Hong Kong's Securities and Futures Commission (SFC) has issued its much anticipated final word on how structured products are to be regulated going forward, declining to accept the submissions made by industry participants on many key issues. The removal of the minimum denomination HK$500,000 safe harbour will have a significant affect on the offering of structured products in Hong Kong.
The SFC issued its "Consultation Conclusions on Possible Reforms to the Prospectus Regime in the Companies Ordinance and the Offers of Investments Regime in the Securities and Futures Ordinance" (Conclusions) on Friday evening, 23 April 2010. The Conclusions follow a consultation paper issued in October 2009 and several months of consultation with industry participants.
Going forward, all structured products (whether in the form of a share or debenture, including equity and credit linked notes) will be regulated by the SFC under the Securities and Futures Ordinance (SFO) and not the Companies Ordinance (CO).
The form of the code (SP Code) which details the mechanics for a public offering of unlisted structured products (and which was subject to a parallel consultation process) is yet to be finalised.
The good news
There are a limited number of positive developments.
Certain products will not be caught
The new rules will not apply to securities that are traditional sources of capital including:
- ordinary and preference shares
- depositary receipts
- plain vanilla debentures
- floating rates notes - although the carve-out will not apply to notes that contain structured "bells and whistles"
- convertible and exchangeable bonds and subscription warrants.
The SFC confirms that insurance contracts, employee incentive schemes and loan arrangements are not caught.
Whilst also confirming collective investment schemes are not subject to the new rules, the Conclusions hint at the possibility that structured funds will be subject to the SP Code.
Relief for currency-linked and money market instruments
The banking industry will be pleased that treasury products will remain outside the scope of the SFO although equity-linked deposits and gold and silver-linked products will be subject to the new regime.
Currency-linked and interest rate-linked instruments may even contain knock-in or knock-out features as long as there is no "derivative element". It is unclear what that qualification means.
The exemption will apply to:
"instruments issued by authorized financial institutions that are referenced to:
(a) changes in the level of any interest rate or a basket of interest rates...; or
(b) changes in the level of any currency exchange rate or a basket of currency exchange rates; or
(c) changes in the level of any interest rate/a basket of interest rates and changes in the level of any currency exchange rate/a basket of currency exchange rates. "
This will give structuring flexibility to banks.
Listed structured products will not be subject to the regime
The SFC makes clear that the Stock Exchange of Hong Kong (SEHK) remains the frontline regulator of listed structured products. SEHK-approved products will not be subject to the SP Code or SFC pre-vetting.
Although this confirmation will be welcomed by warrant and other structured product issuers, the reality is that the SEHK consults with the SFC prior to agreeing to list a new product.
Therefore, access to the listed platform will require engagement with the SFC, and possibly, compliance with requirements similar to those set out in the SP Code.
No indiscriminate classification of structured products as securities
The SFC had proposed to regulate "structured products" as "securities" under the SFO. This meant that provisions under the SFO such as the licensing regime would apply to all structured products (whether or not authorised by the SFC). Manufacturers conducting unregulated businesses would need to obtain licenses. The SFC proposes that only structured products which are authorised by the SFC will be brought within the definition of "securities".
The bad news
Removal of the HK$500,000 safe harbour
Currently equity and other asset linked notes are widely sold without SFC approval using the "minimum denomination HK$500,000" safe harbour.
That safe harbour, which has been the key to distribution in Hong Kong, is to be removed. The SFC believes the rationale that supported the introduction of the exemption in 2004 no longer applies.
The SFC acknowledges the significance of this proposal and the possibility "that some businesses may withdraw from Hong Kong".
What does this mean?
The removal of the minimum denomination safe harbour will require manufacturers to either:
- offer products through retail programmes. One example is the popular equity-linked investment product. There is currently a large backlog of programmes awaiting approval by the SFC; or
- rely on the professional investor exemption available under the SFO. A professional must meet a HK$8 million threshold and be judged to understand the nature and risk of the product. The SFC indicates that it will make it easier for investors to demonstrate they satisfy the asset threshold after further consultation.
The reality is that the pool of investors to whom products are sold without SFC approval will be smaller. Those investors unable to satisfy the asset threshold will only be able to buy products approved by the SFC. The SFC approval process is costly and time consuming.
Removal of 50 person safe harbour
The SFC also proposes to remove the offer to "no more than fifty persons" safe harbour on the basis the SFO only applies if there is an offer to the public. The SFC will not confirm how many investors constitute an offer to the public (the concept of which the SFC believes is "well understood") despite suggestions to the contrary during the consultation period.
Publicly offered OTC derivatives will be regulated
The proposed definition of "structured product" is so wide as to capture over-the-counter (OTC) derivatives. The SFC has declined to exclude OTC derivatives on the basis they will not be caught unless they are offered to the public.
The regime will apply where there is an "instrument," meaning a written document. It does not matter whether the instrument is negotiable.
The difficulty for manufacturers is to determine whether there is a public offer of a derivative if it contains different trade specific terms (such as issue date) but similar key features (such as a knock-in feature with the same underlying share or basket of shares).
It remains unclear as to how similar the terms and conditions of a product must be before each offering is aggregated to determine if it is offered publicly.
Offerings by licensed entities will not be exempt
SFC approval is not currently required for the public advertisement of securities issued by entities licensed to deal in securities. That exemption will continue to be available to listed structured product issuers for any marketing materials they issue but will not apply to unlisted structured product offerings.
But there's more - liability provisions could become tougher
The SFC will consider, as part of the CO Phase 3 law reform, whether to include in the SFO the prospectus liability provisions now set out in the CO.
The SFO already contains an extensive liability regime. The CO regime potentially applies a stricter standard of liability to a wider range of persons involved in the issue of a prospectus.
The proposals require amendments to the CO and SFO. The SFC expects a bill to be gazetted and tabled before the Legislative Council during 2010.
Prospectuses authorised under the CO will be grandfathered.
What does this all mean?
The removal of the minimum denomination safe harbour will affect distributors that do not have a large professional investor client base.
The SFC conclusions on many of the other proposals, whilst hotly debated, are not surprising.
A key impediment remains the uncertainty as to timing of the SFC's authorisation of new retail product offerings. There may be further delay until the SP Code is published.
We are keen to help our clients find solutions to the many challenges that confront the structured products industry.
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