Setting up a Hedge Fund - Legal & Operational Requirements
This guide is not a substitute for specific advice but provides an overview of the requirements for setting up a hedge fund in the worlds leading jurisdiction for hedge funds - the Cayman Islands.
FORMATION AND STRUCTURING
1 Type of vehicle
1.1 The first step in establishing a Cayman Islands fund is to determine what type of vehicle(s) to use. The choices are (i) an exempted company, (ii) an exempted limited partnership, (iii) a unit trust, or (iv) a limited liability company (LLC).
1.2 There are few Cayman factors that will drive the selection of one vehicle rather than another and the choice is more commonly dictated by onshore tax and regulatory considerations relevant to the investors, the management or the trading strategy. For example, hedge funds that are looking to take in US tax-exempt investors will typically be formed as exempted companies, while funds that are to be distributed to certain Japanese investors may be structured as unit trusts. Where it is important that one portfolio of assets within the investment fund is protected from any liabilities incurred with respect to another portfolio, it is possible to incorporate an exempted company as a segregated portfolio company.
1.3 This Briefing Note is drafted on the basis that the fund in question is an exempted company. Exempted limited partnerships are also widely used, particularly as master funds, and generally the same principles apply.
2.1 Investment funds may be configured in different arrangements, with the appropriate structure generally driven by the tax treatment and geography of the prospective investors and the fund’s portfolio; the location of the manager; the asset classes and diversification of the portfolio; and investor and sponsor familiarity.
2.2 Typical structures involving Cayman vehicles are (i) a stand-alone fund, whereby all investor monies are pooled in a single vehicle which makes direct investments, (ii) a side-by-side arrangement, whereby a Cayman stand-alone fund operates in parallel to an onshore stand-alone vehicle with an identical investment strategy (but a different investor base) and the two vehicles execute the same trades, and (iii) a master-feeder structure. The typical master-feeder structure involves US tax-exempt investors and non-US investors investing in a Cayman exempted company feeder fund, US taxable investors investing in a Delaware limited partnership feeder fund, and the two feeder funds investing together into a single master fund (typically a Cayman exempted company or a Cayman exempted limited partnership), with the master fund holding the underlying portfolio investments.
2.3 Many variations are possible and it is important that fund sponsors take advice from onshore tax and regulatory experts to settle on the optimum structure.
CAYMAN ISLANDS REGULATORY FRAMEWORK
3 Mutual Funds Law
3.1 The Mutual Funds Law (Revised) (MF Law) is the principal Cayman Islands legislation applicable to investment funds. The MF Law refers to “mutual funds”, being “a company, unit trust, partnership or LLC that issues equity interests, the purpose or effect of which is the pooling of investor funds with the aim of spreading investment risks and enabling investors in the mutual fund to receive profits or gains from the acquisition, holding, management or disposal of investments…”.
3.2 “Equity interest” is further defined to include a share, trust unit, partnership interest or LLC interest which is “redeemable or repurchasable at the option of the investor”. As such, the MF Law applies only to open-ended funds, since interests in closed-ended funds are not redeemable at the option of the investor.
3.3 The MF Law generally requires that “mutual funds” falling within the above definition be registered or licensed with the Cayman Islands Monetary Authority (CIMA) under the MF Law in order to carry on business in or from the Cayman Islands. A vehicle with a single investor (which investor is not a mutual fund registered with CIMA) is not a mutual fund, on the basis that there is no “pooling” of investor funds.
3.4 Master funds are treated as registrable mutual funds if:
(a) they are incorporated in Cayman and hold investments and conduct trading activities for the principal purpose of implementing the overall investment strategy of one or more feeder funds registered with CIMA; or
(b) they otherwise fall within the definition of a mutual fund, for example a Cayman master fund in a mini-master structure where the only feeder fund is a Delaware LP but the master fund also takes in investors directly.
