"The Cayman Islands is undeniably the most important financial centre in the Caribbean and ranks amongst the largest and most important financial centres in the world."
The Cayman Islands is the global leader for domiciling non-retail investment funds. It is estimated that the Cayman Islands has 55% of the total global share of offshore hedge funds. As of 23 January 2003 there were 4,187 investment funds registered with the Cayman Islands Monetary Authority ("CIMA"). This figure does not include the hundreds of additional closed end and debt only funds that do not require to be registered with the CIMA.
The various terms used to describe collective investment schemes are often used interchangeably. "Investment fund" is a generic term comprising both open-ended investment schemes such as mutual funds and closed-ended schemes such as investment trusts. There are many attractions to promoters and managers in establishing investment funds offshore, not least the freedom to define investment strategies and objectives without restrictions imposed by onshore regulators in the name of consumer protection and the consequent absence of expensive reporting requirements to onshore regulators such as the SEC in the U.S. and the FSA in the U.K.
There are a number of reasons why the Cayman Islands is the leading domicile for offshore investment funds:
(a) Political and Economic Stability - The Cayman Islands is a British overseas territory and although a governor is appointed by the British government there is a large measure of internal self-government. The British government retains responsibility for internal security, defence and external affairs. The Cayman Islands enjoy a high standard of living with a robust economy which is built on the joint pillars of tourism and financial services.
(b) Cutting Edge Legislation and Regulations - The Cayman Islands was quick to recognise the world wide trend and phenomenal growth area in investment funds and was the first offshore jurisdiction to enact specific legislation, the Mutual Fund Law, regulating and enabling this particular area of financial services, in 1993. The legislation relating to financial services is the result of a close partnership between the government and the private sector and has enabled the Cayman Islands to achieve the right level of regulation. It provides adequate protection for investors, but is flexible enough such that the cost is not prohibitive and investment funds can be established in a timely and efficient manner.
There are no specific statutory or regulatory constraints in respect of the investment policies or strategies that may be adopted by an investment fund or any requirement for the appointment of local administrators, custodians or investment managers. The focus of the law is to ensure that proper disclosure is made and that investment funds either (i) are licensed in which case the directors must demonstrate that they are fit and proper persons, or (ii) have a licensed mutual fund administrator, or (iii) only accept investors who are sophisticated persons.
An example of a recent legislative change is the amendment to the Companies Law which allows for the formation of a segregated portfolio company to act as a multi-class mutual fund. The advantage of a segregated portfolio company is that it allows a multi-class fund to segregate the assets and liabilities referable to a class of shares and thus to overcome the cross-class liability issues.
(c) Professional Infrastructure - The Cayman Islands is home to a concentrated level of fund expertise, including experienced law firms, administrators and all of the major accounting firms and hedge fund specialist audit firms such as Goldstein Golub & Kessler and Rothstein Kass. Although it is not typical for the investment manager to be situated in the Cayman Islands full services can be provided and as so many of the major international financial institutions have a presence in the Cayman Islands and there is healthy competition on pricing and services offered.
In addition, the Cayman Islands has a very successful stock exchange. The Cayman Islands stock exchange ("CSX") was established in 1997 and now has over 700 listings and has attracted many large hedge funds. The CSX listing rules were especially designed with mutual funds in mind and contain no restrictions on investment policy. The CSX continues to experience significant international interest in listing alternative investments and continues to attract the listing of specialist debt securities programmes by Cayman Islands special purpose vehicles.
(d) Absence of Direct Taxes and Exchange Controls – The Cayman Islands revenue system is consumption based and accordingly there are no corporation, capital gains, income, profits or withholdings taxes that apply to investment funds established in the Cayman Islands or that would apply to investors in such funds. The Cayman Islands has no double tax treaties and is committed to remain so unencumbered. There are no exchange controls and the Cayman Islands dollar is tied to the U.S. dollar and the latter is freely accepted and used within the local economy.
(e) Legal System - As the Cayman Islands is a British Overseas Territory the British government retains responsibility for the appointment of certain public offices, including judges. The Cayman Islands has a well developed and experience court system which has been tested with large commercial cases, including the massive BCCI liquidation. The final court of appeal is the Privy Council in London and it is common practice for leading advocates from the U.K. to appear before the Cayman Islands courts on major litigation matters. As noted above the legislation dealing with commercial matters is specifically relevant to the Cayman Islands role as an offshore financial centre and the general law is derived from English common law.
