Alternative Investment Funds Guide 2014: Cayman Islands

June 8, 2014

By Grant Dixon, Andrew Keast Investment Funds Maples and Calder Cayman Islands

This article appeared in the 2014 edition of The International Comparative Legal Guide to: Alternative Investment Funds; published by Global Legal Group Ltd, London. Click here to view the publication’s website.

Grant Dixon and Andrew Keast recently participated in a Q&A focused on practical cross-border insight into alternative investment funds work. Their Cayman Islands contribution formed part of the second edition of the Alternative Investment Funds Guide, published in June 2014.

1 Regulatory Framework

1.1 What legislation governs the establishment and operation of Alternative Investment Funds?

Schedule 3 to SIBL specifically excludes certain activities from the definition of securities investment business, although those exclusions are unlikely to apply to a person conducting discretionary investment management or investment advisory

The Mutual Funds Law (2013 Revision) (the “MF Law”) provides for the regulation of open-ended investment funds and mutual fund administrators. Responsibility for regulation under the MF Law rests with the Cayman Islands Monetary Authority (“CIMA”).

In addition, the Retail Mutual Funds (Japan) Regulations (2007

Revision) as amended by the Retail Mutual Funds (Japan) (Amendment) Regulations, 2012 (together, the “Japan Regulations”), provide a regulatory regime for retail mutual funds that are marketed to the public in Japan.

Although not Cayman Islands law, the broad scope and extra- territorial effect of the EU Directive on Alternative Investment Fund Managers (“AIFMD”) will capture most types of Cayman Alternative Investment Funds, regardless of whether they are open- ended or closed-ended and regardless of their legal structure and investment strategy, with very few exceptions, to the extent that they are being marketed or managed in Europe (as such terms are defined for the purposes of the AIFMD).

1.2 Are managers or advisers to Alternative Investment

Funds required to be licensed, authorised or regulated by a regulatory body?

A manager or adviser which is established in or, in the case of a foreign company registered in, the Cayman Islands and which conducts “securities investment business”, whether or not that securities investment business is carried on in the Cayman Islands, will fall within the scope of the Securities Investment Business Law (2011 Revision) (“SIBL”).

“Securities investment business” is defined as being engaged in the course of business in any one or more of the activities set out in Schedule 2 to SIBL. Those activities include managing securities belonging to another person on a discretionary basis and advising in relation to securities, but only if the advice is given to someone in their capacity as investor or potential investor or in their capacity as agent for an investor or a potential investor and the advice is on the merits of that person (whether acting as principal or agent) buying, selling, subscribing for or underwriting a particular security or exercising any right conferred by a security to buy, sell, subscribe for or underwrite a security. “Securities” are defined to include most forms of shares and stock, debt instruments, options, futures, contracts for differences, and derivatives.

Any person within the scope of SIBL conducting securities investment business must be licensed by CIMA, unless that person is exempt from holding a licence. A licence may be restricted (meaning that securities investment business may only be transacted with particular clients) or unrestricted. A licence may also be issued subject to conditions or may be unconditional.

A person carrying on securities investment business may be exempt from the requirement to obtain a licence but will still be subject to certain provisions of SIBL. In the case of the exemptions referred to below, which are the exemptions likely to apply to fund managers or advisers, an “Excluded Person” is required to register with CIMA by filing a declaration and paying a fee of CI$5,000 (approximately US$6,097.56), prior to carrying on securities investment business and annually thereafter, confirming that they are entitled to rely on the relevant exemption.

An “Excluded Person” includes:

(a) a company carrying on securities investment business exclusively for one or more companies within the same group;

(b) a person, whose registered office in the Cayman Islands is provided by a licensee under SIBL, carrying on securities investment business exclusively for one or more of the following classes of person:

(i) a sophisticated person (a person regulated by CIMA or a recognised overseas regulatory authority or whose securities are listed on a recognised securities exchange or who by virtue of knowledge and experience in financial and business matters is reasonably to be regarded as capable of evaluating the merits of a proposed transaction and participates in a transaction with a value or in amounts of at least US$100,000 in each single transaction);

(ii) a high net worth person (an individual whose net worth is at least US$1,000,000 or any person that has any assets of not less than US$5,000,000); or

(iii) a company, partnership or trust of which the shareholders, limited partners or unit holders are all sophisticated persons or high net worth persons; or

(c) a person who is regulated by a recognised overseas regulatory authority in the country or territory (other than the Cayman Islands) in which the securities investment business is being conducted.

