With a constant stream of new regulatory requirements as a result of the continuing financial crisis, Ingrid Pierce and Tim Clipstone examine how Cayman has managed to successfully maintain its position as a leading jurisdiction for hedge funds.
The Cayman investment funds market received a significant boost last year after the final terms of the EU’s Alternative Investment Fund Managers Directive (the Directive), which seeks to regulate the hedge fund and private equity industry’s operations or marketing in the EU, confirmed that fund managers could continue to market Cayman Islands investment funds to European professional investors under the terms of the Directive. With hedge fund registrations in Cayman also firmly back on the growth track during the first half of 2011, with an average of 81 new funds established each month during the period, the industry has demonstrated its resilience throughout the global financial crisis. Amid the improving mood, investment managers who market their funds in the EU are looking to understand the manner in which the Directive will be implemented.
Current Status of the Directive
The final text of the Directive was published in the Official Journal of the European Union on July 1, 2011, and provided that the new regime for investment managers operating or marketing within the EU is targeted to begin on July 22, 2013, being the final date for transposition of the Directive into law in each of the EU member states.
The detailed rules on the manner in which the Directive will be implemented are being finalised (known as the Level II process) and the European Securities and Markets Authority (ESMA) has issued two consultation papers as part of the Level II process, seeking input from industry stakeholders on the implementation of the Directive, and is due to make its recommendations to the Commission on November 16, 2011.
Private Placement and Passive Marketing
The Directive confirms that non-EU domiciled investment funds may continue to be marketed in EU jurisdictions under the private placement rules existing in those jurisdictions on a jurisdiction by jurisdiction basis, subject to certain criteria (see below), and as such each regime will run until at least 2018. Furthermore, the Directive does not apply to passive marketing or reverse solicitation of investment funds, so European investors contacting non-EU fund managers to invest in existing Cayman Islands, British Virgin Islands or Jersey funds that have not been actively marketed to them will not bring the fund or manager into the scope of the Directive. As such, for non-EU managers marketing Cayman Islands, British Virgin Islands or Jersey hedge funds in the EU, this means that the status quo is largely maintained; for EU managers, using their existing Cayman Islands, British Virgin Islands or Jersey funds lessens the burden of implementing the Directive as they will be able to market those funds within the EU largely as before.
EU Marketing Passport
EU domiciled managers operating EU domiciled funds will be required to comply in full with the Directive from July 2013. Since the Level II process is still underway, its final shape is yet to be known, however, one of the benefits for EU managers marketing EU domiciled funds will be access to a pan-EU passport to market their funds to EU professional investors once authorised in one member state. This EU marketing passport will not be available to non-EU managers and EU managers for their non-EU domiciled funds until at least July 2015, after which time it is proposed, subject to a favourable recommendation from ESMA, to give such managers the option of electing to become subject to the Directive in full and utilise the EU marketing passport to market their funds within this regime rather than under the private placement regime.
Such confirmation that EU and non-EU fund managers will be able to continue marketing Cayman Islands, British Virgin Islands and Jersey funds in Europe is excellent news for the industry in these jurisdictions and is also welcomed by European investors who will retain access to those leading global asset managers who offer their strategies into Europe through those funds.
Criteria for Access to EU Markets
The criteria for allowing a manager to market a non-EU fund in the EU by opting in to the EU marketing passport are broadly similar to those required for continued access to the private placement marketing regime.
Criteria common to both regimes include the need for supervisory co-operation arrangements to be in place between the regulator of the EU member state in which the fund is being marketed and the regulator of both the fund manager and the fund; further, the fund must have independent functionaries to carry out various administrative and custodial procedures and the manager must comply with the transparency and reporting requirements imposed by the Directive in relation to the fund’s activities; finally, the countries in which the fund and the manager are established cannot be on the Financial Action Task Force (FATF) blacklist.
Additionally, for the EU marketing passport, non-EU fund managers will also need to be authorised in the EU member state of reference applicable to them and they must be fully compliant with the Directive or equivalent regulations in their home jurisdiction. At the jurisdictional level, OECD-compliant tax information exchange agreements (TIEAs) will be required between the fund domicile and both the fund manager’s EU state of reference and each other member state in which the fund is proposed to be marketed.
