There is no comprehensive legal or universally accepted definition of ‘hedge funds’ in China.1 Generally, they share certain common characteristics, including: being privately offered; requiring investors to have a certain minimum net worth and/or level of financial sophistication; investing in equity securities, fixed income securities, derivatives, futures and other financial instruments; having a perpetual term; imposing liquidity restrictions on investors’ capital; pursuing absolute return rather than measuring investment performance in relation to a benchmark; compensating managers with incentive fees; allowing considerable flexibility in investment strategies; being highly leveraged; and being subject to limited regulatory supervision.
In China, strictly speaking, hedge funds as described above are not recognised by law. Nevertheless, various regulated hedge fund-like financial products have been thriving in the Chinese market for 10 years. The number of one such product, called ‘sunshine funds’ (discussed in section 3.1), has grown from single figures in 2003 to almost 1,000 at the end of 2011.2Regulatory changes currently under discussion by the Chinese legislature may provide some legitimacy for hedge funds and lay the basis for a regulatory framework. If so, hedge funds in China should expect to see faster growth.
Outside China, international managers have been accessing Chinese stock markets for over a decade. The regulatory framework for this is now fairly established. By contrast, foreign exchange controls and the lack of a private placement regime have prohibited international managers from accessing Chinese investor capital. The announcement by the Shanghai municipal government that it has initiated a pilot programme to allow qualified Chinese investors (including those domiciled outside Shanghai) to invest in qualified international hedge funds has been the most significant breakthrough for international hedge fund managers. The development of this programme has the potential to open up a new, stable source of investor capital to the global hedge funds industry.
2. Regulatory landscape
2.1 Securities Law
The unrecognised and unregulated status of hedge funds in China is largely attributable to the fact that ‘securities’ regulated under the Securities Law of the People’s Republic of China are narrowly confined to stocks, bonds and shares in regulated mutual funds. As such, the private offering provision in the Securities Law technically does not apply to the offering of interests in hedge funds, whether they are organised as limited partnerships or limited liability companies. This is in contrast to US securities regulations, where interests in hedge funds, typically organised as limited partnerships and limited liability companies, are considered ‘securities’ as defined in the US Securities Act of 1933 and the offering of interests in hedge funds is subject to the private offering rules of the act and related regulations.
2.2 Securities Investment Funds Law
Another factor contributing to hedge funds’ current state of non-recognition and non-regulation is the limited scope of application of the Securities Investment Funds Law of the People’s Republic of China. This law, enacted in 2003, only applies to publicly offered mutual funds. Provisions concerning privately offered funds were removed from the final text of the law following intense debate on whether the Chinese regulators should recognise such privately offered funds, how to regulate them and when would be the appropriate time to enact legislation.
At the beginning of 2011, a consultation draft of a proposed amendment to the Securities Investment Funds Law was circulated to various governmental authorities and certain market participants for comment. One main feature of the proposed amendment is to extend the application of the law to privately offered investment funds. Among other things, a noteworthy provision in the consultation draft is that privately offered funds will generally be required to register with the appropriate regulators, with the exception for those funds whose assets under management or number of investors is below a threshold to be specified by the regulators. In July 2012, a revised consultation draft of the proposed amendment to the Securities Investment Funds Law was published by the Chinese National People’s Congress on its website to solicit public comments. The 2012 draft again sought to bring privately offered securities investment funds into the new law’s coverage. If the final amendment includes the privately offered funds provisions, it will effectively recognise the legitimacy of hedge funds and provide a regulatory framework for them. Such developments could promote the development of the funds industry in China, especially the hedge funds sector.
2.3 Regulation by financial institutions and products
A third aspect of the Chinese regulatory regime that is fundamentally different from that of the United States is that the Chinese regulatory framework is based on the ‘regulation by financial institutions and their products’. In other words, banks and trust companies, as well as their financial products, are regulated by the China Banking Regulatory Commission (CBRC), while securities companies and fund management companies, and their financial products, are regulated by the China Securities Regulatory Commission (CSRC). Similarly, insurance companies and their products are regulated by the China Insurance Regulatory Commission (CIRC). Thus, hedge fund-like products developed by different financial institutions are regulated by different regulators and are subject to different regulations.
