The headline writes itself for corporate law as it heads out of 2015 and into 2016: Costs and competition abound, with the former sparking concerns and the latter innovation.
One of the chief drivers of costs took effect Jan. 1. The new global “common reporting standards, or CRS,” devised by the Organisation of Economic Cooperation and Development, are modeled on Washington’s Foreign Account Tax Compliance Act, which itself sharply boosted compliance costs for financial institutions globally with U.S. clients. As of two weeks ago, CRS boosted costs for everyone else.
Simply stated, CRS rules “remedied” – according to the OECD – a situation in which parties to international agreements for sharing tax information had previously supplied those details only upon request.
In early May 2014, 34 OECD countries, plus another dozen, decided this was ineffective in preventing tax evasion and agreed on comprehensive rules to transfer information automatically and systematically. Four months later, the G-20 issued its “Common Reporting Standard Implementation Plan.”
Cayman on board
“Fee pressure” is the phrase employed by Alasdair Robertson, global managing partner at Maples and Calder. The Cayman Islands and the British Virgin Islands moved first on the standards, mitigating any shock waves from suddenly rising costs, enabling local implementation to occur “relatively seamlessly.”
“We are one of the early adopters of CRS,” Robertson said, and “as a result of the good working relationship between the public and private sector and the high quality of service providers in the jurisdiction … clients hav[e] been educated, laws brought in on time and service providers are ready to advise and assist clients with complying with CRS.”
Publicly, advisers and managers prefer to speak of new – and often expensive – rules as “developments,” but concern is audible in comments not only from Robertson, but also from Walkers Partner Dawn Howe.
“The introduction of FATCA and CRS to the Cayman Islands, which has required a significant overhaul of fund documents and fund administration arrangements has probably been the biggest drain on hedge funds’ balance sheets in terms of Cayman Islands-based regulations,” Ms. Howe said.
Both the complexity of the legislation and the “ever-increasing volume of information that needs to be collated and reported year-on-year,” have driven costs, she said in a series of written responses.
Additional fee pressure has come from local changes: the Director Registration and Licensing Law, which has further taxed corporate hedge funds by charging fees for each director, “and the change to CIMA’s audit waiver policy will have significant cost implications for funds winding down their operations going forward,” she said.
The new audit waiver policy came in late 2015 when CIMA shifted its long-standing practice of waiving final audits for funds preparing to terminate. While CIMA has always required funds to file annual reports, it had routinely waived the rule for funds about to de-register. In October 2015, however, the authority decided to suspend waivers for that “stub period,” a partial year and final period of operation.
According to one counselor, the move “created difficulties for some funds” that had, for example, paid out its investors but not completed their de-registration and had not provided for resulting audit costs.
Another problem arose as the result of the inevitable time-lag between the end of a given investment period and the time required to produce an audited statement for that period.
“For managers operating in the European hedge fund space, navigating AIFMD [the European Union-created Alternative Investment Funds Managers Directive] and registering their Cayman funds for distribution into Europe will have had a significant impact on costs,” Howe said.
“As for regulation in the U.S., this seems never-ending and must be hitting U.S. managers hard, which in turn will have an impact on the Cayman products that they manage.”
Jon Fowler, global head of funds at Maples and Calder, indicated the range of new expenses, while not a happy circumstance, had not proved overwhelming. He described as “relatively modest,” for example, director fees now due under DRLL rules: “In terms of compliance, directors can maintain their information and interact with CIMA directly via CIMA’s dedicated web portal, without needing to involve legal counsel.
Howe agreed in regard to the new DRLL fees, which may not achieve their ostensible purpose of limiting multiple directorships by any single individual, but wondered about the cumulative effect: While any particular licensing fee may not be onerous, the new charges apply to “every single director on a corporate registered mutual fund/SIBL excluded manager,” she said. “This must run into several thousand people and will certainly cover the several hundred Cayman-resident independent directors.”
While the registration fee is not, in itself, “a significant cost for directors who serve on a number of fund boards … it is another cost factor that needs to be taken into account when launching a hedge fund,” Howe said. “The CIMA portal seems to have functioned well. However, turnaround times need to be factored into the launch timetable when starting up a new fund.”
Wider impact of regulations
She suggested the wider impact of escalating regulation and charges could prove daunting, however.
“For the industry as a whole, the costs have been huge,” Howe said. “Clearly there are some very visible costs, e.g. the new director licensing fee …, administrator fees for additional FATCA/CRS services, but these are just the tip of the iceberg.
“In order to comply with new regulations (particularly FATCA/CRS/AIFMD), hedge funds have had to create and introduce brand-new policies and procedures, often engage new service providers to assist with compliance, revisit all core documentation for necessary revisions and spend considerable man-hours familiarizing themselves with complex regulatory requirements.
“Many of the larger hedge fund institutions have needed to employ large teams of people to manage the additional compliance burden,” Howe said. “The overall scale of costs runs into many millions (if not billions) of dollars industry-wide.”
