Cayman Islands | Loeb Smith

Administrative Fines Regulations in respect of Cayman Private Funds

1. Administrative Fines Regulations in respect of Cayman Private Funds

1.1. The administrative fine regime in the Cayman Islands was implemented pursuant to the Cayman Islands’ Monetary Authority (Administrative) Fines (Amendment Regulations), 2020, as amended (“Administrative Fines Regulations”) and extend the application of the fines administered by CIMA from the Anti-Money Laundering regime, to all regulatory laws, regulations and any rules issued by CIMA thereto.

1.2. The Administrative Fines Regulations categorize breaches as ‘minor’, ‘serious’ or ‘very serious’. For example, a Private Fund which accepts capital contributions from investors in respect of investment before it is registered with CIMA as a Private Fund is a “very serious breach”.

1.3. The Administrative Fines Regulations impose a scale of fines dependent on the categorization of the breach as set out in paragraph 1.2 above, starting from an initial fixed fine of US$6,100 for a minor breach to a single fine up to a maximum of US$121,955 for individuals or US$1,219,515 for corporate bodies (e.g. exempt companies, SPCs, LLCs). Any administrative fines set out in the Administrative Fines Regulations which are applicable specifically to Private Funds, will be in addition to any fines which may be imposed on a Private Fund under the PFA.

2. Supervisory and enforcement powers of CIMA in respect of Private Funds

2.1. CIMA has broad discretionary supervisory and enforcements powers in respect of Private Funds.

2.2. If CIMA knows or has reasonable grounds to believe that a Private Fund:

2.2.1. is unable or appears likely to become unable to meet its obligations as they fall due;

2.2.2. is carrying on business fraudulently or otherwise in a manner detrimental to the public interest, to the interest of its clients or to the interest of its creditors;

2.2.3. is carrying on or attempting to carry on business or is winding up its business voluntarily in a manner that is prejudicial to its investors or creditors;

2.2.4. has contravened any provision of PFA or Anti-Money Laundering Regulations (2020 Revision) as amended;

2.2.5. has failed to comply with a condition of its registration; or

2.2.6. has not conducted the direction and management of its business in a fit and proper manner or has Directors, senior officers, managers or persons who have acquired ownership or control who are not “fit and proper persons”,

CIMA may take certain actions, including:

(a) cancel the registration of the Private Fund;
(b) impose conditions or further conditions on the Private Fund and to amend or revoke those conditions;
(c) require the substitution of any promoter or operator of the Private Fund;
(d) appoint a person to advise the Private Fund on the proper conduct of its affairs;
(e) appoint a person to assume control of the affairs of the Private Fund;
(f) apply to the Cayman Islands’ Grand Court for an order to take such other action as it considers necessary to protect the interests of investors in, and creditors of, the Private Fund; and
(g) if a magistrate is satisfied on an application made by CIMA or a police officer of the rank of Inspector or above that there are reasonable grounds for suspecting that an offence under the PFA has been, is being or is about to be committed in certain premises, the magistrate may issue a warrant authorizing CIMA or a police officer and such other persons as may reasonably be needed to enter and search the premises.

This publication is not intended to be a substitute for specific legal advice or a legal opinion. For specific advice on Funds in Cayman Islands, please contact your usual Loeb Smith attorney or any of the following:

E: gary.smith@loebsmith.com
E: robert.farrell@loebsmith.com
E: elizabeth.kenny@loebsmith.com
E: vivian.huang@loebsmith.com
E: yun.sheng@loebsmith.com
E: faye.huang@loebsmith.com
E: wendy.au@loebsmith.com

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Cayman Islands Monetary Authority’s Statement of Guidance – Corporate Governance

What is the significance of the Statement of Guidance issued by the Cayman Islands Monetary Authority?

1. The Statement of Guidance is in line with international governance practices and re-affirms certain principles and practices that have been discussed in Cayman Islands case law in this area (e.g. in Weavering Macro Fixed Income Fund Limited .v. Peterson and Ekstrom [2011] 2 CILR 203).

2. The Statement of Guidance only applies to Regulated Mutual Funds. It does not extend to regulated entities in the banking and insurance sectors. It applies to all Regulated Mutual Funds (i.e. licensed funds, administered funds, and section 4(3) registered funds) irrespective of the manner in which they are regulated under the Mutual Funds Law.

