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Hedge Fund Monthly

Hedge Funds in the Cayman Islands
Spencer J. Privett, Maples and Calder Asia, Hong Kong

October 2003

The Cayman Islands make up the world's fifth largest financial centre. There are approximately 580 licensed banks and trust companies in the Cayman Islands with assets of around US$747.6 billion. 47 of the world's 50 leading banks have a presence in the Cayman Islands.

The Cayman Islands is one of the leading offshore jurisdictions for funds with over 3,600 regulated mutual funds. There are also a significant number of unregulated funds in the Cayman Islands which fall under available exemptions. In the last few years, the Cayman Islands have emerged as the jurisdiction of choice for many hedge fund managers. In fact, it has been estimated that over 80 per cent. of all new offshore hedge funds are domiciled in the Cayman Islands. Why are the Islands such an attractive jurisdiction?

Legal Framework

The laws of the Cayman Islands are substantially based upon English common law, and a number of "key" English statutes with the addition of local statutes which have in many respects changed and modernised the common law to reflect the demands of the global financial industry. This gives Cayman Islands law and legal system a common origin with those of many of the jurisdictions of its users. It also means that the fund vehicles available and the types of securities offered by them are well recognised and accepted around the world.

Structures Available

There are three main structures available: the company, the unit trust and the limited partnership.

Unit trusts are particularly favoured by promoters wishing to market their funds to investors in Japan. This is because participations in a unit trust are considered more acceptable or attractive than shares in a company or interests in a limited partnership. Units may result in more favourable tax treatment for the investor or, in some other jurisdictions, offer regulatory advantages.

Cayman Islands trust law essentially follows English trust law and employs the substantial body of English case law on the subject. The concept of a unit trust is that subscribers contribute funds to a trustee which essentially holds those funds as custodian whilst they are managed by the investment manager for the benefit of the subscribers, known as unitholders. Each unitholder is entitled to a pro-rata share of the trust's assets.

For investors outside Japan, the most common vehicle for mutual funds in the Cayman Islands is the company.

Companies are almost always incorporated with limited liability; although it is possible to incorporate companies with unlimited liability or with liability limited by guarantee. The liability of a shareholder of a company incorporated with limited liability is limited to the amount paid up and agreed to be paid up on the shares taken by that shareholder.

Shares of the same class in a company rank equally with each other. However, by appropriate adaptation of the articles of association (constitutional documents) of the company, it is possible to create separate share classes (or separate series within the same class). This may be necessary if, for example, performance fees payable to the investment manager are to be calculated on a per investor basis or if certain categories of investors are not permitted to participate in certain assets or classes of assets.

The vast majority of Cayman Islands companies issue shares of a stated par value (although no par value shares are permitted). The Cayman Islands legislation permits amounts standing to the credit of a company's share premium account to be used for dividends or other distributions, subject to the company being solvent, even if no profits are available.

Shares in a Cayman Islands company may be redeemed or repurchased from capital, subject to the company being able to pay its debts as they fall due in the ordinary course of business.

The other major form of investment vehicle which the Cayman Islands currently offers is the limited partnership. The limited partnership concept is essentially similar to that which applies in the United States and indeed the Exempted Limited Partnership Law of the Cayman Islands is based substantially on the Delaware equivalent. For that reason, the limited partnership is very popular with United States promoters and their advisers.

Each of the available vehicles can be used to create any investment fund structure including master/feeder, multiclass, umbrella, multiple allocator (replicating partnership accounting in a corporate vehicle) and hybrid debt/equity structures.

Fundamental Advantages

In addition to its legal framework, the Cayman Islands offers the following fundamental advantages for establishing mutual funds:

Quality of Local Service Providers

The quality of the service providers (attorneys, mutual fund administrators, trust companies, company managers, etc.) in the Cayman Islands is generally very high. Of particular interest to Japanese fund managers and promoters is that there are Cayman Islands service providers located within the Asian region making the Islands an extremely convenient jurisdiction for offshore funds.

