Offshore structured finance transactions depend in large part on the integrity of the legal arrangements by which a finance company enters into its financial obligations. Where a company is used, the aim is to ensure that the separate legal personality of the company is maintained, and the company is not consolidated on the originator's balance sheet. Under Cayman Islands law, the corporate integrity of a finance company depends on the observance of corporate formalities and professional standards by the directors. It also requires the directors to have a thorough business understanding of the transaction in which the finance company is involved.
The observance of corporate formalities is essential if the arrangements are to be upheld in a court of law. Corporate formalities cover everything from the holding of proper board meetings to observing restrictions in organizational documents. This holds true under Cayman Islands law and will also apply under the law of the on-shore jurisdiction. The US bankruptcy court opinion in Re Kingston Square Associates, et al highlights that devices such as the right to appoint an independent director provide little protection where the board never meets and the independent director takes no part in the running of the company and has no understanding or awareness of the issues the directors should be addressing. Furthermore the observance of corporate formalities requires that directors make sure they follow the correct corporate procedures to ensure they are personally in compliance. In most transactions and especially rated ones, the finance company typically covenants in relation to corporate formalities. Non-observance by the director is therefore not only a personal default but also a company default, which could affect the entire transaction.
Corporate integrity also requires professional standards of the directors of the finance company, particularly in relation to their duties of care and skill. The principles established by the early English cases have to some extent been developed and extended. English decisions relating to Section 214 of the Insolvency Act 1986 (which, while not binding on the courts of the Cayman Islands, are persuasive) have suggested that the standard of care and skill laid down by that section (which includes an objective test of competence), now reflects the standard required by English common law. On this basis, directors are held to an objective standard in relation to their duties of care and skill and that standard would be increased if a particular director actually possessed abilities and skills that should have enabled them to meet a higher standard.
In view of the specialist nature of the business carried on by finance companies, the importance of the directors' understanding of their business and their ability to assess the cashflows and risks related to the finance companies role in the process cannot be underestimated. With the complexity of financial transactions increasing it is no longer safe for directors to rely on the earliest English cases, which required directors to bring to the boardroom table only such expertise as they happened to possess. It is also right to expect higher levels of expertise from the directors who are appointed by professional service providers.
A finance company, and the directors appointed to it, have to do more than simply accommodate the other parties' commercial aims. The finance company has a voice in the transaction like the other parties. It may be saying different things and have fewer points but its approach is and should be as a commercial party. The directors of the finance company will need to understand what the transaction involves and be able to assess and calculate the risks and rewards of the transaction. The directors will also need to assess what should be said to investors in the company's securities and if appropriate should undertake their own due diligence to the extent they have taken responsibility for the disclosure. In making this assessment they will need to get professional (and possibly independent) advice.
The reality is that finance companies and their directors take commercial risks all the time. What is becoming more difficult is identifying, calculating and then evaluating those risks. Usually the risks turn out to be small but they must nevertheless be calculated in order for the directors to be comfortable approving the transaction as being in the interests of the company. The taking of such risks may be commercially necessary if, in fact, the transaction is to be done at all. The transfer of risk to the finance company is a developing area which offers considerable opportunities to service providers. However, the corollary is that the systems and personnel must be in place to evaluate and deal with that risk.