1.3 Are Alternative Investment Funds themselves required to be licensed, authorised or regulated by a regulatory body?

Subject to the section 4(4) fund exception described below, an investment fund qualifies as a “mutual fund” and is required to be regulated under the MF Law if:

(a) it is a Cayman Islands company, partnership or unit trust;

(b) it issues “equity interests” to investors (i.e. shares, partnership interests or trust units that carry an entitlement to participate in profits or gains and which may be redeemed or repurchased at the option of those investors prior to winding up); and

(c) its purpose or effect is the pooling of investor funds with the aim of spreading investment risks and enabling investors to receive profits or gains from investments.

There are three categories of mutual funds:

1. a licensed fund under section 4(1)(a) of the MF Law;

2. an administered fund under section 4(1)(b) of the MF Law;

and

3. a registered fund under section 4(3) of the MF Law.

1. A mutual fund licence will be granted if CIMA considers that the promoter is of sound reputation, there exist persons of sufficient expertise to administer the fund, who are of sound reputation, and that the business of the fund and any offer of equity interests will be carried out in a proper way. Detailed information is required concerning the directors, trustee or GP of the mutual fund (as the case may be) and the service providers. However, few investment funds are fully licensed under the MF Law, as this is generally only necessary for retail funds. From the statistics published on CIMA’s website, at the end of 2013 there were only 111 licensed funds.

2. Registration as an administered fund requires the designation of a Cayman Islands licensed mutual fund administrator as the fund’s principal office. The administrator must satisfy itself that the fund’s promoters are of sound reputation, that the fund’s administration will be undertaken by persons with sufficient expertise who are also of sound reputation and that the fund’s business and its offering of equity interests will be carried out in a proper way. The administrator is obliged to report to CIMA if it has reason to believe that a mutual fund for which it provides the principal office (or any promoter, director, trustee or GP thereof) is acting in breach of the MF Law or may be insolvent or is otherwise acting in a manner prejudicial to its creditors or investors. This imposes a quasi- regulatory role and an obligation to monitor compliance on the administrators themselves, and the higher fees charged by administrators in relation to this category of investment fund may not be considered to outweigh the increased obligations, as administered funds have declined in popularity over recent years, from 510 in 2008 to 398 in 2013.

3. Mutual funds registered under section 4(3) of the MF Law are divided into three sub-categories:

(a) where the minimum investment per investor is US$100,000; (b) where the equity interests are listed on a recognised stock

exchange; or

MF Law) and either:

(i) the minimum investment per investor is US$100,000;

(ii) the equity interests are listed on a recognised stock exchange.

A master fund is a Cayman Islands entity that has at least one feeder fund (either directly or through an intermediate entity established to

invest in the master fund) that is itself regulated by CIMA under the MF Law that holds investments and conducts trading activities for the principal purpose of implementing the overall investment strategy of the regulated feeder. Based on CIMA’s statistics, at the end of 2013, 2,635 of the 10,870 regulated section 4(3) funds were registered as master funds.

There is also an exception to the need to register with CIMA for funds (other than master funds), known as “section 4(4) funds”, that are open-ended “mutual funds” for the purposes of the MF Law but which have 15 or fewer investors, a majority in number of whom have the power to appoint and remove the fund’s directors, GP or trustee, as applicable.

1.4 Does the regulatory regime distinguish between open- ended and closed-ended Alternative Investment Funds (or otherwise differentiate between different types of funds) and if so how?

Yes; closed-ended funds are not subject to regulation under the MF Law. The key distinction between open-ended and closed-ended funds is the ability of investors to voluntarily redeem or repurchase some or all of their investment prior to winding up. Cayman Islands practitioners and CIMA generally consider that a lock-up period must be at least five years for an investment fund to be regarded as closed-ended at the outset.

1.5 What does the authorisation process involve?

CIMA has established an online e-business portal, CIMAConnect, which enables the online submission of mutual fund applications and documentation. An application for a section 4(3) fund involves the submission of:

(a) the fund’s offering document, other than in the case of a master fund, which will often not have an offering document separate from that of its feeder fund(s);

(b) the relevant statutory application form;

(d) the relevant fee (currently US$4,628, initially and annually); (e) an affidavit relating to the authorisation of submission of the

online application; and

(f) certain information regarding the fund’s operator (the directors, GP or trustee, as the case may be).

