Real World Asset Legal Structure

Real World Asset Legal Structure

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The Real World Finance Core Unit (the “Core Unit”) recommends that MakerDAO (“MakerDAO”), with guidance from the Real World Asset Committee (“Committee”), review the following legal structure to implement financings in the United States and, subject to tax review on a case-by-case basis, other jurisdictions.

This memorandum does not address any Maker token holders’ individual tax circumstance.

Given the decentralized nature of Maker, the Core Unit prioritized (a) the ability of the Maker community to exercise “control” over real world activities and (b) minimizing tax leakage upon repayments of interest by the underlying borrowers (directly or indirectly) to Maker.

The Core Unit proposes to cause the formation of a Cayman Islands Foundation Company (“FoundationCo”) under the Foundation Company Law of the Cayman Islands.

FoundationCo will have substantial organizational and operational flexibility under the Foundation Company Law and can, as a legal matter, be structured in a manner to satisfy the MakerDAO’s requirements and/or concerns.

Further, FoundationCo will avoid many of the existing uncertainties and complexities associated with utilizing Cayman Islands trusts:

  1. there is not a requirement for a charitable beneficiary,

  2. there is no risk of unlimited trustee liability as the foundation company does not have trustees,

  3. FoundationCo’s organizational documents permit the use of arbitration to resolve disputes in respect of its organizational documents,

  4. FoundationCo will avoid some potential adverse treatment from countries unfamiliar with trusts, and

  5. the absence of a trustee means there is not the need for a mechanism to replace and appoint a new third party trustee.

While the Foundation Company Law is a reasonably recent construct in the Cayman Islands (2017), the Cayman Islands Companies Act applies to foundation companies to the extent not specifically addressed in the Foundation Company Law. As a result, the foundation company will benefit from the existing jurisprudence in respect of Cayman Island companies.

Interestingly, the Cayman Islands did adopt some of the beneficial aspects of trusts in the Foundation Company Law. Namely, the “firewall” feature of Cayman Islands trust legislation gives the foundation company protection against adverse judgments by foreign courts in respect of the structure of the foundation company and the transfer of assets to the foundation company. In addition, like trusts, the foundation company may apply to the Grand Court of the Cayman Islands for opinions, advice or directions.

Legal Entity.

FoundationCo will have a legal personality similar to a Cayman Islands exempt company.

Purpose.

FoundationCo may have any legal purpose - commercial, charitable, private or any combination.

Minimum Capital.

The Foundation Company Law does not have a minimum capital requirement.

Members.

At the time of its formation, FoundationCo will have a single-member shareholder. However, the Core Unit recommends, as permitted by Cayman Islands law, that FoundationCo not have any shareholder members. FoundationCo will, at that point, become a fully, bankruptcy-remote, orphaned entity. When FoundationCo ceases to have a member-shareholder, the Foundation Company Law requires FoundationCo to have at least one supervisor.

Supervisor.

The supervisor will have those powers (limited) set forth in the organizational documents for FoundationCo. The organizational documents may provide that the supervisor carry out the decisions of the Maker Community. The Maker Community may elect and replace the supervisor. If the MakerDAO approves the concept of FoundationCo, the Core Unit will propose the scope of powers to be granted to the Supervisor.

Directors.

A board of directors will manage FoundationCo. The board of directors may constitute one or more persons (a director could also be a corporate entity). Any person of full capacity may be a director and the Foundation Company Law does not require a Cayman Islands director. The directors will owe a fiduciary duty to FoundationCo. The Maker Community may elect and replace each of the directors on the FoundationCo board. This will satisfy, at a minimum, the MakerDAO’s preference to have an independent director.

FoundationCo’s organizational documents will provide for the rights, powers and limitations of the directors. The organizational documents could, for instance, require the directors to verify a Maker community vote on a specific matter before taking (or not taking) any course of action.

If the MakerDAO approves the concept of FoundationCo, the Core Unit will propose the scope of powers to be granted to the board of directors.

