This chapter provides an overview of how changes to the regulatory framework for funds and investment business as well as greater emphasis on accountability, transparency and better corporate governance are affecting the BVI funds industry.
Although long-recognised as a dominant player in the offshore incorporations sphere, the role of the British Virgin Islands (BVI) as a funds jurisdiction has grown over the past 15 years since the BVI's first funds legislation, the Mutual Funds Act, was introduced in 1996. The BVI funds industry has undergone further change over the last two years as a result of market forces and a changing regulatory landscape.
The recent global economic crisis has had a major impact on the offshore hedge funds industry as a whole, including the BVI's industry. This is generally reflected in a decline in new funds formations, whether due to market uncertainty or lack of investor confidence, the winding up or restructuring of existing funds crippled by liquidity constraints and a deluge of funds-related litigation in the courts both onshore and offshore.
A number of legislative and regulatory changes have recently been introduced in the BVI in response to the changing economic landscape, in particular the Securities and Investment Business Act 2010 (SIBA).
Against this backdrop, this chapter considers:
- The features of the BVI's legislative and regulatory framework and the recent changes that have been made.
- Recent trends in funds activity, as well as types of funds and products.
- How corporate governance issues are being dealt with in the BVI.
LEGISLATIVE AND REGULATORY FRAMEWORK
The BVI's legal system has its roots in UK common law and the jurisdiction's ultimate court of appeal is the UK Privy Council. The legal system blends attributes of the UK system with those of jurisdictions like Delaware, as well as other onshore and offshore jurisdictions. For example, the Partnership Act 1996 is heavily influenced by the partnership laws in Delaware and New Zealand. SIBA is similar to the legislative regime in the Cayman Islands although it incorporates lessons learnt over the ten years since the Cayman Islands' Securities and Investment Business Law was introduced.
The size of the BVI and its heavy reliance on the offshore financial services industry allows for legislation to be introduced at a pace that is difficult to achieve onshore. The latest major suite of legislation, in the form of SIBA and its related regulations (the Mutual Funds Regulations 2010 and the Public Funds Code 2010) as well as the Regulatory Code 2009 (as amended), was introduced swiftly on the heels of the global financial crisis. Many of the mechanisms within SIBA and the Regulatory Code address the call for greater accountability and enhanced corporate governance felt within the global financial services industry.
SIBA effectively arose as a result of a push to bring the BVI's financial services industry in line with the guidelines set by the Organisation for Economic Cooperation and Development (OECD) in relation to transparency and accountability, as well as the recognition by the BVI financial services industry of the need to further develop the securities and investment business offerings in the BVI while keeping up to date with international standards of regulation.
SIBA repealed and replaced the Mutual Funds Act in its entirety and reflects standards that are adopted and encouraged as part of good corporate governance and transparency in other sophisticated jurisdictions. SIBA sets out the statutory framework applicable to funds and entities carrying out regulated investment business in the BVI, and introduces securities legislation and financial markets regulation, including provisions on market abuse. The accompanying Mutual Funds Regulations provide the detailed regulations applicable to the establishment and supervision of open-ended funds in the BVI.
SIBA broadens the scope of financial activities that are subject to regulation under BVI law. It brings within its remit persons carrying on "investment business" (as that term is defined in SIBA) in or from within the BVI so that several activities that were previously unregulated under BVI law are now subject to regulation. For example, the scope of the entities that can now be licensed by the BVI's Financial Services Commission (FSC) has been increased to include new categories such as brokers, dealers and services providers to closed-ended funds and other types of investments.
The introduction of new regulated products under SIBA in the form of a licensing regime for brokers, dealers and scope for foreign currency trading platforms is a sign that the BVI financial services industry remains committed to identifying new product offerings in demand. These are proving to be popular, especially with US and European clients looking for a level of regulatory supervision that is robust yet has fewer hurdles (such as prohibitive authorised capital thresholds) to encourage new entrants on those markets.
In light of the greater calls for the protection of retail investors globally, the regulatory regime in relation to public funds has been substantially strengthened by the public fund provisions of SIBA and the Public Funds Code 2010, issued under SIBA. The disclosure threshold has been substantially increased so that very detailed disclosures are required for public funds. These must be contained in the fund's prospectus under the Public Funds Code 2010 and relate to, among other things:
- The fund's service providers.
- The characteristics of the fund.
- The valuation of the fund's property and interests.
- Greater transparency about the remuneration arrangements for service providers.
Overall, the regulatory regime applicable to funds remains similar to that of the previous regime and has not been changed in any substantive way. The updated funds legislation codifies standards and requirements that were previously implemented as a matter of policy by the FSC when considering applications. This codification of policy has brought about clarity and certainty to the law and regulatory approach relating to funds.
