In order to better regulate depositaries of public collective investment schemes (“CIS”) the Securities and Futures Commission (“SFC”) issued a consultation paper on 27 September 2019 (the “Consultation Paper”) on the proposal to establish a regulatory regime over depositaries of SFC-authorised CIS, under which the SFC shall be empowered to take disciplinary or other enforcement actions against trustees and custodians (the “Proposed Regime”). The Consultation Paper is part of the SFC’s strategy to strengthen Hong Kong as an international full service asset management centre and to enhance the regulation of public funds.
Collective Investment Schemes
CIS is defined under Schedule 1 of the Securities and Futures Ordinance (Cap. 571) (“SFO”) to apply to investment products of a collective nature. Common types of CIS familiar to investors include, mutual funds and unit trusts, mandatory provident fund schemes and real estate investment trust. CIS generally comprises of the following four elements:
- it must involve an arrangement in respect of property (property is widely defined under the SFO and could include money, goods, choses in action and real estate – whether local or overseas);
- participants do not have day-to-day control over the management of the property even if they have the right to be consulted or to give directions about the management of the property;
- the property is managed as a whole by or on behalf of the person operating the arrangements, and/or the contributions of the participants and the profits or income from which payments are made to them are pooled; and
- the purpose of the arrangement is for participants to participate in or receive profits, income or other returns from the acquisition or management of the property.
The Financial Secretary is empowered under the SFO to prescribe by notice in the Gazette that certain products are, or not to be regarded as CIS. Under the current regulatory regime, CIS offered to retail investors in Hong Kong are authorised and regulated under section 104 of the SFO and relevant SFC’s product codes, which include, the Code on Unit Trusts and Mutual Funds (“UT Code”), the Code on Real Estate Investment Trusts, the Code on Pooled Retirement Funds and the Code on Open-Ended Fund Companies (collectively, the “Product Codes”). The Product Codes typically set out structural requirements such as the eligibility of scheme operators and investment restrictions for the scheme such as the need for offering documents to contain all the key features and key risks for investors to make informed decisions. The Product Codes also set out various ongoing disclosure requirements for the relevant CIS.
Given the nature of CIS is, in essence, asking investors for a mandate to discretionarily invest in a portfolio of securities and futures, it is necessary to have investor protection to ensure that the operators of a CIS such as the fund manager meet the eligibility requirements laid down in the relevant Product Codes before they can operate to run the CIS.
Under section 103 of the SFO, it is an offence for an operator to offer or sell CIS, or issue an advertisement, invitation or document which contains an invitation to the public to acquire an interest in or participate in CIS without obtaining authorisation from the SFC.
The principal activity of trustees and custodians of CIS is the custody of assets within CIS. Apart from this, certain trustees and custodians are responsible for other functions such as independent monitoring and overseeing of CIS assets and other administrative services.
Reasons for establishing the Proposed Regime
Trustees and custodians of public funds in Hong Kong are currently not subject to any specific licensing regime. Since there is a lack of a specific direct regulatory handle, the SFC does not have supervisory powers over such trustees and custodians. Public authorities such as the Mandatory Provident Fund Schemes Authority, Hong Kong Monetary Authority (“HKMA”) and Insurance Authority merely had limited or indirect regulatory powers over certain trustees and custodians.
As a result, compared to major overseas markets such as United Kingdom and Singapore, Hong Kong lacked a direct supervision over entities that provide trustee, custodial or depositary services for public funds. The SFC considers it of paramount importance to promote an effective regulation over them in order to protect retail investors of public funds. In order to align with the international practice, the SFC therefore proposes to introduce a new regulated activity under Schedule 5 to the SFO namely, “Type 13 regulated activity – acting as a depositary (trustee/custodian) of an SFC-authorised CIS” (“RA 13”).
Proposed scope of RA 13
The term “depositary” shall be used under the Proposed Regime for the intermediary licensed or registered under RA 13, which shall cover “top-level” trustees and custodians, i.e. the entity at the top of the custodial chain. For a relevant CIS structured in the form of a unit trust, this entity shall be the person appointed as the trustee pursuant to the trust deed which constitutes or governs such CIS. For a relevant CIS structured in any other form such as an open-ended fund company authorised under the SFO or a mutual fund corporation, it shall be the person who is appointed to perform the functions of a custodian pursuant to a written agreement entered into between the person and such CIS. A depositary’s nominees, agents and delegates, such as a sub-custodian or the global custodian appointed by a “top-level” trustee, shall not fall within the proposed scope of RA 13.