Beneficiaries.

FoundationCo may or may not have beneficiaries. The Core Unit recommends that FoundationCo have Maker DAO as the Foundation’s exclusive beneficiary.

Secretary.

FoundationCo must have a secretary who is licensed or permitted under the Companies Management Act to provide company management services. The secretarial position will be outsourced.

Registered Office.

FoundationCo must have a registered address. The registered address may be the same as that of the Secretary.

Cayman Tax.

The Cayman Islands does not impose corporate or income tax on foundation companies. FoundationCo may register to be a tax exempt entity and then apply a tax undertaking certificate that will guarantee its tax status in the Cayman Islands for thirty years.

Accounts.

FoundationCo is not required to file or audit its company account.

Funding of FoundationCo.

Maker may make periodic loans to FoundationCo on such terms to be agreed. These loans may, for instance, reflect the underlying loan made, indirectly, by FoundationCo to the real world asset.

Annual Fee.

FoundationCo will have to pay an annual fee in the Cayman Islands. The current annual fee is $854.

Subsidiaries.

FoundationCo may form one or more subsidiaries within or without the Cayman Islands.

For transactions to be undertaken in the United States, the Core Unit recommends that FoundationCo organize, as the sole member, a member managed, Delaware limited liability company (“Delaware LLC”).

Delaware LLC will be the legal entity making loans to the actual real world borrower.

As a member-managed limited liability company, the operating agreement of Delaware LLC can be a “flow-through” of the decision-making processes at FoundationCo. In this way, the directors of FoundationCo will direct the decisions made at the Delaware LLC level.

For transactions in other jurisdictions, for example, the European Union, it may be more advantageous for FoundationCo to organize a subsidiary in another jurisdiction.

Cross-Border Tax.

U.S. Federal Income Tax

Delaware LLC.

The Delaware LLC will be a disregarded entity for U.S. federal income tax purposes unless FoundationCo elects to “check the box” and have Delaware LLC treated as a corporation.

As a disregarded entity, Delaware LLC will not be subject to U.S. federal income tax and, for the purpose of U.S. federal income tax, FoundationCo will be viewed as the entity receiving interest income from the underlying borrower.

Foundation Co.

FoundationCo itself should not be subject to United States federal income tax so long as it is not “engaged in a US trade or business”. “Trading in stocks or securities for the taxpayer’s own account” is expressly excluded from being “engaged in a US trade or business”. The term “securities” generally means any “note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing.” On this basis, FoundationCo itself should not be subject to United States federal income tax.

However, to benefit from the securities trading safe-harbor, FoundationCo must assure that its loan trading activities amount to trading securities and not loan origination. Absent any facts indicating that Foundation Co was involved in arranging, the purchase of loans (secondary market acquisitions) should be considered the purchase of securities and should fall within the securities trading safe-harbor. However, if FoundationCo is treated as originating a loan (either directly or indirectly) then such loan origination may expose FoundationCo to US federal income taxes.

Further, to the extent FoundationCo is regularly in the business of making loans to US borrowers, negotiating loan documents in the US and engaging in other regular and systematic business in the US, FoundationCo may itself be subject to US corporate income tax (21%) and a branch profits tax (30%). To address this risk, there may be multiple FoundationCo and Delaware LLCs organized on a deal-by-deal basis or, at a minimum, after a few number of loans.

The acquisition of securities (e.g., US Treasuries) on the secondary market will be considered a passive activity and FoundationCo will not be considered as engaging in business in the US for tax purposes.

Withholding Tax on Interest Income.

Generally, the underlying borrower will have an obligation to withhold a 30% tax on the interest it pays to FoundationCo (indirectly through Delaware LLC). This 30% tax applies to cross-border, US-source “fixed, determinable, annual, or periodic” (FDAP) payments. These payments include interest, dividends, and royalties.

