Part 1
It is not difficult to find negative views on Japan these days. Little has changed since the burst of the economic bubble more than 10 years ago. The constant preaching as to whether the so-called economic band-aid should be removed slowly or quickly has progressed from bad to worse. Political turmoil and scandals continue and with the third recession in a decade upon us, few have thrived over the years. However, there is one financial tool that has not changed and has in many ways thrived over this span of time - that is the use of structure finance involving Cayman Islands special purpose companies (SPCs).
Until the development of the Japanese version of the Cayman SPC - also known as the TMK (tokubetsu mokuteki kaisha) - in September 1998, the use of Cayman SPCs and, in particular, the double SPC structure, was more or less the norm in the majority of Japanese securitization transactions that utilized offshore vehicle.
At its inception, when compared with the Cayman SPC, the TMK was strongly criticized as being user-unfriendly and time consuming. Hence, it was not until further amendments to the Japanese SPC law in late 2000 that the TMK became more efficient and began to appear in more structures. However, the TMK has still not become the promised 'holy grail' because the requirement for a Cayman SPC (owned by a charitable trust) has remained; not only for structures that involve a TMK, but also for other common structures that have recently utilized a Yugen Kaisha (YK) or Limited Liability Company. YK structures generally involve the Yugen Kaisha borrowing monies from a lender and accepting contributions from a Tokumei Kumiai (TK) investor that acquires the beneficial interest in real estate or other assets. This trend of using the Cayman SPC essentially as a holding company in both TMK and YK transactions continues to remain a viable choice for its ease of use and for ensuring both off-balance sheet and bankruptcy remote status.
An important recent trend has been the growing number of smaller, domestic originators that are less familiar with structured finance transactions and uncomfortable working with English language documents or overseas-based, English-speaking service providers. And to make matters more difficult, the requirements from a due diligence perspective brought on by new anti-money laundering legislation in the Cayman Islands (as well as most other leading offshore centres), has in some rare cases prevented transactions from closing in a timely manner. Service providers should expect not only higher competition, but also the requirement to show more commitment and flexibility. The Cayman Islands service provider in particular, is required to provide comfort locally as the options to go elsewhere have grown.
The developments make it a necessity for a Cayman service provider to demonstrate not only a more reliable and responsive service, but also to provide services within the clients' own environment, and, if possible, language. This has been seen by the number of law firms, both Japanese and foreign, which are increasing their capacity and capabilities both via recruitment, mergers and joint ventures. The increasing number of options Japanese originators have when choosing between a Cayman versus domestic structure has put pressure on all offshore service providers to prove their willingness and capabilities to show which is the better route to take.
More recently, it seems the Japanese structured finance market has appeared to mature, and because of this maturity there have been differences in the way deals are won - and lost. Ultimately, with originators facing the task of choosing between an increasingly large number of arrangers, law firms and service providers, its only natural that everyone will begin to experience narrower margins and increasing pressure to reduce fees. As the offshore service provider's role in the Japanese structured finance market has been commoditized over the past few years, an environment has been created where not only fee levels will determine who wins mandates, but also the quality and motivation to provide a better service.
The Cayman Islands SPC has been used in the Japanese market for nearly two decades and with both structured finance transactions and investment funds continuing to use the Cayman Islands, it is fair to say that the Cayman Islands remains the offshore domicile of choice.
Part 2
Structured finance in the Cayman Islands
The essential element of a structured finance transaction is the conversion of various types of assets into marketable securities.
Transactions often involve the creation of a special purpose company (SPC), set up for a specific purpose, in an offshore jurisdiction such as the Cayman Islands, to hold assets and/or issue securities to investors. In its simplest structure, the offshore SPC will purchase a pool of receivables or other assets generated by the originator of the transaction that will be seeking to raise cash in the international capital markets to fund the growth of its business. The SPC will fund its purchase by the issue of securities to investors. The SPC's obligations to the investors in relation to the securities will be secured by the SPC's rights in respect of the purchased asset pool.
Often the pool of receivables can be repackaged in such a way to create a quite different credit or revenue stream profile from the underlying asset pool. Examples of the results that financial engineering of the more complex structures can achieve include:
the use of interest rate or currency hedging arrangements with counterparties converting fixed rate payments into floating rate payments, currencies into different currencies, or providing cap or collar arrangements;
having a monoline insurer wrap a note issue by issuing a guarantee to the noteholders providing that in the event of any failure of the receivables to service the noteholder debt, the monoline insurer will make up the deficit ensuring the notes will attract the monoline insurer's credit rating;
the use of credit enhancement in respect of which a pool of sub-investment grade debt can be repackaged into several tranches of debt at the note level, the most senior of which can achieve a higher rating than the underlying pool as a result of over-collateralization;
use of contractual subordination or debt/preferred share structures under which security holders agree among themselves varying risk reward profiles for each category of security, the more deeply subordinated notes or preference shares securing a greater return in exchange for accepting the risks inherent in being the last to be paid out in the relevant transaction payment waterfalls.
