Hong Kong SFC’s Proposed Amendments To Rules On Public Offers Of Unlisted Structured Products

The Hong Kong Securities and Futures Commission (SFC) has published proposed amendments to the legislation regulating public offers of structured products.

The amendments provide a new definition of structured products, and will result in public offers of these products being regulated under the Securities and Futures Ordinance in future, regardless of legal form.

This shift would remove many of the safe harbours previously available to offers of structured products in the form of shares and debentures under the Companies Ordinance, and may drive financial institutions to devising simpler, more standardised structured products for their high net worth clients.

Background

On October 30, 2009, the SFC issued a Consultation Paper on Possible Reforms to the Prospectus Regime in the Companies Ordinance and the Offers of Investments Regime in the Securities and Futures Ordinance (the Consultation Paper) (see WSLR, November 2009, page 29).

The Consultation Paper set out the proposed amendments to the public offering regimes contained in the Companies Ordinance (Cap. 32) (CO) and the Securities and Futures Ordinance (Cap. 571) (SFO).

Under the existing legal framework, public offers of structured products are regulated under either the CO prospectus regime (if the structured product is in the form of shares or debentures, such as equity-linked notes and credit-linked notes) or the SFO offers of investments regime (if the structured product is in another form, such as a hybrid of securities and equity-linked instruments).

If the proposed amendments are adopted, Hong Kong will retain two separate offering regimes where: 1) offers of all structured products (whether or not in the form of shares or debentures) will be regulated under the SFO, and 2) offers of shares and plain-vanilla debentures will continue to be regulated under the CO. (According to the CO Phase 3 Consultation Conclusions, the CO prospectus regime for shares and plain-vanilla debentures will be transferred to a separate and discrete part of the SFO when the CO Phase 3 initiatives are implemented. In the long term, both regimes are expected to be housed in separate parts of the SFO.)

On April 22, 2010, following public consultation, the SFC published its revised proposed amendments to the CO and the SFO, which are summarised below.

Disapplying the CO Prospectus Provisions to Structured Products in the Form of Shares or Debentures

One of the key proposed amendments is to transfer the regulation of offers of structured products in the form of shares or debentures from the CO regime to the SFO regime. It is proposed that a new Section 38AA of the CO will provide that the prospectus provisions in the CO (Sections 37, 38, 38A, 38B, 38BA, 38D, 39A, 39B, 39C, 40, 40A, 40B, 41, 41A, 42, 43, 44, 44A, 44B, 48A of the CO, Part XII of the CO and the Third Schedule, and the Seventeenth to the Twenty-second Schedules to the CO) will no longer apply to offers of structured products (including those in the form of shares or debentures).

However, other provisions in the CO relating to shares or debentures will continue to apply. For example, Hong Kong incorporated issuers of structured products in the form of debentures will still have to comply with the provisions set out in Sections 74A to 79 of the CO regarding register of debenture holders, meetings of debenture holders and liability of trustees for debenture holders, etc.

Safe Harbour Provisions

As a result of the proposed amendments, the safe harbour provisions contained in the Seventeenth Schedule to the CO, which set out a number of situations where an issuer is exempted from the requirement to seek the SFC’s prior authorisation before issuing offering documents, will no longer be available for structured products in the form of shares or debentures.

The safe harbours under the CO (as amended in 2004) which are commonly relied upon are: 1) offers in respect of which the minimum denomination of the shares or debentures is not less than HK$500,000; 2) offers to not more than 50 persons; or 3) offers to professional investors.

While Part IV of the SFO contains an exemption for offers to professional investors and does not apply to offers not made to the public, it does not have an equivalent “HK$500,000 minimum denomination” or “no more than 50 persons” exemption. Following the proposed amendments, the SFC has stated that these last two exemptions will no longer apply to offers of structured products in the form of shares or debentures.

The SFC acknowledged that the “HK$500,000 minimum denomination” safe harbour is heavily relied on at present, but believes that it would be inappropriate to introduce this safe harbour into the SFO at this time for a variety of reasons.

