Cayman Islands: Key Considerations On Lending To Investment Funds In The Form Of Cayman Islands ELPs And LLCs

Last Updated: 25 October 2016
Article by Tina Meigh

VEHICLES

In the Cayman Islands, investment funds are often structured as exempted limited partnerships (each, an "ELP"). Whilst this is a sophisticated, highly flexible and commercial vehicle, it has no separate legal personality and, as such, all management is vested in its general partner(s) (each, a "GP") pursuant to the terms of a limited partnership agreement entered into by the GP and each of the limited partners. Subject to the terms of its limited partnership agreement and the Exempted Limited Partnership Law, 2014 (the "ELP Law"), the GP would typically be delegated wide powers to undertake the business of the ELP, including the ability to incur indebtedness on behalf of the ELP and grant supporting security interests for those debts and obligations.

Contrast this with the new Cayman Islands limited liability company ("LLC"), a flexible, hybrid entity that is subject to the Limited Liability Companies Law, 2016 (the "LLC Law"). The LLC is a new vehicle anticipated to be utilised significantly in the investment funds space and which incorporates advantageous features from both company and limited partnership regimes. Unlike an ELP, the LLC is a body corporate with separate legal personality in the same way as a company and has capacity, in its own name, to sue and be sued, and to incur debts and obligations. The members of a Cayman LLC will, in most instances, agree and adopt an LLC agreement which regulates the conduct of business and the affairs of the LLC. All members, and the LLC itself, are bound by the terms of the LLC agreement and, in most cases, we expect the day-to-day management of the LLC to be delegated under that agreement to a manager, although an LLC may alternatively be managed by one or more of its members. The manager will have specific powers set out in the LLC agreement, although this may not be, and is not required to be, as detailed as the agreement put in place for ELPs. In those circumstances, lenders should only need to look to the manager approvals for the authorisation of entry by the LLC into the finance transactions and the grant of any related security interests.

GRANT OF SECURITY

One of the most important elements for any lender lending into a financing structure for an investment fund is the security package available to them upon a default. In taking a security interest, there are three key questions that a lender should ask:

  1. Has a valid security interest been taken?
  2. Has the security interest been perfected?
  3. Can the security interest be enforced and, if so, where and against whom?

HAS A VALID SECURITY INTEREST BEEN TAKEN?

In order to answer the first question, a lender must have a clear understanding of the nature of the assets that will be subject to the proposed security interest. It is important for both the funds and the lender to know and understand how title to the assets and any associated contractual rights are owned.

Security interests can only be properly granted by the owner of the assets (or any agent on its behalf). Other than assets held through a custodian or other intermediary, tangible assets would typically be owned directly by either the ELP (acting through its GP) or the LLC itself, and security agreements would, as a result, be entered into by the ELP and the LLC. However, if security is to be taken over intangible assets and, as is frequently seen in the investment funds market, any intangible is in the form of a chose in action (including the contractual right to call capital from investors (being the limited partners of the ELP or the members of the LLC)), the position is not so straight forward.

Whilst the right to call capital in the case of an ELP is deemed to be a partnership asset pursuant to the ELP Law, the assets of the ELP are ultimately vested in the GP. As a contractual matter this means that those contractual rights to call capital from the investors are delegated to the GP pursuant to the terms of the limited partnership agreement. As a result, any security interest over such contractual rights should be granted by the GP with the ELP also being party to the security agreement in order to create security over its contractual assets, being the right to receive proceeds of any capital calls and any associated enforcement rights following non-payment by the limited partners.

Conversely, in the case of an LLC, the LLC agreement should provide the manager with broad powers to enter into any transactions on behalf of the LLC and not otherwise prohibited by the LLC Law. As there is no prescribed form of LLC agreement under the LLC Law, a careful review of the contractually agreed terms should be undertaken on a case by case basis. However, given the legal personality attaching to an LLC, the expectation is that the manager on behalf of the LLC will have specific powers set out in the LLC agreement to call and receive capital from the members. This should simplify any proposed security arrangements as the LLC, and not the manager, should be the party granting the security interest.

HAS THE SECURITY INTEREST BEEN PERFECTED?

Lenders must always ensure that the security interest that they have been granted is perfected in accordance with the applicable governing and local laws.

