Protected Cell Companies - A Vehicle For Multi Asset Structures?

Introduction

The concept behind Protected Cell Companies (PCCs) is to provide a single corporate vehicle which has multiple separate identities for bankruptcy purposes. This concept is not entirely new as, for example, the insurance market of Lloyds of London provides one legal entity that issues policies but which is not affected if one of the underwriting participants or syndicates goes bankrupt. The legal concept involved is that of ring-fencing the activities of certain participants in a corporate vehicle so that in the event of a bankruptcy, or some sort of corporate reorganisation, each parcel of assets represented by a cell would have to be treated separately.

At first sight to the Anglo Saxon practitioner the concept of the PCC may seem somewhat devious but if the matter is thought about logically then the concept of a PCC is not so strange. For example, in a Limited Partnership (“LP”), the partnership could become bankrupt but the limited partners would only be liable to the partnership capital they have already contributed. Similarly, in a collective investment scheme, which was in the legal form an umbrella fund, there are a number of sub-trusts gathered together under a master trust, each of which has a separate legal personality.

Therefore, the object of the PCC is to provide a corporate vehicle which provides perpetual succession (ie it does not die when its members die), unlike a partnership, without at the same time making all the assets in the vehicle available to the general creditors of the corporation.

Overview

In order to fully grasp the concept of the PCC vehicle, it is necessary to understand the evolution of business forms that western capitalism has devised in order to facilitate economic activity. Clearly each form of vehicle has its advantages and disadvantages and governments have been careful to always balance shareholder rights against potential creditor rights in order to promote the smooth working of the capital markets. If, for example, shareholder rights are too deeply entrenched then the owners of capital will be reluctant to provide funds for business ventures, whilst on the other hand if creditor rights are too deeply entrenched, entrepreneurs and venture capitalists will be deterred from generally providing funds. As noted earlier, there are a number of trading vehicles each having different strengths and weaknesses in balancing shareholder against creditor rights have evolved.

  1. The most simple of these is, of course, the sole practitioner or trader, who trades exclusively in his own name but is fully liable to any and all creditors for his engagements.
  2. The next possibility which has evolved is the general partnership, where one or more people join together in some common enterprise with a view to making profit. However, under this structure not only is each partner fully liable to the extent of his personal wealth for creditor claims but he is also liable for claims made against his partners (i.e. joint and several liability).
  3. After a general partnership, the next possibility is a limited partnership, which typically comprises one general partner and one or more limited partners. Here again the general partner is fully liable to the extent of his personal assets for claims made against the partnership.
  4. Next is the limited liability partnership. In this structure all partners (i.e. even the general partner) have claims against them limited to the size of the partnership capital.
  5. The next possibility is the corporation, which is a fully artificial legal personality as it can sue and be sued in its own name. The funding of creditor claims is limited to its paid up share capital non-distributed reserves. While claims against its shareholders are limited to the amount of their capital contributed and/or any capital un-provided at the date of the bankruptcy.
  6. The final evolution of the corporate vehicle is the PCC, which being a corporation has perpetual succession unlike a partnership which technically ceases when any partner dies.

    However, on the other hand not all its assets are available to meet general creditor claims. In the PCC structure (see Figure 1) there is a core of ordinary share capital which is available to the general creditors of the company but there are also cells, which are capitalised by preference shares and such cells are only liable to claims against them to the extent of the assets held on behalf of the cell concerned. Here creditor and shareholder interests are balanced by requiring the corporation to use the words “protected cell company” in its title, in return for which certain creditor claims are limited to the assets of the cell which was carrying out the business in question.

FIGURE 1

Case Studies

PCCs can be formed in relatively few jurisdictions, the most prominent ones being Nevada, the Isle of Man, Guernsey, Mauritius, and Bahamas. It should be noted that Jersey is expected to introduce PCC legislation in early 2004.

As can be imagined all the governments concerned have gone to considerable lengths to try to protect their jurisdiction from criticism by stating quite explicitly that the corporation concerned is a “protected cell company” in its legal name. This is to ensure that suppliers and other third parties fully understand that they are dealing with the protected cell entity. In other words, considerable effort has gone into ensuring that suppliers are not misled by the nature of any claims they may have against the PCC. At the moment PCCs are used for two major types of work, these are mutual fund structures and insurance based products.

In the mutual fund structure underlying assets are kept in the PCC’s name for the account of a specific cell. That cell will effectively be a sub-fund and will have assets which produce either high growth, income, a balanced portfolio, or special situations. Investors buy into a relevant sub-fund by buying preference shares issued just by that cell. If members wish to move from one fund to another, they merely redeem the preference shares in he fund they are already invested in and request shares from another cell to be issued to them instead. The managers then merely re-balance the funds at the end of each dealing day by selling investments held to the order of the cell that has had a net loss and re-investing in investments which underpin the cell which has had the corresponding net gain. The main thing to understand is that all the underlying investments are held collectively in the name of the entire PCC and if there is relatively little real movement between the cells in any particular dealing day, then underlying assets merely have to be re-designated rather than sold in favour of the cell which has got the higher new worth. In other words, by using a PCC there could be huge savings in dealing costs and stock transfer costs, which obviously could be passed on to the investor by way of a keener preference share price.

