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Hong Kong Law

April 2014

FSTB Consults on Open-ended Fund Company Structure

Introduction

The Financial Services and the Treasury Bureau (FSTB) published the Open-ended Fund Companies Consultation Paper (see archive) (Consultation Paper) and a press release (see archive) on 20 March 2014 setting out the government's proposals to allow the establishment of open-ended fund companies under the Securities and Futures Ordinance (SFO).

Currently, an open-ended investment fund may be established under Hong Kong law in the form of a unit trust by way of a trust deed but not in corporate form due to the various restrictions on capital reduction under the Companies Ordinance (CO).

Following the announcement by the Financial Secretary in the 2013-2014 Budget in relation to legal and regulatory frameworks that would enhance Hong Kong's position as an international asset management centre, the government proposed to complement the existing unit trust structure by an open-ended company fund (OFC) structure, which will be an open-ended collective investment scheme structured in corporate form with limited liability and variable share capital.

Given the greater popularity of corporate fund structures internationally, the proposals aim to offer market participants greater flexibility in establishing and operating funds in Hong Kong in the hope of encouraging more mutual and private funds to domicile in Hong Kong.

The FSTB welcomes responses to its proposals during the three-month consultation period ending 19 June 2014. This newsletter will summarize the proposed structures of OFCs as set out in the Consultation Paper.

Proposals

The proposals set out in the Consultation Paper cover the legal framework, regulators, legal structure, formation and incorporation, administration and operation, protected cells, termination and winding up, regulatory regime, and tax and other issues relating to OFCs.

The amended SFO and OFC subsidiary legislation

Key areas to be covered under the new legislation

The FSTB envisages that the new legislation will cover the following key areas:

Core structural requirements:

Key ongoing compliance obligations:

SFC regulatory powers:

A separate OFC Code

Some of the key requirements proposed to be included in the OFC Code issued by the SFC are:

2. Regulators

SFC as the primary regulator

Registration

It is proposed in the Consultation Paper that the SFC will be empowered under the SFO/OFC subsidiary legislation to register OFCs and to approve the appointment and replacement of key operators of the OFC including individual board directors, the OFC custodian and SFC-licensed or registered investment managers.

Regulation

It is also proposed that OFCs which are seeking to offer their shares to the public must obtain SFC authorization under Part IV of the SFO unless an exemption applies, and comply with the SFC Handbook.

The Consultation Paper proposes that the SFC will undertake the securities-related enforcement matters relating to OFCs.

Please refer to section 9 below for more details on the SFC's supervisory role in the proposed OFC regime.


Companies Registry (CR) to be responsible for incorporation and corporate filings

It is proposed that the CR will be responsible for the incorporation and relevant statutory corporate filings of OFCs. The aim is to ensure that those dealing with OFCs will have access to basic corporate information regarding OFCs which is included in the corporate public filings kept by the CR. The relevant corporate filings functions proposed to be undertaken by the CR for OFCs will include:

  1. maintaining a register for OFCs which will be in line with the existing arrangement for companies registered under the CO;

  2. accepting and registering relevant statutory corporate filings and registering company documents which are applicable to OFCs; and

  3. providing the public with services to access the OFC information held by the CR.

Please refer to section 5 below for more information on corporate filing functions.


The Consultation Paper proposes that the CR will administer relevant corporate filing breaches under its existing enforcement procedures.

Termination of an OFC

The termination of an OFC is proposed to be subject to the SFC's prior approval.

Winding up of an OFC

It is proposed that the Official Receiver's Office (ORO) will administer any court-ordered compulsory winding up procedures (similar to those applicable to conventional companies formed under the CO) of an OFC. The ORO will administer relevant breaches under its existing enforcement procedures.

Please refer to section 7 below for more information on the procedures for termination and winding up of an OFC.


It is envisaged that OFCs will:

  1. be open-ended collective investment schemes in corporate form whose main purpose is to serve as an investment fund vehicle;

  2. have their own legal personality and be governed by a board of directors;

  3. shareholder liability will be limited to their shares in the company;

  4. be managed by professional investment managers on behalf of shareholders; and

  5. have their assets held by independent custodians.

