The United Kingdom (UK) government has today notified the European Council of its intention to withdraw from the European Union (EU), in accordance with Article 50 of The Treaty on European Union (the Article 50 notification). This means that:
- the European Council (on behalf of the EU and having obtained the consent of the European Parliament) and the UK government must now conclude an agreement setting out the arrangements for the withdrawal of the UK from the EU;
- the Treaties (that is, The Treaty on European Union and The Treaty on the Functioning of the European Union) will cease to apply to the UK on the date that a withdrawal agreement is entered into or, failing that, two years after the Article 50 notification, unless this period is extended by agreement between the European Council (acting unanimously) and the UK; and
- at the end of that period, the UK will automatically leave the EU.
This creates a number of challenges for UK fund managers because, not only is the timetable for Brexit uncertain, but the terms of the ongoing relationship between the UK and the EU, including any transitional arrangements during the immediate post-Brexit period, remain to be negotiated. And, whilst the UK wishes to negotiate "the greatest possible access" (having regard, for example, to cross-border access for the provision of financial services in the EU), the political will within the EU is such that it will not permit the UK to have an "à la carte" relationship with the EU, that is, to cherry-pick those parts of the Treaties which it favours. For this reason, the expression "hard Brexit or no Brexit" should be of great concern for those involved in the financial services sector.
The issues posed by Brexit for UK domiciled funds and UK based fund managers are similar in many respects to the issues that the EU's Alternative Investment Fund Managers Directive (AIFMD) poses for Cayman Islands (Cayman) domiciled funds and non-EU managers. So what is Cayman doing to address the issues AIFMD currently poses for Cayman domiciled funds?
Cayman's New AIFMD Regime
Commencement legislation to bring into force the Cayman AIFMD Regime (as defined below) is currently under review.
The Cayman AIFMD Regime has been designed to provide an opt-in, AIFMD like regime in Cayman to assist with Cayman's approval as an eligible jurisdiction for the extension of the marketing "passport" available under AIFMD to non-EU countries (Third Countries).
The passporting regime, once fully in place, will provide for the possibility of managers of alternative investment funds based in Third Countries (Third Country Funds) being permitted to market the Third Country Funds across all EU jurisdictions on a passport basis after registration in one EU country.
At present Third Country Funds (including Cayman Islands established funds) may be marketed in EU member states under the particular country's National Private Placement Regime (NPPR). Responding to reverse solicitation is also generally permitted though the application of this varies between EU member states. Once the Third Country Fund passport becomes available it is intended that the NPPRs will cease to operate.
However, timing of the extension of the AIFMD passport to any Third Countries is unclear as the European Securities and Markets Authority (ESMA) has to date only given unqualified approval 5 Third Countries and it is generally considered that full approval of further Third Countries will be required before the role of the NPPRs can be removed. In addition, the impact of the United Kingdom's decision to leave the EU, which is expected to occur by April 2019, has not yet been assessed. The UK is a significant market within the EU both for the domicile of investment managers (which will automatically become Third Country resident on Brexit) but also for investor capital, marketing to which will likely fall under the UK domestic regime following exit from the EU.
Notwithstanding the uncertainty around the introduction of the passport, as the world's largest alternative fund jurisdiction, the Cayman Islands government and the Cayman Islands Monetary Authority (CIMA) (the Cayman Island's financial services regulator) have been actively engaging with ESMA to ensure that Cayman are approved as an eligible jurisdiction for passport applications as soon as possible.
ESMA has adopted a country by country approach in assessing Third Countries for approval and has at present only given unqualified approval 5 Third Counties (of 22 identified for the first wave of review). In its last Advice, published in July 2016, ESMA assessed Cayman positively for extension of EU passporting to Third County Funds established in Cayman in respect of competition and market disruption but were not able to make an assessment in respect of investor protection until an AIFMD-like regime was in place in Cayman and was not able to assess the effectiveness of regulatory enforcement in Cayman until additional proposed powers are granted to CIMA to impose fines for breaches of regulatory laws, rules and regulations.
