Hong Kong: Setting the Regulatory Standard

Hong Kong maintains its place as a leading financial centre and continues to adapt to market conditions with new regulatory and legislative developments. In the first months of 2014, we have seen the introduction of the new Companies Ordinance, draft OTC derivatives regulations, a consultation on dark pools and proposals for a new open-ended investment company.

The Companies Ordinance

Hong Kong's new Companies Ordinance came into force on 3 March 2014. As one of the major initiatives intended to facilitate business, the new Ordinance permits more small and medium-sized companies to issue simplified financial reporting. This new flexibility will apply from the financial year of the company, which begins after the new Ordinance comes into effect.

The new Companies Ordinance also brings significant changes to the articles of association of a Hong Kong company and abolishes the requirement for a memorandum of association.

Other changes which have been introduced include:

• Restricting the appointment of corporate directors (such that every private company must have at least one natural director).

• Clarifying a director’s duty of care, skill and diligence.

• Requiring public companies and larger private companies to prepare a more comprehensive business report to be known as a ‘business review’.

• Allowing companies to dispense with AGMs by unanimous shareholder consent.

• Allowing general meetings to be held in more than one location using electronic technology.

OTC Derivatives Regulation

The Securities and Futures (Amendment) Ordinance 2014 was gazetted in April 2014. The new Ordinance amends the Securities and Futures Ordinance (SFO) to create the framework for regulation of OTC derivatives in Hong Kong. The Ordinance also creates new regulated activities relating to OTC derivative transactions and sets out the transitional arrangements for persons who currently engage in OTC derivatives transactions in Hong Kong.

The new Ordinance:

• Empowers the Securities and Futures Commission (SFC) to make rules for the mandatory reporting, clearing and trading of OTC derivatives.

  • Sets out the role, responsibility and powers of the SFC and the Hong Kong Monetary Authority over participants in the OTC derivatives market.

  • Expands the scope of asset management regulated activity to include ‘OTC derivative products management’.

  • Creates two new regulated activities – for dealing in OTC derivative products or advising on OTC derivative products and for providing clearing agency services for OTC derivative transactions.

  • Amends the definitions of existing regulated activities to provide exemptions from the need to be licensed for either type 11 or type 12 regulated activities in certain circumstances.

In addition, the Ordinance amends Part XV 'Disclosure of Interests' of the SFO to require that notifications and reports under this Part are filed electronically, and amends the SFO and the Organised and Serious Crimes Ordinance to enable criminal courts to make disgorgement orders for the purpose of recouping illegal gains from committing a market misconduct offence.

REIT Code Consultation

In February 2014, the SFC concluded a one-month consultation on proposals to amend the Code on Real Estate Investment Trusts (REIT Code) to introduce more flexibility in the investment scope of real estate investment trusts.

The SFC proposes to allow REITs to undertake property development investments and related activities, subject to a maximum threshold of 10 per cent of the REIT’s gross asset value (10% GAV Cap). The SFC also proposes to allow a REIT to acquire vacant land (subject to the 10% GAV Cap) provided that the REIT manager can demonstrate that such acquisition is part of a property development project within the investment objective or policy of the REIT. The properties completed under such property development projects are subject to a minimum two-year property holding period requirement.

It is proposed that (subject to certain diversification and liquidity requirements) a REIT may invest in financial instruments such as listed securities, unlisted debt securities, government and other public securities and local or overseas property funds. However, at all times at least 75 per cent of the gross asset value of a REIT must be invested in real estate that generates recurrent rental income.

REIT managers should ensure compliance with the ongoing disclosure and reporting requirements under the REIT Code. The REIT managers must also have sufficient and appropriate skills, resources, risk management processes and controls in place to manage and monitor the investments and associated risks.

Proposals for New HK Fund Vehicle

On 20 March 2014, Hong Kong's government issued a three-month public consultation paper on proposals for a new open-ended company structure for both public and private funds. 

