An exempted company is the most common form of Cayman company and this client briefing seeks to address the issues involved when security is granted over shares in a Cayman exempted company.
This client briefing is intended to provide a general summary of the position in law as at the date shown above, and is not to be taken as specific legal advice applicable to particular issues or circumstances. If such advice is required, please contact your usual Ogier contact or one of our partners listed here.
Nature of Exempted Company Shares
The ownership interests in an exempted company are registered (i.e. book entry) shares. Legal title to shares derives from entry in the register of members, and it is typical for a company's constituent documents (i.e. the memorandum and articles of association) to provide that the company shall not recognise any interest in shares other than the interest of the registered holder, whom it treats as the legal and beneficial owner.
There are two ways of taking security over shares of an exempted limited company, a legal charge or an equitable charge.
A legal charge over shares is created by the transfer of the shares into the name of the secured party, or its nominee and the registration of that person as a holder of the charged shares in the register of members of the company. A legal charge is a more secure and comprehensive form of security interest, as it transfers legal title to the charged shares to the secured party and prevents the chargor from dealing with the shares while they are subject to the charge. In a legal charge, the secured party undertakes to re-transfer the shares on discharge of the secured obligations.
As registered holder of the charged shares, the secured party is entitled to receive all benefits derived from, and to exercise all rights attaching to, the charged shares. Generally speaking, the registered holder's ability to exercise such rights will be contractually limited in the security document and, provided no event of default has occurred, the secured party will pay over to the chargor sums received in respect of the charged shares by way of a dividend and will exercise voting rights attaching to the charged shares in such manner as the chargor may require, provided that it is not required to exercise such rights in a manner which would be prejudicial to the security. Following the occurrence of an event of default, the secured party will be entitled to all rights and benefits deriving from and attaching to the charged shares without restriction.
A legal charge has the advantage that, since the secured party obtains legal title to the charged shares, it is not subject to any pre-existing equitable interest in the charged shares, unless such secured party had actual or constructive notice of that equitable interest prior to the creation of the legal charge.
A further advantage of a legal charge is that if it becomes necessary to enforce the security, the secured party is already in control as the registered owner of the charged shares. The secured party can therefore, subject to provisions to the contrary in the constituent documents, sell the charged shares to whomever it wishes and take other action available to a shareholder. Note, however, that a transfer of registered shares is effected by a written instrument of transfer which is registered in the register of members. That register is under the control of the directors and in the event that the directors purport to exercise their right to decline to register a transfer of the charged shares in the event of the sale of the charged shares, then, on enforcement, the secured party under a legal charge may, as the registered shareholder, need to exercise powers available to it in the articles of association to remove the directors.
The disadvantage to a legal charge is that strictly speaking, where a secured party takes a legal charge over, and so becomes the registered holder of, the whole of (or the majority of) the issued share capital of an exempted company, that company may be treated as its subsidiary from an accounting perspective. Whether this is an issue may depend upon the law and the accounting principles of the jurisdiction in which the accounts of the secured party are prepared. In addition, there may be tax and/or regulatory implications for a secured party in taking legal title to shares pursuant to a legal charge. As a result it is much more common for a secured party to take an equitable charge over shares.
An equitable charge transfers only the beneficial interest in the charged shares to the secured party, the legal title remaining with the chargor. The contractual position is the inverse of that under a legal charge, which is to say that the chargor remains entitled to all the benefits deriving from, and the rights attaching to, the charged shares, subject to whatever contractual restrictions are contained in the security document relating to the manner in which these may be exercised.
There are a number of disadvantages to an equitable charge:
(i) the directors of a company, having power to decline to register transfers, may decline to register the share transfer submitted by the secured party on enforcement and the constituent documents of the company are also likely to contain a provision to the effect that the company is not affected by notice of the interest of the secured party in shares nor is it required to recognize a beneficial interest in its shares. Unless the secured party is the person entered in the register of members as holder of the charged shares it will have no rights vis-à-vis the company in respect of the shares. It will only have a contractual right against the chargor pursuant to the share charge;
(ii) a fraudulent or negligent chargor, having remained the registered holder of the charged shares, could transfer the shares held by it to a third party. Since the company itself does not recognize the rights of anyone other than the legal holder of the charged shares, should such a fraudulent transfer be registered it would frustrate the registration of the secured party as a member upon enforcement of the equitable charge; and
(iii) a legal charge of shares for value will rank before a prior equitable charge of shares provided that the legal secured party does not have actual or constructive notice of such prior equitable interest at the time of the creation of the legal charge. Actual notice will include the registration of a prior equitable charge in the register of mortgages and charges of the chargor (if the chargor is a Cayman company). In this regard a certified copy of the register of mortgages and charges of the chargor (if the chargor is a Cayman company) noting the security interests created by the equitable charge should always be obtained at the time an equitable charge is taken.
Despite such disadvantages the customary and more practical approach is to use an equitable charge and take steps in order to mitigate the difficulties associated with an equitable charge.
An equitable charge security package often incorporates the following in order to address the deficiencies associated with an equitable charge:
(i) Obtaining the original share certificates representing the shares (if share certificates exist – under Cayman law a company is not required to issue share certificates) and an executed but undated share transfer form in respect of the shares, together with an irrevocable power of attorney (note under Cayman law a power of attorney must be executed by way of deed). Upon enforcement of the equitable charge the share transfer form would be dated and delivered to the registered office of the company for registration and updating of the register of members;
(ii) Obtaining signed, undated letters of resignation from all the directors of the company to be dated upon enforcement of the equitable charge in order to remove the directors. A Cayman company's directors are responsible for approving the registration of any share transfer. Any directors unwilling to register the transfer could frustrate enforcement. In these circumstances an option would be to remove the directors using the pre-signed resignation letters;
(iii) It would be normal to provide for notice of the equitable charge to be given to the company whose shares are the subject of the equitable share charge and for the company to acknowledge, amongst other things, that it has not received notice of any prior equitable interest in the charged shares;
(iv) Obtaining an irrevocable proxy from the chargor in favour of the secured party in order that the secured party can vote the charged shares on behalf of the chargor. This proxy could be used on enforcement to appoint replacement directors who could then take steps to register the share transfer and update the company's register of members;
(v) Requiring the company to amend its articles of association to build in provisions to assist on an enforcement. For example, a Cayman company's articles of association will typically give the directors discretion to refuse registration of share transfers – this provision would typically be amended to ensure that the directors are obliged to transfer the shares to the secured party upon enforcement of the share charge and also to prevent the directors from registering any transfer of the charged shares to any person other than the secured party for as long as the share charge exists. The share charge itself would include a requirement that the secured party's consent is required for any subsequent amendments to the articles;
(vi) It is also market practice to require a notation to be made in the register of members of the company noting that the shares are subject to the equitable share charge. This is in order to put any third party on notice in the event that they were to inspect the register of members. Practically, since the register of members is not publicly available, such notation will only be of value where a prospective purchaser of the shares requires sight of the register of members to check whether there are any encumbrances over the shares; and/or
(vii) Filing a "stop notice" with the Grand Court of the Cayman Islands, which is then served on the company whose shares have been charged. This notice requires that in the event of any proposed dealing with the charged shares by such company, fourteen days prior written notice has to be given to the secured party and no dealing with the shares may be completed within that period. A "stop notice" is not necessary to perfect the security (but does provide additional protection) and will often be resisted by the chargor, since the existence of the security will, on the filing of the "stop notice", be a matter of public record (which would not otherwise be the case).
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.