This fragmented regulatory regime has hampered the creation of a uniform private offering regime and the development of privately offered funds. Additionally, it has allowed regulatory arbitrage by market participants. As discussed above, the Chinese regulators are in the process of amending national laws, such as the Securities Investment Funds Law, and promulgating regulations to govern private equity funds. These efforts will help to clarify the regulatory responsibilities of different agencies and create a widely recognised private offering regime in China.
3. Market practice
3.1 Regulated privately offered funds/sunshine funds
Currently ‘sunshine funds’, a closed-end product offered by trust companies and regulated by the CBRC, are widely regarded by the market as the best representation of Chinese hedge funds. They are closed-end funds, seeking absolute returns and charging performance fees, and only investors meeting certain qualification standards are allowed to invest in them. According to a report by Morningstar, the total assets under management of sunshine funds reached between RMB 180 billion and RMB 190 billion at the end of 2011.3
There is no official definition of ‘sunshine funds’ in any regulation. The term sunshine funds was created to distinguish from unregulated (underground) privately offered funds. From a regulatory perspective, ‘sunshine funds’ refers to pooled funds schemes or ‘trust units’ launched by trust companies under the Administrative Measures on the Pooled Funds Schemes of Trust Companies (Pooled Funds Schemes Measures), promulgated by the CBRC and brought into force on March 1 2007.
The measures prescribed the type of trust companies that are eligible to offer trust units, the methods that are permitted in the distribution of the trust units, the maximum number of investors permitted in each trust unit, the qualification requirements of investors, and the regulatory investment restrictions applicable to trust units. Generally, qualified investors have to meet at least one of the following tests:
- capable of investing a minimum of RMB 1 million in a single trust unit;
- (for natural persons) having verifiable personal or family financial assets in excess of RMB 1 million at the time of subscription; or
- having verifiable annual income in excess of RMB 200,000 (or RMB 300,000 if counting spouse’s annual income) in each of the previous three years.
Each trust unit can have no more than 50 natural person investors.
Since trust units are one of the very few available regulated privately offered funds, they have become popular among individual investors. To overcome the regulatory restriction on the number of investors in each trust unit, trust companies often launch mirror or parallel trust units, which have substantially the same investment strategy and appoint the same investment adviser.
Generally, trust units follow the same structure, with a CBRC-licensed China onshore trust company as the sponsor/trustee, which delegates to some degree day-to-day investment management functions to an investment adviser, a bank as the custodian for cash and a securities company as the custodian for the securities. Trust companies, investment advisers and custodians can be domestic Chinese entities or Sino-foreign joint ventures. Some trust units offer two classes of sub-units - preferred units and common units. Preferred unit holders are generally provided with a fixed coupon regardless of whether the trust unit has a positive return, while common unit holders participate in the gain and loss of the trust unit like holders of common shares of a public company.
Permissible investments under the Pooled Funds Schemes Measures include stocks, bonds and real property. In general, other than regulatory investment restrictions, trust units do not impose many strict investment restrictions so as to preserve flexibility in investment strategies. Typically, a 20% performance fee (chargeable only upon the dissolution and winding-up of the trust units) and a fixed, asset-based management fee are charged to investors. Sponsors must publish the trust unit’s net asset value at least once a week and send net asset value statements to investors on a monthly basis.
Under the Pooled Funds Schemes Measures, trust units may not be publicly offered or distributed through non-financial institutions. In practice, sunshine funds are distributed through many channels in China, including commercial banks’ wealth management divisions, private banks, securities companies, fund management companies and trust companies themselves.
3.2 Other regulated privately offered funds
In addition to sunshine funds offered by trust companies, the CSRC permits two types of regulated private asset management service for China onshore fund management companies and securities companies, respectively.4 Fund management companies offering separate account products and securities companies conducting both single client and collective client asset management businesses are similar to sunshine funds in that their products are offered only on a private basis to qualified investors under the relevant regulations. These products also follow an absolute return strategy and charge performance fees.
