There are a range of factors contributing to Guernsey’s leading position in this space, including: (i) over 800 years of independent self-governance as a Crown Dependency of the United Kingdom; (ii) an AA-/A-1+ credit rating from S&P Global Ratings, representing Guernsey’s very strong capacity to meet its financial commitments; (iii) historical familiarity with the jurisdiction by investors and fund sponsors; and (iv) the increasing dominance of the private equity sector in the funds market. In addition, Guernsey law, which is derived from a combination of English common law, Norman customary law and local legislation, ensures that Guernsey funds are recognised as internationally accepted and well-recognised vehicles for all kinds of fund-related activity. Collaboration between the Guernsey government and the private sector also ensures that Guernsey laws keep pace with market evolution and demand. New products are being introduced to the market regularly to keep Guernsey at the forefront of the international funds market; previous products include private investment funds (PIFs) and the Alternative Investment Fund Managers Directive (AIFMD), marketing passport-ready, manager-led products (MLPs).
The growth in this area shows a strong correlation with the fund finance space, where Appleby’s Guernsey office continues to see steady growth year on year in the subscription credit facility market. Indeed, Appleby’s Guernsey office continues to be a market leader in this area, representing the majority of the largest global banks on a variety of different financing structures.
An increase in fund size across the globe has meant higher commitments being expected of general partners, and this in turn has given rise to market demand for general partner support facilities over and above the standard subscription lines. These facilities tend to bring with them more bespoke security packages, tailored depending on the make-up of each individual general partner and the fund it manages.
Fund formation and finance
Lending to Guernsey funds
Guernsey private equity funds have typically been registered as limited partnerships (LPs) under the Limited Partnerships (Guernsey) Law, 1995, as amended (LP Law). Though registered pursuant to the LP Law, an LP is not generally a separate legal entity (although it can elect to have separate legal personality from its partners at the time of registration).
An LP reflects a formal legal arrangement between one or more general partners of the LP and one or more limited partners of the LP. A general partner of a Guernsey LP is liable for all of the debts and obligations of an LP and is vested with certain duties and powers with respect to the business of the LP. On the other hand, limited partners contribute or agree to contribute specific sums to the capital of the LP only, and have no liability for any of the debts or liabilities of the LP beyond this amount so long as they refrain from taking part in its management.
Any rights and obligations of the general partner and the limited partners are governed by the LP agreement and any subscription agreements or side letters entered into by the limited partners, and are therefore contractual in nature. The LP’s rights and property of every description, including any right to make capital calls and to receive the proceeds thereof, are held by the general partner in trust as an asset of the LP (and this remains the case even if an LP elects to have separate legal personality).
The typical security package
This contractual arrangement and ownership structure largely dictates the structure of the security package available to lenders offering subscription credit and general partner support facilities to Guernsey vehicles. As previously mentioned, limited partners of an LP will usually commit in the partnership agreement and/or subscription agreement to fund investments or to repay fund expenses when called upon to do so by the general partner from time to time. It is this contractual obligation of a limited partner to make these capital contributions, to the extent that they have not already been called (Uncalled Capital), and the corresponding right of the general partner on behalf of an LP to call for Uncalled Capital (Capital Call Rights), that is at the core of the typical subscription credit facility security package. Given that these rights are contractual in nature and will be governed by the laws of Guernsey, the appropriate form of security over such rights is an assignment of title in the form of a security interest agreement in accordance with section 1(6) of the Security Interests (Guernsey) Law, 1993, as amended (the Security Law).
As legal title to the assets of the LP ultimately vests in the general partner, the Capital Call Rights are exercisable by the general partner for the benefit of the LP. As such, the proper parties to any grant of security over the LP’s assets (and in particular, the Capital Call Rights) must be the general partner as well as the limited partnership (acting through the general partner). The security package must be in strict compliance with the requirements of the Security Law and, ideally, should incorporate an express irrevocable power of attorney in favour of the secured party, entitling the secured party to exercise the general partner’s Capital Call Rights following the occurrence of an event of default.
