Hedge fund regulation in the Cayman Islands

By Neal Lomax, partner, Quin & Hampson

There has been a great deal of debate in the US and England recently as to whether hedge funds should be subject to increased regulation. From a Cayman Islands perspective, the success of the domicile in attracting hedge funds1 and the limited number of failures bears testimony to the effectiveness of the current regulatory system. 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, 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.

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 must ensure that the fund has provided CIMA with 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.

The need to maintain a balance between commercial flexibility and an appropriate level of regulation of hedge funds is widely recognised by regulators and stakeholders in the Cayman Islands hedge fund industry. This is well demonstrated in the report of a mutual fund working group (MFWG) established by CIMA, comprising government officials and private-sector representatives, which reviewed the Mutual Funds Law and made recommendations for certain amendments.2 Some of the key recommendations of the MFWG are summarised below.

In response to concerns expressed by the International Organisation of Securities Commissions (IOSCO) and the International Monetary Fund (IMF), it is recommended that the distinction between public and non-public funds is clarified. The term ‘mutual fund’, which is more typically associated with the retail market in other jurisdictions, will be replaced with the term ‘investment fund’ to bring the Mutual Funds Law (to be renamed the Investment Funds Law) more in line with international terminology.

It is proposed that the minimum investment threshold for funds registered under section 4(3) of the Mutual Funds Law is increased to US$100,000, bringing the Cayman Islands into line with the rules in many other jurisdictions and satisfying an IMF recommendation. This increase in the minimum investment threshold is unlikely to have much impact in practice, as 80 per cent of funds registered with CIMA have a minimum subscription of US$1m or more, and only 5 per cent have an investment minimum of less than US$100,000. Existing funds will be ‘grandfathered’, and will not be affected by the change.

Other noteworthy 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 Cayman to be registered as foreign companies in Cayman 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 Cayman Islands Government recently confirmed that most of the recommendations of the MFWG have been accepted by the Portfolio of Finance and Economics. It is anticipated that the proposed amendments to the Mutual Funds Law will be enacted before the end of 2006.

References

1. 2005 was another record year for the Cayman Islands hedge fund industry with some 1,700 new funds being registered compared with some 1,500 in 2004. It is expected that approximately 8,000 funds will be registered in the Cayman Islands by the end of the 2006 calendar year.

2. “Review of the Regulatory Regime for Mutual Funds in the Cayman Islands – Report by the Mutual Funds Working Group – May 12, 2004”.