New Frontiers in Bankruptcy

The Cayman Islands are the hedge fund industry's Delaware, a welcoming home with business-friendly laws. That might be a problem for investors and creditors.

Investors in the two Bear Stearns hedge funds that collapsed after making bad bets on mortgage-backed securities could have a hard time getting their money back, Bloomberg reports. That's because the funds will liquidate under the jurisdiction of the Cayman Islands, where they were incorporated.

At the same time, the funds plan to use a 2005 U.S. bankruptcy law that protects their assets from lawsuits here while allowing U.S. bankruptcy judges to assist with liquidation in the Caymans.

Distributions to creditors would be ultimately handled by the Cayman court system, which is less transparent and more favorable to management than U.S. courts, says Jay Westbrook, a professor at University of Texas Law School in Austin who helped write the 2005 bankruptcy law.

The arrangement hasn't been tested before, and it could set a precedent for the thousands of hedge funds based in the Cayman Islands. It's estimated that three out of every four new funds register there, where the tax and regulatory systems favor corporate interests.

The Cayman government has also made it remarkably easy and cheap to incorporate there. It takes about two weeks and $35,000 to earn a brass plaque in the Caymans, according to the New York Times. That's about one-tenth of the cost to incorporate in Delaware, where most American companies file their papers. There are more than 8,500 funds registered in the Caribbean jurisdiction.

In recent months, U.S. legislators have openly criticized tax structure and offshore status of much of the hedge fund industry. Tax-exempt American organizations like pension plans and endowments can invest in Cayman-based funds and avoid income taxes that they would otherwise have to pay if they were invested in domestic funds.

Hedge funds and their investors have so far adamantly opposed any additional regulation from U.S. agencies. But if more funds join the ill-fated Bear ones in the bankruptcy abyss, some investors may become more willing to write a check to Uncle Sam in exchange for the right to fight for their money in court.

by Megan Barnett