In September 2009, the Securities and Futures Commission (SFC) issued a Consultation Paper to solicit feedback on its proposals to fine tune the existing regulatory regime for the sale of investments in Hong Kong.
Although many see the SFC's focus on the selling practices of intermediaries (such as the disclosure of commissions and ongoing information related to long-term investments, the KYC assessment of derivative product knowledge, the introduction of audio recordings and a cooling off period) and a new Code on Unlisted Structured Products as a reaction to the Lehman Minibond Saga in Hong Kong, the ambit of the Consultation Paper is far wider as it also seeks to bring the SFC's Code on Unit Trusts and Mutual Funds into line with other markets, a process which was already underway at the time of Lehman's bankruptcy.
This update focuses on six key proposals in relation to the marketing of SFC authorised funds in Hong Kong.
Six Key Proposals
Although the body of the Consultation Paper and appendices run into several hundred pages, the SFC identifies the following items as the six key changes to the Code on Unit Trusts and Mutual Funds.
1. Structured funds which invest substantially all of their assets in market access products
As a result of the increasing use of financial derivative instruments, the SFC has created a new category of funds called structured funds (in addition to the existing regime for hedge funds) which seek to achieve their investment objective primarily through investing in market access products, swaps, repos or similar arrangements. The SFC's proposals address the independence of counterparties and those undertaking mark to market valuations, the risk of over exposure to a single counterparty, eligible collateral and contingency plans for counterparty credit events.
2. Non UCITs funds which invest some of their assets in market access products
This proposal is designed to level the playing field for non-UCITS schemes e.g. domiciled in the Cayman Islands or Hong Kong wishing to use financial derivative instruments for investment purposes, subject to a 100% of the net asset value exposure limit, thereby allowing comparable investment flexibility for efficient portfolio management to UCITS III schemes with expanded powers. The manager will be required to demonstrate that it has appropriate risk management and controls in place to monitor the use of financial derivative instruments.
3. Hybrid funds which invest in other funds as well as securities
Currently, funds that invest more than 10% but less than 100% of their net asset value in other collective investment schemes are not contemplated, nor permitted. The SFC therefore proposes, notwithstanding the conceration risk, to allow a ‘hybrid structure’ whereby a fund which invests more than 10% of net asset value in other collective investment schemes may concurrently also invest in other financial instruments such as bonds, equities or money market instruments. The SFC proposes to allow hybrid funds to invest: up to 10% of net asset value in non-recognised jurisdiction schemes, up to 30% of net asset value in any one of SFC authorised funds or recognised jurisdiction schemes, and more than 30% of net asset value in an SFC authorised fund (but not a recognised jurisdiction scheme) if the underlying scheme is specifically named in the prospectus and its key investment information is disclosed therein.
4. Chinese language versions of annual reports to become mandatory for Hong Kong domiciled and other schemes, optional for recognised jurisdiction schemes
Chinese language versions of annual reports in respect of each financial year ending on or after 31 December 2010 will be required for SFC authorised funds with Hong Kong investors which are not domiciled in a recognised jurisdiction. Chinese language versions of interim reports are not required. Distributors of SFC authorised funds exempt from this requirement on the ground that they are domiciled in a recognised jurisdiction such as Ireland or Luxembourg are required to inform investors that annual reports will only be made available in English if that is to be the case.
5. Key Fact Statements (or Key Information Documents) to become mandatory
The SFC believes key fact statements should be prepared for all investment products offered to the Hong Kong public in order to provide investors with information which they can readily understand and compare. The Consultation Paper includes an illustrative template which, unlike a fund fact sheet, will form part of the prospectus and will therefore make the existing requirement for an upfront risk disclosure box superfluous. The content includes the name of the manager, the investment strategy, key risks, asset allocation, fees and charges. If financial derivative instruments are used for investment purposes, this fact and the associated risks must be stated. To facilitate comparison with other funds, one of the key objectives behind this proposal, the general subject matter, layout and format should be substantially similar. If performance information is included, it should be updated every six months in order to comply with the Advertising Guidelines. The SFC raises the possibility of UCITS schemes using Key Information Documents that satisfy their EU regulations provided they contain the same information, and their format and presentation also adhere to the principle of providing information in a manner which is user friendly and facilitates comparison.
6. Miscellaneous aspects where greater flexibility is proposed
CPTs - the use of brokers connected to the manager monitored by reference to six principles, such as arm's length terms and best execution standards, is proposed in lieu of the existing 50% limitation on the value of connected party transactions in any one year.
Hong Kong Representatives - the appointment of a representative within the manager's group of companies, licensed or registered in Hong Kong, is proposed to facilitate communication with managers of non Hong Kong based schemes.
Performance Fees - referencing a manager's performance fee to out performance of a benchmark or asset class is proposed in lieu of the existing requirement that NAV must be greater than the high water mark when a performance fee was last calculated and paid.
Fund Redemptions - the maximum interval between the receipt of a redemption request and the payment of redemption proceeds may exceed one month if realisation of a substantial portion of the fund's investments is subject to legal, regulatory or currency approvals.
Multi Manager Schemes - managers with less than five years experience and a demonstrable record of managing public funds may be allowed where the manager exercises and discloses proper due diligence procedures in selecting and monitoring sub managers.
Electronic Communications - the use of websites to enable investors to readily access annual and interim reports, in lieu of the existing requirement to distribute hard copies, as well as key fact statements, prospectuses, shareholder letters and net asset values, is described as best practice.
The proposals are expected to come into effect some time in 2010 as the consultation period ends on 31 December 2009.
However, existing SFC authorised funds will have a grace period of up to twelve months for compliance with the new disclosure requirements.