Typical types of transactions
Other than transactions between dealers, what are the most typical types of over-the-counter (OTC) equity derivatives transactions and what are the common uses of these transactions?
OTC equity derivatives transactions in Hong Kong include forwards, swaps and options (or a combination thereof) valued by reference to an underlying such as shares or an index, margin loans and repurchase arrangements. Participants use these products for a variety of reasons, including to hedge or obtain economic exposure to an underlying, to monetise a shareholding, as part of a corporate finance or private equity strategy, for tax reasons or to maximise returns or minimise losses, as set out in the following table.
Collars, collar loans and prepaid forward contract
To hedge or monetise a position.
For example, a shareholder simultaneously purchases an out-of-the money put option and writes an out-of-the-money call option. By implementing this protective option strategy (typically after a long position in a stock has experienced substantial gains), the shareholder limits the range of possible positive or negative returns.
Put or call transactions or swaps
Allow a shareholder to borrow using existing assets (cash or shares) as security, leveraging these assets to enter into larger trades.
Repurchase agreement (aka repo)
Loan amount is determined by reference to the value of these assets (which may be subject to a margin percentage ratio) and the loan to value ratio to be maintained. Lenders in Hong Kong have lists of stocks acceptable as collateral and these typically include stocks quoted on The Stock Exchange of Hong Kong Limited (SEHK).
Can be used to acquire a shareholding in (or economic exposure to) a company, including where that company may become the target in a takeover.
A bilateral agreement where one party sells securities to another in return for cash and agrees to repurchase equivalent securities at an agreed price and on an agreed future date. Has similarities to collateralised borrowing and lending but involves an outright sale (so full ownership of the securities passes to the purchaser).
OTC equity derivatives may also be entered into by reference to A-shares (shares listed in China) under the Stock Connect link between China’s mainland markets and the SEHK. This allows Chinese investors to purchase select Hong Kong and Chinese companies listed in Hong Kong and lets foreigners buy China A-shares in a less restrictive manner than before. The link between Shanghai and Hong Kong was launched in 2014 and extended to Shenzhen in 2016. In December 2017, the Securities and Futures Commission (SFC) and the China Securities Regulatory Commission jointly announced that they had entered into a Memorandum of Understanding (MOU) on Supervisory and Enforcement Cooperation on Matters concerning Futures. This MOU facilitates regulatory and enforcement cooperation in the China and Hong Kong futures markets, and enhances supervisory assistance, enforcement cooperation and information exchange on various matters, including cross-boundary derivatives, futures exchanges and futures brokers.
Borrowing and selling shares
May market participants borrow shares and sell them short in the local market? If so, what rules govern short selling?
Yes, the general position is that market participants may borrow shares listed on the SEHK and sell them short in the local market, subject to the following requirements:
- the securities must be designated as eligible for short-selling: Hong Kong Exchanges and Clearing Limited (HKEX) sets the criteria for securities eligible for short-selling;
- reporting obligation: in general, any person who has a reportable short position is required to notify the SFC;
- market misconduct: the Securities and Futures Ordinance (Cap 571 of the laws of Hong Kong) (SFO) imposes certain obligations, including in respect of market misconduct; and
- SEHK trading rules.
However, naked or uncovered short-selling is prohibited.
Investors on Stock Connect may engage in short-selling, subject to certain restrictions and requirements (which shares are eligible for short-selling, pricing and reporting requirements, etc).
Applicable laws and regulations for dealers
Describe the primary laws and regulations surrounding OTC equity derivatives transactions between dealers. What regulatory authorities are primarily responsible for administering those rules?
The main regulators, who cooperate closely, are:
- the Hong Kong Monetary Authority (HKMA);
- the prudential regulator; and
- the SFC, the securities regulator.
Primary legislation in this area is the SFO and the Banking Ordinance (Cap 155 of the laws of Hong Kong) (BO), with detailed subsidiary legislation, regulations and guidelines (eg, the HKMA may issue statutory guidelines under the BO).
