Hedge Funds: Jurisdictional Comparisons 2013 Hong Kong chapter

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1 Hedge Funds: Jurisdictional Comparisons 2013 Hong Kong chapter BRIEFING JANUARY 2014 Slaughter and May Jason Webber, Peter Lake and Ben Heron Hong Kong s hedge fund industry has had remarkable growth over the past 10 years. The number of hedge funds managed by Securities and Futures Commission (the SFC) licensed fund managers was 676 as at 30 September Notwithstanding the challenges in the global financial markets, including the European sovereign debt crisis and the slow recovery of the major developed economies, assets under management/advisory amounted to US$87.1 billion as at 30 September The SFC has identified 371 Hong Kong based licensed corporations that were hedge fund managers as at 31 March Hedge funds in Hong Kong are primarily Asia Pacific-focused with 65.4% of the assets under management/advisory as at 30 September 2012 being invested in the Asia-Pacific markets. Hong Kong remains a leading centre for the hedge fund industry for a number of reasons, including: its rigorous but flexible and accommodating regulatory regime; its proximity to the Chinese markets; its world class financial infrastructure comprising international service providers such as prime brokers, custodians, administrators and legal, accounting and tax advisers; its reliable common-law legal system; and its flexible tax regime. 1. REGULATION OF FUNDS 1.1 Authorisation and licensing requirements applicable to funds and fund managers When analysing the application of Hong Kong law and regulation in the context of hedge funds, distinctions must be drawn between retail and nonretail hedge funds and between hedge funds themselves and fund managers. Whereas retail hedge funds must be authorised by the SFC, non-retail hedge funds generally structure and conduct themselves in such a manner as to avoid the need to be authorised by the SFC. However, even where nonretail hedge funds are able to avoid the need to be authorised, the approach of the regulatory regime is generally to require their Hong Kong-based fund managers to be licensed by the SFC.

2 The principal source of regulation in respect of both authorisation and licensing is the Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) (the SFO) and its subsidary codes, guidelines and circulars. The authorisation regime and licensing regime are discussed below. 2. AUTHORISATION FOR RETAIL HEDGE FUNDS (SECTION 104 OF THE SFO) 2.1 Authorisation by the SFC Hong Kong is one of a small number of places in the world where interests in hedge funds can be sold to retail investors. According to statistics provided by the SFC, there were four authorised retail hedge funds in Hong Kong as at 30 June 2013 and the net asset value of authorised retail hedge funds was US$630 million as at 31 December Unless a hedge fund can benefit from any of the exemptions under section 103 of the SFO, the SFC s policy is that funds targeted at the public in Hong Kong require prior authorisation by the SFC. The SFC is empowered to authorise collective investment schemes, which include hedge funds (section 104 of the SFO). 2.2 Authorisation requirements The revised Code on Unit Trusts and Mutual Funds issued by the SFC became effective on 25 June 2010 (the UT Code). Although the UT Code does not have the force of law, in order for the SFC to grant authorisation in respect of a retail fund it expects the fund and relevant parties to comply with the UT Code. The UT Code contains a special section which deals with collective investment schemes that are hedge funds. The Hong Kong regulatory regime does not provide a clear definition of a hedge fund. The SFC takes the view that non-traditional funds that possess different characteristics and utilise investment strategies, that are different from traditional funds will generally be regarded as hedge funds. In light of the wide array of funds that may fall under this category, the SFC may impose additional conditions on hedge funds on a case-by-case basis and at its discretion in addition to the general requirements for the authorisation of hedge funds set out below (Chapter 8.7 of the UT Code). In general, when determining whether to authorise a hedge fund, the SFC will consider: the legal structure of the hedge fund: in particular, the liability of investors must be limited to their investment; the name of the hedge fund: where the name indicates a particular objective, geographic region or market, the hedge fund must utilise at least 70% of its non-cash assets for the purposes of pursuing investments in relation to that objective, geographic region or market; the financial details of the hedge fund: such as the valuation of the hedge fund, the amount of assets under management and the choice of asset class; the hedge fund s key operating parties: including the fund manager, the trustee or custodian and the prime broker; 02

3 the operational details of the hedge fund: such as performance fees, the frequency of dealing and the minimum subscription amount by each investor; the investment and borrowing restrictions, and the use of alternative investment strategies: such as long/ short exposures, leverage and/or hedging and arbitrage techniques; and the contents of the offering document: Appendix C to the UT Code, in particular, provides useful guidelines. 2.3 Place of establishment and structure of the retail hedge fund If a retail hedge fund is established overseas, the guiding principle adopted by the SFC when reviewing the structure of that hedge fund is that the legal and regulatory framework for the fund and the enforcement of investors rights in that particular overseas jurisdiction should provide a level of investor protection comparable with that offered in Hong Kong. 2.4 Investment and borrowing parameters The retail hedge fund must have a set of clearly defined investment and borrowing parameters in its constitutive and offering documents. The offering document must clearly explain: the types of financial instrument in which the fund will invest; the extent of diversification or concentration of investments or strategies; the extent and basis of leverage (including the maximum level of leverage); and the related risk implications of the investment and borrowing parameters. 2.5 Fund manager eligibility Every authorised fund is required to appoint a fund manager which is acceptable to the SFC and satisfies various requirements. These are considered below. 2.6 Minimum subscription The minimum initial subscription by each investor in a single retail hedge fund must be at least US$50,000 and, in the case of a retail fund of hedge funds, the minimum initial subscription must be at least US$10, Performance fees If any performance fee is payable, it may only be payable: no more frequently than once a year; and if the net asset value per unit or share exceeds the net asset value per unit or share on which a performance fee was last calculated and paid (or, if applicable, has outperformed a specified benchmark or asset class). These conditions are not applicable to a fund of hedge funds (see below for further details). 03