It should not be assumed that the assignment of Capital Call Rights is necessarily permitted under the LP agreement governing the LP (although it is common enough that the requisite changes to an agreement to permit such security are fairly uncontroversial). The terms of the LP agreement can have a fundamental effect on the structuring of the collateral package and must be reviewed in detail in order to ensure a number of key elements, including but not limited to:
- the ability of the LP to incur indebtedness and enter into the transaction;
- that security may be granted over (a) the Uncalled Capital, (b) the right to make and enforce capital calls, (c) the related contributions, and (d) the general partner’s share; and
- that Uncalled Capital may be applied (when called) towards the secured obligations.
In general partner support facilities, security is also taken under this section of the Security Law, with the collateral consisting of less well-known receivables than Uncalled Capital, such as general partner investor distributions.
Service of notice in respect of security over Capital Call Rights
In order to be effective and comply with the Security Law, any security over a contractual right must satisfy the following two limbs (the Two Limbs): firstly, the secured party must have title to the collateral assigned to it under a security interest agreement; and secondly, express notice in writing of that assignment must be served on the person from whom the assignor would have been able to claim the collateral (for example, in the case of Capital Call Rights, the limited partners).
On this basis, the serving of notice under the Security Law is a matter not just of the perfection of the security; the service of notice is crucial to the creation of the security interest, and without it, no security interest exists. Attention must therefore be given to the sometimes tricky issue of the service of notice on limited partners who may otherwise be unaware of the financing arrangements proposed for the LP in which they invest; funds are often reluctant to serve notice promptly following the signing of the security interest agreement, and it can be important to educate lenders and fund managers as to the implications of not doing so. Where a security interest is granted over Guernsey Capital Call Rights, priority of the security interest over any competing security interest will therefore be determined in accordance with Guernsey law and, given that a valid security interest is only created once both of the Two Limbs have been satisfied, priority may not be established in accordance with the time of execution of the relevant security interest agreements. A delay in the delivery of the notice will therefore open up the secured party to the possibility that a general partner, on behalf of the Guernsey LP, may (quite unintentionally) grant a competing security interest or an absolute assignment over Capital Call Rights to a subsequent assignee. If both security interest agreements have been executed, provided that notice of the second assignment is provided to the limited partners ahead of notice of the first assignment, the second assignee will rank for repayment ahead of the first assignee.
Limited partners are increasingly aware of subscription facilities, and familiarity with the product means that there is now, generally, less resistance by Guernsey LPs to giving notice to limited partners. This has led to notices typically being circulated to the limited partners immediately upon execution of the security documents in order to ensure that security is created and priority is achieved at closing of the subscription credit facility.
Given the importance of actual delivery of the notice to the limited partners, evidence of the notice having been received also assumes some importance. In general, where the limited partners are not part of the same borrower group, it is unlikely that any form of acknowledgment of the notice will be received. It is increasingly common for Guernsey LP agreements to build in provisions that specify the circumstances in which notices delivered in accordance with their terms are “deemed” to have been received by the limited partners.
Where an LP contains such provisions, lenders can take some comfort in proof of delivery of any notice in accordance with the provisions of the partnership agreement (rather than proof of receipt by way of a signed acknowledgment by the limited partners, which is the ideal). On the other hand, due to recent judicial cases, there has been a particular focus on limited partners receiving actual notice of the security being granted. That being so, we would typically require the general partner or manager (as the case may be) to give back-to-back notice to the limited partners, and confirm that it has done so.
In all cases, the recommendation would be that the general partner sign and deliver the notice to the limited partners in accordance with the provisions of the LP agreement governing service of notices on the limited partners, with a copy delivered to the secured party. Where no such provisions are included regarding the service of notice and deemed delivery, it is important to obtain proof of delivery to limited partners (such as receipt of copies of courier delivery slips).
We have also seen an increasing prevalence of limited partners, within the terms of the LP agreement, appointing an agent specifically to receive notice of this nature on their behalf (and indeed, sometimes, to also acknowledge receipt of the notice on their behalf). Wording of this nature should be examined with caution to ensure compliance with the requirements of the Security Law. Increasingly, local market practice is to have the agent sign an acknowledgment to the notice of assignment, containing a specific confirmation that they (the agent) will send the notice on to the limited partners in satisfaction of the requirements of the Security Law (although, see below under “Key developments”).