Proposed Content of Co-operation Arrangements
One of the key questions for Cayman in the Level II process is the format of the co-operation arrangements between EU and non-EU regulators. In August 2011, ESMA published its consultation paper proposing, among other matters, a format for the third country co-operation arrangements.
In its proposal, ESMA envisaged that the arrangements between EU and third country authorities could take the form of multi-lateral memoranda of understanding and should follow the IOSCO principles regarding co-operation between regulators for the purposes of supervision and enforcement. Included among their other suggestions was that the cooperation arrangements should allow for an on-going exchange of information between EU and non-EU regulators. ESMA also suggested that the arrangements should contain a commitment from the third country authority to assist the relevant EU authority in its performance of its duties under the Directive.
Cayman’s regulator, the Cayman Islands Monetary Authority (CIMA), has commented on both the initial call for evidence by ESMA’s predecessor (CESR) in January 2011 and on the consultation papers issued by ESMA as part of the Level II process, in particular concentrating on the cooperation arrangements.
CIMA has confirmed that the Cayman Islands already satisfies, or will satisfy by the implementation dates, each of the requirements imposed at the jurisdictional level to allow funds domiciled in the Cayman Islands to continue to be marketed to EU investors under both the private placement regime from 2013 and under the EU marketing passport regime when this becomes available.
Cayman is not on the FATF blacklist, having been favourably assessed in its compliance with the FATF’s 10+9 AML/CFT Recommendations, and CIMA is both a member of the International Organisation of Securities Commissions (IOSCO) and a signatory to IOSCO’s multilateral memorandum of understanding. At the time of writing, the Cayman Islands has 25 TIEAs in place, including agreements with the UK, the US, Canada, France, Germany and The Netherlands and negotiations with key EU and other jurisdictions continue to be held.
Walkers continues to be actively involved in providing input on the Level II process through consultations with regulators and through industry bodies such as the Alternative Investment Management Association (AIMA).
Impact of the Directive on Choice of Fund Domicile
While the Directive was subject to a protracted period of negotiation by European politicians, much attention was directed towards whether investment funds marketed to EU professional investors should be established in centres such as Ireland or Luxembourg. This debate was ended when the final text of the Directive confirmed that Cayman Islands, British Virgin Islands and Jersey funds were able to be used as fund vehicles under the Directive. As a result, managers are now able to make a decision to select the appropriate level of regulation for their funds and with Ireland being the jurisdiction of choice for EU domiciled investment funds, Walkers opened an office in Dublin in September 2010.
In an examination of current trends and the future for alternative investment, KPMG in its report ‘Transformation: The Future of Alternative Investments – June 2010’, noted that while some managers have taken steps to domicile funds in the EU “the overwhelming majority of investors are happy to continue to allocate to alternative funds that are located in offshore jurisdictions”, and that trend has been borne out by the up-tick in fund formations observed in Cayman in the first half of 2011.
A report by KMPG and RBC Dexia, ‘Alternative Options: Hedge Fund Redomiciliation Trends in Evolving Markets, 2011’, drilled deeper into the lack of investor demand for change. Many respondents to this survey highlighted that existing regulation and transparency, together with an increased investor focus on due diligence, served to offset the apparent advantages of highly regulated EU domiciled funds. In addition, most functionaries of such funds are now regulated, with a significant number of Cayman funds being administered by regulated firms in either Luxembourg or Ireland, from which some EU investors took comfort.
As such, Cayman’s dominant position in the global hedge fund sector – with an estimated 67 per cent market share of offshore domiciled hedge funds, according to a report by International Financial Services, London – seems set to continue as its offering resonates strongly with both managers and investors, particularly due to familiarity with the way they operate. Overall, managers say that investor perception is still positive and the Cayman Islands hedge fund sector remains highly regarded, thanks to its reputation as a tried, tested and appropriately regulated product.
There appears to be little doubt that Cayman will retain its current dominant position in the hedge fund sector. With much greater certainty on the legislative and regulatory front and renewed activity in fund formation particularly in Asia and in Latin America, the outlook for the Cayman funds industry looks extremely bright.
Tim Clipstone Group Partner
Ingrid Pierce Ingrid Pierce is based in Walkers' Cayman Islands office and is a partner in the firm's Global Investment Funds Group.
Walkers Bermuda, British Virgin Islands, Cayman Islands, Dubai, Guernsey, Hong Kong, Ireland, Jersey, London and Singapore.