By Simon Gray - For years, industry professionals acknowledge, the Cayman Islands financial services sector – and the territory’s government – remained largely silent as the jurisdiction was branded as the epitome of the real and supposed ills of the offshore financial industry – tax evasion, money laundering, fraud and worse. But those days are now decisively over.
For at least two decades the islands have suffered from a dramatic dichotomy between its image among financial sector professionals, among whom its depth of expertise and experience is well established, and that held by the general public – including many politicians, for whom ‘Cayman’ often serves as shorthand for the squirreling away of money out of sight of the taxman.
Perhaps few things contributed as much to this unfortunate public image than The Firm, the 1991 blockbuster novel by the hitherto unknown John Grisham, which painted a picture of a jurisdiction awash with criminal cash brought in by the suitcase-full – cemented two years later by an equally successful film, starring Tom Cruise. The fact that extensive scenes were filmed in Grand Cayman, its beaches and hotels gave the film an unfortunate verisimilitude.
More recently, as a Democratic Party candidate for the presidency and again after taking office in January 2009, Barack Obama repeatedly cited Ugland House – the Cayman home of law firm Maples and Calder – as the home of 12,748 (later 18,857) companies. “Either this is the largest building in the world or the largest tax scam in the world,” Obama said.
Less widely reported is the fact that when a team from the United States Government Accountability Office was dispatched to Cayman by the Senate Finance Committee in 2008 to investigate Ugland House, they found that only 5 per cent of the companies incorporated with the building as their registered office were wholly US-owned and fewer than 50 per cent had a US billing address. They included investment funds and structured-finance vehicles, as well as vehicles used or supported by US government agencies, the Export-Import Bank of the United States and the Overseas Private Investment Corporation.
It’s appropriate, then, that efforts to counter what at times has been a barrage of negative comment and inaccurate information about the Cayman Islands are being spearheaded by Anthony Travers, a longstanding senior partner of Maples and Calder who helped to draft much of the jurisdiction’s key financial services legislation.
Since Travers became chairman of industry association and promotional body Cayman Finance in 2009, the organisation – itself renamed from the rather less snappy Cayman Islands Financial Services Association – has become proactive in tackling and refuting inaccuracies and misinformation about Cayman wherever they appear.
Arguably it’s something that should have been done earlier. “Having a single body representing the Cayman financial services industry was long overdue, but since its establishment Cayman Finance has done well in responding to some of the misinformation about the jurisdiction,” says Neal Lomax (pictured), managing partner of law firm Mourant Ozannes in the Cayman Islands. “If there is a negative, it is that we should have started it five or six years ago.”
Lomax says the task is a never-ending one. “There’s still a huge amount of misinformation about Cayman disseminated, and it’s very frustrating to see the inaccuracies that appear,” he says. “Cayman is a well-regulated jurisdiction where hedge funds and other investment vehicles suitable for institutional investors can be set up on a tax-neutral basis.
“While the importance of a tax-neutral platform may be misunderstood in some quarters, the reality is that the world financial system needs such jurisdictions to facilitate cross-border capital flows. Our hope is that this reality will become better understood and more broadly acknowledged by policy-makers and others as the reasons for the recent financial crisis are more fully analysed and as the ensuing regulatory response evolves.”
Some industry members are more forceful in their response to the criticism, noting that while the Obama campaign was expressing shock about the number of companies at Ugland House, the home state of his vice-presidential running mate Joe Biden, Delaware, boasts buildings housing the registered offices of as many as 120,000 companies.
Ogier partner Peter Cockhill agrees that the change of strategy is overdue. “Unfortunately in the past we may not have paid enough attention [to adverse publicity], we were far too reactive, but that’s changed in the past 18 months,” he says. “We have an invigorated financial services body, Cayman Finance, able to spread a message and disabuse the mythmakers. When we see an ill-informed statement or wrongful characterisation, we immediately respond – our approach is zero tolerance of misinformation. And that’s beginning to pay dividends.”
Alan Milgate, a director of Harbour, a firm that specialises in providing independent directors and trustees to funds in Cayman, says local companies have banded together to defend the jurisdiction and to convey a coherent message to the outside world about the quality products and services that the islands offer. “All the service providers here are making a concerted effort to create a united front to stand up for our jurisdiction,” he says.
