The use of the Cayman Islands as the preferred jurisdiction for the incorporation of securitisation vehicles can be traced back to the emergence of the Cayman Islands as a dominant jurisdiction for capital markets transactions during the 1980's. The Cayman Islands became the favourite centre for capital market transactions through the political and economic stability of the Islands, an effective judicial system, a favourable tax system, the absence of exchange control or currency restrictions, the availability of professional and support services and the presence of light but effective regulation which did not impact capital markets transactions.
The first bond issues using a Cayman Islands incorporated issuer were structured in the late 1970's and the volume of capital markets transactions grew significantly throughout the 1980's as the Cayman Islands was 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, and subsequently medium term note programmes. The mid 1980's saw the development of the repackaging market in which the Cayman Islands dominated, and continues to dominate, as the preferred jurisdiction for the issuer of the repackaged debt. 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 the early repackaged debt was backed by ex-warrant bonds issued by Japanese corporates but subsequently, 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 1980's 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 a programme. This was rapidly followed by the development of repackaging programmes using issues of medium term notes, and to 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.
From these financing techniques, and in particular the repackaging transactions, can be seen the development of the typical securitisation transactions where instead of the underlying asset being the income and principal payments of an underlying bond, often coupled with a swap transaction, the underlying asset was an income stream of receivables generated by a limitless varieties of sources, such as aircraft lease receivables, royalty contracts, payments under steel, aluminum and petroleum contracts, automobile lease receivables, credit card receivables, and home mortgage payments. Securitisations using these financing techniques are only limited by the imagination of arrangers and the appetite of investors.
The typical securitisation transaction involves a debt issue made by a Cayman Island SPV which will then apply the net proceeds to acquire the underlying assets from the promoting financial institution or originator. Any receivables 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 receivables and thereby, the financial characteristics of those underlying receivables 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 securitisation transactions are both economic and regulatory and include:
- 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;
- 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 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;
- fee income to the originator for the administration of the structure;
- 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.
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 originator or 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 any rating of the issue of the debt by the SPV by a 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 firstly, (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.
There is no limitation under Cayman Islands law on 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 SPVs in securitisation 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 SPV or holders of securities issued by the SPV) or indirect (by way of withholding on payments made by the SPV). The SPV, if incorporated as an exempted company (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 SPV or the holders of its securities.
- Exchange Controls.
There are no foreign exchange controls in the Cayman Islands.
Restrictions on business
There are no restrictions on an SPV in the Cayman Islands lending, borrowing or issuing debt securities (none of these activities, for example, constitute banking business requiring the SPV to be licenced as a bank).
2. Substantive Consolidation
- 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 SPV will be ignored so as to allow creditors of an SPV to proceed against its shareholders or to allow creditors of shareholders to proceed against the SPV. Most of these cases involve fraud.
- The typical on balance sheet SPV 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 they should look at the legal substance of the arrangements and in that case found that the court could not disregard the principle of the separate corporate personality of the SPV and treat a closely integrated group of companies (which included the SPV) as a single economic unit on the basis merely 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.
3. Bankruptcy Remote Vehicles
The establishment of bankruptcy remote vehicles in the Cayman Islands is well established.
As many securitisation transactions are likely to be rated it is useful to consider briefly the typical rating agency requirements in relation to bankruptcy remote SPVs.
The way in which the requirements are accommodated in the Cayman Islands does not necessarily reflect the practice, say, in the United States or elsewhere. These requirements are usually:-
- Restrictions on objects and powers.
This is generally explained as necessary in order to restrict the scope of activities of the SPV to those activities which ensure a sufficiency of cash flow to pay the rated securities. The rating agencies explain that the constitutional documents of the SPV are the best place to locate such constraints because, first, the documents are publicly available and so all creditors and others will become aware of the restrictions and, secondly, because such restrictions are less likely to become lost in the corporate files and more likely to remind the management to act in accordance with the restrictions. In the Cayman Islands none of these reasons hold true entirely. In particular, the Cayman Islands has a limited ultra vires rule and an SPV's Memorandum and Articles of Association are not public documents. In practice, the rating agencies will generally not require limited objects in the case of a Cayman SPV and will simply rely on contractual restrictions continued in the transaction documents.
- Debt Limitations
For the reasons mentioned above, these are typically included in the transaction documents rather than the Memorandum and Articles of Association. The rating agencies will also require non-petition language in agreements between SPV and its creditors. Non-petition language together with the limited recourse language is effective under Cayman law in limiting the creditors right to petition as an unpaid creditor.
- Independent Director
The reason for this requirement seems to be principally the concern that the board of directors can file for bankruptcy. Under Cayman Islands law (based on English cases which are persuasive but not binding in Cayman) the Directors do not have power to put a Cayman SPV into voluntary liquidation (the exceptions are cases where the Articles of Association provide for them to have this power expressly and where the shareholders have themselves resolved to liquidate the Company and delegate the power to present the petition to the Directors). Accordingly, the reasons for the "independent director" concept are not applicable in the case of an SPV. Instead, it is necessary to focus on the shareholders who have the power to liquidate an SPV voluntarily by special resolution. This means that, in effect, an independent shareholder rather than an independent director is required. The independent shareholder may own all the voting shares or simply have the power to block a special resolution to wind up the SPV. In fact, most structures go further in that the voting rights attached to the shares held by the independent shareholder are "locked up" under the terms of the typical off-balance sheet charitable trust arrangement i.e. the shareholder agrees not to exercise the voting rights to liquidate the SPV until six months or whatever preference period they wish to use after the debt securities issued by the SPV have been repaid.
