The events of the past two years have led to profound changes. Law firms are confident the tried and tested Cayman hedge fund vehicles will remain popular.

Gates and suspensions may have subsided but Cayman’s legal community is busier than ever. Onshore lawyers are sending more work to Cayman lawyers. Opinions on Cayman law are being sought and ‘expert witnesses’ are appearing in US courts and elsewhere explaining Cayman law.

There is increased litigation which may have in the past caused a bit of a backlog in the Cayman courts. No longer.

Large commercial disputes are now brought in the financial services division (FSD) of the Grand Court. The FSD started operations in November 2009.

The opening of the division has significantly speeded up court proceedings as well as given Cayman more of a legal edge.

Two of the judges sitting in the FSD come from Walkers and Maples and Calder in Cayman and are familiar with the intricacies of the law as well as the complexities of fund structures and documents. There are a total of six judges available for cases heard by the FSD.

Colette Wilkins, a litigation partner at Walkers, is pleased with the FSD. Several important judgments have already been passed affecting hedge funds.

One of the more significant cases has been before the Cayman Islands Court of Appeal.

It decided in favour of a solvent hedge fund that was faced with a winding up petition from a disgruntled investor.

The court ruled that such petitions should not put companies under pressure to accede to investor demands.

In September 2009 the investor filed two identical winding up petitions with the Grand Court, one before the judge’s final decision and one just after that decision was sealed.

The fund appealed against the petitions. In March this year the Court of Appeal decided ordinary litigation in the Grand Court’s FSD was a more suitable course of action in this case.

It also found that the winding up petitions were designed to put pressure on the fund to give in to the investor’s demands. This was an abuse of process and so was struck out by the Court of Appeal.

The case confirmed Cayman companies law, introduced in 2009, did not expand the grounds on which an investor or shareholder can present a winding up petition, although it did expand the relief available to successful petitioners.

Previously the Court of Appeal dealt with various questions on the suspension of redemptions. The ruling (December 12, 2008) in Strategic Turnaround Master Partnership (based in New York) v Culross Global specifically defined the meaning of redemption in an investment fund context and at what point a member is actually redeemed from an investment fund.

In its judgment the court emphasised the fact that the effect and timing of redemptions and suspensions must be carefully considered in light of a fund’s constitution documents.

An important aspect of the court’s decision was a finding that this particular fund’s constituent documents gave it the power to suspend the payment of redemption proceeds after the redemption date.

The case also confirms the widely held view that a redeeming investor will become a creditor on the redemption date, even if payment of the debt is subsequently suspended as allowed under the fund’s constituent documents.

One peculiar result of the judgment is that, after the relevant redemption date but before a redeeming investor is removed from the register and perhaps until he is paid, an investor will be both a creditor and a shareholder of a fund bound by its constitutional documents.

The ruling does not overturn or significantly change the Chief Justice’s finding that redeeming but unpaid investors will rank ahead of other investors but behind “ordinary” unsecured creditors, according to a report by Maples and Calder on the case.

Wilkins expects further judgments to clarify various issues thrown up by the financial crisis, although she and her colleagues at Walkers believe the Cayman fund structures have stood up well.

More issues
One of the issues Wilkins expects to eventually come before the court is on valuation of assets. This is an issue exercising the legal minds of many in Cayman.

The debate has become somewhat philosophical, given that the true value of a security cannot be known until it is actually sold.

Wilkins also thinks the issues surrounding valuation of funds and payment in kind could be another potential area of litigation in future.

Trends that Ingrid Pierce, a partner in the global hedge fund group and head of the Cayman hedge fund practice of Walkers, sees include more managed and segregated accounts.

There is a “driving desire” for managed accounts. The reason is that investors want direct reporting and transparency. She also says there are tensions coming from the increased use of side letters.

The practice of using side letters is one that most would like to avoid.

Pierce says many funds are creating separate classes for investors. Most of these share classes give different liquidity or fee terms to individual investors.

The use of segregated portfolio companies remains popular, but as these have not yet been tested in court, there is some concern that the intention to separate assets may not hold up if challenged.

Heidi de Vries, another partner at Walkers, says she is seeing different business models cropping up over the last two years. Liquidity issues are again driving this trend.

Appleby is seeing a trend toward more concern over how assets are held by custodians.

In the more “relaxed” days prior to the crisis little thought was given to this, notes partner Richard Addlestone.

He says the norm now is to have assets ringfenced and completely segregated from other investment fund assets.

Like Wilkins at Walkers, he is seeing growing concerns over valuation of assets. The focus, he says, is on who is doing the valuation and whether they are providing a number independent of the fund manager.

Administrators that confirm the valuations without an independent source may find this is not enough in future.

Addlestone is also seeing investor interest on provisions for redemption and in particular what the relationship of creditors as shareholders really is, although this has to some extent been clarified by the Strategic Turnaround case.

Addlestone is also aware of what he calls the ‘Obama effect’. The closing of proprietary trading desks could lead to a surge in former traders looking to use their skills in hedge fund vehicles.

