Cayman Islands: Digital Securities Landscape Overview
The Cayman Islands are well-known as a leading jurisdiction for investment funds with flexible financial markets regulation, a tax-free regime for offshore businesses, and a free flow of capital. As of March 2018, the number of regulated funds reached 10,500. In comparison, the next largest offshore jurisdictions, by a number of reported regulated funds in each respective jurisdiction, were Ireland with 2,538 funds, The British Virgin Islands with 1,496 registered funds, and Jersey with 1,104 funds.
There is no specific legislation for digital securities or security tokens in the Cayman Islands, they are rather covered by conventional securities legislation if the instruments fall under the corresponding definition. Considering that most issues are targeted at offshore jurisdiction, the securities and fund legislation in those jurisdictions has much more impact on the issuers. In order to have the freedom to offer fund units, the fund manager should be registered in corresponding jurisdictions, although there are some exemptions.
The drawback of a soft regulatory oversight is the weakened protection of investors in such an offering, although the specific degree of protection depends on the structure of the offering. For this reason, it is advisable that issuers use means of enhancing the trust to the offering, such as partnerships with reputable firms as shown in one of the cases discussed, or offer higher returns to compensate for the risk.
Generally, conducting an offering from within the Cayman Islands is feasible for smaller offerings of issuers that wish to minimize compliance costs or to offer non-classical instruments that don’t fall under the definition of securities.
The financial market of the Cayman Islands is regulated by the local authority Cayman Islands Monetary Authority (CIMA) within the framework of the following legislation pieces:
- Securities Investment Business Law (SIBL)
- Mutual Funds Law
- Cayman Islands Anti-Money Laundering Regulations
- Companies Law
- International standards to which CIMA adheres (CRS, FATCA)
The definition of “securities” in the understanding of the local regulator is reflected in the Securities Investment Business Law and includes stocks, debt instruments, stipulating the rights to other securities instruments, securities certificates, options, futures contracts. All these securities can be issued, offered for sale and turnover, as well as advertised by the subjects of the financial market of the Cayman Islands.
An important feature of the financial market of the Cayman Islands is the differentiated regulation of companies and foundations that operate within the jurisdiction and outside it (“exempted”). In general, the requirements for local market operators are much more stringent. Companies oriented to markets outside of the Cayman Islands should be registered as “exempted” and be guided by the laws for such companies.
An issuer may use several types of entities for its offering depending on the nature of the project. The most common type of Cayman-based Issuer is an Investment Fund. However, stand-alone companies may use this jurisdiction as well.
Regulation in establishing and operating investment funds varies depending on their type and some key parameters.
First of all, some funds do not require mandatory regulation. These include closed-end funds, as well as open-end funds with fewer than 15 investors. Such funds are free from CIMA regulations, but still fall under the Anti-Money Laundering Regulations, and their parent companies must comply with corporate law requirements enforced in the Cayman Islands.
CIMA regulates open-end funds based on the Mutual Funds Law of the Cayman Islands (“MFL”). According to the law, there are a few following streams for fund regulation:
Must meet the following minimum requirements:
- The minimum initial capital of at least 100,000USD from each investor.
- Provision of audited financial statements annually.
- Appointment of an authorized Manager responsible for operations. Typically, a fund Director performs as a Manager.
- Passing the registration procedure in CIMA.
Allow a minimum initial contribution of participants less than 100,000USD. Must have a designated licensed administrator to operate a principal office in the Cayman Islands. This administrator has primary regulatory and legal responsibility for the management of the fund and is required to ensure compliance with legal and ethical standards during its operation.
Typically, licensed funds are established by major reputable institutions for retail investors. The issuer of the fund is required to undergo licensing with CIMA
EU Connected Funds
This class of funds was introduced in 2017 as a reaction to the Alternative Investment Fund Manager Directive (AIFMD) of the European Union. This directive limited promotion and trading rights of non-resident funds in the EU for European investors. According to the minimum requirements of AIFMD, funds offered in the EU must be regulated in their home jurisdiction.
Thus, funds that otherwise do not require regulation in the Cayman Islands have the opportunity to voluntarily go through the registration procedure to comply with the AIFMD directive and to earn permission to operate (advertise, trade) in the EU countries.
It should be added that this minimum requirement of AIFMD can optionally be toughened up by local regulators of the EU countries and so the Cayman Islands Fund would need to cooperate with the local legislation of individual EU countries. The final decision allowing a specific fund to the EU market is taken by regulators of individual EU member states on the basis of submitted applications and they are entitled to refuse at their discretion.
Formally, the AIFMD directive implies the requirement to achieve bilateral agreements between regulators of individual EU countries and third jurisdictions whose funds are interested in working in the EU. Actually, CIMA reached arrangements with regulators in most EU member states.
Structured Portfolio Company
A Segregated Portfolio Company (SPC) is a structure that can create and operate one or more segregated portfolios that have statutory segregated assets and liabilities between portfolios. Under the Cayman Islands law, a Segregated Portfolio Company is an exempted company that has been registered as an SPC. It has the full capacity to undertake any activity subject to restrictions imposed by its Articles of Incorporation.
