The credit crisis and associated market turmoil over the last 12 months has undoubtedly stress tested the role of the directors of offshore special purpose vehicles (SPVs) and the structures used for structured finance transactions. This article looks at some of the key Cayman Islands legal principles underlying director's duties and their application in some practical contexts.
If anyone at the beginning of 2008 had said to you that by the end of the year, Bear Stearns, Lehman Brothers, Merrill Lynch and AIG would have to be either rescued or would be insolvent, you would have been forgiven for thinking they must be crazy. Yet that is what happened and directors of SPVs, as with many other market participants, were faced with an unpredicted set of challenges.
The insolvency of key counterparties, in particular Lehman, revealed gaps in transaction structures and documentation. Deterioration in the value and liquidity of portfolio collateral presented collateral managers with new challenges and unforeseen obstacles in meeting collateral quality tests and in the disposal and valuation of assets. In addition, 'scatter-gun' litigation has resulted in the assets of numerous SPVs being subject to contingent claims and the SPV being subjected to litigation process and associated expense. Finally, structured finance transactions have experienced unprecedented levels of events of default over the last couple of years.
As a result, SPVs are increasingly asked to assist in implementing amendments to transaction documentation, replacing various transaction parties and also in facilitating the disposal of collateral, the redemption of securities and the defence of litigation against the SPV. It has certainly not been a case of sign up the transaction and sit back and wait until maturity or redemption.
Directors have had to be extremely careful to understand the implications of any changes and to take great care when taking or authorising any action on behalf of the SPV. Any sensible director will have been taking steps to ensure that proper administrative and legal processes are followed, the appropriate interests are considered (for example, if changes prefer certain creditors over others) and that their corporate duties are properly discharged.
Duties of directors
Broadly speaking, the duties that a director owes to a Cayman Islands company may be divided into two categories. The first category encompasses duties of care, diligence and skill. The second category encompasses fiduciary duties, that is, the duties of loyalty, honesty and good faith. Each is considered in turn below. The duties are owed to the company itself and not, for example, to individual shareholders or creditors.
The duties of care, diligence and skill have been traditionally regarded as subjective. Therefore, a director of a Cayman Islands company is normally only obliged to exhibit such skill as he actually possesses and not such care and diligence as would be displayed by a reasonable man in the circumstances.
The three tests laid down in the leading English case (Re City Equitable Fire Insurance Co Ltd) are as follows:
(a) A director need not exhibit, in the performance of his duties, a greater degree of skill than may reasonably be expected from a person of his knowledge and experience.
(b) A director is not bound to give continuous attention to the affairs of the company. He should attend such meetings as he ought to attend whenever in the circumstances he is reasonably able to do so.
(c) In respect of all duties that, having regard to the exigencies of business and the Articles of Association, may properly be left to some other manager, a director is, in the absence of grounds for suspicion, justified in trusting an official or manager to perform such duties honestly.
This case was decided in 1924. We are of the opinion that the standard of care now required of a director is probably higher. Although the tests set out in this case have been specifically imported into Cayman Islands law, the thrust of English case law has been to expand and increase the burden on directors.
For example in certain cases it has been suggested that the duties of directors are to be assessed in accordance with a test contained in s214(4) Insolvency Act 1986 in England and Wales, based on what a "reasonably diligent person having both (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company and (b) the general knowledge, skill and experience that director has" would do.
It should be noted however that there is no equivalent statutory provision in Cayman Islands law, and it remains to be established whether the Cayman Islands court would consider that this test is appropriate to import into Cayman Islands law. Nonetheless, with the complexity of financial transactions increasing, it is no longer safe for directors to rely upon the earliest English cases which required directors to bring to the boardroom table only such expertise as they happened to possess – a subjective standard.
