Comments on the Open-Ended Fund Companies Consultation Paper
We would like to thank the Financial Services and the Treasury Bureau for the opportunity to comment on its proposed regime for open-ended fund companies (“OFCs”). We welcome the introduction of OFCs and believe that if the enabling legislation and supporting regulations are appropriate, OFCs can play a major role in the global funds universe. However, as set out more specifically in our comments below, we are concerned that the proposed regime is heavily biased towards appropriate regulation of domestic public funds and fails to sufficiently distinguish between public funds and private funds and between domestic funds and international funds. If this bias is not changed, Hong Kong may lose an opportunity to serve as a base for private funds (e.g. hedge funds) and international funds (e.g. mutual funds offered and managed globally).
In suggesting further consideration of what regulations may be appropriate for domestic funds rather than international funds and for public funds rather than private funds, we are not advocating that Hong Kong position itself as a jurisdiction with light touch regulation to attract fund sponsors. Instead, we are suggesting that for the proposed regime to succeed as a base for private funds and international funds, it is essential to balance regulatory objectives with commercial realities.
In this regard, it is already possible, as the consultation paper recognizes, to establish a Hong Kong based fund through a unit trust with a Hong Kong trustee. For funds which do not assume liabilities that a trustee may be unwilling to bear, if an OFC is more difficult, costly or slow to establish than a unit trust, fund sponsors will be unlikely to adopt an OFC structure. At issue will be whether any regulation imposed by the OFC regime will justify the limited liability afforded by the OFC structure. So far as we are aware, there is no suggestion that the present regulation of Hong Kong unit trusts falls short.
Equally, as the consultation also recognizes, it is already possible to establish a fund in the form of an open-ended company with limited liability in a number of overseas jurisdictions.
1. Do you agree with the overarching principles for OFCs as set out above?
We agree with the principles outlined in 10(a) and 10(c), but feel that the principle outlined in 10(b) is misguided in respect of private funds. Private OFCs should be given complete flexibility in terms of investment strategies, as they are in other jurisdictions.
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?
Yes. Given the approach being taken, the legislative framework for OFCs should be set out via enabling provisions in the SFO and a separate piece of subsidiary legislation governing the detailed regulation of OFCs. However, an easier approach would be to use the Companies Ordinance and provide OFCs with special status whereby certain requirements under the Companies Ordinance are relaxed.
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?
The form of a fund should be neutral from a regulatory perspective and being structured as an OFC should not result in a fund facing more regulation than a Hong Kong domiciled unit trust or an overseas domiciled OEIC. As set out very clearly in para. 6 of the Financial Services Development Council's (“FSDC”) research paper “The basic premise for Public OEICs is that, like retail unit trusts, these should mainly be governed by the SFC Code on Unit Trusts and Mutual Funds (“Code”). The FSDC did not consider it appropriate to impose additional requirements on Public OEICs which are not contained in the Code, except in very limited cases, nor to grant exceptions from Code requirements. The Code is neutral as to the legal form of schemes authorized by the SFC and already applies to foreign OEICs established in other jurisdictions seeking SFC authorization in Hong Kong.”
Separately, given that (i) detailed regulation of OFCs will be contained in the subsidiary legislation to be made under the SFO, (ii) all public OFCs will be bound by the provisions of the Code on Unit Trusts and Mutual Fund, (iii) all managers of public OFCs will be subject to the provisions of the Fund Manager Code of Conduct, there appears to be no need to subject public OFCs to another set of codes and guidelines. Many of the proposed chapters of the OFC Code are either already dealt with in the Code and the remaining chapters could be dealt with in the subsidiary legislation.
Given that private OFCs will not be authorized under the SFC for sale to the public in Hong Kong and will only be “registered” with the SFC, we cannot see on what basis it would be appropriate or necessary for private OFCs to have to comply with additional SFC codes or guidelines.
4. Do you agree with the proposal that the SFC should be the primary regulator of OFCs?
Yes, we agree that the SFC is best placed to be the primary regulator of OFCs. However, in our view private OFCs require little or no regulation. As stated in para. 9 of the FSDC's research paper “The incorporation if OEICs would be subject to approval by the SFC, but only public OEICs would be considered “regulated” by the SFC.”
5. Do you agree with the proposed role and functions of CR in the OFC regime?
Yes we agree with the proposed role and functions of the CR.
6. Do you agree with the proposed role of ORO and SFC in respect of proposed termination and winding up arrangements for OFCs?
Yes we agree with the proposed roles of the ORO and the SFC.
7. Do you think the proposed features comprise the essential features of an OFC? If not, what other essential features should an OFC possess?
