Administration & Custody: Starting up - Where, How and Why?

Good morning ladies and gentlemen.

The subject that I have been asked to talk about today is:

"Administration and Custody, Starting up: Where, How and Why",
with three sub texts:

The first question that people ask when setting up a fund, is "Where should I set it up - which jurisdiction?" Unfortunately, that immediately begs several other questions, which include: What type of fund is the proposed fund to be? and "Who are the targeted investors going to be?"

 

Let us first consider why anyone would want to set up an offshore fund in the first place. There are, I think two primary considerations. The first is tax efficiency, both for the investors and, for that matter, for the fund manager, who can often achieve a tax deferral by delaying acceptance and recognition of management and incentive fees. The second consideration has, historically, been the fund manger's desire to try and avoid the hassle of over-aggressive domestic regulation.

 

It used to be easy - take a flight to one of the Islands in the Sun, where few people could spell "regulation" and no one knew what the word "taxation" meant. Walk into a bank, a trust company or a lawyer and you had your package before lunch. It is not so easy today. Tax efficiency is still available and relatively easily arranged, but regulation has now been introduced, to a greater or lesser extent, in all the main Caribbean jurisdictions.

 

Let us step back a second and consider the subject of regulation. However much traders and fund managers may want to get away from domestic regulatory hassle, there is no doubt that all investors want some regulation, or at least, - some protection, which is not necessarily the same thing - in place, so that their primary risk, indeed hopefully their only risk, is limited to the market risk. But I am getting slightly ahead of myself.

 

We are, at this conference, discussing Hedge Funds. Although, I do not know the exact figures, Hedge Funds are, predominantly, an Atlantic Zone investment product. I suspect that 75% or 80% of all Hedge Funds in the world are US based and that 50% of the balance would be European based, (which, I respectfully suggest for the purposes of this talk, should include the United Kingdom, regardless of the political persuasions of some of you here today). Because these funds are managed by managers who live predominantly in what I call the "Atlantic Zone", most Hedge Funds are established in the North Atlantic and Europe, and it is these jurisdictions that I will be talking about today.

 

There are in my opinion three groups of jurisdictions in the Atlantic Zone:

 

 

Firstly, the Caribbean, which includes the Bahamas, the British Virgin Islands and the Cayman Islands. Each of the primary centres of these territories has introduced some mutual fund legislation over the past few years and, on the whole, it is quite effective. But it is not overly intrusive and, although compliance is essential, it is not like working under the predatory eye of the SFA or FSA, or whatever it is called today, or the CFTC, or the SEC. The second group includes Bermuda, the Channel Islands and the Isle of Man. Each of these territories have stronger regulations than the Caribbean Islands, but still fall short of the two European centers - Dublin and Luxembourg, which comprise the third group. In these two jurisdictions, regulation is very strong, reflecting the standards set by the European Union - and I will pause here, while some of you say, "God help us all" at the very thought of any European Union regulations.

 

What can be seen, is that, as you move eastwards across the Atlantic, you climb up the regulatory curve, from reasonably flexible and relatively non-intrusive regulation in the Caribbean through tighter, more demanding regulation in Bermuda and the Channel Islands, up to the full weight of European regulations. And of course it will come as no surprise to learn that as you move east up the regulatory curve, you also climb the cost curve, both in terms of organisational costs and, in fact, on-going operational costs and the time curve - what may take only four weeks in the Caribbean, can take four to six months in Europe.

It is my opinion - and I must stress that the choice of a jurisdiction is not based on an exact science, it is based on personal preferences and prejudices - therefore, I repeat that it is my opinion, that for most Hedge Funds, there is little point in considering the second group. They are neither "fish nor fowl." If you believe that you or your investors are going to require more regulation than the Caribbean offers, then go the whole way and set up in Dublin or Luxembourg.

 

This is where the Target Investor comes into the equation. It goes without saying that if you are considering a retail fund, you must - and I repeat "must" - go for the strongest regulation you can get - not because it will necessarily buy more protection for the investor, but because, if anything does go wrong and things go wrong all the time, you must be able to show that you went "the extra mile" in protecting the investor. If you don't and something does go wrong and you end up in court, you are likely to lose regardless - remember the investor, and, especially the retail investor, starts with a huge advantage - he is the innocent underdog - you are a ruthless, skillful rich, manipulator - you must be, after all, you are that pariah - a "Hedge Fund Manager".

 

Having said that, this discussion, is about Hedge Funds and those Hedge Funds will be, I presume, targeted at professional, institutional and sophisticated investors, who are presumed to be able to understand the risks involved and, what is more, accept those risks. It is perhaps ironic that these investors, the professional, institutional and sophisticated investors, are much more cost conscience than the average retail investor. Perhaps that is because the retail investor rarely has the opportunity to work out what the costs really are. Nevertheless, I suspect that, in the light of their cost conscious attitude, many of these professional, institutional and sophisticated investors question, as I did a few minutes ago, whether regulation actually equates to investor protection and, therefore, whether the cost of complying with such regulation is value for money.

