The Cayman Islands is a popular domicile for hedge funds globally. This is due to its tax neutral status, flexible structuring options and strong legal system combined with an established and experienced financial services sector. The simplicity of establishing Cayman Islands investment funds — and speed to market — play a key role in influencing the decision of hedge fund promoters and managers in using the jurisdiction. This article provides an overview of the legal and regulatory framework applicable to hedge funds established in the Cayman Islands.
Fund Formation And Structuring Options
There are a number of options available for structuring hedge funds in the Cayman Islands, including the exempted company, limited liability company (LLC), limited partnership and unit trust. Exempted companies limited by shares are the most commonly used vehicle. Umbrella structures, such as segregated portfolio companies and umbrella unit trusts, are also available for managers looking to form umbrella funds with segregation of assets and liabilities between sub-funds of the umbrella fund.
The formation process for all types of entities is streamlined and efficient, with entities generally formed on a same day basis upon filing of the requisite documents with the Registrar. It ordinarily takes three to five business days for the certificate of incorporation/registration to be issued, although this can be reduced to one business day if express service is used.
Under existing legislation, the Cayman Islands government does not impose any form of direct tax on profits, income, gains or appreciations, or by way of withholding on the payment of dividends or other distributions of income or capital by hedge funds structured in the Cayman Islands, which affords considerable flexibility to the structuring process. However, while the Cayman Islands adds no additional tax layer to the fund structure, investors and investee entities are still subject to their home jurisdictions' relevant taxes and are responsible for complying with those obligations.
Regulatory Regime For Hedge Funds
Cayman Islands hedge funds are generally regulated under the Mutual Funds Act (As Revised) (the Act) which provides the legislative framework for the regulation of open-ended pooled investment funds. A mutual fund is defined to mean any company (including LLC), partnership or unit trust that issues equity interests redeemable or re-purchasable at the option of the investor, the purpose or effect of which is the pooling of investor funds with the aim of spreading investment risks and enabling investors to receive profits or gains from investments.
Responsibility for regulation of mutual funds rests with the Cayman Islands Monetary Authority (CIMA) and as at the end of June 2023, there were 12,995 registered or licensed with CIMA. There are a number of categories of mutual funds under the Act with the most common being the "Registered Fund". A hedge fund can register as a Registered Fund, if (i) it has a minimum initial investment per investor of at least US$100,000 or its currency equivalent (the Minimum Investment Requirement); or (ii) its equity interests are listed on a recognised stock exchange.
The process for registration as a Registered Fund is straightforward and involves the submission of an application form, together with a copy of the fund’s offering document, and consent letters from its administrator and its Cayman Islands auditor via CIMA's dedicated web portal, together with payment of the registration fee. There are no government or regulatory pre-approvals required, although the registration must be submitted to CIMA prior to the launch date.
Fund Terms And Disclosure Requirements
The Act does not impose any restrictions or limitations with regard to the investments that Registered Funds may make, nor are there any restrictions imposed on borrowing/leverage. The Act also does not prescribe any requirements with respect to fund terms, which provides for considerable flexibility.
However, the offering document of a Registered Fund 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 to invest. In addition, the offering document is also required to contain disclosures mandated by CIMA's Rule on the Contents of Offering Documents (Content Rule). All fund offering documents are also subject to general statutory obligations with regard to misrepresentation and general common law duties of proper disclosure of all material matters.
Registered Funds are required to have a registered office in the Cayman Islands and must have their accounts audited annually by a Cayman Islands based auditor approved by CIMA. There are currently almost 50 Cayman-based approved auditors, including most of the major international audit firms, and in practice this may be done by way of sign-off by the CIMA-approved auditor of accounts prepared elsewhere. Registered Funds are also required to appoint an administrator although the administrator need not be based in the Cayman Islands.
CIMA operates a ‘four-eyes’ principle with respect to mutual funds, such that all mutual funds regulated by CIMA must have a minimum of two directors (in the case of an exempted company), managers (in the case of an LLC), or equivalent persons in respect of the general partner (in the case of a limited partnership). Where a single corporate director or manager is appointed, then such corporate director or manager in turn is required to have a minimum of two individual directors/managers. Each director or manager of a registered fund structured as an exempted company or LLC is required to be registered or licensed by CIMA pursuant to the Directors Registration and Licensing Act (DRLA). Director registration under the DRLA is straightforward using CIMA’s dedicated web portal, while the more onerous licensing regimes of the DRLA are relevant only to professional directors and corporate directors. There is no requirement for any of the directors to be resident in the Cayman Islands.
