By Nicholas Butcher and Julian Ashworth, Maples and Calder

Introduction

The Cayman Islands has an internationally respected legal system, developed from English common law, and a robust regulatory system which equally benefits managers and investors alike. The jurisdiction offers an established and responsive professional infrastructure which is capable of implementing large and complex international business transactions, a tax neutral platform and a reputation for equal treatment of investors from different jurisdictions.

The Cayman Islands is also on the OECD’s “white list” for jurisdictions which have substantially implemented the internationally agreed tax standard and has entered into bilateral tax information exchange agreements with a significant number of jurisdictions (including the United States and the United Kingdom).

Cayman authorities co-operate with governments worldwide to ensure that Cayman cannot be used to evade home country taxes and there are, for example, laws which require automatic reporting. The Cayman Islands’ government is actively co-operating on initiatives such as US and UK FATCA.

As a result, the Cayman Islands continue to be the offshore jurisdiction of choice for the formation of international investment funds (both hedge and private equity funds).

Most commonly, private equity funds are structured as limited partnerships and this article examines the principal structuring issues in forming a Cayman Islands private equity fund as an exempted limited partnership. There are some sponsors who, depending on the investor base and other onshore considerations, look to structure funds as a corporate vehicle and this article also notes salient matters in structuring a Cayman Islands private equity fund as an exempted company.

As a general matter, closed-ended funds, however structured, are not currently regulated by the Cayman Islands Monetary Authority (CIMA) under the Mutual Funds Law (2012 Revision), as equity interests are not redeemable or re-purchasable at the option of investors. CIMA may have oversight in relation to compliance with other laws and regulations which may be applicable to a closed-ended fund depending on the fact specific nature of a particular structure.

Exempted limited partnerships

Registration

An exempted limited partnership is formed and registered with the Registrar of Exempted Limited Partnerships in the Cayman Islands under the Exempted Limited Partnership Law (2012 Revision) (ELP Law). It is primarily governed by its partnership agreement into which the partners are able to easily build the applicable commercial terms.

An exempted limited partnership requires at least one general partner and one limited partner, neither of whom needs to be a Cayman Islands entity (although the general partner must satisfy one of the qualification tests in the ELP Law (see below, Operator: duties)). A general partner is liable for the debts and obligations of an exempted limited partnership to the extent its assets are inadequate. Conversely, a limited partner has limited liability (see below, Investors: limited liability).

A certificate of registration is conclusive evidence that compliance has been made with all the requirements of the ELP Law in respect of formation and registration of an exempted limited partnership.

Equity interests

An investor’s equity participation is represented by a partnership interest, the rights and obligations of which are determined with reference to the partnership agreement. The partnership agreement will set out a partner’s rights to participate in profits, capital and otherwise vote on partnership matters.

A consultation is currently in progress with a view to revising the ELP Law. Anticipated statutory amendments are, broadly, intended to further codify and confirm the contractual freedom of parties to regulate their arrangements with appropriate statutory safeguards and to reflect market practice. Several of these changes will further enhance the flexibility of Cayman-domiciled limited partnership structures.

Legal personality

Notwithstanding registration, an exempted limited partnership is not a separate legal person and it is a requirement of the ELP Law that an exempted limited partnership acts by, or on behalf of, its general partner. The general partner can delegate functions to service providers; including a manager.

The ELP Law affords an exempted limited partnership many of the features synonymous with separate legal personality, such as the ability to hold assets in the name of the partnership. Technically, under Cayman Islands law, any property of the exempted limited partnership held in its own name will be deemed to be held by the general partner(s) upon trust, as an asset of the exempted limited partnership in accordance with the terms of the partnership agreement.

Requirements

An exempted limited partnership must have and maintain a registered office in the Cayman Islands for the service of process and to which notices and correspondence can be sent. This requirement is typically satisfied by engaging a corporate administration services provider in the Cayman Islands to act in this capacity.

An exempted limited partnership must maintain a register of partnership interests, a register of mortgages over limited partnership interests and books of account which give a true and fair view of the business and financial condition of the exempted limited partnership and explain its transactions. Books of account must be maintained for a minimum period of five years from the date on which they have been prepared.

Certain filings must be submitted to the Registrar upon a change in prescribed particulars; most notably any change in the general partner which change will, as a matter of Cayman law, take effect upon the prescribed statement being filed. These are notified by way of a prescribed form (a section 10 statement). Neither the partnership agreement, nor amendments to the partnership agreement are filed.

