HIGHLY DEVELOPED FINANCIAL INFRASTRUCTURE
Forty seven of the world’s leading fifty banks have branch or subsidiary operations all of which are regulated in accordance with the Basle Convention. The banking industry’s aggregate bookings and deposits as at 31st December 1998 are in excess of US$600 billion. This places the Cayman Islands as the seventh largest banking centre in the world. Under the mutual funds legislation there are in excess of 2000 regulated companies, unit trusts and limited partnerships with an aggregate dollar investment for both open and closed ended funds estimated at US$200 billion placing the Cayman Islands second in the list of offshore jurisdictions behind Luxembourg. All the recognised international service providers have established operations in the Cayman Islands.
ABSENCE OF INTRUSIVE REGULATION
Cayman Islands Law does not restrict the investment objectives or introduce investment restrictions with respect to structured debt transactions.
LEGAL SYSTEM AND ANTI MONEY LAUNDERING LEGISLATION
The financial industry in the Cayman Islands is founded on a common law legal system, with modern legislation and a very effective court system. Whilst the Cayman Islands Companies Law and common law follows in many respects English legal principles more flexible legislation has responded to the requirements of both the international markets and regulators. This continuous development of the Cayman Islands has also been aided further by their proximity to the United States with which the Cayman Islands entered into the Mutual Legal Assistance Treaty in 1986. This Treaty, ratified by the United States Senate in 1990, provided a highly effective framework of anti money laundering legislation in relation to criminal activity and provided a major disincentive to any form of tainted activity. Further, the Cayman Islands were the first UK Overseas Territory to have in place legislation modeled on the Criminal Justice Act 1993 requiring "suspicious transaction" reporting in relation to criminal transactions and which meets the standards required the United States, the United Kingdom and the Financial Action Task Force. Such legislation is now generally regarded as essential if an offshore jurisdiction is to be accepted as part of the international financial community.
OFF BALANCE SHEET STRUCTURE
Cayman Island law has also facilitated the treatment of the SPV as a bankruptcy remote entity (there being no equivalent to US Chapter 11 or English administration proceedings under Cayman insolvency law) specifically by the use of the charitable or purpose trust as the parent. The charitable trust when properly structured is well recognised in the financial markets in London, New York and Tokyo as an appropriate vehicle for ensuring that the SPV will be treated as off the balance sheet of the originator. The SPV will be owned by a charitable trust established in the Cayman Islands by a Cayman Islands trust corporation and which will take up by subscription the equity capital of the SPV and will also usually provide an independent board of directors for the SPV. The board of directors must ensure the SPV functions as a wholly independent entity in accordance with recognised corporate principles. The SPV is funded by the proceeds of its debt issue which it will in turn use to acquire the underlying asset pool from the originator. In this way, the SPV should be treated as separate from the originator, is thereby held off the balance sheet of the originator and is not consolidated for accounting purposes or regulatory purposes. It should be noted that the well-structured transaction must meet all applicable legal, regulatory and accounting tests which differ jurisdiction by jurisdiction and that careful consideration needs to be given by onshore counsel particularly where the originator determines that for commercial reasons it wishes to maintain some involvement with the underlying asset pool after the sale of that underlying asset pool to the SPV. Usually this involvement will be with respect to administration but the originator may also seek an interest in any residual profit in the underlying assets once the debt issued by the SPV has been redeemed.
Typically, the Cayman exempt company is used as the SPV to benefit from the flexible corporate regime, low cost and simple, same day, incorporation procedures, Cayman limited duration and limited life companies have been introduced which possess the relevant criteria to enable the SPV to be treated as a partnership in certain other jurisdictions for tax purposes enabling the shareholders (where the SPV is not owned by a charitable trust) to benefit from the tax transparency. Unit trusts and limited partnerships are also used as alternative vehicles where participation in a unit trust or partnership is more attractive to investors for tax or regulatory reasons.
BENEFITS OF SECURITISATION AND STRUCTURED DEBT TRANSACTIONS
Structured debt transactions and particularly securitisations have been recognised in the Cayman Islands as being of importance because many institutional investors are precluded by regulation, applicable investment policy or their constitutional documents from investing in certain types of securities or indeed anything other than debt securities. This may be because such securities do not have a rating from a rating agency or may simply be recognised under applicable law and regulation as equity rather than debt. Debt securities issued by Cayman SPVs may be structured to meet these requirements and in addition, by use of derivatives, the principal and income stream payable to the investor on the debt security issued by the SPV may be customised as to term, currency and fixed or floating rate of interest. Furthermore, whilst the typical transaction will issue a security to investors which is characterised as debt, under Cayman Islands law that debt may carry with it an equity kicker so that in addition and for the benefit of the investor, the equity element will strip out from the SPV the whole or part of any profit remaining in the SPV after redemption of the principal and interest payments. SPVs formed for this type of transaction are nevertheless not within the regulatory regime applicable to mutual funds in the Cayman Islands. Structured debt transactions also enable companies to access new sources of lower cost funds.
