History of the Regulations

The Mutual Funds Law (the "MF Law") first enacted in 1993, provides for the regulation of open-ended mutual funds and mutual fund administrators. Closed-end funds are not subject to regulation under the MF Law. Responsibility for regulation under the MF Law rests with the Cayman Island Monetary Authority ("CIMA") (which also supervises banks, trust companies, insurance companies and company managers), a statutory government body established under the Monetary Authority Law.

> For purposes of the MF Law, a mutual fund is any company, trust or partnership either incorporated or established in the Cayman Islands, or if outside the Cayman Islands, managed from the Cayman Islands, which issues equity interests redeemable at the option of the investor, the purpose or effect of which is the pooling of investors funds with the aim of spreading investment risk and enabling investors to receive profits or gains from investments. Exempted from regulation is any mutual fund where the equity interests are held by not more than fifteen investors who by majority are capable of appointing and removing the directors, the trustee or the general partner of the mutual fund (as the case may be). As at 6th January, 2004, there were approximately 4,820 active regulated open-ended mutual funds, of which, about 48 were "licensed" mutual funds.

Prior to 1st December, 1998, mutual funds incorporated or established in the Cayman Islands could not be offered to the public in Japan because the Cayman Islands were not a member of the Organisation for Economic Co-operation and Development ("OECD"). However, on 1st December, 1998, the requirements in Japan changed so that a member of the Japan Securities Dealers Association (the "JSDA") could sell a Cayman Islands mutual fund publicly in Japan subject, inter alia, to certain requirements of the JSDA's Rules concerning Foreign Securities Transactions (the "JSDA Rules") being met by the Cayman Islands.These included that:

a) the laws and regulations as to the overall system of foreign investment fund securities ("FIFS") are well provided;
b) the law and regulations, etc. as to disclosure for FIFS are well provided;
c) there is a supervisory authority or similar agency which supervises the issuers of the FIFS; and
d) remittance and receipt of funds for purchase, sale, distribution and so forth in respect of FIFS is possible.

As the JSDA Rules do not specify with sufficient clarity the extent of the laws and regulations in the local jurisdiction, there was debate in Japan as to whether the Cayman Islands complied. Some JSDA members took the view that the applicable Cayman Islands legal and regulatory regime did meet the requirements of the JSDA Rules. In fact, according to the JSDA's own statistics, 23 Cayman Islands mutual funds had been approved for public sale in Japan as at August 2002. However, there were other JSDA members who took a contrary view, preferring instead to market to the public in Japan mutual funds established in other offshore jurisdictions.

Following a lengthy period of consultation with leading law firms and financial institutions in Tokyo, the Retail Mutual Funds (Japan) Regulations, 2003 (the "Regulations") were introduced in the Cayman Islands on 17th November, 2003. The Regulations provide a new regulatory regime for Cayman Islands mutual funds that are sold to the public in Japan and should now resolve the debate as to whether the applicable Cayman Islands legal and regulatory regime offers sufficient protection for the Japanese retail investor.

Overview of the Regulations

Application

The Regulations apply to any trust, partnership or company any of "whose securities have been or are intended to be offered to the public in Japan" which are defined in the Regulations as "retail mutual funds". There are two specific exemptions. The first exemption is for a mutual fund which issues its securities to Japanese qualified institutional investors as that expression is defined in the Securities and Exchange Law of Japan, and in the relevant Japanese Ordinance of Cabinet Office. The second exemption is a grandfathering provision which applies to any retail mutual fund in existence as at the date the Regulations were introduced, and to any sub fund or sub trust of any such grandfathered retail mutual fund, unless it decides to comply with the Regulations. Although not specifically exempted, it is clear that the Regulations do not apply to Cayman Islands funds that are offered to Japanese investors on a private placement basis.

The Regulations operate by requiring a new retail mutual fund to make application to CIMA for a mutual fund licence. The licence will be issued subject to such conditions as CIMA considers appropriate and one of the conditions will be that the retail mutual fund must conduct its business in accordance with the Regulations. This establishes the regulatory nexus between CIMA and the retail mutual fund through the trustee of the fund, the directors if it is a company, or the general partner if it is a limited partnership.