4 The level or basis of calculation of all costs and charges payable from a retail hedge fund s property must be clearly stated. The total level of fees for investment management or advisory services (including the fund manager s remuneration) should also be disclosed. The following must not be paid from a retail hedge fund s property: commissions payable to sales agents arising out of any dealing in the units or shares of the fund; expenses arising out of any advertising or promotional activities in connection with the fund; expenses which are not ordinarily paid from the property of funds authorised in Hong Kong; and expenses which have not been disclosed in the constitutive documents as required under the UT Code. 2.8 Redemptions A retail hedge fund must have at least one regular dealing day per month. Redemption monies must be paid to a redeeming investor within 90 calendar days of the redemption request. Compulsory redemptions are allowed only in limited circumstances when the fund manager is reasonably satisfied that it is to the overall benefit of the retail hedge fund to do so. Redemptions are permitted, for example, when the redemptions are required by law or regulation, or the continued holding of an interest in the retail hedge fund by a particular investor would cause the fund to breach a provision of law or regulation. Redemptions in specie are permitted only with the prior consent of individual redeeming investors. The offering document must disclose both the possibility of such a redemption and the requirement of the retail hedge fund to obtain the consent of the relevant individual investor prior to effecting such a redemption. The offering document must include a warning to the effect that the redemption price may be affected by fluctuations in the value of the underlying investments during the period between the lodgement of the redemption request and the date when the redemption price is calculated (Chapter 8.7 of the UT Code). 2.9 Non-Hong Kong based funds If a retail hedge fund s management company is neither incorporated in Hong Kong, nor has a place of business in Hong Kong, the management company is required to appoint a representative in Hong Kong (Chapter 9 of the UT Code) Retail funds of hedge funds The UT Code contains a specific section which deals with retail funds of hedge funds. Some of the more important provisions of that section are set out below. In order to achieve diversification, a retail fund of hedge funds must invest: (i) (ii) in at least five underlying funds; and no more than 30% of its total net asset value in any one underlying fund. 04

5 The relevant diversification strategy should be clearly explained in the offering document. A retail fund of hedge funds is expected to achieve investment returns through the performance of its underlying funds rather than direct investments in securities, futures, options, derivatives, currency or other investments through proprietary trading or managed accounts. It is therefore generally not acceptable for a retail fund of hedge funds to carry out proprietary trading directly or through the use of managed accounts. A retail fund of hedge funds may not invest in another fund of hedge funds. Where a retail fund of hedge funds invests in hedge funds which are not authorised by the SFC, this must be disclosed in the offering document. The requirements in relation to performance fees described above is not applicable to a retail fund of hedge funds. For a retail fund of hedge funds, the offering document must disclose whether a performance fee is levied at both the fund level and the underlying funds level. It must also: (i) summarise the bases of how performance fees are calculated and paid by the underlying funds; and (ii) disclose the aggregate amount or give an indicative range of all the fees and charges of the retail fund of hedge funds and each of its underlying funds. The management company of the retail fund of hedge funds must ensure that an independent trustee or custodian is appointed to safe-keep the assets of the underlying funds (Chapter 8.7 of the UT Code) Authorisation procedures Application and timing Retail hedge funds must use the prescribed application form and the prescribed information checklist published on the SFC s website to apply for authorisation. Although the time required for authorisation of a retail hedge fund depends on the facts of each case, in general the Investment Products Department of the SFC would take up an application within two working days of receipt of the application and the necessary application fees and a take-up letter will then be issued to the applicant. If 12 months have elapsed and no authorisation has been granted, the application will lapse subject to the SFC s right to grant an extension at its sole discretion. For a straightforward single hedge fund application, the SFC s aim is to provide its initial comments within seven days after the application is taken up. A complete list of the documents for inclusion in the submission pack is set out in the UT Code. A requirement introduced by the SFC in June 2010 is the product key facts statements, which must be prepared in respect of all SFC-authorised products. It forms part of the offering document and is intended to highlight key information in respect of the product to investors in a clear, concise and effective manner. 05