(f) Good Communications and Access - The Cayman Islands is conveniently located in the northern Caribbean and has regular direct flights to London, Miami, New York, Chicago, Toronto, Atlanta, Houston, Tampa and Nassau and remains on the same time (GMT – 5 hours) throughout the year.
The communications system is first class and the legal and financial service providers operate information technology systems on a par with those available at any other major financial centre.
(g) Attractive Location - The combination of geography, climate, standard of living and culture make the Cayman Islands an attractive place to work and visit. As a result the Cayman Islands continues to attract professionals from other jurisdictions which further strengthens its position given the cosmopolitan nature of modern day international financial services.
2. Common Structures
There is no definitive list of investment fund structures which are available in the Cayman Islands. Our laws have been drafted to provide flexible vehicles regardless of whether a company, partnership or trust is being used. As a result, the appropriate vehicle can normally be adapted to meet the required criteria.
Investment funds in the Cayman Islands may be structured as open-ended (i.e. with regular subscriptions and redemptions) or structured as closed-ended where, after the initial subscription period for investors, the fund is closed until liquidation. Typically, private equity deals will be structured as closed-ended funds with the ability for the vehicle to make capital calls to meet its funding obligations. It is also possible for a hybrid to be designed, whereby the fund might begin life as a closed-ended fund but following a liquidity event or a passage of time, may convert to an open-ended fund. A number of common structures are discussed below.
The plain vanilla mutual fund is usually set up using a company with one class of investor and one investment portfolio. However, the structure of a plain vanilla fund is impacted by the manner in which incentive fees will be taken, and several classes of shares may be offered to allow for different fees, different shareholder rights and to deal with eligibility of investors to participate in "hot issues". Furthermore, each class of shares may be issued in multiple series (one series per issue date) to ensure that the incentive fee is fairly borne by investors.
This vehicle will have multiple investment portfolios and will issue a different class of equity interest attributable to each portfolio of investments. Such a structure can be attractive because of the administrative cost saving and common branding, but it is subject to inherent risks. Whilst a mutual fund may segregate the assets and liabilities attributable to each class in its books and records, any third party creditor will be a creditor of the mutual fund and therefore, if the mutual fund defaults under any liability owed to such third party, where the relevant liability is attributable to a particular class, such third party will have recourse to all of the assets of the mutual fund to satisfy such liability.
There are steps that can be taken to minimise cross-class liability risk, including not using such a vehicle for portfolios with high risk investment strategies, entering into limited recourse contracts with counterparties or by the use of a trading company. Now due to a recent amendment to the Companies Law it is possible to use a segregated portfolio company so that the segregation of portfolios in a multi-class fund is backed by express statutory provision.
A master-feeder structure enables both domestic investors and onshore investors to participate in the same investment programmes. Using the U.S. as an example, this is normally achieved by having the U.S. taxable investors invest directly in a limited partnership domiciled in the U.S. and having the offshore investors and U.S. tax exempt investors investing in an offshore company (or, occasionally, a limited partnership). Each feeder will then invest all of its assets in the master fund, which is typically an offshore company. The investment manager will then manage the portfolio at master fund level. The advantage of the structure is the administrative ease since the investment manager will only need to maintain one set of books for the investments at master fund level.
The objective in a side by side fund is the same as the master-feeder fund, but instead the onshore fund and the offshore fund invest in parallel, in the same investment pool managed by the same investment manager.
In recent years, the traditional mutual fund structures have evolved to include side pockets. This allows the fund to invest in what are typically called "designated investments", being securities for which there is no ready market, such as private or restricted securities and to separate the designated investments from the fund's main portfolio. Generally, a separate class or series will be established to represent each designated investment purchased by the fund and only those shareholders who are shareholders on the date of such purchase will participate in that designated investment.
A variation to the standard mutual fund structure which is increasingly popular is a guaranteed fund, whereby a mechanism is put in place so that on a particular date in the future an investor will, at the very least, have the ability to redeem his equity interest at its original subscription price. This will give an investor the confidence that, at a specified time in the future, if the fund has done poorly, he will be able to get his original investment back.
It is possible to mimic a mutual fund in a structured note programme with multiple classes of debt, usually senior, mezzanine and subordinated. Subordinated debt performs like equity since the investment leverage for the subordinated debt is extremely high. Typically, an off-balance sheet corporate vehicle is used with a share capital owned by a charitable or purpose trust.
