Client briefing

September 2010

Hong Kong Hedge Fund

Regulatory Update

Introduction Key Issues

There has been much discussion and publicity surrounding significant legislative
and regulatory changes globally that will impact the hedge fund industry, in Introduction
particular the AIFM Directive in Europe, the Dodd-Frank financial reform
legislation in the US and closer to home the new proposals by the MAS to Public consultation on proposed anti-
money laundering legislation
change the current regime regulating fund managers in Singapore. But what
about Hong Kong? Clarification on the interpretation of
SFC licensing exemptions
Regulators in Hong Kong have been quietly reviewing existing laws, regulations Reliance on the "SFC Adopts a
and policies, and proposing change in a variety of areas which may affect, albeit Pragmatic Approach to Licensing Fund
not fundamentally, the hedge fund industry in Hong Kong. Managers"

This briefing aims to highlight recent or impending changes in Hong Kong Proper use of SFC licences
affecting, or likely to affect, the Hong Kong hedge fund industry. Revised Code of Conduct for persons
licensed by or regulated with the SFC
Public consultation on proposed anti-money laundering Public offers of unlisted structured
(AML) legislation products in Hong Kong
The Financial Services & Treasury Bureau (FSTB) has issued two rounds of Public consultation on increased
consultation (on 9 July and 7 December 2009) on proposals which will include a transparency of short positions
new statutory obligation for financial institutions to conduct customer due
diligence and keep records. Regulation of credit rating agencies

Consultation Paper on the Draft

Importantly for the hedge fund industry, a financial intermediary (e.g. a licensed Guidelines on Disclosure of Inside
corporation such as a Type 9 licensed hedge fund advisor or registered Information
institution) may continue to rely on customer due diligence carried out by third
party intermediaries provided certain conditions are satisfied. It is however a Enforcement
condition that the financial intermediary must be able to obtain the necessary
information relating to customer due diligence requirements from the third party
intermediary. Such an intermediary must also fall within a specified category of
persons – largely regulated entities.

The new AML legislation proposes the introduction of criminal liability to deal
with breaches of statutory customer due diligence and record keeping
requirements in cases of knowing or intentional contravention of the statutory
regime. Inadvertent non-compliance will not be subject to criminal sanctions.
The FSTB noted in the second AML consultation paper that it envisaged most
breaches would be dealt with through regulatory supervision and discipline
rather than criminal sanctions.

Clarification on the interpretation of SFC licensing If you would like to know more about the
exemptions subjects covered in this publication or our
The SFC clarified its interpretation on the acting "as principal" exemption in a services, please contact:
recent SFC circular published on 24 July 2009 entitled "Circular concerning the
James Walker +852 2825 8874
licensing obligations of Inter-dealer Brokers under the Securities and Futures
Ordinance"; the SFC emphasised that the "as principal" exemption is rather Charlotte Robins +852 2826 2482
narrow in scope and it does not interpret the exemption as being applicable to
transactions by inter-dealer brokers such as back-to-back arrangements which To email one of the above, please use
involve the temporary interposition of a third party (e.g. an inter-dealer broker) firstname.lastname@cliffordchance.com
between the parties who are, in real sense, the buyer and seller. While the
context of the interpretation is not directly relevant to the investment fund Clifford Chance, 28th Floor, Jardine House,
industry, it is an exemption from licensing relied upon by directors and/or officers One Connaught Place, Hong Kong SAR
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Hong Kong Hedge Fund Regulatory Update

of a general partner of a hedge fund when marketing or promoting the hedge

fund - a "dealing in securities" regulated activity. A similar narrow interpretation
of acting "as principal" may be adopted in this context.

Further it is worth noting this Circular as an illustration of the more conservative approach that the SFC is currently
adopting when dealing with licensing matters.

Reliance on the "SFC Adopts a Pragmatic Approach to Licensing Fund Managers"

The SFC circular "SFC Adopts a Pragmatic Approach to Licensing Fund Managers", dated 11 June 2007 has been a
useful addition to the SFC's range of exemptions from the requirement for responsible officers to take local regulatory
exams. Experience however has highlighted that whilst this exemption may be relied upon by responsible officers for
both hedge fund managers and other types of fund manager, relevant persons must show eight years of trading
experience in recognised markets i.e. public markets. In this case the type of industry experience is different to the type
of experience that qualifies for the basic three years, minimum relevant industry experience to be a responsible officer.

