Regulators across the globe have been increasingly proactive in detecting and taking action against unlicensed activities. Taking the Hong Kong Securities and Futures Commission (SFC) as an example: in the past 3 years, the SFC initiated over 90 investigations into suspected unlicensed activities, resulting (so far) in 19 criminal prosecutions in which 16 persons were convicted and only 2 were acquitted1. Conducting unlicensed activities is a serious offence with a potential jail term of up to 7 years. This client alert identifies some non-obvious ways in which you can fall foul of the SFC’s licensing regime; and previews the new issues raised by the proposed new over-the-counter (OTC) derivatives regime.

Do not be caught off-side under the current licensing regime

Under the Securities and Futures Ordinance (SFO), there are currently 10 types2 of “regulated activities” (each an RA), the conduct of which in Hong Kong requires a licence from the SFC. The RA definitions are wide, and there are a few non-obvious risky areas that we highlight below.

  1. Holding out as carrying on a business in regulated activity

Section 114(1)(b) of the SFO prohibits an unlicensed person from holding out as carrying on a business in a regulated activity in Hong Kong. The term “holding out” is not defined in the SFO or by the SFC. It is a question of fact depending on the circumstances.

Enforcement cases show that publications and representations made in websites can be particularly problematic. If you are not licensed, but by use of marketing or promotional materials, lead others to believe that you provide regulated activities, you may well be in breach of the SFO. The standard that the SFC appears to use is that any language that will lead a reasonable man to believe that you are providing regulated services will constitute “holding out”. As examples, here are some cases publicised by the SFC :

  • HKBSS Worldwide Limited and HKBSS Limited, which are unlicensed entities, represented on their websites – freely accessed by the public - that they and other companies within the group provided services of advising on corporate finance and asset management. They were prosecuted for holding themselves out and issuing advertisements to hold themselves out as being prepared to carry on a business of advising on corporate finance and asset management. (September 2007)
  • Eminent Investment (Asia Pacific) Limited, which is an unlicensed entity, stated in its website that it provided investment banking, investment advisory and capital raising services to emerging growth to multinational companies. It was convicted of holding itself out as carrying on a business in advising on securities and advising on corporate finance. (April 2011)

Prosecution can occur even if the offending advertisements are removed, or where the advertisements do not attract any clients (although these may be mitigating factors).

  1. Active marketing to Hong Kong public

Unlike section 114(1) of the SFO which captures activities in Hong Kong, section 115(1) of the SFO expands the licensing net to persons actively marketing from a place outside Hong Kong, to the public in Hong Kong, any services that if provided in Hong Kong, would constitute a regulated activity.

The SFC, in its answers to Frequently Asked Questions (FAQs), has indicated that it would consider a number of factors when determining whether a person “actively markets3 :

  • whether there is a detailed marketing plan to promote the services;
  • whether the services are extensively advertised via marketing means such as direct mailing, advertisements in local newspapers, broadcasting or other “push” technology over the Internet (as opposed to where the services are passively available e.g. on a “take it or leave it” basis);
  • whether the related marketing is conducted in a concerted manner and executed in accordance with a plan or a schedule which indicates a continuing service rather than an one-off exercise
  • whether the services are packaged to target the public of Hong Kong, e.g. written in Chinese and denominated in Hong Kong dollars; and
  • whether the services are sought out by the customers on their own initiative.

Section 115(1) is extra-territorial; interestingly, so far most prosecutions for issuing advertisements to promote unlicensed activities have been based on section 114(1) instead of section 115(1) of the SFO. Overseas entities are more difficult to investigate and penalise. Nevertheless, the SFC will use section 115 when it is appropriate and did, in fact, do so recently. Hantec International Limited (HI)4 was prosecuted for inducing Hong Kong individuals to open accounts with an unlicensed sister subsidiary, Cosmos Hantec Investment (NZ) Limited (CHI), to trade leveraged foreign exchange contracts. CHI remunerated HI’s executives for trades conducted by their clients and its internal documents showed that Hong Kong was a target market. CHI was physically present for a while in Hong Kong, although following the SFC’s raid of its offices in 2005, CHI moved out of Hong Kong.

We expect more section 115 cases in due course.

  1. Private equity

When the phrase “private equity” is used, it generally refers to the shares of private companies. In Hong Kong, such shares are excluded from the definition of “securities” under the SFO; however the exclusion only applies to the shares or debentures of a company that is a private company within the meaning of section 29 of the Hong Kong Company Ordinance.

According to section 29 of the Hong Kong Companies Ordinance (CO), a private company means a company which by its articles:
  • restricts the right to transfer its shares;
  • limits the number of its members to 505; and
  • prohibits any invitation to the public to subscribe for any shares or debentures of the company.

Company” within the meaning of “private company” covers companies, which are incorporated under the CO, or registered as non-Hong Kong companies under the CO. Accordingly, dealing in or advising on the shares of companies which are incorporated overseas and not under the CO potentially constitutes a regulated activity and thus is required to be licensed under the SFO. There may be structures that do not require a licence; you may wish to do some specific, or review you previous, legal analysis.

