Like the hedge fund industry, the British Virgin Islands is at a turning point. With the threat of increased regulation of the industry – and financial services in general – looming, the jurisdiction is facing the challenge with pragmatism.

These are challenging times for the British Virgin Islands (BVI) hedge fund industry. The jurisdiction is feeling the pinch of the global financial crisis. Like other offshore jurisdictions, it is also facing the prospect of having to adapt to a sea change in international attitudes towards the supervision and regulation of hedge funds and financial services in general.

The BVI is the world’s second largest jurisdiction for hedge fund domiciliation behind the Cayman Islands. There are nearly 3,000 open-ended fund structures registered with the regulator, the Financial Services Commission (FSC). The vast majority of these are believed to be hedge funds.

In recent years the fund business has emerged as the fastest-growing segment of the BVI financial services industry, with the number of funds registered in the jurisdiction growing by almost 33% between 2004 and mid-2008. Some of the high-profile hedge fund managers choosing a BVI domicile include Tudor Investment and Gottex Fund Management.

Local industry experts estimate BVI hedge funds had over $100 billion in assets under management (AUM) at their peak in mid-2008, although this figure has probably dropped by at least 30% in line with the global fall in AUM.

The appeal of the BVI as a hedge fund domicile rests in its modern and flexible legal environment and balanced approach to regulation. Local lawyers say the rules governing company and fund formations in the BVI are among the best in any jurisdiction and in some aspects superior to the legislation in the Cayman Islands, the market leader for hedge fund domiciliation. “The BVI compares favourably against Cayman,” says Simon Schilder, a partner at the law firm Ogier. “The legislation in the BVI is more modern. The insolvency and company rules in particular are really excellent pieces of legislation,” he says.  

The majority of BVI hedge funds are incorporated as companies under the BVI Business Companies Act, although funds can also be set up as partnerships or unit trusts. The Mutual Funds Act recognises three types of funds differentiated according to the level of sophistication of the target investors.

Valerie Georges-Thomas, a partner specialising in investment funds work at offshore law firm Appleby, describes the fund formation process as “quick, easy and straightforward”. She says the corporate and insolvency laws in the BVI are modern and provide for the simple incorporation, restructuring and merger of fund vehicles, while the regulator is business-friendly.

“The Mutual Funds Act is a very good piece of legislation,” Georges-Thomas says. “The distinction between public, private and professional funds means structures are subject to the appropriate level of regulation. The BVI is a very efficient place to incorporate funds aimed at sophisticated investors.”

Following the introduction of an online registry system known as VIRRGIN in 2008, a fund can be incorporated as a BVI company within 24 hours. Funds aimed at professional investors can begin operations immediately while the application to register the fund with the FSC is still pending. The registration of funds aimed at sophisticated investors is fast-tracked by the regulator and is typically approved in a matter of days.

Cost is another advantage of establishing a fund in the BVI. The fee for incorporating a fund there is $350 compared to around $1,000 or more in the Cayman Islands.

All open-ended investment funds domiciled in the jurisdiction must be registered with the regulator and locally incorporated management companies need a licence.

Nigel McPhail, director of the audit and accounting department of Baker Tilly in the BVI, says the regulator understands the needs of the business community. “The BVI is undoubtedly a well-regulated jurisdiction. The FSC understands the hedge fund industry and they have worked with the private sector to create an effective and appropriate regulatory regime,” he says.

The FSC combines a tough stance on anti-money laundering (AML) and know-your-customer (KYC) requirements with a principles-based approach to supervising investment funds based in the jurisdiction. Nicholas Carter, managing director of PricewaterhouseCoopers in the BVI, says the AML and KYC requirements in the BVI are stricter than in many onshore jurisdictions. The strength of the regime was recognised by the Caribbean Financial Action Task Force and earned a seal of approval from the International Monetary Fund in 2004.

BVI-based hedge funds are permitted to outsource AML and KYC compliance to an administrator or other functionaries based in the BVI or in another recognised jurisdiction (see box, page 6).

Brodrick Penn, director of the investment business division of the FSC, says the philosophy of the regulator has always been to establish a prudent regulatory framework which is also commercially attractive. “We strive to ensure that our regulatory processes are sufficiently flexible and responsive to the demands of the hedge fund industry,” says Penn.

This is evidenced by the fast-track registration process and light regulatory requirements for funds aimed at sophisticated investors. BVI based hedge funds aimed at professional investors are not required to provide an audit or file financial statements with the regulator and there is no obligation to appoint local directors or service providers. The regulator does impose an informal ‘four eyes’ policy which requires BVI hedge funds to have at least two directors in order to be registered.