Fiduciary duties
The second category of duties that a director owes to a Cayman Islands company encompasses fiduciary duties. The fiduciary duties may be described as being those of loyalty, honesty and good faith to the company. In practical terms, this means that directors have to act bona fide in what they consider is in the best interests of the company, that they must exercise the powers vested in them for a proper, and not collateral, purpose, that they should not improperly fetter the powers that have been granted to them and that they should not place themselves in a position in which there is a conflict between their duty to the company and their personal interest.
It is a central part of the discharge of such fiduciary duties for the directors of a Cayman SPV that the directors ensure that the SPV can be anticipated to meet all its obligations and ultimately obtain a net benefit from its activities. While the taking of risk is inherent in business, the directors must be able to properly identify, evaluate and deal with that risk in the context of the rewards to the SPV (usually fairly nominal). This requirement converts into a range of practical issues depending on the particular circumstances, including limited recourse, external guarantees or indemnities, suitable provisions for ongoing expenses being made and ensuring that representations and warranties are carefully addressed and appropriately backed-up.
Directors should also be mindful of solvency issues as once a company is insolvent, or doubtfully solvent, case law suggests that the directors must consider the creditor's interests as part of their duty to act in the interests of the company itself. A properly structured transaction should contain appropriate limited recourse language in order to ensure that the unsatisfied creditor's claims are extinguished upon the application of the collateral and accordingly that the SPV is never technically insolvent. Having said that, directors will need to consider the SPV's position carefully (especially with regard to competing interests of the various transaction parties) if they are aware that a default is imminent.
In view of the specialist nature of the business carried on by SPVs, the importance of the directors' understanding of their business and their ability to assess the cash flows and risks related to the SPV's role cannot be underestimated. SPVs need to have both directors and advisors who understand the international capital markets and who are able to adapt to and understand the increasing innovation and complexity of structured transactions.
Amendments to transaction documentation
As investment banks or collateral managers are downgraded or exit out of the structured finance market, SPVs are being increasingly asked to provide consents to, or effect, the replacement or removal of the same. For the most part, the documentation governing structured finance transactions identifies clear processes and conditions for changes to parties and structure. For example, it is likely that the replacement of a collateral manager requires the consent of a specified percentage and/or class of noteholders, the consent of any swap counterparties and/or note insurers and that the relevant rating agencies confirm that the proposed action will not cause a reduction in or withdrawal of the ratings of the securities issued by the SPV.
In such instances, provided that the relevant conditions precedent are met, there is often little discretion on the part of the SPV and the role of the directors in approving the same is largely procedural. Nonetheless, directors of SPVs should take care to ensure that the relevant requirements of the documentation are complied with and that counsel are engaged to advise upon the same as appropriate. In particular, directors of SPVs should not rely on rating agency confirmation having been obtained as an assurance that the proposed actions are in accordance with the transaction documentation. As stated by Standard & Poor's in their ratings criteria entitled "Methodology for Analyzing CDO Transactions That Purchase Their Own Debt":
"When reviewing rating agency confirmation requests (RAC) requests, we typically look at the impact the proposed changes will have on ratings given our current criteria. To determine the impact, we may conduct a full set of cash flow analyses. Standard & Poor's does not, however, generally evaluate whether proposed amendments need investor consent. Under the terms of the transaction documents, it is the issuer and its legal counsel who typically make this determination."
An area of current concern for managers is the potential need to amend the indenture to take into account the current market dislocation in terms of pricing of loan assets. In the face of deteriorating portfolio collateral, managers are proposing amendments to collateralised loan obligation (CLO) indentures to provide them with more flexibility to permit the substitution of deteriorating loan assets for loan assets of better credit quality without causing a breach of the overcollateralisation test (the OC Test).
While the rating agencies may be prepared to provide rating agency confirmation on the basis of the increase in credit quality, it should be noted that investors may have differing agendas and it may not necessarily be in each of their interests that, by allowing an amendment to the indenture, a breach of the OC Test is avoided. For example, a breach of the OC Test may give the senior noteholders a right to call the deal and for the SPV's cash to be diverted to the senior noteholders in accordance with the payment priorities upon default. Accordingly, given the potential for conflicting interests, directors of SPVs should approach amendments to indentures with caution and take advice as appropriate. This is especially the case in circumstances where the indenture is silent on the need for investor consent and the same is not being sought.
