Author: Rory Gallaher
Service Area: Financial Services
Date: August 2012
Country: Hong Kong


Financial Services Newsletter
Issue 5 of 2012: August


New U.S. swap regulations – Impact on Asian private fund managers

by Rory Gallaher ( and
Ethan W. Johnson (

As part of the Dodd-Frank Act's sweeping changes in the
U.S. regulatory regime governing the financial industry, a non-U.S. fund manager may need to register as a commodity pool operator (CPO) with the U.S. Commodity Futures Trading Commission (CFTC) and become a member of the National Futures Association (NFA).

What has happened?

  1. The most relied-upon exemption from CPO registration – set out in CFTC Rule 4.13(a)(4) – has been repealed; and
  2. The CFTC's authority over non-U.S. funds and their managers is to be extended by the inclusion of most swaps and forwards within the definition of regulated commodity interests.

Do any useful exemptions remain?

CFTC Rule 4.13(a)(3) exempts a hedge fund manager or adviser from registration as a CPO if the fund meets a de minimis test for its commodity interest trading. However, from 31 December 2012 onwards, certain swaps and non-deliverable forwards will be considered as commodity interests for the purposes of determining eligibility to rely on this exemption. The swap definitional rules were approved by the CFTC and the SEC on 10 July 2012 and will become effective on 12 October 2012.

The de minimis test in CFTC Rule 4.13(a)(3) covers managers of funds with commodity interest positions, including swaps, whether entered into for hedging purposes or otherwise, for which either (a) the aggregate initial margin and option premiums will not exceed 5% of the liquidation value (NAV) of the fund; or (b) the aggregate net notional value does not exceed 100% of the liquidation value (NAV) of the fund. The de minimis test is calculated separately for each fund managed by the manager or adviser.

Who needs to register?

The rules are being interpreted to apply to any manager of a non-U.S. private fund that has at least one U.S. investor. A manager of such a fund is required to register as a CPO unless one of the de minimis tests in Rule 4.13(a)(3) apply. To claim an exemption from CPO registration under
Rule 4.13(a)(3), a manager must make a notice filing with the NFA.

What is the timing?

Managers of funds formed on or before 24 April 2012, including those managers formerly relying on the 4.13(a)(4) exemption must register as a CPO by 31 December 2012 or claim an exemption from registration under 4.13(a)(3) by meeting one of the de minimis tests. Managers of funds formed on or after 10 July 2012 that would have been able to rely on the exemption from CPO registration in Rule 4.13(a)(4) are eligible for no-action relief from the CFTC that would allow them until 31 December 2012 to register as a CPO or claim an exemption from registration. A manager of a fund launched after 24 April 2012 but on or before 10 July 2012 should have registered as a CPO unless they could claim an exemption from CPO registration under Rule 4.13(a)(3) by meeting one of the de minimis tests.

How difficult is it to register?

The registration process is reasonably straight-forward and only requires the filing of electronic forms containing certain information regarding the CPO and biographical information regarding the principals and associated persons (APs) of the CPO. Principals generally include persons that are executive officers or owners of the CPO. APs generally include persons that solicit investors or supervise the solicitation process. However, APs must be registered with the NFA and have passed a competency exam (FINRA Series 3). Portfolio managers generally do not need to be registered with the NFA unless they are principals or APs.

What are the implications of registration?

CPOs must comply with applicable U.S. commodity futures laws and regulations, will be subject to the jurisdiction of the NFA and CFTC, will be subject to occasional examination by the NFA, and must file periodic reports with the CFTC and NFA on form CPO-PQR. CPOs that operate pools that are not exempt under CFTC Rule 4.7 also will be subject to extensive disclosure, reporting and record-keeping requirements.

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Clarification of short position reporting obligations for partnerships
by Scott Carnachan (

Hong Kong's new short position reporting rules, the Securities and Futures (Short Position Reporting) Rules, came into effect on 18 June 2012. The Securities and Futures Commission (SFC) revised its FAQ shortly prior to the first reporting date to simplify the reporting process for partnerships. The change is of particular relevance to limited partnerships.

The Rules contemplate that the partners in a partnership can authorise one of the partners or a third party to report short positions on behalf of all the partners. The original process required the relevant partner or third party to disclose the name, address and contact details of all partners in the partnership at the time it registered with the SFC for a short position reporting ID. Under the revised FAQ, the SFC has stated that it is no longer necessary to disclose the name, address and contact details of the partners, either at the time of registration or at the time of making a report. However, if the SFC asks subsequently, you must provide a full and complete list of partners.

For limited partnerships, the revised FAQ means that the general partner can report on behalf of the partnership without disclosing details of the limited partners. As a result, limited partnerships are treated in a similar manner to unit trusts, where the trustee is required to report short positions of the trust but not of individual beneficiaries under the trust.

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Side letters - Know your rights
by Scott Carnachan (

A recent case in the Cayman Islands has once again raised the importance of understanding what rights side letters give fund investors, and how those rights can be lost.

Medley Opportunity Fund, Ltd v. Fintan Master Fund, Ltd and Nautical Nominees Limited involved a dispute arising from the terms of a side letter that Fintan and Medley had agreed when Fintan (through its nominee) invested in Medley. The court found that Fintan was not able to exercise its preferential redemption rights under the side letter because:

  1. although Fintan had signed the side letter, it was not a shareholder in Medley; rather, Fintan's nominee was the shareholder;
  2. the terms of Medley's restructuring made after the date of Fintan's investment and agreed by Fintan's nominee overrode the redemption provisions in Medley's articles - the restructurings were proposed after Medley encountered liquidity issues in 2008. Under the restructurings, investors' redemption rights were limited in return for quarterly distributions of excess cash pro rata to those investors who had agreed to the restructurings. Fintan's nominee was one of the investors that signed documents agreeing to the restructurings of Medley.

