Corporation, Securities & Business Law Forum
July 2002 Vol. 40, No. 1
Statements or expressions of opinion or comments appearing herein are those of the editors or contributors, and not necessarily those of the association or section.
(Notice to librarians: The following issues were published in Volume 47 of this newsletter during the fiscal year ending June 30, 2001: December, No. 1; February, No. 2; May, No. 3.)
Contents
* The protected cell companies in a nutshell
This edition of the newsletter has several interesting articles, including one that describes the concept of protected cell companies and their use in finance transactions. This edition also contains a handy checklist of some of the issues to deal with in connection with the purchase or sale of a business. Finally, we present an article that describes some of the new laws and other developments from around the country that business lawyers should be aware of. I note that the recent developments in Illinois are not discussed in this article and will be the subject of a separate article in a future edition of this newsletter.
We look forward to your comments and suggestions. We also welcome your submissions to the newsletter.
David E. Doyle
10 S. La Salle Street
Suite 3500
Chicago, Illinois 60603
312/606-0529
The protected cell companies in a nutshell
By Francisco Perez Ferreira1
I. Introduction
Among the different factors that contribute to economic growth are the roles played by "offshore" jurisdictions,2 which in many ways assist or ease different business activities (of commercial, financial or patrimonial nature) around the globe. The operational and business flexibility offered by these jurisdictions is achieved by means of the use of their various legal vehicles or instruments, which in many circumstances facilitate trade, capital flows, legitimately help reduce high/prohibitive tax burdens on business or even assist in fulfilling people's natural and legitimate desires for asset planning and protection. The spectrum of these instruments is broad.3 One of the relatively recent tools available for corporate, tax planning and financial services law practitioners in the comparative legal context is the Protected Cell Company (PCC), an innovative corporate instrument whose concept, characteristics and uses in the international financial arena are explained in the following paragraphs.
II. The protected cell company in a nutshell
(a) Background
Protected cell companies originated in Guernsey, by means of The Protected Cell Companies Ordinance 1997.4 5
This regulatory scheme constitutes a response to claims and heavy lobbying from the captive insurance industry and comes to resolve structural inefficiencies of the "rent-a-captive" concept. In short terms, a "captive" is an in-house, self-insurance corporate vehicle whose main purpose is to provide insurance for determined risks of a parent company (or of the corporate group to which it belongs), as an alternative to the traditional insurance coverage provided by the insurance industry.6 7
They represent commercial, economic and tax advantages to their sponsors due to the reductions in costs they help create, the ease for insurance risk management and the flexibility for cash flows they generate.8
The "rent-a-captive" scheme comes into play in cases in which a company is not financially capable to self-insure itself. A company then shares the services of a captive with other companies of relatively similar size, by "renting" part of the capital of the "rented" captive (unrelated companies may use the same captive to insure their risks). The "rent-a-captive" structure notwithstanding has a major flaw, because it constitutes a single entity vis-à-vis third parties. Its single patrimony is exposed to third-party claims, which risks the assets allocated to cover claims for other companies participating in the sponsored rented captive structure. To circumvent such patrimonial risk-fencing deficiency, the insurance industry developed the PCC.
(b) The PCC explained
What is a PCC and which are its uses? How does it work? The PCC is a corporation structured with different patrimonies (group of assets), all segregated through "cells", which are independent and separate from each other and from a "core" patrimony of the entity. The segregation of assets helps avoid commingling of funds and assets of the different sponsoring participants, ensuring thus that no claim against one participant-beneficiary of the captive-insurance entity would be covered by funds or assets furnished by another participating/sponsoring enterprise. Based on the aforementioned, a PCC may be defined as:
A corporation whose patrimony is composed of assets contained in structurally separate parts named "cells" [cellular assets], which are legally and functionally separate, distinct and independent among each other, and of assets not constituting "cells" [non-cellular assets], also structurally and legally independent, that has as its main legal characteristic the fact that the portion of capital designated to a specific cell is neither liable for the general obligations, commitments or liabilities of the corporation, nor for the specific liabilities of the other cells.
