Under the Rules Governing Offshore Funds of August 2005, private placement of offshore funds may only be offered to:

Private Investors are individuals having:

The number of “private investors” who invested, the total amount invested and any changes in investors or investment amounts must be reported to the FSC.

From 17 February 2006, the FSC has further expanded the investment scope of private funds domiciled in Taiwan which are set up by Taiwanese managers (Private Funds). According to an order made pursuant to the Regulations Governing Securities Investment Trust Funds, Private Funds may invest in offshore funds which have not been approved or registered with the FSC. However, the underlying offshore funds must comply with the following requirements:

• they must not invest in gold or commodities;
• they may only have very restrictive investments in Mainland China securities;
• their manager must have been established for more than one year and must not have been punished by the relevant regulatory authority for the recent two years; and
• they must have regular valuation of fund price.

It must be stated in the offering documents of the Private Funds that the fund may invest in offshore funds (including hedge funds) which have not been approved or authorised by the FSC. Thus, there maybe increased appetite for offshore funds from Taiwanese managers.

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Doctrine of Privity of Contract - Proposed Law Reform in Hong Kong

The Law Reform Commission (Commission) published a report on 25 October 2005 recommending proposals to reform the doctrine of privity of contract in Hong Kong. The aim of the reform is to allow a person who is not a party to a contract to enforce the contract if that was the intent of the contracting parties.

Under the existing doctrine of privity of contract, a person cannot acquire and enforce rights under a contract to which he is not a party. The doctrine has been criticised as frustrating contracting parties’ intention to benefit third parties and could lead to unfairness.

The report recommended that the doctrine should not be completely abolished but should be reformed by means of a clear and straightforward legislative scheme. The Commission made twenty-one recommendations, for example that a third party should be expressly identified by name, as a member of a class or as answering a particular description, and that it should be possible to confer rights on a third party who was not in existence at the time of contracting. The Commission also recommended that a third party’s contractual right may not only be derived from express clauses, but also be implied from provisions of the contract.

The Commission recommended excluding certain contracts from the operation of the legislation because intervention of third parties might not always be appropriate. Such contracts include contracts of employment, companies’ Memorandum and Articles of Association, negotiable instruments, contracts for the carriage of goods by sea or air and letters of credit.

The underlying principle of the reform is to respect contract parties’ freedom of contract and, where appropriate, to give effect to their intention to benefit a third party. If the parties prefer, they will be able to contract out of the proposed legislation. Contracting parties are advised to make it clear in the contract whether or not any terms are designed to be enforceable by a third party.

The doctrine of privity of contract has been reformed in many common law jurisdictions including Canada, England, New Zealand, Singapore and some states and territory in Australia.

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Revised Rules on Forex Controls in PRC M&A Transactions

The State Administration of Foreign Exchange (SAFE) issued the Notice on Relevant Issues in the Foreign Exchange Control over Financing and Round Trip Investment through Special Purpose Companies by Residents Inside China (关于境内居民通过境外特殊目的公司融资及返程投资外汇管理有关问题的通知) on 21 October 2005. The Notice, which became effective on 1 November 2005, repeals the earlier notices regarding the use of overseas holding companies for round trip investment: the Notice of the State Administration of Foreign Exchange on Relevant Issues in Perfecting Foreign Exchange Control in Mergers and Acquisitions by Foreign Investors (关于完善外资并购外汇管理有关问题的通知) and the Notice on Relevant Issues in the Registration of the Offshore Investments of Individual Domestic Residents and Foreign Exchange Registration of Mergers and Acquisitions by Foreign Investors (关于境内居民个人境外投资登记及外资并购外汇登记有关问题的通知). These earlier Notices required residents of China who, directly or indirectly, invested in the establishment or assumed control of an enterprise outside China for the purpose of making investment in China to carry out approval and registration formalities with the foreign exchange authorities.

The new Notice details the procedures relating to the application process including the application documents which need to be submitted for this purpose. New definitions such as "special purpose company", "round trip investment", "legal person resident inside China" and "natural person resident inside China" have been introduced in this Notice to allow investors to determine more accurately whether they fall into the category of people required to register their overseas investment with SAFE.

Before a Chinese resident may establish or control a special purpose company outside China, it must register the overseas investment with its local foreign exchange authority.

Thereafter a Chinese resident can inject assets or equity of a Chinese enterprise into the special purpose company and then engage in overseas equity financing. Upon completion of the financing, the Chinese resident may repatriate the funds which were earmarked for use inside China in accordance with the planned use of the funds stated in its registration materials.

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Enforcement Steps up on Disclosure of Interest Breaches

Investors, investment managers and others with direct or attributed interests of 5% or more of any Hong Kong listed company are subject to Hong Kong’s substantial shareholder disclosure regime. Inadvertent breaches of the regime are common, largely because of its complexity and investors’ misapprehensions of the requirements.

A review of enforcement actions over the last year indicates an increasingly aggressive approach by the Hong Kong Securities and Futures Commission (SFC). People have been prosecuted for a variety of breaches including:

• failure to notify relatively small changes of level in an already disclosed interest;
  
• failure to keep registers of interests;
  
• failure by a principal to require his agent to report transactions to him;
  
• failure to make requisite disclosures as a director of a substantial shareholder. 

