On 2 June 2017, the Securities and Futures Commission (SFC) issued a circular about responsible officers and substantial shareholders (June Circular). Interestingly, it echoed much of our experience working on the flurry of recent acquisitions involving SFC-licensed entities. It also got us thinking that some practical tips for prospective buyers might be helpful.
So here we go – 5 things you should know about buying an SFC-licensed entity.
1. You need SFC approval
One of the first things you should do when structuring an acquisition that involves an SFC-licensed entity is to look at the post-acquisition structure, to identify the direct and indirect “substantial shareholders”. Any prospective substantial shareholder of an SFC-licensed corporation requires pre-approval. A failure to do so can result in criminal liability under the Securities and Futures Ordinance (Cap. 571) (SFO).
The SFO defines “substantial shareholder” very broadly. Generally speaking, it captures >10% direct owners, and 35%+ indirect owners. However, care is needed, because the test is complex and the interests of “associates” (another broad concept) are aggregated.
The following diagram illustrates the key elements of that definition and the key persons caught.
This chart should not be read so as to exclude “Other Corporation I” and “Other Corporation II” as substantial shareholders of the licensed corporation. This chart is only intended to guide your review of the relevant SFO definition. Please refer to the SFO for full details and obtain advice as needed.
Importantly, a substantial shareholder can be an individual or a corporation. Based on our experience, the SFC also takes a pragmatic view about partnerships and trust arrangements, so these should not be excluded from consideration.
If there is a transitional structure, that also needs to be examined. For example, if the acquisition (or a restructure) is taking place in stages, then each stage should be reviewed to see if pre-approval is required.
Clever structures – and what the SFC thinks
Many transactions involve a combination of equity acquisitions, security and/or financing arrangements. It is essential to carefully review these against the “substantial shareholder” test, which is not limited to equity interests. There may also be multiple layers, all of which must be considered.
If you are using an SPV or other “dormant” (non-operating) entity, expect a particularly strong degree of probity. As the SFC noted in the June Circular:
“This is because there may be concern that the new substantial shareholder is seeking to avoid the normal assessment and vetting process involved with a new licensed corporation application.”
In addition, the SFC confirmed that:
- it reviews a proposed substantial shareholder’s source of funding and financial strength. This enables it to “assess the legitimacy of the funds” and ensure that all the right people have applied for approval. We have seen first hand that the SFC examines sources of funding closely, and may ask for proof; and
- it may review whether, in practice, representations made by the proposed substantial shareholders about the post-acquisition business plan and senior management structure have held true. False and misleading information is a criminal offence.
Substantial shareholders must be “fit and proper”
The SFC will not approve a person as a substantial shareholder unless the SFC is satisfied that the licensed corporation will remain a fit and proper person to be licensed if the application is approved.
The SFC may impose reasonable conditions on the applicant and the licensed corporation and may amend, revoke or impose new conditions by notice in writing.
Once the acquisition arrangements are reasonably settled, prepare and lodge your application as soon as possible. Applications take at least two months with the SFC, and usually take 2-4 weeks to prepare given the volume of information that must be submitted, particularly if there are multiple applicants.
It is not necessary to have signed any documents yet. Remember, this is pre-approval.
Pre-approval typically remains ‘fresh’ for six months. Notifications are required once completion occurs.
2. Regulatory due diligence is essential
In addition to your usual checks on the Target and any relevant affiliates, make sure you conduct regulatory due diligence. This includes thinking about:
- regulatory licences and approvals;
- compliance with licensing conditions;
- current responsible officers and licensed representatives;
- client agreements and onboarding documents;
- historical regulatory action, including any public disciplinary actions;
- current investigations on foot, if the Target is able to disclose; and
- the Target’s compliance framework, including policies and procedures.
Certain regulatory risks can be mitigated to a degree by representations, warranties, undertakings and indemnities. However, not everything can be cured by contract. The more you know, the more you can fix before completion and/or price into the deal.
3. You need contractual protections
There are several risks that arise with acquiring an SFC-licensed entity, ranging from a failure to obtain SFC approval for a particular substantial shareholder, to tail liability for things like investor claims or regulatory penalties.
The following chart summarises some of the key things you should look at:
4. Management is key
Each licensed corporation requires at least two responsible officers for each regulated activity – otherwise the regulated business must be suspended. Each responsible office must be pre-approved by the SFC and satisfy a range of competence criteria. “Managers-in-charge” must also be in place under new SFC requirements.
Based on our experience:
- time – it takes at least 10 weeks to have a responsible officer approved. It can take much longer than that to find someone experienced in the market;
- experience – the SFC reviews CVs very closely – you must be able to demonstrate adequate experience that is specifically relevant to the regulated activity/ies for which they will be responsible; and
- contingency – retaining at least one of the outgoing responsible officers – if only for a few months – can be invaluable.
The June Circular also re-affirmed that:
- all responsible officers must have sufficient authority to carry out that role;
- responsible officers “in name only” will not be approved;
- the SFC may contact responsible officers to check they are in fact carrying out the duties they said they would be undertaking – false or misleading information is a criminal offence;
- a responsible officer must have sufficient time to discharge their obligations;
- the SFC will not approve applications where it has concerns about conflicts of interest – for example, it will not approve a person to become a responsible officer to act for more than one licensed corporation, unless the licensed corporations are within the same corporate group or owned by the same controlling shareholders (in our experience, joint ventures generally do not qualify).
5. The SFC will want to know about your business plan
As part of substantial shareholder applications, the SFC always asks whether the business plan of the licensed will be changing. Sometimes the acquisition is so far upstream that no changes occur. However, in most cases, there will be at least some changes that arise from the new opportunities and strategies you bring to the table.
Some things to think about include:
- target clients;
- products and services;
- delivery channels;
- additional regulated activities that would be beneficial (these need approval); and
- the control framework needed to deliver any updates to the business plan.
As flagged above, the SFC may test this down the track, so do not breeze over this. Business plans do not need pre-approval, but they are taken seriously by the SFC. Any significant changes require notification, as do various other changes.