From this definition it is possible to extract the main characteristics of these entities:
(1) Legal entity: The PCC has its own juridical personality and is capable of owning rights and assuming obligations on its own. The "cells" do not constitute separate entities themselves;
(2) "Cellular" and "Core" Patrimonies: The patrimony of the entity is divided into different "protected cells," which allow segregation of funds, thus enabling ring-fencing among the distinct cells and the core patrimony. A portion of the PCC's patrimony is composed of general assets ("non-cellular" assets), which are separate and distinct from each of the assets composing the protected cells, creating what is commonly known as the "core cell";
(3) Segregation of assets and liabilities: The assets allocated to each specific cell may only be liable for liabilities incurred by such cell and thus should not be attached by creditors of the other company's cells. The liabilities unrelated to a specific cell are covered by the non-cellular assets or the core cell. The core assets respond--on subsidiary grounds--once the specific cellular assets are depleted.
A PCC, structurally speaking, involves a core capital, cellular capital, cellular assets and liabilities, and core assets and liabilities. The ring-fencing rules are also applicable to any liquidator or receiver of the entity. Thus the insolvency of a cell should not affect the business of the whole entity or the performance of the other cells. For each business, activity or agreement contracted, the PCC must disclose which cell is contracting or if the entity is committing its core assets or both, core and specific cell assets. The PCC must have a name and each and every cell must also be clearly identified in the formation documents of the entity. Once formed, these entities may issue shares ("cellular" or "non-cellular" shares, depending on whether they represent an equity interest in a specific cell or in the core assets) or other types of securities. The entity must keep accounting books showing the corresponding patrimonial divisions among the segregated cells and the core cell within the entity.9
III. The PCC: a new vehicle for investment funds
PCCs are also authorized in Guernsey to operate as investment funds.10
These entities are suitable vehicles for the operation of mutual funds, especially in the form of umbrella funds, having each "cell" as a sub-fund. A sponsor, for example, may structure a multiple series fund by creating a PCC, in which case each cell may represent the different group of investments for which the distinct classes or series of shares are offered to the fund's investors. According to the existing legislation in Guernsey, the persons investing in and dealing with a cell of a PCC fund may only have recourse to--that is a right to claim--and their interests may be limited to the assets that from time to time are attributable to such specific cell and such persons may not have rights to claim over assets conforming other cells (which may be the other sub-funds within the structure) of the PCC; thus cross claims among creditors of the different series (cells) may not be allowed.11
The use of a single entity structure for the different funds (series fund)--in contrast to a "family of funds" structured with multiple entities in which each separate legal entity represents a particular fund--would eliminate or reduce costs, by using, for example, a single board, the same distributor, custodian, transfer and payment agent, and the same prospectus.12
IV. The PCC: a structured finance conduit13
Although a relatively new vehicle, the uses of a PCC have grown and diversified in the past few years. Since its inception in 1997, this entity has evolved from being an alternative to the rent-a-captive scheme and an investment fund vehicle to become a suitable conduit for insurance risk management. 14
The PCC may be used for securitizing insurance risk against catastrophic losses, such as natural disasters, thus increasing sources and availability of capital and stabilizing underwriting results of domestic insurance companies.15 Various states in the United States have adopted the PCC concept, looking for ways to generate insurance risks securitization business "onshore."16 With this in mind, the National Association of Insurance Commissioners' Insurance Securitization Working Group focused in the adoption of a model law on "special-purpose vehicles,"17 and on February 6, 2001 agreed--in principle--to such model act,18 which would facilitate establishing securitization special purpose entities within the United States. This trend shows the increasing and strong competition among jurisdictions to provide the best vehicles to generate structured finance business. 19 If properly structured and with the adequate regulatory scheme in place, a PCC may be used for multi-series structured finance transactions. For example, the PCC may act as the special purpose vehicle-issuer for the securitization of different pools of assets, by re-packaging them and issuing different types of asset-backed notes, each type of note backed by the assets, forming a separate protected ring-fenced cell (giving rise to "cellular-asset-backed securities"). Even the core assets may be used as a credit enhancement mechanism within the structure. The PCC may be structured in a way in which it would have as many distinct cells as needed for the different pools of receivables that may be repackaged. In this sense, a bank or finance company may pool and repackage loans per geographic areas, per outstanding balances, per type of loans or by type of security backing such credits.20
A segregated cell "X" would then back the notes "X," the cell "Y" would back notes "Y" and so on. In the event of default on the X notes, then the assets repackaged in cell Y backing the Y notes would not be affected, giving complete ring-fencing protection to the different asset-backed securities-holders, enabling the bank or finance company to structure the deal with such flexibility that it may issue ring-fenced multi-series of securities for different markets or types of investors. The segregated cells may provide for a legally strong manner for "tranching"21 (thus creating different levels of prioritization or subordination among the securities), in which case each separate cell may represent a tranche, and even within such cell, different levels of tranches may be established. Obviously, the transaction documentation must clearly set forth the rights and obligations of the parties, including the ones of each protected-segregated cell.