Contingent liabilities
SPVs are susceptible to being named as defendants in actions concerning assets held or acquired by the SPV. In the usual course, the SPV will have delegated the function of managing the assets to a collateral manager. As a consequence, the collateral manager will act on the SPV's behalf with respect to such litigation and no action will be required of the directors of the SPV.
However, in certain circumstances, litigation with respect to assets of the SPV has necessitated the directors of the SPV taking a more involved approach.
For example, an asset of the SPV might be subject to litigation at a time when the SPV is seeking to liquidate its collateral and redeem its securities. The existence of litigation in respect of the asset means that the claim against the SPV arising under or from such suit (however tenuous) constitutes a contingent liability which might may not be fully determined or settled for an extended period of time. The SPV will be unable to liquidate the asset and will itself need to continue in existence (resulting in the incurrence of ongoing costs to the SPV), until the suit is determined or settled.
The claim is typically a full recourse liability against the SPV on the basis that the claimant does not have a direct contractual relationship with the SPV containing the usual limited recourse language. A director owes his fiduciary obligations to the company and, if there is any doubt as to the solvency or potential solvency of the company, the directors must consider the creditors' interests as part of their duty to act in the best interests of the SPV itself. Accordingly, in determining whether or not to make a redemption payment which would leave the SPV with substantially no other funds to meet the full recourse claim if it ceases to be contingent, the directors of the SPV must take into account the interests of any potential creditors in determining what is in the SPV's best interests.
If the directors breach their fiduciary duties, they may be personally liable to the SPV in damages. The measure of damages will be either the loss suffered by the SPV or the improper profit made by the director. Consequently, in this particular situation, if the directors of an SPV authorise a full redemption payment to the SPV's security holders without making any provisions to cover the costs of the litigation claim then, to the extent such a claim succeeds against the SPV, the directors could be personally liable for any shortfall that the SPV would suffer from not being able to meet such claim.
While it might be an option in certain instances to delay the redemption of the securities until the claim has been determined, the transaction documentation often does not provide for the redemption to be deferred or such deferral may be unpalatable to the security holders (especially where the claim is tenuous and likely to be drawn out). Accordingly, directors of SPVs are being asked to consider allowing the redemption to proceed notwithstanding the existence of the claim.
In such circumstance, directors should seek advice from counsel and the collateral manager as to the likelihood of the claim being successful, the amount of any such claim and/or the timing as to settlement. Based upon such exposure analysis, the directors of the SPV may be willing to authorise a redemption payment provided that sufficient funds will be set aside to cover: (i) the ongoing costs and expenses of the keeping the SPV in existence (including fees of service providers and legal advisers) pending the outcome of the litigation; and, (ii) if necessary, the contingent liability.
With respect to the latter, it may be that, based on the exposure analysis, a decision is made to set aside a reserve for only a proportion of the total exposure under the claim. If only a proportion of the claim is set aside as a reserve, the directors should also consider requiring the security holders to enter into a disgorgement agreement. Here, security holders agree funds distributed to them can be clawed back at a later date if the claim against the SPV is successful. If the claim is unsuccessful, any reserve can then be distributed to the security holders.
What is appropriate in any instance will need to be determined by the directors on a case-by-case basis taking into account the potential exposure and balancing the interests of the security holders in receiving timely redemption payments and the duties of the directors to act in the best interests of the SPV.
