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Introduction
This article explains the types of investment vehicles most
commonly used for establishing hedge funds and sets out the
possible regulatory requirements imposed on hedge fund managers/investment
advisers under the Securities and Futures Ordinance ("SFO").
The article assumes that the hedge funds will not be marketed
or offered "to the public" in Hong Kong and therefore
will not need to be authorised by the Securities and Futures
Commission ("SFC"), nor comply with the SFC Hedge
Fund Guidelines, which regulates the "public" offering
of hedge funds in Hong Kong.
Hong Kong investor preference and the limitations imposed
by Hong Kong law and legislation have meant that onshore Hong
Kong hedge fund vehicles have not been established. However,
offshore hedge funds, that is, investment vehicles incorporated,
registered or domiciled in a jurisdiction other than Hong
Kong have been offered to high net worth investors and financial
institutions in Hong Kong on a private placement basis.
Legal Entities and Structures Available
It is not currently possible to establish locally incorporated
"open-ended" investment vehicles in Hong Kong with
a corporate structure given restrictions contained in the
Companies Ordinance ("CO") on redeemable shares,
although amending the CO to allow for open ended investment
companies has been the subject of recent discussion in Hong
Kong. In addition, although in certain jurisdictions it is
possible to establish hedge funds as unit trusts, for a variety
of reasons these are not a common structure for hedge funds
offered in Hong Kong. However, it is possible that Hong Kong
unit trusts could be used for this purpose. The limited partnership
is a vehicle favoured by United States investors although
in Asia the limited partnership structure has historically
also been attractive to some Japanese investors. It should
be noted that interests in limited partnerships (and, in fact,
units in unit trusts) do not fall within the definition of
shares or debentures of a "company" under the CO
and therefore may be offered to investors in Hong Kong without
any restriction under the CO (i.e., the prospectus requirements
under the CO will not apply). However, offers of interests
in limited partnerships will be regulated under the SFO as
they will constitute interests in a "collective investment
scheme". See "Legislative Developments" section
below for further details on "Collective Investment Schemes".
Accordingly, the preferred structures for Hong Kong investors
have been offshore hedge funds established as companies. The
main factor in determining which of these vehicles is the
most appropriate in each particular case is likely to be (i)
tax; (ii) investor familiarity; and (iii) operational simplicity.
Investment Companies
Investment companies continue to be the main vehicle of choice
for Hong Kong investors in hedge funds. Aside from investor
familiarity, this type of vehicle also has the advantage of
being relatively low risk to the hedge fund manager (i.e.
having a separate legal identity distinct from the management
functions) and easy to operate with respect to day-to-day
subscription and redemption of shares.
The investment company will typically be incorporated in a
jurisdiction that imposes minimal or no taxation; for example,
Hong Kong managers and investors in recent years have established
hedge fund corporate vehicles in the Cayman Islands and the
British Virgin Islands.
Legislative Developments
Securities and Futures Ordinance
The SFO, which came into force on 1 April 2003, has been
an important development in the legal and regulatory environment
of Hong Kong. The SFO consolidates and modernises ten existing
ordinances and introduces some new concepts that impact significantly
on both the provision of management and investment advisory
services out of Hong Kong and the marketing and offering of
securities and other interests of hedge funds for sale in
Hong Kong.
If the hedge fund is established as a corporate entity, the
CO will also be relevant to the offer of its shares in Hong
Kong.
Licensing Requirements
Under the SFO, a new "single licence" regime is
established, and permits a business entity to carry on different
regulated activities under the one licence.
Of the nine "regulated activities" in the SFO,
the most relevant to hedge funds include asset management
(Type 9) in relation to both securities and futures contracts,
advising on securities (Type 4) and futures contracts (Type
5), leveraged foreign exchange trading (Type 3) and dealing
in securities (Type 1). The SFO defines "securities"
very widely and expressly includes interests in any collective
investment scheme . Accordingly, marketing or distribution
activities in respect of shares or interests in a hedge fund
will generally amount to the Type 1 regulated activity of
"dealing in securities" for the purposes of the
SFO.
Licensing Exceptions
There are various exceptions to what will constitute regulated
activities under the SFO. The most relevant to hedge fund
managers / advisers include:
- "wholly-owned group" exceptions (this is a new
exception available under the SFO) available to Types 4,
5 and 9 regulated activities, applicable where a corporation
provides services solely to any of its wholly owned group
companies. However the SFC has recently attempted to give
a narrower interpretation to this exemption by importing
words into the SFO - providing asset management or advice
to its group company (on a wholly-owned basis) but only
"in respect of that group company's assets". Unfortunately,
this has therefore cast some doubt on the usefulness of
this exemption. Some caution should therefore be used when
relying on this exemption and its use should be considered
on a case-by-case basis;
- a person who is licensed for Type 9 (asset management)
activities may buy and sell securities (or futures contracts),
without being licensed to conduct Type 1 (or Type 2 dealing
in futures contracts) activities, provided that the dealing
is performed solely for the purposes of asset management.
This exception is not, however, available where the manager
undertakes a fund distribution function, which will generally
require the manager to hold a licence permitting it to conduct
Type 1 activities;
- where offers of securities are made to, and transactions
effected through, a person who is licensed or registered
for Type 1 regulated activity which would not constitute
"dealing in securities";
- in terms of Type 3, under the SFO there is a "class"
exception, under which persons who satisfy certain requirements
in relation to average transaction size or where the principal
business is not in leveraged foreign exchange spot transactions
and who also satisfy minimum credit rating requirements
may be exempted from the licensing requirement on notification
to the SFC.
