Cayman island's Hedge Fund Haven Faces Challenges

Date: Monday, March 20, 2006
Author: David Clarke Investmentnews.com

OTTAWA - Late last year, the Cayman Islands' hedge fund industry celebrated a milestone: the registration of the 10,000th fund to be authorized by the Cayman Islands Monetary Authority.

But the celebration may have been premature, since as of Feb. 1, hedge funds physically located in the United States have had to be registered with the Securities and Exchange Commission, regardless of where the actual fund is domiciled.

"We think the SEC regulations will have a neutral or positive impact on the industry here," said Jonathan Tonge, a partner and joint head of the investment fund practice at Walkers, a law firm in George Town, Grand Cayman. He said that SEC regulation could affect the structure of the fund administration sector.

Others think differently

"In the medium to long term, Cayman is likely to face increased competition, not from other offshore fund centers but from onshore centers," said Sean Flynn, chief executive of UBS Hedge Fund Services, which has offices in George Town, Grand Cayman, and Dublin, Ireland. "As more long-only managers move into hedge funds, and as institutional investors increase their exposure to alternative assets, hedge funds will progressively become more of a mainstream asset class, and it is institutions that may prefer to invest in funds domiciled in an onshore regulatory framework."

Indeed, UBS announced March 7 that it is opening a new hedge fund services office in Toronto, providing a range of hedge fund administration services for international asset managers.

"Toronto is a leading financial services center with a concentration of corporate headquarters as well as associated professional services," said Pearse Griffith, who will head up the new office. "With a large pool of highly qualified financial and technical employees, the city offers many businesses the opportunity to grow effectively."

In the short term, SEC attitudes toward the hedge fund industry are much on the minds of Cayman Islands professionals.

Numerous experts in the hedge fund industry spoke last month at the Cayman Fund Focus conference in the city of Grand Cayman on the island of the same name.

"There is an emphasis by the SEC on trading violations such as short selling, soft selling, insider trading and front running. The SEC is also concerned about conflicts being properly disclosed to investors," Keith Miller, a New York-based partner with Pittsburgh law firm Kirkpatrick & Lockhart Nicholson Graham LLP, told conference attendees.

In an interview, Mr. Miller said: "The SEC will go after investment advisers and hedge fund managers regardless of where they are located, particularly if U.S. securities or investors are involved. Judging from recent settled cases, however, the SEC's strategy on who it will charge can be inconsistent.

"For example, recently, the SEC settled a series of cases involving hedge funds that had engaged in market-timing and late-trading activities. For the most part, the SEC charged the hedge funds and the hedge fund managers under the anti-fraud provisions of the federal securities laws and obtained orders of disgorgement from the hedge funds relating to the illegal profits that the hedge funds made.

"It is hard to make a broad statement on this," said John Nestor, SEC spokesperson. "But in general, the SEC will charge both entities or individuals who have violated the regulations."

"In one matter, though," Mr. Miller said, "the SEC did not charge the hedge fund but rather the hedge fund managers, claiming the managers defrauded the hedge fund by failing to tell the investors in the hedge fund about the market-timing and late-trading activities. Why the SEC decided to charge the hedge funds in three actions and not the other are unknown."

That leaves Cayman Islands hedge fund operators much to ponder.

Around half of the world's hedge funds are registered there, and the islands are home to 90% of the new hedge funds being launched in the U.S. market, according to the CIMA, which is based in Grand Cayman.

According to the CIMA, there are more than 160 licensed administrators, comprising 88 full licensees, 66 restricted administrators - which are permitted to service no more than 10 funds - and seven exempted administrators, which service a single fund.

The passage of the Caymans' Mutual Funds Law in 1993 paved the way for the islands to become the world's leading hedge fund domicile and a major center for the servicing of alternative funds. Under it, funds domiciled abroad must register with the CIMA in order to be administered in the Caymans.

The Mutual Fund Working Group, an advisory body comprising senior authority personnel and professional-group representatives, has submitted to the Cayman Islands government a series of formal recommendations for amendment of the legislation.

Among the working group's proposals is a counterattack on U.S. fund administration operations.

It would exempt foreign funds administered in the Cayman Islands from regulation by the CIMA, since they already are regulated in the jurisdictions where they are domiciled. The Cayman administrators that service them already are regulated by the CIMA.

Raising the bar

The Mutual Fund Working Group also has proposed increasing the minimum threshold for an initial investment to $100,000 (U.S.), from $50,000, which would satisfy a recommendation of the International Monetary Fund in Washington. This will simplify the regulations with current market practice.

Fully 80% of funds registered with the authority require minimum subscriptions of $1 million or more, while no more than 5% have a minimum of less than $100,000, according to the CIMA.

In-force funds with thresholds that low would not be affected by the proposed change.

Where hedge funds will go from here is the theme of the International Hedge Fund Conference, scheduled for May 1-3 at Seven Mile Beach, Grand Cayman. It will feature speakers on recent hedge fund blowups, SEC investigations and managing operational risk.