Subscription Finance for Corporates - Pushing The Envelope?

Oct 29 2015 | 6:23pm ET

 Editor's Note: Security over investor capital commitments has become a highly prevalent form of taking collateral in private equity and real estate lending, typically via secured, senior revolving credit facilities issued by a Cayman Islands exempted limited partnership (ELP).

However, a recent trend has emerged in which similar security arrangements aredeployed, but the borrower is a Cayman company rather than an ELP.

In this contributed article, Tony Heaver-Wren and Caroline Barton of law firm Appleby take a close look at risk profile of applying a subscription finance model to a Cayman Islands exempted limited company, how it differs from the orthodox ELP model, and lay out considerations and risks that apply when a lender takes security over capital contribution obligations of shareholders, rather than limited partners.


Subscription finance for Corporates - Pushing the envelope?

By Tony Heaver-Wren, Partner, Dispute Resolution, and Caroline Barton, Senior Associate, Corporate

Security over investor capital commitments has become a highly prevalent form of taking collateral in private equity lending.  The facilities offered by lenders are typically secured, senior revolving credit facilities and the borrower is most commonly a Cayman Islands exempted limited partnership (ELP), created pursuant to statute and governed by contract, without separate legal entity status.  

The security given, in such financing arrangements, is an assignment by way of security of the general partners’ rights to make capital calls on the partnership’s investors, the limited partners. Upon enforcement, an existing contingent liability of the limited partners is converted into an actual liability to make a capital contribution, with payment of the contribution being applied towards satisfaction of the secured liabilities, pursuant to the assignment of the capital call right. 

Although the enforceability of this form of security has not been subject of any ruling in the Cayman Islands, there has been jurisprudence in the United States which has vigorously upheld the enforceability of subscription finance in a variety of challenging circumstances, even extending to an upholding of the capital call obligations of limited partners where a fund’s principals were convicted of fraud in relation to the fund (Mayer Brown, 2011)

On the back of the growth and resilience of the subscription finance practice using ELP structures, a recent trend has emerged of deploying a similar security arrangement where the borrower is a Cayman company rather than an ELP.  This article considers the different considerations and risks that apply when a lender takes security over capital contribution obligations of shareholders, rather than limited partners. 

Material differences – ELP vs. Corporate

The application of the subscription finance model to a Cayman Islands exempted company raises issues and creates a risk profile that differs from the orthodox model of an ELP.  

In traditional subscription finance, in which the borrower is a Cayman Islands ELP, the limited partner receives the whole of its limited partner interest at the time of subscription, subject to express contractual agreement that capital commitments will be paid in future, by the limited partner, in accordance with the terms of the ELP agreement.  That is, in the orthodox ELP arrangement, there are no additional steps to be taken before the lender (exercising the assigned rights of the general partner) can seek payment of a capital commitment obligation pursuant to enforcement of security.

In contrast, in subscription finance arrangements where the borrower is a Cayman company rather than an ELP, the security relies upon the shareholders to purchase additional shares in the future.  That is, upon an event of default and the making of a capital call by the secured lender pursuant to its security, a contractual provision is triggered which obligates the company to issue further shares, and shareholders to purchase those shares.  Before examining the ramifications of this aspect of corporate subscription finance, it is worth considering whether this future issue is the only way in which such security could be structured. 

Alternative bases for corporate subscription finance?

In the corporate context, there are, theoretically at least, three alternatives for the source of the shareholders’ obligation to make capital contribution contributions to the lender, as set out in the nearby table.

Appleby

Each of these alternatives is considered below.

Call on unpaid share capital

The first question to arise in this context is whether it is permissible for the unpaid portion of share capital to be subject to security, particularly given that the amount by which shares are unpaid is the measure of a shareholder’s liability to contribute to the debts of the company in an insolvency; that is, in the event of a liquidation of a Cayman company, a liquidator would ordinarily make demand for payment of any unpaid capital and the receipts would form part of the liquidation estate, to which unsecured creditors may look for payment. 

While the law has traditionally resisted treating unpaid share capital as property of a company, a company may grant security over such unpaid capital provided that:

  • The company either has that power in its articles of association, or a special resolution is passed to alter the company’s articles to include such power, and 
  • The debenture creating the security expressly and specifically charges the company’s uncalled share capital.  

Given the satisfaction of these requirements, there appears to be no legal impediment to a capital call obligation, in the corporate subscription finance context, being linked to the amount of shareholders’ unpaid share capital.

In practice, however, private equity funds will generally have a modest authorised share capital, because annual registration fees increase proportionately to the value of share capital. Accordingly, even if a corporate borrower has unpaid share capital, the value of the unpaid portion is unlikely to be of sufficient value to constitute a meaningful source of security for the lender.