The following are also relevant:
- HKMA authorisation: the HKMA regulates and supervises banking business in Hong Kong, and entities must be licensed and comply with all HKMA requirements (including CapAd, liquidity and risk management);
- SFC licensing regime: the SFO specifies certain ‘regulated activities’ for which a licence is needed. For example, subject to certain exceptions, a licence is required for Type 8: Securities Margin Financing. The SFC introduced new regulated activities, including Type 11: Dealing in OTC derivatives products or advising on OTC derivatives products. The licensing-related provisions in relation to Type 11 have not yet come into effect. A further consultation paper was published in December 2017 proposing refinements to the scope of certain types of regulated activities, including Type 11 (Consultation Paper on (i) the OTC derivatives regime for Hong Kong - proposed refinements to the scope of regulated activities, requirements in relation to OTC derivative risk mitigation, client clearing, record-keeping and licensing matters; and (ii) proposed conduct requirements to address risks posed by group affiliates). In December 2018, the SFC released its consultation conclusions, confirming that the risk mitigation requirements will become effective on 1 September 2019, while the client clearing requirements will become effective when the new Types 11 and 12 regulated activities take effect. The conduct requirements to address risks posed by group affiliates and other connected persons will become effective on 14 June 2019. Market participants in OTC equity derivatives products will therefore need to keep this under review and apply for a licence when appropriate;
- OTC derivatives regulatory reform: the HKMA and SFC are participating in the global reform of the OTC derivatives markets. Rules regarding reporting, record-keeping, clearing and margining are covered below and market participants will need to keep this under review. For example, on 27 June 2017, the HKMA and SFC published their conclusions that adjustments should be implemented to: (i) prescribe certain additional markets and clearing houses so that products traded and cleared through them will not be regarded as ‘OTC derivative products’ and (ii) exclude Delta One Warrants from the definition of ‘OTC derivative product’. In April 2018, subsidiary legislation introducing these changes subsequently came into effect (Securities and Futures (Stock Markets, Futures Markets and Clearing Houses) (Amendment) Notice 2018; Securities and Futures (OTC Derivative Products) Notice);
- trading rules: when dealing on any exchange, members must adhere to the trading rules. For example, as stated above, when market participants in Hong Kong borrow shares listed on the SEHK and sell them short in the local market, the trading rules of the SEHK will apply; and
- standardised documentation: while not required by law, it is accepted practice in Hong Kong that certain OTC equity derivatives are documented using standard documents. Swaps, forwards, options and collars are commonly documented using ISDA forms (see question 15), margin financing using loan documentation (possibly based on the Asia Pacific Loan Market Association (APLMA) or the Loan Market Association (LMA) documents) and stock loans by the Overseas Securities Lender’s Agreement or the Global Master Securities Lending Agreement.
In addition to dealers, what types of entities may enter into OTC equity derivatives transactions?
Besides dealers, the other types of entities allowed to enter into OTC equity derivatives transactions are:
- non-financial entities (such as private equity funds and sovereign wealth funds);
- corporates; and
- individuals (eg, high net worth individuals (HNWIs) and shareholders entering into margin financing or collar transactions).
Applicable laws and regulations for eligible counterparties
Describe the primary laws and regulations surrounding OTC equity derivatives transactions between a dealer and an eligible counterparty that is not the issuer of the underlying shares or an affiliate of the issuer? What regulatory authorities are primarily responsible for administering those rules?
Counterparties other than dealers are, in general, exempt from the SFC licensing regime.
Dealers need to comply with the rules relating to the marketing of derivatives and structured products in Hong Kong, which are set out in the SFO. There is a general prohibition on advertising or offering structured products to the public. It is a criminal offence for a person issuing, or having in his or her possession for the purposes of issuing, whether in Hong Kong or elsewhere, an advertisement, invitation or document which to his or her knowledge is or contains an invitation to the public to enter into or offer to enter into an agreement to acquire, dispose of, subscribe for or underwrite any structured product.
There are several exceptions to this general prohibition, one of the most frequently used being the ‘professional investor exemption’, meaning that the general prohibition on financial promotion does not apply to the issue of advertisements, invitations or documents made in respect of products offered only to professional investors. ‘Professional investor’ is defined in Schedule 1 to the SFO and includes various institutional investors, and that definition is broadened for certain purposes only by section 3 of the Securities and Futures (Professional Investor) Rules (the SFO Rules) to include various corporate and HNWI investors. For example, under the SFO Rules, an individual with a portfolio of not less than HK$8 million or a corporation or partnership with a portfolio of not less than HK$8 million or total assets of not less than HK$40 million is regarded for the purposes of the section 103(3)(k) exemption as a professional investor.
The general prohibition set out above only applies to offers made in Hong Kong. Any advertisement, invitation and offering document made in respect of securities or structured products, or interests in any collective investment scheme issued, or in the possession for the purposes of issuing, to any person outside Hong Kong (section 103(3)(j) SFO) is exempt from the SFC authorisation requirement.