Because FoundationCo should not be “engaged in a US trade or business” and therefore outside the jurisdiction of the Internal Revenue Service (“IRS”), the FDAP tax law imposes the withholding tax obligation (and liability for nonpayment of the tax) on the payer rather than the recipient. The payer, as a withholding agent, is required to deduct and pay any required withholding tax and report the payments and withholding to both the recipient and the IRS.

Notwithstanding the 30% tax on FDAP, FoundationCo may qualify for the “portfolio interest exemption”. The “portfolio interest exemption” exempts certain interest income from U.S. withholding tax. Each loan made by Delaware LLC will need to incorporate the “portfolio interest exemption” requirements. These include:

  1. The debt instrument is in “registered form” (basically meaning that the identity of the holder of the debt instrument (i.e., Delaware LLC) is registered by the issuer (i.e., the Borrower) or the issuer’s agent or the debt instrument is held in a book-entry system – i.e., the debt instrument is not a bearer instrument);

  2. FoundationCo does not own 10% or more of the capital or profits interests of the payor of the interest (i.e., the borrower);

  3. FoundationCo provides the borrower (as payor of the interest) certain documentation regarding the recipient’s non-U.S. status, including IRS Form W-8BEN or W-8BEN-E; and

  4. FoundationCo is not a bank.

To mitigate any adverse tax consequences, Delaware LLC may require that the underlying borrower gross-up its payment of interest to include the withholding tax. This may be a point for commercial negotiation as it will increase the underlying borrower’s costs and the borrower may require a more efficient tax structuring.

In addition to the tax consequences for Delaware LLC, there are further legal issues in the Cayman Islands to consider.

Cayman Islands “International Tax Co-Operation (Economic Substance) Act

The Cayman Islands recently enacted the “International Tax Co-Operation (Economic Substance) Act” (the “Act”) to ensure the Cayman Islands’ commitment to the OECD’s Base Erosion and Profit Shifting Inclusive Framework.

The Act mandates that all Cayman Islands entities (subject to limited exceptions) must satisfy certain economic substance requirements in the Cayman Islands and submit an annual return to the Cayman Islands attesting to that satisfaction. Cayman Islands trusts are currently exempt from the economic substance requirements application to foundation companies and other companies.

If FoundationCo makes equity contributions into Delaware LLC (as opposed to shareholder loans), FoundationCo will qualify as a “Pure Equity Holding Company” under the Act. As a Pure Equity Holding Company, FoundationCo will have to demonstrate that it has adequate human resources and premises in Cayman for holding and managing equity participations in other entities. The Cayman Islands has issued guidance that states that a Pure Equity Holding Company may engage its registered office service provider in the Cayman Islands to satisfy this reduced economic substance test depending on the level and complexity of activity required to operate its business.The requirements for a Pure Equity Holding Company are lower than those for a Cayman Island company engaged in a financing business outside of the Cayman Islands.

Ogier (Cayman Islands) and Latham & Watkins (US tax) have advised on certain matters addressed in this submission.

The Core Unit has not investigated other potential structures utilizing legal entities established in jurisdictions that may benefit from a treaty with the United States for the avoidance of double taxation. There may be legal entities in other jurisdictions that afford the same level of flexibility as the Cayman Islands foundation company. However, such jurisdiction by jurisdiction review is outside the scope of this submission.

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Hello Christian–I was reading on a blog by Bedell Cristin (Guernsey/Jersey/Cayman Law) that “The creator of the FC may, but need not be, specifically named as the founder.” If needed, would the “founder” of FoundationCo fall on the Secretary, or the Supervisor? Or, none.

Also, there’s no need for FoundationCo to have a physical office since you can outsource to the Secretary, correct? If so, where does the Supervisor need to reside?

The “Founder” of a Foundation Company is like the promotor of any other Cayman company that is newly organized. In the Maker context, I do not anticipate that the Founder will have any continuing rights in FoundationCo.

FoundationCo will have to have a physical address, and this will typically be outsourced to the Secretary . . . which must be a Cayman Islands person.

