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It has become increasingly popular in recent years for venture capital (VC) and private equity (PE) firms to set up exempted companies limited by shares in the Cayman Islands for the purposes of pre-IPO equity financing rounds.
Why the Cayman Islands?
Other than offering a tax neutral jurisdiction for international investors, the Cayman Islands benefit from financial and political stability, a business-friendly regulatory environment, a sophisticated legal regime based on English common law with a respected court system and a pool of highly skilled professional service providers; all of these factors combine to make it a jurisdiction of distinction for equity financing.
A quick word on exempted companies in the Cayman Islands
The flexibility of Cayman Islands exempted companies is certainly one of their main appeal. For example, Cayman Islands’ corporate law does not require any director or officer of the exempted company to be resident in the Cayman Islands. An exempted company which is not regulated is not required by statutory law to hold an annual general meeting of its shareholders. Equally, there is no statutory requirement for a non-regulated exempted company to undertake an annual audit. More on the advantages of using Cayman Islands exempted companies for investment purposes here: Advantages of Using Cayman Islands Exempted Companies for Investment Purposes and to… – Loeb Smith.
Exit strategies
Whilst investors in PE and VC investment companies would ordinarily look to realise their investment within 3-6 years, these exit strategies have been severely impacted in recent years by macro-economic factors and geopolitical developments, which have made it increasingly difficult for investors to exit their investment. In this economic landscape, investors may have to explore less traditional routes to exiting their investment. In this article, we seek to provide some insight on how investors can navigate the not-so-unconventional waters of exit enforcement when issued with preference shares in a Cayman Islands exempted company.
Preference shares provisions
In usual circumstances, the memorandum and articles of association of the exempted company as well as the subscription and shareholders’ agreements are drafted to include various investor protection provisions such as preference dividend rights, liquidity preference rights, exit rights on the occurrence of certain events, and rights to redeem preference shares in the event that anticipated trigger events for an exit do not materialize.
Share rights limitations
Investors in Cayman Islands exempted companies ought to be aware that under Cayman Islands law, dividends can only be paid out of available profits or from the company’s share premium account, however, in the latter case, such payment can only be made if immediately following the date on which the distribution or dividend is proposed to be paid, the company is able to pay its debts as they fall due in the ordinary course of business. More on dividends and on what constitutes profits here: Payment of dividends by a Cayman Islands company and what constitutes “profits” – Loeb Smith.
Similarly, it should be noted that the Cayman Islands’ Companies Act (As Revised) prescribes that share redemptions and share buybacks can generally only be funded out of profits, out of a company’s share premium account or out of the proceeds of a fresh issue of shares. However, in limited circumstances, a company can make a payment out of capital provided that immediately following the date on which the payment out of capital is proposed to be made, the company is able to pay its debts as they fall due in the ordinary course of business.
Interestingly, in what is a leading authority on the matter, the Cayman Islands Court of Appeal has held that the cash flow test of solvency mentioned above is not confined to consideration of debts that are immediately due and payable but also permits consideration of debts that will become due and payable in the reasonably near future.
The provisions on distribution of the company’s assets on a winding up or a liquidation under Cayman Islands law are also drafted so as to prioritise creditors over shareholders, and within this group, in particular, preferential and secured creditors. The law of voidable preference which is written into the Companies Act may also be invoked in the event the directors of the exempted company had paid a particular shareholder or a redeemed shareholder ahead of other creditors at a time when the company was unable to pay its debts with a view to giving such redeemed shareholder a preference over the creditors. In such circumstances, such transactions would be voidable upon the application of the company’s liquidator if made within six (6) months of the commencement of the company’s liquidation.
Directors’ duties
Against this backdrop of limitations on dividends, redemptions and distributions are directors’ fiduciary duties. The duties of directors of a Cayman Islands exempted company are found in the common law and include, amongst others, the duty to act in good faith in the best interest of the company. It is important to note that whilst in many circumstances the best interest of the company align with the best interest of its shareholders, this is not always the case, particularly when a company is nearing insolvency. In those circumstances, the directors, as part of their duties, will likely put the company’s creditors’ interests ahead of the interests of its shareholders and may find themselves unable to satisfy redemption requests from shareholders. This is in spite of the investor protection provisions which may have been negotiated into the preference share financing documents.
Redemption requests
Notwithstanding the above, there may be benefits in submitting early redemption requests in situations where the company is in financial difficulty. As a first step, however, any shareholder looking to submit a redemption request should familiarize themselves with the procedure and, if necessary, consult with their legal counsel as procedural compliance can often be the difference between a simple shareholder and a creditor. The company’s articles of association and/or shareholders’ agreement usually set out a detailed procedure where certain steps must occur within a strict timeframe for the redemption request to be valid.
