Offshore Financial Centers and Deregulation

Syndications and Participation Concepts

One of the core benefits to be derived by virtue of Offshore Financial Centers relate to issues of regulation. The emergence of global capital markets has fostered cutting edge competitive financial environments. In efforts to avert cumbersome regulatory costs, participants in the global economy have sought Offshore Financial Centers to achieve a less burdensome regulatory regime.

Many Offshore Financial Centers have developed legislation to induce foreign financial market participants to avail themselves of a more cost efficient operation. Similarly, international bankers have sought an escape from reserve requirements, deposit insurance requirements, and other burdensome regulatory compliance to compete more efficiently in the global financial markets. (1) These international business ventures also seek to avoid securities regulation. In the process of utilizing the Euro markets, bank syndications must contend with the confines of whether they are subject to security regulations and its attendant compliance expenses. This is an important aspect of the use of Offshore Financial Centers that allows for greatly reduced cost of regulatory processes.

Regulatory Avoidance: Offshore Securities Company

Offshore Financial Centers are designed to accommodate the avoidance of expensive regulation some governmental sovereigns impose. In this regard, the United States is one of the most fully articulated securities regulated systems in the world. It regulates more completely than any other jurisdiction. Its cost compliance is extremely expensive.

There are two basic frameworks to approach issuing of securities by a foreign broker-dealer in an effort to raise capital for a particular purpose. One approach is the issuance of securities by a Foreign Broker-Dealer to United States markets and investors. The other is the issuance of securities by a United States security offering to the public—but to foreign purchasers. To appreciate how the cost of regulation is avoided and the benefits to be gained, it is helpful to review a few basic United States security laws regarding issuing these instruments to the public and to demonstrate the applicability by use of an offshore offering.

The United States federal statutory provision central to this security issuance to the public is Section 5 of the Securities Act of 1933. (2) Section 5 provides that the sale of any security must be accompanied or preceded by a prospectus that is a part of a registration statement. It is the core of the United States securities law of registration requirements. It not only addresses the regulation of selling and offering to sell securities, but also addresses offers to purchase securities. The main underlying purpose of this general section is to provide essential information to the public about an offering prior to it being sold.

Section 5 of the Securities Act accomplishes several basic goals. It makes it unlawful to sell securities in interstate commerce, which includes using the mails and telephone. In addition, it makes it unlawful to offer a buyer, securities unless a registration statement has been filed with the SEC. (2) In connection with the registration requirement of the security sought to be sold, it is unlawful to send a prospectus relating to the security unless it is first registered. (3)

A prospectus is regarded as a writing or a television or radio spot containing information about a company and the securities it is offering. In this information age, technology that accomplishes the same purpose should be considered as a prospectus and subject to this regulation. Therefore, the registration process is designed to place the duty to disclose information through the registration process.

The registration process requires many things and is an expense sought to be avoided. It requires a prospectus be filed with the registration, underwriting agreements, description of the securities, use of the proceeds of the offering plan, a plan for the distribution of the proceeds, and financial statements. The financial statements must provide an analysis of operations that is a very difficult and costly document to assemble. It must list officers and directors, description of the business, the organization aspect of the company, and other detailed inquiries.

Obviously, not only is the registration process an expensive and time- consuming process, it also causes the revelation of very sensitive company materials to the general public. But importantly in seeking to expedite and simplify accessing the United States investor from an offshore location, it is desirable to avail oneself of an exception of exemption from the general registration requirements of Section 5 of the Securities Act of 1933. The SEC has provided such an exemption to Foreign Broker-Dealers. (4) It provides exemptions for broker-dealers’ registration for foreign entities engaged in certain activities involving United States investors and securities markets.

The activities for Foreign Broker-Dealers for which conditional exemption from broker-dealer registration is granted are activities including non-direct contacts by Foreign Broker-Dealers. Those non-direct contacts with United States investors and markets are acts accomplished through the execution of unsolicited securities transactions and provision of research to certain United States institutional investors.

