Comment: Cayman hedge funds and the credit crunch
Paul Scrivener and Laura Hatfield of Cayman Islands law firm Solomon Harris note the continuing strength of the world's largest offshore hedge fund domicile and examine the implications for the jurisdiction of US court decisions on the bankruptcy of two Bear Stearns hedge funds.
For quite some time now the Cayman Islands have been the global market leader for hedge funds, dwarfing other offshore centres such as Bermuda, the British Virgin Islands and the Channel Islands. In June this year the number of hedge funds registered in Cayman exceeded 10,000, and hedge fund activity remains very strong despite the credit crunch and the general turmoil in the world economy, with the current annual growth rate being 12 per cent.
In June the regulator, the Cayman Islands Monetary Authority, published its first Investments Statistical Digest. The data relate to 2006 but nevertheless provide a fascinating insight into the make up of the Cayman Islands hedge fund sector. At December 31, 2006, net assets under management within Cayman hedge funds totalled USD1.387trn, with 28 per cent of those assets in the hands of New York-based managers and 18 per cent managed by London-based managers.
Investors in Cayman hedge funds are predominantly high net worth individuals and institutions. The Digest found 50 per cent of the funds to be master/feeder (a reflection of the importance of the US market) and 29 per cent were funds of funds. The most popular strategies were multistrategy and long/short equity.
The dominance of the Cayman Islands in this sector is attributable principally to the political stability of the jurisdiction, the regulatory regime, and the depth and breadth of professional service providers, in particular fund administrators, lawyers, accountants and independent directors.
The regulatory regime is particularly suitable for fund managers because of an absence of prescriptive rules that must be adhered to, such as rules that constrain investment policies or strategies, or restrict leveraging or investment concentration. Instead, there is an overriding obligation under the applicable legislation, the Mutual Funds Law (2007 Revision) of fair disclosure to investors. This disclosure-based approach towards investors is entirely appropriate bearing in mind that the investor base is typically highly sophisticated.
Under the Mutual Funds Law, Cayman funds are placed into categories, with the dominant category being registered funds, the category aimed at sophisticated investors. Most registered funds must have an initial minimum subscription of at least USD100,000. In June 2007, registered funds totalled 9,378, well over 90 per cent of all regulated Cayman investment funds.
For most registered funds, the initial minimum subscription is significantly in excess of the USD100,000 minimum, and it is not uncommon to find Cayman funds with a minimum subscription in the seven-figure range. Almost two-thirds of the funds covered in the Digest required initial minimum subscriptions of USD500,000 or more.
Unless there are onshore tax, regulatory or other commercial reasons why a fund should be structured as a partnership or a unit trust, a Cayman fund will invariably be established as a Cayman Islands company. The corporate structure means that the fund will have a board of directors with important fiduciary duties to act at all times in the best interests of the fund and its investors. There is increasing focus on the responsibilities of the directors as the emphasis on good corporate governance spreads from the onshore to the offshore world.
Frequently, a hedge fund manager looking to set up an offshore fund will be guided toward Cayman by their onshore advisers, for various reasons. At the top of the list is that Cayman is tried and tested in the alternative investments arena. The process will be time-efficient and cost-effective. The regulatory regime is proportionate and ideally suited to hedge funds, and service providers have a wealth of experience and a 'can-do' approach to business.
It is important for any hedge fund manager that the establishment of the fund is dealt with properly and on a timely basis. Onshore counsel will outline the key features of the proposed fund, covering structuring, investment objective, target investors, likely size of the fund, liquidity, minimum subscriptions, tax issues and so on.
Cayman counsel will invest time at the beginning to gain a clear understanding of the proposed fund and the manager's objectives and aspirations, and with onshore will agree responsibility for document preparation and a timetable. The offering memorandum is typically prepared by onshore counsel and reviewed by Cayman counsel. Where the fund manager has not engaged onshore counsel, Cayman counsel is more than happy to act as lead counsel.
Timing is usually at the forefront of the fund manager's mind. The manager will frequently have investors lined up before they have even considered the domicile of the fund. Therefore, there is frequently considerable time pressure to get the fund up and running. Cayman service providers are used to this, and with full commitment to the process from all involved, a Cayman fund is frequently launched within four to six weeks.
This rapid turnaround time has been a major factor in the huge growth Cayman has experienced in the hedge funds arena. The timeframe is assisted by the speed with which the fund vehicle can be incorporated (usually within 24 hours of all paperwork being in place) and then registered with the Monetary Authority. The registration certificate is normally issued within three or four business days of filing the registration particulars.
What impact have the credit crunch and problems in world markets had on Cayman's hedge fund industry? Clearly, there have been closures and blow-ups, some high-profile, but this is inevitable when Cayman has such a large proportion of hedge funds worldwide. For some managers these have been particularly stressful times, with redemptions being suspended and redemption gates imposed to maintain stability or, in the case of funds beyond repair, to ensure an orderly wind-down. There has also been increasing use of side pockets to segregate hard-to-value assets.
In the case of fund closures, cross-border insolvency issues between Cayman and the US have proved interesting. There is frequently a US angle to any hedge fund collapse because the fund's assets or investors, or both, will be in the US. An important new consideration for a Cayman fund is the so-called Centre of Main Interest, which will be considered by a US court in considering whether to give recognition to any liquidators appointed by a Cayman court.
Chapter 15 of the US Bankruptcy Code states that the COMI of a company is presumed to be the place of the registered office location in the absence of evidence to the contrary. Cases in Europe and the US on the criteria for establishing COMI have found relevant "the existence of factors which are objective and ascertainable by third parties", which have been held to include the location of headquarters, management, primary assets, creditors and the law governing disputes.
The much-publicised Bear Stearns decisions have found that the liquidators of the Cayman-incorporated Bear Stearns hedge funds could not show that the COMI of those companies was in the Cayman Islands due to the absence in Cayman of the sort of connections listed above. It was also established that the US courts should not simply accept a registered office location as definitive of the COMI but should look at these factors set out above, even where there is no opposition to the application for recognition of the liquidators.
Another way to obtain recognition in US courts for the Cayman liquidation, albeit a form of recognition that automatically gives the liquidators less power, is to show that the fund has an establishment in the location where the liquidators were appointed. An establishment is defined as a "place of operations where the company carries out non-transitory economic activity", although the meaning of this phrase has still to be determined by the courts.
It is possible that a Cayman COMI or establishment could be achieved through structuring of the fund, for instance ensuring that the fund service providers are based in Cayman, directors hold board meetings in Cayman, and there is a bank account in Cayman. However, some commentators suggest that these recognition decisions from the US courts will lead to a greater 'bricks and mortar' physical presence in the Cayman Islands for hedge funds and that the jurisdiction will develop to a new level beyond a domiciliary and service provider centre. This may or may not happen, but one thing is clear - the Cayman Islands have become the world centre for the establishment of hedge funds and, whilst there can be no complacency, there is no reason why it should not remain so for the foreseeable future.
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