CIMA Regulatory Roundtable

In September, ComplianceAsia co-hosted with Ogier, CIMA, Ernst & Young and Fortis a regulatory roundtable discussion on hedge fund regulation.

Peter Cockhill from Ogier and Gary Linford of CIMA spoke prior to the Q&A and here are their presentations:

Ogier Roundtable: Cayman's Regulatory Philosophy
Hong Kong
11 September 2006

An Update of Cayman's Fund Industry
By: Peter Cockhill
Partner, Ogier

Good afternoon. This is intended to be an interactive session and I would like to encourage everyone to feel free to ask questions following Gary Linford’s presentation. The reason we have assembled a panel of leading industry participants is so that we can obtain the benefit of different perspectives: regulatory, legal, audit, administrator and compliance. Although I am sure my fellow panellists have one or two questions in mind which they propose to ask of Gary and the rest of the panel, much of the value of these forums is derived from suggestions or queries from industry participants which in due course may lead to regulatory or legal clarifications or changes, so please speak up.

Before Gary shares CIMA’s regulatory philosophy with the rest of us, I would like to briefly set the scene of spending a few moments looking at the growth of Cayman as a domicile for investment funds and bringing you up to date with some of the industry developments that are currently taking place.

Screen 1 - Licensing Activity as at 30 June 2006

The screen shows the number of Fund licensed entities in Cayman as at 30 June 2006. The number of registered funds was 7,161 approximately double the number that were registered in June 2003. Registered funds account for approximately 90% of the 7,845 funds which CIMA regulates, and of those registered funds, 95% or more fall within the broad definition of what we understand to be a hedge fund. Registered funds are those which have a minimum subscription amount of US $50,000 or whose securities are listed as a recognised stock exchange (principally, the Irish Stock Exchange and the Cayman Stock Exchange).

Registered (i.e. non-public) funds continue to drive the growth of Cayman with CIMA registering new funds at an average rate of 37 per week during the first half of 2006.

As you probably know, there are two other types of funds regulated by CIMA: the administered funds and the licensed funds. Licensed funds are those which are effectively retail funds, offered to the general public, and you can see that the number of such funds is relatively insignificant (approximately 1% of all regulated funds). Administered funds tend to fall between the retail and the institutional sectors, these are funds which cannot take advantage of the registered funds filing (as minimum investment is not at least $50,000 and their shares are not listed), but which can avail of a relatively light regulatory environment because they are being administered by a regulated Cayman Islands administrator which is responsible for ensuring appropriateness of the promoter and principals of the investment fund. Overall numbers of administered funds have increased only slightly over the last three years, but these quasi-non public funds represent about 8% of regulated funds and I believe Gary will mention them later on as they continue to be used by Asian and Hong Kong based promoters.

The remaining statistics deal with administrators. The number of full licence holders has increased and CIMA now licences 15 of the world’s top 20 fund administrators, as ranked by assets under administration according to Hedge Fund Manager survey of November 2005. The restricted category is now largely a legacy as it was a way of investment managers being registered prior to the SIB Law which came into effect in 2004. Likewise the exempted category.

How does Cayman compare to the other offshore jurisdictions?

(Slide 2 - Jurisdictional Comparison: Dec 2000 - Dec 2005)

The number of funds globally has increased and each of the offshore centres (with one exception) has increased its number of domiciled funds. However, Cayman continues to dominate and in 2005 grew by a net 1,174 funds compared to a net growth of 234 by BVI, Cayman’s nearest competitor.

(Screen 3 - No. of Regulated Funds: 2000 - 2005)

