A number of leveraged funds, futures and options funds and market neutral funds seeking absolute returns were authorised by the Securities and Futures Commission in Hong Kong (SFC) during the 1990s, although most have since been wound up or deauthorised.
The SFC’s Code on Unit Trusts and Mutual Funds (which sets out the constitutional and operational requirements with which a fund has to comply in order to be authorised) was amended in May 2002 to introduce guidelines for the authorisation of hedge funds.
One of the factors which has restrained the development of a hedge fund industry in Asia has been the restriction imposed on short selling of securities in most of the Asian jurisdictions.
An open-ended fund which has not been authorised by the SFC can only be sold in Hong Kong in an offer which does not constitute an offer to the public.
As of 1 April 2003, the principal securities requirements for offers of securities in Hong Kong are contained in the Securities and Futures Ordinance (SFO) and the Companies Ordinance. The SFO superseded and consolidates 10 different ordinances, which previously governed the securities industry, and introduced a number of significant changes to the regulation of the securities and futures market in Hong Kong. In general, Part IV of the SFO prohibits any issue to the public of advertisements and documents relating to a wide range of investment products unless authorised by the SFC. There are several exceptions to this general rule, the main one being offers made only to ‘professional investors’, which term is defined to include, inter alia, trust corporations with at least HK$40 million in assets, high net worth individuals with portfolios of at least HK$8 million and corporations or partnerships with assets of HK$40 million or a portfolio of at least HK$8 million.
The Companies Ordinance was amended with the introduction of the Companies (Amendment) Ordinance 2004 on 3 December 2004 to conform with the professional investor exemption in the SFO, and introduced a number of other significant exemptions.
Prior to 3 December 2004, the Companies Ordinance prohibited any person from issuing, circulating or distributing in Hong Kong any ‘prospectus’ offering for subscription shares in, or debentures of, a company incorporated outside Hong Kong, whether that company had established a place of business in Hong Kong or not, unless the prospectus complied with the various requirements of Part XII of, and the Third Schedule to, the Companies Ordinance.
Failure to register a complying prospectus can result in the fund, and any person who is knowingly a party to the issue of the prospectus (or any application form), being liable for a fine of up to HK$100,000. Additional penalties (including fines of up to HK$500,000 and imprisonment for up to three years) may also be incurred for matters such as the prospectus containing an untrue statement.
The term ‘prospectus’ was widely defined in the Companies Ordinance to mean:
any prospectus, notice, circular, brochure, advertisement, or other document:
• offering any shares or debentures of a company to the public for subscription or purchase for cash or other consideration; or
• calculated to invite offers by the public to subscribe for or purchase for cash or other consideration any shares or debentures of a company.
Offer to ‘the public’
In order to be exempt from the requirement to prepare and register a prospectus, it is necessary to establish that the offer is either not made to ‘the public’ (as a matter of common law) or that the offer falls within one of the available statutory exemptions.
The term ‘public’ is not defined, and there have been no judicial decisions in Hong Kong on this point. However, the Companies Ordinance specifically provided that references to offering shares to the public included references to offering them to any section of the public, including where selected as clients of the person issuing the prospectus or in any other manner. Despite this, many intermediaries and private banks appear to have operated under the misapprehension that an offer made only to their own clients was not an offer to the public.
With effect from 3 December 2004, the Companies (Amendment) Ordinance 2004 has introduced certain far-reaching changes. Two main changes relevant to hedge funds were: (i) the introduction of a new definition of prospectus; and (ii) the introduction of a broader range of exemptions (enumerated in a new Part I to the Seventeenth Schedule) which are more in line with the exemptions afforded under the SFO. Under the amended Companies Ordinance, the following (non-exclusive) list of offers do not fall within the statutory definition of a ‘prospectus’:
(1) offers made to ‘professional investors’ as defined in the SFO and subsidiary legislation on an unlimited basis;
(2) offers made to not more than 50 persons and containing a specified warning statement;
(3) offers in respect of which the total consideration payable for the shares or debentures concerned does not exceed HK$5 million or its foreign currency equivalent and containing a specified warning statement; and
(4) offers in respect of which the minimum denomination of, or the minimum consideration payable by any person for the shares, or in the case of debentures, the minimum principal amount to be subscribed or purchased, is not less than HK$500,000 or its foreign currency equivalent and containing a specified warning statement.
The first two exemptions can be combined, so that an offer may be made to an unlimited number of professional investors plus not more than 50 offerees who do not qualify as professionals.
Since most hedge funds are established in corporate form, the above amendments are expected to have a positive influence on the development of the hedge fund industry in Hong Kong.