Securities registration issues
Do securities registration issues arise if the issuer of the underlying shares or an affiliate of the issuer sells the issuer’s shares via an OTC equity derivative?
Such OTC equity derivatives transactions are uncommon.
May issuers repurchase their shares directly or via a derivative?
A Hong Kong incorporated company that is listed on the SEHK may buy back its shares by way of:
- a general offer;
- an on-market share buy-back; or
- an off-market share buy-back.
In each case, they are subject both to the SFC’s Code on Share Repurchases and the fact that share buy-backs by a listed company may be funded out of capital (other than in the case of on-market share buy-backs).
There are restrictions on matters such as the manner and timing of the buy-back, the prices paid and the volume of shares repurchased, reporting and the treatment of repurchased shares. Share buy-backs funded out of share capital must be approved by a special resolution passed by disinterested shareholders and supported by a solvency statement. There are also requirements for publishing public notices and making filings with the Companies Registry. On 19 January 2018, the SFC issued a Consultation Paper outlining proposed amendments to the Codes on Takeovers and Mergers and Share Buy-backs, following which revised versions of the Codes were published in July 2018. The key amendments included increasing the voting approval threshold for whitewash waivers to 75 per cent of independent shareholders, and allowing offerors of share buy-backs transactions, if they are listed companies, to incorporate information required to be disclosed by reference to other documents published in accordance with the Listing Rules.
A company may enter into an equity derivative referencing its own shares. If this is cash-settled, it will not be subject to the buy-back requirements detailed above.
What types of risks do dealers face in the event of a bankruptcy or insolvency of the counterparty? Do any special bankruptcy or insolvency rules apply if the counterparty is the issuer or an affiliate of the issuer?
The principal legislation in Hong Kong relating to corporate insolvencies is the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap 32 of the laws of Hong Kong), which is supplemented by the Companies (Winding Up) Rules (Cap 32H).
If a counterparty in Hong Kong is insolvent, the key risk faced by a dealer is credit risk (eg, is the trade in the money? Is there collateral?). A dealer will also need to be mindful of operational and reputational risk.
When faced with an insolvent corporate counterparty, a dealer that is a creditor has a number of options available to it, including initiating a winding up (when a winding up order is made, there is an automatic stay on all actions and proceedings against the company without the leave of the court).
Under Hong Kong law, insolvency set-off applies between a creditor and a debtor provided there is mutuality (ie, mutual debts or other liabilities) and, for a creditor to take advantage of any set-off, the mutual claims must have existed on the date the company is wound up.
For dealers who are ISDA members and closing out under an ISDA Master Agreement, ISDA has commissioned a legal opinion that addresses the enforceability of the termination, bilateral close-out netting and multi-branch netting provisions of the 1992 and 2002 Master Agreements as a matter of Hong Kong law.
There are a couple of scenarios where a transaction can be challenged by a liquidator. For example, unfair preference: if a payment was made to a creditor (eg, the dealer) in the six months before the commencement of the winding up, the effect of which payment was to put the recipient in a better position than other creditors when the liquidation starts, the court can make any order it wishes, including reversing the payment. If the creditor (eg, the dealer) is an associate of the counterparty, this time frame increases to two years and there is a statutory presumption that the debtor was influenced by a desire to improve the creditor’s position.
The Companies (Winding Up and Miscellaneous Provisions) (Amendment) Ordinance came into effect on 13 February 2017. It introduced important changes to modernise Hong Kong insolvency law (eg, an introduction of transactions at an undervalue, a stand-alone concept of unfair preferences for corporates, amended clawback provisions and a simplified winding up process).
What types of reporting obligations does an issuer or a shareholder face when entering into an OTC equity derivatives transaction on the issuer’s shares?
Listed issuers have (i) a statutory obligation under Part XIVA of the SFO to disclose price-sensitive information as soon as is reasonably practicable after it has come to their knowledge, and (ii) disclosure obligations under the Listing Rules, for example, in respect of transactions that are of a sufficient size to fall within the definition of ‘disclosable transactions’ or ‘major transactions’. These are in addition to any obligations imposed under the laws of an issuer’s jurisdiction of incorporation.
Part XV of the SFO requires directors and others to disclose certain interests in listed securities, and changes therein, to the SEHK and the listed issuer. This covers both long and short positions (netting off long and short positions is not permitted) and economic interests and is triggered at thresholds (eg, a disclosable long position is triggered at 5 per cent or above, and when crossing over a whole percentage point above 5 per cent (eg, from 6.8 per cent to 7.1 per cent)). The disclosure rules apply to interests in equity derivatives and to short positions in shares and equity derivatives alike.
