In asset-backed multi-issue structured finance vehicles, for example vehicles issuing under repackaging programmes, one of the core structuring features is to ensure that each series of notes issued to investors is properly "ring-fenced". Amendments to the Companies Law in the Cayman Islands late last year has created a statutory alternative to contractual "ring fencing" through the use of segregated portfolio companies.
The purpose of this article is to explain, in summary: the current methods of ring-fencing; what a segregated portfolio company or "SPC" is; the benefits of the SPC legislation; some of the potential key issues that may arise; other potential applications for SPCs; and certain points in the SPC legislation to bear in mind with respect to capital markets transactions.
Current Methods of Ring Fencing Multi-issue, Structured Finance Vehicles
In essence, ring fencing should ensure that the cash flows from the underlying assets for one specific series of notes flow to the investors of that series in accordance with the terms of the notes and are unavailable to meet the liabilities on any other series of notes of the same issuer. This "cross contamination" risk has been addressed in the past through contractual methods contained in the issue documentation for the relevant issue of notes.
The documentation for most multi-issue transactions is typically governed by English or New York law and the courts of the Cayman Islands will generally recognise the choice of law and the creation of the security interest under such law.
Under English law, the ring fencing is currently achieved using a combination of two elements. The first is for the underlying assets to be charged in favour of the trustee of the notes for the benefit of the noteholders of that series (i.e. the notes of each series are secured by the underlying assets). The second element is to utilise limited recourse and non-petition provisions to limit the ability of each of the noteholders to claim against underlying assets not attributable to their series. Once the underlying assets for the relevant series have been exhausted, such provisions provide that any remaining liability under such notes will be extinguished and the holder will have no further claim against the issuer or its assets.
Although not as common as the English law governed repackaging programmes, we are aware that as a matter of New York law, the key requirements from the rating agencies involve such transactions using limited or, in U.S. terms, non-recourse wording, and non-petition wording as well as subordination agreements which would constitute an enforceable subordination agreement under Section 510 of the Bankruptcy Code.
Segregated Portfolio Companies
The segregated portfolio legislation contains a potential alternative to the above structures by providing for ring fencing by way of statute. The legislation, which is set out in Part XIV of the Companies Law (2003 Revision) (the "Companies Law"), permits within a single company or issuer (the "SPC"), the segregation of assets and liabilities amongst various "portfolios" in a way which binds third parties as a matter of Cayman Islands law.
The core provisions are set out in Section 240 and 241 of the Companies Law and provide that the assets of each portfolio shall only be available and used to meet liabilities owed to the creditors of that portfolio and that any creditor of a particular portfolio shall only be entitled to have recourse to the assets of that portfolio, and if not prohibited by the SPC's articles of association, the general assets (but not the assets of the other portfolios) of the SPC. With regards to the availability of the general assets, please see further below.
Accordingly, an SPC achieves through statute, as a matter of Cayman Islands law, the objective of the current ring fencing techniques used in the international capital markets with each "portfolio" having as assets, the underlying assets and as liabilities, the obligation to pay the principal and interest of the notes (subject to limited recourse) for that series. In other words you can think of each current series and its corresponding underlying assets as a portfolio. As with current structures, the equity share capital would be held by a licenced trust company, such as Maples Finance Limited, on trust for charitable and other philanthropic purposes.
The obvious benefit of using an SPC is the fact that the ring fencing is embedded in statute rather than contract and accordingly has the benefit of statutory recognition in the place of incorporation of the issuer. However, the other important benefit of the segregated portfolio regime is that as a statutory regime, it would also bind non-consensual third parties as well as consensual third parties under Cayman Islands law. This therefore extends the ring-fencing concept to parties who would otherwise not be covered by the current contractual ring fencing, which would only bind contractual parties.
Potential Key Issues
Although the segregated portfolio legislation, as a matter of Cayman Islands law offers a viable alternative on its own, one critical point to be acknowledged is that invariably the underlying assets are located in other jurisdictions, primarily New York or London. One issue which needs to be addressed, therefore, is the recognition of the segregated portfolio legislation in the jurisdiction in which the underlying assets are located.
To the extent that such jurisdiction may not recognise the segregation provided for by the Cayman Islands legislation, or where insolvency proceedings could be commenced against the SPC in a jurisdiction which would ignore the segregated portfolio legislation, then the use of the SPC legislation on its own may not in itself meet the objective of ring fencing the series or portfolio.