Personnel
In terms of complying with the licensing requirements, a
fund manager / adviser licensed to conduct regulated activities
under the SFO will have to ensure:
- each individual executive director (a director of the
fund manager / adviser who either actively participates
in or is responsible for directly supervising the business
of a regulated activity for which the fund manager is licensed)
is approved by the SFC as a "responsible officer;
- not less than two individuals, at least one of whom is
an executive director, of the fund manager are approved
by the SFC as responsible officers of the fund manager in
relation to each regulated activity it is licensed to conduct;
- all investment management staff who are involved in carrying
out a function of the regulated activity and responsible
officers of the fund manager are licensed as "licensed
representatives" accredited to the fund manager.
In order to be a licensed representative or a responsible
officer, certain recognised industry qualifications are required
and a pass in specified local regulatory framework examinations
(provided by the Hong Kong Securities Institute), subject
to exemptions. Details of these are contained in the SFC's
Guidelines on Competence. Discussions of these are beyond
the scope of this article.
Licensing Application
The SFC have issued a set of forms (available on their website
(www.hksfc.org.hk) which need to be submitted along with any
relevant supporting documents and an application fee. The
SFC state that an application may take up to fifteen weeks
to process.
Financial Resources
With the introduction of the single licence regime, licensed
corporations will be able to engage in a number of different
regulated activities through one corporate vehicle, hopefully
reducing costs and administrative burdens. In terms of the
financial resources requirements for licensed corporations,
a licensed corporation, generally, must have and maintain
at all times the required amount of paid-up share capital
and liquid capital which is applicable to it as set out in
the SFC's Financial Resources Rules (or FRRs). Where a corporation
is a licensed for more than one regulated activity, the highest
amount for the different regulated activities must be maintained.
It is not necessary to aggregate the different monetary requirements
for the different regulated activities. The amount required
is reduced where the licensed corporation does not hold client
assets in Hong Kong.
Offers of investments
Part IV of the SFO, establishes the regulatory framework
for marketing investment products to the public in Hong Kong.
It is an offence for any person to issue, or have in his possession
for issue, whether in Hong Kong or elsewhere, any advertisement
(which is widely defined), document or invitation (which is
expressly defined to include an offer and an invitation made
by means of oral or electronic forms of media) which contains
an invitation to the public (or any class of the public) of
Hong Kong, amongst other things, (a) to enter into an agreement
to acquire, dispose of or underwrite securities; or (b) to
acquire an interest in or participate in a "collective
investment scheme".
It should also be noted that an advertisement, document or
invitation whose contents are likely to be accessed or read
by the public will be regarded as an advertisement, document
or invitation which is or contains an invitation to the public.
Exceptions to Part IV of the SFO
One exception to the general prohibition above is the "professional
investor" exception: the definition of "professional
investor" in the SFO sets out a new and exhaustive list
of investors who are categorised as professionals, including
intermediaries, authorised financial institutions and insurance
companies. The SFC has in the Securities and Futures (Professional
Investor) Rules, extended the categories of persons who fall
within the definition of "professional investor"
in the SFO to include:
- trustee companies with at least HK$40 million in assets;
- high net worth individuals with a portfolio of at least HK$8
million; and
- a corporation or partnership with either a portfolio of at
least HK$8 million or not less than HK$40 million in assets.
The classification of these categories should give more certainty
as to the types of investor who may buy interests in hedge
funds on a "private placement" basis in Hong Kong
and thereby reflect the likely target offerees.
Companies Ordinance
The regulatory regime under the CO is not amended by the
SFO and, therefore, continues to apply to the offer of shares
or debentures in a company, but not to offers of interests
in a limited partnership or unit trust. It should be noted
that, unlike the SFO, the CO retains the so-called "professional
investor" exception for "persons whose ordinary
business is to buy or sell shares or debentures, whether as
principal or agent", usually considered to include broker
dealers, fund managers, investment advisers, banks, financial
institutions and insurance companies and would not generally
include high-net-worth investors. This exception is more restrictive
than the categories of professional investors in the SFO.
In light of the discrepancy, until the CO is amended, where
a hedge fund is structured as a corporate entity, care will
need to be taken to ensure that the investors targeted in
Hong Kong do not fall between the "gap" in the two
regimes. Under the Companies Amendment Bill (the "Bill")
the CO will be amended and will adopt the definition of "professional
investor" contained in the SFO. This is advantageous
for two reasons: (i) it extends the scope of the exemption
as the SFO distribution is wider than the CO distribution;
and (ii) it brings the CO in line with the SFO. It is hoped
that the Bill will become law before the end of 2003.
Another exception to the general prohibition under the SFO
(and the CO) is the so-called "limited persons rule".
Although there is no such rule or exception contained in the
SFO (or currently under the CO), the SFC has taken the view
that an offer or invitation should not be deemed to be made
to the public if it involves a distribution of numbered documents
to a limited number of named persons in Hong Kong, ideally
between 20 and 30 offerees, depending on all the circumstances
of the offer. The Bill however proposes to permit an offer
to 50 persons along with a suitable warning statement included
in the offer document. As yet we are not aware of any proposed
amendments to the SFO in this respect or that the SFC has
expressed a view on this yet. Consequently, either there is
an intention that the SFO should continue to be construed
as it is now with respect to offers of and marketing collective
investment schemes to a limited number of persons, or, alternatively,
and perhaps the better approach, the SFC will relax the position
under the SFO in line with CO once the Bill is passed and
in force.
Conclusion
Whilst the SFO has introduced a new licensing regime, the
regulated activities for which a hedge fund manager may be
required to be licensed are distinct and there are a number
of useful exemptions. Additionally, the SFO introduces much
welcomed clarity as to the meaning of "professional investor",
an advance that will be particularly worthwhile when the CO
is amended to mirror the new SFO definition.
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