Introduction
The Cayman Islands has been the dominant offshore jurisdiction for capital markets transactions since the 1980’s due to its political and economic stability, an effective judicial system, a nil direct tax system, the absence of exchange control or currency restrictions, the availability of highly skilled professional and support services and the presence of light but effective regulation which did not negatively impact on capital markets transactions.
Development of Capital Markets in the Cayman Islands and the Market Today
From the first bond issues by a Cayman Islands issuer in the late 1970’s, the volume of capital markets transactions grew significantly throughout the 1980’s as international corporations and financial institutions increasingly funded their activities through Cayman bond issuing vehicles. Acceptance of Cayman issuing vehicles in the euro bond, MTN and CP markets lead, in the mid 1980’s, to the emergence of the repackaging market in which the Cayman Islands dominated, and continues to dominate. This market saw a huge increase in business from 1987 with hundreds of billions of dollars of repackaged debt being issued by Cayman issuers, much originally backed by ex-warrant bonds issued by Japanese corporates but subsequently the underlying assets came from a wide variety of credit risks ranging from sovereign issuers to emerging market debt. This lead to the Cayman Islands being the first choice jurisdiction for a vast array of structured finance transactions which dominate the capital markets practices in the Cayman Islands today.
From the late 1980’s there was a move away from the stand-alone repackaging issue to issuing under repackaging programmes where one issuer is used to repackage numerous tranches of debt, structured on adequate security and limited recourse provisions to compartmentalise the risk. In the event of a default by the finance vehicle, the noteholders or counterparty will only be entitled to look to the security for that issue and after this has been realised and the proceeds distributed, any balance remaining in respect of that transaction will be extinguished, all other transactions by that vehicle unaffected by the default. Cayman Islands law will uphold such contractual "ring-fencing" provisions provided that they are effective as a matter of the governing law of the contract. The repackaging programme has become a valuable tool in the market as its lower cost margins has permitted arrangers to service clients with smaller issues of repackaged securities. In addition it has lent itself to, and has contributed significantly to the growth of, the synthetic repackaging market with credit-linked note issues being the most frequent type of issue in the market today. By further amendment to the Companies Law at the end of 2002, the Cayman Islands introduced a significant change in the legal structure of companies to permit the segregation of assets and liabilities amongst various "portfolios" within a single company such that a liability in respect of a particular segregated portfolio entitles a creditor of that segregated portfolio to have recourse only to the segregated portfolio assets attributable to such segregated portfolio, and not to the assets of other segregated portfolios. The Segregated Portfolio Company, while not dispensing with the need for properly structured security and limited recourse arrangements, is expected to be a useful vehicle, particularly for multi issue transaction as, amongst other benefits, it will bind non-consensual as well as consensual parties as a matter of Cayman Islands law.
The mid-1990's saw the emergence of the CBO market in which the Cayman Islands has been consistently the preferred issuer jurisdiction. Here, instead of the underlying credit risk being a single credit risk, multiple or variable credit risks are collateralised through a Cayman Islands vehicle. There has been a huge growth in recent years in the volume of synthetic CBOs where the collateralised assets are credit derivative instruments. The Cayman Islands is particularly attractive for CBO issues which are typically made in several tranches with different payment priorities as contractual subordination is recognised by express statutory provision (assuming it to be effective as a matter of the governing law of the contract). There has also been a trend with CBO transactions to include an offering of preferred shares as the first loss tier, largely to meet US requirements that such first loss tier constitutes true equity. Cayman Islands law is particularly suitable in this regard to such transactions as it provides significant flexibility in allowing shares to be redeemed or repurchased, or dividends paid, not only out of profit but also out of any credit balance in the share premium account provided the company is able to meet its debts as they fall due. This may be important as it allows the stripping from the company of any residual net equity after the redemption of principal and interest in the debt.
Similar to the CBO market is the structured instrument vehicle market where the Cayman Islands has been the forward jurisdiction for the incorporation of AAA-rated specialist finance companies which aim to achieve a credit spread on assets over their costs of funds fully hedging any exposure to interest rate and currency exchange risks and being funded by issuing commercial paper and medium term notes both in the Euro and US Markets with equity either in the form of a mix of shares and deeply subordinated debt (which is given statutory recognition in the Cayman Islands) or, more commonly, deeply subordinated debt only.
Other structured finance transactions which use Cayman Islands vehicles include catastrophe bonds, a capital markets insurance linked product which capitalises on Cayman’s insurance expertise as the second largest jurisdiction for captive insurance companies and securitisation transactions where the underlying asset is an income stream of receivables generated by limitless varieties of sources. There is no limitation under Cayman Islands law on the relevant pool of underlying assets or receivables that can be acquired.
Offshore Capital Markets Jurisdiction of Choice
The Cayman Islands jurisdiction offers the key legal elements that arrangers and investors require and as a result is the first choice location for the majority of offshore capital markets transactions, particularly structured finance transactions. Principally these key legal elements include:
- Neutrality
- No Taxation: There is no form of corporation, income or capital taxation in the Cayman Islands, whether direct (on the finance vehicle or holders of securities issued by the finance vehicle) or indirect (by way of withholding on payments made by the finance vehicle). If incorporated as an exempted company (the typical form of vehicle for capital markets transactions), the finance vehicle can obtain a tax undertaking from the Cayman Islands Government that no taxation introduced for a period of up to 30 years will be applicable to the finance vehicle or to the holders of its securities.
