Segregated portfolio companies - from a fund governance perspective
By Vumi Dube and James Kattan (pictured), Directors, DMS Governance – As of 31 March 2018, there were 933 segregated portfolio companies (SPCs) out of 10,500 entities registered as mutual funds with the Cayman Islands Monetary Authority. While this represents about 9 per cent of the list of registered mutual funds, it is worth noting that as of the same date there were many more segregated portfolios (SPs) linked to these SPCs.
The ability of each SP to follow a different strategy and to attract different investors from other SPs within the same SPC presents an opportunity for a more economic structure, one that minimizes formation and operational costs compared with a traditional single entity for each strategy. Furthermore, SPCs incorporated in the Cayman Islands as exempted companies are versatile in nature, usually used for the formation of umbrella funds and setting up of fund platforms. They can also employed for master feeder structures.
SPCs do, however, present directors with certain challenges. For example, an SP does not constitute a separate legal entity from its SPC. To this point, an article by a legal firm, Ogier, further explained that since an SP is not a separate legal entity, distinct from the SPC or from any other SP, the general case law stipulating that a company may not purchase shares in itself applies so that an SP is not able to invest into another SP of the same SPC. Another challenge is that SPC structures have not yet been tested in Cayman Islands courts.
Cross liability and other considerations
In an SPC set up, directors are appointed at the SPC level, overseeing the business of the SPC and that of the SPs, entered on their behalf by the SPC. In addition, directors appoint service providers and counterparties who enter into agreements with the SPC. Such agreements increase the number of future potential claimants against an SPC or its SPs. If assets of a particular SP are not sufficient to meet a claim, other SPs become exposed to risk of cross liability similar to share classes in a traditional fund. In the event of such a shortfall, a service provider or counterparty may seek recourse from assets of other SPs or the general assets of the SPC. From a fund governance perspective, an SPC structure comes with an added duty, prescribed by Companies Law (2018 Revision), for directors to establish and maintain procedures to segregate and keep separately identifiable, SP assets from general assets of the SPC and assets of other SPs. There are practical solutions that can be employed by directors to enable an SPC to pursue its objectives, therefore reducing the risk of cross liability without limiting a director from fulfilling his/her legal duties.
A director should be able to demonstrate that he/she has taken measures to ensure the segregation of assets and liabilities by considering factors that can affect the potential of a claim. For example, a separate bank account opened in the name of an SPC on behalf of a specific SP can be viewed as a step towards segregation compared to a bank account in the name of an SPC with SPs listed as sub-accounts. A bank account used for receiving subscriptions and paying out redemptions, otherwise maintained with a zero balance may pose a low risk of a claim. When considering an ISDA agreement with offsetting arrangements, directors should be more vigilant about protecting assets of other SPs as such agreements, by design, increase the risk of cross liability, in the event of a claim. While directors should strive for the best mechanisms to ensure that there is segregation, they should always review each situation on a case by case basis.
In the course of its life, and particularly pre-launch, an SPC may enter into agreements on behalf of its SPs with an investment manager, administrator, bank, broker, auditor and/or other service providers or counterparties.
Many service providers and counterparties are familiar with the requirement for directors to segregate SP assets and have their own version of limited recourse language that can be inserted into their service provider or counterparty agreements.
“Any liability of the SP to the Service Provider arising with respect to any such transaction hereunder or in connection with this Agreement shall extend only to, and the Service Provider shall, in respect of that liability, be entitled to have recourse only to the assets of the SP. For the avoidance of doubt, the Service Provider shall in no circumstances have any recourse in respect of any liability arising hereunder or in connection with this Agreement to the general assets of the SPC or to the assets of any other segregated portfolio of the SPC.”
However, this is not the case for all service providers or counterparties. Occasionally service providers or counterparties do not recognize the legal requirement for SPs to segregate their assets, while others understand it but are inflexible with their agreements. Such issues can arise at critical times for example when a fund launch is imminent. Early involvement of the SPC’s directors and Cayman Islands counsel in the review process can help alleviate these issues. Where difficulties are encountered with service providers or counterparties with respect to limited recourse, consultation with Cayman Islands counsel is recommended.
Where it has not been possible to insert appropriate limited recourse language into a service provider or counterparty agreement - a common example would be where a bank has a standardized, non-negotiable agreement – the SP could enter into a side agreement with a service provider or counterparty. This side agreement would include limited recourse language and be signed by an SPC on behalf of its SP and a service provider or counterparty. If a service provider or counterparty is unwilling to include limited recourse language in its agreement, or sign a side agreement, the board should consider the risk profile of a service provider or counterparty relationship. In some scenarios, the board may consider sending a letter to the service provider or counterparty, providing formal notice of the requirement under Cayman Islands law for the assets of an SP to be segregated so that they become aware of it and in other scenarios, selecting an alternative service provider or counterparty may be advisable.
In conclusion, SPCs can provide an excellent solution for investment managers looking for a cost efficient, flexible Cayman Islands structure for their new fund product. While there are nuances that directors and investment managers should be aware of, including potential cross SP liability risk and the duty prescribed by Cayman Islands law to segregate SP assets, there are mechanisms available, such as inclusion of limited recourse language within service provider or counterparty agreements, which can help to ensure that the requirements for segregation are addressed appropriately.