Modernization through regulation has been saved
Modernization through regulation
Two years on, what have we learned from the Cayman Islands’ private capital funds regulatory regime?
Performance Magazine - Issue 38 ⬤ Published on 25 February 2022
Modernization through regulation
Two years on, what have we learned from the Cayman Islands’ private capital funds regulatory regime?
Partner, Investment Management - Audit, Deloitte
Director, Investment Management - Audit, Deloitte
To the point
In February 2020, the Cayman Islands introduced the Private Funds Act, regulating closed-end private funds for the first time. Expanding on its established mutual funds regime for open-end funds, the new regulation’s purpose was to improve access and quality of information available to its regulator, enhance confidence in the jurisdiction across stakeholders, and set the stage for continued growth in the private capital sector. This article examines the global regulatory trends that led to an enhanced regulatory framework, implementation of key provisions to comply with the Private Funds Act, including registration statistics, and an analysis of registration and operating requirements of the modernized regulatory measures.
Regulation of investment funds has been an established practice in the Cayman Islands and other jurisdictions globally for decades. Open-end investment funds have been regulated by the Cayman Islands Monetary Authority (CIMA) since the introduction of the Mutual Funds Act in 1997. The regime was further enhanced in 2003 when CIMA gained operational independence from Government giving it full rein to exercise its powers in meeting international standards of supervision and regulation. Led by a vision of creating a thriving, innovative, and well-regulated financial services system1, CIMA sought a balanced approach to meet applicable international standards while providing value to stakeholders—and it worked.
The Cayman Islands quickly became a leading international financial center known for its stable political environment and top tier legal, accounting, and fiduciary experts, offering unequaled expertise and stability to stakeholders. While CIMA’s oversight of mutual funds was long established, the complex population of Cayman Islands-domiciled private funds remained largely unregulated.
The changing landscape
The acceleration of globalization in recent years has led the Organization for Economic Co-Operation and Development (OECD) to revisit cross-border transactions in the spirit of fairness. In 2015, the OECD introduced the Base Erosion and Profit Shifting (BEPS) Initiative which seeks to reform international tax rules and ensure that multinational enterprises pay a fair share of tax wherever they operate2. The Cayman Islands counted itself among the initiative’s early adopters, alongside 137 countries signed up to implement BEPS’ 15 Actions. The first Action under review was Action 53 on harmful tax practices, focusing on transparency, and substance. Action 5 seeks to ensure that where a company is domiciled and tax resident, it also maintains a physical presence and discharges key operating activities that support its revenues being taxed in that jurisdiction and not elsewhere.
Applying the concept to an investment fund, however, was not so clear-cut. The OECD understood that an investment fund, being a structure that pools capital but outsources all aspects of its management, did not fit within the concept of economic substance. Given a fund cannot reasonably demonstrate physical presence due to its very nature, an acceptable remedy for this issue was to subject unregistered investment funds to an appropriate level of regulatory oversight. Similar to other member jurisdictions, the Cayman Islands quickly set about enhancing its regime and enacted the Private Funds Act in February 2020.
The Private Funds Act is intended to regulate Cayman-domiciled closed-end private funds and AIVs that are pooling capital and offering interests to investors.
Key stakeholders impacted by the Private Funds Act
The ‘operator’ of a closed-end fund is responsible for registration, compliance with ongoing operating requirements, and the fund’s regulatory reporting obligations. Given the importance of this role, the operator must be a natural person from the applicable governing body (e.g., board of directors, general partner, or trustee). Failure to register or other instances of non-compliance may carry substantial monetary penalties for the operator personally, and CIMA has communicated that fines will be issued for non-compliance. The basis for such actions is expected to be proportionate to the infraction and within the range of prescribed dollar amounts.
The ‘four-eyes’ principle applies to operators of a closed-end fund, whereby a minimum of two directors for companies, or two natural persons for general partners and corporate directors, must be named for each registered fund.
Scope of the Private Funds Act: When is registration required?
Careful consideration of all elements of the definition of a private fund must be made in order to determine whether a closed-end fund falls within the scope of the Private Funds Act, and would ultimately result in registration as a private fund with CIMA.
Closed-end fund managers should be mindful that registration must be accomplished within 21 days of accepting any capital commitments and in no circumstances prior to calling any capital. Most Cayman-based legal advisors have developed efficient processes for raising, launching, and registering funds that can easily meet client’s timing needs.
The definition of “private funds” in the context of the Private Funds Act includes any closed-end funds whereby:
- The fund is established for more than one investor;
- It is established as a company, unit trust, or partnership;
- It offers, issues, or has issued investment interests to investors with the aim of enabling investors to receive profits or gains from such activities;
- The investors do not have day-to-day control over the fund’s investment activities; and
- The investments are managed as a whole by or on behalf of the fund operator, either directly or indirectly.
The Private Funds Act explicitly exempts certain “non-fund” arrangements. Some examples of non-fund arrangements include:
- Securitization special purpose vehicles;
- Joint ventures;
- Proprietary vehicles;
- Holding vehicles;
- Structured finance vehicles;
- Employee incentive schemes;
- Sovereign wealth funds;
- Single family offices; and
- Funds listed on a stock exchange.
