The special purpose entity (‘SPE’) typically used in securitisations in many parts of the world has been receiving some bad press in recent times. Most of the sins of the corporate and financial world seem to have been laid at its door. Accusations of stripping assets from corporate coffers, confusing investors as to the real liabilities of connected parties and illegitimately reducing tax revenue of the onshore jurisdictions are now commonplace. This is unjustified. Many of the cases we read about are simply cases of fraud. The cases that do not involve fraud should really be turning the spotlight on issues such as disclosure, transparency and cashflow and risk assessment. These areas are part of the process in which the SPE is involved. There is nothing inherently evil about an SPE.
The use of the Cayman Islands as a preferred jurisdiction for the incorporation of SPEs for securitisations can be traced back to the emergence of the Cayman Islands as a dominant jurisdiction for capital markets transactions during the 1980s. The Cayman Islands became the favourite centre for capital market transactions because of its political and economic stability, effective judicial system, favourable tax system, light but effective regulation (which did not impact capital markets transactions) and the absence of exchange control or currency restrictions and the availability of professional and support services.
The first bond issues using a Cayman Islands incorporated issuer were structured in the late 1970s and the volume of capital markets transactions grew significantly throughout the 1980s as the Cayman Islands were used by international corporations and financial institutions as the jurisdiction of choice for bond issuing vehicles to fund their activities. The debt issued reflected market conditions and practice. The early days saw plain vanilla issues but techniques gradually became more sophisticated, with debt programmes emerging firstly in the form of commercial paper programmes, including specialties such as sterling commercial paper.
The mid 1980s saw the development of the repackaging market in which the Cayman Islands dominated, and continues to dominate, as the preferred jurisdiction for the repackaged debt’s issuer. Repackaging transactions saw a huge increase in volume of business from 1987, with hundreds of billions of dollars of repackaged debt being issued. Much of the volume of early repackaged debt was backed by ex - warrant bonds issued by Japanese corporates, but later the underlying assets came from a wide variety of sources and credit risks ranging from sovereign issuers to junk bonds and emerging market debt.
The late 1980s saw the development of medium-term note programmes, and many Cayman Islands vehicles moved away from the traditional bond issue to establish and issue notes under such programmes. This was rapidly followed by the development of repackaging programmes using issues of medium term notes, and to a lesser extent, commercial paper, to finance the acquisition of the underlying asset, as a quick, less document intensive and cheaper means to issue repackaged debt using a Cayman Islands issuer.
A typical securitisation transaction involves a debt issue made by a Cayman Island SPE, which then applies the net proceeds to the acquisition of the underlying assets from the promoting financial institution or originator. Any receivables or other assets, which provide income stream s, may be acquired by the SPE. The underlying assets may be converted into readily transferable, marketable debt by the SPE, which may comprise notes or bonds and which may be rated and listed. Acceptance of such issues was established beyond doubt when debt issues by Cayman Islands SPEs first obtained AAA ratings from the rating agencies .
The specific benefits to the originator are both economic and regulatory and include:
- diversification – by providing new sources of funds at lower cost securitisation transactions allow originators to move away from their dependence on banks and quasibank funding markets as sources of funds;
- reduction of any interest mismatch and maturity risks, to which the originator may be exposed by reference to the underling assets;
- the removal of the underlying assets from the originator’s balance sheet, thereby avoiding the cost of meeting increased capital adequacy ratios or risk ratios and enabling that institution to write new business;
- generation of fee income for the administration of the structure;
- accelerating the originator’s recognition of its income or losses on the underlying assets; and
- improving the return on assets and capital asset calculations.
The investor in the debt securities issued by the SPE enjoys the following benefits:
- rather than investing in the security issued by a corporation or institution which carries the usual credit risk of that corporation or institution, by reference to its overall financial standing, the risk to the investor in a securitised transaction is isolated to the performance of the specific underlying asset pool;
- derivatives may be employed by the SPE and the income stream and principal payable on the debt issued by it may be specifically tailored to the investor, providing the required fixed or floating rate of interest currency and maturity; and
- credit enhancement features may be added to the debt and a rating can be obtained for it.
- The credit enhancement may be provided through:
- overcollaterlisation of the SPE;
- a letter of credit
- a repurchase agreement made between the originator and the SPE to buy back the underlying asset pool at a fixed rate;
- the issue by the SPE of a series of subordinated securities by way of a financial cushion, and usually taken up by an affiliate of the originator or financial institution; and
- the provision to the SPE of residual asset guarantees or pool insurances, such as mortgage indemnity policies.