Constitution

The Regulations require that a retail mutual fund's constitution, which would be the trust deed in the case of a unit trust, include provisions for the following matters:

• the rights and restrictions attaching to the retail mutual fund's securities;
• the terms for valuation of its assets and liabilities;
• the manner of calculating the net asset value and the issue and redemption prices of its securities;
• the terms on which the retail mutual fund's securities are issued including the terms and circumstances, if any, upon which the rights and restrictions attaching to the securities may be changed;
• the terms on which its securities may be transferred or converted;
• the terms on which the retail mutual fund's securities may be redeemed or such redemption suspended; and
• the appointment of an auditor.

The administrator

The Regulations require that a retail mutual fund appoint and maintain an administrator approved by CIMA pursuant to the MF Law. Written notice of any proposed change in the appointment of an administrator must be given to CIMA, the retail mutual fund's investors and its other service providers at least one month before the change. A retail mutual fund may not make a change in the appointment of an administrator without the prior approval of CIMA.

Regulation 13(1) sets out various functions that are to be performed by the administrator. These include ensuring that:

• the issue, transfer, conversion and redemption or repurchase of the retail mutual fund's securities are carried out in accordance with the constitution of the retail mutual fund, the prospectus and all applicable laws;
• the calculation of the net asset value of the securities and their issue, conversion and redemption or repurchase prices are calculated in accordance with the constitution of the retail mutual fund, the prospectus and made available to investors or potential investors;
• all necessary office facilities, equipment and personnel are available to enable the administrator to carry out its functions;
• periodic reports are prepared for investors in such form, subject to the Regulations, the Companies Law (2003 Revision) and the MF Law, as the operator of the retail mutual fund may agree. The operator is the trustee in the case of a unit trust, the directors in the case of a company or the general partner in the case of a limited partnership;
• the accounts of the retail mutual fund are maintained in good order;
• except where the administrator is maintaining the register of investors, that the procedures of the registrar and instructions given to the registrar relating to the maintenance of the register are effectively monitored;
• except where a separate registrar is appointed, that the register of investors required by the constitution of the retail mutual is maintained; and
• the distribution to the investors of all dividends or other distributions which may from time to time be declared are paid by the retail mutual fund on its securities.

In addition, the administrator must keep a copy of the register of investors available for inspection by investors during normal business hours, prepare or ensure that certificates for securities of the retail mutual fund are prepared, ensure that such certificates are issued or cancelled, provide or ensure the provision of facilities for the replacement of certificates or transfer of securities of the retail mutual fund and must make available on request without charge the most recent issue and redemption or repurchase prices of securities of the retail mutual fund.

When requested by the retail mutual fund's custodian, the administrator must provide the custodian with copies of records and information relating to various matters. These include the receipt of subscription monies, the issue and redemption of the retail mutual fund's securities, the application of all capital and income of the retail mutual fund and the calculation of the net asset value and issue and redemption prices.

Regulation 7 introduces an entirely new duty imposed only on the administrator, which is to advise CIMA forthwith upon it becoming aware that some or all of the retail mutual fund's assets have not been invested in accordance with the investment objectives and restrictions contained in the prospectus, or to notify CIMA forthwith if an operator of the retail mutual fund or its investment adviser is not conducting the business affairs of the retail mutual fund materially in accordance with the provisions of the constitution or the prospectus. This will obviously involve some careful consideration of Administrators' service agreements and appropriate exculpations should be included in the documentation to authorise disclosures.

An administrator must also notify CIMA in writing of any suspension of subscriptions or redemptions in respect of the retail mutual fund and the reasons for such suspension and any intention to liquidate the retail mutual fund and the reasons for such liquidation.

Subject as may be provided in the constitution and the prospectus of a retail mutual fund, an administrator may delegate any or all of its functions or duties to any person incorporated or otherwise lawfully carrying on business in the Cayman Islands or in a jurisdiction included in the list of jurisdiction in Schedule 3 to the Money Laundering Regulations (2003 Revision) of the Cayman Islands (a "Schedule 3 territory"). However, the administrator will remain responsible for the performance of any function or duty so delegated. The administrator must give prior notification of the delegation to CIMA and immediate notice upon delegation to the operator, the other service providers and to the investors.

