28 March, 2020
Seasoned derivatives practitioners will know that there are certain issues under Hong Kong law which they should be aware of when dealing in over-the-counter and/or securitised derivatives with Hong Kong counterparties or where there is a nexus to Hong Kong law. For those new to the market, it is important to be aware of these issues to ensure a smooth deal execution. The Structured Finance and Derivatives team in Linklaters has prepared this publication which highlights some of these issues as a reminder to all derivatives practitioners of these important points.
The topics discussed in this guide are not meant to be exhaustive; we have picked out some of the issues which may be easily overlooked. We would be happy to answer any further questions you may have on these topics.
Which Hong Kong entities are not covered by the industry netting and collateral opinions?
ISDA netting and collateral opinions provide comfort to counterparties as to the enforceability of the netting arrangements in the ISDA Master Agreement and as to credit support arrangements. Hong Kong opinions cover Hong Kong companies (including banks) and were extended in 2016 to cover Hong Kong insurance companies and trusts with Hong Kong corporate trustees.
However, notwithstanding this extension, some entities are not covered by the industry opinions, including:
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Parties may wish to seek additional comfort from their legal advisors when trading with these types of counterparties.
The industry opinions also do not cover the situation where the governing law of the ISDA Master Agreement is not English or New York law or where core provisions of the agreement have been materially altered.
Security interest may be void for non-registration with Companies Registry
Parties to collateral documents under which a Hong Kong company creates a security interest, for example, initial margin (IM) documentation, will want to make sure that the applicable document is registered with the Hong Kong Companies Registry (“HKCR”) within the applicable time limits.
Under Hong Kong law, specified charges granted by
(i) Hong Kong incorporated companies and
(ii) foreign companies registered as non-Hong Kong companies over property in Hong Kong, must be registered with the HKCR within one month of creation of the charge. To this end, the most common types of “specified charge” in relation to derivative transactions are “charges over book debts” and “floating charges”.
A completed Form NM1, a certified copy of the relevant security document by which the charge is created or evidenced and a registration fee must be delivered to the HKCR. The certified copy should be certified as a true copy by a director or company secretary of the party delivering the copy for registration, or a person authorised by the party for such purpose. Any other person interested in the charge, or (if the interested person is a natural person) a person authorised by such person or (if the interested person is a company) a person authorised by such person or a director or company secretary of such person may also certify the relevant security document.
There are severe penalties for non-registration including that the charge is void against any liquidator and creditor of the company and the company and every responsible person of the company is liable to prosecution and fines.
Equity derivatives are subject to extensive disclosure of interests regime Parties to equity derivative transactions should note that Hong Kong has one of the world’s most stringent and far reaching disclosure of interests regimes and non- compliance can have far reaching consequences.
Part XV of the Securities and Futures Ordinance (Cap. 571) requires that parties that have long positions of over 5% in shares listed on the Hong Kong Stock Exchange disclose such interests to the listed corporation and to the Stock Exchange within a short time period. Hong Kong’s disclosure regime is extensive and goes further than the disclosure regimes in jurisdictions such as the UK and Australia. For example:
> Interests that a party may have in equity derivatives are disclosable |
> Not only long positions in shares are disclosable but also short positions. A party cannot net off any short position it has against its long position |
> Changes in the nature of a party’s interest must be disclosed. This includes, for example, the exercise of an option or the return of shares under a stock borrowing and lending agreement |
> Interests in purely cash-settled equity derivatives are disclosable |
Failure to comply with the disclosure obligations is a criminal offence, punishable by fines and/or imprisonment.
FAQs on how to make the applicable disclosures and guidance on how to fill in the forms is available on the SFC’s website.
Registration of stock lending borrowing agreements for stamp duty relief Parties that transfer interests in Hong Kong stock will wish to ensure that the applicable share transfer documents are stamped within the time limits permitted, whether such transfers are effected in or outside Hong Kong. Under the Stamp Duty Ordinance (Cap. 117), contract notes for the sale and purchase of Hong Kong stock are chargeable to stamp duty at 0.1% of the value of the stock on the date that the stocks are transferred. Generally, “Hong Kong stock” includes shares and debentures of companies incorporated in Hong Kong and stocks listed on the Hong Kong Stock Exchange.
There is stamp duty relief for stock lending and borrowing agreements provided the documents are registered and record keeping requirements are met.
The stock must have been borrowed for a specified purpose, specifically:
(a) the settling of sales;
(b) the settling of future sales;
(c) replacement of stock borrowed;
(d) on-lending;
(e) other purposes as specified and accepted by the Collector of Stamp Revenue
(the “Collector”).
To claim stamp duty relief:
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copies of the stock borrowing and lending agreement and the applicable registration form must be lodged with the Collector along with the prescribed fee before the expiry of 30 days after the first stock borrowing is effected
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for every 6 month period ending on 30 June/ 31 December, the borrower is required to file a Return
of Stock Borrowing Transactions reporting all the stock borrowing and lending agreements registered in the last 6 months and listing any transactions that do not meet the stamp duty relief requirements under the SDO -
as a continuing obligation, the borrower must keep a stock borrowing ledger in a prescribed form into which required particulars of stock borrowings and stock returns are entered. A copy of the ledger to the Collector must be produced upon request by the Collector.
The registration requirements typically fall on the borrower. However, the Collector is aware that lenders may not be in a position to ensure that the borrower registers the stock borrowing and lending agreement or may not be aware of the borrower’s failure to do so. Hence the Collector will not impose stamp duty on the lender provided the lender has taken reasonable care to ensure that the borrower is aware of its obligations to register. As a precaution, the lender may file a Notification of Execution of Stock Borrowing and Lending Agreement by Lender (Form SBUL26) to notify the Collector of the execution of a stock borrowing and lending agreement.