Credit enhancement features are key to the issue’s rating by a rating agency, and in the typical structure the note or bond issue undertaken by the SPE is collateralised by way of a grant of security interests over the underlying assets for the benefit of the investors holding the notes. The SPE then has its collateral and credit enhancement mechanisms in place from the outset. This will enable the rating agency to rate the issue and not the issuer. To do this the rating agency investigates:
- the adequacy of the collateral;
- the administrative structures, which will ensure that the principal and interest payments may be paid to the investors; and
- as mentioned above , the SPE’s integrity and, most importantly, they ensure that it is bankruptcy remote.
There is no limitation under Cayman Islands law regarding the relevant pool of underlying assets or receivables that can be acquired, and Cayman Islands law recognises and facilitates the use of different systems of law governing different aspects of the transaction and the grant of security interests.
The reason why the Cayman Islands has become the first choice location for SPEs in capital markets transactions is that the jurisdiction offers the key legal elements that arrangers and investors require.
There is no form of corporation, income or capital taxation in the Cayman Islands, whether direct (on the SPEs or holders of the securities issued by the SPEs) or indirect (by way of withholding on payments made by the SPEs). The SPEs, if incorporated as exempted companies (the typical form of vehicle for structured debt transactions), can obtain a tax undertaking from the Cayman Islands government that no taxation introduced for a period of 20 years (or in certain circumstances, for example, an issue of long dated or perpetual bonds, up to 30 years) will be applicable to the SPEs or the holders of their securities.
There are no foreign exchange controls in the Cayman Islands.
Restrictions on business
There are no restrictions on a Cayman Islands SPE lending, borrowing or issuing debt securities (none of these activities, for example, constitute banking business, which would require the SPE to be licensed as a bank).
- Under Cayman Islands common law it is only in certain specific cases (English case law is persuasive in this context) that the separate corporate personality of an SPE will be ignored so as to allow creditors of an SPE to proceed against its shareholders, or to allow creditors of the shareholders to proceed against the SPE. Most of these cases involve fraud.
- The typical on balance sheet SPE 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 said that the legal substance of the arrangement should be looked at and found in that case that it could not disregard the principle of the SPE’s separate corporate personality and treat a closely integrated group of companies (which included the SPE) as a single economic unit merely on the basis of perceived injustice. Accordingly, we believe there is no general principle of substance over form in the Cayman Islands which, as a general matter, could lead to the recharacterisation of the typical structured debt transaction.
Bankruptcy remote vehicles
The use of bankruptcy remote vehicles is well established in the Cayman Islands. For an SPE to be bankruptcy remote, the following conditions, typically must be met. There must be:
- restrictions on the originator’s powers over the SPE;
- debt limitations on the SPE;
- independent directors of the SPE;
- no mergers or reorganisations of the SPE;
- covenants separating the SPE and the originator; and
- security interests over assets.
Creditor-friendly legal system
The legal system in the Cayman Islands is creditor-friendly and therefore ideally suited to securitisation transactions.
- the Cayman Islands does not have any system of corporate rehabilitation ,such as the English ‘administration’ procedure or Chapter 11 proceedings under the US Bankruptcy Code, where by a debtor can effectively ‘freeze’ the rights of creditors, including, in certain cases, the creditors’ rights to enforce security interests.
- Cayman Islands law does not prevent secured creditors enforcing their security in a liquidation of an SPE. There is no concept of a stay of insolvency.
- liquidators of a Cayman Islands company cannot disclaim onerous contracts. The contractual rights of creditors continue to exist following liquidation.
- the fraudulent preference rules only apply when (amongst other requirements) a disposition is made with a view to preferring one creditor to another. It is not sufficient that an asset or payment was simply made under circumstances, which resulted in one creditor losing out.
- netting and set-off arrangements are recognised by express statutory provisions and will be enforced both before and after the 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 provisions (assuming it is effective as a contractual matter under the governing law of the contract).
- there is no general concept of substance over legal form - this means that heavily subordinated debt, long-term and perpetual debt, for example, would continue to be treated as debt and therefore benefit from the favourable treatment given to creditors, rather than being treated as equity. Similarly, participating debt will not be regarded as equity; notwithstanding that it has most of the characteristics of equity.
- the list of ‘preferred creditors’(creditors that generally rank ahead of all creditors other than those with fixed security, with one irrelevant exception relating to claims for severance pay under the Labour Law,) is limited. In practice, in the case of an SPE (which would have no employees in the Cayman Islands) only the government (relating to unpaid government fees) would be a preferred creditor.