The Schedule 3 territories are those that have been approved by the Financial Action Task Force and the Cayman Islands as having an appropriate level of anti-money laundering legislation. The Schedule 3 territories include all of the major OECD member states such as Japan and also Hong Kong which can therefore be satisfactory locations for services providers to a retail mutual fund subject to local tax and regulatory advice.

The custodian or prime broker

A retail mutual fund must appoint and maintain a custodian (or prime broker) which is regulated in the Cayman Islands, a Schedule 3 territory or any other jurisdiction approved by CIMA. A retail mutual fund must give CIMA, the investors and the other service providers of the retail mutual fund at least one month's prior notice in writing of any change to the custodian.

The Regulations set out the functions of the appointed custodian which are to provide for the safekeeping of certificates and documents of title relating to investments of the retail mutual fund and to carry out the instructions of the administrator, investment adviser and operator in relation to any investments, unless those instructions conflict with the retail mutual fund's constitution, the prospectus, the subscription agreement or applicable laws and regulations.

Subject to anyprovisions of the retail mutual fund's constitution or prospectus to the contrary, the custodian may appoint a sub-custodian and the custodian must exercise reasonable skill, care and diligence in the selection of a suitable sub-custodian. The custodian must give one month's notice in writing of any delegation of its obligations to a sub-custodian to other service providers. The custodian is responsible for ensuring, on a continuing basis, the suitability of the sub-custodian to provide custodial services and must maintain an appropriate level of supervision of each sub-custodian and make periodic enquiries to confirm that each sub-custodian continues to competently discharge its obligations.

The investment adviser

A retail mutual fund must appoint and maintain an investment adviser that is incorporated in or otherwise lawfully carrying on business in the Cayman Islands, a Schedule 3 territory or any other jurisdiction approved by CIMA. An investment adviser is widely defined in the Regulations and includes any person appointed to render investment advice or investment management services or both. Any change to the investment adviser must be notified in writing to CIMA, the investors and the other service providers of the retail mutual fund one month prior to the change. An investment adviser may not make any change to the membership of its board of directors without the prior approval of CIMA or of a majority in value of the investors of each retail mutual fund it manages.

Regulation 21 requires, as a condition of obtaining a mutual fund licence under the MF Law, that certain functions must be included in the contract appointing the investment adviser. These functions include:

• ensuring that the subscription monies received by the retail mutual fund are applied in accordance with its prospectus and its constitution;
• ensuring that on the sale of any assets of the retail mutual fund the net proceeds are remitted to the custodian within reasonable time limits;
• ensuring that the income of the retail mutual fund is applied as required in its prospectus and constitution;
• ensuring that the investment of the assets of the retail mutual fund is in accordance with its investment objectives and within its investment restrictions; and
• providing in reasonable time such information and instructions as may be required to enable the custodian or any sub-custodian to perform its contractual obligations in respect of the retail mutual fund.

In addition, the investment adviser must deposit with or to the order of the custodian or any sub-custodian all certificates or documents of title to the investments of the retail mutual fund and must establish or monitor procedures for the holding of investments of the retail mutual fund by the custodian or any sub-custodian.

Regulation 21(4) specifies functions that an investment adviser must not undertake. Thus the investment adviser must not:

• enter into any transactions with itself or any of its directors as principal;
• enter into any transactions which are intended to benefit the investment adviser or any party other than the retail mutual fund;
• acquire the shares of any one company if as a result of such acquisition the total number of shares of such company held by all mutual funds managed by the investment adviser would exceed 50 per cent. of the total number of all issued and outstanding shares of such company;
• acquire the shares of any one company if as a result of such acquisition, the total number of shares of such company held by the retail mutual fund would exceed 10 per cent. of the total number of all issued and outstanding shares of such company; or
• acquire any investment which is not listed on an exchange or which is not readily realisable if as a result thereof the total value of such investments held by the retail mutual fund would immediately following such acquisition exceed 15 per cent. of the value of its net assets.