“We’re very proud of our product and that we won’t let false representations go unchallenged. Cayman Finance is actively searching for inaccurate stories and rebutting them, but at the same time service providers are going out to sell our product much more aggressively than we have in the past.”
Milgate says the financial crisis, which saw a dip in both the number and the aggregate assets of Cayman funds as well as a downturn in other major business areas such as securitisation, has prompted a wide-ranging rethink of the way the jurisdiction is marketing itself. “It has forced us to look at what we’re offering people and to improve it, and to understand better what they want,” he says.
“We continue to have a great advantage here in having a government and a regulatory body that interact actively with the local industry. We’re very fluid, enabling us to develop our laws and regulations and strengthen our product much more quickly than many other jurisdictions. Whereas eight or nine years ago people were more focused on running their own businesses, today we recognise that we all have a responsibility to the jurisdiction if we are to be as strong as we need to be.”
Certainly the current inflows of new business indicate suggest that the Cayman name is not putting off institutional investors, as was suggested might be the case a year or two ago. Industry members report that much of the capital returning to hedge funds is going to established managers with solid reputations, and that while a wave of new talent is entering the market, spinning off from existing managers or big institutions shedding proprietary trading operations, they are finding the money-raising process long and arduous.
“We are finally seeing some growth returning to the market following the financial crisis, but it is a lot slower than what we saw during our heyday, and funds are certainly a lot smaller,” says Don Seymour, managing director of corporate governance specialist dms Management. He notes that there is a lot of interest in start-up activity, but the capital-raising process is much more protracted than three or four years ago, especially for smaller managers.
“One large administrator told me they had something like 40 start-up managers in the pipeline, but they can’t launch their funds because they haven’t been able to raise sufficient capital,” Seymour says. “There is a big-name bias. Our existing clients, who have been established for 10 years or more with a structure and a long track record, are seeing capital inflows.”
He adds: “Large institutions are still allocating capital to hedge funds or even increasing their allocations, but this process is favouring the bigger managers. There is still nervousness among allocators in the wake of the financial crisis, and no-one will ever get fired for allocating to a big manager. They are still cautious about taking a risk on a smaller, less established manager, and certainly a start-up.”
KPMG partner Anthony Cowell says: “A few years ago we would see capital coming in within a few months of a start-up, but now that period is being stretched, even though the environment now is clearly better than what it was. There is consolidation as some larger managers grow by taking over smaller competitors. Meanwhile, what we call entrepreneurial institutional managers are diversifying into mainstream fund management, proprietary trading, restructuring of distressed vehicles and structured products rather than just hedge funds.
“That’s a huge change for the industry. Previously managers tended to offer core products, and grow into super-boutiques, but now firms are coming out with a huge variety of products to attract institutional capital. Sometimes the products stick, sometimes not. The difference between these players, whose controls and processes are institutional, and traditional asset management houses is that they’re very much more focused on generating alpha.”
Cowell argues that the new money is not all institutional: “Interestingly, high net worth investors are coming back into the industry, albeit principally to larger rather than smaller managers and to fairly straightforward strategies. The fact we’re starting to see new inflows from high net worth individuals as well as institutional investors is very positive for Cayman.”
Large institutional managers have largely resumed their pattern of activity from before the crisis, according to Ingrid Pierce, a partner and head of the Cayman Islands hedge funds group at law firm Walkers, but she says newcomers are starting to gain some traction, especially if they have a track record from another firm. “Our staple large clients may have experienced some dislocation, and they may not be completely back to normal, but they are continuing to set up funds,” she says.
“However, there seems to be much more movement among start-up managers now than earlier last year, when there was a lot of noise that didn’t translate into actual fund launches.
“By and large, these start-up clients have some sort of track record, perhaps because they’ve been affiliated with a well-respected manager. There aren’t that many truly new boys – more those who have build a reputation somewhere else and have taken it to a new outfit.”
One of the most important changes to the alternative investment management environment since the crisis has been the adoption (more or less) of the Volker rule, conceived by the former US Federal Reserve chairman and more recently Obama adviser Paul Volker, designed to restrict proprietary trading and other types of speculative investment by US commercial and investment banks. Despite the currently difficult fund-raising environment, this could prompt a continuing flow of business for Cayman over the long term, according to industry members.
