Of course, while the politicians are happy to keep making the pronouncements (there are no votes offshore) and the media laps it up, it can become self-perpetuating. However, any detailed analysis of the events of last year largely absolves the hedge fund industry of blame. Similarly, analysis of the offshore model used by such funds shows that the current system has worked well.
Cayman has long been the domicile of choice for hedge funds, going back 15 years or so. I have been a funds lawyer for all of that time and have seen the country evolve to serve the purpose of a major financial centre in keeping with the modern world. At the time the industry was starting to grow, Cayman’s mutual fund legislation, coupled with a tax-neutral basis, worked well and resulted in a rapid growth in the number of funds domiciled there. This in turn led to a growing body of lawyers and other professionals who were expert in this area establishing themselves in Cayman. For example, I am currently involved in a multi-party matter requiring teams of lawyers from five different firms to be involved. How many jurisdictions around the world have that number of expert firms, with more on the sidelines to choose from? This wealth of expertise has built up over many years and has stood the country in good stead. In addition, the courts, based on the British system, and drawing on a panel of judges who have a good understanding of the industry – as it is such an important part of the economy of the country – are providing an excellent forum for dispute resolution. Instead of the gin-addled, panama hat wearing colonial/Gene Hackman figure carrying bags of cash (pick your own stereotype), Cayman is based on top professional firms staffed by dedicated experts.
As well as the quality of the professionals involved, when looking at the suitability of a jurisdiction in which to establish a fund, the question of the framework of regulation is key. For many years, part of Cayman’s undoubted appeal was that its regulation was light touch and the process was simple and straightforward. Companies can be incorporated on a same-day basis for example and, essential to the hedge fund world, there is no limitation on the investments which can be made. The golden rule is that provided the investor is given all necessary information on which to base a decision whether or not to invest, then the manager is free to pursue that mandate with no external limitations.
The offshore world is a market place, with the leading players looking to attract funds to their domicile. As a result, there was a move by many countries to make their legislation more like Cayman’s – Jersey, Guernsey and Ireland amongst others came in with their look-a-likes. The cry in the pre-crash days was “look, it is almost as easy to do business here as in Cayman, come to us”. “The Irish SuperQIF – Authorisation in 24 Hours” was the heading on the proclamation from PwC’s Dublin office. While the heads of government in major onshore centres were promoting their new lighter touch regulation, everyone seemed to be playing the same game. Cayman found it easier as it did not have the overhang of a retail funds industry with its resultant legislation to protect granny and her £20/month savings scheme. On the funds side, it has always been an institutional industry and the same level of regulation is not required to protect investments by the big and ugly.
Suddenly, the rallying cry has changed. “We are the regulated centre for alternative investments – unlike Cayman” is the new angle. However, let’s look at the regulation that we have in Cayman, as it has evolved with the industry and changing financial world. For a start, President Obama and the world at large would be staggered to learn that Cayman has some of the strictest anti-money laundering laws in the world. It does not want the business of wealthy individuals looking to evade tax responsibilities in their home countries. It wants to serve a useful role in the global financial world assisting in the efficient development of capital, where gains and income can be made in a tax neutral jurisdiction with investors left to sort out their liabilities in their own country. Cayman has happily signed tax exchange treaties because signing them will only deter the sort of business Cayman does not want in the first place. When the anti-money laundering laws were introduced, Cayman had a five-year retrospective requirement, and most Cayman attorneys lost their weekends for most of the year as they trawled back through the archives to ensure that the correct information was held on all clients, and if it couldn’t be obtained, the relationship was terminated. During all this period, becoming a client of a US law firm required a handshake; forming a Delaware company required a phone call. In Cayman it required passports, utility bills, source of funds, tax justification, reference letters from professionals and financial institutions…
As for the laws covering the funds set up by such clients, examples of Cayman requirements include:
• All hedge funds are individually registered with the Cayman Islands Monetary Authority (CIMA);
• All registered funds must file their offering documents with CIMA, which must include amongst other things all details of all directors of the fund, and must notify CIMA of any changes;
• These funds must have an annual audit by a firm on an approved list, and must file those audited accounts with CIMA;
• Any Cayman entity providing directors to a Cayman fund must have appropriate licences from CIMA;
• Any Cayman firm providing administration services to a fund must have the relevant licence from CIMA;
Of equal relevance is how the industry actually works. I have been a Cayman Islands lawyer for around 13 years and have never helped to set up a hedge fund which did not have an independent administrator responsible for net asset value (NAV) calculations. One accusation levelled is that managers are lightly regulated in Cayman. They are, because the actual management happens in one of the world’s major financial centres. Again, I have never helped to set up a fund where the assets have not been managed somewhere such as London or New York. Regulation of the actual entity deciding on investments rests with the likes of the FSA and the Securities and Exchange Commission (should the US choose to regulate such managers). They are free to make whatever rules they like for the managers of Cayman funds operating within their jurisdiction. Management does notactually happen in Cayman, so looking at its regulation is largely redundant. The legislation and regulator are in place in Cayman but little used in this regard due to the realities of the situation.