Where there has been a valid redemption request which has been accepted but the company has failed to satisfy, such failure has the important effect of raising the investor’s status to that of an unsecured creditor as opposed to a mere shareholder. At this point, the investor/unsecured creditor has the option to either (i) commence legal proceedings, or (ii) issue a statutory demand to the company requiring it to pay the sums owed under the accepted redemption request within twenty-one (21) days of the date of service.
Option (i) (i.e. the commencement of formal legal proceedings), will be subject to whatever terms regarding dispute resolution were contractually agreed between the investor and the company in the preference share financing documents. Arbitration is often found in these types of agreements. Whilst commencing legal proceedings against the company may cause the company to pay the sums owed, these proceedings are often time-consuming and expensive and, in the event such proceedings are successful and the investor comes out with a judgment or an arbitral award in its favour, even then it may be difficult for the investor to enforce judgment that against the company if the company is insolvent as preferential and secured creditors would take priority under Cayman Islands insolvency law.
Option (ii), on the other hand, only requires the investor to issue the company with a formal letter in a prescribed form called a “statutory demand” requiring it to pay the debt owed within a prescribed period or dispute the debt. Should the company fail to engage, this provides rebuttable evidence that the company is unable to pay its debts as they fall due and such evidence can be used as the basis for winding up proceedings against the company. The next step would then be to petition the Cayman Islands court to wind up the company. It should be noted, however, that a public notice will be advertised which will give other interested parties the opportunity to join the proceedings. The scheduled hearing may result in the company being placed into liquidation unless it can raise a substantive defence as to why the debt has not been paid. Once the company is in liquidation, the appointed liquidator will look into its accounts, realise the company’s assets and pay the creditors in ranking order.
“Legally available funds”
One of the defences that companies often raise in winding up proceedings is that of lack of “legally available funds”. This is due to the fact that when it comes to negotiating the initial set of documents for the preference share financing, provisions restricting the payment of redemptions to situations when the company has “legally available funds” will often be drafted into the articles of association and/or the shareholders’ agreement. It then becomes a question of interpretation as to what “legally available funds” actually means in that particular context. Cayman Islands courts have held such term to mean funds owned by the company or funds that the company could obtain by exercising its legal rights, however, such funds would not include any monies which are required for the company’s ordinary course of business. Generally speaking, to the extent that wording has been drafted into the documents and the company does not have sufficient legally available funds to satisfy the redemption requests, Cayman Islands courts are inclined to hold such a defence as a genuine and substantive dispute of the debt and have set aside winding up proceedings on that basis.
Jurisdiction over the dispute
As mentioned at option (i) above, arbitration clauses are often drafted into preference share finance documents and Cayman Islands courts would ordinarily grant a stay of a winding up petition based on a disputed debt where the underlying dispute falls within the scope of an arbitration clause. Importantly, however, the stay of winding up proceedings in favour of arbitration is not automatic and the Cayman Islands courts will first need to be satisfied as to the existence of a bona fide dispute on substantial grounds prior to being able to exercise their discretion to stay the petition in favour of arbitration. In other words, the Cayman Islands courts will not stand for any delaying tactics where there does not appear to be a genuine dispute of the debt.
Alternative dispute resolution
If a company has run into financial difficulties, there may be scope for the company and the investors to come together and agree to a voluntary restructuring. Where a consensual solution cannot be reached with all interested parties, the agreement may take the form of a court-supervised process such as a scheme of arrangement which may have the potential for a better return to investors than a liquidation of the company.
The corporate team at Loeb Smith has extensive experience in advising companies and investors on the negotiation of these finance documents, the enforcement of redemption requests and the implementation of suitable strategies and solutions for financially-stricken companies.
Further Assistance
This publication is not intended to be a substitute for specific legal advice or a legal opinion. If you require further advice relating to the matters discussed in this Briefing, please contact us. We would be delighted to assist.
E: gary.smith@loebsmith.com
E: robert.farrell@loebsmith.com
E: ivy.wong@loebsmith.com
E. elizabeth.kenny@loebsmith.com
E: cesare.bandini@loebsmith.com
E: vivian.huang@loebsmith.com
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E: yun.sheng@loebsmith.com
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Introduction
The Court of Appeal of the Cayman Islands has delivered a landmark judgment which has provided clarification of and, arguably, amendments to, Section 238 of the Cayman Islands’ Companies Act (the “Act”).
The Court had to consider whether there was an error in or an omission from Section 238 of the Act and whether it was possible to interpret the law in a manner that gives effect to the original intention of the Cayman Islands’ Parliament.
