SFC Proposes Rules and Code for Open-Ended Fund Companies

by Dechert LLP
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Recently, the Hong Kong Securities and Futures Commission (SFC) published a consultation paper on the Securities and Futures (Open-ended Fund Companies) Rules (Rules) and Code on Open-ended Fund Companies (Code) which, if adopted, will provide the detailed legal and regulatory requirements for the new open-ended fund company vehicles (OFCs) introduced pursuant to legislation last year1.  As opposed to the typical unit trusts, the corporate structure for OFCs would offer tax and regulatory flexibility to investors.

The Rules will be subsidiary legislation enacted under the Securities and Futures Ordinance (SFO). The proposed Rules set out the detailed statutory requirements concerning: the formation, maintenance and the key operators of an OFC; the functions of the Companies Registry (CR); the segregated liability feature for umbrella and sub-fund structures and cross-investments of sub-funds of OFCs; disqualification of directors, arrangements and compromises with creditors, winding-up; and offences.

The Code will be issued by the SFC and compliance with the Code will be one of the registration conditions for an OFC. The proposed Code contains a set of general principles in relation to all OFCs and their key operators, elaborations on various requirements for the registration of OFCs and some baseline requirements, as well as rules that are applicable only to non-public OFCs (private OFCs). While private OFCs will be allowed the flexibility to pursue their investment strategies as set out in their instruments of incorporation and offering documents, all public OFCs will be required to comply with the detailed requirements set out in the SFC Products Handbook, which are not to be duplicated in the Code.

It is worth noting that the potential profits tax exemption for private OFCs will be subject to a separate legislative exercise led by the Financial Services and the Treasury Bureau with the support of the Inland Revenue Department (IRD). However, clarity would be needed from the IRD as to whether such tax exemption would be automatic upon registration of an OFC or would require separate application.

This article provides an overview of key features and proposals in relation to the OFC regime.

Establishment Process

One-Stop Processing for Registration, Incorporation and Business Registration

Under the Ordinance, an OFC is established by obtaining a registration from the SFC and a certificate of incorporation from the CR. This can be accomplished via a one-stop process whereby the SFC communicates directly with the CR. The proposed Rules further elaborate on this one-stop approach, under which the applicant would only need to deal with the SFC for all registration purposes. A similar process would apply to business registration with the IRD. 

Instrument of Incorporation

Save for statutory mandatory provisions, it is proposed that an OFC should be provided with the flexibility to alter its instrument of incorporation. This may be allowed where shareholder approval has been obtained, or where the custodian has certified as to the immateriality of the change or the necessity to comply with regulatory requirements. However, any material change to an OFC’s instrument of incorporation would likely require SFC approval. A non-exhaustive list of material changes is provided in the proposed Code.

Legal Capacity of an OFC

While an OFC has a legal capacity similar to a conventional company, the proposed Rules provide that any transaction entered into by an OFC that falls outside its operation as a collective investment scheme would be invalid, in order to ensure that the OFC will only be operated as an investment fund. Given the now-abolished ultra vires doctrine (which deemed an act of a company void if not authorised by its constitution), this requirement has the potential to be problematic and cumbersome. 

Key Operators

Directors

Under the Ordinance, an OFC must have a board of directors with at least two directors who are natural persons. The proposed Rules require that appointments of directors must be approved by the SFC.

The proposed Rules provide that the collective experience and expertise of the directors should be appropriate for the purposes of carrying on the business of the OFC. The proposed Code further elaborates on the experience and the expertise required of an OFC director, and provides that the board of an OFC must have at least one independent director who may not be a director or employee of the custodian. While an overseas director may be appointed, the proposed Rules require such a director to appoint a process agent to facilitate the service of process. A process agent can be: (a) an individual whose usual residence address is in Hong Kong; (b) a company formed and registered under the Companies Ordinance in Hong Kong; or (c) a firm of solicitors or certified public accountants in Hong Kong.

Note that there is no proposal for a director of an OFC to be independent from the investment manager. The industry should be aware, however, of the trend in other major fund jurisdictions requiring funds to appoint independent directors to their boards in an effort to strengthen fund governance.

As provided by the Ordinance, the directors of an OFC owe a fiduciary duty to the OFC, as well as the duty to take reasonable care, skill and diligence. They must also comply with their statutory duties and applicable codes (including the Code and SFC Products Handbook) when discharging their functions in respect of an OFC.

Under the proposed Rules, a director may be disqualified pursuant to the disqualification provisions of the Companies (Winding Up and Miscellaneous Provisions) Ordinance, subject to appropriate modifications.

