The last three years have seen extreme volatility in the global equity markets. Despite this volatility - or perhaps because of it - the offshore hedge fund industry continues to thrive. As investment managers have adjusted their strategies away from the traditional long/short model, they have found a willing pool of investors looking to diversify bruised portfolios with alternative investments.

The jurisdiction at the centre of this activity is the Cayman Islands. To date, 4,580 mutual funds have registered in the Cayman Islands, an increase of over 50% since 2000. Eurekahedge's directory of Asia and Japan Hedge Funds currently lists 253 funds that are domiciled offshore, of which 172 (68%) are domiciled in Cayman.

Other jurisdictions are gaining a share of the hedge fund market, and one of the newer entrants has been the British Virgin Islands (the "BVI"). The BVI has for many years been the jurisdiction of choice for offshore holding companies, but its mutual funds legislation only came into force in 1998. Currently 2,899 mutual funds have been recognised or registered in the BVI, although differences in the criteria used by the jurisdictions mean that direct comparisons are difficult. It is certainly the case that many managers and service providers remain unfamiliar with the BVI hedge fund regime.

This article highlights some of the features common to both Cayman and the BVI; describes the process required to set up a hedge fund in Cayman and the BVI respectively; and examines some of the factors to consider when deciding which jurisdiction to use. A table at the end summarises the key features of the hedge fund regime in each jurisdiction. Although both Cayman and the BVI have legislation applicable to retail funds, this article focuses on non-public hedge funds.

COMMON FEATURES

General

Both Cayman and the BVI are British Overseas Territories, and as such offer all the security and stability traditionally associated with the British flag. Each jurisdiction is responsible for its own internal self-government, while the United Kingdom remains responsible for external affairs, defence and the courts.

Both jurisdictions have an independent legal and judicial system based on English common law, with a right of final appeal to the Privy Council in London. Each jurisdiction benefits from advanced telecommunications, infrastructure and support services, and an educated and well-trained workforce.

In both Cayman and the BVI, policies and legislation have been developed in close partnership with the private sector to ensure that they meet the needs of the financial community. Through this partnership, the respective governments have established sophisticated and efficient supervision and regulation to safeguard their jurisdiction's integrity while creating an operating environment that is highly attractive to private enterprise.

Mutual fund structures

Mutual funds may be formed in either jurisdiction as companies, partnerships or unit trusts, and each such vehicle will be exempt from taxation in the relevant jurisdiction. Companies remain the most common vehicle used and both Cayman exempted companies and BVI international business companies are very flexible entities with no minimum capital restrictions. There are no legal restrictions on the percentage of interests in a mutual fund that may be held by one person or a related group of persons.

Umbrella funds and fund of funds are permitted in both jurisdictions. In both Cayman and the BVI, corporate mutual funds may issue shares in multiple classes or series. Such shares may be issued with or without voting rights. In the latter case, a small number of voting management shares are typically held by the investment manager allowing minor changes to be made to the operating structure of the mutual fund without the need to call a meeting of the investors. Non-voting shareholders would, however, have the right to vote in respect of matters which vary the rights of their shares.

There are no residency requirements for directors, and no requirements for local administrators or local custodians. Neither Cayman exempted companies nor BVI international business companies are required to hold annual board or shareholder meetings.

Investment restrictions

There are no restrictions on the investment policies and strategies of a mutual fund in Cayman or the BVI, and no legal restrictions on its power to borrow, other than those specifically contained in the fund's prospectus or its constitutional documents. There are no restrictions on the arrangements which a Cayman or BVI fund may wish to make with respect to prime brokers.

CAYMAN ISLANDS

Regulation under the Mutual Funds Law (2003 Revision)

The Mutual Funds Law (2003 Revision) (the "Cayman MFL") regulates all mutual funds established in or operating from the Cayman Islands. A mutual fund is defined in the Cayman MFL as a company, unit trust or partnership that issues equity interests, the purpose or effect of which is the pooling of investor funds with the aim of spreading investment risks and enabling investors in the mutual fund to receive profits or gains from the acquisition, holding, management or disposal of investments.

Under the Cayman MFL, an equity interest is defined as a share, trust unit or partnership interest that carries an entitlement to participate in the profits or gains of the company, unit trust or partnership and that is redeemable or repurchasable at the option of the investor (but does not include debt).

The Cayman MFL does not therefore cover (a) funds with only one investor (because there is no "pooling of investor funds"), or (b) closed-ended funds (because the investors do not have the right to redeem or require repurchase of their interests).

