Co-written by Justin Appleyard
The Jurisdictional Risk
Lenders and other providers of finance to groups located in some overseas jurisdictions often encounter difficulties in taking and enforcing security over assets located in those jurisdictions. These difficulties typically relate to:
- perfecting security;
- the operation of insolvency stays under local law;
- the requirement for a court proceeding to enforce security or a public auction in connection with the sale of assets;
- local rules relating to the timing of the sale of assets, the identity of the purchaser (in particular their affiliation with the secured lender) and the price which must be achieved on the sale; and
- a hostile local insolvency regime, for example, in relation to preferences, voidable transfers and disclaimer.
A Possible Solution
If the security package can be structured so that all the relevant elements take place in a neutral creditor friendly jurisdiction it may be possible to minimise the risks associated with the local jurisdiction. In practice this means locating the grantor of the security and the asset over which the security is taken in the chosen creditor friendly jurisdiction and, if possible, having the law of that jurisdiction govern the creation of the security interest.
Take the case of a borrower which has a valuable local subsidiary (the same issues arise with any local asset). Taking direct security over the shares in the subsidiary under local law may be unattractive for any of the reasons already mentioned.
Suppose however that the valuable subsidiary is not held directly by the parent but through a chain of two Cayman Islands companies (see diagram). In this case the first Cayman Islands company could grant a Cayman Islands law governed charge over the second Cayman Islands company's shares as security for the loan to its parent. The security arrangement is then taken outside the local jurisdiction's insolvency and security rules as the security is granted by a Cayman Islands company over Cayman Islands property under Cayman Islands law. It should be possible for the directors of the Cayman Islands company to reach the view on appropriate facts that the granting of this upstream security is in the best interests of the Cayman Islands company and thereby satisfy their fiduciary duties.
Arranging for the Cayman Islands companies to be interposed between the borrower and the valuable asset requires careful planning as the borrower will not want to incur a tax liability by triggering a disposal of that asset. In many jurisdictions it may be possible to treat the transfer of the asset to the interposed company as a neutral transaction if it can be characterised as a simple exchange.
The holding company structure does not interfere with the flow of funds from the valuable subsidiary back to the parent or the day to day operation of the subsidiary as the Cayman Islands is neutral in terms of taxation and exchange control and has flexible rules in relation to the repatriation of funds.
Further Protection for the Secured Lender
The secured lender will need protection against the interposed Cayman Islands companies going into voluntary winding up and the risk of third party creditors petitioning for their winding up. As the directors of the Cayman Islands companies will be individuals employed by the borrower the secured lender will also want to restrict the activities of the Cayman Islands companies and their dealings with the valuable subsidiary. These objectives can be achieved by incorporating the usual devices introduced into bankruptcy remote structures, including:
- restrictions on the objects and powers of the Cayman Islands companies (these can be contractual restrictions in the transaction documents and restrictions in their constitutional documents);
- a security interest over the shares in the valuable subsidiary (although this presupposes that the security is not effective for some reason its purpose here is not to realise the value of the asset following a default but to place restrictions on dealings with the asset by the Cayman Islands companies);
- the requirement for shareholder consent in relation to certain actions e.g. reorganisation, merger, disposals of assets and other significant corporate actions; and
- having the top Cayman Islands company issue a "Golden Share" which has no economic rights and no voting rights except in relation to the liquidation of the Cayman Islands companies, the amendment of their constitutional documents and other significant actions which, under Cayman Islands law or under their constitutional documents, require shareholder approval. The constitutional documents of the Cayman Islands companies would effectively prevent such actions taking place without the affirmative vote of the holder of the Golden Share.
The Golden Share Arrangements
The Golden Share is owned by a Cayman Islands trust company as trustee of a STAR (Special Trusts Alternative Regime) Trust. The trustee holds the Golden Share for the non-charitable purpose of making the Cayman Islands companies bankruptcy remote and is obliged to vote in a particular way in respect of the relevant resolutions. If the security over the shares in the Cayman Islands company is enforced, the purposes cease to apply and instead the Golden Share is held for the secured lender (this may be useful to protect against a winding up during any applicable preference period). If the security is released following repayment of the loan, the purposes cease to apply and instead the Golden Share is held for the borrower. The lender (or a security trustee or collateral agent if one is appointed) can also be made the enforcer of the STAR Trust to give the secured lender a direct right to enforce the provisions of the STAR Trust against the trustee. On the enforcement of the security or on its release, the lender or borrow as the case may be can become the enforcer and thus able to ensure the trustee delivers the share accordingly.
The benefits of using Cayman Islands Companies
The effect of these arrangements is that the security is taken out of a hostile legal system and placed into one which is creditor friendly particularly in relation to the perfection and enforcement of security. The Cayman Islands offers a number of benefits in this respect, in particular:
- the perfection of a charge over shares in a Cayman Islands company is straightforward;
- the Cayman Islands recognises self-help remedies upon enforcement, such as the power of sale, without requiring a court proceeding;
- a secured lender is not required to sell the assets upon enforcement by any particular method, for example, by public auction;
- although the sale must be made at the "true market price" there are no specific rules relating to the price which must be achieved on the sale;
- there is no prohibition on selling to an affiliate;
- the Cayman Islands does not have any system of corporate rehabilitation enabling a debtor effectively to freeze or suspend the rights of creditors, including creditors rights to enforce security interests;
- the Cayman Islands gives secured creditors the right to enforce security notwithstanding the winding up of the grantor of the security in the Cayman Islands: there is no concept of an insolvency stay;
- liquidators of Cayman Islands companies cannot disclaim onerous contracts;
- the fraudulent preference rules in the Cayman Islands require, as a minimum, that any disposition be made with a view to preferring one creditor over another before that disposition can be attacked - it is not sufficient simply that an asset or payment was made in circumstances which resulted in one creditor losing out;
- netting and set off arrangements are recognised by express statutory provisions in the Cayman Islands and will be enforced both pre and post insolvency (assuming they are effective as a contractual matter under the governing law of the contract in which they are contained);
- contractual subordination is recognised by express statutory provision (assuming it is effective as a contractual matter under the governing law of the contract);
- the list of preferred creditors in the Cayman Islands (which generally rank ahead of all creditors other than, with one irrelevant exception relating to claims for severance pay under the Labour Law, those with fixed security) is limited and, in practice, in the case of companies which have no employees in the Cayman Islands, relates only to unpaid Government fees;
- there is no general principle of substantive consolidation under which the separate corporate personality of a Cayman Islands company may be ignored and their assets consolidated with those of other members of the foreign group. The typical on-balance sheet special purpose vehicle structure has been considered by the English courts (Re Polly Peck International plc (1996)) in the context of such issues as legal substance, corporate personality, sham arrangements and piercing the corporate veil - the English court in Polly Peck decided that they should look at the legal substance of the arrangements and in that case found that the separate corporate personality of the Cayman Islands company could not be disregarded so as to treat a closely integrated group of companies (which included the Cayman Islands company) as a single economic unit merely on the basis of perceived injustice.
The use of Cayman Islands holding companies and STAR trusts may in appropriate cases offer a simple and effective solution to dealing with some of the jurisdictional risks associated with financing overseas groups with valuable local assets.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.