“In a way, the Volker rule is actually helping Cayman,” says Darren Stainrod, head of alternative fund services at UBS Global Asset Management, Cayman’s largest fund administration business. “We’re seeing a fair number of launches from new managers leaving prop desks to set up their own businesses and spin-offs from existing managers, although they are struggling to attract the start-up capital they might have done in the past.”
In addition, he says, the beleaguered fund of hedge funds industry is showing renewed health, albeit a year after the single manager hedge fund sector began to enjoy renewed inflows. “Our fund of funds clients are now seeing a lot of activity in terms of requests for proposal. In addition, we are seeing large inflows from family offices, sovereign wealth investors and other institutional investors.”
To help start-up managers get their business underway despite the capital constraints, administrator Ifina has just launched the Cayman-domiciled Primary Development Fund, a segregated portfolio umbrella fund allowing managers to establish a regulated, audited and transparent fund at a vastly lower cost than would be entailed by going it alone. Ifina’s partners in the venture are Barclays in the Isle of Man, offering banking services, broker MF Global, auditor Baker Tilly and Cayman law firm Solomon Harris.
“Particularly over the last year or so, many traders have left banks or brokers with some sort of client base and an asset management idea,” says Ifina (UK) director Derek Adler. “But to get the business up and running, get regulated and meet requirements such as capital adequacy rules takes time and effort, as well as money that the start-up manager may not have to begin with.
“The Cayman structure provides an opportunity and a stepping stone for serious professional money managers – although we check out their credentials very thoroughly. It would not be possible for some of these new managers to set up a mutual fund in another jurisdiction, but the Cayman rules make it possible.
“Very few fund administrators will take on managers starting up with as little as USD5m or USD10m, but that’s right up our street. It provides the managers with a structured framework that they can’t get elsewhere, and in fact many of the new businesses we take on become regulated in their home jurisdiction, such as the UK, within six months or a year. But in the meantime it provides a start to managers who might turn out to be the industry stars of tomorrow.”
Cayman may not have the capacity to provide on-island services to all the funds domiciled in the jurisdiction, but the size of its administration sector is often overlooked. Like the industry as a whole, administrators have suffered from the shrinkage of fund numbers and assets as a result of the crisis – the number of firms holding full licences fell from 102 in at the end of 2008 to 94 in September 2010 – but there are signs of recovery, like the establishment of a Cayman office last January by HedgeServ, which is now one of the top 15 administrators worldwide.
“We have been seeing new business mostly from existing clients, and activity this year has been stronger on the private equity side than among hedge funds,” says Rick Gorter, managing director of Trident Trust in Cayman. “Toward the end of last year, however, we saw increased interest in the launch of new funds, especially from the Far East, although we have also been winning business involving existing funds being transferred to us from other administrators.”
However, Gorter is confident about the future outlook for the industry. “Cayman offers a very sophisticated administration base, with the expertise and experience that may be lacking in some of the international financial centres new to the business, and in terms of IT infrastructure we can offer the same if not better service as onshore centres,” he says.
“In the case of some clients for which previously we might have been doing registrar and transfer agent work, we are doing full administration. This reflects the impact of the Madoff and other scandals in the US, which has led investors to push managers to use external administrators rather than do it in-house. Third-party administration has long been the norm in Europe and now it is becoming so in the US.
“Trident is also benefiting from investor demands about the kind of service providers managers use, especially in the case of larger funds. They are insisting not only that the administrator is independent but that they are a business of substance, with an international footprint, state-of-the-art IT systems, SAS 70 certification and appropriate professional indemnity cover.”
Essentially, Gorter argues, investors want to see administrators offering an independent institutional operational environment. “They also require independent directors, individuals who actually provide meaningful oversight to the operations and do not have conflicts of interest with the other service providers,” he says.
“In a nutshell, the regulatory environment has increased exponentially, and so has investor due diligence. Whereas in the past investors might have distanced themselves from the fund’s operations, now they’re not only doing due diligence on the fund but also on its service providers, especially the administrator.”