Legislative background
For those who might not be familiar with this part of the Act, Section 238 affords important protection to minority shareholders who dissent to a merger or consolidation involving the Cayman company in which they are a shareholder. Section 238(1) of the Act states that a shareholder of a company is “entitled to payment of the fair value of that person’s shares upon dissenting from a merger or consolidation” and the remainder of Section 238 sets out the steps by which such ‘fair value’ is achieved. The process begins with the dissenting shareholders serving notice of their objection on the relevant company1 and in the absence of agreement on ‘fair value’, culminates in an application being made to the Court for ‘fair value’ to be determined there.2
Crucially, section 238 of the Act is drafted on the assumption that the shareholders of the relevant company will be able to vote on the proposed merger or consolidation. However, such a vote is not always required. If the proposed merger or consolidation is between a parent company and a subsidiary company both of which are incorporated in the Cayman Islands, the requirement for such a vote can be dispensed with provided that a copy of the plan of merger is provided to all shareholders.3
As a matter of terminology, mergers or consolidations where a vote is required are known as ‘long-form mergers’ and those where no vote is required are known as ‘short-form mergers’.
The question to be answered by the Court in this case was therefore whether minority shareholders in a subsidiary company (which it was proposed would merge with a parent company by way of a short-form merger) could benefit from the protection provided by Section 238 of the Act.
Is the wording of Section 238 ‘wrong’?
Section 238(1) of the Act establishes the “fair value” principle for the benefit of dissenting shareholders and it reads as follows:
“(1) A member of a constituent company incorporated under this Act shall be entitled to payment of the fair value of that person’s shares upon dissenting from a merger or consolidation.”
Section 238 of the Act therefore does not, on its face, distinguish between long-form mergers or short-form mergers. The same cannot be said of the remaining sub-sections, however, and the Court noted that “it is plain that subsections (2) to (16) of section 238 apply only to long-form mergers. This is evident from the fact that the opportunity to object and the opportunity to dissent depend upon the existence of a shareholder vote, and the timing of the matters set out in subsequent subsections depends upon the existence of such a vote.”4
The Court held that subsection (1) of Section 238 is a ‘free-standing provision’ and so is capable of applying to both long-form mergers and short-form mergers whilst noting that the remainder of Section 238 of the Act is “not apt to apply to short-form mergers”.5
The Court considered further that “this is not what the legislature intended”6 with the Judge observing that “the sensible and commercially justifiable decision to dispense with a shareholder vote in a short-form merger has had the unintended and hitherto unrecognised effect of depriving minority shareholders in a short-form merger of appraisal rights which the legislature intended them to have.”7
Conclusion
Regardless of the Court’s view that Section 238 of the Act had been incorrectly drafted, the Judge did not consider it to be within the Court’s powers to interpret Section 238 so as to give effect to Parliament’s original intentions by using ordinary means of construction. The reason for this was because there was no ambiguity in the drafting of Section 238 as it clearly excluded short-form mergers from its ambit because so many of the subsections were predicated on the requirement for a vote of shareholders on the proposed merger or consolidation in every such case.
The Court therefore gave consideration to the principles of construction mandated by the Constitution of the Cayman Islands to see if they produced a different result. In particular, the Court considered section 15 of the Bill of Rights of the Cayman Islands which affords the right of peaceful enjoyment of property with protection against dispossession of such property, save in certain limited circumstances prescribed by law.
The Court found that section 15 of the Bill of Rights is precise as to the provision that must be made by applicable law in circumstances where personal property is interfered with. Such provision must require the “prompt payment of adequate compensation and for securing a right of access to the Grand Court for the determination of the amount of any compensation”.8
As the Court had concluded that there were no other remedies available to protect the interests of minority shareholders in cases of short-form mergers, the Court considered it to be necessary to consider how that would affect its interpretation of Section 238 of the Act. It was noted as part of this consideration that section 25 of the Bill of Rights required all legislation to be interpreted in a manner that is compatible with the Bill of Rights.
In light of this, the Court concluded that “the effect of section 25 of the Bill of Rights is to give the court a greater degree of interpretative latitude than is available under the ordinary rules of construction”.9
Section 238 ‘as amended’ by the Court’s judgment
In exercising such ‘interpretative latitude’, the Court set out in paragraph 79 of the judgment a mark-up of Section 238 of the Act to more visually demonstrate its interpretation of that section for the benefit of dissenting shareholders in short-form mergers. It is as follows (with amendments shown in red by us):
Section 238
(1) A member of a constituent company incorporated under this Act shall be entitled to payment of the fair value of that person’s shares upon dissenting from a merger or consolidation.