In addition to facilitating the creation of a security interest, delivery of a notice to a Guernsey LP’s limited partners of an assignment of Capital Call Rights has other distinct advantages. Two of the more important advantages of delivery of the notice include preventing: (i) the limited partners from obtaining good discharge for their obligations to fund their Uncalled Capital in any manner other than as specifically indicated in the notice; and (ii) set-off arising after the date of service of such notice (on the basis of the common law principle that set-off works between the same parties in the same right).
Other elements of a typical security package
The typical security package will also include the grant of a security interest over a designated bank account under the control of the lenders into which any capital call proceeds must be paid. Although the security interest agreement over Capital Call Rights in a Guernsey LP must be granted under a Guernsey law security interest agreement that complies with the requirements of the Security Law, security over such designated bank accounts should usually be governed by the law of the jurisdiction in which the account itself is situated.
Whilst Guernsey is a popular choice for the accounts of both Guernsey and non-Guernsey private equity funds due to the well-established and regulated status of the jurisdiction, it is equally common for such accounts to be sited in the United Kingdom or United States and, in such instances, it would be usual for such security to be granted under a New York or English law-governed security agreement. If the account is Guernsey situate, security should be taken in compliance with the requirements of the Security Law and take the form of a security interest agreement. Assuming that the secured party is not also the account bank, then notice is once again a key factor, and time should be factored in to deal with the requirements of individual account banks who maintain the accounts which are the subject of the security.
Less typical security elements
Other, less typical security packages may include security directly from the limited partners over their interests in the LPs themselves, and, particularly in relation to hybrid facilities and funds nearing the end of their life cycle, security is often taken over underlying assets of the fund, as this is where the fund’s value lies. In Guernsey, these might include shares in Guernsey-registered subsidiary companies, units in Guernsey unit trusts, and/or contract rights arising under Guernsey law contracts. In respect of these asset types, security is taken by way of a Guernsey law security interest agreement, and the formalities to finalise the creation of the security are as follows:
- Shares – notice of the assignment is given to the company whose shares are secured, possession is taken of the share certificates (together with blank stock transfer forms), and the register of members is annotated to reflect the security interest.
- Units – notice of the assignment is given to the trustee of the unit trust whose units are secured, possession is taken of the unit certificates (together with blank unit transfer forms), and the register of unit holders is annotated to reflect the security interest.
- Contract rights – notice of the assignment is given to the contract counterparty and acknowledgment obtained.
With the exception of land located in the Bailiwick of Guernsey, vessels flagged in Guernsey and Guernsey-registered aircraft, there are no registration steps required in Guernsey and there is no general register of security interests in Guernsey accessible to the public. There is similarly no statutory requirement that a Guernsey entity keeps a private register of security interests.
The protection afforded to investors in funds proposed by the AIFMD has been at the forefront of the minds of the entire Guernsey funds industry and has seen increased emphasis on the substance of both funds and fund managers, in particular.
Guernsey has worked hard to ensure that from the outset, its regulatory infrastructure is suitable to enable the distribution of Guernsey-domiciled funds to both EU and non-EU countries. In July 2016, the European Securities and Markets Authority announced its recommendation that Guernsey be included in the first round for the granting of a third country passport for the purposes of AIFMD. Guernsey is still one of only five non-EU jurisdictions to be given such an assessment, and the recommendation (subject to relevant approvals at an EU level) will enhance Guernsey’s position as a gateway to the European funds market. It is anticipated that, Brexit notwithstanding, this enviable position will further strengthen Guernsey’s position in the offshore market in the EMEA time zones and make Guernsey a first point of call for the purposes of structuring funds distributing to both EU and non-EU markets. Guernsey publicly stated its intent to participate in the OECD’s Base Erosion and Profit Shifting (BEPS) Project as an Associate in March 2016 and remains committed to the collective aim to reach a globally fair and modern international tax system. Accordingly, it has signed a Multilateral Agreement to exchange tax information. The Multilateral Competent Authority Agreement provides for automatic exchange of information in accordance with country-by-country reporting by large, multinational enterprises. BEPS refers to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low- or no-tax jurisdictions where there is little economic activity, resulting in little or no overall corporate tax being paid.
In May 2016, the Guernsey Financial Services Commission (GFSC) launched the MLP. The MLP is aimed at alternative investment fund managers (AIFMs) seeking to market into one or more EU Member States under national private placement regimes.