It is worth noting that the Consultation Paper published by the HKEX in September 2017 in relation to Delisting and Other Rule Amendments proposed amendments to the Listing Rules on disclosure, including amending the continuing obligations of an issuer to publish periodic announcements of the developments of its listed securities for which trading has been suspended to be a ‘quarterly’ obligation. HKEX subsequently published its conclusions in May 2018, and the proposed amendments came into effect on 1 August 2018.
Are counterparties restricted from entering into OTC equity derivatives transactions during certain periods? What other rules apply to OTC equity derivatives transactions that address insider trading?
Under the SFO, directors can be subject to absolute prohibitions (eg, if he or she is in possession of inside information) and blackout periods (eg, for a certain number of days before the publication of financial results and on the day of publication itself). These also apply to non-directors (whose role means they possess inside information), spouses, children and controlled companies.
The SFO also establishes dual civil and criminal regimes (under Parts XIII and XIV respectively) in respect of a broad range of types of market misconduct offences, including insider dealing. The SFO sets out several scenarios that constitute insider dealing, including:
- when a person connected with the corporation has information that he or she knows is inside information in relation to that corporation and deals in the corporation’s listed securities or their derivatives or in those of a related corporation, or counsels or procures another person to deal in such listed securities or derivatives, knowing or having reasonable cause to believe that the other person will deal in them; and
- when a person connected with a listed corporation has information that he or she knows is inside information in relation to the corporation and discloses the information, directly or indirectly, to another person, knowing or having reasonable cause to believe that the other person will use the information to deal, or counsel or procure another person to deal, in the corporation’s listed securities or their derivatives or in those of a related corporation.
Inside information is knowledge of certain facts about a company that the public does not have and which, if known to the public, would have an impact on the price of that company’s shares; it is also referred to as disclosure of price sensitive information or PSI. There are defences to a claim of insider dealing.
Market participants also need to be mindful of other market misconduct offences including:
- false trading;
- price rigging;
- disclosure of information about prohibited transactions;
- disclosure of false and misleading information inducing transactions; and
- stock market manipulation.
What additional legal issues arise if a counterparty to an OTC equity derivatives transaction is the issuer of the underlying shares or an affiliate of the issuer?
There will be additional legal issues if the transaction is a ‘connected transaction’ (meaning it is entered into with a ‘connected person’, which includes a director, a substantial shareholder (with 10 per cent or more of the voting rights) of the issuer or any of its subsidiaries). Subject to various exemptions, these require certain disclosures and shareholder approvals.
The relevant provisions are in Chapter 14A of the Listing Rules. Where the prescribed procedures have not been followed, the SEHK will take action (often adopting a name-and-shame approach).
What types of taxation issues arise in issuer OTC equity derivatives transactions and third-party OTC equity derivatives transactions?
Entering into equity derivatives transactions does not attract stamp duty.
If an equity derivatives transaction in respect of Hong Kong stock is physically settled, share transfers will be involved and stamp duty will be charged at 0.2 per cent on the higher of the consideration or market value of the shares (0.1 per cent on the shares sold and a further 0.1 per cent on the shares bought), together with a fixed amount of HK$5 on the instrument of transfer.
If the transaction is cash-settled, it will not attract stamp duty (as this does not fall within the definition of ‘Hong Kong stock’ in the relevant statute).
Describe the liability regime related to OTC equity derivatives transactions. What transaction participants are subject to liability?
Liabilities can arise in relation to market misconduct activities, including insider dealing (see question 10) and in respect of claims relating to breach of contract and negligent misstatement (see question 30 in respect of structured products).
Stock exchange filings
What stock exchange filings must be made in connection with OTC equity derivatives transactions?
The disclosure obligations are set out in questions 9, 10 and 11. There may be other disclosure obligations in relation to other transactions, such as corporate finance activity.
Typical document types
What types of documents are typical in an OTC equity derivatives transaction?
OTC equity derivatives transactions are typically documented using the standard form documents published by the International Swaps and Derivatives Association (ISDA). The two counterparties enter into a framework master agreement (the ISDA Master Agreement together with a schedule) that sets out the legal and credit relationship between them. The economic terms of each transaction that they subsequently enter into are set out in a separate confirmation and that confirmation is governed by the terms of the ISDA Master Agreement.
Margin loans are typically documented using the dealer’s standard contract, although this may follow the form of the loan agreements published by the LMA and the APLMA.