Use of an offshore SPC
The use of an offshore SPC in such structures allows the transaction assets to be moved away from the originator and its associated credit risks to a clean entity with no operating history. This entity does not enter into any other transaction, so the obligations it owes are solely those to the transaction parties and are clearly set out in the transaction documents.
The vehicle achieves insolvency remoteness by agreeing to enter into no other business and receives the benefit of limited recourse and non-petition covenants from all parties to the transaction that can then rely on the fact that any enforcement of rights on default will be carried out in an orderly manner in accordance with the transaction documents. Shares of this entity are usually held pursuant to the terms of a charitable trust to provide independence and an off-balance sheet treatment from the originator. Autonomous offshore resident directors are provided to ensure a real degree of independence from the originator and to further remove any risk that the company will be consolidated to the originator's group.
Use of Cayman SPCs in Japanese transactions
From a Cayman Islands perspective there have been a number of receivables financing transactions coming out of the Japanese market recently, particularly for the refinancing of receivables generated by Japan's consumer finance companies. Japanese legislation passed in the late-1990s, such as the Perfection Law (1998), clarified the nature of the security that could be provided in such transactions. Consumer finance companies searching for other sources of finance following the liquidity problems of the Japanese banks have securitized large portions of their loan portfolios using Cayman SPCs to issue notes to investors. There have also been collateralized debt obligation (CDO) transactions from Japan, but the expected explosion of this market is still awaited.
Cayman advantages
The Cayman Islands have become the first choice location for the creation of SPCs for structured finance transactions. There are advantages of using Cayman as opposed to other offshore jurisdictions or the use of offshore-style entities created by legislation in onshore jurisdictions such as the TMK law of Japan:
The Cayman Islands is an Anglo-Saxon jurisdiction where the principle of freedom of contract is paramount and bonafide contractual relationships are not generally subject to judicial or governmental interference. Governmental consents or approvals are not required in connection with an SPC's participation in any particular securitization transaction or the changes in any plan of securitization or the company's constitutional documents. Instead, the requirement for transaction party and noteholder consents to amendments can be determined at the outset of the transaction and can be included in the transaction documents. US investors are familiar with the law of Anglo-Saxon jurisdictions such as Cayman and are therefore more comfortable buying securities issued by Cayman vehicles.
There is no limit on the type of asset classes that can be acquired by a Cayman SPC or the types of notes or bonds that can be issued by that entity;
Speed and professionalism. The Cayman SPC can be set up within one working day at express rates. Many of the service providers and attorneys on the Island have extensive experience in working in the main financial centres such as London, Tokyo and New York, are proactive and appreciate the need for the rapid closure of transactions.
The Cayman Islands does not impose any restriction on the appointment of service providers to Cayman SPCs and the trustees, agents and administrators of transactions can be located in the jurisdiction that is most convenient for the transaction.
Cayman does not impose its own accounting standards and to the extent that accounts need to be prepared for an SPC, they can be prepared using the most suitable international accounting principles taking into account the jurisdiction of the law governing the receivables.
There is no statutory minimum capital for the establishment of an SPC but a minimum of $1,000 share capital would normally be recommended. This is a much lower figure than the equivalent minimal capitalization of other jurisdictions.
Cayman Islands legislation has been continuously updated to reflect the requirement of complex international finance transactions. In particular, netting, subordination and set-off arrangements are recognized by express statutory provisions and will be enforced both pre- and post-insolvency.
Transfer by way of continuation - Cayman Islands law allows a Cayman Islands SPC to quickly and cheaply relocate in another jurisdiction to the extent that changes in tax or other laws adversely affect the tax or regulatory treatment of a specific transaction.
Overview of the jurisdiction
The financial services industry in the Cayman Islands 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), and together with its prudent economic policies and strong financial services sector, results in the Cayman Islands enjoying an AAA sovereign risk rating. Cayman also 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 from 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 provide directors and other corporate services to SPCs.
Legal framework
The Cayman Islands has a modern and flexible framework of commercial legislation. While certain statutory provisions may differ from English law providing greater flexibility, the central issues of corporate power, directors' fiduciary duties, corporate personality and limited liability are, in all substantive respects, the English common law. At the same time, the Cayman Islands' commercial legislation has evolved to accommodate the complex structures found in international financings.