Other than as set out above, the Act does not mandate the appointment of particular service providers, and Registered Funds may appoint other service providers such as investment managers, prime brokers and custodians based anywhere in the world. There is generally no restriction on an investment manager from another jurisdiction managing a Registered Fund and a non-Cayman Islands investment manager is not generally required to be regulated in the Cayman Islands.
In addition to the annual audit requirement, Registered Funds must notify CIMA within 21 days of any material change that affects information contained in its offering document. There is also a requirement to file an amended offering document or a supplement thereto with CIMA within 21 days of such a material change if the Registered Fund is continuing to offer its equity interests. Registered Funds are also required to pay an annual registration fee by January 15 of each year following registration.
CIMA has issued a number of rules and statements of guidance which Registered Funds are required to comply with. In addition to the Content Rule mentioned above, CIMA has also issued Rules on the Segregation of Assets (Segregation Rule) and Calculation of Asset Values (Valuation Rule). The Segregation Rule imposes certain requirements relating to the segregation, accounting and safekeeping of a fund's portfolio, while the Valuation Rule relates to the establishment, implementation and maintenance of pricing and valuation practices, policies and procedures to ensure a fund's net asset value is fair, complete, neutral and free from material errors and verifiable. The Valuation Rule also requires that a fund's net asset value be calculated at least quarterly.
In April 2023, CIMA issued new Rules on Corporate Governance and Internal Controls that require Registered Funds to establish, implement and maintain a corporate governance framework and adequate and effective internal controls. These new Rules came into effect on 14 October 2023, and represent an evolution of CIMA's 2014 Statement of Guidance on Corporate Governance, setting out CIMA's minimum expectations with respect to the governance of mutual funds.
CIMA has wide-ranging powers under the Act to address non-compliance and may also impose administrative fines for breaches of prescribed provisions of the Act and relevant CIMA rules.
Aside from the requirements under the Act and the various CIMA rules outlined above, hedge funds are generally required to comply with the registration, due diligence and reporting requirements under the automatic exchange of information regimes adopted by the Cayman Islands, generally comprising of local legislation implementing FATCA and CRS. Cayman Islands hedge funds are also required to maintain anti-money laundering, countering of terrorism, and proliferation financing and sanctions procedures in accordance with the relevant Cayman legislation and regulations, which includes appointing natural persons in the roles of anti-money laundering reporting officer, money laundering reporting officer and deputy money laundering reporting officer. These functions can be outsourced to third-party service providers, subject to satisfaction of certain conditions.
Registered Funds are currently exempted from complying with the primary obligations of the Cayman Islands beneficial ownership regime and are currently also outside the scope of the Cayman Islands economic substance legislation. However, Registered Funds are required to file a written confirmation of exemption under the beneficial ownership regime and must make an annual notification confirming their classification as an "investment fund" for the purposes of the economic substance legislation
The ubiquitous nature of Cayman Islands hedge funds is due in large part to the jurisdiction's tax neutrality, combined with its established legal and regulatory system tailored to meet the demands of the hedge funds industry and international best practice. The simplicity and speed with which it is possible to establish hedge funds in the Cayman Islands, and the continued improvements to the jurisdiction's robust yet flexible laws to respond to developing international trends, should enable the Cayman Islands to continue to maintain its position as the premier jurisdiction for the establishment of hedge funds.
Harjit Kaur is head of Maples and Calder's London Funds & Investment Management practice, the largest UK-based offshore funds group in the region. The growing dynamic team continues to be selected to act on innovative and high profile transactions and is recognised annually for its preeminent expertise. Harjit specialises in in the establishment and maintenance of all kinds of alternative investment funds in the Cayman Islands. She advises numerous leading European fund managers and their onshore counsel on the formation, ongoing legal and regulatory compliance, restructuring and termination of different types of Cayman Islands investment vehicles, including hedge funds, hybrid funds and private equity funds