A second activity to be exempted is direct contacts involving the execution of transactions through a registered broker-dealer intermediary with or for certain United States institutional investors. This direct contact is provided for as long as it is done without an intermediary with or for registered broker-dealers, banks acting in a broker or dealer capacity, certain international organizations, foreign persons temporarily present in the United States, United States citizens-residents abroad, and foreign branches and agencies of United States persons. (4)

The underlying purpose in allowing for this exemption of Foreign Broker-Dealers is that the pace of internationalization in securities markets around the world continues to accelerate and multinational offerings of securities have become frequent. Linkages are developing between secondary markets and clearing systems. (5) There is a desire of the investor to trade in financial markets around the world and many major institutional inventors are active on an international basis. (6)

As stated, the general rule requires any broker or dealer using the mails or any means of instrumentality of interstate commerce to induce or effect transactions in securities to register as a broker-dealer with the SEC. By virtue of this SEC Ruling (7), registration is not required on non-direct contacts when a Foreign Broker-Dealer affects an unsolicited trade for a United States investor. It exempts from registration a Foreign Broker-Dealer to the extent that transactions are effected in securities with or for persons who have not been solicited by the Foreign Broker-Dealer. The Commissioner of the SEC views solicitation as most effectively addressed by the staff on a case-by-case basis.

As important, transactions with United States institutional investors are also exempt for registration. The Commissioner of the SEC believes it is desirable to broaden United States investors’ access to foreign sources and therefore supports allowing direct contact between Foreign Broker-Dealers and United States institutional investors, subject to requirements concerning the contacts and the execution of the orders. (8) The rule adopted allows a Foreign Broker-Dealer to contact the United States institutional investor if an associated person of a registered Broker-Dealer participates in each of these contacts. Additionally, it allows a Foreign Broker-Dealer to contact major United States institutional investors without the participation of an associated person of a registered broker-dealer in any of those contacts. In either circumstance, any resulting transaction must be effected through an intermediary registered broker-dealer and any resulting transaction must be pursued through an intermediary registered broker-dealer. (9)

Previously pursuant to a temporary ruling, (10) the United States institutional investors contemplated for this treatment and exemption were domestic banks, savings and loan associations, brokers or dealers registered under Section 15(b) of the Exchange Act, insurance companies, registered investment companies, small business investment companies, employee benefit plans, private business development companies, among others. Registered investment advisors were also included if they had under management in excess of $100 million in assets. The reasoning for this threshold is that the direct asset test was based on the view direct United States oversight of the competence and conduct of a foreign sales personnel may be of less significance where they are soliciting only United States institutional investors with high levels of assets under management. The $100 million asset level is intended to increase the likelihood the institution or its investment advisers have prior experience in the foreign markets that provide insight into the reliability and reputation of Foreign Broker-Dealers. (11)

Banking Syndications

Banking syndication is an expansion from a single bank transaction to multiple bank transactions. One of the underlying reasons for this type of financing is that banks are faced with lending limits and the amount they can lend to any one customer. Bank syndication of a loan is a device to make a larger amount of funds available to a borrower by bringing together a group of banks. This enables the individual banks to avoid exceeding their lending limits to a specific customer.

Lending limits are used in this context as perhaps there is a 10 percent lending limit of capital plus surplus of the bank. Syndication enables it to participate in a loan when it would otherwise be precluded by these limitations. It enables a group of banks to lend close to their lending limitations by coming together as a group to achieve the desired result of the borrower. This can also be achieved by using the mechanism or variation known as participations in loans. There is a distinction between syndication and participation.

In the 1960’s and 1970’s, the Euro Dollar market appeared. The market was comprised of financial individuals who would arrange to put these multi-bank transactions together for a fee. This development took on the characteristics of marketing activity one would generally see in a securities transaction. It was, in fact, a borrowing of the securities concept to make commercial loans available to borrowers with high money demands; those took on the names of bank syndications and participations.

An organizer, sometimes an investment banker, would designate himself as the manager or lead bank. The lead manager would receive either an indication that a borrower desired a loan or would be solicited to find a source of funds. An agreement to funds located was then placed in a document referred to as a mandate. The borrower gives a mandate to the lead manager—a request or order for a certain amount of money.

