Recent regulatory changes affecting the hedge fund industry in Hong Kong include changes to the guidelines on retail hedge funds issued by the Securities and Futures Commission (the "SFC"), changes to the private placement regime, the SFC's review of the rules relating to the disclosure of interests in Hong Kong listed companies, changes to the licensing requirements relating to "regulated activities" and, at the time of writing, it is most likely that a bill will be enacted in late February 2006 which will exempt offshore funds from Hong Kong profits tax on transactions effected through an agent in Hong Kong. The following is an outline of these changes.

Changes to Hedge Fund Guidelines

Chapter 8.7 of the Code on Unit Trusts and Mutual Funds (the "Code") sets out the requirements for the authorisation of a retail hedge fund for sale to the public in Hong Kong. These requirements were amended with effect from September 2005.

In assessing compliance of the personnel of investment managers with the requirement for five years relevant experience, a wider range of hedge fund experience will now be acceptable. The requirement for key personnel to possess specific public funds experience (as set out in Chapter 5.5(a) of the Code) may be satisfied if the management company on a firm-wide basis is able to demonstrate that it possesses the requisite experience and resources to administer public funds. This, in effect, means that large institutional fund managers will find it easier to have a hedge fund authorised by the SFC than core hedge fund operators, as they will be more likely to satisfy this requirement by virtue of the public funds management undertaken by other divisions of the institutional fund manager's organisation.

Increased levels of disclosure will be required in the fund's offering document relating to the risk management operations of the scheme, management of conflicts of interest, the relationship between the prime broker and the fund, ring-fencing arrangements for umbrella structures, the on-going monitoring of the scheme's investment and asset allocation process and the performance of the scheme, the ongoing monitoring of the standards of the services provided by key service provides and the replacement process for such service providers.

The SFC's proposals to reduce the minimum investment requirement for a single strategy hedge fund from US$50,000 to US$30,000 and to permit an increase in the value of the assets of a hedge fund that may be charged to a prime broker have not been implemented.

Offering Funds on a Private Placement Basis in Hong Kong

Exemptions Available Pursuant to the Securities and Futures Ordinance (the "SFO")

The Hong Kong securities law is that only investments which are subject to certain regulatory safeguards should be offered to the public in Hong Kong. Thus, subject to some exceptions, only authorised funds may be offered to the public and only licensed or regulated persons may make such offers. There are a number of exceptions to this requirement which may be relevant to offering hedge funds. These include:

1. offers made by a licensed person or registered institution in respect of a financial product covered by its regulated activity (but this does not apply to anything done in respect of unauthorised collective investment schemes);
2. offers made by the Government;
3. offers made by and/or on behalf of a person acting as a trustee of a trust not being a collective investment scheme to beneficiaries under the trust;
4. offers that can be made without a prospectus for the purposes of the Companies Ordinance (see below);
5. invitations made by an authorised financial institution in relation to a certificate of deposit;
6. documentation in respect of an unauthorised collective investment scheme or regulated investment agreement to persons outside Hong Kong; and
7. the issue of documentation in respect of any collective investment scheme or regulated investment agreement only to professional investors.

The definition of "professional investor" is defined to include, inter alia:

1. a recognised exchange or clearing house;
2. a provider of investment services licensed in Hong Kong or regulated under foreign laws;
3. an authorised financial institution, or a bank regulated under foreign laws;
4. persons carrying on insurance business and regulated in or outside HK;
5. a collective investment scheme authorised in Hong Kong or overseas or its operator;
6. a retirement scheme registered under the Hong Kong Mandatory Provident Fund Scheme Ordinance or any of its service providers;
7. a Hong Kong registered pension scheme or its administrator;
8. any government, central bank or multilateral agency;
9. a wholly owned subsidiary of, a holding company which holds 100% of, or a wholly owned subsidiary of a holding company which holds 100% of category (b) or (c) investors above; and
10. any person of a class prescribed by rules made under section 397 of the SFO.

In reliance on its powers to make rules, the SFC has provided for additional categories of "professional investor" in the Securities and Futures (Professional Investor) Rules. Accordingly, offers of securities and/or collective investment schemes will not need to be authorised if the investors fall within one or other of the following definitions:

1. trust corporations with at least HK$40 million (US$5 million) in assets;
2. high net worth individuals with portfolios of at least HK$8 million (US$1million);
3. corporation or partnership with assets or a portfolio of at least HK$8 million (US$1 million); or
4. corporations which act solely as investment holding companies and are wholly owned by individuals who are themselves professional investors will also qualify.

Exemptions Available Pursuant to the Companies (Amendment) Ordinance 2004
The following exemptions have applied only to corporate funds (not to unit trusts or limited partnerships) since December 2004, and relate to offers that can be made without a prospectus for the purposes of the Companies Ordinance:

1. an offer made to not more than 50 persons;
2. an offer to investors falling within the definition of "professional investors" under the SFO as described below;
3. an offer in respect of which the total consideration payable does not exceed HK$5 million (approximately US$ 650,000) or its equivalent in another currency (small-scale offer exemption);
4. an offer in respect of which the minimum denomination of, or the minimum consideration payable by any person for shares, is not less than HK$500,000 (approximately US$65,000)or its equivalent in another currency (minimum denomination/consideration exemption); and
5. an offer of shares in a company free of charge to any or all shareholders in the company or, as an alternative to a dividend or other distribution, an offer of shares to all shareholders of a particular class in the company.

With the exception of the small-scale offer and minimum denomination/consideration exemptions, it is possible to combine the new exemptions under the Companies Ordinance. This means that (apart from small-scale offer and minimum denomination/consideration exemptions) it would be possible to carve up an offer into two and apply one of the given exemptions to each part and claim exemption for the whole offer. For instance, an offer to both an unlimited number of professional investors and to no more than 50 ordinary investors would be exempted pursuant to the Companies (Amendment) Ordinance 2004.