- No Exchange Controls: There are no foreign exchange controls in the Cayman Islands.
- No Restrictions on Business: There are no restrictions on a finance vehicle in the Cayman Islands lending, borrowing, or issuing debt securities or entering into derivatives transactions.
- 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 a finance vehicle will be ignored, so as to allow creditors of a finance vehicle to proceed against its shareholders or to allow creditors of shareholders to proceed against the finance vehicle. Most of these cases involve fraud.
- Bankruptcy Remote Vehicles
The structuring of bankruptcy remote vehicles in the Cayman Islands is well established and accepted by rating agencies, regulators and accountants alike. The use of a charitable trust when properly structured is well recognised in the financial markets as an appropriate vehicle for non-consolidation issues. Typically the trust corporation establishing the charitable trust will also provide an independent board of directors who will ensure the finance vehicle functions as a wholly independent entity in accordance with recognised corporate principles.
- Creditor Friendly Legal System
The legal system in the Cayman Islands is creditor friendly and therefore ideally suited to structured debt transactions. In particular:
- The Cayman Islands does not have any formal 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, a creditor's right to enforce his security interest.
- Cayman Islands law does not prevent secured creditors enforcing their security in a liquidation of a finance vehicle. There is no concept of an insolvency "stay".
- Liquidators of a Cayman Islands company cannot disclaim owners contract. 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 with a contract on which they are contained).
- Contractual subordination is recognised by express statutory provisions (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 favorable 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 relevant exception relating to claims for severance pay under the Labor Law, those with fixed security) is limited and, in practice, in the case of a finance vehicle, which will have no employees in the Cayman Islands, relate only to unpaid Government fees.
- The Cayman Islands allows companies to move to or move from the Cayman Islands without triggering their disposal of assets or requiring a novation of liabilities – this is used in the event that the selected jurisdiction ceases to be viable for taxation or securities regulation reasons.
- Security, Set-Off, Netting and Subordination
- 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 Islands has no general system of registration of security interests to perfect or obtain priority (there are registration systems in place for Cayman Islands real estate, ships and aircraft registered in the Cayman Islands, limited partnership interests of Cayman Exempted Limited Partnerships and "personal chattels" under the Bills of Sale Law).
- Credibility and Rating Agency and Institutional Acceptance
- Cayman Islands legal opinions are regularly accepted by the major institutions and rating agencies. Many industry organisations such as ISDA and various bankers association recognise that finance vehicles established in the Cayman Islands are acceptable counterparties in derivative transactions. Cayman Islands legal opinions have been produced for various bankers associations, ISDA, ISMA, BBA and other industry organisations relating to swaps, credit support annexes, stock lending agreements, repurchase agreements and others.
- Rating agencies are familiar with Cayman Islands vehicles and S&P have published specific Cayman Islands legal criteria for structured finance companies thus endorsing their use.
- Regulation
There is no specific transaction regulation of debt issues (unless such issues are listed on the Cayman Islands Stock Exchange) or derivatives transactions. The issue of securities by a Cayman issuer and surrounding activities will not require licencing under the recently introduced Securities Investment Business Law which regulates all other securities investment business. There are no restrictions on finance vehicle in the Cayman Islands lending, borrowing or issuing debt securities (none of these activities for example, constitute banking business requiring the vehicle to be licenced as a bank) other than no offer of such securities to the public in the Cayman Islands may be made unless the issuing vehicle is listed on the Cayman Islands Stock Exchange. The Cayman Islands does not regard instruments such as credit linked bonds or credit default swaps as insurance products which would require the vehicle to obtain an insurance licence.
- Speed and Cost
Since Cayman entities can be formed on the day of filing and there are no lengthy regulation or filing procedures, transactions can very quickly be brought to market. The cost of forming and maintaining Cayman entities is competitive and usually minimal in the context of most transactions.
Types of Entities
Typically the exempted company is the vehicle used in most capital markets transactions as it benefits from the flexible corporate regime, low cost and simple, same day incorporation procedures in addition to qualifying for the tax concessions referred to above. There is also no requirement to appoint Cayman Islands directors or shareholders or to prepare or file accounts with any Cayman Islands authority nor does the law specify any minimum issued or paid-up capital or other thin capitalisation rule. However, other entities, such as unit trusts and, in particular, exempted limited partnerships may also be used for on-shore tax or regulatory reasons which are equally straight forward to establish.
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.
Cayman Islands Stock Exchange
The Cayman Islands Stock Exchange (CSX) is the most recent addition to the full range of financial services that the jurisdiction offers and has particular synergy with the finance vehicle. The listing rules are tailor made for specialist products such as debt securities and derivative warrants issued by finance vehicles 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 January, 2003, the CSX had a total of 716 listed issues including debt issues by institutions such as Merrill Lynch, Deutsche Bank and Lehman Brothers with a combined market capitalisation in excess of US$36 billion.
Conclusion
The Cayman Islands legal framework and laws are flexible in terms of meeting the objective of arrangers, issuers and investors in capital markets transactions yet at the same time provide a credible and well-established foundation for creditor rights. The Cayman Islands has as a result become the first choice location for vehicles in capital markets transactions by offering the key legal elements that arrangers, issuers and investors require.
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.