Special purpose vehicles (SPVs) are commonly employed as a structuring tool in many cross-border and structured finance transactions, and collateralised loan obligation (CLO) transactions are no exception. The Cayman Islands has a long history of acting as a structuring jurisdiction for CLO SPVs. The stable political climate, flexible corporate regime and well established, creditor friendly legal system within the Cayman Islands, coupled with the availability of tried and tested bankruptcy remote SPV structures and the possibility of listing notes on the Cayman Islands Stock Exchange, make it an ideal choice of jurisdiction for establishing a CLO vehicle.
1. What is a CLO?
Although CLOs sound complex, they are at their core relatively simple, commoditised financing structures. At its most basic level, a CLO is a portfolio of senior secured loans made to companies that have relatively high levels of debt (usually called leveraged loans or high yield loans). A series of debt obligations (typically notes) are then issued against those loans, with cash flows generated from the loans being used to pay principal and interest on the CLO's debt obligations. The debt obligations are "tranched" into various classes with different priorities in the CLO's cash flow waterfall. Residual cash flows are paid to the holders of the CLO's most junior tranche, generally referred to as its equity. In this way, a CLO is a kind of fund that specialises in owning leveraged loans. CLOs are now – collectively – the biggest investor in leveraged loans.
Like some other investment funds, CLOs are usually set up as basic limited liability companies (though other legal forms such as limited partnerships, segregated portfolio companies or LLCs are possible). These companies have a very limited purpose (being the holding of the debt obligations, hence being a "special purpose vehicle") and no employees. Like investment funds, these SPVs are usually based in jurisdictions such as the Cayman Islands that levy no direct taxes on the vehicle. And in common with most investment funds, CLOs have a manager, a company which makes decisions on behalf of the fund. In theory, the manager of a fund is an outside advisor to the company. In practice, the manager of a fund or a CLO is often its driving force and therefore considered its 'sponsor'. Of all the service providers to a CLO or fund, the manager will receive the majority of the fees paid by the CLO. Within certain limits, the manager decides which investments the CLO or fund will buy (at least up until the expiry of what is known as its reinvestment period).
However, CLOs differ from hedge and other open-ended funds in a number of ways. Firstly, a CLO will have a predetermined life-span and final maturity date (though in practice the structure will be unwound and investors will get their money back earlier than this scheduled long-stop date). Furthermore, there is generally limited liquidity in the debt obligations issued by CLOs. A CLO can typically be redeemed if its most junior class of investor (its equity) votes to wind it up but that can only happen after the expiry of an initial (typically two-year long) non-call period. A CLO will also have a number of CLO-specific features (over and above other structural features such as bankruptcy remoteness [see section 3 below] common across the wider securitisation and repack markets) which are built into its documentation and are not typically seen in other investments funds.
2. CLO transactions use standardised documentation which allows for more efficient structuring
Because CLOs are already well established and generally follow very standardised structures, they benefit from documentation that is broadly standardised across the market, meaning that new CLO structures can be set up quickly and efficiently. Once a manager has settled on a structure they are happy with, it is generally very straightforward to undertake new issuances, as the documentation will be in a pre-agreed form and, assuming a broadly similar target investor base as previous deals, will be subject to minimal negotiation. This makes it possible to paper multiple CLOs concurrently and for the transactions to be originated, documented, booked and executed within a relatively short time span.
3. Cayman Islands CLO Issuers can be structured to ensure bankruptcy remoteness
One of the key considerations in establishing a CLO structure is to ensure that the structure is "bankruptcy remote". The primary purpose of a bankruptcy remote structure is to avoid any risk of the assets held by the Issuer from becoming subject to bankruptcy proceedings in the event of the bankruptcy of one of the transaction counterparties.
In order to achieve bankruptcy remoteness, the Issuer will need to be structured in such a way that it is legally independent from both the seller/issuer of the underlying collateral and the investors in the notes, and that none of the other transaction parties is able to exercise any direct control over the Issuer. Cayman Islands bankruptcy remote Issuers will typically utilise an orphan trust structure.