Speed of Formation

The fund vehicle can be established very quickly, usually within one working day of the constitutional documents being settled, and without the need for any prior governmental approvals.

Absence of Tax

The Cayman Islands have no direct taxes of any kind. There are no income, corporation, capital gains, withholding taxes or death duties. Under the terms of relevant legislation it is possible for all the types of fund vehicle - the company, the unit trust and the limited partnership - to register with and apply to the government of the Cayman Islands for a written undertaking that they will not be subject to various descriptions of direct taxation, for a minimum period, which in the case of a company is usually twenty years and, in the case of the unit trust and limited partnership, fifty years.

Absence of Exchange Control Restrictions

There are no exchange control restrictions or regulations in the Cayman Islands (unlike many other jurisdictions, including some of the Cayman Islands' offshore competitors). This means that funds can be freely transferred in and out of the Cayman Islands in unlimited amounts.

No Local Service Providers Required

There is no requirement that a Cayman Islands' fund should have any local directors or officers; these may be provided by the advisors, administrators, promoters or the investors themselves. Nor is there any requirement for local service providers, for example, administrators or custodians; except that for funds regulated under the Mutual Funds Law, there is now a requirement for their audited accounts to be signed-off by a local firm of auditors.

No Requirement for Annual Shareholder Meeting

Expenses may, if desired, be minimised by virtue of the absence of a statutory requirement for company meetings to be held in the Cayman Islands. There is no requirement that an exempted company hold any shareholders' meetings at all, if the shareholders or directors do not wish to do so. Nor is there any requirement to hold directors' meetings in the Cayman Islands.

Mutual Funds Law (2003 Revision) (the "Law")

The Cayman Islands have, for a number of years, regulated banks, trust companies, insurance companies and managers. As part of the overall good governance of the financial industry, the Law regulating mutual funds and mutual fund administrators came into force in July 1993. The aim of the Law is to protect investors and the Cayman Islands against undesirable promoters and managers of mutual funds by ensuring that only those with the appropriate experience and standing are permitted to establish and manage mutual funds in the Cayman Islands. The Law supplements the statutory regime and common law rules that existed prior to the enactment of the Law and which regulated the establishment and operation of mutual funds. As such Cayman Islands mutual funds are widely regarded within Japan as meeting the Standards of Selection of Foreign Investment Fund Securities prescribed by the Japanese Securities Dealers Association, which has resulted in the Islands becoming an increasingly popular jurisdiction for funds that are publicly offered to investors in Japan. The Cayman Islands are already an established jurisdiction for funds marketed to Qualified Institutional Investors or on a private placement basis in Japan.

Responsibility for regulation of mutual funds rests with the Cayman Islands Monetary Authority (the "Authority"). Mutual funds are required to be licensed before commencing business. Fees payable by mutual funds under the Law - typically US$2,439 initially and annually - are in addition to fees payable under the Companies Law, the Trusts Law or the Exempted Limited Partnerships Law (depending on the structure of the mutual fund).

A mutual fund is defined as any company, trust or partnership either incorporated or established in the Cayman Islands, or if outside the Cayman Islands, managed from the Cayman Islands, which issues equity interests redeemable at the option of the investor, the purpose or effect of which is the pooling of investors funds with the aim of spreading investment risk and enabling investors to receive profits or gains from investments. Thus, mutual funds which provide no redemption or repurchase rights to investors, i.e. closed-ended funds, are excluded from the definition and regulation.

Exempted under section 4(4) of the Law from regulation is any company, unit trust or limited partnership where the equity interests are held by not more than fifteen investors who by majority are capable of appointing and removing the directors, the trustee or the general partner of the mutual fund (depending on whether the mutual fund is structured in a corporate form, a unit trust or a limited partnership). The reasoning is that mutual funds should be excluded if the number of investors is conveniently small and if together they control the appointment and removal of managers or operators of the mutual fund, i.e. control of the mutual fund rests with those investors.

