With the launch of Hong Kong’s open-ended fund company (OFC) vehicle tipped for 2018, the Government aims to deliver on one facet of its long-stated policy initiative of bolstering Hong Kong as a full-service asset management hub.
For Hong Kong based managers, the preferred hedge fund structure has tended to be an offshore limited liability company, typically domiciled in the Cayman Islands. In the retail space, managers looking to establish a Hong Kong platform have opted to seek local authorisation for either an offshore vehicle or, more recently, a Hong Kong unit trust. The policy aim of the OFC is to offer an alternative local legal structure for funds and to boost Hong Kong as a fund domicile.
In this article, we examine the key advantages and perceived disadvantages for a Hong Kong manager in using the OFC, based on current proposals, when compared to the most common type of Cayman Islands’ investment vehicle, the exempted company (Cayman fund). In its Fund Management Activities Survey published in July 2017, the Securities and Futures Commission (SFC) valued Hong Kong’s combined fund management business at $18,293 billion as of 31 December 2016. Will the OFC entice more managers and sponsors to set up their funds in Hong Kong?
The legal framework for the establishment of OFCs is set out in the Securities and Futures (Amendment) Ordinance 2016, which was enacted in 2016 and amends the Securities and Futures Ordinance (SFO). It is expected to come into force in 2018. Detailed rules (OFC Rules,subsidiary legislation to the SFO) and a non-statutory OFC code (OFC Code) are the subject of an SFC consultation which closes on 28 August 2017. Proposals for a profits tax exemption for certain privately offered OFCs are set out in the Inland Revenue (Amendment)(No.4) Bill 2017 (Tax Bill).
The OFC structure is designed to be used by both retail and private funds. Retail funds in Hong Kong must be authorised by the SFC for public sale under the SFO. The conditions for authorisation are set out in the SFC’s Code on Unit Trusts and Mutual Funds (the UT Code). As OFCs are collective investment schemes, the OFC regime will be established under the SFO and supervised by the SFC rather than the Companies Ordinance and Registrar of Companies (CR) framework.
The advantages for a Hong Kong manager in setting up an OFC over a Cayman fund largely centre around the savings in management time and money, and the simplicity, in dealing with one jurisdiction instead of two.
Use of a Hong Kong domiciled vehicle by a Hong Kong manager avoids the Cayman layer of service providers – auditors, lawyers, corporate services – and allows for a single regulator, the SFC, for both the manager and the fund. Instead of dealing with both the Cayman Islands Monetary Authority (CIMA) and the SFC, the manager may focus on dealing with one regulator and complying with one regulatory regime and may enjoy relatively lower regulatory fees.
As an adjunct to the single regulator approach, the SFC is proposing a streamlined application process. The OFC establishment and registration process involves dealing with one authority (the SFC) who in turn will deal with the CR for the incorporation certificate and the Inland Revenue Department for the business registration certificate. Similarly, post-establishment, the SFC has proposed a streamlined process for ongoing filings, with filings requiring SFC approval being submitted only to the SFC and filings not requiring SFC approval being submitted only to the CR.
The OFC also allows for a simpler fund operating structure, with a Hong Kong manager serving a Hong Kong fund and no requirement for an offshore manager – one less entity to establish and maintain – and no requirement for the fund’s directors to be CIMA registered or licensed.
Drawbacks to adopting the OFC structure largely impact private funds and their managers. The level of prescription and oversight which is contemplated by the OFC regime, whilst familiar to operators of Hong Kong authorised funds, will be new to managers of private Cayman funds. Here we set out some of the key additional obligations and requirements:
- Constitutional documents
The OFC’s governing document will be an instrument of incorporation with certain provisions prescribed by the SFO, such as a provision as to the kinds of property in which the OFC can invest. Any material change to the instrument of incorporation will require the SFC’s approval. The Cayman fund does not have prescribed provisions in, and CIMA’s approval is not required for any changes to, its memorandum and articles of association.
The name must end with “OFC” or “Open-ended Fund Company”; must not, in the opinion of the SFC, be misleading or otherwise undesirable; and must not be the same as the name of another OFC. Any change of name is subject to the SFC’s approval. In contrast, the name of a Cayman fund must not be the same as the name of another existing company, must not contain certain sensitive words and may choose not to include “Limited” or “Ltd” in its name. No approval is required to a change of name, subject to these confines.
