when selecting a
service provider (for either board membership, administration or
audit and legal counsel) so that the company will have the
integrity to withstand onshore legal, accounting and regulatory
challenge.
Homegrown fraud, at least from the perspective of the US, has
produced measures that impose direct regulatory obligations on
foreign market participants and apply indirect requirements and
greater controls on dealings with offshore subsidiaries. As for the
move toward more prescriptive rules for corporate governance,
whether the Sarbanes-Oxley Act (or any other substantive law for
that matter) has extraterritorial reach or not, we should be alert
to potential regulatory changes outside of the US reflecting
similar requirements. Such well-publicized regimes have a tendency
to either creep informally or shadow the legal framework of
associated jurisdictions. It should be remembered that the
regulatory regime in the US was tailored to treat distinct issues
and might be too unwieldy for its own members, let alone provide a
model example for the future of corporate governance.
Author
biography
Martin
Livingston
Maples and Calder
Martin graduated from the University of Otago, New Zealand, in
1994 and was admitted as a barrister and solicitor of the High
Court of New Zealand in 1994. Before joining Maples and Calder in
2002 he worked for Phillips Fox, a large Australasian law firm, and
then for Deloitte and Touche, and Barclays Private Bank & Trust
in the Cayman Islands. He was admitted as a Cayman Islands
attorney-at-law in 2003.
Martin specializes in advising clients on regulatory and
anti-money-laundering issues, including licensing, risk control and
compliance matters. He is a member of the New Zealand and Cayman
Islands law societies and is president of the Cayman Islands
Compliance Association.
Maples and Calder
PO Box 309GT, Ugland House
South Church Street
George Town, Grand Cayman
Cayman Islands
Tel: +1 345 949 8066
Fax: +1 345 949 8080