The prognosis for the Japanese market is, we are told, that
domestic banks will increasingly rely on securitization to meet
regulatory capital requirements and that small and medium-sized
companies will look to diversify their sources of funding and,
equally, will be looking to securitization.
Whether or not this is the case is difficult for Cayman Islands
attorneys to determine from a small and sunny island in the
Caribbean. However, we are in a position to remark on the
continuing involvement of Cayman Islands special purpose vehicles
in Japanese structured finance transactions.
Such involvement ranges from the simple use of Cayman corporate
vehicles as holding companies at one end of the spectrum to the
use, at the other end, of a Cayman company as the entity that
itself issues notes or asset-backed commercial paper, enters into
credit derivative transactions or assumes obligations in
credit-linked loan transactions.
At each extreme, the involvement of a Cayman company is
testament to the particular features of Cayman Islands corporate
and insolvency law that continue to make the Cayman Islands the
offshore jurisdiction of choice for structured finance
transactions.
Structured finance transactions and the special purpose
company
Structured finance transactions usually involve the creation of
a special purpose company (SPC) set up for the sole purpose of
participating in a given transaction. The SPC is often incorporated
in an offshore jurisdiction such as the Cayman Islands for tax
reasons.
The involvement of the Cayman SPC in Japanese transactions may
be limited to acting as a holding company, where it is the sole
unitholder of a Japanese yugen kaisha (YK) or tokutei mokuteki
kaisha (TMK) - the active, participating entity in the structure.
In such cases, certain elements of bankruptcy remoteness as well as
orphan status for the Japanese YK or TMK are achieved by using the
Cayman holding company, whose voting shares are held under the
charitable trust arrangements with which the rating agencies and
investors are familiar.
The Cayman SPC may also issue preferred shares as a means to
fund the capitalization of the Japanese subsidiary as well as an
additional profit extraction mechanism at the top of the structure.
These holding company structures are increasingly common in
smaller, often property-related, transactions that may then be
subject of a further securitization by the entity lending to the YK
or TMK.
In secured credit-linked loan transactions, the SPC will use
borrowings from a lender (who may be seeking synthetic exposure to
certain underlying securities) to fund its purchase of securities
and enter into credit default and/or asset swap transactions whose
provisions will closely correlate to its repayment obligations to
the lender.
In the simplest securitization structure, the SPC will purchase
a pool of receivables or other assets from the originator of those
assets, who will be seeking to raise cash in the international
capital markets to fund the growth of its business or to address
regulatory capital concerns. Such purchase will be funded by the
issuance of securities, repayments in respect of which will be met
from the cashflows generated by the underlying assets as modified
or enhanced by ancillary derivatives and insurance
arrangements.
Despite the passing of the Law Concerning the Securitization of
Specified Assets (the Securitization Law), which provided a
legislative framework for securitization transactions in Japan and
for the creation of a new type of legal entity (the TMK) dedicated
to such structures, Cayman SPCs have continued to be involved in
transactions involving assets originated in Japan. In certain
cases, the reasons for Cayman's continued involvement in such
structures (on occasions in a structure also incorporating a
Japanese TMK) has been something more than the familiarity of the
international capital markets with Cayman issuers.
In such cases, certain features of Cayman law, particularly in
relation to the granting of security interests, have provided an
interface between the particularities of domestic legislation and
the expectations of investors outside Japan. Similarly, despite the
enactment of the Chukan Houjin Law in 2002 and the expected arrival
of domestic legal concepts enabling the attainment of bankruptcy
remoteness, which is integral to structured finance transactions,
Cayman SPCs continue to be seen in many Japanese structures.
One explanation for this is that Cayman Islands law, the
particular forms of corporate entity evolved by that law and the
very nature of the jurisdiction itself continue to make the Cayman
Islands an attractive option when transactions are being
structured.
Cayman Islands law: suited to structured finance
The Cayman Islands is a jurisdiction that is outward-looking.
Most corporate entities already incorporated or presently being
incorporated are exempted companies - companies that conduct their
business mainly outside the Cayman Islands. The companies
legislation in the Cayman Islands has its origins in English law
but has evolved into a form that meets the demands of international
transactions conducted outside the Cayman Islands and that is
flexible enough to accommodate the changing and developing nature
of such transactions.
Below are some of the features of Cayman law that make the
Cayman SPC particularly suitable for international financing
transactions.
First, there is statutory enforcement of contractual
subordination, set-off and netting agreements. Under the Cayman
Islands Companies Law, contractual subordination, set-off and
netting arrangements have statutory force, both before and after
the onset of the SPC's insolvency. This means that both those
structuring transactions and creditors can be confident that a
priority of payments agreed by a Cayman SPC is enforceable by
creditors even if those creditors do not have the benefit of an
associated security interest. This ensures that a payment waterfall
will bind all creditors even where some creditors may only have an
unsecured and subordinated interest.