Robertson said climbing costs had not significantly discouraged clients because new regulation and fee increases are universal, rendering “comparison shopping” pointless.
“There is an acceptance among investors that sensible and proportional regulation is part of the current investment market and the reputation of the Cayman Islands as a well-regulated, transparent and cooperative jurisdiction is often seen as a positive by clients.”
For her part, Howe fears erosion of client numbers, and points to a score of affiliated costs that accompany fresh regulation: “Yes – without a doubt,” she said of diminished client numbers. “It is expensive to set up a new hedge fund and clients need to be sure that they can raise a decent amount of capital to dilute the burden of set-up fees before they will proceed.
“Investors are now also increasingly capping the amount of costs that managers can reclaim from the fund for regulatory, legal, etc., services – demonstrating that sophisticated investors are waking up to the significant compliance costs that can be incurred and which cause a significant drag on returns. Flat returns generally mean that investors will look to alternative products,” she said.
Being forced to seek alternative products may, in fact, mark the upside of 2016 as innovation carves out new markets, develops appropriate instruments and keeps regulators alert and employed.
“Clients are looking for value, in particular in providing added-value services such as in-house seminars, secondees, client updates, etc.,” Robertson said. “Our ability to provide an integrated-service line including registered-office services, fiduciary services, fund administration, board support, Automatic Exchange of Information-related services and AIFMD-related services helps clients in providing that added value. In particular, our ability to offer our eServices Web-based platform to clients who have their registered office with us has proved very popular.
“What is clear is that while there is an acceptance post-financial crisis that increased regulation is a norm, clients want to see efficient and creative solutions to these issues,” he said. “A great example of this is with respect to AEOI (both FATCA and CRS) where our affiliate MaplesFS is able to provide a number of FATCA/CRS services to clients.”
Antonia Hardy, Walkers Cayman office managing partner, felt similarly about the June 2015 launch of Walkers Professional Services, calling the move “overwhelmingly positive.”
“We made a conscious decision to focus on service in those areas which are complementary to, and do not conflict with, our legal-services offering. We made significant investment in technology and resources,” she said, offering a network of corporate and fiduciary functions such as administration, record-keeping, corporate secretarial services, regulatory filings, independent directors for SPVs, financing and investment transactions and meeting reporting and registration obligations.
Limited liability companies
The latest local product innovation was Dec. 18 legislation creating limited liability companies, a vehicle new to Cayman, though commonplace in the U.S. since 1976, and modeled on the “offshore” structures embodied in Delaware law.
The advantages of an LLC are that the members of the company cannot be held personally responsible for corporate debt or liabilities. It is a flexible hybrid of a corporation and a partnership, suited particularly to a single owner. In the U.S., an LLC also confers certain tax advantages.
Among the disadvantage are that an LLC has to be dissolved upon the death or bankruptcy of a member. Corporate governance is defined only by an operating agreement among its members.
“The introduction of the LLC responds to requests from the investment funds industry,” Robertson explained. “The flexible nature of the vehicle means that it will also be well-suited to a broad range of general corporate and commercial applications. We expect that the introduction of the LLC will further cement the Cayman Islands’ position as the domicile of choice for offshore investment funds and structuring vehicles.”
Government has not specified when it is likely to launch.
New fund formation
New fund formation also looms as a significant 2016 development, reinforcing trends from 2014 and 2015: “Open-ended fund formation continues at least in line with 2014,” Fowler, of Maples and Calder, said. “CIMA’s figures for Q1 and Q2 [in] 2015 show 581 funds formed against 528 formed in the same period in 2014, an increase of 10 percent year on year.
“We will have to wait until the new year for official figures from CIMA to see if this rate of formation continues and to see the 2015 level of de-registrations.”
According to the October 2015 U.S. Securities and Exchange Commission report, Cayman holds 37.5 percent – in terms of net asset value – of all U.S. private funds, up from 2013’s first quarter 36.5 percent, which Walkers Global Managing Partner Ingrid Pierce said “indicates both stability and growth in the Cayman market.”
She also pointed to anticipated growth in credit hedge fund strategies, which are built around arbitrage of capital structures and exploitation of differences between senior and junior securities from the same corporate issuer.
“There has been a large rise in credit hedge fund strategies,” Pierce said, acknowledging that while managers have had problems gaining access to credit, “it illustrates the growth of nonbank finance and the key role hedge funds continue to play in this space.”
Howe looked forward to 2016, citing growth in hedge fund assets under management, “albeit at a fairly modest pace,” while anticipating challenges with marketing into Europe, at least “until the necessary decisions are made on whether or not to extend the passport to Cayman funds.
“There is also increased competition from external markets such as Bermuda, who are looking to take a slice of the hedge fund market which means that Cayman needs to remain at the forefront of innovation in the funds industry,” she said, looking to LLCs as a counter.
A second counter specific to Walkers will come in early 2016 when the firm opens a full-service operation – its ninth – in Hamilton, Bermuda, offering litigation, insolvency, corporate, investment funds, finance, insurance and trusts.