To illustrate this process, take this circumstance. A lead manager under a mandate to provide $100 million United States dollars finds 5 large financial institutions to contribute to that amount. Each of those banks is a co-manager and takes on $20 million of the total $100 million mandate. In summary, the structure brings together large sums of money, disburses the risk, meets lending limit considerations, and provides organization in which a transaction can be put together without the various participating banks knowing each other.

It is important to remember the crux of the issue with these financial structures. As this structure becomes larger and larger, it approaches a structure similar to the manner in which securities are marketed. The reason for this concern is that under any jurisdiction, securities transactions are subject to very high regulation, whereas commercial banking transactions are not. It becomes a question of whether syndication of commercial loans transmutes into an issuance of securities to the general public.

To understand this question, it is helpful to look to the end product. The end product is a loan agreement developed by the lead manager with the borrower and results in each bank making a commercial banking loan to the borrower. If each loan agreement were a separate transaction, this does not become an issue. When this structure is put into the form of a number of banks participating, it can take on the appearance of a security rather than a banking syndication. (12)

In this financial structure, the rights and obligations the managers owe to the other parties are unique relationships. There is a relationship between the manager and the banks, legal obligations flowing between the parties. The relationship is between the lead manager and the borrower who initially established the mandate. The lead manager negotiates all the terms of the loan transaction with the borrower: the interest rate, term, amount, and the purpose of the use of the funds. That is the nexus of the inherent conflict between the lead manager and the other banks.

Syndicating transactions involves a loan agreement. There are several methods that can be used to structure it. One structure, the participation structure, is done in a manner in which a borrower enters the loan agreement and a contract is established between the borrower, the agent, and the banks. All of those parties are executing parties to the contract. From that loan agreement, individual debt obligations arise as to each bank. Each bank has a promise to pay based upon the agreement issued. Contrast that to the sale of participating units.

At one time, it was common for a syndication governing this to have the borrower enter into a loan agreement with the lead bank. The lead bank acted as the bank for 100 percent of the amount of the loan. The lead bank would subsequently sell participations in the loan to other banks. The legal relationship as to the borrower remained with the lead bank. The lead bank provided 100 percent of the credit; in the event the amount was in excess of its limit, it would sell off the excess to maintain requisite lending limits. The selling off of those units is the participation in the loan. This is the first method of syndication.

That type of structure left the question of the type of interest purchased from the lead bank. It was not a direct debt obligation issued by the borrower. It did not run from the borrower to the bank that purchased the participation. The purchaser was issued a participation certificate—a share in an asset owned by the lead bank in which the bank had title. The individual banks do not have any legal relationships to the borrower; their relationship is with the lead bank. When this syndication structure is used, it raises the question of what the legal relationship is. It also raises the question whether it reaches the threshold of being a public offering of a security.

As to the legal relationship issue, it can be said the lender is issuing debt obligation through the loan transaction and it is a normal commercial banking function. Banks sell their share in their loans to other banks. However, it can also be viewed in another way. The borrower enters into an agreement with the lead bank and the lead bank’s main intent is to sell the interests to the group of banks. There is an appearance of purchasing a share of a loan.

The theory of distinction can be thought of as buying something different as opposed to the purchasing bank making a direct loan, a loan evidenced by a note or debt obligation. From a securities law perspective, it has a different look, which is a consideration with participations and this type of structure. These are more commonplace when a bank is trying to comply with capital adequacy requirements to properly structure their balance sheets to compliance. It is basically a loan-sale transaction in which the bank is ridding itself of loans from their balance sheet.

The primary legal issue is whether the banks purchasing the participating interests have direct rights to enforce against the borrower. If there is no debtor-creditor relationship, there is no right to directly enforce. A participation certificate may not impart that legal right; it is a participation certificate as opposed to a promissory note. A participation structure brings a number of legal issues to a transaction. (13)

A participation certificate often states the lead bank will make the payments to the participating banks as received from the borrower. The language is different with a direct promissory note, reflecting a different legal theory. If the borrower defaults, the participation certificate may not necessarily entitle one to bring enforcement against the borrower. There is no necessary debtor-creditor relationship. This is the underlying reason why most banks prefer a promissory note type transaction that can be defined as a direct debtor-creditor relationship.

