Financial Services Newsletter
Issue 2 of 2008: May

SUMMARY OF CONTENTS

CHINA QDII UPDATE

Commercial Banks
Since the China Banking Regulatory Commission (CBRC) announced measures in May 2007 to widen the permitted scope of investments by commercial banks in China under the qualified domestic institutional investors (QDII) scheme, there have been further developments to open more markets for investment by banks (2007 CBRC Notice). The QDII scheme allows Chinese nationals to invest in offshore markets through investment products issued by QDIIs such as commercial banks.

Pursuant to the CBRC Notice, QDII investment products issued by banks can invest in equities listed on permitted stock exchanges and in permitted mutual funds. Such stock exchanges or mutual funds must be supervised by regulatory authorities which have signed a memorandum of understanding (MOU) with the CBRC on regulatory cooperation relating to the QDII scheme. Hong Kong was the first jurisdiction to enter into a MOU in May 2007. From December 2007 to date, the United Kingdom, Singapore, Japan and USA have followed suit. It was reported in March 2008 that Luxembourg had also entered into a MOU with the CBRC, although the official announcement has not yet been released, pending the completion of certain formalities.

Fund management companies
Chinese fund management companies and securities companies may also issue QDII fund products in China. The China Securities Regulatory Commission (CSRC) promulgated the Provisional Administration Measures governing Offshore Securities Investments of Qualified Domestic Institutional Investors and the implementing Notice (CSRC Measures) which came into effect on 5 July 2007. The CSRC Measures allow the appointment of foreign investment advisors (FIAs) to manage the offshore investements of QDII fund products. To date, there have been eight QDII fund products issued by Chinese fund management companies and all have appointed FIAs.

To supplement the CSRC Measures, the CSRC issued Instructions for Issues Related to the CSRC Measures (Instructions) in December 2007. It is stated that a full delegation of discretionary investment management of a QDII product to a FIA by the QDII is not encouraged by the CSRC, despite such delegation being permitted under the CSRC Measures. The CSRC considers one of the long term objectives of the QDII regime is to nurture the global investment management capability of domestic securities institutions. The CSRC's current policy is for domestic securities institutions to maintain control over investment management of QDII products.

However, FIAs are allowed to conduct a variety of supporting and servicing activities, such as giving public presentations on QDII products, providing the QDIIs and their third party distributors with training or provision of market information or materials in respect of the QDII funds, so long as such activities do not constitute the public marketing of services, products or brand names by FIAs to onshore institutions or individuals in China. Whilst there is no further explanation on what constitutes "public marketing", it would be advisable for all seminars on QDII products to be organised and led by the QDII, with the FIA playing only a secondary role. Where the presentation materials of FIAs are to be distributed in written form, the same should be accompanied by other reference materials provided by the QDIIs.

The CSRC further requires a FIA to comply with Chinese laws and regulations. This obligation should be stated in the investment advisory agreement and such agreement should be governed by Chinese law.

To be appointed as an FIA, a foreign investment manager should meet the following requirements:

As regards the investment scope of QDII products, the CSRC Measures stipulate the permitted investments include listed securities and registered public mutual funds in the countries or regions which have signed a MOU with the CSRC, money market instruments, government or corporate bonds, asset-backed securities, structured products, and financial derivatives listed on offshore exchanges recognized by the CSRC. The CSRC further expresses its current policy in the Instructions that investments in hedge funds or in funds which have substantial exposure to financial derivatives for hedging purposes are prohibited, even if such funds are authorised for public sale in the home jurisdiction.

To date, over thirty countries have signed a MOU with the CSRC on bilateral regulatory cooperation, including Hong Kong, the USA, the United Kingdom, Japan, Luxembourg, Singapore and Germany. However, Ireland has not yet entered into a MOU with the CSRC, making current funds domiciled in Ireland not accessible by QDII products.

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Electronic Submission of Substantial Shareholder Disclosures

The Securities and Futures Commission (SFC) has released its conclusions on the proposal to make electronic submission of disclosure of interests notices mandatory. Deacons made a submission broadly supportive of the proposal, which we believe should make the filing process more efficient and should improve the timeliness of the publication of potentially market sensitive disclosure of interests notifications.

The SFC aims to implement the proposal as soon as possible. Thereafter, substantial shareholders will be required to file disclosure notices with the Stock Exchange of Hong Kong (SEHK) using prescribed web-based forms. As well as continuing to publish the disclosures on the SEHK website, the SEHK will also provide copies of the notices to the relevant listed corporations - removing the requirement for substantial shareholders to do so.

In response to submissions concerning alternative filing procedures in exceptional circumstances, such as disruption of internet access, the SFC has indicated that it will clarify the types of circumstances which will be a reasonable cause for delay in making electronic filing.

As a practical matter it can be difficult to find out a listed corporation's current number of shares in issue, even though this information is necessary for preparing disclosure of interests notices. The SEHK currently requests monthly notifications by listed corporations of movements in their issued shares, and proposes that this practice be formalised in the Listing Rules. This information is published on the SEHK website. The information may nonetheless be out of date, and there is still no "official" source of issued share capital information upon which substantial shareholders are entitled to rely.

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How the Credit Crunch is Affecting Funds
by Robert Searle

Some investment funds have been exposed to the credit crunch by different means, both as investors and counterparties to SPVs holding sub-prime mortgages or other asset-backed assets. To date, it is not clear for several reasons what proportion of investment funds have been caught up in the turmoil.

