Oversight September 2016 - SFC updates FAQs on Offers of Investments in relation to real estate arrangements

Introduction

On 17 June 2016 the Securities and Futures Commission of Hong Kong (SFC) issued an updated version of its Frequently Asked Questions (FAQs) in relation to “Offers of Investments” under the Securities and Futures Ordinance of Hong Kong (SFO). The updated FAQs include a new Appendix 1, which provides further guidance with regard to Part IV of the SFO and collective investment schemes (CIS) connected with interests in real property. The new Appendix 1 summarises aspects of the current regulatory regime applicable to CIS in Hong Kong, the features of real estate projects that the SFC considers may constitute a CIS and explains the consequences of promoting or offering interests in a CIS involving real property. 

Whilst there has been no change to the black letter law regulating CIS, there are common misconceptions regarding property funds and so the clarification of the SFC’s policy on such CIS should not be overlooked. In 2013, Cheung Kong (Holdings) unwound sales of its Apex Horizon hotel suites in Kwai Chung after the SFC opined that the units in the hotel amounted to a CIS because day-to-day management of the hotel was in the hands of a separate operator, not the individual owners. More recently in April 2016 the SFC lost a case against IPFund Asset Management for marketing 16 funds investing in real estate without being duly licensed under the SFO. The FAQs seek to clarify the position regard real estate funds, to set out the SFC’s expectations and to alert interested parties that close regulatory scrutiny can be expected.

The updated FAQs are available here.

Regulation of offers of CIS

In Hong Kong the promotion and the offering of interests in a CIS to the public is regulated by the SFC under the SFO. It is an offence under section 103(1) (b) of the SFO to offer to the public to acquire an interest in, or to participate in, a CIS unless the relevant advertisement has been authorised by the SFC or an exemption under section 103(2) or section 103(3) of the SFO applies. A SFC licence is also required for carrying on a business of dealing in securities. An interest in a CIS is a security as defined in Schedule 1 to the SFO. As such promoting a CIS to prospective investors is likely to amount to Type 1 (dealing in securities) regulated activity under the SFO (unless, as with IPFund Asset Management, its CIS were private companies as defined in the Companies Ordinance shares of which are not “securities”).

CIS is defined broadly in Schedule 1 to the SFO. It has four relevant elements:

• it must involve arrangements in respect of any property
• investors do not have day-to-day control over the management of the property even if they have the right to be consulted or to give directions about the management of the property
• the property is managed as a whole by or on behalf of the person operating the arrangements, and/or the contributions of the investors and the profits or income from which payments are made to them are pooled, and
• the purpose or effect of the arrangements is for the investors to participate in or receive: (i) profits, income or other returns from the acquisition, holding, management or disposal of the property, or (ii) payments or other returns from the acquisition, holding or disposal of, the exercise of any right in, the redemption of, or the expiry of, any interest in the property.

It should be noted that “property” in which a CIS invests or intends to invest need not be comprised of securities. A CIS will be subject to the constraints of the SFO if it has these four elements regardless of the nature of what the CIS holds or will hold. In other words an interest in a CIS will be a security for the purposes of the SFO even if the CIS is a real estate fund. It should also be noted that the definition of a CIS under the SFO does not require that the CIS be “open-ended” as is the case in certain jurisdictions although the Hong Kong definition is derived from the old section 75 of the United Kingdom’s Financial Services Act of 1986. A CIS does not therefore have to offer any redemption facility at the election of an investor to be characterised as a CIS.

Real estate projects that may be CIS

The SFC opines in the Appendix to the FAQs that whether or not the sale of any type of real estate and/or real estate project amounts to a sale of interests in a CIS is situational, depending on whether the sale arrangement or scheme satisfies the four elements referred to above.

The term CIS is defined broadly in Schedule 1 to the SFO to cover “arrangements” in respect of any “property”, whereas “property” is widely defined under the SFO and includes “land” or any estate in land. As such, if an arrangement in respect of real estate in Hong Kong (or overseas) has these elements, it would be a CIS.

The SFC places emphasis in its guidance on how the arrangements involving real estate are operated and how the property in question is managed under the relevant arrangement. The SFC is of the view that real estate projects involving interests in hotels or holiday resorts, serviced apartments, student accommodation and shopping malls are generally more likely to be a CIS because it is more likely that these need to be managed on behalf of investors. Moreover, the SFC also believes that real estate projects with “buy-to-let” or “buy and leaseback” features are more likely to be a CIS as these often involve a centralised letting and management service.

In the FAQs, the SFC gives an example of those real estate projects which in its view are likely to amount to a CIS. If investors own the individual units in a real estate project where (i) the units are rented, (ii) the rent is pooled, and (iii) a manager makes decisions about how to rent units, to whom, on what terms and whether any unit should be left unlet for a period, the arrangements are likely to amount to a CIS because the four elements giving rise to a CIS are then satisfied. This is because:

• the real estate project involves “arrangements” in respect of real property, even though investors may have rights with regard to their own units
• the centralised letting service means that owners of units do not have day-to-day control over the management of the property
• the property is managed as a whole by the operator of the arrangements, and
• the purpose of the arrangements is for the investors to receive income from the property.

As regards the second element, “day-to-day control” the SFC says that this means routine, ordinary, everyday management or operational decisions. The SFC emphasises that the test focuses on whether all investors can make management decisions about the property in practice, or in other words, have de facto control over the property. The emphasis of “all investors” is crucial because the SFC says that it would still regard the arrangements as constituting a CIS even if only one investor does not have day-to-day control over the property. Even if the contracts appear to give the investors day-to-day control by granting investors a right to be consulted or to give directions in respect of such management, the arrangement may still in the SFC’s view be a CIS if the investors do not have control in practice. For instance, if the operator makes all management decisions using generic mandates (such as powers of attorney) from investors in the arrangement, even where the investors may have notional control over decision-making, the SFC says that it would still consider that the arrangement is a CIS because the operator, instead of the investors, has effective day-to-day control over the management of the property.

