Registration, reporting and liability for derivatives transactions in Hong Kong

Liability and enforcement

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).

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 [2015] 18 HKCFAR 138; [2015] 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:

1. comply with the contents requirements of C(WUMP)O; and
2. 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.

Exemptions

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

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).