V. Conclusion
Intense competition among traditionally known "offshore" jurisdictions and "onshore" players, such as various states of the United States of America, have caused a visible trend in increasing innovation in the creation and evolution of legal structures, all with the aim of providing better and cost-effective financial services to the international markets. The Protected Cell Company, a multi-use corporate structure, constitutes a clear reflection of this legal-financial engineering dynamic phenomenon, whose success in the marketplace remains a challenge.
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1. The author holds a law degree from the University of Panama, is a Fulbright Scholar and a graduate from IIT-Chicago Kent College of Law/Center for Law and Financial Markets' LLM in Financial Services Law (2001). He practices commercial, corporate and securities law with the Panamanian law firm Patton, Moreno & Asvat (www.pmalawyers.com). He may be contacted at fperez@pmalawyers.com.
2. There is no uniform meaning for "offshore jurisdiction." For purposes of this article I refer to the traditionally known low-tax/zero-tax jurisdictions, i.e., Cayman Islands, Bahamas, Channel Islands, the British Virgin Islands, Panama, etc., which impose either no tax or low-rate taxes on extraterritorial operations carried out by entities incorporated in their respective territories.
3. It may include--inter alia--the well-known international business corporations, the traditional common law trusts and captive insurance companies, private interest foundations, the British nominee companies, international headquarters company, dual resident company and the open-ended investment companies (OEIC), the international corporations from Manx and Jersey, the Irish non-resident company, the American limited liability companies (LLCs) and the Cayman Islands STAR Trusts. See Eaton, Chris; "Demand for Creation of New Offshore Products Increases," The OFC Report 1997/98, Campden Publishing Limited, London, UK, 1997, pp. 23-24.; the author's publication Las Fundaciones de Interés Privado en Panamá, (Private Interest Foundations in Panama), Portobelo Edit., Panama, 1997; Budd, Elizabeth; "Open-ended Investment Companies. An Emerging Form of Investment Fund," PLC Practical Law for Companies, Vol. IX, No. 7, Legal & Commercial Publishing Limited, London, Aug. 1998, pp. 29-37; and STAR Trusts by Antony Duckworth, edited by Gostick Hall Publications, 1998.
4. As amended by "The Protected Cell Companies (Amendment) Ordinance, 1998." I follow the provisions of these acts when describing the structure, rights and obligations of a PCC.
5. Other offshore jurisdictions have followed the path of Guernsey, including the Cayman Islands with its Segregated Portfolio Companies; Bermuda (which passed the New Providence Mutual Ltd. Private Act allowing a PCC structure for this entity); Mauritius (which approved The Protected Cell Companies Act of 1999 [amended in 2000]); and St. Vincent and The Grenadines with their International Insurance (Amendments and Consolidation) Act of 1998 which allows "protected premium accounts" introducing elements of the PCC; see "St. Vincent and The Grenadines. Law on Confidentiality, Insurance and Mutual Funds," The OFC Report 1999, Campden Publishing Limited, London, UK, 1999, pp. 149-150.