 

Of course, the word on everyone's lips in this industry today is "Manhattan" - a British Virgin Islands domiciled fund, which was administered and audited out of Bermuda, but managed out of New York and has apparently loss over 90% of its assets, having reported consistent audited profits of circa 20% p.a. for the past few years. And the question that is on nearly everyone's lips is, "Would whatever happened, still have happened if Manhattan had been domiciled in a more highly regulated center, such as Dublin or Luxembourg,?" And, of course, one cannot answer the question - only speculate. Having said that, one experienced member of the Hedge Fund community said to me in New York last week, that, if the fund has been highly regulated, the odds are that even more money would have been lost, because many more investors would have been tempted by the so-called protection that regulation is perceived to provide.

 

This perception is of course a fallacy. We should not forget that the vast majority of financial scandals over the past ten or fifteen years all took place under the noses of the regulators and in highly regulated centres, including London and New York. Who here cannot recall: Sumitomo; Barings; Kidder Peabody; Diawa; BCCI; Morgan Grenfell; Maxwell; and the odious Roger Levitt?

 

I am not sure what this proves, except that there is very little that anyone can do to stop a dedicated crook and especially one with a financial death wish, which would appear to be the case with many fraudsters. They almost never seem to run off with the money - they just wait to be caught. And what is the penalty of regulation once they have been caught? Several million pounds of public money is spent in court and, if the perpetrator is eventually found guilty, (which often is not the case, because the jury cannot - indeed cannot be expected to - understand the complex financial issues involved) he probably will end up mowing the lawns in Ford Open Prison.

 

The point I am making is that, in my experience, most professional investors in Hedge and Alternative Investment Funds are more concerned with doing their due diligence on the investment manager than they are with the regulatory supervision of the fund. And it is only when the investor has made that leap of faith and decided to place money with the manager, that he will study the fund - after all if he does not like the manager, it would not matter if the fund was set up in Fort Knox.

 

As I said, having made that decision, the professional investor will study the offering memorandum and see who is involved and what restrictions and other terms and conditions apply. The investor will, or should, carry out a full in depth due diligence on the administrator, review the agreements, ensure that there is independent third party pricing- all those obvious things, we all know should be done. The investor should also check the standing and expertise of the custodian or prime broker and find out who is the auditor.

 

If all of this pans out, and the investor is comfortable with the parties involved and with the offering memorandum, or prospectus, which we should remember, is a contract between the investor, the service providers and the manager, then I suggest that for most investors the actual domicile is almost of minor consequence.

 

We, at Custom House, have set up multi-manager funds in the British Virgin Islands for both Credit Suisse Asset Management and American Express Bank, both of whom are jealously protective of their reputations. And I have never heard of anyone refusing to buy into Haussman or Quantum because they are Caribbean funds. So I don't think that the past reputation that these jurisdictions may have had, that they are somehow "dodgy" applies any longer.

 

If you now accept that the Caribbean may be the best choice of jurisdiction, from a regulatory point of view, you must now decide which of the three main jurisdictions you should choose. Again, this is often a personal choice based on prejudice and perceptions. I know one UK lawyer, who may even be in the audience today - he is certainly speaking later - who would no more dream of setting up a fund in the British Virgin Islands, than he would bungee-jump off the London Eye. Nevertheless, we, at Custom House, have set up many - by which I mean a hundred or so - perfectly satisfactory offshore hedge and alternative investment funds in the British Virgin Islands.

 

 

Because we have established a very efficient "machine" - in the form of associations with a local law firm and a local trust company that acts as agent. Also costs come into it. We can set up a simple British Virgin Islands fund for about US$15,000 whereas the Bahamas and the Cayman Islands costs around US$20,000, but that sort of difference is not almost immaterial in the context of the US$20 or US$50 million fund. But we are not overly prejudiced in favour of the BVI. We have also set up several Cayman Islands funds, because the clients wanted it and the customer is often (not always) right. And we have set up and act for both Bahamian and Bermudan funds. But, in this ever-changing world, I believe that sentiment is changing and many people are today leaning towards the Bahamas as their jurisdiction of choice.

Why should this be happening?

 

The answer takes us back to our primary consideration - tax. We have all heard of the moves within the European Union, to introduce tax harmonisation and withholding tax on some investment income. As the Market membership grows and, inevitably, the per capita income in the EU falls, this could have a negative effect on Dublin and Luxembourg, in the context of the offshore fund industry. As the EU commission grows more powerful the pressure for tax harmonisation from the EU will also grow. The thirst for tax dollars, not only to sustain the commissioners profligate life style - but also to fund members pension requirements, will accelerate. Therefore, it is possible that zero tax funds in Dublin and Luxembourg will be squeezed out. I personally don't think that that is likely - what I believe is more likely, is that share registers may have to be opened up for inspection by the tax authorities in Dublin or Luxembourg, which would be like putting the data on an "Inter-Tax" Reuters. After all no tax official understands the words "discretion" or "confidentiality".