Proposed OFC structure

Source: p. 12, the Consultation Paper

i. OFC fund

ii. Board of directors

iii. Investment manager

iv. Custodian

4. Formation and Incorporation

Setting up an OFC

The proposed flow of events in setting up an OFC is summarized as follows:

The applicant applies to the SFC for approval of the OFC.
The SFC reviews the application, including whether it meets the regulatory requirements to be stipulated in the SFO and relevant subsidiary legislation, rules, regulations and codes.
Upon CR's receipt of specified documents and the SFC's issuance of an approval-in-principle for registration, CR incorporates and registers the OFC.3
The registration of the specified form and the constitutional documents and the issuance of a certificate of incorporation by the CR confer corporate status upon the applicant entity from the date of the incorporation (i.e. the date of the certificate of incorporation).
The body corporate may exercise all functions of an incorporated company as a full legal person.
Once incorporated, the SFC will include the OFC's name in the SFC's list of registered OFCs. The CR will also include the OFC's name in the CR's list of OFCs and make relevant documents available for public search (e.g. constitutional documents and the certificate of incorporation).


Naming convention

In order to distinguish OFCs from companies formed under the CO and to ensure that OFC names are not misleading or undesirable, it is proposed that:

Articles of incorporation

It is proposed that the basic mandatory content requirement will cover the core elements of an OFC, such as:

  1. operating as an open-ended fund company with variable capital;
  2. the investment scope;
  3. having segregation of liabilities between sub-funds;
  4. limiting shareholders' liability to their investments in the OFC; and
  5. entrusting the OFC's property to a separate, independent custodian for safe keeping.

Investment scope and strategies

The proposed investment scope aims to

Publicly offered OFCs

Publicly offered OFCs must comply with applicable investment restrictions set out in the SFC Handbook.

Privately offered OFCs

Investment managers of privately offered OFCs may have the flexibility to pursue their own investment strategies, subject to:

Offering documents

It is proposed that in line with the existing arrangement adopted for investment fund offerings in Hong Kong, OFC share offerings would be made under an offering document. Basic disclosure requirements for offering documents would be set out in the new legislation and/or the OFC Code and any misrepresentations would be subject to liability under sections 107 and 108 SFO. Offering documents would be required to:

Publicly offered OFCs

It is proposed that offering documents of publicly offered OFCS will be required to:

Privately offered OFCs

It is proposed offering documents of privately offered OFCs will not be required to:

5. Administration and Operation

Corporate administration

i. Meetings

ii. Reports and accounts

iii. Corporate filings

Fund operation

i. Share capital

ii. Valuation and pricing

Rules, requirements, and codes of conduct

iii. Issue and redemption of shares

Under the proposals,

iv. Distributions to shareholders

6. Protected Cells

Segregation of liabilities between sub-funds

Proposed protected cell regime for Hong Kong

Under the proposed OFC legislation

The proposed new OFC legislation will mandate the following if an OFC is established as an umbrella company:

  1. the assets of a sub-fund will belong exclusively to that sub-fund and cannot be used to discharge the liabilities of any other person, including the OFC itself or another sub-fund;

  2. a liability incurred on behalf of a sub-fund must be discharged solely out of the assets of that sub-fund; and

  3. where assets or liabilities are not attributable to any particular sub-fund, the OFC may allocate them in a manner which it considers to be fair to shareholders.

Winding up of a sub-fund

The aforesaid segregation will also make it easier for individual sub-funds to be wound up as if it were a legal person in its own right and therefore any winding up of a sub-fund could be done more efficiently and without much impact to the umbrella OFC.

Disclosure warning in OFC prospectus

There is no guarantee that Hong Kong's interpretation of a protected cell regime would be upheld by courts in other jurisdictions. The Consultation Paper therefore suggests that the OFC prospectus should include a disclosure warning that such protected cells may not be upheld in foreign courts.