Appleby partner Jeremy Walton agrees. He says a lot of star traders at hedge funds came out of the investment banks. More importantly, however, he sees the fund industry bifurcating significantly across the Atlantic.

There are different forces and agendas being pursued by US President Obama compared with the European Union. There could be completely different structures coming out of the US and EU in future, he suggests.

Henry Smith, gglobal managing partner of Maples and Calder worldwide, agrees with Pierce at Walkers that there is a trend towards managed accounts.

He confirms a number of clients are talking to the firm about this but cautions that managed accounts are “not a magic solution for transparency issues”.

Meltdown madness
He says some investors saw the meltdown and decided they wanted the ability to ensure access to their investments. They believe a managed account is the answer, rather than running the risk of being gated.

He believes large institutional investors are able to bear the costs of managed accounts but that the economies of scale found in a fund structure may be a better option.

He has seen some large institutional investors putting together single investor fund vehicles for their own benefit with the fund manager.

There is more focus on some documentation features, such as side pocket language, says Smith. Investors are keen to see how clauses in documents dealing with gating and suspensions are written, too.

Like Pierce, Jon Fowler, head of Maples’ investment funds group in Cayman, is seeing the use of separate share classes to provide different liquidity terms for investors.

These different share classes have different redemption terms and set fees depending on what the liquidity terms are.

One point Smith is keen to make is that Cayman structures when reviewed post financial crisis were seen to be robust. He says they were a “good legal model” mainly because they had already been tried and tested.

Looking at the onshore/offshore debate and looming legislation from onshore jurisdictions, Smith thinks Cayman has little to fear.

He believes some of the regulated products favoured by European investors, like Ucits hedge funds, are a complement to Cayman fund vehicles.

He believe there will be a strong attraction of managers based in Europe to European fund structures but from what his firm is seeing there has been little impact on Cayman so far.

Smith says Maples has been lobbying the European Union over the alternative investment fund managers (AIFM) directive and hopes the final legislation satisfactorily addresses the many contradictions of the existing draft as well as the concerns of the funds industry.

A different perspective comes from Alistair Walters, managing partner at Campbells, one of the oldest and largest of Cayman law firms. Unusually for a Cayman firm dealing with hedge funds, Campbells operates only in Cayman and according to Walters has no plans to change this.

His view of the AIFM directive is similar to others on the island. He believes the law is unlikely to have any great impact on Cayman business. Even if Europeans decide not to use Cayman, the bulk of work comes from US-based managers.

With new regions like South America, the Far East and other emerging countries beginning to enter hedge funds, he is confident the jurisdiction will remain the leading domicile for funds.

However, he says Cayman has been “galvanised” due to the “new dynamics” of the world post financial crisis.

This environment offers business opportunities to the more efficient offshore financial services industries. One advantage he sees in the Cayman jurisdiction is the FSD.

Efficient court system
Like Walkers, he thinks the streamlined court is picking up big ticket and complex cases and providing an efficient venue for proceedings. He thinks the specialisation of the FSD, particularly in hedge fund cases, is a real boost for Cayman.

Walters expects to see more litigation coming to the courts and thinks the decisions being rendered will further establish Cayman’s place as a premier domicile for hedge funds.

Over the past 18 months, he says the “boiler plate” approach to fund documentation has given way to more bespoke phrasing.

The financial crisis has also meant more scrutiny is given to many of the provisions within documents with a lot of “what if” testing. Investors want to know what the implications are of various clauses, whether directors and fund managers have the tools, remedies and powers to cope with any crisis in future.

Another outlier in the legal profession in Cayman is Solomon Harris. Paul Scrivener, a partner at the firm, believes it has been fortunate that it has a base in Switzerland, too.

“It is a great European base, close to the EU, but not the EU. It is a good centre to develop a European practice,” he confirms.

Alpine first mover advantage
Solomon Harris was the first Cayman Islands law firm to open an office in Switzerland. With the establishment of its Zurich branch in May 2008, the Zurich office is a full service corporate and commercial law firm practising exclusively Cayman Islands law.

He agrees with others in Cayman that the AIFM directive is a concern. “I think there is no doubt that we are nervous about the directive if it does not go through a bit diluted,” comments Scrivener.

At Ogier, Peter Cockhill, marketing partner of the Cayman legal practice and co-head of the firm’s global investment funds team, agrees. “I think the biggest problem facing hedge funds is actually one of perception.

“They have been unjustly vilified in the press and by regulators and journalists in the popular media. Politicians in the US, UK and EU have been quick to seize the opportunity and give into popular sentiment.

“The biggest threat to Cayman is to ensure the regulatory response is appropriate and proportionate rather than extreme and ill informed,” comments Cockhill.

He thinks Cayman is on course to meet equivalency requirements and cautions that Cayman should not be pressured into an “inappropriate” regulatory response.

At Mourant de Feu & Jeune  partner Neal Lomax thinks it may be too early to say what will be the outcome of the regulatory debates in the US and EU.