For what types of OTC equity derivatives transactions are legal opinions typically given?
Legal opinions that are typically given include:
- the entity’s power, capacity and authority to enter into the transaction;
- the interpretation or application of a particular piece of legislation;
- the enforceability of netting provisions in relation to a particular jurisdiction or counterparty (also known as a netting opinion); and
- the enforceability and validity under a particular jurisdiction of collateral arrangements under the ISDA Credit Support Documents.
For ISDA members using ISDA documentation, ISDA has commissioned Hong Kong legal opinions on (i) the termination, bilateral close-out netting and multi-branch netting provisions of the 1992 and 2002 Master Agreements, and (ii) the enforceability of the ISDA Credit Support Documents in various jurisdictions, each of which is updated annually. ISDA also commissioned client clearing opinions on: (i) the enforceability of the close-out, set-off and default provisions of the ISDA/FIA Client Cleared OTC Derivatives Addendum, for reliance by a clearing member or by a client and (ii) the enforceability of a US-registered FCM’s close-out and netting rights under the FIA-ISDA Cleared Derivatives Addendum.
May an issuer lend its shares or enter into a repurchase transaction with respect to its shares to support hedging activities by third parties in the issuer’s shares?
This is not possible in Hong Kong.
What securities registration or other issues arise if a borrower pledges restricted or controlling shareholdings to secure a margin loan or a collar loan?
A ‘controlling shareholder’ is a person or group entitled to exercise or control the exercise of 30 per cent or more of the shares of the issuer, or control the composition of a majority of the board of directors of the issuer and they are subject to the restrictions set out below.
- Subject to limited exceptions, for the first six months after listing, there is a lock-up period during which controlling shareholders of newly listed companies are prohibited from disposing of any shares. For the subsequent six months after listing, they are required to hold at least 30 per cent. Certain other parties involved in the listing may agree to abide by similar restrictions (eg, underwriters).
- The Listing Rules impose a continuing disclosure obligation (which also applies during the 12 months after listing). Where an issuer’s controlling shareholder has pledged all or part of its interest in the issuer’s shares to secure the issuer’s debts, or to secure guarantees or other support of its obligations, the issuer must announce information including the number and class of shares being pledged, the amounts of debts, guarantees or other support for which the pledge is made and any other necessary details (Rule 13.17).
If a borrower in a margin loan files for bankruptcy protection, can the lender seize and sell the pledged shares without interference from the bankruptcy court or any other creditors of the borrower? If not, what techniques are used to reduce the lender’s risk that the borrower will file for bankruptcy or to prevent the bankruptcy court from staying enforcement of the lender’s remedies?
When a borrower enters into a margin loan, the collateral (cash or shares) will be placed into an account in the name of the borrower maintained with the lender. Security (typically by a mortgage or pledge) will be granted over that collateral, with a prohibition on the borrower granting any further security over that account.
On the occurrence of a specified default event (eg, the borrower becoming insolvent), the lender is able take enforcement action and its enforcement options and rights in that circumstance will be set out in the security documentation (these typically include appropriation, sale and assignment). It is important that the document provides that the lender can exercise such rights without the consent of the borrower, or even notice to the borrower in order to expedite the enforcement process. Provided that the lender complies with the terms of the margin lending documents and any local law requirements on enforcement, and does not act in a way that seeks to take improper advantage of a borrower, it will be difficult for margin borrowers to challenge forced sales of portfolio securities on the grounds that they were precipitate, that the market might have rallied or that they were somehow unfair.
On commencement of the winding up of a company incorporated in Hong Kong (which, in Hong Kong, is the date on which the winding-up petition is filed in the Hong Kong court, not the date on which the winding-up order is made), there is an automatic stay on actions or proceedings against the company. However, this stay will not prevent the lender holding a fixed security or mortgage from enforcing the security against a borrower.
Generally, it is difficult for third-party creditors to stay or frustrate the enforcement of valid security.
Note that there is no specific bankruptcy court in Hong Kong. Insolvency cases are heard in the High Court.
What is the structure of the market for listed equity options?
Listed equity options in Hong Kong are traded on the SEHK and cleared through SEHK Options Clearing House Limited (SEOCH), a central clearing house and a wholly owned subsidiary of HKEX. By novation, SEOCH acts as a counterparty to its participants in relation to each option contract.
Option contracts are US-style and exercise of the stock option results in the physical delivery of the stock (ie, physical settlement).
Describe the rules governing the trading of listed equity options.