Proposed structure: OFC umbrella with segregated liabilities

Source: p. 27, the Consultation Paper

7. Termination and Winding Up

Streamlined termination of a solvent OFC

Termination

De-registration

Winding up of an OFC

Solvent OFCs

Similar to conventional companies, it is proposed that

Insolvent OFCs

Winding up by the court

Dissolution in other circumstances

8. Regulatory Regime

Supervision

Proposed enforcement

While there will be a mandatory delegation of all investment functions and the day-to-day management of the OFC to a SFC-licensed or registered investment manager, neither the OFC itself nor its directors will be required to be licensed by the SFC (please refer to the section "Legal Structure" above for more information).

Since the SFC's existing powers over licensees will not extend to the OFC or its directors, the SFC has proposed that it should have additional enforcement powers over the OFC vehicle itself and the individual directors to safeguard investor interests.

i. Investigatory powers

It is proposed that the SFC should be vested with:

ii. Powers of restriction

iii. Criminal and civil powers

Criminal, civil and market misconduct proceedings

Remedies

Court orders

9. Tax and Other Issues

Profits tax exemption for OFCs authorized by SFC or OFCs with their central management and control outside Hong Kong

Stamp duty on transfer of OFC shares

Under the proposals, allotments, transfers and surrenders (e.g. in the case of redemptions) of shares in OFCs may be treated in the same way as units in unit trusts for stamp duty purposes. The Consultation Paper sets out details of the stamp duty treatment of allotments, transfers and surrenders of units in unit trusts, as below.

Transfers

If the transfer of a unit in a unit trust is required to be registered in Hong Kong, then that unit is "Hong Kong stock" and instruments effecting the transfer thereof are liable to duty in accordance with Head 2 of the First Schedule of the Stamp Duty Ordinance (SDO). The rules relating to contract notes as set out in section 19 of SDO generally apply to dealings in the units. Transfers of ETF instruments are not stampable if the value of Hong Kong stocks does not exceed 40% of the aggregate value of the underlying portfolio.

Allotments

The initial allotment of a unit by the trustees is not subject to stamp duty because according to section 19(16) of SDO, "sale or purchase" is defined to mean any disposal or acquisition (other than an allotment) for valuable consideration.

Surrenders

Where the unit is surrendered to the trustees or managers (e.g. in the case of redemption) and the unit is then extinguished, no ad valorem duty (i.e. 0.1%) is payable by the managers as section 19(1A)(a) of SDO provides that section 19(1) of SDO (which requires a person effecting the sale or purchase of Hong Kong stock to make, execute, and stamp contract notes) does not apply to a sale or purchase of a unit under a unit trust scheme where the transaction is effected by extinguishing the unit. Only a fixed duty of $5 is payable on the surrender of a unit where this involves extinguishing the unit.

Tax filing

While an OFC is an investment fund vehicle, it takes a corporate form and it is therefore proposed that OFCs should be required to register for business under the Business Registration Ordinance and complete tax returns to report income accrued to employees and profits whether fully or partially exempt from profits tax.

Submission of Comments

FSTB, the SFC and relevant departments will work on the details of the proposals set out above, taking into account comments received during the public consultation. Members of the public and the industry are welcome to send their written comments on or before 19 June 2014, by any one of the following means:

By mail to: Consultation on Open-ended Fund Companies
Financial Services Branch
Financial Services and the Treasury Bureau
24/F Central Government Offices
2 Tim Mei Avenue
Tamar
Hong Kong
By fax to: +852 2294 0460
By email to:


