A summary and commentary on the recent decision of the Hong Kong Court of Final Appeal regarding service of originating process by the Securities and Futures Commission

On 30 October 2023, the Hong Kong Court of Final Appeal (the “CFA”) handed down its reasons for dismissing the appeal in Securities and Futures Commission v Isidor Subotic and Others [2023] HKCFA 32[1]. The CFA confirmed that leave is not required for the Securities and Futures Commission (the “SFC”) to serve proceedings out of jurisdiction as the relevant provisions in the Securities and Futures Ordinance (the “SFO”) has empowered the Court of First Instance (the “CFI”) to hear and determine a claim made against persons who are not within the jurisdiction.

  1. Background

In July 2019, the SFC commenced the present proceedings against various individuals and companies under sections 213 and 274 of the SFO. It was alleged that these parties were operating a false trading scheme involving artificially inflating the price of the share of a Hong Kong listed company before “dumping” them and causing loss to market participants and lenders. The SFC sought, amongst other relief, a restoration order in favour of the market participants involved and an injunction to freeze certain assets.

As six of the defendants in this case were located outside of Hong Kong (the “Foreign Defendants”), the SFC applied for and was granted leave to serve a concurrent writ on them outside of Hong Kong. The Foreign Defendants applied to set aside the order granting leave and sought a declaration that the CFI lacks jurisdiction over them, arguing that leave was wrongly granted as the SFC’s claims did not come within any of the “gateways” specified in Order 11, rule 1(1) of the Rules of the High Court (the “RHC”) (i.e., the types of claims for which leave to effect service outside of Hong Kong could be obtained).

The CFI[2] and the Court of Appeal[3] both upheld the decision granting leave to effect service out of the jurisdiction on the basis that claims of the SFC were either a claim founded on tort and damage was sustained or resulted from an act committed within the jurisdiction (“Gateway F”) or a claim for an injunction restraining a conduct within the jurisdiction. The Foreign Defendants then appealed to the CFA on grounds that the relief sought by the SFC under Section 213 of the SFO cannot be properly characterized as a claim and even if it is a claim, it is not founded on tort for the purpose of invoking Gateway F.

Before the CFA hearing, the CFA directed the parties to make submissions on whether leave was in fact necessary in the circumstances because under Order 11, rule 1(2) of the RHC, if a legislative provision already confers the CFI with jurisdiction in respect of a claim over a defendant outside of Hong Kong or in respect of a wrongful act committed outside Hong Kong, leave from the court is not required for effecting service of a writ out of the jurisdiction.

  1. CFA’s Decision

The CFA unanimously dismissed the appeal and held that, according to Order 11, rule 1(2) of RHC, it was not necessary for the SFC to seek leave from the CFI to serve its claim on the Foreign Defendants.

In coming to such conclusion, the CFA looked into three questions in particular, namely (1) what are the claims that the SFC is making; (2) whether the CFI is empowered to hear and determine the claims made by the SFC by virtual of any written law; and (3) whether the CFI is so empowered notwithstanding that the person against whom the claim is made is not within the jurisdiction of the court or that the wrongful act giving rise to the claim did not take place within the jurisdiction.

On the first question, it was observed that the writ which the SFC served upon the Foreign Defendants seeks declarations that they are persons within section 213 of the SFO who have engaged in false trading activities in contravention of sections 274 and/or 295 of the SFO.

On the second question, having identified the claims of the SFC, the CFA then considered the effect of sections 213 and 274 of the SFO. The CFA held that these provisions are intended to operate in combination and must be read together. Whilst section 274 of the SFO defines the prohibited acts of false trading, section 213 of the SFO provides for the orders that the CFI may impose against the contraveners. It is clear that by virtue of the written law, CFI is empowered to hear and determine the claims put forwarded by the SFC under sections 213 and 274 of the SFO.

On the last question, the CFA found in the affirmative because upon contravention of section 274 of the SFO, the CFI is empowered under section 213 of the SFO to grant relief against a person “in Hong Kong or elsewhere” where such person does anything that constitutes false trading affecting the Hong Kong market. It was noted that the policy to confer the CFI with extraterritorial jurisdiction over persons outside of Hong Kong is justified considering that trading on the Hong Kong Stock Exchange is global and therefore it would be necessary to make sanctions legally available against overseas fraudulent parties who cause disruption to the local market and losses to other investors.

Notwithstanding the above, the CFA also made clear that the application of Order 11 rule 1(2) of the RHC is limited to cases where the written law in question clearly contemplates proceedings being brought against persons outside of jurisdiction or where the wrongful act did not take place within the jurisdiction. It is not sufficient if the written law is of general application and may be invoked against persons within or outside the jurisdiction.

  1. Comment

This decision confirms that no leave is required for the SFC to serve a writ seeking reliefs such as restoration orders, damages and compensation orders or restraint orders under section 213 of the SFO on foreign defendants out of jurisdiction.

Such decision is consistent with the intent of the SFO to seek redress in relation to wrongful acts damaging to market participants whether such acts took place within or outside Hong Kong and to provide appropriate legal recourse against the wrongdoers. In light of the decision, it is expected that the SFC may take more aggressive enforcement actions against parties who have engaged in cross-border market misconduct and pursue them regardless of their physical location.

____________________________

[1] https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=155879

[2]https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=137397&currpage=T

[3]https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=149666

The following Gibson Dunn lawyers assisted in preparing this alert: Brian Gilchrist, Elaine Chen, Alex Wong, and Cleo Chau.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, or the following authors in the firm’s Litigation Practice Group in Hong Kong:

Brian W. Gilchrist OBE (+852 2214 3820, bgilchrist@gibsondunn.com)
Elaine Chen (+852 2214 3821, echen@gibsondunn.com)
Alex Wong (+852 2214 3822, awong@gibsondunn.com)
Cleo Chau (+852 2214 3827, cchau@gibsondunn.com)

© 2023 Gibson, Dunn & Crutcher LLP.  All rights reserved.  For contact and other information, please visit us at www.gibsondunn.com.

Attorney Advertising: These materials were prepared for general informational purposes only based on information available at the time of publication and are not intended as, do not constitute, and should not be relied upon as, legal advice or a legal opinion on any specific facts or circumstances. Gibson Dunn (and its affiliates, attorneys, and employees) shall not have any liability in connection with any use of these materials.  The sharing of these materials does not establish an attorney-client relationship with the recipient and should not be relied upon as an alternative for advice from qualified counsel.  Please note that facts and circumstances may vary, and prior results do not guarantee a similar outcome.

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On November 2, 2023, Hong Kong’s Securities and Futures Commission (“SFC”) published two circulars providing guidance to intermediaries engaging in tokenised securities-related activities (the “Tokenised Securities Circular”),[1] and on the tokenisation of SFC-authorised investment products (the “Investment Products Circular”) (collectively, the “Circulars”).[2]

As further explained below, the Circulars reflect a distinct evolution in the SFC’s views on tokenised securities, in particular by explicitly superseding the SFC’s previous March 2019 statement characterising security tokens as complex products requiring extra investment protection measures and restricting their offering to professional investors (the “March 2019 Statement”).[3] Instead, the SFC has made it clear in the Tokenised Securities Circular that it now considers tokenised securities to be traditional securities with a tokenisation wrapper, as discussed further below, and has noted that there is a growing interest in tokenising traditional financial instruments in the market, including the issuance and distribution of tokenised funds by fund managers and management of funds that invest in tokenised securities. The two Circulars aim to assist intermediaries interested in exploring tokenisation by providing more guidance on regulatory expectations with respect to tokenised securities-related activities and how to address the risks specific to tokenised securities.

I. The Tokenised Securities Circular represents an important evolution in the SFC’s views of Tokenised Securities

As a starting point, the SFC has indicated that for the purposes of the Tokenised Securities Circular, it considers tokenized securities to be traditional financial instruments (e.g. bonds or funds) that are securities (as defined in the Securities and Futures Ordinance (“SFO”)) which utilise distributed ledger technology (e.g. blockchain technology) (“DLT”) or a similar technology in their security lifecycle (“Tokenised Securities”).[4] In the SFC’s words, these securities are “fundamentally traditional securities with a tokenisation wrapper”. Given this, the SFC has emphasised in the Tokenised Securities Circular that the existing legal and regulatory requirements for securities will continue to apply to Tokenised Securities.

In taking this approach, the Tokenised Securities Circular represents an important step forward from the March 2019 Statement, which characterised Security Tokens as complex products and imposed a “professional investor-only” (“PI-only”) restriction on the distribution and marketing of these securities. However, the SFC has now made it clear that tokenisation should not alter the complexity of the underlying security. Therefore, instead of a blanket categorisation of Tokenised Security as a “complex product”, the SFC now instructs intermediaries to adopt a “see-through approach”. In other words, intermediaries should determine the complexity of a Tokenised Security by assessing the underlying traditional security against the factors set out in the Guidelines on Online Distribution and Advisory Platforms and the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “Code of Conduct”),[5] as well as guidance issued by the SFC from time to time.

Similarly, the SFC has indicated that as Tokenised Securities are fundamentally traditional securities with a tokenisation wrapper, there is no need to impose a mandatory PI-only restriction. However, the offerings of Tokenised Securities to the Hong Kong public will continue to be subject to the prospectus regime in the Companies (Winding Up and Miscellaneous Provisions) Ordinance and offers of investments regime under Part IV of the SFO (“Public Offering Regimes”). As such, Tokenised Securities that have not complied with the prospectus requirements or offers of investments regime can only be offered to PIs.

The SFC has also noted that existing conduct requirements for securities-related activities will apply to the distribution of or advising on Tokenised Securities, management of funds investing in Tokenised Securities and secondary market trading of Tokenised Securities on virtual asset trading platforms.

II. Key regulatory expectations when engaging in Tokenised Securities-related activities

The Tokenised Securities Circular goes on to set out guidance regarding the SFC’s expectations for intermediaries choosing to engage in Tokenised Securities related-activities, as summarised below.

Risk management considerations

The SFC has emphasised in the Tokenised Securities Circular that its approach remains “same business, same risks, same rules”. However, the SFC considers that tokenisation has created new risks for intermediaries in relation to ownership (e.g. in relation to how ownership interests are transferred and recorded) and technology risks (e.g. forking, network outages and cybersecurity risks).

These risks can vary depending on the type of the DLT network utilised for the Tokenised Securities, with the SFC flagging that intermediaries should apply particular caution in relation to Tokenised Securities in bearer form issued using permissionless tokens on open, public network that does not restrict access for privileges and offers decentralised, anonymous, and large-scale user base (“Public-Permissionless Network”). This is on the basis that these sorts of securities are exposed to increased cybersecurity risks due to the lack of restrictions for public access and the open nature of these networks. In the event of a cyberattack, theft or hacking, the SFC has flagged that investors may experience increased difficulties in recovering their assets or losses, and may face potentially substantive losses without recourse. Intermediaries should address such risks accordingly by adopting adequate safeguards and controls.

Considerations for intermediaries engaging in Tokenised Securities-related activities

In general, the SFC has noted that:

  • Intermediaries engaging in Tokenised Securities-related activities need to ensure that they have appropriate manpower and expertise to understand and manage the nature of these activities, especially the new risks posed by the underlying technology.
  • Intermediaries must also ensure that they act with due skill, care and diligence, and perform due diligence on both the underlying product (e.g. the underlying security such as a bond which is being tokenised) and the technology used for the tokenisation.

Issuance of Tokenised Securities

Where intermediaries issue or are substantially involved in the issuance of Tokenised Securities which they also intend to deal in or advise on (e.g. fund managers of tokenised funds), the SFC will consider that these intermediaries remain responsible for the overall operation of the tokenisation arrangement, even if they have entered into outsourcing arrangements with third party vendors or service providers. The SFC has set out a non-exhaustive list of considerations that intermediaries involving in issuance should consider in relation to technical and other risks (see Part A of the Appendix to the Tokenised Securities Circular).[6] These considerations include, for example, the experience of the third party vendors involved in the tokenisation process, the robustness of the DLT network, data privacy risks and enforceability of the Tokenised Security.

The SFC has also stated that for custodial arrangements, intermediaries should consider the features and risks of the Tokenised Securities when considering the most appropriate custodial arrangement in relation to such Tokenised Securities, and that it expects custodial arrangements for bearer form Tokenised Securities using permissionless tokens on Public-Permissionless Networks to take into consideration the factors set out at Part B of the Appendix.[7] These factors include, for example, the custodian’s management of conflicts of interest, its cybersecurity risk management measures and its experience in providing custodial services for Tokenised Securities.

Dealing in, advising on, or managing portfolios investing in Tokenised Securities

Intermediaries should conduct due diligence on the issuers and their third party vendors / service providers, as well as the features and risks arising from the tokenisation arrangement when dealing in, advising on, or managing portfolios investing in Tokenised Securities. Intermediaries should also ensure that they are satisfied that adequate controls have been put in place by the issuers and their third party vendors / service providers to manage ownership and technology risks posed by the Tokenised Security before engaging in any of these activities.

Disclosure obligations

The SFC expects intermediaries to make adequate disclosures to clients of relevant material information (including risks) specific to Tokenised Securities. Such material information should include, for example:

  • Whether off-chain or on-chain settlement is final;
  • Any limitations imposed on transfers of the Tokenised Securities;
  • Whether a smart contract audit was conducted before the smart contract was deployed;
  • Key administrative controls and business continuity plans for DLT-related events; and
  • The details of any custodial arrangement where applicable.

III. Other clarifications regarding Tokenised Securities

The Tokenised Securities Circular also includes three important clarifications regarding the SFC’s approach to Tokenised Securities going forward:

  • The SFC has previously stated that the “de minimis threshold” under the Proforma Terms and Conditions for Licensed Corporations which Manage Portfolios that Invest in Virtual Assets (“Terms and Conditions”) only applies to virtual assets, as defined under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance.[8] [9] Viewed in conjunction with the Circulars, fund managers managing portfolios investing in Tokenised Securities which meet the “de minimis threshold” would not be subjected to the Terms and Conditions unless these portfolios also invest in virtual assets meeting the “de minimis threshold”.
  • Virtual asset trading platforms (“VATPs”) licensed by the SFC are currently required to set up a SFC-approved compensation arrangement to cover potential loss of security tokens.[10] On application by the VATP, the SFC has indicated that it is willing to consider, on a case-by-case basis, excluding certain Tokenised Securities from the required coverage.
  • The SFC has also provided guidance in relation to digital securities other than Tokenised Securities – i.e. products which the SFC defines as securities as defined in the SFO which utilise DLT or other similar technology but which are not traditional financial instruments. The SFC has indicated that these sorts of digital securities which are not Tokenised Securities are likely to be complex products on the basis that they are likely to be bespoke in nature, terms and features, and not easily understood by a retail investor. Given this, intermediaries distributing such digital securities would be required to comply with the requirements for sale of complex products. Further, the SFC has reminded intermediaries not to offer these sorts of digital securities to retail investors in breach of the Public Offering Regimes. The SFC has also emphasised that intermediaries should exercise their professional judgment to assess each digital security which they deal with, including whether the security is a Tokenised Security, and should ensure that additional internal controls are implemented to address the specific risks and nature of such digital securities.

IV. Key considerations for the tokenisation of SFC-authorised investment products

The Investment Products Circular separately sets out the SFC’s requirements for considering allowing tokenisation of investment products authorised by the SFC for offering to the Hong Kong public. It must be emphasised that the SFC requirements for Tokenised Securities (as set out in Section II above) will also apply to the tokenisation of SFC-authorised investment products.

Echoing the approach taken by the SFC in the Tokenised Securities Circular, the SFC has indicated in the Investment Products Circular that it will take a “see through” approach to tokenised SFC-authorised investment products, and will allow primary dealing of tokenised SFC-authorised investment products provided that the underlying product meets certain specified product authorisation requirements and safeguards, as summarised below.

Tokenisation arrangement

Product providers of tokenised SFC-authorised investment products (“Product Providers”) should:

  • Remain and ultimately be responsible for the management and operational soundness of the tokenisation arrangement and record keeping in relation to ownership, regardless of any outsourcing arrangement;
  • Ensure that proper records of token holders’ ownership interests are maintained;
  • Ensure that the tokenisation arrangement is operationally compatible with involved service providers;
  • Impose additional and proper controls before adopting Public-Permissionless Networks (e.g. use of a permissioned token);
  • Confirm and, where requested by the SFC, demonstrate that the tokenisation arrangement, record keeping of ownership information and integrity of the smart contract is properly managed and operated, and (where requested by the SFC) obtain third party audit or verification of the same; and
  • Where requested by the SFC, obtain a satisfactory legal opinion to support the application for primary dealing of  a tokenised SFC-authorised investment product.

Disclosure obligations

The following disclosures must be made clearly and comprehensively in offering documents of a tokenised SFC-authorised investment product:

  • The nature of the tokenisation arrangement, including whether off-chain or on-chain settlement is final;
  • The ownership representation of the tokens, including legal and beneficial title of the tokens, and ownership of or interests in the product; and
  • The associated risks of the tokenisation arrangement, including cybersecurity, system outages, the possibility of undiscovered technical flaws, evolving regulatory landscape and potential challenges in the application of existing laws.

Distribution of tokenised SFC-authorised investment products

Only regulated intermediaries (e.g. licensed corporations or registered institutions) can distribute tokenised SFC-authorised investment products. This requirement extends to Product Providers who wish to distribute their own products.

These regulated intermediaries must comply with existing requirements (e.g. client onboarding requirements and suitability assessments) as applicable.

Staff competence

Product Providers must ensure that they have at least one competent staff member with the relevant experience and expertise to operate and/or supervise the tokenisation arrangement and to manage the ownership and technology risks of the arrangement.

Prior SFC consultation or approval

Prior consultation with the SFC will be required for tokenisation of existing SFC-authorised investments and the introduction of new investment products with tokenisation features.

Changes made to the tokenisation of existing SFC-authorised investments must also be approved by the SFC. For example, the SFC has noted that its prior approval must be sought before adding the disclosure of new tokenised unit or share class of an SFC-authorised fund to the offering documents for offering to the Hong Kong public, unless the tokenisation arrangement is substantially the same as the existing arrangement.

Meanwhile, driven by investor protection concerns, the SFC has adopted a more cautious attitude towards secondary trading of tokenised SFC-authorised investment products, on the basis that further careful consideration is required in order to provide a substantially similar level of investor protection to investors to that afforded to those investing in a non-tokenised product. The considerations flagged by the SFC include maintenance of proper and instant token ownership record, readiness of trading infrastructure and market participants to support liquidity, and fair pricing of tokenised products. The SFC has indicated that it will continue to engage with the market on proper measures to address risks involved in secondary trading.

V. Conclusion

While the Circulars provide welcome guidance to intermediaries in relation to tokenisation of traditional financial instruments, it is clear that the SFC will expect intermediaries to closely engage with them prior to embarking on any activities in relation to tokenised products. Given the fast-changing nature of the cryptocurrency space, the SFC may provide further guidance or impose additional requirements for Tokenised Securities and/or tokenised SFC-authorised investment products from time to time. In particular, it appears that the SFC may well release further guidance in relation to secondary trading of SFC-authorised investment products following further engagement with market participants. Interested intermediaries should closely monitor such developments and ensure continuous compliance.

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[1] “Circular on intermediaries engaging in tokenised securities-related activities”, published by the SFC on November 2, 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC52

[2] “Circular on tokenisation of SFC-authorised investment products”, published by the SFC on November 2, 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC53

[3] “Statement on Security Token Offerings” published by the SFC on March 28, 2019, available at: https://www.sfc.hk/en/News-and-announcements/Policy-statements-and-announcements/Statement-on-Security-Token-Offerings

[4] “Securities” is defined under section 1 of Part 1 of Schedule 1 to the SFO, available at: https://www.elegislation.gov.hk/hk/cap571

[5] See Chapter 6 of the Guidelines on Online Distribution and Advisory Platforms, published by the SFC in July 2019, available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/guidelines-on-online-distribution-and-advisory-platforms/guidelines-on-online-distribution-and-advisory-platforms.pdf?rev=689af636b3ad4077929d46a94631e458. See also paragraph 5.5 of the Code of Conduct, published by the SFC, available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/code-of-conduct-for-persons-licensed-by-or-registered-with-the-securities-and-futures-commission/Code_of_conduct-Sep-2023_Eng-Final-with-Bookmark.pdf?rev=209e9f3b717e4d70b45bfe45a0bb6288

[6] See Part A of Appendix to the “Circular on intermediaries engaging in tokenised securities-related activities” published by the SFC on November 2, 2023, available here: https://apps.sfc.hk/edistributionWeb/api/circular/openAppendix?lang=EN&refNo=23EC52&appendix=0

[7] See Part A of Appendix to the “Circular on intermediaries engaging in tokenised securities-related activities” published by the SFC on November 2, 2023, available here: https://apps.sfc.hk/edistributionWeb/api/circular/openAppendix?lang=EN&refNo=23EC52&appendix=0

[8] The Terms and Conditions are imposed on licensed corporations which manage or plan to manage portfolios with (i) a stated investment objective to invest in virtual assets; or (ii) an intention to invest 10% or more of the gross asset value of the portfolio in virtual assets (i.e. the “de minimis threshold”). See the Terms and Conditions, published by the SFC in October 2019, available at: https://www.sfc.hk/web/files/IS/publications/VA_Portfolio_Managers_Terms_and_Conditions_(EN).pdf

[9] “Joint Circular on Intermediaries’ Virtual Asset-Related Activities”, jointly published by the SFC and Hong Kong Monetary Authority on October 20, 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/suitability/doc?refNo=23EC44

[10] See paragraph 10.22 of the “Guidelines for Virtual Asset Trading Platform Operators”, published by the SFC in June 2023, available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/Guidelines-for-Virtual-Asset-Trading-Platform-Operators/Guidelines-for-Virtual-Asset-Trading-Platform-Operators.pdf?rev=f6152ff73d2b4e8a8ce9dc025030c3b8

The following Gibson Dunn lawyers prepared this client alert: William Hallatt, Emily Rumble, and Jane Lu.*

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact any member of Gibson Dunn’s Global Financial Regulatory team, including the following members in Hong Kong and Singapore:

William R. Hallatt – Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)
Grace Chong – Singapore (+65 6507 3608, gchong@gibsondunn.com)
Emily Rumble – Hong Kong (+852 2214 3839, erumble@gibsondunn.com)
Arnold Pun – Hong Kong (+852 2214 3838, apun@gibsondunn.com)
Becky Chung – Hong Kong (+852 2214 3837, bchung@gibsondunn.com)

*Jane Lu is a paralegal in the firm’s Hong Kong office who is not yet admitted to practice law.

© 2023 Gibson, Dunn & Crutcher LLP.  All rights reserved.  For contact and other information, please visit us at www.gibsondunn.com.

Attorney Advertising: These materials were prepared for general informational purposes only based on information available at the time of publication and are not intended as, do not constitute, and should not be relied upon as, legal advice or a legal opinion on any specific facts or circumstances. Gibson Dunn (and its affiliates, attorneys, and employees) shall not have any liability in connection with any use of these materials.  The sharing of these materials does not establish an attorney-client relationship with the recipient and should not be relied upon as an alternative for advice from qualified counsel.  Please note that facts and circumstances may vary, and prior results do not guarantee a similar outcome.

We are pleased to provide you with the next edition of Gibson Dunn’s digital assets regular update. This update covers recent legal news regarding all types of digital assets, including cryptocurrencies, stablecoins, CBDCs, and NFTs, as well as other blockchain and Web3 technologies. Thank you for your interest.

Enforcement Actions

United States

  1. Sam Bankman-Fried Convicted On All Charges After Weeks-Long Criminal Fraud Trial

On November 2, a New York jury convicted FTX founder Sam Bankman-Fried of stealing billions of dollars’ worth of FTX customer deposits, culminating one of the highest-profile criminal fraud trials in recent history. The prosecution’s case took up the bulk of the four-week trial and was highlighted by the testimony of a half-dozen former FTX and Alameda Research employees and close friends of Bankman-Fried. The defense’s only witness was Bankman-Fried himself, whose testimony spanned two and a half days. After just over four hours of deliberation, the jury returned a conviction on all seven counts, including fraud, money laundering, and conspiracy. Sentencing is scheduled for March, with Bankman-Fried facing up to a life sentence. Bankman-Fried also faces additional charges, including bribery and bank fraud, which were charged after Bankman-Fried was extradited from the Bahamas. These charges could be separately tried next year. WSJ 1; New York Times; WSJ 2; CoinDesk; CoinTelegraph.

  1. Federal Judge Denies SEC’s Bid To Appeal Ripple Labs’ Partial Win; SEC Drops Claims Against Two Executives

On October 3, U.S. District Judge Analisa Torres denied the SEC’s request to certify an interlocutory appeal of the judge’s partial ruling in July, holding that her prior order did not involve a controlling question of law and that there was not a “substantial ground for difference of opinion.” The SEC sought to appeal the judge’s holding that Ripple’s programmatic offers of XRP to consumers via crypto trading platforms did not constitute a sale or offer of a security under SEC v. Howey Co., 328 U.S. 293 (1946). The SEC argued in its request for certification that the Howey test was improperly applied. The SEC may appeal the July decision once the district court enters a final judgment resolving all claims.

On October 19, the SEC voluntarily dismissed its claims against Ripple Labs’ Executives Bradley Garlinghouse and Christian Larsen. The SEC previously alleged that the two aided and abetted Ripple’s Securities Act violations and a trial was set to begin in April 2024. Law360 1; Reuters; Law360 2.

  1. US Targets Hamas, Warns Against Crypto Funding Following Israel Attack

On October 27, U.S. Treasury Deputy Secretary Wally Adeyemo warned that the U.S. would undertake enforcement against cryptocurrency firms that fail to stop terrorist groups from moving funds. Adeyemo’s statements followed a letter earlier in the month by Senator Elizabeth Warren and dozens of members of Congress that called on the Biden administration to crack down on the use of cryptocurrency by terrorists, citing a disputed report that Hamas and Palestinian Islamic Jihad were able to raise over $130 million in funds using cryptocurrency.

Elliptic, the firm behind some of the data cited in the report, responded in a blog post that there was “no evidence to suggest that crypto fundraising has raised anything close to” the figure cited, although some money included in the total number might have gone to small crypto brokers sometimes designated as terrorist organizations for their role in financing. Other crypto analysts, who did not provide data for the report, noted that some estimates have inaccurately assumed that all funds routed through these smaller service providers are associated with terrorism. Adeyemo’s remarks follow the Treasury’s October 18th imposition of sanctions on key Hamas members managing assets in a secret investment portfolio, as the Biden administration faced growing pressure to disrupt Hamas’s financing. Financial Times; WSJ; U.S. Department of the Treasury; Bloomberg; Washington Post; Elliptic 1; Elliptic 2; Reuters; CoinDesk; Seattle Times.

  1. The New York Attorney Sues General Gemini, Genesis, And DCG

On October 19, the New York Attorney General Letitia James sued Genesis Global, its parent company Digital Currency Group (DCG), and Gemini Trust, claiming that the companies defrauded investors. The defendants have denied all of the claims. NY AG Press Release; CNN.