Details of limited partners are not filed with the Registrar and no filings need to be made to maintain the limited liability of limited partners.

Access to information

Generally, a partner’s access to information can be limited or expanded by the terms of the partnership agreement. In addition, the partnership agreement will usually provide that any information disclosed to partners and relating to the exempted limited partnership is confidential (with limited carve-outs for investors which are themselves investment vehicles or certain freedom of information-subject investors such as state pension plans). The public, therefore, usually does not have access to partnership information.

Cayman regulatory authorities may request certain information with respect to an exempted limited partnership to fulfil their applicable statutory, regulatory and/or treaty obligations.

Operator: duties

Since an exempted limited partnership does not have separate legal personality, the general partner acts as principal for itself and agent for each of the other partners.

Currently, the ELP Law requires that at least one general partner of an exempted limited partnership be either an individual resident in the Cayman Islands, or a company incorporated or otherwise registered as a foreign company, under the Companies Law or another exempted limited partnership.

Accordingly, an exempted limited partnership may need to appoint a second administrative general partner if the proposed general partner does not satisfy the existing test (by way of example, if a Delaware limited partnership is to act as managing general partner). This is because the general partner, as agent, owes fiduciary duties in relation to the business of the exempted limited partnership as defined by the partnership agreement.

General partners are subject to a statutory duty to act at all times in good faith in the interests of the exempted limited partnership. The prevailing view is that the statutory duty largely codifies the existing common law duties, the effect of which is that a general partner must act in good faith in exercising its management rights and for a purpose for which the applicable power has been conferred.

Although the statutory duty of good faith cannot be excluded, the extent and scope of a general partner’s duties with respect to a specific fund will need to be determined by reference to the underlying contractual relationship as between the parties because the general partner, as agent, owes fiduciary duties in relation to a business as defined by the partnership agreement. Its position, therefore, is different from other fiduciaries, such as a trustee or director. For example, it has been held that a partner (hence a general partner) can use property or information for its own benefit that is not of value to the partnership provided it is not used in competition with the partnership’s business.

It is therefore helpful to ensure that, amongst other matters, a partnership agreement sufficiently sets out the matters which a general partner must consider in exercising its powers and duties (for example, with respect to allocation of deal flow as between the relevant partnership and a prior or successor partnership).

Operator: liabilities

As noted above, in the event the assets of the exempted limited partnership are inadequate, a general partner is liable for all debts and obligations of the partnership.

Investors: duties

Although limited partners may owe duties of good faith to each other, it is submitted that the nature and extent of those duties are limited in scope. This is because, unlike with an ordinary partnership, limited partners are not agents of each other or the exempted limited partnership and do not have the power to bind the partnership in transactions with non- partners.

A statement to the effect that a limited partner of an exempted limited partnership will not owe any fiduciary duty in exercising any of its rights or authorities or otherwise in performing any of its obligations under the partnership agreement to the exempted limited partnership or any other partner is commonly incorporated into a partnership agreement. It is submitted that such provisions will be enforceable as between the partners given the contractual freedom of partners to modify limited partners’ duties and obligations by express or implied agreement, subject to public policy limitations (such as good faith, actual fraud and wilful default).

Investors: limited liability

Registration under the ELP Law means that the exempted limited partnership becomes subject to the benefits of the ELP Law and, in particular, the limited partners are afforded the benefit of limited liability from the date the exempted limited partnership is registered with the Registrar.

A limited partner of an exempted limited partnership, therefore, will not be liable for the debts and obligations of the exempted limited partnership, except:

.           As expressed in the partnership agreement.

.           If that limited partner becomes involved in the conduct of the partnership’s business in its dealings with persons who are not partners. However, limited partners will only be liable to a person who transacts business with the exempted limited partnership during such period with actual knowledge of such participation and who then reasonably believed that limited partner to be a general partner.

.           If that limited partner is obliged under the ELP Law to return a distribution made to it in

certain circumstances where the exempted limited partnership is insolvent.

Advisory committees

In practice, limited partners may want to appoint a member to an advisory committee where entitled or requested to do so but, once appointed, these representatives are often concerned with:

 

.           Whether participation breaches restrictions on involvement in the management of the exempted limited partnership’s business.

.           The nature and scope of duties owed by the limited partner’s representative to other partners

and the partnership.