Under the MLP regime, all regulatory standards are borne by the AIFM and, by virtue of the AIFM’s sponsorship, no alternative investment fund or underlying licensee will have rules imposed on it. The MLP regime avoids duplicating regulatory requirements over several entities. Further, derogation requests acceptable to the host country will be considered by the GFSC. The GFSC will be able to register a fund and license an underlying licensee within 24 hours of notification.
The regime is intended to be used by AIFMs seeking to market an AIF into an EU Member State under its national private placement regime. In addition, it is anticipated that the MLP regime will assist Guernsey AIFMs in utilising the EU AIFMD third-country passport (once available) in order to market in the EU. For that reason, the MLP regime anticipates that the AIFM will opt into the Guernsey AIFMD Rules – which replicate the rules of the EU AIFMD.
Until the EU AIFMD third-country passport has been extended to Guernsey, it is unlikely that a Guernsey AIFM would wish voluntarily to submit to the additional regulatory burden of Guernsey’s AIFMD Rules. For that reason, the GFSC has indicated that significant derogations from the MLP regime requirements may be available. The GFSC intends to extend Guernsey’s suite of MLPs to include a similar offering for marketing outside the EU.
Private investment fund
In November 2016, the GFSC introduced a PIF regime that provides fund managers with greater flexibility and simplicity. The PIF, which was developed in response to market demand by the GFSC in consultation with the island’s funds industry, recognises that certain investment funds are characterised by a relationship between management and investors that is closer than that of a typical agent. The PIF dispenses with the formal requirement for information particulars, such as a prospectus, in recognition of that relationship, significantly reducing the cost and processing time of launching of a fund.
The PIF, which can be either closed- or open-ended, should contain no more than 50 legal or natural persons holding an economic interest in the fund. A key strength of the product is that, where an appropriate agent is acting for a wider group of stakeholders, such as a discretionary investment manager or a trustee or manager of an occupational pension scheme, that agent may be considered as one investor. While there is a limit imposed on the number of investors in the PIF, no attempt has been made to limit the number of investors to whom the PIF might be marketed – a feature not available under comparable regimes.
The PIF is predicated on a close relationship between investors and the licensed manager, who will be responsible for providing warranties on the ability of the investors to assume loss. Under the new rules, both the PIF and its manager benefit from an application process that can be completed in one business day. The two processes may be completed in tandem by the GFSC, ensuring a short regulatory timescale.
As a result of certain judicial cases in the last year, we have seen a tightening of legal structures, with increased scrutiny of the way in which security in fund finance transactions is created, or perfected, in foreign jurisdictions.
From a Guernsey perspective, as noted above, service of a notice of assignment under the Security Law is fundamental to the creation of a Guernsey security interest, and so due service on the counterparty must occur contemporaneously with, if not before, completion occurring.
Where we have seen key developments in the market is in lenders’ internal policy requirements for the service of such notices of assignment. The internal policies often contain little to no room for flexibility in the mode of service, regardless of the terms of the partnership agreement, so as to minimise the risk of a counterparty challenging the security on the grounds of non-receipt.
Such a clear movement in internal thinking has given rise to multiple market discussions around the mode of service of notices to bigger funds with larger pools of limited partners; discussions which will no doubt continue to develop over the coming year.
The year ahead
Foreseeing the year ahead would require the ability to read a crystal ball. The fallout from Brexit (which is looking increasingly as though it will take the form of a “hard Brexit”) is difficult to predict accurately. Similarly, it is hard to assess the effect of the election of Joe Biden as president of the United States, given that this constitutes somewhat of an unknown quantity from a European, economic perspective.
The Guernsey market continues to see sophisticated lenders providing increasingly complex and tailored solutions to the funds market, with loans being made to the full cast of players in the funds market including funds, secondary funds (against their LP interests, to finance the acquisition of LP positions and release capital to investors), limited partners and general partners (to help finance general partner and fund commitments). As the funds industry continues to flourish, so will the fund finance industry; the market shows all the signs of continuing to expand in 2021, particularly as we see “series funds”, which may previously have flirted with other jurisdictions, now returning to Guernsey’s shores.
For the original chapter in GLI – Fund Finance 2021 please visit: https://www.globallegalinsights.com/practice-areas/fund-finance-laws-and-regulations/guernsey