On 27 January 2016, the Securities and Futures (Amendment) Bill 2016 (the “Bill”) was introduced into the Legislative Council. The Bill seeks to introduce a new ‘open-ended fund company’ (“OFC”) structure in Hong Kong – currently unavailable due to restrictions on the reduction of share capital under the Companies Ordinance (Cap 622) – to complement the existing unit trust structure. This will be done by introducing a new Part IVA (comprising sections 112A to 112ZT) to the Securities and Futures Ordinance (Cap 571) (“SFO”).
Incorporating an OFC will have the following advantages over establishing a unit trust:
- Increased saleability of the fund in other jurisdictions. It is generally difficult to sell unit trusts offshore, particularly in jurisdictions that are unfamiliar with trusts law. It is therefore often necessary for issuers to set up separate funds that employ the same investment strategy in other jurisdictions, which is both administratively burdensome and costly.
- Ability to establish sub-funds with different risk profiles. Although unit trusts can currently be set up as an umbrella fund, the Securities and Futures Commission (“SFC”) has said that it expects sub-funds within the same umbrella unit trust to share similar investment objectives and risk profiles, possibly due to concerns arising from the absence of any requirement to ring-fence assets of individual sub-funds from the liabilities of other sub-funds under the same umbrella, save in respect of hedge funds. There appears to be no similar expectation in respect of sub-funds established under umbrella OFCs however, as fund managers will be legally required to implement a “protected cell structure” in respect of all umbrella OFCs (see below). The OFC structure will therefore provide greater flexibility for fund managers, without creating additional risks for investors.
- Simplicity of the pricing structure. Unit trusts are dual priced, with the spread between the offer and bid price reflecting the initial fees and charges (with additional charges deducted from the net asset value (“NAV”) of the fund on a periodic basis). By contrast, OFCs will have a single price that is based on the NAV of the OFC, as adjusted to take into account the fees and charges disclosed in the offering document. The simplicity of OFCs’ single price structure should be more user-friendly to investors, and should make the administration of the fund more efficient.
It is hoped that the introduction of the OFC structure will increase Hong Kong’s competitiveness in the international funds market, through providing an additional investment vehicle (which is already available in most major fund centres including the UK, Ireland, Luxembourg, the US and the Cayman Islands) for fund managers and investors to choose from, and attract more funds to domicile in Hong Kong; this in turn should increase demand for local fund administration and servicing work.
The Bill lays down the enabling provisions. More detailed provisions relating to the creation, operation and regulation of OFCs will be set out in SFO and OFC subsidiary legislation and a separate OFC Code, to be enacted under the SFO at a later date after further public consultation.
The Open-Ended Fund Company
The proposed OFC is an open-ended collective investment scheme structured in the corporate form with limited liability and variable share capital, and may either be a publicly offered fund (i.e. a fund that is offered to the public in Hong Kong) or a privately offered fund.
As a corporate structure, the OFC will share the following characteristics with conventional limited companies:
- OFCs will have separate legal personality;
- OFCs will need to have a constitutional document, namely the ‘Instrument of Incorporation’ which must, amongst other things, contain a statement of the objects of the company, a statement that the company is an open-ended fund company with variable share capital, and a statement of the kinds of property in which the company is to invest (proposed section 112K, SFO);
- OFCs will be governed by a board of directors, who will be legally responsible for the affairs of the OFC;
- Liability of shareholders will be limited to the amount unpaid on their shares in the OFC (proposed section 112Q, SFO).
However, as an investment vehicle:
- OFCs will not be subject to restrictions on:
(i) the reduction of share capital, but will have the flexibility to issue and cancel shares according to the subscription and redemption demands of the market; and
(ii) distribution out of share capital, but may distribute out of share capital subject to solvency and disclosure requirements.
- OFCs will need to be registered with, and, if their shares are offered to the public, authorised under section 104 of the SFO by the SFC; however, OFCs will not need to be registered as a licensed corporation under the SFO as they are intended to be pure legal vehicles for investment only.
- OFCs’ investment management functions will have to be delegated to an investment manager appointed by the board that is licensed by or registered with the SFC to carry out Type 9 regulated activity, i.e. asset management (proposed section 112Z, SFO).
- All the assets of an OFC will have to be segregated from the investment manager and entrusted to a separate, independent Hong Kong incorporated or overseas custodian for safekeeping (proposed section 112ZA, SFO).
- The amount of an OFC’s paid-up share capital will have to equal its net asset value at all times (proposed section 112P(3), SFO).
Under the proposed section 112R of the SFO, an OFC may, where permitted by its Instrument of Incorporation, establish sub-funds. Where sub-funds are established, each sub-fund may be managed in accordance with its own investment objectives and policies. However, its assets and liabilities must be segregated from the umbrella OFC and any other sub-fund established thereunder, such that the assets of the sub-fund can only be used for the purposes of that sub-fund and cannot be used to discharge the liabilities of the umbrella OFC or any other sub-fund. However, where assets and liabilities are received or incurred on behalf of the OFC’s sub-funds, and are not attributable to any particular sub-fund, the OFC may allocate them between the sub-funds in a manner it considers fair to its shareholders (proposed section 112S, SFO).
The Financial Services and the Treasury Bureau has proposed that:
- Publicly offered OFCs be allowed to invest in asset classes in accordance with the SFC’s product code requirements and authorisation conditions, i.e. mainly in securities, futures and OTC derivatives; whilst
- Privately offered OFCs be permitted to invest in the same asset classes allowed under a Type 9 (asset management) licence, subject to a 10% de minimis exception for investing in other asset classes.
Registration & Incorporation
A ‘one-stop’ service will be provided in respect of the registration, incorporation and business registration of OFCs. Applicants thus need only apply to the SFC for registration, and should submit all the required application documents and fees, including those required by the Registrar of Companies (“CR”) and the Inland Revenue Department, to the SFC. Once the SFC is satisfied that all registration requirements are met, it will issue a notice of registration and forward the relevant incorporation and business registration documents and fees to the CR. Where the CR is satisfied that the requirements for incorporation are met, it will issue a certificate of incorporation and a business registration certificate (on behalf of the Commissioner of Inland Revenue) to the OFC, whereupon the OFC will be incorporated (proposed sections 112C and 112D, SFO; proposed amendment to section 5A, Business Registration Ordinance).
Regulation of OFCs
The SFC will act as the primary regulator of OFCs, and is, under the Bill, empowered to:
- Intervene in the business and management of OFCs in specified circumstances, through requiring the OFC to cease the issue and/or redemption of its shares, or requiring a director to cease transferring his shares in the OFC (proposed section 112ZF, SFO);
- Cancel the registration of OFCs (proposed section 112ZI, SFO);
- Make subsidiary legislation and publish codes and/or guidelines on the incorporation, management, operation, business and regulation of OFCs (proposed sections 112ZK to 112ZN, 112ZR, SFO).
- Apply to the court in specified circumstances to (proposed amendment to section 213, SFO):
(i) Remove a director, investment manager or custodian of the OFC;
(ii) Require part or all of the investments of the OFC to be realised, and the proceeds to be distributed to its shareholders; and/or
(iii) Wind up the OFC.
Aside from the above, the Bill also proposes implementing a streamlined procedure for the termination of OFCs, amending the Stamp Duty Ordinance so as to effectively exempt the sale and purchase of shares in OFCs from stamp duty liability, and extending to OFCs the same profit tax exemptions currently available to unit trusts.
This post comes to us from Alison Tsang and Ernest Lim from the University of Hong Kong.