On Friday 25 September 2009, the Securities and Futures Commission (SFC) issued an important consultation paper covering: (i) the authorisation of different types of investment products, (ii) the sales process for these products, and (iii) after-sales arrangements. This article will focus on the proposed changes to the Code on Unit Trusts and Mutual Funds (UT Code) which will eventually form part of a new SFC product handbook.

The changes to the UT Code seek to codify the regulatory principles for structured funds and to provide a broadly level playing field between UCITS III schemes and non-UCITS schemes with respect to their investment in financial derivative instruments (FDIs).

Chapter 8.8 on Structured Funds

A new Chapter 8.8 sets out the SFC's requirements for authorising structured funds (including structured funds established as UCITS). A structured fund is defined as a scheme which invests substantially in FDIs such as swaps, access products, repo agreements or similar arrangements.

Whilst the investment manager of a structured fund must be independent of the issuer of the FDIs, the two entities, acting in different capacities, may belong to the same group of companies.

The SFC proposes to introduce a 10% limit on uncollateralised exposure to a single counterparty for FDIs and global exposure to FDIs shall be no more than 100% of the net asset value of a structured fund. This requirement is in line with UCITS requirements. Chapter 8.8 will contain other requirements relating to the valuation of FDIs, acceptability of collateral, counterparty credit ratings, diversification and disclosure requirements.

A diagrammatic illustration must be included in the offering documents of a structured fund to help potential investors understand how the fund will operate. Most (if not all) of the new disclosure requirements under Chapter 8.8 have already been reflected in the offering documents of structured funds that have recently been authorised by the SFC.

Chapter 8.9 on Funds that Invests in Financial Derivative Instruments

Under Chapter 8.9, non-UCITS schemes will be permitted to use FDIs for investment purposes subject to a 100% of the net asset value exposure limit. Non-UCITS schemes are most commonly at present collective investment schemes that are domiciled in the Cayman Islands or in Hong Kong. Although Chapter 8.9 is new to the UT Code, the requirements are consistent with the SFC's current practice in processing UCITS III schemes and creates a more level playing field for non-UCITS schemes. The investment manager of a scheme authorised under Chapter 8.9 needs to have appropriate risk management and controls in place to monitor the use of FDIs. The SFC takes the view that the commitment approach is more conservative and preferable to the "value-at-risk" approach used by some UCITS schemes. However, the SFC is keeping an open-mind regarding the use of other methods of calculating global exposure to FDIs.

Other Proposed Changes to the UT Code

Various other changes are being proposed by the SFC, some of which provide greater flexibility.

  • There is a new requirement to issue a Product Key Facts Statement in a standardised format containing salient features of a fund. However, the SFC is receptive to the idea that an authorised UCITS fund may use its Key Information Document to satisfy this requirement, depending on the content.
  • The maximum interval between the receipt of a redemption request and the payment of redemption proceeds may exceed one month if a substantial portion of investments is subject to certain legal or regulatory requirements (e.g. foreign exchange control).
  • Where a fund's performance fee is calculated by reference to the outperformance of a benchmark, it appears that the previous strict "highwater mark" rule may be waived.
  • A fund can invest up to 30% of its total net assets in one or more collective investment schemes authorised by the SFC or from a recognised jurisdiction, and 10% in other types of collective investment schemes. Previously, a fund authorised under Chapter 7 would only be able to invest in aggregate 10% of its total net assets in other collective investment schemes.
  • Chapter 8.6 will be updated to clarify that the new Chapter 8.8 will also apply if an index tracking fund adopts a synthetic replication strategy.
  • The restrictions and limitations on connected brokerage are to be replaced by a more principles based approach.
  • Financial statements will need to be translated into Chinese starting from the financial year ending on or after 31 December 2010. At the initial stage, this will only apply to the annual report for non-recognised jurisdiction schemes and will be voluntary for recognised jurisdiction schemes. The possibility of making financial statements available either online or for collection rather than mailing them out to investors is also raised.
  • Fund issuers are encouraged to create websites where offering documents, notices to shareholders, financial statements and NAVs for SFC authorised funds are made available

The consultation period will end on 31 December 2009.