6. See Tamosius, Alwin; "The Enigma offshore Captives," The OFC Report 1996/97, Campden Publishing Limited, London, UK, 1996, p. 65.
7. Captives may take the form of a "pure" entity (which is a 100 percent-owned subsidiary of the self-insured parent company); of a "mutual" captive (which insures the collective risks of industry members) and of an "association" captive (which self-insures individual risks of the members of a professional, commercial or industrial association).
8. Additionally, they may provide coverage of risks which are neither available nor offered in the traditional insurance market at reasonable prices.
9. The European-originated PCC concept has another American parallel company structure. I refer to the Delaware Series Limited Liability Companies or "Series LLCs," as authorized to be formed pursuant to the Delaware Limited Liability Company Act (hereinafter the "Delaware LLC Act" or "Act"). The limited liability company (LLC) has rapidly become a business entity of choice in the United States. The LLC allows business owners to achieve limited liability for debts of the business while being taxed on passthrough basis (which means that tax is not levied on an entity level as is generally the case of corporations-, but passes through the entity to the owners/members of the LLC). The Delaware LLC Act provides for the creation of separate "series" within an LLC whose debts and other liabilities are enforceable against that series alone. This law also allows for the provision of whatever rights the classes or groups of members may deem convenient to established in the LLC formation agreement. Thus a series could be treated in many ways as a separate and distinct LLC. The series provisions contained in the Act allow for the creation of separate protected "cells" within one limited liability entity without the need to create separate entities, thus avoiding the inefficiencies that exist when setting up or having multiple related companies. The Series LLC concept thus is functionally similar to the PCC corporate scheme.
The Act allows an LLC agreement (the document whereby the LLC is created) to designate series of members, managers or LLC interests, that have separate rights and obligations with respect to specific LLC property or obligations. Each series then can be tied up to specific assets and can also have different members and managers. Each series can have its own separate and distinct business purposes too. A series can be terminated without affecting the other series of the LLC and can make distributions to its own members without regard to the financial condition of the other series. Most importantly, the Delaware LLC Act provides that debts, liabilities and obligations incurred, contracted for or otherwise existing with respect to a particular series are enforceable against that series only, and not against the assets of the LLC generally or any other series of the LLC. To gain such ring-fencing protection under the law, each series must be treated separately, for which purposes books and records must be kept for each series and the assets of each series must be held and accounted for separately.
Series LLCs may be used as holding entities for real property, having each cell as holder of the different parcels. These entities may also be used for structuring equity compensation programs within large corporations with multiple divisions and branches or subsidiaries. Each division may be segregated into a separate series for purposes of allocating equity compensation benefits.
For additional comments see Christopher M. Riser's article "Delaware Series LLC", published at http://www.mayer-riser.com/Articles/business/seriesllc.htm.
10. See Milroy, Robert; "Offshore Investment Funds in Jersey, Guernsey, and the Isle of Man," Offshore Finance U.S.A., Vol. 1, No. 1, March-April 1999, pp. 58-60. The Cayman Islands, for instance, have restricted the Segregated Portfolio Companies to the captive insurance business.
11. See, for example, the Offering Memorandum of Investec Premier Funds PCC Limited, dated March 22, 2001. Investec Premier Funds PCC is an open-ended investment protected cell company created and governed by the laws of Guernsey.
12. Using a multiple entities structure would entail multiplication of expenses.
13. Structured financings are characterized and distinguished by the fact that generally they involve the setting up of legal structures (i.e., contractual arrangements and/or entities) within the schemes to structurally and legally enhance the protection of investors/creditors.
14. Even though I have not explore in depth the issue, with a clear regulatory framework and if properly structured, PCCs may be also used in the creation of timesharing schemes, by having each protected cell constituted with the different assets subject to the regime, securing each cell the rights of the various co-owners.