3.5 There are four categories of registrable mutual funds:
(a) a fund registered under Section 4(3) of the MF Law (s4(3) fund): this is by far the most common form of mutual fund. The principal requirement is that the minimum initial investment purchasable by a prospective investor is US$100,000;
(b) a fund registered under section 4(4) of the MF Law (s4(4) fund): this is a mutual fund with fifteen or fewer investors, a majority of whom are capable of appointing or removing the operators of the mutual fund. A s4(4) fund is not subject to the minimum initial investment requirement of a s4(3) fund nor is an offering document required to be filed with CIMA;
(c) an administered fund: this requires a licensed mutual fund administrator in Cayman to agree to provide the fund’s principal office and to apply to CIMA on the fund’s behalf. The primary advantage is that the US$100,000 minimum initial investment requirement also does not apply to administered funds. However, the additional role and responsibilities of the administrator may increase administration fees and limit choice; and
(d) a licensed fund: this is designed to be suitable for retail funds and as such involves a more prescriptive and iterative process with the regulator.
The remainder of this note focuses on s4(3) funds, s4(4) funds and administered funds, referred to for convenience as registrable funds.
4 Anti-money laundering legislation
4.1 The Proceeds of Crime Law (Revised) (PCL), the Proliferation Financing (Prohibition) Law, 2017 and the Anti-Money Laundering Regulations (AML Regulations) and Guidance Notes issued by CIMA together comprise the anti-money laundering regime of the Cayman Islands (AML Regime). The Misuse of Drugs Law (Revised) and the Terrorism Law (Revised) may also be of relevance. Generally, whether regulated or not, Cayman investment funds fall within scope of the Cayman Island's AML Regime as they will be considered to be engaged in "relevant financial business" as defined under the PCL.
4.2 The AML Regime requires that a Cayman investment fund should not form a business relationship, or carry out a one-off transaction, with or for another person unless it maintains as appropriate, having regard to the money laundering and terrorist financing risks and size of the business of such Cayman Fund.
Cayman investment funds must appoint named individuals to the roles of anti-money compliance officer (AMLCO), money laundering reporting officer (MLRO) and deputy money laundering reporting officer (DMLRO); the AMLCO and MLRO may be the same individual. The AMLCO will be responsible for overseeing the effectiveness of the investment fund's AML systems, compliance with applicable AML legislation and guidance and the day-to-day operation of the AML policies and procedures. The MLRO/DMLRO must receive all reports of suspicious activity in relation to any aspect of the fund and its activity; the MLRO/DMLRO should determine whether the information contained in any report supports the suspicion reported in order to determine whether, in all the circumstances, he/she in turn should submit a suspicious activity report to the Financial Reporting Authority of the Cayman Islands (FRA).
Bell Rock is able to provide individuals to serve as AMLCO, MLRO and DMLRO if required.
FATCA and CRS
5.1 The Foreign Account Tax Compliance Act (FATCA) provisions of the U.S. Hiring Incentives to Restore Employment Act (HIRE Act) provide that a Reporting Cayman Islands Financial Institution must disclose the name, address and taxpayer identification number of certain United States persons that own, directly or indirectly, an interest in such vehicle pursuant to the terms of an intergovernmental agreement between the United States and the Cayman Islands (US IGA) and implementing legislation and regulations which have been adopted by the Cayman Islands. If a fund fails to comply with these requirements then a 30% withholding tax may be imposed on payments to the fund of United States source income and proceeds from the sale of property that could give rise to United States source interest or dividends.
5.2 Almost every open-ended Cayman investment fund will be a Reporting Cayman Islands Financial Institution for this purpose. The Cayman legislation requires Reporting Cayman Islands Financial Institutions to make an annual report to the Cayman Islands Tax Information Exchange Authority (TIA). Any information provided to the Cayman TIA will be shared with the Internal Revenue Service of the United States.
5.3 In addition, over 100 countries have signed the OECD Multilateral Competent Authority Agreement and Common Reporting Standard (CRS) for the implementation of the automatic exchange of tax information based on the OECD's Multilateral Convention on Mutual Administrative Assistance in Tax Matters. The CRS is similar in form and substance to the US IGA.
