Offshore: Cayman Islands Mutual Funds FAQ

Last Updated: 1 July 2015

There are very specific and narrow definitions of what falls to be regulated under the Mutual Funds Law (2013 Revision). Firstly, the vehicle must be a “mutual fund” as defined, which includes any company, unit, trust or partnership which issues equity interests. Equity interests are defined as any share, trust unit, or partnership interest that participates in profits or gains which are redeemable or re-purchaseable at the option of the investor. But interests redeemable at the option of the fund or interests in closed ended limited partnerships or corporations necessarily fall outside of the definition. There is also a specific exclusion for debt interests including those with an equity kicker. Secondly, and in addition, the interest must be in a company, unit, trust or partnership which pools investor funds with the aim of spreading investor risk. Thus, it may be possible in a vehicle which has segregated accounts and avoids investor pooling or avoids the spreading of investment risk by targeting specific investments on a class or series basis to avoid the definition. There are specific provisions dealing with feeder funds and master funds. Prior to the 2012 amendment, a master fund was not separately regulated where there were less than 15 feeder funds invested in it and indeed, although master funds are specifically caught, otherwise it remains the case that a company, unit, trust or partnership with less than 15 investors also falls outside the definition of a mutual fund. So too a feeder fund is only defined as such if it conducts more than 51% of its investing into a master fund and so, very simply, it is possible by reference to the 51% level to create multiple master fund structures with cross interests from feeder funds which avoid master fund regulation.

There are three types of regulation available. Over 90% of regulated funds proceed with the registration route because of its simplicity and speed, and because it avoids the scrutiny by the Cayman Islands Monetary Authority of the form and content of the offering document, save, the Authority has an overriding obligation to ensure that any director, manager, or officer of a regulated mutual fund is a fit and proper person which is defined as requiring a combination of (a) honesty, integrity and reputation, (b) competence and capability and (c) financial soundness. In fact, the emphasis thus on the directors of the fund is probably over-emphasized given the extent to which issues of management control may be delegated (see further below). The section 4(3) route is available to a mutual fund in which the minimum aggregate equity interest purchaseable is US$100,000, or in which the equity interest are listed on the Stock Exchange approved by the Cayman Islands Monetary Authority. In that event, either the offering document or prescribed details in respect of it are filed with the Cayman Islands Monetary Authority. By comparison, under the licensed regulation route the Cayman Islands Monetary Authority must review the offering document in respect of a licensed regulated mutual fund and determine that (a) each promoter is of sound reputation; (b) the administration of the mutual fund will be undertaken (i) by persons who have sufficient expertise to administer the mutual fund and (ii) by persons who are fit and proper to be directors; and (c) business of the mutual fund and any offer of equity interests in it will be carried out in a proper way. The third category of regulation is available where a licensed mutual fund administrator provides the principal office to the regulated mutual fund which administrator must apply the same tests as those applied by the Cayman Islands Monetary Authority.

The Mutual Funds Law (2013 Revision) does not contain prescriptive regulation for the content of the Offering Memorandum of a regulated Cayman Islands mutual fund. There must be filed with the Cayman Islands Monetary Authority either a current Offering Document or prescribed details in respect of it which must describe the equity interests in all material respects, that is a simple restatement of the Common Law test. That description would normally include reference to economic interests, whether or not the equity interest is issued in one or more series and if so, the distinctions between the same, voting rights, if applicable, terms of redemption and any form of liquidation or other preference and must contain such further information as is necessary to enable a prospective investor to make an informed decision as to whether or not to subscribe. Any promoter or operator of the mutual fund which would include a director, a trustee or a general partner of a company, trust or limited partnership who becomes aware of any change that materially effects any information in the Offering Document or the filed prescribed details must, within 21 days, file a revision describing the change. There are penalties under the Mutual Funds Law (2013 Revision) of up to US$120,000 for filing false or misleading information.

The fees payable to the Cayman Islands Monetary Authority in respect of a mutual fund are described in the “Mutual Funds Fees” Regulations. Currently administered funds, registered funds, and licensed funds carry an annual fee of US$4,268 plus a US$365 annual filing fee. In the case of master funds, the annual fee is US$3,048 and in the case of licensed funds there is additional one off application fee of US$4,268.

The registration process under section 4(3) is by far the fastest route as it does not involve detailed scrutiny of the contents of the offering document by the Cayman Islands Monetary Authority (other than in respect of the directors: see above at question 2) and may take as little as five business days. Whereas, a licensed fund where the Cayman Islands Monetary Authority has a review process to undertake, as is similarly the case with an Administered Fund, may take anywhere between 5-8 weeks.

