[co-author: Stanley Tiu, Registered foreign lawyer]

After a year of consultation with the mutual funds industry regarding changes that aim to modernise the regulatory regime for SFC-authorised funds, the Hong Kong Securities and Futures Commission (SFC) revised the Code on Unit Trusts and Mutual Funds (Revised UT Code), effective as of 1 January 2019. New funds with new managers and trustees/custodians that have not previously been vetted by the SFC must comply with the Revised UT Code from the effective date. Funds authorised (or seeking to be authorised) by the SFC with managers and trustees/custodians that have been vetted by the SFC benefit from a transition period until 1 January 2020 to arrange necessary operational and system changes. Foreign funds are within the scope of the Revised UT Code to the extent they are distributed in Hong Kong, although UCITS from certain jurisdictions are deemed to have generally complied in substance with a number of the Revised UT Code’s provisions.

This article provides a summary of key amendments under the Revised UT Code.

Investment Requirements

Derivatives Investments

Calculating Net Derivative Exposure

The Revised UT Code requires that a fund’s exposure to derivatives, expressed as a percentage of the fund’s total net asset value (Net Derivative Exposure) be calculated and monitored on a daily basis, as well as disclosed in the fund’s offering documents. The Net Derivative Exposure is tantamount to what managers previously referred to as the “commitment approach”, but with additional carve outs in its calculation as set out below. The full calculation methodology of the Net Derivative Exposure, as well as circumstances where the use of derivatives may be excluded from such calculation (Excluded Circumstances), are set out in the SFC’s Guide on the Use of Financial Derivative Instruments (FDIs) for Unit Trusts and Mutual Funds (FDI Guide).

In brief, a fund’s Net Derivative Exposure is calculated as the sum of: (a) the absolute value of the exposure of each individual FDI not falling within an Excluded Circumstance (defined below) and (b) the absolute value of the residual exposure of each individual FDI used, after netting, hedging or risk mitigation arrangements.

The Excluded Circumstances are: (a) netting, hedging or risk mitigation; (b) cash flow management; (c) market access or exposure replication; and (d) investment in conventional convertible bonds. As a general principle, an FDI that falls into the Excluded Circumstances: must be in line with the fund’s investment objectives and policies; may not create incremental leverage at the fund’s portfolio level; and may not materially change the fund’s overall risk profile. Further details as to what each Excluded Circumstance constitutes, as well as examples, are set out in the FDI Guide.

General Requirements Relating to the Use of FDIs

The Revised UT Code reminds managers of their ongoing obligations, which now explicitly extend to their use of FDIs. These obligations are:

• Classification. The manager must classify a fund as either a derivative fund or a non-derivative fund, based on the fund’s Net Derivative Exposure.
• Permissible Investments. A fund may invest only in FDIs that are listed/quoted on a stock exchange or traded on an over-the-counter market, provided that the underlying assets of the FDI are permitted by the Revised UT Code. Where an FDI transaction is over-the-counter, the counterparties to the transaction must each be a substantial financial institution,¹ and the net counterparty exposure to a single entity arising from such transaction may not exceed 10% of the net asset value of the fund.
• Liquidity. A fund’s portfolio investments must be liquid and may not impair the fund's ability to meet redemption and other payment obligations. The fund must be able, at all times, to sell, liquidate or close its FDIs at their fair value by offsetting transactions.
• Valuation. The valuation of the FDIs must be marked-to-market daily. Valuations must be conducted and verified by an independent calculation agent or fund administrator, which must have adequate resources to do so on a regular basis.
• Disclosures. A fund must disclose in its product key facts statement the purposes of the fund’s use of FDIs and the expected maximum Net Derivative Exposure (based on an assessment under normal market conditions) arising from the use of FDIs. In determining the expected maximum Net Derivative Exposure, the manager is expected to exercise professional judgement with due skill, care and diligence, taking into account the specific features and risks of the fund.
• Internal Policy. The manager must establish an appropriate risk management framework to effectively monitor and measure the risks of the FDI positions and the contribution of those risks to the overall risk profile of the fund.
• Ongoing Monitoring. The manager must monitor the Net Derivative Exposure of the fund at least daily, to ensure that the disclosure of the expected maximum is fair and not misleading. During increased market volatility or extreme conditions, more frequent (e.g., intraday) calculations may be required. Where the expected maximum is exceeded due to market movements, the manager must take all necessary steps to reduce the fund's leverage within a reasonable period of time to ensure that the disclosure is not misleading, taking into account the interests of the fund’s investors.
• Financial Reporting. The manager must ensure that details of the underlying assets and the identity of the issuer(s)/counterparty(ies) of the FDIs are included in the fund’s financial reports to comply with certain content requirements under the Revised UT Code.
• Ongoing Supervision. The SFC may collect data or information relating to the use of FDIs by a fund to conduct surveillance and monitoring where appropriate.

Securities Financing Transactions

The Revised UT Code introduces new provisions to regulate securities financing transactions (SFTs) (i.e., securities lending, sale and repurchase, and reverse repurchase transactions). Among other requirements, the Revised UT Code provides that:

• A fund should have at least 100% collateralisation in respect of its SFTs.
• The counterparties to SFTs must be financial institutions that are subject to ongoing prudential regulation and supervision.
• Where collateral is received by a fund, such collateral must satisfy new requirements, including (among others) that the collateral be subject to a prudential haircut policy.

It is worth noting that the SFC did not adopt initial proposals requiring: counterparties to be subject to a minimum net asset value; securities lending agents to provide indemnification; and an overall limit on the SFT exposures of a fund.