The separate account business conducted by fund management companies is defined as activities where the companies act as asset managers, raise and manage funds from qualified clients or manage the assets of qualified clients under investment management agreements. Qualified commercial banks must be engaged as custodians. The assets may be invested in stocks, bonds, securities investment funds, central bank bills, short-term commercial papers, asset-backed securities, financial derivatives or commodity futures. The management fees and custodian fees for separate accounts must be no less than 60% of the management and custodian fees charged to investors in similar publicly offered investment funds. However, fund management companies are permitted to charge a performance fee to separate account clients, not exceeding 20% of the net profits of the managed assets as agreed in the investment management contract.
Clients of the single client asset management business of securities companies may be natural persons or entities established in China. The investment scope of targeted asset management business includes stocks, bonds, securities investment funds, collective asset management plans, central bank notes, short-term financing bills, asset-backed securities, financial derivatives and other investment products permitted by the CSRC. The management fees, performance rewards and other fees must be clearly stated in the relevant asset management contracts.
Compared with sunshine funds, private asset management products offered by fund management companies and securities companies under the CSRC regime are subject to additional regulatory investment restrictions and filing requirements. For example, both fund management companies and securities companies are expressly prohibited by CSRC rules from investing more than 10% of an asset management product’s assets under management in a single stock.5 By contrast, sunshine funds are not subject to any similar regulatory prohibition. Under their respective regulations, fund management companies and securities companies must obtain the CSRC’s approval on a case-by-case basis before offering any private asset management product and must make a filing with the CSRC after the completion of offering. By contrast, trust companies are only required to file with the local branches of the CBRC to launch sunshine funds. These additional restrictions and filing requirements may have contributed to the slower growth of private asset management products of fund management companies and securities companies and the lesser popularity of them among individual investors.
3.4 Unregulated (underground) privately offered funds
In China, funds managed by unlicensed asset managers that raise capital privately through their personal contacts are generally referred to as the ‘underground privately offered funds’. These are largely unsupervised, and are not registered or filed with any authorities. Generally, they do not disclose information on their investments. Typically, managers are given access to individual customers’ accounts and buy and sell securities on the customers’ behalf, deducting management fees and performance fees from the customers’ accounts. There may or may not be an advisory agreement between the manager and the customers, as such contracts are likely to be considered illegal contracts if the parties had a dispute and sought to enforce their agreement.
Underground privately offered funds have been thriving despite their ‘illegitimate’ status. According to one market estimate, the total assets under management of these funds reached RMB 1 trillion by early 20106.
From time to time, the Chinese regulators have launched campaigns to tackle fraudulent capital raising in connection with these funds. Since the advent of underground privately offered funds in the late 1990s, there have been several cases of criminal prosecution of fund managers for illegal capital raising. In December 2010, the Chinese Supreme Court issued a judicial interpretation emphasising that the offering of interests in funds without the approval of the relevant authorities is illegal.7 However, as in other jurisdictions, the supervision of such unauthorised fund distribution is difficult.
3.5 Regulatory groundwork for hedging - introduction of stock index futures, margin trading and securities lending
In recent years, Chinese regulators have issued a set of rules that laid an important foundation for hedging activities conducted by fund managers. In early 2010, after years of preparation, the CSRC promulgated a regulation for stock index futures trading and the pilot regime of margin trading and securities lending8. Since October 2011, the CSRC has officially recognised margin trading and securities lending as a regular business of securities companies, subject to certain qualification requirements.
The formal launch of securities lending and margin trading, as well as stock index futures, has made the Chinese A share market more attractive to hedge fund managers. The introduction of securities lending and stock index futures on the China Financial Futures Exchange (CFFEX) was an important milestone in the Chinese equity market’s progress towards greater liquidity, versatility and sophistication. The Chinese equity market should not be viewed as a ‘long positions only’ market, as market participants will be able to profit from both a rising market and a falling market. This will allow market participants to manage market risks more effectively and is expected to provide an incentive to fund managers and other investors (both onshore and offshore) to trade in Chinese equities.
4. Opportunities for international hedge fund managers
4.1 Accessing the Chinese stock market through the qualified foreign institutional investor regime
International hedge fund managers have long been able to trade in the stocks of Chinese companies listed outside of China, but have been largely excluded from the Chinese A share market due to China’s foreign exchange controls. Many international hedge funds have ventured into the Chinese market through the qualified foreign institutional investor (QFII) regime, whereby qualified foreign financial institutions are permitted to invest in the A share market directly under a foreign exchange investment quota system9.
