An offshore jurisdiction is the ideal vantage point to take stock of a global meltdown in the credit markets, such as the crisis that happened this summer. The hiatus, or ‘credit crunch’, has been very severe, with financial institutions not wishing to trade with each other, some high-profile funds becoming insolvent, conduits that hold literally billions of dollars of assets unable to fund themselves, and the first run on a bank in the UK in 150 years.
With almost all of the world’s top financial institutions doing business in the Cayman Islands in some form, either through having a branch in the jurisdiction or, more significantly, through having some form of financial entity incorporated there, the jurisdiction provides some incredible insights into the overall position in the financial markets. And it was readily apparent that as the onshore markets go, so go the offshore markets.
While the Cayman Islands have not instituted any regulatory changes in response to the credit crisis, lawyers in Cayman have seen a shift in business that follows the market. The use of structured credit securities such as collateralised debt obligations (CDOs), collateralised loan obligations (CLOs) and asset-backed securities (ABS) has dropped sharply.
This drop is a sharp turnaround from March 2007, when sales of CDOs exploded. Almost $23bn (£11.06bn) of new deals were sold in one week, mainly comprising CLOs and structured finance CDOs. These deals were done despite continued spread widening in the US sub-prime mortgage sector.
Now, eight months later, the market looks very different. The growth has not been in CDOs and CLOs, but rather offshore firms are seeing opportunities as more clients look to restructure existing deals, either through the renegotiation of over-collateralisation tests on deals or through the actual repackaging of assets. In certain circumstances there has been the full-scale liquidation of entities.
Cayman firms have also seen an increased use of segregated portfolio companies (SPCs) being established to preserve as much value as possible during the market recovery period, rather than using the traditional limited recourse structure. Traditionally bond or loan ‘repackaging’ transactions have involved a Cayman Islands exempted company issuing notes and using the sale proceeds to acquire pre-existing bonds or other financial instruments. The purpose of a repackaging is to enable an investment bank to tailor a particular investment to its clients to meet their risk profile.
Often, these transactions are carried out by putting in place ‘ring-fencing’ provisions to avoid the creditors of one series of notes being able to have a legal claim on the assets of another series of notes and thereby ensuring that each series of notes does not cross-collateralise other notes issued by the company.
However, with the market for risk dramatically changed, these approaches to repackaging debt are not as attractive. The SPC has a strong advantage in that it encompasses statutory ring-fencing. Unlike debt, it is not possible to use the contractual ring-fencing mechanism in relation to preference shares, since shareholders’ interests cannot be the subject of security; this would be possible through using an SPC. The increase in SPCs will be easy for the Cayman Island Monetary Authority (CIMA) to regulate.
In addition to structured finance deals, Cayman’s hedge funds and private equity funds have also been affected by the market turmoil. Funds such as Basis Capital that had heavy exposure to the securities market are looking to offshore firms to help with recovery plans, which often include restructuring deals. In addition, plans for several IPOs focused on funds that invest in CDOs and other structured finance instruments were pulled.
Because it is home to almost 80 per cent of the world’s hedge funds, any ripples in the market that relate to funds will be important for Cayman.
Julian Black and Philip Paschalides are partners at Walkers