Revamped SFC Code on Unit Trusts and Mutual Funds targeted for implementation on 1 January 2019 with transitional period

On 6 December 2018, the Securities and Futures Commission (SFC) published the conclusions to its consultation on proposed amendments to the Code on Unit Trusts and Mutual Funds (UT Code). The proposed amendments are aimed at updating the regulatory regime for SFC-authorised funds and addressing the risks posed by financial innovation and other developments.

The revised UT Code (and consequential amendments to related codes) will become effective tentatively on 1 January 2019, with a transitional period for existing funds and operators (this will in general be 12 months – see further details at the beginning of the revised UT Code and in section 3 of the conclusions paper).

The SFC will provide further guidance regarding the implementation and transitional arrangements by way of FAQs.

These changes build on a raft of other recent regulatory developments in the funds space, including for example the new regulatory framework for crypto fund managers and fund distributors (see our bulletin of November 2018), the new open-ended fund company regime (see our bulletin of June 2018) and amendments to the Fund Manager Code of Conduct and the main code of conduct to enhance asset management regulation and point-of-sale transparency (see our bulletins of November 2017 and May 2018).

Key amendments

The amendments to the UT Code, which are being introduced to address both international and local market developments, mainly concern the following areas:

  1. Key operators (management companies, trustees and custodians)
  2. Permitted investments
  3. Specialised schemes
  4. Operational matters and on-going disclosure and reporting requirements
  5. Application to undertakings for collective investment in transferable securities (UCITS) funds
  6. Codification of existing requirements

We have summarised some of the key amendments below.

Key operators

  • The minimum capital requirement for management companies will be increased from HK$1 million to HK$10 million.
  • Flexibility will be provided to allow management companies with multinational presence to leverage on group resources in meeting the five-year public fund investment management experience requirement for key personnel.
  • The obligations of trustees and custodians will be enhanced to align with standards by the International Organisation of Securities Commissions (IOSCO) on the custody of collective investment scheme assets and with those in other major overseas jurisdictions.
  • The scope and the level of periodic independent audit review of the internal controls and systems of trustees and custodians will be expanded.

Permitted investments

  • The core investment requirements for SFC-authorised funds contained in Chapter 7 of the UT Code will be modernised by including specific provisions to govern activities such as securities lending, sale and repurchase (repo) and reverse repo transactions (collectively referred to as Securities Financing Transactions).
  • An overall limit of 50% on the use of derivatives for investment purposes by plain vanilla public funds will be introduced with an aim to allow flexibility in the deployment of investment objectives and strategies to deliver value to investors. Following the consultation, the SFC has modified the calculation methodology for a fund’s derivatives investment to exclude the use of derivatives which will not result in incremental leverage at the fund portfolio level. The SFC will publish further guidance on the calculation methodology and criteria for exclusions from the 50% limit.
  • A new disclosure requirement will be introduced where the purpose of and expected maximum leverage arising from derivatives investments based on the commitment approach are to be disclosed in the product key fact statements for all SFC-authorised funds.
  • A new column will be added in the list of SFC-authorised funds shown on the SFC website indicating whether the fund is a derivative fund, to enhance transparency for investors and the industry.
  • New diversification restrictions in relation to the investments in, exposure to and cash deposits with entities within the same group will be introduced.

Specialised schemes

  • The requirements on money market funds in various aspects, such as permitted assets, repo transactions and safeguards, portfolio maturity limits, minimum liquid asset level as well as safeguards for amortised cost accounting and constant net asset value, will be tightened to bring them in line with IOSCO standards.
  • The requirements on unlisted index funds and index tracking exchange traded funds (ETFs) (also known as passive ETFs) will be modernised and codified. These include, for example, clarifying the requirements for funds which adopt hybrid index tracking strategies through derivative investments, enhancing the “broadly based” requirement for an underlying index, enhancing the disclosure requirements for Securities Financing Transactions by passive ETFs.
  • New chapters in the UT Code will be introduced for listed open-ended funds (also known as active ETFs) and closed-ended funds.

Operational matters and on-going disclosure and reporting requirements

  • Certain requirements governing funds’ operations and management will be enhanced in alignment with the standards and good practices published by IOSCO in areas on valuation and pricing, termination of funds and financial reporting.

Application to UCITS funds

The SFC currently adopts a streamlined approach to processing applications for the authorisation of UCITS funds domiciled in Luxembourg, Ireland and the United Kingdom. The streamlined measures will be maintained going forward, with a new set of guidance to be published on the SFC website to replace the existing interim measures issued in 2005 and 2007.

Codification of existing requirements

A number of the existing requirements under various SFC circulars, guidance in the form of FAQs and existing practices will be codified. These include but are not limited to the requirements in relation to:

  • the general obligations of management companies such as those requiring proper risk management systems to ensure that funds are designed fairly and operate as designed;
  • the delegation arrangement for a self-managed scheme;
  • the appointment of and eligibility of trustees and custodians;
  • collateral, investment in other funds and structured funds;
  • the market makers for passive ETFs;
  • valuation of fund assets and liquidity risk management of the fund;
  • disclosure with respect to the calculation basis for performance fees;
  • streamlined measures for handling scheme changes; and
  • fair treatment of the interests of holders in case of fund termination.

Final form of revised codes

The final form of the revised UT Code is attached at Appendix A of the conclusions paper. Consequential amendments to the Code on MPF Products, Code on Pooled Retirement Funds and Code on Investment-Linked Assurance Schemes can be found at Appendices C, D and E of the conclusions paper respectively.

The revisions which differ from those proposed in the consultation drafts of the codes are marked in highlight.

Concluding remarks

Fund managers, trustees, custodians and relevant stakeholders in the fund management industry will need to carefully examine the extensive amendments to UT Code and other relevant SFC codes mentioned above and consider the operational and system changes required in order to comply with the new requirements. As mentioned above, the SFC will publish FAQs regarding the implementation and transitional arrangements for the codes.

In terms of the use of derivatives by SFC-authorised funds, fund managers should take heed of the further guidance to be published by the SFC on the calculation methodology and criteria for exclusions from the 50% limit, as mentioned above. Funds which exceed the 50% derivatives investment limit are subject to enhanced distribution requirements under the SFC’s main code of conduct (note that with effect from 6 April 2019, these will also include requirements in relation to complex products). The SFC has indicated that it will conduct surveillance and monitoring on the use of derivatives and may require fund managers to provide data and other information in this regard going forward.

 

William Hallatt
William Hallatt
Head of Financial Services Regulatory, Asia, Hong Kong
Email | Profile
+852 2101 4036
Hannah Cassidy
Hannah Cassidy
Partner, Hong Kong
Email | Profile
+852 2101 4133
Valerie Tao
Valerie Tao
Professional support lawyer, Hong Kong
Email
+852 2101 4125
Jackie Lam
Jackie Lam
Associate, Hong Kong
Email
+852 2101 4194

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