So, the statistics tell a good story. There are several drivers to this growth, but there is little doubt in my mind that a substantial amount of the credit for Cayman’s continued pre-eminence as the domicile of choice for offshore hedge funds should go to CIMA and its investment and securities division, not least for its willingness to engage with industry and to work on developing with the stakeholders a sound and appropriate regulatory regime. The recent establishment of the Cayman branch of AIMA, the first chapter in an offshore jurisdiction, will provide a very useful conduit for the views of the Cayman hedge fund industry into industry on an international private sector basis. AIMA Cayman will be making contributions to the AIMA recommendations on two key areas which have been identified as areas of specific supervisory focus: the valuation of illiquid assets and the treatment of side letters. Many of you will have noticed that lawyers are recommending more explicit disclosure of the actual or potential existence of Side Letters in a fund’s offering memorandum. We are hoping to have a Cayman industry view on this issue to feed into AIMA in the next few months. In this way bodies representing the hedge fund industry such as AIMA will obtain the benefit of the accumulated hedge fund know-how in Cayman. This expertise resides not just in Cayman, but worldwide through the users of Cayman (such as yourselves) and their dialogue with Cayman service providers engaged in the hedge fund industry. I hope that today’s discussion will be an extension of that dialogue and will lead to greater mutual understanding between industry and the key offshore regulator.

So, at this point I would like to hand over to Gary Linford, head of the Investment and Securities division of the Cayman Islands Monetary Authority.

Cayman Islands Monetary Authority Regulatory Philosophy
By: Gary Linford
Head of Investment & Securities Division
CIMA

Distinguished guests, ladies and gentlemen – Good afternoon.

With all the meetings and events that surround this week’s Hedge Funds World Conference, I know your time is at a premium and therefore I thank you for attending this Ogier- sponsored function.

One of the main reasons for accepting the opportunity to speak at such gatherings, is to ensure our regulatory philosophy with respect to the investment industry, particularly hedge funds, is understood. At the Cayman Islands Monetary Authority (“CIMA”) we monitor the source of hedge fund business very closely to ensure we engage with those markets and jurisdictions that direct business to the Cayman Islands hedge fund industry.

Hong Kong is one such jurisdiction and I will be spending the next few days speaking with local service providers to Cayman hedge funds and obtaining feedback on the proposed changes to our regulatory framework. This is to ensure we maintain the appropriate balance between the needs of the investors and that of promoters as well as other stakeholders in the global hedge fund industry that might be impacted by the actions of service providers to Cayman regulated funds. Indeed, we are mandated by The Monetary Authority Law to undertake formal consultation with industry on any changes to the regulatory framework and this we do. However, we go beyond this and consult widely, on an informal basis, and this is part of the reason for my participation in this afternoon’s roundtable – not only to share my thoughts from the perspective of a regulator of 8,000 hedge funds but also to listen to you and learn more on the direction the Hong Kong hedge fund industry is moving.

Let me quickly remind you that the remarks I make today are generally my own and are not necessarily the thoughts or policies of the CIMA or that of my colleagues, one of whom is with me this afternoon, Judiann Richards.

Before we begin the roundtable, I would like to take 20 minutes or so to discuss the following three issues

1) Our regulatory philosophy towards hedge funds

2) The Goldstein decision in the USA

3) An update on our proposed changes to the regulatory framework governing the fund industry in the Cayman Islands

It is important to note that while our regulatory framework allows for both public and non-public funds, we have very few funds that seek a license under the more prescriptive regime appropriate to retail funds. Most of my comments today therefore relate to hedge funds that are targeted at the non-public investor, whether institutional or high net worth private individuals and are authorized by CIMA as registered funds, typically with a minimum subscription of US$1.0 million or more.

With the Hong Kong market keen to allow retail investors access to hedge funds, I wish to take this opportunity to remind all present that our regulatory regime does cater to this target market. We have what we call an “administered fund” – or for the lawyers in the audience - our s 4 (1) (b) fund, where the responsibility rests with a CIMA licensed fund administrator to ensure a) each promoter of the mutual fund is of sound reputation, b) the administration will be undertaken by persons who have sufficient expertise and c) the business of the mutual fund will be carried out in a proper way. With an “administered fund” we regulate the licensed fund administrator with a physical presence in Cayman who in turn is responsible for looking to the interests of investors. As a service provider already licensed by CIMA has conducted the initial due diligence and will provide ongoing monitoring of the fund in accordance with s16 of our Mutual Funds Law, the approval process to set up such a fund is very quick – typically less than five days.

Our regulatory approach for the sophisticated, non-public funds is “lighter” than our approach to retail funds because for the non-public funds there is either an additional measure of supervision such that another party provides oversight, for example, an approved stock exchange for funds that are so listed, or the investor is considered to be sufficiently sophisticated and capable of performing its own due diligence (because of the minimum subscription amount).