The Regulatory Code provides a framework of corporate governance principles that need to be adhered to by entities licensed under SIBA as well as functionaries licensed to carry out other financial services in the BVI under the regulatory supervision of the FSC, and elaborates on obligations regarding communication with the FSC. Professional and private funds in the BVI are not subject to the Regulatory Code, although adherence to general corporate governance principles by directors of these funds would be expected as a matter of common law principles regarding fiduciary duties.
Other legal and regulatory developments
In a push to further increase transparency, the BVI has entered into tax information exchange agreements (TIEAs) with 22 other jurisdictions, a number of which have been entered into in the last two years, including those with India, Canada, Portugal, China and Ireland.
The introduction of a specialised Commercial Court to deal with sophisticated disputes is another relatively recent development in the BVI.
TRENDS IN FUND ACTIVITY
Events such as the global economic crisis and the Bernard Madoff fraud have inevitably had a negative impact on the offshore funds industry, including in the BVI.
However, the jurisdiction has seen some new fund activity within the last year or two as investor confidence appears to be returning, although at a slower pace. The latest statistics issued by the FSC for the first quarter of 2011 show an increase in the number of new funds incorporated in the jurisdiction in the first quarter of 2011 (57 new funds) over the last quarter of 2010 (31 new funds). This is encouraging given prevailing market conditions, but it remains to be seen whether this uptick in new funds will continue over the next several months.
It is important to note, however, that as closed-ended funds are not regulated by the FSC there are no official figures to capture how active the private equity market has been in the BVI, although informal feedback from other legal practitioners reveals that private equity activity is still strong, particularly in relation to investments in emerging markets and/or natural resources.
This section considers recent developments in the BVI funds industry, including:
- The types of funds and new products that are emerging.
- The impact of SIBA on funds activity.
- Trends in the structuring of funds and documentation that governs funds, including changes to the mechanics of funds and how regulatory changes have brought about changes to documentation.
TYPES OF FUNDS AND NEW PRODUCTS
In the past year, there has been renewed interest from sponsors and managers considering establishing funds in the BVI with new fund inquiries received on a regular basis. Note, however, that generally they are proceeding more cautiously and there is typically a longer lead time between receipt of formal instructions and the launch of a new product. More time is being spent weighing the options concerning the fund's structure and in the careful and thorough drafting of the fund documentation.
Professional funds continue to be the most popular type of fund in the jurisdiction, although private funds remain attractive, particularly for managers looking for a regulated product that does not have stringent minimum subscription requirements. The BVI private fund fits the bill in that regard and also allows the managers to court smaller investors who may not satisfy the definition of a sophisticated or "professional" investor, but who have some capital that is valuable in a tight market.
With the exception of new funds for existing well-established and large managers, funds invariably seem to be smaller in size than pre-2008, which is not surprising in the current market, and their less risky strategies are attuned to the desire of the investor base to seek lower returns with less volatility and risk. More funds seem to be either exclusively focused on, or incorporating as an alternative asset class, investments in more tangible assets such as art, wine or gold. This raises issues in relation to valuation as well as appropriate custody arrangements of these assets.
The BVI has historically been attractive for start-up managers, mainly due to the recognised cost-efficiency of the jurisdiction and the flexibility of being able to engage service providers located outside the BVI, and this trend appears to be continuing. In particular, there seems to be a trend towards a number of managers wanting to set up incubator funds seeded with their own or family money to "test the waters" so that they can both experiment with investment strategies and try to develop an auditable track record at lower costs than starting a regulated fund immediately. The intention here, if successful, is that the fund will eventually be expanded into a fully-fledged regulated product for marketing to external investors.
Inquiries are also being received for managed accounts or single investor funds, particularly as a response to demands from investors not wanting to pool their investments with other investors in a traditional hedge fund with limited control. These are often structured as single investor companies ensuring that the investor retains a greater degree of control over the fund and does not have to be concerned about his investments being co-mingled with that of other parties. However, this can be a costly option as the operating costs of the structure are not diluted among a number of investors. It will be interesting to see if this wariness continues if market confidence returns and the prospect of higher returns for lower costs tempts investors back into more traditional fund structures.
As can be expected following the upheaval of the markets and the funds industry over the last one to two years, a significant amount of work is occurring in relation to restructuring existing funds, whether as a result of liquidity issues, a changing investor base or a drive to minimise costs until better market conditions return.
Established managers are still active, whether in relation to their existing funds or in the setting up of new asset classes or funds. In particular, a lot of existing stand-alone funds are being restructured into master-feeder funds to accommodate US and non-US investors.
