Previously published in Hedgeweek Cayman Special Report, December 2012.
Last year's Weavering case could have been a hammer blow for Cayman as the world's leading offshore fund domicile. But, if anything, it helped reinforce its image as a jurisdiction where fund governance is taken seriously, where directors are members of the Cayman Islands Directors Association (CIDA), and where the island's regulator, the Cayman Islands Monetary Authority (CIMA), is committed to evolving its fund regulation framework.
"While there may be a perception that independent directors have only recently focused on their roles, the genuine development – and key recent change – is the realisation by investors and managers of the significance of the role of independent directors and the increased priority which investors and managers are placing on their credentials," comments Andrew Morehouse (pictured, partner, Ogier (Cayman Islands). "Investors view the use of independent directors not as key to the fund, but certainly of great importance."
Looking at regulatory developments in 2012, the hot topic, according to Tim Buckley, partner at Walkers Global (Cayman), is the potential regulation of independent directors.
"How it ends up is not clear at the moment. Having said that, the industry itself is well ahead of the curve on this. Director services firms have known for a while that something's coming and they've been self-regulating very well."
There are several strands to this proposed regulation. First, is a consideration of the ability under Cayman law to disqualify directors. Currently, investors coming into Cayman funds have to do their own due diligence on the board of directors without really knowing whether a director is a bad egg or not. The ability to strike off errant directors from involvement with Cayman funds seems to have "garnered support" according to Matt Mulry, partner at Dillon Eustace (Cayman).
Second, is the potential introduction of a public register of directorships for each director. With the issue of "jumbo directorships" having made headlines last year, not all directors will feel comfortable with such a register.
"The problem with a limit being placed on the number of board positions which a director is permitted to hold is that there's a difference in the approach taken to the delivery of fund directorship services in the Cayman Islands. The "jumbo" directorship model is based on a structured system which escalates any issues arising through the organisation which is providing the directorship services and offers a streamlined efficient service. At the other end of the scale directors devote more time personally to their funds and give a more hands-on service in respect of the issues. Both approaches have their place," states Mulry.
Third, is a possible cap on the number of directorships: this could, however, be too ambiguous to enforce effectively. One director might hold multiple directorships across a range of similar funds being held in an umbrella structure, whereas another director might focus all of his efforts on a handful of diverse, complex fund strategies, meaning the number of directorships he holds will be less.
How, then, to decide on what is too high a number? "I expect that the approach taken by CIMA will be one that provides an appropriate level of regulation without impeding business in Cayman. My feeling is that CIMA is unlikely to set a hard and fast rule on the number of directorships which can be held by a single director," opines Mulry.
Buckley notes that Ireland introduced such a limit, which in the long run didn't work too well, and for Cayman would potentially cause more issues than it may seek to resolve: "Cayman has approximately 10,000 registered funds. If you were to limit the number of directorships you'd end up having to potentially find hundreds of new directors. You could well end up with the quality of those directors dropping, so a balance will need to be found."
Yolanda McCoy, Head of Investments & Securities at CIMA, clarifies: "We will soon be presenting a consultation paper as well as a corporate governance survey. The survey will touch on capping but CIMA does not have any affirmative position on any measures at this time. Consultation is key for us before any measure is adopted."
Further evidence that CIMA is enhancing the control and transparency of Cayman funds is the registration of master funds under the Mutual Funds (Amendment) Law, 2011.
"This is consistent with the policy position of the jurisdiction, which is to uphold and keep pace with global standards given the size and scope of our funds industry. It was not intended to be a marketing tool or be seen as a competitive advantage. The amendment is formalising something that was already happening," states Morehouse.
McCoy says that part of the reason behind amending the Mutual Funds Law to register master funds was over transparency concerns and the risk of unregulated funds in the international financial system. In particular the concerns of the September 2010 Global Forum on the Transparency & Exchange of Information for Tax Purposes Peer Review Report regarding the availability of investor information on unregulated Cayman funds: "By bringing master funds under CIMA's remit we closed that gap."
One important issue that needs to be resolved relates to FIN 48 regulation. Currently, there is a contradiction between the Foreign Judgment Law and the underlying Companies Law in Cayman in relation to tax liabilities.
"A literal reading of the law is that overseas tax authorities cannot enforce judgment, yet at the same time the FJL says certain recognized jurisdictions can but then creates it's own internal conflict within a rider to the provision. There is a conflict of law issue in Cayman that should be clarified," says Keiran Hutchison, restructuring partner at Ernst & Young.
This potential threat of future tax liabilities when a fund is being unwound might influence the way hedge funds trade; for example, rather than buying securities some managers might choose to trade synthetically with their prime broker using equity swaps.
Adds Jeff Short, AM partner at Ernst & Young: "Many of our clients are working with their tax director to develop a process so that their traders are aware of what they should and shouldn't be trading. If the system red flags a trade the manager will evaluate whether it's still worth pursuing the trade, or examine other ways of avoiding the liability issue."
Perhaps the most important piece of global regulation that Cayman is having to respond to is the AIFM Directive in Europe.
When the Directive is introduced in 2013 it will be necessary for offshore jurisdictions to have the relevant tax agreements in place with European member states to allow offshore managers to continue with the private placement process. When asked whether CIMA was doing enough to evolve, Buckley responds: "Yes, they are. I've been on one of the committees advising CIMA on the AIFMD and the need to get in place exchange and other agreements. CIMA is well down the path on that and in the next couple of months they'll be making some positive announcements."