This means that legal title to the shares of the Issuer will be held by a corporate trust provider (the "Share Trustee") that is independent from both the seller/collateral issuer and the investor, and also from the other transaction parties. A nominal number of shares will be issued by the Issuer to the Share Trustee at par value, and beneficial title to the shares will be held by the Share Trustee on the terms of a trust (typically a charitable trust, although STAR trusts are also sometimes used) established pursuant to a declaration of trust (the "Declaration of Trust") for the benefit of one or more qualifying charities. The Share Trustee will only be entitled to act in relation to the shares of the Issuer on and subject to the terms of the Declaration of Trust. In order to further ensure independence of the Issuer, a majority (and commonly all) of the directors of the Issuer will be professional directors provided by a corporate administrator in the Cayman Islands.
4. CLO transactions will be entered into on a limited recourse, non-petition basis
Given the orphan nature of the CLO Issuer, the directors will need to ensure that any transactions undertaken by the Issuer are entered into on a limited recourse basis. This means that any liability of the Issuer will be limited to the assets held by the Issuer in connection with the transaction (and, as noted above, in the case of a program, the liability of the Issuer in connection with each series will be limited to the proceeds of the issue of that particular series). Limited recourse protections will be built into the transaction documents to ensure that the Issuer is not put in a position where it incurs liabilities that it would not otherwise be able to meet.
In addition to the limited recourse provisions, and in order to support the bankruptcy remote analysis, the transaction documents should also contain non-petition language. This means that the transaction parties agree not to petition for a liquidation or winding up of the Issuer until following the termination of the financing transaction, avoiding the risk of an early termination of the structure as a result of the winding-up the Issuer during the life of the transaction. Typically the non-petition protections will extend for a period following the termination of the transaction to ensure that any residual claims are also captured.
5. The Cayman Islands offer an ideal political, legal and fiscal environment for establishing a CLO Issuer
The Cayman Islands are recognised as a leading international financial centre, combining a well-established, stable and trusted legal and political framework with a flexible yet robust corporate regime, creditor-friendly laws and a tax neutral environment. These are all important considerations for investors and structuring banks when deciding where to establish a CLO Issuer.
As a British overseas territory, the legal system is based on English common law, and the Privy Council forms the ultimate court of appeal. The laws of the Cayman Islands are passed by a democratically elected parliament and the electoral system is based on the British parliamentary model.
The Cayman Islands are a tax neutral jurisdiction, and there is currently no income, capital gains or withholding tax imposed by the Cayman Islands government on any Cayman Islands company (or arising within the Cayman Islands as a result of any transactions entered into with a Cayman Islands company). Furthermore, a Cayman Islands Issuer can apply to the Cayman Islands government for a tax exemption certificate confirming that for a period of 20 years from the date of the certificate the Issuer will not be subject to any such taxes in the Cayman Islands.
6. Cayman Islands Issuers offer a high degree of flexibility
The Cayman Islands corporate regime offers a great deal of flexibility, without burdening the Issuer and its directors with excessive regulation. A Cayman Islands exempted company, which is the most popular corporate vehicle used for CLO transactions, offers the following benefits:
- Cayman Islands SPVs are generally incorporated with limited liability and have separate legal personality.
- A Cayman Islands SPV can have a single director.
- There are prima facie no nationality or residency requirements for directors or shareholders of a Cayman Islands exempted company (though commonly the independent directors would be Cayman Islands residents).
- There is no minimum level of authorised or issued share capital for an SPV (though we most commonly see SPVs with authorised share capital of US$250 divided into 250 ordinary shares of US$1 each). A Cayman Islands exempted company has a great deal of flexibility in issuing, redeeming and repurchasing shares. In particular, the company may issue shares at a premium to their par value, and can use any proceeds of the share premium account arising from such issue to pay dividends.