6 2.12 Appointment of fund manager General Every fund for which authorisation is sought must appoint a management company that is acceptable to the SFC (except for self-managed funds, where the fund is managed by its own board of directors). Various fund manager related requirements under the UT Code will need to be satisfied in order for the fund to be authorised by the SFC. A general overview of the relevant requirements is set out below Requirements under the UT Code The fund manager must be engaged primarily in the business of fund management and have sufficient financial resources at its disposal to enable it to conduct its business effectively and meet its liabilities (in particular, it must have a minimum issued and paid-up capital and capital reserves of HK$1 million). The fund manager should be based in a jurisdiction with an inspection regime that is acceptable to the SFC. The SFC has compiled a list of acceptable regimes which includes, among others, regimes in Australia, France, Germany, Hong Kong, Ireland, Luxembourg, the United Kingdom and the United States of America. The SFC will consider regimes in other jurisdictions on a case-by-case basis (Chapter 5 of the UT Code). Directors of the fund manager company must be of good repute and possess the necessary experience for the performance of their duties. The fund manager must have the requisite competence, expertise and appropriate risk management and internal control systems, it must be adequately and suitably staffed in order to manage properly the risks and operational issues in connection with the retail hedge fund s business. Acceptability criteria include: the fund manager having suitable and sufficient human and technical resources and not relying solely on a single individual s expertise; appropriate risk management systems being in place. In particular, the SFC must be satisfied with the overall integrity of the fund manager. The fund manager must have appropriate risk management and internal control systems commensurate with the fund manager s business and risk profile, including a clear risk management policy and written control procedures; and in the case of the management of a retail fund of hedge funds, the fund manager must: (i) (ii) (iii) have in place a due diligence process for the selection of the underlying funds and ongoing monitoring of their activities; demonstrate its ability to assess and monitor the performance of the managers of the underlying funds, and the ability to replace the underlying funds whenever necessary to protect the interests of investors; and submit a plan to explain its due diligence and ongoing monitoring processes and include a summary of the plan in the offering document of the fund of hedge funds. 06

7 When assessing the acceptability of a fund manager, the SFC will consider the amount of assets it manages. Generally, the SFC expects the total amount of assets under management that follow hedge fund strategies to be at least US$100 million. The SFC has recognised that: in view of the globalisation of fund management groups, an increasing number of international fund management groups establish regional hubs; there is a growing trend for them to set up local affiliates to be close to the markets in which the funds invest; and there is a need for fund management groups to have flexibility to delegate investment functions to non- Hong Kong jurisdictions. In view of this, the SFC has issued guidelines to facilitate managers of authorised funds which are licensed by the SFC and subject to regulatory supervision in an acceptable inspection regime, and who wish to delegate their investment management functions to their affiliates in a jurisdiction that is not an acceptable inspection regime, provided there are satisfactory measures in place to ensure investors interests are not compromised. 3. LICENSING REQUIREMENTS FOR FUND MANAGERS 3.1 Restriction on carrying on business in regulated activities The starting point is that no person is permitted to carry on a business in a regulated activity (nor hold himself out as carrying on a business in a regulated activity) unless he holds a licence which covers him for the relevant regulated activity (section 114(1) of the SFO). In addition, no person shall perform any regulated function in relation to a regulated activity carried on as a business (nor hold himself out as performing such function) unless he holds a licence which covers him for the relevant regulated activity (section 114(3) of the SFO). For this purpose, regulated function in relation to a regulated activity carried on as a business by any person, means any function performed for or on behalf of or by arrangement with the person relating to the regulated activity, other than work ordinarily performed by an accountant, clerk or cashier (section 113 of the SFO). A person who, without reasonable excuse, contravenes section 114(1) of the SFO commits an offence and is liable to a fine and imprisonment (section 114(8) of the SFO). Although there is no specific provision in the SFO which disapplies the licensing regime under the SFO in relation to hedge fund entities, in practice it is the investment manager rather than the fund which obtains a licence in Hong Kong. This paragraph 3 will therefore focus on the licensing requirements that are applicable to fund managers rather than to funds themselves. 07

8 3.2 Definition of carrying on business The terms carrying on a business in a regulated activity and holding oneself out as carrying on a business in a regulated activity are not defined under the SFO. However, certain activities are deemed to fall within the ambit of carrying on a business under the SFO and this term has been considered in case law. Two characteristics of carrying on a business recognised in case law are continuous conduct and profit purpose Continuous conduct Carrying on a business requires a degree of continuity as stated by the Hong Kong Court of First Instance in Chung Fai Holdings Ltd v D.H. International Ltd HCA 3351/1998 (CFI). Accordingly, if there is no continuous conduct in a regulated activity by a person, that person is unlikely to be regarded as carrying on a business in a regulated activity and is unlikely to be subject to any licensing or registration requirement Profit purpose Carrying on a business requires an element of profit motive or purpose (Smith v Anderson (1880) 15 Ch D 247). Accordingly, if a person engages in a regulated activity otherwise than for the purpose of producing a profit, such a person would not be subject to any licensing or registration requirement. This, of course, is unlikely to apply to hedge funds or fund managers. If it is established that a hedge fund manager is carrying on a business in Hong Kong, the next step is to consider whether any of its activities constitute a regulated activity. 3.3 Regulated activities There are 10 types of regulated activities, which are set out in Part 1 of Schedule 5 to the SFO: Type 1 dealing in securities; Type 2 dealing in futures contracts; Type 3 leveraged foreign exchange trading; Type 4 advising on securities; Type 5 advising on futures contracts; Type 6 advising on corporate finance; Type 7 providing automated trading services; Type 8 securities margin financing; Type 9 asset management; and Type 10 providing credit rating services. 08