It should also be noted that, this exemption is strictly for responsible officers and not licensed representatives.

Proper use of SFC licences

In a circular dated 1 April 2010 the SFC clarified the licensing obligations of corporations and individuals and in particular
licensed persons based outside Hong Kong. This should be specifically noted by offshore responsible officers and their
licensed Hong Kong based hedge fund advisors. It is not sufficient to be a brass plate responsible officer; there must be
a genuine role for such persons in relation to the onshore regulated activity. For those applying for a licence albeit
largely based outside of Hong Kong, it will be necessary to explain the regulated function that will be conducted for the
Hong Kong corporate applicant.

The SFC also expressed the concern that persons based outside Hong Kong holding a licence from the SFC might,
through reliance on the licence offshore, mislead others as to the extent of the SFC's supervision which is "very
restricted" outside Hong Kong. The Circular reminded licensed corporations that they are responsible for the conduct of
overseas SFC licensed representatives (including responsible officers), persons and improper conduct by such licensed
persons may reflect on the fitness and properness of the Hong Kong licensed corporation.

Whilst not specifically noted in the circular, responsible officers have various legal and regulatory obligations and
responsibilities, which if they fail to discharge could result in not only disciplinary action but also legal action pursuant to
the Securities and Futures Ordinance (the SFO).

Revised Code of Conduct for persons licensed by or Registered with the SFC
Many in Hong Kong will be aware of the SFC's consultation paper, and subsequent conclusions, on Proposals to
Enhance Protection for the Investing Public. The proposals and resulting changes largely relate to the retail fund industry
but amongst the significant number of wide-ranging proposals there are also proposals to enhance intermediary conduct
contained in the revised Code of Conduct for Persons Licensed by or Registered with the SFC (the Revised Code). In
particular there are changes relating to the suitability assessment of a client for a particular product/security; an
intermediary will be required (in addition to existing requirements) to assess whether a client is a "client with derivative
knowledge" or not.

Whilst the Revised Code does not strictly apply to discretionary managers of collective investment schemes e.g. hedge
fund managers, it would be relevant to a manager of a managed account. It is therefore worth noting that the Revised
Code also spells out criteria which a high net worth professional investor should satisfy before it may be treated as such,
and consequently aspects of the conduct requirements can be waived. The Revised Code stresses the importance of
suitability, and although the assessment (which must be in writing) may be less intensive in the case of professional
investors, a professional investor cannot be assumed to be suitable for all products they may invest in.

Additionally, the consultation process raised the question as to whether the monetary threshold of the existing HK$8
million for an individual who qualifies as a "professional investor" should be revised. This proposal has not been taken
forward. The SFC has however indicated (in its conclusions) that it will reconsider the evidential requirements to
establish whether a professional investor meets the minimum monetary threshold and will consult the market in due
course. This stems from, in particular, the requirements under the Securities and Futures (Professional Investor) Rules
which require the monetary thresholds for high net worth individuals (and certain corporations and trusts with assets) to
be ascertained through custodial or audited statements.

Public offers of unlisted structured products in Hong Kong

Following a consultation process at the end of 2009 on Possible Reforms to the Prospectus Regime in the Companies
Ordinance and the Offers of Investments Regime in the Securities and Futures Ordinance, the SFC published its revised
proposed amendments to the Companies Ordinance (the CO) and the SFO in the Securities and Futures and

© Clifford Chance September 2010

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Hong Kong Hedge Fund Regulatory Update

Companies Legislation (Structured Products Amendment) Bill 2010 (the Bill). The proposed legislation would transfer
the regulation of offers of structured products in the form of shares or debentures from the CO to the SFO regime; the
safe harbour provisions in 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 (e.g. HK$500,000 minimum
denomination offer or offers to not more than 50 persons exceptions) – will no longer be available for structured products
in the form of shares or debentures. In respect of the SFO, a wide definition of "structured product" will be introduced to
ensure 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.

Private placement of collective investment schemes (i.e. funds) will continue to be regulated as before. However the
wide scope of the definition of "structured product" may potentially catch a collective investment scheme that invests
substantially in structured products.

It is expected that the Bill, which was tabled before the Legislative Council for its first reading on 14 July 2010, will be
gazetted by the end of 2010.