The Supervisor does not need to be in the Cayman Islands.

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Hi Christian,

Thank you for the informative memo. I may circle back on this later but one quick question comes to mind: are we thinking of this structure as a wrapper for the entire DAO or simply as a real-world entity that can interact with other real-world partners for various services (potentially providing KYC for institutions, for example).

Tosh

The latter … an entity to interact with real-world partners in respect of real world assets.

Great job Chris! So it seems that this structure will work if MKR is buying the notes, instead of providing credit facilities. That is still good and MKR is becoming an alternative to Fannie Mae.
However, is it so important to avoid US taxpaying? It could be beneficial for MKR to pay taxes in the US in long term.

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Solid piece of analysis, Christian! I had a question on the gross-up you mention:

Is this because the application of the portfolio interest exemption is uncertain? The gross-up to cover for 30% WHT is not very attractive and makes us less competitive.

Thank you Maarten. The “portfolio interest exemption” is well defined in US tax law. Commercially, MakerDAO may want to propose the tax gross-up as a potential mitigant (agreements always seek to address the possible (even if unlikely)). Of course, a sophisticated borrower would then seek to have the loan made by Delaware LLC made from a more tax efficient jurisdiction to reduce its costs. This type of back and forth is common in international lending transactions. I only identified the mitigant for purposes of completeness. I fully understand the concern about “competitiveness”.

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Why do you prefer this structure over a trust that follows the 6s model?

With this kind of custom structure that doesn’t involve a trust or another regulated, reliable neutral party, it’s hard to predict what will happen if some of the centralized actors that act as agents of the DAO go rogue.

IMO the trust model is superior because there is actually a level of certainty that it will behave as expected (with the assumption that we can trust the trust companies and their legal frameworks) and in general it seems so obvious to me that the trust model is the perfect fit for a what a project like Maker needs, as it is the closest thing to a “smart contract” in the legal world, where actual hard recourse against the collateral exists. I don’t understand why it is being overlooked and instead alternatives like this are promoted without explaining what makes them superior, safer and have better recourse compared to a trust.

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@Replenish2030 , I will let @christiancdpetersen explain more in detail, but it’s based on:

  • legal advice from a law firm
  • giving more control to the DAO

It is not designed to be less secure than a Trust. The supervisor and most (all?) directors can be professionals which a high reputation at stake (same level as Trustees). The Trust still has a limitation in what Trustee accepts to do and need to be supplemented by more autonomous third parties. In this case, MakerDAO will be the beneficiary and will be able to discuss with the Foundation through the blockchain. So we guess it will be easier (but probably not enough, we will see).

It is our view that the Foundation gives us more flexibility to express exactly what we need with no clear downside except the name.

From the Ogier memo:

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The trust model has both its advantages and disadvantages. As an advantage, you correctly point out that the trustee will act as expected. At the same time, this is a disadvantage, as the trustee will generally not act without instruction from someone (a natural or legal person). One other potential disadvantage of the trust structure, and one of the reasons the Cayman Islands created the foundation company construct, is that trusts tend to be cumbersome and, at times, complicated to operationalize.

In terms of the “rogue” actor, this does present a risk in either scenario as both the foundation company and the trust require a person (or persons) to make a decision. Remember that trusts do not independently act without instruction.

There are potential strategies to address the “rogue actor” scenario. And in the first case, it is important to specifically identify what scenarios need to be addressed. On the assumption that “running off with money” is probably the most relevant concern, there are contractual mechanisms to address this risk . . . including contractually binding written directions re funds flows, requiring more multiple signatories above certain amounts (or any amounts) and/or requiring the sign-off an independent director.

After discussions with Cayman counsel, we concluded that the foundation company concept may afford more structuring flexibility to Maker than the Cayman STAR trust. Cayman counsel advised that we NOT use the charitable trust.

I am unclear what you mean by “actual hard recourse against the collateral”. Neither the trust nor the foundation company structure creates this recourse. This recourse, if any, is created by perfected security interests under applicable law.