 

How will this effect non-European jurisdictions?

 

We have all read about the OECD initiative, if that is the right word, targeting "tax havens". And, furthermore, we have already seen the first rumblings in the UK, with Tony Blair and Robin Cook's guidelines, concerning the disclosure that the UK is demanding from the Channel Islands, and what used to be called, the "Dependent Territories", but which I would call the "Vulnerable Territories". These include the Channel Islands, the Isle of Man, as well as Bermuda, the British Virgin Islands and the Cayman Islands. You will note that I have not included the Bahamas in that list because, whereas the British Government can bring pressure to bear on the Channel Islands and the Isle of Man and the Dependent Territories, the Bahamas are an independent nation and have been independent for a quarter of a century. They can tell Tony Blair to go and play in his dome and leave them alone. What is more the Bahamas has very strong confidentiality regulations, which are subject to criminal penalty for those who infringe them. At the same time they have strong anti-money laundering regulations and a good regulatory system, which is being updated, but is nevertheless business friendly.

 

In my opinion, the Bahamas take the anti-money laundering legislation very seriously, and it is my understanding that in the near future there will be a headline case, where an example will be made. Having said that, there is of course the spectre of the "All Crimes" anti-money laundering regulations, which has been introduced basically by the United States, quite obviously as a tax gathering exercise, more than an anti-crime exercise. I think it is fair to say that, in the United States today, there is little or no difference between tax avoidance and tax evasion - the IRS just deem any tax avoidance to be abusive and, et ergo, it becomes tax evasion and, therefore, it becomes criminal. Having said all that, there is a requirement under treaties invoicing crime, that the crime in question has to be deemed to be a crime in both jurisdictions.

 

The Bahamas do not consider themselves to be a tax haven, because no one pays any tax in the Bahamas. They do not treat anybody who comes to the Bahamas differently to anybody that lives in the Bahamas. The Bell Boy in your Paradise Island Hotel does not pay any tax. Therefore, avoidance, or evasion of tax is not a factor in the Bahamas. After all you cannot avoid or evade something that does not exist. Therefore, the All Crimes regulations will not include tax matters in the Bahamas and that could prove a considerable attraction to the international investor.

I know that the Cayman Islands, Bermuda and the British Virgin Islands would all take the same stance, but they are not independent and therefore, they are subject to pressure from Westminster, until they become independent.

 

This is a matter that could be discussed for hours and hours, but in summary I think that it is very possible that the Bahamas may become, once again, as it was many years ago, the offshore jurisdiction of choice. It must be said that when I was in the British Virgin Islands, meeting with the BVI Mutual Funds Registrar last week, I asked him point blank what he thought of this theory and he said "It will never happen" - but he would say that wouldn't he?

 

Of course, I don't know what will happen - but if people get nervous or frightened, then I believe they will head for Nassau.

 

I realise now that I have not said anything about custody. I think that it is sufficient to say that all investors will, or, again, should, look for a strong custodial arrangement to be in place in the fund. Traditionally the custodian would be a bank, but with Hedge Funds, that sell short or trade on a leveraged basis, it is now the norm that the prime broker acts as the custodian, because the Hedge Fund is usually required to leave all, or the lion's share of its assets with the prime broker, as collateral for its short or margined positions.

 

This can cause problems in the context of trying to get a Hedge Fund listed on The Irish Stock Exchange, let alone establishing such a fund in Ireland or Luxembourg. Both the Irish Stock Exchange and the Financial Regulator, (formerly the Central Bank of Ireland) of Ireland have issued new guidelines in this regard, which has substantially clarified the situation, if not entirely resolved the problem. Suffice it to say that, if you are going to use a prime broker, you should use one that is extremely well capitalised and you should remember and make it clear to investors that for the most part, prime brokers are a counterparty to the fund and a principal to many of the contracts entered into by the fund. As such, the prime brokers have a definite and clear conflict with regard to their custodial responsibilities. Although it may not please the prime brokers, managers of Hedge Funds should consider the manner in which the fund's assets are held, and in this regard, I would suggest either using a cash manager, if possible, or entering into an agreement with the prime broker to ensure not only that any assets, surplus to their margining or collateral requirements, are held in a true custodial account and are not at risk in the event of anything disastrous happening to the prime broker, but also that any cash assets are properly managed.

 

This is an example of one thing that has already come out of the Manhattan debacle - an increased demand from investors for genuine transparency - not only in terms of trading activity, but also in terms of administrative and custodial arrangements of the fund and what we could perhaps describe as "collateral risk management".

Thank you very much.