So, fund investors take note. Make sure the legal entity that will be registered as the investor signs the side letter. And, review fund restructuring proposals carefully against any preferential terms you have agreed in a side letter to ensure you don't inadvertently give up those rights.

Fund managers also need to be careful when entering into and amending side letters, to ensure that the terms reflect legal and regulatory requirements as well as commercial terms. Hong Kong's Securities and Futures Commission will generally ask fund managers to provide copies of side letters and the disclosures that have been made to fund investors about side letters when the Commission conducts routine inspections.

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The regulation of electronic trading in Hong Kong
by Peter Poon (

Hong Kong's Securities and Futures Commission (SFC) issued a consultation paper on 24 July 2012 on the regulation of electronic trading and has requested comments by 24 September 2012. The paper is available here:

The SFC's objective is to build on existing regulatory requirements to provide a more coherent and comprehensive regulatory framework for electronic trading. The new requirements would apply to all banks, fund houses and brokers which use electronic trading systems or provide electronic trading systems to clients.

The proposals consist of general requirements on electronic trading as well as specific requirements for internet trading, direct market access (DMA) and algorithmic trading. The SFC has proposed amending both the general SFC Code of Conduct and the Fund Manager Code of Conduct as well as the Internal Control Guidelines.

The SFC's proposals replicate certain checks and balances which exist in a traditional trading environment to enable prompt assessment of a client's creditworthiness, identification of possible errors in an order, potential short selling / market manipulation and comparison with a client's usual trading patterns prior to execution of an order.

Key new requirements proposed by the SFC include:

(a) in relation to all electronic trading:

  1. intermediaries will be ultimately responsible for the orders
  2. at least one responsible officer will take up overall responsibility
  3. audit logs / incident reports will be kept for at least two years

(b) in relation to internet trading and DMA, firms have:

  1. automated risk management controls
  2. post-trade monitoring
  3. brakes on suspected manipulative or abusive trading activities

(c) firms engaging in algorithmic trading should ensure that their system designers/developers and users have relevant regulatory knowledge.

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SFC AML fining guidelines
by Nick Chiu ( and
Jane McBride (

On 29 June 2012, Hong Kong's Securities and Futures Commission (SFC) published its Disciplinary Fining Guidelines under the Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance (AMLO) to indicate how it will exercise its power to impose fines under this new AML legislation.

The guidelines came into effect on 1 July 2012 and are largely consistent with the previous guidelines published in 2003. The SFC has restated its policy of publishing all fining decisions.

Key points under "General considerations" are:

  • intentional / reckless conduct is more serious than negligent conduct
  • conduct that hurts Hong Kong's reputation (note this is not in the 2003 guidelines), damages the integrity of the securities and futures market or that facilitates or increases the risk of money laundering or terrorist financing, is taken seriously
  • typically, "technical" breaches are considered less serious

In terms of the "Specific considerations", the SFC will consider whether the firm:

  • sought prior advice from its advisors
  • brought the conduct to the SFC's attention quickly
  • cooperated closely with the SFC
  • took remedial steps after the conduct was identified
  • took disciplinary action against those involved
  • has a previous disciplinary record

The SFC will also consider whether the conduct was "one-off"; was wide-spread in the industry; or reveals serious or systemic weaknesses particularly in respect of the firm's customer due diligence and record-keeping procedures.

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SFC licensing and compliance hints
by Rebecca Yip ( and
Albert Chan (

Grace period: When the SFC gives an applicant six months to pass a licensing exam, it is important to remember that this is a "one-off" grace period. If the applicant has not passed the paper within six months, the licence will automatically lapse. The SFC is usually very reluctant to grant extensions to this grace period.

Board approval: In responsible officer applications, the individual must declare that the board of directors has resolved to appoint him/her as an RO to supervise the business of regulated activities. The RO application form can only be signed after the board resolution has been passed.

CAD: Participation in the Common Anniversary Date programme is optional and enables a licensed company or group to select one CAD on which to submit the annual returns and fees for all the companies and licensed individuals concerned. Participation can reduce administrative time and costs. The specific date is up to the licensees, subject to SFC approval.

New SFC website and forms: The SFC has revamped its website. There are some interesting additions (including statistics on on-site inspections) and users can now follow amendments to the codes and guidelines online. The SFC has also amended the licensing forms with immediate effect. As a result of the new forms:

  1. licensed companies, corporate substantial shareholders and corporate directors need to complete a vetting authorisation form;
  2. corporate substantial shareholders and corporate directors are required to provide copies of their incorporation documents;
  3. boards can appoint authorised signatories to sign; and
  4. new corporate licence applicants do not need to provide client agreements.

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Recent Deacons' publications

Closer Economic Partnership Arrangement Between Mainland China and Hong Kong

China Legal Alert, Issue August 2012

Hong Kong's OTC derivatives proposals – What do they mean for asset managers?

Litigation & Dispute Resolution Newsletter, Issue 4 of 2012: August

Hong Kong's New Competition Ordinance

Companies Ordinance 2012

Opportunities for Foreign Investment in the Distribution Sector

Key Employment Tips for China Operations

China Legal Alert, Issue July 2012

Amendments to Hong Kong's Data Privacy Regime

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.