I have added a link that provides a summary of the differences between a STAR trust and a Cayman foundation company.

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Hi !

I have been lurking in the Maker forum for a certain time and this subject piqued my interest as I have previous experience with solar projects.

I was just wondering, how do you envision the scenario where there is a default on the part of SolarX? Also, what kind of oversight do you think will be required concerning the progress of this project over time?

Thank you

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Thank you for the questions. In the case of a DAO as lender and any off-chain real world assets, a borrower default presents a unique set of issues as the lender will have to take real world actions against collateral (if any). This is obviously different than a code-based smart contract. This situation presents itself in either the trust or foundation company model.

We are working on the governance aspects of the foundation company, but in terms of real world actions against collateral, it is reasonable to anticipate that any actions to enforce against collateral will be done at the direction of a Maker DAO vote. This is not disimiliar to what a trustee will require.

For Solar X specifically, Maker will want to preserve the power purchase agreement . . . which is the sole source of revenue. But, from my perspective as a project finance lawyer, this is not any different than any other power project or other similar energy project that is dependent on one or more long-term offtake contracts. This right to preserve the PPA is typically effected through a direct agreement with the offtaker, in which the offtaker agrees not to terminate the offtake agreement without giving the lender an opportunity to cure the default.

Obviously, the reliance on the power purchase agreement vs a collection of receivables or the potential for new tenants is a material difference between project finance and other types of financings (receivables or real estate).

In terms of oversight during construction, Solar X can be requested to provide written updates on the construction process. In the absence of an independent engineer to verify those reports, the lender will have to rely on their accuracy.

Of course, the lender can mitigate this risk further by either (1) engaging an independent engineer to verify the reports (only a cost issue (which in my experience is typically paid by the borrower)) or (2) making its loan at the completion of construction.

Option (2) clearly eliminates the associated construction risk.

In terms of oversight during operation, there are many potential options from comprehensive oversight (e.g., if there was technology-related risk) to none at all (where the facility is plain vanilla and with proven technology). Given that solar farms are not, compared to other power projects, technically complicated to construct or operate, it would seem that Maker may not require the more comprehensive solutions.

But as we have not yet embarked on the negotiation of the loan agreement, I will admit that I have not sought out any comparables to benchmark this particular issue.

I hope that I have responded to your questions.

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Shouldn’t the Maker Community take the same approach for all Construction Projects? How does Deutsche/Nomura conduct/maintain oversight of a construction site in London/New York? I can’t imagine they hand out money and let the builders do as they please. But I could be wrong.

And what happens if Solar X goes over budget ? Construction projects can be opaque. How does that work? Will there be covenants that include a renewal or extension of loan terms, extension of additional credit, or a restructuring with, or without concessions? Just wondering.

Also, should the Maker Community have policies/procedures that dictate when collateral valuations should be updated/revised, and maybe keep up with credit review? I mean market conditions change right, and a borrower’s financial status can easily deteriorate. We have seen this movie before haha

Alright I think we might have gotten out of subject here :slight_smile:

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I love innovative legal structuring and thinking like this. Great work. I look forward to working with you publicly and / or privately to see how and where our two unique structures can work together.

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Given @christiancdpetersen project finance experience I believe we shall sleep well at night :wink: Option (2) would be the greatest but in general money disbursement in tranches based on realized milestones (PPA signed; PSPA signed; positive DD, etc.) should work nicely too. Of course, not to mention earlier risk assessments, e.g. whether it’s an experienced developer/investor or is it basically a venture debt…

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Absolutely. To go back to your answer @christiancdpetersen, I do believe the progression of construction should be monitored and verified by either a trusted third party or an in-house individual with appropriate skills. Otherwise, I would echo @ElProgreso

When the project will be up and running, there are many monitoring platforms that are often used by solar project managers which Maker could (maybe?) have access to which would simplify things greatly.

Looking forward to seeing further developments.

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