Our overriding regulatory objective for non-public funds is to compel proper disclosure by fund operators so that investors are not misled about the nature of the risk taken. The objective is achieved chiefly by requiring these funds to prepare and file offering documents that describe the equity interests in all material aspects such that a prospective investor may make an informed decision whether or not to subscribe. The principle of “buyer beware” is paramount, since it is the investor, and not CIMA, that is responsible for its own due diligence on a fund’s service providers, promoters, operators, strategy, risk-profile, track record, etc. With the debacle at Refco Inc, which, lets be clear, had nothing to do with hedge fund risk, more accounting irregularities or fraud at a US listed company, some 30 or more Cayman hedge funds were left with counter party exposure to the brokerage and cash management divisions of Refco. For some funds the exposure was fatal and they have commenced liquidation or have suspended redemptions and await creditor claims to be settled, others have managed to side-pocket the claims against Refco or sold out to distressed debt hedge funds. Notably, CIMA has not received one investor complaint. Why? Because the professional investors knew what they were buying and the offering document highlighted these risks. Disappointed investors – sure, aggrieved and looking to the regulator for help, no. An interesting consequence of the Refco debacle is that trading and cash management is increasingly spread amongst a number of prime brokerage houses, as hedge fund managers are now more alert to counter party risk.

Promotion of separate regulatory frameworks between non-public funds, such as our registered funds on one hand, and public or retail funds on the other hand, will allow the innovation, flexibility and creativity of the traditional hedge funds to prevail while also allowing access to funds of hedge funds by retail investors to progress under a more prescriptive, rule based, regulatory regime.

There has been considerable press coverage of late on the number of hedge funds closing down. Earlier Peter Cockhill, of Ogier, provided the impressive growth statistics on the number of new funds being established, some 37 per week. It should be no surprise to all of you that our friends in the press have instead focused on the increase in funds closing. Let me say that CIMA does not view the high fund closures with alarm, as we believe it demonstrates our industry is working, where sophisticated investors do not allow poor performance to go unpunished.

Of course, not all 600 terminations will be a result of poor performance. Many funds are simply unable to attract sufficient capital to commence trading and others reach the end of their useful life. In addition, ahead of the introduction of E-Reporting, CIMA is working hard on clearing a number of dormant funds from our list of active funds so do not be alarmed should the press misuse this number of fund closures in support of their never-ending suggestion that the hedge fund success story is over. In fact, our termination of approximately 600 funds in 2006 while authorizing 1,800 is almost the same percentage as the 13-year cumulative average - where we will have terminated a little less than 4,000 of the approximate 12,000 authorized since the fund legislation was introduced in 1993.

Where the barriers to entry are low, particularly cost of capital and regulatory, then it is understandable that more hedge fund managers will get into the game that possibly should not. As long as the lower barriers to entry from a regulatory perspective relate to professional, non-public funds, it is my view that investors can take better care of themselves than any regulator and can probably do so at lower cost. As long as we are establishing three times as many funds as we are closing, and frauds are kept to a minimum, I am not concerned with the current level of terminations.

When the FSA first set out its perceptions of the regulatory risks posed by hedge funds in 2005, it offered no convincing evidence at that time to suggest that hedge fund managers are likely to cause any more disruption to the market than other players - yet the FSA attributed a number of significant risks to the hedge fund sector. There is no rationale to justify a different regulatory focus for hedge fund managers from that applicable to other investment managers, or indeed other market participants.

Thankfully, the FSA views in their feedback to the 2005 consultation provided earlier this year reflect the commonsense approach that is needed for the regulation of hedge funds. At a time when IOSCO, FATF and the FSF continue to warn of the systemic risks posed by hedge funds, it is heartening to hear other national regulators have taken the time to understand the industry and provide some balance to this argument. This change in view at national regulator level is no more evident than with the new Chairman of the U.S. SEC. Let me quote from his statement on the 25^th July 2006 to the U.S. Senate Committee on the Regulation of Hedge Funds:

“Hedge funds are not, should not be, and will not be unregulated”. However, Mr. Cox went on to say, “I would counsel that to the maximum extent possible our actions should be non-intrusive. There should be no interference with the investment strategies or operations with hedge funds, including their use of derivatives trading, leverage and short selling. Nor should the federal government trammel upon their creativity, their liquidity or their flexibility. The costs of regulation should be kept firmly in mind. There should be no portfolio disclosure provisions. Hedge funds should be able to continue to charge their clients performance fees, just as they do now.”