(2) A member who desires to exercise that person’s entitlement under subsection (1) shall give to the constituent company, before the vote on the merger or consolidation (if any such vote is to be held) or (if no such vote is to be held) immediately after the date on which the plan of merger is given to the member pursuant to section 233(7), written objection to the action.
(3) An objection under subsection (2) shall include a statement that the member proposes to demand payment for that person’s shares if the merger or consolidation is authorised or approved.
(4) Within twenty days immediately following the date on which the vote of members giving authorisation for the merger or consolidation is made, or (if no such vote is to be held) within twenty days immediately following the date on which the plan of merger or consolidation is filed with the Registrar pursuant to section 233(9), the constituent company shall give written notice of the authorisation or filing to each member who made a written objection.
(5) A member who elects to dissent shall, within twenty days immediately following the date on which the notice referred to in subsection (4) is given, give to the constituent company a written notice of that person’s decision to dissent, stating-
(a) that person’s name and address;
(b) the number and classes of shares in respect of which that person dissents; and
(c) a demand for payment of the fair value of that person’s share.
Conclusion
Mergers and consolidations can be contentious and highly emotive processes, especially for minority shareholders who consider that the initial price they are being offered for their shares is below ‘fair value’. Whilst shareholder dissent from such processes is already a well-trodden path in the Cayman Islands, the conclusions reached by the Court in this case are surely correct whilst the clarification that has been provided in the context of short-form mergers is very much welcome. However, what will undoubtedly raise a few eyebrows is the willingness of the Court to essentially re-write statutory provisions.
This publication is not intended to be a substitute for specific legal advice or a legal opinion. For specific advice on value dissenting merger/take-private in Cayman Islands, please contact your usual Loeb Smith attorney or:
Robert Farrell
E: robert.farrell@loebsmith.com
T: +1 345 749 7499
[1] Section 238(2) of the Act.
[2] Section 238(9) of the Act.
[3] Section 233(7) of the Act.
[4] CICA (Civil) Appeal 6 of 2021 – In the matter of Changyou.Com Limited – Judgment (FSD 120 of 202) (ASCJ)) at para. 44.
[5] Ibid.
[6] Op cit. at para. 44.
[7] Op cit. at para. 52.
[8] Op cit. at para. 65.
[9] Op cit. at para. 78
The Private Funds Act (2021 Revision) (PFA) of the Cayman Islands requires certain Cayman Islands-domiciled, closed-ended investment funds (private funds) to submit an application to register with the Cayman Islands Monetary Authority (CIMA) as a private fund within 21 days of acceptance of capital commitments, and before accepting capital contributions from investors for the purposes of investment.
The PFA also requires any alternative investment vehicle (AIV) that meets the definition of a private fund and is: (1) formed under the constitutional documents of a private fund to make, hold and dispose of one or more investments wholly or mainly related to the business of the private fund; and (2) only has as its members, partners or trust beneficiaries, persons that are members, partners or trust beneficiaries of the private fund to register with the CIMA.
Private fund operations
Once a private fund has received capital contributions from investors, following Part 3 of the PFA, it is required to comply with the requirements below.
Valuation. A private fund is required to implement a net asset value calculation policy, which sets out appropriate and consistent procedures to value its assets. A valuation should be carried out: (1) at least once per year, or at greater frequency that is appropriate to the assets held by the private fund; and (2) the frequency of valuations of the private fund’s assets should be consistent with its constitutional document and marketing materials to investors.
The valuation of assets of a private fund is required to be performed by either: (1) an independent third party that is appropriately qualified to carry out the valuations in a non-high-risk jurisdiction (i.e. a jurisdiction that is not on the list of high-risk jurisdictions issued by the Financial Action Task Force); or (2) the manager or operator or a person with a control relationship with the manager of the private fund (connected person).
Safekeeping of fund assets. Unless it is neither practical nor proportionate to do so (e.g. owing to the asset class), a private fund is required to: (1) appoint a custodian to hold the custodial fund assets in a segregated account in the name of or for the account of the private fund; and (2) verify that the private fund holds title to any other fund assets, and maintain a record of those other fund assets based on information provided by the private fund and available external information (title verification).
If a private fund does not appoint a custodian, it must notify the CIMA and appoint: (1) an administrator or another independent third party; or (2) the manager or operator or connected person to perform title verification of the private fund’s assets.
If the private fund appoints a connected person to carry out title verification, this function must be independent from the portfolio management function of the private fund, and potential conflicts of interest must be properly identified, monitored and disclosed to the investors.