CIMA’s practice with section 4(3) funds is to make the effective date of the application the date on which all application requirements have been submitted and applications must be completed prior to a fund launching in order to be compliant with the MF Law.

The authorisation process is more involved for licensed and administered fund applications.

1.6 Are there local residence or other local qualification requirements?

The sole local requirement for Cayman Islands regulated funds is to appoint a local auditor approved by CIMA.

1.7 What service providers are required?

Every regulated mutual fund must have an approved local auditor and will generally have an investment manager/adviser and an administrator (which, for an administered mutual fund, must be a licensed mutual fund administrator).

Although not required, it is becoming market practice for corporate regulated investment funds to appoint independent directors. Such independent directors are not required to be based in the Cayman Islands but often are, due to the depth of the Cayman fiduciary services industry. Based on statistical analysis conducted by Maples and Calder, 75 per cent of funds launched in 2013 by managers based in North America had at least one independent director. The trend is the same for Asia-based managers where 75 per cent also had at least one independent director; the trend is higher for funds with Europe-based managers, with approximately

85 per cent of the funds launched in 2013 having at least one independent director.

The statistics compiled by Maples and Calder reflect a snapshot of the regulated funds established during the relevant period for which Maples and Calder acted as Cayman Islands legal counsel. Although this represents a significant sample size (approximately 35 per cent of new registered funds in 2013), it is inevitable that

these statistics would vary if they were based on all funds established during the relevant period.

1.8 What co-operation or information sharing agreements have been entered into with other governments or regulators?

The Cayman Islands has Tax Information Exchange Agreements and similar bilateral arrangements with 32 countries as at 21 March 2014 and is on the OECD “white list” with respect to the exchange of tax information. In addition, CIMA has entered into bilateral regulatory cooperation agreements pursuant to the AIFMD with the competent authorities of 27 of the EU and EEA Member States.

2 Fund Structures

2.1 What are the principal legal structures used for Alternative Investment Funds?

Three types of vehicle are most commonly utilised by Cayman Islands investment funds: exempted companies, exempted limited partnerships (“ELPs”) and exempted unit trusts. The term “exempted” in this context means that the vehicle is eligible to

apply to the Cayman Islands government for an undertaking (lasting 20 or 50 years depending on the type of vehicle) that if any taxation is introduced in the Cayman Islands during the period to which the undertaking applies, such taxation will not apply to the vehicle in question. In return, exempted vehicles are not generally permitted to carry on business within the Cayman Islands.

Exempted companies are by far the most common vehicle for open ended funds (including master funds). Based on statistics published by CIMA, 80 per cent of reporting funds were exempted companies (including segregated portfolio companies) in 2011. Based on Maples and Calder’s statistical analysis, the exempted company was used as the principal fund vehicle in 86 per cent of North American managed funds, 93 per cent of European managed funds and 73 per cent of Asian managed funds in 2012.

However, it is not common to see closed-ended funds established in the Cayman Islands as exempted companies. The ELP is usually the vehicle of choice for closed-ended or private equity funds.

The Cayman ELP concept is similar to that which applies in the United States and indeed the Exempted Limited Partnership Law, 2014 (the “ELP Law”) is based substantially on the Delaware equivalent (although a Cayman Islands partnership is not a separate legal person). Whilst exempted companies are extremely flexible in

the extent to which voting and economic rights can be mixed and matched across separate classes of shares, companies have certain limitations that do not apply to ELPs. Fewer statutory rules govern the approvals processes within an ELP, which makes them generally more flexible and suitable for closed-ended vehicle purposes.

Unit trusts are the vehicle primarily used for investors in Japan, where the demand is driven by familiarity with the unit trust structure and historical local tax benefits relating to trust units as opposed to other forms of equity interest. Such investment funds can elect to comply with the Japan Regulations when applying for a licence under the MF Law that, under current guidelines set by the Japan Securities Dealers Association, permit them to be marketed to the public in Japan.

2.2 Please describe the limited liability of investors.

The limited liability of investors in a Cayman Islands investment fund depends upon the nature of the vehicle used and whether the investor has agreed to contribute additional funds to that vehiclepursuant to the terms of the governing documentation.

With exempted companies limited by shares, the liability of the investors is limited to the amount unpaid on their shares pursuant to the constitutional documents of the company and in accordance with the Companies Law (2013 Revision), as amended.

