For private fund managers (Managers) planning to launch a Hong Kong open-ended fund company (OFC), one key first step to settle is the selection of key operators. Under the OFC structure, there are three key operators which are required to be selected and confirmed in order to make a formal application to the Hong Kong Securities and Futures Commission (SFC) to register the OFC. These key operators include the investment manager, the directors and the custodian of the OFC, each of which are subject to the SFC’s approval on a case-by-case basis.
Under the OFC laws and regulations, all scheme property (including cash held in a bank account in the name of the OFC) must be properly entrusted to a custodian for safekeeping. We discuss in this article strategies and considerations for choosing a custodian for a private OFC (Private OFC Custodian).
Eligibility criteria for Private OFC Custodians
As a first hurdle, Managers will need to consider the range of service providers available that meet the eligibility criteria to act as a Private OFC Custodian, which are prescribed under the Code on Open-Ended Fund Companies (OFC Code). The types of entities that are eligible to act as a Private OFC Custodian can be categorised into three types:
(a) Holders of Type 13 licence: A depositary licensed or registered to carry on Type 13 regulated activities (providing depositary services for relevant collective investment schemes) under Chapter 571 Securities and Futures Ordinance (SFO) is eligible to act as a Private OFC Custodian. This eligibility criterion is provided for under the Code on Unit Trusts and Mutual Funds (UT Code) which also applies to mutual funds that are authorised by the SFC. Presently there are 20 entities in Hong Kong licensed to carry out Type 13 regulated activities.
(b) Holders of Type 1 licence: These are commonly brokers licensed or registered for dealing in securities under the SFO, provided they meet the specific criteria set out in the OFC Code.
(c) Overseas entities: The OFC regime does not restrict overseas entities to act as a Private OFC Custodian provided that such entity is a banking institution incorporated outside of Hong Kong which is subject to prudential regulation and supervision on an on-going basis, or an entity that is authorised to act as a trustee or custodian of a scheme and prudentially regulated and supervised by an overseas supervisory authority acceptable to the SFC. This criterion will generally enable traditional overseas prime brokers to qualify as a Private OFC Custodian.
Services contemplated and capability
Tailor strategies to custody / prime brokerage needs
In selecting a suitable service provider, Managers may need to consider the types of services required for the private OFC from the custodian, which may differ depending on the type of investment strategy to be adopted by the OFC. For example, whilst funds adopting a fixed income strategy or where the private OFC intends to only hold illiquid assets (such as private equity funds, private credit funds and real estate funds, etc) only traditional custody services may be required, however some hedge funds may require full prime brokerage services to support high-volume global trading strategies and to facilitate financing, leverage (margin borrowing) and securities borrowing for short-selling.
It is important to note that under the OFC regime, there is no distinction between a custodian and prime broker. Provided that a prime broker will be holding scheme property of a private OFC, it will be considered as Private OFC Custodian by the regulator. As such, a hedge fund may appoint a prime broker that meets the OFC Code’s eligibility requirement to act as Private OFC Custodian. From a practical perspective, prime brokers less familiar with the OFC regime may require longer onboarding timelines to ensure full compliance with the regulatory framework.
Third party payments
In the normal operations of the private OFC, it needs the ability to make distributions to shareholders, pay fees and expenses to service providers and to pay redemption proceeds to redeeming shareholders. It would therefore be important for Managers to determine that its selected custodian is capable of facilitating such transactions or if alternative custody arrangements are required.
Unlike bank custodians, which often facilitate payments to third parties on behalf of the private OFC, many brokers approved to act as Private OFC Custodians are structured primarily for securities trading and custody, instead of cash management or third-party disbursements given that such brokers will typically only recognise the private OFC as its “client on record” and will only arrange cash payments and transfers to a bank account in the name of the private OFC rather than that of its investors or service providers. This may have implications on cash flow operations and custodial arrangements. In particular the SFC has in the “Frequently Asked Questions relating to Open-ended Fund Companies” clarified that monies which form part of the private OFC’s scheme property must be entrusted to the Private OFC Custodian who must maintain a segregated client bank account for safekeeping of such monies.
Multiple custodian arrangements
To accommodate varying operational needs, a private OFC may utilise multiple custodian arrangements, either by appointing different custodians with respect to different sub-funds within an umbrella OFC, or by designating more than one custodian for a standalone structure or an individual sub-fund of an umbrella structure.
Where multiple custodians are appointed, the Manager will need to consider how the duties and obligations as between the different custodians will be allocated, in particular which of them will be acting as a main custodian with respect to any scheme property arising at the umbrella OFC level, if any. The SFC prescribes for multiple custodian arrangements and considerations to be explicitly provided for in the constitutive documents of the OFC and/or the relevant custodian agreements of the OFC. Managers will need to be vigilant as to such requirements in order to fully comply with the regulator’s expectations.
Fee arrangements and contractual terms
From a commercial perspective, custody fee will also be an important consideration for Managers when selecting suitable Private OFC Custodians. Different fee structures may be applicable for different types of custodians depending on the transactions contemplated, including some charging a minimum fee commencing from the time the Private OFC Custodian is appointed.
The custody fee forms a key contractual term in the custody agreement to be entered into by the private OFC. Managers will also need to consider other important contractual arrangements such as any indemnities and liability provisions applicable to the custodian’s services, the rights to appoint sub-custodians at the election of the custodian as well as triggers and fees applicable upon termination, which may need to be negotiated. The SFO, the OFC Code and the Securities and Futures (Open-ended Fund Companies) Rules also prescribes for statutory duties, obligations and limitations on liabilities that should be properly reflected under the custody agreement, certain arrangements of which are required to be disclosed under the offering documents of the private OFC.
The safekeeping of scheme property of a private OFC is an important area of focus of the SFC. Managers and directors of private OFCs often seek legal advice to support its review and negotiation of custody arrangements as part of its custodian selection process to ensure that the proposed arrangements fully comply with the OFC laws and regulations.
Compliance with Fund Manager Code
Under the Fund Manager Code of Conduct (Fund Manager Code), Managers are subject to custody obligations regardless of a fund’s domicile or structure, requiring the Managers to ensure safety of fund assets. Managers must exercise due skill, care and diligence in the selection, appointment of and ongoing monitoring of a custodian, by evaluating the custodian’s (1) asset segregation procedures, (2) legal/regulatory status and financial stability, (3) conflicts of interest management, (4) organisation capabilities and delegation arrangements. Additionally, the Fund Manager Code requires disclosure of the custody arrangements and material risks associated to fund investors. These duties collectively safeguard investor interests, operating in parallel with the Managers’ obligations under applicable OFC laws and regulations.
At Deacons, we have experience in advising private OFCs in structuring its custodial arrangement as well as custodians in preparing and advising on its custody agreements. For further information or bespoke advice, please reach out to our team to explore how we can best support you.