  1. Crowdfunding

The new phenomenon of crowdfunding occurs when individuals pool their money to support a project or an activity; this unique method has been used to fund budding entrepreneurs, aspiring moviemakers, charitable works and any number of diverse activities. In the United States (US), crowdfunding is permitted by virtue of a specific exemption from securities registration6 after the implementation of the Jumpstart Our Business Startups Act in April 2012.

In Hong Kong, there is no crowdfunding exemption equivalent to that in the US. Would it be possible, provided the right investors (that is, professional investors) are found, to rely on either Schedule 17 of the CO or Section 103 of the SFO? These provisions exempt:

  • offer for sales of securities to professional investors7, the number of which is less than 50, from registration of the prospectus with the Companies Registry; and
  • advertisements, invitations or documents made in respect of securities, or interests in any collective investment scheme which are intended to be disposed to only professional investors8, from authorization by the SFC.

Reliance on these provisions should be considered carefully. Whilst these provisions allow certain offers to be exempt from registration or authorisation requirements, it does not allow such offers to be made without the appropriate licence.

Do not be blind-sided : understand the expanded licensing regime under the new OTC derivatives regime

Soon, the SFO will be amended to:

  • introduce 2 new types of regulated activities:

Type 11: Dealing in and/or advising on OTC derivatives transactions (RA 11); and

Type 12: Providing clearing and settlement services in respect of OTC derivatives transactions (RA 12)

  • expand the scope of the current:

Type 7 regulated activity (Providing automated trading services) (RA 7); and

Type 9 regulated activity (asset management) (RA 9)

  1. New RA 11

The new RA 11 captures dealing and advising activities in relation to OTC derivatives transactions. Though the definition of “OTC derivatives transactions” is yet to be finalised by the SFC, it will be based on the current - wide - definition of “structured products” in the SFO, and covers the commonly traded equity derivatives, FX derivatives, interest rate swaps /options, non-deliverable forwards and credit derivatives (Commonly Traded OTC Products). Will the new regime cover the popular “Accumulator9”? We believe probably not; however we do note that the SFC has yet to issue some key consultation conclusions and things may change.

If you are an issuer of, or dealer in, the Commonly Traded OTC Products, or if you issue research relating to them, you may need a RA 11 licence. The good news is that there will be (limited) crave-outs for currently licensed intermediaries. For example:

  • If you are a trader licensed for Type 1 regulated activity (dealing in securities), you may be exempted from licensing for the new RA 11 to the extent that you trade equity derivatives.
  • If you are a research analyst licensed for Type 4 regulated activity (advising on securities), you may be exempted from licensing for the new RA 11 to the extent that your research reports cover equity derivatives.

You should monitor developments in this area in order to assess if you need a RA 11 or if a carve-out will apply.

  1. New RA 12

The new RA 12 captures agency clearing and settlement services in relation to OTC derivatives transactions. It will likely catch intermediaries between a member of central counterparties (CCP) and a counterpart to the OTC derivatives transaction in respect of which the clearing agency services are provided.

The current thinking of the SFC is to exempt the following persons from licensing for the new RA 12:

  • A member of CCP;
  • An authorized institution;
  • An approved money broker; and
  • A clearing agent that does not have place of business in Hong Kong, is regulated under the laws of an acceptable overseas jurisdiction in respect of provision of clearing agency services, and does not provide clearing agency services to persons in Hong Kong or provides clearing agency services to persons in Hong Kong provided that any marketing of such services is conducted by a person that is either an authorized institution or a licensed corporation.

Because of these wide carve-outs, it is anticipated that only a limited number of clearing and settlement agents will need a RA 12 licence.

  1. Expanded RA 9 & RA 7

Providing asset management services in Hong Kong currently requires a RA 9 licence. The current scope of RA 9 covers management of portfolios of securities, futures contracts and real estate investment trusts, but excludes OTC derivatives products. Therefore, if you manage a portfolio of OTC derivatives products, you may not currently require a RA 9 licence.

Going forward, the definition of RA 9 will be expanded to include OTC derivatives products, so:

  • If you are not currently licensed for RA 9 because you manage only OTC derivatives products, you need to consider if you need to apply for a SFC licence.
  • If you are currently licensed for RA 9 and also manage OTC derivatives portfolios or use OTC derivatives products as hedging tools, do be aware that the SFC intends to assess the competence/experience of your ROs and the sufficiency of your internal controls for such management and hedging activities. You may wish to take some preparatory steps to review the adequacy of your internal control procedures and credentials of your responsible officers.

Automated Trading Services (ATS) refers to services provided by electronic platforms that automatically matches and executes trading orders, and operators of ATS are required to be licensed for RA 7. Dark pool operators are normally RA 7 licensees. As the current scope of RA 7 captures orders relating to securities and futures contacts, ATS operators are also concurrently licensed for other types of regulated activities (i.e. dealing in securities and/or futures contracts).

Going forward, the definition of RA 7 will be expanded to include OTC derivatives products, so:

  • If you are currently not licensed but running a pool for trading and/or clearing of OTC derivatives products, you need to consider if you need to apply for an SFC licence.
  • If you are currently licensed for RA 7 but your dark pool is also a venue for trading and/or clearing of OTC derivatives products, you may need to be additionally licensed for RA 11 and/or RA 12 and comply with new requirements for running an ATS for OTC derivatives products.