All financial assets of a private fund must be segregated and accounted for separately from any assets held by the person carrying out the custodian or title verification role. However, this does not prohibit prime brokerage or custody arrangements that, following established and accepted industry practice, allow a custodian or sub-custodian to hold all client assets in a commingled client omnibus account, along with the assets of other clients.
Cash monitoring. A private fund is required to appoint either: (1) an administrator, custodian or another independent third party; or (2) the manager or operator or a connected person to perform cash monitoring for the private fund.
A person appointed by a private fund to provide the cash monitoring function should: (1) monitor the cash flows; (2) ensure that all cash has been booked in cash accounts for the account of the private fund; and (3) ensure that all payments made by investors to the private fund in respect of investment interests have been received.
Where the valuation of assets, title verification and/or cash monitoring of a private fund is not performed by an independent third party, the CIMA may require the private fund to have such a function verified by an independent third party.
Identification of securities. A private fund that regularly trades or holds securities is required to maintain a record of the identification codes.
Reporting obligations
A private fund is required to have its accounts audited annually, signed-off by a CIMA approved auditor and submitted to the CIMA with a fund annual return within six months of the end of each financial year. The audited accounts must be prepared in accordance with International Financial Reporting Standards, or the generally accepted accounting principles of a non-high-risk jurisdiction.
Elizabeth Kenny is a senior associate at Loeb Smith Attorneys in the Cayman Islands
Contact details:
Tel: +1 345 749 7594
Email: elizabeth.kenny@loebsmith.com
This Article was first published in the Asia Business Law Journal – https://law.asia/obligations-cayman-islands-private-funds/
Background
The Alternative Investment Fund Managers Directive1 (“AIFMD”), which came into effect on 21 July 20112, as a policy response to the 2008 global financial crisis, aimed to provide a harmonized, stringent and more transparent regulatory and supervisory framework for both EU alternative investment managers (“EU Fund Managers”) and non-EU Fund Managers.
Further rules and regulations from the European Parliament and the Council of the European Union in relation to the cross-border distribution of funds were published on 2 August 20213 (“Rules”), which amend the AIFMD. The Rules were implemented in order to address the divergences in the different pre-marketing conditions between EU Member States and create a harmonized definition of “pre-marketing” and the conditions under which an EU Fund Manager can engage in pre-marketing.
However, despite the objective of the Rules, there is still much uncertainty as to the impact of the pre-marketing rules on reverse solicitation (i.e. where a prospective investor approaches an investment fund or its manager, by the investor’s own exclusive initiative) in each Member State, in particular in relation to non-EU Fund Managers.
What is “pre-marketing” and who does it impact?
The pre-marketing provisions in the Rules apply directly to EU Fund Managers. The Rules are silent on the application to non-EU Fund Managers.
Pursuant to the Rules, pre-marketing is addressed to a potential professional investor and concerns an investment idea or investment strategy in order to test an investor’s interest in an alternative investment fund (“Fund”). The definition of pre-marketing is broad enough (i) to encompass fundraising roadshows, a due diligence questionnaire requested by potential investors, a teaser document and any other materials which refer to the investment strategies of a Fund, and (ii) to capture a Fund which has not even been incorporated at the time of such activity.
What are the restrictions in relation to pre-marketing?
(a) Documents circulate to investors
During the course of pre-marketing, an EU Fund Manager is not permitted to distribute subscription forms (including in draft form) and facilitate a subscription into the Fund. If an offering document is issued to a potential professional investor during pre-marketing, this should not contain sufficient information to allow an investor to take an investment decision and must include certain disclosures which emphasize that the offering document does not constitute an offer or invitation to subscribe and is subject to change.
(b) Duration of pre-marketing
Any subscription by professional investors within 18 months of the EU Fund Manager starting pre-marketing of a Fund is automatically considered as a result of the marketing and is subject to notification procedures in the EU, as set out under paragraph (c) below.
(c) Notification procedure
An EU Fund Manager is required within two weeks of commencing pre-marketing in an EU Member State to send an informal letter to the competent authorities of its home Member State specifying (i) the Member States in which it is or has engaged in pre-marketing, (ii) the periods during which pre-marketing is taking place or has taken place, and (iii) details of the Fund. It then becomes the responsibility of the competent authorities of the home Member State of the EU Fund Manager to promptly inform the competent authorities in the EU Member State in which the EU Fund Manager is or has pre-marketed a Fund.
Who can pre-market?
The Rules restrict the ability of EU Fund Managers to appoint non-EU distributors or placement agents to conduct pre-marketing on behalf of a Fund. EU Fund Managers are only permitted to appoint certain types of authorised EU financial institutions to engage in pre-marketing activities (“Third Party AIFM”).