Participation in an advisory committee does not amount to involvement in the management of the exempted limited partnership’s business for the purposes of the ELP Law, provided that the member only takes action that is expressly reserved to the limited partners under the terms of the partnership agreement. It is expected that this safe harbour will be further confirmed in anticipated revisions to the ELP Law.

There is currently no specific statutory provision or case law which deals directly with the nature and scope of an advisory committee member’s duties. From a practical perspective, however, the partnership agreement and any appointment terms may seek to modify the nature and scope of the duties owed by a representative on an advisory committee with a common formulation being that an advisory committee member owes no fiduciary duties to the partners or the exempted limited partnership provided that the member acts in good faith.

Tax undertakings

The Cayman Islands does not currently impose any direct corporate taxes on investment vehicles, including an exempted limited partnership or its limited partners. The Cayman Islands is not party to a double tax treaty with any country that is applicable to payments made to or by investment fund vehicles.

A general partner can apply for, and obtain, a tax undertaking from the Cayman Islands Government, which is valid for a period of 50 years from the date of the undertaking, the effect of which is that no law which is enacted in the Cayman Islands imposing any tax to be levied on profits, income, gains or appreciations will apply to the exempted limited partnership, or to any partner of that exempted limited partnership, in respect of:

.          The operations or assets of the exempted limited partnership.

.          The interest of a partner in that partnership.

The tax undertaking can further provide that any such taxes or any tax in the nature of estate duty or inheritance tax will not be payable in respect of the obligations of the partnership or the interests of the partners in that partnership.

Contractual provisions

As the ELP Law allows partners to freely determine their arrangements, there are a number of key legal provisions which should be addressed in the partnership agreement in addition to the economic and commercial arrangements, including the following matters.

Borrowing, security and guarantees. The partnership agreement should address the power of the general partner to incur indebtedness, grant guarantees and grant security interests in respect of the exempted limited partnership’s assets or rights over the general partner’s ability to assign the right to call capital contributions and receive proceeds of those capital contributions.

Side letters. The general partner’s ability to enter into side letters and any limitations to that power, including:

.           Whether there is to be a general most favoured nations clause.

.          The extent to which, if at all, limited partners receive copies of the terms offered in executed side letters.

Conflicts/allocations. Clear authority should be provided which permits the general partner, particularly where it acts as general partner to multiple exempted limited partnerships, to allocate investment opportunities as between predecessor and successor funds and generate and retain fee income from other activities or otherwise contract with, for example, portfolio companies on an arm’s length basis.

Indemnification/advancement of expenses. The scope of indemnification for the general partner, an advisor, any other relevant parties and their directors, officers, employees and other relevant persons should be included. Cayman Islands law generally permits indemnification subject to public policy limitations (actual fraud and wilful default) and partners may agree that expenses to cover indemnification claims may be advances to indemnified persons.

These provisions will regularly be supported by way of ancillary documentation, such as a deed poll, given third party beneficiary rights are not currently enforceable in Cayman.

Winding up/general partner removal. The circumstances by which the partners can wind up the exempted limited partnership other than as contemplated in the ELP Law should be set out. Generally, the ELP Law provides for winding up upon consent, in certain insolvency events pertaining to the general partner or by order of the Grand Court of the Cayman Islands. The partnership agreement should contemplate:

.           Whether the general partner can be removed for cause and/or on a no-fault basis.

.           The economic consequences of such a removal (for example, carry entitlements).

.           Any additional circumstances by which the exempted limited partnership can be wound up (for example, upon expiration of a specified term or on a no-fault basis upon consent of a specified majority-in-interest of limited partners).

Default provisions. The consequences of a limited partner defaulting on its obligations should be set out in the partnership agreement. Generally, those consequences may include interest accruing on unpaid contributions, forfeiture of a portion of a limited partner’s partnership interest or other sanctions, although as a general approach there should be proportionality between the sanction and the remedy imposed to ensure it can be considered a genuine pre-estimate of loss.

Exempted companies

Registration

An exempted company is incorporated under the Companies Law (2012 Revision) (Companies Law) with the primary governing document between investors being its memorandum and articles of association.

An exempted company can be formed by any one or more persons, none of whom needs to be a Cayman Islands entity. An exempted company is managed by its directors, who have supervisory oversight of its business and who may, and will regularly, delegate various functions to one or more appointed service providers.