9 Given the diversity of activities that hedge funds and/or their fund managers conduct, the type of licence required by a hedge fund and/or its fund manager will vary from case to case. The more relevant activities are usually Type 1 (dealing in securities), Type 2 (dealing in futures contracts), Type 4 (advising on securities), Type 5 (advising on futures contracts) and Type 9 (asset management) regulated activities. A typical fund manager will hold a licence only in respect of the Type 9 (asset management) regulated activity Type 9 activity (asset management) Asset management (Type 9) includes the discretionary management of a portfolio of securities or futures contracts for another person (Part 2 of Schedule 5 to the SFO). It catches the business activities of a typical fund manager operating in Hong Kong. Fund managers are therefore usually licensed to carry out Type 9 regulated activities Type 1 activity (dealing in securities) Dealing in securities (Type 1) includes the making or offering to make an agreement with such person for the acquisition, disposal or subscription of securities (or inducing a person to enter into such an agreement). It therefore catches the marketing of interests in a hedge fund (Part 2 of Schedule 5 to the SFO). If a fund manager is licensed for Type 9 regulated activity and deals in securities solely for the purposes of carrying on the Type 9 regulated activity, a Type 1 licence would not be necessary. Accordingly, a Type 9 fund manager may rely on this exemption in order to engage in marketing activities relating to the funds under its management without requiring a licence for Type 1 regulated activities. However, this exemption would not apply if the fund manager purports to market other funds which are not under its management Type 2 activity (dealing in futures contracts) Dealing in futures contracts (Type 2) includes the making or offering to make an agreement with another person to enter into, or to acquire or dispose of a, futures contract (or inducing a person to enter into, or to offer to enter into, a futures contract). If the hedge fund or the fund manager is licensed for Type 9 regulated activity and deals in futures contracts solely for the purposes of carrying on that regulated activity, a Type 2 licence would not be necessary (Part 2 of Schedule 5 to the SFO) Type 4 activity (advising on securities) Advising on securities (Type 4) broadly means giving advice, or issuing analyses or reports, on whether, which, the time of which, or the terms on which, securities should be acquired or disposed of (Part 2 of Schedule 5 to the SFO). Although the definition of advising on securities is wide enough to catch the activities of a fund manager, there are a number of exceptions including: (i) where a person holding a licence for Type 9 activities (asset management) gives advice solely for the purposes of providing the asset management services; and (ii) where a person gives advice solely to certain related group companies. 09

10 If a fund management group seeks to have a presence in Hong Kong, but does not wish to be licensed, exemption (ii) can be used if the Hong Kong entity merely provides investment advice and research reports to its group companies outside Hong Kong. If this mechanism is used, the overseas group companies should assess such advice or reports rendered by the Hong Kong entity before using it, and any advice/reports to third parties should be published in the names of the overseas group companies (and not in the name of the Hong Kong entity). In this way, the Hong Kong entity is limited to operation within exemption (ii) to advising on securities and therefore need not be licensed. Note that the Hong Kong entity may not exercise any investment discretion Type 5 activity (advising on futures contracts) Advising on futures contracts (Type 5) broadly means giving advice, or issuing analyses or reports, on whether and, if so, which, the time at which, or the terms on which, futures contracts should be entered into (Part 2 of Schedule 5 to the SFO). Exceptions available are similar to those available to Type 4 regulated activity and accordingly, fund managers who avail themselves of these exceptions do not need to be licensed for Type 5 activities. 3.4 Extra-territorial effect of section 114 of the SFO The SFO provides that where: (i) a person actively markets his services to the public, whether by himself or through another person on his behalf and whether in Hong Kong or from a place outside Hong Kong; and (ii) such services are regulated activities, then such a person is to be regarded as carrying on a business in that regulated activity (section 115 (1)(i) of the SFO) Actively markets The SFC takes the view that the term actively markets includes: frequently calling on Hong Kong investors and marketing services to them (including offering products); running a mass media programme targeted at the investing public in Hong Kong; and internet activities that target Hong Kong investors. In determining whether or not any person actively markets its services to the public, the SFC will consider the nature of the business activities as a whole and a number of factors including whether: there is a detailed marketing plan to promote the services; services are extensively advertised via marketing means such as direct mailing, advertisements in local newspapers and broadcasting; marketing is conducted in a concerted manner and executed in accordance with a plan or a schedule which indicates a continuing service rather than a one-off exercise; services are packaged to target the Hong Kong public (for example, the advertisements are written in Chinese and prices are denominated in Hong Kong dollars); and services are sought out by customers on their own initiative. 10