Insolvency of key transaction parties
The insolvency of Lehman Brothers in late 2008 triggered a flurry of activity – particularly on structured finance transactions where Lehman entities acted as swap counterparties and credit support providers. In most situations, directors of SPVs were able to look to the collateral manager for the appropriate course of action (based on the manager having been delegated the responsibility of managing swap transactions). But the insolvency of Lehman did highlight deficiencies in transaction structures on non-managed deals, such as static synthetic CLOs, and in structures sponsored or serviced by Lehman-affiliated entities. In relation to such transactions, Lehman typically performed multiple roles and was integral to the transaction structure. In many instances, the documentation did not envisage or adequately provide for the circumstance of Lehman being unable to perform its designated roles.
For example, on certain static deals Lehman acted in various roles such as swap counterparty, calculation agent and market or disposal agent. Upon Lehman's insolvency, the swap documentation generally enabled the SPV as counterparty to designate an early termination date and terminate the swap. For the most part, the documentation allowed the noteholders to direct the SPV as to whether to terminate the swap. In other instances, the trustee assumed the rights in this regard on the basis of the swap counterparty default having triggered an event of default under the indenture. However, in some cases, the documentation merely gave the SPV the right to terminate the swap without any provision being made for the SPV to act at the direction of a third party. Accordingly, directors of SPVs were placed in the unenviable position of determining whether the termination of the swap was in the SPV's best interests.
Added to the difficulty was that the interests of noteholders were not necessarily aligned. In many cases, senior noteholders preferred termination (even where the swap was out of the money to the SPV) on the basis that the occurrence of a termination event would result in Lehman losing priority to the senior noteholders in the payment priorities waterfall. However, notwithstanding such loss in priority, Lehman would continue to rank ahead of the subordinated noteholders. Accordingly, some subordinated holders preferred the swap to remain in place in such circumstance on the basis that, if the swap was terminated at that point in time, the subordinated holders were unlikely to receive payment under the waterfall. If the swap remained in place there was always the potential of an upside (no matter how remote) to the subordinated noteholders in the event that the swap came back in the money.
Even in circumstances where swaps were successfully terminated, difficulties remained where Lehman was engaged to perform roles such as calculation agent or disposal agent and the documentation did not cater for the insolvency of such agents. In some instances, directors of SPVs were able to obtain directions from noteholders as to the appointment of appropriate replacements. Even so, the deals did not necessarily have free cash flow from which replacement agents would be remunerated. Also, in circumstances where Lehman had contracted to meet the ongoing expenses of the SPVs, there were additional questions as to how such expenses would be funded. Accordingly, directors of SPVs were called upon to assist in resolving such issues, often at considerable expense and at risk of exposure to potential liability. Directors of SPVs will wish to ensure that such deficiencies are addressed in future transaction structures.
The salient lesson from the last 12 months has been that directors need to be fully aware of competing interests, should strive to ensure that the terms of the deal documentation are strictly complied with and that counsel are engaged to advise as appropriate. If anybody still thought that the role of the directors in an SPV was simply to sign where required and merely tick the right boxes, it is safe to say that the impact of the credit crisis has, for any sensible market participant, buried that notion forever.
| Author biographies |
Alasdair Robertson, partner
Maples and Calder
Alasdair Robertson specialises in structured finance, structured investment funds, derivatives, corporate finance, equity capital markets and structured products for hedge funds. He also advises on financial regulatory issues.
He joined Maples and Calder's Hong Kong office in 1999. He moved to the Cayman Islands office in 2001 and was made partner in 2004. Robertson previously worked for Clifford Chance in London and Hong Kong. He is recommended by the PLC Which Lawyer? Yearbook 2009.
Robertson graduated from Edinburgh University, Scotland with honours.
Joanne Ziegler, associate
Maples and Calder
Joanne Ziegler specialises in capital markets and structured finance and works primarily on collateralised loan obligations, collateralised debt obligations and net interest margin transactions. She also advises on general corporate and commercial matters.
Ziegler joined Maples and Calder in 2005. She previously worked for Russell McVeagh in New Zealand.
Ziegler graduated from the University of Auckland, New Zealand with honours. |