The Cayman Islands’ ‘orphan’ special purpose company (SPC) has long been an important tool in structured finance transactions. However, the role of the SPC has come under increased scrutiny from onshore tax, regulatory and accounting authorities in a variety of jurisdictions (frequently as a result of issues arising onshore rather than offshore).
A common line of attack brought against an SPC participating in a structured finance transaction is that it is not independent from the arranger or some other transaction party. To counter this, appropriate due diligence by the SPC directors and effective corporate governance are required.
Typical SPC transactions might include the following elements:
- The SPC issuing notes, secured on underlying assets.
- The underlying assets being held by a trustee for noteholders.
- Transaction documents prohibiting the SPC from entering into any transactions other than as contemplated by those documents.
- The SPC’s obligations being limited in amount and recourse to the assets over which the security is granted.
Directors of a Cayman company are required to act honestly and in good faith with a view to the best commercial interests of the company. Accordingly, transactions that involve the participation of an SPC must be structured to produce some corporate benefit for the SPC.
In determining the level of benefit payable to the SPC, the directors must undertake a ‘risk-reward’ analysis and satisfy themselves as a matter of fact that the profits that may be made by the SPC are commensurate with the risks taken on.
In this context, limited recourse language is critical. It provides the directors with an opportunity to conclude that (assuming arrangements are in place for all running costs and expenses to be met out of a ‘waterfall’), as recourse of the secured creditors is limited to the assets charged, there is little risk of an insolvent liquidation. Therefore a relatively modest transaction fee may be sufficient to ensure that entering into the transaction is in the best commercial interests of the SPC. Without limited recourse language, the director’s role is more complicated, given the risk of an insolvent liquidation. They will need to evaluate the market sector and whether the risks outweigh the potential profit – this requires a level of commercial judgement not demanded in a simpler, limited recourse/transaction fee scenario.
Expertise and independence
SPC directors must have the experience and expertise to understand the proposed transaction and they must document their actions and decisions. Directors need to participate actively at board meetings by tabling questions, airing their views, analysing the deal and ensuring that the proposed transactions are for the benefit of the SPC.
They must ensure that the SPC’s participation in the transaction is justified, that it will be able to meet its obligations and that the directors have verified the accuracy of representations and warranties that the SPC has been asked to make.
The SPC directors must be independent and ensure that they do not simply take instructions from another commercial party to the transaction or their lawyers. This is not simply a question of form, but also of substance. Occasionally, the interests of the SPC (which could be described as taking a more neutral position) may differ from those of the parties taking on an economic risk on the structure. However, the directors must not be put in a position where they are not given sufficient time to review proposals being put to them. They must come to a careful determination of what action will be in the best interests of the SPC.
Failure to follow the correct corporate formalities and to comply with directors’ duties may, in certain circumstances, open up the SPC (and the transaction) to attack. This would not only mean potential personal liability for the directors on an insolvent liquidation, but would open up the possibility of a further attack on the enforceability of the security package where the secured party was on notice of the breach of duty.
Mahonia Ltd & JPMorgan Chase Bank v WestLB AG (2004) is an English High Court case in which the court ordered WestLB to honour a letter of credit issued to Mahonia (a Jersey orphan special purpose vehicle (SPV)). It highlights the importance of an independent and credible board of directors and of adhering to robust corporate governance principles.
As part of its counterclaim, WestLB argued that Chase controlled Mahonia. However, after hearing evidence about the way the directors managed Mahonia, the court found that Mahonia was independent of Chase. The court recognised that control in relation to the commercial terms of a particular transaction is very different from control of the SPV. This case, while technically not binding in the Cayman courts, would nevertheless be regarded as highly persuasive.
In reaching its decision, the court emphasised the fact that the Mahonia directors had evaluated each transaction proposed by Chase and had decided independently whether to enter it. The court also noted that, when representations were sought from Mahonia, the directors would verify whether they could be given. Indeed, the judge noted that the directors had refused to give representations not within Mahonia’s knowledge.
Structured finance lawyers must ensure that, in proceeding to get transactions closed in a timely and cost-effective manner, the directors discharge their duties properly and do not sacrifice the aforementioned principles.
Owen Jones is a partner at Mourant du Feu & Jeune