  1. PayPal Receives SEC Subpoena Regarding Stablecoin

On November 1, PayPal revealed in a quarterly earnings report that it received a subpoena from the SEC’s Enforcement Division regarding its USD stablecoin, PayPal USD (PYUSD), which was launched in August. PayPal did not disclose additional details about the subpoena. The SEC has taken the position in enforcement actions that certain stablecoins qualify as securities. CoinDesk; WSJ.

  1. FTC Settles With Voyager; Both The FTC And CFTC Proceed With Parallel Charges Against Former CEO

On October 12, the Federal Trade Commission (FTC) announced a settlement with crypto lending firm Voyager for allegedly deceptive marketing but has yet to settle with Stephen Ehrlich, a former Voyager executive, for charges arising from the same events. In their federal complaint, the FTC alleged that Voyager violated the FTC Act and the Gramm-Leach-Bliley Act (GLBA) by falsely claiming that customer deposits of cash and cryptocurrency would be insured by the Federal Deposit Insurance Corporation (FDIC). The complaint further alleges that both the company and Ehrlich were aware that their claims could mislead customers. In the proposed settlement, Voyager and its affiliated companies agreed to a judgment of $1.65 billion, which will be suspended in order for Voyager to distribute its remaining assets to consumers in bankruptcy proceedings. The settlement will also permanently ban the companies from offering, marketing, or promoting any product or service related to depositing, exchanging, investing, or withdrawing consumers’ assets. A parallel claim filed against Ehrlich by the Commodity Futures Trading Commission (CFTC) has not been settled. FTC Announcement; Blockworks; JDSupra.

  1. CFPB Investigating Crypto Platform Hacks

The Director of the Consumer Financial Protection Bureau (CFPB), Rohit Chopra, announced recommendations for regulators’ future approach to payments policy, including CFPB having direct authority to address crypto platforms. “[T]o reduce the harms of errors, hacks and unauthorized transfers, the CFPB is exploring providing additional guidance to market participants to answer their questions regarding the applicability of the Electronic Fund Transfer Act (EFTA) with respect to private digital dollars and other virtual currencies,” said Chopra during the Brookings Institution event. The CFPB is investigating how to apply EFTA, which protects consumers from payments fraud, to crypto accounts. Financial Times; Forbes India.

  1. SafeMoon Executives Arrested And Charged By DOJ And SEC

On November 1, SafeMoon CEO John Karony and Chief Technology Officer Thomas Smith were arrested in connection with criminal charges relating to their operation of the SafeMoon crypto project. Prosecutors allege that Karony, Smith, and founder Kyle Nagy (who also was charged) told investors that their funds were “locked” safely in liquidity pools, when instead the defendants allegedly used the funds to purchase luxury cars and real estate. The SEC contemporaneously filed related civil charges against the defendants based on allegations that the company’s SafeMoon token was an unregistered security. CoinDesk; FortuneCrypto; The Block; CoinTelegraph.

International

  1. Three Arrows Capital Co-Founder Arrested In Singapore For Failing To Cooperate With Investigations

Local police arrested Su Zhu, co-founder of the defunct crypto hedge fund Three Arrows Capital Ltd., at Singapore’s Changi Airport on September 29. Su Zhu was attempting to flee the country after a Singapore court issued a “committal order” authorizing the arrest of Zhu and his co-founder Kyle Davies and sentencing them to four months in prison for failing to cooperate with investigations. According to liquidators of the bankrupt hedge fund, co-founders Su Zhu and Kyle Davies failed to produce requested documents and were unhelpful in locating assets needed to repay the company’s creditors. Three Arrows Capital collapsed in June 2022 after allegedly defaulting on $660 million in debt. At this time, the location of co-founder Kyle Davies remains unknown. Law360; CoinDesk.

  1. Israel Orders Freeze Of Crypto Assets In Bid To Block Funding For Hamas

A week after the October 7 attack on Israel, Israeli authorities closed more than 100 cryptocurrency accounts and requested information on up to 200 additional accounts, in coordination between the country’s defense ministry and intelligence agencies. This follows Israel’s reported seizure of funds linked to Palestinian Islamic Jihad on July 4, including crypto exchange wallets in Tether (USDT), USD Coin (USDC), and Tron (TRX). Financial Times; Elliptic 1; WSJ; Elliptic 2; Reuters; CoinDesk.

  1. Kenya Calls For Shutdown In Operations Of Worldcoin Due To Privacy Concerns

In late September, a Kenyan parliamentary panel issued a report recommending that the country’s information technology regulator, the Communications Authority of Kenya, shut down the operations of cryptocurrency project Worldcoin. The panel proposes to suspend Worldcoin’s “physical presence in Kenya until there is a legal framework for regulation of virtual assets and virtual service providers.” In August, Kenyan officials ordered a halt to WorldCoin’s operations and announced that an investigation revealed privacy concerns, including that Worldcoin may have scanned the eyes of minors, as the project lacks an age-verification mechanism. Reuters; Business Insider; Parliamentary Report; Digital Assets Recent Update.

  1. Hong Kong Authorities Opened Investigation Into Japan Exchange (JPEX) For Fraud Allegations

Hong Kong opened an investigation into alleged fraud by Japan Exchange, or JPEX, as the city’s regulator, the Securities and Futures Commission, has accused the company of misleading investors. Up to 26 suspects have been arrested. The city’s authorities have received more than 2,300 complaints about the platform, with claims of losses totaling as much as $192 million USD. Allegations also include that JPEX misled investors by disclosing that they had applied for a crypto trading license and charged users exorbitant fees to withdraw funds. Financial Times; Bloomberg; South China Morning Post; The Standard.

  1. London Metropolitan Police Establishes Specialized Unit For Crypto Investigations

The London Metropolitan Police has established a specialized 40-member team dedicated to investigating crypto-related offenses, including organized crime. Crypto fraud cases in the UK surged by 41% over the past year, causing losses of more than 306 million euros. The team has investigated 74 intelligence referrals to date and have 19 current active criminal investigations. Criminal networks use digital assets because of its capability to conceal assets and seamlessly facilitate cross-border transactions. The operations runs alongside the government’s ambition to make London a hub for crypto assets and the city’s new standards for the promotion of crypto products, which are among the toughest in the world. Financial Times; TronWeekly; AP News.

  1. UK Financial Conduct Authority Imposes Restrictions On Rebuildingsociety.com Ltd

On October 10, the UK Financial Conduct Authority (FCA) restricted peer-to-peer lending platform rebuildingsociety.com Ltd from approving cryptoasset financial promotions. The FCA has targeted 146 unregistered crypto firms as promotional rules take effect. FCA Release; Blockchain; Blockworks 1; Blockworks 2.

Regulation and Legislation

United States

  1. Government Accountability Office Reports SEC’s Cryptocurrency Accounting Guidance Is Subject To Congressional Oversight

On October 31, the Government Accountability Office reported that cryptocurrency accounting guidance that the Securities and Exchange Commission issued in 2022, SEC’s Staff Accounting Bulletin 121, is an agency “rule” as defined in the Administrative Procedures Act and therefore is subject to congressional oversight under the Congressional Review Act (CRA). The CRA requires regulators to submit reports on new rules to Congress and the comptroller general for review, yet the SEC did not comply with those procedures for Staff Accounting Bulletin 121. The determination has prompted some crypto advocates to call on the SEC to take steps to either withdraw the guidance or formalize it via rulemaking. Bloomberg; Law360; CoinTelegraph.

  1. IRS Extends Broker Reporting Crypto Tax Rule Comment Period

On October 24, the U.S. Department of the Treasury and the IRS extended by two weeks the deadline for submitting comments on the agencies’ proposed rule that would impose tax-reporting obligations on a wide range of digital asset firms deemed to be “brokers.” The agencies extended the deadline to November 13 in response to “strong public interest”; thousands of comments already have been submitted. The agencies propose to define digital asset “brokers” to include centralized and decentralized trading platforms, digital asset payment processors, and digital wallet providers, among others. The proposed rule would exempt individual miners and validators from the “broker” classification. Senators Elizabeth Warren, Bernie Sanders, Sherrod Brown, and four other senators recently urged the Treasury and IRS to expedite issuance of a final rule. Federal Register; BlockWorks; CoinTelegraph.

  1. Expectations Mount That SEC Will Soon Approve Bitcoin ETFs

Several asset managers have amended their applications seeking SEC approval of an exchange-traded fund, sparking optimism that the SEC is on the verge of approving a spot Bitcoin ETF. The SEC has previously approved only Bitcoin futures ETFs, yet it must decide at least two pending spot Bitcoin ETF applications by January 10, 2024 and others by March and April of 2024. The renewed optimism follows the D.C. Circuit’s ruling vacating the SEC’s denial of Grayscale’s application for a Bitcoin ETF. The SEC has declined to seek en banc or Supreme Court review of the decision. Yahoo Finance; Reuters; CoinDesk 1; CoinDesk 2; Financial Times; Business Insider.

  1. FinCEN Proposes New Regulation For Transparency In Crypto Mixers And To Combat Terrorist Financing

On October 19, the U.S. Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) issued a proposed rule that would identify international Convertible Virtual Currency Mixing (CVC Mixing) as “a class of transactions of primary money laundering concern.” FinCEN grounded the proposal in part on “the risk posed by the extensive use of CVC mixing services by a variety of illicit actors.” Comments on the proposed rule must be submitted by January 22, 2024. FinCen Press Release; Notice of Proposed Rulemaking; CoinTelegraph.

  1. California Governor Signs Crypto Licensing Bill

On October 13, California Governor Gavin Newsom signed Assembly Bill 39, which establishes the Digital Financial Assets Law, a comprehensive regulatory scheme akin to New York’s BitLicense. The Digital Financial Assets Law will require individuals and firms to obtain a Department of Financial Protection and Innovation (DFPI) license to engage in “digital financial asset business activity,” subject to certain exemptions. The law broadly defines “digital financial asset” to mean a “digital representation of value that is used as a medium of exchange, unit of account, or store of value, and that is not legal tender.” The law, which is set to go into effect on July 1, 2025, gives the DFPI authority to adopt a more detailed regulatory framework implementing the law’s requirements. CA Legislative; CoinDesk.

  1. CFPB Director Suggests Applying The Electronic Fund Transfer Act To Digital Assets

At the Brookings Institution’s payments conference on October 6, Rohit Chopra, director of the Consumer Financial Protection Bureau, suggested potentially applying the Electronic Fund Transfer Act (EFTA) to “private digital dollars and other virtual currencies” to “reduce the harms of errors, hacks and unauthorized transfers.” The EFTA was enacted to protect consumers from electronic payments fraud and requires financial institutions to notify consumers of if or when they are liable for unauthorized electronic funds transfers. Chopra recommended the Treasury’s Financial Stability Oversight Council to classify some crypto activities as “systemically important payment clearing or settlement activity” to “ensure that a stablecoin is actually stable.” He further stated that the CFPB will issue orders to “certain large technology firms” to gain information on their practices on personal data and issuing private currency. Financial Times; CoinTelegraph.

  1. NYDFS Announces Proposed Updates To Guidance On Listing Of Virtual Currencies

On September 18, the New York Department of Financial Services (NYDFS) issued proposed updates to its guidance on the listing and delisting of cryptocurrencies. NYDFS has proposed (i) heightened risk assessment standards for coin-listing policies and tailored, enhanced requirements for retail consumer-facing products or service offerings, and (ii) new requirements associated with coin-delisting policies. Comments on the proposed guidance were due by October 20, 2023. NYDFS plans to issue its final guidance following the closure of the comment period. NYDFS; Axios.

International

  1. UK Publishes Report Clarifying Regulatory Approach For Crypto Ecosystem

On October 30, the UK government published a policy update further clarifying its approach for regulating the crypto industry. Consistent with its prior guidance, the government intends to seek legislation in two phases. First, in early 2024, the government intends to bring forward legislation allowing the Financial Conduct Authority to regulate fiat-backed stablecoins. Second, at a later time, the government plans to seek legislation to regulate activities relating to wider types of stablecoins and other digital assets, including algorithmic and crypto-backed stablecoins. This aligns with UK Prime Minister Rishi Sunak’s policy to make the UK a digital-asset hub. Report; CoinDesk 1;  CoinTelegraph.

  1. UK Lawmakers Pass Bill To Aid Seizure Of Illicit Cryptocurrency

On October 26, the UK government passed the Economic Crime and Corporate Transparency Bill, allowing UK law enforcement agencies to seize, freeze, and recover crypto assets to combat crime and terrorism. UK authorities can assess and verify identities of company directors, remove invalid registered office addresses, and share information with criminal investigation agencies. GOV.UK; GOV.UK Bill Stage; Parliament; CoinDesk 1; CoinDesk 2.

  1. UK Financial Conduct Authority (FCA) Warns Crypto Promoting Firms

On October 25, UK’s Financial Conduct Authority (FCA) added 221 companies to its alert list for non-compliant firms after a new marketing regime took effect on October 8, 2023. The statement identifies common issues regarding safety or security claims, inadequately visible risk warnings, and inadequate information on the risks provided to customers. The new rules require crypto asset service providers to register with the FCA or seek an authorized firm to approve communication to local clients. FCA Statement; CoinTelegraph; CoinDesk.

  1. European Securities And Market Authority (ESMA) Publishes Statement Clarifying Implementation of MiCA

On October 17, the European Securities and Markets Authority (ESMA) published a statement clarifying the timeline for the implementation of Markets in Crypto-Assets Regulation (MiCA). During the implementation stage until December 2024, ESMA, the National Competent Authorities (NCAs) of the Member States and other European Supervisory Authorities (ESAs) will prepare technical standards and guidelines specifying the application of rules on issuers, offerors, and digital asset service providers. ESMA specified that full MiCA rights and protections will not apply in the implementation stage until December 2024. Further, even after MiCA becomes applicable, the Member States may allow existing crypto-asset service providers to operate without a MiCA license up to an additional 18-month transitional period. ESMA Statement; JDSupra.

  1. Australian Treasury Proposes To Regulate Crypto Exchanges

On October 16, the Australian Treasury proposed to require any crypto exchange that holds more than AUD 1,500 of any one client or more than AUD 5 million in total assets to obtain an Australian Financial Services license, granted by the Australian Securities and Investments commission. Australian Treasury; CoinDesk.

Civil Litigation

United States

  1. SEC Declines To Appeal Grayscale Ruling

Earlier this month, the SEC chose not to appeal the ruling of the D.C. Circuit Court of Appeals that vacated the SEC’s denial of Grayscale Investment’s application to convert their Grayscale Bitcoin Trust (GBTC) into an exchange traded fund (ETF). With $14 billion in assets, GBTC is the largest traded closed-end fund tracking the price of Bitcoin (BTC). The SEC denied Grayscale’s application in June 2022 and Grayscale appealed the following day in the D.C. Circuit Court of Appeals. In August 2023, the court ruled that the SEC’s denial of the application was “arbitrary and capricious.” The SEC did not seek en banc rehearing by the October 13 deadline. On October 23, the D.C. Court of Appeals issued its formal mandate effectuating its decision. With this victory, Grayscale has re-entered the pool of nearly a dozen pending spot Bitcoin ETF applications. SEC chair Gary Gensler commented that the review is before staff and that he would “let that play out” before commenting on the matter. Grayscale’s win has strengthened market confidence that one or many spot bitcoin ETFs will be approved in the next year, although that result is not guaranteed. The SEC could still reject the applications on grounds different from those used in the now-overturned Grayscale denial. CoinDesk 1; CoinDesk 2; Cryptonews; Axios.

  1. Judge in FTX Bankruptcy Case Rules To Keep Customer Names List Under Seal

Despite objections from media companies, Delaware Bankruptcy Judge John T. Dorsey allowed the names and addresses of companies on FTX’s creditor list to be shielded for another three months, after being shielded for 90 days in June. FTX argued that the creditor list should remain confidential because its customer list remains a valuable asset. On the other hand, the U.S. Trustee’s Office argued that the right of public access to court records must be taken into account. FTX’s Chapter 11 case began late last year, involving approximately 9 million individual and institutional customers who are creditors in the case. In over-the-counter markets where investors trade bankruptcy claims, the level of expected payouts for FTX creditors has more than tripled this year. Law360; CoinDesk.

Speaker’s Corner

United States

  1. SEC Commissioner Hester Peirce Issues Statement Of Dissent On LBRY

On October 23, LBRY Inc., a crypto-based media project, dropped its challenge to a New Hampshire federal court ruling that it sold unregistered securities. LBRY announced that it had settled with the SEC and would shut down, its assets to be placed in receivership and used to satisfy debts. On October 27, SEC Commissioner Hester Peirce issued a dissent describing the case against LBRY as unsettling and manifesting “the arbitrariness and real-life consequences of the Commission’s misguided enforcement-driven approach to crypto.” Peirce argued that the SEC’s case against LBRY conflicted with the SEC’s mission “to ensure that people buying securities receive accurate and reliable information.” Peirce further criticized the Commission as having taken “an extremely hardline approach,” seeking remedies “entirely out of proportion to any harm.” Peirce also observed that LBRY’s disclosures did not cause investors any harm since the disclosures were not proven to be inadequate or misleading. Instead of pursuing this case, Peirce argued, the Commission should have “devoted [the time and resources] to building a workable regulatory framework that companies like LBRY could have followed.” Peirce Dissent; Law360; Odysee; Policy at Paradigm.

  1. U.S. Senators Gillibrand And Lummis Press For Stablecoin And Illicit Finance Legislation

On October 24, U.S. Senators Kirsten Gillibrand (D-N.Y.) and Cynthia Lummis (R-Wyo.) spoke at the State of Crypto Policy & Regulation Conference, echoing the potential to pass a bipartisan stablecoin bill. Named after the two senators, the Lummis-Gillibrand bill, which cleared the House Financial Services Committee in 2022, proposes that the Commodity Futures Trading Commission (“CFTC”) regulate crypto exchanges and require regulated depository institutions to oversee all stablecoin users. The bill also pushes to more clearly define decentralized finance platforms in order to help entities determine whether they are centralized businesses, which would need to register with the CFTC under the bill. CoinDesk.

International

  1. Brazil’s Central Bank President Strikes Balance Between Open Networks And Privacy In Digital Brazilian Real, A Form Of CBDC

Brazil Central Bank President Roberto Campos Neto aims to accelerate international transactions through the issuance of Digital Brazilian Real (DREX), a form of a central bank digital currency (CBDC). Neto stated, “if every country has a digital currency, and we are able to connect those currencies digitally, in a fast and secure way, you actually have achieved the goal of having a common currency without actually having to sacrifice your monetary policy.” DREX operates alongside PIX, the instant payment system that has digitized Brazil’s economy. PIX has resulted in more than 170 million transactions in one day. The Block; Banco Central Do Brasil.

  1. Mexican Senator And Presidential Candidate Indira Kempis Pushes For Bitcoin As Legal Tender In Mexico

Mexican Senator and Presidential Candidate Indira Kempis reported that the digital peso should arrive sometime in 2024 and stated that she has been “looking for clear positions” from her fellow legislators on her 2022 proposal to make Bitcoin legal tender in the country. As of October 25, Mexican legislators have reacted both positively and negatively towards the bill, upon the installation of a Bitcoin ATM in the Mexican Senate. Decrypt; Forbes; Bitcoin.com.

Other Notable News

  1. Argentina’s Pro-Bitcoin Javier Milei Heads To Run-Off Election Against Pro-CBDC Finance Minister Sergio Massa

On October 2, during an Argentinian presidential debate, Finance Minister and presidential candidate Sergio Massa announced the imminent launch of an Argentinean digital currency project to address the country’s inflation crisis. He wants to launch a CBDC to also address the corruption within the country, including instances of money laundering. Considered an ambitious idea, local specialists are skeptical of Massa’s plan. Rodolfo Andragnes, the President of ONG Bitcoin Argentina, expressed that Massa’s announcement intended to attract attention to his campaign, rather than proposed a defined action plan. The other frontrunner of the presidential election, Javier Milei, supports bitcoin, the “dollarization” of Argentina’s economy, and the elimination of the Central Bank of Argentina. The run-off election will take place on November 19, 2023. CoinDesk; El Cronista; La Nacion; Forbes.

  1. Bitcoin Gains Recognition In Shanghai As A United Digital Currency

On September 25, the Shanghai Second Intermediate People’s Court in China published a report analyzing the legal attributes of digital currencies, the difficulties faced by judicial disposition of digital currencies, and adopting this perspective as an entry point to demonstrate the legal attributes of virtual currencies. The report highlighted the uniqueness and non-replicability of Bitcoin. The court focused on Bitcoin’s scarcity, inherent value of holders, ease of circulation and storage, and emphasized that Bitcoin can be obtained through mining, inheritance, or selling and buying. The People’s Republic of China has issued a blanket ban on cryptocurrencies. Shanghai Judicial Committee Member Report; ODaily; Yahoo Finance; CryptoNews; Forbes India.

The following Gibson Dunn lawyers prepared this client alert:  Ashlie Beringer, Stephanie Brooker, Jason Cabral, M. Kendall Day, Jeffrey Steiner, Sara Weed, Ella Capone, Grace Chong, Chris Jones, Jay Minga, Nick Harper, Raquel Sghiatti, Peter Moon, Emma Li*, Elizabeth Walsh*, Vannalee Cayabyab and Yoo Jung Hah*

*Emma Li, Elizabeth Walsh, and Yoo Jung Hah are associates practicing in the firm’s New York, Denver, and Los Angeles offices, respectively, who are not yet admitted to practice law.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s FinTech and Digital Assets practice group, or the following:

FinTech and Digital Assets Group:

Ashlie Beringer, Palo Alto (650.849.5327, aberinger@gibsondunn.com)

Michael D. Bopp, Washington, D.C. (202.955.8256, mbopp@gibsondunn.com

Stephanie L. Brooker, Washington, D.C. (202.887.3502, sbrooker@gibsondunn.com)

Jason J. Cabral, New York (212.351.6267, jcabral@gibsondunn.com)

Ella Alves Capone, Washington, D.C. (202.887.3511, ecapone@gibsondunn.com)

M. Kendall Day, Washington, D.C. (202.955.8220, kday@gibsondunn.com)

Michael J. Desmond, Los Angeles/Washington, D.C. (213.229.7531, mdesmond@gibsondunn.com)

Sébastien Evrard, Hong Kong (+852 2214 3798, sevrard@gibsondunn.com)

William R. Hallatt, Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)

Martin A. Hewett, Washington, D.C. (202.955.8207, mhewett@gibsondunn.com)

Michelle M. Kirschner, London (+44 (0)20 7071.4212, mkirschner@gibsondunn.com)

Stewart McDowell, San Francisco (415.393.8322, smcdowell@gibsondunn.com)

Mark K. Schonfeld, New York (212.351.2433, mschonfeld@gibsondunn.com)

Orin Snyder, New York (212.351.2400, osnyder@gibsondunn.com)

Jeffrey L. Steiner, Washington, D.C. (202.887.3632, jsteiner@gibsondunn.com)

Eric D. Vandevelde, Los Angeles (213.229.7186, evandevelde@gibsondunn.com)

Benjamin Wagner, Palo Alto (650.849.5395, bwagner@gibsondunn.com)

Sara K. Weed, Washington, D.C. (202.955.8507, sweed@gibsondunn.com)

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On July 27, 2023, Hong Kong’s Securities and Futures Commission (“SFC”) published a “Circular on Licensing and Registration of Depositaries of SFC-authorised Collective Investment Schemes and Related Transitional Arrangements” (the “Circular”).[1] Trustees and custodians of SFC-authorised collective investment schemes (the “relevant CIS”) will have to be licensed or registered with the SFC for the new Type 13 regulated activity (“RA 13”) from October 2, 2024.

The Circular should be read in tandem with the soon to be enacted Schedule 11 to the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (“Schedule 11”).[2] Together, the Circular and Schedule 11 provide guidance on the SFC’s expectations regarding RA 13 licensing arrangements.

The new RA 13 regulatory regime intends to remedy what the SFC has previously described as a “patchy” approach to the regulation of depositories, whereby the SFC was unable to directly supervise depositaries. Instead, the SFC could only exercise indirect oversight through the requirements under the Product Codes.[3]  The RA 13 regulatory framework was proposed by the SFC in September 2019 to fill this void left by a lack of specific, direct supervision mechanism over trustees and custodians of public funds.[4] In doing so, the new RA 13 regulatory regime will also align Hong Kong’s fund custody framework with international standards; most major jurisdictions (such as the United Kingdom and Singapore) have some form of direct regulatory powers over entities providing trustee, custodian or depositary services for public funds (at a minimum). Viewed broadly, the introduction of RA 13 is also consistent with the SFC’s focus on regulating entities providing custody services – for instance, its recent decision to regulate virtual assets custody under its new virtual assets trading platform (“VATP”) regime by requiring custody be undertaken by a wholly owned subsidiary of a licensed VATP operator.

I. Who needs a RA 13 license?

The amendments made to the Securities and Futures Ordinance (“SFO”) to introduce RA 13 define it as “providing depositary services for relevant CISs”.[5] In essence, what this means is that trustees and custodians (i.e. depositaries as defined under the amendments to the SFO) of a relevant CIS at the “top level” of the custodian chain will be required to be licensed or registered for RA 13 in order to provide the following services:

  • the custody and safekeeping of the CIS property, including property held on trust by the relevant CIS (“CIS Property”); and
  • the oversight of the CIS to ensure that it is operated according to scheme documents.[6]

In practice, many of these depositaries were not previously supervised by the SFC until the introduction of the new RA 13 regime. This suggests that individuals who will now be required to be licensed to undertake RA 13 activities will be subjected to direct SFC supervision for the first time, and may not be accustomed to being licensed.

