This article was first published on Thomson Reuters Regulatory Intelligence on March 9, 2021.
In June 2018, the Hong Kong Securities and Futures Commission (SFC) introduced the legal and regulatory framework for the open-ended fund company (OFC) regime. Two years later, it became clear the structure needed a rethink, with only five OFCs having been established in Hong Kong during that time. In late 2020, following market consultation, the SFC brought in some important enhancements to the OFC regime to increase its competitiveness and boost its adoption by open-ended funds. This article outlines the changes to be aware of, and explores the opportunities this will provide for fund managers.
Background to the OFC regime
The OFC regime allows investment funds to be established in Hong Kong in a corporate form. Open-ended funds work in a similar way to unit trusts, and can increase or decrease their capital or the distribution of their capital without the approval of the shareholder(s) of the company.
The main features of an OFC are that it:
What are the changes to the OFC regime and why were they made?
The changes to the OFC regime mirror similar legislative amendments implemented in other financial jurisdictions such as Luxembourg, Singapore and Ireland in the last year, as they look to attract new investors. The updated OFC, along with the new limited partnership fund (LPF) in Hong Kong, are designed to further strengthen Hong Kong’s position as a leading international hub for the fund management industry. In the recent Hong Kong budget it was disclosed that 11 OFCs have already been established.
The major enhancements made by the SFC following a market consultation include, but are not limited to:
What does the removal of investment restrictions mean in practice?
An important change is the removal of investment restrictions for private OFCs, enabling them to invest in all asset classes. The investment restrictions will now be as per the investment objective of the OFC as disclosed in its offering document. The overriding restriction that an OFC must not be a business undertaking for general commercial or industrial purposes will continue to apply, however.
Private OFCs can now invest in shares and debentures of private companies, non-financial assets (i.e., real estate and infrastructure projects) and more exotic asset classes (such as virtual assets). Disclosure is required, however, when the OFC intends to invest 10% or more of its gross asset value in these non-financial or other less common asset classes.
Who is now eligible to be the custodian of private OFCs and what are their obligations?
Added to the list of custodians set out in the Code on Unit Trusts and Mutual Funds (UT Code), entities holding a Type 1 regulated activity licence can now act as custodians of an OFC, provided their licence conditions do not prohibit them from holding client (i.e., the OFC) assets. If the custodian is a licensed corporation then it has at all times to maintain paid-up share capital of not less than HK$10 million and liquid capital of not less than HK$3 million.
The custodian must be independent of the investment manager and have sufficient experience and competence in safekeeping the asset type in which the OFC invests. The custodian must maintain internal controls and systems commensurate with the custodial risks specific to the nature of assets in which the OFC invests, and have at least one responsible officer or executive officer responsible for the overall management and supervision of its custodial function.
These changes dramatically increase the choice of custodians, as Type 1 licensed corporations become eligible, with a concurrent fall in costs for the OFC.
Who are mandatory intermediaries and what is their role?
An OFC must be managed by an investment manager who has a Type 9 (asset management) regulated activity licence issued by the SFC. The OFC should delegate to the investment manager, at a minimum, the function of the investment management, valuation and pricing of the scheme property. An OFC should appoint an auditor who is independent of the investment manager, the custodian and the directors of the OFC. The OFC’s accounts should be compliant with Hong Kong Financial Reporting Standards or International Financial Reporting Standards.
What does the proposed re-domiciliation mechanism of overseas corporate funds mean to managers?
The industry has welcomed the re-domiciliation mechanism in particular as a way to further promote Hong Kong as an asset management hub in Asia. There is a growing trend for offshore funds to move onshore, as international tax and law practice continues to evolve. Economic substance requirements and the increasing need for transparency in connection with the Organisation for Economic Cooperation Development’s (OECD) BEPS 2.0 package mean that offshore jurisdictions will increasingly come under scrutiny, and the costs of staying compliant are likely to rise.
Hong Kong’s February budget revealed plans for a legislative proposal in the second quarter of 2021 which would allow foreign investment funds to re-domicile to Hong Kong as OFCs or LPFs. The budget also proposed the provision of government subsidies to cover 70% of the expenses paid to local financial service providers for OFCs set up in, or re-domiciled to, Hong Kong in the next three years, subject to a cap of $1 million per structure.
This new structure not only provides a supportive regulatory environment for new funds to be established in Hong Kong but also creates an attractive proposition for managers in other jurisdictions who might be looking to redomicile. There has already been a higher level of interest from managers looking to establish parallel structures to their existing offshore funds.
What are the proposed changes to customer due diligence requirements?
The SFC is consulting further on the client due diligence requirements for OFCs. At present, there is no prescribed anti-money laundering/countering terrorist financing (AML/CTF) obligation imposed on OFCs, and the investment manager of each OFC is expected to carry out the relevant AML/CTF measures.
The consultation also proposes that all retail and private OFCs keep a register of significant controllers, similar to the requirement under the Companies Ordinance for all other conventional companies, to provide transparency about corporate beneficial ownership of OFCs.
Given the open-ended nature of the OFC, however, there would be significant challenges in keeping a register of significant controllers, as the investors in a public OFC change constantly due to the frequent subscription and redemption of shares in retail funds.
The SFC has proposed, therefore, that an OFC will be required to appoint a responsible person to perform AML/CTF functions, in line with the requirements imposed for LPFs.
Adoption and outlook
The reforms outlined above have been welcomed by many in the industry as a way of addressing concerns that the previous OFC regime was restrictive, lacked flexibility and did not offer an appropriate alternative to the fund structures in other developed jurisdictions. They should enable the OFC to become the fund structure of choice for Hong Kong open-ended fund managers. As well as having the benefit of being in scope of a single regulator, Hong Kong offers lower government fees than many offshore jurisdictions and has a healthy and competitive ecosystem of service providers. The latest proposals provide further financial incentives for the establishment of new OFCs and the re-domiciliation of foreign funds.
The changes are likely to increase the rate of adoption of the OFC structure and will help to further cement Hong Kong’s position as a leading investment funds hub in Asia. The outlook is encouraging, and the author has already seen a substantial increase in inbound enquiries regarding such structures.
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