Hong Kong – SFC Consults On New Rules And Code For Open-Ended Fund Company Structure.

 

20 July, 2017

 

On 28 June 2017, the Securities and Futures Commission (SFC) launched a two-month consultation (Consultation) on the detailed legal and regulatory requirements applicable to the new open-ended fund company (OFC) structure.

Currently, investment funds in Hong Kong are established only in unit trust form. The OFC structure will allow investment funds to be established in corporate form. The Securities and Futures (Amendment) Ordinance 2016, which is yet to take effect, provides the basic legal framework of the OFC structure and also empowers the SFC to make subsidiary legislation and issue codes and guidelines for the regulation of OFCs.

On this basis, the SFC launched the Consultation, which sets out the SFC’s proposed Securities and Futures (Open-ended Fund Companies) Rules (OFC Rules) and Code on Open-ended Fund Companies (OFC Code). Drafts of the OFC Rules and the OFC Code are attached to the Consultation paper as Appendices A and B respectively.

All OFCs (whether publicly or privately offered) will be subject to the OFC Rules and the OFC Code. OFCs which are intended to be offered to the public will also have to obtain the SFC’s authorisation under Part IV of the Securities and Futures Ordinance unless an exemption applies (public OFCs). These public OFCs will also be subject to the authorisation and ongoing post-authorisation requirements set out in the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products (SFC Products Handbook).

Further background regarding the proposed OFC structure and the previous round of consultation can be found in our article of March 2016.
 

OFC RULES AND OFC CODE

The proposed OFC Rules will set out the more detailed statutory requirements concerning company formation and maintenance; the key operators of the OFC; the functions of the Companies Registry (CR); the segregated liability feature for umbrella and sub-funds structures and cross-investments of sub-funds of OFCs; disqualification of directors; arrangements and compromises; winding-up; and offences.

The proposed OFC Code contains a set of general principles which all OFCs and their key operators are expected to comply with in the management and operation of OFCs. The proposed OFC Code also elaborates on various requirements applicable to all OFCs seeking the SFC’s registration as well as baseline requirements applicable to all OFCs. The proposed OFC Code further sets out some basic investment restrictions, disclosure and operational requirements applicable to non-public OFCs (private OFCs) and requirements and procedures for termination by application to the SFC.

The key aspects of the OFC Rules and OFC Code are highlighted below.

 

