A Q&A guide to investment funds law in Hong Kong.
This Q&A is part of the PLC multi-jurisdictional guide to investment funds. It provides a high level overview of investment funds in Hong Kong, looking at both retail funds and hedge funds. Areas covered include a market overview, legislation and regulation, marketing, managers and operators, restrictions and requirements, tax and upcoming reform.
Hong Kong allows local and foreign funds to be authorised for public sale. In December 2011, there were 1,854 retail funds (excluding assurance and retirement schemes), with most of them established and managed outside Hong Kong. In the first nine months of 2011, gross fund sales to Hong Kong retail investors were US$31.5 billion (as at 1 November 2011, EUR1 was about US$1.4). Net sales were US$6.1 billion (compared with US$6.2 billion for the whole of 2010, and a previous annual record of US$6.9 billion in 2007). Bond funds accounted for 42% of net sales, further eroding the dominance of equity funds, now at 46%. Balanced funds doubled their share, but still accounted for only 6% (Hong Kong Investment Funds Association). Following investor demand, the fund industry in Hong Kong has continued to show particular enthusiasm for renminbi-denominated products.
The principal market for closed-ended retail funds in Hong Kong is in real estate investment trusts (REITs) authorised by the Hong Kong Securities and Futures Commission (SFC) and listed on the Hong Kong Stock Exchange. There are nine listed REITs, including the first renminbi-denominated REIT in the world, which was listed in April 2011. The listed REITS had an aggregate market capitalisation of US$14.9 billion in December 2011, rising from US$13.2 billion at the end of 2010.
Regulatory framework. Retail funds are regulated principally under the Securities and Futures Ordinance (SFO) and its subsidiary legislation, together with codes and guidelines issued by the SFC, in particular the Code on Unit Trusts and Mutual Funds (UT Code). Listed funds are also subject to Stock Exchange Listing Rules. In particular, Chapter 20 sets out the rules for the listing of interests in SFC authorised schemes.
Regulatory bodies. Open-ended retail funds are regulated by the SFC.
Regulatory framework. The SFC generally authorises closed-ended retail funds only if they are listed and therefore subject to Stock Exchange Listing Rules. Retail REITs must also comply with the SFC's Code on Real Estate Investment Trusts.
Regulatory bodies. Closed-ended retails funds are regulated by the SFC.
Local and foreign funds must be authorised by the SFC before being offered on a retail basis. SFC authorisation involves a review of the suitability of the fund, as well as the suitability of the fund's operators, in particular the manager and the custodian.
Applicants must submit, among other things:
An application form and applicable fee.
Copies of the fund's constitutive and offering documents, annotated for compliance with the UT Code.
Agreements appointing service providers.
Authorisation requirements and procedures for REITs are similar to those for open-ended retail funds. Operational and documentation requirements for the REIT, and qualifying requirements for its service providers, are set out in the REIT Code. For listing, closed-ended funds must engage a sponsor responsible for preparing the application and liaising with the Stock Exchange.
Generally, persons marketing local or foreign funds must be licensed by the SFC for Type 1 regulated activity (dealing in securities).
See above, Open-ended retail funds.
Local and foreign SFC authorised funds can be marketed to the general public.
See above, Open-ended retail funds.
Management companies and their investment personnel operating in Hong Kong must have a Type 9 (asset management) SFC licence and comply with the SFC's Fund Manager Code of Conduct.
Chapter 5 of the UT Code sets out the requirements applicable to managers of authorised funds (whether local or foreign) including in relation to:
Financial, technical, and human resources.
Integrity and honesty.
Internal controls and procedures.
Local funds can appoint a foreign manager provided the manager is subject to proper regulatory oversight by a securities regulator in an acceptable inspection regime (AIR). The current list of AIRs comprises:
The SFC will, on application, consider other jurisdictions on their individual merits. To date the SFC has approved sub-investment managers based in non-AIR jurisdictions including Belgium, Japan, The Netherlands and Singapore on a case-by-case basis. Foreign managers must appoint a Hong Kong representative to liaise with the Hong Kong-based investors of the fund and with the SFC.
