With the enhancement of Cayman Islands' regulatory framework in the form of the introduction of the International Tax Co-operation (Economic Substance) Law, 2018 and its related Regulations (ES Law) and welcome updates in 2019 and early 2020 to the Securities Investment Business Law (SIBL), the Anti-Money Laundering Regulations (AML Regulations) and the Mutual Funds Law (MFL), the last 12 months have been a busy time for Cayman Islands funds and their managers and advisers. While the dust is still settling on the full implementation of these regulations, there is increasing clarity on what is now required of these entities and the ongoing role they can offer in the Asian fund landscape.
Use of Cayman Island entities
The Asian fund market is starting to show its intent to provide alternatives to traditional fund structures which cater and appeal more to Asia-based investors. Arguably, the most significant steps taken in recent years have been the introduction of the Variable Capital Company (VCC) in Singapore and the Open-Ended Fund Company (OFC) in Hong Kong. While these may acquire a share of their respective markets, it will likely take a while for their prime use to be established and even then it could well be alongside Cayman Islands funds in the same structure. For the time being, with 10,857 funds regulated by the Cayman Islands Monetary Authority (CIMA), the Cayman Islands certainly remains the domicile of choice for hedge funds globally.
The Cayman Islands was ranked as the Top Specialised Financial Centre by The Banker for nine years running, it is a contracting state of 36 tax information exchange agreements (also the OECD's multilateral agreement which now has over 100 countries as signatories) and it benefits both from a stable economy with flexible investment legislation and an efficient and responsive regulator. Combine these factors with the speed and low costs associated with fund formations (neither of which are matched by the VCC or OFC) and the depth of professional expertise available on the ground in the Cayman Islands and it is easy to see why Asia-based investors still look to Cayman as the gold standard for hedge funds.
A manager or adviser to a Cayman Islands fund does not itself need to be based in the Cayman Islands, nor does any foreign manager or adviser need to be authorised there for so long as it does not establish a presence or carry out business there. There will often, however, be commercial or tax reasons for why the sponsor of the fund will establish an offshore management or advisory entity that forms part of its onshore group. It is typical, especially for Hong Kong-based asset managers, to use a Cayman Islands entity as a discretionary manager for investment fund structures. The overseas manager could choose either to incorporate a new Cayman Islands entity, or it has the option of registering itself as a 'foreign entity' in the Cayman Islands.
Most Cayman Islands managers and advisers (and registered foreign entities acting in such capacity) will fall under the SIBL requirements by virtue of carrying out 'securities investment business', which captures (i) dealing in securities; (ii) arranging deals in securities; (iii) managing securities; (iv) advising on deals in securities; and (v) acting as an 'EU Connected Manager'.
Helpfully, SIBL offers a lower regulatory burden for entities that fall within one of the following categories:
- An entity within a group of companies carrying on securities investment business exclusively for one or more companies within the same group.
- An entity with a registered office in the Cayman Islands provided by a licensed service provider, that carries on securities investment business exclusively for one or more of the following classes of persons:
(a) 'Sophisticated persons', being persons: (i) regulated by CIMA or a recognised overseas regulatory authority; (ii) with securities listed on a recognised security exchange; or (iii) who by virtue of knowledge and experience in financial and business matters are capable of evaluating the merits of a proposed transaction, and where the transaction has a monetary value of at least US$100,000.
(b) 'High-net-worth persons', being persons with: (i) a net worth of at least US$1,000,000; or (ii) total assets of at least US$5,000,000.
(c) Companies, partnerships or trusts whose shareholders, limited partners or unit holders are all sophisticated persons and/or high net worth persons.
- An entity regulated in respect of securities investment business by a recognised overseas regulatory authority in the country or territory (other than the Cayman Islands) in which the securities investment business is being conducted.
If the entity falls within one of the above categories it need only register with CIMA as a 'Registered Person' (which has replaced the previous 'Excluded Person' regime). This straightforward process involves filing an application form (accompanied by certain information and declarations from each 10% ultimate beneficial owner) and paying the registration fee of US$6,100. Provided CIMA is satisfied that its shareholders and the operators/senior officers of the entity are 'fit and proper persons' it will then proceed to register and issue a Certificate of Registration to the entity.
As with CIMA-registered funds, Registered Persons must appoint at least two individual directors/managers or one corporate director/manager, each registered with CIMA under the Directors Registration and Licensing Law, 2014.
Consistent with international practice, Registered Persons must also appoint an Anti-Money Laundering Compliance Officer, Money Laundering Reporting Officer and Deputy MLRO, and have suitable policies and procedures in place to combat money laundering, terrorism financing and proliferation financing.
Unlike entities holding a full CIMA licence under SIBL, Registered Persons are (a) not required to submit annual audited financial statements or business plans, (b) not subject to pre-approval of any change of directors, shareholders or beneficial owners, and (c) not subject to certain Conduct of Business and Financial Requirements made under SIBL.
Economic substance requirements
The other key regulatory consideration for Cayman Islands managers and advisers is that of meeting the requirements of the ES Law. In short, 'relevant entities' carrying out 'relevant activities' are required to meet an economic substance test (ES Test) in respect of gross income deriving from that activity.
Helpfully 'investment funds' (including entities through which they invest) are not 'relevant entities' and therefore not subject to an ES Test. Conversely, Registered Persons will likely be a 'relevant entity', but 'fund management business' is the only management limb of SIBL caught within the 'relevant activities'. A Registered Person only acting as an advisor will therefore likely have no ES Test to satisfy.
Those acting as a manager will need to satisfy the corresponding ES Test, which is currently as follows: (i) conducting Core Income Generating Activities relating to the 'fund management business' from the Cayman Islands; (ii) be directed and managed in an appropriate manner in the Cayman Islands; and (iii) with regard to the income generated from the 'fund management business', have incurred adequate operating expenditure, have an adequate physical presence and an adequate number of full-time employees or other personnel with appropriate qualifications in the Cayman Islands. Carey Olsen can advise on how a specific ES Test may be met. Helpfully there is the ability for managers to outsource the Core Income Generating Activities, which an increasing number of managers are taking advantage of.
At the start of 2019 there were 2,926 'Excluded Persons' under SIBL, and they had until 15 January 2020 either to re-register as a Registered Person or restructure in such a way that that entity was no longer carrying out securities investment business. At the same time they needed to consider how they were going to comply with the ES Law. We are now seeing an increasing number of successful Registered Person registrations and the process will no doubt become even smoother with the initial rush to meet the deadline now subsiding. With an enhanced regulatory framework in place but still a relatively cost-effective and sensible approach to registration and on-going regulatory oversight, we expect Cayman Islands managers and advisers to continue to play an important role in Asian fund structures.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.