Cayman Islands: The Regulation Of Hedge Funds: A Cayman Islands Perspective

The term "hedge fund" has no precise legal or universally accepted definition but it generally refers to an investment fund that follows one or more alternative investment strategies and utilises return enhancing tools such as leverage and arbitrage. Investors in hedge funds are permitted periodic subscriptions and redemptions, as distinguished from venture capital funds or private equity funds. Hedge funds are also characterised by their fee structure, which compensates the adviser based upon a percentage of the hedge fund’s capital gains and capital appreciation.

It has been estimated that hedge fund assets now total more than US$1 trillion worldwide amounting to two per cent of global investment assets. The spectacular worldwide growth in hedge funds to date has been fuelled by the prolonged bear market, heightened investor interest in absolute returns and the inflow of top talent capable of generating high returns. In the near future neither the bear market nor high returns are expected to drive growth, and the pace of expansion may slow. However, a recent KPMG report predicts that "significant growth is still expected: hedge funds are perceived as part of the holistic solution to achieve absolute returns, aided by rising awareness of their benefits by pension consultants, especially in Europe. The benefits of uncorrelated returns in a diversified portfolio are widely recognised".¹

The Cayman Islands has established itself as the domicile of choice for offshore hedge funds. 2004 saw a 112 per cent increase in the number of new hedge funds that were established in the Cayman Islands and a record number of new hedge funds were established in the Cayman Islands in the first half of 2005. In August 2005 the Cayman Islands Monetary Authority reported that it was registering almost 35 new funds per week. More than 80% of the world’s hedge funds (approximately 6,500 funds) are now registered in the Cayman Islands.

The Cayman Islands offer a number of advantages which underpin its domination of the offshore hedge fund market. The Cayman Islands have no direct taxes of any kind. There are no corporation, capital gains, income, profits or withholding taxes. In addition, there are no exchange control restrictions or regulations. Cayman Islands law derives from English common law, supplemented by local legislation. Consequently, the legal form and structure of the fund vehicles and the securities offered are well recognised and widely accepted. As Cayman entities can be formed on the day of filing, transactions can be brought to market very quickly. With a number of internationally recognised law firms, affiliates of the top ranked administration firms, the top four accounting firms and other notable hedge fund auditors, professional services are readily available to service hedge funds established in the Cayman Islands.

Another key advantage is the light but effective regulation of hedge funds in the Cayman Islands. Emphasis is placed on the statutory requirement for full and proper disclosure in the offering document of all information necessary to enable a prospective investor to make an informed investment decision and involvement of service providers which in turn means no regulatory consents are required with respect to investment policy, the contents or circulation of offering memoranda or prime broker arrangements. The Cayman Islands legislation which governs hedge funds, the Mutual Funds Law, was drafted on the clear principle of "caveat emptor", that is, acceptance of risk by the investor.

Hedge funds are regulated by the Cayman Islands Monetary Authority (CIMA). No hedge fund may carry on or attempt to carry on business in or from the Cayman Islands unless it complies with one of three registration alternatives, or is within the class of hedge funds that is exempt from this requirement. The most common alternative used by hedge funds is registration under section 4(3) of the Mutual Funds Law which is applicable 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, including the Cayman Islands Stock Exchange.

To register a hedge fund with CIMA, the directors, general partner or trustee of the fund must ensure that the fund has filed with CIMA a fund filing form, the current offering document and consent letters from an administrator and an approved auditor agreeing to act for the fund. Once the fund has been registered, its continuing obligations are to have its accounts audited annually by a local auditor approved by CIMA and to send a copy of those accounts to CIMA within six months of the end of the relevant financial year, to file with CIMA a revised offering document or revised prescribed details if there is any change materially affecting any information in those documents and to pay an annual registration fee. CIMA has various supervisory powers with respect to regulated hedge funds and may at any time instruct a hedge fund to have its accounts audited and submitted to CIMA. In addition, CIMA may request the directors, general partner or trustees of a fund to provide CIMA with such information or explanation in respect of the fund as CIMA may reasonably require to enable it to carry out its duties.

All regulated hedge funds established in the Cayman Islands are required, as "financial service providers", to comply with the Cayman Islands money laundering legislation by putting in place appropriate procedures for the prevention of money laundering. CIMA permits delegation of a hedge fund’s money laundering obligations to persons or institutions that are regulated in a country with equivalent anti-money laundering legislation. Delegation is usually made to the hedge fund’s administrator or to the investment manager.

Achieving a balance between commercial flexibility and an appropriate level of regulation is a challenge. There has been a great deal of debate in both the United States and in England recently as to whether hedge funds should be subject to increased regulation. One view is that increased regulation is in a sense incompatible with the fundamental role and character of hedge funds which are designed by law to operate with maximum flexibility. These funds are able to achieve the returns they do precisely because they operate without many of the financial constraints that would otherwise hobble their complicated strategies. From a Cayman Islands perspective, the success of the domicile in attracting hedge funds and the limited number of failures bears testimony to the effectiveness of the current system. Any proposal to increase the level of regulation will require careful review and detailed analysis.