CORPORATE INTEGRITY AND DIRECTORS' DUTIES IN STRUCTURED FINANCE TRANSACTIONS

Offshore structured finance transactions depend upon the integrity of the legal arrangements by which a special purpose vehicle ("SPV") is constituted to enter into various obligations. Where an offshore company is used, the aim is to ensure that the separate legal personality of the company is maintained, and the company is not consolidated upon the issuer's balance sheet. Under Cayman Islands law the corporate integrity of an SPV depends in part upon the observance of corporate formalities and professional standards by the directors. It also requires the directors to have a thorough business understanding of the transaction in which the SPV is involved.

The observance of corporate formalities is essential if the arrangements are to be upheld in a court of law. Corporate formalities cover everything from the holding of proper board meetings to observing restrictions in organisational documents. This holds true under Cayman Islands law and may also apply under the law of the on-shore jurisdiction. The U.S. bankruptcy court opinion in In Re Kingston Square Associates, et al. highlights that devices such as the right to appoint an independent director provide little protection where the board never meets and the independent director takes no part in the running of the company and has no understanding or awareness of the issues the directors should be addressing. In that case the independent director’s existence was effectively ignored and the action of the other directors (seeking protection under Chapter 11 of the United States Bankruptcy Code) was upheld and could not be opposed by the investment bank which had the ability to appoint the independent director onto the board. Although the facts of that case were by no means typical, it does demonstrate that it is not sufficient simply to put the relevant documents and procedures in place and then to forget about the proceedures and formalities that have been agreed: it is essential to ensure that they are actually acted upon. Furthermore the observance of corporate formalities requires that directors make sure they follow the correct corporate procedures to ensure they are personally in compliance. In most transactions and especially rated ones the SPV typically covenants in relation to corporate formalities. Non-observance by the director is therefore not only a personal default but also potentially a company default which could affect the entire transaction. Corporate governance is also on the list of priorities for assessment by the IMF based on the principles developed by OECD and set out in their publication "OECD Principles of Corporate Governance".

Corporate integrity also requires professional standards of the directors of the SPV, particularly in relation to their duties of care and skill. The principles established by the early English cases, in particular City Equitable Fire Insurance Co. Ltd. Re (No. 1) [1925] Ch 407 , have to some extent been developed and extended. English decisions relating to Section 214 of the Insolvency Act 1986 (which whilst not binding on the courts of the Cayman Islands, are persuasive) have suggested that the standard of care and skill laid down by that section (which includes an objective test of competence) now reflects the standard required by English common law. On this basis a director is held to an objective standard in relation to his duties of care and skill and that standard would be increased if the particular director had subjective abilities and skills which enabled him to meet a higher standard. An objective approach has also been endorsed by the Court of Appeal in England in Re Barings plc (No.4) . The Court of Appeal approved the following description of the scope of the duties of a director by Jonathan Parker J at first instance:

"(i) Directors have, both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company’s business to enable them properly to discharge their duties as directors,

(ii) Whilst directors are entitled (subject to the articles of association of the company) to delegate particular functions to those below them in the management chain, and to trust their competence and integrity to a reasonable extent, the exercise of the power of delegation does not absolve a director from the duty to supervise the discharge of the delegated functions,

(iii) No rule of universal application can be formulated as to the duty referred to in (ii) above. The extent of the duty, and the question whether it has been discharged, must depend on the facts of each particular case, including the director’s role in the management of the company."

In view of the specialist nature of the business carried out by SPV's the importance of the directors’ understanding of their business and their ability to assess the cash flows and risks related to the SPV's role in the process cannot be underestimated. With the complexity of financial transactions increasing it is no longer safe for directors to rely upon the earliest English cases which required directors to bring to the boardroom table only such expertise as they happened to possess i.e. a subjective standard. It is also becoming common for participants to expect higher levels of expertise from the directors who are appointed by the local service providers. This may be motivated by on-shore issues such as management and control for tax purposes, regulatory laws or security laws but is also important from an off-shore viewpoint too.

A corporate SPV, and the directors appointed to it, have to do more than simply accommodate the other parties’ commercial aims. The SPV has a voice in the transaction like the other parties. It may be saying different things and have fewer points but its approach is and should be as a commercial party. The directors of the SPV will need to understand what the transaction involves and be able to assess and calculate the risks and rewards of the transaction. The directors will also need to assess what should be said to investors in the company’s securities and if appropriate should undertake their own due diligence to the extent they have taken responsibility for the disclosure. In making this assessment they will need to get professional (and possibly independent) advice.

The reality is that SPV's and their directors take commercial risks all the time. What is becoming more difficult is identifying, calculating and then evaluating those risks. Usually the risks turn out to be small but they must nevertheless be calculated in order for the directors to be comfortable approving the transaction as being in the best interests of the company. The taking of such risks may be commercially necessary if, in fact, the transaction is to be done at all. The transfer of risk to the SPV is a developing area which offers considerable opportunities to service providers. The corollary however is that the systems and personnel must be in place to evaluate and deal with that risk.

This article was written by:

Gavin Lowe
Maples and Calder
P O Box 309 GT
Ugland House
South Church Street
Grand Cayman
Cayman Islands
E-mail: gavin.lowe@maplesandcalder.com