Low interest rates combined with a prolonged bear market have contributed in recent years to the growth in public demand for investments that offer an enhanced risk/return profile, often with inbuilt safeguards. In response to this demand for more sophisticated investments, banks and asset managers have launched a vast array of ‘structured equity products’ targeted at retail investors. The past 12 months have witnessed a significant increase in the number of these products issued by special purpose vehicles (SPVs) incorporated in the jurisdictions of Jersey and Guernsey.
The product typically takes the form of non-voting, redeemable preference shares that are ‘structured’ to generate a return, linked to the performance of one or more reference points. For example, the return may be linked to the performance of a public equity index (such as the FTSE100), a hedge fund index or specific trading strategy, or even the performance of a commodity or currency price. The overall return comprises capital growth (in the form of a premium or bonus payable at maturity), income (in the form of a periodic dividend) or a combination of the two. The shares may have other economic features, such as capital protection or a minimum or enhanced rate of return.
The preference shares are often designed to be eligible for the stocks and shares component of a UK individual savings account (ISA). In such cases, the shares are marketed to UK retail investors by an authorised plan manager engaged by the issuer to establish, administer and promote an ISA plan for the shares. In some instances, they are designed for and marketed to high-net-worth investors, often through the private banking arm of the sponsoring bank.
The issuer is typically a Jersey or Guernsey SPV whose ordinary voting shares are held by a charitable trust; in other words, an ‘orphan’ or ‘off balance sheet’ SPV. Such companies are usually established as multi-class, closed-ended investment companies and are typically regulated within their jurisdiction of incorporation as collective investment funds.
The inherent flexibility of a multi-class issuer means that each class of shares can be tailored to suit a particular category of investor. This might be achieved by, for example, altering the level of capital protection to reflect the investor’s risk profile, or changing the ratio between the potential income and capital returns to suit the investor’s tax status. The need to establish a new vehicle for each issue is avoided, thus enabling the sponsor and plan manager to react quickly and cost-effectively to market changes; being first to market with a new product can often mean enhanced margins and increased market share.
The proceeds of issue of each share class are used by the issuer to acquire one or more equity derivatives (or other financial instruments, which might include debt securities and deposits) that are together designed to hedge the issuer’s payment obligations on the shares. These assets are acquired on day one and held by the issuer until the shares are redeemed when they reach maturity. By means of contractual segregation (or ‘ring-fencing’), the issuer ensures that the assets of each class of shares are available only to the holders of that class and the recourse of the holders is limited to those assets. In essence, the issuer is a pass-through vehicle that repackages equity derivatives in the form of a listed preference share, and employs capital markets financing techniques in order to create an investment product designed for private individuals, as opposed to institutional investors.
The advantages of Jersey and Guernsey
As the target market is retail, it is particularly important to establish the issuing vehicle in a well-regulated jurisdiction. Jersey and Guernsey both have developed reputations for stability, integrity, professionalism and competence, plus they have a flexible legal and regulatory regime. These factors, together with their tax-neutral environment and their competitive stock exchange, are increasingly encouraging sponsors – typically investment banks and financial institutions – to establish structured equity platforms in the Channel Islands. Five leading US and European investment banks currently sponsor one or more structured equity issues established in the Channel Islands. Mourant du Feu & Jeune is currently in discussions with four other investment banks that are looking to follow suit.
Legal and regulatory developments
Following recent amendments to the Collective Investment Funds (Restriction of Scope) (Jersey) Order 2000, Jersey companies that issue ‘structured’ shares may, in certain circumstances, now fall outside the scope of Jersey’s collective investment fund regulation. In practice, this development results in reduced costs, a lighter regulatory regime and a faster regulatory approvals process.
While historically the issuers have been established using a traditional corporate structure, there is growing interest in the use of protected cell companies (PCCs). PCCs have been available in Guernsey since 1997 (Guernsey’s PCC legislation was the first of its kind) and are expected to be available in Jersey, together with incorporated cell companies (ICCs), from 1 February 2006.
With a PCC, it is possible to create a series of cells within a single company and then segregate assets by allocating them to one or more cells. An ICC is a new type of corporate structure not available elsewhere. The key distinction between PCCs and ICCs is that the protected cells of a PCC do not have a legal identity separate from the cell company. However, the ‘incorporated cells’ of an ICC will each have a separate legal identity and be companies in their own right, although those cells will also form part of the ICC as a whole.
Using PCCs and ICCs enables a multi-class issuer to achieve statutory segregation of its assets instead of, or in addition to, contractual segregation.
The Channel Islands Stock Exchange
In order to qualify for inclusion within a UK ISA, the shares must be listed on an exchange recognised by the UK Inland Revenue. In December 2002, the Channel Islands Stock Exchange (CISX) received such recognition. Not surprisingly, this development led to a significant growth in structured equity listings on the CISX. As at 31 December 2005, 60 structured equity products issued by Jersey or Guernsey issuers were listed on the CISX, up from 45 in the previous year.
According to Tammy Menteshvili, chief executive of the CISX: “The formal recognition of the CISX has generated considerable interest in structured product listings, which are an important area of business for the exchange.”
Investor appetite for structured equity products shows no sign of diminishing – despite recent improvements in stock market performance. The experience gained by Jersey and Guernsey practitioners in establishing structured product platforms, combined with constructive legislative developments and the competitiveness of the CISX, will ensure that the Channel Islands are well placed to capitalise on the continued public demand.
Jonathan Rigby is a partner at Mourant du Feu & Jeune