(g) Seed capital arrangements
The prospects for success of many new investment funds can be greatly enhanced by a seed investor’s capital or other services and the nature of the deal struck by the investment manager, the seed investor and the fund will vary on a case by case basis. An additional class of shares with special shareholder rights are usually required to give the seed investor a tax-efficient means of sharing fees with the investment manager and to safeguard certain agreed rights.
3. Regulation in the Cayman Islands
The Mutual Funds Law (the "MF Law") provides for the regulation of mutual funds by the CIMA. The definition of a mutual fund as set out in the MF Law is 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 or repurchaseable at the option of the investor, the purpose of which is the pooling investors’ funds with the aim at spreading investment risk and enabling investors to receive profits or gains from investments. Accordingly, closed-ended funds and funds which issue only debt instruments are outside the scope of the MF Law altogether.
No mutual 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 prescribed by the MF Law or is within the class of mutual funds which is exempt from this requirement. A mutual fund is exempt from the requirement to be registered with the CIMA if it is a mutual fund in which equity interests are held by not more than fifteen investors, the majority of whom are capable of appointing or removing the operator (for this purpose the operator is a director of a company, a general partner of a limited partnership or the trustee of a unit trust).
Any mutual fund which does not have the benefit of the above exemption is a regulated mutual fund and may not carry on business or attempt to do so in or from within the Cayman Islands (it should be noted that a fund carries on business in the Cayman Islands merely by being incorporated there) unless:
- it is the holder of a mutual fund licence and it has a registered office in the Cayman Islands (if it is a company or a limited partnership) or a Cayman Islands licensed trust company acts as its trustee (if it is a unit trust); or
- a licensed mutual fund administrator provides its principal office in the Cayman Islands; or
- it is a fund in which the minimum aggregate equity interest purchasable by a prospective investor is CI$40,000 (or its equivalent in any other currency, e.g. US$48,000) or in which the equity interests are listed on a stock exchange specified by the CIMA and the mutual fund is registered with the CIMA.
The registration procedure for a mutual fund differs depending which of the foregoing routes is taken. In each case, it is necessary to file an offering memorandum and to pay a registration fee of CI$2,000 (US$2,439) which is payable upon registration and annually thereafter. The MF Law requires that, without prejudice to any duty of disclosure under the common law or any other law, the offering document in respect of equity interests in a mutual fund must describe the equity interests in all material respects and contains such other information as is necessary to enable a prospective investor in the mutual fund to make an informed decision as to whether or not to subscribe for or purchase the equity interest. There is no requirement for the offering memorandum to be pre-approved by the CIMA and it falls within the services to be provided by the legal advisers to ensure that the offering memorandum meets the foregoing requirements so that a promoter of a Cayman Islands mutual fund can be confident that the fund can commence offering immediately following its registration with the CIMA.
A Cayman Islands registered mutual fund owes continuing regulatory obligations to the CIMA to file within twenty-one days details of any change to an offering document that materially affects any information in the offering document previously filed with the CIMA, to file annual audited accounts within six months of the end of the financial year and to pay the prescribed annual fee, currently CI$2,000 (US$2,439). The CIMA has various supervisory powers with respect to regulated mutual funds and may at any time instruct a mutual fund to have its accounts audited and submitted to the CIMA, require a promoter or operator of a mutual fund to provide such information or explanation as the CIMA may require in order to carry out its duties under the MF Law. If the CIMA is satisfied that a regulated mutual fund is or is likely to become unable to meet its obligations as they fall due or is a carrying on or attempting to carry on business or is winding up its business voluntarily in a manner which is prejudicial to its investors or creditors or it is a licensed mutual fund which does not comply with any commission of its licence, then the CIMA has the following powers:
- to revoke a mutual fund’s licence;
- to impose conditions or further conditions on any mutual fund licence, or to amend or revoke any such conditions;
- to require the substitution of any promoter or operator of a mutual fund;
- to appoint a person to advise the mutual fund on the proper conduct of its affairs; or
- to appoint a person to assume control of the affairs of the mutual fund.
There is a right of appeal against any action taken by the CIMA and any appeal must be made to the Executive Council of the Cayman Islands within sixty days of receipt of written notice of the CIMA’s actions.
As investment funds continue to evolve and be sold into new markets, the Cayman Islands, as the established pre-eminent offshore jurisdiction, is well placed to continue to provide the structures and services required to offshore investors.