Retail Hedge Funds in Hong Kong

HEDGE FUND GUIDELINES

This article looks at the application of the SFC authorisation process for retail hedge funds in Hong Kong. The SFC, breaking new ground in the regulation of these complex products, has proven to be thorough in its vetting process.

In May 2002, after a process of consultation conducted by the Securities and Futures Commission (SFC) in Hong Kong with industry participants, the SFC issued its long-awaited guidelines which permit hedge funds to be offered for sale to the public in Hong Kong. This is a significant development from the previous position where hedge funds have generally only been able to be sold in Hong Kong by way of an offer which does not constitute an offer to the public. 

On 28 November 2002, the SFC announced the authorisation of the first three hedge funds under these guidelines: one fund of hedge funds and two single strategy hedge funds. Concurrently, the SFC also released the Guidelines on Hedge Funds Reporting Requirements and investor educational materials on hedge funds. Since then, two further single strategy funds have been approved, one of which is linked to a guaranteed fund.

AUTHORISATION OF HEDGE FUNDS

The SFC is empowered under the Hong Kong Securities Ordinance to authorise mutual fund corporations and unit trusts for sale to the public in Hong Kong. Authorisation may be granted subject to such conditions as the SFC considers fair and reasonable. The requirements for authorisation are contained in the SFC's Code on Unit Trusts and Mutual Funds (Code). The Code does not have the force of law, with the result that the SFC has considerable discretion in implementing or adopting provisions on a case-by-case basis. Waivers may be granted if an application is supported by appropriate arguments.

The hedge fund guidelines, which now form part of the Code, set out the specific criteria that a hedge fund and its operators must satisfy in order to be authorised. The other provisions in the Code, which are of general application, must also be complied with. The SFCs authorisation process has a dual focus, namely: 

• the SFC reviews the suitability of the operators of the fund, in particular the manager and the custodian; and 

• the SFC also reviews the suitability of the fund itself and its offering and constitutive documents.

SUITABILITY OF OPERATORS

In looking at the suitability of operators, the suitability of the manager is crucial. There are several criteria that the manager must fulfill. First, there are the general criteria in the Code that apply to managers of funds seeking authorisation in Hong Kong, regardless of whether these funds are hedge funds or not. These require that the manager must be engaged primarily in the business of fund management, have sufficient financial resources to carry out its business and meet its liabilities (a minimum issued and paid-up capital and capital reserves of HK$1 million or its equivalent in a foreign currency is required), it must not lend to a material extent and must maintain a net positive position at all times. 

The Code also requires that the investment management operations of the manager be based in a jurisdiction with an inspection regime that is acceptable to the SFC (an 'acceptable inspection regime'). The following is the current list of acceptable inspection regimes: 

The Cayman Islands, Bermuda, the BVI, and the other Caribbean jurisdictions are not considered by the SFC to have acceptable inspection regimes, neither are the Channel Islands or Switzerland. As many hedge funds have managers based in these jurisdictions, this can be a major obstacle to getting a fund authorised in Hong Kong. 

In addition, the hedge fund guidelines set out new criteria that managers of hedge funds must fulfill, namely:

• That a manager must have at least US$100 million in hedge fund assets under management.

• The manager must have sufficient resources including at least two key personnel with relevant experience. 'Relevant experience' for a single strategy fund means at least five years' experience in hedge fund strategies in general and two years' experience in the relevant strategy of the fund. For a fund of hedge funds, it means five years' general hedge fund management experience and two years' experience as a fund of hedge funds manager.

• Suitable risk management and internal control systems must be in place, including, in the case of a fund of hedge funds, a due diligence process for the selection and monitoring of underlying funds.

The SFC has been applying these requirements strictly and requires detailed and specific information demonstrating compliance.

Note that in the case of a fund of hedge funds, while the manager of the fund of hedge funds needs to fulfill all the criteria set out above, the managers of the underlying funds (which do not need to be authorised) do not. The only requirement is that 90% of the underlying funds in which a fund of hedge funds invests must have key personnel with at least two years' hedge fund management experience. The managers of the underlying funds do not need to have US$100 million of hedge fund assets under management, nor do they need to be based in a jurisdiction with an acceptable inspection regime. However, the fund of hedge funds' manager will have to submit a detailed compliance plan to satisfy the SFC as to how it proposes to monitor the activities of the underlying fund managers on an ongoing basis. 

In addition to the potential difficulties that hedge fund managers may face in fulfilling all of the above criteria, a change of approach appears to have occurred within the SFC in its recent reviews of hedge fund applications which exacerbates these difficulties. In the past, when reviewing the suitability of traditional long-only funds, the SFC appeared to take the view that where a manager delegated investment management discretion to an investment adviser, the delegate (and not the top-level manager) would need to fulfill the SFC's criteria set out in the Code. Accordingly, the top-level manager of a fund could be based in the Cayman Islands (which is not an acceptable inspection regime) without key personnel with the relevant experience, provided that it delegated investment management discretion of the fund to a suitably qualified manager in an acceptable inspection regime.

