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Structured debt transactions regularly involve special purpose companies (SPC’s) established in an offshore jurisdiction. There are a wide range of commercial objectives that may be met by the use of an offshore SPC. Common objectives include:

• converting one type of asset into another e.g. if an investor can only buy bonds under its domestic law but wants to invest in equities, it can buy a bond issued by an SPC which then buys equities using the proceeds of the bonds;
• converting cash flows e.g. changing fixed rate payments into floating rate payments by having an SPC buy the fixed payments and swap them into floating rate payments;

• splitting an instrument into its component parts e.g. a convertible bond can be converted into a straight bond with a separately tradable warrant relating to the convertible element of the underlying convertible bond;

• enabling investors to hedge credit risks in circumstances where a direct hedge is not permitted under their local law e.g. if an insurance company or pension fund wants to hedge a country risk (or even take a country risk for a return) but is not permitted to do so directly by entering into a derivative contract, they may be permitted to buy bonds issued by an SPC where the return on the bond is linked directly to the performance of the country credits;

• credit enhancement - 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 higher rating than the underlying pool as a result of over collateralisation (such as the typical cbo); and

• isolating a transaction from unrelated insolvency risks, for example, the typical bankruptcy remote vehicle used in securitizations.

The Cayman Islands have become the first choice location for SPCs in structured debt transactions. The reason for this is that the jurisdiction offers the key legal elements that arrangers and investors require.

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). The SPC, if incorporated as an exempted company (the typical form of vehicle for structured debt transactions), can obtain a tax undertaking from the Cayman Islands Government that no taxation introduced for a period of 20 years (or in certain circumstances, for example, an issue of long dated or perpetual bonds, up to 30 years) will be applicable to the SPC or the holders of its securities.

There are no restrictions on an SPC in the Cayman Islands lending, borrowing or issuing debt securities (none of these activities, for example, constitute banking business requiring the SPC to be licenced as a bank). The Cayman Islands does not generally regard instruments such as credit linked bonds or credit default swaps as insurance products which would require the Cayman Islands company to obtain an insurance licence.

• 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 or to allow creditors of shareholders to proceed against the SPC. Most of these cases involve fraud.

• 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. The English court in Polly Peck looked at the legal form of the contractual arrangements and not the ‘economic substance’ and declined to overturn the very firm principle of English Company law that, except in exceptional circumstances, the court would not disregard the principle of separate legal personality of the SPC. It would not treat a closely integrated group of companies (which included the SPC) as a single economic unit simply on the basis of a perceived injustice. Accordingly, we believe there is no general principle of substance over form in the law of the Cayman Islands which, in general terms, would lead to the re-characterisation of the typical structured debt transaction.

The structuring of bankruptcy remote vehicles in the Cayman Islands is well established.

As many structured debt transactions are likely to be rated it is useful to consider briefly the typical rating agency requirements in relation to bankruptcy remote SPCs. These are usually:

The way in which these requirements are accommodated in the Cayman Islands does not necessarily reflect the practice, say, in the United States or elsewhere.

Rating agencies generally require the scope of activities of the SPC to be limited in scope to those activities which ensure a sufficient cash flow to pay the rated securities. The rating agencies generally prefer these restrictions to be included in the constitutional documents of the SPC. This is because, firstly, the documents are publicly available and so all creditors and others will become aware of the restrictions and, secondly, because such restrictions are less likely to become lost in the corporate files. In the Cayman Islands these reasons don’t apply: the Cayman Islands have a limited ultra vires rule, and an SPC’s Memorandum and Articles of Association are not public documents. In practice, the rating agencies will generally not require limited objects in the case of a Cayman SPC and will simply rely on contractual restrictions continued in the transaction documents.

For the reasons mentioned above, these are typically included in the transaction documents rather than the Memorandum and Articles of Association. The rating agencies will also require non-petition language in agreements between SPC and its creditors. Non-petition language together with the limited recourse language is effective under Cayman law in limiting the creditors right to petition as an unpaid creditor.

The reason for this requirement seems to be principally the concern that the board of directors can file for bankruptcy. Under Cayman Islands law (based on English cases which are persuasive but not binding in Cayman) the directors do not have power to put a Cayman SPC into voluntary liquidation (the exceptions are cases where the Articles of Association provide for them to have this power expressly and where the shareholders have themselves resolved to liquidate the Company and delegate the power to present the petition to the directors). Accordingly, the reasons for the “independent director” concept are not applicable in the case of an SPC. Instead, it is necessary to focus on the shareholders who have the power to liquidate an SPC voluntarily by special resolution. This means that, in effect, an independent shareholder rather than an independent director is required. The independent shareholder may own all the voting shares or simply have the power to block a special resolution to wind up the SPC. In fact, most structures go further in that the voting rights attached to the shares held by the independent shareholder are “locked up” under the terms of the typical off-balance sheet charitable trust arrangement i.e. the shareholder agrees not to exercise the voting rights to liquidate the SPC until six months or whatever preference period they wish to use after the debt securities issued by the SPC have been repaid.