Equity interests

An investor’s equity participation is represented by shares, either partly or fully-paid, the rights and obligations of which are principally determined with reference to the memorandum and articles of association and the Companies Law.

Shares are generally issued as fully-paid with a corresponding obligation to subscribe for additional shares up to the amount of an investor’s commitment. Fully-paid shares are more flexible in that they can be redeemed and repurchased, which often provides an effective manner in which to make distributions to investors. Unlike nil or partly-paid shares, fully-paid shares do not have to be numbered.

Legal personality

An exempted company has separate legal personality and is a body corporate. A company is able to enter into its own agreements, hold assets and bring proceedings in its own name.

Requirements

An exempted company must have and maintain a registered office in the Cayman Islands for the service of process and to which notices and correspondence can be sent. As with an exempted limited partnership, this requirement is typically satisfied by engaging a corporate administration services provider in the Cayman Islands to act in this capacity. An exempted company must maintain:

.           A register of shareholders/members.

.           A register of mortgages over its assets.

.           A register of directors and officers.

.          Books of account which give a true and fair view of the business and financial condition of the exempted company and explain its transactions.

Books of account must be maintained for a minimum period of five years from the date on which they have been prepared.

Certain filings must be made to the Registrar of Companies, in particular a change in directors and any amendments to the memorandum and articles of association.

Access  to information

Generally, an investor’s access to information is limited although such rights may be contractually broadened through the articles, a subscription agreement or side letter. The public generally does not have access to company information.

Cayman regulatory authorities may request certain information with respect to an exempted company to fulfil their applicable statutory, regulatory and/or treaty obligations.

Operator: duties

A company requires at least one director, which may be either a corporate or natural person.

As a matter of Cayman law, directors are responsible for the supervisory oversight of a company’s affairs, even where day-to-day functions are delegated to a service provider (such as an investment manager) and each director is in a fiduciary relationship to the company.

Directors’ duties are essentially imported from pre-2006 English common law. Broadly, the duties that a director owes to a company can be divided into two categories; the first encompassing fiduciary duties, and the second encompassing duties of care, diligence and skill.

The fiduciary duties may be described as being those of loyalty, honesty and good faith to the company, with the most significant being a duty to act in the best interests of the company as a whole. Directors must also exercise powers that are vested in them for the purpose for which they were conferred.

Operator: liabilities

A director of a Cayman Islands company who breaches the relevant duties may incur personal liability and, by way of example, the Cayman courts have held liable directors who have fallen short of the duty of care, diligence and skill (see, for example, Weavering Macro Fixed Income Fund Limited (In Liquidation) v Peterson and Ekstrom, 2011 (2) CILR 203).

However, if a director complies with the fiduciary duties and the requisite duties of care, diligence and skill, the fact that a decision turns out to be wrong, not beneficial, or causes loss, will not of itself necessarily establish personal liability. The Cayman courts will not look to put itself in a position of reviewing, with the benefit of hindsight, an otherwise proper exercise of a discretion by a director purely on the basis that, as matters transpired, the decision proved to be wrong, not beneficial, or caused loss to the company. The court will ordinarily only interfere if it determines that no reasonable director could have concluded that a particular course of action was actually in the best interests of the company.

Directors can incur contractual or tortious liability directly to third parties, for example, if they make negligent misrepresentations,  directly or indirectly on behalf of the company, and criminal liability, if, for example, they are knowingly involved in the issue of accounts or statements which are materially misleading or false.

Generally, directors will enjoy the benefit of indemnities and other limitations on liability which have been provided for in the articles of association or, otherwise, by way of a director services agreement.

Investors: duties

Shareholders of an exempted company do not generally owe duties to each other.

Investors: limited liability

Each shareholder’s liability is typically limited to the amount, if any, unpaid on the shares held under the Companies Law. Contractually, it is typical for an investor to agree to subscribe for shares in an exempted company up to an amount equal to its commitment.

Tax undertakings

An exempted company can obtain a tax undertaking, which is valid for a period of 20 years from the date of the undertaking, the effect of which is that no law which is enacted in the Cayman Islands imposing any tax to be levied on profits, income, gains or appreciations will apply to the exempted company, or its operations. In addition, the tax undertaking can also provide that no tax will be levied on profits, income, gains or appreciations, and that no tax which is in the nature of estate duty or inheritance tax will be payable:

.          On or in respect of the shares, debentures or other obligations of the exempted company.

