Providers fear collapse in private placement volumes and shift of business to Singapore

Structured product issuers, distributors, private bankers and industry associations have called on Hong Kong's Securities and Futures Commission (SFC) to reconsider its proposal to remove the so-called 'safe harbour' rules that they have long relied on to distribute structured products. Some parties believe as much as 95% of structured products' notional value sold in 2007 and 2008 in Hong Kong was through private placement. Safe harbour rules have enabled providers to issue products without having to meet onerous offering requirements, such as a prospectus.

While the Hong Kong securities regulator has closed its consultation on transferring regulation of all structured products from the Companies Ordinance prospectus regime, to the offers of investments regime under the Securities and Futures Ordinance (SFO), bankers and lawyers are hoping that among the many changes proposed by the regulator, the HK$500,000-minimum safe harbour rule would stay.

Under the city's disclosure-based regulatory approach, issuers are free to launch investment products, as long as adequate disclosure is made to enable informed investment decisions by their investor clients. This prospectus requirement and the authorisation system under the Companies Ordinance and the SFO are the pillars that regulators rely on to ensure adequate disclosure.

In its October consultation, the SFC proposed to align regulation on all structured products under the SFO's 'offers of investments regime' - a shift in policy that would likely trigger a removal of the various safe harbour exemptions linked to the Companies Ordinance, as the Ordinance becomes irrelevant. These safe harbours have been in place since 2004.

"If Hong Kong wants to fulfill its role as an international financial centre, it needs to give investors access to a variety of issuers and different products. If over the long term [such diversity of product and issuer mix] is constrained, investors might look elsewhere [for their investments]," said Wendy Yuen, head of the structured product department of Hang Seng Bank in Hong Kong.

A much-used safe harbour is that a product can be offered as long as it has a minimum denomination of no less than HK$500,000 - in which case no SFC-authorised prospectus needs to be issued. Other safe harbours include an offer being to less than 50 persons or an offer made solely to professional investors.

Aligning regulation of all structured products under the SFO means the HK$500,000 minimum requirement becomes inapplicable, the SFC said in its consultation paper.

The private placement market has long been an important avenue for issuers to make products with greater flexibility and a faster time to market. At such a minimum investment amount, industry participants say the private placement market is, by nature, intended for investors with more market knowledge, and could also an avenue where corporates would invest company money.

"What the SFC is concerned with is when some distributors are aggregating small investors' orders and gross them up to HK$500,000, [claiming those are one ticket from one investor]," said the head of equity derivatives at a European bank, who is based in Hong Kong. "But removing such safe harbours because of this small minority of [offenders] is unfair to banks and distributors who comply with this rule, as they obviously chose the right investors to market their products."

Meanwhile, because many structured products that are sold through private placements are bilateral, over-the-counter products, the industry is concerned that by shifting all structured product under the same SFO regulatory regime, these products would also be subjected to the various sub-ordinance and rules under the SFO that may not be applicable to the nature of OTC derivatives transactions.

"For example, under the Securities and Futures (contract notes, statements of account and receipts) Rules, the bank must prepare a contract note no later than two days after entering into the trade; but for OTC products they may need longer time for settlement so these products may not be able to follow the same T+2 settlement requirement," says Yuen, adding this is just one example of the various technical details that needed to be defined clearly after the shifting of the regulatory regime. A contract note spells out the details of a trade position such as the quantity, name of the securities or foreign exchange contracts and on what market they are traded.

Along with the removal of the safe harbours, the SFC has also sought views on introducing new definition of what constitute a 'structured product'. One proposal that banks view as a much-needed relief is that the SFC has proposed to keep its exemption on regulating currency-linked and money market instruments, as they are generally regarded as banking transactions or treasury instruments of banks.

Under the existing regulatory regime, structured products could be regulated either under the Companies Ordinance or the SFO depending on the legal form of a product. Products such as equity-linked or credit-linked notes are considered debentures in legal form and thus are regulated under the Companies Ordinance - leaving the rest of the structured products not considered debenture to the purview of the SFO. In the October consultation, the SFC has proposed to disregard such legal form considerations going forward.