This requirement is intended to ensure that while the rated securities are outstanding, the bankruptcy remote status of the SPC will not be undermined by any merger or consolidation of the SPC. The rating agencies also generally request that the SPC not amend its Memorandum and Articles without prior written notice to the rating agencies. Generally these matters are dealt with in contractual covenants by the SPC rather than the provisions in the SPC’s Articles of Association although it should be noted that the amendment of the Articles of Association is within the control of the shareholders of the SPC not the SPC itself. Typically, however the share trustee in the usual off-balance sheet arrangement agrees that it will not do anything to cause the SPC not to comply with its contractual covenants.

These are designed to ensure that the SPC holds itself out as an independent entity so as to avoid substantive consolidation of the SPC and its assets with those of the parent or other affliates.

In practice in the context of a wholly off balance sheet entity (i.e. one that is wholly owned under the terms of a charitable trust) the rating agencies seem to be happy to receive an opinion from Cayman counsel that the SPC will not be beneficially owned by the Cayman trust company and that in any liquidation of the Cayman trust company the liquidator will have no claim against the property of the SPC.

In most transactions security interests are created over non-Cayman assets under non-Cayman law governed security agreements. However, Cayman Islands insolvency law will be relevant which as explained below is generally recognised as creditor friendly and therefore acceptable to the rating agencies.

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 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 rights to enforce his security interests.

• Cayman Islands law does not prevent secured creditors enforcing their security in a liquidation of an SPC. There is no concept of an insolvency "stay".

• 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 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 of the contract in which they are contained).

• contractual subordination is recognised by express statutory provision (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 favourable 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 irrelevant exception relating to claims for severance pay under the Labour Law, those with fixed security) is limited and, in practice, in the case of an SPC, which will have no employees in the Cayman Islands, relates only to unpaid Government fees.

• Redomiciliation provisions – the Cayman Islands allows companies to move to or move from the Cayman Islands without triggering a disposal of assets or requiring a novation of liabilities – this is useful in the event that the selected jurisdiction ceases to be viable for taxation or securities regulation reasons.

The Cayman Islands has no general system of registration of security interests to perfect or obtain priority (there are registration systems in place for ships and aircraft registered here, limited partnership interests of Cayman exempted limited partnerships and “personal chattels” under our Bills of Sale law). Companies are required to keep an internal (private) register of mortgages and charges but failure to make the appropriate entries does not, of itself, affect the creation of the security interest or its perfection or priority. The law which governs the creation of the security interest, its perfection and the priority of the secured party depends upon the application of our conflict of law rules which in general terms look to the law governing the security agreement and the law constituting the asset over which the security has been taken or the law of the place where the asset subject to the security interest is situated depending upon the issue being determined and the nature of the asset over which security is taken.

Cayman Islands legal opinions are regularly accepted by the rating agencies. Many industry organisations recognize that SPC’s established in the Cayman Islands are acceptable counterparties in derivative transactions.

Regulation in the Cayman Islands is carried out on two main fronts. First, the regulation of the local service providers and professionals who participate in structured debt transactions and secondly, in certain cases, the regulation of specific transactions. In the latter case, however, the regulation is non-intrusive and, in many cases throws the onus onto the local service providers to ensure that any local requirements are met. There is no specific transaction regulation of debt issues (unless such issues are listed here).

Establishment costs for SPCs are low. Fees payable to the Cayman Islands Government are based on the SPC’s authorised share capital (a minimum fee of US$574 and up to a maximum fee of US$1,722). Annual Government fees are also based on authorised share capital and registered office fees and the fees of local administrators are similarly competitive. Cayman Islands stamp duties only apply to documents which are executed here or after execution outside the Cayman Islands brought into the Cayman Islands. Even if duty is payable there are various caps which apply to transactions involving exmpted companies being the usual form of company used in strucured debt transactions.

The laws in the Cayman Islands are flexible in terms of meeting the objectives of arrangers structuring debt transactions yet at the same time provide a credible and well established foundation for creditors rights.

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

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Structured Debt in the Cayman Islands: Use of Special Purpose Companies