Limited partners (“LPs”) of an ELP shall not be liable for the debts or obligations of the ELP under the ELP Law, (a) save as provided by the terms of the applicable partnership agreement, and (b) subject to the provisions of the ELP Law (i) providing that an LP who takes part in the conduct of the business of the ELP may lose its limited liability with respect to a third party who deals with that

ELP and who reasonably believes such LP to be a GP of such ELP, and (ii) providing for claw back of capital distributions (together with interest) made to LPs within six months of the ELP becoming insolvent.

Investors who are unit holders of an exempted trust must look to the wording of the relevant declaration of trust to provide them with limited liability status and protection.

Despite the limited liability nature of an equity interest purchased by an investor, it is common practice for the subscription and certain transaction documents of Cayman Islands investment funds to impose payment obligations on investors over and above the obligation to pay for their investment. Such additional obligations

regularly include indemnification for misrepresentations and the requirement to repay excess redemption or withdrawal proceeds which were calculated and paid on the basis of unaudited data.

2.3 What are the principal legal structures used for managers and advisers of Alternative Investment Funds?

The principal structures are exempted companies and exempted limited partnerships.

2.4 Are there any limits on the manager’s ability to restrict redemptions in open-ended funds or transfers in open- ended or closed-ended funds?

Not as a general matter of Cayman Islands law; the ability to redeem or transfer equity interests in a fund and any restrictions thereon will be governed by the governing documents.

2.5 Are there any legislative restrictions on transfers of investors’ interests in Alternative Investment Funds?

No, subject to restrictions on the assignment of certain liabilities by

LPs pursuant to the ELP Law.

3 Marketing

3.1 What legislation governs the production and offering of marketing materials?

The MF Law requires that every regulated mutual fund issue an offering document which must describe the equity interests in all material respects and contain such other information as is necessary to enable a prospective investor to make an informed decision whether or not to invest.

To supplement this requirement, CIMA has issued a rule in relation to the content of offering documents for licensed funds, which is generally applied to the offering documents of all regulated funds. The Japan Regulations also set out additional disclosure requirements for the prospectus of a retail mutual fund, which are more onerous.

3.2 What are the key content requirements for marketing materials, whether due to legal requirements orcustomary practice?

The minimum disclosure requirements include the following:

(a) details of the date of establishment of the fund, its registered office, fiscal year and its operator together with biographies;

(b) a description of the fund’s investment objectives, policy, and restrictions;

(c) a description of the fund’s investment manager or adviser, together with biographies of the portfolio managers and information regarding remuneration;

(d) the names and addresses of the fund’s other service providers, together with details of the services to be performed and remuneration;

(e) the classes of interests available for investment or issue, together with descriptions of any minimum investment, eligibility requirements and subscription procedures;

(f) details of the principal rights and restrictions attaching to the fund’s equity interests, including with respect to currency, voting, circumstances of winding-up or dissolution and the procedures and conditions for repurchases, redemptions or withdrawals of such equity interests, including suspensions;

(g) the NAV calculation policy; and

(h) details of the fund’s material risks and potential conflicts of interest.

3.3 Do the marketing or legal documents need to beregistered with or approved by the local regulator?

The offering document of a regulated mutual fund must be filed with CIMA as part of the initial application, however it is not technically subject to approval by CIMA prior to its circulation to prospective investors. An amended offering document or supplement must be filed with CIMA within 21 days in the event of material changes, e.g. changes in directors, trustee, GP, administrator, auditors, etc., where there is a continuing offering.

3.4 What restrictions are there on marketing Alternative Investment Funds?

No offer or invitation to subscribe for equity interests in a Cayman Islands investment fund may be made to the “public in the Cayman Islands”. Persons excluded from the “public in the Cayman Islands” include sophisticated persons and high net worth persons (each as defined under SIBL, as described above), Cayman Islands exempted companies and foreign companies registered in the Cayman Islands.

3.5 Can Alternative Investment Funds be marketed to retail investors?

Yes, subject to the US$100,000 minimum investment for section 4(3) funds noted above.

3.6 What qualification requirements must be carried out in relation to prospective investors?

None, although potential investors will generally be subject to screening in accordance with the Cayman Islands’ anti-money laundering regime.

3.7 Are there additional restrictions on marketing to public bodies such as government pension funds?