For the “no more than 50 persons” safe harbour, the SFC noted that it is not commonly used and is therefore unnecessary; of course, the “no more than 50 persons” safe harbour is not commonly relied on because issuers have traditionally had the “HK$500,000 minimum denomination” safe harbour available to them. It is worth noting here that the “no more than 50 persons” safe harbour was only introduced into the CO in 2004 on the basis that, in practice, offers to fewer than 50 persons had been considered as an appropriate benchmark for private placements that did not constitute an offer to “the public”. It may be that this practice, without the backing of a statutory bright line test, will be set to continue, but with less certainty.

None of the other safe harbours contained in the Seventeenth Schedule to the CO (such as that relating to shares or debentures offered as consideration in a takeover offer) will be replicated in the SFO. However, there will be an exclusion in the definition of “structured product” so that employee incentive schemes (e.g., phantom share option schemes) will not be caught by Section 103 of the SFO.

In addition, and in recognition of the practical difficulties in applying the professional investor safe harbour to “high net worth” clients, the SFC is expected to conduct a consultation exercise on amending the evidential requirements in the Securities and Futures (Professional Investor) Rules in the near future.

Liability for Misstatements

One key difference between the two regimes is that “promoters” (defined under the CO as a party to the preparation of the prospectus) is not a category of persons identified in Part IV of the SFO as being liable for misrepresentation in offering documents, whereas they would be liable for untrue statements in prospectuses under the CO.

Whilst the proposed amendments do not extend to liability issues, the SFC notes that it will consider, as part of the CO Phase 3 law reform exercise, whether any elements of the statutory requirements and liability provisions in the CO prospectus regime should be aligned with those in the SFO offers of investments regime (or vice versa).

Introducing a New Definition of ‘Structured Product’

It is proposed that the term “structured product” be widely defined to include:

• instruments where some or all of the return or amount due (or both the return and amount due) or the method of settlement is determined by reference to one or more of:

• changes in the value or level (or a range within the value or level) of any type of securities, commodity, index, property, interest rate, currency exchange rate or futures contract;

• changes in the value or level (or a range within the value or level) of a basket of more than one type of securities, commodity, index, property, interest rate, currency exchange rate or futures contract; or

• the occurrence or non-occurrence of an event or events specified in the instrument; and

• regulated investment agreements.

The wide definition of “structured product” is intended to ensure that all forms of derivatives, whether in the form of an over-the-counter bilateral contract or a securitised form, will fall within the scope of the SFO offering regime.

The SFC has proposed that offerings of the following products will continue to be regulated under the CO prospectus regime:

• ordinary shares;

• preference shares;

• depository receipts over or in respect of shares;

• plain-vanilla debentures (e.g., fixed rate bonds, zero coupon bonds, promissory notes);

• floating rate notes, to the extent that these products have no derivative element attached to them; and

• convertible and exchangeable bonds and subscription warrants issued for fund raising purposes that entitle the holder to convert, exchange or subscribe for shares of the issuer or a related company.

Collective investment schemes (i.e., funds) will continue to be regulated under Part IV of the SFO and are outside the scope of these reforms.

Amending the Definition of ‘Securities’ in the SFO to Include Structured Products

In order to ensure that the regulatory requirements in the SFO (and not only the disclosure requirements) will apply to all structured products being offered to the public, the SFC proposes that the definition of “securities” be amended to include structured products (not in the form of securities) in respect of which any offering document would be subject to Section 103(1) of the SFO and any structured product which is listed on the Stock Exchange of Hong Kong (SEHK).

The original proposal was simply to include all “structured products” in the definition of “securities” for the purposes of the SFO. This was modified following industry concerns regarding the wide and potentially unintended consequences of such an amendment, which would have resulted in many institutions which deal exclusively in the professional markets being brought within the licensing regime and having to comply with other conduct requirements under the SFO.

Exempting Currency Linked Instruments and Money Market Instruments Issued by Authorised Financial Institutions

In line with current regulatory policy and practice, the SFC proposes to exempt from the SFO authorisation requirements any offering document in respect of instruments issued by authorised financial institutions that are referenced to:

• changes in the level of any interest rate or a basket of interest rates;

• changes in the level of any currency exchange rate or a basket of currency exchange rates; or

• changes in the level of any interest rate or a basket of interest rates and changes in the level of any currency exchange rate or a basket of currency exchange rates.

However, the authorised financial institution would need to ensure that any “bells and whistles” that are attached to currency linked instruments and money market instruments do not contain any derivative element.