The presence of independent directors on the board is also more important than three or four years ago, according to Seymour, who as head of the investment services division of the Cayman Islands Monetary Authority, the industry regulator, established the regulatory framework for hedge funds in the late 1990s. Within a few years, he says, it became clear that the common thread in enforcement cases against Cayman hedge funds that were not being operated in a fit and proper manner was a lack of proper corporate governance.
“Although we had the best independent administrators and auditors, where things were going wrong was that we didn’t have the best independent directors, which was the final piece in the fund control structure,” Seymour says. “But the industry has changed dramatically since 2000 and independent directors are now viewed as a critical piece of the fund control structure.
“To be successful marketing a fund today, you need best of breed standards in the areas of transparency, liquidity, infrastructure and independence. These issues were already coming to the fore, but Madoff brought them more sharply into focus. There was not proper segregation and due diligence within his structure, and it showed investors everywhere that these are critical issues. It is investors that are now driving demand for independent directors. They recognise that a good independent director on the board is one of the best insurance policies against things going wrong.”
Milgate says it’s important not only that directors be independent and bring relevant expertise to the job but that where practical each fund should make use of local service providers. “We prefer relevant services to be provided by people in Cayman,” he says. “You need an appropriate amount of infrastructure to support more than 10,000 Cayman-domiciled funds, and we think it’s good for service providers to be actually resident in Cayman and an active part of the regulatory model.”
Nevertheless, Stainrod says that some Cayman administrators have adapted to capacity issues by outsourcing some functions to operations in other jurisdictions, although the jurisdiction remains the focus of the services UBS provides to clients. “The trend over the past few years has been to move certain processes to onshore or lower-cost jurisdictions,” he says. “For example, many have moved the NAV accounting and portfolio valuation to Canada, with corporate and shareholder services staying in Cayman.
“The migration of administration processes made sense during the period from 2005 to 2007 when the industry was booming and Cayman was running up against the limits of its capacity. Our business has a workforce in the hundreds, but the infrastructure in Cayman would not be able to cope with operations employing thousands of people. There are also cost issues.”
However, Stainrod says the jurisdiction has certain advantages, such as offering an attractive living and working environment that helps firms to recruit well-qualified staff. He points to the establishment in Cayman of new administration firms as evidence that it remains an attractive and competitive business environment. “Certain processes suit Cayman, such as funds of funds, share registry and corporate services, and some clients prefer working with a service provider here due to confidentiality and high service levels,” he says.
Cockhill acknowledges that the business environment in which Cayman operates has changed over the past few years, but he is confident that the jurisdiction will continue to thrive. “We’ve heard lots of stories about how the world is going to be more prescriptive and restrictive, but there are opportunities in every evolution,” he says. “There are definitely opportunities for a well-regulated international financial centre in a dominant position, which Cayman is.
“Whenever laws or regulations change, it’s people that transact business, and Cayman is uniquely well positioned. The law firms, administrators and auditors here are all part of international networks. The audit firms here are all plugged into their North American counterparts, US onshore and offshore auditing goes on all the time, and our banks are subsidiaries or branches of onshore institutions with global reach.
“The world has shrunk, and Cayman is on the main grid. This could be a good opportunity for us. Things like the Dodd-Frank Act in the US often wind up with unintended consequences, but very few have the agility and the wit to understand what the market wants and give it to them within the requirements of an interconnected financial regulatory system.”
Cockhill insists that he and his colleagues are bullish today in a way that they weren’t 12 months ago. “The storm clouds have come, threatened us and now seem to be passing, although I’m not complacent,” he says. “There are always challenges ahead, especially with France holding the presidency of the G20, so I’m sure there will be more anti-offshore rhetoric.
“However, I do think the world has become a lot better informed. International tax information exchange agreements are a very good thing because more than anything else gives the lie to the notion that financial centres such as Cayman are in some way obstructing the needs of the onshore economies.
“We’ve been making information on individuals with money in Cayman available under the EU Taxation of Savings Directive for six years, a completely transparent mechanism that assures European countries that their tax laws are not being flouted. Today we are competing on a true argument rather than a mischaracterisation, and in the future that will be very much to our advantage.”
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