Since its inception in late 2002 and UBS AG being granted the first QFII licence in mid-2003, China’s QFII regime has grown, rapidly attracting a wide range of international institutions - from securities firms and banks to fund managers, insurance companies, sovereign wealth funds, central banks, pension plans and universities. By April 2012, the CSRC has approved 158 QFIIs from 23 countries, of which 129 QFIIs had been granted investment quotas by the State Administration of Foreign Exchange (SAFE, China’s foreign exchange regulator) totalling US$24.55 billion10.
Before October 2009, many international fund managers were able to ‘rent’ a portion of the investment quota from, for example, a QFII that is an investment bank, to trade in the A shares market. In general, there were three structures through which non-QFII hedge funds could access Chinese A shares market:
- by using a direct trading facility, whereby an international hedge fund could place orders to buy or sell A shares by borrowing a proportion of a QFII’s quota;
- by entering into a total return swap with a QFII, which created an equivalent economic exposure to the relevant A shares via a direct trading facility; and
- by investing in indirect market access products, such as participatory notes or other structured products offered by QFIIs.
On September 29 2009, SAFE issued the Provisions on the Foreign Exchange Administration of Domestic Securities Investments by Qualified Foreign Institutional Investors (SAFE QFII Rules), which set out in detail how the foreign exchange investment quota would be granted and how QFIIs would be allowed to bring capital into China and to repatriate profits out of China. The SAFE QFII Rules prohibited QFIIs from engaging in ‘quota-renting/selling businesses’11. Following the introduction of the SAFE QFII Rules, a number of QFIIs have now terminated the trading facility described in the first structure.
Although the second and third structures described above were not explicitly prohibited under the SAFE QFII Rules, they are discouraged by the CSRC and the SAFE, since they shield the true identity of foreign managers or financial institutions that are trading in the Chinese A shares market.
The Chinese regulators, already uncomfortable with the ‘unregulated’ nature of hedge funds, want to be able to monitor and supervise foreign access to the Chinese domestic market. As such, those structures are considered by the Chinese regulators to be inconsistent with the regulatory intentions behind the QFII regime.
The net result is that some hedge fund managers have applied for a QFII licence directly. To date, there are a number of foreign fund managers operating both traditional and hedge fund businesses that have obtained QFII licences and a foreign exchange quota. However, it is unclear how much of their QFII quota has been allocated to the hedge fund side of the business (if any).
On the other hand, some well-known international hedge fund managers have applications that are ‘pending’ at the Chinese regulators, even though they meet the eligibility requirements set out by the CSRC. Possibly, this is because, while the CSRC wants to encourage long-term investors to participate in the Chinese A shares market, it does not generally view hedge fund managers as belonging to the category of long-term investors, based on hedge funds’ use of short positions.
Not all hedge funds follow strategies that give rise to concern with the Chinese authorities. Hedge fund managers interested in operating in China should seek more communication with Chinese regulators to help demystify the industry’s perceived image in China. Furthermore, the Chinese regulators’ experience of monitoring and regulating foreign investment in the A shares market, enhanced by the QFII programme, and their increased understanding of hedge funds may change their stereotyped view of the hedge fund industry and their cautious stance on it in the future.
4.2 Accessing the Chinese stock market through establishment of a presence in China
Some international hedge funds and managers have established a presence in China under China’s existing foreign direct investment regime as a way to gain access to China’s A shares market. Generally, there are three structures that can be deployed:
- representative offices of foreign securities institutions (securities rep offices);
- unregulated general representative offices (general rep offices); and
- wholly foreign owned consulting companies12.
(a)Representative offices of foreign securities institutions
Securities rep offices are usually set up by foreign investment banks, securities brokers and fund managers. As a starting point, the CSRC regulations require a foreign entity seeking to establish a securities rep office to be engaged in the securities business and subject to oversight by a financial regulator in its home country. Thus, it will be relatively easy for the CSRC to accept applications to set up a securities rep office from hedge fund managers that are also engaged in the mutual fund business. While this form of presence may seem to be a natural choice for international hedge fund managers wishing to access the Chinese market, the CSRC has not yet issued a securities rep office licence to an international hedge fund manager, despite the fact that an increasing number of hedge fund managers meet the eligibility requirements.