II. What are the RA 13 regulatory requirements?

In the table below, we highlight the key regulatory requirements applicable to depositaries licensed for RA 13 (“RA 13 Depositaries”):

Capital thresholds

RA 13 Depositaries are required to maintain a paid-up share capital of not less than $10,000,000 and a liquid capital of not less than $3,000,000.[7]

Treatment of Scheme Money

RA 13 Depositaries that hold or receive scheme money under a relevant CIS (“Scheme Money”) must deposit such Scheme Money into segregated and designated trust accounts or client accounts within three business days after receipt. Each segregated account must be established and maintained for one relevant CIS only.[8]

RA 13 Depositaries must not pay Scheme Money out of the segregated account unless such payment is (i) instructed in writing, or (ii) for the purpose of meeting payment, distribution, redemption settlement, or margin requirements, or (iii) to settle any charges or liabilities on behalf of the relevant CIS, as per the scheme documents.[9]

Treatment of Scheme Securities

Similarly, an RA 13 Depositary must deposit client securities which it holds or receives when providing depositary services (“Scheme Securities”) into a segregated and designated trust account or client account. Alternatively, the RA 13 Depositary can register the Scheme Securities in the name of the relevant CIS.[10]

An RA 13 Depositary can only deal with Scheme Securities in accordance with written instructions or scheme documents. It must take reasonable steps to ensure that Scheme Securities are not otherwise deposited, transferred, lent or pledged.[11]

Record keeping obligations

In line with the record keeping requirements generally applicable to licensed intermediaries, RA 13 Depositaries are required to keep accounting, custody and other records to sufficiently explain and reflect the financial position and operation of the business, and support accurate profits and loss or income statements.  Specifically, RA 13 Depositaries must also account for all relevant CIS Property, and make sure that its accounting systems can trace all movements of relevant CIS Property.[12]

OTCD reporting

RA 13 Depositaries are exempted from reporting specified over-the-counter (“OTC”) derivative transactions to the Hong Kong Monetary Authority (“HKMA”) when acting as a counterparty to the OTC derivative transaction.[13] Similarly, authorized institutions need not report the OTC derivative transaction to the HKMA if the counterparty of the transaction is an RA 13 Depositary acting in its capacity as a trustee of the relevant CIS.[14]

Further, the SFC has previously clarified that the Managers-In-Charge (“MIC”) requirements under the current licensing framework extend to RA 13 licensees.[15]

III. Are there any additional requirements applicable to specific classes of RA 13 Depositaries?

Schedule 11 sets out additional requirements applicable to specific classes of RA 13 Depositaries. In the table below, we summarize the key requirements applicable to RA 13 Depositaries authorized under the Code on Unit Trusts and Mutual Funds[16] and Code on Pooled Retirement Funds (“UT/RF RA 13 Depositaries”).[17] These are mostly RA 13 Depositaries operating Chapter 7 Funds (i.e. plain vanilla funds investing in equity and/or bunds), specialized schemes (such as hedge funds, listed open-ended funds), and pooled retirement funds.

Appointment and oversight of delegates or third parties

UT/RF RA 13 Depositaries should establish internal control policies and procedures to oversee appointed delegates or third parties. These internal control policies and procedures should cover the following:

  • the selection of a delegate or third party, including assessment procedures and criteria on the delegate or third party’s competence, regulatory and financial status, capabilities and the effectiveness of their internal controls and systems;
  • ongoing and regular monitoring of the delegate or third party to ensure compliance with regulatory requirements and maintenance of effective internal controls and systems; and
  • management of actual or potential conflicts of interests arising from the appointment and oversight of delegates or third parties (where applicable).

UT/RF RA 13 Depositaries should also establish appropriate contingency plans to cater for instances of breaches or insolvency of these delegates or third parties.[18]

Oversight of the relevant CIS

UT/RF RA 13 Depositaries should have oversight over the operations of the relevant CIS, and ensure that the CIS is operated or administered in accordance with the relevant constitutive documents.[19]

Subscription and redemption

UT/RF RA 13 Depositaries should monitor the relevant operators of each CIS to ensure (among other things):

  • timely processing of subscription and redemption transactions;
  • execution of subscription and redemption orders in accordance with the constitutive documents of the relevant CIS;
  • timely deposits of subscription and redemption proceeds into a segregated bank account designated as a trust account or client account holding relevant CIS Property;
  • reconciliation of subscription and redemption, and that the frequency of such reconciliation is consistent across subscription and redemption; and
  • proper documentation of reasons for (i) suspension of dealing of unit or shares of the relevant CIS, and (ii) suspension of valuation, price or net asset value calculations of the relevant CIS.[20]

Distribution payments

UT/RF RA 13 Depositaries should supervise the relevant operators of each CIS to ensure that:

  • distributions are calculated in accordance with the constitutive documents of the relevant CIS; and
  • complete and accurate distribution payments are made on a timely basis.

With respect to each relevant CIS, UT/RF RA 13 Depositaries should ensure that distribution proceeds are transferred according to the operator’s instruction on a timely basis into a designated and segregated or omnibus bank account.[21]

Custody and safekeeping of CIS Property

UT/RF RA 13 Depositaries can adopt the safeguards to ensure the safekeeping of CIS Property:

  • assess and manage custody risk by making adequate organisational arrangements to minimise the risks of loss of the CIS Property;
  • register the CIS Property in the name of the UT/RF RA 13 Depositary;
  • verify ownership of the CIS Property using reliable sources;
  • maintain updated and comprehensive records of the CIS Property; and
  • ensure reconciliation is carried out daily for CIS Property in cash form.[22]

Notwithstanding the above, there are specific requirements applicable to RA 13 Depositaries authorized under the Code on Real Estate Investment Trusts (“REIT RA 13 Depositaries”).[23] These are RA 13 Depositaries operating closed-ended funds primarily investing in real estate. REIT RA 13 Depositaries are under a fiduciary duty to hold assets of Real Estate Investment Trusts (“REIT”) on trust for the benefit of the unitholders of the REIT. While the requirements applicable to UT/RF RA 13 Depositaries summarized above are generally applicable to REIT RA 13 Depositaries, Schedule 11 tailors some of these requirements to account for the unique features and product structure of REITs. The key modifications are summarized as follows:

Cash flow monitoring and cash reconciliation

Under the Code on Real Estate Investment Trusts (“REIT Code”), the management company of a REIT bears the obligation to manage cash flows. Schedule 11 modifies the custody requirements – which require UT/RF RA 13 Depositaries to carry out cash reconciliation of CIS Property daily – to instead require REIT RA 13 Depositaries to ensure that the management company has put in place proper cash flow management policies and controls, and supervise the implementation of such policies and controls.

Custody and safekeeping of CIS Property

REIT RA 13 Depositaries should ensure that all REIT assets (including the title documents of REIT-owned real estate) are properly segregated and held for the benefit of the unitholders in accordance with the REIT Code and the constitutive document of the REIT.

Where the REIT RA 13 Depositary considers it in the interests of the REIT for certain assets of the REIT to be held by the management company on behalf of the REIT, the REIT RA 13 Depositary should make sure that the management company has established proper safeguards and controls to properly segregate REIT assets. Additionally, the REIT RA 13 Depositary must maintain on-going oversight and control over the relevant assets.

IV. What are the next steps?

The SFC has begun accepting licensing applications for RA 13 since July 27, 2023. Depositaries are reminded to submit RA 13 applications on or before November 30, 2023. The RA 13 regime will take effect on October 2, 2024.

_____________________________

[1] “Circular on Licensing and Registration of Depositaries of SFC-authorised Collective Investment Schemes and Related Transitional Arrangements” (July 27, 2023), published by the SFC, available at https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC32

[2] The final text of Schedule 11 can currently be found at Appendix C, “Consultation Conclusions on Proposed Amendments to Subsidiary Legislation and SFC Codes and Guidelines to Implement the Regulatory Regime for Depositaries of SFC-authorised Collective Investment Schemes” (March 24, 2023), published by the SFC, available at https://apps.sfc.hk/edistributionWeb/api/consultation/conclusion?lang=EN&refNo=22CP1

[3] Namely, the Code on Unit Trusts and Mutual Funds, the Code on Open-Ended Fund Companies, the Code on Real Estate Investment Trusts, and the Code on Pooled Retirement Funds.

[4] “Consultation Paper on the Proposed Regulatory Regime for Depositaries of SFC-authorised Collective Investment Schemes” (September 27, 2019) (“2019 Consultation Paper”), published by the SFC, available at https://apps.sfc.hk/edistributionWeb/api/consultation/openFile?lang=EN&refNo=19CP3

[5] Section 3, “Securities and Futures Ordinance (Amendment of Schedule 5) Notice 2023” (March 20, 2023), available at https://www.gld.gov.hk/egazette/pdf/20232712/es22023271262.pdf

[6] “Scheme document” refers to (i) the trust deed constituting or governing the relevant CIS if the CIS is constituted in the form of a trust, (ii) the documents governing the formation or constitution of the relevant CIS if the CIS is constituted in any other form other than a trust, or (iii) other documents setting out the requirements relating to (a) the custody and safekeeping of any CIS Property, or (b) the oversight of the operations of the relevant CIS.

[7] Amended Schedule 1 of the Securities and Futures (Financial Resources) Rules, set out under section 10 of the “Securities and Futures (Financial Resources) (Amendment) Rules 2023” (March 20, 2023), available at https://www.gld.gov.hk/egazette/pdf/20232712/es22023271256.pdf

[8] Amended rule 10B of the Securities and Futures (Client Money) Rules, set out under section 7 of the “Securities and Futures (Client Money) (Amendment) Rules 2023” (“CMR Amendment Rules”) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln055-e.pdf

[9] Amended rule 10C of the of the Securities and Futures (Client Money) Rules, set out under section 7 of the CMR Amendment Rules

[10] Amended rule 9B of the Securities and Futures (Client Securities) Rules, set out under section 6 of the “Securities and Futures (Client Securities) (Amendment) Rules 2023” (“CSR Amendment Rules”) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln054-e.pdf

[11] Amended rules 9C and 10A of the Securities and Futures (Client Securities) Rules, set out under sections 6 and 7 of the CSR Amendment Rules respectively

[12] Amended rule 3A of the Securities and Futures (Keeping of Records) Rules, set out under section 5 of the “Securities and Futures (Keeping of Records) (Amendment) Rules 2023” (“KKR Amendment Rules) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln057-e.pdf

[13] Amended rule 10 of the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules, set out under section 4 of the “Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) (Amendment) Rules 2023” (“OTCD Amendment Rules”) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln061-e.pdf

[14] Amended rule 11 of the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules, set out under section 5 of the OTCD Amendment Rules

[15] Paragraph 26, 2019 Consultation Paper. The SFC’s MIC requirements are listed in the “Circular to Licensed Corporations Regarding Measures for Augmenting the Accountability of Senior Management” (December 16, 2016), available at https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=16EC68, and the related Frequently Asked Questions published by the SFC (last updated on January 26, 2022), available at https://www.sfc.hk/en/faqs/intermediaries/licensing/Measures-for-augmenting-senior-management-accountability-in-licensed-corporations

[16] “Code on Unit Trusts and Mutual Funds” (January 1, 2019), published by the SFC, available at https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/section-ii-code-on-unit-trusts-and-mutual-funds/section-ii-code-on-unit-trusts-and-mutual-funds.pdf

[17] “Code on Pooled Retirement Funds” (December 2021), published by the SFC, available at https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/code-on-pooled-retirement-funds/code-on-pooled-retirement-funds.pdf?rev=9badf81950734ee08c799832be6ff92b

[18] Section 6, Schedule 11

[19] Section 8, Schedule 11

[20] Section 9, Schedule 11

[21] Section 11, Schedule 11

[22] See section 14, Schedule 11 for the full list of safeguards.

[23] “Code on Real Estate Investment Trusts” (August 2022), published by the SFC, available at https://www.sfc.hk/-/media/EN/files/COM/Reports-and-surveys/REIT-Code_Aug2022_en.pdf?rev=572cff969fc344fe8c375bcaab427f3b

The following Gibson Dunn lawyers prepared this client alert: William Hallatt, Emily Rumble, and Jane Lu.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact any member of Gibson Dunn’s Global Financial Regulatory team, including the following members in Hong Kong:

William R. Hallatt (+852 2214 3836, whallatt@gibsondunn.com)
Emily Rumble (+852 2214 3839, erumble@gibsondunn.com)
Arnold Pun (+852 2214 3838, apun@gibsondunn.com)
Becky Chung (+852 2214 3837, bchung@gibsondunn.com)

© 2023 Gibson, Dunn & Crutcher LLP.  All rights reserved.  For contact and other information, please visit us at www.gibsondunn.com.

Attorney Advertising: These materials were prepared for general informational purposes only based on information available at the time of publication and are not intended as, do not constitute, and should not be relied upon as, legal advice or a legal opinion on any specific facts or circumstances. Gibson Dunn (and its affiliates, attorneys, and employees) shall not have any liability in connection with any use of these materials.  The sharing of these materials does not establish an attorney-client relationship with the recipient and should not be relied upon as an alternative for advice from qualified counsel.  Please note that facts and circumstances may vary, and prior results do not guarantee a similar outcome.

We are pleased to provide you with the next edition of Gibson Dunn’s digital assets regular update. This update covers recent legal news regarding all types of digital assets, including cryptocurrencies, stablecoins, CBDCs, and NFTs, as well as other blockchain and Web3 technologies. Thank you for your interest.

Enforcement Actions

United States

  1. Feds Charge Tornado Cash Developers Facilitated $1 Billion in Money Laundering

On August 23, the Manhattan U.S. Attorney’s Office brought charges in the Southern District of New York against two developers of Tornado Cash, Roman Storm and Roman Semenov. Tornado Cash is a crypto application that obscures the source of assets transferred through it. Prosecutors allege that more than $1 billion was laundered through Tornado Cash, including hundreds of millions by North Korea’s Lazarus Group. Charges include conspiracy to engage in money laundering, conspiracy to violate U.S. sanctions targeting North Korea, and conspiracy to operate an unlicensed money transmitting business. Storm was arrested and released after posting bond. Also on August 23, the Office of Foreign Asset Control (OFAC) sanctioned Semenov and eight Ethereum addresses allegedly controlled by Semenov. Law360; Forbes; Indictment

  1. SEC Brings First Enforcement Actions Alleging NFTs Are Securities

On August 28, the U.S. Securities and Exchange Commission (SEC) issued an order simultaneously filing and settling charges against Impact Theory, LLC, a Los Angeles-based media company, related to its sales of non-fungible tokens (NFTs). Applying the Howey test, the SEC concluded that Impact Theory’s KeyNFTs were investment contracts primarily because Impact Theory’s marketing statements promised “tremendous value” and “massive” appreciation. As part of a settlement of the charges, the SEC ordered Impact Theory to disgorge over $5 million. SEC Commissioners Hester Pierce and Mark Uyeda issued a joint dissent from the order, arguing in part that the tokens were not investment contracts because they were not shares of the company and did not generate any type of dividend for purchasers. Order; Law360; CoinWire

Weeks later, on September 13, the SEC issued an order simultaneously filing and settling charges against Stoner Cats 2 LLC (SC2), alleging an unregistered securities offering in the form of profile-picture NFTs. The order states that SC2 raised approximately $8 million from the sale of around 10,000 NFTs to finance the animated web series Stoner Cats, starring Mila Kunis and Ashton Kutcher. In an accompanying press release, the SEC stated that the offering led “investors to expect profits because a successful web series could cause the resale value of the Stoner Cats NFTs in the secondary market to rise.” SC2 agreed to pay a $1 million fine and destroy all remaining NFTs in its possession. Commissioners Pierce and Uyeda dissented from this order as well, arguing that “the Stoner Cats NFTs are not that different from Star Wars collectibles sold in the 1970s” and that the order “carries implications for creators of all kinds.” Order; Press Release; CoinDesk

  1. CFTC Charges DeFi Platforms Over Crypto Derivatives

On September 7, the Commodity Futures Trading Commission (CFTC) issued orders simultaneously filing and settling charges against three decentralized finance (DeFi) trading platforms—Opyn, Inc., ZeroEx (0x), Inc., and Deridex, Inc.—for offering digital asset derivatives trading. The orders require Opyn, ZeroEx, and Deridex to pay civil penalties of $250,000, $200,000, and $100,000, respectively, and “cease and desist from violating the Commodity Exchange Act (CEA) and CFTC regulations.” The companies were all said by the CFTC to have cooperated in the investigation, getting a reduced penalty as a result. “The DeFi space may be novel, complex, and evolving, but the Division of Enforcement will continue to evolve with it and aggressively pursue those who operate unregistered platforms that allow U.S. persons to trade digital asset derivatives,” said Director of Enforcement Ian McGinley. Release; CoinDesk

  1. LBRY to Appeal Ruling That It Violated U.S. Securities Law

On September 7, crypto file-sharing protocol LBRY filed a notice of appeal of a New Hampshire federal court’s decision that it failed to register the sale of its native LBRY tokens (LBC) with the SEC. The court’s final judgment ordered LBRY to pay a $111,614 civil penalty and barred it from participating in any unregistered crypto securities offerings in the future. “LBRY is appealing the [court’s] decision because it is unjust and incorrect,” said CEO Jeremy Kauffman. LBRY previously indicated that it would shut down following the July 11 ruling. Notice of Appeal; CoinDesk; CoinTelegraph

  1. Former FTX Executive Ryan Salame Pleads Guilty Ahead of Bankman-Fried Trial

On September 7, former top FTX executive Ryan Salame pleaded guilty to one count of conspiracy to operate an unlicensed money transmitting business and one count of conspiracy to make unlawful political contributions and defraud the Federal Election Commission. Salame faces a maximum of 10 years in prison. He also has agreed to forfeit up to $1.5 billion and make restitution of $5.6 million to FTX debtors. His sentencing is set for March 6, 2024. This plea comes less than one month before Sam Bankman-Fried, co-founder of FTX, is set to go to trial on October 2. Salame’s attorney previously told prosecutors he would invoke his Fifth Amendment rights against self-incrimination if called as a witness against Bankman-Fried at trial. CNN; Reuters; New York Times

  1. Former OpenSea Head of Product Receives Three-Month Prison Sentence for NFT Insider Trading

On August 23, Nate Chastain, the former Head of Product at OpenSea, the NFT trading platform, was sentenced to three months in prison for making around $50,000 by trading NFTs that he knew would be featured on the OpenSea homepage. In May, he was convicted by a jury of wire fraud and money laundering in what is considered the first insider-trading case involving digital assets. Prosecutors had sought a two-year prison sentence, but U.S. District Judge Jesse Furman imposed a shorter sentence based on Chastain’s limited profits. Judge Furman also sentenced Chastain to 200 hours of community service following his imprisonment, a $50,000 fine, and forfeiture of 15.98 ether. Reuters; Crypto News

Regulation and Legislation

United States

  1. Treasury and IRS Propose Tax-Reporting Rules for Crypto Industry

On August 25, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) released controversial proposed regulations governing tax-reporting requirements for the crypto industry. The long-awaited regulations would broaden the definition of “broker” to encompass digital asset trading platforms, payment processors, wallet providers, and “some” DeFi platforms. Under the proposed regulations, starting on January 1, 2025, these entities would be subject to similar tax reporting rules as brokers for securities and other financial instruments. The proposal exempts crypto miners from these requirements. The proposed regulations are open for public comment until October 30. The proposed regulations were criticized by Chairman Patrick McHenry (R-NC) of the House Financial Services Committee as “an attack on the digital asset ecosystem.” Treasury; IRS; Axios; WSJ

  1. FASB Announces New Bitcoin Accounting Rules

On September 6, the Financial Accounting Standards Board (FASB) announced forthcoming accounting rules under which companies that hold or invest in cryptocurrencies will be required to report their holdings at fair value. This would allow companies to recognize gains and losses in cryptocurrencies immediately, as they would with other financial assets. This change is widely seen as an improvement over the current practice of treating cryptocurrencies as indefinite-lived intangible assets. The forthcoming rules include other requirements as well, including that companies must make a separate entry in their financial statements for cryptocurrencies. The accounting rules will be mandatory for all companies—public and private—for fiscal years beginning after December 15, 2024, including interim periods within those years. WSJ; Bloomberg

International

  1. UK Crypto Firms Can Apply for Extra Time to Comply with New Restrictions on Crypto Promotions

On September 7, the UK’s Financial Conduct Authority (FCA) announced that UK crypto firms could be given an extra three months to implement new restrictions on crypto promotions. The “[t]ough new rules designed to make the marketing of cryptoasset products clearer and more accurate” are set to take effect on October 8, but can be delayed until January 2024 for otherwise compliant firms to develop the right technical setup. The FCA said that it still intends to take enforcement action against overseas or unregulated firms that continue to unlawfully market to UK consumers starting October 8. Release; CoinDesk

  1. Travel Rule Regulation Goes into Force in the UK for Crypto Asset Firms

On September 1, a new rule requiring crypto firms in the UK to comply with the Financial Action Task Force’s Travel Rule went into effect. The UK Travel Rule requires UK-based Virtual Asset Service Providers (VASPs) to collect, verify, and share information on domestic and cross-jurisdictional transactions. According to an FCA statement, crypto businesses domiciled in the UK are required to “comply with the rule when sending or receiving a cryptoasset transfer to a firm that is in the UK, or any jurisdiction that has implemented the Travel Rule.” If information is missing or incomplete, businesses must make a risk-based assessment before releasing the cryptoassets to the beneficiary. FCA Statement; The Block

Civil Litigation

United States

  1. D.C. Circuit Vacates SEC Denial of Grayscale Bitcoin ETF as Arbitrary and Capricious

On August 29, the U.S. Court of Appeals for the D.C. Circuit ruled that the SEC will have to take another look at Grayscale Investments’ application to list a bitcoin exchange-traded product (ETP), because the SEC’s rejection of the submission was “arbitrary and capricious” and thus violated the Administrative Procedure Act. The three-judge panel’s unanimous ruling was authored by Judge Neomi Rao (a President Trump appointee) and was joined by Judges Edwards and Srinivasan (President Carter and Obama appointees, respectively). The court concluded that the SEC “failed to adequately explain why it approved the listing of two bitcoin futures ETPs but not Grayscale’s” proposed spot product, and rejected every rationale offered by the SEC for treating bitcoin spot ETPs differently than comparable bitcoin futures products. “In the absence of a coherent explanation,” the court concluded, “this unlike regulatory treatment of like products is unlawful.” The court’s ruling requires the SEC to reconsider Grayscale’s application, but it does not require the SEC to approve the application. Opinion; Law360; Barron’s

  1. Federal Court Dismisses Uniswap Class Action

On August 30, U.S. District Court Judge Katherine Polk Failla dismissed a class action suit brought against Uniswap and its developers and investors by users claiming that they lost money on scam tokens sold on the Uniswap platform. In dismissing the claims, Judge Failla reasoned in part that “the identities of the Scam Token issuers are basically unknown and unknowable” due to Ethereum’s “decentralized nature,” and that the plaintiffs’ claims therefore were akin to “attempting to hold an application like Venmo or Zelle liable for a drug deal that used the platform to facilitate a fund transfer.” Judge Failla also rejected the plaintiffs’ claims that Uniswap was liable for the losses under the Securities Exchange Act of 1934, refusing to “stretch the federal securities laws to cover the conduct alleged.” In rejecting the securities-law claims, Judge Failla stated in passing that ether and bitcoin are “crypto commodities,” potentially suggesting that she believes those assets are not subject to the securities laws at all. Judge Failla also is presiding over the SEC’s enforcement action against Coinbase. Opinion; Fortune; Bitcoinist

  1. New York Federal Court Holds that Electronic Fund Transfer Act Does Not Apply to Certain Crypto Transactions

On August 11, Judge Lewis J. Liman dismissed a claim asserting that the Electronic Fund Transfer Act (EFTA) applies to cryptocurrency transactions. In Yuille v. Uphold HQ, Inc., No. 1:22-cv-07453 (S.D.N.Y. Aug. 11, 2023 ), a Michigan retiree sued Uphold HQ, a crypto trading platform and wallet provider, after a hacker drained $5 million from his account. The plaintiff argued in part that Uphold HQ failed to meet the requirements of the EFTA, which imposes obligations on financial institutions to expeditiously investigate and correct errors related to electronic fund transfers. Earlier this year, a different judge in separate suit against Uphold held that the term “electronic funds transfer” in the EFTA was capacious enough to include crypto transactions. Rider v. Uphold HQ Inc., 2023 WL 2163208 (S.D.N.Y. Feb. 22, 2023) (Cote, J.). Instead of resolving that issue, Judge Liman held that the plaintiff’s transactions fell outside the EFTA because his crypto wallet was not an “account,” which is defined under the Act to include only accounts “established primarily for personal, family, or household purposes.” Judge Liman held that the plaintiff’s crypto wallet account was instead established primarily for profit-making purposes. Opinion; Law360

  1. Gemini Earn Customers Could Recover All Funds in New Proposed Renumeration Scheme

On September 13, bankrupt crypto lender Genesis and its parent company Digital Currency Group (DCG) filed a new proposed remuneration plan. Genesis and DCG stated that, under the proposal, over 230,000 creditors who used Gemini’s Earn program “are estimated to recover approximately 95-110% of their claims.” Gemini Earn was an investment program implemented by crypto exchange Gemini with financing from Genesis. Gemini Earn customers were affected when Genesis was forced to freeze withdrawals and its lending arm—Genesis Global Holdco LLC—filed for bankruptcy in January 2023. DCG hopes to file an amended version of the proposed plan by October 6, and solicit votes by December 5. On September 15, Gemini issued a statement criticizing the proposed plan as “misleading at best and deceptive at worst.” Gemini stated that “[r]eceiving a fractional share of interest and principal payments over seven years from an incredibly risky counterparty . . . is not even remotely equivalent to receiving the actual cash and digital assets owed today by Genesis to the Gemini Lenders.” Proposed Agreement; CoinTelegraph; CoinDesk; Gemini Filing

Speaker’s Corner

United States

  1. Former SEC Chair Says Spot Bitcoin ETF Approval Is ‘Inevitable’

On September 1, former SEC chair Jay Clayton appeared on CNBC Television to discuss the SEC’s deferral of bitcoin ETP applications: “It is clear that bitcoin is not a security. It is clear that bitcoin is something that retail investors want access to, institutional investors want access to, and, importantly, some of our most trusted providers who are fiduciaries or have duties of best interest want to provide this product to the retail public. So I think [spot bitcoin ETP] approval is inevitable,” Clayton told CNBC. Clayton’s comments follow a federal court’s ruling in Grayscale v. SEC (discussed above) that there was no justification for the SEC to allow bitcoin futures-based ETPs but deny spot bitcoin ETPs. CNBC; The Block; Grayscale Opinion

  1. SEC Chair Gary Gensler Testifies Before Senate Banking Committee

On September 12, SEC Chair Gary Gensler testified before the Senate Banking Committee in an SEC oversight hearing. In his prepared testimony, Gensler maintained his stance that most cryptocurrencies qualify as securities that should be regulated by the SEC: “As I’ve previously said, without prejudging any one token, the vast majority of crypto tokens likely meet the investment contract test.” Gensler also reiterated his strong criticism of the crypto industry: “I’ve never seen a field that’s so rife with misconduct,” said Gensler. “It’s daunting.” The most substantive discussion on digital assets came during questioning from Senator Cynthia Lummis (R-WY), who expressed concerns over Gensler issuing an SEC staff bulletin that would require companies to report customer crypto assets on their balance sheets. Also during the hearing, Chairman Sherrod Brown (D-OH) was highly critical of the crypto industry. “The problems we saw at FTX are everywhere in crypto—the failure to provide real disclosure, the conflicts of interest, the risky bets with customer money that was supposed to be safe,” said Brown. Brown also praised the SEC’s approach to regulating crypto: “I’m glad the SEC is using its tools to crack down on abuse and enforce the law.”