However, the SFC's approach in the recent reviews of hedge fund applications appears to be as follows:

• In general, all levels of management with investment discretion must fully comply with all the SFC's criteria, including being based in an acceptable inspection regime and having the requisite key personnel with relevant experience (notwithstanding delegation of investment management discretion). 

• However, where the fund is based in a jurisdiction which has regulations requiring that the manager be based in the same jurisdiction as the fund itself (albeit a non-acceptable inspection regime), and where the investment management discretion is delegated to a suitably qualified investment advisor within the same group of companies, based in an acceptable inspection regime, the SFC appears to be satisfied with limiting its review to the delegate. It would seem then, that where a particular jurisdiction does not have such a requirement, and the top-level manager is based in that jurisdiction (which is not an acceptable inspection regime), then even if discretionary powers are delegated to a fully qualified investment adviser within the same group of companies, based in an acceptable inspection regime, the SFC will not permit such a structure. This appears to be a significant change of policy, and it is not clear whether the same principles will apply to traditional funds.

• In addition, where the top-level manager delegates investment management discretion to an investment adviser outside the top-level manager's group of companies, the SFC insists that the both the top-level manager and the delegate fully comply with its guidelines. Here, it appears that the SFC is concerned that managers or fund management groups which are otherwise unqualified to establish authorised retail hedge funds try to circumvent the rules by appointing outside advisers who do have this experience. The SFC is concerned as to the impact on the hedge fund and its investors should such an outside adviser resign or be removed by the manager. They have also voiced doubts as to how a top-level manager without the requisite experience can properly monitor risk and ensure compliance by their delegate.

SUITABILITY OF THE FUND AND ITS OFFERING/CONSTITUTIVE DOCUMENTS

The hedge fund guidelines set out the requirements that the fund itself must fulfill. Some of these requirements are highlighted below. 

Minimum subscription: The minimum level of initial subscription in a single hedge fund must be no less than US$50,000. For a fund of hedge funds, the level is US$10,000. There is no minimum subscription level for a hedge fund that provides at least a 100% capital guarantee. 

Limited liability: The liability of holders must be limited to their investment in the hedge fund. Where the hedge fund is structured as an umbrella fund, there must be legally enforceable provisions to ring-fence the assets and liabilities between sub-funds. 

Performance fees: These must be paid no more frequently than annually and calculated on a high-on-high basis. Note, however, that the underlying funds of a fund of hedge funds do not have to comply with this requirement. 

Dealing: The fund must provide for at least one regular dealing day per month and the maximum interval between the lodgment of a redemption request and the payment of redemption money to holders may not exceed 90 calendar days. 

Investment and borrowing restrictions: There must be a set of clearly defined investment and borrowing parameters disclosed. While the SFC has not imposed any investment or borrowing restrictions for single strategy funds, the manager will be required to make appropriate disclosures on the type of investments and strategies it will undertake, the expected degree of diversification or concentration of investments, the expected and maximum level of leverage and the risk factors involved in the strategy employed. In a fund of hedge funds structure, some limited restrictions are imposed to ensure sufficient diversification: a fund of hedge funds must invest in at least five underlying funds with no more than 30% of its total net asset value invested in any one fund. Also, a fund of hedge funds may not invest in another fund of hedge funds. 

While the philosophy of the SFC with respect to investment restrictions is generally to permit managers to employ their strategies quite freely provided proper disclosure is made, the SFC has been resistant to allow funds of hedge funds to invest in managed accounts. The SFC is concerned that investments in managed accounts may have unknown adverse implications to investors particularly in relation to cross-liability, where the manager is unable to ensure that the liability of the fund of hedge funds is limited to the investment in the managed accounts. The SFC is concerned that liability of the managed accounts may spiral out of control (especially where it engages in derivatives trading and short-selling) and may have a contagion effect on the entire fund of hedge funds. 

Reporting requirements: An authorised hedge fund will be required to issue annual, semi-annual and quarterly reports to investors. The SFC has issued its Guidelines on Hedge Funds Reporting Requirements that set out the required contents of these reports.

Prime broker: Where a hedge fund uses a prime broker, the guidelines set out various requirements that the prime broker must adhere to. One issue for most prime brokers has been the limit on the value of the assets which may be charged to the prime broker to secure the fund's indebtedness.

Independent trustee/custodian: The hedge fund must have an independent trustee or custodian.

Monitoring of distribution agents: The SFC, being mindful that distribution agents who have direct contact with the investing public play a big role in investor education and protection, requires the manager to take all reasonable care in the selection of the distribution agents selling hedge funds and to provide all necessary information and training to these agents.

CONCLUSION

The road to the authorisation of hedge funds has not been an easy one so far. This is hardly surprising as the initial applications are breaking new ground. The SFC has vetted these applications very thoroughly as these products are complex and represent the cutting edge of regulatory development.

There are still a number of applications pending with the SFC, and undoubtedly some which have yet to be submitted. It is hoped that over the next few months, the SFC will authorise further applications so as to enhance investor choice in Hong Kong.

Whilst every effort has been made to ensure the accuracy of this publication, it is intended to provide general guidance and not definitive legal advice.

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