Requirements applicable to managers of REITs are set out in Chapter 5 of the REIT Code. The manager must demonstrate that it has the requisite competence, experience and resources to analyse property investment-related issues and risks. It must also develop, implement and maintain effective internal controls and risk management systems to deal with these risks.
The assets must be held by a trustee or custodian that fulfils the requirements of Chapter 4 of the UT Code, which include:
Being independent of the investment manager.
Being a licensed bank or trust company.
Having issued and paid-up capital, and non-distributable capital reserves, of at least HK$10 million (as at 1 November 2011, US$1 was about HK$7.8).
See above, Open-ended retail funds.
Legal vehicles. Local open-ended retail funds are usually unit trusts constituted under bilateral trust deeds, under which the trustee and manager are parties. Interests in a unit trust are called units. Assets of the trust may be held by the trustee or a custodian appointed by it. The trustee bears the risk of personal liability if the fund's liabilities exceed its assets. For this reason trustees of highly leveraged funds may require that investments be made through a wholly-owned subsidiary company with limited liability.
Hong Kong company law does not currently provide for companies with variable capital. Accordingly, open-ended retail funds structured as companies, although available to Hong Kong investors, are domiciled offshore. Investors in the fund acquire shares of the company. The directors control the direction and operation of the fund in accordance with their powers as prescribed by the fund's articles of association. The directors usually delegate investment management, custodial and administrative functions to third party service providers, although the fund and the manager often have common directors.
Advantages. Certain changes to a unit trust's operational features can be made by agreement between the trustee and manager without unitholder approval.
Disadvantages. The operation of a unit trust is more restrictive than a corporate fund due to the relatively onerous obligations imposed on trustees.
Legal vehicles. See above, Open-ended retail funds. In addition, closed-ended retail funds are listed on the Stock Exchange, and REITs are structured as unit trusts.
Advantages. See above, Open-ended retail funds.
Disadvantages. See above, Open-ended retail funds.
Chapter 7 of the UT Code prescribes restrictions on borrowings and the type, spread and exposure of investments for equity and bond funds. Chapter 8 of the UT Code prescribes different restrictions for different types of specialised schemes, namely:
Unit portfolio management funds (funds of funds).
Money market or cash management funds.
Futures and options funds.
Structured funds (passively managed index funds investing in financial derivative instruments).
Funds that invest in financial derivative instruments (other than structured funds).
Closed-ended retail funds must have a reasonable spread of investments to apply for listing. For REITs, the only permissible investment is generally income-generating real estate. They cannot invest in vacant land or engage in property development, and investments in uncompleted units in a building are limited to 10% of the REIT's net asset value.
Permissible restrictions, subject to adequate disclosure in the fund's offering document, include:
Imposing a requirement for prior notice on applications for the subscription or redemption of interests.
Imposing a redemption gate (that is, redeeming no more than a specified percentage of the interests on a particular redemption day, with all excess applications for redemption being dealt with on subsequent redemption days).
Prohibiting the issue or transfer of interests to any person whose holding would be illegal or which may result in regulatory, pecuniary, legal, taxation or material administrative disadvantage for the fund or its unitholders or shareholders generally.
Declaring a suspension of the calculation of the net asset value of the fund and, therefore, the issue and redemption of shares or units, on the occurrence of certain specified events.
See above, Open-ended retail funds in relation to restrictions on the issue of interests. In addition, issues of units by a REIT must usually first be offered to existing holders in proportion to their existing holdings. Units not taken up by existing holders in accordance with this entitlement can be allotted or issued to other persons, or to existing holders in proportions other than their existing holdings.
Interests in closed-ended funds are not redeemable at the investor's option. REITs can purchase their own units on the Stock Exchange subject to requirements similar to those applicable to listed companies under the Stock Exchange Listing Rules.
There are no statutory restrictions, although funds commonly impose restrictions on transfers to persons whose holding of interests in the fund would be illegal or which could result in regulatory, pecuniary, legal, taxation or material administrative disadvantage for the fund or its unitholders or shareholders generally.
See above, Open-ended retail funds.
Investors. Annual reports and accounts containing the information stipulated in Appendix E of the UT Code must be published and distributed to holders within four months of the end of the scheme's financial year, and interim reports within two months of the end of the period they cover.