The general assets and liabilities of the SPC are held within a separate general account rather than in any of the SP accounts. Each SP, as well as the main SPC company, should have a separate bank account, brokerage accounts and other accounts as applicable to hold assets in a segregated way.
SPC has been historically used by fund managers to employ various investment strategies and manage assets and investors related to such strategies separately. However, it may also be used as a securitization vehicle for project financing. That is, for each project a separate segregated portfolio is created which manages investments in each project. This is beneficial as it protects investors in one project from financial hurdles or default of other projects.
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The Foundation Company is a special kind of company that may be used for structuring financial transactions, wealth management, charitable purposes, and others. It is a body corporate with separate legal personality, which may be limited by shares, or guarantee, or without share capital, as there are no minimum capital requirements. A Foundation Company may be established for any lawful purpose, which must be specified in its Articles of Incorporation. Like any other exempt company, Foundation Companies will be exempt from any income tax. A Foundation Company is required to appoint a local qualified secretary licensed under the Companies Law, who would maintain full and proper records of the company activities.
The Foundation Company may be structured for the purposes of investment on behalf of its beneficiaries, where participation in a foundation is represented by a DLT-token, which would not be considered a security.
Security vs Non-Security
An instrument issued by a Cayman-incorporated entity may be classified as a security or not depending on how the offering is structured. The general criteria are as follows: if an instrument entitles the holder to any rights that it could claim, such an instrument would be considered a security.
A unit in the fund or any right attached to a segregated portfolio is security. However, a foundation company may be used for issuing an instrument that does not fall under the definition of security. If a token represents participation as a beneficiary in a foundation, it does not directly entitle the holder to any rights as he or she does not have decision-making authority and the director of the foundation company can issue payments on its own discretion.
The benefit of the instrument that is not classified as security is that compliance standards for it are lower. Particularly, it should have to register the investment in the EU, partner with EU-licensed fund managers or EU-licensed Investment Firms authorized to place financial instruments.
The drawback of such structure is that it provides no legal protection to investors, compared to security which creates an obligation for the issuer to conduct payments. This means that raising funds will be complicated and marketing expenses may be higher unless the offering has other strong pillars that would create reasons to trust its intentions.
Note that the aforementioned classification refers to the Cayman Islands and the EU. In the US such an instrument would be considered a security under the Howey Test.
The Cayman Islands offshore companies are exempt from corporate income tax. Furthermore, there is no withholding tax on dividends or similar payments. However, the Cayman Islands have double taxation with the majority of world countries, which reduces the benefits of that regime.
For tax optimization purposes it is feasible to set up a corporate structure that would transfer all the revenue to the Cayman company in such a way that it is not registered as profits in the operational company. This is determined by the nature of relations between Cayman and operational companies. If the former owns an equity stake in the latter, then the transfer of profits would definitely be subject to a withholding tax. A structure that would minimize taxation is to be determined by local tax advisers.
Marketing in Other Jurisdictions
The general rule is that the securities should be registered in the jurisdiction in which they are offered unless being exempted from registration requirements. Even when making use of exemptions, an offering should be conducted through financial institutions registered in corresponding jurisdictions.
The most stringent registration requirements are imposed on investment funds as they should have an EU-registered fund manager, appoint a single depositary, etc. For this reason, offshore funds often don’t offer their units in the EU except when the client itself approaches the fund. This so-called “reverse solicitation” regime allows non-EU funds to conduct preliminary marketing before the fund is launched and the units are offered for the subscription.
There is also a grey area in the marketing of such funds in the EU on the Internet where it is not always possible to determine whether the marketing is targeted at investors from a particular jurisdiction. The general rule is that if the local press is not involved, and the website is not translated to the local language and does not have a local domain, the offering is not considered as being targeted at local investors.
For securities that don’t represent participation in investment funds registration and reporting requirements are significantly simpler. In particular, it is possible to offer financial instruments with total consideration in the Union up to 5–8 million EUR depending on the Member State.
Instruments that don’t qualify as securities are not subject to any marketing limitations.
What Stobox Does?
Stobox is a provider of multiple professional and technology services related to securities operations with a strong focus on fundraising.
Stobox operates a technical platform for the management of a full lifecycle of digital securities, i.e. primary offering, secondary transfer, investor identity verification and risk assessment, shareholder register maintenance, dividends payment, processing of corporate actions, and corporate governance. The platform utilizes private ledger with banking-level security to provide resilient infrastructure with a certain legal status.
Stobox provides a range of legal management services to structure the offering of securities: the definition of the best-suited jurisdiction and corporate structure, formation of the corporate structure, preparation of the necessary documentation, including Prospectus or the offering memorandum. Stobox has a network of legal partners in multiple jurisdictions and conducts all the management and communication so that the client could have a single provider.
Stobox provides marketing strategy development and execution services in order to enhance the odds of the successful offering and optimize marketing budgets, which often constitute the largest cost of the offering. The marketing expertise is based on the analysis of multiple offerings of digital securities, which allows Stobox clients to avoid widespread mistakes.
Stobox Feasibility Assessment service provides a holistic view of the offering to see whether offering a suitable option for the given business on a given stage, what type of offering is the best fit for the business objectives, what marketing campaign would work best and how to manage potential risks.