3. The Statement of Guidance applies to all “Operators” of Regulated Mutual Funds wherever in the world they may reside. It does not apply solely to those Operators who are resident in the Cayman Islands. A Director of the Fund will be an “Operator” where the Regulated Mutual Fund is a corporate, a general partner will be an “Operator” where the Regulated Mutual Fund is an exempted limited partnership, and a trustee will be an “Operator” where the Regulated Mutual Fund is a unit trust.

4. The Statement of Guidance is not intended to be prescriptive or exhaustive as to CIMA’s expectations with regard to corporate governance of Regulated Mutual Funds.

5. The Statement of Guidance is not mandatory but it does reflect CIMA’s expectations of what should be the minimum level of “sound and prudent governance” (rather than best practice) that should be in place for Regulated Mutual Funds. Though the Statement of Guidance is not mandatory, it will most likely become a benchmark against which investors, CIMA, service providers, and Courts measure actual practices of Regulated Mutual Funds. Accordingly the corporate governance principles set out in the Statement of Guidance should be reviewed by Operators of Regulated Mutual Funds and, at the very least, become the minimum standards for corporate governance arrangements and practices for Regulated Mutual Funds.

Main features of the Statement of Guidance

Oversight Function

The Statement of Guidance states that a Regulated Mutual Fund’s “Governing Body” (that is, the board of directors where the Regulated Mutual Fund is a corporate, the general partner(s) where the Regulated Mutual Fund is an exempted limited partnership, and the trustee(s) where the Regulated Mutual Fund is a unit trust) should:

i. monitor and regularly take steps to satisfy itself that the Regulated Mutual Fund is conducting its affairs in accordance with all applicable laws, regulations, rules, statements of principles, statements of guidance and anti-money laundering or combating terrorist financing requirements;

ii. regularly take steps to satisfy itself that the Regulated Mutual Fund’s service providers are monitoring compliance with applicable laws, regulations, rules, statements of principles, statements of guidance and anti-money laundering or combating terrorist financing requirements;

iii. request appropriate information from the Regulated Mutual Fund’s service providers and/or professional advisors to enable it to satisfy itself regularly that the Regulated Mutual Fund is operating in compliance with the applicable laws, regulations, rules, statements of principles, statements of guidance and anti-money laundering or combating terrorist financing requirements;

iv. where required, provide appropriate directions to the Regulated Mutual Fund’s service providers to rectify any non-compliance with the applicable laws, regulations, rules, statements of principles, statements of guidance and anti-money laundering or combating terrorist financing requirements;

v. require regular reporting from the Regulated Mutual Fund’s investment manager and its other service providers to enable the Governing Body to make informed decisions and to adequately oversee and supervise the Regulated Mutual Fund.

Conflicts of Interest

The Governing Body must:

i. suitably identify, disclose, monitor and manage all its conflicts of interest;

ii. document the disclosed conflicts of interest.

Board Meetings

The Governing Body should:

i. meet at least twice a year in person or via a telephone or video conference call;

ii. where the circumstances or size, nature and complexity of the Regulated Mutual Fund necessitates it, meet more frequently than the twice a year, so as to enable it to fulfil its responsibilities effectively;

iii. request the presence of the Regulated Mutual Fund’s service providers (e.g. representatives from the Regulated Mutual Fund’s administrator, investment manager, and auditor) at these meetings.

Operators’ Duties

i.Exercise Independent Judgment – There is no formal requirement in the Statement of Guidance for Regulated Mutual Funds to appoint independent directors. However it does require, among other things, that the Operator “must exercise independent judgment”. It could be argued that this requirement will be more often tested in Regulated Mutual Funds where all Operators are affiliated to the investment manager and/or there are no independent appointees.

ii. Act in the best interests of the Regulated Mutual Fund – taking into consideration the interests of its investors as a whole and/or, where applicable, the interests of the Fund’s creditors.

iii. Operate with due skill, care and diligence and act honestly and in good faith at all times.

iv. Sufficient capacity to apply mind to overseeing and supervising the Regulated Mutual Fund – The Operator must ensure that he/she has sufficient capacity to apply his/her mind to overseeing and supervising the activities of each Regulated Mutual Fund for which he/she is the Operator.