Another use for PCCs is to issue special purpose insurance policies out of individual cells. A PCC insurance company should be seen as a general alternative to the captive insurance company, which was traditionally created to insure just the risks of one particular trading group, all the subsidiaries of which were in common ownership. In the captive insurance situation a special purpose insurance company (“SPIC”) was set up. This was typically owned by a trading group and the SPIC would then be used to insure the various types of risk that the group had, such as overseas creditors, real estate risks, and indeed public liability risks of a special nature.

A perceived weakness of the captive insurance company was that tax authorities could say that the nature of the transaction was not real insurance, in that there is no transfer of economic risk to an external third party. To overcome this criticism PCC insurance companies were set up where the core or ordinary share capital (see figure 1) is owned by a third party insurance company and the large number of cells can be owned by trading companies who wish to insure their own risks. Actuaries would ascertain suggested premium rates for each type of risk being covered. A certain number of PCC preference shares per cell would be issued (usually with the permission of the relevant regulatory authorities) to capitalise the risks assumed under the policies. Policies at the risk of identified cells would then be issued in return for a premium (payable to the cell in question) received from each policyholder.

There are two principal effects from this structure. The first one is a business or management effect, in that all risks of a particular type arising in a group can be insured through a particular cell. This would have the effect of aggregating these risks, thereby allowing the group to purchase a proportion of its cover on the general insurance market at a wholesale rather than a retail rate.

The other effect, if the cover for the risk in question is either not available in the commercial market or uneconomically expensive thereby effectively forcing the group to self-insure, will be to create an onshore tax deductible insurance premium. This is typically paid by fellow subsidiaries to a PCC offshore so that a tax efficient self-insurance fund can be rapidly built up.

The final use for these types of vehicle is typically found in North America where they are sometimes used as real estate holding entities. The theory being that each building is placed in a separate cell so that when the corporation accounts are viewed on a consolidated basis a true understanding of its real estate position can be easily ascertained. However, with regard to creditor claims, each building if owned through a separate cell would be held on a stand-alone basis, thereby mitigating the dreaded “trip and fall” claims that are endemic to US real estate.

Commentary

As will be seen from the case study section, there appear to be a number of perfectly valid business cases for the protected cell vehicle. However, some writers have indicated a worry that such vehicles could be misused to frustrate perfectly proper creditor claims. The theory behind this argument is that the general body politic is not familiar with PCC operations that would therefore be misled in their dealings with this type of commercial entity as to their rights as creditors in the event of an insolvency. However this argument is difficult to sustain when considered in the light of LP and LLP entities, which have some of the ring-fencing characteristics as the PCC.

Another difficulty is how foreign judges may treat the vehicle. They may take the view that because PCCs do not exist in their jurisdiction that on public policy grounds they would ignore the title of assets being assigned or held for particular cells. Clearly if this were the case it would have disastrous results for the assets held in the other cells, where under the law of the domicile of the PCC these would be segregated and separate from the assets of the bankrupt cell. This would be highly undesirable but until a case actually comes to court in a particular jurisdiction it is somewhat difficult to see how the judiciary may deal with a PCC and the assets that it holds.

Conclusion

The PCC is obviously an attractive vehicle for the modern world in that it is theoretically flexible about the types of asset it can hold and can present one unified balance sheet for review and analysis purposes, whilst at the same time for bankruptcy purposes keeping the title of assets remote from general creditor claims. As noted above, the difficulty is that not many jurisdictions have PCC legislation and one must therefore be somewhat cautious in holding assets in such a structure outside the jurisdiction where it is domiciled.

PCCs are obviously of great use in the mutual fund industry and also the insurance industry. They could possibly by of great use in the fullness of time for holding shipping assets and possibly real estate assets. What is really required is for some major onshore jurisdiction, such as the UK or Germany, to pass PCC legislation and for it to become widely acceptable in either Western Europe or North America.

It may be in years to come that the use of PCCs will become much less restrictive in that perhaps the relevant regulatory authorities may come round to the thinking that the ordinary share capital should be issued to a regulated financial institution, and thereafter the cells could be used for any type of asset holding purposes. The thinking here being that at the moment the regulators are seeking to protect the public by restricting the use of PCCs to only certain types of business. Perhaps the public would be better protected by restricting the ownership of ordinary share capital to properly regulated entities which could be made to account for their use of the vehicle if it was put to some undesirable purpose.

It does seem that gradually more and more jurisdictions are beginning to permit PCC legislation, given that it is a very useful and flexible vehicle for permitting financial services. Similarly the public cannot be misled into whom they are contracting with because of the insistence on the form of words in the name. Also the judiciary in Western European jurisdictions, as well as North American jurisdictions, must become more familiar with the PCC form and hopefully would give recognition to it in the event of a dispute between a PCC preference shareholder and a creditor.