The typical securitisation transaction involves a debt issue made by a Cayman Island SPV which will then apply the proceeds to purchase the underlying assets from the promoting financial institution or originator. The underlying assets may be fixed or revolving but will usually convert into cash within a finite period of time thereby redeeming the debt issued by the SPV. Such financing arrangements undertaken by the SPV can encompass everything from the simple capital markets Euro paper issue, repackagings, aircraft and ship financing to the more complex securitised transactions which involve the acquisition by the SPV of real property mortgages, credit card or other receivables, finance leases or indeed interests in mutual funds. Any financial or other asset which provides an income stream may be acquired by the SPV. The essential element of this type of transaction is the acquisition by the SPV of these underlying assets from the promoting financial institution and thereby, the financial characteristics of those underlying assets may be converted into readily transferable marketable debt by the SPV 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 SPVs first obtained Triple A ratings from the rating agencies.
The specific benefits to the originator of the structured finance transaction are both economic and regulatory and include:
- the removal of the underlying assets from the balance sheet of the originator thereby avoiding the cost of meeting increased capital adequacy ratios or risk ratios and enabling that institution to write new business;
- the reduction of any interest mismatch and maturity risks to which the originator may have been exposed by reference to the underlying assets;
- fee income to the originator for the administration of the structure;
- potential cost savings to the originator which undertakes the structured finance transaction in volume;
- diversification by providing new sources of funds at lower cost which may move away from the dependence on bank and quasi-bank funding markets as sources of funds;
- accelerating the recognition by the originator of 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 SPV obtains 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 SPV and the income stream and principal payable on the debt issued by it 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 obtained.
CREDIT ENHANCEMENT AND THE RATING AGENCIES
The credit enhancement features may be provided by over-collaterlisation of the SPV, by provision of a letter of credit, by a repurchase agreement made between the originator and the SPV to buy back the underlying asset pool at a fixed rate, by the issue by the SPV of a series of subordinated securities by way of a financial cushion, and usually taken up by an affiliate of the promoting financial institution, and lastly by the provision to the SPV of residual asset guarantees or pool insurances such as mortgage indemnity policies.
The credit enhancement features will be central to the rating of the issue of the debt by the SPV by the rating agency and in the typical structure the note or bond issue undertaken by the SPV will be collateralised by way of the grant of security interests over the underlying assets for the benefit of the investors holding the notes. The SPV will then have its collateral and credit enhancement mechanisms in place from the outset and this will enable the rating agency to rate the issue and not the issuer which will involve the rating agency in investigating f irstly, (1) the adequacy of the collateral, (2) the administrative structures to ensure that the principal and interest payments may be paid to the investors, and (3) as mentioned above, the integrity of the SPV and most importantly ensuring that it is bankruptcy remote.
WHAT ASSETS CAN BE SECURITISED?
There is no limitation under Cayman Islands law on the relevant pool of underlying assets or receivables that can be acquired. The usual structure, particularly in multi-issue vehicles, will involve the issue of limited recourse notes to third party investors secured over those assets. In recent years, financial institutions have used Cayman Islands SPVs:
- As issuing vehicles for private placements and listed securitisations, some of which are triple A rated in respect of residential property in Hong Kong and Australia; Japanese, German and Italian automobile receivables; Hong Kong, UK and Mexican credit card receivables; aircraft lease receivables in countries as diverse as China and Argentina; steel, oil and aluminium contracts in Brazil, the United States and Venezuela; trade receivables and the income stream on hydrocarbon contracts.
- As off-balance sheet vehicles for repackaging all types of securities often coupled with derivatives to tailor the income stream.
- As vehicles for use as holders of purchase options, interests in swaps and other derivatives in multi-tier structured financings.
- As vehicles for off-balance sheet credit enhanced futures and derivatives trading.
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 Cayman courts will recognise or enforce netting, set off and subordination agreements (which are given express statutory recognition) and security interests created under laws other than Cayman Islands law if validly created under the relevant law.
THE CAYMAN COMPANIES LAW - STRENGTH AND FLEXIBILITY
Unlike a number of jurisdictions which have developed their own Companies Law, one of the attractions of the Cayman Islands is that the Companies Law is modelled on the English Law and it has not, therefore, cut itself off from English precedent. Whilst certain statutory provisions may differ to provide greater flexibility under the Cayman Island Companies Law on the core issues of corporate powers, directors fiduciary duties, and duties of care and skill, the concept of corporate personality and limited liability and corporate benefit and proper purpose are, in all substantial respects, the English Law. These principles have been applied by the Cayman Islands Grand Court (see also Re Polly Peck International plc (in administration) 1996 2 All England, 433). There are two noteworthy refinements under the Cayman Islands Companies Law. The first provides, much in the manner of the new UK OIEC that shares are redeemable, but in the Cayman Islands not only out of profit but also from the credit balance to the share premium account provided the Company is able to meet its debts as they fall due. This may be important in relation to the structured debt transaction which may include redeemable preference shares in addition to the Note or Bond Issues with a view to stripping any residual net equity out of the SPV after redemption of the principal and interest on the debt.