11 3.4.2 Definition of public Public is defined as the public of Hong Kong, and includes any class of that public (section 1 of Part 1 of Schedule 1 to the SFO and section 3 of the Interpretation and General Clauses Ordinance (Cap 1 of the Laws of Hong Kong). Following previous market practice, as noted in the Report of a Working Group entitled Offers of Securities and Other Investments published by the SFC in December 1991 (the SFC Working Group Report), the general consensus was that 50 persons (or less) in Hong Kong would not constitute the public. The SFC Working Group Report noted that the SFC had informally stipulated that, in order not to issue a document or an invitation to the public: not more than 50 copies of the offering document or invitation should be issued; each copy should be serially numbered; each copy should be individually addressed to a named person; and each copy should make clear that only the named addressee is entitled to take up the offer or invitation, and that they are not entitled to transfer their acceptance to any other person. 3.5 Licensing A fund manager who engages in a regulated activity which does not fall within the exceptions will require a licence. Some of the more significant points in respect of the licensing process and ongoing obligations are set out below Application process Items that need to be submitted to the SFC in respect of an application for a licence include: the prescribed application forms, which can be downloaded from the SFC s website; supporting documents such as the corporate and shareholding structure of the applicant; operational and internal controls procedures manual; standard client agreement; and the application fee payable to the SFC (the application fee in respect of a Type 9 licence is currently HK$4740 (and further fees will be due in respect of the individuals employed by the applicant)). The SFC generally takes approximately 15 weeks to issue a licence for a licensed corporation, eight weeks for a licensed representative and 10 weeks for a responsible officer. As explained below, an expedited licensing process is available, predominantly, to hedge fund managers already licensed or regulated in the United Kingdom or the United States. 11

12 3.5.2 Expedited licensing process An expedited licensing process may be available to a hedge fund manager if: it is already licensed or registered by the Financial Conduct Authority (the FCA) in the United Kingdom or by the Securities and Exchange Commission (the SEC) in the United States; it has a good compliance track record; and it serves only professional investors (as defined in Section 1 of Part 1 of Schedule 1 to the SFO and supplemented by the Securities and Futures (Professional Investor) Rules (Cap. 571D of the Laws of Hong Kong). A hedge fund manager may also benefit from this expedited licensing process if its parent company satisfies the first two points above. A hedge fund manager that is not licensed or registered in the United Kingdom or the United States may also be able to benefit from the expedited process if it or its parent company has a good compliance track record in another jurisdiction Fit and proper criteria The fit and proper criterion is one of the most important criteria when accessing an applicant s licensing application. The SFC published the Fit and Proper Guidelines in October Although the guidelines do not have the force of law, they set out a number of matters that the SFC would normally consider in determining whether a person is fit and proper Who may obtain a licence Only bodies corporate may be licensed as licensed corporations, and only individuals may be licensed as responsible officers or other licensed representatives, to conduct regulated activities (sections 116 and 120 of the SFO) Licensed corporations A licensed corporation may be a company incorporated in Hong Kong or an overseas company registered with the Companies Registry of Hong Kong. Sole proprietorships or partnership are not acceptable forms of business structure for the purposes of licensing (Paragraph of the Licensing Information Booklet issued by the SFC in April 2013 (the Licensing Booklet)). The corporation must satisfy the SFC that it has a proper business structure, good internal control systems and qualified personnel to ensure proper management of risks that it will encounter in carrying on its proposed business as detailed in its business plan. The SFC has published detailed guidelines in: (i) the Guidelines on Competence dated March 2003; (ii) the Code of Conduct for Persons Licensed by or Registered with the SFC dated October 2013 (the Code of Conduct); and (iii) the Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the SFC dated April

13 3.5.6 Responsible officer A licensed corporation must appoint at least two responsible officers to supervise directly the conduct of each regulated activity. For each regulated activity, there should be at least one responsible officer available at all times to supervise the business (paragraph of the Licensing Booklet). Pursuant to the Guidelines on Competence dated March 2003 issued by the SFC, a responsible officer should have at least three years relevant industry experience over the six years immediately prior to the date of the application to the SFC for approval as a responsible officer. In the circular entitled SFC adopts a Pragmatic Approach to Licensing Fund Managers issued by the SFC on 11 June 2007, the SFC clarified the requirements concerning responsible officers of overseas hedge fund managers applying for a Type 9 licence: (i) (ii) at least one of the responsible officers is required to be based in Hong Kong, and at least one of the responsible officers must be immediately contactable at all times by the SFC and by the fund manager s staff who work from its Hong Kong office; experience acquired from asset management, proprietary trading, research, private equity as well as experience in dealing with other alternative investments, will be considered as industry experience directly relevant to hedge fund manager. If the proposed responsible officers do not fulfil criteria specified in the above circular, they will likely be required to sit Hong Kong regulatory examinations Substantial shareholders, etc. Substantial shareholders, officers and any other person who is or is to be employed by, or associated with, a licensed corporation for the purposes of the regulated activity for which the application is made must also satisfy the fit and proper test (section 129 of the SFO) Licensed representatives In order for an individual to perform any regulated function in their principal s business involving a regulated activity, that individual is also required to be licensed by the SFC as a licensed representative (section 114(3) of the SFO). The SFC also requires the applicant to be fit and proper in order to be licensed for the regulated activity (section 120 of the SFO). A proposed licensed representative may well be required to sit Hong Kong regulatory examinations Financial resources A licensed corporation is subject to various minimum paid-up share capital and minimum liquid capital requirements prescribed in the Securities and Futures (Financial Resources) Rules (Cap. 571N of the Laws of Hong Kong). 13

