Alert

Who does this affect?

All participants involved in the issuance of structured products in Hong Kong.

What do you need to do?

Read the proposals, attend seminars we will conduct to explain the proposals and give us your input so that we can respond to the SFC on your behalf.

Authors
Minny Siu  (蕭乃瑩)
Partner

Richard Mazzochi  (馬紹基)
Partner

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Richard Mazzochi
(馬紹基)
Partner
T +852 3443 1046

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Hong Kong
Minny Siu  (蕭乃瑩)

Beijing
David Olsson  (沈文)

London
Rowan Russell  

Sydney
Scott Farrell  
Martin James  

Melbourne
Ian Paterson  

Perth
John Naughton  

Brisbane
Berkeley Cox  

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Hong Kong’s Securities and Futures Commission (SFC) issued the “Consultation Paper on Proposals to Enhance Protection for the Investing Public” last Friday. Many of the proposals and the principles supporting them are expected. There are however, many details that are unexpected. The proposals will have far reaching implications for future product development.

What is the bottom line?

The proposals apply to all unlisted structured products offered to the public (other than deposits linked to foreign currency or interest rates). The Paper does not affect listed structured products such as warrants and CBBCs.

The key points for market participants are:

• issuers and guarantors - must make more disclosure about themselves, the product and associated risks. The SFC is considering whether to require a local arranger to be appointed if the issuer or guarantor is not locally licensed. It will be difficult to appoint an entity to that role unless it is related to the issuer or guarantor. Issuers must provide market making support and disclose matters that arise after the issue of the product and which may affect amounts payable to investors;

• hedge counterparties - more onerous requirements on the selection of hedge counterparties including that they are independent of the other transaction parties and that the hedge is on “best available terms”;

• SPVs - in addition to the new requirements for issuers and guarantors, special purpose vehicles (SPVs) must make extensive disclosure about any collateral and related hedge. Collateral is subject to an extensive eligibility criteria, including the need to be readily marketable and diversified;

• distributors - must disclose commissions and other benefits and additional matters such as the capacity in which they act . Gifts must have a low resale value. Products that embed a derivative cannot be sold widely. The categorisation of high net worth individuals as “professional investors” will become much more difficult; and

• trustees - it will become more difficult for trustees to rely on protective provisions that are now commonly accepted.

By way of example, a product such as Lehman Mini-bonds (the prime cause for the issue of the Paper) will not qualify for sale to the public under the new regime.

Background

The Paper is the latest in a long series of publications issued by the SFC and the Hong Kong Monetary Authority (HKMA) following the collapse of Lehman in September 2008. Please see our previous alert Reforms to the offering and distribution of structured products in Hong Kong - 2 April 2009.

The Paper contains proposals that affect:

• unlisted structured products (including equity linked deposits);

• unit trusts and mutual funds; and

• investment-linked assurance schemes.

This alert covers changes to the regulation of unlisted structured products only. A separate alert will be issued in respect of funds and investment linked-assurance schemes.

The SFC’s attempt to bundle together all these products in the same Paper (in order to demonstrate a consistent approach to all products) means that the Paper is lengthy and complex.

The SFC invites responses before 31 December 2009.

The Handbook

Attached to the Paper is a draft of a Handbook that will govern the SFC’s approval, and after-sale supervision, of each category of product.

Failure to comply with the Handbook could result in the withdrawal of product approval at any time during the tenor of the product or disciplinary action. Compensation could be payable to investors. There is no qualification to this measure.

It is unclear from the Paper whether the consequence of the withdrawal of approval applies only with respect to future issuance and does not affect products issued in the past.

The SFC has made clear that all products offered to the public are subject to its prior authorisation unless an express exemption applies. A consequence is that the Handbook applies to all “structured products”, the definition of which is yet to be determined but will include equity linked deposits and all forms of asset linked products (including ELIs). There is no proposal to change the regulation of currency and interest rate linked deposits. They will not be regulated as structured products.

The SFC’s practice will be to require issuers of equity linked deposits to substantially amend their offering documents to comply with the more extensive disclosure standards that apply to other retail structured products. Substantial changes will be required to offering and advertising materials.

Who qualifies as an issuer or guarantor?

The Handbook specifies detailed conditions as to which entities will qualify to issue, or guarantee, structured products including:

• being of “good standing” and not being subject to “any” disciplinary proceeding or other types of events often included as events of default under a lending arrangement;

• exercising due care and diligence in the appointment of any distributor;

• providing transaction legal opinions to the SFC;

• in the case of SPVs, having independent directors; and

• extensive obligations to monitor compliance with the Handbook.

These proposals will have consequences that we expect the SFC does not intend. For example, most issuers or guarantors are subject to some form of disciplinary proceedings from time to time. Many of the conditions require further detail.

The SFC must confirm that substantial issuers and guarantors (that is, other than SPVs) are not required to disclose swaps entered into in respect of a particular structured product.