The features set out in para. 37(a) of the Consultation would appear to comprise the essential features of an OFC. The requirement for a Hong Kong registered office may be necessary for a Hong Kong OFC but is clearly not an essential feature of OFCs generally. The matters set out in paras. 37(c) and (d) do not appear to be essential features of an OFC. We are concerned that the current features will limit the practical use of OFCs for fund managers in other jurisdictions which will limit the growth of OFCs globally.
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?
Whilst it is common for a fund using a corporate form to have a board and to delegate day to day investment management to an investment manager, in our view the proposed requirements regarding the Board of Directors are too onerous and may hinder the development of OFCs. In particular, the requirement to have a Hong Kong resident director may have negative consequences from both a taxation perspective and a commercial perspective as an overseas fund company may not have any personnel in Hong Kong.
In addition, given that the directors are simply providing an additional layer of oversight, we hope that any requirements regarding their functions and duties and the applicable corporate governance standards are in the form of a light touch and not too onerous.
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 that is licensed by or registered with the SFC to carry out Type 9 (asset management) regulated activity?
No. For public funds (i.e. funds authorised by the SFC), this means there will be a clear difference in the requirements applicable to OFCs on the one hand and existing unit trusts domiciled in Hong Kong and collective investment schemes (whatever their structure) domiciled elsewhere on the other. There appears to be no reason to draw this artificial distinction.
It is likely that many overseas fund companies may wish to set up an OFC to be sold to the public in Hong Kong (and in the PRC if the relevant framework is introduced), but will not necessarily want that fund to be managed from Hong Kong (e.g. the relevant investment team may be in the US or the UK). Overseas fund companies should be able to use the OFC structure without also having to have the fund managed by a Hong Kong licensed asset manager. Such an overseas fund company can already set up a Hong Kong domiciled unit trust and appoint a manager in any acceptable inspection regime. This is a clear disadvantage of the OFC structure and will limit the use of OFCs globally. We would suggest that entities licensed for asset management in other specified jurisdictions should also be able to act as the managers of OFCs.
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?
We agree with the proposal to require an independent third party custodian in the OFC structure and agree that for public OFCs such custodian should be acceptable to the SFC, but we do not see why such custodian must be incorporated in Hong Kong. In the context of funds authorized under the SFO, this draws are artificial distinction between OFCs on the one hand and all other funds on the other, including Hong Kong domiciled unit trusts which are not required to have a trustee/custodian incorporated in Hong Kong. This goes against the aim to make the structure of the fund neutral. We also note that para. 13 of the FSDC's research paper did not recommend that the custodian must be incorporated in Hong Kong, it simply stated “Another prerequisite for OEICs to strengthen investor protection will be a requirement for an independent eligible third party custodian to be appointed by the OEIC.”
11. Do you agree with the proposed arrangements in relation to the incorporation of OFC?
We agree with the proposed arrangements for public OFCs but are concerned that for private OFCs the requirement to apply to the SFC for approval may severely slow down the process of registering the OFC if the SFC does not have a separate department solely for handling private OFC registrations. This would be in contrast to other jurisdictions where a privately offered fund can be established very quickly.
12. Do you consider the proposed naming convention provides sufficient level of clarity to investors?
Yes. However, we are concerned that the process whereby the name has to be checked against the investment objectives and strategies may in practice be slow and cumbersome if this will, in reality, require the fund's offering document to be prepared and submitted to the SFC so that the investment objectives and strategies can be checked.
13. Do you agree that the proposed Articles are adequate? What features should the Articles include?
There is not sufficient information available to comment on whether the proposed Articles are adequate.
Where there are subsequent material amendments to the Articles, we assume such amendments will need to be approved by the shareholders by way of special resolution before the amended Articles are submitted to the SFC approval. For administrative ease, we would suggest that once the Articles have been approved by the SFC, they should be automatically filed by the SFC with the CR.
In respect of private OFCs, whilst we understand the requirement to submit the original articles to the SFC as part of the registration process and can understand that a revised copy of the Articles should be submitted to the SFC each time there is a material amendment (in addition to filing the same with the CR), it seems unduly burdensome and unnecessary for a private OFC to require the SFC's approval for material amendments in addition to requiring the approval of its shareholders by way of special resolution.
The inclusion of investment scope and strategies in the Articles for private funds should not be mandatory.
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?
15. Do you agree with the proposed arrangements in relation to the offer of OFC shares?
Yes. However, for administrative ease, we would suggest that once the offering document of a publicly offered OFC has been approved by the SFC, it is automatically filed by the SFC with the CR.
16. Do you agree with the proposed arrangements regarding corporate administration?
In general, but we would seek to remove a duplicative approval and filing requirements. For example, if an OFC needs to apply to the SFC for approval to appoint or remove a director, it is burdensome for the OFC to then have to make a separate filing with the CR once the approval has been received. It would be administratively easier for such matters if there was one form which can be submitted to the SFC and which on approval will be sent by the SFC directly to the CR.