The scheme's latest available offer and redemption prices or net asset value must be published at least once a month in an English language and a Chinese language daily newspaper in Hong Kong (assuming the offering document is published in both languages).
Regulators. Financial reports produced by or for the scheme, its manager, or its trustee or custodian must be filed with the SFC. On request by the SFC, the manager or its Hong Kong representative must supply all information relevant to the scheme's financial reports and accounts.
The SFC should also be notified as soon as possible of any change to the data originally provided in the fund's application for authorisation.
Investors. See above, Open-ended retail funds. In addition, specific requirements for REITs are set out in Chapter 10 of the REIT Code, and listed funds must inform shareholders or unitholders, in a timely and transparent manner, of any material information concerning the issuer.
Regulators. See above, Open-ended retail funds.
Funds. SFC authorised funds are exempt from Hong Kong profits tax. Stamp duty (at a rate of 0.2%) is payable on transfers of Hong Kong registered stock, subject to some exemptions.
Resident investors. Investors carrying on a trade or business in Hong Kong are subject to tax on distributions and gains (which are not capital profits) from the sale of shares or units in a fund that arise from that business and that have a Hong Kong source.
Dividends from a company (but not a unit trust) are not taxable. Distributions from a non-Hong Kong resident fund may be treated as offshore sourced. Profits from the disposal of an interest in a fund could be considered to have a Hong Kong source if the fund is listed on the Stock Exchange or the investor negotiates and/or concludes the acquisition or disposal of the interest in the fund in Hong Kong.
Non-resident investors. See above, Open-ended retail funds: Resident investors.
Funds. See above, Open-ended retail funds.
Resident investors. See above, Open-ended retail funds.
Non-resident investors. See above, Open-ended retail funds.
The evidential requirements for determining whether a person qualifies as a professional investor will be relaxed. As proof that a high net-worth investor meets the required asset thresholds to be considered a professional investor, firms may continue to rely on the proof of assets documentation prescribed by subsidiary legislation. But they will also be able to use any other method to satisfy themselves that their clients have the required net worth. The SFC expects proper records of the assessment process to be maintained.
By contrast, "suitability" requirements have become more stringent as a consequence of changes to the SFC's Code of Conduct for Persons Licensed by or Registered with the SFC. Distributors and issuers of derivative products will need to assess an investor's knowledge of derivatives. Whether a particular fund will be classified as a derivative product will depend on the investment strategy, and the nature, extent and function of the derivatives being used and the purpose for which they are used. The fact that an investor is not an expert in derivatives does not automatically mean that an investment in a fund which uses derivatives is not suitable for that investor. It will depend upon whether an investor has sufficient knowledge and understanding to make an informed investment decision.
In 2011, retail funds also saw the implementation of a requirement to distribute product key fact statements. After conducting a surveillance exercise, the SFC identified material inconsistencies between some key fact statements and the related offering documents, requiring the issuers to take immediate remedial action. In some cases this included a cessation of marketing and subscriptions, pending rectification of the deficiencies.
As at March 2011, there were 326 SFC licensed hedge fund managers/advisers; a record high. Most hedge funds managed by Hong Kong managers are equity long-short or multi-strategy, invested predominantly in the Asia-Pacific markets.
According to Eurekahedge, the aggregate assets under management (AUM) of hedge funds managed in Hong Kong was US$32 billion in November 2011. The great majority of the AUM derives from overseas institutional investors. However, Hong Kong was one of the first jurisdictions in the world to authorise hedge funds for distribution to the public, a decade ago. After the de-authorisation of several retail hedge funds, in part due to the costs of complying with new requirements to produce a product key fact statement, there were six remaining by October 2011, with an aggregate AUM of US$801 million.
Retail hedge funds are subject to the SFO and its subsidiary legislation, as well SFC guidelines, in particular Chapter 8.7 of the UT Code (the Hedge Fund Guidelines). A Hong Kong listed hedge fund would also be subject to the Stock Exchange Listing Rules.
The SFC does not regulate funds unless they are authorised for sale to the public. However, investment managers must be licensed before they can carry on business in Hong Kong, whether they manage retail funds or private funds. The SFC seeks to ensure that managers are fit and proper and adequately resourced.
