Cayman Islands: Asset-backed and Structured Financing
1 December 1999
The Cayman Islands are a UK Overseas Territory and one of the largest banking centres in the world. The Islands are home to some 575 bank and trust licensees, including nearly all of the world's top 50 banks, and footings in excess of $600 billion. Over 125 licensed financial institutions have a physical presence in the Islands.
Political, social and economic stability (and a sovereign risk rating of the UK), together with specific, responsive and reliable legislation and a sound judicial system (with ultimate appeal to the Privy Council in London), has made the Cayman Islands the primary offshore financial centre for all types of capital markets transactions. In recent years Cayman Special Purpose Vehicles (SPVs), usually in corporate but also in trust form and typically offbalance sheet and bankruptcy remote, have been used as vehicles for:
- securitizations — which are often listed and some of which are triple A rated — of residential and commercial property mortgages in Hong Kong, Australia and Japan (commercial property only so far); Japanese, German, Indonesian, Italian and Thai auto receivables; Hong Kong, Mexico, UK and US credit card receivables; Japanese consumer receivables; aircraft lease receivables in countries as diverse as China and Argentina; steel, oil and aluminium contracts in Brazil, the US and Venezuela; trade (eg shipping freight and airline) receivables and the income stream on hydrocarbons contracts; infrastructure projects such as toll roads, bridges and housing projects in China; loan portfolios of Japanese and Swiss banks; and loans to Malaysia;
- repackaging all types of securities often coupled with derivatives swaps to tailor the income and currency stream;
- use as holder of purchase options, interests in swaps and other derivatives in multi-tier structured financing; and
- credit-enhanced futures and derivatives trading.
Many of these cross-border transactions can only be structured if the cost benefits are not reduced by the impact of capital requirements, debt/equity ratios, tax and exchange control restrictions. Accounting, legal, tax and regulatory regimes and efficient support services in the jurisdiction in which the participants or the transaction vehicles are domiciled, for instance the Cayman Islands, can improve the cost benefits.
Securitization and structured finance transactions may also meet the demands of many institutional investors which may under home jurisdiction regulation or applicable investment policy only invest in debt. Debt securities issued by Cayman SPVs can meet these requirements and, by the use of derivatives, the principal and income stream payable to the investor on the debt security issued by the SPV may be customized as to term, currency and fixed or floating rate of interest.
Cayman Islands Law
Cayman Islands law is substantially based on English common law with the addition of complimentary local legislation. Consequently the basic common law principles essential to financing transactions exist under Cayman Islands law. The courts largely follow English practice and procedure. They will therefore recognize or enforce netting, set off and subordination agreements (which are given express statutory recognition) and security interests created under laws other than Cayman Islands law, if validly created under the relevant laws.
Typically, a Cayman company is used as the SPV to benefit from the flexible corporate regime, economic and speedy incorporation procedures. Capitalization can be nominal and there are no debt/equity ratios. Limited duration and limited life companies are possible enabling the SPV to be treated as transparent in certain other jurisdictions for tax purposes. Trusts and limited partnerships are also used where more attractive to investors for tax, regulatory or internal reasons.
Cayman Islands law facilitates the status of the SPV as a bankruptcy remote entity (there being no equivalent to US Chapter 11 or English administration proceedings under Cayman insolvency law) by the use of the charitable, and now the purpose, trust as the parent. The trust has become well accepted as the preferred ownership structure for ensuring that the SPV will be treated as off balance sheet. The trust will typically be established in the Cayman Islands by a Cayman Islands institutional trust corporation (often the subsidiary of a household name international bank). The SPV will have an independent board of directors so it is recognized as an entity separate from the originator. The transfer of the originator assets to the SPV should also be treated as a true sale and with no substantive consolidation. Such Cayman Islands SPVs have been scrutinized by the rating agencies and the securities awarded triple A ratings.
The Cayman Islands have no income, corporation, capital gains or withholding taxes and no currency or exchange control restrictions. Tax exemption guarantees are granted for between 20 and 50 years, depending on the vehicle used. Although the Cayman Islands are not party to any double tax treaties, it is often possible to structure the transactions to eliminate or reduce the domestic withholding tax rate to an economic level, eg by the use of intermediate swaps into a low interest bearing currency (Thailand), by establishing a domestic branch of the SPV subject to tax and thus no withholding (Japan) or by a sale of the interest element for a capital sum (Indonesia). Alternatively, the Cayman SPV may be treated as a pass through vehicle for tax treaty purposes or a subsidiary may be established in a jurisdiction with favourable double tax treaties, eg Ireland, Labuan or Mauritius.
Since the launch of the Cayman Islands Stock Exchange in 1997, a growing number of debt securities issued by Cayman SPVs have been listed on the Exchange. This trend seems set to continue.
Structured finance transactions are now routinely seen in the international arena and the technique is being adopted by a broad array of institutions worldwide. As markets become more unified, increased capital regulatory standards are imposed domestically and demand increases for alternative funding, the use of structured finance transactions offshore is likely to accelerate. It is anticipated there will be particularly strong growth wherever there is a significant demand which cannot be met through traditional sources at the right price, and elsewhere where there is balance sheet pressure to improve capital, adequacy ratios, liquidity and gearing. Certainly, the Hong Kong market has shown renewed strength with property securitizations from Wharf and Sino Land in the first half of 1999. Even more so, the Japanese demand to securitize their way back to health seems insatiable. Whether investor appetite will keep up will depend on the ability of arrangers to meet their requirements for diversification, exposure, term, yield and security.
Anthony Travers and Timothy Ridley