United States

Finding the balance

INVESTMENT INDUSTRY INSIGHTS  | 

Background
In an investment environment plagued by market crises, corporate scandals, increasing investor demands for operational oversight and continued concern about risk of all types, the fine line between excessive regulatory creep and appropriate, risk-based regulation is an ever-sharper razor's edge.

The Cayman Islands, as the largest domicile of offshore funds, must always be looking for the equilibrium by paying close attention to and meeting the demands of investors, while standing firm in its regulatory philosophy, which is based on providing the right amount of intelligent regulation in the appropriate places.

In its latest move to bolster Cayman Islands hedge fund regulation, the jurisdiction has implemented new legislation that requires Cayman master funds to register with the regulator, the Cayman Islands Monetary Authority (CIMA). This legislation makes some clarifications and improvements to the Cayman Islands hedge fund regulatory regime in response to trends in the international marketplace and to suggestions from various international regulatory bodies, including the Organisation for Economic Co-operation and Development (OECD) that have stated that the regulatory status of these funds could be improved.

So what has initiated this change in approach? Although some Cayman master funds were previously registered with the regulator under the Mutual Funds Law (MFL), most were exempt under provisions that eliminated registration requirements for those funds which had fewer than 16 investors, or the funds did not constitute as mutual funds under the MFL. This type of exception is not mainstream in the hedge fund world and although standing out from the crowd is often desirable from a competitive standpoint, it is sometimes best if the differentiator is not a subject of criticism.

This criticism was highlighted in the OECD Peer Review (2010) Global Forum on Transparency and Exchange of Information. The Peer Review report identified Cayman as having "a well-developed legal and regulatory framework" and "in respect of access to information, the competent authority of the Cayman Islands is invested with broad powers to gather relevant information." But, the report also refers to the Cayman master funds and states that "there are potentially significant adverse consequences on the availability of information in respect of these exempt funds."

The amendment
The amendment to the Mutual Funds Law (2009 Revision), which came into effect on Dec. 22, 2011, applies to every mutual fund that is incorporated or established in the Cayman Islands that holds investments and conducts trading activities, issues equity interests redeemable at the option of the investor and has more than one shareholder, including feeder funds which are registered with CIMA. A regulated feeder fund is defined as a "regulated mutual fund that conducts more than 51 percent of its investing through another mutual fund."

In a traditional Cayman master-feeder structure, the majority of assets are usually held at the master fund level, so it is understandable that the structure be regulated at the master level, along with any Cayman regulated feeder fund investing into the Cayman master fund.

The registration process and the duties and obligations of the fund operators (directors, general partners or trustees) and service providers are similar to those which Cayman Islands hedge funds already registered with CIMA are subject to. The registration requires: a confirmation of which Cayman-based service provider will be the point of contact for queries and will be responsible for the payment of the registration fee of CI$2,500 (US$3,048.79); and the submission of a registration form (the MF4 form) and the fund's certificate of incorporation or equivalent. For those Cayman master funds which already have a specific offering document, this will also need to be filed, and where one does not already exist, the MF4 must include a summary of the material terms of the master fund's offering.

On an ongoing basis, CIMA must be notified within 21 days of any changes to these offering documents or the terms outlined in the MF4 and the regulator must also be advised as to whether there are investors in the master fund other than the regulated feeder funds. Future requirements subsequent to registration include the filing of annual financial statements signed off by a CIMA-approved auditor; and a FAR form (the electronic Fund Annual Return form) filed within six months of the fund's financial year end.

From the audit perspective of the fund, there are a few material changes to the audit process. Existing master funds are required to appoint a CIMA-approved auditor and the master funds currently audited by an overseas affiliate of the Cayman regulated feeder funds are expected to appoint the same auditor as the regulated feeder funds. There is no need for an auditor consent letter (or an administrator consent letter) for a master fund, provided the auditors (and the administrators) are the same for both the regulated feeder fund(s) and the master fund.

Summary commentary
This new legislation has had its healthy share of industry debate in the jurisdiction, with diametrically opposed views expressed. Some service providers welcomed the changes as advancement in the international regulatory arena. Some feared the new fees would cause funds to potentially flee the jurisdiction, or new funds to domicile elsewhere (although the fee is lower than it is for other types of registered funds). Others observed that since the feeder funds are already registered and regulated, there was no need to register the master fund, which increases the operating costs of the fund. Another group felt that the registration process did not go far enough to sufficiently address the concerns of the OECD and other regulatory bodies, which are often quick to disapprove of every Cayman effort to rise above the fray of unfounded negative scrutiny and shifting goal posts.

But the long and short of it is this: the registration of Cayman master funds simply ensures that CIMA has a regulatory reach to the fund and that the service providers to that fund will be subject to certain conditions. These enhancements to the regulation make a significant step towards further protecting the interests of investors and ultimately, the reputation and continued success of the jurisdiction. Also, it certainly will provide Cayman with more accurate and undoubtedly more impressive domiciliation statistics, showing an in-fact truer picture of fund activities in Cayman, which is sure to ire some of Cayman's competitor jurisdictions.

In our view at RSM Cayman, it is obvious that appropriately weighted regulations considered with investor protection in mind, is powerful and necessary for Cayman's continued development and leadership as a hedge fund domicile. This registration process is a basic anchor to a form of regulation that incrementally strengthens investor protection with minimal charges and changes to existing processes, making Cayman more attractive as a jurisdiction for fund operators and investors alike. Cayman's risk-based regulatory regime has for decades been continually developed under the philosophy of transparency and the provision of a stable, responsible business environment. If a fund does not want to be subject to an appropriate level of regulatory oversight, then Cayman is not the right jurisdiction for it.

The time is right to make proactive changes to the regulatory regime - to quell questions from the international regulatory bodies and to meet the trend of regulatory accountability in the investment funds industry. This does not, however, and nor will it ever, take the place of sound due diligence and quality service providers to operate the fund. The appointment of a solid audit firm that has a complete understanding of the Cayman's fund industry is the cornerstone for both fund operator and investor protection.

By Alex Bodden, managing partner, RSM Cayman Ltd, 345.743.3000. Mr. Bodden has more than 23 years of experience in the audit and finance sector markets in the United Kingdom, US and the Cayman Islands.

RSM Cayman is the U.S. member of RSM International ("RSMI"), the sixth largest network of independent accounting, tax and consulting firms worldwide, with offices in more than 90 countries and more than 32,000 people to serve clients' business needs. The member firms of RSMI collaborate to provide services to global clients, but are separate and distinct legal entities which cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party.