Requirements Related to Managers

Eligibility

The Revised UT Code introduced two notable changes to eligibility requirements for managers:

• The minimum capital requirement for a manager has been increased from HK$1 million to HK$10 million (or its equivalent in foreign currency). Indebtedness owed by the manager to its parent company may still be considered as part of the capital, subject to certain requirements.
• Key personnel requirements are now more flexible and may be fulfilled by managers belonging to well-established fund management groups, if the managers can demonstrate on a group-wide basis that they possess the requisite experience, resources and expertise to administer public funds.

General Ongoing Obligations

The Revised UT Code now explicitly sets out the ongoing obligations with which managers are expected to demonstrate compliance. A manager must:

• Take all reasonable steps to ensure that the trustee or custodian for the fund is properly qualified to perform its duties and functions, and that such parties are in fact discharging their obligations.
• Demonstrate at all times that the fund’s appointed representatives and agents possess sufficient know-how, expertise and experience to deal with the underlying investments of the fund.²
• Establish and maintain at all times effective: risk management and control systems; liquidity risk management policies and procedures (including stress testing, where applicable); and internal policies and procedures to assess the credit risk of the fund’s portfolio investments.
• Have sufficient resources to properly implement at all times the fund’s risk management policies and procedures.
• Ensure that the fund is designed and operated fairly on an ongoing basis – this includes managing the fund in a way that is cost-efficient, taking into account the size of the fund and the level of fees and expenses.

Operational Requirements

New provisions relating to valuation and pricing require, among other matters, that:

• Appropriate policies and procedures for independent valuation of each type of fund asset must be established in consultation with the trustee or custodian.
• Valuation policies and procedures must be periodically reviewed (at least annually) by a competent and functionally-independent party.
• Where fair value adjustments are necessary, the manager, in consultation with the trustee or custodian, must conduct such adjustments in good faith and with due skill, care and diligence.

Prospectus Disclosures

The Revised UT Code now requires that fund prospectuses disclose the following:

• A general description of SFTs that may be used by the fund, as well as other related information (e.g., counterparty selection criteria, the custody arrangement subject to SFTs, maximum and expected levels of net asset value available for SFTs, and involvement of any connected persons in the carrying out of the SFTs).
• In respect of collateral holdings, further details relating to the quality of collateral, counterparty selection criteria, policies on reinvestment of cash collateral, custody arrangements and risks associated with collateral management and reinvestment of cash collateral.
• A summary of valuation policies and procedures of the fund, including a description of circumstances under which fair valuation adjustments may be employed and circumstances under which such policies and procedures can change.
• Details as to: the liquidity risk management of the fund (including the liquidity risk management policy and process); liquidity risk management tools that may be employed; and liquidity risks to which the fund and its investors are subject.
• Calculation methodology for any performance fees, together with illustrative examples demonstrating the charging method and the impact of any absence of an equalisation arrangement.
• Soft dollar arrangements and related policies and procedures.
• Arrangements for handling unclaimed proceeds of holders during a termination process.
• Custody arrangements for the fund’s assets and any associated material risks.

Other Changes

A manager should also take note of the following new provisions of the Revised UT Code:

• Trustees and Custodians. Additional internal control responsibilities are imposed on fund trustees and custodians requiring them to establish a framework to ensure the effective operation of the fund’s internal controls and systems.
• Contents of Financial Reports. Financial reports of a fund must contain additional information relating to (among other matters): soft dollar arrangements; FDIs (including Net Derivative Exposure); SFTs; and collateral holdings.
• Money Market Funds. Revised investment limitations and new underlying asset requirements have been introduced. Further, where a fund offers a constant net asset value and/or adopts an amortised cost accounting method for valuation, additional safeguards must be implemented to address associated risks. Notably, funds that demonstrate characteristics of a money market fund are subject to these new requirements, notwithstanding that they are not marketed as such.
• Enhancement of Investment Core Requirements. Certain restrictions have been reformulated, such as: the diversification requirements (e.g., change of the single issuer limit to a single entity limit; introduction of a 20% limit for group entities; introduction of separate 20% diversification limit for cash deposits); and the maximum borrowing limit (lowered from 25% to 10% of net asset value).
• Unlisted Index Funds and Index-Tracking Traded Funds (Passive ETFs). Certain requirements (e.g., relating to market makers) have been codified, while others (e.g., relating to diversification and disclosure regarding SFTs) have been enhanced. Among other changes, the SFC removed provisions regarding the “Acceptable ETF Regime” to streamline existing requirements. Further, where a Passive ETF intends to offer listed and unlisted units or share classes, the manager must first consult with the SFC and include disclosure in the offering documents regarding dealing arrangements and associated risks.
• Listed Open-Ended Funds. (Active ETFs). This is a new type of fund that may be authorised under the Revised UT Code. Notably, due to risks of front running and risks that the manager’s strategy in an Active ETF may be reverse engineered, the SFC does not require daily public portfolio disclosure, but allows participating dealers and market makers to have access to such information.
• Closed-End Funds. This is another new type of fund that may be authorised. In short, closed-end funds are expected to have a broad base of investors and are generally subject to redemption restrictions, unless flexibility is granted by the SFC. Although it is generally expected that closed-end funds invest primarily in securities and other financial products in accordance with the SFC’s core investment requirements under Chapter 7 and 8 of the Revised UT Code, certain investment restrictions in the Revised UT Code may be relaxed subject to consultation with, and approval by, the SFC.

Transitional Changes

If an existing fund makes changes to its offering documents in order to comply with the Revised UT Code, and those changes do not materially affect the fund’s investment objectives, policies or strategies, the fund generally will not need the SFC’s prior approval nor be required to provide advance notice of such changes to investors.