Morehouse expands: "By July 2013 there are three things that Cayman has to do to allow Cayman funds to have access to European investors. First, CIMA has to put into place a co-operation agreement with ESMA and we're in the final stages of negotiation. Second, to ensure that Cayman is not on the FATF blacklist (which it isn't). Third, Cayman has entered into tax agreements with various EU member states and strong progress is being made on this front as well."
McCoy confirms that CIMA has been diligent in "trying to expand on potential bilateral co-operation agreements with key regulators in Europe as well as discussing the draft model with ESMA. We concluded a formal working group in early August, during which we looked at the Directive comprehensively. We are doing everything possible to ensure the funds industry in Cayman is safeguarded."
Aside from Europe, the Cayman government also has to consider US regulation; in particular FATCA and the US government's drive to ensure US investors pay their taxes.
"There's been a memorandum of understanding entered into between CIMA and the SEC this year which reflects a wider international regulatory co-operation in the Cayman Islands. The implementation of FATCA and the AIFMD is likely to lead to more regular and structured co-operation and a convergence of regulation between the Cayman Islands and the US and between the Cayman Islands and Europe," says Mulry.
One of the concerns relating to the AIFM Directive was the potential threat that Cayman would face from onshore fund jurisdictions like Ireland and Luxembourg. The catalyst behind this was a shift among investors, post-08, for more transparent regulated funds such as UCITS and QIF/SIFs. However, the wholesale re-domiciliation of funds simply hasn't manifested.
"We have been watching the onshore European market space very closely but we have had less than 10 funds over the last two years transfer to Europe," confirms McCoy.
Fund numbers in Cayman remain strong, and a recent report by Appleby shows that the number of company registrations there has grown 13 per cent over the past six months. Farrah Ballands, Appleby Partner & Global Head of Fiduciary & Administration Services, comments: "Cayman has a reputation for harnessing an environment that has contractual flexibility and legal certainty for companies incorporated in the Cayman Islands.
"Cayman is seeing an increase in the use of Cayman Companies to hold investments in North America in view of increasing regulation in these markets. We expect this trend of fast growth to continue well into 2013 and beyond."
On the redomiciliation issue, managers are starting to look at the bigger picture, understand who their investors are and develop fund structures that meet those needs. That might mean developing an onshore UCITS fund for European retail investors in parallel with an existing offshore Cayman feeder fund for US non-taxpayers and Asian investors, a Delaware-incorporated feeder fund for US taxpayers, and perhaps even a QIF for European institutions.
Says Bryan Hunter, managing partner of Appleby's Cayman office: "In our experience, there has been limited evidence of a loss of funds re-domiciling to Ireland or Luxembourg. In some specific cases it has proved appropriate to change to a European domicile and to utilise structures available in Europe. However there remains a growth trend in Cayman fund formation which would indicate that what Cayman has to offer is still much in demand."
Buckley is more emphatic, stating: "I can tell you with absolute certainty that from what we've seen it's no more prevalent now than it ever was. Sure we get asked the question, although not as much as we used to because it is prohibitively expensive. I know there are certain jurisdictions that are saying clients are moving their funds to them from Cayman in significant numbers but if that were correct, we'd be seeing that here...and we're simply not."
Giorgio Subiotto, partner and global head of investment funds at Ogier, agrees on the cost issue, noting that managers have to consider whether the additional capital raised in Europe would outweigh high set-up costs and on-going costs that, combined with greater investment restrictions, would eat into performance.
Moreover, the US is the biggest capital raising market right now. "You see far more UK managers looking to market into the US than the other way round. Really the move is for parallel structures to be set up. We haven't seen any moves away from Cayman because right now Europe isn't the main market for fund raising.
"Our recent experience indicates that currently the United States is where the real capital raising is taking place and the Cayman fund is naturally the vehicle of choice for that capital raising. We are seeing more European managers establishing Cayman funds to tap into the United States market than the other way around," confirms Subiotto.
One of the great advantages of Cayman is its flexibility as a fund jurisdiction. To that end, Subiotto notes that Ogier is seeing managers incorporate features of QIFs and SIFs into their Cayman funds so as to meet their "exact transparency, governance, and liquidity and reporting requirements".
This helps provide for the enhanced level of corporate governance that some investors may desire, but leaves the enforcement between the parties as a matter of contract rather opening the fund up to potential regulatory heavy handedness, says Subiotto, adding: "It has always been a strong advantage of Cayman funds that they can be established in a framework that allows the potential investors and promoters to tailor the terms of the fund to their respective needs."
Certainly, there's now a growing trend of more regulated Cayman funds launching with independent directors. According to survey data provided by Walkers, for the period January through October 2012, 72 per cent of regulated funds had some form of independent director: up from 64 per cent on last year's survey.
Of those funds which had independent directors, 49 per cent had majority independent boards, 37 per cent had fully independent boards, and only 4 per cent had a minority of independent directors on their boards.
Buckley points out that managers aren't just selecting two or three directors from a service provider, they are also, at times, cherry picking directors to bring different and complementary skills to the board.
"Increasingly, managers accept the fact that they've got to have independent directors, and like any good manager they want to get value out of them. Maybe they are looking to complement the board with a legal background, a compliance, trading, administration or regulatory background: whatever it is, we're seeing an increase."
Despite the deluge of global regulation, one advantage working in Cayman's favour is CIMA's willingness to engage in dialogue with the island's service providers.
"We have a straight line to CIMA, they listen to us and are proactive so we're fortunate in that regard," states Buckley.
Concludes McCoy: "Service providers in Cayman are working hard to ensure that their clients are kept up to speed, that their systems are able to meet any international standard. So we'll continue to collaborate with industry participants and move forward in 2013. We will be ready."
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