SFC confirms enhanced Open-ended Fund Company regime

IN BRIEF

On 2 September 2020, Hong Kong's Securities and Futures Commission (SFC) released the conclusions ("Conclusions") to its open-ended fund companies (OFC) regime consultations ("Consultations"), which commenced in December 2019.

The amendments to the Code on Open-ended Fund Companies ("OFC Code") in the Conclusions contained several welcome enhancements for private OFCs, including liberalization of the types of entities that can act as custodian, removal of investment restrictions and ongoing development of a re-domiciliation capability. The amendments took effect on 11 September 2020, other than the safekeeping requirements for private OFCs for which existing custodians have a six-month transition period and must be complied with by 10 March 2021. We discuss the Conclusions in more depth in this Alert.

CUSTODIAN-RELATED CHANGES AND CLARIFICATIONS

Eligibility requirement for private OFCs

Pursuant to the Conclusions1, in the alternative to an eligible custodian pursuant to the SFC's Code on Unit Trusts and Mutual Funds ("UT Code"), an intermediary ("Intermediary") licensed or registered to carry on Type 1 regulated activities (RA) can also be appointed as a custodian of OFC assets ("scheme assets"). This appointment will have to be predicated on the conditions that the Intermediary:

  1. holds a license or registration under section 116(1) or section 119(1) of the Securities and Futures Ordinance (SFO) (as the case may be) that is not subject to the condition that it shall not hold client assets;
  2. meets the capital requirements of a minimum HKD10 million in paid-up share capital and minimum HKD3 million in liquid capital if it is a licensed corporation;
  3. ensures the private OFC is the Intermediary's client in respect of its Type 1 RA business at all times (though there will be a six-month transition period to transfer scheme assets to an alternative custodian if this ceases to be the case);
  4. is independent of the investment manager;
  5. has at least one responsible officer or executive officer responsible for the overall management and supervision of its custodial functions; and
  6. complies with the requirements of Appendix A (to be newly added to the OFC Code) which sets out the requirements for the safekeeping of private OFC scheme assets.2

Additional requirements for custodians of public and private OFCs

A custodian of a public or private OFC must have experience, expertise and competence in safekeeping the scheme assets in which the OFC invests and maintain internal controls and systems commensurate with the custodial risks.3

Clarifications

In addition, the SFC has provided further useful feedback that custodians and OFCs will need to consider as part of their compliance reviews. This includes:

  1. Clarifying the SFC's intention that the custodian and the investment manager must be separate legal entities. Personnel can be shared amongst the separate legal entities of affiliates (as is relatively common in Hong Kong), but an effective functional separation will require that custodial functions be undertaken by staff pursuant to appropriate internal controls and with separate reporting lines to any investment management functions.
  2. Confirming that whilst the OFC scheme assets must be segregated from the assets of the Custodian, as is common, they may be held in omnibus structures, provided there are adequate safeguards in line with international standards and best practices to ensure proper recording and frequent reconciliation of the scheme assets.
  3. There is no limitation restricting an OFC from appointing more than one custodian and custodians are also not prohibited from appointing sub-custodians as necessary to hold assets. This may be needed, for example, in the context of specialized custody services for digital or physical assets.
  4. Highlighting that any provision within a contract that seeks to exempt a custodian from, or otherwise requires a custodian to be indemnified against any liability arising from the custodian's own negligence, default, breach of duty or breach of trust will be void under section 112ZC of the SFO.

INVESTMENT SCOPE OF PRIVATE OFCs

What was discussed in the Consultation process

The SFC had proposed in the Consultations to allow an expansion of the investment scope of private OFCs to include both loans and shares and debentures of Hong Kong private companies. However, in order to ensure that the SFC would continue to have a regulatory nexus under the SFO to supervise the management of private OFC assets, the Consultation proposed that the private OFC would also have been required to simultaneously hold a portfolio of assets, the management of which would constitute a Type 9 RA under the SFO.

In a very favourable step, the SFC reconsidered this position and noted that its regulatory powers under the OFC Code are already broad enough to enable oversight of various aspects of the operation of the OFC. These include, but are not limited to, sanctioning any misconduct by an investment manager, approval or cancellation of registration, and the imposition of conditions on any registration of a custodian or investment manager of the OFC. Similar powers exist for the SFC to take action directly against the management of the OFC.

