Cayman Islands vehicles

Author: | Published: 5 Jan 2004
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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