Investment Manager

Under the Ordinance, an OFC must have an investment manager that is licensed by or registered with the SFC to carry out Type 9 (asset management) regulated activity. The investment management function of the OFC must be delegated to the investment manager. It is worth noting that overseas investment managers, though allowed to manage SFC-authorised funds under the current regime, cannot be appointed as an investment manager of an OFC (including a public OFC). Such overseas managers can only be sub-managers. In addition, an investment manager of an OFC must be licensed for Type 9 regulated activity, and not other types of regulated activities such as Type 1 (dealing in securities) and Type 4 (advising on securities).

Under the proposed Rules, there must be an initial investment manager at the time an application to register the OFC is made. Subsequent appointments are to be made by the directors of the OFC. An investment manager that ceases to meet the eligibility requirements under the SFO must cease to hold office as the investment manager of the OFC. The instrument of incorporation of the OFC may also set out circumstances in which an investment manager may be removed.

The proposed Rules and Code are silent as to whether an investment manager is internal or external. Given the various successful precedents of having internal management (for instance, Link REIT, which was the first real estate investment trust in Hong Kong), an OFC should be open to having this option. It would be beneficial if the proposed Rules and Code could expressly address this issue.

Custodian

The Ordinance provides that an OFC must have a custodian to whom all the property of the OFC is entrusted for safe-keeping, in relation to which the custodian is required to take reasonable care, skill and diligence. The proposed Code further elaborates on the duties expected of the custodian, including proper segregation and safekeeping of the OFC’s assets. 

The proposed Code sets out eligibility requirements for the custodian, which are essentially the same as those applicable to custodians of SFC-authorised funds in the SFC Products Handbook. For example, the custodian must be one of the following entities: a bank licensed in Hong Kong; a trust company subsidiary of such a bank; or an overseas banking institution or its subsidiary acceptable to the SFC. The custodian should also meet relevant capital and internal control requirements. 

Under the proposed Rules, appointment of a custodian would require approval of the SFC. There must be an initial investment manager at the time an application to register the OFC is made, and subsequent appointments are to be made by the directors of the OFC. A custodian incorporated outside Hong Kong must appoint a process agent unless the custodian is a registered non-Hong Kong company under Part 16 of the Companies Ordinance. 

While a custodian may appoint delegates (including sub-custodians), the proposed Code requires the custodian to exercise due care in the selection, appointment and monitoring of its delegates. Sub-custodians would also be subject to a requirement under the proposed Rules to take reasonable care, skill and diligence to ensure the safekeeping of the property of the OFC that is entrusted to it. 

Upon its cessation of office, a custodian would be required to provide to the OFC and the SFC: a “statement of circumstances” if the custodian deems that there are circumstances to be brought to the attention of the OFC’s shareholders or creditors; or a statement that there are no such circumstances. 

General Principles for OFCs and Their Key Operators

The SFC adopted a principles-based approach in formulating the proposed Code, and proposes to introduce seven fundamental general principles in the Code that are applicable to all OFCs and their key operators (general principles). These are: (1) acting fairly; (2) diligence and competency; (3) proper protection of assets; (4) managing conflicts of interest; (5) disclosure; (6) regulatory compliance; and (7) compliance with constituent documents. 

Share Issuance, Transfer, Rights and Register of Shareholders

The proposed Rules include provisions on share issuance, transfer of shares, rights attached to shares, and register of shareholders and evidence of title, which are similar to those under the Companies Ordinance. Under the proposed Rules, an OFC may provide in its instrument of incorporation for the creation of different classes of shares and the rights attached to such shares.

Under the proposed Rules, a shareholder’s title to the shares in an OFC would be evidenced by entry of the shareholder’s particulars and holdings into the register of shareholders. No issuance of share certificates would be required. Transfer of shares would be conducted by delivering to the OFC an instrument of transfer, and the OFC must either register the transfer or send a notice of refusal to the transferee and transferor. 

Auditors and Financial Reports

While the eligibility, rights, privileges and cessation of office of an auditor are largely the same as those for conventional companies under the Companies Ordinance, the proposed Code clarifies that the auditor must be independent of: the investment manager; the custodian; and the directors of the OFC. The proposed Rules require that, upon cessation of office, the auditor must give the OFC a statement of circumstances, similar to that for a custodian. 

An OFC must prepare an annual report for each financial year unless it has obtained approval from the SFC that a financial report is not required. A public OFC must prepare an interim report in accordance with the SFC Products Handbook, while a private OFC would be allowed flexibility in this regard. 

Segregated Liability of Sub-Funds and Cross-Sub-Fund Investments

The Ordinance provides for the segregation of liability of sub-funds for an OFC with an umbrella and sub-funds structure. The regime is strengthened by the proposed Rules, which set out certain statutorily implied terms in the contracts and transactions entered into by an umbrella OFC. In essence, these implied terms prohibit a party contracting with the OFC from seeking recourse to any assets of a sub-fund in discharge of a liability not incurred on behalf of that sub-fund. The proposed Code requires the offering documents of an OFC to include a statement as to the segregated liability of the sub-funds and a warning that such a regime might not be recognised in foreign courts. 

