Timing of derivative fund categorisation for SFC-authorised funds

The industry has a 12-month transition period from 1 January 2019 to categorise and notify the SFC whether their SFC-authorised funds are “derivative funds” (i.e. they have more than 50% net derivative exposure). However, we would recommend commencing the process sooner rather than later. Reference should be made to the Guide on the Use of Financial Derivative Instruments for Unit Trusts and Mutual Funds (Derivative Guide) which is available here.

As part of the current sales process, an intermediary needs to conduct product due diligence (including making appropriate enquiries of the issuer) in order to understand the product and its use of derivatives, and the intermediary must characterise their clients based on their knowledge of derivatives (see 5.1A(a) of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct). Many intermediaries are reluctant to distribute derivative funds/products because of compliance concerns over their obligation to satisfy themselves that their clients have the requisite knowledge of derivatives.

Under the revised Code of Conduct (scheduled to come into effect on 6 April 2019), intermediaries must determine whether a product they are selling is a complex product for the purpose of complying with their suitability obligations. In making such determination, intermediaries are required to exercise due skill, care and diligence having regard to the factors set out in the notes to paragraph 5.5 of the revised Code of Conduct. An SFC-authorised fund which has been confirmed as a derivative fund will be deemed to be a complex product for the purposes of the revised Code of Conduct, thereby triggering suitability obligations even though there is no solicitation/recommendation or investment advice (see the article in our newsletter of 23 January 2019) unless the fund is traded on an exchange in Hong Kong or in a specified jurisdiction. The list of specified jurisdictions is available here. In the case of SFC-authorised funds it seems likely (and reasonable) that intermediaries will seek to rely on a fund’s categorisation/registration appearing on the SFC’s website, for the purpose of determining whether a fund is a derivative fund.

The benefits of commencing such categorisation as soon as possible include:

  1. Early categorisation and registration of a fund with the SFC as a non-derivative fund should facilitate distribution arrangements with intermediaries. Intermediaries are likely to rely on the SFC register in determining whether a fund is a derivative fund (and therefore a complex product requiring a suitability and derivative knowledge assessment under the new conduct requirements of the Code of Conduct which takes effect from 6 April 2019).

  2. An SFC-authorised fund which has been categorised/registered as a non-derivative fund is unlikely to be a complex product.

  3. It is possible that certain funds which are currently categorised as derivative funds by some intermediaries as a result of their usage of derivatives for investment purposes may not be so categorised under the Derivative Guide, which will facilitate distribution going forward.

  4. Pursuant to the Derivative Guide, it is the responsibility of the fund manager to determine whether a fund is or is not a derivative fund. It seems reasonable for intermediaries to rely on the fund manager’s categorisation of a fund following its publication on the SFC’s register of authorised funds.