A regulated Cayman Islands mutual fund must provide an annual audit signed off by an auditor approved by the Authority which, in practice, means a recognized Cayman Islands audit firm. This may well involve liaison between the Cayman Islands audit firm and its overseas affiliated office which may undertake the greater part of the audit work in and from within the jurisdiction where the books and records of the fund evidencing the trading activity are maintained. Most usually, this will be in the location of the investment manager, which in the great majority of cases will be in New York or London. It should be noted that there is a whistleblowing obligation placed on an auditor which applies if, in the course of the audit, the auditor obtains information or suspects that the fund is likely to be unable to meet its obligations as they fall due, is carrying on business in a manner prejudicial to investors or creditors, is not maintaining sufficient documents to enable proper accounts to be kept, or in the event of fraud or criminal conduct, in which case the auditor should give written notice to the Cayman Islands Monetary Authority immediately. (A similar whistleblowing obligation applies to a licensed mutual fund administrator providing a principal office to a regulated fund). The position in the Cayman Islands differs therefore from, say, a Bahamian Smart Fund where there is no audit requirement, although it may be said that increasingly onshore regulators are insisting on an audit if the fund is to be regarded as regulated for the purposes of onshore tax treatment. The consequences of including the master fund as a separately regulated entity pursuant to the 2012 revision to the Mutual Funds Law is that the master fund must be audited also, in addition to the feeder funds.. There has been widespread criticism of this revision undertaken largely at the behest of the accounting profession; prior to the amendment, assets of the fund invested through the master fund were necessarily the subject of the audit at feeder fund level. Costs of auditing the master /feeder fund structure have accordingly been commensurately increased with very little in the way of additional investor protection. However, it should be noted that the circumstances of the Madoff fraud are unlikely to be capable of replication in the Cayman Islands given the requirement for audit by recognized and approved accounting firms.

Closed ended funds are most usually established as forms of exempted limited partnership pursuant to the provisions of the Exempted Limited Partnership Law as being typical for a private equity investment. Provided the limited partnership interests or shares in the case of a closed ended corporate fund are not redeemable at the option of the limited partner, the equity does not fall to be regulated under the provisions of the Mutual Funds Law. There are some 14,000 of such partnerships registered in the Cayman Islands, which is a major center for offshore private equity structuring.

Contrary to a good deal of comment from onshore commentators about the demise of the offshore fund industry in light of the additional regulatory regime, and particularly the European Union Alternative Investment Managers Funds Directive (“EUAIMFD”) introduced post the financial crisis, the Cayman Islands funds industry has proved remarkably robust.  Mutual and hedge funds including the newly registrable master funds now total approximately 11,400, (anecdotally some 75% of the world’s offshore hedge fund industry) with assets under management having increased over the prior 12 month period up to 31st December 2014, from approximately US$1.8 trillion to US$1.964 trillion.  To compare like with like, the number of funds needs to be corrected by deducting the newly registrable master funds, in which event the number of regulated funds in the Cayman Islands comes in at around 8,750,  dwarfing the statistics in other offshore jurisdictions, and at about the same level as the number of funds regulated in 2006.  It is clearly not the case that the EUAIMFD has had a statistically negative effect on funds established in the Cayman Islands.  More interestingly, the pre-EUAIMFD statistics reveal that whilst 20% of Cayman funds were managed out of the City of London, that figure has most recently dropped to 16%.  The logical explanation for this is that UK-based fund managers of Cayman Islands funds have decided to move outside of the EU rather than subject themselves to the additional regulatory restrictions of the EUAIMFD.  In that respect, the EUAIMFD has had a more negative effect on the United Kingdom and employment in the City of London and Mayfair than it has with respect to the Cayman Islands.

It is the view of this writer that the recent emphasis placed on governance and compliance as a discipline distinct from the well-established legal rules and principles laid down by English and Cayman Islands precedent is misplaced.  For the most part, Cayman Islands law applies the principles of directors’ fiduciary duty and the distinct duties of care, skill and diligence which when taken together and applied to the facts of any particular fund, establish the operating procedures and level of enquiry required and therefore the responsibility of the board of directors.  In any event, in determining the level of directors’ responsibility, much will depend upon the facts and the precise structure in place but typically, given the importance of the institutional service providers to the fund, particularly the investment manager, the prime broker and the administrator, the role of the directors can be reduced to that of mere supervision only, a standard which found favor in Weavering at first instance and on appeal.  No doubt, statements of guidance such as that issued by the Cayman Islands Monetary Authority on Corporate Governance for Regulated Mutual Funds (December 2013 Edition) are not unhelpful but it should be recognized that these guidance notes do no more than attempt a synopsis of the extensive fiduciary and common law duties abovementioned.  