The other type of offshore bank syndicating transaction is a direct relationship between borrower and the individual banks. Either method ends up in a loan agreement. It can be structured as an agreement and a contract among the borrower, the agent, and the individual banks. In that instance, all banks sign the agreement. Out of this type of syndication comes individual debt to each bank, which creates a direct debtor-creditor relationship to each bank. That may be a preferred method, but it is weighted against the aspect of multiple parties in the transaction making it difficult to administer.

In addition to the debtor-creditor relationship issues, the taxing of interest payments needs to be considered as well. Normally, a standard clause in the loan agreement of a banking syndication will state the lender is entitled to payments of interest, free and clear of any tax. The location of an agent bank receiving payments may have a bearing on the reality of that function. Again, this underscores the first structure concept, financing and the need to utilize offshore locations not subject to withholding tax from the borrower. This takes into consideration treaty-friendly locations. The implications of withholding tax upon interest payments are a very important aspect in the structuring of banking syndications from offshore.

In the syndication process, it therefore becomes necessary to inquire of each bank whether it will be required to treat the payments pursuant to the loan agreement as income effectively connected with their business in the United States. If so they will be able to provide a Form 4224 (14) required by the United States Department of Treasury to substantiate that treatment. On the other hand, banks in the syndication may be within the confines of a treaty or like treatment and exempt from withholding. If that is the case, the financial institution will be able to provide a Form 1001 (15) as evidence it is not subject to withholding tax by virtue of a double-tax treaty. If a bank proposed for the syndicate cannot come within either of those withholding exemptions upon income of interest payments, its participation must be viewed accordingly.

In summary, the paramount issues to resolve are the question of whether a bank syndication structure can possbily be construed as a security and thus subject to regulatory costs, whether the structure will be one that is simplistic for administering but legally vulnerable on default recourse, and finally, determining how the interest payments are to be taxed.

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Footnotes

1.. See generally, Richard Dale, handbook of International Banking, Prentice Hall Publishers, 1984.
2.. Section 5(a) of the Securities Act of 1933; 15 U.S.C. 78c.
3. Section 5 (c) of the Securities Act of 1933; 15 U.S.C. 78c.
4. Section 5 (b) of the Securities Act of 1933; 15 U.S.C. 78c.
5. See Registration Requirements for Foreign Broker-Dealers, Exchange Act Release No. 27017, July 11, 1989. It became effective as of August 15, 1989.
6. Id. at note 5.
7. See Internationalization of the Securities Markets, Report of the Staff of the U.S. Securities and Exchange Commission to the Senate Committee on Banking, Housing and Urban Affairs and the House Committee on Energy and Commerce (July 27, 1987) (“Report on Internationalization”) at III-43 to III-53.
8. Id. at note 7.
9. Supra at note 4.
10. See Release 34-25801, FR at 23652.
11. Id. at note 10.
12. This was proposed Rule 15a – 6.
13. Release 34 – 25801, 53 FR at 23652
14. Reves v. Ernst Young, 108 L.Ed. 47 (1990).
15.. See Credit Francais v. Sociedad Financiera, 490 N. Y. S. 2nd 670 (1985); also see A. I. Credit Corp. v. The Government of Jamaica, 666 F. Fupp. 629 (S. D. N. Y. 1987).

In accordance with Circular 230 Disclosure

William Richards is a Sole Practitioner in Orlando, Florida, USA 32626. Attorney at Law, Legal Advisor. 1978 – Present

PUBLICATIONS: International Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2012, 378 pages. The Handbook of Offshore Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2004, 266 pages; Offshore Financial Centers and Tax Havens, Archives of Tulane Law Library, Tulane Law School, Tulane University, New Orleans, Louisiana, Copyright, 1996, 512 Pages.

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