The consequences of late registration are fines and penalties. In addition, documents that are not duly stamped are not admissible as evidence court proceedings. There are also civil liabilities for failure to pay stamp duty.
How is CNH different from CNY and Renminbi?
Hong Kong is one of the key offshore centres for CNY (renminbi) trading. Derivatives traded in the Hong Kong market will frequently feature offshore CNY (or “CNH”, which refers to renminbi in the offshore market) as an underlier. However, the crucial difference between derivatives with CNY as an underlier and CNH derivatives is the risks which are perceived to be particular to offshore CNY and which may require additional disruption events to be considered:
- Illiquidity: an event occurs that makes it impossible for a party to the applicable transaction to obtain a firm quote of an offer price in respect of an amount in CNY equal to the amounts to be paid under the transaction on the applicable settlement date or payment date;
- Inconvertibility: an event occurs that makes it impossible for a party to the transaction to convert an amount of CNY into or from USD (or the applicable settlement currency) in the general CNY exchange market in the applicable offshore CNY centre (e.g. Hong Kong), other than where such impossibility is due solely to the failure of that party to comply with any law, rule or regulation enacted by any governmental authority;
- Non-transferability: the occurrence of an event that makes it impossible for a party to the transaction to transfer CNY (A) between accounts inside an offshore CNY centre, (B) from an account inside an offshore CNY centre to an account outside such offshore CNY centre and outside Mainland China, or (C) from an account outside an offshore CNY centre and outside Mainland China to an account inside such offshore CNY centre, other than where such impossibility is due solely to the failure of that party to comply with any law, rule or regulation enacted by any governmental authority.
To this end, ISDA has developed a set of industry- standard Revised Additional Disruption Event Provisions for an Offshore Deliverable CNY Transaction and the ISDA Offshore Deliverable CNY Transaction Disruption Fallback Matrix, which are supplemental to the 1998 FX and Currency Options Definitions (as published by ISDA, EMTA and the Foreign Exchange Committee) specifically for offshore CNY transactions.
Massive reform of OTC derivatives market in Hong Kong
The OTC derivatives market in Hong Kong is undergoing reform in line with Hong Kong’s G20 obligations. Regulatory reform has been conducted on the following key areas:
- Mandatory reporting
- Mandatory clearing
- Mandatory margin for non-centrally cleared derivatives
- Licensing requirements
- Other risk mitigation standards for non-centrally cleared derivatives
The mandatory clearing and mandatory reporting of certain OTC derivatives have been implemented. Starting from July 2017, mandatory reporting applies to OTC derivatives transactions that fall within the five key asset classes (interest rate derivatives, FX derivatives, equity derivatives, credit derivatives and commodity derivatives). Separately, starting from September 2016, mandatory clearing applies to certain plain vanilla interest rate swaps entered into by major dealers.
Meanwhile, HKMA margin requirements are already in effect for authorized institutions. SFC’s margin requirements for non-centrally cleared derivatives for licensed corporations will also commence on 1 September 2020.
In addition, the SFC has introduced the new regulated activities of dealing in and advising on OTC derivatives transactions (Type 11 regulated activity) and providing clearing and settlement services (Type 12 regulated activity). These new regulated activities are on the statute books but have not yet come into effect.
On 1 September 2019, SFC risk mitigation standards in respect of trade relationship documentation, trade confirmation, valuation, portfolio reconciliation, portfolio compression and dispute resolution have become effective.
The SFC has also reformed its conduct rules for licensed persons that carry out regulated activities.
Should I choose Hong Kong law and Hong Kong courts when transacting with Mainland Chinese counterparties?
It is increasingly common to see the use of Hong Kong law and Hong Kong courts to govern cross-border derivatives transactions with Mainland Chinese counterparties. Whilst a judgment from an English court or New York court may not be enforceable by a Mainland court, a judgment from Hong Kong court is directly enforceable in the Mainland under the Arrangement on Reciprocal Enforcement of Judgment in Civil and Commercial Matters between Mainland and Hong Kong so long as the judgment is one from the Hong Kong High Court (or a higher) and appropriate certification is obtained from such court. Interestingly, following an amendment to the Arrangement in 2018, the choice of Hong Kong court in the agreement does not even need to be sole or exclusive to qualify for enforcement; moreover, an order for specific performance (in addition to an order for damages) from a Hong Kong court could now be effected in the Mainland.
Should I choose Hong Kong Courts when transacting with State-owned Entities from Mainland China?
If the Mainland party is part of the China government, it may be entitled to claim crown immunity under Hong Kong law which means that Hong Kong courts are debarred from entertaining any claim against it. While the immunity can be waived, to be effective, the waiver must be given to the Hong Kong court at the time of the court proceeding; a mere waiver provision in the derivative contract would not be sufficient. There have been concerns whether state-owned enterprises (SOEs) from the Mainland undertaking commercial activities would be entitled to claim such crown immunity before the Hong Kong courts.
This is a very real concern since the vast majority of the enterprises from the Mainland are state-owned in one form or another. Helpfully, a Hong Kong Court of First Instance (TNB Fuel Services Sdn Bhd v China National Coal Group Corporation) ruled in 2017 that a state-owned entity from the Mainland undertaking commercial activities could not invoke crown immunity. See our client bulletin for further information: PRC state- owned entities may not invoke Crown immunity when carrying out commercial activities (June 2017)
For further information, please contact:
Chong Liew, Partner, Linklaters
chin-chong.liew@linklaters.com