Examples of particular ways in which Cayman law is suited for international financing transactions include:
Contractual subordination
Under the Cayman Islands Companies Law, contractual subordination is given statutory force. This means that both those structuring transactions and creditors can be confident that a priority of payments agreed by a Cayman Islands 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.
Financial assistance
Unlike the position in many other jurisdictions, the provision of financial assistance for the purchase of a company's shares in the Cayman Islands 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.
Preference shares
The ability of a Cayman Islands SPC to pay dividends on shares out of share premium, and to redeem shares out of capital and share premium, enables transactions to be structured whereby an instrument issued that has 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 very small proportion of their issue price, thereby ensuring that the majority of the proceeds are entered into the share premium account of the Cayman Islands SPC. The resulting effect is that dividends do not need to be paid out of company profits but can be quasi-debt payments in the amount of the notional interest payments payable to investors. It is as easy for preference shares to be repaid as it is for debt. Structuring of this nature is not readily achieved in other offshore jurisdiction where redemption of shares and the payment of dividends are subject to greater restrictions.
Creditor-friendly legal system
Cayman Islands Law is one of the most creditor-friendly of all jurisdictions and is therefore ideally suited to structured finance transactions. As previously stated, contractual netting, set-off and subordination provisions are all recognized by Cayman legislation and given effect both before and after the commencement of any liquidation. There are no provisions for corporate rehabilitation such as the English administration procedure or US Chapter 11 proceedings that 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. As the jurisdiction does not levy a tax on SPCs and an SPC will have no employees, only unpaid Cayman Island 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 restricted to apply only to a limited 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.
No re-characterization or consolidation
Except in the case of fraud, the Cayman Islands courts will not step in to re-characterize transactions. Heavily subordinated debt with the economic characteristics of equity will not be re-characterized as equity and so subordinated creditors have certainty that their securities will be have the contractual rights as creditors of the SPC contemplated in the transaction documents. Again, except in the case of fraud, and providing the SPC is separately managed by a local administrator in the Cayman Islands, Cayman Islands law will also respect the separate legal personality of an SPC and will not seek to consolidate the SPC with the originator of the transaction to allow the creditors of the originator to claim against the SPC or vice versa.
Non-intrusive regulation
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.
Anti-money laundering
The Cayman Islands has earned a good reputation throughout the world as a cooperative jurisdiction in the fight against money laundering and criminal tax evasion.
By signing an advance commitment letter to the Organization for Economic Cooperation and Development in May 2000, Cayman avoided a listing on the OECD's blacklist of jurisdictions practising harmful tax competition.
In 2002, the international Financial Action Task Force (FATF) on money laundering praised the country's efforts to conform to FATF's 40 recommendations. Cayman has adopted a code of good practice governing the prevention of money laundering, including the issuance of money laundering regulations and amendments to Cayman's Monetary Authority Law and Proceeds of Criminal Conduct Law.
Tax analysis of a structured finance transaction
A structured finance SPC must be set up to be tax neutral and an analysis of the following key tax aspects needs to be made in respect of each transaction:
SPC corporation tax in the jurisdiction in which the company is incorporated;
SPC corporation tax in any other jurisdiction in which, by virtue of its activities, it is deemed to be doing business;
withholding taxes due with respect to payments made by the SPC;
withholding taxes with respect to the payments received by the SPC; and
other relevant taxes, such as stamp duty.
Tax treatment of Cayman SPCs
There are no direct taxes in the Cayman Islands. The usual form of corporate vehicle used in a structured finance transaction - an exempted company - is 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. This is supported by an undertaking given by the government of the Cayman Islands that companies with exempted company status will remain tax-free for a period of 20 years. This undertaking will generally be extended at the end of the 20-year period for a further period of 10 years if the particular transaction requires. The use of Cayman Islands administrators to manage and control the company from the Cayman Islands mitigates the risk that an SPC will be brought onshore by local tax regimes. Documents may be executed outside of Cayman by attorneys appointed by the Cayman SPC, and provided those documents are not brought into the Cayman Islands, they will not attract any stamp duty.
Administration
An SPC can be set up in less than 24 hours. It must have a registered office in the Cayman Islands, but there is no longer any requirement for an annual meeting of the board of directors to be held in the Cayman Islands. The 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 and there is no Cayman requirement for audited accounts to be prepared. Set up 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. For the vast majority of SPCs this should be only $574 per year.
Walkers SPV Limited, Tokyo Branch
11F, Yurakucho Building
1-10-1 Yurakucho, Chiyoda-ku
Tokyo, 100-0006
Japan
Tel: 81 3 5219 2587
Fax: 81 3 5219 2588