Establishment process and name of OFC	The registration, incorporation and business registration of OFCs will be done via a one-stop process whereby the SFC will notify the CR of the registration of the OFC, and the SFC’s registration will take effect upon the issuance of a certificate of incorporation by the CR. A similar process will apply to a business registration with the Inland Revenue Department. The name of the proposed OFC and any change to the name of a registered OFC will be reviewed and approved by the SFC only. The proposed OFC Code also provides guidance on the factors which would be considered by the SFC in determining whether a proposed OFC name would be regarded as “misleading or otherwise undesirable”.
Instrument of incorporation	The draft OFC Rules propose that the instrument of incorporation of an OFC must include a statement that the object of the OFC is the operation of the company as a collective investment scheme and the objects of the OFC must include a statement that the OFC is formed for a lawful purpose. The proposed OFC Rules also provide that any material change to an OFC’s instrument of incorporation requires the SFC’s approval. The SFC will make available a template for an OFC instrument of incorporation on its website.
Legal capacity of an OFC	The draft OFC Rules propose that any transaction entered into by the OFC which falls outside its operation as a collective investment scheme will be invalid.
General principles for the OFC and its key operators	The draft OFC Code proposes to take a principles-based approach and the SFC proposes to introduce seven fundamental general principles in the OFC Code with which all OFCs and their key operators are expected to comply when managing and operating an OFC, namely (1) acting fairly, (2) diligence and competency, (3) proper protection of assets, (4) managing conflicts of interest, (5) disclosure, (6) regulatory compliance, and (7) complying with constitutive documents.
Key operators	The proposed OFC rules provide for the eligibility, appointment and removal and duties of the key operators of OFCs, ie, directors, investment manager and custodian. Appointments of directors and the custodian must be subject to SFC approval. The proposed OFC Rules also formalise the requirement that an overseas director and a custodian incorporated outside Hong Kong (unless it is a registered non-Hong Kong company) must appoint a process agent.
Corporate administration matters	The proposed OFC Rules and OFC Code include provisions on share issuance, transfer, rights and register of shareholders, meetings and resolutions, and auditors and financial reports. Key points to note include the following:   an OFC can provide for the creation of different classes of shares and provide for the rights attached to its shares in its OFC’s instrument of incorporation; the auditor must be independent of the investment manager, the custodian, and the directors of the OFC; and in preparing its accounts, the OFC may apply Hong Kong Financial Reporting Standards or International Financial Reporting Standards.
Filings with the CR	Under the proposed OFC Code, filings which require the SFC’s approval will be submitted by the OFC to the SFC and the SFC will then pass the documents to the CR after approval, whereas filings which do not require the SFC’s approval will be submitted directly by the OFC to the CR.
Segregated liability of sub-funds (protected cell) and cross sub-fund investments	To strengthen the protected cell regime, the proposed OFC Rules set out terms to be implied in the contracts and transactions entered into by an umbrella OFC, which terms surround the recourse to assets of a sub-fund in discharge of a liability not incurred on behalf of that sub-fund. The proposed OFC Code also requires the offering documents of the OFC to include a statement on the segregated liability of the sub-funds, and a warning that such protected cells may not be recognised in foreign courts. Separately, the proposed OFC Rules introduce a provision to enable cross sub-fund investments by an umbrella OFC.
Arrangements and compromises	The proposed OFC Rules contain provisions on arrangements and compromises that are similar to the Companies Ordinance.
Termination and winding up	The proposed OFC Code sets out detailed requirements and procedures for termination of an OFC by application to the SFC. Among other things, the proposed OFC Code provides that the OFC and its key operators should ensure that the termination is carried out fairly, taking due account of the best interests of its shareholders. Under the proposed OFC Rules, the provisions of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (including its subsidiary legislation) relating to the winding-up of an OFC would apply with relevant modifications.
Requirements applicable to private OFCs	The second main section of the proposed OFC Code (Section II) sets out some basic investment restrictions and disclosure and operational requirements applicable to private OFCs. All public OFCs should comply with the relevant requirements set out in the SFC Products Handbook instead of Section II. Below are some of the key points of Section II: The investment scope of private OFCs should be largely aligned with type 9 (asset management) regulated activity so that SFC licensing, supervision and enforcement would apply to investment managers of OFCs; The offering documents of a private OFC are required to be filed with the SFC following the registration of the OFC, and after any changes are made; and Material changes to a private OFC would require the approval of shareholders, and also the approval of the SFC where the change involves an alteration of the instrument of incorporation.

 

OTHER MATTERS

The major fees proposed to be chargeable in respect of the registration, incorporation and winding-up of OFCs are set out in Appendix C to the Consultation paper but such fees are not the subject matter of the Consultation. Comments on the Consultation should be submitted by 28 August 2017. Implementation of the new OFC regime is envisaged in 2018 following the conclusion of the Consultation and completion of the legislative process.

In addition to the Consultation, the relevant authorities have taken other steps recently to prepare for the implementation of the OFC regime. On 23 June 2017, the government gazetted the Inland Revenue (Amendment) (No. 4) Bill 2017 to implement the 2017-2018 budget initiative of extending profits tax exemption to private OFCs, the central management and control of which is exercised in Hong Kong.

This is the first time that Hong Kong is granting tax exemption to onshore funds which are privately offered (as opposed to offshore funds). The exemption conditions will ensure that the OFC is non-closely held and that the transactions are carried out through or arranged by a qualified person in permissible asset classes. In the meantime, a 10 per cent de minimis limit for investing in non-permissible asset classes and a gear-up period to meet the non-closely held condition will be allowed, to provide some flexibility.

CONCLUSION

The Consultation represents another step forward in implementing the OFC regime. Investment funds which intend to adopt the OFC structure and their key operators should pay close attention to the latest development and familiarise themselves with the applicable laws and regulations ahead of the implementation of the OFC regime envisaged in 2018. Potential public OFCs should also take note of the separate requirements under the SFC Products Handbook.

 

 

For further information, please contact:

 

William Hallatt, Partner, Herbert Smith Freehills

William.Hallatt@hsf.com