Gensler is scheduled to testify next before the House Financial Services Committee on September 27. These scheduled appearances follow mounting criticism from lawmakers over the SEC’s approach to regulating crypto, which they argue prioritizes enforcement over providing clear guidance. Sept. 12 Prepared Testimony; Sept. 12 Hearing; CryptoSlate; CryptoNews

International

  1. Chinese Central Bank Official Says China’s Digital Yuan Must Be Available in All Retail Scenarios

During a trade forum in Beijing on September 3, Changchun Mu, the head of the digital currency research institute at the People’s Bank of China, said that an essential step for the development of China’s digital yuan “is to use digital yuan as the payment tool for all retail scenarios.” Although the digital yuan is being tested in pilot regions across China, it remains far from achieving widespread adoption. “In the short term, we can start by unifying QR code standards on a technical level to achieve barcode interoperability,” Mu added. Mu’s comments follow the Chinese central bank’s pledge last year to push for universal QR payment codes. The use of QR code payment systems, dominated by WeChat Pay and Alipay, is already widespread in China. The Block; CoinTelegraph

Other Notable News

  1. SEC Defers Decisions on All Bitcoin ETFs

On August 31, the SEC delayed until October its decisions on all pending applications for a spot bitcoin exchange-traded product, which have been filed by BlackRock, Grayscale Investments, and others. The SEC’s decisions come days after Grayscale won a key victory over the SEC (discussed above), which many have viewed as clearing a path for the long-awaited product. Bloomberg; CoinDesk; PiOnline

  1. Visa to Use Solana and USDC Stablecoin to Boost Cross-Border Payments

On September 5, Visa announced that it has expanded its stablecoin settlement capabilities with Circle’s USDC stablecoin to the Solana (SOL) blockchain. According to its statement, Visa is one of the first major financial institutions to use the Solana network at scale for settlements. “By leveraging stablecoins like USDC and global blockchain networks like Solana and Ethereum, we’re helping to improve the speed of cross-border settlement and providing a modern option for our clients to easily send or receive funds from Visa’s treasury,” said Cuy Sheffield, head of crypto at Visa, in a statement. CoinDesk; The Block

  1. Vitalik Buterin Co-Authors Paper on Regulation-Friendly Tornado Cash Alternative

On September 9, Ethereum co-founder Vitalik Buterin published a research paper that he co-authored with Ethereum core developer Ameen Soleimani, researcher Jacob Illum from blockchain analytics firm Chainalysis, and academics Matthias Nadler and Fabian Schar. The paper proposes a privacy protocol called Privacy Pools. The core idea of the proposal is to allow users to publish a zero-knowledge proof, demonstrating that their funds do not originate from unlawful sources, without publicly revealing their entire transaction graph. The authors argue that this proposal, if implemented, could allow financial privacy and regulation to co-exist. SSRN; The Block

  1. FTX, BlockFi, and Genesis Claimant Data Breached in Cyberattack

On August 25, Kroll LLC, announced that cybercriminals exposed data belonging to claimants in the FTX, BlockFi, and Genesis Global Holdco bankruptcies following a sophisticated cyberattack directed against Kroll employees. Kroll stated that a cybercriminal targeted a cell phone account belonging to one of its employees “in a highly sophisticated ‘SIM swapping’ attack.” Law360; CoinDesk

  1. Ant Group Launches Overseas Blockchain Brand ZAN

On September 8, Ant Group—the owner of the world’s largest mobile payment platform, Alipay—launched ZAN, a new blockchain service aimed at Hong Kong and overseas markets. According to the official press release, ZAN “comprises of a full suite of blockchain application development products and services for both institutional and individual Web3 developers.” ZAN will also provide “a series of technical products, including electronic Know-Your-Customer (eKYC), Anti-Money Laundering (AML) and Know-Your-Transactions (KYT), to help Web3 businesses build up their capabilities in customer identity authentication, security protection and risk management.” Press Release; CoinTelegraph; The Block

The following Gibson Dunn lawyers prepared this client alert:  Ashlie Beringer, Stephanie Brooker, Jason Cabral, M. Kendall Day, Jeffrey Steiner, Sara Weed, Ella Capone, Grace Chong, Chris Jones, Jay Minga, Nick Harper, Apratim Vidyarthi, Alexis Levine, Zachary Montgomery, and Tin Le.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s FinTech and Digital Assets practice group, or the following:

FinTech and Digital Assets Group:

Ashlie Beringer, Palo Alto (650.849.5327, aberinger@gibsondunn.com)

Michael D. Bopp, Washington, D.C. (202.955.8256, mbopp@gibsondunn.com

Stephanie L. Brooker, Washington, D.C. (202.887.3502, sbrooker@gibsondunn.com)

Jason J. Cabral, New York (212.351.6267, jcabral@gibsondunn.com)

Ella Alves Capone, Washington, D.C. (202.887.3511, ecapone@gibsondunn.com)

M. Kendall Day, Washington, D.C. (202.955.8220, kday@gibsondunn.com)

Michael J. Desmond, Los Angeles/Washington, D.C. (213.229.7531, mdesmond@gibsondunn.com)

Sébastien Evrard, Hong Kong (+852 2214 3798, sevrard@gibsondunn.com)

William R. Hallatt, Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)

Martin A. Hewett, Washington, D.C. (202.955.8207, mhewett@gibsondunn.com)

Michelle M. Kirschner, London (+44 (0)20 7071.4212, mkirschner@gibsondunn.com)

Stewart McDowell, San Francisco (415.393.8322, smcdowell@gibsondunn.com)

Mark K. Schonfeld, New York (212.351.2433, mschonfeld@gibsondunn.com)

Orin Snyder, New York (212.351.2400, osnyder@gibsondunn.com)

Jeffrey L. Steiner, Washington, D.C. (202.887.3632, jsteiner@gibsondunn.com)

Eric D. Vandevelde, Los Angeles (213.229.7186, evandevelde@gibsondunn.com)

Benjamin Wagner, Palo Alto (650.849.5395, bwagner@gibsondunn.com)

Sara K. Weed, Washington, D.C. (202.955.8507, sweed@gibsondunn.com)

© 2023 Gibson, Dunn & Crutcher LLP.  All rights reserved.  For contact and other information, please visit us at www.gibsondunn.com.

Attorney Advertising: These materials were prepared for general informational purposes only based on information available at the time of publication and are not intended as, do not constitute, and should not be relied upon as, legal advice or a legal opinion on any specific facts or circumstances. Gibson Dunn (and its affiliates, attorneys, and employees) shall not have any liability in connection with any use of these materials.  The sharing of these materials does not establish an attorney-client relationship with the recipient and should not be relied upon as an alternative for advice from qualified counsel.  Please note that facts and circumstances may vary, and prior results do not guarantee a similar outcome.

Multinationals doing business in Asia are facing unique compliance risks arising from the rapidly evolving regulatory and geopolitical landscape in the region. Please join us for a discussion on how companies can navigate the compliance risks of doing business in Asia.

A panel of Gibson Dunn lawyers provides a comprehensive walkthrough of the compliance due diligence process in cross-border transactions and offer insights on strategies to effectively mitigate the compliance risks associated with cross-border transactions. The panel discusses recent FCPA enforcement actions that highlight internal audit’s role in identifying, communicating and addressing potential compliance issues within a company, and outlines practical steps that companies can take to ensure their compliance programs align with regulators’ expectations and industry best practices.

Topics discussed include:

  • How to Conduct Compliance Due Diligence
  • Key Risk Areas and Compliance Expectations
  • Diligence Considerations in M&A Transactions
  • Internal Audits
  • Recommended Best Practices

PANELISTS:

Kelly Austin leads the Gibson, Dunn & Crutcher LLP White Collar Defense and Investigations Practice Group in Asia and is a global co-chair of the firm’s Anti-Corruption and FCPA Practice Group. She is a partner in the firm’s Denver office and a partner (non-resident) in the Hong Kong office. Kelly served as Partner in Charge of the Hong Kong office from 2012 to 2022 and has twice served as a member of the firm’s Executive Committee. Her practice focuses on investigations, regulatory compliance and international disputes. She has extensive expertise in government and corporate internal investigations, including those involving the Foreign Corrupt Practices Act and other anti-corruption laws, and anti-money laundering, securities, and trade control laws. Kelly also regularly guides companies on creating and implementing effective compliance programs. Ms. Austin graduated with distinction with a Bachelor of Arts degree from the University of Virginia and received her law degree from Georgetown University. She is a member of the bars of Colorado, Virginia and the District of Columbia, and is admitted to practice in a variety of district and appellate courts in the United States. She is also admitted to practice as a solicitor in Hong Kong.

Oliver D. Welch is a resident partner in the Hong Kong office and a partner in the Singapore office of Gibson, Dunn & Crutcher. He is a member of the firm’s Litigation and White Collar Defense and Investigations Departments. Mr. Welch has extensive experience representing clients throughout the Asia region on a wide variety of compliance and anti-corruption issues. His practice focuses on internal and regulatory investigations, including those involving the Foreign Corrupt Practices Act (FCPA). He regularly counsels multi-national corporations regarding their anti-corruption compliance programs and controls, and assists clients in drafting policies, procedures, and training materials designed to foster compliance with global anti-corruption laws. Mr. Welch frequently advises on anti-corruption due diligence in connection with corporate acquisitions, private equity investments, and other business transactions. Mr. Welch received his law degree cum laude from the University of Michigan Law School, where he was an Executive Editor of the Michigan Law Review. Mr. Welch speaks Korean.

Bonnie Tong is an associate in Hong Kong. She is a member of the firm’s Litigation and White Collar Defense and Investigations, as well as the Antitrust and Competition Practice Groups. Prior to joining the firm, Bonnie worked at the United Nations Headquarters in New York City and the American Bar Association Rule of Law Initiative in Washington, D.C., specializing in international law and human rights law. She completed her training contract at an international firm in Hong Kong and served as a law clerk to the Justices at the Court of Final Appeal. Bonnie received her Bachelor of Laws degree with honors from the University of Hong Kong in 2009, where she was a member of the Dean’s List. She earned her Master of Laws degrees from Columbia University in 2016 as a James Kent Scholar and Georgetown University in 2014 with Distinction and was placed on the Dean’s List. Bonnie is admitted to practice in Hong Kong. She is fluent in Mandarin and Cantonese.

MCLE CREDIT INFORMATION:

This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.0 credit hour, of which 1.0 credit hour may be applied toward the ethics/professionalism requirement. This course is approved for transitional/non-transitional credit.

Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.0 ethics hour.

Gibson, Dunn & Crutcher LLP is authorized by the Solicitors Regulation Authority to provide in-house CPD training. This program is approved for CPD credit in the amount of 1.0 hour. Regulated by the Solicitors Regulation Authority (Number 324652).

The Law Society of Hong Kong has accredited this program in the amount of 1.0 hour.

Neither the Connecticut Judicial Branch nor the Commission on Minimum Continuing Legal Education approve or accredit CLE providers or activities. It is the opinion of this provider that this activity qualifies for up to 1.0 hour toward your annual CLE requirement in Connecticut, including 1.00 hour(s) of ethics/professionalism.

Application for approval is pending with the Colorado, Virginia, Texas and Washington State Bars.

On August 8, 2023, Hong Kong’s Securities and Futures Commission (“SFC”) published its consultation conclusions on proposed amendments to enforcement-related provisions of the Securities and Futures Ordinance (“SFO”) (the “Consultation Conclusions”).[1] We previously covered the SFC’s consultation paper regarding the same (“Consultation Paper”) in a client alert.[2]

By way of refresher, the SFC had previously proposed in its Consultation Paper to make three key significant reforms to the SFO: (i) to amend the scope of section 213 to allow it to seek orders under this provision where the SFC has exercised its disciplinary powers under sections 194(1), 194(2), 196(1) or 196(2) against a regulated person, including an order that would allow the Court of First Instance (“CFI”) to restore parties to any transaction to the pre-transaction position; (ii) to amend section 103(3)(k) to focus on the point in time when the advertising materials are issued; and (iii) to extend the scope of the insider dealing provisions in Hong Kong to address insider dealing in Hong Kong with regard to overseas-listed securities or their derivatives, and to address conduct outside of Hong Kong in respect of Hong Kong listed securities or their derivatives.

In light of significant concerns raised by the industry, the SFC has eventually decided to only proceed at this stage with the amendments to the insider dealing provisions. However, the SFC has stressed that it remains committed to investor protection despite deciding not to proceed with the other amendments at this stage, as discussed further below. In this client alert, we provide some colour to the SFC’s responses and policy rationale under the Consultation Conclusions.

I. Expansion of section 213 of the SFO

The SFC had proposed to:

  • introduce an additional ground in section 213(1) which would allow the SFC to apply for orders under section 213 where it has exercised any of its powers under sections 194(1), 194(2), 196(1) or 196(2) of the SFO against a regulated person (i.e. wherever it finds that a regulated person has engaged in misconduct or is no longer fit and proper);
  • introduce an additional order in section 213(2) that would allow an order to be made by the CFI to restore the parties to any transaction to the position in which they were before the transaction was entered into, where the SFC has exercised any of its powers under sections 194 or 196 in respect of the regulated person; and
  • enable the CFI to make an order under section 213(8) against a regulated person to pay damages where the SFC has exercised any of its disciplinary powers against a regulated person (collectively, the “Section 213 Amendments”).

The concerns raised by respondents in relation to the Section 213 Amendments can be grouped into five key themes, as summarised below alongside the SFC’s responses to each of these concerns:

Concerns raised by respondents  

The SFC’s responses

Legal and jurisprudence concerns

A number of respondents questioned whether it would be appropriate from a jurisprudential perspective to allow the SFC to seek court orders for a breach of codes and guidelines (e.g. the SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (“Code of Conduct”)) which do not themselves have the force of law and are not subject to the same scrutiny and oversight in their formulation. Respondents also considered this to be a concern given that the SFC’s codes and guidelines are broad and principles based and as such the Section 213 Amendments could create significant legal and regulatory uncertainty to intermediaries. Respondents also noted that the proposed amendments were likely contrary to section 399(6) of the SFO, which provides that any failure to comply with the provisions of codes and guidelines does not give rise to a right of action.

The SFC did not agree that allowing legal consequences to stem from a breach of the SFC’s codes and guidelines would fundamentally alter the status of these codes and guidelines. The SFC pointed out that the current law already allows the SFC to seek section 213 orders for breaches of licensing conditions, which also do not have the force of law.

The SFC further stated that the legislative intent of section 213 has always been “to allow the court to exercise its discretion and order relief as it considers necessary to protect investors adversely affected by others’ misconduct (in a general sense of the word), whether in the form of a breach of a statutory provision or a condition of a licence.”

Further, while reiterating that it did not consider these amendments would have changed the legal status of codes and guidelines, the SFC acknowledged that it would have needed to amend section 399(6) to align the two provisions if it had proceeded with these changes to section 213 in order to avoid inconsistencies.

Implementation difficulties

Some respondents pointed to a risk of parallel proceedings and conflicting outcomes, namely, where an appeal to disciplinary proceedings to the Securities and Futures Appeals Tribunal (“SFAT”) and the Court of Appeal could lead to a different outcome from the CFI’s decision in relation to section 213 proceedings.

The SFC acknowledged that the Section 213 Amendments would have created a new link between the disciplinary regime and section 213 where currently none exists. While noting that it was aware of the possibility of parallel proceedings prior to the release of the Consultation Paper, the SFC noted that this issue could be “administratively mitigated” by the SFC not commencing section 213 proceedings until the appeal process in relation to disciplinary proceedings had been exhausted.

Fairness and proportionality concerns

Some respondents raised concerns that the Section 213 Amendments would result in all forms of disciplinary action potentially triggering an action under section 213, including where the misconduct in question was minor. Other respondents noted that intermediaries could face both disciplinary sanctions and section 213 orders (including significant monetary penalties) stemming from the same misconduct, which they considered could lead to an unduly harsh burden on intermediaries.

Other respondents pointed out that the Section 213 Amendments could lead to a potential extension of the limitation period. At present, the statutory limitation period starts from the date of the loss or the date of the breach. Under the SFC’s proposal, the SFC’s power to apply for section 213 orders would be triggered after a disciplinary action is made. Effectively, this could mean that the statutory limitation period commences from the date of the disciplinary action as opposed to the date of the loss or breach. This extension could significantly increase the potential liability of intermediaries.

The SFC acknowledged the industry’s concerns regarding the impact of the Section 213 Amendments, and indicated that it would consider these concerns in further detail. In particular, the SFC noted that while it was not its intention to extend the statutory limitation period, that would have been the “natural result” of the proposed amendments in their initial form.

They noted that while the industry may perceive section 213 compensation orders as “punitive in nature” due to their size, the fundamental nature of these orders is to restore aggrieved investors to the position that would have been in had the intermediary’s misconduct not taken place. This is distinct from the purpose of regulatory fines which are to deter future non-compliance.

Concerns regarding Hong Kong’s competitiveness and status as an international financial centre

Many respondents raised concerns regarding the Section 213 Amendments’ impact on Hong Kong’s competitiveness and status as an international financial centre. In particular, respondents argued that the lack of predictability about the total financial impact of SFC enforcement actions, coupled with the combined financial burden of compensation orders under section 213 and disciplinary sanctions, could dissuade companies from participating in high risk regulated activities (e.g. sponsoring of IPOs), or even drive businesses away from Hong Kong.

The SFC strongly rejected these concerns. Instead, the SFC emphasised that:

  • it considered an effective regulatory regime should aim to strike a balance between “providing a proportionate degree of protection for investors and enabling the industry to conduct business in an environment which is not hampered by unnecessary regulatory barriers to innovation and competition”; and
  • higher regulatory standards and active enforcement of such standards would in fact strengthen investor confidence in the market, thereby making Hong Kong an attractive and competitive market for international investors.

Concerns regarding adequacy of current investor compensation regime

Several respondents stated that the current laws already provide adequate legal protection and safeguards for investors, and questioned whether there was a need for the Section 213 Amendments. These respondents pointed to existing frameworks under consumer protection laws, the option of civil litigation, the Financial Dispute Resolution Scheme, as well as  intermediaries’ own complaint handling procedures.

The SFC strongly rejected these concerns, and expressly stated that it did not consider that the current regime ensured investors (especially retail investors) were appropriately compensated when they suffer loss as a result of intermediaries’ misconduct. The SFC noted that this was due to the limited resources often available to retail investors to pursue civil actions and the lack of a class action mechanism in Hong Kong. Given these factors, the SFC stated that it considered it to be appropriate for the SFC to obtain compensation on behalf of investors.

While ultimately stating that it would place the Section 213 Amendments “on hold” for the time being, the SFC was at pains to emphasise that it considers its inability to require intermediaries to compensate aggrieved clients or investors for losses as a result of breach of SFC codes or guidelines to be a “clear regulatory gap” which these amendments were intended to fix. However, the SFC has acknowledged that respondents raised a number of complex concerns which warrant further study, and noted that it may need to consider a broader range of options for remedying this gap, including strengthening the existing disciplinary regime.

Given this, we consider the key takeaway from the Consultation Conclusions in relation to the Section 213 Amendments to be that the SFC remains determined to protect investors by improving their ability to receive fair compensation in intermediary misconduct cases. As such, we expect to see future proposals from the SFC in this space in the short to medium term which will be intended to either overcome or avoid the concerns raised by the industry in relation to the Section 213 Amendments.

II. Amendments to exemptions in section 103 of the SFO

The second change proposed by the SFC was to amend section 103(3) of the SFO.  Section 103(1) makes it a criminal offence to issue or be in possession for the purposes of issue of an advertisement, invitation or document which, to the person’s knowledge, contains an invitation to the public to enter into an agreement to deal in securities or any other structured products, to enter into regulated investment agreements, or to participate in a collective investment scheme, unless authorized by the SFC to do so. Section 103(3)  further contains a list of exemptions to the marketing restrictions under section 103, including section 103(3)(k), which provides an exemption from the authorization requirement for advertisements of offers of investments that are disposed of, or intended to be disposed of, only to professional investors (the “PI Exemption”).

In the Consultation Paper, the SFC proposed the amendment of section 103(3)(k) (and consequential amendments to section 103(3)(j)) to focus on the point in time when the advertising materials are issued, by exempting from the authorisation requirement those advertisements which are issued only to PIs (the “Section 103 Amendments”).

The respondents’ comments centred on the necessity of the Section 103 Amendments and the operational difficulties and impact on business development and marketing processes. In light of the feedback received, the SFC has decided not to proceed with the Section 103 Amendments, as summarized below:

Concerns raised by respondents  

The SFC’s responses

Necessity of the Section 103 Amendments

Many respondents questioned whether the amendments are necessary on the basis that they viewed there to be no material risk to retail investors from merely being exposed to unauthorised advertisements of investment products given that these investors are not allowed to invest in these products.

Respondents raising these concerns emphasised that the existing framework, current suitability requirements,[3] risk disclosures and know-your-client (“KYC”) procedures already provide sufficient safeguards to investors. As such, respondents argued that the SFC has not identified a specific harm posed to investors by general distribution of advertisements concerning investment products.

Operational difficulties and impact on business

Many respondents also argued that the Section 103 Amendments are detached from commercial realities, and would have unnecessarily disrupted common marketing activities. These respondents pointed out that PIs are usually reluctant to provide KYC information upfront at the preliminary marketing stage. By limiting marketing efforts to PIs who have already been identified through intermediaries’ KYC procedures, the Section 103 Amendments would significantly reduce intermediaries’ ability to market to prospective investors. Furthermore, the Section 103 Amendments would also disproportionately restrict online marketing efforts, which could jeopardise Hong Kong’s competitiveness and status. For example, many intermediaries currently make marketing materials freely available on their website to users, or allow only self-certification of PI status to access certain marketing materials. If the Section 103 Amendments were made, many forms of online marketing would likely be in contravention.

The SFC reasoned that the original legislative intent of section 103 of the SFO is to protect investors at the point when marketing materials are issued. The proposed amendments to section 103(3)(k) aim to reflect this original legislative intent.

The SFC noted that it was also motivated by multiple instances of intermediaries selling products intended for PI to retail investors (e.g. Chapter 37 bonds) in breach of suitability requirements.[4] That being said, it acknowledged that the upside of investor protection must be balanced against the practical impact any such amendments have on existing marketing processes. In particular, it acknowledged two practical difficulties (see table at left) highlighted by respondents in relation to i) PIs’ reluctance to provide detailed KYC information in the pre-marketing stage and ii) impact on online distribution of investment products.

The SFC’s decision not to pursue the Section 103 Amendments should not be seen as an abandonment of the issue, as the SFC emphasised that it would monitor the need for amendments in this area in the longer term and would consult again if necessary. However, it also noted that it would take a strong view against anyone misusing the PI Exemption to attempt to sell unsuitable products to retail investors. Instead, the SFC stated in the Consultation Conclusions that any person seeking to rely on section 103(3)(k) must be able to demonstrate a clear intention to dispose of investment products only to PIs, and that in order to do so, it should be “plainly apparent” from the face of the advertisement that the underlying investment product is intended only for disposal to professional investors.

Importantly, the SFC noted that it considers the “clear display of an appropriate message or warning on all advertising materials would go a long way” in helping an issuer in establishing this intention, and that intermediaries should consider how best to present this message or warning and put in place appropriate safeguards. Notably, it has indicated that it is considering providing further guidance to the market on this point.

III. Amendment to territorial scope of insider dealing provisions

The final change proposed by the SFC concerns the civil and criminal regimes under sections 270 and 291 of the SFO in respect of insider dealing. The SFC’s proposed amendments will extend the scope of the insider dealing provisions in Hong Kong to address insider dealing in Hong Kong with regard to overseas-listed securities or their derivatives, and to address conduct outside of Hong Kong in respect of Hong Kong listed securities or their derivatives (the “Insider Dealing Amendments”).

Most respondents supported the Insider Dealing Amendments on the basis that it would strengthen investor protection, protect the integrity and reputation of Hong Kong’s markets, and align the SFC’s insider dealing regime with other major common law jurisdictions. In light of this support, the SFC will proceed with the Insider Dealing Amendments.

During the consultation, several respondents requested clarifications on the scope and application of the Insider Dealing Amendments. These requests and the SFC’s corresponding responses are summarized as follows:

Clarifications requested by respondents

The SFC’s responses

Whether insider dealing would be determined by reference to Hong Kong or the laws of the overseas jurisdiction when assessing  insider dealing of overseas-listed securities or their derivatives

The SFC stated that the amended insider dealing provisions will stipulate that the misconduct would also need to be unlawful in the relevant overseas jurisdiction. However, the SFC will not prescribe a list of selected overseas markets to which the amended insider dealing provisions will apply, as this would counterintuitively narrow the scope of enforcement against cross-border insider dealing.

Whether the Insider Dealing Amendments would apply to over-the-counter (“OTC”) transactions in overseas-listed securities

The SFC clarified that the Insider Dealing Amendments change the territorial scope, and not the applicability, of the insider dealing regime. This means that once the Insider Dealing Amendments are enacted, the insider dealing regime would apply to OTC transactions in overseas-listed securities, just as how existing insider dealing laws apply to OTC transactions in Hong Kong-listed debt securities.

Whether the SFC will provide a transition period to enable firms to update their internal compliance policies and manuals to reflect the Insider Dealing Amendments

The SFC will not be introducing any transitional period. From the SFC’s standpoint, firms will have sufficient time to update their internal procedures and manuals once the legislative amendments are published.

Whether a regulated person is required to report breaches with respect to overseas-listed securities and how such reports should be made, especially considering data transfer restrictions in different jurisdictions

The SFC clarified that reporting obligations set out under the Code of Conduct would apply to breaches of the Insider Dealing Amendments, once enacted.[5]

The SFC’s responses make clear that its intention is to expand its ability to take action in relation to cross-border insider dealing to better protect the reputation of Hong Kong’s markets. In explaining its decision to proceed with these amendments, the SFC noted that while it is open to it to deal with cross-border insider dealing by providing intelligence to securities regulators in other jurisdictions under existing cross-border regulatory cooperation arrangements, this is not always the most effective means to tackle cross-border insider dealing.

IV. Next steps

The SFC indicated that it will now proceed with introducing the Insider Dealing Amendments, although it has not specified a timeframe for introducing the draft text of the amendments to the Legislative Council. It has indicated that the industry will have the opportunity to review the draft text of these amendments in the course of the legislative process.

We recommend that intermediaries continue to monitor this issue to ensure that they update their internal policies and procedures in relation to insider dealing in a timely fashion once the timeline for the enactment of the Insider Dealing Amendments becomes clearer.

We suggest that intermediaries also review their use of disclaimers in advertisements reliant on the PI Exemption to ensure that they are in line with the SFC’s guidance in the Consultation Conclusions. We recommend intermediaries also continue to monitor for any further guidance from the SFC with respect to best practices when relying on the PI Exemption.

_________________________

[1] “Consultation Conclusions on Proposed Amendments to Enforcement-related Provisions of the Securities and Futures Ordinance” (August 8, 2023), published by the SFC, available at: https://apps.sfc.hk/edistributionWeb/api/consultation/conclusion?lang=EN&refNo=21CP3.

[2] “Hong Kong SFC Consults on Significant Reforms to the SFO Enforcement Provisions” (June 14, 2022), published by Gibson, Dunn & Crutcher, available at: https://www.gibsondunn.com/hong-kong-sfc-consults-on-significant-reforms-to-the-sfo-enforcement-provisions/.