Having established a platform for success, the BVI’s future as an offshore financial centre and hedge fund domicile hinges on how effectively it aligns itself to the international response to the financial crisis.

The first priority is dealing with moves by some onshore governments to stifle offshore centres. For example, US senator Carl Levin has re-introduced his 2007 Stop Tax Haven Abuse Act, originally co-sponsored with then senator Barack Obama. If passed as it now stands, this law would create a presumption that companies established by US persons in offshore financial centres like the BVI are taxable in the US.

Grey-listed
Following the G20 summit in London in April, the BVI also finds itself on the Organisation for Economic Co-operation and Development (OECD) grey list of 38 jurisdictions accused of failing to adequately implement international standards on tax transparency and the exchange of information. The list also includes the Cayman Islands, the Bahamas and Bermuda. These countries have until November to meet the benchmark of 12 tax information exchange agreements (TIEAs) set by the G20 or face possible sanctions.

Ralph O’Neal, the BVI premier, emphasises the BVI’s commitment to the OECD standards on transparency and the exchange of information, which it signed up to in 2002. The jurisdiction has three TIEAs in place with the US, the UK and Australia. O’Neal said his government would sign seven additional agreements with the Nordic countries on May 18. Negotiations with other OECD countries are close to conclusion and the BVI is on track to meet the G20 benchmark in the near future, according to O’Neal.

Finding an answer to shifting attitudes towards the regulation of hedge funds is likely to be a more complex issue. The G20 summit agreed to greater oversight and regulation of the hedge fund industry. The wheels are already in motion. In the US the Hedge Fund Transparency Act has been tabled. This would require US hedge fund managers to register with the Securities and Exchange Commission and disclose details of their activities to the regulator.

The move towards tougher, hands-on regulation and oversight of the hedge fund industry in onshore markets stands in stark contrast to the principles-based formula favoured by offshore jurisdictions like the BVI.

O’Neal said he expected onshore governments to recognise the robustness of regulation in the BVI and its willingness to exchange information on tax issues. “What we need now is for all jurisdictions to work together to ensure that there is a proper framework of global financial regulation which has to be based on a level playing field. The BVI stands ready to be part of the process to contribute to policy developments in this area,” O’Neal concludes.

Sherri Ortiz, chief operations officer at the BVI International Financial Centre (IFC), says the territory is prepared to accept new regulatory standards provided they do not compromise the quality of service provision in the jurisdiction. “The financial crisis will lead to significant changes in the way financial services business is conducted. Those that want to be a part of this business in the long term will have to sign up to that change. Resistance to change will be seen as an anomaly and the BVI does not see itself as part of the resistance,” she says.

The FSC remains committed to maintaining high standards. Penn says the requirement for BVI-based management companies to be licensed will remain in place despite some complaints from service providers that it stifles the flow of business to the jurisdiction. Local practitioners say the long expected Securities and Investment Business Act (SIBA), which is to be enacted this year, provides a platform to further enhance and expand the BVI’s regulatory framework.

According to Penn, SIBA will consolidate the regulatory requirements for conducting all types of securities and investment business in the BVI within one piece of legislation. At present only entities conducting business as funds and companies providing services to these entities are regulated under the Mutual Funds Act. SIBA will expand this to include all types of securities business carried out in the jurisdiction, including dealing and the provision of investment advice.

The Mutual Funds Act will be rolled into SIBA to avoid replication of regulation. SIBA will beef up some of the requirements for BVI-domiciled hedge funds. This is expected to include a requirement for BVI funds to be audited. Local funds will also have to file an annual report with the regulator detailing key information about their activities.

There was some concern that the law might detract from the proven formula of the Mutual Funds Act. Penn says the regulator was aware of this concern. “The effect on existing funds and service providers will likely be minimal as we have tried to maintain the status quo,” he says. Additional requirements being introduced in SIBA are in line with the paradigm shift in global attitudes towards regulation.

SIBA is currently under consultation. Those in the financial sector say they are comfortable with the proposed provisions of SIBA and say it gives the BVI an opportunity to respond to broader changes in the regulatory landscape.

While the future remains uncertain, local financial services professionals are quietly optimistic about long-term prospects. They believe the jurisdiction’s legislative framework and robust regulations remain attractive to hedge funds and others seeking an offshore base.