Outcome in the Conclusions

Taking these factors into account, and to put OFCs on a level playing field with the recently implemented Limited Partnership Fund (LPF) structure,4 the SFC determined to remove all investment restrictions on a private OFC.

On the other hand, new provisions will be included in the OFC Code to require that investment managers and custodians have sufficient expertise and experience in managing and safekeeping the asset classes in which the OFC invests. The investment manager's activities need to be undertaken in the course of, and as an integral part of the Type 9 RA for which it is licensed or registered.5 There will also be enhanced disclosure requirements in the offering documents6 and proper record keeping will be required.7

It is important to note that there will be no corresponding change to the profits tax exemption requirement under the Inland Revenue Ordinance (IRO). As such, profits tax liability would arise if the private OFC makes investments in certain situations under which profits tax exemption under section 20AN of the IRO does not apply.

RE-DOMICILIATION

The SFC has confirmed that it will proceed with its re-domiciliation proposal. This will be implemented through the introduction of new provisions in Part IVA of the SFO and further amendments to the Securities and Futures (Open-ended Fund Companies) Rules ("OFC Rules"). The introduction of a statutory mechanism will provide benefits including corporate identity continuity and costs savings along with preservation of the fund's past performance track record. While the final rules applicable to the re-domiciliation process are yet to be issued by the SFC, as part of the Conclusions, the SFC has confirmed that:

  1. An overseas corporate fund re-domiciling to Hong Kong as an OFC will need to meet the same registration requirements as a newly formed Hong Kong OFC.
  2. Changes to the fund structure can be made after re-domiciliation, provided they do not affect the fund's ability to meet the key requirements of the SFO, OFC Rules and OFC Code.
  3. The re-domiciled OFC will be entitled to a profits tax exemption, subject to the same requirements as other OFC's.

AML REQUIREMENTS - ADDITIONAL CONSULTATION

The SFC had originally proposed in the Consultation that an OFC would be required to adopt and implement a Significant Controllers Register (SCR). Currently, the SCR arrangements apply to all Hong Kong incorporated companies other than those listed on the Hong Kong Stock Exchange. Noting that such requirements would be difficult for a publicly-traded OFC to fulfil, the SFC is proposing:

  1. to align the OFC anti-money laundering/counter-terrorist financing (AML/CFT) requirements with those recently implemented for LPFs - namely those applicable under Schedule 2 to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO);
  2. that an OFC must appoint a responsible person (being any of an authorized institution,8 a licensed corporation, an accounting professional or a legal professional9) to undertake AML/CFT functions on its behalf.

The SFC's proposals would, in effect, mean that the same obligations as for other financial institutions in Hong Kong to comply with the AMLO will be imposed on the OFC. This proposal (subject to any changes arising from the consultation process) will require legislative amendments to facilitate implementation and is envisaged to take effect following a six-month transition period after completion of the legislative process.

The SFC is currently seeking comments regarding this proposal, with submissions due on 5 October 2020.

EFFECTIVE DATE

On September 11, 2020, the SFC issued a Circular10 confirming that the amendments to the OFC Code contained in the Consultations had been gazetted and became immediately effective. The SFC also confirmed that to enable existing private OFC custodians to ensure compliance with the requirements in the new Appendix A, they will be provided with a six-month transition period commencing on 11 September 2020 and ending on 10 March 2021.

ADDITIONAL RESOURCES

As part of the commencement of the revised OFC Code provisions, the SFC also released in its Circular details of updated Information Checklists, Template of Instrument of Incorporation for Umbrella Private OFC and an updated version of the Frequently Asked Questions relating to Open-ended Fund Companies, all of which have been published on the SFC website.

CONCLUSION

We will continue to monitor further developments in the OFC regime as the SFC refines the necessary legislative changes to give further effect to its proposals. If you have any questions on any of the above matters, please do not hesitate to liaise with your usual contact at Baker McKenzie or the lawyers listed in this Alert.

Partner, Baker McKenzie, Hong Kong

Registered Foreign Lawyer, Baker McKenzie, Hong Kong

Knowledge Lawyer, Baker McKenzie, Hong Kong