[3] See “Frequently Asked Questions on Compliance with Suitability Obligations by Licensed or Registered Persons” (last updated on December 23, 2020), published by the SFC, available at: https://www.sfc.hk/en/faqs/intermediaries/supervision/Compliance-with-Suitability-Obligations/Compliance-with-Suitability-Obligations#759450F3651D4BBF8AAA2F39C9F2BE88.

[4] The SFC has previously clarified that bonds offered for subscription and listed under Chapter 37 of the Main Board Listing Rules (“Chapter 37 Bonds”) are unsuitable for sale to retail investors, and warned intermediaries against this practice. See “Circular to Licensed Corporations distribution of bonds listed under Chapter 37 of the Main Board Listing Rules and local unlisted private placement bonds” (March 31, 2016), published by the SFC, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/suitability/doc?refNo=16EC18.

[5] Under the Code of Conduct, a licensed or registered person should report to the SFC immediately upon (among other things) “any material breach, infringement of or non-compliance with any law, rules, regulations, and codes administered or issued by the [SFC], the rules of any exchange or clearing house of which it is a member or participant, and the requirements of any regulatory authority which apply to the licensed or registered person”. See paragraph 12.5 of the “Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission” (“Code of Conduct”) (March 2023 edition), published by the SFC, available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/code-of-conduct-for-persons-licensed-by-or-registered-with-the-securities-and-futures-commission/Code_of_conduct-Mar-2023_Eng.pdf?rev=7b4576843262491cb40638b09441d89b.

The following Gibson Dunn lawyers prepared this client alert: William Hallatt, Emily Rumble, and Jane Lu.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact any member of Gibson Dunn’s Global Financial Regulatory team, including the following in Hong Kong:

William R. Hallatt (+852 2214 3836, whallatt@gibsondunn.com)
Emily Rumble (+852 2214 3839, erumble@gibsondunn.com)
Arnold Pun (+852 2214 3838, apun@gibsondunn.com)
Becky Chung (+852 2214 3837, bchung@gibsondunn.com)

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

On July 28, 2023, the Securities and Futures Commission (“SFC”) and the Hong Kong Monetary Authority issued a joint circular that sets out their expectations regarding allowing a proportionate and risk-based streamlined approach (the “Streamlined Approach”) for complying with the suitability obligations when dealing with sophisticated professional investors (“SPIs”) (the “Joint Circular”).[1]  The Joint Circular included two Annexes, an explanatory document outlining the Streamlined Approach and an FAQ to facilitate intermediaries’ application of the Streamlined Approach.

As explained below, the Streamlined Approach, when applicable, simplifies the point-of-sale procedures in eligible investment transactions executed by SPIs who exhibit a higher level of sophistication and loss absorption ability. The Streamlined Approach should be beneficial for intermediaries accustomed to dealing with clients who are likely to qualify as SPIs, such as private banks and multi-family offices.

I. Who qualifies as a Sophisticated Professional Investor (SPI)?

An SPI is an individual professional investor[2] who satisfies all of the following requirements:

  • Financial situation: the SPI has (i) a portfolio of at least HK$40 million (or its foreign currency equivalent), or (ii) net assets, excluding primary residence, of at least HK$80 million (or its foreign currency equivalent);[3]
  • Knowledge or experience: the investor is sufficiently sophisticated such that he/she understands the risks of being treated as an SPI and the application of the Streamlined Approach. The requisite level of sophistication should be ascertained based on the client’s academic[4] or professional qualifications,[5] or work experience,[6] or accumulated trading experience in the relevant categories of investment products (by having executed at least five transactions within the past three years in the same category of investment products based on their terms, features, characteristics, nature, and risks).[7]
  • Investment objectives: the client is not a conservative client, i.e. the client’s investment objective is not capital preservation and/or seeking regular income.[8]

A corporation can also qualify as an SPI if its principal business is the holding of investments and it is wholly owned by one or more SPIs. This will be relevant to wholly owned investment holding company that are often set up by very high net worth investors.

Intermediaries can rely on information obtained during the onboarding or know-you-client reviews to determine whether an investor qualifies as an SPI.

II. What are Eligible Investment Transactions?

The Streamlined Approach allows for a simplified point-of-sales procedure only when executing investment transactions for an SPI within the Product Category and Streamlining Threshold specified by the SPI (the “Eligible Investment Transactions”):

  • Project Category: intermediaries are required to devise product categories to categorise investment products based on their terms and features, characteristics, nature, and risks (each a “Product Category”). The SPI specifies the Product Categories within which investment transactions can be executed under the Streamlined Approach. Intermediaries are required to document the SPI’s choices and provide the SPI with a Product Category Information Statement which explains the terms, features, characteristics, nature and risks of investment products within the Product Category.  Intermediaries must ensure that an SPI possesses the requisite knowledge or experience criteria (please refer to Section I above) before applying the Streamlined Approach to investment transactions within a Product Category for the SPI.[9]
  • Streamlining Threshold: the SPI should specify a maximum threshold of investment, either being (i) an absolute amount, or (ii) a percentage of the SPI’s assets under management (“AUM”) with the intermediary, that can be executed under the Streamlined Approach (the “Streamlining Threshold”). The SPI should specify a Streamlining Threshold appropriate to his/her circumstances, and intermediaries are required to maintain records of the setting of such thresholds, including the SPI’s rationale for supporting the threshold set.  For example, a higher amount may still be suitable if the AUM maintained with the intermediary represents an insignificant portion of the SPI’s portfolio and/or net assets.  Intermediaries are required to establish and maintain effective systems and controls to ensure continuous compliance with the Streamlining Threshold (please refer to Section VI below).[10]

III. What steps need to be completed before applying the Streamlined Approach?

Before an intermediary applies the Streamlined Approach, it must have completed all of the following procedures:

  1. The intermediary has assessed that the SPI satisfies all of the qualifying criteria with respect to its financial situation, knowledge or experience, and investment objectives (please refer to Section I above). This assessment must be in writing, and records of the assessment and all relevant information and documents obtained for the assessment must be kept by the intermediary.[11]
  2. The SPI has specified the Product Categories and the Streamlining Threshold, and the intermediary has maintained records to support the choices made by the SPI.[12]
  3. The intermediary is required to enter into a written agreement with the SPI, for the SPI to acknowledge and give consent to being treated as an SPI.[13] The intermediary is also required to (i) specify in writing the assessment criteria under which the client qualified as an SPI, and (ii) the Product Categories and the Streamlining Threshold under which Eligible Investment Transactions can be executed under the Streamlined Approach.[14]
  4. The intermediary is required to fully explain to the SPI the consequences of being treated as an SPI, and the SPI’s right to withdraw from being treated as an SPI at any time. When explaining the consequences of being treated as an SPI, the intermediary shall at a minimum cover the points set out in paragraph 13.2 of Annex 1 of the Joint Circular.[15]

IV. How does the Streamlined Approach simplify the regulatory obligations when dealing with SPIs in Eligible Investment Transactions?

After an intermediary has completed the procedures referred to in Section III above, the intermediary can then apply the Streamlined Approach when dealing with the SPI in Eligible Investment Transactions.  Under the Streamlined Approach, an SPI sets aside an amount (i.e. the Streamlining Threshold) to invest in a portfolio of investment products within the specified Product Categories.  For these Eligible Investment Transactions, the intermediary is no longer required to match the SPI’s risk tolerance level, investment objectives and investment horizon, or to assess the SPI’s knowledge, experience and concentration risk.  The explanation of product characteristics, nature and extent of risks can also be provided to the SPI upfront.

Therefore, when applicable, the Streamlined Approach simplifies the point-of-sale processes that are normally required when dealing with retail clients or individual professional investor clients.

The table below summarises the key differences between the normal, non-streamlined approach, and the Streamlined Approach when dealing with an SPI in Eligible Investment Transactions.  Please be aware that the table below is not a summary of all the regulatory obligations applicable to intermediaries when executing transactions with clients, it is only intended to highlight the key differences under the Streamlined Approach.

Note that there are some differences in the application of the Streamlined Approach: (a) when executing transactions in an investment product with a recommendation or solicitation, and (b) when executing transactions in a complex product[16] without recommendation or solicitation.  These differences are also shown in the table below.

Regulatory requirement

Normal approach

Streamlined Approach

Applicable to transactions both (a) in an investment product with a recommendation or solicitation, and (b) in a complex product without recommendation or solicitation

Suitability assessment

Intermediaries are required to assess that each recommended investment product is suitable for, and in the best interests of, the client, taking into account the client’s investment objectives, investment horizon, investment knowledge and experience, risk tolerance, and financial situation, etc.

Intermediaries are also required to assess concentration risk when assessing the suitability of a recommended investment product for the client, taking into account the risk profile and nature of a product, the client’s risk tolerance level and financial situation, etc.[17]

Intermediaries are not required to match an SPI’s risk tolerance level, investment objectives and investment horizon with Eligible Investment Transactions.[18]

Intermediaries are not required to assess an SPI’s knowledge and experience, and concentration risk in Eligible Investment Transactions.[19]

Product disclosure and product explanation

Intermediaries are required to provide each client with up-to-date prospectuses or offering circulars of the recommended investment products, and other up-to-date documents relevant to the investments.

Intermediaries are also required to help each client make informed decisions by giving the client proper explanations of why recommended investment products are suitable for the client and the nature and extent of risks the investment products bear.[20]

Intermediaries are required to provide an SPI with up-to-date product offering documents for Eligible Investment Transactions, which could be done by sending a hyperlink to the offering documents or as attachments via electronic means (e.g., email).

Intermediaries are not required to provide product explanation for Eligible Investment Transactions, except upon request and/or any material queries being raised by an SPI.[21]

Applicable to transactions in an investment product with a recommendation or solicitation

Record keeping

Intermediaries are required to maintain records documenting the rationale underlying investment recommendations made to the client and provide a copy of the rationale for the recommendations to the client upon his/her request.[22]

Intermediaries are not required to maintain records documenting the rationale underlying investment recommendations made to an SPI in Eligible Investment Transactions.[23]

Applicable to transactions in a complex product without recommendation or solicitation

Product due diligence on complex products[24]

Intermediaries are required to perform product due diligence on a complex product even where the sale of the complex product was without solicitation or recommendation (i.e. on an unsolicited basis).[25]

Subject to the provision of offering documents to the SPI, intermediaries are not required to perform product due diligence for investment products (that are complex products) which fall within the Product Categories specified by the SPI.

For bonds (that are complex products), where offering documents are not provided to the SPI, intermediaries should prepare and provide their own summaries of the key terms and features of the investment product; or provide to the SPI sufficient information on the key terms and features of the investment product based on information available from reliable public domain or data providers.[26]

Warning statements for complex products

Intermediaries are required to provide the complex products warning statements on a transaction-by-transaction basis prior to and reasonably proximate to the point of sale.[27]

Intermediaries can provide warning statements in relation to the distribution of a complex product on an annual basis instead of a transaction-by-transaction basis.[28]

V. Is there an annual review requirement?

Intermediaries are required to carry out annual reviews to ensure that each SPI continues to satisfy the requirements to qualify as an SPI, and continues to agree for the intermediary to deal with the SPI in Eligible Investment Transactions under a Streamlined Approach.  As part of the annual review, intermediaries are required to remind the client in writing of the following:

  • the consequences of being treated as an SPI;[29]
  • the Product Categories specified by the SPI, including information on the Product Categories as per the Product Category Information Statement;
  • the Streamlining Threshold specified by the SPI and an alert to the SPI where there was any incidents of breach; and
  • the client’s right to withdraw from being treated as an SPI, right to add or remove a Product Category, and/or right to revise the Streamlining Threshold at any time.[30]

VI. How to prepare for the implementation of the Streamlined Approach?

For intermediaries interested in applying the Streamlined Approach, they should consider taking the following steps:

Devise product categories

Intermediaries will need to devise Product Categories (see Section II above) to categorise their offered investment products based on their terms and features, characteristics, nature and risks.  As a non-exhaustive example, the SFC notes that the following types of products should fall into separate Product Categories in order to differentiate them from other products with different characteristics, nature, risks and/or product-specific regulatory requirements:[31]

  • accumulators and decumulators;
  • collective investment schemes whose investment objective or principal investment strategy is investing in insurance-linked schemes;
  • debt instruments with loss-absorption features and related products; and
  • virtual assets and virtual asset-related products.[32]

Prepare the Product Category Information Statements

Intermediaries will need to prepare the Product Category Information Statements to provide to SPIs to explain the terms and features, characteristics, nature, and risks of investment products within each Product Category that the SPI may choose from (see Section II above).  The Product Category Information Statements can be distributed in the form of an information booklet or hyperlinks.[33]  Where the Product Category concerns complex products, intermediaries should also include the required warning statements for complex products in the Product Category Information Statement.[34]

Update existing client agreements and acknowledgments

Intermediaries will need to update its written agreements and client documents to specify the following:

  • the SPI’s acknowledgment and consent to being treated as an SPI;
  • the assessment criteria under which the client is assessed to qualify as an SPI;
  • the SPI’s specified Product Categories and the Streamlining Threshold under which an Eligible Investment Transactions can be executed using the Streamlined Approach;
  • an explanation of the consequences of being treated as an SPI;[35] and
  • the SPI’s right to withdraw from being treated as an SPI at any time.[36]

Update internal policies and controls

Intermediaries are responsible for ensuring the proper application of the Streamlined Approach, including ensuring compliance with the regulatory requirements described above.

In this regard, one of the requirements that intermediaries must comply with is to establish and maintain effective systems and controls to ensure continuous compliance with the Streamlining Threshold for each SPI. To achieve this, intermediaries can either:

  • ensure the gross exposure arising from investment transactions executed under the Streamlined Approach remains at or below the Streamlining Threshold upon execution; or
  • devise designated accounts (or sub-accounts) to consolidate Eligible Investment Transactions of the SPI executed under the Streamlined Approach, and ensure that the gross exposure arising from all positions maintained in the designated account remains at or below the Streamlining Threshold after receiving top-up or deposit of new funds into such designated account. The amount or percentage of the SPI’s AUM held with the intermediary to be allocated to the designated account should be discussed with the SPI at least annually, or whenever new funds are deposited into the designated account.

Intermediaries are also required to implement measures to detect outsize or material transactions and issue warning statements to SPIs for these transactions.  Intermediaries will need to review compliance with the Streamlining Threshold at least annually.

If the gross exposure in the designated account exceeds the Streamlining Threshold, intermediaries are not expected to reduce/unwind the gross exposure to comply with the Streamlining Threshold.  Rather, intermediaries may continue to operate and execute transactions in such designated account while restricting any top-up or deposit, or alternatively, intermediaries can execute investment transactions without applying the Streamlined Approach (e.g., outside of the designated account).[37]

Intermediaries should update its internal policies, and systems and controls, to ensure ongoing compliance with the regulatory requirements when applying the Streamlined Approach, including keeping necessary records of all relevant information and documents from the application of the Streamlined Approach.

_________________________

[1] “Joint circular to intermediaries – Streamlined approach for compliance with suitability obligations when dealing with sophisticated professional investors” (July 28, 2023), published by the SFC, available at https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/suitability/doc?refNo=23EC35

[2] An “individual professional investor” is an individual having a portfolio of not less than HK$8 million as ascertained according to the Securities and Futures (Professional Investor) Rules (Cap. 571D).

[3] Paragraph 3.1, Annex 1 of the Joint Circular

[4] By holding a degree or post-graduate diploma in accounting, economics or finance, or a related discipline.

[5] By having attained a professional qualification in finance (such as Chartered Financial Analyst (CFA), Certified International Investment Analyst (CIIA), Certified Private Wealth Professional (CPWP), Chartered Financial Planner (CFP) or other comparable qualifications).

[6] By having at least one-year relevant work experience in a professional position in the financial sector in Hong Kong or elsewhere (e.g., licensed for conducting relevant regulated activities).

[7] Paragraph 4.1, Annex 1 of the Joint Circular.

[8] Paragraph 5.1, Annex 1 of the Joint Circular.

[9] Paragraphs 7.1 to 7.3, Annex 1 of the Joint Circular.

[10] Paragraphs 8.1 and 8.2, Annex 1 of the Joint Circular.

[11] Paragraphs 12.1 and 12.2, Annex 1 of the Joint Circular.

[12] Paragraph 12.3, Annex 1 of the Joint Circular.

[13] Paragraph 13.1(a), Annex 1 of the Joint Circular.

[14] Paragraph 13.1(b) and (c), Annex 1 of the Joint Circular.

[15] See paragraphs 13.1(d) and 13.2, Annex 1 of the Joint Circular.

[16] “Complex product” refers to an investment product whose, terms, features and risks are not reasonably likely to be understood by a retail investor because of its complex structure. See the definition of a “complex product” in the “Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission” (the “Code of Conduct”). See also the non-exhaustive list of examples of non-complex and complex products, published by the Securities and Futures Commission, available at https://www.sfc.hk/en/Rules-and-standards/Suitability-requirement/Non-complex-and-complex-products.

[17] Questions 5A and 5B of the “Frequently Asked Questions on Compliance with Suitability Obligations by Licensed or Registered Persons” (the “Suitability FAQ”), last updated by the SFC on December 23, 2020 and available at: https://www.sfc.hk/en/faqs/intermediaries/supervision/Compliance-with-Suitability-Obligations/Compliance-with-Suitability-Obligations#759450F3651D4BBF8AAA2F39C9F2BE88.

[18] Paragraphs 10.1 and 11.2, Annex 1 of the Joint Circular.

[19] Paragraphs 10.2 and 11.3, Annex 1 of the Joint Circular.

[20] Questions 6A and 6B, the Suitability FAQ.

[21] Paragraphs 10.3 and 11.4, Annex 1 of the Joint Circular.

[22] Question 7, the Suitability FAQ.

[23] Paragraph 10.4, Annex 1 of the Joint Circular.

[24] For the avoidance of doubt, product due diligence is required when an intermediary recommends an investment product, irrespective of whether the investment product is a complex product or not, see Question 4, Suitability FAQ. This row in the table concerns transactions in complex products where there is no recommendation or solicitation.

[25] Paragraph 5.5(a) of the Code of Conduct, which provides that the suitability requirements (including product due diligence), applies to the sale of complex products without a solicitation or recommendation.

[26] Paragraph 11.1, Annex 1 of the Joint Circular.

[27] Paragraph 5.5(a)(iii) of the Code of Conduct. See also the “Minimum information to be provided and warning statements” (June 12, 2019), published by the SFC, available at: https://www.sfc.hk/en/Rules-and-standards/Suitability-requirement/Non-complex-and-complex-products/Minimum-information-to-be-provided-and-warning-statements.

[28] Paragraph 11.5, Annex 1 of the Joint Circular.

[29] The consequences of being treated as an SPI are listed under paragraph 13.2, Annex 1 of the Joint Circular.

[30] Paragraph 14, Annex 1 of the Joint Circular.

[31] Question 3, Annex 2 of the Joint Circular.

[32] “virtual asset-related products” are investment products which: (a) have a principal investment objective or strategy to invest in virtual assets; (b) derive their value principally from the value and characteristics of virtual assets; or (c) track or replicate the investment results or returns which closely match or correspond to virtual assets.

[33] Paragraph 7.2, Annex 1 of the Joint Circular.

[34] Question 4, Annex 2 of the Joint Circular.

[35] The consequences of being treated as an SPI are listed under paragraph 13.2, Annex 1 of the Joint Circular.

[36] Paragraph 13.1, Annex 1 of the Joint Circular.

[37] Question 6, Annex 2 of the Joint Circular.

The following Gibson Dunn lawyers prepared this client alert: William Hallatt, Arnold Pun, and Jane Lu.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact any member of Gibson Dunn’s Global Financial Regulatory team, including the following members in Hong Kong:

William R. Hallatt – Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)
Emily Rumble – Hong Kong (+852 2214 3839, erumble@gibsondunn.com)
Arnold Pun – Hong Kong (+852 2214 3838, apun@gibsondunn.com)
Becky Chung – Hong Kong (+852 2214 3837, bchung@gibsondunn.com)

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

On June 1, 2023, Hong Kong’s long-awaited licensing regime for virtual asset trading platforms (“VATPs”) went live, with the Hong Kong Securities and Futures Commission (“SFC”) marking the occasion by issuing a flurry of regulatory guidance for operators of VATPs (“Platform Operators”) in the form of guidelines, FAQs and handbooks.

This client alert discusses that regulatory guidance, with a particular focus on the key practical takeaways for prospective VATP licence applicants set out in the SFC’s Consultation Conclusions on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission (the “Consultation Conclusions”). However, the guidance issued by the SFC spans a wide range of topics, including transitional arrangements, senior management accountability, onboarding of clients and cybersecurity. Prospective VATP licence applicants should ensure that they familiarise themselves with the SFC’s guidance and expectations for Platform Operators.

Consultation Conclusions Published on May 23, 2023

In February 2023, the SFC issued a highly-anticipated consultation paper inviting public comments on the proposed regulatory requirements applicable to Platform Operators.[1] We previously published a client alert on this topic.[2] Following a feedback period that concluded on March 31, 2023, the SFC published its Consultation Conclusions on May 23, 2023, which considered 152 submissions received by the SFC from industry associations, professional and consultancy firms, market participants, licensed corporations, individuals and other stakeholders.[3]

While the SFC found respondents generally supportive of the proposed regulatory requirements for Platform Operators in Hong Kong, a number of comments noted that the technical and implementation details may have been insufficiently clear.  In response, the SFC has modified or clarified some of the regulatory requirements as set out in the Guidelines for Virtual Asset Trading Platform Operators (the “VATP Guidelines”), and also published additional circulars, FAQs and guidelines on May 31, 2023 and June 1, 2023.

The SFC maintains that providing clear regulatory expectations will be critical to fostering responsible development, especially within Hong Kong’s virtual assets (“VA”) landscape. Adopting the principle of ‘same business, same risks, same rules’, the SFC aims to support and develop the VA industry by ensuring robust investor protection and critical risk management.

Circular on Transitional Arrangements

On May 31, 2023, the SFC issued the Circular on Transitional Arrangements of the New Licensing Regime for Virtual Asset Trading Platforms (the “Transitional Arrangements Circular”) to provide additional guidance on the transitional arrangements for VATPs under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) licensing regime (the “AMLO VASP Regime”).[4]  The guidance in this Circular is consistent with the transitional arrangements explained in the SFC’s consultation paper published in February 2023 but provides further detail that will be relevant to VATPs preparing to apply for a licence by no later than February 29, 2024.

An important point to note is that, upon reviewing a licence application, if the SFC considers that the VATP licence applicant does not meet any of the deeming conditions (which includes proving to the SFC’s satisfaction that the VATP is capable of complying with the regulatory requirements applicable to VATPs), then the SFC may issue a notice to the VATP (the “no-deeming notice”) to inform the VATP that the deeming arrangement will not apply to it.  A VATP that receives a no-deeming notice will be subject to a deemed withdrawal procedure and must proceed to close down its business by May 31, 2024 or by the expiry of three months beginning on the day of the issuance of the no-deeming notice (whichever is the later), irrespective of whether it has objected to the deemed withdrawal of its licence application.  It will therefore be crucial for a VATP licence applicant to submit a robust licence application that proves that it can meet all of the deeming conditions, or else it risks being ineligible for the deeming arrangement.

Other regulatory guidance applicable to VATPs

In addition to the recently published Consultation Conclusions, the VATP Guidelines, and the Transitional Arrangements Circular, operators of VATPs should also be aware of additional regulatory guidance contained in the following documents published between May 31 and June 1, 2023:

  • Licensing Handbook for Virtual Asset Trading Platform Operators;[5]
  • Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Corporations and SFC-licensed Virtual Asset Service Providers);[6]
  • Prevention of Money Laundering and Terrorist Financing Guideline issued by the Securities and Futures Commission for Associated Entities of Licensed Corporations and SFC-licensed Virtual Asset Service Providers;[7]
  • Disciplinary Fining Guidelines;[8]
  • Scope of External Assessment Reports;[9]
  • Circular on implementation of new licensing regime for virtual asset trading platforms;[10]
  • Eight (8) FAQs on VATP licensing-related matters;[11] and
  • Nine (9) FAQs on VATP conduct-related matters.[12]

The regulatory guidance set out in the documents above, in addition to the VATP Guidelines, will be essential to VATP licence applicants, as applicants will need to ensure that its licence application provides to the SFC that it is capable to comply with these regulatory requirements – or else the applicant may be issued a non-deeming notice (as explained above).

VATP licence application forms

The licensing forms for the new AMLO VASP licensing regime (which includes making a simultaneous licence application under the Securities and Futures Ordinance (Cap. 571) (“SFO”) for Type 1 and Type 7 regulated activities) are also now available on the SFC’s licensing forms website.[13]  Licensing forms will need to be submitted to the SFC electronically through the WINGS platform.

Some of the key aspects of the regulatory requirements highlighted in the Consultation Conclusions

Licensing requirement

The SFC has reiterated that Platform Operators should, as a matter of prudence, apply for approvals under both the existing SFC licensing regime and the AMLO licensing regime[14] to ensure business continuity, given that a VA’s classification may change from security to non-security, or vice versa. The SFC rejected the propositions that Platform Operators under the AMLO regime can withdraw a particular token which evolves into a security token and simply allow the client to sell down the token, as this will not be in the client’s best interests.  This stance suggests that applicants seeking an AMLO only licence should expect to face tough questions from the SFC as to their rationale for not also seeking a licence under the SFC’s existing licence regime.

The SFC has also stated that the AMLO regime will cover VA trading platforms which are centralised and function in a manner similar to the types of automated trading venues licensed under the SFO – i.e., they use automated trading engines which match client orders and provide custody services as an ancillary service to their trading services. Given this, the SFC has also clarified that the scope of the AMLO regime does not include over-the-counter VA trading activities and VA brokerage activities, as these do not involve providing VA services with an automated trading engine and ancillary custody services.

Retail access and onboarding requirements

Platform Operators will be allowed to provide their services to retail investors provided that they comply with a range of robust investor protection measures covering onboarding, governance, disclosure and token diligence and admission, before providing services to retail investors.

The SFC notes that it is crucial for retail investors to understand the features and risks of investing in VAs, as well as the potential losses.  As such, the SFC will require Platform Operators to conduct the full scope of the onboarding requirements, including assessing the investor’s risk tolerance, conducting an holistic assessment of the investor’s understanding of the nature and risks of VAs, etc.  The assessment made during the onboarding process will also be relevant in order to comply with the suitability requirements.

It is relevant to note that Platform Operators will be required to comply with the full scope of the onboarding requirements, even if the retail client is knowledgeable about VAs (e.g. as a result of trading VAs for a number of years) or the client is an individual professional investor.  These requirements are broadly consistent with the regulatory requirements applied to traditional licensed corporations more generally.

The SFC has also now issued FAQs providing further guidance on onboarding requirements, including matters such as how to assess an investor’s knowledge of VAs and risk tolerance levels.[15]

Governance

A Platform Operator will be required to set up a token admission and review committee that consists of senior management who are principally responsible for managing the Platform Operator’s key business line, compliance, risk management, and information technology functions (i.e., at a minimum the Manager in Charge (MICs) for these functions).