I could not have articulated this better myself and yet, what Mr Cox suggested to the US Senate less than two months ago is our core regulatory philosophy to the hedge fund industry and has been for the last 13 years. This is the reason we have 8,000 active funds.

I share similar views to Mr. Cox when it comes to the issue of “retailization” which I understand to be a little at odds with the UK FSA and the HK SFC, where both regulators see some merit in retail participation in hedge funds. I do not think we should “regulate away” the current concerns with hedge fund valuation practices, the conflicts in determining fund performance fees, other inherent conflicts of interest found in many hedge fund structures and the higher risk that accompanies a hedge fund’s expected higher returns – these are simply not investments for Mom and Pop. Thankfully Mr. Cox does not advocate eliminating such risks; rather he proposes to limit retail investor’s exposure to these risks while promoting an improvement in “best practices” in the area of NAV calculation etc. One way to minimize retail exposure is to amend the current definition of “accredited investor” and Mr. Cox has suggested raising the net worth suitability threshold from $1 million to $1.5 million.

While I agree with this suggested increase in the net worth requirement for the U.S. market, it does not necessarily work in all markets. It is for this reason I have my reservations with the suggestion in the feedback to the FSA discussion paper that it might be advantageous to better coordinate regulatory consultation to minimize further fragmentation in regulatory requirements for hedge funds. While such an approach may reduce the likelihood that industry players will be subject to widely differing regulations, global regulators need to be careful that in dispensing guidance we are not forcing the hedge fund industry into a “one size fits all” approach. With Hong Kong and other jurisdictions pushing for retail investors to be given access to funds of hedge funds, I believe further differentiation between the retail and sophisticated market needs to be encouraged. Any attempt to harmonize hedge fund regulation could very well have adverse effects on innovation.

The one area I strongly disagree with the U.S. SEC is their requirement for non-U.S. hedge fund managers to register with the SEC when they have 15 or more U.S. investors. Since the US Court of Appeals vacated the hedge fund manager registration rule in the Goldstein case, I am not aware if the SEC is still wedded to the idea of regulating non-US investment managers. It is my belief that the SEC should work with regulators like the CFTC, UK FSA, HK SFC and others to avoid such duplicative regulation.

This extraterritorial nature of the former registration requirement of the SEC is not helpful and the US authorities should be mindful of unintended consequences. Good intentions do not mitigate disastrous outcomes – one need look no further than the introduction of Sarbanes-Oxley in the USA. According to Paul Atkins, SEC Commissioner, the actual costs of compliance were 20 times more than the SEC estimate when it first introduced the legislation. The SEC Commissioner went on to quote the Wall Street Journal that up until the year 2000, nine out of every ten dollars raised by foreign companies through new stock listings were done in New York. By 2005, the ratio reversed such that nine out of every ten dollars are raised outside of the USA. I am sure all of you know this well as I believe the Hong Kong Stock Exchange is probably a huge beneficiary of Sarbanes-Oxley.

OK, let me now turn back to Cayman and talk a little about the latest developments in our jurisdiction.

Some 85-90% of our 8,000 regulated funds have a December year-end. With most funds taking the full six months or more before they file the audited accounts, it is July and August when we receive approximately 6,800 sets of audited accounts through the post or by fax. With each set of audited accounts running to 50 pages or more, you can imagine what my division’s daily in-tray looks like. Our new electronic reporting initiative is designed, in part, to improve the efficiency in handling these accounts.

For the past several months, we have invested heavily in structuring the E-Reporting proposal, and in the last week of August, we signed with an IT vendor to deliver the business requirements set out in the public RFP. We expect a tested system to be in use by 31^st March 2007.

