19 June 2006
The hedge fund industry continues to experience remarkable growth in assets under management and in the number and type of institutions that are investing in hedge funds. It has been estimated that hedge fund assets now total more than $1tr (£542.68bn) worldwide, amounting to 2 per cent of global investment assets.
The growing importance of the industry is recognised by the UK Financial Services Authority (FSA) which recently noted in discussion paper Hedge Funds: A discussion of risk and regulatory engagement that hedge funds are "a major source of liquidity and can significantly enhance market efficiency. Increasingly, they are fundamental to the efficient re-allocation of capital and risk and provide a mechanism for increasing investment portfolio diversification".
The Cayman Islands has established itself as the domicile of choice for offshore hedge funds. Last year was a record year for the fund industry with some 1,700 new funds being registered compared with around 1,500 in 2004. New fund launches in 2006 have remained robust and in the first quarter an average of 37 new funds were registered each week. It is expected that by the end of 2006 around 8,000 active funds (95 per cent or more of which will be hedge funds) will be registered in the Cayman Islands.
The benefits of the Cayman Islands
The Cayman Islands offers a number of advantages which underpin its domination of the offshore hedge fund market. There are no corporation, capital gains, income, profits or withholding taxes. In addition, there are no exchange control restrictions or regulations. The legal form and structure of fund vehicles established under Cayman Islands law and the securities offered are internationally recognised and accepted.
Cayman entities can be formed on the day of filing and 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 of the Cayman Islands is the light, but effective, regulation of hedge funds. 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.
This means no regulatory consents are required with respect to investment policy, the contents or circulation of offering memorandums or prime broker arrangements. The law which governs hedge funds, the Mutual Funds Law, was drafted on the clear principle of caveat emptor, or the acceptance of risk by the investor.
Regulation of hedge funds
Cayman Islands 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 $50,000 (£27,130) 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 partners or trustees 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 partners 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.
Change in mutual funds law
In 2004, a mutual fund working group established by CIMA and comprising government officials and private sector representatives, reviewed the Mutual Funds Law and made recommendations for certain amendments. The Cayman Islands government recently confirmed that most of the recommendations of the working group have been accepted by the Portfolio of Finance and Economics. It is anticipated that the proposed amendments to the Mutual Funds Law will be implemented before the end of 2006.
In response to concerns expressed by the International Organisation of Securities Commissions (IOSCO) and the International Monetary Fund (IMF), the working group recommended that the distinction between public and non-public funds be clarified.
It is also recommended that the minimum investment threshold for funds registered under Section 4(3) of the Mutual Funds Law is increased to $100,000 (£54,270), bringing the Cayman Islands into line with the rules in many other jurisdictions and satisfying a recommendation of the IMF. Existing funds will be 'grandfathered', and will not be affected by the change. Other proposed changes to the Mutual Funds Law include: allowing CIMA to waive the submission of audited financial statements in certain circumstances, such as where a fund was not launched or was in the process of being wound up; no longer requiring funds domiciled in IOSCO member jurisdictions, which are administered in the Cayman Islands to be registered as foreign companies in the Cayman Islands, and regulated by CIMA; and the introduction of a 14-day grace period within which professional funds could operate legally without registration while an application was being processed by CIMA.
The evolving nature of hedge funds
There has been considerable discussion in the US and the UK as to whether hedge funds should be subject to increased regulation. Achieving a balance between commercial flexibility and an appropriate level of regulation will always be a challenge.
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.
As undersecretary for domestic finance at the US Treasury, Randal Quarles, recently noted in testimony before a Senate banking committee hearing on hedge funds, that we should keep in mind that "the role of hedge funds in our financial markets is continuously evolving; and in recent years it has been evolving rapidly".
Quarles said: "While change like this often brings about improvements and efficiencies, it can also create insecurity and concern. The lens through which we examine the evolution of hedge funds' role in the financial markets often shapes our view of what, if anything, [needs to be done] to react to the changes so we should ensure this lens is as clear and polished as possible." n
Neal Lomax is a partner at Quin & Hampson.