It is currently rare for bona fide investment managers to be prosecuted. In February 2006, however, a Magistrate fined an SFC licensed investment manager $12,000 plus SFC investigation costs of $13,876. The investment manager had pleaded guilty to failure to make initial disclosure of its interests in a listed company, and failure to make subsequent disclosures when its interests passed through 6% and 8%. In other cases "financial settlements" have been negotiated with the SFC as an alternative to prosecution, though such settlements sometimes also include a public reprimand.

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Exempt Fund Manager Status under the Code on Takeovers and Mergers

An exemption from “acting in concert” is available under the Hong Kong Codes on Takeovers and Mergers and Share Repurchases (Takeovers Code) to entities within a large financial group which manage investment accounts on a discretionary basis and which maintain acceptable levels of segregation regarding confidential information through Chinese Walls. The exemption recognises the fiduciary duties owed by discretionary fund managers to their clients and that fund management activities within certain large organisations may be conducted on a day-to-day basis separately from the other activities of that organisation such as its corporate finance activities. Exempted fund managers will not be regarded as acting in concert with the corporate finance operations of their group.

Fund managers who wish to apply for the exemption must submit an application containing details of the group structure and operations, their Chinese Wall and compliance procedures to prevent a flow of information between the fund manager and other parts of the Group, and details of the financial interests of the fund manager in the performance of the Group. The Takeover Executive may require further information from the applicant and may ask for a meeting with the applicant to discuss the relevant fund management activities before granting the exemption. A fee of HK$24,000 per ruling is payable.

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FSA's feedback on side letters

The UK's Financial Services Authority (FSA) has issued a Feedback Statement on its discussion paper DP05/4 "Hedge funds: A discussion of risk and regulatory engagement" and has urged firms to focus on the risks posed by side letters "which will remain an area of supervisory focus". Side letters have become a common feature for institutional investors investing in hedge funds with the result that such investors receive preferential treatment and more information than other investors. The FSA expects managers to ensure that all investors understand that a side letter has been granted and that conflicts may arise. An industry working group has been established by the Alternative Investments Management Association to examine ways of reducing the use of side letters and is considering incorporating common issues into the funds' documentation.

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The 2006 ISDA Fund Derivative Definitions

At its Singapore 2006 AGM, ISDA announced the publication of a new set of definitions – the ISDA 2006 Fund Derivative Definitions (Fund Definitions). The Fund Definitions are intended to provide basis terminology for use in confirmations of derivatives transactions linked to interests in various types of pooled investment vehicles, such as hedge funds and mutual funds, for which a liquid secondary market may not exist. The Fund Definitions are a streamlined version of the 2002 ISDA Equity Derivatives Definitions, tailored to account for the particular valuation and settlement characteristics of fund interests. For example, the Fund Definitions provide two new methods – the Reported Value Method and the Deemed Payout Method – for valuation of fund interests as an alternative to the methodology of the 2002 Definitions, which is more suitable for equity securities whose value is primarily derived from secondary market transactions.

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Deacons in the international media

International news wire service Dow Jones ran a story on 1 March quoting Deacons’ Financial Services practice group's Rory Gallaher on Hong Kong's Legislative Council passing a bill that exempts offshore funds from applying profits tax, a move that will likely improve the territory's standing as a regional financial centre. Revenue Bill 2005, which takes effect retroactively from the tax assessment year starting April 1996, exempts offshore fund entities that are not Hong Kong residents and don't have any businesses in Hong Kong apart from the transactions related to their portfolios.

Rory was quoted as saying the bill "introduces a good degree of certainty” which puts to rest concerns raised by international fund managers since 2000. Rory also pointed out that deeming provisions in the new legislation which tax resident investors may impose tax on start-up fund managers which are encouraged by investors to put their own money into funds. Rory commented it would have been better for the local industry if the bill encouraged start-up fund managers to invest in their own funds and allocate those funds in local investments.

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Deacons 2006 IFLR Hong Kong Law Firm of the Year

Deacons was awarded the 2006 IFLR Hong Kong Law Firm of the Year by the International Financial Law Review magazine (IFLR) at the IFLR Asian Awards ceremony held in Hong Kong on 15 March 2006.

This highly prestigious and coveted award is given in recognition of innovative and complex work in the areas of capital markets work, M&A, project finance and restructuring. In selecting the nominees and winners, the IFLR committee look for firms which have offered high-quality advice on a variety of novel and important transactions.

The IFLR Committee were particularly impressed with Deacons work on deals such as the Lenovo equity financing for the acquisition of IBM’s pc business deal; where we acted as Hong Kong legal advisers to Yahoo Inc. in relation to the transfer by Yahoo Inc. of its China business to Alibaba.com Corporation; and where we acted for SUNDAY Communications Limited in relation to the mandatory general offer made by PCCW Limited.

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Whilst every effort has been made to ensure the accuracy of this publication, it is for general guidance only and should not be treated as a substitute for specific advice.