This can be addressed in two ways: firstly, where possible legal opinions in the relevant jurisdictions should be obtained confirming the point; and secondly, using the SPC legislation in addition to contractual ring fencing, rather than as an alternative in itself. Even if a legal opinion is obtained, in light of potential cost of jurisdictional 'reviews' and acknowledging the cross-border nature of structured finance, our recommendation would be to use an SPC as a "bolt on" or in addition to the existing contractual ring fencing.
In doing so, participants would benefit from the current market acceptance of the current structure and the neutralization of the potential issue regarding recognition of the segregated portfolio legislation in the jurisdiction on which the underlying assets are located while at the same time participants would gain the benefits mentioned above, including the ability to bind non-consensual parties as a matter of Cayman Islands law.
The SPC Legislation was initially introduced into the Cayman Islands in 1998, but was limited only to regulated insurance companies. After several years of insurance companies successfully utilising the legislation to create segregated portfolios for separate pools of risk (59 SPCs formed with 240 segregated portfolios), the Cayman Islands government in 2002 extended the SPC legislation to any type of exempted company with the intention that SPCs could be used more generally within the mutual fund industry (where it has particular application with respect to umbrella funds) and also in capital market transactions. After representations from various industry bodies in Cayman and with the leading assistance of Maples and Calder, the Cayman Islands government then amended the SPC legislation to remove a provision which permitted a moratorium on security being enforced in the event that a receivership order was made in respect of a portfolio, such provision obviously made SPCs unattractive for capital markets issuers and hedge funds where security was often granted. At the same time the Cayman Islands government also amended certain other provisions with the overall intention to make SPCs more attractive to the international capital markets and also the mutual funds industry, where already at least 58 SPC's have been used for mutual fund transactions1.
Other Points to Note in the context of using SPCs for Capital Markets Transactions
As permitted by Section 241 of the Companies Law, unless the articles of association so prohibit, a creditor can have recourse to both the assets of the segregated portfolio and also the general assets of the SPC. This concept is generally known as "flow over". On the basis that the general assets will only be used to pay the general expenses of the SPC, it may make sense to prohibit recourse to the general assets in the articles of association in order to prevent any flow over into the general assets for the creditors of each of the segregated portfolios. This should ensure that the SPC is always adequately funded to meet its general expenses, such as annual return fees. Such a provision would also limit the ability of a creditor to wind up the SPC as opposed to the portfolio.
Another point to note is that the SPC legislation specifically contemplates that a receivership order can be obtained in respect of any segregated portfolio. Obviously, it would make sense to extend the wording of the non-petition covenant to prohibit any known creditor from applying for any such receivership order.
A further issue is that it must be clear in each contract or agreement to be entered into by each segregated portfolio, that such contract or agreement is entered into by or on behalf of the directors for, and on behalf of, the segregated portfolio and where the contract is in writing, the contract or agreement must indicate that such execution is in the name of, or by, or for the account of, such segregated portfolio. It would therefore be advisable for a specific covenant to be given in the transaction documents that the directors will comply with this requirement so that that the relevant contracts or agreements are binding on or enure to the benefit of that portfolio.
With respect to administration and fees, there should not be any material change to the current structures used. As noted above, there would need to be arrangements put in place to ensure that the general ongoing expenses of the SPC are funded out of general assets. This can obviously be done by having either a large reserve in general assets or alternatively have each of the segregated portfolios' cash flow transfer pro rata amounts to the general assets to meet such expenses.
Although we would anticipate in the context of structured finance transactions for a new entity to be formed and to apply for registration as a segregated portfolio company on incorporation, it is possible for existing exempted companies to apply to convert to a segregated portfolio company. The legislation contains specific provisions to ensure that existing assets and liabilities are properly allocated upon conversion.
Following the recent amendments to the SPC legislation, there is definite potential application for the use of SPCs in the international capital markets for asset backed multi-issue transactions. However, as indicated above, we believe the most natural step forward would be to utilise the SPC legislation by way of an addition or bolt on to the current tried and tested methods used to ring-fence multi-issue vehicles.
1 Information provided by the Cayman Islands Monetary Authority.
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.