- Investment scope
A privately offered OFC may only invest in securities and futures contracts (plus OTC derivatives once the new Hong Kong licensing regime for OTC derivatives comes into effect), cash, bank deposits, certificates of deposit, foreign currencies and foreign exchanges contracts, with a maximum of 10% of gross asset value in other assets classes. As shares in private companies are not “securities” under the SFO, the OFC will likely not be a suitable option for private equity managers. There are no restrictions imposed by the Cayman regime on investment strategies of Cayman funds or their use of leverage.
An OFC must have at least two individual directors including at least one director that is independent of the custodian. The appointments are subject to the SFC’s approval, and the SFC will require the directors to be appropriately qualified and experienced. By contrast, CIMA requires directors to register but does not impose an approval process nor any requirements as to qualifications, experience or independence.
- Removal of directors
It is not uncommon for Cayman funds to be structured with different voting rights so that, for example, one class has the right to vote on the appointment and removal of directors, whilst the other classes have the right to vote on all matters other than the appointment or removal of directors. The OFC Rules as currently drafted prohibit such structures.
An OFC must appoint a custodian which is approved by the SFC and meets the eligibility requirements set out in the UT Code, even if it is a privately offered OFC. The custodian is required to take reasonable care, skill and diligence to ensure the safe-keeping of all the OFC’s property. A Cayman fund sold in Hong Kong is not required to appoint a custodian unless it seeks SFC authorisation for public sale. In practice, many hedge funds appoint one or more prime brokers, and many prime brokers may not meet the eligibility requirements under the UT Code and may not agree to accept more onerous liability than the Cayman fund model.
- Investment manager
An OFC must appoint an investment manager which is licensed by or registered with the SFC for type 9 (asset management) regulated activity. The appointment is subject to the SFC’s approval. The investment manager must be and remain “fit and proper” throughout its appointment. Whilst there are no prescriptive requirements for the investment manager of a Cayman fund, in practice a hedge fund manager operating its business in Hong Kong will hold a type 9 licence.
The OFC Code requires that the valuation and pricing of the OFC’s property is within the investment manager’s remit. This is inconsistent with the typical hedge fund model, where valuation and pricing is the responsibility of the board of directors and is typically delegated to the fund’s administrator.
- Ongoing compliance
The OFC Rules and OFC Code contemplate a number of post-registration compliance requirements which have no parallel in the Cayman regime. For private OFCs, material changes, such as to the OFC’s investment objectives and policy or its maximum permitted leverage, require shareholders’ approval and are also subject to the SFC’s approval if such change involves an amendment to the instrument of incorporation.
Termination, even for a solvent OFC, requires a submission of proposal to the SFC. The OFC regime grants the SFC the power to terminate an OFC in certain circumstances, such as a breach of the OFC Rules. No equivalent vetting process is afforded to CIMA for a Cayman fund.
Transfers of OFC shares will be subject to Hong Kong stamp duty, in contrast to Cayman funds that maintain their register of shareholders outside Hong Kong. Offshore funds enjoy an exemption from Hong Kong profits tax where their central management and control is located outside Hong Kong. Funds authorised under the SFO in Hong Kong are exempt from profits tax. The Government has proposed, in the form of the Tax Bill, a profits tax exemption for private OFCs, subject to a number of conditions and anti-avoidance measures such as the requirement that the OFC is “non-closely held”. The proposals have drawn criticism for being both complex and unclear.
- Safe harbours
For funds that have a corporate legal structure, the Companies (Winding Up and Miscellaneous Provisions) Ordinance (CWUMPO) provides a number of safe harbours from the SFO prohibition on marketing unauthorised funds to the public. As the OFC will be established and incorporated under the SFO, it will not be a “company” and therefore privately offered OFCs may not enjoy the CWUMPO exemptions but rather must rely on the more limited exemptions under the SFO (i.e. the fund may only be marketed to “professional investors” and/or in other circumstances that do not amount to an offer to “the public”).
Hong Kong fund industry participants have welcome the Government’s commitment to the introduction of an alternative vehicle for Hong Kong domiciled funds. The level of SFC oversight and prescription in the proposed OFC Rules and OFC Code will be largely familiar to managers and custodians of SFC-authorised funds. However, the OFC regime as currently drafted (together with the complexities of the proposed profits tax exemption in the Tax Bill) faces a significant challenge to tempt private fund managers away from the flexible, simply-established and more lightly regulated Cayman structure. Appetite for the OFC is therefore likely at the outset to be weighted more to the retail sector.
The SFC consultation on the draft OFC Rules and OFC Code is open for comment until 28 August 2017.