Introduction

Currently, an open-ended investment fund in Hong Kong can only take the form of a unit trust. This is mainly due to the restrictions on capital reductions in the Companies Ordinance (Cap. 622) (“CO”) which restricts a Hong Kong company from altering its share capital freely to meet shareholder subscription and redemption requests. However, Hong Kong based managers will soon have the choice of an alternative structure, the open-ended fund company (“OFC”), for establishing investment funds in Hong Kong. The objectives of introducing OFC is to offer an alternative legal structure for setting up local funds, to attract more funds to domicile in Hong Kong and to boost Hong Kong’s status as an international asset management centre.

The OFC has come into effect on 30 July 2018.

Background

Legislative History

In June 2016, the Securities and Futures (Amendment) Ordinance 2016 was gazetted. It provides the basic legal framework for the OFC regime and empowers the Securities and Futures Commission (“SFC”) to make subsidiary legislation and to issue codes and guidelines for regulating OFCs. On 28 June 2017, the SFC issued a consultation paper on the Securities and Futures (Open-ended Fund Companies) Rules (“OFC Rules”) and Code on Open-ended Fund Companies (“OFC Code”), which set out the proposed detailed legal and regulatory requirements for the new OFC vehicle. On 18 May 2018, the SFC published the consultation conclusions and the modified OFC Rules and OFC Code with clarifications. They can be downloaded at this link.

Industry Development

The OFC regime was designed amid a few significant industry developments. In December 2016, the SFC and the Swiss Financial Market Supervisory Authority signed a MoU on Switzerland-Hong Kong Mutual Recognition of Funds and Asset Managers, under which eligible Swiss and Hong Kong public funds can be distributed in each other’s market through a streamlined vetting process. Further, in January 2017, 54 cross-border funds were approved under the Mainland and Hong Kong Mutual Recognition of Funds (“MRF”) scheme. The MRF scheme allows mainland investors to broaden their offshore investment spectrum via fund products from the Hong Kong platform and gives fund managers a greater incentive to set up more Hong Kong-domiciled funds. The OFC is therefore believed to be the government’s initiative to strengthen Hong Kong’s legislation in order to keep up with industry development.

What is OFC?

OFCs are specifically designed for use as investment funds, established in company form under the Securities and Futures Ordinance (Cap. 571) (“SFO”) (as opposed to under the CO for a conventional Hong Kong company). Although it is a company, it is not designed to operate as a corporate entity for general commercial and industrial purposes. In addition, it will be subject to specific requirements.

An OFC has limited liability and variable share capital. It is a separate legal entity that has its own constitution and a board of directors. It is able to contract and hold assets under its own name. As OFC is designed to be an investment vehicle, it will have greater flexibility than a conventional company. OFCs may/will:

• vary their share capital (through issuing redeemable shares) to meet investor subscription and redemption requests and to distribute assets out of share capital, subject to solvency and disclosure requirements.
• issue multiple classes of shares and be structured as an umbrella fund with multiple sub-funds. Each sub-fund would have a pool of assets that is managed in accordance with the investment objectives and policies specific to that sub-fund. There are statutory provisions to provide for segregated liability of each sub-fund and to permit cross-investment between sub-funds of the same OFC.
• take the form of a publicly or privately offered fund (but private funds can only be sold to professional investors).

Why choose OFC over Unit Trust?

Potential benefits of introducing an OFC include:

• Increased saleability of Hong Kong-based funds to offshore investors who are more familiar with corporate fund structures as opposed to unit trusts;
• Ability of OFC to contract and hold assets in its own name, which will improve operational and administrative efficiency (in contrast, a unit trust is not a separate legal entity; assets are held and contracts are entered into by the trustee in its capacity as trustee of the unit trust (or by the manager, where permitted by the trust deed));
• For Hong Kong managers who preferred setting up funds in corporate form, convenience and simplicity in dealing with only one jurisdiction and one regulator, the SFC, for both the investment manager and the fund; and
• Flexibility to organize investment fund as an umbrella fund, which can cater for broad investment objectives, with increased attractiveness to a wider spectrum of investors.