With one exception, the Cayman MFL requires all open-ended mutual funds to be regulated. The exception is a mutual fund in which the equity interests are held by not more than fifteen investors, the majority of whom are capable of appointing or removing the operator of the fund. The operator for these purposes means the directors in the case of a corporate mutual fund, the general partner of a partnership or the trustee of a trust. It does not include a manager operating under a contractual arrangement with the mutual fund. This exception is often used in a master-feeder structure to avoid having to register the master fund.

Types of mutual funds

Mutual funds which are required to be regulated under the Cayman MFL must either:

1. apply for and hold a licence under the Cayman MFL (suitable for retail funds);
2. have a licensed Mutual Fund Administrator provide its principal office in the Cayman Islands; or
3. register as a mutual fund under section 4(3) of the Cayman MFL on the basis that (i) the fund's minimum equity interest purchasable by a prospective investor is US$50,000 (or its equivalent in another currency), or (ii) the fund's equity interests are listed on an approved stock exchange or over-the-counter market.

Regulation under the third category is designed for mutual funds with sophisticated investors, who are assumed to be better able to afford professional advice in the management of their affairs. As it is the simplest and by far the most commonly used approach, this article will only describe the procedure involved under this third option.

Procedure to register a mutual fund

The steps required to form and register a mutual fund under section 4(3) of the Cayman MFL are as follows:

1. Form the vehicle, ie. incorporate the company, form the partnership or create the unit trust.
2. Prepare the fund's offering document. This must describe the equity interests in all material respects and contain such other information as is necessary to enable a prospective investor to make an informed decision as to whether or not to subscribe for or purchase the equity interests.
3. Prepare the fund's constitutional documents to reflect the terms of the offering document.
4. Prepare the service agreements, including the administration agreement and the investment management/advisory agreement.
5. Prepare the form of subscription agreement to be signed by the investors.
6. Approve the fund documents. The operator will pass resolutions to approve the terms of the offering document and the service agreements, and to approve the issue of equity interests by the fund.
7. Submit the following documents to the Cayman Islands Monetary Authority ("CIMA"):

   (i) a certified copy of the fund's Certificate of Incorporation/Formation;
   (ii) the offering document;
   (iii) an application form (Form MF1);
   (iv) a letter of consent to act from the fund's auditors;
   (v) a letter of consent to act from the fund's administrator;
   (vi) the registration fee of US$2,440.

The Certificate of Registration as a mutual fund will typically be issued 3 to 5 days following submission of these documents to CIMA. However, the Certificate will be dated the day of submission and this, combined with CIMA's consistency of approach, means that the fund may commence operations from the date of submission of the documents.

Ongoing requirements for a registered mutual fund

The ongoing requirements for a mutual fund registered under section 4(3) of the Cayman MFL are to:

1. submit to CIMA a revised offering document and a revised Form MF1 within 21 days of any change materially affecting any information in the fund's offering document or Form MF1. Common examples of such changes would include a change of directors, alteration of share capital (eg. creation of a new class of shares) and a change of service providers;
2. submit to CIMA audited annual accounts within 6 months of the fund's year end; and
3. pay an annual mutual fund registration fee of US$2,440.

The Cayman MFL also contains enforcement provisions allowing CIMA to inspect the fund's books and records, call for accounting and to take action to protect investors where appropriate. The penalties imposed by the Cayman MFL for breach of any statutory requirement are stringent.

BRITISH VIRGIN ISLANDS

Regulation under the Mutual Funds Act, 1996

The Mutual Funds Act, 1996 (the "BVI MFA") regulates mutual funds carrying on business "in or from within the BVI". This term has been interpreted to include (i) a BVI constituted entity that carries on business in the BVI or elsewhere, and (ii) a foreign constituted entity that carries on business in the BVI. A mutual fund that is not constituted in the BVI is deemed to be carrying on business in the BVI if it solicits an individual within the BVI to purchase its shares except where the purchase is made as a result of an approach made by the individual without any solicitation being made.

The BVI MFA defines a mutual fund as a company, partnership or unit trust which:

1. collects and pools funds for the purpose of collective investment; and
2. issues shares (or similar interests) that entitle the holder to receive on demand or within a specified period after demand an amount computed by reference to the value of a proportionate interest in the whole or part of the net assets of the company, partnership or unit trust.

The BVI MFA does not cover (i) funds with only one investor (where that investor is a mutual fund that is regulated by the BVI MFA), or (ii) closed-ended funds (because the investors do not have the right to receive the NAV of their interests on demand).