5.4 As a result, a Cayman fund will be required to:
(a) register with the US Internal Revenue Service in order to obtain a Global Intermediary Identification Number (GIIN) and, accordingly, give one or more individuals authority to complete such registration. This is typically applied for by the manager on the fund’s behalf following incorporation of the fund;
(b) conduct requisite due diligence on all of its investors in order to identify the tax residency of each investor and to determine whether the interest held by that investor constitutes a “reportable account” under the regulations issued under the US IGA and CRS. Generally, funds address this by (i) seeking appropriate self-certifications and beneficial ownership information from investors at the time of subscription, and (ii) engaging the fund administrator or another specialist provider to assist with the fund’s FATCA and CRS due diligence and reporting obligations;
(c) provide notification to the Cayman TIA of certain prescribed details, and to identify a Principal Point of Contact and Change Notice Person; and
(d) report the requisite information on each of its “reportable accounts” to the TIA prior to the applicable deadlines.
6 Directors Registration and Licensing Law
6.1 Registrable funds are “covered entities” for the purposes of the Directors Registration and Licensing Law (DRLL). Every director or manager of a covered entity must be a corporate director, a professional director or a registered director under the DRLL (which in the case of an LLC shall be deemed to refer to every manager).
6.2 Corporate directors are uncommon, in part because of the higher fees and more onerous obligations for corporate directors under the DRLL.
6.3 Professional directors are defined as natural persons appointed as directors for 20 or more covered entities. There are exceptions that mean that in practice few individuals are required to register as a professional director.
6.4 Registered directors are natural persons appointed as directors for fewer than 20 covered entities, and represent by far the most common category.
6.5 Individuals must be registered or licensed before they are appointed as directors of a covered entity. Registration is effected through an online portal and takes approximately 48 hours to be processed.
Bell Rock routinely provides highly experienced and independent directors to the board of investment funds, management companies and investment committee’s. We are a leader in fund governance services and our director team is composed of professionals with over 25 years of senior level industry experience, having worked for well-known names in the global financial industry. This will not only bolster your fund offering but strengthen your governance framework and provide comfort to investors and regulators.
7.1 While a detailed analysis is beyond the scope of this note, if it is proposed to market a Cayman fund to EU investors, this will be governed by the EU Alternative Investment Fund Managers Directive (AIFMD). AIFMD applies in relation to (a) the management, by managers established in the EU, of alternative investment funds (wherever the funds are established) and (b) the marketing of alternative investment funds (wherever established) by managers (wherever located) to non-retail EU investors. Accordingly, even a Cayman fund with a non-EU manager must comply with AIFMD if the manager wishes to market that fund to non-retail EU investors.
7.2 There are three options to market to non-retail EU investors:
(a) Passporting, which is currently not available to non-EU funds;
(b) Private placement in each relevant EU member state based on such state’s national private placement regime (where available); or
(c) Reverse solicitation, which is considered to be very limited in scope and relies on the investor actively approaching the manager to obtain information on investment opportunities in the particular fund.
Documents required for CIMA registrable funds
12.1 For registrable funds, the following documents are required under the MF Law:
(a) other than in respect of s4(4) funds, an offering document – see above for a description of its primary function;
(b) CIMA forms - the MF Law requires registrable mutual funds to disclose certain core information to CIMA. Such disclosure must be made to CIMA on specific forms (known as Forms MF1, MF2, MF2A, MF3 or MF4 (to be used as appropriate));
(c) auditors’ consent letter - this is a letter from the mutual fund’s auditors to CIMA confirming that they consent to act as auditors to the fund and are aware of their duties under the MF Law. The mutual fund’s auditors must be approved by CIMA. Typically for a master-feeder structure a single letter will cover both;
(d) administrator's consent letter - this is a letter from the mutual fund’s administrator to CIMA confirming their consent to act as administrator of the fund and agreeing to make documents relating to the fund available to CIMA when required. The administrator need not be based in the Cayman Islands. Typically for a master-feeder structure a single letter will cover both; and
(e) an affidavit of a director in relation to certain online filings.