The current proposals envisage a structure, referred to as an open-ended fund company (OFC), which is:

• a company with variable capital,

• established under the SFO,

• regulated and supervised by the SFC, and

• registered with, but not licensed by, the SFC.

Under the proposals, an OFC will:

• delegate all investment management functions to an asset manager holding an SFC type 9 asset management licence,

• entrust all assets to a Hong Kong-incorporated custodian acceptable to the SFC,

• comply with an OFC Code, to be the subject of a future consultation, whether the OFC is publicly or privately offered, and

• have at least two directors, at least one of which will be independent of both the investment manager and the custodian, and at least one will be a Hong Kong resident.

The consultation paper argues that since investment activities will be delegated to a type 9 (asset management) licensee, the OFC’s scope of investment should be restricted to managing investments, which are regulated by the SFO, namely securities and futures, and OTC derivatives once the new OTC regime is in force. This would seem to preclude investments in other asset classes such as cash or real property which could be considered unduly restrictive.

For the private funds industry, much depends on the nature of the registration process, the supervisory approach adopted by the SFC and the detail of the OFC Code, to be the subject of a separate consultation. Retail fund managers will be keen to understand how the OFC Code will work with the existing regulatory framework for retail funds.

SFC Consults on Dark Pools

In April 2014, the SFC concluded a public consultation on the regulation of alternative liquidity pools (ALPs or dark pools). Currently, the SFC imposes conditions on the licences of Hong Kong ALP operators on a case-by-case basis. The SFC proposes to standardise and enhance the regulatory obligations for Hong Kong ALP operators and set out those regulatory obligations in the Code of Conduct for Persons Licensed by or Registered with the SFC.

The SFC proposals affect both ALP operators and licensed corporations that route client orders to an ALP (such as brokers and asset managers that operate a central dealing desk in Hong Kong).

Third Party Rights – Contract Law Reform

The Hong Kong government published the Contracts (Rights of Third Parties) Bill earlier this year. 

Under the existing Hong Kong law, a third party cannot acquire and enforce rights under a contract to which he is not a party.  The Bill seeks to reform this aspect of the doctrine of privity of contract to enable a third party to enforce a contract to which he is not a party in some circumstances.  The reform is long-awaited and its implementation will bring Hong Kong's contract law regime more into line with other common law jurisdictions.

Independent Insurance Authority

A new Independent Insurance Authority (IIA) is expected to be established in Hong Kong in 2015 by the recently published Insurance Companies (Amendment) Bill. In contrast to the existing Office of the Commissioner of Insurance, the IIA will be financially and operationally independent of the Government.

Under the current regime, the conduct of insurers and insurance intermediaries is carried out by three self-regulatory organisations. The new regulatory regime will remove the regulatory functions of these self-regulatory organisations and the IIA will assume responsibility for setting conduct requirements for insurance intermediaries and for licensing, investigating and disciplining insurance intermediaries.

Lessons for IPO Sponsors

Recently the Securities and Futures Appeals Tribunal affirmed the decision of the SFC to reprimand and fine an IPO sponsor and suspend its licence to advise on corporate finance for one-year after concluding that there was clear evidence that the sponsor failed to exercise proper due diligence and to maintain adequate records in its sponsor work relating to a listing on the Growth Enterprise Market (GEM) of The Stock Exchange of Hong Kong Limited.

The SFC’s Chief Executive Officer, Ashley Alder, said “Material failings by sponsors directly damage investors and affect market confidence. This outcome sends a clear message to all sponsors”.

Following this case IPO sponsors should consider the following when conducting due diligence and record keeping:

• Apply the same standards of due diligence in GEM and Main Board listings.

• Make a reasonably detailed enquiry to address concerns raised by a ‘red flag’.

• Bear in mind the obligations of a sponsor are not only to the client but, equally importantly, to the integrity of the market.

• Blind reliance on an expert's advice is not regarded as reasonable due diligence.

• Critically assess statements and representations made by the company and be alert to information that contradicts or questions their reliability.

• Keep adequate records of due diligence work, especially in respect of matters that may be contentious or material.