Assessing the valuation of positions in these SPVs ranges from difficult to educated guesswork as these assets are not generally traded. Given the realization of current "paper" losses facing any counterparty that unwinds a position or executes trades, there are even fewer trades than would be normal to benchmark prices for net asset value (NAV) calculation purposes.

Where investor lock-ups (i.e. prohibitions on redemptions) are not already in place, funds in distress are generally considering four options to cope with the increasing volume of redemption requests:

a) Establishing side pockets and/or suspending redemptions in accordance with the terms of the constitutional documents of the fund. A side pocket places illiquid, or impossible to fairly value, assets in a separate sub-account of the fund, with a corresponding proportion of existing investors’ shares converted into non-redeemable shares until the relevant assets can be disposed of or fairly valued. This is the preferred route as the mechanism for limiting/postponing redemption requests has been described to investors at the outset of their investment.

b) Restructuring with the consent of investors, which may include a wide number of proposals including staggered redemptions and distribution in specie of the underlying assets.

c) The investment manager conducting an orderly disposal of assets of the fund over a period of time to meet redemptions. This presumes there is sufficient time within the redemption payment period to conduct an orderly disposal of the relevant assets.

d) Insolvency/liquidation of the fund. This allows investors to have a party experienced in dealing with distressed assets decide how and when to dispose of assets. However, this is likely to eliminate the ability of the manager of the fund to judiciously take advantage of further opportunities and/or dispose of assets that the manager is intimately familiar with.

As a general rule, documentation governing a fund generally provides for time to be granted to managers not to rush any asset disposals, so as to avoid realising paper losses, but the timing for taking certain decisions e.g. as to when to suspend, can be critical and the governing documents should be reviewed carefully in this regard.

Robert Searle is a partner of Campbells, one of the leading law firms in the Cayman Islands. Robert can be contacted on +345 914 5850 or email rsearle@campbells.com.ky.

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Best Practice Standards for Hedge Funds

On 15 April 2008, the US President's Working Group on Financial Markets published a set of best practice standards aimed at improving the transparency and risk management practices of hedge funds. This follows publication in January of a set of best practice standards for hedge fund managers by the UK-based Hedge Fund Working Group.

The Alternative Investment Management Association has welcomed both reports and commented that "The challenge now is for the industry to bring about convergence between these various standards proposed." Deacons anticipates that ongoing international harmonisation of best practice standards will help improve investor confidence in the industry and ultimately prove beneficial for hedge fund managers.

The UK standards may be of particular interest to Hong Kong based managers. While aimed primarily at UK managers, the Hedge Fund Working Group hopes they will be adopted on a wider basis. Whether a manager signs up to the standards or not, it is probable that a litigator or regulator may cite them as expected industry practice.

The standards address five particular areas.

Disclosure

There should be transparency about a fund's fee structure, investment policy, associated risks, and commercial terms.

Valuation

Valuation arrangements should address and mitigate conflicts of interest in relation to asset valuation, where possible by appointing an independent and competent third party valuation service provider.

Risk Management

There should be a governance structure for the manager's risk management activities, specifying reporting lines, responsibilities and control mechanisms.

Governance

There should be suitable and robust governance arrangements capable of dealing with potential conflicts between managers and investors.

Shareholder Conduct, Including Activism

Managers should ensure they have internal compliance arrangements designed to identify, detect, and prevent breaches of market abuse laws and regulations. Members should not generally borrow stock in order to vote.

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Marketing Materials and Notices to Hong Kong Investors

The SFC recently issued a consultation paper on the proposed streamlining of the pre-vetting of notices and advertisements relating to SFC authorised funds.

The consultation paper paves the way for SFC licensed corporations (licensed for types 1, 4 or 6 regulated activity - dealing in securities, advising on securities and advising on corporate finance) to issue marketing materials and advertisements for SFC authorised funds without having to obtain the SFC's prior approval. However, relevant marketing materials are required to be submitted to the SFC after they have been issued.

Under the new process the focus will be shifted from pre-vetting towards post-vetting and monitoring. Apart from marketing materials, the SFC also proposed to extend the "post-vetting" to notices to Hong Kong investors. In future, it would not be necessary to obtain the SFC's prior approval before issuing notices to Hong Kong investors, unless the relevant notices relate to the termination, merger or deauthorisation of an SFC authorised fund. The relevant notices will need to be filed for the SFC's record after they have been issued and the SFC may make follow-up enquiries.

Under the streamlined process, although the SFC may no longer need to pre-approve communications to Hong Kong investors, proposed changes to an SFC authorised fund will still need to be approved by the SFC before the relevant notice (setting out such changes) can be issued. Unfortunately, the consultation paper did not provide any guidelines on this approval process and how an overseas regulator's approval of the proposed changes would impact the timing of the SFC's approval. We hope that the SFC's conclusions to the consultation will provide some guidance. Also, it is a concern for overseas managers with no local office as to how they will comply with the new policy in the absence of an associated Hong Kong Representative.

The consultation paper was issued in January 2008 and the consultation period ended on 29 February 2008. The proposals were generally favourably received and the SFC are currently considering feedback from industry participants. We would expect the SFC to implement the proposed changes set out in the consultation paper in the second half of this year.

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Deacons Financial Services Seminar Series

The next seminar in our 2008 Financial Services Series will be held on Wednesday 28 May 2008 in our Hong Kong Office.

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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.