In October 2001, the SFC published a consultation paper on the public offering of hedge funds in Hong Kong and invited comments from the public and the industry in particular. The level of response demonstrated the high degree of interest in this area, with 36 individual submissions and a group response co-ordinated by Deacons on behalf of 24 industry practitioners. The SFC published its conclusions on 2 May 2002, together with the revised guidelines on the authorisation of hedge funds which became effective on 17 May 2002.
The SFC has created a regulatory environment to stimulate the growth of funds of hedge funds, which will in turn act as incubators for smaller hedge funds and niche, start-up managers. Fund of funds managers will act as ‘gate keepers’ for the industry. This has been achieved by imposing relatively high entry requirements for managers. These requirements rule out most single manager, single strategy funds, but they are likely to be met by many large established fund of funds managers. At the same time, the SFC has placed very few limits on fund of funds managers’ investment discretion. Accordingly, single strategy, single manager funds will benefit indirectly from the flow of retail money into funds of hedge funds, as they will qualify for investment by authorised funds of hedge funds notwithstanding that they themselves may not qualify to raise money directly from the retail public.
This balance will suit many single strategy, single manager funds, which have neither the desire nor the resources to deal with the retail public.
The requirement for the manager to be regulated in a jurisdiction recognised by the SFC as having a suitable inspection regime prevents funds managed in most other Asian countries from being authorised in Hong Kong, but again, they are quite likely to benefit indirectly because Hong Kong-authorised funds of hedge funds will be able to invest in them.
If a manager regulated in a jurisdiction which has not been recognised as having a suitable inspection regime wants to get authorised directly, it will be necessary to persuade the regulators in the manager’s home jurisdiction to explain to the SFC how managers in that jurisdiction are regulated. This will involve a detailed explanation of the regulatory system, and in particular the ongoing monitoring, supervision and reporting obligations of regulated entities. The local regulator will also be required to enter into a memorandum of understanding with the SFC, which provides for mutual co-operation and the exchange of information about regulated entities.
The SFC has adopted a market segmentation approach for the authorisation of hedge funds, distinguishing between guaranteed hedge funds, funds of hedge funds and other hedge funds which one might categorise as single strategy funds. A different level of minimum subscription is prescribed for each of these categories of fund.
Hedge funds offered with a 100% capital guarantee are not required to impose any minimum subscription.
For funds of funds, the minimum subscription requirement is US$10,000.
For single strategy funds, the minimum subscription is US$50,000.
In order to be approved, a manager will need to show that it has US$100 million in assets under management in hedge fund strategies. Proprietary assets can be counted, although the SFC will generally look for experience in managing third-party assets.
Single strategy fund managers require five years’ general experience in hedge fund strategies with at least two years’ experience in the strategies to be used by the proposed hedge fund.
Fund of funds managers will require five years’ relevant experience with at least two years’ experience as a fund of funds manager. Fund of funds managers are expected to perform due diligence in selecting and monitoring the underlying funds and their managers. Much emphasis is placed on the manager’s due diligence process and monitoring systems.
The manager must be able to demonstrate that it has experience managing public funds.
Managers of the underlying funds of hedge funds will not be required to comply with the assets under management requirement, but will need at least two years’ experience in the relevant investment strategy. Up to 10% of the NAV of a fund of funds may be invested in underlying funds managed by managers with less than two years’ experience. The fund of funds manager will be obliged to ensure that the managers of the funds in which they invest meet these requirements. Neither the underlying funds themselves nor their managers need to be authorised.
It is not necessary for the managers of the underlying funds to be regulated in a jurisdiction with a suitable inspection regime.
Fund of funds managers will be required to submit a compliance plan to the SFC to explain how they propose to monitor the activities of underlying fund managers on an ongoing basis. This compliance plan, and the manager’s internal controls, risk management systems and monitoring systems will be examined closely by the SFC as part of the application process.
Risk warnings are required in fund of funds’ offering documents to reflect the fact that the underlying funds and their fund mangers are not regulated.
Authorised funds must have monthly dealing days and are required to pay out redemption proceeds within 90 days of receipt of a valid redemption request. They can charge performance fees but only on an annual basis and subject to a high water mark, so that investors do not end up paying a performance fee where the increase in the share price is merely making up for a previous decline. Again, these requirements need not be met by the underlying funds of a fund of hedge funds, but appropriate disclosures must be made in the offering document of the fund of funds.
The SFC has not imposed any investment or borrowing restrictions for single strategy funds. The manager is, however, obliged to make appropriate disclosure of: the type of investments and strategies the fund will undertake; the expected degree of diversification or concentration of investments; the expected and maximum level of leverage; and the risk implications of the managers’ investment and borrowing parameters.
Some limited investment restrictions are imposed on funds of funds to require a level of diversification: funds of funds must invest in at least five underlying funds, with no more than 30% of NAV invested in any one fund. The manager’s diversification strategy must be disclosed in the offering document. A risk description of the fund of funds will be required and the investment strategy will have to match that risk description.
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