v. Ensuring that the Regulated Mutual Fund’s investment strategy and conflicts of interests policy are all clearly described in its offering document.

vi. Approving the appointment and removal of the Regulated Mutual Fund’s service providers and the terms of their contracts with the Fund; and ensuring that the Fund’s investors and CIMA are notified of these appointments/removals.

vii.Retain ultimate responsibility for functions delegated to the Regulated Mutual Fund’s service providers, and should regularly monitor and supervise the delegated functions.

viii. Ensure that the Regulated Mutual Fund’s service providers are performing their functions in accordance with the terms of their respective contracts and that their roles and responsibilities are clearly defined.

ix. Regularly monitor whether the investment manager is performing in accordance with the defined investment criteria, investment strategy and restrictions.

x. Review and approve the Regulated Mutual Fund’s financial results and audited financial statements and regularly monitor the Fund’s net asset valuation policy and check that the calculation of its net asset value is being done in accordance with this policy.

xi. Assess whether he/she has, together with any other Operator of the Regulated Mutual Fund, sufficient collective knowledge and experience to perform the duties imposed upon the Operator.

xii. On an on-going basis, disclose to CIMA (i) any matter which could materially and adversely affect the financial soundness of the Regulated Mutual Fund, or (ii) any non-compliance by the Regulated Mutual Fund with applicable laws.

Management

The Statement of Guidance specifies that an Operator should ensure that it provides suitable oversight of the risk management of the Regulated Mutual Fund, ensuring that the Fund’s risks are always appropriately managed and mitigated (with material risks being discussed at meetings of the Governing Body and the Governing Body taking appropriate action where necessary).

January 2014

Speaker

Gary Smith

Elizabeth Kenny

Keeping the relevant entity’s business under constant review

What is required to comply with the applicable economic substance test varies greatly between businesses and there is certainly no ‘one size fits all’ approach to meeting the requirements, even for entities that carry on the same ‘relevant activity’.

For example, determining, as part of the relevant economic substance test, whether a business has adequate operating expenditure, an adequate physical presence and an adequate number of employees in the Cayman Islands is entirely dependent on the specific circumstances of that business, such as its size, number of customers, global footprint and income etc.

As businesses evolve and, hopefully, grow over time, what was ‘adequate’ in 2019 may no longer be adequate almost four years later. Indeed, given the (in some cases) material changes in business practices caused by the COVID-19 pandemic, it may be that the way some relevant entities carry on their relevant activities has changed beyond recognition since the Act came into force. Therefore, in most cases it will not be appropriate to simply maintain the same office space and number of employees year after year where the business has undergone material changes. To do so risks being found to be non-compliant with the economic substance test as it is by no means a ‘box ticking’ exercise.

Therefore, relevant entities that must comply with the economic substance test should periodically (at least annually) review whether its business footprint in the Cayman Islands adequately meets the true scale of its operations. To the extent any changes are required in order to ensure compliance with the Act, the business should take those steps well in advance of the next submission date for its economic substance notification so that it is compliant at the time of submission. Any shortcomings cannot be retrospectively corrected.

Regular board meetings

One of the requirements of the economic substance test is that a relevant entity carrying on a relevant activity must be ‘directed and managed in an appropriate manner’ in the Cayman Islands. In determining whether this standard has been met, the TIA will have regard to the frequency with which board meetings are held in the Cayman Islands and whether a quorum of such meetings is present in the Cayman Islands.²

Relevant entities carrying on relevant activities must ensure that these board meetings are in fact held and that they are held in accordance with the quorum requirements of the Guidance. All too often it appears that relevant entities are leaving it later and later in the year to comply with these obligations and in so doing they risk being found to be non-compliant with the economic substance test if, for any reason, those meetings cannot be scheduled and properly held before the end of the reporting period.

Further, any such board meetings must not be tokenistic. They must fully consider the activities of the business and take such strategic and other decisions that a prudent board of directors would take in order to ensure the effective management of the business. Of course, the number of board meetings required to be held will vary from business to business depending on its specific line of trade and its other circumstances.

Ensure an accurate categorisation of the business in question

Anyone who has reviewed the Act and the associated Guidance will agree that the requirements are, to say the least, nuanced and it can be tricky to work out exactly where a living, breathing business which is fraught with its own complexities and subtleties falls within the requirements.

