The Mainland-Hong Kong Mutual Recognition of Funds (MRF) scheme was launched in May 2015, and since the first funds were approved late 2015, to-date, more than 20 Mainland funds have been approved and authorized by the Hong Kong Securities and Futures Commission (SFC) to be offered in Hong Kong. At the same time, 3 Hong Kong-domiciled funds have so far gained approval in the Mainland for cross-border distribution. On both fronts, the number of funds to be approved are expected to continue to increase.

The MRF arrangement has made the establishment of Hong Kong-domiciled funds attractive and enhanced Hong Kong’s position as an asset management centre. The next step forward for Hong Kong to further develop into a global cross-border fund hub is, as most industry participants believe, to enhance its attractiveness as a fund domicile by introducing an open-ended fund company (OFC) structure.

We may soon see the adoption of the OFC regime in Hong Kong towards meeting its long-standing aspiration of becoming a global cross-border fund centre.

Securities and Futures (Amendment) Bill 2016

On 15 January 2016, the proposed Securities and Futures (Amendment) Bill 2016 was gazetted to be put before the Hong Kong Legislative Council, with the intention to introduce the legal, regulatory and tax framework for Hong Kong’s OFC regime.

The proposals put forward are the result of more than two years of design and industry consultations on the framework. The Hong Kong Financial Services and Treasury Bureau (FSTB), the SFC and other relevant authorities have coordinated and developed the details of the proposed framework which was first announced in early 2014. A consultation paper was published in March 2014, and the consultation conclusions were published earlier this month by FSTB. The consultation conclusions culminated in the release of the detailed proposed legal and regulatory frameworks in respect of the OFC regime.

In particular, the proposed Bill shall introduce a new Part IVA to the Securities and Futures Ordinance (Cap. 571) (SFO) on OFC, containing provisions on the incorporation, registration, capacity and specific requirements on the establishment and operations of OFC (including on the directors, investment manager, custodian, sub-custodian and auditor of an OFC).

The Bill also outlines the powers of the SFC who shall be the primary regulator of OFCs, including for the SFC to make further rules on the regulation of OFCs. It is expected that the SFC will also issue a new OFC Code detailing the operational requirements to supplement the legislation.

The Companies Registry (CR) shall be responsible for the incorporation and administration of statutory corporate filings of OFCs, alongside such role of the CR with respect to Hong Kong companies in general.

Fund market landscape in Hong Kong

As at the end of September 2015, among the 2,090 SFC authorized unit trusts and mutual funds in Hong Kong, there were only 628 domiciled in Hong Kong, with the rest mainly in Luxembourg (1,010), Ireland (281) and the Cayman Islands (92), according to the latest available data of Securities and Futures Commission (SFC). The current fund market in Hong Kong is overwhelmingly dominated by Luxembourg or Irish Undertakings for Collective Investment in Transferable Securities (UCITS).

While the number of Hong Kong-domiciled funds increased by around 54% from 386 in March 2012 to 594 in March 2015, according to FSTB, creating the OFC structure will provide asset managers with an additional option and flexibility for Hong Kong to be more attractive as a fund domicile.

Corporate structure a more popular form of investment fund

The OFC is seen as an increasingly popular fund vehicle in the industry globally, in particular for cross-border funds, and is available in most major fund centers such as Luxembourg, Ireland, Cayman Islands and United States.

At the moment, an open-ended investment fund established in Hong Kong can only take the form of a unit trust. Due to various restrictions on capital reduction under the Hong Kong Companies Ordinance, and lack of flexibility to vary its capital in order to meet investors’ subscriptions and redemptions, open-ended funds cannot be established as a Hong Kong company.

The unit trust structure has been described as “inflexible” once it is established and “not particularly suitable” for some investment strategies currently used by both public and private funds. Onerous trustee provisions in trust deeds may deter asset managers from structuring their funds as a unit trust or render some trustees unwilling to accept appointment for funds of certain investment strategies.

Further, unit trust is not a familiar structure to asset managers in jurisdictions which do not have well-established trust law, such as in the Mainland. From this perspective, there may indeed be attractiveness in a Hong Kong OFC structure for funds that may seek to be authorized by the SFC for public offer and eventually to apply for approval by the Mainland securities regulator for distribution in the Mainland.