Secondly, unlike the position in many other jurisdictions, the
provision of financial assistance by a Cayman company for the
purchase of shares in that company is not unlawful, although the
directors must ensure that the transaction is demonstrably for the
material benefit of the company. This makes Cayman an attractive
jurisdiction for use in whole business securitizations.
Thirdly, the ability of a Cayman SPC to pay dividends on shares
out of share premium, and to redeem shares out of capital and share
premium as well as profits, enables transactions to be structured
whereby securities that have the legal characteristics of equity
can have the economic substance of debt. This is achieved by
arranging for shares to be issued with a par value as a small
proportion of their issue price, thereby ensuring that most of the
proceeds are entered into the Cayman SPC's share premium account -
this exists for accounting purposes in relation to the issuance of
shares at a premium. The existence of a credit balance on the share
premium account facilitates making periodic payments as well as
payments which are more in the nature of a return of capital or
repayment of principal. Structuring of this nature is not readily
achieved in other offshore jurisdictions where redemption of shares
and the payment of dividends are subject to greater
restrictions.
Fourthly, Cayman Islands law is one of the most creditor
friendly of all jurisdictions and is therefore suited to structured
finance transactions. As stated, contractual netting, set-off and
subordination provisions are all recognized by Cayman legislation
and given effect to both before and after the onset of any
liquidation. There are no provisions for corporate rehabilitation
such as the English administration procedure or US Chapter 11
proceedings, which have the effect of freezing secured creditors'
rights, and no general concept of an insolvency stay. Liquidators
cannot disclaim onerous contracts as in the UK and other
jurisdictions. Since the jurisdiction does not levy a tax on SPCs
and an SPC will have no employees, only unpaid Cayman government
charges, which should be minimal, will be preferred to the claims
of secured transaction creditors on insolvency. In relation to
fraudulent preference rules, these are limited in scope insofar as
they apply only to a six-month pre-insolvency period where a
company has evidenced a dominant intention to prefer one creditor
to another at the time of the granting of the relevant
preference.
Fifthly, in the absence of fraud, the Cayman courts will not
generally step in to re-characterize transactions. Heavily
subordinated debt with the economic characteristics of equity will
not be re-characterized as equity. Subordinated creditors therefore
have certainty that their securities will have the contractual
status of debt, as contemplated in the transaction documents, and
they will enjoy the rights of creditors against the SPC.
Sixthly, there is no established doctrine in the Cayman Islands
of substantive consolidation - the principle that, on a bankruptcy
or liquidation or in other insolvency proceedings, the assets and
liabilities of two companies may be treated as though such assets
and liabilities were owned and incurred by one entity. Cayman
Islands law recognizes the fundamental principle of English law
that a company has separate legal personality from its
shareholders. Absent exceptional circumstances where there is some
compelling case for disregarding this principle (such as fraud),
the Cayman courts would not consolidate the assets and liabilities
of one entity with those of another entity. Moreover, the Cayman
courts do not have jurisdiction (and would not be able to assert
jurisdiction) to wind up any entity incorporated other than under
the laws of the Cayman Islands.
Finally, there are no restrictions on an SPC in the Cayman
Islands lending, borrowing or issuing debt securities. In
particular none of these activities require any banking or other
financial services registration or licensing. Specifically, no
regulatory approval is required, as in some offshore jurisdictions,
for the acquisition of consumer loan receivables by an SPC.
The exempted company: a legal entity suited to structured
finance
Most structured finance transactions using the Cayman Islands
employ the exempted company, although note issuances by
Cayman-formed partnerships and by Cayman law governed trusts have
been effected more recently in non-Japanese transactions. In
addition, segregated portfolio companies (whose assets and
liabilities are statutorily ring-fenced within one or more of the
separate and independent portfolios of which such entities are
composed) have been used in transactions involving multiple
issuances or transactions where natural ring-fencing has not been
provided by security and by conventional limited recourse
arrangements. But the exempted company remains the usual corporate
vehicle.
There are various reasons why the Cayman exempt company is
particularly suitable for structured finance transactions. Many of
these are also applicable to other types of vehicle under Cayman
law, but the markets are familiar with exempted companies and their
particulars advantages.
Tax
Exempted companies are free from any form of
income tax, capital gains tax or corporation tax, and no
withholding tax is imposed by the Cayman Islands on any cash flows.
Exempted companies are eligible to apply for an undertaking from
the Cayman government to the effect that they will remain tax-free
for a period of 20 years (which can be extended to 30 years where
the term of the transaction requires this) in the event of any
legislative changes relating to taxation matters.
Government consents or approvals
No such consents or
approvals are required in connection with an SPC's participation in
any particular securitization transaction or in connection with a
company's amending its constitutional documents.
Asset types
There is no limit to the classes of
asset that can be acquired by an SPC or the types of notes or bonds
that can be issued by that entity.
Directors
There is no requirement that directors of
an exempted company be residents of the Cayman Islands or that
board meetings be held in the Cayman Islands.