17. Do you agree with proposed arrangements in relation to fund operation? Are the proposed principles and arrangements adequate to cater for the practical operation for OFCs?
Yes. The proposed arrangement appear sensible and adequate to cater for the practical operation of an OFC. Leaving flexibility for matters to be set out in the OFC's offering document or articles, as applicable, is welcomed.
18. Do you agree with the proposed arrangements in relation to protected cells?
No. The legal enforceability of protected cells is untested and concerns have been raised that protected cell structures established outside Hong Kong do not provide adequate asset protection where there is a risk of involuntary cross-default across cells. A major concern with traditional protected cell structures is that provisions that direct the segregation of the asset pools attributable to the different cells and which provide for the appropriation of those specific pools to satisfy the cellular liabilities may not be recognised by foreign courts. This is because these rules may be viewed as procedural only (rather than substantive), and as such a foreign court may be less inclined to enforce them as a matter of private international law. A further concern affecting PCCs incorporated outside Jersey is the ability of a creditor or shareholder of a single cell in effect, to have all the other cells of the PCC placed into an administrative moratorium or “Chapter 11” type proceeding, which would be likely to defeat the expectations of investors or counterparties regarding timely payment or performance of obligations. This feature has previously rendered certain protected cell fund structures unacceptable to rating agencies for rated transactions.
Notwithstanding the requirement for a mandatory disclosure of the risks of unenforceability to be included in the OFC prospectus, the proposal appears to be contrary to the protection of investors in Hong Kong. If the courts of the jurisdictions in which the OFC has incurred liabilities do not uphold the contractual terms of the protected cell OFC, it is the investors in the other cells, which are likely to include Hong Kong investors, who will lose out.
By way of comparison, we note that in Jersey the concept of the incorporated cell was developed in response to concerns regarding the effectiveness of the ring-fencing and liability segregation provisions in relation to the ‘traditional’ protected cell structures established in other jurisdictions. Under the incorporated cell structure, each cell is created as a separately incorporated Jersey company. Incorporation is a substantive provision of law that is more likely to be recognised by foreign courts in the same way as that of the limited liability of a traditional stand-alone company. We would suggest that Hong Kong considers a similar structure instead of copying a structure in respect of which there are existing concerns.
19. Do you think the proposed termination procedures are adequate to provide an expedient way for terminating a solvent OFC?
Yes. The proposed proposed procedures appear to be adequate to provide an expedient way for terminating a solvent OFC, although the adequacy will ultimately depend on the specific provisions of the OFC's articles.
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 the court to wind up an OFC?
21. Do you consider the proposed powers are essential and proportionate?
We would not say that all of the powers are essential, but they appear proportional to achieve the regulatory objectives.
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?
The current exemption regime is clearly adequate to cover public OFCs because they will be authorised under section 104 and therefore exempt on a statutory brightline basis. However, the current exemption may not apply to private OFCs in light of the fact that they will be incorporated in Hong Kong, have a Hong Kong licensed manager, and have at least 1 director resident in Hong Kong. It is apparent that many such funds will exercise their “central management and control” in Hong Kong and would therefore not be able to take advantage of the current exemption unless they go to the inconvenience and expense of moving their central management and control offshore, however that may be achieved.
We also note the FSDC's research paper specifically recommended at para. 15 that “Private OEICs should benefit from the same profits tax exemptions currently available to offshore funds and on the same conditions, except that the central management and control of Private OEICs can take place in Hong Kong to promote good corporate governance.”
We agree with the recommendation set out in the FSDC's research paper and to achieve this the current exemption will clearly need to be expanded.
23. Do you consider that the proposed stamp duty treatment on sale and transfer of shares in OFCs can cater for the market needs?
Yes. If implemented correctly, the proposed stamp duty treatment should exempt most dealings in the shares of OFCs from Hong Kong stamp duty. However, the language of the relevant sections of the SDO will need to be amended to specifically cover shares in OFCs as the exemptions currently cover only units in unit trust schemes.
[It should also be noted that the last sentence of para. 133 of the Consultation may be too general. Under section 19(1A) and section 47B of the SDO, no fixed duty is payable on the surrender of a unit (i.e. when an investor redeems the unit), where such surrender involves extinguishing the unit.]
24. Do you consider the proposed tax filing arrangement agreeable?
The requirement to register for business under the Business Registration Ordinance seems unduly burdensome, unless it will be an automatic application that is triggered at the time the OFC is incorporated.
The requirement to complete tax returns seems both burdensome and unnecessary. It is unlikely that OFCs, as the fund vehicle, will have employees and if the FSDC's recommendations are followed, both public and private OFCs should be exempt from tax. It should be noted that Cayman Islands funds can apply for a tax exemption certificate from the Cayman Islands' government and are not required to file tax returns.