He believes regulation is an issue of concern but give equal weight to the evolving relationship between managers and investors. Like others he is seeing an emphasis on flexibility within documents, particularly on the management of liquidity issues.

He, too, is seeing a resurgence of side letters, but cautions the use of these is full of pitfalls, particularly if managers are trying to give differential treatment to investors.

Lomax is bullish about Cayman and is also positive about the merger of his law firm with Ozannes in the Channel Islands. He sees the merger as “very positive; a no brainer for both of us” and expects the deal to boost Mourant’s market share in both the Channel Islands and in Cayman.

At Higgs & Johnson, associate Winton McDonald II, head of investment funds, is focused on the managers coming from the emerging markets. His practice oversees around 400 funds mainly based in Russia, Cyprus, China, Hong Kong, Venezuela, Brazil and Eastern Europe.

He believes for his practice emerging markets is the area to focus on. He expects 2010 to continue the firm’s success in gaining clients form these areas.

He believes Higgs & Johnson is attracting emerging managers mainly because of its lower fee structure compared to the ‘magic circle’ law firms in Cayman.

“Funds want the kudos of being in a premier jurisdiction,” says McDonald.

He is concerned about competition coming from Europe and other jurisdictions and wants to see Cayman being more aggressive in its marketing. He also believes the jurisdiction needs to continue to offer innovative products.

“We are a premier offshore jurisdiction. We need to continue to find innovate ways to service funds. Without the funds industry, what would we do?” he says.

Harneys, a relatively recent addition to the Cayman Islands legal scene although it is one of the most established firms in the British Virgin Islands, is finding life in the jurisdiction beneficial.

The firm is expanding, recruiting more litigators and other fund specialists for its Cayman operation.

According to partner Tim Clipstone the firm has been instructed on a number of fund liquidations and is acting as counsel for some litigation. He says the Cayman team is likely to expand further this year.

Like Higgs & Johnson he is seeing a lot of business coming out of Brazil and Latin America. This he says is good news, particularly after the tough times the funds industry has gone through.

Clipstone says, however, the financial crisis has made a lasting imprint on the funds industry. Harneys has learnt at lot about the potential ways a fund can be liquidated as well as other terms that need to be in the fund offering documents, notes Clipstone.

Perfection achieved
He says it is possible to build a perfect fund that protects the manager, but too many conditions could create an “unsaleable fund”. Balance, he says, should prevail.

In general Clipstone says investors are more sensitive to the clauses in the offering documents. Onshore lawyers are also keen to have opinions from Cayman lawyers on the legality of provisions and how potential challenges might play out in a Cayman court.

One challenge he sees concerns explicit statements concerning the use of special purpose vehicles and side pockets to cope with illiquid assets. This is now standard and accepted in fund documents.

On the AIFM directive Clipstone believes the “uncertainty is worse than knowing”. The sooner the EU makes clear what its equivalency criteria are and spells out how this can be measured, the better for offshore fund jurisdictions.

At Conyers Dill & Pearman, concern over the AIFM directive and the move towards more regulation is muted. Olivaire Watler, an associate, believes there should be little impact on Cayman as most of the funds work is with managers based outside Europe.

“We need to take a view on the net effect it may have on Cayman. But it is early days yet to assess how it will impact on us, if at all. It may be necessary to increase the degree of regulation in order to satisfy the EU,” he concedes.

The firm is a relatively new entrant to Cayman, set up 2003 and as a result has a corresponding smaller market share of the hedge funds industry.

“What are developing in general our funds practice, but we have not seen meteoric growth. So we have not also seen the same decline in business other practices experienced due to the financial crisis,” notes partner Richard Finlay.

Like others associate Maree Martin is seeing more attention given to particular issues in fund documents.

These related to liquidity terms, net asset value calculation, gating, suspension of redemption and the provision of payment in kind through the distribution of shares in special purpose vehicles set up to hold illiquid investments.

“Investors are paying more attention to the details. They are looking closely at the risk factors and are doing more due diligence. More investors are also asking for side letters with reference to disclosure of key information and transparency,” says Martin.

Finlay adds that different structures are being used to implement what are in effect managed accounts. He says some funds are forming segregated portfolio companies for individual investors. The level of complexity and cost may deter many from using managed accounts, he thinks.

Like Harneys and Higgs & Johnson, Finlay expects new business to come out of emerging markets. He says his firm is looking at the BRICs (Brazil, Russia, India, China) in particular and their need to access capital markets.

He believes it is important to penetrate these markets, believes Finlay. As Cayman is now a full member of Iosco, that should open markets in Brazil and India, predicts Finlay. Conyers already has offices in Sao Paulo and Mauritius and is planning to open in Cyprus this year.

The firm has been in Hong Kong for over 20 years and was one of the first international law first to set up there. “It is now our third biggest practice,” says Finlay.

In general Finlay expects to see more deal flow out of Brazil and Russian this year. He believes the first mover advantage in Brazil and Hong Kong will also prove important for attracting new business.

While many challenges remain for legal services in Cayman, it is clear the overwhelming view is that the jurisdiction is well placed to continue to attract significant hedge funds business.