14 The provisions governing these capital requirements are complex, but the basic position is as follows: the specific amount of capital to be held varies depending on the type of regulated activity that the licence is intended to cover and on conditions that may be attached to the licence; the amount of paid-up share capital that must be held is set at a specified minimum; and the amount of net liquid capital that must be held is the higher of: (i) (ii) a specified minimum; and 5% of the sum of on-balance sheet liabilities (including incurred or contingent liabilities) less client money that is held in certain specified accounts Continuing obligations Licensed or registered persons are subject to, inter alia: continuing reporting obligations upon the happening of various events and changes, such as cessation of business (section 135 of the SFO and paragraph 8.6 of the Licensing Booklet) or change of business; restrictions on unsolicited calls. Section 174 of the SFO prohibits most types of cold-calling and/or unsolicited calls. A useful exemption is set out in the Securities and Futures (Unsolicited Calls Exclusion) Rules (Cap. 571A of the Laws of Hong Kong), which exempts any communication that is not made in the course of any visit in person, telephone conversation or other interactive dialogue (where statements and responses to them are exchanged immediately). Cold calls to professional investors are also exempted from these restrictions; obligations to pay annual fees and to submit annual returns to the SFC within one month after each anniversary date of the licence(s) (section 138 of the SFO); an obligation to manage risks prudently. The SFC stated in its circular to all licensed corporations dated 25 February 2008 (supplemented by its circular dated 15 September 2011) that deficiencies in risk management policies and procedures will attract firm regulatory action from the SFC, including imposition of conditions on licences. This will involve public notification of the restrictions imposed. Unacceptable risk management practices include: (i) (ii) (iii) absence of formal risk management policies and procedures; imprudent credit policies; and lax margin call procedures; and the Fund Manager Code of Conduct issued by the SFC in April This applies to licensed persons whose business involves the discretionary management of collective investment schemes (whether authorised or unauthorised). It sets out minimum standards of conduct that is expected of a fund manager and covers areas such as organisation and structure, staff ethics, conduct in relation to fund management, custody of client s assets and dealing with clients. It also sets out the minimum content requirements for 14

15 discretionary client agreement. While a failure by a licensed or registered person to comply with this Code will not of itself render the licensed or registered person liable to any judicial or other proceedings, the SFC will consider whether such failure tends to reflect adversely on the licensed or registered person s fitness and properness to remain a licensed or registered person. 4. REGULATION OF ACTIVITIES OF HEDGE FUNDS AND HEDGE FUNDS MANAGERS 4.1 Regulation of advertisements Prohibition against unauthorised issue of investment advertisements The SFO generally prohibits the unauthorised issue of documents containing invitations to the public to, inter alia, purchase or dispose of securities, or participate in a collective investment scheme unless an exemption can be relied upon (section 103 of the SFO). The prohibition would catch an issue by a hedge fund, and an issue by a fund manager, of such documents Advertisements, invitations and documents delivered on the internet In addition, in March 1999 the SFC published the Guidance Note on Internet Regulation and specifically confirmed that the prohibition applies equally to advertisements, invitations and documents delivered on the internet. However, the SFC would not generally seek to apply the regulatory requirements to activities where they are not targeted at people residing in Hong Kong Exemptions to the investment advertisement regime The more relevant exemptions to the prohibition against advertisements to the public are set out below: advertisements, invitations and documents which are (or are intended to be) targeted only at professional investors (section 103(3)(k) of the SFO); and advertisements, invitations and documents issued by a licensed or registered intermediary (section 103(2) (a) to (c)). However, this exemption is disapplied in relation to anything done by any person in respect of any interest in a collective investment scheme that is not authorised by the SFC under section 104 of the SFO (section 103(11) of the SFO). 4.2 Public offers regime On 13 May 2011, the regulation of the Hong Kong public offers regime in respect of structured products was transferred to the SFO. The effect is that all structured products, regardless of their legal form, are regulated under the SFO. As collective investment schemes, which generally include openended hedge funds, are specifically excluded from the meaning of structured products, the Companies Ordinance public offers regime will therefore continue to apply to hedge fund offerings to the extent that they take the form of either shares or debentures. Under the Companies Ordinance (Cap. 32 of the Laws of Hong Kong) (CO), it is not lawful to issue any form for application for shares in or debentures of a company (other than structured products as defined in section 70) unless the form is issued with a prospectus which: 15

16 complies with specified content requirements, to be issued with the application form for such shares or debentures; and is registered with the Hong Kong Companies Registry. However, these requirements do not need to be complied with if, among others: the shares or the debentures are not offered to the public; or the issue is within a safe harbour, such as private placements, offers to professional investors and offers in connection with an authorised collective investment scheme (ie, an excluded offer specified in Part 1 of the Seventeenth Schedule to the CO). 4.3 Short selling The SFO sets out requirements and obligations in respect of short selling in Hong Kong. A breach of them may constitute a criminal offence punishable by fines and/or imprisonment. The requirements and obligations are summarised below Prohibition on naked short selling Unless exempted under section 170(3) of the SFO, on-exchange naked short selling is prohibited under section 170(1) of the SFO. The selling of securities at or through The Stock Exchange of Hong King Limited (the Exchange) is naked short selling unless, at the time of sale, the seller (or its client, if it is an agent): has a presently exercisable and unconditional right to vest the securities in the purchaser of them; or believes and has reasonable grounds to believe that it (or its client if it is an agent) has such a right Regulations on covered short selling Subject to certain limited exemptions contained in the Rules of the Exchange, on-exchange covered short sales may only be effected in certain securities prescribed by the Exchange ( designated securities ), and all such short selling activities must be executed at or through the Exchange. One of the more important rules applicable to a short sale of designated securities is the Tick Rule, which requires that a short sale must not be made on the Exchange below the best current ask price Requirements to flag short sales Section 172 of the SFO requires that an Exchange participant (a person who is authorised to trade on or through the Exchange) who knows that an order is a short selling order must: if passing on the order to another person for execution, inform that person that the order is a short selling order; or if inputting the order into the Exchange trading system, mark it as a short sale in accordance with the Rules of the Exchange. 16