Based on experiences we have had with our own clients, we would strongly advise any relevant entity to ensure that its advisers fully understand the precise nature of its business as the slightest misunderstanding or lack of information can result in an incorrect categorisation under the Act (with consequent incorrect advice on how compliance with the Act is to be achieved).

Further, to the extent that a relevant entity’s business has evolved since the Act came into force, we would recommend that the relevant entity’s advisers be advised of those changes so that a new economic substance analysis can be undertaken in the context of the business as it now stands, so that the next economic substance return can be prepared with this evolution in mind.

Income, not profit!

We have advised a number of clients on compliance with their obligations under the Act and from time to time we have advised clients that, in our opinion, they were not meeting the requirements of the economic substance test. This was often on the basis that their physical presence, operating expenditure and/or number of employees was insufficient based on the income of the business.³

In these circumstances it has not been uncommon for our client to respond and point out that, based on their most recent accounts, the business had either traded at a loss or had made only negligible profits and that therefore they were only required to maintain a negligible presence in the Cayman Islands and that they were therefore compliant. However, per the precise wording of the Act and of the Guidance, it is very clearly the income of the business that is the relevant metric here.

Conclusion

Whilst businesses and their advisers are undoubtedly more familiar with the expectations of the TIA as regards meeting the applicable economic substance test now that we have several years’ experience, satisfying the economic test remains an exercise in trying to aim at a moving target as businesses evolve over time. If you are in any doubt as to your obligations (if any) under the Act or if it has been a while since this has been considered in the context of your business, we would be delighted to assist.

[1] Economic Substance for Geographically Mobile Activities Guidance, Version 3.1 issued on 30 June 2021, page 1 (the “Guidance”).
[2] See page 26 of the Guidance.
[3] Per the requirements of the Guidance – see page

This publication is not intended to be a substitute for specific legal advice or a legal opinion. For specific advice on Economic Substance, please contact your usual Loeb Smith attorney or any of the following:

E: gary.smith@loebsmith.com
E: robert.farrell@loebsmith.com
E: elizabeth.kenny@loebsmith.com
E: vivian.huang@loebsmith.com
E: yun.sheng@loebsmith.com

In the context of a reported increasing number of bond defaults by property developers in the People’s Republic of China and also the reported growing prevalence of non-performing debt due to rising interest rates across Asia, lenders have progressively been managing their risks by restructuring or divesting their bad debts. The ongoing economic fallout from the COVID-19 pandemic and related restrictive measures have contributed to this trend.

In this article, we consider the British Virgin Islands (“BVI”) and the Cayman Islands law aspects of a transfer by a financial institution of an existing loan portfolio and the relevant security package. We anticipate that this is a point of interest to many lenders across the Asian market in the current distressed environment and we expect that the volume of refinancing and restructuring activity with respect to non-performing loans that are supported by an offshore security package will continue to grow.

Transferability of the loan portfolio

The starting point to assessing the transferability of a loan portfolio is to review the loan agreement to identify any restrictions on the ability of a lender to effectuate a transfer of the relevant loan(s). For example, the borrower’s prior written consent may be required to the transfer of the loan(s) and the loan agreement may prescribe the circumstances under which the borrower may refuse to provide that consent. Furthermore, there may be restrictions on the transferability of certain types of loan portfolios, such as those including mortgages or consumer loans, and the transferor may also be subject to onerous internal confidentiality rules and data protection requirements. Although these are principally points of onshore law to be determined under the governing law of the loan agreement, to the extent that the borrower is incorporated in the BVI or the Cayman Islands and is a party to the transfer agreement(s), it is customary for offshore legal counsel to the lender to issue a legal opinion to confirm (among other things) that the relevant company has the requisite capacity and power to enter into the transfer agreement(s).

Offshore security package

Most cross-border loans in Asia are supported by an offshore security package. A potential purchaser of a loan portfolio should therefore keep the following points in mind.

– Careful consideration must be given to the method by which the outgoing secured party’s security interests are transferred to the purchaser or its nominee. For example, there is generally no way to assign legal title to a chose in action or other property right under BVI law. Therefore, if a party wishes to transfer legal title to a right in action under BVI law, this can normally only be accomplished by way of novation. However, it is possible for choses in action to be assigned in the BVI in equity, and this is the normal mechanism by which this is done.