Listed equity options are traded on the SEHK and cleared through SEOCH, the operational procedure of which is governed by the SFO Rules.
Types of transaction
What categories of equity derivatives transactions must be centrally cleared and what rules govern clearing?
Listed equity options are cleared through SEOCH.
For OTC derivatives transactions, mandatory clearing of certain standardised interest rate swaps (in Hong Kong dollar, euro, pound sterling, Japanese yen or US dollar) through a central counterparty designated by the SFC has been implemented since 1 September 2016 pursuant to the Securities and Futures (Amendment) Ordinance 2014, which came into effect on 26 March 2014 (the Amendment Ordinance). The Amendment Ordinance is being implemented in stages, and at present only transactions between major dealers (eg, authorised institutions, licensed corporations or approved money brokers) with an OTC threshold of US$20 billion are mandated for clearing. As yet, there are no details on whether OTC equity derivatives will be subject to mandatory clearing.
What categories of equity derivatives must be exchange-traded and what rules govern trading?
Listed equity options in Hong Kong are traded on the SEHK and cleared through SEOCH. There are currently no requirements for OTC derivatives transactions to be exchange traded.
Describe common collateral arrangements for listed, cleared and uncleared equity derivatives transactions.
Common collateral arrangement
Listed equity options
Short positions: SEOCH requires margin for all short positions. Marked-to-market daily following market close and margin is collected on the transaction date plus one day basis.
Long positions: no margin required.
Assigned or exercised positions: subject to margin requirement pending stock settlement but short call positions that are covered by a corresponding amount of the underlying stock deposited with the SEOCH as collateral are not.
Dealers carrying customer option accounts: may impose higher margin standards than SEOCH.
Uncleared OTC equity derivatives transactions
Counterparties typically document collateral arrangements using ISDA credit support documentation (eg, Credit Support Annex to the ISDA Master Agreement).
Typically, bespoke security arrangements are used (eg mortgage over shares).
OTC equity derivatives transactions are not centrally cleared, although it remains to be seen whether this will change in the future.
Must counterparties exchange collateral for some categories of equity derivatives transactions?
The requirements for counterparties to non-centrally cleared OTC derivatives to exchange collateral (ie, margin rules for uncleared derivatives) have recently been finalised. These reflect the BCBS-IOSCO margin framework and IOSCO’s standards for risk-mitigation techniques for non-centrally cleared OTC derivatives and set out the minimum standards to be adopted. The regulations cover matters such as:
- the exchange of initial margin (IM);
- variation margin (VM);
- substituted compliance; and
We have seen the following go-live dates most recently:
- 1 March 2017 for margin requirements with a six-month transition period for IM in the first phase and VM. For OTC equity derivatives transactions, early in 2017 HKMA stated that margin provisions applicable to non-centrally cleared derivatives transactions will not apply to, inter alia, transactions, such as reps and securities lending transactions, which are not themselves derivatives but share some attributes with derivatives; and
- 1 March 2017 to 29 February 2020 for non-centrally cleared single-stock options, equity basket options and equity index options.
The following collateral instruments are eligible as margin (both VM and IM):
- cash funds (money credited to an account or similar claims for the repayment of money) in any currency;
- marketable debt securities issued or fully guaranteed by a sovereign;
- marketable debt securities issued or fully guaranteed by a multilateral development bank;
- marketable debt securities issued or fully guaranteed by a public-sector entity;
- other marketable debt securities;
- gold; and
- publicly traded equities included in the Hang Seng Index or any other main index.
Securities issued by authorised institutions or foreign banks and securities whose value exhibits a significant correlation with the creditworthiness of the counterparty or the value of the underlying non-centrally cleared derivatives portfolio in such a way that would undermine the effectiveness of the protection offered by the margin (wrong-way risk) are not eligible for VM or IM.
In June 2018, the SFC launched a consultation on proposals to impose margin requirements on non-centrally cleared over-the-counter derivatives applicable to all licensed corporations.
For information on listed equity options and margin loans, see question 24.
Liability and enforcement
Territorial scope of regulations
What is the territorial scope of the laws and regulations governing listed, cleared and uncleared equity derivatives transactions?
The territorial scope varies, depending on the product and the law or regulation.
For listed equity options, the rules and procedures set out above (eg, in relation to the SEHK and SEOCH, see questions 20 to 23) apply, regardless of the jurisdiction of incorporation of the dealer or counterparty.