17 The Securities and Futures (Short Position Reporting) Rules (Cap 571AJ of the Laws of Hong Kong) set out additional short position disclosure requirements. A short seller will need to compute his or her short position in certain listed shares on the Exchange at the end of the last trading day of each week in order to determine whether it amounts to, or exceeds, 0.02 per cent of the issued share capital of that particular listed company; or the value of the short position amounts to, or exceeds, HK$30 million, whichever is lower. If the short position amounts to, or exceeds, such threshold then the gross short position must be reported to the SFC. 4.4 Futures contracts and stock options position limits and large open position reporting requirements The Securities and Futures (Contracts Limits and Reportable Positions) Rules (Cap 571Y of the Laws of Hong Kong) prescribe limits and reporting positions applicable to futures contracts and stock options contracts traded on the Exchange or the Hong Kong Futures Exchange Limited. Unless exempted, no person may hold or control futures contracts or stock options contracts in excess of the prescribed limit. Any person who holds or controls a prescribed reportable position must lodge a written notice with the relevant exchange. Any person who, without reasonable excuse, fails to comply with these requirements commits an offence and is liable to a fine or imprisonment. 4.5 Disclosure of interests If a hedge fund is interested in more than 5% of voting shares in a listed corporation in Hong Kong, it would be considered a substantial shareholder for the purposes of the SFO disclosure regime. An obligation on a substantial shareholder to make a disclosure arises upon the happening of certain relevant events, which include: the substantial shareholder ceasing to be interested in at least 5% of theshares; there is an increase or decrease in the percentage figure of the substantial shareholder s holding that results in its long position crossing over a whole percentage number which is above 5% (eg, the substantial shareholder increases its long position from 7.8 to 8.1%); the substantial shareholder acquiring or ceasing to have a short position of more than 1% in the shares (eg, the substantial shareholder takes a short position of 1.5%); there is an increase or decrease in the percentage figure of the substantial shareholder s short position that results in its short position crossing over a whole percentage number which is above 1% (eg, the substantial shareholder increases its short position from 1.8 to 2.2%); and the nature of the substantial shareholder s interest in the share changes (eg, on exercise of a share option). Upon the occurrence of a relevant event, a prescribed notice must generally be filed with the Exchange within three business days. 4.6 Side letters Side letters which provide preferential terms for certain hedge fund investors (such as preferential redemption rights, preferential information rights and fee rebates) are common in Hong Kong. In relation to side letter arrangements which provide preferential terms for certain hedge fund investors (such as preferential redemption rights and preferential information rights), the SFC considers that, in order to ensure fair treatment of investors, it is good practice to: 17

18 disclose material terms to all existing and potential investors; and highlight, where applicable, that side letters have been entered into with any investors with significant shareholdings or interests. In relation to preferential terms regarding fees, some hedge fund groups grant such terms through the investment manager rather than through the fund, so the matter becomes one between the investor and the fund manager rather than between the investor and the fund. 4.7 Regulation of OTC derivatives The SFC and the Hong Kong Monetary Authority have proposed a new regulatory regime for over-the-counter (OTC) derivatives, the framework of which is to be set out in the SFO. The proposals include a new regulated activity covering dealers, advisers and clearing agents in the OTC derivatives market, mandatory reporting requirements and mandatory central clearing requirements. The legislative framework will be implemented by the Securities and Futures (Amendment) Bill 2013, which was gazetted on 28 June Further details will be provided in subsidiary legislation (which has yet to be published). 4.8 Inspection and enforcement action Recently, the SFC has been taking a more robust approach in its inspection and enforcement actions. The SFC s regulatory reach has been extended by the Securities and Futures Commission v. Tiger Asia Management LLC and others (HCMP 1502/2009) case, which established that Hong Kong s High Court may (for remedial or protective purposes) determine market misconduct and make orders against persons located outside its jurisdiction, allowing for the swift sanction of fund managers engaged in market misconduct. This enforcement avenue is in addition to the other enforcement mechanics set out in Parts XIII and XIV of the SFO. 4.9 Professional investor regime and client agreement requirements In May 2013, the SFC published proposals to revise the existing professional investor regime in Hong Kong as well as proposals to introduce additional requirements for client agreements. The proposals include classifying professional investors, for the purpose of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the Code of Conduct), as institutional professional investors, corporate professional investors or individual professional investors. Under the proposals, certain existing waivers from provisions of the Code of Conduct will no longer be available to intermediaries when dealing with individual professional investors. In addition, the proposals include the requirement that an intermediary s agreements with its clients contain the suitability requirement (the obligation to ensure the suitability of any recommendation or solicitation for their clients is reasonable); and do not contain terms which are inconsistent with the Code of Conduct and accurately set out in clear terms the actual services to be provided to the client. The proposal that the suitability requirement be incorporated as a contractual term has raised market concerns, in particular in respect of execution-only deals. It has been suggested that the requirement will transfer the onus of investment decision making from clients to their licensed advisers. It appears, however, that the proposals will not affect registered persons that are acting in the capacity of a management company in relation to the discretionary management of collective investment schemes, to whom the Code of Conduct does not apply. 18

