Cayman Islands: Cayman Islands Special Purpose Vehicles

The term ‘special purpose company’ is not a term of art. A special purpose company (SPC) can mean different things in different situations and may appear in several forms and guises.The common element in all cases, however, is that an SPC is inserted in a financial structure to achieve a particular purpose.

Many transactions can be effected using an SPC in one form or another. Types of SPC include:

• off-balance sheet bankruptcy remote companies;
• on-balance sheet finance companies e.g. bond issuing subsidiaries;
• companies which have part of their share capital held on charitable trust (the usual off-balance sheet arrangement) and part held by an investor;
• off-balance sheet companies where the share capital is subject to an option in favour of one party so that the company can be brought on-balance sheet (one way to recover residual value which may be left in a usual off-balance sheet company);
• companies which issue shares carrying certain preferential rights in relation to dividends, redemption, liquidation preference and voting.
• The list is limitless simply because the structure of the SPC is not being driven by the jurisdiction in which the SPC is established but by the objectives of the parties putting the transaction together. Some common uses and examples include:

If an investor prefers securities in the form of debt but wants the economics of investment in equities, it can buy a bond issued by an SPC which buys equities using the proceeds of the bonds (or vice versa).

For example, changing fixed rate payments into floating rate payments by having an SPC buy the fixed payments and swap them into floating rate payments (a typical ‘repackaging’).

A convertible bond can be converted into a straight bond by creating a separately tradable warrant linked to the convertible element of the underlying convertible bond.

If an insurance company or pension fund wants to hedge a country risk (or even take a country risk for a return) but does not wish to do so directly by entering into a derivative contract, it might rather buy bonds issued by an SPC where the return on the bond is linked directly to the performance of country credits (either as a result of the SPC buying loans to sovereigns or corporates located in the relevant jurisdiction or the SPC entering into the relevant credit derivative itself).

If an SPC buys low rated, high yield debt this can be repackaged into several tranches of debt, the most senior of which can achieve a high rating as a result of over collateralisation, insurance or other forms of credit enhancement.

Liquidity can effectively be given to illiquid securities, for example, by combining them with other more saleable or lower risk assets such as US Treasuries.

The typical bankruptcy remote vehicle used in securitisations will not be dependant on the solvency of other transaction parties.

The economics of holding an asset may be preserved without continued ownership by selling it to an SPC and entering into a swap with the SPC which entitles the seller to a return equal to the performance of the underlying assets or acquiring preference shares issued by an SPC which will ultimately return any profit to the shareholder.

There are many examples of the use of SPCs to obtain preferable tax treatment in an investor’s jurisdiction:

• repackaging an income stream (for example, interest) into a different type of income stream (for example, dividends) or a capital return;
• converting one type of instrument into another;.
• utilising fiscal transparency of an SPC whilst maintaining a separate corporate existence with limited liability (for example, a Cayman Islands Company can generally, by election, be treated as fiscally transparent for US taxation purposes).

Bringing the transaction or assets within a friendly or familiar legal environment or out of a perceived political or country risk. For example, ownership of aircraft operated by third world airlines.

In the typical ‘square trip’ transaction a series of credit sales involving an SPC can have the same effect as a conventional loan which may be prohibited or restricted in the investor’s jurisdiction.

Arrangers and investors are attracted to Cayman Islands SPCs as a combination of the following attributes render the jurisdiction an ideal location to structure transactions:

• There is no form of corporation, income or capital taxation in the Cayman Islands whether direct (on the SPC or holders of Securities issued by the SPC) or indirect (by way of withholding on payments made by the SPC).
• There are no foreign exchange controls in the Cayman Islands.
• There are no restrictions on an SPC in the Cayman Islands lending, borrowing or issuing debt securities.
• The Companies Law in the Cayman Islands provides significant flexibility in allowing SPCs to issue shares, redeem or repurchase shares and to pay dividends (for example, an SPC can pay dividends out of any premium subscribed for its shares), subject in most cases to an overriding solvency test.
• 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 SPC will be ignored so as to allow creditors of an SPC to proceed against its shareholders. Most of these cases involve fraud or impropriety of one sort or another.
• The typical on-balance sheet SPC 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. In that case the English court concluded that they should look at the legal substance of the arrangements and should not disregard the principle of the separate corporate personality of the SPC to treat a closely integrated group of companies (which included the SPC) as a single economic unit on the basis merely of perceived injustice. Accordingly, there is no general principle of substance over form in the Cayman Islands which would lead to the recharacterisation of this type of structured finance transaction.

