Financial Services Newsletter
Issue 3 of 2008: October

SUMMARY OF CONTENTS

Disclosure Standards for Retail Investment Products

The SFC recently issued a press release and a circular on risk disclosure. The circular reminds issuers of retail investment products, including authorised funds, of their duty to include in offering documents sufficient relevant risk information for investors to make an informed investment decision, and for marketing materials to be "clear, fair and present a balanced picture with adequate and prominent risk disclosure".

Addressing recent market events, the circular also advises issuers that marketing materials should contain "upfront, prominent and adequate" warnings of all relevant risks "including any new risks that may have emerged in the prevailing market circumstances". The press release focuses on the adequacy of risk disclosure covering bankruptcy and extreme market conditions.

For authorised funds, the promoter is required to review the risk statements in the prospectus and marketing materials and consider whether they should be enhanced in the current market conditions. An area which is likely to be given attention is any information describing the fund’s use of financial derivative instruments and the associated risks.

In the case of product authorisation applications which are pending with the SFC, the circular prompts applicants to "revise their documents in the light of recent market events".

For products currently in the market, the circular advises that marketing materials should be reviewed. If the offering documents and marketing materials for a retail fund do not make adequate, balanced and prominent disclosure and warning of risks in light of the prevailing market circumstances and public concerns, immediate steps should be taken to amend the documents.

It is incumbent on issuers to ensure their offering documents continue to be up-to-date and to contain sufficient information necessary for investors to make an informed investment decision given the new circumstances. In addition, marketing materials issued must be clear, fair and present a balanced picture with adequate and prominent risk disclosure in compliance with all applicable regulations.

Accordingly, investment product issuers should ensure that their current offering documents and marketing materials in issue contain upfront, prominent and adequate warnings of all the risks associated with their products, including any new risks that may have emerged in the prevailing market circumstances.

What is expected of retail investment product issuers in the SFC circular issued on 3 October 2008 is not just a review of new offering documents or marketing materials that are seeking SFC authorisation but also those with pre-existing authorisation from the SFC who would like to continue the marketing of their products with previously authorised documents.

The press release and the circular are available on the SFC’s website.

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Offering Hong Kong Funds in Australia

Our legal update of July this year discussed the Declaration on Mutual Recognition of Cross-border Offering of Collective Investment Schemes (Declaration) which had been signed by the SFC and the Australian Securities and Investments Commission (ASIC). The update noted that further details of the Australian requirements were anticipated.

The Declaration contemplates that SFC-authorised funds that satisfy certain criteria will enjoy conditional relief from registration with ASIC and certain other licensing and product disclosure requirements. Details of eligibility and applicable conditions were incorporated into a regulatory instrument (Class Order) issued by ASIC on 15 September 2008.

Key pre-conditions for SFC-authorised funds to qualify for the application of the Class Order include:

• The relevant fund should primarily be regulated by the SFC. Whilst the Class Order applies to an overseas fund if it is primarily regulated in Hong Kong, other funds authorised by the SFC as recognised jurisdiction schemes, such as UCITS funds, will not qualify if they enjoy any exemptions "or other relief (however described or effected)" from HK regulatory requirements. This may preclude UCITS funds from applying.
• The fund must not be principally marketed to Australian investors. No more than 30 per cent of the value of the scheme's interests should be held by Australian residents.

The exemptions afforded to qualifying HK funds as set out in the Class Order include dispensation from ASIC registration requirements and from certain product disclosure requirements, provided the investor is given a copy of the current SFC-authorised offering document. The regulations also provide relief from certain licensing requirements, however a scheme operator wishing to issue interests in its SFC-authorised fund will need to enter into an intermediary arrangement with an Australian financial services licensee.

Applications to ASIC for relief must be supported by extensive documentation relating to the fund, its HK authorisation and its compliance plan for satisfying Australian regulatory requirements.

Consideration should also be given as to how Australian residents may be taxed on a HK fund investment. In the absence of any dispensation by the Australian Tax Office, rules relating to the taxation of foreign investment funds still apply which render offshore funds unattractive to Australian investors.

Meanwhile, ASIC and the US Securities and Exchange Commission (SEC) entered into a mutual recognition arrangement in August with a view to providing a streamlined regulatory approach for securities brokers and exchanges conducting financial services business in each other's jurisdictions. The arrangement contemplates securities exchanges and their broker participants being granted exemptions from the overseas regulator and permitting those exempted entities to do business in certain securities with eligible investors. The mutual recognition arrangement has an initial term of five years and is the first of its kind for the SEC.

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Prime Broker Default

Recent events in the financial markets have caused hedge fund managers to consider how fund assets may be protected from the insolvency of its prime broker.

Briefly, the key issues in the legal analysis are title, segregation and co-mingling. If title to the asset passes to the broker, then the asset forms part of the broker's estate on insolvency and the fund is an unsecured creditor. If title is not intended to pass and to ensure that the fund can gain control of the assets as quickly as possible, the assets will need to be kept segregated in separate and identifiable accounts with no co-mingling with assets of others.

Given the prime brokerage industry comprises elements of asset title transfer as collateral for cash lines, we set out below some of the strategies for enhancing asset protection currently under discussion.