So, as a result of this, what does the average Cayman Islands hedge fund look like? Everyone involved in its establishment will have provided detailed personal information to the law firm. An offering memorandum will have been produced which contains all relevant information which an investor needs to make an informed decision whether or not to invest, and it will be filed with the regulator. The directors’ details and background will have been included. A manager in a major onshore centre will have been mandated. An independent administrator responsible for NAV calculations will have been appointed. Either the prime broker or the administrator, or a third party, will have been appointed as custodian of the assets. An auditor from the approved list will have been appointed and will be required to file yearly audited accounts.
On the regulatory side, in addition to the usual criminal sanctions, CIMA has far-reaching powers under Cayman law, which it can and has used. For example:
• It can require a special audit of a fund;
• It can appoint advisors or persons to assume control of the affairs of a fund;
• Each promoter or operator must provide CIMA with such information and access to such records as it requires;
• CIMA can revoke a licence or impose conditions,
• An auditor must immediately notify CIMA if the fund cannot meet its obligations as they fall due or is carrying on business prejudicial to investors.
Are the differences in the other major offshore centres which are portraying themselves as more highly regulated and more appropriate for the brave new world in which we now all live sufficient to justify a regulated/unregulated distinction, or is it just a marketing ploy? Is gaining sign-off by the administrator (the requirement in Ireland for example) – the entity that stands to make hundreds of thousands of euros in annual fees if the fund goes ahead, and zero if it doesn’t – a basis for significant investor comfort? I am not casting an iota of doubt on the integrity of the average administrator, but there is just a hint of a conflict of interest here which doesn’t necessarily form the best basis for regulation.
So where did all this leave Cayman during the recent turmoil? Firstly, all the managers were in New York or London. I think we can all come to our own conclusions as to how well they were regulated and monitored, but whatever your view, that had nothing to do with the domicile of the fund. The domicile is relevant when investors are looking to bring actions in respect of their investment. In Cayman, investors were able to look at the fund documentation produced by law firms with the benefit of operating in the industry’s leading jurisdiction, home to most of the world’s hedge funds. There is a regulator responsible for a huge number of funds and staffed accordingly. There is a robust legal system, staffed by sophisticated judges, and culminating in the Privy Council in London, with a great deal of familiarity with the hedge fund industry. There are a significant number of expert law firms. Once different firms have been appointed by the fund, the directors, the seed investor and the manager, you want to make sure that doesn’t leave you with the guy above the fish shop who normally does divorces. It certainly won’t in Cayman.
There are a number of cases still going through the process, resulting from disgruntled investors. They are receiving the benefit of a robust system and will not only get to have their day in court, it will be a day when all parties are well-advised and the judge is familiar with the industry.
So where does this leave Cayman now? Well, judging by the proposed EU Directive and comments surrounding it from EU politicians, they get their information on Cayman from John Grisham and their understanding of the hedge fund industry from a socialist Danish MEP. Cayman works well because all the information with regard to the fund is held by or is accessible to the regulator. Management happens elsewhere and is regulated as the government in that country sees fit. Taxation also happens elsewhere, again as determined by the manager’s and the investor’s relevant taxing authority. By placing emphasis on the domicile of the fund, rather than the manager, the EU is seeking to implement a blatantly protectionist measure under a veneer of regulatory respectability. The measures as they stand in the current draft favour EU funds managed by EU managers with no reasoning given as to why the rest of the world (including US managers) should be given a harder time when trying to do business in the EU.
Where should we be heading now? The world needs well-run financial centres that are fit for the purpose for which they operate. This means thorough anti-money laundering laws, access to professional expertise, relevant tax disclosure treaties, appropriate regulation and adequate dispute-resolving forums. This should apply universally. The OECD briefly put Cayman on the grey list as it had not signed enough double tax information treaties. It had in fact long held treaties with major centres such as the US, but it didn’t meet the arbitrary figure of 12. It is now back on the white list, following the implementation of treaties with the Faroe Islands amongst others. It is not difficult to see why the machinations of the major countries and political organizations around the world can be seen as protectionist and politically motivated rather than actually serving the purpose of ensuring that we have well-run financial centres with appropriate measures to stop money-laundering and tax evasion.
Cayman has proven itself to be capable of providing a robust and stable framework for funds. The world at large should be looking to work collectively to ensure that this vital and beneficial role that jurisdictions such as Cayman hold can continue to be carried out as now. With managers being based in the onshore centres, those regulators can continue to apply the rules as they see fit. If an FSA-regulated manager is running a fund, it is difficult to see why the rules regulating its marketing should be hugely different if the fund is one of the few now being formed in Malta than if it has been set up by the highly professional and world leading hedge fund centre of Cayman. Cayman is open, regulated, and has a host of professional expertise. Let’s make use of that, make sure it fits in with the requirements of the modern world and ensure managers and investors can continue to benefit from its status.
Gray Smith is a Partner and a member of the Funds and Investment Services Team within the Corporate and Commercial group of Appleby Global at the Cayman Islands office.