In this seven part series, Barnabas Finnigan and Nick Ward dissect special purpose vehicles and bankruptcy-remote orphan structures of the type used in the US CLO market. Together they explore how SPVs are formed, how they work, who (or what) owns them, and the various measures taken to enhance marketability and mitigate transactional risks. Whether you are a seasoned finance professional or just dipping your toes into structured finance, this series offers a deep dive into the architecture behind some of the most resilient financing structures in the market.
Part 1: What are bankruptcy remote structures and how and why are they used?
The fundamental point of utilising an orphan SPV structure in a financing transaction is to insulate the transaction in question from certain risks (which are not strictly related to the performance of the collateral assets underlying the deal).
More particularly, as the name suggests, the purpose of a “bankruptcy remote” structure is to insulate the underlying assets from the risk of being pulled into bankruptcy proceedings should something happen to one or more of the parties in a transaction.
The primary goal is to create a legal and operational separation between the assets being financed and the potential financial troubles of the entity that originated or sold those assets. This means that participants in the transaction can focus their credit and risk analysis on the relevant assets themselves and need not conduct time consuming due diligence on the operations and history of the obligor or parties connected with it.
Most structured finance or asset-backed transactions including CLOs and CFOs are conceived in this way and have been the subject of extensive analysis by, amongst others, the credit-rating agencies, who over the years have provided extensive guidance as to how one attains the coveted state of “bankruptcy remoteness”. Tick every box (non-petition covenants, independent directors and limited-recourse language thick enough to stop a cavalry charge) and the transaction should win the coveted rating agency seal of approval, enhancing investor confidence in the transaction, making the deal more marketable (e.g. by lowering regulatory capital requirements) and allowing for tighter pricing.
Part 2: What is a special purpose vehicle or “SPV” in the context of orphan structures?
The SPV is usually a limited liability company with no prior operating history, newly established for the sole or “special” purpose of participating in the financing transaction in question. The vehicle of choice in the vast majority of CLOs and other structured finance transactions utilising a Cayman Islands note issuing SPV is almost always the “exempted company”, an entity incorporated under the Companies Act (as amended) of the Cayman Islands (the “Companies Act”) which can be established in as little as 24-48 hours. The shares of this company are typically held on trust (usually a trust ultimately for charitable purposes) by a Cayman Islands licensed trust company such as Conyers Trust Company (Cayman) Limited, whose members/shareholders enjoy limited liability and over which directors take responsibility for day-to-day business and management (assuming associated fiduciary duties). This means the SPV is an “orphan” — it does not form part of a wider corporate group or have traditional shareholders in the background, just a trust company (working in conjunction with a corporate administrator) making sure everything is above board.
The directors of the SPV are responsible for running the show, taking on all the usual fiduciary duties, but with a twist: the SPV’s activities are strictly limited to what is required for the transaction at hand. No side hustles, no entrepreneurial spirit, just a laser focus on the job it was created to do.
Because the SPV is freshly minted for each transaction, it comes with a squeaky-clean record — no skeletons in the closet and no historic liabilities to keep anyone up at night. This makes it a dream come true for risk analysts and credit committees, who can rest easy knowing there is no hidden baggage. And since the SPV is all about keeping things simple, it does not need to think about HR headaches or lease agreements. Just a corporate administrator and professional directors ensuring that the SPV is running properly and efficiently. Its sole purpose is to facilitate the transaction, and once that is done, it quietly fades into the background — mission accomplished.
Part 3: How are the SPV’s activities limited?
It is important that the SPV does not at any time carry out any activities which might expose the transaction parties to any extraneous risks. The activities of the SPV are therefore limited in several ways:
- the administrator of the SPV will undertake not to do anything which is inconsistent with the transaction documents or the SPV’s limited corporate objects as set out in its constitutional documents – this means no dabbling in side projects, no moonlighting, and certainly no “just for fun” investments;
- the corporate objects of the SPV will generally be limited in its memorandum of association to participating in the transaction and entering into the relevant transaction documents and other activities related thereto. As a matter of Cayman Islands law, the powers of the directors of a company are to be used in furtherance of the corporate objects set out in the memorandum of association and the directors of the SPV would be using their powers improperly if they were to engage the SPV in activities beyond its corporate objects – if they try to take the SPV on a detour—say, opening a chain of beachside taco stands—they would be acting outside their authority, and that’s a big no-no (regardless of how appealing beachside taco stands in Cayman might be); and
- negative covenants are included in the documents relating to the transaction which contractually restrict the SPV from entering into any activities unrelated to the transaction. Breaching these covenants constitutes an event of default which can give rise to various remedies, including enforcing the security interests granted over the relevant assets, and may entitle participants in the transaction to seek an injunction restraining the SPV from acting in a particular way.
The combined effect of the foregoing measures is to restrict the SPV’s activities to those which are expressly contemplated by the transaction which serves to ensure that the vehicle does not engage in other arrangements or transactions, incur indebtedness or become exposed to litigation risk or other creditors’ claims, all of which could cut across the transaction or adversely affect the rights of participants and/or dilute expected returns or recoveries.
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