Regarding the third element referred to by the SFC, this is a two-limb test in the alternate and so an arrangement would likely amount to a CIS if it satisfies either limb. The second limb concerns the pooling of contributions and profits or income to be paid to investors. An example of such pooling would be where an investor owns one unit out of the 200 units of the property, and receives 1/200 of the total income from all units as a result of the arrangement. Even if there is no pooling of contributions and profits or income, it may still be a CIS if it satisfies the first limb of the third element - where the property is “managed as a whole” by or on behalf of the person operating the arrangements. This is an aspect of the Hong Kong definition of CIS which is often overlooked - to be a CIS for the purposes of a CIS it is not necessary for there to be pooling of contributions to the CIS. 

Whether a property is being “managed as a whole” can only be determined on a case-by-case basis. For example, if investors owning different units in the same project happen to appoint the same property agent to lease their units for them, the SFC says that it generally would not regard the property agent as managing these units as a whole if the individual investors only engage the property agent to carry out administrative steps to lease out their units and individual investors direct as well as make decisions on key matters relevant to their respective profits, including the identity of the tenant, the terms of the lease and the amount of rent. Likewise, the SFC indicates that it would not generally regard a project as being managed as a whole if the investors make the key profit-generating decisions. Accordingly in the SFC’s view such a project would not be “managed as a whole” by the managing agent even if the agent decides ancillary matters like cleaning and maintenance of common areas, or can get block discounts for all investors for insurance.

Although there is no doubt that the definition of CIS in the SFO is very broad (and perhaps more widely drafted than other jurisdictions), the SFC’s interpretation does not have the force of law and is not free from debate. In the event that the SFC choses to seek to prosecute a person selling real estate schemes, the SFC’s interpretation is likely to be challenged. It is noteworthy that the SFC has not chosen to exercise power through the Financial Secretary under section 393 of the SFO to prescribe real estate arrangements to be CIS although this has been done in connection with gold schemes under the Securities and Futures (Collective Investment Schemes) Notice.

Consequences of promoting or offering interests in a CIS involving real property

Investment in real estate is generally not subject to the provisions of the SFO. Moreover, unless a person is managing a real estate investment trust (REIT) authorized by the SFC and listed on The Stock Exchange of Hong Kong Limited (SEHK), the management of a CIS which only invests in real estate is not of itself a regulated activity because Type 9 (asset management) regulated activity under the SFO governs portfolio management of securities or of SFC authorized REITs only. However, as mentioned above, marketing a promoting a CIS is likely to amount to Type 1 (regulated activity) regardless of the underlying assets of the CIS.

The FAQ refers to two categories of possible offences. The first category of offence concerns offering interests in a CIS to the Hong Kong public. Under section 103(1)(b) of the SFO, it is an offence to issue marketing materials which are or contain an offer to the Hong Kong public to acquire an interest or participate in any type of CIS, unless the advertisement has been authorised by the SFC or an exemption under section 103(2) and (3) of the SFO applies. To seek the SFC’s authorisation in relation to a CIS investing in real property, the CIS is generally required to comply with all the applicable requirements under the Code on Real Estate Investment Trusts (REIT Code) including:

• the CIS must be structured as a Hong Kong domiciled REIT listed on the SEHK
• the CIS manager must be SFC licensed or be licensed by the regulator of an overseas regime acceptable to the SFC
• there must be a trustee of the REIT, and
• the assets of the CIS must be segregated and held in trust by the trustee for unitholders.

Establishing a REIT and obtaining authorisation under the REIT Code is a difficult, costly and time consuming procedure and is unlikely to be suitable or possible for most property arrangements seemingly caught by the SFC’s guidance.

The maximum penalties for the breach of section 103(1) are a fine of HK$500,000 and three years' imprisonment. One of the available exemptions is on the issue of advertisements, invitations or documents made in respect of interests in a CIS that are or are intended to be disposed of only to “professional investors” (as defined under Schedule 1 to the SFO and the Securities and Futures (Professional Investor) Rules).

The second category of offence regards the activity of promoting interests in a CIS.  It is an offence to carry on a business of promoting interests in a CIS without an SFC licence under section 114 of the SFO unless the person under taking the promotion holds a Type 1 (dealing in securities) license.  Unlike the first category, the promotion of interests in a CIS to only professional investors is not an exemption to this offence (unless the person is dealing as principal with professional investors which are financial institutions).  The maximum penalties for a breach of section 114 are a fine of HK$5,000,000 and seven years’ imprisonment. 

In addition, under section 107(1)(b) of the SFO, it is an offence to make a fraudulent or reckless misrepresentation to induce another person to invest in a CIS. This offence carries heavier penalties, with the maximum penalties of a fine of HK$1,000,000 and seven years’ imprisonment. 

Conclusion

The updated FAQs do not change the law or even suggest any changes in the SFC’s interpretation of the SFO and its regulatory approach.  However the FAQs flag the SFC’s obvious discomfit with certain property investment arrangements which are akin to CIS.  If nothing else, the FAQs help participants in the real estate industry to better understand whether they will be operating, managing or promoting a CIS under the SFO, which is a question easily overlooked.  Too often, it is assumed that because an arrangement relates to real estate, the SFO can be ignored.  Given the SFC’s approach and the risks of breaching the SFO (attracting criminal sanction), it is therefore advisable to take legal advice before marketing property investment schemes in Hong Kong.

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