SPVs must appoint an arranger

SPVs must appoint an entity that is locally licensed to act as arranger. The arranger’s role is to ensure that the issuer at all times complies with the Handbook. This obligation of the arranger is so onerous that arrangers are unlikely to agree to act for unrelated issuers or guarantors. Arrangers are not given the benefit of any defences.

The SFC is also considering requiring the appointment of an arranger when neither the issuer nor the guarantor is locally licensed.

The product must be “fair”

The Handbook requires an issuer and the arranger to confirm to the SFC that a product is “designed fairly and is appropriate for the market(s) for which it is intended”. Issuers are therefore being required to take responsibility for product suitability which is not the current position in Hong Kong or overseas.

In addition to requiring the product design to be fair and appropriate (issuers must have the “highest regard to the protection of investors’ interests”), issuers and arrangers must:

• be independent of any hedge counterparty;

• amongst other things, have regard to the “financial resources and creditworthiness” of any hedge counterparty;

• ensure that any hedge is at a “fair market value and on the best available terms”; and

• ensure that each hedge counterparty or guarantor submit to the jurisdiction of the laws of Hong Kong.

These requirements go well beyond current requirements and the need for change consequent upon the failure of Lehman Mini-bonds. It is unclear how any party would demonstrate compliance with some of these conditions to the satisfaction of the SFC.

Requiring a hedge counterparty to be independent of the issuer and guarantor is very difficult. The technology that supports the hedge for a structured product is confidential and not usually provided to unrelated parties.

The SFC will continue to approve the identity of assets to which structured products are linked.

Collateral

Assets held as collateral must:

• be readily tradeable;

• have a top three investment grade credit rating;

• not embed any derivative;

• not be issued by an SPV;

• be acquired at the “best available” price;

• be diversified and “not subject investors to any undue risk”; and

• be marked to market daily.

Many of these requirements do not fit easily with each other (for example, requiring a credit rating and banning the use of embedded derivatives). Few assets that are commonly used as collateral will qualify.

The proposals require investors to rank first in priority to all other claims to the proceeds of collateral (after the fees and expenses of transaction parties have been deducted).

This is a direct response to Lehman Mini-bonds where the swap counterparty had first recourse to the relevant collateral. This requirement will severely restrict structuring opportunities. Swap counterparties usually rank first because they provide the funds necessary to enable investors to be paid. The requirement is difficult to reconcile with other measures (including proposals designed to require the demonstration of the creditworthiness of hedge counterparties).

The SFC will require issuers and arrangers to confirm that any collateral “adequately protects the interests of investors”. This appears to be equivalent to guaranteeing the collateral will be adequate to pay amounts owed to the investors.

Key Fact Statements and other information

Key Fact Statements (KFS) must be included as part of every offering document for a structured product. The KFS is a user-friendly summary not exceeding four pages in length. A template is attached to the Paper.

Products recently approved by, and currently before, the SFC already include a KFS.

An appendix to the Handbook identifies in some detail the information that the SFC requires to be included in an offering document. Much of it reflects the SFC’s current practice but there are a few surprises including the requirement to include:

• the names, descriptions and addresses for service of process of the directors of the issuer, guarantor and arranger;

• detailed explanations of the limitations on enforcement of any guarantee and collateral and the limitations on the duties of the trustee; and

• particular balance sheet and profit and loss items if not included in any interim report.

Directors do not currently take personal responsibility for the contents of an offering document regulated under the SFO. They do take responsibility for a document which offers debentures regulated under the Companies Ordinance (CO). We assume that the requirement to name directors is necessary because the SFC anticipates a change in law to require directors to take that responsibility for disclosure in respect of all structured products (we hope together with an appropriate due diligence defence).

We question whether the additional information will assist investors understand what they are buying. It will certainly add to length and complexity of offering documents.

The Handbook will include advertising guidelines which largely reflect current market practice. The SFC has confirmed that pre-vetting by the SFC of all advertising material will continue. The Handbook requires a designated senior manager of the issuer to review all advertising material.

Post sale obligations

Issuers will be obliged to give extensive information to investors and the SFC including:

• firm (fair and reasonable) price quotations at least weekly unless the tenor of the product is one calendar month or less. Break funding and unwinding costs may be taken into account;

• indicative (fair and reasonable) valuations daily. Material fluctuations must be explained;

• the annual and interim financial reports and any other financial report of the issuer, the guarantor and hedge counterparty in English and Chinese;

• notice of any material adverse change in the financial condition of the issuer, the guarantor or the hedge counterparty or their ability to comply with the terms of the structured product; and

• responses to “any enquires” made by the SFC.

These requirements are very onerous. We assume (although it is far from clear) the updated financial material must only be included in a supplemental offering document for continuously offered structured products (and not for an issued, but unexpired, product). Of considerable concern is a further proposal that issuers and arrangers compensate investors for “any disadvantage” suffered because of a failure to comply with the Handbook. There is no due diligence or other qualification to this requirement.

Are trustees spared?