Types of mutual funds

The BVI MFA distinguishes between two types of non-public mutual funds:

1. Private fund - a mutual fund whose constitutional documents specify that either (a) it will have no more than 50 investors, or (b) the making of an invitation to subscribe for interests is to be made "on a private basis", ie. the invitation is made (i) to specified persons (however described) and is not calculated to result in shares becoming available to other persons or to a large number of investors, or (ii) by reason of a private or business connection between the person making the invitation and the investor.
2. Professional fund - a mutual fund (a) the initial investment in which, in respect of the majority of the investors, is not less than US$100,000, and (b) whose interests are made available only to "professional investors", ie. persons (i) whose ordinary business involves, whether for its own account or the account of others, the acquisition or disposal of property of the same kind as a substantial part of the property of the fund, or (ii) whose net worth (whether individually or jointly with his or her spouse) exceeds US$1,000,000 and who consents to being treated as a professional investor.

There is little to choose between a private fund and a professional fund from a regulatory or cost perspective. One advantage of a professional fund where timing is tight is that a professional fund may carry on business for up to 14 days prior to being recognised by the BVI Financial Services Commission (the "BVI FSC").

Procedure for recognition of a mutual fund

Private and professional mutual funds are required to be recognised by the BVI FSC. The procedure to form a mutual fund and have it recognised under the BVI MFA is as follows:

1. Form the vehicle.
2. Prepare the fund's constitutional documents to reflect the terms of the offering.
3. Prepare the service agreements.
4. Prepare the form of subscription agreement, which must include appropriate representations as to the private or professional status of the fund.
5. Approve the fund documents.
6. Submit the following documents to the BVI FSC:

   (i) a certified copy of the fund's Certificate of Incorporation;
   (ii) a certified copy of the fund's constitutional documents;
   (iii) a copy of the fund's subscription agreement;
   (iv) an application form for recognition; and
   (v) a statutory notice detailing the address of the fund, its registered agent in the BVI and the fund's business address.

Where all criteria are satisfied, the Certificate of Recognition as a mutual fund will typically be issued 5 days following submission of these documents to the BVI FSC.

The BVI MFA does not require a recognised fund to have an offering document, but the BVI FSC will in practice require as much information about the fund as possible to evaluate the application for recognition. It is therefore advisable to submit a summary of the principal terms of the fund where there is no offering document.

Ongoing requirements for a recognised mutual fund

A mutual fund recognised as a professional or a private fund must:

1. notify the BVI FSC within 21 days of any change to the details in the notice referred to in paragraph 6(v) above; and
2. pay an annual fee of US$350. For the year in which the fund is registered, the fee is US$350 if the fund is registered prior to June 30, and US$175 if the fund is registered after that date.

A professional or private fund is not required to file audited accounts. The BVI FSC is, however, empowered to require access to the information and records of the fund in order to ascertain compliance by the fund with the BVI MFA.

CAYMAN ISLANDS OR BRITISH VIRGIN ISLANDS?

As noted under "Common Features" above, there are a number of similarities between Cayman and the BVI. In deciding where to domicile a new fund, a fund manager is likely to be influenced primarily by factors such as previous experience, personal contacts and where comparable funds are domiciled. Certain differences between Cayman and the BVI which may also guide this decision are set out below.

Cayman Islands advantages

• Industry perception
• Quality of service providers (although many of the leading firms have operations in the BVI as well)
• Segregated cell legislation available to address cross-class liability issues
• Exemption from registration available where closely held fund (see 15 investor rule referred to above)
• Cayman Islands Stock Exchange established in 1997: permits listing of mutual funds

British Virgin Islands advantages

• Cheaper
• No requirement for offering document
• No audit requirement (unlike Cayman which requires that the fund's accounts be signed off by local auditors)
• Fast track procedure for a professional fund whereby it may carry on business for up to 14 days prior to being recognised by the BVI FSC
• Constitutional documents of a BVI international business company may be drafted to allow amendments to be made by a resolution of the directors. No shareholder approval would then be required unless the proposed amendments would vary the shareholders' class rights.

The statistics provided at the beginning of this article clearly demonstrate that Cayman is the preferred jurisdiction for offshore hedge funds. However, with its proven track record as the leading domicile for offshore companies, the BVI is raising its profile in the hedge fund market and certainly merits consideration when considering the domicile of an offshore fund.

SUMMARY