For licensing, the general position is that where a person actively markets in Hong Kong services falling within a regulated activity, the licensing provisions of the SFO will apply, regardless of the jurisdiction of incorporation of the person marketing.
For the marketing of derivatives and structured products, the general prohibition on marketing does not apply to offers made outside Hong Kong (see question 5).
The market misconduct provisions of the SFO have extraterritorial effect, applying regardless of a person’s location, citizenship and country of origin. Indeed, there have been cases of the SFC bringing actions against individuals based in other countries (eg, the US).
Some of the laws and regulations issued in connection with the OTC derivatives regulatory reform have extraterritorial effect. For example, since July 2017:
- record-keeping and reporting obligations apply to all transactions (in all five key asset classes, namely interest rates, foreign exchange, equities, credit and commodities - which would include OTC equity derivative transactions) that are either booked in Hong Kong or are conducted in Hong Kong; and
- margin provisions for uncleared OTC derivatives have extraterritorial scope (eg, they apply where an authorised institution incorporated outside Hong Kong in respect of non-centrally cleared derivatives, which it enters into with a ‘covered entity’ that are booked in its Hong Kong branch, subject to any applicable substituted compliance).
Registration and authorisation requirements
What registration or authorisation requirements apply to market participants that deal or invest in equity derivatives, and what are the implications of registration?
See questions 18, 29, 31 and 32 for a discussion about registration and authorisation requirements.
What reporting requirements apply to market participants that deal or invest in equity derivatives?
Record-keeping and reporting obligations apply to all transactions (in all five key asset classes, namely interest rates, foreign exchange, equities, credit and commodities - that would include OTC equity derivative transactions) that are either booked in Hong Kong or are conducted in Hong Kong. As noted in question 3, the SFC issued a Consultation Paper (on (i) the OTC derivatives regime for Hong Kong - proposed refinements to the scope of regulated activities, requirements in relation to OTC derivative risk mitigation, client clearing, record-keeping and licensing matters; and (ii) proposed conduct requirements to address risks posed by group affiliates) in December 2017, which proposed additional record-keeping obligations for inclusion in the Securities and Futures (Keeping of Records) Rules. The SFC published its conclusions in December 2018, in which it stated that contracting parties to OTC derivative transactions are required to keep certain accounting, trading and other records to ensure compliance with the relevant rules.
See also questions 2, 7 and 9, in which reporting requirements are discussed.
What legal issues arise in the design and issuance of structured products linked to an unaffiliated third party’s shares or to a basket or index of third-party shares? What additional disclosure and other legal issues arise if the structured product is linked to a proprietary index?
Legal issues that arise include:
- ensuring that the advertisement, invitation or document complies with the applicable marketing requirements and restrictions set out in the SFO (see question 30); and
- establishing if the documentation is a prospectus (see question 32) for which an exemption does not apply, in which case it must, inter alia, (i) comply with the contents requirements of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (C(WUMP)O), and (ii) the SFC must authorise its registration with the Registrar of Companies.
Documentation must also contain an adequate description of the product. This will vary from product to product, but will typically include key commercial terms, the workings of any index referenced in the product, costs and fees, any conflicts of interest, the nature of the underlying securities and all appropriate disclosures.
Certain legal issues are product specific. For example, products that offer exposure to the shares of a company listed on the SEHK may require disclosure.
If a structured product is linked to a proprietary index, the terms of the licensing agreement and underlying intellectual property will need to be considered to ensure that the index data and the licensor’s trademarks can be used as intended.
Describe the liability regime related to the issuance of structured products.
A person commits an offence under the SFO if he or she issues, or has in his or her possession for the purposes of issue, whether in Hong Kong or elsewhere, an advertisement, invitation or document that to his or her knowledge is or contains an invitation to the public to enter into or offer to enter into an agreement to acquire, dispose of, subscribe for or underwrite securities unless either an exemption applies or the issue is authorised by the SFC under the SFO.
The available exemptions include offers solely to persons outside of Hong Kong and offers that are or are intended to be disposed of only to professional investors (professional investors being defined at some length in section 1 of Part 1 of Schedule 1 to the SFO).
For authorisation by the SFC under the SFO, both the issue of offering documents and advertisements for unlisted structured products and unlisted structured investment products offered to the public in Hong Kong must be authorised. This is done by way of an application to the SFC and guidelines are set out in the Code on Unlisted Structured Investment Products (known as the SIP Code). Authorisation may be granted subject to such conditions as the SFC considers appropriate and, typically, the SFC does not authorise a product under the SFO without a concurrent authorisation of its offering documents.
