Hedge Funds in Hong Kong - Approaching a Watershed?

As Hong Kong's investment community eagerly awaits the release of a consultation paper on the distribution of hedge funds, this article summarises the current regulatory position with regard to private placements, written offers, etc, and the exemptions that exist.

In step with Singaporean regulators, Hong Kong's authorities are moving toward a less rigid distribution system for hedge funds, something some traditional managers are wary of. Given the increasing appetite for alternative investments in Asia this fundamental change in the regulators' approach is being watched with keen interest.

CURRENT STATUS

There has been a strong upsurge of interest in hedge funds in Asia in recent years. Not surprisingly, investors' patience with traditional investments yielding negative returns is wearing thin, as witness the success of the large number of guaranteed funds launched during the last year in Hong Kong. It has been said that you can get used to being hit repeatedly by a cricket ball but nobody believes that an investor can get used to losing money. Accordingly, the prospect of an investment product that can make money in falling markets is likely to be highly attractive.

At the Hedge Funds World Asia 2001 Conference in Hong Kong in May this year, it was alleged by a number of commentators that no hedge fund has been authorised for sale to the public in Hong Kong. This is in fact not the case (unless you define hedge funds very narrowly). A number of leveraged funds, futures and options funds and market neutral funds seeking absolute returns were authorised by the Securities and Futures Commission in Hong Kong (SFC) during the 1990s. However, many of these funds suffered significant falls and have since been wound up or de-authorised. Only the AHL Diversified Futures Fund remains authorised in its original form and has provided consistent positive performance.

What the SFC has never authorised is a fund which is able to go short to any material extent. The SFC's Code (which sets out the constitutional and operational requirements with which a fund has to comply in order to be authorised) prohibits any short sale which will result in the fund's liability to deliver securities exceeding 10% of its total net asset value. In addition, the security to be sold short must be actively traded on a market where short selling activity is permitted.

One of the factors which has restrained the development of a hedge fund industry in Asia has been the restriction on short selling of securities imposed in most of the Asian jurisdictions.

The current interest in hedge funds is primarily concentrated on long/short funds. As these funds do not qualify for authorisation, they can only be sold in Hong Kong in an offer which does not constitute an offer to the public.

REGULATORY PARAMETERS

The principal securities requirements for offers of securities in Hong Kong are contained in the Companies Ordinance, the Protection of Investors Ordinance and the Securities Ordinance.

The Companies Ordinance provisions do not apply to a fund constituted as a unit trust, but such vehicles are not common in the hedge fund industry: trustees are concerned that the leverage strategies of hedge funds may result in the trustee incurring personal liability.

The Companies Ordinance prohibits any person from issuing, circulating or distributing in Hong Kong any `prospectus' offering for subscription shares in, or debentures of, a company incorporated outside Hong Kong, whether that company has established a place of business in Hong Kong or not, unless the prospectus complies with the various requirements of Part XII of, and the Third Schedule to, the Companies Ordinance.

Failure to register a complying prospectus can result in the fund and any person who is knowingly a party to the issue of the prospectus (or any application form) being liable for a fine of up to HK$100,000. Additional penalties (including fines of up to HK$500,000 and imprisonment for up to three years) may also be incurred for matters such as the prospectus containing an untrue statement.

The term `prospectus' is widely defined in the Companies Ordinance to mean:

any prospectus, notice, circular, brochure, advertisement, or other document,

OFFER TO 'THE PUBLIC'

In order to be exempt from the requirement to prepare and register a prospectus, it is necessary to establish that the offer is either not made to `the public' (as a matter of common law) or the offer falls within one of the available statutory exemptions.

The term 'public' is not defined, and there have been no judicial decisions in Hong Kong on this point. However, the Companies Ordinance states that references to offering shares to the public include references to offering them to any section of the public, including where selected as clients of the person issuing the prospectus or in any other manner. Despite this, many intermediaries and private banks appear to operate under the misapprehension that an offer which is made only to their own clients is not an offer to the public.

There are two available exemptions which are likely to be applicable, namely:

• professionals only - where the offer is made only to those such as fund managers, certain divisions of banks, insurance companies and certain pension funds. High net worth individuals are not professional investors unless they carry on a business of investing; and

• private placement - which, as its name suggests, is often relied on in connection with private placements or offerings to a limited number of persons.

PROFESSIONALS ONLY EXEMPTION

Section 343(2) of the Companies Ordinance provides that a document offering shares or debentures only to persons `whose ordinary business is to buy or sell shares or debentures, whether as principal or agent' need not comply with the prospectus requirements. This definition of `professionals' is restrictive.

Relevant points include the following:

• dealers in securities and professional fund managers would qualify;

• investors who are not buying or selling shares or debentures by way of their ordinary business will not qualify - therefore the exemption is unlikely to extend to high net worth individuals or commercial or industrial companies however large, but it could apply to banks or insurance companies with established proprietary trading desks or investment trading subsidiaries;

• the equivalent phrase in the Chinese version of the Companies Ordinance translates as `ordinary course of business', so that the definition may in fact be wider than at first appears; and

• a person who qualifies as a `professional' for these purposes cannot be regarded as simply a conduit for the distribution of offering materials to a wider group of `non-professional' investors, being, for instance, the customers of an intermediary.

PRIVATE PLACEMENT EXEMPTION

A formal prospectus is only necessary where securities are offered to the public. The requirements do not apply to a private offer.

The Companies Ordinance states that an offer or an invitation is not required to be treated as being made to the public if it can properly be regarded, in all the circumstances, as not being calculated (ie, likely) to result, directly or indirectly, in the shares becoming available for subscription or purchase by persons other than those receiving the offer, or otherwise as being a domestic concern of the persons making and receiving it.