Call on unpaid share capital and/or contractual promise to pay

As set out, above, there is no reason why shareholders’ obligation to pay the unpaid portion of share capital could not be the subject of security in a corporate subscription finance transaction, other than the fact that, in most instances, it would have insufficient value as collateral to the lender.  This leads to the question of whether the payment obligation being the unpaid portion of existing shares could be complimented with an additional payment obligation as a condition to the issuance of those shares, rather than a payment obligation in respect of future shares – i.e. would it be feasible to create classes of shares in which there is an obligation to pay the par value for the shares, and to contribute an additional sum by way of share premium?  

Questions of consideration for the capital obligation that exceeds the par value of the shares could arise, although the commercial reality of units of ownership of a company ordinarily having a higher worth than the par value stated for the purpose of setting authorised capital would usually prevent any significant concerns about the finance contract being undermined by arguments of lack of consideration.   

Indeed, there does not necessarily have to be any element of unpaid share capital at all in order for a capital call security to be granted in the corporate context. This has been underlined by recent instances in which investors were issued (fully paid) shares at par value on closing, on terms that included shareholders being subject to an obligation to fund an additional capital commitment with respect to those shares when called upon by the company to do so.  Pursuant to the facility terms, in such an arrangement, the shareholders are issued shares to which “springing rights” (rights for the lender, payment obligations for the shareholder) are attached.

There have also been instances where the obligation of shareholders to make payments pursuant to capital calls has been unconnected with the issuance of further shares, though such arrangements have tended to be deployed in circumstances where the memorandum and articles and subscription agreement have been amendable by special resolution.  It is likely that creative solutions of this kind will become increasingly common in corporate subscription finance deals.

Call by way of payment for additional shares

To date, the prevailing practice when corporate borrowers seek to secure lenders with security over the company’s rights to make capital calls of shareholders is to create an obligation of (a) the company to issue, and (b) the shareholders to purchase, additional shares in the company, following an event of default under the terms of the lending facility. 

This orthodox practice, while contractually achievable, does come with certain inherent risks, referred to, below, along with corresponding measures to mitigate such risks:   

RISK:Where the lender is reliant upon the company (namely, a majority of the board of directors) to instruct its share registry agent to register new shares in the names of the shareholder, and the agent acting in accordance with that instruction, as a precondition to the shareholders having the payment obligation upon which the lender relies, risk is introduced.  

MITIGATION:This risk may be mitigated to some extent, by (a) obtaining irrevocable proxies and executed undated letters of resignation from the directors (b) ensuring that the subscription documents and Articles of Association of the company remove any discretion not to issue shares in an enforcement scenario and that the directors shall issue shares when directed to do so by the lender, and (c) ensuring that the investment manager has no right of veto or ability to influence or block any issuance of shares, however the fact of there being antecedents to the payment obligation at all means that risk cannot be eliminated 

In practical terms, these risk mitigation benefits are not always easy to obtain. Further, potential future arguments regarding the fiduciary duties of the directors in relation to the share issue or the scenario of a replacement board  taking an obstructive approach may also arise

RISK:The share issue and payment obligation will often arise when a borrower defaults on its obligations under the facility agreements and a call is made.  Other than in cases of technical default that are readily and swiftly rectified without need for enforcement, this means that the issue and payment obligations often arise when the borrower is distressed and quite possibly insolvent.  When a company is and remains insolvent, its shareholders’ interests are subordinated to the interests of the company’s creditors.  This means that the shareholders are being asked to pay for shares that are likely to be or will almost certainly be, worthless.  In such a scenario, shareholders will be unmotivated to pay for shares, even if issued, and may seek legal advice with a view to resisting the payment obligation.  

MITIGATION:These risks may be mitigated, to some extent, by (a) inserting contractual provisions that seek to avoid any opportunities for shareholders to successfully challenge the effectiveness of the subscription agreement or any call, (b) amending the Articles of Association to ensure payment obligations subsist, irrespective of whether the shares are prevented from being issued, and by (c) securing fund bank accounts and ensure representations as to capital call and payments are valid through insolvency in all constitutional documents. Although the starting point is that shareholders should be held to their contractual obligations, depending on the quantum of those obligations, some degree of resistance could reasonably be expected, and such resistance could extend to a legal challenge that could prevent the lender from enforcing under its security for an indefinite period.  

Lenders taking security in subscription finance deals where the borrower is an ELP can remain confident of a clear passage to enforcement of such security, should the need arise.  For lenders who extend their reach to subscription finance in deals in which the borrower is a Cayman exempted company, an entirely different set of issues and risk profile arises.  While the use of corporate structures in this context presents new challenges, they are not insurmountable, particularly where funds and their counsel have contemplated such financing arrangements upon formation of the funds. 


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