13.1 An exempted company is entitled to apply under section 6 of The Tax Concessions Law (Revised) for an undertaking that no law enacted in the Cayman Islands after the date of the undertaking imposing any tax to be levied on profits, income, gains or appreciations shall apply to the company or its operations, and that no tax to be levied on profits, income, gains or appreciations or which is in the nature of estate duty or inheritance tax shall be payable on or in respect of the shares, debentures or other obligations of the company or by way of withholding in whole or in part on any dividend payment or other distribution of income or capital by the company to its members or to a payment of principal or interest or other sums due under a debenture or other obligation of the company.
13.2 The undertaking may be for a period not exceeding 30 years from the date of approval of the application but, in practice, the undertaking is normally given for 20 years.
13.3 Similar provisions apply in respect of exempted limited partnerships and LLCs, in each case for a 50 year period.
14 Fund Registration Process
14.1 For a registrable fund, once the documents listed in paragraphs 11 and 12 above are in agreed form and the directors have approved the launch of the fund, the fund must apply to CIMA for registration as a mutual fund.
14.2 The following items are required in order to register the fund with CIMA:
(a) other than in respect of a s4(4) fund, an offering document in final form – see paragraph 12.1(a) above;
(b) for a s4(4) fund only, a certified copy of an extract of the constitutional documents of the s4(4) fund specifying that a majority of the investors in number are capable of appointing or removing the operator of the s4(4) fund;
(c) Form MF1 or equivalent - see paragraph 12.1(b) above;
(d) Auditors’ consent letter - see paragraph 12.1(c) above;
(e) Administrator’s consent letter - see paragraph 12.1(d) above;
(f) Director’s affidavit - see paragraph 12.1(e) above;
(g) Application fee – currently US$4,635;
(h) Certified copy of the fund’s Certificate of Incorporation.
14.3 The application is made through an online portal, and will invariably be submitted by Ogier as Cayman counsel to the fund. For registrable funds, a complete application will be processed without further communication with CIMA: there is no process of comment and response as there may be in the case of a full licence application.
14.4 It takes approximately two weeks to receive a copy of the Certificate of Registration and for the fund to be listed on CIMA’s website. It is not permissible to take in money, issue shares or commence trading before the fund is CIMA registered. However, the Certificate of Registration will be dated with the date of submission of the registration documents. On this basis, and as a result of CIMA's consistency of approach in registering funds, most funds are confident to commence operations after the date of registration but before the Certificate of Registration has been received. Although this carries with it the risk that CIMA will reject or delay the registration of the fund for some reason, in our experience this would be very unusual.
14.5 From a Cayman law perspective it is permissible for the offering document to be used for marketing purposes ahead of CIMA registration, although if the offering document states that the fund is registered with and regulated by CIMA then it should be notified to recipients of the document that such registration and regulation is pending.
15 Continuing obligations
15.1 Once the fund is registered and has commenced operations, it must comply with certain ongoing Cayman Islands obligations.
15.2 In brief, these include:
(a) obligations under the Companies Law (Revised), for example in relation to maintenance of statutory records and books of account, filings with the Registrar upon changes to the company’s constitution and its directors and officers, and annual filings;
(b) in the case of registrable funds, obligations under the MF Law including filing of updated details within 21 days of material changes, submission of audited financial statements within six months of the fund’s year end and payment of annual fees;
(c) compliance with AML requirements;
(d) compliance with ongoing due diligence and reporting requirements under FATCA and CRS; and
(e) general common law and statutory obligations in relation to the offering of the fund’s shares, for example to avoid misrepresentation, negligent misstatement, breach of contract and criminal liability.
We routinely work on all aspects of setting up the legal infrastructure of a Cayman fund. Our expertise enables us to advise on the appropriate legal structure, appoint required service providers, advise on regulatory requirements and provide on-going support. Contact us for further information and we will be happy to set up a call to provide an overview: firstname.lastname@example.org