It is desirable for these purposes to obtain from placees both representations as to long-term investment intentions and a lock-up undertaking of a minimum of six months. It must, however, also be reasonable to rely on these representations and the undertaking when given. In this respect, the number of placees should be small enough to make the placement reasonably controllable and regard should be had to the relationship between the issuer and the distributor and the relevant investor (eg, whether they deal with them regularly and can trust them to comply with their undertakings and the character of the investors themselves, their trading history and investment strategies).

In addition, a substantial body of market practice has developed in Hong Kong in relation to the requirements for private placements. These can be summarised as follows:

• the offer in Hong Kong must be made to a strictly limited number of offerees (not final investors): we recommend limiting the number of offerees in Hong Kong to a maximum of 50 persons, although there is no guarantee that limiting the number to 50 would be decisive. The fewer offerees involved, the less likelihood there is of the issue being regarded as an offer to the public;

• only the offeree to whom the offer is made (or, if a company, its subsidiary) should be capable of accepting the offer and taking up the securities;

• the offeree should give the long-term investment representations and six month lock-up undertaking referred to above;

• each offer document should be numbered and marked to indicate the offeree to whom it is addressed, and records should be kept accordingly;

• the offer document should contain appropriate wording indicating the restricted nature of the offering and should expressly note that the offer document should not be passed to any other person;

• the minimum number of securities to be acquired should be sufficiently high to make it clear that the offer is only intended for investors of substantial means;

• participation should be in registered form; and

• there must be no advertising, press release or press conference relating to the proposed offering.

There is no case law as to what the maximum number of offerees for a private placement may be. However, the SFC has stated:

'It appears that some members of the industry believe that it is the SFC's view that an offer to 50 or less investors is not an offer to the public. This is not the case now, nor will it be in the future. Whether a particular offer is an offer to the public will continue to be determined under the law and on the facts of each case.'

A consultation paper some years ago on the laws relating to offers of securities recommended an exemption for private placements to 50 or fewer investors, and recorded the fact that it used to be the SFC's practice to give informal guidance to the effect that an offer to no more than 50 people was not an offer to the public. The fact that a wider offering is being made outside Hong Kong will not prejudice a private placement in Hong Kong: offers outside Hong Kong will be disregarded in determining whether a public offer has been made in Hong Kong.

For all practical purposes, an offering made in compliance with the Companies Ordinance `professionals only' or `private placement' exemptions will also comply with the Protection of Investors Ordinance.

As well as the restrictions described above, various other requirements may also apply to any offer of securities. The main ones are summarised below.

'WRITTEN OFFER' REQUIREMENT

The Securities Ordinance provides that (with certain exceptions) a `dealer' may not in Hong Kong communicate an offer to acquire or dispose of securities of a corporation unless, among other things, the offer is written in English or Chinese (with a translation) and contains the information specified in section 72(1)(b) and Second Schedule to the Securities Ordinance (which is not extensive).

A 'dealer' is defined in the Securities Ordinance to mean a person (whether in Hong Kong or overseas) who carries on a business of dealing in securities, but does not include:

• a solicitor or professional accountant whose carrying on business as a dealer is wholly incidental to the practice of his profession;

• except where specifically provided in the Securities Ordinance, an exempt dealer (being a person declared as an exempt dealer by the SFC); or

• a recognised clearing house.

Any distribution activities in Hong Kong should be conducted by a registered or exempt dealer.

The Securities Ordinance also contains prohibitions against hawking securities and cold-calling.

CONSULTATION PAPER ON HEDGE FUND DISTRIBUTION

The SFC has announced that it is proposing to issue a consultation paper on the distribution of hedge funds. Indications are that the SFC would view favourably changes to the law to permit the sale of hedge funds on a wider basis than is presently permitted.

Much of the capital invested in hedge funds worldwide is sourced from high net worth individuals. At present, this source can only be accessed in Hong Kong by way of private placement with strictly limited distribution.

The Monetary Authority of Singapore issued guidelines in June 2001 which permit hedge funds to be sold to the public in Singapore if the funds have a minimum initial subscription per investor of S$100,000. The manager must have at least two executives each with a minimum of five years' relevant experience, and the guidelines contain a number of disclosure requirements (including specific risk warnings).

It seems likely that the SFC's consultation paper will discuss proposals to permit hedge funds to be sold freely (ie, without limitation on the number of investors) to high net worth individuals and to commercial enterprises which meet various assets and/or income tests.

Managers wishing to take advantage of the new rules will probably be required to impose a high minimum subscription in respect of the hedge funds they wish to sell to qualifying investors, but would not be obliged to comply with investment restrictions and operational requirements applicable to conventional funds. This will constitute a fundamental shift in approach and thinking by the regulator. However, there will probably be relatively onerous disclosure obligations imposed on the manager in relation to the contents of offer documents and accounts for these types of funds.

It was expected that the paper would be issued at the end of August, with the consultation period to be completed by the end of October. However, it has recently been reported that the issue of the consultation paper may be delayed until the end of October. One factor which may affect the process is that it has just been announced that Andrew Procter, the Executive Director of the SFC responsible for the Investment Products Division and a key supporter of the review, will be leaving the SFC shortly to join the FSA in the UK.

Nevertheless, the recent initiatives are an important development for the funds industry in Hong Kong. Concerns have been expressed by some managers that Hong Kong is lagging behind Singapore on this issue. However, many traditional managers are wary of any proposal to open up the market to hedge funds, so the consultation paper will be viewed with a keen interest by both proponents and opponents of the hedge fund industry.

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.