The SFC has also now issued FAQs to augment the accountability of the senior management of Platform Operators through the imposition of a Manager in Charge regime for Platform Operators, which the SFC acknowledges is ‘substantially the same’ as that applicable to licensed corporations.[16]

Disclosure

The SFC notes that, although it understands the potential challenges of obtaining and verifying information provided by the issuer of a VA, it will still expect a Platform Operator to conduct due diligence on each virtual asset prior to admission for trading. As such, the Platform Operator is expected to obtain information for each VA which it can be reasonably satisfied is reliable and sufficient to base its token admission decision on. Accordingly, the SFC will require Platform Operators to take all reasonable steps to ensure that product specific information that they disclose is not false, biased, misleading or deceptive.

The SFC has set out in the VATP Guidelines the minimum information that Platform Operators are required to disclose with regards to the risk disclosure statements, disclosures regarding the platform’s operations, and VA-specific disclosures.

Token admission

Similar to the SFC’s product due diligence requirements applicable to licensed corporations in respect of traditional financial products, the SFC will require a Platform Operator to  conduct due diligence on each VA it plans to admit for trading on its platform to ensure that the VA complies with the admission criteria established by the token admission and review committee.

These due diligence requirements apply even if the VAs are not intended to be made available to retail investors, although there will likely be material differences in the admission criteria applicable to VAs that are or are not available for trading by retail investors. Furthermore, there is no exemption from conducting due diligence even if the VA in question has already been admitted for trading on another licensed VATP.

Relevantly, the SFC has decided that it will not relax the requirement for a non-security token to have at least a 12-month track record (as it is one of the factors which the token admission and review committee must consider). The result is that a newly or recently launched VA with less than a 12-month track record cannot be admitted for trading by a Platform Operator, even if it is not available for trading by retail investors.

However, the SFC has relaxed one aspect of its token admission requirements, with Platform Operators no longer being required to submit to the SFC written legal advice confirming that each token made available for trading by retail clients would not amount to a security token. Nevertheless, Platform Operators will still need to take reasonable steps to ensure that security tokens are not made available for trading by retail clients, as this could be a breach of the prospectus regime under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32).

The SFC has emphasised in the Consultation Conclusions the importance of having additional minimum criteria that need to be satisfied before a non-security token can be made available for trading by retail users. In this respect, the SFC has further tightened the eligible large-cap VA requirements to stipulate that at least one of the two acceptable indices must be issued by an independent index provider (that has experience publishing indices for conventional securities markets, and that is also compliant with the IOSCO Principles for Financial Benchmarks).

Furthermore, in addition to being independent of the Platform Operator, the two index providers will also need to be independent of the issuer of the VA.  Additionally, the SFC emphasised in the Consultation Conclusions that being included in two acceptable indices is merely the minimum criterion for admitting a VA for retail trading, and that Platform Operators will also need to ensure that tokens admitted satisfy the Platform Operator’s token admission criteria (and also ensure that such tokens have high liquidity for tokens available for retail trading).

Stablecoins

The SFC has also clarified in the Consultation Conclusions that, prior to stablecoins being subject to regulation by the Hong Kong Monetary Authority (“HKMA”), Platform Operators should not admit stablecoins for retail trading.  The HKMA published the conclusions on its discussion paper on crypto-assets and stablecoins in January 2023, and the regulatory arrangements for stablecoins are expected to be implemented in 2023/24.  We previously published a client alert on this consultation.[17]

Insurance and compensation arrangements

The SFC will now require Platform Operators to have in place a compensation arrangement approved by the SFC to cover potential loss of 50% of client VAs in cold storage and 100% of client VAs in hot or other storage held by its custodian (see below for further discussion on custody arrangements). The SFC has also noted that the arrangement should be made up of the following:

  • Third-party insurance;
  • Funds (held in a demand deposit or time deposit with less than 6 months maturity) or VAs of the Platform Operator or any corporation within the same group as the Platform Operator which are set aside on trust and designated for such a purpose; and/or
  • A bank guarantee from an authorised financial institution in Hong Kong.

Custody and security requirements

In this aspect of the Consultation, the SFC had sought industry suggestions in relation to technical solutions that could mitigate risks associated with custody of client assets, particularly in hot storage.

However, the SFC’s response in the Consultation Conclusions focused on reiterating the SFC’s view that, given the importance of safe custody of VAs, the SFC will require what it terms a ‘direct regulatory handle’ over a firm exercising control of client VAs, and as such will require custody to be undertaken by a wholly-owned subsidiary of a Platform Operator. For the same reason, the SFC will require  all seeds and private keys holding customer VAs to be securely stored in Hong Kong, noting that if they were stored overseas, this would substantially hinder the SFC’s supervision and enforcement efforts.  As a result, the SFC has reiterated in the Consultation Conclusions that the use of third-party custodians will not be allowed.

The SFC also noted that it had received ‘many’ comments requesting that the SFC amend the requirement that 98% of client VAs must be stored in cold storage and only 2% could be stored in hot or other storage so to permit a lower cold to hot storage ratio to be adopted. However, the SFC has reiterated that it believes that this ratio should not be lowered and that the ‘bulk’ of client VAs should be held in cold storage given that it is generally free of hacking / other cybersecurity risks. Further, while many respondents had indicated that they believed that a lower cold to hot storage ratio was required in order to ensure more expedient asset withdrawals, the SFC appears to have had little sympathy for this position. Instead, the SFC has reminded Platform Operators of the requirement under the Guidelines for Platform Operators’ comprehensive trading and operational rules to cover withdrawal procedures, including the time required to transfer VAs to a client’s private wallet after receiving a withdrawal request on its website.

Virtual asset derivatives

This aspect of the Consultation had sought input in relation to business models that would be adopted by Platform Operators if allowed to provide trading services in VA derivatives and the types of investors that would be targeted.

The SFC noted in the Consultation Conclusions that respondents expressed general support for allowing Platform Operators to provide trading services in VA derivatives, and that the SFC understood the importance of VA derivatives to institutional investors. However, the revised Guidelines maintain the prohibition on Platform Operators offering trading or dealing in VA derivatives, with the SFC instead indicating in the Consultation Conclusions that it will conduct a separate review of this issue ‘in due course’.

Proprietary trading and other services

The SFC has noted that it received submissions suggesting that proprietary trading, including proprietary market making by a Platform Operator’s affiliates, should be allowed in order to enhance liquidity.

While maintaining the prohibition on proprietary trading, the SFC has amended the requirements in the Guidelines to allow trading by affiliates of a Platform Operator other than trading through the Platform Operator (regardless of whether such trading is on-platform or is off-platform). The SFC noted that this amendment has been made on the basis that the previous iteration of the draft Guidelines effectively prohibited group companies of a Platform Operator from having any positions in VAs.

The SFC also noted that it received a number of responses in relation to whether Platform Operators could provide other VA services such as earning, deposit-taking, lending or borrowing. The SFC’s position, however, is that allowing such services could create potential conflicts of interest for Platform Operators (and would require additional safeguards) and as such Platform Operators will not be permitted to conduct these activities ‘at this stage’.

The SFC has also clarified in the Consultation Conclusions that while Platform Operators are prohibited from providing algorithmic trading services to their clients, the platform’s clients can use their own algorithmic trading systems when trading on a licensed platform.

Disciplinary Fining Guidelines

The SFC has clarified that all Platform Operators will be subject to the same fining criteria[18] regardless of the regime under which the Platform Operator is licensed. In rejecting a submission proposing that fines should be determined with reference to the total annual turnover of the Platform Operator, the SFC has stated that it will continue to determine quantum based on the legislative requirement in the AMLO that a fine should not exceed the higher of HK$10 million or three times the profit gained or loss avoided. However, the SFC has also noted that it will closely monitor the implementation of the Fining Guidelines, and determine whether legislative change may be required.

In response to a comment, the SFC specifically noted that the fact that a particular type of conduct is widespread in unregulated entities would not be considered a mitigating factor for any misconduct by licensed Platform Operators.

In the context of submissions requesting greater clarity on factors relevant to the SFC’s decision to take enforcement action against Platform Operators and/or individuals, the SFC has stated that it will take a holistic approach to disciplinary action in order to ensure that all culpable parties are held accountable for their conduct. In this vein, the SFC has noted in the Consultation Conclusions that the VATP Guidelines already provide that senior management of a Platform Operator bear the primary responsibility for ensuring compliance with the rules and guidelines applicable to Platform Operators. Further, as noted above, the SFC has also issued an FAQ on the augmentation of the accountability of senior management for Platform Operators, which extends the SFC’s Manager in Charge regime to Platform Operators.[19]

___________________________ 

[1]  “Consultation Paper on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission”, published by the SFC (February 20, 2023), available at https://apps.sfc.hk/edistributionWeb/gateway/EN/consultation/doc?refNo=23CP1.

[2]  “Hong Kong SFC Consults On Licensing Regime For Virtual Asset Trading Platform Operators”, published by Gibson, Dunn & Crutcher (March 2, 2023), available at https://www.gibsondunn.com/hong-kong-sfc-consults-on-licensing-regime-for-virtual-asset-trading-platform-operators/.

[3] “Consultation Conclusions on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission”, published by the SFC (May 23, 2023), available at https://apps.sfc.hk/edistributionWeb/gateway/EN/consultation/conclusion?refNo=23CP1.

[4] “Circular on transitional arrangements of the new licensing regime for virtual asset trading platforms” published by the SFC (May 31, 2023), available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC27.

[5] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/assets/components/Guidelines/File-current/Licensing-Handbook-for-VATPs-31-05-2023.pdf?rev=a94fa7324a964e328dd2415815611d76.

[6] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/guideline-on-anti-money-laundering-and-counter-financing-of-terrorism-for-licensed-corporations/AML-Guideline-for-LCs-and-SFC-licensed-VASPs_Eng_1-Jun-2023.pdf?rev=d250206851484229ab949a4698761cb7.

[7] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/prevention-of-money-laundering-and-terrorist-fi/AML-Guideline-for-AEs_Eng_1-Jun-2023.pdf?rev=243299fe5b11413495afee886891aa05.

[8] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/SFC-Disciplinary-Fining-Guidelines_Part-5B/230524–SFC-Disciplinary-Fining-Guidelines-Eng.pdf?rev=9a355f946ff74c7892a921ab73461314&hash=0A14F0BC24C3854FB909953BEA90FC2A.

[9] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/files/LIC/Fintech/Scope-of-External-Assessment-ReportsJune-2023-EN.pdf?rev=7faaba6cd7f84f96806588b03dc86cad&hash=C7C407B725E545E7637F80BD4B5BE4F1.

[10] Published by the SFC on May 31, 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC28.

[11] Published by the SFC on May 31, 2023, and available at: https://www.sfc.hk/en/Welcome-to-the-Fintech-Contact-Point/Virtual-assets/Virtual-asset-trading-platforms-operators/Regulatory-requirements/FAQs-on-licensing-related-matters.

[12] Published by the SFC on May 31, 2023, and available at: https://www.sfc.hk/en/Welcome-to-the-Fintech-Contact-Point/Virtual-assets/Virtual-asset-trading-platforms-operators/Regulatory-requirements/FAQs-on-conduct-related-matters.

[13] Available at: https://www.sfc.hk/en/Forms/Intermediaries/Licensing-forms.

[14] Licensing regime for Platform Operators under the Anti-Money Laundering Ordinance and Counter-Terrorist Financing Ordinance (Cap. 615).

[15] Published by the SFC on May 31, 2023 and available at: https://www.sfc.hk/en/Welcome-to-the-Fintech-Contact-Point/Virtual-assets/Virtual-asset-trading-platforms-operators/Regulatory-requirements/FAQs-on-conduct-related-matters/Dealing-with-clients/31-May-2023-Dealing-with-clients#F9658969756741BF96ED6ED786E29D98.

[16] Published by the SFC on May 31, 2023, and available at: https://www.sfc.hk/en/Welcome-to-the-Fintech-Contact-Point/Virtual-assets/Virtual-asset-trading-platforms-operators/Regulatory-requirements/FAQs-on-licensing-related-matters/Measures-for-augmenting-senior-management-accountability-in-Platform-Operators/Measures-for-augmenting-senior-management-accountability-in-Platform-Operators.

[17] “Hong Kong Monetary Authority Introduces Plans To Regulate Stablecoins” published on February 7, 2023, and available at: https://www.gibsondunn.com/hong-kong-monetary-authority-introduces-plans-to-regulate-stablecoins/.

[18] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/SFC-Disciplinary-Fining-Guidelines_Part-5B/230524–SFC-Disciplinary-Fining-Guidelines-Eng.pdf?rev=9a355f946ff74c7892a921ab73461314&hash=0A14F0BC24C3854FB909953BEA90FC2A.

[19] Published by the SFC on May 31, 2023, and available at: https://www.sfc.hk/en/Welcome-to-the-Fintech-Contact-Point/Virtual-assets/Virtual-asset-trading-platforms-operators/Regulatory-requirements/FAQs-on-licensing-related-matters/Measures-for-augmenting-senior-management-accountability-in-Platform-Operators/Measures-for-augmenting-senior-management-accountability-in-Platform-Operators.

The following Gibson Dunn lawyers prepared this client alert: Will Hallatt, Emily Rumble, Arnold Pun, Becky Chung, and Qingxiang Toh.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact any member of Gibson Dunn’s Digital Asset Taskforce or the Global Financial Regulatory team, including the following authors in Hong Kong and Singapore:

William R. Hallatt – Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)
Grace Chong – Singapore (+65 6507 3608, gchong@gibsondunn.com)
Emily Rumble – Hong Kong (+852 2214 3839, erumble@gibsondunn.com)
Arnold Pun – Hong Kong (+852 2214 3838, apun@gibsondunn.com)
Becky Chung – Hong Kong (+852 2214 3837, bchung@gibsondunn.com)
Qingxiang Toh – Singapore (+65 6507 3610, qtoh@gibsondunn.com)

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

On 4 May 2023, the Hong Kong Court of Final Appeal (the “CFA”) handed down its judgment in Guy Kwok-Hung Lam v Tor Asia Credit Master Fund LP [2023] HKCFA 9[1], putting an end to the age-old debate on the effect of an exclusive jurisdiction clause (“EJC”) in the insolvency context.

The CFA upheld the Court of Appeal’s (the “CA”) decision (by majority) to dismiss the bankruptcy petition. The CFA endorsed the approach that in an ordinary case where the underlying dispute of the petition debt was subject to an EJC, the court should dismiss the petition unless there are strong reasons for the court to decide otherwise.

1. Background

The dispute concerned a loan advanced by Tor Asia Credit Master Fund LP (the “Petitioner”), pursuant to a Credit and Guaranty Agreement (the “Agreement”), to a company (the “Borrower”) controlled by Mr. Guy Kwok-Hung Lam (the “Debtor”), whereby the Debtor agreed to provide a guarantee, as primary obligor, to pay in full of all amounts due and owed without any demand or notice. The Agreement contained an EJC in favour of the New York courts in relation to “all proceedings arising out of or in relation to” the Agreement.

The Agreement was subsequently amended and the maturity of the loan was extended. Notwithstanding that, the Borrower was still unable to make repayment. The Petitioner then presented a bankruptcy petition in Hong Kong against the Debtor. The Debtor resisted the petition and argued that there was no event of default and that, pursuant to the EJC, the Petitioner was required to bring proceedings in the New York courts first to establish the Debtor’s liability.

The Court of First Instance (the “CFI”) granted the bankruptcy order, on the basis that the Debtor was unable to demonstrate a bona fide dispute on substantial grounds in relation to the petition debt[2]. The CA allowed the Debtor’s appeal and dismissed the bankruptcy petition[3]. The CA held that if the dispute concerning the underlying debt fell within the scope of an EJC, the bankruptcy petition should not be allowed to proceed without strong reasons.

The Petitioner appealed to the CFA on the proper approach that Hong Kong courts should adopt in a bankruptcy petition where the dispute concerning a debt is subject to an EJC.

2. The CFA’s decision

The CFA unanimously dismissed the appeal and affirmed the decision of the CA.

(i) Jurisdiction and powers of the CFI

The Petitioner contended that parties could not contract out of the insolvency legislation and in these proceedings different considerations were to be taken into account from those involving the upholding of EJCs in private actions. It was argued that to give presumptive weight to EJCs was to erode and undermine the domestic insolvency regime.

Whilst the CFA confirmed that the CFI’s jurisdiction in a bankruptcy matter was conferred by the Bankruptcy Ordinance (Cap. 6), and was not amenable to exclusion by contract, i.e. the parties’ agreement not to invoke the jurisdiction of the CFI had no effect on its jurisdiction, it held that the parties’ agreement to refer their disputes to a foreign court informed the CFI’s discretion as to whether to exercise its jurisdiction.

The CFA observed that the CFI might exercise its discretion to decline jurisdiction in certain classes of cases, such as where the issue of forum non conveniens was raised or where the dispute in a particular action was covered by an arbitration agreement or an EJC.

(ii) The discretion to decline jurisdiction in bankruptcy

Having found that the CFI had the power to decide whether to exercise its jurisdiction, the CFA further held that the determination of whether the debt was bona fide disputed on substantial grounds was a threshold question which might or might not be engaged when the court decided whether to exercise its bankruptcy jurisdiction.

The CFA noted that in the event that the parties had agreed to have all their disputes under an agreement giving rise to the debt determined exclusively in another forum, the CFI had total discretion to choose not to exercise its bankruptcy jurisdiction and refrain from determining such threshold question.

The CFA considered that it was at this stage that the public policy interest in holding parties to their agreements was engaged. Should the CFI proceed with the petition and make a ruling on the threshold question, it assumed jurisdiction to decide a question which the parties had otherwise agreed would be determined in another forum.

The CFA was of the view that parties’ agreement for certain disputes to be resolved in another forum would be highly relevant as to whether the CFI should exercise its bankruptcy jurisdiction at all. In the event that the underlying debt was subject to an EJC, unless the Petitioner could show that there were strong reasons, such as the risk of the debtor’s insolvency impacting third parties, the debtor’s reliance on a frivolous defence, or an occurrence of an abuse of process, the Court should normally dismiss the petition.

3. Comment

This decision crystalises the court’s position on the effect of an EJC in the context of bankruptcy and winding up proceedings. Absent strong reasons, the Hong Kong court will not proceed with the petition before the adjudication of the petition debt by the agreed forum. It also underscores the importance attached by the courts to party autonomy.

The case also serves as an important reminder to parties when entering into agreements with EJCs, they should be aware that such clauses will have significant impact on any insolvency proceedings to be commenced in Hong Kong and they may be required to first have the dispute over the underlying debt adjudicated in the agreed forum before commencing insolvency proceedings in Hong Kong.

__________________________

[1] https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=152321&currpage=T

[2] https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=137308

[3] https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=146843

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, or the following authors in the firm’s Litigation Practice Group in Hong Kong:

Brian W. Gilchrist OBE (+852 2214 3820, bgilchrist@gibsondunn.com)
Elaine Chen (+852 2214 3821, echen@gibsondunn.com)
Alex Wong (+852 2214 3822, awong@gibsondunn.com)
Cleo Chau (+852 2214 3827, cchau@gibsondunn.com)

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome

On October 7, 2022, the Department of Commerce Bureau of Industry and Security (“BIS”) released broad changes in the Export Administration Regulations (“EAR”) that together will create an effective embargo against providing to China the technology, software, manufacturing equipment, and commodities that are used to make certain advanced computing integrated circuits (“ICs”) and supercomputers.  These changes include new restrictions on the participation by U.S. companies on enabling any semiconductor development or production at a facility in China[1] that manufactures or even potentially manufactures certain advanced ICs.  BIS explained that it developed this sweeping set of new regulations to curtail China’s use of these items in the development of weapons of mass destruction, artificial intelligence and supercomputing-enhanced war fighting, and in technologies that enable violations of human rights.  BIS further noted that these broad-based controls are necessary to address China’s mobilization of vast resources to support its defense modernization and the implementation of its “military-civil fusion” development strategy in ways that are contrary to U.S. national security and foreign policy interests.

BIS framed this new set of regulations as an interim final rule, which allows it to impose immediate controls with specified effective dates.  Generally speaking, the new restrictions on exports of items associated with semiconductor manufacturing activities went into effect immediately on October 7, 2022, and the new restrictions on the exports of supercomputers, as well as associated parts, software, and technology, will come into effect on October 21, 2022.  In addition, a new licensing requirement for support of foreign items destined for use in Chinese company development and production of ICs will become effective between these two dates, on October 12.  In the table below we summarize almost 20 separate changes that BIS’s interim final rule is implementing in the coming weeks.

Effective Fri., Oct. 7, 2022
(U.S. Time)		 Effective Wed., Oct. 12, 2022
(U.S. Time)		 Effective Fri., Oct. 21, 2022
(U.S. Time)
15 C.F.R. § 740.2 (NEW restriction on license exceptions for certain ECCNs) 15 C.F.R. § 744.6 (NEW and Expanded controls on U.S. person’s ability to support China development of integrated circuits) 15 C.F.R. § 734.9(e) (Revised Entity List FDP Rule to add additional restrictions to 28 Chinese entities on the Entity List)
15 C.F.R. § 740.10 (Revised recordkeeping requirement for License Exception RPL) 15 C.F.R. § 734.9(h) (NEW Advanced Computing FDP Rule)
15 C.F.R. § 742.6 (NEW Regional Stability (“RS”) Controls for semiconductor manufacturing items sent to China) 15 C.F.R. § 734.9(i) (NEW Supercomputer FDP Rule)
>15 C.F.R. § 744.11(b) (NEW criteria for adding entities to the Entity List) 15 C.F.R. Part 734, Supplement No. 1 (NEW model certification for Advanced Computing FDP Rule)
15 C.F.R. § 744.23 (NEW semiconductor manufacturing end-use prohibitions) 15 C.F.R. Part 736, Supplement No. 1 (NEW Temporary General License for certain newly controlled activities)
15 C.F.R. Part 774, Supplement No. 1 (NEW ECCN 3B090 and Revised ECCNs 3B991, 3D001, and 3E001) 15 C.F.R. § 740.2 (NEW Restriction on License Exceptions for certain ECCNs)
This is an expansion of the new controls implemented on Oct. 7, 2022.
15 C.F.R. § 742.6 (NEW RS Controls for semiconductor manufacturing and advanced computing items to China)
This is an expansion of the new controls implemented on Oct. 7, 2022.
15 C.F.R. § 744.1 (NEW restrictions on supercomputer and semiconductor manufacturing end-use prohibitions)
15 C.F.R. § 744.11 (NEW licensing requirements concerning expansion of Entity List FDP Rule and “Footnote 4” Entity List entities)
15 C.F.R. § 744.23 (New supercomputer and semiconductor manufacturing end-use prohibitions)
This is an expansion of the new controls implemented on Oct. 7, 2022.
15 C.F.R. Part 744, Supplement No. 4 (NEW Footnote 4 added to 28 Chinese entities on Entity List to account for expansion of Entity List FDP Rules)
15 C.F.R. § 762.2 (NEW recordkeeping requirement to retain Advanced Computing FDP Rule supply chain certificate)
15 C.F.R. § 772.1 (NEW definition for “supercomputer” under the Commerce Control List (“CCL”))
15 C.F.R. Part 774, Supplement No. 1 (Revised Note 3 to Category 3, Product Group A; Revised ECCNs 3A991, 3D001, 3E001, 4A994, 4D994, 4E001, 5A992, and 5D992; NEW ECCNs 3A090, 4A090, and 4D090)

On October 7, 2022, BIS also released a final rule adding 31 Chinese technology companies to the Commerce Department’s Unverified List.  It also revised the criteria for inclusion on the Entity List to include an entity’s refusal or a host country’s continued interference in the ability of the entity to provide its bona fides or information to verify end-use checks.  A concurrent rule issued by Commerce’s Export Enforcement division states that it will be applying a new, staged approach to adding companies to the Entity List where a foreign government interferes in end-use checks, essentially using the Unverified List as a first step.

We explain and outline the impacts of each of the new provisions below.

New Controls for Exports to China of Advanced IC, Advanced IC Manufacturing Equipment, and Associated Commodities, Software and Technology (15 C.F.R. §§ 740.2, 740.10, 742.6, and Part 774, Supplement No. 1)

One of the most consequential changes contained in the new regulations is the imposition of unilateral “Regional Stability” or RS controls on exports to China of advanced computing ICs, computer commodities that contain such ICs, and certain semiconductor manufacturing equipment, as well as associated software and technology.  These new unilateral controls impose a license requirement for exports, reexports, and in-country transfers of identified items to or within China.

The new RS-based licensing requirement will be imposed in stages on a set of new and revised items defined by Export Control Classification Numbers (“ECCNs”).  The new RS controls on certain semiconductor manufacturing items, as well as associated software and technology, became effective on October 7, 2022.  Similar controls on certain advanced computing items will come into effect on October 21, 2022.

  • Effective October 7, 2022:

    • New ECCN 3B090 to control certain semiconductor manufacturing equipment and specially designed parts, component, and accessories.
    • Revised ECCNs 3B991, 3D001, and 3E001 to account for new RS controls and corresponding changes in light of new ECCN 3B090.
  • Effective October 21, 2022:

    • New ECCNs 3A090, 4A090, and 4D090 to control specified high-performance ICs; certain computers, electronic assemblies, and components containing ICs; and associated software, respectively.
    • Revised ECCNs 3D001, 3E001, and 4E001 for the software and technology associated with ECCNs 3A090, 4A090, and 4D090, as well as 5A992 and 5D992 for commodities and software that meet or exceed the performance parameters of ECCNs 3A090 or 4A090.

BIS further restricted access in China to the items described by these ECCNs by limiting the availability of most license exceptions for these items, including the widely used license exception for encryption items (referred to as “ENC”).  Prior to this rule change, some advanced ICs did not require licensing when exported to China solely because they incorporated an information security functionality that could qualify for license exception ENC after certain classification, filing, and/or reporting requirements were met.  Under the new rules, license exception ENC will not be available to overcome the new RS license requirements for items that also meet the classification criteria for ECCNs 3A090, 4A090, and the associated software and technology in 3D001, 3E001, 4D090, and 4E001.

Importantly, the new RS controls do not apply to deemed exports or deemed reexports.

BIS will review license applications to export, reexport, and transfer in-country RS-controlled items to PRC-IC fabricators under a presumption of denial.  However, BIS will review applications for semiconductor manufacturing items destined to end users in China that are headquartered in the United States or in certain closely allied nations listed in Country Groups A:5 and A:6 on a case-by-case basis.

New Controls on Specified High-Performance Computing ICs and Commodities That Contain Them (15 C.F.R. Part 774, Supplement No. 1)

BIS is also adding new unilateral “anti-terrorism” or AT controls on the export of certain high-performance ICs, and their associated software and technology.  These ICs can be found in a wide range of applications, including central processing units (“CPU”), graphics processing units (“GPU”), tensor processing units (“TPU”), neural processors, in-memory processors, vision processors, text processors, co-processors/accelerators, adaptive processors, and field-programmable logic devices (“FPLDs”).  These new IC controls are described under ECCNs 3A991p and 4A994.l, and their corresponding software and technology controls under ECCNs 3D991, 3E991, 4D994, and 4E992, and exports, reexports, and transfers of these items to Iran, North Korea, and Syria will now require licensing.