– Until the security provider is notified of the assignment, it may discharge any of its obligations for the benefit of (or making payment to, as the case may be) the original assignor. However, the assignment itself is valid between the assignor and the assignee, and the assignor may need to account to the assignee under the terms of the assignment. There is no requirement that notice to the security provider must be given in writing or that the security provider acknowledge receipt of the notice, although this is customarily done for evidential reasons.

– If the security provider is a BVI company and has registered details of the security in its register of registered charges maintained by the BVI Registrar of Corporate Affairs (the “Registrar”), it must register a variation of charge with the Registrar to comply with BVI law. The Registrar will issue a certification of variation of charge and stamp the particulars of the variation of security as evidence that the variation has been duly registered.

In practice, a well-drafted assignment agreement will impose an express obligation on the relevant parties to complete all of the local law filings and register updates within a mutually acceptable timeframe. Offshore legal counsel should be retained to ensure that all such filings are correctly completed and that the transfer mechanics comply with BVI or Cayman Islands law (as applicable).

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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
Loeb Smith Attorneys
Hong Kong
E: peter.vas@loebsmith.com
www.loebsmith.com
Peter is recognized as a leading offshore lawyer in the Asia Business Law Journal A-List 2022 and Asian Legal Business Offshore Client Choice List 2022

1. https://www.scmp.com/business/china-business/article/3185718/china-bond-defaults-hit-us20-billion-2022-more-double-last
2. https://www.ft.com/content/ccbe2b80-0c3e-4d58-a182-8728b443df9a
3. https://www.flow-tech.ai/non-performing-loans-npl-outlook-for-asian-economies-in-q3q4-2021/

Introduction

The rise of the financial technology businesses in recent years brings new legal issues, requiring entrepreneurs, investors and professional advisors to carefully monitor and adapt to new regulatory developments as well as developing case law. Blockchain in particular has become the new buzzword in financial media, with crypto-currencies, Initial Coin Offerings (ICOs) and tokens coming a close second. In this first issue of our series dedicated to FinTech-specific risk factors applicable to Cayman Islands (“Cayman”) investment funds, we highlight some of the major risk factors that investors in crypto-currencies should become familiar with.

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Brief Overview: Bitcoin and other Cryptocurrencies

A bitcoin is a digital currency that is issued by, and transmitted through, an open source, digital protocol platform (the “Bitcoin Network”). The Bitcoin Network is an online, peer-to-peer user network using a digital transaction ledger known as the “Blockchain”, which is stored, in whole or in part, on all users’ software programs. Each transaction is recorded, time stamped and publicly displayed in a “block” in the publicly available Blockchain, therefore creating a verifiable transaction history of all bitcoins in existence (except for off-Blockchain transactionsⁱ). The protocols for the Bitcoin Network permit the creation of a limited number of bitcoins (not to exceed 21 millionⁱⁱ). Accordingly, other (competing) cryptocurrencies have been developed, such as Ethereum, Ripple and Litecoinⁱⁱⁱ. As cryptocurrency networks do not rely on governmental authorities or financial institutions to create, transmit or determine the value of digital currencies, users may acquire and trade digital currencies without the involvement of intermediaries. However, numerous third-party service providers have appeared, to facilitate transactions and converting digital currencies to or from fiat currency. Cryptocurrencies and related trading platforms and exchanges have experienced an extremely high rate of growth during the past years.

Top 10 Risk Factors specific to Bitcoin and Other Cryptocurrencies

Successfully investing or trading bitcoin and other cryptocurrencies requires technical skill and at least a basic knowledge of how Blockchain works. Below we set out some of the most significant issues that investors should be aware of in this new and rapidly changing industry.