Do the Rules impact non-EU Fund Managers?
The Rules apply to EU Fund Managers and are not intended to apply to non-EU Fund Managers (e.g. fund managers from the Cayman Islands, U.K., U.S., and the British Virgin Islands) that pre-market their funds into Member States using (i) the relevant National Private Placement Regime of each Member State, or (ii) a Third Party AIFM.
However, a non-EU Fund Manager that has established a Fund managed by a Third Party AIFM that wishes to market the Fund to investors in Member States will be affected by the Rules indirectly, as the Third Party AIFM will need to comply with the Rules.
It is also important to note that it is up to each Member State to pass implementing legislation to confirm whether the Rules (including the pre-marketing provisions) apply to non-EU Fund Managers. For example, Germany, The Netherlands and Luxembourg have passed laws to confirm that the Rules will apply to non-EU Fund Managers. In such a case, as a non-EU Fund Manager will not have a home Member State regulator, a pre-marketing notification will be made to the regulator of the Member State where the non-EU Fund Manager is applying to market to investors.
Has there been any further guidance issued in relation to reverse solicitation?
Following the Rules, the European Commission wrote a letter to request for further guidance on reverse solicitation from The European Securities and Markets Authority (“ESMA”) on 24 September 2021 (“EC Letter”), in order to submit a report of the European Parliament and the Council. The EC Letter requested input from the national competent authority of each Member State (together, the “NCAs”), in particular in relation to data from asset managers on the use of reverse solicitation.
ESMA responded to the EC Letter on 17 December 2021, in a response which stated that almost all NCAs have no readily available information on the use of reverse solicitation from asset managers and investor associations. However, the absence of figures on reverse solicitation was noted to be explained by the fact that under EU law, asset managers are not subject to any obligation to report any information on subscriptions from reverse solicitation to the applicable NCA.
ESMA has hinted at the possibility of introducing new reporting requirements in order to facilitate the collection of information on reverse solicitation across the EU.
Any further amendments to AIFMD?
The European Commission published a proposal on 25 November 2021 to further amend AIFMD (“AIFMD II”). However, AIFMD II does not provide for further measures to clarify and harmonize the application of the reverse solicitation regime under AIFMD (as amended by the Rules).
AIFMD II includes a condition that non-EU Fund Managers and non-EU Funds must not be established in jurisdictions identified as high risk under the EU’s anti-money laundering rules.
Practical considerations
The Rules mean that each EU Fund Manager and non-EU Fund Manager will need to carefully select the EU jurisdictions in which it intends to pre-market to investors and to obtain advice in respect of the specific local laws.
It is advisable for an EU Fund Manager and any non-EU Fund Manager that is caught by the implementing legislation of a Member’s State, as set out in paragraph 5 above to (i) seek appropriate advice in order to comply with the applicable local law, (ii) conduct due diligence on any Third Party AIFM used (i.e. to check it has the appropriate regulatory license), and (iii) make sure that any pre-marketing is adequately documented.
Is any notification of marketing to EU investors required to be made to CIMA in respect of a Cayman Fund?
Part IIIA (EU Connected Funds) of the Cayman Islands’ Mutual Funds Act (As Revised) (“MFA”) and certain amendments to the Cayman Islands’ Securities Investment Business Act (As Revised), which came into force on 1 January 2019 (“Amendment Laws”), were implemented in order to ensure consistency with the AIFMD.
The key changes brought into effect by the Amendment Laws include (i) the creation of a framework for Cayman Islands Funds and managers to voluntarily “opt-in” and be licensed by the Cayman Islands Monetary Authority (“CIMA”), via a passport regime, to the AIFMD system in order to manage or market funds to investors in the EU, and (ii) the introduction of a definition of “EU Connected Fund”.
An EU Connected Fund is:
a company, unit trust or partnership carrying on business in or from within the Cayman Islands, which issues shares, units or partnership interests that carry an entitlement to participate in the profits or gains of the fund (whether open or closed-ended) the purpose of which is the pooling of investor funds; and
is either (i) managed by a person whose registered office is in an EU Member State (being either a member of the EU or a part of the EEA in which the AIFMD has been implemented) and whose regular business is managing one or more alternative investment funds, or (ii) marketed to investors or potential investors in an EU Member State.
If a Cayman Islands Fund meets the definition of an “EU Connected Fund”, it is required to notify CIMA within 21 days of the commencement of marketing in a country or territory within the EEA, that it is marketing in a country or territory within the EEA.
Furthermore, as an EU Connected Fund, the Fund is required to comply with the following on-going notification obligations (i) notify CIMA of any changes to the particulars previously submitted to CIMA, (ii) notify CIMA when it has ceased marketing in all Member States of the EEA, and (iii) provide written confirmation to CIMA on an annual basis that there has been no change to the particulars previously submitted to CIMA.