The second refinement of the Cayman Islands Companies Law is central to the structured debt transaction in that the pari passu rule with regard to unsecured debt is specifically rendered subject to the contractual provisions establishing the debt with regard to priority, subordination or as otherwise may be provided. This enables an unqualified opinion to be issued on the question of contractual netting and set off.
The exempted company is the vehicle used in most SPV transactions. The relevant benefits which apply to an exempted company, include the following:
- no requirement to appoint Cayman Islands directors or shareholders;
- no requirement to file an annual return of its shareholders with the Registrar of Companies or the Immigration Board;
- the register of members is not open to inspection;
- an exempted company does not have to hold an annual general meeting;
- an exempted company may issue no par value shares;
- notwithstanding the absence of relevant direct taxation an exempted company may obtain an undertaking against the imposition of any future taxation (such undertakings are usually given for 20 years in the first instance);
- an exempted company may register by way of continuation in another jurisdiction and be deregistered in the Cayman Islands; and
- no obligation to file its accounts with any Cayman Islands authority.
An exempted company may not carry on business in the Cayman Islands except in furtherance of its business abroad and it may not make any invitation to the public in the Cayman Islands to subscribe for any of its shares or debentures unless they are listed on the Cayman Islands Stock Exchange. Nor is it appropriate for the company to own land in the Cayman Islands unless given specific permission by the Financial Secretary.
Unless the Memorandum expressly restricts the company to the objects stated (which is often regarded as important by the rating agency), the SPV has the power to carry out any lawful object and the power to exercise all the functions of a natural person. Thus if the memorandum of association adopts unrestricted legal objects the ultra vires rule is not of application. However the issue of corporate benefit is preserved since the Companies Law preserves an action against the relevant directors or officers for loss arising out of an unauthorised act.
The law does not specify any minimum issued or paidup capital or other thin capitalisation rule except that to complete the incorporation formalities the Memorandum of Association must be subscribed by one or more persons. In the case of the off balance sheet structure it is important that the charitable purpose trust undertakes the share subscription of the SPV.
It is typically the case, and more likely a requirement, that the transaction be structured on a secured limited recourse basis so that the liability of the SPV in relation to any particular transaction is limited to the security provided. In the event of a default by the SPV, the counterparty is only entitled to look to the security concerned and after that security has been realised and the proceeds distributed, any balance remaining of the obligations of the SPV under that transaction should be extinguished.
IMPORTANCE OF INFRASTRUCTURE
Many of these cross border 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 thus the Cayman Islands add value to the transaction. For this reason, Cayman has attracted major institutions with a genuine infrastructure and management functions capable of administering the structured debt transaction within the jurisdiction whether as Note Trustee or issuing or paying agent.
THE CAYMAN STOCK EXCHANGE; AN "APPROVED EXCHANGE"
The Cayman Islands Stock Exchange (CSX) is the most recent addition to the full range of financial services that the jurisdiction offers. Established under The Stock Exchange Company Law 1996, the Exchange takes the modern approach: it is structured as a private limited company owned by the Cayman Islands Government, with a board of directors drawn from the ranks of senior private-sector professionals in the financial services industry. Under the enabling legislation creating it, the CSX has the sole and exclusive right to operate securities markets in the Cayman Islands. The Exchange has particular synergy with two of Cayman’s main financial services products: the mutual fund and the SPV. The listing rules are specifically designed to facilitate the listing of the securities of these entities. There are also tailor made rules for specialist products such as depositary receipts 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 therefor adopts a pragmatic approach to the documentation required for a listing and disclosure requirements have been set at a level which is intended to provide investors with sufficient information without imposing unnecessarily onerous demands. As at the beginning of August 1999, the CSX had a total of 180 listed issuers including debt issues by institutions such as Merrill Lynch, Deutsche Bank and Lehman Brothers with a combined market capitalisation in excess of US$14 billion.
The Cayman Stock Exchange received a tremendous boost when it received "Approved Status" granted by the London Stock Exchange in July 1999. It is the only offshore stock exchange to hold this recognition.
Whilst the present wave of securitisation and structured finance transactions was initiated domestically by onshore banks, as the trend continues in the international arena the technique is being adopted and continually developed by a broad array of multinational financial institutions. To the extent that markets are becoming unified and increased capital regulatory standards are being imposed domestically, the current trend of establishing securitised and structured finance transactions offshore is likely to accelerate with the result that transactions of this type will become an increasingly important f inancial tool and the Cayman Islands an increasingly important financial base.
It should be noted that this memorandum is general in nature and does not purport to constitute formal advice in relation to any specific transaction.