No. The proposals will affect trustees. In particular:

• the trust deed must not contain any term that may “undermine” any applicable provision of the Handbook;

• the trust deed must oblige the trustee to “use its best efforts” to enforce rights in relation to the collateral;

• the trustee must be independent of the issuer, guarantor, arranger and swap counterparty;

• the trustee must not be subject to types of events often included as events of default under a lending arrangement; and

• trustees will require investors’ consent to any substitution of the collateral.

The consequence of these proposals is to deny trustees commonly accepted protections including the power to insist on proper instructions and indemnification before they take action.

Companies associated with trustees will be unable to appoint directors to SPVs. It will become increasingly more difficult to find trustees prepared to act on retail transactions (particularly those that are collateralised). The restrictions on powers of substitution of the collateral are unhelpful. Many asset-linked products contemplate this possibility within narrow boundaries (because of changes that could affect the underlying).

Changes in law

The SFC proposes to press ahead with the amendment of the SFO and CO so that all structured products are regulated under the SFO. Structured products in the form of debentures will cease to be regulated under the CO.

Whilst this is a significant proposal, we expect it will not affect the way those transactions are documented because the SFC has effectively adopted very similar disclosure standards for structured products under the CO and SFO for some time. One potential issue is whether the SFC will require directors to take individual responsibility for the accuracy of disclosure documents (as currently required under the CO but not the SFO).

It is unknown whether the SFC will allow the sale of structured products to individual investors where they pay at least HK$500,000 (being an exemption currently available under the CO but not the SFO).

Distributor issues

Derivative products

The SFC proposes that any structured product that embeds a derivative may only be sold to “clients with derivative knowledge” meaning investors that have:

• attended courses about derivative products;

• derivatives trading experience; or

• derivatives work experience.

Whilst investors without that knowledge may buy a derivative product, more exhaustive steps must be taken by a distributor to warn the investor about the product.

This will be a very onerous requirement if it applies to any product where an issuer enters into a swap to hedge its exposure to the underlying assets. Most structured products involve a swap that matches amounts payable under the product.

Professional investors

Distributors will need to substantially tighten their procedures concerning which investors qualify as high net worth investors. In addition to possessing a minimum portfolio of a minimum amount (currently set at HK$8 million), investors must have knowledge and experience in respect of each type of product that is of a different nature and has different features and risks.

That knowledge and experience will comprise either:

• working for at least one year “in the relevant financial sector”; or

• product-related training.

This requirement will effectively limit high net worth individuals to those employed in the finance industry. We doubt other investors will agree to submit themselves to formal training.

Disclosure of commissions

A number of options are identified to deal with disclosure in relation to:

• payments made by issuers to distributors;

• benefits received by distributors for the distribution of a product issued by a related entity; and

• profits made by a distributor in trading structured products.

The SFC contemplates the disclosure of either the payment or benefit received or a generic description of any benefit. It is proposed to include that disclosure in a “Sales Disclosure Document” (together with other information such as whether the distributor is acting as agent or principal in the sale of the product).

Gifts

The SFC will continue to permit gifts with a low resale value and discounts of fees and charges for substantial purchases.

No other gifts will be allowed.

Audio recording

The SFC does not propose changes to the way distributors currently record their customer risk profiling or sales processes, but invites comments on this issue.

Cooling-off

The SFC is seeking market views on whether investors may cancel an order to buy from, or to sell a product back to, the issuer. The SFC appears to accept that break costs and administrative costs will be deducted. The SFC recognises an array of issues relevant to particular facts (including a concern that cooling-off by one investor may disadvantage other investors who continue to hold the product). Investors will not have deducted amounts greater than the sum they invested.

Other countries do not require cooling-off in respect of structured products because:

• of the difficulties identified by the SFC; and

• the commercial terms of such product and the way they are hedged and sold assume a fixed investment term.

There is usually no ready secondary market for the product. Investors are therefore likely to incur a substantial deduction against their investment. We suggest the emphasis should be on disclosure and the sales process rather than giving investors a right to change their minds.

Products Advisory Committee

The SFC proposes to constitute a new committee for the purpose of advising on policy and market trends across product areas. The Committee will comprise “industry participants and other stakeholders”.

It is unclear exactly what the Committee’s role will be in the product approval process.

Transition period

Issuers of products that have already been approved by the SFC will have six to nine months after the commencement of the new arrangements in which to ensure they comply with the Handbook. Applications before the SFC will be assessed against the Handbook.

Conclusion

The proposals are extensive and include many new requirements. Considerable work needs to be undertaken by industry participants to give a co-ordinated and detailed response to the SFC. Some of the proposals are particularly onerous. The proposals mean:

• more extensive SFC review of all aspects of structured product sales;

• greater levels of disclosure;

• an inability to sell particular types of structured products to the public;

• a narrower class of person qualifying as a professional investor; and

• more avenues for the SFC to take enforcement action in respect of structured products.

Mallesons Stephen Jaques will shortly conduct client seminars explaining the proposals in detail. We will be pleased to join with clients in responding to the Paper.