The MFA also introduced a formal procedure for EU Connected Funds to request attestations or confirmations of status from CIMA (where required to be submitted to regulators of particular Member States in which it is proposed to market the EU Connected Fund) upon the submission of certain details and payment of a fee to CIMA.
This publication is not intended to be a substitute for specific legal advice or a legal opinion. For specific advice on Pre-Marketing and Reverse Solicitation in the EU, please contact your usual Loeb Smith attorney or:
Elizabeth Kenny
E: elizabeth.kenny@loebsmith.com
T: +1 345 749 7594
1. Directive 2011/61/EU of The European Parliament and of The Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010
2. EU Member States given until 22 July 2013 to implement its requirements
3. Rules (EU) 2019/1160 and Regulation (EU) 2019/1156 of the European Parliament and of the Council of 20 June 2019 amending Rules 2009/65/EC and 2011/61/EU
ESG In Finance Transactions and Investment Funds From An Offshore Law Perspective
2021 saw an unprecedented surge in ESG debt issuance which was arguably underpinned by growing investor appetite for sustainable and green-linked investments. For example, UK insurer Aviva reported that the COVID-19 pandemic influenced the likelihood of taking ESG factors into consideration for over 55 per cent of respondents when deciding how to investi, whilst sustainability and green debt more than doubled year-on-year to US$680 billion in the first half of 2021 according to the Institute of International Finance (the IIF).ii
Growth In ESG-linked Financing
The IIF has reported that there was almost a four-fold increase to US$160 billion in the issuance of bonds with sustainability-linked pricing ratchets in the first six months of 2021 on a year-on-year basis.iii This was almost certainly driven by the fact that market participants recognised that implementing a sound ESG strategy facilitates access to new pools of capital and opportunities to lock in favourable pricing. For example, SSAB, which is a Swedish company that aspires to be the first fossil fuel-free steel producer, has issued a US$230 million equivalent five-year senior unsecured sustainability-linked bond with a maturity date of 2026. Under the terms of the relevant bond instrument, a redemption premium will be payable at maturity if SSAB fails to meet certain sustainability performance targets linked to greenhouse gas emissions. We expect that the volume of sustainability-linked bonds will continue to grow moving forward.
ESG-linked Financing In Asia
The IIF has also reported that around 85 per cent of all ESG-linked issuances of debt occur in Europe and North America.iv However, there is evidence that ESG-linked debt is gaining traction across other regions. For example, Chinese real estate company Minmetals Land, Japanese real estate group Mori Hills and India’s Adani Electricity Mumbai have brought, or are reportedly planning to bring, various sustainable and green bonds to market. In contrast to green bonds, where the use of proceeds is linked to qualifying green projects, general sustainability-linked financings have also been used for a variety of corporate purposes and are based on specific ESG targets rather than a limited set of green projects. This has further opened the market to a broader spread of issuers, which is a trend that we expect will continue moving forward.
Standards And Greenwashing
With a growing focus on ESG-linked products, the question of standards has intensified. Whilst there are now a raft of different regulations and proposals in the market, such as the Green Loan Principles, the European Green Bond Standard and the Sustainable Finance Disclosure Regulation, there are concerns that greenwashing may cloud the distinction between genuine ESG-linked debt issuance and opportunism. Lenders and other finance parties that are therefore committed to monitoring compliance with ESG targets need to agree upon reporting standards with the relevant obligor group and ensure appropriate external review mechanisms are implemented.
Offshore Vehicles In ESG-linked Finance Transactions
BVI and Cayman Islands companies are widely utilised in cross-border finance transactions, including those with ESG-linked elements. These jurisdictions have a variety of features that make them attractive to lenders and other finance parties, as well as borrowers and other obligors, on ESG-linked financings. Some reasons for this are as follows:
(a) The BVI and the Cayman Islands are widely recognised as creditor friendly jurisdictions due to the range of self-help remedies that are available to secured creditors in an enforcement. The BVI also has a straightforward system of registering security interests which protects the priority of such interests.
(b) BVI and Cayman Islands companies may have unlimited objects and purposes, including with respect to ESG initiatives, and there is significant flexibility as to how such companies are structured in terms of capital structure, management roles and shareholder involvement.
(c) BVI and Cayman Islands companies are subject to low ongoing maintenance costs and there is no requirement for financial statements to be prepared in relation to companies that are not specifically regulated by the BVI Financial Services Commission or the Cayman Islands Monetary Authority (as applicable).