Public consultation on increased transparency of short positions

On 3 March 2010, the SFC published the conclusions to its "Consultation on increasing short position transparency".
According to the conclusions, disclosure to the SFC will be of gross short positions where such a position satisfies the
lower of (i) an amount equal to or above 0.02 per cent of the issued share capital of the relevant company or (ii) a value
equal to or exceeding HK$30 million. After taking into account concerns expressed by the industry, the SFC has decided
that the calculation of short positions will not include any form of derivatives at inception. The SFC will monitor the
progress of the short position reporting rules as well as ongoing development of the market. If the SFC considers in the
future that derivatives should be included, it will consult the market before expanding the relevant requirements.

In the initial stages, reporting will only apply to short positions in constituent stocks of the Hang Seng Index, the H Shares
Index and other designated securities permitted for short selling by the Stock Exchange of Hong Kong. Where a gross
short position is equal to or above a relevant threshold on the last trading day in a week, this will need to be reported to
the SFC by the end of the second business day in the following week. Reporting on a weekly basis will need to continue
thereafter until the gross short position is below both of the 0.02 per cent and HK$30 million thresholds. Short sellers are
obliged to report, although in practice they may delegate this to an agent. Nevertheless the short seller will remain
responsible for any failure to report.

The next step will be a further public consultation on draft subsidiary legislation which will set out the new rules described
in the conclusions. The industry has already been working with the SFC on a template to facilitate reporting. Part XV of
the SFO on disclosure of interest (e.g. on 5 per cent long interests, short positions, change in nature) will be left
unchanged and will run in parallel with the new rules.

Regulation of credit rating agencies

In July 2010, the SFC initiated a public consultation process on the creation of a new Type 10 regulated activity of
providing credit rating services. Such an activity is distinguished in the consultation paper from an advising on securities
regulated activity. Further, the SFC does not intend ratings prepared pursuant to an "individual order" and which are not
to be publicly disseminated nor the preparation or distribution of information in relation to "indebtedness or credit history
of a commercial enterprise" to fall within the proposed new regulated activity. The carve-out uses a number of undefined
terms which the market will need to assess going forward. The SFC's intention is for legislative amendments to be in
place at the beginning of 2011.

Consultation Paper on the Draft Guidelines on Disclosure of Inside Information

The SFC issued a Consultation Paper on the Draft Guidelines on Disclosure of Inside Information in March 2010. The
Guidelines on Disclosure of Inside Information relates to the Government's proposals to give statutory backing to the
obligation on Hong Kong Stock Exchange listed corporations to disclose price sensitive information. Under the
Government's proposals, a listed corporation would be obliged to disclose to the public as soon as practicable, any "price
sensitive information" that has come to the knowledge of the listed corporation. The Guidelines seek to explain the
circumstances under which a listed corporation may delay disclosure of inside information and how the safe harbours
would operate in different circumstances. The consultation period ended on 28 June 2010 and it is expected that a draft
bill will be introduced into the Legislative Council during the 2010/11 legislative calendar.

Enforcement
The SFC continues to pursue strongly breaches of regulation and legislative requirements not least in relation to market
misconduct. The SFC's recent enforcement philosophy illustrates two particular recent trends: (1) preference for criminal
rather than civil proceedings; and (2) increased use of injunction orders to freeze assets, particularly against overseas
parties.

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Hong Kong Hedge Fund Regulatory Update

On 5 August 2009, the SFC commenced proceedings in the High Court against Tiger Asia Management LLC (Tiger
Asia), a New York-based asset management company, and three of its senior officers and applied for an injunction order
to freeze assets of Tiger Asia and the three senior officers, including those located overseas of up to HK$29.9 million
pending final orders that the SFC is seeking. The amount is equivalent to the notional profit made by Tiger Asia in
alleged insider dealing and market manipulation activities. In addition, in April 2010, the SFC sought court orders to
prohibit Tiger Asia from dealing in all listed securities and derivatives in Hong Kong in light of further insider trading
allegations. This is the first time the SFC has sought orders from a court to exclude any entity from trading in the Hong
Kong market. The SFC has also amended the current proceedings against Tiger Asia to include new allegations and is
seeking to freeze an additional amount of up to HK$8.6 million of Tiger Asia's assets on top of the initial HK$29.9 million.

From the court records we understand a hearing has been set for 21 September 2010. At this stage it is not clear
whether it will be open to the public; however many will be interested in how this matter plays out.

This Client briefing does not necessarily deal with every

important topic or cover every aspect of the topics with which it
deals. It is not designed to provide legal or other advice.

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