Regulation of collective investment schemes

In the February 2015 issue of our Regulatory Compliance newsletter, we introduced the collective investment scheme (“CIS”) and how they are regulated under the Securities and Futures Ordinance (Cap 571)(“SFO”). To recap briefly, under section 103(1) of the SFO, it is an offence to issue an advertisement which is or contains an invitation to the public to acquire, or offer to acquire, an interest in or participate in a CIS without the prior authorization of the Securities and Futures Commission (“SFC”).

However, there is a list of exemptions under which the issue of such invitation will not constitute an offence even without the authorization of SFC. One of such exemptions as provided in section 103(3)(k) SFO is the case where the issue, or the possession for the purposes of issue of any advertisement, invitation or document made in respect of the CIS, that are or are intended to be disposed of only to professional investors.

In Securities and Futures Commission v Pacific Sun Advisors Ltd, FACC 11/2014, the Court of Final Appeal (the “CFA”) made an important decision on what a person must show in order to trigger the exemption under section 103(3)(k) SFO. As will be explained below, the CFA found that such a person would simply need to prove, from the substance of the CIS in question, that the CIS was in fact intended for a professional investor.

Advertisement to all, but intended only to a few

The material facts of the case are undisputed. Here, the 1^st Defendant (“D1”) is a company of which the 2^nd Defendant (“D2”) is the Chief Executive Officer. D1 sent an email (prepared by D2) to various recipients. The email announced the launch of a CIS and attached a press release to the same effect. D1 also published 3 documents relating to the CIS on its website.

It is undisputed that the press release and the 3 documents published on D1’s website were advertisements for the CIS issued to the public or a sector of the public without authorization from SFC. Therefore, on the face of it, D1 and D2 contravened section 103(1) SFO. However, from the evidence, the Magistrates’ Court found that the CIS was or was intended to be available solely to professional investors instead of one for the general public, but such fact was not expressed in the advertisements themselves. The Magistrate eventually acquitted D1 and D2 under section 103(3)(k) SFO as he found that the CIS was or was intended to be available solely to professional investors and not one for investment by the general public. SFC appealed.

The Court of First Instance allowed SFC’s appeal and held that, for section 103(3)(k) to apply, it was necessary for it be seen from the advertisement itself whether it was, by its terms, confined to professional investors to the exclusion of other members of the investing public. In effect, it must be demonstrated from the advertisement in question that the relevant CIS was or was intended to be disposed of only to professional investors. In failing to do so in the advertisements, D1 and D2 could not rely on the section 103(3)(k) exemption and thus contravened section 103(1) of the SFO.

D1 and D2 appealed to the CFA.

The correct approach?

The CFA decided in favour of D1 and D2’s construction of section 103(3)(k) and quashed the Court of First Instance’s decision. It is common ground that D1 and D2 has the burden of showing that the exemption under section 103(3)(k) applies. However, the CFA found that, in order to discharge that burden, nothing in section 103(3)(k) requires a person issuing advertisements of a CIS to use any express terms in the advertisement to provide that the CIS in question is intended only for professional investors. On the contrary, merely because an advertisement states that a CIS is intended only for professional investors do not mean that the exemption under section 103(3)(k) can be claimed. Whether the exemption applies will depend on the substance of the CIS and it is therefore necessary for a person claiming the exemption to demonstrate that the CIS as advertised is in fact intended solely for professional investors.

The SFC argued that the purpose of section 103 SFO is to regulate the advertising of certain investments (as distinct from their subsequent sale) in order to protect the interests of the investing public. They argued that D1 and D2’s construction to section 103(3)(k) go against such purpose and hence cannot be correct. The CFA disagreed. In the CFA’s view, the purpose of the exemption in section 103(3)(k) is clear, namely that professional investors, as opposed to the general public, do not require statutory protection under section 103(1) so that advertisements of products intended only for them are exempted from the prohibition. As in the case here where D1 and D2 could show that the CIS was intended only for professional investors, there is no necessity for protection to be afforded to the general public as they are not exposed to any material risk.

Proposals for amendment coming soon?

The SFC took a big hit from the CFA’s decision. Apparently, in the SFC’s view, in order to protect the interests of the general public, advertisements of CIS that may be unsuitable for their investment should not be available to them even if issuers of such advertisements only intend to market such CIS to professional investors. Also, as argued by the SFC, it was intended by the SFO that the public be protected at the point when the advertisement was issued. However, the CFA’s decision made it clear that a contravention of section 103 of the SFO can only be established well after the offer to the public has been issued. In this regard, it is likely for the SFC to feel that section 103 in its current form is unsatisfactory in terms of regulating the advertising of CIS to the general public. However, as the CFA noted, it cannot distort or ignore the plain meaning of the text of the statute in order to achieve such a result.

In response to the CFA’s judgment, the SFC stated in its press release that it would study the CFA’s decision to determine whether section 103 of the SFO should be amended to better reflect the legislative intent to protect the general public from the advertising of CIS. Therefore, in the future, issuers of CIS should watch out for the SFC’s potential reform proposals when they issue new marketing materials of their investment products to their target group of investors.