- provisions regarding changes in domiciles – in the Cayman Islands companies are allowed to move to or from the Cayman Islands without triggering a disposal of assets or requiring a novation of liabilities. This is useful in the event that the selected jurisdiction ceases to be viable for reasons of taxation or securities regulation.
The Cayman Islands has no general system of registration for security interests to perfect or obtain priority (there are registration systems in place for ships and aircraft, limited partnership interests of Cayman exempted limited partnerships and ‘personal chattels’ under our Bills of Sale law). Companies are required to keep an internal (private) register of mortgages and charges, but failure to make the appropriate entries does not, of itself, affect the creation of the security interest or its perfection or priority. The application of our conflict of law rules determines which laws govern the creation of the security interest, its perfection and the priority of the secured party. Generally, depending upon the issue being determined and the nature of the asset over which security is taken, the following laws will be considered:
- the law governing the security agreement; and
- the law constituting the asset over which the security has been taken; or
- the law in the jurisdiction where the asset subject to the security interest is situated.
Cayman Islands legal opinions are regularly accepted by the rating agencies. Industry organisations recognise that SPEs established in the Cayman Islands are acceptable counterparties in derivative transactions.
Regulation in the Cayman Islands is carried out on two main front s. The local service providers and professionals that participate in securitisation transactions are regulated, and in certain cases, specific transactions are regulated as well. In the latter case, however, the regulation is non-intrusive and, in many cases, throws the onus onto the local service providers to ensure that any local requirements are met. There is no specific regulation of debt issues (unless such issues are listed here).
Establishment costs for SPEs are low and are based on the SPE’s authorised share capital (a minimum fee of US$574, up to a maximum fee of US$2,400). Annual government fees are also based on authorised share capital, and registered office fees and the fees of local administrators are similarly competitive. Cayman Islands stamp duties only apply to documents that are executed here or, after execution outside the Cayman Islands brought into the Cayman Islands. Even if duty is payable, there are various caps which apply to transactions involving exempted companies (this is the usual form for companies that are used in structured debt transactions).
Cayman Islands Stock Exchange
The Cayman Islands Stock Exchange (‘CSX’) has particular synergy with two of Cayman's main financial services products: the mutual fund and the SPEs. The listing rules are specifically designed to facilitate the listing of the securities of these entities. There are tailor made rules for specialist products such as debt securities and derivative warrants, which recognise that products of this nature are usually purchased and traded by a limited number of knowledgeable and sophisticated institutional investors. The CSX therefore adopts a pragmatic approach to the documentation required for a listing, and disclosure requirements have been set at such a level, which provides investors with sufficient information without imposing unnecessarily onerous demands.
Many cross-border securitisation transactions can only be structured if the cost benefits are not eroded by the impact of tax, accounting and regulatory requirements in the jurisdiction in which the participants or the transaction vehicles are placed, and the Cayman Islands add value to such transactions.
The international initiatives of the G8 countries are expected to result in the enhancement of the Cayman Islands as a leading offshore financial centre specialising in institutional business. The OECD in respect of its initiative against harmful tax competition has accepted the system of indirect taxation and tax neutrality in the Cayman Islands and has approved the Cayman Islands as one of six cooperating jurisdictions. Properly structured transactions will not be affected by the changes that the Cayman Islands have agreed on with the OECD (to be implemented over the course of the next few years). The Cayman Islands’ anti-money laundering legislation meets the requirements of the Financial Action Task Force and has little impact on normal securitisation structures. The European Union’s Savings Directive could require tax reporting by European paying agents in respect of European tax residents. These initiatives are creating greater and uniform transparency for cross-border transactions, with a view to maximising tax revenues collected.
The offshore world, and for that matter the onshore world, have no reason to be apologists for securitisation and the associated SPEs. The existence of the SPE in legitimate securitisation transactions can be completely justified. SPEs isolate financial risk and their motivation, like the other participants in the transaction, is to make a profit. How the isolation of the financial risk is accounted for and reported onshore is determined by the onshore rules. From an offshore perspective the key point is to show that an SPE is real. Fundamental to this process is the requirement for offshore service providers to ensure that SPEs have corporate integrity and observe necessary corporate formalities. Their directors must have the skill and resources to evaluate and assess the cashflows, economics and structure of the transactions in which they participate. The SPE is an active commercial party in the process with its own requirements and objectives.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.