There are three available forms of regulation. The most straightforward, and the one usually pursued by hedge funds, is the Section 4(3) Mutual Fund which will be applicable either where the minimum investment per investor is not less than US$50,000 or where the equity interests are listed on a recognised stock exchange (such as the Cayman Islands Stock Exchange). The fund will simply need to file a straightforward form (Form MF1) with the Authority, together with its prospectus and consent letters from the administrator and the auditors. Registration will be virtually immediate.

Alternatively, the fund can apply for a licence or designate its principal office in the Cayman Islands at the office of a licensed mutual fund administrator (which is required to satisfy itself as to the fitness and propriety of the promoter).

The Securities Investment Business Law

The Cayman Islands have recently implemented a new Securities Investment Business Law. This new legislation regulates all securities investment business and creates a new regime for open- and closed-ended fund managers and advisers. The principal advantage for fund operators is the exemption permitted to managers of funds marketed only to sophisticated investors (essentially someone who is regulated by a recognised regulatory authority, or whose shares are listed on a recognised securities exchange, is a high net worth investor or who is reasonably to be regarded as being capable of evaluating the merits of the proposed transaction and invests at least US$100,000 or its equivalent). As a result, managers incorporated in the Cayman Islands, who usually delegate investment management to an entity based elsewhere, are no longer required to be licensed.

These exemptions apply in the case of hedge funds and so will facilitate the establishment of hedge funds in the Cayman Islands. A declaration must be filed with the Authority to obtain the exemption and there is an annual exemption fee of approximately US$1,250.

The OECD and FATF

Recent initiatives by the Organisation for Economic Co-operation and Development (OECD) and the Financial Action Task Force (FATF), have led to the implementation of legislation and commitments by the Cayman Islands Government to ensure they are in line with internationally accepted standards with regard to anti-money laundering measures. These include:

  • No change will be made to the zero tax regime in the Cayman Islands. The OECD has accepted this system of taxation and confirmed that it is not considered "harmful" and the Cayman Islands Government is committed to its continuation.
  • To introduce effective tax information exchange. For criminal tax matters, this will become effective for the first year after 31 December 2003 and for civil and administrative matters this will become effective for the first tax year after 31 December 2005. Information will be provided in response to a request probably pursuant to a treaty mechanism to be negotiated on a country by country basis.
  • No bearer shares, although issues in relation to institutional transactions are not affected.
  • The Government has undertaken to advise service-providers that "aggressive marketing policies based exclusively or primarily on confidentiality or secrecy are not in the national interest and should not be pursued". It is not considered that this more proactive approach will adversely affect the financial services industry which is substantially based on transparent internationally sponsored transactions.

The FATF review process was of a technical rather than substantive nature focusing on the nature of anti-money laundering regulations in place and the sanctions imposed thereunder, rather than the substantive results of any policies and regime in place. The position in practice as reflected in the review conducted by the Caribbean Financial Action Task Force is that the Cayman Islands has implemented a level of regulations substantially in compliance with the "Vienna Principles" enumerated in the 40 FATF recommendations published in its 1990 report and the Caribbean FATF recommendations. Since then, the Government has responded by making amendments to the various pieces of anti-money laundering legislation already in place and, in recognition of this, the Cayman Islands were removed from the FATF's "blacklist" in June 2001.

Conclusion

The essence of the Cayman Islands as a domicile is that they provide a stable, well understood environment with sensible, but non-intrusive, levels of regulation. The impact of the various supranational initiatives will undoubtedly be that well-established and recognised jurisdictions meeting the requirements of bodies such as the OECD and the FATF will continue to prosper whilst the rest will dwindle away. A rationalisation in the offshore world can be expected and the Cayman Islands are well placed not only to maintain their pre-eminent position but to further consolidate it.


If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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