Impact of New AT Controls on Certain Foreign National Employees in the United States – Deemed Exports

Whenever BIS identifies new technologies for control, companies and other organizations that employ foreign nationals in the United States need to consider whether the new controls will impose a requirement for them to obtain “deemed export” licenses.  With respect to these new controls on these high-performance ICs and the commodities that contain them, BIS clarified that foreign national employees who did not previously require a license, but now do, will not require licensing unless they are provided access to new technology or software that exceeds the scope of the technology or software they received previously.  For example, an Iranian national technologist who lawfully accessed technology or software specified in new ECCN paragraphs 3A991.p or 4A994.l prior to the effective date would not need a new license to continue receiving the same technology or software, but would require a license for the release of controlled technology or software different from that previously released, even if the technology or software is classified under the same ECCNs.

Although this clarification creates something of a safe harbor for existing national employees who support U.S. domestic companies with the development of high-performance ICs, the harbor is not particularly deep or wide, and we expect these new export controls to pose significant deemed export compliance challenges for many.  Among other challenges, few companies would have already created detailed inventories of the specific software and technology its employees have access to that Commerce now controls with the new ECCNs prior to their creation last week.  Moreover, even if and when such inventories are developed, the question of what would constitute the release of a new or different software or technology to the foreign national employee will immediately present itself.  For example, would foreign national’s writing of new source code for the same piece of software be considered new?  What if the employee is asked to work on design changes for a similar, but different IC than a company currently sells?  Not only will many companies have significant difficulties identifying access to the newly controlled technologies, and then construing what releases of technology and software are new, but once they determine a license is needed, the companies and the foreign national employees will then be faced with a protracted period of uncertainty as BIS adjudicates the deemed export license application, a process that often takes between six and twelve months.

New and Expanded Foreign Direct Product (“FDP”) Rules

BIS is also significantly expanding the application of its existing Entity List FDP rules and creating two new FDP rules on advanced computing ICs and supercomputers.  These rules come into effect October 21, 2022.

  1. Entity List FDP Rule (15 C.F.R. §§ 734.9(e), 744.11, and Part 744, Supplement No. 4)

After early attempts to cut off the flow of U.S.-origin items to Huawei, BIS modified the national security-related control known as the Foreign Direct Product Rule to enable it to target a broader range of exports to specific companies that it has designated to the EAR Entity List (“Entity List FDP rule”).  The Foreign Direct Product Rule concept is at the farthest end of U.S. efforts to extend its export controls jurisdiction extraterritorially because it applies to non-U.S.-origin items that are the direct products of specified U.S.-origin software and technology, or of “major components” or whole plants that are the direct product of this software and technology.  BIS also has used new FDP rule modifications to limit the access by Russian and Belarusian military end users and military intelligence end users to commodities produced with controlled U.S. software and technology.

BIS has now expanded its Entity List FDP rule to cover 28 China-based entities that it had already designated to the Entity List over the last several years for their alleged participation in nuclear and other weapons of mass destruction proliferation, as well as surveillance and other human rights violations.  Thus, in addition to requiring licenses for exports of U.S. origin items, any non-U.S. based exporters also will require U.S. export licenses to export, reexport or transfer items that are direct products of technology or software classified by the following ECCNs:  3D001, 3D991, 3E001, 3E002, 3E003, 3E991, 4D001, 4D993, 4D994, 4E001, 4E992, 4E993, 5D001, 5D002, 5D991, 5E001, 5E002, or 5E991, as well as the direct product of any plant or “major component” of a plant that is the “direct product” of U.S.-origin “technology” or “software” that is specified in the ECCNs listed above.  These ECCNs apply to most ICs, computers, telecommunications, and information security items controlled by Commerce.

BIS also has created two new, similarly structured FDP rules to target the export, reexport and transfer of foreign direct products used to develop or produce ICs and supercomputers for China-based manufacturers.

  1. Advanced Computing FDP Rule (15 C.F.R. §§ 734.9(h), 762.2, and Part 734, Supplement No. 1)

The Advanced Computing FDP rule expands the scope of the EAR to certain items destined for China, as well as certain items produced in China.  The rule is applicable whenever an exporter has “knowledge” (as defined under the EAR to cover actual knowledge and an awareness of a high probability, which can be inferred from acts constituting willful blindness) that the item is (1) destined for China or will be incorporated into any “part,” “component,” “computer,” or “equipment” (not designated EAR99) destined for China, or (2) the technology is developed by an entity headquartered in China for the “production” of a mask or an IC wafer or die.  The foreign-produced items that are affected by this new rule include those items that are either:

  • (i) the “direct product” of “technology” or “software” subject to the EAR and specified in ECCNs 3D001, 3D991, 3E001, 3E002, 3E003, 3E991, 4D001, 4D090, 4D993, 4D994, 4E001, 4E992, 4E993, 5D001, 5D002, 5D991, 5E001, 5E991, or 5E002; and
    • (a) are described by ECCNs 3A090, 3E001 (for 3A090), 4A090, or 4E001 (for 4A090); or
    • (b) are ICs, computers, “electronic assemblies,” or “components” specified elsewhere on the CCL that meet the performance parameters of ECCNs 3A090 or 4A090;
  • (ii) or are produced by any complete plant or “major component” of a plant that is located outside the United States, when the plant or “major component” of a plant, whether made in the United States or a foreign country, itself is a “direct product” of U.S.-origin “technology” or “software” that meets the requirements discussed immediately above.

As a suggested compliance aid, BIS has provided a suggested (voluntary) sample certification that suppliers can complete to comply with this Advanced Computing FDP.  See Supplement 1 to Part 734.  In this certification, the supplier would assert that an item being provided will be subject to the EAR if a future transaction meets the destination scope outlined above.  If a certificate is not provided by a supplier, BIS explains that the supplier’s customers will need to complete additional due diligence to determine if the item purchased is subject to the Advanced Computing FDP’s licensing requirement for onward exports to China.  BIS further notes, however, that the certification alone should not be the only due diligence conducted before an export occurs.  Moreover, BIS advises that entities outside of China that receive 3E001 for 3A090 technology from China should consider confirming that a license was obtained to export such technology from China, as the provisions of the Advanced Computing FDP also extend to certain items produced in China by China-based manufacturers.  If no such license has been obtained, the item would have been exported from China in violation of the EAR.  In addition, parties involved in supporting the transaction would be subject to the EAR’s General Prohibition 10, which prohibits any person from taking further action on a transaction with knowledge (see definition above) that a violation has occurred or is about to occur.

  1. Supercomputer FDP Rule (15 C.F.R. §§ 734.9(i) and 772.1)

Similarly, BIS has now issued the Supercomputer FDP rule to expand the scope of the EAR to certain items destined for China whenever the exporter has “knowledge” that the foreign-produced item will be (1) used in the design, “development,” “production,” operation, installation (including on-site installation), maintenance (checking), repair, overhaul, or refurbishing of a “supercomputer” (as defined in the EAR) located in or destined to China; or (2) incorporated into, or used in the “development,” or “production,” of any “part,” “component,” or “equipment” that will be used in a “supercomputer” located in or destined to the China.

The foreign-produced items affected by this new rule are as follows:

  • foreign-produced items that are the “direct product” of “technology” or “software” subject to the EAR and specified in ECCNs 3D001, 3D991, 3E001, 3E002, 3E003, 3E991, 4D001, 4D993, 4D994, 4E001, 4E992, 4E993, 5D001, 5D991, 5E001, 5E991, 5D002, or 5E002; or
  • are produced by any plant or “major component” of a plant that is located outside the United States, when the plant or “major component” of a plant, whether made in the United States or a foreign country, itself is a “direct product” of U.S.-origin “technology” or “software” that is specified in the ECCNs 3D001, 3D991, 3E001, 3E002, 3E003, 3E991, 4D001, 4D994, 4E001, 4E992, 4E993, 5D001, 5D991, 5E001, 5E991, 5D002, or 5E002.

As of October 21, 2021, “supercomputer” will be specifically defined under the EAR as “a computing “system” having a collective maximum theoretical compute capacity of 100 or more double-precision (64-bit) petaflops or 200 or more single-precision (32-bit) petaflops within a 41,600 ft3 or smaller envelope.”  Commerce’s definition for “supercomputer” is interesting in at least two ways.  First, it appears that a large variety of advanced ICs can be used to create the level of computing power density outlined by the definition.  Thus, this definition creates a kind of catch-all for computing power regardless of how it is achieved.  Second, data center providers, and those who support them, may need to consider whether any specific data center could conceivably meet this computing power threshold.

  1. Temporary General License (15 C.F.R. Part 736, Supplement No. 1)

Taken together, these new sets of RS, FDP, and ECCN-defined controls will have a significant impact on the ability of China-headquartered companies to obtain access to the commodities, technology and software required to manufacture ICs and Supercomputers.  But a larger policy comes into focus when one considers a Temporary General License (“TGL”) that BIS issued alongside these controls.

The TGL authorizes companies headquartered in the United States or in a subset of other countries (those not headquartered in Country Groups D:1 or D:5 or E) to continue exporting certain ICs and associated software and technology for specified purposes to their affiliates and subsidiaries located in China through April 7, 2023, provided that none of the ultimate recipients of the items being manufactured with these products are located in China.  The announced objective for the TGL is to mitigate the immediate disruption that these new controls will have on users of the TGL’s supply chains.  Once the TGL expires in April 2023, exporters will need to apply for an individually validated export license to export such advanced computing chips, assemblies containing them, and related software and technology to China for supply chain-related activities, such as assembly, inspection, quality assurance, and distribution.  These applications will carry a presumption of denial, although license applications for semiconductor manufacturing items destined to end users in China that are headquartered in the United States or in certain closely allied nations listed in Country Groups A:5 and A:6 will be reviewed on a case-by-case basis.

The TGL allows, at least until April 7, 2023, companies to continue exporting the following items:

  • ECCNs 3A090, 4A090, and associated software and technology in ECCNs 3D001, 3E001, 4D090, or 4E001; and
  • any item that is a computer, IC, “electronic assembly” or “component” and associated software and technology, specified elsewhere on CCL which meets or exceeds the performance parameters of ECCNs 3A090 or 4A090.

The TGL’s expiry in April 2023 provides but a short time for U.S. and other Group A:5 and A:6 headquartered companies to find alternative fabricators for ICs.  Other non-China based fabricators may already be at capacity, and the timeline for bringing new fabrication facilities online and qualifying them to produce new ICs is far longer than the timelines currently contemplated by the TGL.

New End-User/End-Use Controls (15 C.F.R. §§ 744.1 and 744.23)

The new regulations also restrict China’s access to ICs and supercomputing through the imposition of new end-user and end-use controls.  These controls are knowledge-based controls that require exporters to seek BIS licensing when they know, are informed, or are otherwise unable to determine that their exports will be put to certain end uses.

On October 7, 2022, these end-user/end-use prohibitions were extended to the following:

  • any item subject to the EAR used in the “development” or “production” of ICs at a semiconductor fabrication “facility” located in China which fabricates certain ICs such as advanced logic, NAND, and DRAM ICs;
  • any item subject to the EAR and classified in an ECCN in Product Groups B, C, D, or E in Category 3 of the CCL when the individual or entity knows the item will be used in the “development” or “production” of ICs at any semiconductor fabrication “facility” located in China, but for which the individual or entity does not know whether such semiconductor fabrication “facility” fabricates advanced ICs; and
  • any item subject to the EAR for which the individual or entity will be used in the “development” or “production” in China of any “parts,” “components” or “equipment” specified under ECCNs 3B001, 3B002, 3B090, 3B611, 3B991, or 3B992.

On October 21, 2022, these end-user/end-use prohibitions also will apply to certain “supercomputers” as defined under the EAR, namely:

  • any IC subject to the EAR and specified in ECCNs 3A001, 3A991, 4A994, 5A002, 5A004, or 5A992 when the individual or entity knows the item will be used in (1) the “development,” “production,” “use,” operation, installation (including on-site installation), maintenance (checking), repair, overhaul, or refurbishing of a “supercomputer” located in or destined to China; or (2) incorporation into, or the “development” or “production” of any “component” or “equipment” that will be used in a “supercomputer” located in or destined to China; and
  • any computer, “electronic assembly,” or “component” subject to the EAR and specified in ECCNs 4A003, 4A004, 4A994, 5A002, 5A004, or 5A992 when the individual or entity knows the item will be used for the activities described above.

Commerce notes that it will review all end-user/end-use license applications with a presumption of denial, but that it will consider license applications for semiconductor manufacturing items destined to end users in China that are headquartered in the United States or in certain closely allied nations listed in Country Groups A:5 and A:6 on a case-by-case basis.

Activities of U.S. Persons (15 C.F.R. § 744.6)

Effective October 12, U.S. persons will be prohibited from engaging in certain activities, even when dealing with items that are non-U.S. origin.

Specifically, BIS will now require U.S. persons to apply for licenses to facilitate or engage in shipping, transmitting or transferring to or within China the following products:

  • any item not subject to the EAR that the individual or entity knows will be used in the “development” or “production” of ICs at a semiconductor fabrication “facility” located in China that fabricates certain ICs such as advanced logic, NAND, and DRAM ICs; or in the servicing of any such items;
  • any item not subject to the EAR and meeting the parameters of any ECCN in Product Groups B, C, D, or E in Category 3 of the CCL that the individual or entity knows will be used in the “development” or “production” of ICs at any semiconductor fabrication “facility” located in China, but for which the individual or entity does not know whether such semiconductor fabrication “facility” fabricates certain ICs such as advanced logic, NAND, and DRAM ICs; or in the servicing of any such items; or
  • any item not subject to the EAR and meeting the parameters of ECCNs 3B090, 3D001 (for 3B090), or 3E001 (for 3B090) regardless of end use or end user; or in the servicing of any such items.

Commerce will review all such license applications with a presumption of denial, although license applications for semiconductor manufacturing items destined to end users in China that are headquartered in the United States or in certain closely allied nations listed in Country Groups A:5 and A:6 will be reviewed on a case-by-case basis.

Additions to Unverified List (“UVL”) and Changes to Entity List Designation Criteria (15 C.F.R. § 744.11(b))

The new final rule adds specific criteria for designation to the more restrictive Entity List:

  • an entity precludes access to, refuses to provide, or provides false or misleading information related to the parties to the export transaction or the underlying item; or
  • where there is a sustained lack of cooperation by the entity’s host government to facilitate end-use checks of entities on the UVL.

In a related statement of a new policy in line with these changes in the final rule, BIS laid out a two-step process whereby companies that do not complete requested end-use checks within 60 days will be added to the UVL, and if those companies are added to the UVL due to the host country’s interreference, after a subsequent 60 days of the end-use check not being completed, the company on the UVL will be transferred to the Entity List.

The new policy states that for all companies currently on the UVL as of the date of the policy (October 7, 2022), including the 31 new China company additions, the 60-day “escalation” clock begins immediately.

________________________

[1] As a reminder, under current U.S. export controls, China also includes the Hong Kong Special Administrative region after the United States revoked Hong Kong’s special status under U.S. law in 2020.

The following Gibson Dunn lawyers prepared this client alert: Christopher Timura, Chris Mullen, Judith Alison Lee, David A. Wolber, Adam M. Smith, and Stephenie Gosnell Handler.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or the following members and leaders of the firm’s International Trade practice group:

United States
Judith Alison Lee – Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com)
Ronald Kirk – Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, rkirk@gibsondunn.com)
Adam M. Smith – Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com)
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, shandler@gibsondunn.com)
David P. Burns – Washington, D.C. (+1 202-887-3786, dburns@gibsondunn.com)
Nicola T. Hanna – Los Angeles (+1 213-229-7269, nhanna@gibsondunn.com)
Marcellus A. McRae – Los Angeles (+1 213-229-7675, mmcrae@gibsondunn.com)
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, cmbrown@gibsondunn.com)
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, ctimura@gibsondunn.com)
Annie Motto – Washington, D.C. (+1 212-351-3803, amotto@gibsondunn.com)
Chris R. Mullen – Washington, D.C. (+1 202-955-8250, cmullen@gibsondunn.com)
Sarah L. Pongrace – New York (+1 212-351-3972, spongrace@gibsondunn.com)
Samantha Sewall – Washington, D.C. (+1 202-887-3509, ssewall@gibsondunn.com)
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, asyarief@gibsondunn.com)
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, stoussaint@gibsondunn.com)
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, szhang@gibsondunn.com)

Asia
Kelly Austin – Hong Kong (+852 2214 3788, kaustin@gibsondunn.com)
David A. Wolber – Hong Kong (+852 2214 3764, dwolber@gibsondunn.com)
Fang Xue – Beijing (+86 10 6502 8687, fxue@gibsondunn.com)
Qi Yue – Beijing – (+86 10 6502 8534, qyue@gibsondunn.com)

Europe
Attila Borsos – Brussels (+32 2 554 72 10, aborsos@gibsondunn.com)
Nicolas Autet – Paris (+33 1 56 43 13 00, nautet@gibsondunn.com)
Susy Bullock – London (+44 (0) 20 7071 4283, sbullock@gibsondunn.com)
Patrick Doris – London (+44 (0) 207 071 4276, pdoris@gibsondunn.com)
Sacha Harber-Kelly – London (+44 (0) 20 7071 4205, sharber-kelly@gibsondunn.com)
Penny Madden – London (+44 (0) 20 7071 4226, pmadden@gibsondunn.com)
Benno Schwarz – Munich (+49 89 189 33 110, bschwarz@gibsondunn.com)
Michael Walther – Munich (+49 89 189 33 180, mwalther@gibsondunn.com)

© 2022 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

In making a winding-up order against Carnival Group International Holdings Limited (the “Company”), Hong Kong Court emphasizes the importance for the directors of an insolvent company to carefully consider whether they should procure the company to oppose the winding-up petition otherwise they could be personally liable to pay costs arising from the opposition.[1]

The Hon Linda Chan J ordered the winding up of the Company after hearing the petition (the “Petition”) presented in March 2020 by one of the unsecured creditors of the Company (the “Petitioner”), which the Company opposed on the basis that there were pending restructuring proposals. The Court noted that there is a duty on the directors to protect and safeguard the interests of the unsecured creditors. In circumstances where the directors became aware that the restructuring proposals would not come to fruition, it would be incumbent upon them to cause the Company to be wound up. As the directors had failed to do so and incurred costs to oppose the Petition, the Court considered that it may be appropriate to make an adverse costs order against the directors personally, and they were directed to file evidence/submissions to demonstrate why they should not be liable. After considering the directors’ submissions, the Court ordered that the four directors who remained in office on the date of the winding-up order to be personally liable for the costs of and occasioned by Company’s opposition to the Petition at the hearing before the Hon Linda Chan J on 23 August 2022.[2]

1. Background

The Company was listed on The Stock Exchange of Hong Kong. It was incorporated in Bermuda and, until its being wound up, had since February 1994 been registered as an oversea company in Hong Kong under the former Companies Ordinance. The Company was an investment holding company and held a number of subsidiaries incorporated in Hong Kong, the Mainland and the BVI (together, the “Group”).

Since 2018, the Company and the Group had been in financial difficulty and they were unable to meet their debts using the income generated from the business. As at 31 December 2019, the Company’s net liabilities were HK$1 billion, and the total outstanding interest-bearing debts of the Group (consisting of both secured and unsecured debts) was RMB 7.6 billion.

The Petitioner was a holder of a number of unsecured bonds (with an outstanding principal of over HK$30 million at the date of the Petition) which the Company had defaulted. The Petition was supported by other unsecured creditors (the “Supporting Creditors”) to whom an aggregate amount of over HK$878 million was owed by the Company. In addition, one of the 12 institutional (and secured) creditors which had in the past signed letters to support an adjournment of the Petition also indicated support of the Petition before the hearing. No creditor had filed any notice to oppose the Petition.

2. Winding-up order made by the Court

The Petition averred, among other things, that the three core requirements for the Court to exercise its discretionary jurisdiction to wind up the Company were satisfied.[3] Even though in all of its affirmation filed in opposition to the Petition, the Company did not dispute such averments and only relied upon the ground that there had been ongoing restructuring effort which, if implemented, would result in higher return to the unsecured creditors, the Company sought to contend at the hearing (held on 23 August 2022) that the second core requirement (i.e. there must be a reasonable possibility that the winding-up order would benefit those applying for it) was not satisfied.

The Court held that it was not open to the Company to raise the jurisdictional challenge 2.5 years after the Petition was presented and, in any event, there was no merit in such argument.

The Court also noted that there was no evidence to show that the Company had made any real effort in pursuing the restructuring proposals, and that the history of the matter showed that the Company had used the so-called restructuring effort to obtain multiple adjournments and yet failed to comply with a number of orders requiring the Company to file affidavit evidence to deal with the progress of such restructuring.

In the circumstances, the Court was satisfied that it should exercise its discretionary jurisdiction under s.327(3) of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32) (“CWUO”) and made a winding-up order against the Company.

3. Duty of the directors of an insolvent company and potential costs order against the Company’s directors

The Hon Linda Chan J emphasized that the directors of an insolvent company are duty bound to (a) consider whether there is any reasonable prospect of the company avoiding going into insolvent liquidation, and (b) take step to put the company into liquidation where there is no viable restructuring proposal supported by the requisite majorities of creditors. Such duty is enshrined in the avoidance provisions under the CWUO (such as s.266, which renders debts paid subject to unfair preferences voidable, and s.275, which imposes liability on directors for fraudulent trading). Where a company is insolvent or of doubtful solvency, the directors in carrying out their duty to the company must take into account the interests of the creditors, which should be regarded as paramount. This is because the interests of the company are in reality the interests of the creditors, whose money is at stake.

The Court held that it must have been clear to the directors of the Company, who were said to be in discussion with the institutional creditors concerning the restructuring proposals, that there was no reasonable prospect for the Company to be able to implement any proposals to compromise its debts so as to avoid liquidation. As soon as they became aware that the restructuring proposal would not be implemented, the directors should have taken step to cause the Company to be wound up so as to protect and safeguard the interests of the unsecured creditors. When pressed upon by the Court, the Company was unable to identify any justification as to how it was in the interests of the Company and the creditors to oppose the Petition, mindful of the Company’s insolvent state, the directors’ duty to protect the interests of the creditors and the lack of any viable restructuring proposals.

4. Adverse costs order against the directors

The Court further criticized the directors for causing the Company to continue to oppose the Petition by raising the jurisdictional challenge that was devoid of merits. The Court concluded that it may be appropriate to depart from the usual costs order (which is that the costs of the Petitioner and one set of costs for the Supporting Creditors be paid out of the assets of the Company) and to consider ordering the directors to pay for the costs of and occasioned by the Company’s opposition to the Petition from the time when they became aware that the restructuring proposals would not be implemented. The directors of the Company were joined as respondents to the Petition for costs purpose only, and the Court directed them to file and serve evidence and/or submission to explain why they should not be liable for costs.

Upon considering the submissions subsequently filed by the six relevant directors, the Hon Linda Chan J concluded that there was no basis for them to cause the Company to oppose the petition on jurisdictional ground, which was advanced as the only ground in opposition to the Petition at the 23 August 2022 hearing.

The Court ordered three Independent Non-Executive Directors and an Executive Director, who were directors of the Company at the materials times and who remained in office on the date when the Company was ordered to wind up, to pay to the Petitioner, the Supporting Creditors (with one set of costs) and the Official Receiver their costs of and occasioned by the Company’s opposition to the Petition at the hearing on 23 August 2022.  As to the two Executive Directors who had ceased to be directors of the Company from 4 September 2021 and 15 May 2021 respectively, the Court was satisfied that after their resignation, they were not involved in causing the Company to oppose the Petition, and hence they were not ordered to pay the costs occasioned by such opposition.

5. Conclusion

This judgment serves as a useful reminder of the directors’ duty where a company is insolvent or of doubtful solvency. When discharging their duty, directors of an insolvent company must consider the creditors’ interests as paramount and take those into account in exercising their discretion. They are duty bound to consider whether there is any reasonable prospect of the company avoiding insolvent liquidation, and should take step to wind up the company where there is no viable option.

If the directors fail to discharge such duty and yet cause the company to oppose a winding-up petition unreasonably, they may face adverse costs consequence and may be held liable for the costs of and occasioned by opposing the winding-up petition.

________________________

[1] Re Carnival Group International Holdings Limited [2022] HKCFI 2668, available here.

[2] Re Carnival Group International Holdings Limited [2022] HKCFI 3097, available here.

[3] Please refer to paragraph 2 of our client alert “Hong Kong Court of Final Appeal Confirms That ‘Leverage’ Satisfies the ‘Benefit’ Requirement for Winding Up Foreign Companies”, available here, for an explanation of the three core requirements.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, or the authors and the following lawyers in the Litigation Practice Group of the firm in Hong Kong:

Brian Gilchrist (+852 2214 3820, bgilchrist@gibsondunn.com)
Elaine Chen (+852 2214 3821, echen@gibsondunn.com)
Alex Wong (+852 2214 3822, awong@gibsondunn.com)
Celine Leung (+852 2214 3823, cleung@gibsondunn.com)

© 2022 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Following a three-month consultation period, the Securities and Futures Commission’s (“SFC”) Code of Conduct (“Code”) provision, paragraph 21, has come into effect on August 5, 2022.[1]  The provision outlines new conduct requirements for intermediaries carrying out bookbuilding and placing activities in equity and debt capital market transactions, including, the introduction of enhanced obligations applicable to an Overall Coordinator (“OC”).  This client alert discusses these new requirements and how they could raise certain sanctions-related questions for the OC as they consider their new obligations under the Code during their review of the order book.

    1. The Role of the Overall Coordinator

The OC is the “head of syndicates” responsible for the overall management of the share or debt offering, coordination of bookbuilding or placing activities, and exercise control over bookbuilding activities and market allocation recommendations to the issuer.  In order to address deficiencies in bookbuilding and allocation practices, the SFC has expanded the role of an OC in paragraph 21 of the Code.

In particular, in its Consultation Paper on (i) the Proposed Code of Conduct on Bookbuilding and Placing Activities in Equity Capital Market and Debt Capital Market Transactions and (ii) the “Sponsor Coupling” Proposal (“Consultation Paper”), the SFC highlighted the following key concerns:[2]

  • Inflated demand: The SFC observed practices where intermediaries knowingly placed orders in the order book which they knew had been inflated. There had also been instances where heads of syndicate disseminated misleading book messages which overstated the demand for an Initial Public Offering (“IPO”).  The SFC considered that these inflated orders undermine the price discovery process and can mislead investors.
  • Lack of transparency: In debt capital market bookbuilding activities, the SFC considered the use of “X-orders,” which are orders where the identities of investors are concealed, as problematic. In these cases, since investors’ identities are only known to the syndicate members who place the orders and to the issuers, the SFC was concerned that duplicated, or potentially fictitious orders might not be identified.
  • Lack of documentation: Heads of syndicates did not properly maintain records of incoming client orders, important discussions with the issuer or the rest of the syndicate, or the basis for making allocation recommendations. The SFC criticized this practice as it undermined the integrity of the book-building process, which is meant to be the keeping of contemporaneous records to establish the position in case of any dispute.