Annex: Consultation Questions

Question 1 Do you agree with the overarching principles for OFCs?
Question 2 Do you consider it agreeable to set out the legislative framework for OFC in the SFO and the relevant subsidiary legislation in the proposed manner?
Question 3 Do you think the proposed scope of the code and guidelines could adequately cater for the OFC regime? If not, what other essential features should the codes and guidelines include?
Question 4 Do you agree with the proposal that the SFC should be the primary regulator of OFCs?
Question 5 Do you agree with the proposed role and functions of CR in the OFC regime?
Question 6 Do you agree with the proposed role of ORO and SFC in respect of proposed termination and winding up arrangements for OFCs?
Question 7 Do you think the proposed features comprise the essential features of an OFC? If not, what other essential features should an OFC possess?
Question 8 Do you agree with the proposed features for the Board of Directors? Do you think the proposed structure of the Board and the proposed criteria of directors will be able to render adequate investor protection to those investing in OFCs? Or do you think the proposed structure is too onerous, and would hinder the development of OFCs in Hong Kong?
Question 9 Do you agree that the OFC board must delegate the day-to-day management and investment functions of the OFC to an investment manager who is licensed by or registered with the SFC to carry out Type 9 (asset management) regulated activity?
Question 10 Do you think the proposal to require a custodian in the OFC structure could foster the protection of investors in an OFC? Do you consider the proposed requirements and duties for a custodian adequate to meet this objective?
Question 11 Do you agree with the proposed arrangements in relation to the incorporation of OFC?
Question 12 Do you consider the proposed naming convention provides sufficient level of clarity to investors?
Question 13 Do you agree that the proposed Articles are adequate? What features should the Articles include?
Question 14 Do you consider the proposed investment scope and strategies could provide a competitive framework for OFCs in Hong Kong with sufficient safeguards for investor protection?
Question 15 Do you agree with the proposed arrangements in relation to the offer of OFC shares?
Question 16 Do you agree with the proposed arrangements regarding corporate administration?
Question 17 Do you agree with the proposed arrangements in relation to fund operation? Are the proposed principles and arrangements adequate to cater for the practical operation for OFCs?
Question 18 Do you agree with the proposed arrangements in relation to protected cells?
Question 19 Do you think the proposed termination procedures are adequate to provide an expedient way for terminating a solvent OFC?
Question 20 Do you have any comments on the proposed termination, winding up and dissolution arrangements for OFCs, including the proposed power to be given to the custodian to petition to the court to wind up an OFC?
Question 21 Do you consider the proposed powers are essential and proportionate?
Question 22 Do you think the existing profits tax exemption regimes for public funds authorised under section 104 of the SFO / bona fide widely held regulated funds and offshore funds are adequate to cater for OFCs?
Question 23 Do you consider that the proposed stamp duty treatment on sale and transfer of shares in OFCs can cater for the market needs?
Question 24 Do you consider the proposed tax filing arrangement agreeable?



  1. In addition to registration, if the OFC wishes to offer its shares to the public, it will have to seek SFC authorization under section 104 of the SFO and comply with the applicable requirements under the SFC Handbook.

  2. The same director may satisfy the independence and residency requirement.

  3. The Consultation Paper highlights that this registration status is not the same as an authorization under section 104 of the SFO. If the OFC wishes to offer its shares to the public, it is proposed that the OFC will have to seek authorization under section 104 of the SFO which can be processed concurrently with its application for registration as an OFC.

  4. Namely securities, futures (and over-the-counter derivatives once the relevant proposed legislative amendments to the SFO have become effective) as defined under the SFO.

  5. Under section 105 of the SFO, prior to issue, similar to all investment funds offered to the public in Hong Kong.

  6. Other administrative and procedural matters relating to member meetings may be determined by individual OFC's Articles.

  7. All accounts must be prepared in accordance with the Hong Kong Financial Reporting Standards.

  8. Audited accounts must be audited by an independent auditor who is appointed by the OFC board.

  9. Including shareholders' approval, appointment of liquidator, notices, final meeting and final accounts.

  10. Section 107 of the SFO; Part XIV of the SFO; section 300 of the SFO.

  11. This may include the establishment of bespoke remedial orders to deal with the consequences of misconduct in the affairs of an OFC.

  12. Including mutual funds, unit trusts or similar CIS authorized by the SFC under section 104 of the SFO or similar bona fide widely held investment schemes.

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Charltons - Hong Kong Law Newsletter - Issue 237 - 16 April 2014

Financial Services and the Treasury Bureau FSTB

Open-ended fund companies OFC

Securities and Futures Ordinance SFO

Open-ended Fund Companies Consultation Paper

Open-ended company fund OFC structure

Open-ended collective investment scheme structured in corporate form with limited liability and variable share capital

OFC Code

Part IV of SFO

Official Receiver's Office ORO

Proposed OFC Structure

Setting up an OFC