The industry’s stakeholders, particularly lawyers, auditors, and fund administrators, regularly ask us for current statistics concerning the Cayman Islands funds industry, such as size, growth, change, market share, and investments by and in funds. At the same time, international bodies such as the International Monetary Fund continue to ask financial centers around the world to provide aggregate statistics so that they may understand and map macro-economic and global financial flows. The data we collect from E-Reporting will provide that kind of information. In fact, I believe that the information that we will be able to supply (once the new system has been running) will be better in quality and quantity than any other hedge fund jurisdiction.

We have taken great care to ensure that E-Reporting does not increase the scope of regulation. We are aware that our regulatory philosophy is a significant factor in Cayman’s success as a hedge fund jurisdiction, and we are seeking to make it more efficient, and even more cutting edge.

Our E-Reporting Proposal asks all regulated funds to submit their Annual Audited Financial Statements to CIMA as a PdF through a secure electronic transmission. In and of itself, this is not cutting edge, and should not pose any concern for any party. It will, however, reduce the physical storage space that CIMA requires. In addition, with the growth rate in CIMA-regulated funds, electronic reporting will also enable the Authority to maintain the appropriate supervisory capacity without a proportionate increase in staff.

CIMA also proposes that 32 specific data items be reported on a web-based electronic form.

This list of questions can be found on our website. You will note that approximately half of the data should be contained in any set of financial statements, and the other half is an update to information that is generally in a funds’ offering memorandum or registration documents.

In this way we are hoping to be able to provide some useful statistics for the 8,000 funds we expect will be active as at December 2006. For example, it should be possible to highlight the subscriptions versus redemptions for a particular year, for a particular investment strategy, for all funds or a group of funds in a specific geographic location, say hedge funds associated with distressed securities managed out of Hong Kong. We should also be able to compare expense ratios of, say, single managed funds to fund of funds and be able to produce useful statistics on the number of funds that receive a qualified audit.

The funds will file their financial statements and the key data through their locally approved audit firms. There are 24 such firms approved by CIMA. While we are asking the auditors to file the key data and PdF of the audited accounts with us, we will stipulate clearly in the regulations and guidance notes that the legal responsibility to provide the information remains with the operator, in keeping with the operators’ other obligations under the Mutual Funds Law. We have had preliminary talks with the USA SEC to ensure the filing of data by auditors on behalf of the operators will not be a breach of the SEC independence rules for the auditors.

We have worked hard to ensure the impact for the fund and its service providers, both in terms of time and cost, is minimal and we are confident that compliance with this new process for submitting audited accounts will be good. Information submitted to CIMA has always been and will continue to be managed in an extremely confidential manner. In no way will fund- or manager-specific information be made available to the public, only aggregate industry statistics.

The Mutual Funds (Amendment) Bill, 2006 has been drafted and will shortly be tabled before the Cayman Islands Legislative Assembly. There are no major changes to our fund regulatory framework. The Bill proposes:

· An increase in the minimum subscription for Section 4(3) funds from US$50,000 to US$100,000.

· An amendment to the definition of “carrying on business in or from the Islands” to allow a foreign-domiciled fund to be administered in the Cayman Islands without the need for registration with CIMA.

· An amendment to allow CIMA to specify the manner in which audited accounts are to be transmitted. This is to cover the E-Reporting initiative I discussed earlier.

· To give CIMA the discretion to waive the requirement for an annual audit to be submitted

· To empower CIMA to cancel the registration of a mutual fund in certain circumstances, if, for example, the fund is carrying on business in a manner prejudicial to its investors.

· To obligate an auditor to notify the Monetary Authority if, in the course of carrying out an audit of the accounts, the auditor obtains information, or suspects that a regulated fund is

1. Insolvent, or likely to become so

2. Carrying on business, or effecting a voluntary winding up, in a manner prejudicial to investors or creditors

3. Not keeping adequate, auditable accounting records

4. Carrying on business in a fraudulent or criminal manner, or without due compliance with pertinent Laws and licence conditions

There are other minor amendments but the ones I have mentioned will be of interest. Sadly for you lawyers, we have “grand-fathered” all existing funds in respect of the increase in the minimum subscription so there will not be a need for you to update 8,000 offering documents.

