A structured investment vehicle or "SIV" is a finance company which engages in market arbitrage by purchasing financial assets in the market (such as medium and long term fixed income bonds) and funding itself with cheaper senior debt instruments such as commercial paper and medium term notes. Typically a SIV will be capitalised with either a mix of equity and subordinated debt or, increasingly, subordinated debt only. Equity investors in SIVs therefore have the benefit of leverage on their exposure to the underlying assets. The economic incentives behind the establishment of SIVs has been the generation of management fees for the financial institution managing the SIV and the generation of significant, consistent returns for equity investors. This article examines the use of SIVs in the Cayman Islands and explores the reasons why Cayman has always been and continues to be the jurisdiction of choice for the incorporation of such companies.
The use of the Cayman Islands for the incorporation of SIVs can be traced back to the emergence of the Cayman Islands as the dominant jurisdiction for offshore capital market transactions during the 1980s. The Cayman Islands became the leading offshore centre for such transactions as a result of political and economic stability, an effective judicial system, the absence of any direct taxation or currency exchange controls, the availability of first class professional and administrative support services and the presence of light but effective regulation.
The first bond issues using Cayman Islands companies appeared in the 1970s. The 1980s brought enormous diversification in the type of capital markets products utilising Cayman Islands vehicles with the development of various securitisation and structured finance techniques, the use of repackaging and derivatives and on-balance sheet finance subsidiary capital market issues and programmes. The late 1980s also saw the development of SIVs as investment managers sought to take advantage of market arbitrage with the first SIV launched in 1988. The use of Cayman Islands companies in the commercial paper and medium term note markets was already well established so the SIV was a natural progression.
SIVs are structured so that senior liabilities of the vehicle will be assigned the highest long and short term rating categories by the rating agencies. The overall structure of the SIV will therefore reflect this objective. The typical SIV raises funds through senior funding programmes such as MTN and CP programmes with a corresponding subordinated capital funding programme which may be in the form of equity or subordinated debt or both. While SIVs in the Cayman Islands were originally established with a mix of subordinated notes and equity share capital as the means of raising the subordinated form of capital, the trend now is towards the issue of subordinated notes only (the subordination of which is statutorily recognised in the Cayman Islands).
To obtain the highest rating assignments for the senior debt, the SIV will need to demonstrate to the rating agencies that it has adequate capital, adequate liquidity, quality investment management, appropriately rated servicers and supporting entities and last, but not least, proper legal structure. The first four points are beyond the scope of this article and are not therefore dealt with herein.
A Cayman SIV will be incorporated pursuant to and be subject to the Companies Law of the Cayman Islands and common law applicable to companies. Cayman Islands law is derived from a mix of local statutes passed by the Cayman legislature, English statutes extended to the Cayman Islands and English common law. Hence corporate legislation in the Cayman Islands resembles and in some cases derives from English legislation. The decisions of the English courts are also persuasive in the Cayman Islands courts (especially where the statutory provisions are similar) and the ultimate court of appeal is the Privy Council in the United Kingdom. Many concepts of Cayman Islands law will therefore be familiar to transaction managers and lawyers operating out of New York and London.
Legal documentation relating to the various funding programmes, the administrative and security arrangements will typically be governed by English or New York law. There are no issues with such selection of governing law for transactions involving Cayman SIVs and judgments of New York or English courts will in most cases be enforced by the Cayman courts without re-examination of the merits.
Arrangers and investors in SIVs are also attracted to the Cayman Islands as the following attributes render the jurisdiction an ideal location for the establishment of the SIV:
- Since there is no form of corporation, income or capital gains taxation in the Cayman Islands whether direct (on the SIV or holders of securities issued by the SIV, whether senior or subordinated) or indirect (by way of withholding on payments made by the SIV), annual application for exemption from taxation is unnecessary (unlike some other offshore jurisdictions). The tax concessions certificate in the Cayman Islands is commonly misunderstood to be an exemption from current taxation when in fact it is an undertaking not to apply taxation to the company should taxation ever be introduced by the Cayman Islands Government in the future. Accordingly, it is not necessary to demonstrate to the rating agencies that the documentation relating to the SIV limits the tenor of senior liabilities (e.g. notes and hedging contracts) to the period remaining on a tax exemption certificate.
- There are no foreign exchange control in the Cayman Islands.
- Regulation in the Cayman Islands is carried out on two main fronts. First, the regulation of the local service providers and professionals who participate in finance transactions and secondly, in certain cases, the regulation of specific transactions. In the latter case, the regulation is non-intrusive and, in many cases, throws the onus onto the local service providers to ensure that any regulatory requirements are met. There is no specific transaction regulation of debt issues (unless such issues are listed on the Cayman Islands Stock Exchange). Accordingly, most SIVs in the Cayman Islands are not subject to any regulatory restrictions on acquiring, lending, borrowing or issuing debt securities.
- The Companies Law in the Cayman Islands provides significant flexibility in allowing SIVs to issue shares, redeem or repurchase shares and to pay dividends (for example, SIVs can pay dividends out of any premium subscribed for its shares), subject in most cases to an overriding solvency test. In addition, the Companies Law specifically recognises subordinated debt thus allowing the SIV to structure its equity either through shares or subordinated debt.
- Under Cayman Islands common law it is only in certain specific cases (English case law being persuasive in this context) that the separate corporate personality of an SIV will be ignored so as to allow creditors of an SIV to proceed against its shareholders. Most of these cases involve fraud or impropriety of one sort or another.