The SFC also noted that instruments issued by authorised financial institutions that are referenced to the price of gold or silver would not constitute currency linked instruments or money market instruments for the purposes of the SFO offering regime (and accordingly would not be exempt from the authorisation requirement on such grounds).

Disapplying the Exemptions in Sections 103(2)(a) and 103(5)(a) of the SFO to Unlisted Structured Products

Section 103(2)(a) of the SFO provides that the requirement to seek the SFC’s authorisation before issuing any advertisements, invitations or documents for securities does not apply if such documents are issued by intermediaries licensed or registered for Type 1 (dealing in securities), Type 4 (advising on securities) or Type 6 (advising on corporate finance) regulated activities. Section 103(5)(a) of the SFO provides that a person issuing such documents shall not be regarded as committing an offence if it is done by or on behalf of a Type 1, Type 4 or Type 6 intermediary.

The SFC is proposing to carve out unlisted structured products from the exemptions in Section 103(2)(a) and 103(5)(a) to ensure that their offering documents and marketing materials would need to be authorised by the SFC prior to their issuance.

However, in order to avoid regulatory duplication, the exemptions under Section 103(2)(a) and 103(5)(a) would continue to apply to listed structured products. This is consistent with the SFC’s view that the SEHK should remain the frontline regulator responsible for reviewing and approving marketing documents for all listed structured products.

Introducing a New Section 104A in the SFO

The authorisation process for unlisted structured products will be set out in a proposed new Section 104A of the SFO, which will be similar to the process set out in the existing Section 104 for collective investment schemes.

Under this new proposed section, the SFC’s authorisation of an unlisted structured product will depend upon compliance by the issuers and other stakeholders with the codes and guidelines in the proposed Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Products to be published by the SFC, which is currently the subject of a separate consultation.

Other Amendments to Exemptions in Section 103 of the SFO

Certain existing exemptions from the requirement to obtain SFC approval under Section 103 of the SFO will be extended to refer to structured products in all forms:

• Section 103(2)(e) will be amended to exempt offerings made by or on behalf of a corporation to holders of securities, creditors of, or employees employed by or agents acting in a professional capacity on behalf of the corporation, or a related corporation of that corporation in respect of structured products issued by that corporation or a related corporation;

• Section 103(2)(f) will be amended to exempt offerings made by or on behalf of the Hong Kong Special Administrative Region Government in respect of Government-issued structured products;

• Section 103(2)(i) will be amended to exempt offerings made by or on behalf of a person who is engaged in the business of buying and selling property other than securities and structured products;

• Section 103(3)(h) will be amended to exempt structured products which have been approved for listing by the SEHK;

• Section 103(3)(j) will be amended to exempt structured products that are offered to overseas investors; and

• Section 103(3)(k) will be amended to exempt structured products that are intended to be disposed of to professional investors.

Next Steps

The SFC has provided its recommendations on the legislative amendments to the Government, and it is expected that the bill will be gazetted and tabled before the Legislative Council within 2010.

Implications for the Market for Unlisted Structured Products

It is acknowledged that a number of financial institutions rely on the HK$500,000 minimum denomination safe harbour to offer and sell structured notes to high net worth clients. The unavailability of this safe harbour for structured notes will mean that such financial institutions will need to 1) rely on the professional investor’s safe harbour, or 2) ensure that offers of structured products are not construed as offers to “the public”, or 3) obtain SFC approval of structured products intended to be offered to a wider audience.

We would expect that the practical difficulties of relying on the professional investor’s safe harbour (with respect to high net worth clients), the uncertainty surrounding the meaning of “the public”, and the cost and timing implications of obtaining SFC approval will drive financial institutions towards offering simpler, more standardised structured products that can be approved by the SFC on a “programme” basis (such as equity-linked investments) rather than those requiring “per series” approval.

Where more complex structured products are offered, their terms are more likely to be tailored to the requirements of a select number of potential investors to mitigate the risk of any offer being characterised as an offer to the public.

It is hoped that the SFC will shortly consult the market on the Securities and Futures (Professional Investor) Rules with a view to making the professional investor safe harbour a useful alternative to the existing HK$500,000 minimum denomination safe harbour.

It also remains to be seen whether the proposed amendments will have an adverse impact on the ability of financial institutions to structure financial products for potential investors in an innovative and flexible manner that is responsive to market needs.