Assets owned by ELPs and LLCs are not usually held in the Cayman Islands and are, therefore, not typically subject to Cayman Islands law. In those circumstances, Cayman Islands law will not impose any additional perfection requirements on those security interests but will simply require the Cayman Islands entity to comply with its obligations under local statute. In the context of an LLC, this includes the obligation on the LLC to update its register of charges to reflect the creation of the security interest granted in favour of the lender. A lender should not be confused as to the form of this document which is an internal register of the LLC only and is not something that is filed with any central registry or government body. It confers no perfection of the security interest and should only be treated as an aid to contracting parties with the LLC so as to place them on notice of the existence of prior security interests created by the LLC from time to time. The fact that a security interest is not referenced on the register will not, however, invalidate the security interest as a matter of Cayman Islands law, but will simply place the LLC in breach of its statutory obligations. Notwithstanding this point, a lender should insist on receiving a copy of the register at the closing of the financing transaction to ensure that this has been updated so as to place third parties on notice of the existence of the security interest created in favour of the lender.

An ELP has no corresponding obligation under the ELP Law to maintain a register of security interests (other than a register where security is granted by a limited partner over its limited partnership interest in the ELP). However, whilst there is no specific Cayman Islands authority as to whether a Cayman Islands company which holds property on trust or in any other fiduciary capacity (such as a GP), should make registrations in respect of such property, a GP may voluntarily make an entry on its register with respect to security interests created by the ELP and this is commonly requested by lenders in most financing structures.

Contractual rights created under a Cayman Islands law governed partnership agreement or LLC agreement are, however, subject to Cayman Islands law thereby requiring compliance with Cayman Islands laws to ensure perfection and priority of the security interests created over those contractual rights. Under Cayman Islands law, a legal assignment by way security over the contractual rights of an ELP, a GP or an LLC derived from the limited partnership agreement or LLC agreement (or any subscription agreement entered into by the parties) should be perfected by the delivery of a written notice to the investors in each fund to place them on notice of the existence of the security interest. This perfection requirement is built into Cayman Islands legislation (in much the same way as the equivalent legislation in England and Wales) and should be adhered to even where the security interest over the contractual rights is governed by a law other than Cayman Islands law. Timing of the notice will also determine the priority of any security interest that a lender has been granted (the so called "Dearle v Hall" rule).

In a large number of cases, investors in the funds will be asked to acknowledge receipt of the notice as well as provide additional certifications and undertakings to the lender to confirm that no other security interests have been granted over the rights of the GP, the ELP or the LLC, as applicable, under the related limited partnership agreement or LLC agreement that is in place, and that the investor will act on the lender's instructions in a default scenario. Whilst the acknowledgement and undertakings of the investors are, from a lender's perspective, welcomed in any transaction, they should be treated as a commercially prudent measure rather than as a guarantee or perfection requirement. Many investors will push back on any request for the provision of information to the lender, let alone the granting of undertakings to a third party lender with whom they are not otherwise obliged to contract or incur potential liability.

CAN THE SECURITY INTEREST BE ENFORCED?

Whilst all lenders hope that they will never have to enforce the security interests that they have been granted, it is always preferable to prepare for a worst case scenario. Lenders should know exactly what steps must be taken in an enforcement situation. The Cayman Islands is a leading creditor friendly jurisdiction and both the ELP Law and LLC Law support this position by each clearly confirming that, irrespective of the governing law of any security interest, a secured party has the right to enforce its security interests without leave of the Cayman Islands court or the liquidator of the LLC or ELP. There are no Chapter 11, moratorium or standstill type provisions that would affect a creditor's right to enforce its security. This ultimately allows the lender to seize and realise the assets of the vehicle (including calling for capital from the limited partners of an ELP and the members of an LLC) to satisfy the secured obligations.

As the markets evolve and the structuring of investment funds develop, lenders are exposing themselves to new risks and creating new security packages to ensure the continued growth of their businesses. It is critical that lenders not only ask themselves these three key questions but ensure that they are properly addressed so that the lenders are fully protected in any default scenario.

Originally published the Global Banking and Financial Policy Review 2016 2017, IFLR Yearbooks

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.

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