- There are no statutory restrictions under Cayman Islands law preventing a company from providing financial assistance for the purchase of its own shares, and consequently no need for any whitewash procedure.
- There is no requirement as a matter of Cayman Islands law for a Cayman Islands exempted company to appoint an auditor or file audited financial statements with the Registrar of Companies or any governmental body within the Cayman Islands.
- There are no exchange controls in the Cayman Islands.
- It is very straightforward to structure a Cayman Islands SPV alongside a Delaware co-issuer.
7. The incorporation requirements for Cayman Islands SPVs are quick and straightforward
Incorporating a Cayman Islands SPV is a straightforward process. The Cayman Islands registrar of companies offers incorporation on an express basis, meaning that an Issuer can be established within as little as 1-2 business days.
In order to incorporate a Cayman Islands company to act as Issuer, the following documents will need to be filed with the registrar of companies:
- a signed copy of the memorandum and articles of association of the company;
- a declaration from the subscriber confirming that the activities of the company will primarily be conducted outside the Cayman Islands; and
- the appropriate filing fee.
The corporate services provider filing the incorporation will typically act as the initial subscriber to the memorandum and articles of association of the Issuer for the purpose of incorporation. Following this, the subscriber share will be transferred to the ultimate shareholder (i.e. the Share Trustee). There is no requirement for a director to be in place at the time of incorporation, although the registrar will need to be notified following their appointment.
The fees for incorporating and maintaining a Cayman Islands company are competitive and are calculated on a sliding scale based on the authorised share capital of the company.
8. The Cayman Islands have a pool of independent directors, Share Trustees and service providers with extensive experience in CLO transactions
The Cayman Islands have a strong and well established financial services industry. There are several large corporate service providers (such as Conyers Trust Company (Cayman) Limited and Conyers FIG (Cayman) Limited), experienced offshore attorneys and Class A banking institutions with detailed industry knowledge and experience in complex structured finance transactions and CLO structures on hand to provide specialist services to structured finance and CLO SPVs.
In addition to providing independent and corporate directors with extensive market-specific experience in the structured finance space to CLO Issuers, corporate service providers are also able to offer complementary fiduciary and regulatory support services such as FATCA and CRS reporting, AML services and accounting, audit and financial reporting functions.
9. The Cayman Islands meet international regulatory and compliance standards
The Cayman Islands are a member of the Caribbean Financial Action Task Force (CFATF) and have implemented measures to comply with global FATF and OECD standards on anti-money laundering and anti-corruption. The Cayman Islands have consistently taken a proactive approach to ensuring they are in line with global standards on compliance and adhere to global tax transparency and reporting requirements under FATCA and the Common Reporting Standard (CRS). The Cayman Islands have also recently introduced legislation relating to beneficial ownership and economic substance to bring them in line with current global standards.
10. Where a CLO is required to be listed, the Cayman Islands Stock Exchange offers a flexible and competitive listing solution
In some cases the parties may require a CLO to be listed, which allows access to a wider investor base and increases the marketability of the program, or specific series. Where this is the case, then the Cayman Islands stock exchange (the "CSX") is able to provide a solution.
The CSX is a well-regulated and internationally recognised stock-exchange. Not only is it registered with the World Federation of Stock Exchanges as an affiliate member, but it is also designated by the UK Inland Revenue and various other tax authorities as a "recognised stock exchange". Accordingly, debt securities listed on the CSX are eligible for the "Quoted Eurobond Exemption". This allows issuers to make payments of interest on the listed securities gross without deduction for UK tax (or tax in such other applicable jurisdictions).
Unlike other listing centres, there are no requirements in the CSX's listing rules for a local listing agent to be appointed in connection with an application to list specialist debt securities. The lead manager or the issuer's legal advisors may deal directly with the CSX's listing department. This approach helps to reduce costs and improve efficiency.
In addition, again unlike other listing centres, the CSX is not bound by the European Union Listing Directives. This permits the CSX to be more flexible in its approach to listing securities.
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.