(d) Except for the payment of nominal filing fees in connection with the optional filing of a security interest that is granted by a BVI chargor, there are no income, corporate or capital gain taxes, withholdings, levies, registration taxes, or other similar taxes or charges imposed on BVI or Cayman Islands companies in connection with the execution, delivery or the performance of finance documents by a BVI or a Cayman Islands company, or the finance parties.
ESG In Investment Funds From An Offshore Law Perspective
The emergence of ESG principles is not confined to debt finance, as the topic of sustainable investing has quickly gathered momentum in the investment funds space. Indeed, in its Supervisory and Issues Information Circular dated 13 April 2022 (the Circular), the Cayman Islands Monetary Authority (CIMA) recognises that ESG considerations and sustainable investing “is increasingly becoming the fastest growing investment strategy within the financial services sector”.
However, as has been observed in the boom of digital asset funds over the last few years, the emergence of a new investment strategy at such a rapid pace does present various regulatory issues. Indeed, CIMA notes in the Circular that whilst ESG strategies have the potential to make significant contributions to addressing matters such as climate change and in encouraging sustainable investing, as the regulator in the Cayman Islands, it must strike a balance between allowing this sector to flourish whilst also mitigating the emerging risks that are unique to this investment strategy.
It is perhaps for these reasons that in late 2021, the Cayman Islands government announced that it is due to consult on legislation which will introduce a framework for ESG criteria in the Cayman Islands and which will, in particular, target the issue of greenwashing with a view to enhancing investor protection. The International Organization of Securities Commissions (IOSCO) recognises the risk of greenwashing in its November 2021 report entitled ‘Recommendations on Sustainability-Related Practices, Policies, Procedures and Disclosure in Asset Management’, where it recommends, amongst other things, that regulators should strongly consider reviewing their existing regulations that ensure accurate disclosure against sustainability standards and, where necessary, to make these more robust. Given the prevalence of Cayman Islands and BVI funds in the international funds market, these jurisdictions have a unique opportunity to be at the forefront of tackling these issues and leading the way in our view.
Greenwashing presents itself in a variety of ways in the funds market; ranging from inadvertently mis-describing an investment’s green credentials to a deliberate misrepresentation of them with a view to attracting investment as a result. The IOSCO has identified the following ways in which greenwashing typically presents itself in the context of investment funds:
Unsurprisingly, it is the marketing of a fund that poses one of the main greenwashing risks as this provides an opportunity for ESG credentials to be overstated or left open to interpretation by potential investors where intentionally loose language is adopted. Further, something as simple as the name of the fund can also imply that the fund has sustainable objectives and strategies that it might not in reality have. In its report, the IOSCO gives the examples of a produce that includes ESG factors in its name, but “its investment objectives only state that it seeks to provide capital appreciation by investing primarily in global equity securities” or alternatively the fund might adopt only basic or limited negative screening to exclude investments that would not meet its stated ESG criteria;
A deviation from the original investment strategy once the fund has successfully launched. The IOSCO notes that such a failure can be “intentional or be the result of poor asset management”, which emphasises the need to ensure that investment funds have, where applicable, investment managers who are aware of and who fully buy into the ESG objectives. This risk can be amplified in circumstances where there is a ‘fund of funds’ with an ESG focus. For example, if a fund invests in another fund which espouses its ESG credentials in its marketing materials which aren’t accurate, the investor fund may unwittingly undermine its own commitment to ESG principles; and
The making of misleading claims about a product’s ESG performance, which the IOSCO notes is “perhaps one of the most prevalent types of greenwashing”. This can happen, for example, where a product claims that it will achieve certain measurable outputs (e.g. reduced energy usage) but the actual performance is not as good as is claimed.
It will therefore be interesting to observe what measures the Cayman Islands government suggests to tackle these issues in a meaningful way. Indeed, perhaps the greatest challenge faced by the Cayman Islands government is developing a framework that can be of universal application, given the varied and highly nuanced nature of ESG regulation across the globe.
- Interest in ESG investing boosted by Covid – Aviva plc
- Global sustainable debt issuance will crack $1 trillion mark in 2021 -IIF | Reuters
- The Institute of International Finance > Advocacy old > Policy Issues > Sustainable Finance Working Group (SFWG) (iif.com)
- As above.
This publication is not intended to be a substitute for specific legal advice or a legal opinion. For specific advice, please contact:
Peter Vas
Partner
E: peter.vas@loebsmith.com
Santiago Carvajal
Senior Legal Consultant
E: santiago.carvajal@loebsmith.com
Robert Farrell
Senior Associate
E: robert.farrell@loebsmith.com
This Article was first published in IFC Review –
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