The Hong Kong Court of Final Appeal has made it clear that the burden of proof of the material elements of the offence in section 103(1) rests on the prosecuting authority, while the burden of proof that the exemption in section 103(3) applies rests on the person charged with the offence (Pacific Sun Advisors Ltd & Anor v Securities and Futures Commission  18 HKCFAR 138;  2 HKC 595; FACC 11/2014 (20 March 2015)). A person guilty of an offence under section 103(1) is liable on summary conviction to a fine and imprisonment.
Other offences under the SFO relating to the issuance of structured products include:
- to fraudulently or recklessly induce others to invest money (section 107 SFO): a person commits an offence if he or she makes any fraudulent misrepresentation or reckless misrepresentation for the purpose of inducing another person to enter into or offer to enter into an agreement to acquire, dispose of, subscribe for or underwrite securities. A person who commits this offence is liable on conviction to a fine of up to HK$1 million and to imprisonment for up to seven years; and
- civil liability for inducing others to invest money in certain cases (section 108 SFO): any fraudulent misrepresentation, reckless misrepresentation or negligent misrepresentation by which another person is induced to enter into or offer to enter into an agreement to acquire, dispose of, subscribe for or underwrite securities will result in a liability (whether or not any other liability whether under Part IV of the SFO or otherwise) to pay compensation by way of damages for any pecuniary loss sustained as a result of the reliance on the misrepresentation.
There are also offences that relate to all marketing of investment products and potential liability under common law (for example, misrepresentation).
What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is convertible for shares of the same issuer?
First, it should be noted that the marketing regime for convertible bonds in Hong Kong is different from that which applies to structured products (see question 30).
The offer of shares or debentures to the public is regulated by Cap 32 (C(WUMP)O), which provides that, unless an exemption applies, for Hong Kong incorporated companies, any prospectus issued by or on behalf of the company and, in the case of overseas companies, any prospectus distributed in Hong Kong, must:
- comply with the contents requirements of C(WUMP)O; and
- the SFC must authorise its registration with the Registrar of Companies in Hong Kong.
A prospectus is widely defined as any prospectus, notice, circular, brochure, advertisement or other document that offers any shares or debentures of a company to the public for purchase or subscription or is calculated to invite offers by the public to subscribe for or purchase any shares or debentures of a company.
A company that issues a prospectus that does not comply with the disclosure and registration requirements, and every person who is knowingly a party to the issue, commits an offence under C(WUMP)O.
There are several exemptions set out in Schedule 17 to C(WUMP)O and include:
- offers to not more than 50 persons;
- offers only to professional investors (as defined in the SFO, namely certain institutional investors and certain HNWIs);
- offers for which the total consideration payable is less than HK$5 million; and
- offers for which the minimum consideration payable (for shares) or the minimum principal amount to be subscribed (for debentures) is less than HK$500,000.
Stamp duty is payable on instruments evidencing a transfer of Hong Kong stock (broadly defined in the Stamp Duty Ordinance to include debentures, loan stocks, bonds or notes issued by any corporate or incorporate body, any government or local government authority). If a Hong Kong company issued a Hong Kong dollar-denominated convertible bond, stamp duty would be payable. The conversion into Hong Kong stock may trigger stamp duty liability as a transfer of Hong Kong shares from the issuer to the bondholder.
As a general rule, stamp duty is not payable on convertible bonds that are denominated in a currency other than Hong Kong dollars or convertible bonds that are issued by a non-Hong Kong company.
Listed companies and the SEHK Listing Rules
If the bonds are convertible into shares in Hong Kong-listed companies, attention will need to be paid to the SEHK Listing Rules:
- the issue of bonds to a connected person may constitute a connected transaction under the SEHK Listing Rules;
- the listed issuer will be required to make an application to the SEHK for permission to list and deal in, shares converted from bonds;
- there may be public float concerns if the conversion of the bonds into shares will cause the bondholder to become a substantial shareholder of the listed company; and
- disclosure obligations by the listed issuer may arise under the inside information provisions.
Attention shall also be paid to the disclosure obligations under Part XV of the SFO, under which a holder of equity derivatives (including convertible bonds) may be required to disclose his or her interests in such equity derivatives, and the failure to make such disclosure may constitute a criminal offence under the SFO.
What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is exchangeable for shares of a third party? Does it matter whether the third party is an affiliate of the issuer?
With exchangeable bonds, matters such as registration and tax are similar to those for convertible bonds, but different from that which applies to structured products (see question 30).