- No merger or reorganisation
This requirement is intended to ensure that while the rated securities are outstanding, the bankruptcy remote status of the SPV will not be undermined by any merger or consolidation of the SPV. The rating agencies also generally request that the SPV not amend its Memorandum and Articles without prior written notice to the rating agencies. Generally these matters are dealt with in contractual covenants by the SPV rather than the provisions in the SPV's Articles of Association although it should be noted that the amendment of the Articles of Association is within the control of the shareholders of the SPV not the SPV itself. Typically, however the share trustee in the usual off-balance sheet arrangement agrees that it will not do anything to cause the SPV not to comply with its contractual covenants.
- Separateness covenants
These are designed to ensure that the SPV holds itself out as an independent entity so as to avoid substantive consolidation of the SPV and its assets with those of the parent or other affliates.
In practice in the context of a wholly off balance sheet entity (i.e. one that is wholly owned under the terms of a charitable trust) the rating agencies seem to be happy to receive an opinion from Cayman counsel that the SPV will not be beneficially owned by the Cayman trust company and that in any liquidation of the Cayman trust company the liquidator will have no claim against the property of the SPV.
- Security Interests over Assets
In most transactions security interests are created over non-Cayman assets under non-Cayman law governed security agreements. However, Cayman Islands insolvency law will be relevant which as explained below is generally recognised as creditor friendly and therefore acceptable to the rating agencies.
4. Creditor Friendly Legal System
The legal system in the Cayman Islands is creditor friendly and therefore ideally suited to securitisation transactions. In particular:-
- the Cayman Islands does not have any system of corporate rehabilitation, such as the English "administration" procedure or the United States 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 interests.
- Cayman Islands law does not prevent secured creditors enforcing their security in a liquidation of an SPV. There is no concept of an insolvency "stay".
- 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 only apply when, amongst other requirements a disposition is made with a view to preferring one creditor over another - it is not sufficient simply that an asset or payment was made in circumstances which resulted in one creditor losing out.
- netting and set off arrangements are recognised by express statutory provisions and will be enforced both pre and post 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 provision (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 for Cayman Islands purposes notwithstanding that it has most of the characteristics of equity.
- the list of "preferred creditors" in the Cayman Islands (which generally rank ahead of all creditors other than, with one irrelevant exception relating to claims for severance pay under the Labour Law, those with fixed security) is limited and, in practice, in the case of an SPV, which will have no employees in the Cayman Islands, relates only to unpaid Government fees.
- Redomiciliation provisions – the Cayman Islands allows companies to move to or move 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 taxation or securities regulation reasons.
The Cayman Islands has no general system of registration of security interests to perfect or obtain priority (there are registration systems in place for ships and aircraft registered here, 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 law which governs the creation of the security interest, its perfection and the priority of the secured party depends upon the application of our conflict of law rules which in general terms look to the law governing the security agreement and the law constituting the asset over which the security has been taken or the law of the place where the asset subject to the security interest is situated depending upon the issue being determined and the nature of the asset over which security is taken.
Cayman Islands legal opinions are regularly accepted by the rating agencies. Many industry organisations recognize that SPVs established in the Cayman Islands are acceptable counterparties in derivative transactions.
7. Non-Intrusive Regulation
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 securitisation transactions and secondly, in certain cases, the regulation of specific transactions. 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 transaction regulation of debt issues (unless such issues are listed here).
Establishment costs for SPVs are low. Fees payable to the Cayman Islands Government are based on the SPV's authorised share capital (a minimum fee of US$574 and 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 which 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 being the usual form of company used in structured debt transactions.
The Cayman Islands Stock Exchange (CSX) is established under The Stock Exchange Company Law 1996. 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 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 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.
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 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 institutional transactions within the jurisdiction whether as Note Trustees or issuing or paying agent.
The current initiatives of the G8 countries are expected to result in the enhancement of the Cayman Islands as a leading offshore financial centre specialising as it does 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 co-operating jurisdictions. Properly structured transactions will not be affected by the changes the Cayman Islands has agreed with the OECD to implement over the course of the next five years. It is proposed that information will be exchanged in certain specified circumstances, and in response to specific requests on criminal and ultimately civil tax matters within the frame work of the existing Cayman Islands anti-money laundering legislation.
The naming of the Cayman Islands by the Financial Action Task Force (FATF) as a non co-corporation jurisdiction in anti-money laundering matters has been met by skepticism by the markets, particularly in the light of FATF's own statement in its summary report that the Cayman Islands has been "a leader in developing anti-money laundering programmes throughout the Caribbean region. It has served as the President of the Caribbean FATF and it has provided substantial assistance to neighbouring states in the region. It has demonstrated co-operation on criminal law enforcement matters and uncovered serious cases of fraud and money laundering otherwise unknown to authorities in FATF member states". The FATF review process was of a technical rather than substantive nature focusing on the nature of anti-money laundering regulations in place and the sanctions imposed thereunder, rather than the substantive results of any policies and regime in place. The position in practice as reflected in the review conducted by the Caribbean Financial Action Task Force is that the Cayman Islands has implemented a level of regulations substantially in compliance with the "Vienna Principles" enumerated in the 40 FATF recommendations published in its 1990 report and the Caribbean FATF recommendations. A number of additional recommendations have since been proposed by the FAFT and the Cayman Islands Government has responded by making amendments to the anti-money laundering legislation already in place which will enable the Cayman Islands to be removed from the list of non co-operative jurisdictions in due course. The Cayman Islands has had anti money-laundering legislation in place since the early 1980's and the Cayman Islands is not considered a money laundering centre by financial institutions, despite popular fiction, as evidenced by the limited number of requests for information arising under the Mutual Legal Assistance Treaty between the United States of America and the Cayman Islands.
Whilst the present wave of securitisation and other structured finance transactions was initiated domestically by the money centre 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 transactions offshore is likely to accelerate with the result that transactions of this type will become an increasingly important financial 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.