Cayman's legislative response
The Mutual Funds (Amendments) Law, 2015 (the AIF Law) and The Securities Investment Business Law, 2015 (the AIFM Law) along with the Mutual Funds (EU Connected Fund (Alternative Investment Fund Managers Directive)) Regulations, 2016 (the AIF Regulations) and the Securities Investment Business (EU Connected Fund (Alternative Investment Fund Managers Directive)) Regulations, 2016 (the AIFM Regulations and, together with the AIF Law, AIFM Law and AIF Regulations the Cayman AIFMD Regime) are intended to deliver the "AIFMD" like regulatory regime. The AIF Law and AIFM Law have been approved but require further legislation to bring them into force, the AIF Regulations and AIFM Regulations will automatically be brought into force with the relevant laws.
The Monetary Authority (Amendment) Law, 2016 has been introduced to allow CIMA to implement an administrative fines regime as a mechanism to ensure the industry's compliance with Cayman's regulatory laws and AML/CFT regime. CIMA will develop regulations for these administrative fines, in conjunction with the Ministry of Finance and industry; Cabinet approval would be necessary for these regulations to take effect. As yet these regulations have not been put forward for approval but are expected to be designed to satisfy ESMA's requirements regarding CIMA's ability to impose fines for breaches of regulatory laws, rules and regulations.
The AIF Law will amend the Mutual Funds Law (Revised) (the Mutual Funds Law), which is the principal regulatory law relating to investment funds in Cayman, to introduce the concept of an "EU Connected Fund". An EU Connected Fund is defined to include both open and closed ended funds established as companies, unit trusts or partnerships and which are: (i) managed by a person whose registered office is in a Member State1; or (ii) marketed to investors or potential investors in a Member State.
An EU Connected Fund will be required to provide CIMA with certain particulars set out in the AIF Regulations, notify CIMA of any changes to that information and advise CIMA if it ceases to market in any Member State and provide an annual confirmation that there have been no changes to the information provided and any marketing in a Member State is being carried out in accordance with that Member State's laws. As the definition of EU Connected Fund includes structures not presently regulated under the Mutual Funds Law all Cayman funds marketing in Member States will need to consider their reporting obligations on the commencement of the AIF Law.
An EU Connected Fund will be able to elect to apply for a licence or to be registered with CIMA under the AIF Law permitting closed ended funds, which are not currently regulated under Cayman Islands law, to elect to be regulated by CIMA.
The AIF Law will also provide authority to CIMA to provide attestation or confirmation of the status of any EU Connected Fund.
The AIFM Law will amend the Securities and Investment Business Law (Revised) (SIBL), which is the principal regulatory law relating to the carrying out of investment management activities in Cayman, to introduce three new regulated activities, "Managing EU Connected Funds", "Marketing EU Connected Funds" and "Acting as a Depository of an EU Connected Fund". The AIFM Law will also introduce the concept of an "EU Connected Manager", being a person to whom SIBL applies carrying on any of these activities.
The AIFM Regulations set out substantial new requirements which will apply to any EU Connected Manager that applies to be licensed in relation to the activities of "Managing EU Connected Funds" or "Marketing EU Connected Funds". These broadly mirror the requirements of AIFMD and its supporting regulations.
Additionally, entities carrying out either of the managing and marketing activities which do not apply to be licensed under SIBL (because they are exempt as an "excluded person") will also be required to provide certain details to CIMA as set out in the AIFM Regulations.
The AIFM Law will also provide authority to CIMA to provide attestation or confirmation of the status of any EU Connected Manager whether they are licensed by CIMA or not.
The continued engagement by the Cayman government with ESMA and other EU authorities to ensure that Third Country Fund passport options are available to Cayman established alternative investment funds and managers will be integral to the continued flow of capital into what is the world's largest fund's domicile namely the Cayman Islands.
However, the delays in ESMA's approval of Third Country jurisdictions and the likely dislocations and diversion of effort which can be expected in connection with Brexit negotiations raise questions over when, or perhaps even if, the Third Country Fund passport regime will become effective.
Although for a number of investment managers an effective passporting regime will open significant opportunities to market to investors in new markets, for many managers and particularly Asia based managers, only one or a small handful of EU countries are likely going to be relevant targets for marketing efforts.
Non-EU managers who require marketing access to the whole of the EU may wish to consider a fund domiciled in an EU member state (for example Luxembourg). However, for many Asian managers who are marketing to only a very limited number of EU Countries, the use of a Cayman Islands domiciled fund and the applicable NPPR regime is likely to continue to be the preferred option for some time.
1Under both the AIF Law and AIFM Law "Member State" means a state which is (i) a member of the EU; or (ii) a part of the EEA in which the AIFMD has been implemented.
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.