This article first appeared in the November 2014 issue of Hong Kong Lawyer, the official journal of The Law Society of Hong Kong.
In January 2013, Alexa Lam, the Deputy Chief Executive Officer of Hong Kong’s Securities and Futures Commission (SFC), announced that the SFC and the China Securities and Regulatory Commission (CSRC) planned to implement mutual fund recognition between Hong Kong and mainland Chinese fund products. When this recognition takes effect, PRC and Hong Kong investors will, for the first time, be able to access each other’s investment funds directly. This accessibility concept is similar to the Shanghai-Hong Kong Stock Connect (Stock Connect), a scheme which allows investors and funds to buy and sell eligible stocks listed on the other city’s stock exchange.
Currently, foreign or offshore funds lack formal access to Chinese investors. For the past six years, the Qualified Domestic Institutional Investor scheme (QDII) has given some institutional investors access to offshore funds. Retail investors in the mainland, however, have had limited indirect access only.
But with mutual fund recognition, that will change, presenting opportunities for fund managers in China and elsewhere. Offshore funds will get access to investors in the PRC, a country with a high savings rate, a strong record of economic growth, and comparatively low market penetration by the financial services industry. Access to Hong Kong investors, in turn, will give PRC fund managers a platform from which to compete globally, helping them acquire knowledge of best practices in asset management and customer service, while building an international brand. The result is the proverbial win-win.
Yet mutual recognition also involves uncertainty about the exact details of the rules, and about what legal structures fund companies will need to establish. There are also questions about which documents must be submitted to regulators, and other legal and procedural matters. As Alexa Lam put it in her 2013 speech, mutual recognition will allow more fund managers to get on the highway that leads to other markets, but they will still need to cross the checkpoint at the border.
What follows is our understanding, based on available information, of fund eligibility and requirements, as well as necessary documentation and procedures that are likely to be required. We have drawn analogies from current requirements for fund authorisation in both jurisdictions, but final guidance from regulators could change the situation materially.
Issue #1: criteria for recognition
- Hong Kong domicile with an unencumbered type 9 licence
At this stage, it seems certain that, in order to qualify under the proposed mutual recognition scheme for marketing into the PRC, funds must be domiciled in Hong Kong and operated by a management vehicle, which has a Type 9 licence issued by the SFC and has relevant qualifications with respect to fund compliance and governance. A Type 9 licence gives the fund manager permission to market and sell to retail investors, which are regulated activities under Hong Kong law. Meeting this requirement may present a challenge for overseas asset managers that have set up sales offices in Hong Kong with a Type 1 licence. While a sales office can enable overseas asset managers to establish a presence, to market funds and to conduct brand-building activities, it does not permit them to manage investors’ money.
Furthermore, the Type 9 licence must be unencumbered by conditions. Many fund managers, when applying for a Type 9 licence, have no immediate plans to open a retail business. Under those circumstances, the SFC may impose a condition stating that the fund can deal only with professional investors. Any fund manager wishing to extend its services beyond professional investors, including the management of a retail fund, must apply to the SFC’s licensing teams to remove the professional investor condition. Typically the SFC will do this only if the fund manager has updated its business plan to cover the expanded scope of business and its compliance manual to include obligations related to the company’s new retail business.
- RMB 200 million in assets under management
Based on research and interviews, we believe that to qualify under mutual recognition, a fund intended to seek CSRC approval will need to have a minimum one-year track record with assets under management of 200 million Chinese renminbi, or about US$32 million at current exchange rates.
- Two qualified portfolio managers and two responsible officers
The fund manager must be staffed by two key full time portfolio managers with five years or more retail funds experience. It also requires two responsible officers for licensing purposes, at least one of whom resides in Hong Kong. Regarding the types of funds eligible for mutual recognition, we believe that authorisation will probably come in waves or batches. The first batch will encompass equity and fixed-income funds, and perhaps balanced funds. The second batch will likely include exchange-traded funds (ETFs). The mutual recognition scheme probably will not extend to short-term depositary instruments such as money market funds, since regulators do not want to encourage people to shift money frequently. Qualified Foreign Institutional Investor (QFII) funds and Renminbi Qualified Foreign Institutional Investor (RQFII) funds will not be eligible because the CSRC believes that these fund managers should raise money offshore and then invest it into China.
Because the renminbi is still not freely convertible, regulators probably will impose quota controls. This means that funds raised in the PRC will not be allowed to exceed the assets under management of unit trusts in Hong Kong. Balances are likely to be monitored daily. This quota system may take reference from the Stock Connect.
Issue #2: distribution of retail funds
In Hong Kong, fund managers rarely sell directly to investors. Instead, they enter into nominee arrangements with commercial banks or other distributors holding a Type 1 licence, which allows an organisation to deal in securities.