At all times, to comply with the fiduciary duty of a director, he must act bona fide in what he honestly considers (and not what a court might consider with the benefit of hindsight) to be in the best interests of the company.  The Court may investigate whether the belief was honestly held but it cannot substitute the exercise of its business discretion for that of the director.  In this respect, Cayman Islands law differs from Delaware law in that there is no equivalent of the business judgment rule.  All powers vested in the directors must be exercised for the purpose for which they are conferred and not for collateral purpose and a director cannot, without specific authorization pursuant to the articles of association, ever act in a position of conflict of duty and interest.  Simply put, the fiduciary duties require a director to act at all times honestly, and for that reason, breach of a fiduciary duty, as it is understood under Cayman Islands law, cannot be exculpated nor indemnified against.  The duties of care, skill and diligence are distinct and the most recent applicable judicial statement requires that a director (i) need not exhibit greater expertise in the performance of his duties than may reasonably be expected from a person of his knowledge and experience; (ii) is not bound to give continuous attention to the affairs of the company (although it is less likely that this protection could be relied upon in the case of a professional director) (there is judicial comment to the effect that the level of a director's remuneration may be a factor in determining the scope of his responsibility); and (iii) in the absence of the grounds for suspicion, the director is justified in entrusting a third party service provider to perform such duties honestly.  Interestingly, one leading English case, Re Brazilian Rubber, has been recently reaffirmed in the Court of Appeal decision in Weavering.  It was said by Neville J at first instance in that case "A director’s duty has been laid down as requiring him to act with such care as is reasonably expected from him having regard to his knowledge and experience.  He, I think, not bound to bring any special qualifications to his office, he may undertake the management of his rubber company with complete ignorance of anything rubber, without incurring responsibility from any mistakes that may result from such ignorance; while if he is acquainted with the rubber business, he must give the company the advantage of his knowledge when transacting the company's business".

Ironically, the professional company director who claims specific expertise of hedge fund operations may therefore be setting himself a higher standard of responsibility.  With that said, it should be perfectly possible to structure the operations of the board of directors of a fund in a way that renders their responsibility supervisory only.  In this respect, we disagree with comments in the Cayman Islands Monetary Authority Guidance Notes to the effect that a director of a fund retains “ultimate responsibility” for functions delegated to the service providers, which statement clearly overreaches the legal position.  Furthermore, it ignores the legal fact that a high level of exculpation and indemnity is available to a director of a Cayman Islands fund, which is higher than available under English law. 

We have noticed that a trend, which began some years ago in the audit profession in the form of introducing limitation of liability clauses for negligent conduct (in the preparation of the audit) (invariably to a three or five times multiple of the auditors fee), appears to be moving across to other service providers, notably administrators.  From the perspective of the investors in the fund, this is a wholly undesirable trend as any mistake in the calculation of NAV by an administrator may have significant financial impact.  But there is a greater problem.  If the limitation of liability holds against a negligent administrator (and there may well be good arguments to the effect that it may not) then the exposure of the directors may be commensurately increased.  This is particularly so where the directors are the employees or agents of an organization with deep pockets, as an adversely affected investor frustrated by a limitation of liability clause in the administrators’ agreement may well seek recompense from whomsoever he deems in any way responsible.  A derivation of the same problem arises in relation to the indemnity clauses sought by the fund, by service providers and indeed, increasingly, auditors for negligent and even non-negligent misrepresentations given by and on behalf of a board member.  Particular focus needs to be brought to bear on the terms of the service provider agreements overall.  In this respect, there are no "standard form agreements" and reliance by structuring counsel on earlier precedents may be misplaced in relation to the fact pattern of the current matter.

The Authority is under an obligation to maintain a general view of Mutual Fund business in the Islands and may undertake onsite inspections to ensure the affairs or business of a regulated Mutual Fund meet the requirements of the Law and any Regulations and those of the Proceeds of Crime Law.  There are broad powers to impose conditions and suspend any registration or licensing and to appoint a controller if it appears to the authority that the Fund is likely to become insolvent, or is conducting its business in a manner prejudicial to investors or creditors, or there is a breach of the requirements of the Law or applicable Registration, or indeed, that the management regulated fund is not being conducted in a fit and proper manner or by a fit and proper person. 

The provisions of this law apply not only to directors acting for a regulated mutual fund but also to those exempt from licensing under the Securities Investment Business Law (2011 Revision) (both a “covered entity”).  The new law defines a registered director as one conducting less than 20 professional directorships of covered entities and a professional director as one who conducts 20 or more of such directorships.  The registered director must register with the Cayman Islands Monetary Authority, whereas the professional director must obtain a license.   There is an on-line portal to do so.  Of the options available, it is fairly clear that the terms of this new law do little to avoid the criticism that certain professional directors are undertaking directorships in respect of too great a number of covered entities.  Whether or not this criticism is justified is another matter, however, since given the applicable law in the Cayman Islands, it is possible for directors of Cayman Islands covered entities to delegate substantially all of the business activity rendering their role supervisory only and indeed, this particular arrangement was upheld in the recent case of Weavering, the first instance conclusions in that regard not being affected in the Appeal decision. 

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