In general, it seems that the impetus for new funds in the BVI continues to come mostly from the US and, to a lesser extent, from Europe, although there is less activity than pre-2008. That said, Latin America and the emerging markets also show some activity. The BVI has always been a popular option for Latin American clients looking to set up family funds and other investment structures due to cost-efficiency as well as targeted marketing by BVI service providers in Latin American markets.
Impact of SIBA
The enactment of SIBA has broadened the regulatory landscape to include financial activities that were previously unregulated under BVI law (see above, SIBA). Specifically, SIBA governs persons carrying on "investment business" in or from within the BVI, which encompasses various activities including:
- Dealing in investments, whether as an agent or a principal.
- Arranging deals in investments, whether as an agent or a principal.
- The provision of investment advice.
- The provision of custodial or administrative services.
The term "investments" is also broadly defined and includes shares, interests in a partnership or fund interests, debentures, certificates representing investments, options and futures.
The amount of interest that has been engendered as a result of these changes, in particular by the broker and dealer licensing options, has been immense. A source of many inquiries is Cyprus, which has historically been a portal for Russian capital and the traditional corporate structures using combinations of BVI and Cypriot entities to service the Russian and former Eastern Bloc markets.
There is also interest from the US as already regulated brokers or dealers there look towards the BVI to cater for some of their non-US client arrangements. For example, the first broker/ dealer licensed in the BVI was US-based Gallant Capital Markets (Gallant) in June 2011, which enables Gallant to offer its services within the confines of a respected regulatory framework, while expanding its products and services for its global clientele.
Structuring of funds and documentation governing them
The structuring of funds and the documentation that governs them have evolved rapidly in the last couple of years. Given the limited capital available and the pressure for funds to get new capital, the balance of power has shifted decidedly in favour of investors. The latter are now conducting more extensive due diligence when looking at which fund to invest in, and are exercising greater influence and control over the terms of the fund.
This is apparent from greater investor pressure over areas that investors previously had little influence over. Investors are more acutely examining whether there is sufficient independence both at board level and between the manager, administrator and other functionaries (for example, the structure of the fund, including the composition of its board of directors and the relationships between the fund and its various services providers). Auditors and legal advisers are being approached more frequently by prospective investors wanting confirmation that they do indeed fulfil functions for the proposed fund. Investors are also more closely examining the fund documentation that accompanies the subscription documents.
It is interesting to note that, for new start ups, as a result of the pressure to attract capital, some managers are now taking into account potential investor perception at the inception of the fund in order to craft the documentation so that their new offerings are competitive and more attractive to investors.
The drive to increase transparency towards investors has also prompted initiatives such as the establishment of valuation committees, and provisions are being incorporated into fund documentation to enable this.
Mechanics of funds. Fund managers, onshore and offshore funds and their investors all learnt hard lessons as a result of difficult market conditions, liquidity constraints and diminished investor confidence during the height of the global economic crisis. This has been a catalyst for changes to the way in which funds are now being structured and has increased the scrutiny of mechanics within a fund, particularly in relation to liquidity and redemptions.
In terms of the documentation of funds, following the way in which various fund mechanics were severely tested by liquidity issues and in light of the judicial insight offered in the resultant case law, many providers and their clients are fine-tuning their fund documentation to ensure that it is sufficiently flexible, clearly drafted and provides the tools and mechanisms necessary to deal with potential problems. A noticeable difficulty is the struggle between having mechanics to protect the fund and its assets, and trying to make a fund attractive to more demanding investors in a market where cash is all important.
The importance of retaining flexibility in suspension provisions was underscored by the liquidity crisis. Funds that were facing liquidity issues realised that the suspension provisions in many fund documents did not enable some funds to suspend redemptions while keeping the fund operational and able to issue shares and to determine net asset value (NAV). In some cases, a complete lock-down of the fund was the only option provided for in the fund documentation, and this was sometimes a disproportionate way to control liquidity.
Suspension provisions are now being drafted more broadly to ensure that they are sufficiently flexible to enable, should the need arise, the fund to suspend one or more actions (such as redemptions and/or subscriptions and/or valuations), rather than lock-down the fund entirely.
Following recent case law, which provided legal interpretations of what had been traditionally accepted practice in the fund administration industry, there is now more care being taken to clarify the status of investors who are caught in a state of flux during the redemption process when a suspension has been implemented.
Redemption in kind provisions, which until recently were rarely used, were shown to be invaluable during states of illiquidity and more providers and managers are now incorporating these into their documentation. However, where investors have more say in the construction of fund documentation, this mechanic can be desired or rejected depending on whether the investor would prefer cash only redemptions or to have control of an illiquid asset rather than be locked into a frozen fund.
Where possible, detailed gate and lock-up provisions are either being included in the constitutional documents or, to the extreme, are being left out of some documents entirely to make the fund more attractive to investors.