.          By way of the withholding (in whole or in part) of a payment of dividend or other distribution of income or capital by the exempted company to its members, or a payment of principal or interest or other sums due under a debenture or other obligation of the exempted company.

Contractual provisions

An exempted company must conform with many of the statutory provisions set out in the Companies Law. Although key features of a private equity fund are more readily built into the flexible limited partnership structure, it is possible to build those features into a corporate format by way of the articles of association and subscription agreement.

There are a number of mechanics which must be addressed in a manner which is different to an exempted limited partnership, including the following matters.

Borrowing/guarantees. There are no prescribed investment and borrowing restrictions and the articles often permit directors the power to enter into broad-based borrowing and security arrangements which will be supported by broad based power in the subscription agreement to assign the right to make capital calls. However, restrictions can be agreed with investors and will typically be set out in core documentation.

Commitments, contributions and issue  price  of shares.  It is possible for investors to subscribe for partly-paid shares but it is more common for a company fund vehicle to issue fully-paid shares with a corresponding obligation to subscribe for further shares set out in the subscription agreement. This approach more readily facilitates withdrawals and payment of distributions to investors during the vehicle’s lifecycle. Each investor would also generally receive its own class or series of share.

The issue price for the shares to be subscribed for will also be set as a premium to the par or nominal value of such shares given. In the Cayman Islands, share premium can be applied to a wide range of purposes (see below, Contractual provisions: Distributions and withdrawals). The issue price will often be a fixed price (for example, US$1,000 per share) as a company fund vehicle will typically seek to incorporate partnership style accounts into its articles.

Voting rights. An exempted company can issue one or more classes of shares with either voting or non-voting or limited voting rights. By way of example, an exempted company which serves as a feeder fund may simply look to afford investors pass-through rights with respect to underlying interests in a master fund.

Default  provisions. On the assumption an exempted company issues fully paid shares, the sanctions in respect of an investor who defaults on their obligation to fund commitments will commonly be set out in the subscription agreement and, possibly, the articles. The sanctions will be similar to those applicable for an exempted limited partnership, and could include interest accruing on unpaid contributions, enforced sale of shares and/or disenfranchisement of voting rights. Again, as a general rule there should be proportionality between the sanction and the remedy imposed, with a view to a court enforcing those sanctions on the basis that they amount to a genuine pre-estimate of loss.

Distributions and withdrawals. Amounts available for distribution can be paid out by way of redemption or repurchase on fully-paid shares. An investor can also be withdrawn in the same manner. Partly paid shares cannot be redeemed or repurchased until such time as they are fully paid, and a holder of such shares would need to effect an exit by way of a transfer of such unpaid or partly-paid shares to a qualified investor.

It is also possible to pay a dividend on shares with such proceeds to be sourced out of either profit or share premium accounts but not from “pure” capital (being the amount representing the par or nominal value of such shares).

The directors must be satisfied that, upon payment of a distribution, the exempted company will be able to pay its debts as they fall due in the ordinary course of business (and in relation to a dividend paid out of share premium, any director knowingly and wilfully authorising such a dividend in contravention of the applicable provision commits a criminal offence).

Transfers. The articles regularly provide that shares, either partly or fully paid, may only be transferred with the consent of directors.

In addition, a transferee of a partly paid share will also be required to sign a share transfer form as that transferee is assuming liability for the unpaid balance of the transferred shares. A transferor of a partly paid share will also remain liable as a past member if both:

.           A winding up commences within one year from when the transferor ceased to be a member.

.           The current member is unable to contribute the amount due to satisfy the unpaid portion of such shares.

Conversely, a transferor of fully paid shares has no such residual liability and therefore this is an additional benefit in a company fund vehicle only issuing fully paid shares.

Conclusion

An exempted limited partnership structure is, overall, a more familiar and flexible structure by which to establish a Cayman Islands private equity fund structure. Sponsors and investors alike are able to readily legislate for sophisticated and tailored commercial arrangements by way of the partnership agreement. The Cayman Islands reputation as a jurisdiction with a strong legal system which benefits both managers and investors will be further enhanced after implementation of anticipated amendments to the ELP Law.

The company regime also provides a framework which is sufficiently permissive to accommodate the objectives of target investors and replicate the concepts which are commonly adopted in a limited partnership structure.