Alasdair Robertson and Tina Meigh
18 July 2011
Alasdair Robertson and Tina Meigh look at the three big questions lenders should be asking with regard to custody of assets in Cayman vehicles
The concept of securities has evolved over the past few decades in line with the ever-changing financial markets. The custody industry is no longer characterised solely by the safekeeping of physical securities and bearer certificates, but instead by the administration and settlement of immobilised and dematerialised securities, being securities with no certificates or other evidentiary paper trails. These types of securities are of paramount importance in today’s financial markets and commonly feature as collateral in financing transactions.
The dematerialised nature of securities is commonly overlooked in financing transactions, thereby placing lenders at a significant risk of loss upon a default. It is therefore critical that lenders understand the legal risks and steps required to ensure they obtain a valid and enforceable security interest that will allow realisation of the underlying securities.
There are particular questions on the issue of taking security over these forms of dematerialised securities from the perspective of a lender to a Cayman Islands entity. This is especially relevant in today’s hedge fund and fund of funds market, where the underlying funds are Cayman-domiciled vehicles.
Lend an ear
In taking a security interest over dematerialised securities there are three key questions lenders should ask: has a valid security interest been taken?; has this been perfected?; and can it be enforced, and if so where?
To answer the first question, a lender must have a clear understanding of the nature of the underlying assets and the parties involved. If assets are held on behalf of a fund by a third-party custodian, the terms of the custodial arrangement will likely be that the legal title to those assets will be held by the custodian, with only the beneficial title being held by the fund.
It is important for any hedge fund and its lenders to know and understand how the title to the securities is owned. For example, where assets are held by a custodian or directly by the fund in clearing systems such as the Depository Trust Company and Clearstream/Euroclear, the rights of the fund as against the assets will be determined by the applicable regulations and the local law of the depository holding the assets for the clearing system.
The only real and valuable security interest that a lender should take in a custodial structure is an assignment of the contractual rights of the fund that are created under the custodial agreement entered into with the custodian. If a valid security interest is taken over these contractual rights, the lender will be entitled to step into the shoes of the fund on a default and demand the immediate return or realisation of the assets in order to apply the proceeds as against the debt due.
Purporting to take security directly over the assets is at best an equitable security over a pool of assets and relies on the fund getting the custodian to transfer legal title.
Agree to differ
If the agreement is not a true custody agreement and is really a prime brokerage agreement that contains a rehypothecation clause, whereby the custodian or prime broker is given the right to use the underlying securities, including to repo the securities to third parties, in many jurisdictions there is often a question mark as to the nature of the security interest.
While there will be some cases where custodians are located in Cayman, the majority of transactions will involve custodians in either the UK or New York. In these cases it is usual for English or New York law custodial agreements to have been put in place with the Cayman fund and, accordingly, any assignment by way of security of the contractual rights of the fund under those agreements should also be put in place and governed by the same governing laws.
Once the governing law of the assignment has been agreed it will be necessary for appropriate local counsel to be instructed in order to properly draft the security assignment or local law equivalent document so as to create a valid security interest over those contractual rights.
If the assignment of the rights of the fund under the custodial agreement is to be governed by the laws of Cayman, a statutory or legal assignment by way of security should be granted in favour of the lender.
Lenders must always ensure that the security interest they have been granted is perfected in accordance with the applicable local law. Under Cayman law, a legal assignment by way of security over the contractual rights of a hedge fund under a custody agreement should be perfected by the delivery of a written notice to the custodian that places them on notice of the existence of the security interest.
This perfection requirement is built into Cayman legislation in a similar manner to England and Wales. Timing of the notice will also determine the priority of any security interest a lender has been granted. This is known as the ’Dearle v Hall rule’.
In a large number of cases custodians are asked to acknowledge receipt of the notice as well as provide additional certifications and undertakings to the lender to confirm that no other security interests have been granted over the rights of the fund under the custody agreement, and that the custodian will act on the lender’s instructions in a default scenario.
While the acknowledgement and undertakings of the custodians are, from a lender’s perspective, welcome in any transaction, they should be treated as a commercially prudent measure rather than as a guarantee or perfection requirement. Many custodians will push back on the provision of any information to the lender, let alone the granting of undertakings to a third-party lender with whom it is not otherwise obliged to contract or incur potential liability.
In the case of a non-Cayman custodian, where notice of the assignment of the contractual rights of the fund is governed by the laws of another jurisdiction, Cayman law will not impose any additional perfection requirements on that security interest, but will simply require the fund to comply with its obligations under local statute. In the context of a corporate fund, this includes the obligation on the fund to update its register of mortgages and charges to reflect the creation of the security interest granted in favour of the lender.
A lender should not be confused as to the form of this document, as it is an internal register of the fund and not something
that is filed with any central registry or government body. It confers no perfection of the security interest and is treated only as an aid to contracting parties with the fund, which should place them on notice of the existence of prior security interests created by the fund from time to time.
The fact that a security interest is not referenced on the register will not invalidate the security interest as a matter of Cayman law, but will simply place the fund in breach of its statutory obligation. However, a lender should insist on receiving a copy of the updated register at the closing of the financing transaction to ensure that this has been updated so as to place third parties on notice of the existence of the security interest created in favour of the lender.
All lenders hope they will never have to enforce the security interest they have been granted, but that does not mean they should not know what steps must be taken in an enforcement situation.
Cayman is a creditor-friendly jurisdiction. The Companies Law and the Exempted Limited Partnerships Law have recently been amended to codify the pre-existing common law proposition that, irrespective of the governing law of any security interest, a secured party has the right to enforce its security interest without leave of the Cayman court or the liquidator of a corporate or exempted limited partnership fund.
This in essence allows the lender to go directly to the custodian to enforce their rights without being caught up in the liquidation of the fund. This, assuming the presence of a sensible third-party custodian and a well-drafted security agreement, would allow the lender to seize and realise the assets of the fund to satisfy the secured obligations.
Before the bankruptcy of Lehman Brothers International (Europe) rocked the marketplace, it is fair to say that no real regard was paid to the risks associated with custodial-held securities and the appropriate security interests that should be granted over them, given their dematerialised form.
Following the Lehman insolvency we have seen many disputed claims relating to the ownership of dematerialised securities as well as claims attacking the validity of basic security structures. In such cases lenders have exposed themselves to significant legal risk solely as a result of not ensuring that the correct security interests have been granted in the correct form and by the correct entities.
The main lesson from all of this is that lenders must ask themselves three key questions and ensure these are addressed so that secured lenders are properly and adequately protected.
Alasdair Robertson is a partner and Tina Meigh is an associate at Maples and Calder