Side pockets have taken on greater importance as a result of circumstances caused by the global economic crisis such as the collapse of custodian firms like Lehman or, more recently, MF Global. Side pockets were typically set up to enable managers to acquire positions that are illiquid at the time of acquisition and hold them until such time as they become liquid and can be moved into the main pool of assets of the fund. The current environment has highlighted the importance of drafting side pockets broadly enough to capture not only investments that were illiquid at the time of the acquisition, but also those that subsequently become illiquid as a result of market conditions.
Changes to reflect regulatory updates. Some of the changes to the documentation governing funds have also been driven by SIBA, which requires certain statutory disclosures to be included in the fund documentation. One of the more important changes is the requirement for the inclusion of a statutory investor warning in the offering document of a private or professional fund or, where no offering document is issued, in a separate document to investors. The warning emphasises the need for investors in a private or professional fund to be aware of the greater risk involved in that type of investment as compared to a public fund, because these funds are not subject to the same level of regulatory supervision as a public fund.
A key change to the constitutional documents of a fund is that a professional fund must now include a statement to reflect what type of fund it is, that is, a professional fund subject to statutory minimum subscription requirements. A similar requirement had always been applied in relation to private funds which had to include the basis on which they were classed as a private fund (that is, because the fund's shares were offered on a private basis, or because the fund was limited to a certain number of investors).
CORPORATE GOVERNANCE ISSUES
Corporate governance has been a major issue for hedge funds since the US-led initiatives in relation to the Sarbanes-Oxley Act 2002 and the increasing demand for a higher standard of performance by a fund's board of directors. For the most part, some offshore jurisdictions applied, or expected the application of, corporate governance principles as good practice in any event, but have only more recently taken steps to enshrine these into legislation.
During the global economic crisis, it became apparent that some funds had directors on their boards who were either:
- Not sufficiently experienced.
- Not active in the operations of the fund.
- Not able to perform their functions independently of the manager.
The drive for transparency coupled with the pressure by investors to further investigate the composition of the boards of directors of funds in which they invest, has worked together with legislative changes calling for greater attention to be paid to corporate governance.
These forces, and the recent decision in the Cayman Islands in Weavering Macro Fixed Income Limited (In Liquidation) v Peterson and Ekstrom (Cayman Islands, August 2011), have caused the bar in relation to the role of the directors of an offshore fund to be substantially heightened. (In Weavering, the Cayman Islands court found a fund's independent directors guilty of wilful default in the discharge of their duties and ordered them to pay substantial damages in the amount of US$114 million (as at 1 November 2011, EUR1 was about US$1.4) to the fund's liquidators representing losses suffered by the fund caused by their default.)
It is now more important for funds to demonstrate that their directors are playing a bona fide role in the operation of the fund, and that they have the relevant expertise, background and skills to oversee the fund and are functionally independent of the manager. Directors themselves are also becoming more aware of the importance of playing an active role in the fund and are understandably concerned about the prospect of personal liability for not doing so. There is more examination on the provision of independent directorship services and much discussion as to how many directorships can realistically be taken on whilst demonstrating that the role is being properly carried out.
With specific regard to the BVI, the former regime under the Mutual Funds Act did not prescribe any particular requirements for corporate governance, particularly for private and professional funds, although as a matter of policy the FSC was aware of these issues when examining fund applications. This situation has been fortified under SIBA and the law now has a minimum director requirement calling for private and professional funds to have at least two directors, at least one of which must be an individual, at all times. This reflects the longstanding "four-eyes" policy that the FSC applied to licensed fund managers and administrators under the former regime, and is in line with regulatory and investor-driven demands for greater supervision from those controlling the funds.
The Public Funds Code 2010 contains clear corporate governance rules for public funds' governing bodies. It requires public funds to have an adequate number of directors who:
- Are capable of exercising independent judgement and have sufficient knowledge, skills, experience and understanding of the fund's business to ensure that the board is able to fulfil its responsibilities.
- Have sufficient time and commitment to undertake their duties.
The recent trends discussed above that are emerging in the hedge funds industry are generally considered to be positive for the future of the industry. SIBA has raised the regulatory standard in the BVI to that in other sophisticated jurisdictions. The new regulatory regime's focus on higher standards of accountability, better corporate governance and open communication with the regulator mirrors global changes within the funds industry, and illustrates a commitment by the BVI financial services industry to remain a credible leading offshore financial centre.
Along with the changes that are now being demanded in hedge fund corporate governance, a clear movement towards accountability and transparency in the operation of hedge funds can be observed, enabling hedge fund managers to both re-acquire the trust and confidence of investors and improve the overall image of the industry.
Originally published in "Practical Law: Multi-Jurisdictional Guide 2012 - Investment Funds"
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