Disclosure of Interests in Securities of Hong Kong Listed Companies

Any shareholder which comes to be interested in 5% or more of a the voting shares of a company listed on the Hong Kong stock exchange, including the underlying shares of equity derivatives, must disclose its interests by serving a notice in the prescribed form on the Hong Kong Stock Exchange and the listed company in question. Thereafter, a cessation of a notifiable position and changes which take a holding up or down through a whole percentage level require disclosure, as do changes in the nature of the shareholder's interests, subject to new exemptions for small changes.

All short positions of 1% or more in a Hong Kong listed company's voting shares held by a shareholder which also has a notifiable "long" interest in that company's shares (and changes which take a short position up or down through a whole percentage level) must be disclosed separately. Because the requirement to disclose short positions is dependent on having a notifiable long position, it is possible for a shareholder to have very large short positions which, depending on how they are covered, do not require disclosure. Short positions must not be netted off against long positions.

In January 2005, the SFC issued a Consultation Paper on the disclosure of interests in securities of Hong Kong listed companies . Conclusions to the consultation were issued in May 2005. The most significant of these include the following:

Investment managers: non-aggregation

Interests (and short positions) of companies are attributed to their holding companies and other "controllers". This can make for onerous monitoring and disclosure requirements for financial services groups' holding companies, and the SFO contains an exemption which provides for the interests and short positions of certain "qualified" investment managers which operate independently of other group companies.

This exemption has flaws which restrict its applicability, for instance where, as is common, different investment management entities within a group co-ordinate their activities.

The SFC proposed various changes which are intended to make it easier to qualify for the exemption in circumstances where qualified investment managers co-ordinate their activities, and for investment management operations which are within the same legal entity as other operations.

To count as a "qualified" investment manager for these purposes, the investment manager must be regulated in an approved jurisdiction – including Hong Kong, the UK and the USA but not, for example, Singapore. The SFC does not intend to widen this category in the short term, despite pressure to do so.

Security interests given by substantial shareholders

The giving of securities interests to "qualified lenders" can currently be exempt from disclosure on both the chargor's and chargee's parts. This has been subject to considerable public debate, and the SFC has canvassed opinion on a range of possible changes, including the acceleration of disclosure where security is being enforced. No conclusions were reached, and the SFC is setting up a working group to consider this difficult area further.

Changes in the nature of interests

The issue of what changes in relation to a person's interests require disclosure is one of the most difficult, and least understood, areas of the disclosure regime. The range of events which may give rise to a disclosure obligation is extraordinarily wide and arbitrary. The SFC is proposing to restrict disclosure obligations to a few specified types of change; this would be a welcome reform of a most unsatisfactory area of the law.

Notification of Interests in REITS

Since December 2005 similar provisions must be incorporated into the trust deeds of all real estate investment trusts ("REITS"). Holders of units in REITS will be required to submit notifications to the manager of the REIT and the Hong Kong Stock Exchange upon acquiring 5% of the units in a REIT.

Licensing Issues – Amendments to "Regulated Activities"

Entities conducting business in activities regulated by the SFC in Hong Kong are generally required to be licensed by or registered with the SFC. There are nine types of regulated activities, namely dealing in securities (Type 1 activities), dealing in futures contracts (Type 2 activities), leveraged foreign exchange trading (Type 3 activities), advising on securities (Type 4 activities), advising on futures contracts (Type 5), advising on corporate finance (Type 6), providing automated trading services (Type 7), securities margin financing (Type 9) and asset management (Type 9).

The SFC published its conclusions on the Consultation Paper on Proposed Amendments to the Schedule 5 to the Securities and Futures Ordinance in September 2005.

The Consultation Paper had proposed amendments to the definitions of certain regulated activities as set out in the SFO. The main proposals were:

1. to extend the definition of "asset management" to include management of real estate investment trusts.
2. to amend the definition of "dealing in securities" so that:
   (a) the dealing activities of approved money brokers on behalf of authorised financial institutions are excluded; and
   (b) the exemption for disposing of securities as a principal would no longer apply; and
3. to amend the definitions of "advising on securities" and "advising on futures contracts" so that the giving of advice by a licensed asset manager, solely for the purposes of carrying on fund management activities pertaining to collective investment schemes under his management, is to be excluded. This carve out enables managers to introduce their products to the market without having to obtain a separate licence for advising on their products. It only applies to products which they themselves manage.

In the light of comments received, the SFC decided not to implement the proposal to remove the exemption for disposing of securities as a principal for the time being and will reconsider such amendment in a separate consultation exercise.

The other amendments came into effect in December 2005.

Offshore Fund Tax Exemption

At the time of writing a Bill to exempt offshore funds and non-residents from Hong Kong profits tax on transactions effected through an agent in Hong Kong is expected to be voted on at the Legislative Council in early March. The Bill was prompted by concerns raised by the fund management industry regarding the issue of tax returns by the Inland Revenue Department to Hong Kong based investment managers and advisors of offshore funds in relation to these funds.

It is proposed that the exemption will take effect retroactively from 1 April 1997 subject to certain conditions. In order to qualify for the exemption, funds must not be resident in Hong Kong. The concept of residence for tax purposes is relatively unfamiliar in Hong Kong, although it is of course well recognised in other jurisdictions. The residence of a corporate fund will be determined by reference to the situs of its central management and control. Central management and control reside with the board of directors.

Funds managed in Hong Kong should take immediate steps to ensure that at least half the board of the fund is resident outside Hong Kong. Meetings of the board of the fund should also be conducted outside of Hong Kong.

Further information relating to the establishment and distribution of hedge funds in Hong Kong is available from our website www.deacons.com.hk