Arrangements and Compromises

Similar to the Companies Ordinance, the proposed Rules provide that an OFC may enter into an arrangement or compromise with its creditors, shareholders or both, which may be sanctioned by the court if 75% of those concerned agree to such arrangement or compromise. The court would have additional powers to facilitate a reconstruction or amalgamation if the property or undertaking of one OFC is to be transferred to another OFC. 

Termination and Winding-Up of an OFC

Under the Ordinance, an OFC can be terminated by application to the SFC according to detailed requirements and procedures set out in the proposed Code. In particular, the OFC and its key operators should ensure that the termination is carried out fairly, taking due account of the best interests of shareholders. This includes: undertaking a fair valuation of assets; addressing any conflicts of interest; and providing adequate and timely disclosure of the termination process to investors. An application for termination should be made to the SFC after the OFC’s assets have been fully distributed to shareholders.

Other than termination by application, an OFC may also be deregistered by the SFC upon the occurrence of circumstances specified in the Ordinance (such as a breach of the SFO or of a registration condition, or where the SFC is not satisfied that the continued registration of the OFC is in the interest of the investing public). 

The proposed Rules incorporate the winding-up regime under the Companies (Winding Up and Miscellaneous Provisions) Ordinance with minimal modifications. The modifications would enable the SFC and the custodian to petition for the winding-up of the OFC or a stay of relevant proceedings, and would enable the SFC to receive relevant winding-up related documents. However, the grounds of winding-up that are applicable only to conventional companies (such as when a company has no members or company secretary) are excluded from the proposed Rules. 

A one-stop approach is also proposed in relation to the cancellation of an OFC’s registration with the SFC and the CR.

Requirements Applicable to Private OFCs Only

Investment Scope

The proposed Code sets out the investment scope of private OFCs as follows:

(a)At least 90% of the OFC’s gross asset value must consist of: (1) asset types whose management would constitute a Type 9 regulated activity: and (2) cash, bank deposits, certificates of deposit, foreign currencies and foreign exchange contracts;

(b)The OFC may invest in other asset classes of a value not exceeding a maximum of 10% of the gross asset value of the OFC (with a 10% de minimis limit); 

(c)In the case of an umbrella OFC, the 10% de minimis limit is applicable to each sub-fund as well as the umbrella OFC as a whole; and 

(d)The 10% de minimis limit must be set out in the OFC’s instrument of incorporation. 

Contravention of the 10% de minimis limit may result in the SFC’s intervention as detailed below under the heading “Supervision and Enforcement”. It is worth noting that the 90% threshold is very high, and accordingly may make a private OFC not a suitable vehicle for a real estate or hybrid private equity fund.

Fund Operations and Disclosure

Private OFCs should comply with the general principles and basic requirements set out in the proposed Code. A private OFC’s instrument of incorporation and offering documents should set out the pricing, dealing arrangements, valuation, distribution policy, use of leverage, and fees and charges in relation to fund operations of the OFC. 

Material Changes 

Under the proposed Code, material changes to a private OFC would require the approval of shareholders, as well as the approval of the SFC where an alteration of the instrument of incorporation is involved (including material changes to the OFC’s investment objectives and policies). For changes that may reasonably be expected to affect investors’ investment decisions (such as changes to the OFC’s key operators, fee structure, and dealing and pricing arrangements), reasonable prior notice should be provided to shareholders.

Supervision and Enforcement

The SFC has been granted investigatory, supervisory and intervention powers under the Ordinance. As such, the SFC may investigate the affairs of an OFC if the SFC has reasonable suspicion of misconduct in connection with the management of the OFC or its property. The SFC also may conduct inspections and make inquiries with the OFC’s investment manager as to whether it is complying with the relevant statutory and regulatory requirements. In case of a breach of any registration condition (including a Code breach), the SFO or the Rules, the SFC may cancel the registration of an OFC and take enforcement action against the OFC and its key operators. Further, the SFC may exercise disciplinary powers under SFO against the investment manager of an OFC for misconduct that is prejudicial to the interest of the investing public. 

The SFC is currently inviting market participants and interested parties to comment on the consultation, which is open until 28 August 2017.

Footnote

1) The Securities and Futures (Amendment) Ordinance 2016 (Ordinance) was enacted in June 2016, introducing a legal framework for OFCs. The Ordinance mainly amends the SFO. The amendments will be consolidated into the SFO and come into operation on a day to be designated by the Secretary for Financial Services and the Treasury, which is expected to be in 2018 following the conclusion of the consultation on the Rules and Code and the completion of the legislative process.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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