The CSRC has indicated informally that if an international hedge fund manager can satisfy the eligibility requirements, it would be willing to consider their application to set up a securities rep office. The establishment of securities rep offices by international hedge fund managers should be less of a concern for the CSRC given the material difference between a securities rep office and a QFII - while a hedge fund manager with a QFII licence and quota may trade A shares directly on behalf of the hedge funds that it manages, a securities rep office cannot engage in any securities trading in China.
(b) Unregulated general representative offices
Unregulated hedge fund managers may want to consider setting up a general rep office, which would not require CSRC prior approval. A general rep office is not a separate legal entity - only a branch ‘office’ of the foreign investor in China. It is not permitted to conduct any income-generating activities. A hedge fund manager can establish a general rep office by registering with the State Administration for Industry and Commerce (SAIC) or its local counterpart directly.
Early market entrants experienced some difficulties in registering with the SAIC, mainly because local SAIC bureaus took the view that hedge fund management was a form of securities business and therefore requires prior approval by the CSRC. If a hedge fund manager uses an unregulated affiliate to set up a general rep office, the local SAIC bureaus will be more willing to accept its application. A few hedge fund managers, including Fairfield Greenwich Group and Blackstone Group (investing in hedge funds through Blackstone Alternative Asset Management), have chosen this structure and established a general rep office in China13.
(c) Wholly foreign owned consulting companies
An international hedge fund manager may establish a wholly foreign owned consulting company in China to engage in general consulting business. This is a separate legal entity and its establishment requires prior approval from the Ministry of Commerce or its local counterpart. While there is no capital requirement for a securities rep office or a general rep office, a wholly foreign owned consulting company is subject to a minimum registered capital requirement of RMB 30,000 (approximately US$5,000), under the Company Law of the People’s Republic of China. In practice, in major cities such as Shanghai and Beijing, where most international hedge fund managers want to establish a presence, the minimum registered capital requirement is RMB 100,000 (approximately US$16,000) and the ministry, or its local counterpart, has a discretion to require more capital depending on the company’s business plan.
4.3 New developments - accessing Chinese investor capital through qualified domestic limited partners pilot scheme
Although the Chinese market has some way to go before it opens up to international hedge funds and managers, a recent development in Shanghai has introduced some exciting opportunities.
It has been reported that the Shanghai municipal government is rolling out a pilot programme, called Qualified Domestic Limited Partners, to allow approved international hedge fund managers to set up onshore funds and raise RMB capital from domestic institutional and individual investors as qualified domestic limited partners. The RMB funds will invest it in overseas securities markets, and will be required, among other things, to be registered with the Shanghai regulators. Similarly to the QFII regime, a certain amount of foreign exchange quota will be granted to the qualified funds for their overseas investments.
This initiative is driven in part by Shanghai’s ambition to become an international financial hub by 2020. Although it remains to be seen how the programme will work after its official launch, the market reaction has been very positive, given that it is the first time that overseas hedge funds have been allowed to establish onshore fund managers in China to sponsor overseas investment funds. According to press reports, some of the world’s largest hedge fund/fund managers are preparing to participate in the pilot programme.
5. Conclusion and outlook
While it is still not possible for an international hedge fund manager to establish a fully fledged operation in China, now is still an excellent time for international fund managers to build a presence in China. A local presence in China can help fund managers better understand China’s securities market, as well as its business culture. It can also facilitate the necessary ongoing communication between the Chinese regulators and those managers that have obtained QFII licences. Finally, a local presence is likely to be required for hedge fund managers who wish to take advantage of the new Qualified Domestic Limited Partners pilot schemes and access Chinese investor capital.
Contributed by Clifford Chance and first published in "Hedge Funds: A Practical Global Handbook to the Law and Regulation" by Globe Law and Business ( www.globelawandbusiness.com/HFH ).
Ying focuses on onshore and offshore funds formation for private equity and hedge funds, RMB funds, and offshore investments by Chinese institutions. She leads the drafting committee of the China Association of Private Equity in developing China's first national private equity and venture capital industry best practices and self-regulatory principles. She also acts as legal advisor to the Beijing Private Equity Association. She obtained her LLM in 1998 from Columbia University School of Law, and her JD from Stetson University College of Law in Florida in 1997. Ying was born in China and graduated from Peking University in 1992.