CIS included in the Proposed Regime would be schemes or funds authorised by the SFC under section 104 of the SFO, including unit trusts, mutual fund companies, real estate investment trusts, pooled retirement funds authorised under the SFO and open-ended fund companies that are registered and authorised under the SFO and governed by the Product Codes.
It is proposed that since MPF-approved trustees are already subject to the Mandatory Provident Fund Schemes Authority’s regulation and supervision, trustee services relating only to pure MPF products that are offered to MPF schemes, employers and employees or professional investors (as opposed to retail investors) shall not be required to be licensed or registered under RA 13.
Proposed regulatory framework
Corporations carrying on a business in RA 13 (i.e. acting as a depositary) are required to be licensed by or registered with the SFC. This requirement also extends to individuals performing any regulated function in relation to an intermediary’s business of “acting as a depositary”, who shall be required to be licensed representatives or relevant individuals accredited to the intermediary. This applies to staff members who perform more than a clerical role in a business function directly relating to the depositary’s discharge of its regulatory obligations set out in the Product Codes. Clerical staff members who perform operational tasks are generally not required to be licensed or registered under the Proposed Regime.
While “top-level” trustees and custodians may delegate their functions to third parties, the responsibilities of an RA 13 depositary with respect to these functions remain with the depositary. The “top-level” entities have the responsibility to exercise reasonable care, skill and diligence in the selection and monitoring of delegates.
A person applying for a licence or registration to carry on a regulated activity must satisfy the SFC that he or she is fit and proper to be licensed or registered. Similarly, registered institutions should ensure that their relevant individuals are fit and proper to be engaged. Existing licensing criteria shall apply equally to firms and individuals seeking to be licensed by or registered with the SFC under RA 13. It was specified in the Consultation Paper that the Guidelines on Competence shall be amended to set out the recognised industry qualifications and the local regulatory framework papers applicable to RA 13.
Financial resources requirements
Pursuant to the Securities and Futures (Financial Resources) Rules (Cap. 571N), the SFC proposed that corporations licensed to carry on a business as a depositary under RA 13 must maintain adequate financial resources as follows:
- a minimum paid-up share capital of HK$10,000,000 which is similar to the current requirement under the Product Codes; and
- a minimum liquid capital of HK$3,000,000.
Professional indemnity insurance requirement
The SFC also proposed to impose a non-statutory requirement for an RA 13 depositary to maintain a professional indemnity insurance policy which provides adequate coverage for claims for liability arising from breaches of duty in the course of carrying on its RA 13 business.
Conduct and internal controls requirements
RA 13 depositaries and individuals shall be governed by the applicable legal and regulatory requirements including the SFO, and guidelines issued by the SFC, such as the Code of Conduct for Persons Licensed by or Registered with the SFC (the “Code of Conduct”) and the Management, Supervision, and Internal Control Guidelines for Persons Licensed by or Registered with the SFC.
An RA 13 depositary is required to meet the existing provisions in the Product Codes, which shall be revised to cater for the specific nature of each type of product where necessary to reflect the introduction of RA 13. For example, under the UT Code, since depositaries shall be subject to the SFC’s ongoing supervision (or HKMA’s supervision in case of registered institutions), it is proposed to remove the current requirement to submit the annual internal control reports to the SFC. It should be noted that any consequential amendments to subsidiary legislations will be subject to further public consultation and the legislative process.
Furthermore, the SFC proposed to include in the Code of Conduct a new Schedule 11 which shall provide guidance on the internal controls that an RA 13 depositary is required to put in place. The senior management of an RA 13 depositary is responsible to exercise professional judgment to implement internal controls systems in accordance with the proposed Schedule 11.
Transitional arrangements for existing staff of depositaries
Given that depositaries of SFC-authorised CIS have been in operation in Hong Kong for a long period of time and are largely managed by experienced staff, the SFC proposed to adopt a “grandfathering” approach to include existing staff of the depositaries under the Proposed Regime. These staff shall be assessed according to academic qualification, relevant industry experience and management experience tests. They shall be required to complete a course of not less than five hours on the legal and regulatory framework for RA 13 conducted by a continuous professional training provider within 12 months of securing licensing or registration approval, and do not need to complete the abovementioned local regulatory framework papers.
Since the depositaries of CIS are entrusted with the custody of assets of CIS, it is expected that the Proposed Regime shall provide a comprehensive regulatory system over intermediaries that provide trustee and custodial services in Hong Kong to adequately safeguard CIS assets and effectively protect interests of retail investors. The consultation is open until 31 December 2019.
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|Published by ONC Lawyers © 2019|