19 4.10 Electronic trading In March 2013, the SFC published its consultation conclusions on a regulatory framework for electronic trading. The rules will apply to fund managers and brokers who conduct/facilitate electronic trading of securities and futures contracts, including internet trading, direct market access and algorithmic trading. Although not held strictly liable for any violations committed by clients, fund managers and brokers will be responsible for orders sent to the market through their electronic trading systems and for implementing policies, procedures and controls to supervise the making of those orders in accordance with applicable regulatory requirements. The rules are detailed and cover: management and supervision: the responsibility to ensure compliance rests with the responsible officers or executive officers and the management of the fund managers and of the relevant brokers; adequacy of system: the responsibility to ensure electronic trading systems are subject to testing and meet regulatory standards with respect to reliability, controls, security and capacity and that contingency measures are in place; record keeping: the obligation to keep, or cause to be kept, proper records on the design, development, deployment and operation of the electronic trading systems; and risk management: the obligation to put in place risk management and supervisory controls to monitor orders and trades, including automated pre-trade controls and regular post-trade monitoring. In addition to fund managers and brokers, the rules will also apply to the operators of Automated Trading Services (ATS)/dark pools to the extent that the orders are transmitted to the ATS/dark pools by their electronic trading systems, including via the internet. The electronic trading rules will be included in the Code of Conduct and the Fund Manager Code of Conduct and will take effect on 1 January LISTING OF HEDGE FUNDS It is possible for a hedge fund to list on the Exchange. If a hedge fund is authorised under section 104 of the SFO, its listing on the Exchange would follow Chapter 20 of the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (the Hong Kong Listing Rules). If a hedge fund is not authorised under section 104 of the SFO, its listing on the Exchange would follow Chapter 21 of the Hong Kong Listing Rules. Some of the principal differences between a listing pursuant to Chapter 20 and a listing pursuant to Chapter 21 are: The Exchange s timetable is triggered by filing with the Exchange a set of prescribed documents (including an advanced proof of listing document): (i) in the case of a listing under Chapter 20, 10 clear business days before the hearing by the Listing Committee of the Exchange; and 19

20 (ii) in the case of a listing under Chapter 21, 25 clear business days before the hearing by the Listing Committee of the Exchange. For a listing under Chapter 20, most of the preparatory work will take place at the stage of the SFC authorisation. The Exchange would normally grant a listing in respect of a collective investment scheme which has been authorised by the SFC. However, given Chapter 21 would be used for a hedge fund that is not authorised under section 104 of the SFO, the SFC would not be the primary regulator involved in the process. 6. TAXATION OF HEDGE FUNDS 6.1 Hong Kong income taxes Hong Kong has three separate types of income tax: property tax, which is charged on the owner of land or buildings situated in Hong Kong; salaries tax, which is charged on a person in respect of his income arising in or derived from Hong Kong from employment or pensions; and profits tax, which is charged on a person carrying on a trade, profession or business in Hong Kong in respect of income profits (and excluding capital gains profits) arising in or derived from Hong Kong from that trade, profession or business. Unlike many other jurisdictions, Hong Kong does not have a separate capital gains tax regime. Of the three income taxes, the one most relevant to hedge funds is profits tax. The rate of profits tax for corporations is 16.5% for the year of assessment commencing 1 April Hong Kong stamp duty Hong Kong stamp duty is chargeable on: the transfer or lease of land or buildings situated in Hong Kong; the transfer of Hong Kong stock (which in practice usually means shares in Hong Kong incorporated companies or companies listed on the Exchange); and the issue of certain bearer instruments. Of the different heads of stamp duty, the one most relevant to hedge funds is stamp duty chargeable on the sale and purchase of shares in Hong Kong incorporated companies or companies listed on the Exchange. Unit trusts, bonds and bearer instruments are often structured so as to fall outside of the charge to stamp duty. As a redemption of shares in a fund is not considered a sale or purchase of shares and a redemption of units in a unit trust is specifically exempted from stamp duty by section 19(1A) of the Stamp Duty Ordinance (Cap. 117 of the Laws of Hong Kong), stamp duty is not chargeable in respect of the redemption of either shares of or units in a fund. Stamp duty is chargeable at the rate of 0.2% of the consideration for (or, in the case of gifts, the value of) the shares in a Hong Kong incorporated company or a Hong Kong listed company. 20