Read our legal update for an outline of the proposed legal, regulatory and tax provisions for the Hong Kong OFC structure: Hong Kong Proposed OFC Framework

On 8 December 2015, the Securities and Futures Commission (“SFC”) of Hong Kong published its “Consultation Conclusions on the Client Agreement Requirements” (“Consultation Conclusions”), requiring licensed financial intermediaries to include a new clause in their client agreements on the suitability of investment recommendations and solicitations.

The required new clause reads:

“If we [the intermediary] solicit the sale of or recommend any financial product to you [the client], the financial product must be reasonably suitable for you having regard to your financial situation, investment experience and investment objectives.  No other provision of this agreement or any other document we may ask you to sign and no statement we may ask you to make derogates from this clause.”

The SFC’s “Code of Conduct for Persons Licensed by or Registered with the SFC” will be amended to incorporate this minimum content requirement for client agreements. In addition, a new paragraph will also be inserted into the Code of Conduct to disallow any contractual term or provision in the client agreement or other document signed or statement made by client at the request of the intermediary which is inconsistent with the Code of Conduct obligations or which misdescribes the actual services provided to a client.

There is an 18 months transitional period (i.e. 9 June 2017 being 18 months from 8 December 2015) for all intermediaries to comply with the new requirements, although the SFC expects that “all intermediaries will commence reviewing and revising their client agreements immediately, as well as to make revised client agreements available as soon as possible so that new clients can execute them and existing clients can amend or replace their existing agreements.”

The intended effect of the new requirements is that banks and other financial intermediaries will now be under a contractual obligation on suitability of investment recommendations and solicitations of financial products, and will no longer be able to use non-reliance clauses as a defence to a mis-selling claim.

As set out in the SFC’s response in the Consultation Conclusions:

“The New Clause is derived from the Suitability Requirement under the Code, which is the cornerstone of investor protection.  This requirement has been in place for many years and intermediaries should be fully aware of their compliance obligations under it. However, because the Suitability Requirement is limited to being a regulatory obligation, the SFC can only take disciplinary action against the relevant intermediary which has breached it; it cannot require the intermediary to compensate aggrieved investors from losses arising from such breach.  The New Clause aims to enable aggrieved investors to seek redress as a contractual right under the client agreement in such a situation.”

Implications of the New Clause

As a result of the new clause now required, investors may now seek to rely on the client agreements to seek redress against banks as a contractual right. The new clause imposes contractual obligations on banks and intermediaries on suitability of investment recommendations and solicitations (as opposed to only regulatory obligations under the Code of Conduct).  By also requiring no other terms or provisions in the contract may derogate from this contractual obligation, banks and financial intermediaries may no longer be able to rely on non-reliance clauses as an estoppel to limit their duties and obligations to investors.

Instead, the focus of attention on any potential claims brought by investors will shift to the actual issue of suitability of the financial products which have been sold to them by the banks and/or intermediaries.  As the phrase “reasonably suitable” is an objective standard, it will be decided by the Court as to the particular facts of each case in applying the standard to the prevailing circumstances.  The SFC has also stated that any future Court decisions would constitute referable guidance on the interpretation of the suitability obligations under the new clause, which the SFC will take into account as precedents.

The new requirements should also be considered in the context of expanded requirements with respect to certain categories of “professional investors”.  While the suitability requirement has always applied to retail clients (i.e. “non-professional investors”), with effect from 25 March 2016, the suitability requirement will also apply to (a) professional investors who are individuals, and (b) certain trusts and corporate investors (e.g. those not engaged in investment activity in business and not qualified under an assessment on the knowledge, experience and investment process). Correspondingly, while it was previously possible to be exempted from a need to enter into a client agreement when dealing with “professional investors”, with effect from 25 March 2016, the exemption will no longer apply for such categories of individual professional investors and corporate professional investors.

The issues of suitability and mis-selling continue to be in regulatory focus. In Hong Kong, a series of measures to enhance protection for the investing public was first rolled out in May 2010, including the introduction of the requirement that financial intermediaries should assess a client’s knowledge of derivatives which impacts the suitability standard to be applied. Hong Kong regulators have since further reviewed requirements on suitability assessment and selling practices on investment products, and made significant changes to the professional investors’ regime which will be effective 25 March 2016. In the latest development, intermediaries will now be required to include a contractual duty on suitability in client agreements. On the other hand, in recent years there have been a number of court decisions in the UK, Hong Kong and Singapore on claims of mis-selling of financial products by banks.

For an overview of the key developments and requirements in Hong Kong on the subject, together with an analysis on notable case law as background to this development, please refer to our article –