The Hedge Fund Guidelines require the manager of a retail hedge fund to have suitable internal controls and risk management systems appropriate for its business and risk profile, including a clear risk management policy and written control procedures. All relevant risks must be properly monitored and controlled in accordance with the investment strategy of the fund.
The Hedge Fund Guidelines require investments of retail hedge funds to be independently and fairly valued on a regular basis. Where appropriate, generally accepted accounting principles and the industry's best practices should be applied on a consistent basis.
The Hedge Fund Guidelines require the manager of a retail hedge fund to demonstrate that its delegates and agents (including administrators, brokers and valuation agents) possess sufficient know-how and experience in dealing with hedge funds.
There are six forms of market misconduct prohibited under the SFO:
Disclosure of information about prohibited transactions.
Disclosure of false or misleading information inducing transactions.
Stock market manipulation.
Civil sanctions include:
Disgorgement of profits.
Cease and desist orders.
Cold shoulder orders (banning a person or entity from operating on a securities market).
Disqualification from directorship or management of a company.
Suspension or revocation of SFC licence.
Criminal penalties include up to ten years' imprisonment and fines of up to HK$10 million.
The UT Code requires retail funds to issue an up-to-date offering document containing the information necessary for investors to be able to make an informed judgement of the investment. For retail hedge funds, this includes all relevant matters relating to investment strategy and risk management. The manager must disclose the measures and safeguards put in place for the management of conflicts of interest, and advertisements must include warning statements concerning risks inherent in hedge funds.
Hong Kong recently enacted an Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance, which will come into effect on 1 April 2012. The SFC has published a consultation paper on proposals for new guidelines to assist licensed corporations and associated entities to comply with the new legislation. The proposed guidelines will replace the SFC's Prevention of Money Laundering and Terrorist Financing Guidance Note.
Covered short sales are permitted on designated securities. Hong Kong has retained the uptick rule, under which stocks cannot be shorted below the most recently traded price, and short sales must be declared when orders are placed. Hong Kong's disclosure of interests regime for listed securities requires persons with a long position of 5% or more to also disclose short positions of 1% or more.
In addition to this existing transactional reporting regime, the SFC has proposed weekly positional reporting requirements for short positions reaching 0.02% or HK$30 million, whichever is lower. Legislative amendment would be required before the regime can be implemented.
Marketing hedge funds (whether local or foreign) constitutes Type 1 regulated activity (dealing in securities). Anyone carrying on a business in a regulated activity must be licensed accordingly by the SFC. Managers holding a licence for Type 9 regulated activity (asset management) may promote the funds which they manage, as this should fall within an incidental exemption.
SFC authorised hedge funds (whether local or foreign) can be marketed to the public subject to a minimum subscription of US$50,000, or for funds of hedge funds, US$10,000. No minimum investment is required for 100% capital guaranteed funds.
Unauthorised hedge funds can be marketed to professional investors, including:
Collective investment schemes and their operators.
Trust companies having trust assets of at least HK$40 million.
Corporations and partnerships having either a portfolio of at least HK$8 million or assets of at least HK$40 million.
Individuals having a portfolio of at least HK$8 million.
Unauthorised hedge funds can also be marketed to up to 50 persons who do not qualify as professional investors.
Unauthorised hedge funds can also offer shares or debentures in relation to which:
The total consideration payable does not exceed HK$5 million.
The minimum subscription per investor is not less than HK$500,000.
In each case, the offering document must include a statutorily prescribed warning statement.
Restrictions are imposed on marketing to local investors, but there are no restrictions on investment by local investors. See above, Question 19.
For retail hedge funds, Chapter 4 of the UT Code requires the assets to be held by a trustee or custodian. Any assets charged to a prime broker must remain in a segregated custody account in the name, or held to the order, of the trustee or custodian.
A retail hedge fund must disclose all relevant matters relating to the investment operations and risk management aspects of the hedge fund in its offering document, and give clear explanations of the investment strategy of the hedge fund and its risk factors. The SFC has indicated that retail hedge funds should disclose in their offering documents the existence of side letters and their material terms (such as preferential redemption rights and key man provisions). The offering document must be approved by the SFC before it can be distributed to the public. Retail funds must now also issue a product key fact statement, based on a template formulated by the SFC.