The establishment of bankruptcy remote vehicles in the Cayman Islands is very well established and familiar to the major rating agencies. In particular:

• The charitable or purpose trust in the Cayman Islands is a well recognised method of having independent ownership of the SPC. The trust will be established by a Cayman Islands trust company. In the relevant declaration of trust the trustee will covenant for the lifetime of the transaction not to wind up the SPC or interfere in the conduct of the SPC except to the extent expressly permitted.
• The same local trust company will also usually provide directors and officers to the SPC either exclusively or in addition to individuals who are connected with other transaction parties (although it is generally not advisable for these connected directors to constitute a majority on the board owing to the risk of consolidation).
• Cayman Islands law recognises limited recourse arrangements provided their effect, under the governing law of the document in which they are contained, is to extinguish any residual claim against the SPC.
• Cayman Islands law requires directors to observe certain fiduciary duties. In the context of a structured finance transaction this typically translates into the directors deciding independently that the transaction is in the best commercial interests of the SPC itself. If the SPC is an on-balance sheet vehicle this usually goes without saying. In the case of an off-balance sheet company, where the cash flows are usually structured in such a way that the SPC derives no benefit from the transaction itself, the SPC receives a modest fee for undertaking the transaction and the recourse against the SPC under the transaction documents is limited to its available net assets.The directors can then approve the transaction on the basis that the transaction is limited recourse, there is little practical risk to the SPC and, if the SPC receives a fee of, say, US$1,000, the SPC should ultimately make a significant return on its issued share capital (which is usually only US$1,000 or less).

The legal system in the Cayman Islands is creditor friendly. In particular:

• The Cayman Islands do not have any system of corporate rehabilitation, such as the English ‘administration’ procedure or the US 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 upon a default.
• Cayman Islands law does not prohibit secured creditors from enforcing their security in a liquidation.
• 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 require, as a minimum, that any disposition must be made with a view to preferring one creditor over another before that disposition can be attacked. It is not sufficient simply that an asset was charged or payment was made in circumstances which may subsequently prove to have been detrimental to a particular creditor.
• 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).
• There is no general concept of substance over legal form.This means that heavily subordinated debt, long-term and perpetual debt, for example, would, for the purposes of Cayman Islands law, 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 notwithstanding that it can have most of the economic characteristics of equity.
• The list of ‘preferred creditors’ in the Cayman Islands (which generally rank ahead of all creditors other than those with fixed security) is limited and, in practice, in the case of an SPC, which will have no local employees, limited to unpaid government fees.

Fees payable to the Cayman Islands Government are based on authorised share capital (a minimum fee of US$500 and up to a maximum fee of US$1,750).

Annual government fees are also based on authorised share capital and registered office fees and the fees of local administrators are similarly competitive..

Satisfactory legal opinions are readily obtained in relation to Cayman Islands’ SPCs. Industry organisations such as the International Swaps and Derivatives Association, Inc., and, major bankers associations and rating agencies all recognise SPCs established in the Cayman Islands as acceptable, and often preferred, offshore counterparties in structured finance and derivative transactions.

Unlike some other offshore jurisdictions, the Cayman Islands does not insist on the use of local service providers such as paying agents or custodians etc. However, the Cayman Islands have institutions able to provide a complete range of financial services as may be required.The Cayman Islands Stock Exchange also has rules specifically designed to assist the listing of specialist debt securities of the kind issued in structured finance transactions.

All indications are that the deregulation of the financial markets globally will increase the use of structured finance transactions.The need for capital throughout the world and in particular in the new emerging markets including Latin America and Asia is likely to result in increasing demand for structured products, and Cayman Islands’ SPCs are set to continue their established role.