The Cayman Sandwich: Risks for Institutional and Venture Capital Markets Development

The entrepreneurial landscape in Latin America has evolved dramatically in recent years, transitioning from mostly closed markets comprised of traditional business models to emerging innovation hubs. Global venture capital (VC) investors have increased their presence in the region, leading to the rise of unicorns in sectors such as fintech, e-commerce, healthtech, and agtech. Despite these advancements, international VCs are still hesitant to invest directly in Latin American startups. Instead, they usually require founders to create a three-layered corporate structure in which the Latin American startup is owned by a Delaware LLC, which in turn is owned by a Cayman Islands holding company. This structure, known in market jargon as the Cayman Sandwich, is primarily aimed at enhancing investor protection and has enabled a growing number of companies to access larger pools of capital. What, if any, are the tradeoffs of its adoption?

In a recent working paper, we offer the first critical analysis of the Cayman Sandwich. We begin by identifying two overlooked costs of this structure. On the one hand, direct costs associated with the creation and operation of legal entities in three different jurisdictions. On the other hand, and most relevantly, indirect costs for institutional and VC markets development. By exporting the finance and governance of startups, the Cayman Sandwich hampers opportunities for domestic contractual innovation and the development of a body of jurisprudence in corporate law and financial contracting that can assist judges and practitioners. Furthermore, while in the wake of the 21st century, many Latin American countries have pushed legal reforms to corporate statutes and financial regulations that might ultimately help promote VC, the widespread use of the Cayman Sandwich makes it more difficult for local policymakers to distinguish the policies effecting positive change from those who are not.

To the extent that addressing the underlying motives for the use of the Cayman Sandwich can directly benefit startups and contribute to institutional and capital markets development, it is imperative to focus on investors’ concerns. In that regard, we distinguish perceived from actual legal risks. We argue that the former are the result of outdated (if not plainly wrong) assumptions about limited freedom of contract in civil law jurisdictions as well as legal indexes, which are influential but imperfect measures of the quality of the law, especially as it relates to VC. Dissecting perceived risks requires better communication from governments and collaboration between domestic institutions, but not necessarily changes to legal systems.

Finally, we identify three sets of actual legal risks that merit further study and discussion:

• Investor liability. This risk emerges from inconsistent approaches to piercing the corporate veil that expose VC funds and their limited partners to potential liability. While some countries, like Brazil, have taken steps to limit the liability of limited partners through regulatory reforms, a clear, consistent approach to when corporate liability extends to shareholders is still lacking. Addressing this issue through legal reforms could provide much-needed certainty for investors.

• Corporate law. Corporate laws in Latin America often prevent startups and investors from replicating standard US VC investment structures, limiting the flexibility to negotiate and enforce agreements. While some countries, such as Chile and Colombia, are making progress with more flexible corporate forms and binding shareholder agreements, these developments are not uniform across the region and have yet to be tested judicially.

• Enforcement. The lack of specialized decision-makers renders Latin American legal systems less adaptable to dynamic business environments. Two specific developments could inform solutions. One is requiring mandatory arbitration of corporate legal disputes in venture-backed companies, a solution adopted by Chile and Brazil. Another is Colombia’s creation of a specialized court for corporate disputes that operates within the executive branch. To be sure, these measures have limitations. Arbitration restricts the development of a consistent, publicly available body of case law, and Colombia’s quasi-judicial body raises concerns about judicial independence. Still, considering the difficulties of a comprehensive reform to the judiciary, they represent concrete alternatives to mitigate actual legal risks for international investors in the short and medium term.

In conclusion, while the Cayman Sandwich structure has facilitated the growth of Latin American startups by attracting global VC investment, it comes at a significant cost to the region’s institutional and VC markets development. The indirect consequences of exporting corporate governance and financial transactions to foreign jurisdictions stifle local legal innovation and hinder the assessment of the impact of domestic reforms aimed at fostering a more vibrant VC ecosystem. Addressing both perceived and actual legal risks is crucial for reducing the need to rely on this structure. Governments, market participants, and academics should focus on dispelling obsolete assumptions about Latin American legal systems, while policymakers must consider implementing legal reforms that provide more robust investor protection, greater flexibility in corporate governance, and more reliable enforcement mechanisms. By doing so, Latin America can reduce the costs of the Cayman Sandwich, allowing its legal systems and VC markets to evolve alongside its entrepreneurial ecosystem.

The authors’ paper can be found here.

This post is published as part of the special series ‘The Law and Finance of Private and Venture Capital’.

Raphael Andrade has a PhD in Corporate Law from the University of São Paulo (USP) and is a Partner at Andrade Chamas Advogados.

Alvaro Pereira is an Assistant Professor of Law at Georgia State University.