Multiple brokers: It is possible to diversify credit risk by appointing more than one prime broker. An additional prime broker may be used to split the fund's assets or merely as a back-up for the transfer of assets if the viability of the broker comes into question. For the sake of the manager's bargaining power, negotiation of the terms of a new prime brokerage arrangement should not wait until the creditworthiness of the prime broker is questioned.

Custodian: Managers can consider appointing a custodian in addition to the prime broker, and setting up a daily sweep to remove from the prime broker any assets not being used as collateral. In addition, the appointment of a designated cash custodian could result in cash being protected by a trust arrangement.

Collateral arrangements: Managers should examine existing relationships to ascertain to what extent the prime broker is able to re-hypothecate assets. If, for commercial reasons, the manager accepts that the prime broker may use the fund's assets, it is advisable to ensure the right does not extend beyond assets held as collateral.

In order to serve investors, managers are advised to review their prime brokerage arrangements to explore how best to protect the assets of the fund.

As a practical matter, given there will inevitably be dislocation when a liquidator goes in, the manger should keep its own complete records, and work with the liquidator pro-actively to identify its assets.

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Amendments to the Mandatory Provident Fund Schemes Ordinance

The Mandatory Provident Fund Schemes (Amendment) (No.2) Ordinance 2008 (Amendment Ordinance) was recently gazetted.

In brief, the new provisions require the prior written consent of Mandatory Provident Fund Schemes Authority (MPFA) to be obtained in relation to:

• the appointment of officers of an approved trustee including director, chief executive officer or Hong Kong chief executive officer;
• a person becoming an indirect controller of an approved trustee; and
• a person becoming a substantial shareholder of an approved trustee.

In all cases, the MPFA may only give consent if it is satisfied that the person is of good reputation and character and has not been found guilty whether in Hong Kong or elsewhere of an offence involving fraud or dishonesty.

Any person who proposes to become a director or chief executive officer must also satisfy the MPFA that he has the skill, knowledge, experience and qualifications that, in the opinion of the MPFA, are necessary for the successful administration of provident fund schemes.

The MPFA in granting its consent may also impose reasonable conditions on the approved trustee and the proposed indirect controller or proposed substantial shareholder and may at any time by notice in writing amend or revoke such conditions or impose new conditions as may be reasonable in the circumstances.

The MPFA may also serve notice on an existing controller objecting to such controller continuing to be a controller of the approved trustee.

Failure to comply with the above may attract financial penalties.

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Short Selling: Developments in Hong Kong and China

In response to recent market developments overseas, the SFC issued two press releases and a circular on short selling in Hong Kong.

Whilst many regulators around the world have recently made significant changes to rules regarding short selling, the SFC reminded participants that the current regulations governing short selling in Hong Kong are stricter than many of the affected markets.

Hong Kong only allows short selling of certain designated stock, as prescribed by the Stock Exchange of Hong Kong Ltd (HKEx). In addition, short selling may only be executed at or above the best current asking price (the up tick rule). Whilst the SFC had earlier this year announced that it was studying the feasibility of relaxing the up tick rule, the Circular issued on 26 September 2008 confirmed that this proposal has been suspended. At the request of the SFC, HKEx has increased the default fee for settlement failure from 0.25% to 0.50% of the market value of the failed transaction. On 30 September 2008, the SFC issued a warning that it would not hesitate to act against abusive short selling and is prepared to implement more aggressive measures should any abusive activity be identified.

Meanwhile the China Securities Regulatory Commission has announced that it will introduce short selling of A-shares on a trial basis. Initially, only a small number of brokerages will be able to participate and it will only be possible to short a designated set of stocks. It is understood that that the measures may be implemented as soon as November.

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Responsible Officers

A licensed corporation needs to appoint at least two responsible officers (ROs) to supervise each regulated activity it is licensed to carry on. If one RO resigns unexpectedly, the licensed corporation should cease to carry on the related regulated activity and notify the SFC immediately. Contravention with this requirement, without reasonable excuse, is an offence under the law and if convicted, the licensed corporation is liable to a fine of up to HK$100,000 and to a further fine of HK$2,000 for every day during which the offence continues. The licensed corporation and its related ROs may also be subjected to disciplinary proceedings, so it is important to give due regard to finding replacements and keeping the SFC updated.

To avoid inadvertently breaching the minimum requirement, licensed corporations with only two ROs should consider appointing additional ROs to supervise each regulated activity to avoid having to suspend operations due to departures.

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FSPG Compliance Services

We are delighted to welcome Jane McBride back to Deacons. Jane recently joined FSPG as Compliance & Regulatory Consultant, heading up the Compliance Services Unit. The team now consists of eight professionals (all former regulators, audit professionals and in-house legal or compliance professionals) providing practical assistance for clients in connection with their SFC licensing, regulatory and general compliance matters. The team also provides compliance advice and conducts due diligence reviews for clients.

Jane already knows Deacons very well. She joined the Commercial Department in 1994, was promoted to partner in 1997, and worked in Tokyo from 1998 until 2006. She has spent the last eight years in industry, based in Tokyo and then in Hong Kong, in senior regional legal and compliance positions. She has worked at investment banks as well as asset managers and so brings with her a wealth of practical experience. She is qualified as a solicitor in New South Wales (Australia), England & Wales and Hong Kong. Jane is Australian and is fluent in Japanese.

Jane McBride, Compliance & Regulatory Consultant
Email: jane.mcbride@deacons.com.hk
Tel: +852 2825 9213
For more information about Deacons Compliance Services

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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.