15. I have defined "Securitization" as "the legal, operative, financial and structural process of transferring and packaging from an originating entity a group of determined predictable-cash-flow-generating assets into a distinct and separate pool - legally owned by a special limited purpose vehicle or conduit--which exclusively backs up debt, equity or hybrid securities or instruments issued by such separate entity, with the aim of reducing and reallocating risks inherent in owning or providing credit against the grouped underlying financial assets from the originating entity to investors in the capital markets"; see "Securitization in Panama," Independent Research paper on file with the Illinois Institute of Technology's Center for Law and Financial Markets (Chicago, 2001).
Securitization of catastrophe risk have taken several forms, which include among the principal ones "contingent surplus notes", catastrophe or "Act of God" bonds (CAT Bonds), CatEPuts, and exchange-traded catastrophe options; see "Catastrophe Risk Securitization. Insurer and Investor Perspectives" by Glenn Meyers and John Kollar of Insurance Services Office, Inc.; "Insurance Securitization: The Developments of a New Asset Class" by Richard W. Gorvett, both papers presented at the 1999 Casualty Actuarial Society "Securitization of Risk" discussion program, http://www.casact.org. For literature on the use of SPVs and PCCs for securitizing insurance risks see, among others, "Special Purpose Risk Financing Vehicles," by Kate Westover, published at http://www.captive.com/service/srs/SPV_p4.html, October 4, 2000; Lisa Howard's article "Protected Cells Ease Access to Capital Markets," National Underwriter Property & Casualty-Risk & Benefits Management, Vol. 104, Issue 15, April 10, 2000; "Legal and Regulatory Issues Affecting Insurance Derivatives and Securitization," Practising Law Institute, November 1999, written by Michael P. Goldman, Michael J. Pinsel and Natalie Spadaccini Rosenberg; Shann, Jonathan; "The Art of Securitizing Catastrophe Risk," International Financial Law Review, August 1999; A. Levin, P McWeeney and R. Gugliada, "Criteria for Insurance Securitization," published at http://www.wtexec.com, October 4, 2000.
16. In this regard, for example, sponsored by the National Association of Insurance Commissioners (NAIC) -which approved a model law-, Illinois adopted the Protected Cell Company Law (amending its Insurance Code), which purpose is the creation of "more efficiency in conducting insurance securitization, to allow domestic companies easier access to alternative sources of capital, and to promote the benefits of insurance securitization generally" (see section 179A-5; http://www.ilga.gov/ilcs/ch215/ch215act5articles/ch215act5Sub23.htm,). Rhode Island copied the strategy by means of The Protected Cell Companies Act (Chapters 27-64 of Title 27 Insurance of its Code). Vermont followed the trend with the concept of the "Sponsored Captive Insurance Company", which is defined in such law as any captive insurance company that segregates each participant's liability through one or more protected cells. Lastly, South Carolina also joined the club. For references see "Illinois Among First to Pass Protected Cell Legislation," The Underwriters' Wire Report on June 18, 1999, and Illinois Insurance, The Regulatory Newsletter of the Illinois Department of Insurance, #5, October 1999. For the materials on Rhode Island see http://www.rilin.state.ri.us/Statutes/TITLE27/ 27-64/S00004.HTM, and Vermont refer to §6001 paragraph 22 of Chapter 141 Captive Insurance Companies under Title 8 Vermont Statutes Annotated.
17. See "Insurance Securitization Broadened" by William D. Boyd, http://www.namic.org/s/ey/naic1099is.htm, as of October 5, 2000.
18. According to reports shown at http://www.vinodkothari.com/secnews11.htm.
19. I see no obstacle, for example, for Panama to adopt the PCC concept by means of a special law and thus allow these entities to fulfill the role of multi-series special purpose vehicles. The following factors support my argument:
a) Panama's longstanding tradition in rendering offshore services;
c) Legislative experience in the adoption of foreign law concepts and traditions (ie, common law trust);
d) The existing flexible and modern legal regimes for captive insurance companies, captive management companies and reinsurance business;