Importantly, there are no other specific restrictions on investment, trading or objectives. Extensive consultation with investment managers led to the conclusion that specific limitations on short sales, gearing or other derivative positions could be counter productive in terms of effective risk management of the assets of a retail mutual fund.

It should be noted that a breach by the investment adviser of any of the aforesaid restrictions is a matter that should be reported to CIMA by the administrator under Regulation 7.

The investment adviser may appoint a sub-adviser as it thinks fit to carry out on its behalf any or all of its obligations but will remain responsible to the retail mutual fund for the performance of any function so delegated. Any appointment of a sub-adviser must be notified in advance to other service providers, the operator and CIMA.

Financial reports

Part VI of the Regulations is devoted to financial reports of the retail mutual fund. A retail mutual fund must within six months of the end of each financial year prepare a financial report containing audited financial statements which must be distributed to investors in accordance with the MF Law. Interim financial statements need only be prepared and distributed in a manner represented to investors in the retail mutual fund's prospectus.

All relevant financial information that is distributed to investors and financial information used to determine the net asset value must be prepared in accordance with the generally accepted accounting principles specified in the prospectus. The relevant accounting principles must be selected by the operator of the mutual fund after considering the requirements of any relevant securities regulator, the jurisdiction of the investors, the jurisdictions in which the sponsor, promoter and investment adviser are located and the proposed business of the retail mutual fund and the nature of its proposed investments.

Regulation 26 sets out certain minimum information to be included in a retail mutual fund's audited financial statements, including details relating to the retail mutual fund's assets and liabilities, its income and expenses, material changes in net assets and financial position and any significant accounting policies.

Audit

A retail mutual fund must appoint and maintain an auditor. Any change to the appointment of the auditor must be notified by at least one month's notice in writing to CIMA, investors and other service providers. A change in auditor requires the prior consent of CIMA.

A retail mutual fund must not publish or distribute any report of the auditor in respect of a retail mutual fund without first receiving the written consent of the auditor. An auditor may use the generally accepted auditing standards of a jurisdiction other than the Cayman Islands and in such a case the report of the auditor will disclose this fact and name the jurisdiction. An auditor must be independent of the operator of the retail mutual fund and the other service providers of the retail mutual fund.

In addition, the auditor must be a CIMA approved auditor with a physical presence in the Cayman Islands. This policy does not however require that all of the audit work is carried out in the Cayman Islands or carried out solely by the approved auditor of record. However, a Cayman Islands firm of auditors must sign off the audited accounts and their written consent to the appointment must be filed at the time of the initial application for a mutual fund licence.

Regulatory reporting
Regulations 9 and 10 provide for periodic reporting to CIMA. Under Regulation 9, an operator of a retail fund must submit or cause to be submitted to CIMA within 20 days after the end of the six month period following the end of each financial year, a written report on the activities of the retail mutual fund which must contain various details relating to the net asset value and the net asset value of each security, the percentage change in the net asset value and of each security from the previous reporting period, the number and value of new subscriptions and redemptions in the relevant reporting period and the total number of securities in issue at the end of the reporting period.

In addition, the operator of a retail mutual fund must submit to CIMA annually a declaration confirming that to the best of the knowledge and belief of the operator the retail mutual fund's investment guidelines, restrictions and constitution have been complied with and that the retail mutual fund has not operated in a manner prejudicial to investors or creditors.

The prospectus

Part VIII of the Regulations set out minimum disclosure requirements for the prospectus of a retail mutual fund. The prospectus must be filed with CIMA in accordance with Section 4(1) of the MF Law. Any material change to the prospectus must be filed with CIMA. The prospectus of a retail mutual fund must be available without charge from the registered office of the retail mutual fund or from the office of one of the service providers in the Cayman Islands.