In China, fund managers can deal directly with investors, which could imply the need for a mainland sales force to market the fund manager’s offerings. Currently, some distribution is done online, but several well-known fund operations have physical branches, referred to in the mainland as “wealth management centres.” Commercial banks also play an important role in distributing retail funds; securities firms, futures companies, insurance firms, investment advisors, and third-party distributors can also play a part. All distributors need a securities distribution licence from the CSRC.
In addition, under mutual recognition, the CSRC will follow the Master Agent model similar to that used in Taiwan. This model requires each offshore fund manager to hire a single company to represent it in offering and selling funds. The Master Agent will then appoint sub-distributors, though the fund manager may appoint the distributors directly. Usually the Master Agent will be a fund management company or the custodian bank of a PRC retail fund. Foreign banks that have not yet acquired custodian authorisation for domestic funds are not included in this group. Distributors must be institutions with a fund distribution licence approved by the CSRC. Offshore fund managers will have the option of either (a) finding distributors through the Master Agent, which means the Master Agent will organise the distribution activities on behalf of the fund manager, or (b) appointing local distributors directly by signing an agreement with them.
Issue #3: application process and required documents
Generally, for “plain vanilla” onshore China funds, such as equity and fixed-income funds, the CSRC allows for a fast-track authorisation of 20 working days. (That means 20 working days for the CSRC. Time the applicant spends revising documents or engaged in other administrative work is not included in the 20 days.)
However, not all funds can use the fast-track procedure, which is generally available only to standard products such as stock, bond, index and money market funds. Fast-track approval may also be available to some single-market ETFs (ie, those tracking the index of a single stock exchange). Cross-market ETFs, which cover stocks listed on multiple exchanges, can usually expect approval to take six months. So can leveraged funds, short-term wealth management funds, and other “innovative products,” or those for which there is no market precedent. We anticipate initially that Hong Kong domiciled funds will not be able to take advantage of the fast-track route.
People’s Republic of China
In the PRC, documents are submitted electronically via the CRSC website. CSRC staff may make comments requiring the revision of the fund contract and custodial agreement.
Unlike Hong Kong funds, the CSRC also requires a PRC legal opinion on the qualifications of the fund manager and the custodian. The legal opinion will also cover the fund itself: its investment scope, its name, and certain internal approval processes used by the fund. A PRC law firm will be retained to assist in this undertaking.
We expect the application documents required by CSRC to be as follows:
- Offering documents of the fund. For Hong Kong domiciled funds, we expect that regulators will want to see the fund prospectus, as well as a draft Covering Document, which sets out dealing procedures, risk factors, and disclosures required in the PRC.
- The fund’s audit reports for the past three years.
- A legal opinion issued by a PRC law firm, as noted above. Although the content of the opinion is uncertain at this point, we believe it probably will evaluate the merits of the fund itself, as well as the qualifications of the fund managers.
- Other documents required by the CSRC, including the Master Agent agreement. All documents will be submitted through the Master Agent, rather than by the offshore fund managers. This means that that the Master Agent will be the party that communicates with the CSRC.
In Hong Kong, applicants must submit documentation to the SFC in hard copy format. There is also an internal due diligence process encompassing different areas that the fund issuer must consider. The issuer must confirm to the SFC that this internal due diligence process has been undertaken – a new requirement as of spring 2014. The SFC may ask for clarification, with a particular emphasis on subjects such as whether the investment product is suitable for the market and whether its fees are consistent with those of comparable products.
Applicants will need to submit an Explanatory Memorandum and Product Key Facts Statement (KFS). These offering documents contain the terms of the investment and are given to potential investors to ensure they are fully informed. Applicants will be required to make the Explanatory Memorandum and KFS available in both Chinese and English. In Hong Kong, the Trust Deed can be in English only.
While China allows for a 20 working day fast-track procedure using standard document templates for simple products, applications in Hong Kong are processed on a case-by-case basis, so the length of time required varies.
What fund managers can do now
Even without every piece of the regulatory puzzle in place, fund managers may want to begin thinking about how to take advantage of the coming mutual fund recognition scheme.
Those without a Hong Kong presence must decide whether to commit the significant resources needed to establish an office there. In particular, they must consider the level of resources they are willing to dedicate to the Hong Kong office. It seems likely that each issuer will need two responsible officers and two key portfolio managers with five years of relevant fund experience (which may overlap), and that one or both of the responsible officers may need to be based in Hong Kong, depending on the individual circumstances of the issuer.
Those that do not currently have a Type 9 licence may wish to apply for one now.
Fund issuers should think about the types of investment products they may wish to offer in China, and should identify potential funds that may qualify for mutual recognition.
Fund managers should consider the different documents they will need to have translated. Those going into China will need the Trust Deed translated into Chinese (the Trust Deed is equivalent to the Fund Contract), while fund managers entering Hong Kong will need the KFS and the Explanatory Memorandum (ie, the prospectus) available in English.
Taking these steps now could be advantageous for early movers. Again, the preceding analysis is based on our understanding of fund eligibility and requirements under a proposed mutual recognition scheme. As regulators issue new guidance, those factors could change substantially.