Mark Chapman, managing partner of Deloitte in the BVI, believes the jurisdiction is ideally placed to benefit from the recovery of the hedge fund industry in 2009. “The BVI offers managers the ability to quickly and economically form new hedge funds. There are a lot of very talented people looking to take advantage of the opportunities in the market. The hedge fund industry will see a lot of new entrants this year and the BVI is an ideal jurisdiction for these managers to establish their fund structures,” he says.

Ortiz says the jurisdiction is also attracting interest from hedge funds in emerging markets, particularly Latin America and India. The BVI has been a preferred domicile for Brazilian hedge fund managers for some time and Ortiz says business flows from India are also growing steadily.

Looking east
The IFC recently returned from a business trip to India where Ortiz says she received positive feedback from private-sector companies in Mumbai and Delhi. There are also plans to have the Indian regulator recognise the BVI as an approved jurisdiction for Indian companies.

Ortiz says efforts to build the profile of the BVI in Latin America and India are part of the IFC’s strategy to diversify business flows. This is borne out of a recognition that the centres of economic activity are shifting. “While wealth is still largely concentrated in the west, we believe business activity and wealth creation will increase exponentially in the east and south in places like India and Latin America,” she explains. The BVI is actively positioning itself to cater to this growth, she adds.

BVI government upbeat following UK review

In March 2009 Michael Foot, head of the UK government’s independent review of British offshore financial centres, visited the BVI to discuss a variety of concerns to the UK government.

Announced by the UK government in November 2008 as part of its annual budget review, the Foot review was aimed at identifying “current and future risks in financial supervision, transparency and taxation” and assessing the impact of offshore centres on financial stability.

Issues being explored include how these centres are managing the effects of the economic downturn; what opportunities are likely to arise as global markets recover; whether more should be done to strengthen regulatory co-operation and the sharing of technical expertise, particularly between local regulators and the UK’s Financial Services Authority; the mechanisms available for responding to major economic shocks and the implementation of new international standards of regulation and information exchange.

In the current political (and financial) climate, the report could have major implications.

But if the BVI government is nervous about the results, its political leaders are not showing it. At a press conference at the end of the Foot visit, Ralph O’Neal, BVI premier and finance minister, said the BVI was a “model financial centre”.

He said the jurisdiction was in full compliance with all existing standards on financial regulation and international co-operation. This has been recognised by the UK and Australian governments in past reviews of the BVI, he added.

Foot said the UK recognised the important role of offshore financial centres like the BVI in the capital markets and acknowledged to some extent the need for a level playing field.

“My report will be making clear that while it deals with just nine jurisdictions [the overseas territories of the UK], you cannot look at that subset alone. You have to look at the likes of Switzerland, Singapore, Luxembourg and others because they are the international comparison,” Foot said.

The main concern among offshore jurisdictions like the BVI is that they could be subject to the same requirements as onshore financial centres.

BVI overhauls AML rules

The BVI introduced its anti-money laundering (AML) legislation in 1999, one of the first offshore jurisdictions to do so. The AML law is complemented by specific rules on know-your-customer (KYC) due diligence. This is an area the BVI takes seriously.

The AML rules have been reinforced through the issuance of codes of conduct. In 2008 the Financial Services Commission (FSC) issued the Anti-Money Laundering and Terrorist Financing Code of Practice and the Non-Financial Business (Designation) Notice.

In February 2009 the FSC made significant changes to this code of practice. The amendments included provisions that allow BVI funds to outsource AML compliance, including the money reporting officer function, to administrators or other functionaries in recognised jurisdictions.

The FSC also produced a list of countries and territories it acknowledges as “recognised jurisdictions” equivalent to the BVI for AML. The FSC said a non-BVI overseas administrator in a recognised jurisdiction observing its local AML/KYC regime for a BVI fund is compatible with the fund’s own obligations under the code.

New obligations in the amended code of practice include the requirement for a BVI fund to have written outsourcing agreements in place with administrators setting out how its AML compliance will be achieved.

Managers and administrators are also obliged to ensure adequate staff training on AML compliance and are required to have an independent audit function for KYC and AML compliance.

Recognised jurisdictions include Argentina, Aruba, Australia, Bahamas, Barbados, Bermuda, Belgium, Brazil, Canada, Cayman Islands, Chile, China, Cyprus, Denmark, Dubai, Finland, France, Germany, Gibraltar, Greece, Guernsey, Hong Kong, Iceland, Ireland, Isle of Man, Italy, Japan, Jersey, Luxembourg, Malta, Mauritius, Mexico, Netherlands, Netherlands Antilles, New Zealand, Norway, Panama, Portugal, Singapore, Spain, South Africa, Sweden, Switzerland, the UK and the US.