SIVs are established either with their voting shares held by a substantial number of investors so that it is not consolidated on the balance sheet of any particular investor, or as off balance sheet vehicles so as to isolate the assets and liabilities from those of the sponsor and other servicer entities. The use of the Cayman Islands for bankruptcy remote vehicles is very well established and the techniques involved are familiar to the major rating agencies. It should be noted that:
- Where the subordinated capital in the SIV is structured as subordinated debt or non-voting preferred shares, the voting shares in the SIV may be held by a Cayman Islands trust company on the terms of a charitable or purpose trust. The terms of that trust will likely require the trust company not to wind up the SIV or interfere in the conduct of the SIV except to the extent expressly permitted by the terms of the trust. Where the voting shares are held by the investors directly, the company will be structured such that no single investor has control of the voting. A separate class of shares may also be issued which only carry certain voting rights, such as the right to wind-up the company, and those shares may be held on charitable trust on the same terms as set out above.
- One or more Cayman Islands trust companies will typically provide directors and officers to the SIV and independent directors may also be appointed.
- Cayman Islands law recognises limited recourse arrangements provided their effect, under the governing law of the document in which they are contained, is to extinguish any residual claim against the SIV. For technical reasons, limited recourse arrangements will be employed in SIVs where the subordinated capital is structured only as subordinated debt. This is much less of an issue where the subordinated capital is structured in the legal form of equity.
- Cayman Islands law requires directors to observe fiduciary duties to the company. In the context of a SIV this typically translates into the directors deciding independently that the transaction is in the interests of the SIV itself. Where the subordinated capital is in the legal form of equity (i.e. shares) and the equity investors are receiving (or are expected to receive) significant spreads over LIBOR then there are unlikely to be any issues as to the "corporate benefit" of engaging in SIV activity. Where subordinated capital is provided in the form of subordinated debt, the subordinated debt will be structured as first loss so as to have the economic attributes of equity and limited recourse arrangements may also be used. The directors may then give their approval on the basis that the transactions are limited recourse and that there is little risk to the SIV (given its low level of share capital).
Another attractive feature of the Cayman Islands is that the legal system in the Cayman Islands is creditor friendly. In particular:
- The Cayman Islands do not have any system of corporate rehabilitation, such as the English 'administration' procedure or the US Chapter 11 proceedings under the Bankruptcy Code whereby a debtor can effectively 'freeze' the rights of creditors, including, in certain cases, the creditors' rights to enforce security upon a default.
- Cayman Islands law does not prohibit secured creditors from enforcing their security in a liquidation.
- The liquidators of a Cayman Islands company cannot disclaim onerous contracts. The contractual rights of creditors continue to exist following a liquidation.
- The fraudulent preference rules require, as a minimum, that the company must in the context of disposing of assets be unable to pay its debts as they fall due and that any disposition must be made with a view to preferring one creditor over another before the disposition can be attacked. It is not sufficient simply that an asset was charged or payment was made in circumstances which may subsequently prove to have been detrimental to a particular creditor.
- Netting, set off and subordinated debt arrangements are recognised by express statutory provisions and can be enforced in liquidation (whether or not insolvent) (assuming such arrangements are effective as a contractual matter under the governing law of the contract in which they are contained).
- There is no general legal concept of substance over form. This means that heavily subordinated debt, long-term and perpetual debt, for example, would, for the purposes of Cayman Islands law, 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 can have most of the economic characteristics of equity. This is particularly helpful in current SIV structures where subordinated capital is in economic terms equity but legally in the form of subordinated debt.
- The list of 'preferred creditors' in the Cayman Islands (which generally rank ahead of all creditors other than those with fixed security) is limited and in practice limited to unpaid government fees where the SIV has no local employees.
The fees payable to the Cayman Islands Government on incorporation are based on authorised share capital (a minimum fee of approximately US$573 and up to a maximum fee of US$2,400) as opposed to the paid up capital which could be significantly higher. Annual government fees are also based on authorised share capital (US$573 - US$2,400) and registered office fees and the fees of local administrators are equally competitive in the offshore market.
Satisfactory legal opinions are readily obtainable in relation to Cayman Islands SIVs. Industry organisations such as ISDA, major bankers associations and rating agencies all recognise SIVs established in the Cayman Islands as acceptable, and often preferred, vehicles in structured finance and derivative transactions.
Unlike some other offshore jurisdictions, the Cayman Islands does not insist on the use of local service providers (for example paying agents or custodians) or Cayman resident directors allowing individuals from the manager or investors to sit on the Board where necessary. However, the Cayman Islands have institutions able to provide a complete range of financial services (including the provisions of directors) as may be required. The Cayman Islands Stock Exchange also has rules specifically designed to assist the listing of specialist debt securities of the kind issued by SIVs.
The Cayman Islands have in place anti-money laundering legislation which is fully compliant with the international standards set by the Financial Action Task Force. Indeed, the Cayman Islands has had anti-money laundering legislation in place since the early 1980s as evidenced by the Mutual Legal Assistance Treaty with the United States. In addition, the OECD in its efforts to curb harmful tax competition has approved the Cayman Islands as co-operative and has accepted Cayman's system of indirect taxation and tax neutrality.
Indications are that investors in the financial markets globally are attracted to the high quality investment opportunities offered by SIVs. SIVs can only be structured if the benefits to investors and investment managers are not eroded by tax, accounting and regulatory requirements of the jurisdiction in which the participants or the transaction vehicles are established. It is expected therefore that the Cayman Islands will continue to attract major institutions seeking to establish their own SIVs.
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.