1. Loss or destruction of the private key: Bitcoins (and this applies to other cryptocurrencies) are stored in a digital wallet and are controllable only by the possessor of both the public key and the private key relating to the digital wallet in which the bitcoins are held, both of which are unique. If the private key is lost, destroyed or otherwise compromised, an investor may be unable to access the bitcoins held in the related digital wallet which will essentially be lost. If the private key is acquired by a third party, then this third party may be able to gain access to the bitcoins.
2. Other cyber-security risks including malicious activity: Trading platforms and third-party service providers may be vulnerable to hacking or other malicious activities. For example, in August 2016, nearly 120,000 units representing US$72 million-worth of bitcoins were stolen from the Bitfinex exchange in Hong Kong, which led to an immediate 23% drop in pricing^iv. One year earlier, in September 2015, BitPay lost approximately $1.8 million of bitcoins due to a phishing attack^v. Also, if one or more malicious actor(s) obtain control of sufficient consensus nodes on the Bitcoin Network or other means of alteration, then a Blockchain may be altered. While the Bitcoin Network is decentralized, there is increasing evidence of concentration by creating of “mining pools” and other techniques, which may increase the risk that one or several actors could control the Bitcoin Network or other similar Blockchain.
3. Risks associated with peer-to-peer transactions: Digital currencies can be traded on numerous online platforms, through third party service providers and as peer-to-peer transactions between parties. Many marketplaces simply bring together counterparties without providing any clearing or intermediary services and without being regulated. In such a case, all risks (such as double-selling) remain between the parties directly involved in the transaction.
4. Other risks related to trading platforms and exchanges: Digital currency trading platforms, largely unregulated and providing only limited transparency with respect to their operations, have come under increasing scrutiny due to cases of fraud, business failure or security breaches, where investors could not be compensated for losses suffered. Although one does not need a trading platform or an exchange to trade bitcoins or other cryptocurrencies, such platforms are often used to convert fiat currency into cryptocurrency, or to trade one cryptocurrency for another.
5. Loss of confidence in digital currencies: Digital currencies are part of a new and rapidly evolving “digital assets industry”, which itself is subject to a high degree of uncertainty. For a relatively small use of digital currencies in the retail and commercial marketplace, online platforms have generated a large trading activity by speculators seeking to profit from the short-term or long-term holding of digital currencies. Most cryptocurrencies are not backed by a central bank, a national or international organization, or assets or other credit, and their value is strictly determined by the value that market participants place on them through their transactions, which means that loss of confidence may bring about a collapse of trading activities and an abrupt drop in value.
6. Regulations preventing or restricting trading of digital currencies: There are significant inconsistencies among various regulators with respect to the legal status of digital currencies. Regulators are also concerned that bitcoin and other cryptocurrencies may be used by criminals and terrorist organizations^vi. In the future, certain countries may restrict the right to acquire, own, hold, sell or use digital currencies.
7. Currency-conversion risks: Policies or interruptions in the deposit or withdrawal of fiat currency into or out of the trading platforms may impact the ability of certain investors to convert. For example, when two of the largest trading platforms in China stopped margin lending and withdrawals in February 2017 and started implementing stricter anti-money laundering policies following discussions with Chinese authorities, this immediately triggered a decrease in pricing and trading volume^vii.
8. Taxation of digital currencies: For investors in cryptocurrencies, it should be noted that there is substantial uncertainty with respect to the tax treatment of an investment in digital currencies. Bitcoins and other cryptocurrencies may be considered assets in certain jurisdictions and currency in others. Sales or value-added taxes may be imposed on purchases and sales of digital currencies. The investors, based on their home jurisdiction, may require specific tax advice on a regular basis to ensure the tax treatment of their investments in digital currencies.
9. Slow-down of network: For bitcoins, mining is the process by which bitcoins are created and transactions verified. Through downloading a specific software, the user’s computer becomes a “node” that validates blocks (i.e. details of some or all of the most recent transactions). Miners which are successful in adding a block to the Blockchain are automatically awarded bitcoins (plus transaction fees for transactions recorded). However, if the rewards for solving blocks and transaction fees are not sufficiently high, or if a high volume of transactions occur at the same time, the Blockchain may experience a slow-down. A slow-down is also possible for other cryptocurrencies, if the number of transactions on the blockchain is very high.
10. Dilution due to competition or “fork” in the Blockchain: Last but not least, cryptocurrencies are based in protocols which govern the peer-to-peer interactions between various users. Dissent between users as to protocols to be used may result in a “fork”, opening two separate networks. For example, in 2016, Ethereum experienced a permanent fork in its Blockchain that resulted in two versions of its digital currency, Ethereum (ETH) and Ethereum Classic (ETC), which trade very differently. Very recently, Bitcoin also experienced its first fork, leading to the creation of Bitcoin Cash (BCC), a new cryptocurrency.