In addition to the requirements of the MF Law, Regulation 37 sets out the minimum disclosure requirements for the prospectus of a retail mutual fund, which must include the following details:

• the name of the retail mutual fund, and in the case of a company or partnership, the address of its registered office in the Cayman Islands;
• the date of incorporation or establishment of the retail mutual fund (indicating whether or not the duration is limited);
• a statement of the place where copies of the constitution and any annual or periodic reports may be inspected and obtained;
• the date of the financial year end of the retail mutual fund;
• the name and address of the auditor;
• the administrator, including the name of the administrator and the address of its registered or principal business office or both;
• the custodian and any sub-custodian, including the name of the custodian and sub-custodian (if any) and the address of their registered or principal business offices or both, and the main business activity of the custodian and any sub-custodian;
• the investment adviser, including the name of any and all directors of the investment adviser, details of their experience and the addresses of the investment adviser's registered or principal business office or both, and the material provisions of any contract engaging the service of any and all investment advisers;
• the names and business addresses of the directors and officers, registrar, legal adviser, and other persons (if any) having significant involvement in the affairs of the retail mutual fund;
• details of the authorised and issued capital of the retail mutual fund which is a mutual fund company including, where applicable, any existing initial, founder or management shares;
• details of the principal rights and restrictions attaching to the securities, including with respect to currency, voting rights, circumstances of winding up or dissolution, certificates, entry in registers and other similar details;
• where applicable, an indication of stock exchanges or markets where the securities of the retail mutual fund are, or are to be, listed or dealt in;
• the procedures and conditions for the issue and sale of securities;
• the procedures and conditions for the redemption or repurchase of securities and the circumstances in which such redemption or repurchase may be suspended;
• a description of the intentions with respect to the declaration of dividends or distributions on the securities of the retail mutual fund;
• a description of the retail mutual fund's investment objectives, investment policy and any limitations on that investment policy, a description of the retail mutual fund's material risks and an indication of any techniques and instruments or borrowing powers which may be used;
• a description of the rules applicable to valuation of the retail mutual fund's assets;
• a description of the rules applicable to the determination of issue and redemption or repurchase prices (including the frequency of dealings) and the places where information as to the prices may be obtained;
• information concerning the manner, amount and calculation of remuneration to be paid to the operator, the administrator, investment adviser, custodian and any other service providers receiving or likely to receive fees from the retail mutual fund;
• a description of the potential conflicts of interest between the retail mutual fund, its operator and its service providers;
• a statement if the retail mutual fund is registered or licensed, as the case may require, (or intends to be registered or licensed) in any jurisdiction or with any supervisory or regulatory authority outside the Cayman Islands;
• the following statement:

"A MUTUAL FUND LICENCE ISSUED BY THE CAYMAN ISLANDS MONETARY AUTHORITY DOES NOT CONSTITUTE AN OBLIGATION OF THE AUTHORITY TO ANY INVESTOR AS TO THE PERFORMANCE OR CREDITWORTHINESS OF THE RETAIL MUTUAL FUND.

FURTHERMORE, IN ISSUING SUCH A LICENCE THE AUTHORITY SHALL NOT BE LIABLE FOR ANY LOSSES OR DEFAULT OF THE RETAIL MUTUAL FUND OR FOR THE CORRECTNESS OF ANY OPINIONS OR STATEMENTS EXPRESSED IN ANY PROSPECTUS.";

• details of the nature and frequency of financial reports to be distributed to investors;
• the generally accepted accounting principles to be adopted in preparing the retail mutual fund's financial statements; and
• the material provisions of any law or regulations of the Cayman Islands governing the investors' interest in the retail mutual fund.

Conclusion

The Regulations serve two very useful purposes. Firstly, they introduce a clear regulatory standard for an appropriate level of investor protection, providing additional security for public investment. Secondly, the consultation process has enabled a consensus to be developed amongst leading practitioners and institutions in Tokyo on the form and content of the Regulations and their suitability.

It is therefore hoped that the Regulations will change the profile of the Cayman Islands in Japan significantly. The Cayman Islands are the leading jurisdiction for hedge and mutual fund formation and in opening up the Cayman Islands investment fund marketplace, the enhanced returns available to investors from Cayman Islands investment products are now therefore fully available to the public in Japan.

This article was prepared by Spencer Privett, for the Eurekahedge Japan Compendium and the September issue of the AIMA Journal.