However, if an OFC will be marketed to the Hong Kong public, the regulatory requirements are substantially the same as for a unit trust as the OFC will additionally need to comply with the Code on Unit Trusts and Mutual Funds (the Code).

It is expected that the OFC will not be a popular structure for private funds, because the regulatory requirements will be greater than if the private fund were established in an offshore jurisdiction such as the Cayman Islands. For example, the specific investment restrictions for private OFC may not be sufficient for the intended investment strategy, and private OFC may not easily satisfy the criteria for exemption from Hong Kong profits tax.

Key Regulations

Incorporation and registration

OFCs will have to be registered with the SFC before they can be incorporated by the Companies Registry (“CR”). To strengthen investor protection, the application for registration must include, inter alia, disclosure and warning statements in the offering documents in relation to certain special features of the OFC.

In order to streamline the incorporation process, the SFC will offer a one-stop platform for registration and incorporation. The SFC will handle registration application and liaise with the CR, who will issue the incorporation certificate. On-going filings which require SFC approval will only be submitted to the SFC, and those which do not require SFC approval will need to be submitted only to the CR.

The constitutional document of an OFC will be an instrument of incorporation with certain provisions prescribed by the SFO, such as those providing for object and structure of the fund and sub-fund, investment restrictions, and requirements for scheme changes etc. Any material change to the instrument of incorporation will require the SFC’s approval.

Name

The name must end with “OFC” or “Open-ended Fund Company”. It must not, in the opinion of the SFC, be misleading or otherwise undesirable and must not be the same as the name of another OFC. Any change of name is subject to the SFC’s approval.

Investment scope

An publicly offered OFC will need to comply with the investment restrictions in the Code and any authorisation conditions, and the asset classes it can invest in consists mainly of securities, futures and OTC derivatives. For a privately offered OFC, at least 90% of its gross asset value should consist of (a) those asset types allowed with Type 9 regulated activity (securities, futures and OTC derivatives), and (b) cash, bank deposits, certificates of deposit, foreign currencies and foreign exchange contracts, with a 10% de minimis limit for investment in other asset classes. The 10% de minimis limit is applicable to each sub-fund as well as to the umbrella OFC as a whole. Furthermore, as shares in private companies are not “securities” under the SFO, the OFC will likely not be a suitable option for private equity managers.

Key parties

The OFC must have at least 2 directors and must appoint an investment manager, a custodian and an auditor. At least one of the directors must be independent, who must not be an employee or director of the custodian. Directors are subject to statutory duties of care, skill and diligence when overseeing the activities of the investment manager and the custodian. The OFC board must delegate the investment management function to an investment manager, who must be licensed to conduct Type 9 regulated activity (asset management). An OFC’s assets must be entrusted to an independent custodian, who is required to take reasonable care, skill and diligence to ensure the safe-keeping of the scheme assets. The appointments of directors, investment manager, custodian, and any changes thereto are subject to SFC approval.

Tax treatment

An SFC-authorised OFC will benefit from the exemption from Hong Kong profits tax. A private OFC will be exempted from Hong Kong profits tax only if it meets certain qualifying criteria. In particular, the private OFC must not be closely held, which will depend on the number and nature of the investors and how much each investor has invested in the OFC. There is a 24 month grace period for a private OFC to satisfy the requirement that it is not closely held. If it fails to satisfy this requirement within 24 months of the initial investment, the private OFC will lose its exemption from Hong Kong profits tax from its inception.

Conclusion

The introduction of the OFC regime is generally welcomed. The OFC may soon prove itself to be an attractive legal structure for SFC-authorised public funds due to its flexibility and streamlined formation process. For managers of private funds, the decision of whether to use an OFC over an offshore fund structure will be a balancing exercise of the potential benefits from administrative convenience against investment strategies and tax planning.

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.