Regulation of Cayman Funds investing in Bitcoin and other Cryptocurrencies

Investors may also choose to invest in a fund trading (exclusively or as part of a more diversified portfolio) in cryptocurrencies, which would be in a better position to avoid or better manage some of the risks above.
Cayman investment funds looking to invest in cryptocurrencies and other digital assets would still be required to comply with the Cayman Islands Mutual Funds Law (the “Funds Law”) if they issue to their investors equity interests (i.e. shares, interests or unit trusts, depending on the fund structure) which entitle the investors to participate in the profits or gains of the investment fund, and which are redeemable or repurchasable at the option of the investors before the commencement of winding-up or the dissolution of the fund (i.e. open-ended funds). Cayman investment funds which issue debt instruments, private equity funds, and other closed-ended funds (which do not give investors the right to redeem their shares, units or interests from the fund at the investor’s option) do not fall within the scope of the Funds Law.

In the case of Cayman open-ended funds, the Funds Law specifically sets out that the offering materials shall describe the equity interests offered in all material respects, and contain such other information as is necessary to enable a prospective investor in the fund to make an informed decision as to whether or not to subscribe for or purchase the equity interests^viii. Whether governed by the Funds Law or not, investment funds should disclose to investors all the material terms of their offering (including risk factors to be considered) in order to avoid potential lawsuits based on, among other things, breach of contract, fraudulent misrepresentation, or negligent misstatements at common law. The material terms of the offering are usually set out in a Private Placement Memorandum or Offering Memorandum (“PPM”) and Cayman Courts would expect the PPM to contain all information that is necessary to enable a prospective investor to make an informed decision as to whether or not to subscribe for or purchase the shares, units or interests being issued by the investment fund.

Although for the moment the Cayman Islands Monetary Authority (CIMA) has not (yet) issued any guidance on digital assets, it is expected that CIMA would have a position similar to the one adopted in the United States by the Securities and Exchange Commission (SEC), which very recently clarified that securities laws generally apply to offerings of tokens, Initial Coin Offerings (ICOs) and other digital assets based on the underlying economics of a transaction, irrespective of the technology used and irrespective of whether the investments are made in fiat currencies or cryptocurrencies^ix.

This publication is not intended to be a substitute for specific legal advice or a legal opinion.

For more specific advice, please contact:

E: ramona.tudorancea@loebsmith.com

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ⁱ“Off-Blockchain transactions” involve the transfer of control over, or ownership of, a specific digital wallet holding bitcoins, or of the reallocation of ownership of certain bitcoins in a pooled ownership digital wallet. Information regarding such transactions is generally not publicly available.
ⁱⁱ As of August 15, 2017, 16.51 million bitcoins had been created according to https://blockchain.info/charts/total-bitcoins.
ⁱⁱⁱ As of August 15, 2017, more than 800 alternate digital assets were tracked by CoinMarketCap.com, with a total market capitalization (including bitcoin) of approximately $142 billion, out of which bitcoin’s market capitalization was $71 billion, and the second largest digital currency, Ethereum, had reached $28.4 billion.
^iv Reuters Technology News, 3 August 2016, “Bitcoin worth $72 million stolen from Bitfinex exchange in Hong Kong”, available on http://www.reuters.com and last accessed on 29 June 2017.
^v American Banker, 15 September 2015, “Bitcoin Payment Processor BitPay Loses $1.8M in Phishing Hack”, available on https://www.americanbanker.com and last accessed on 29 June 2017.
^vi According to news released by Sandia National Laboratories in August 2016, the U.S. Department of Homeland Security (DHS) and Sandia National Laboratories are working together on a bitcoin de-anonymization tool – see Sandia LabNews, Vol. 68, no. 16.
^vii Reuters INTEL, 10 February 2017, “China’s OkCoin, Huobi exchanges to stop bitcoin withdrawals”, on http://www.reuters.com and last accessed on 29 June 2017.
^viii See Section 4(6) of the Funds Law.
^ix See SEC’s investigation report on The DAO dated July 25th, 2017, available online at https://www.sec.gov/litigation/

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

Administrative Fines Regulations in respect of Cayman Private Funds

Cayman Islands Monetary Authority’s Statement of Guidance – Corporate Governance

Main features of the Statement of Guidance