Yin Ge is a senior associate at Clifford Chance LLP’s Shanghai office. She specialises in finance regulation, investment management and funds. Yin holds LLM degrees with Honors from Cornell University and from Wuhan University, China. She passed the People’s Republic of China bar examination in 2005 and was admitted to the New York State bar in 2009. She is a native Mandarin speaker and is fluent in English. Yin has worked as an in-house counsel at the head office of China Merchants Bank and as an associate with Allen & Overy LLP.
Clifford Chance is one of the world’s leading law firms, helping clients achieve their goals by combining the highest global standards with local expertise. The firm has unrivalled scale and depth of legal resources across the four key markets of the Americas, Asia Pacific, Europe and the Middle East, and focuses on the core areas of commercial activity: capital markets; corporate and M&A; finance and banking; real estate; tax; pensions and employment; litigation and dispute resolution. Clifford Chance has 35 offices in 25 countries with some 3,400 legal advisers. For more information please visit www.cliffordchance.com.
1 In this chapter, China means the People’s Republic of China (PRC or China, which, for the purposes of this chapter only, does not include Hong Kong, Taiwan or Macau).
2Morningstar 2011 Annual Report on Private Securities Investment Funds.
4The relevant regulations include: the Pilot Measures on Selected Client Asset Management Business of Fund Management Companies, issued by the CSRC on August 15 2011, in force October 1 2011; the Implementing Rules for the Collective Asset Management Business of Securities Companies (for Trial Implementation), issued by the CSRC on May 31 2008, in force July 1 2008; and the Implementing Rules for Targeted Client Asset Management Business of Securities Companies (for Trial Implementation), issued by the CSRC on May 31 2008, in force July 1 2008.
5See Tentative Implementation Measures for the Client Asset Management Business of Securities Companies, issued by the CSRC on December 18 2003, in force February 1 2004; and the Administrative Measures for the Operation of the Securities Investment Funds, issued by the CSRC on June 29 2004, in force July 1 2004.
6See China’s Privately offered funds Reach RMB$1.0 trillion in assets under management, March 25 2010, available at www.cnstock.com/index/gdxw/201003/435651.htm and China’s Underground Financing Fuels Inflation, November 23 2010, available at http://m.ftchinese.com/story/001035668/en.
7See Interpretations of the Supreme People’s Court on Certain Issues Relating to Application of Laws with respect to Criminal Cases involving Illegal Fund Raising, issued by the Supreme People’s Court on December 13 2010, in force January 4 2011.
8See Provisions on Establishing a Regime for Suitability of Investors of Stock Index Futures (Trial), issued by the CSRC on February 8 2010, in force February 8 2010; and the Trial Guidelines of Margin Trading and Securities Lending, issued by CSRC on January 22 2010, repealed by the subsequent Administrative Measures for Margin Trading and Securities Lending of Securities Companies, promulgated by CSRC on October 26 2011, in force October 26 2011.
9See Administrative Measures on Domestic Securities Investments by Qualified Foreign Institutional Investors promulgated by the CSRC, SAFE and the People’s Bank of China (the Chinese central bank) in August 2006.
10See Clifford Chance Client Briefing: China’s QFII Regime - A Complete Review of the Regulatory Scheme and Compliance Risks, May 25 2012, for additional background reading.
11See Provisions on the Foreign Exchange Administration of Domestic Securities Investments by Qualified Foreign Institutional Investors, promulgated by SAFE on September 29 2009, in force September 29 2009.
12See Clifford Chance Client Briefing: China for Hedge Fund Managers - A Regulatory and Tax Update, August 2010, for additional background reading.
13See AIC registration of the two examples at http://qyxy.baic.gov.cn/kscx/kscxAction!view.dhtml?kscxModel.reg_bus_ent_id=
C5BAC4ED09554E3E943B59DA8495722F&flag_cer=0 and http://qyxy.baic.gov.cn/kscx/kscxAction!view.dhtml?kscxModel.reg _bus_ent_id=