A retail hedge fund must send annual, semi-annual and quarterly reports to its investors and the SFC. The UT Code sets out minimum content requirements for these reports.
In addition to the requirements that apply to traditional fund managers (see Question 6), the SFC also considers the following when assessing the suitability of retail hedge fund managers:
Professional expertise. Key personnel must have a minimum of five years' general experience in managing hedge funds, with at least two years in the particular strategy of that hedge fund.
AUM. The manager (not its corporate group) should have at least US$100 million AUM.
Risk management and internal control systems. The manager should have proper, clearly written risk management and control procedures that are appropriate for its business profile and risk exposure.
Local funds can appoint a foreign manager provided the manager is subject to proper regulatory oversight by a securities regulator in an AIR (see Question 6).
Hedge funds can be structured companies domiciled offshore in a tax-neutral jurisdiction such as the Cayman Islands. They can also be unit trusts, but this is very uncommon.
Advantages. Where there is likely to be a broad investor base with a large number of investors, a corporate structure is often more appropriate. It may also be preferable if it is the structure that the manager and target investors are more familiar with, or if their tax considerations favour a corporate structure.
Disadvantages. For a company structure, it is unlikely that the constitutive document (the articles of association) will be negotiated by the investors. Side letters are sometimes entered into to provide for preferential terms to core investors.
Hedge funds can be structured as limited partnerships domiciled offshore in a tax-neutral jurisdiction such as the Cayman Islands. In a limited partnership structure, the investors hold interests as limited partners in proportion to their investment, and share in the profits or loss of the fund in that proportion. As limited partners, their exposure is limited to the amount they invest. The general partner has unlimited liability but would typically itself be a company incorporated with limited liability. See also Question 8.
Advantages. A limited partnership may be preferable as it provides greater flexibility in negotiating terms. It may also be preferable if it is the structure that the manager and target investors are more familiar with, or if their tax considerations favour a limited partnership structure.
Disadvantages. A limited partnership structure may be more costly if the limited partnership agreement is heavily negotiated by the core investors.
SFC authorised funds are exempt from Hong Kong profits tax (see Question 13).
For unauthorised funds, exposure to Hong Kong profits tax (currently at a rate of 16.5%) arises if the fund is treated as carrying on a trade or business in Hong Kong. This exposure only exists in relation to any profits which arise in or are derived from Hong Kong, from that trade or business and which are not capital profits. These amounts may include:
Profits arising from the disposal of securities (except those held as capital assets) listed on the Hong Kong Stock Exchange.
Unlisted securities where the purchase or sale contracts are effected in Hong Kong.
Interest on Hong Kong deposits.
Interest income arising from certain debt instruments where the loan funds were first made available to the issuer in Hong Kong.
Funds resident outside Hong Kong are exempt from Hong Kong profits tax if certain conditions are met. Among other things, the fund's central management and control must not be in Hong Kong. A majority of a corporate fund's directors should be resident outside of Hong Kong and any board meetings should be conducted offshore.
See Question 13. In addition, the Revenue (Profits Tax Exemption for Offshore Funds) Ordinance includes deeming provisions that apply to a Hong Kong resident who, alone or jointly with his associates, holds a beneficial interest of 30% or more in an exempt offshore fund, or holds any percentage where the exempt offshore fund is an associate of the Hong Kong resident investor (a relevant interest). The Hong Kong resident investor is deemed to have derived assessable Hong Kong sourced profits in relation to the proportion of the Hong Kong sourced profits earned by the offshore fund represented by the Hong Kong resident investor's relevant interest. The deeming provisions do not apply where the offshore fund is bona fide widely-held.
See Question 13.
The Hedge Fund Guidelines require retail hedge funds to have:
At least one regular dealing day per month.
A maximum interval of 90 calendar days between lodging a properly documented request for redemption of units or shares and the payment of redemption proceeds.
There are no statutory restrictions on the right of participants to transfer their interests to third parties. However, funds commonly impose restrictions on transfers to persons whose holding of interests in the fund would be illegal or which could result in regulatory, pecuniary, legal, taxation or material administrative disadvantage for the fund or its unitholders or shareholders generally.
See Question 17 (in relation to positional reporting for short positions).