Administration
Cayman Islands law does not impose
any restriction on the appointment of service providers to Cayman
SPCs and the trustees, agents and administrators of transactions
can be placed in the jurisdiction that is most convenient for the
transaction.
Accounting
The Cayman Islands does not impose its
own accounting standards and, to the extent that accounts need to
be prepared in respect of an SPC, they can be prepared using the
most suitable international accounting principles taking into
account the jurisdiction of the law governing the receivables.
Reporting requirements
Annual reporting requirements
are minimal, consisting of statements signed by a company director
or secretary that the SPC has conducted its operations mainly
outside the Cayman Islands. There is no requirement for audited
accounts to be prepared.
Capitalization
There is no statutory minimum capital
for setting up an SPC although paid-up share capital of $1,000 is
customary. This is a much lower figure than the equivalent minimal
capitalization of other jurisdictions.
Costs
Establishment costs for an SPC remain low, as
do the fees of the local corporate administrators and law firms.
The only fees payable to the Cayman Islands government are based on
the SPC's authorized share capital, which, for most SPCs, is only
$574 per year.
Speed
An exempted company can be incorporated within
one working day at express rates.
Migration
Cayman Islands law allows a Cayman Islands
SPC quickly and cheaply to de-register and relocate to another
jurisdiction if changes in tax or other laws adversely affect the
tax or regulatory treatment of a specific transaction.
The Cayman Islands - the jurisdiction to service structured
finance
The Cayman financial services industry has developed over nearly
four decades into one of the most professional and sophisticated
offshore centres. The Cayman Islands has a constitutional
relationship with the UK (being a British Overseas Territory),
which, together with its prudent economic policies and strong
financial services sector, results in the Cayman Islands' enjoying
a AAA sovereign risk rating. The Cayman Islands has autonomy in
respect of domestic matters such as taxation and financial
regulation.
The Cayman Islands has a robust judicial system through the
Grand Court, which has ultimate appeal to the Privy Council of the
House of Lords. This results in a level of predictability in
relation to Cayman Islands law and inspires confidence in investors
and arrangers. All of the leading accountancy firms are represented
in the Cayman Islands.
The jurisdiction also has excellent professional trust and
corporate administration companies that act as trustees and who
provide directors and other corporate services to SPCs. Many of the
service providers and attorneys on the island have extensive
experience of work in large financial centres such as London, Tokyo
and New York, and appreciate the need for the swift closing of
transactions that are sensitive to the markets and timing.
Conclusion
The Cayman Islands is an English common law jurisdiction and, to
that extent, belongs within a legal tradition that has given rise
to some of the legal concepts that are fundamental to transactions
taking place in the international financial markets. But, at the
same time, Cayman Islands legislation has simplified some of those
areas that have caused technical difficulties under, for example,
English law. When combined with the Cayman Islands' developed
infrastructure and expertise, the result is a user-friendly, modern
and commercial jurisdiction that is sensitive to the new ways in
which business is transacted and able dynamically to accommodate
the evolving needs of the markets.
Author
biographies
Philip
Paschalides
Walkers
Philip Paschalides graduated from the University of St Andrews
with first class honours and The City University with a
Commendation in the CPE/Diploma in Law in 1995. Philip was called
to the Bar in 1997 and completed pupillage at specialist banking
and finance chambers before he moved to the international finance
group of Sidley Austin Brown & Wood in London, where he spent
around four years working in a dedicated securitization and
structured finance team.
Paschalides has worked for arrangers, issuers, credit enhancers
and trustees on a wide range of structured finance transactions,
both cross-border and domestic, publicly listed and privately
placed. Securitizations on which he has worked have used a variety
of structures and involved numerous asset classes employing future
flow, whole business and more traditional income streams. He has
been especially involved in securitizations of Japanese consumer
loan receivables.
Paschalides joined Walkers in 2002 and focuses principally on
securitizations, note programmes, repackagings, collateralized debt
obligations and other structured finance and capital markets
transactions, although his practice extends to other matters of
banking and finance law.
Heather
Bestwick
Walkers
After obtaining arts degrees in the UK and Canada, Heather
Bestwick trained as a solicitor with Norton Rose in London.
Following admission in 1993, she joined the banking department,
specializing in asset finance and acting for banks, ship owners and
the UK Department of Trade & Industry. In 1996, she was
seconded to the Norton Rose office in Piraeus, Greece, where she
worked mainly for banks and financial institutions.
As a member of Walkers' corporate and international finance
department since 1999, Bestwick works on a wide range of structured
finance transactions, including securitizations, secured note
programmes, collateralized bond obligations and collateralized debt
obligations. She also works on investment funds, including mutual
funds (and their listing on the Cayman Islands Stock Exchange) and
hedge funds. She became a partner in 2003.
Walkers/Walkers SPV Limited
Ark Hills Executive
Tower 4F
1-14-5 Akasaka
Minato-ku
Tokyo 107-0052
Japan
T: + 81 3 3560 1321
F: + 81 3 3560 1322
Web: www.walkers.com.ky;
www.wspv.com