- REEFS Application Form (APP-101-77);
- Certificate of Incorporation/Registration (as applicable);
- Constitutive Documents (Memorandum and Articles of Association/Trust Deed/ Declaration of Partnership (as applicable);
- Offering Memorandum/Summary of Terms/Marketing Material (as applicable);
- Auditor’s letter of consent;
- Administrator’s letter of consent (if applicable);
- Structure chart; and
- Application Fee CI$300 (US$365).
More information on CIMA’s gazette here, or their Investment Funds FAQ section here.
The Private Funds Act obligates registered funds to comply with several operating provisions. These provisions are modeled after the ESMA guidance for regulation of alternative investment funds. Operators continue to actively consult with compliance professionals, independent advisory board members, and their Cayman-based legal and accounting professionals.
CIMA’s framework for regulation recognizes that compliance regimes should be fit for purpose, and therefore a variety of approaches to satisfy the operating requirements may be acceptable as long as any inherent conflicts of interest are identified, managed, monitored, and disclosed to investors. In keeping with CIMA’s pragmatic and risk-based approach to oversight, the requirements have been discharged with minimal impact to fund managers’ existing operations and infrastructure.
While certain operators have been exercising the necessary due care in upgrading their own compliance and reporting practices, our experience has largely been that the prescribed operating requirements have essentially codified commonplace industry best practices.
Adoption of the operating requirements was also a positive outcome for managers who concurrently reviewed their compliance and regulatory reporting programs, which offered the opportunity to harmonize various global-reaching internal compliance programs, all while revisiting and mitigating any identified gaps.
Fund Annual Return
The Fund Annual Return is required to be completed by the operator and is subsequently submitted by the local auditor or other CIMA-approved third party. The Fund Annual Return includes select information related to the closed-end fund, its investors, portfolio, service providers, and related entities of the fund (co-invest funds, parallel funds, and AIVs). A signed declaration from the operator attesting to the fund’s compliance with certain operating requirements is also required. These items are to be submitted alongside the audited financial statements within six months of financial year-end.
Audited financial statements
Annual financial statements are required to be audited by an approved local auditor and submitted to CIMA within six months following fiscal year-end.
The requirement to submit annual audited financial statements had a largely benign impact to fund managers as existing limited partners or other regulators generally required distribution of audited financial statements; and CIMA accommodated existing industry practices of combined financial reporting to suffice for their purposes.
The introduction of the locally approved auditor regime was new to some private capital managers, however, this approach mirrors the longstanding practice in place for hedge funds under CIMA’s purview. CIMA is able to establish a local point of contact for all funds subject to its oversight by leveraging local expertise and the global networks of the approved audit firms. Auditors are obligated to notify CIMA in writing upon becoming aware of a fund that:
- Is likely to be or currently insolvent;
- Is operating in a prejudicial manner to investors;
- Has insufficient books and records to prepare financial statements;
- Is attempting to carry on business in a fraudulent or criminal manner; and/or
- Is in non-compliance with the Private Funds Act and other AML/KYC requirements.
In practice, accounting firms auditing CIMA-regulated hedge funds have a history of notifying CIMA of any such irregular scenarios, which is largely viewed as enhancing the effectiveness of the regulatory regime while optimizing the footprint of CIMA’s internal team of trained analysts and supervisors.
The Private Funds Act requires that a closed-end fund’s investment portfolio be fair-valued at least annually. Many fund managers employ third-party valuation agents to value their portfolios in part or whole. As a means of balancing the cost with the benefits of this requirement, the valuation function may also be performed in-house, by someone independent of the portfolio management function. If it is not practical or proportionate to employ a third-party or delegate valuation to an independent individual, conflicts of interest must be disclosed.
The Private Funds Act requires that a closed-end fund appoints a custodian(s) to hold custodial assets in segregated accounts. Custodial fund assets would generally include assets that are capable of being transferred and held in custody by a custodian, such as cash and listed securities. If not practical based on the nature of assets, a closed-end fund may notify CIMA and disclose any conflicts of interest.
The Private Funds Act requires that a closed-end fund appoint a person to monitor all cash and ensure payments made from investors for investment interest have been received by the fund. This function can be outsourced to an independent third-party such as an administrator. Conflicts must be disclosed if the function is performed by the fund manager.
The form of such conflict of interest disclosures related to the above operating requirements is not prescribed; however, industry norms for disclosure of conflicts of interest in LPAs largely sufficed. Any necessary revisions have been adopted by legal practitioners with minimal impact.
CIMA has also released various rules, statements of guidance, policies, and procedures over many of the operating requirements to assist registered funds in applying the general provisions of the Private Funds Act.
2 Base erosion and profit shifting - OECD BEPS
Figure 1 | Hedge funds: SEC-registered advisers (percentage of NAV)
Figure 2 | Private equity funds: SEC-registered advisers (percentage of NAV)
Figure 3 | CIMA-registered investment funds
Two years later…
The Cayman Islands remains a leading jurisdiction for formation of investment funds. The introduction of closed-end funds to the Cayman regulatory regime has proven to increase transparency, investor protection, and confidence in the jurisdiction.
The notable 16% increase in closed-end funds registrations in 2021 further demonstrates that investors and managers have adapted to the recently enacted global regulatory measures (please see figure 3 above), and Cayman continues to be the domicile of choice for investment fund formations outside the United States.
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