In Cayman, our fund administrators often look after the offshore fund in a Master-Feeder structure involving an onshore fund, for example Delaware. Where the U.S. promoter wants the Cayman administrator to look after the books and records of the domestic fund, our legislation requires the Delaware fund (or BVI fund in case of some Asian structures) to register with CIMA. The Bill seeks to remove this impediment and allow our administrators to take on more business in the Cayman Islands without imposing Cayman regulatory requirements on foreign funds. Sensibly, however, the Bill proposes that we limit such derogation to foreign funds from countries approved by CIMA. To avoid duplication, we will probably make use of our Schedule 3 list that is currently used in determining appropriate jurisdictions for Anti-Money Laundering purposes. I am certain Hong Kong will be on this list.

The existing legislation requires a fund to submit audited accounts on an annual basis and gives CIMA no discretion to vary this condition. Let me be clear, CIMA has absolutely no intention on waiving the need for audited accounts due to cost reasons, or because all investors so agree, or because audit firms have not completed the audit in a timely manner or the audit firm unexpectedly resigns. This waiver will only be used for exceptional circumstances.

The existing legislation does not allow CIMA to terminate the registration of a regulated fund if we believe circumstances so warrant. CIMA does not have a heavy-handed enforcement style. We typically look to the corporate governance structure of a fund to resolve any issues and generally work with the service providers to a fund to find a cost-effective solution to complications that arise from time to time. There are some of you in the audience who have had experience in working with me, on so called “problem funds” that can attest to CIMA’s approach to enforcement. Thankfully, it is only occasionally that a fund promoter or operator will walk away from a fund prior to terminating the fund in compliance with our requirements. If there are still investors in such a fund, we will typically ask the Court to appoint a Controller to effect an orderly liquidation. However, where the assets have been redeemed it will not be cost-effective to go through the Court and this amendment will now provide CIMA with the authority to terminate the fund, where circumstances so dictate, and to do so as an enforcement action, with the names of the promoter and/ or operators posted to our website.

The whistle-blowing responsibilities of an auditor that I mentioned earlier already exist in the current law. However, it is proposed that the obligations be extended to include reference to an auditor that was engaged to carry out such an audit but resigned before carrying out the audit or whose contract was otherwise terminated. It will therefore be important for an auditor to withdraw the Letter of Consent that is provided to CIMA if an auditor wishes to limit their exposure. Until CIMA is notified that an auditor no longer acts for a fund, the liability attached to the whistle-blowing obligation remains. In the past the liability was limited to a fine, payable upon summary conviction but the Bill now empowers CIMA to disqualify a firm, temporarily or permanently, from being an auditor to a regulated fund.

The changes in the law proposed by this Bill follow many of the findings of the Mutual Funds Working Group that was made up of representatives of relevant private sector associations and senior personnel from CIMA. When considering such recommendations we recognise the need for proportionality and that any benefits to be obtained from amending legislation, regulation or policy should exceed the burden imposed on the industry. We believe we have retained all the flexibility and attractiveness of the existing legislation. Indeed, we believe we have added to it with the proposal to allow CIMA to waive audits and allow foreign funds to be administered in the Cayman Islands without the need to register, while enhancing the scrutiny obligations imposed on service providers. We will also be in a position to provide meaningful, credible statistics on the global hedge fund industry once the E-Reporting initiative has captured the December 2006 audits. I suspect CIMA will be ready to provide aggregate statistics in a year from now – perhaps at the 2nd Annual Ogier-sponsored HK event in 2007?

I am confident that the global hedge fund industry will continue to grow and that the Cayman Islands will remain the jurisdiction of choice for the domicile of funds. We do not see centres like Hong Kong as a threat to our business and we welcome the appointment of Hong Kong based investment managers, administrators and operators to Cayman domiciled funds. I remain convinced that our regulatory philosophy towards hedge funds remains attractive to all and continues to balance the needs of investors, promoters, operators, investment managers, prime brokers and fund administrators while increasingly finding favour with national regulators who come to realise the benefits the hedge fund industry has to play in our global financial system.

You have been a very patient audience, and I appreciate your attention. I trust you will participate actively in the roundtable format that follows by asking a number of difficult and probing questions of E&Y, Fortis and Ogier while giving me the easy ones.

Thank you.

Gary Linford