“Our entry into the Bermuda market is a direct result of key client feedback – simply put, a number of them were asking us to be there,” Hardy told the Journal, pointing to “great synergies” with Walkers’ core practices.
”Walkers will provide multijurisdictional legal services to clients who require legal advice on any combination of Bermuda, Cayman Islands, British Virgin Islands, Irish and Jersey law,” according to the firm’s May announcement.
Finally, both have words to say about ongoing pressure from London to expand “beneficial ownership,” publicly listing owners of Cayman-registered companies as part of efforts to combat excessive secrecy and tax avoidance. The push has been resisted not only by local law firms, but also by elected officials, led by Premier Alden McLaughlin, who most recently pushed back at December’s Joint Ministerial Conference of British Overseas Territories in London.
“Beneficial ownership is quite a difficult topic to distil in a couple of sentences,” Robertson said, but he articulated the standard response: Access to ownership information already exists under certain legal parameters, and that until jurisdictions globally embrace beneficial ownership changes, Cayman is unlikely to accept it.
“The key point is that the Cayman Islands already has a G-20-recognized system in place that enables us to meet international standards in relation to anti-money laundering and other financial crimes,” Robertson said.
“The U.K. has now recognized that having a public register is not the only way to meet those standards and that ‘similarly effective systems’ can do that. Our current regime of having regulated corporate service providers who are legally required to maintain AML information including beneficial ownership information is, in our view, a ‘similarly effective system.’”
Mark Lewis, Walkers senior partner, said, “The rationale behind establishment of registers of beneficial ownership is to improve the overall sharing of information between countries in terms of tax cooperation and collaboration … in relation to the global investigation and prosecution of serious crime.”
He said Cayman has long had legislation requiring service providers “to obtain, verify and retain information on beneficial ownership” of all locally registered entities.
He indicated the U.K.’s proposed public register raised “very real concerns about the lack of accuracy and verification of the data collected in the U.K.,” saying Cayman had a “far more robust, effective and proven system … where reliable and verified beneficial ownership information is collected through a network of licensed, registered office-service providers.
“Cayman will make beneficial ownership information available to regulators and law-enforcement agencies that make appropriate application for that information,” Lewis said, pointing to the communiqué following the JMC gathering, and that local practice is “in accordance with current international standards.”
Any unilateral and premature move toward publicly accessible registers “would negatively impact not only Cayman, but also those regulators and law enforcement agencies operating throughout the world that rely so heavily on the quality of the information obtained in Cayman … [I]ncoming business to Cayman would simply transfer to less-regulated jurisdictions with significantly reduced standards in recording beneficial ownership information,” the senior partner said.
In his Dec. 31 New Year’s message, Premier McLaughlin reaffirmed government’s position: “We continue to attract companies that want to domicile in Cayman because we are engaged in vigorous international cooperation regimes complemented by our robust anti-money laundering and countering of terrorist-financing programs.”
Pointing to the JMC, he said London had tried “to strong-arm the Overseas Territories on beneficial ownership,” but that local policies remained unchanged. “We have effective mechanisms for the sharing of information for tax purposes both on request and by automatic exchange of information. We are transparent for tax purposes and we collaborate to avoid any abuse of our system by criminals.”
Remaining unmoved by London, he suggested, had actually boosted Britain’s confidence in Cayman: “ … because we stand our ground when we know we’re right … the U.K.’s confidence in the Cayman Islands government … is all the … stronger.”
In summary, Robertson said Cayman is on the right track: “I think we are heading in the right direction. The key is to keep our competitive edge and there are a lot of reasons to be positive on that front.”
LLCs, he said, exemplify “the already strong stable of legal entities that are attractive to global investors,” while “our revisions to the exempted limited partnerships law last year ha[ve] been very well received … [L]ooking forward, we are also looking at other innovations such as foundations and limited liability partnerships.
“A lot of progress has been made by Cayman Finance [in] the past year to promote and help understand our industry both locally and internationally and looks to grow from strength to strength in the future. It was very encouraging to see government commit … an additional $3 million to CIMA as they will need increased resources,” Robertson said.
“Investment funds continue to look for compelling investment opportunities. We have seen a number of private equity funds buying loan portfolios, including distressed mortgage portfolios. This can help provide liquidity to the markets and, in the case of mortgage portfolios, often help mortgage borrowers agree revised loan terms under which their loans can be maintained.”
Walkers’ Howe looked for strong performances from “the private equity space,” although she warned of increasing regulation, saying both FATCA and CRS applied to every fund strategy.
Partner Rolf Lindsay said “credit and direct-lending funds … are leveraging unique industry knowledge and more flexible balance sheets to fill the holes left by traditional lenders struggling under their own weight of regulation.”
Finally, Hardy pronounced Cayman as robust and ready for the new year.
“As a long-standing and sophisticated financial-services jurisdiction, she said, “Cayman is well placed to continue to play a huge part in global capital flows. We have seen the market for Cayman services becoming increasingly institutional as regulation increases and would expect that to continue.”