In March of this year, the Hong Kong government issued an industry consultation paper (Proposal) introducing a new regime for establishing Hong Kong-domiciled open-ended fund companies (OFCs) that might be structured as investment funds. The Proposal has been a long time coming in response to industry feedback that such a regime – and the ability to establish OFCs in Hong Kong – is in line with structuring options available in other prominent funds and financial services centres around the world. If adopted, the Proposal can only increase Hong Kong’s stature as such a leading financial services centre and funds hub.

Proposed Structure

Presently, a unit trust is the only structure that can be utilized by Hong Kong-domiciled open-ended funds, due to restrictions in the current Companies Law. OFCs are corporate entities with limited liability and variable share capital. OFCs adopt the protected cell regime, whereby the assets and liabilities of one sub-fund are legally segregated from the assets and liabilities of other sub-funds within the same umbrella. Under the Proposal, the Hong Kong Companies Registry will be responsible for the incorporation and the relevant corporate filings of OFCs; the OFC regime will be governed by the Securities and Futures Ordinance (SFO), and a new OFC Code will be issued by the Securities and Futures Commission (SFC).

Under the Proposal, OFCs that are publicly offered to retail investors in Hong Kong must be authorized by the SFC, while privately offered OFCs must also be registered with (although they obviously need not be authorized by) the SFC. An OFC is managed by a board of directors, which must delegate the investment management activities to an investment manager licensed by the SFC to conduct a business in Hong Kong in Type 9 (asset management) regulated activity. There must be at least two directors in an OFC – at least one of whom must be independent of both the investment manager and the custodian of the Fund, and at least one director must be a Hong Kong resident. Directors of OFCs are not required to be licensed by the SFC in Hong Kong, but are subject to statutory and fiduciary duties under Hong Kong Companies laws.

Investor Protection?

The proposed requirement that a privately offered OFC be registered with (although not authorized by) the SFC has raised questions in the industry as to the actual level of “registration” that will be imposed, and whether such registration can be completed efficiently without creating an administrative hurdle. This is a more onerous regulatory requirement than is currently the case – privately offered funds (including OFCs) need not be registered with (or even notified to) any regulator in Hong Kong before interests in such funds may be offered on a private placement basis in Hong Kong to non-retail investors.

In addition, even publicly offered funds available for retail investment in Hong Kong need not have a Hong Kong-based and licensed investment manager, which the Proposal suggests for all OFCs (both publicly and privately offered funds). It should be noted that Hong Kong-domiciled unit trusts are not subject to this requirement, and there does not appear to be any proposal to impose it on them.

Other proposals to “enhance” investor protection include the following:

• The assets of an OFC must be entrusted to a Hong Kong-incorporated custodian that is acceptable to the SFC. The existing registered fund regime in Hong Kong does not restrict the selection of a fund’s custodian in this way, which may be viewed as potentially burdensome and impractical, especially for privately offered OFCs that may engage offshore prime brokers, in light of a limited choice of Hong Kong-incorporated custodians.

• In order to align the investment activities of OFCs with the SFC’s licensing regime, the investment scope of OFCs is to be limited to securities, cash and, upon promulgation of the Securities and Futures (Amendment) Bill 2013, over-the-counter (OTC) derivatives. This restriction effectively precludes any OFC (whether publicly or privately offered) from investing in any other asset class, and may be viewed as overly restrictive, potentially rendering OFCs less attractive as a Hong Kong-domiciled investment vehicle. A strong argument may be made that there should be no such restriction on the investment scope of OFCs, especially privately offered OFCs, if the policy intention is to enable Hong Kong to compete as a viable fund domicile option for global asset managers. 

Taxation

OFCs authorized for retail distribution would enjoy the same tax concession currently afforded to SFC-authorized funds, by qualifying for the profits tax exemption under s104 of the SFO. A privately offered OFC, on the other hand, is eligible for the profits tax exemption only if its central management and control is located outside Hong Kong. The lack of tax concessions available to privately offered OFCs will likely reduce the attractiveness of the vehicle to alternative investment fund managers.

Conclusion

While it is generally viewed as a step in the right policy direction by the Hong Kong government, after years of encouragement to do so by the funds and financial services industry in Hong Kong, the Proposal clearly does not go far enough to present Hong Kong as a competitive fund domicile option to alternative fund managers (who would not publicly offer their funds). The proposed restrictions on offshore service providers and permissible investments, as well as the required registration, are generally in line with what is expected of publicly offered – but not privately offered – funds. Therefore, the government would do well to heed the comments of industry to improve the Proposal in order to have a workable, competitive, attractive regime under which Hong Kong-domiciled OFCs may be established and used by both public and private fund managers.