In order to plug the gaps in the bookbuilding process identified above, the SFC has expanded the role of an OC to cover additional responsibilities, such as, consolidating orders from all syndicate members in the order book, taking reasonable steps to identify and eliminate duplicated orders, inconsistencies and errors, ensuring that identities of all investor clients are disclosed in the order book (except for orders placed on an omnibus basis), and making enquiries with capital market intermediaries[3] if any orders appear to be unusual or irregular.[4]

The OC is under an obligation to advise the issuer on pricing and allocation matters.  With respect to allocation, the OC is expected to develop and maintain an allocation policy which sets out the criteria for making allocation recommendations to the issuer, for example, the policy should take account into the types, spread, and characteristics of targeted investors, as well as the issuer client’s objectives, preferences and recommendations.  The OC should then make allocation recommendations in accordance with the policy.[5]  In practice, the OC’s powers are limited to providing recommendations or advice to the issuer on a best efforts basis, and do not go as far as preventing or rejecting an allocation.  The final decision on whether to make an allocation lies with the issuer.  Therefore, where an issuer decides not to adopt the OC’s advice or recommendations, the OC should explain the potential concerns of doing so (i.e., that the issuer’s decision may lead to a lack of open market, an inadequate spread of investors, or may negatively affect the orderly and fair trading of such shares in the secondary market), and advise the issuer against the decision.[6]

    1. Potential Sanctions Considerations

These new requirements, however, which aimed to plug the gaps in the bookbuilding process as noted above, may raise new risks or questions for OCs in other regulatory areas, namely whether there may be implications for the OC in terms of its compliance and legal obligations under the various economic and trade sanctions laws and regulations to which the OC may also be subject, such as those issued by the United Nations, United States (“U.S.”), European Union (“EU”), United Kingdom (“UK”) and others.  Specifically, because OCs will now be made aware of the identities of the ultimate investors in an allocation, a financial institution operating as an OC may have concerns about being able to perform its duties under the SFC requirements in cases where an investor has been identified as a possible subject of sanctions under laws that are applicable to the OC.

For example, under U.S. sanctions administered and enforced by the U.S. Department of the Treasury, Office of Foreign Assets Control (“OFAC”), U.S. financial institutions and their foreign branches are generally prohibited from engaging in, approving or otherwise facilitating transactions with individuals and entities designated to OFAC’s Specially Designated Nationals and Blocked Persons (“SDN”) List.  The contours of what kind of activity constitutes prohibited “facilitation” under U.S. sanctions law is not completely defined and is largely fact dependent.  Thus, it is unclear whether or not, under U.S. law, the subsequent actions a U.S. financial institution might perform in its role as OC after an investor has been identified as a potential sanctioned person could run afoul of U.S. sanctions regulations.  Similar issues may exist under the laws of other jurisdictions such as the EU or UK, depending on the jurisdictional hooks over the OC in question.

Whether or not there is risk here will depend on a variety of factors, including but not limited to: the precise nature of the OC’s actions subsequent to the identification of a sanctions concern (is the OC “approving” or “recommending” action, merely passing along information, recusing itself, etc.); the role, if any, of the OC in actual transactions involving the sanctioned person; the ability of the OC to affect or direct the actual allocation; the precise nature of the sanctions in question; and potentially any contractual protections that may be in place in the underlying operative agreements governing the OC’s role.

In addition, OCs will need to weigh the extent to which any potential sanctions obligations, including anti-boycott / blocking statute related, could conflict with the OC’s obligations under the Code, to provide adequate allocation advice to the issuer with due skill, care and diligence.[7]

Our view is that ultimately both sets of risks and obligations can be effectively managed and met, and we are working with clients and industry to understand and address the impact of these new regulations on the policies and procedures of financial institutions serving in the OC capacity.

_________________________

[1] Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (August 2022), published by the Securities and Futures Commission, https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/code-of-conduct-for-persons-licensed-by-or-registered-with-the-securities-and-futures-commission/Code_of_conduct_05082022_Eng.pdf.

[2] Consultation Paper on (i) the Proposed Code of Conduct on Bookbuilding and Placing Activities in Equity Capital Market and Debt Capital Market Transactions and (ii) the “Sponsor Coupling” Proposal (February 2021), published by the Securities and Futures Commission, https://apps.sfc.hk/edistributionWeb/api/consultation/openFile?lang=EN&refNo=21CP1.

[3] “Capital Market Intermediaries” is defined as licensed or registered persons that engage in capital market activities, namely bookbuilding and placing activities and any related advice, guidance or assistance.  See paragraph 21.1.1 of the Code.

[4] Paragraph 21.4.4(a)(i) of the Code.

[5] Paragraph 21.4.4(c) of the Code.

[6] Paragraph 21.4.2(c) of the Code.

[7] Paragraph 21.4.2(a) of the Code.

The following Gibson Dunn lawyers prepared this client alert: William Hallatt, David Wolber, Becky Chung, Richard Roeder and Jane Lu*.

If you wish to discuss any of these developments, please contact any of the authors of this alert, the Gibson Dunn lawyer with whom you usually work or any of the following leaders and members of the firm’s Global Financial Regulatory or International Trade teams:

Global Financial Regulatory Group:
William R. Hallatt – Co-Chair, Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)
Michelle M. Kirschner – Co-Chair, London (+44 (0) 20 7071 4212, mkirschner@gibsondunn.com)
Jeffrey L. Steiner – Co-Chair, Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com)
Emily Rumble – Hong Kong (+852 2214 3839, erumble@gibsondunn.com)
Arnold Pun – Hong Kong (+852 2214 3838, apun@gibsondunn.com)
Becky Chung – Hong Kong (+852 2214 3837, bchung@gibsondunn.com)
Chris Hickey – London (+44 (0) 20 7071 4265, chickey@gibsondunn.com)
Martin Coombes – London (+44 (0) 20 7071 4258, mcoombes@gibsondunn.com)

International Trade Group:

Asia
Kelly Austin – Hong Kong (+852 2214 3788, kaustin@gibsondunn.com)
David A. Wolber – Hong Kong (+852 2214 3764, dwolber@gibsondunn.com)
Fang Xue – Beijing (+86 10 6502 8687, fxue@gibsondunn.com)
Qi Yue – Beijing – (+86 10 6502 8534, qyue@gibsondunn.com)

Europe
Attila Borsos – Brussels (+32 2 554 72 10, aborsos@gibsondunn.com)
Nicolas Autet – Paris (+33 1 56 43 13 00, nautet@gibsondunn.com)
Susy Bullock – London (+44 (0) 20 7071 4283, sbullock@gibsondunn.com)
Patrick Doris – London (+44 (0) 207 071 4276, pdoris@gibsondunn.com)
Sacha Harber-Kelly – London (+44 (0) 20 7071 4205, sharber-kelly@gibsondunn.com)
Penny Madden – London (+44 (0) 20 7071 4226, pmadden@gibsondunn.com)
Benno Schwarz – Munich (+49 89 189 33 110, bschwarz@gibsondunn.com)
Michael Walther – Munich (+49 89 189 33 180, mwalther@gibsondunn.com)
Richard W. Roeder – Munich (+49 89 189 33 115, rroeder@gibsondunn.com)

United States
Judith Alison Lee – Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com)
Ronald Kirk – Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, rkirk@gibsondunn.com)
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, cmbrown@gibsondunn.com)
David P. Burns – Washington, D.C. (+1 202-887-3786, dburns@gibsondunn.com)
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, shandler@gibsondunn.com)
Nicola T. Hanna – Los Angeles (+1 213-229-7269, nhanna@gibsondunn.com)
Marcellus A. McRae – Los Angeles (+1 213-229-7675, mmcrae@gibsondunn.com)
Adam M. Smith – Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com)
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, ctimura@gibsondunn.com)
Annie Motto – Washington, D.C. (+1 212-351-3803, amotto@gibsondunn.com)
Chris R. Mullen – Washington, D.C. (+1 202-955-8250, cmullen@gibsondunn.com)
Samantha Sewall – Washington, D.C. (+1 202-887-3509, ssewall@gibsondunn.com)
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, asyarief@gibsondunn.com)
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, stoussaint@gibsondunn.com)
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, szhang@gibsondunn.com)

* Jane Lu is a trainee solicitor working in the firm’s Hong Kong office who is not yet admitted to practice law.

© 2022 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

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Introduction

On 12 January 2022, the Hong Kong Monetary Authority (HKMA) released a Discussion Paper on the expansion of the Hong Kong regulatory framework to stablecoins (e.g. crypto-assets pegged to fiat currencies). The Paper considers the adequacy of the existing regulatory framework in light of the growing use of stablecoins and other types of crypto-assets in financial markets, and the challenges posed by this increase in their prevalence. It further poses eight questions for consideration by the industry, including the scope of a proposed new regulatory regime to cover what the HKMA describes as “payment-related stablecoins”.

This client alert provides an overview of the HKMA’s views on crypto-assets and stablecoins as outlined in the Paper, discusses the implications for players in the stablecoin ecosystem if the proposed changes are implemented, and suggested next steps for interested parties.

The HKMA has requested responses to the Paper by 31 March 2022, and has indicated that it intends to introduce this new stablecoin regulatory regime by 2023-2024.

HKMA’s views on crypto-assets and financial stability

The Paper provides a valuable insight into the HKMA’s views on crypto-assets in general, and stablecoins in particular, including their linkages to the traditional financial system and ramifications on financial stability.

In introducing its proposal to regulate payment related stablecoins, the HKMA has made it clear that while the current size and trading activity of crypto-assets globally may not pose an immediate threat to the stability of the global financial system from a systemic point of view, it does consider the increasing prevalence of crypto-assets to have the potential to impact financial stability. In particular, the HKMA has flagged that it considers the growing exposure of institutional investors, as well as certain segments of the retail public, to such assets as an alternative to, or to complement traditional asset classes, indicates growing interconnectedness with the mainstream financial system.

Further, as noted by the HKMA, it understands that while Hong Kong authorised banks (Authorised Institutions or AIs) currently undertake only limited activities in relation to crypto-assets, AIs are interested in pursuing these activities further, given that they face increasing demand from customers for crypto-related products and services. This is consistent with what we understand is a steady increase in high net wealth investors hungry for yield demanding access to crypto-assets through their private wealth managers, as well as an uptick in demand from retail investors in Hong Kong eager for the same exposure to upside. To this end, the HKMA has flagged that it will soon provide AIs with more detailed regulatory guidance in relation to their interface with and provision of services to customers in relation to crypto-assets.

Finally, the HKMA has also noted its concerns that the ease of anonymous transfer of crypto-assets may make them susceptible to the risk of illicit and money laundering / terrorist financing activities.

The HKMA’s views on stablecoins

The Paper also flags the HKMA’s view that stablecoins are increasingly viewed as a ‘widely acceptable means of payment’ and that this, alongside the actual increase in their use, has increased the potential for their incorporation into the mainstream financial system. In the HKMA’s opinion, this in turn raises broader monetary and financial stability implications and has resulted in the regulation of stablecoins becoming a key priority for the HKMA, which has stated in the Paper that it wishes to ensure that such coins “are appropriately regulated before they operate in Hong Kong or are marketed to the public of Hong Kong”.

The Paper goes on to identify a number of potential risks that may arise in relation to the use of stablecoins, including, in summary:

  • Payment integrity risks where stablecoins are commonly accepted as a means of payment and operational disruptions or failures occur in relation to the stablecoins;
  • Banking stability risks if banks were to increase their exposure to stablecoins, particularly if stablecoins were viewed as a substitute for bank deposits;
  • Monetary policy risks in relation to the issue and redemption of HKD-backed stablecoins, which could affect interbank HKD demand and supply; and
  • User protection risks where a user may have no or limited recourse in relation to operational disruptions or failures of a stablecoin.

Given these potential risks, the HKMA has stated in the Paper that it considers it appropriate to expand the regulatory perimeter to cover payment-related stablecoins in the first instance, although it has not ruled out the possibility of regulating other forms of stablecoins as well.

The HKMA’s discussion questions for industry consideration

The HKMA has noted in the Paper that it considers ‘the need to regulate [stablecoins] is well justified and the tool to regulate…[can] be decided at a later stage’. However, it has indicated that it wishes for feedback from the industry and the public on the scope of the regulatory regime applicable to stablecoins, and to this end has set out eight discussion questions for industry consideration. A summary of the key questions posed by the HKMA, as well as the HKMA’s views on those questions, is set out below.

Question 1: Should we regulate activities relating to all types of stablecoins or give priority to those payment-related stablecoins that pose higher risks to the monetary and financial systems while providing flexibility in the regime to make adjustments to the scope of stablecoins that may be subject to regulation as needed in the future?

In posing this question, the HKMA has noted that it intends to take a risk-based approach focused initially on payment-related stablecoins at this stage given their predominance in the market and higher potential to be incorporated into the mainstream financial market (as discussed above). However, the HKMA has noted that it intends to ensure that whatever regime is introduced is sufficiently flexible that it could extend to other types of stablecoins in the future. As such, issuers and traders of other types of stablecoins should not expect to avoid regulatory scrutiny forever.

Question 2: What types of stablecoin-related activities should fall under the regulatory ambit, e.g. issuance and redemption, custody and administration, reserves management?

The HKMA has proposed regulating a broad range of stablecoin-related activities, including:

  • Issuing, creating or destroying stablecoins;
  • Managing reserve assets to ensure stabilisation of stablecoin value;
  • Validating transactions and records;
  • Storing private keys used to provide access to stablecoins;
  • Facilitating the redemption of stablecoins;
  • Transmission of funds to settle transactions; and
  • Executing transactions in stablecoins.

This broad list is based on a list of activities in relation to stablecoins published by the Financial Stability Board[1] and as such may be viewed as in keeping with international standards. However, as discussed below in relation to Question 5, the breadth of this regime may raise concerns regarding the degree of overlap between this regime and others proposed by Hong Kong regulators, including the proposed VASP regime to be administered by the Securities and Futures Commission (SFC) (see our alert here).

Question 3: What kind of authorisation and regulatory requirements would be envisaged for those entities subject to the new licensing regime?

The HMKA has suggested that it considers that entities subject to the new stablecoin licensing regime would be subject to the following requirements:

  • authorisation and prudential requirements, including adequate financial resources and liquidity requirements;
  • fit and proper requirements in relation to both management and ownership;
  • requirements relating to the maintenance and management of reserves of backing assets; and systems; and
  • controls, governance and risk management requirements.

Further, given that it is common for multiple entities to be involved in different parts of a stablecoin arrangement, the HKMA has noted that such entities could be subject to part or all of the requirements, depending on the services they offer.

If requirements in relation to these matters are ultimately implemented by the HKMA, the stablecoin regime would cover some of the requirements of the proposed VASP regime, with the exception of requirements of reserves of backing assets, which will presumably only be applied to stablecoins given their nature.

Question 4: What is the intended coverage as to who needs a licence under the intended regulatory regime?

The HKMA has signalled that it believes that only entities incorporated in Hong Kong and holding a relevant licence granted by HKMA should carry out regulated activities, to enable the HKMA to exercise effective regulation on the relevant entities. As such, it has stated in the Paper that it expects that foreign companies / groups which intend to provide regulated activities in Hong Kong or actively market those activities in Hong Kong to incorporate a company in Hong Kong and apply for a licence to the HKMA under this regime.

If implemented, this would have significant ramifications for those global crypto-exchanges currently offering trading in stablecoins to Hong Kong users from offshore. These businesses would be faced with a choice between either incorporating in Hong Kong and seeking a licence, or discontinuing their trading for Hong Kong users.

Question 5: When will this new, risk-based regime on stablecoins be established, and would there be regulatory overlap with other financial regulatory regimes in Hong Kong, including but not limited to the SFC’s VASP regime, and the SVF licensing regime of the PSSVFO?

The HKMA has stated that it will collaborate and coordinate with other financial regulators when defining the scope of its oversight and will seek to avoid regulatory arbitrage, including in relation to areas which ‘may be subject to regulation by more than one local financial authority’.

However, an HKMA-administered regime of the breadth proposed above would create a situation in which an exchange undertaking transactions in non-stablecoin crypto-assets would be regulated by the SFC under its proposed new VASP regime while being regulated by both the SFC and the HKMA under its stablecoin regime. In this respect, we note that the proposed definition of ‘virtual asset’ under the proposed new VASP regime ‘applies equally to virtual coins that are stable (i.e. the so-called “stablecoins”)’.[2] While the HKMA and SFC share regulatory responsibility for Registered Institutions (i.e. Authorised Institutions which are separately licensed by the SFC to undertake securities and futures business), that shared regulatory responsibility concerns distinctly different types of activities. In contrast, we consider that from an exchange’s perspective, the act of executing transactions in stablecoins is substantially similar to executing transactions in non-stablecoin crypto-assets. As such, this approach may lead to unnecessary and undesirable regulatory inefficiencies if exchanges are required to be licensed under both the SFC and HKMA regimes to undertake transactions in crypto-assets.

Question 6: Stablecoins could be subject to run and become potential substitutes of bank deposits. Should the HKMA require stablecoin issuers to be AIs under the Banking Ordinance, similar to the recommendations in the Report on Stablecoins issued by the US President’s Working Group on Financial Markets?

While not expressly stating that it will not require stablecoin issuers to be regulated as AIs under the Banking Ordinance, the HKMA has indicated that it expects that the requirements applicable to stablecoin issuers will instead borrow from Hong Kong’s current regulatory framework for stored value facilities (SVF). However, the HKMA has signalled that certain stablecoin issuers may be subject to higher prudential requirements than SVF issuers where they issue stablecoins of systemic importance.

Question 7: [Does] the HKMA also have plan[s] to regulate unbacked crypto-assets given their growing linkage with the mainstream financial system and risk to financial stability?

The HKMA has not expressly ruled out regulating unbacked crypto-assets, and has stated that it is necessary to continue monitoring the risks posed by this asset class. In stating this, the HKMA has also pointed to the VASP regime, suggesting that the HKMA’s approach to this area is likely to depend on the success of that regime once implemented.

Question 8: For current or prospective parties and entities in the stablecoins ecosystem, what should they do before the HKMA’s regulatory regime is introduced?

The HKMA has advised current and prospective players in the stablecoin ecosystem to provide feedback on the proposals set out in the Discussion Paper, and has noted that in the interim, it will continue to supervise AIs’ activities in relation to crypto-assets and implement the SVF licensing regime pending implementation of this new regime.

Conclusion

The Discussion Paper provides a valuable insight into the HKMA’s plans for the future of stablecoin regulation in Hong Kong. While some concerns exist as to the potential overlap between the HKMA’s new proposed regime and the SFC’s VASP regime, it is clear that the HKMA intends to ensure that it is regarded as the primary regulator of stablecoins going forward, and that it sees the regulation of this asset class as closely linked to its key objective of ensuring financial stability.

____________________________

   [1]   See Financial Stability Board, Regulation, Supervision and Oversight of “Global Stablecoin” Arrangements: Final Report and High-Level Recommendations, https://www.fsb.org/wp-content/uploads/P131020-3.pdf, page 10.

   [2]   See Financial Services and the Treasury Bureau, Public Consultation on Legislative Proposals to Enhance Anti-Money Laundering and Counter-Terrorist Financing Regulation in Hong Kong (Consultation Conclusions), https://www.fstb.gov.hk/fsb/en/publication/consult/doc/consult_conclu_amlo_e.pdf, paragraph 2.8.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  If you wish to discuss any of the matters set out above, please contact any member of Gibson Dunn’s Crypto Taskforce (cryptotaskforce@gibsondunn.com) or the Global Financial Regulatory team, including the following authors in Hong Kong:

William R. Hallatt (+852 2214 3836, whallatt@gibsondunn.com)
Emily Rumble (+852 2214 3839, erumble@gibsondunn.com)
Arnold Pun (+852 2214 3838, apun@gibsondunn.com)
Becky Chung (+852 2214 3837, bchung@gibsondunn.com)

© 2022 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

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On December 23, 2021, President Biden signed the Uyghur Forced Labor Prevention Act (the “UFLPA” or “Act”) into law.[1] The UFLPA, which received widespread bipartisan support in Congress, is the latest in a line of U.S. efforts to address the plight of Uyghurs and other persecuted minority groups in China’s Xinjiang Uyghur Autonomous Region (the “XUAR”).

A key feature of the Act is the creation of a rebuttable presumption that all goods manufactured even partially in the XUAR are the product of forced labor and therefore not entitled to entry at U.S. ports. The Act also builds on prior legislation, such as 2020’s Uyghur Human Rights Policy Act,[2] by expanding that Act’s authorization of sanctions to cover foreign individuals responsible for human rights abuses related to forced labor.

I. Background

In recent years, both the executive and legislative branches have demonstrated an increased interest in “lead[ing] the international community in ending forced labor practices wherever such practices occur,”[3] with a particular focus on the XUAR.

2020 saw a boom in efforts across agencies and the houses of Congress, beginning with the Department of Homeland Security’s January publication of a Department-wide strategy to combat forced labor in supply chains.[4] Later that year, DHS joined the U.S. Departments of State, Treasury and Commerce to issue a joint advisory warning of heightened risks of forced labor for businesses with supply chain exposure to the XUAR.[5]

The U.S. also emphasized eliminating forced labor in supply chains through its international obligations at this time. The 2020 United States-Mexico-Canada Agreement (“USMCA”) required each party to this free trade agreement to “prohibit the importation of goods into its territory from other sources produced in whole or in part by forced or compulsory labor.”[6] To carry out this obligation, President Trump issued an executive order in May 2020 establishing the Forced Labor Enforcement Task Force (“FLETF”), chaired by the Secretary of Homeland Security and including representatives from the Departments of State, Treasury, Justice, Labor, and the Office of the U.S. Trade Representative.[7] The implementing bill of the USMCA requires the FLETF to serve as the central hub for the U.S. government’s enforcement of the prohibition on imports made through forced labor.[8]

In Congress, Rep. James McGovern (D) and Sen. Marco Rubio (R) — co-chairs of the Congressional-Executive Commission on China — introduced the first versions of the UFLPA in the House of Representatives[9] and the Senate[10] in March 2020. The bill received unusual, wide bipartisan support, with co-sponsors among Congress’s most conservative and most liberal members.[11] Each bill passed in its respective house in early 2021, and a compromise bill — reconciling differences of timing and reporting processes between the two versions — was sent to the President in mid-December[12] before being signed into law.

II. Presumptive Ban on Imports from the XUAR

The UFLPA’s trade provisions are notable both for their expansive scope and the heightened evidentiary standard required to rebut the Act’s presumptive prohibition on all imports from the XUAR.

a. Scope of the Import Ban

The UFLPA’s scope is broad, instructing U.S. Customs and Border Protection (“CBP”) to presume that “any goods, wares, articles, and merchandise mined, produced, or manufactured wholly or in part in” the XUAR were made with forced labor and are therefore unfit for entry at any U.S. ports.[13]

This presumption extends also to goods, wares, articles, and merchandise produced by a variety of entities identified by the FLETF in its strategy to implement the Act. This includes entities that work with the XUAR government to recruit, transport, or receive forced labor from the XUAR,[14] as well as entities that participate in “poverty alleviation” and “pairing-assistance” programs[15] in the XUAR.[16]

CBP has traditionally had the authority to prevent the importation of “[a]ll goods, wares, articles, and merchandise mined, produced, or manufactured wholly or in part in any foreign country by . . . forced labor” through the issuance of Withhold Release Orders (“WROs”).[17] The UFLPA broadens this power by creating a rebuttable presumption that all articles produced in whole or in part in the XUAR or by entities that source material from persons involved in XUAR government forced labor schemes are automatically barred from entry into the United States, even absent a WRO or any specific showing of forced labor in the supply chain.

b. Exceptions to the Import Ban

Despite this broad prohibition, importers of goods covered by the UFLPA may still be able to rebut the presumption against importation. The Act specifies that the presumption will not be applied if the Commissioner of CBP determines that:

  1. The importer of record has:
    • Fully complied with all due diligence and evidentiary guidance established by the FLETF pursuant to the Act, along with any associated implementing regulations; and
    • Completely and substantively responded to all CBP inquiries seeking to ascertain whether the goods were produced with forced labor; and
  2. “Clear and convincing” evidence shows that the goods were not produced wholly or in part with forced labor.[18]

Each time the Commissioner determines that an exception to the import ban is warranted under the criteria above, the Commissioner must submit a report to Congress within 30 days, identifying the goods subject to the exception and the evidence upon which the determination is based.[19] The Commissioner must make all such reports available to the public.[20]

III. High-Priority Enforcement Sectors

As part of its enforcement strategy, the UFLPA instructs the Forced Labor Enforcement Task Force to prepare both a list of high-priority sectors subject to CBP enforcement, and a sector-specific enforcement plan for each of these high-priority sectors.[21] The Act mandates that cotton, tomatoes, and polysilicon must be among the high-priority sectors, building upon CBP’s existing WRO against all cotton and tomato products produced in the XUAR.[22]

The addition of polysilicon on this list of high-priority sectors directly impacts the U.S. solar energy industry: nearly half of the world’s polysilicon — a key material for the manufacture of solar panels — is produced in the XUAR.[23] Despite the dominance of Chinese polysilicon, however, solar industry groups have embraced the passage of the UFLPA and are encouraging solar companies to move their supply chains out of the XUAR.[24] Corporate responsibility concerns surrounding the sourcing of polysilicon from the XUAR have been circulating for at least a year, and the solar industry groups have acted proactively to create standards and procedures to trace and audit supply chains of this important resource. To further this industry-wide goal of eradicating forced labor from solar supply chains,[25] these industry groups recently published a “Solar Supply Chain Traceability Protocol.”[26]

IV. Sanctions

The UFLPA also amends the Uyghur Human Rights Policy Act of 2020 to underscore that sanctions may be imposed due to “[s]erious human rights abuses in connection with forced labor” related to the XUAR. Within 180 days of enactment, the President is required to submit an initial report to Congress identifying non-U.S. persons subject to sanctions under this new provision.[27] The sanctioned individuals will be subject to asset blocking, as provided under the International Emergency Economic Powers Act,[28] as well as the revocation or denial of visas to enter the United States. The President must submit additional reports at least annually identifying non-U.S. persons responsible for human rights violations in the XUAR, including with respect to forced labor, as provided under the Uyghur Human Rights Policy Act.[29]

V. Compliance Takeaways

a. Establishing “Clear and Convincing” Evidence

The Act does not specify what types of evidence might suffice to establish by clear and convincing evidence that goods are not the product of forced labor. Instead, the Act charges the FLETF with publishing an enforcement strategy containing, among other things, “[g]uidance to importers with respect to . . . the type, nature, and extent of evidence that demonstrates that goods originating in the People’s Republic of China . . . were not mined, produced, or manufactured wholly or in part with forced labor.”[30]

While the Act does not clarify what evidence would be necessary to meet the “clear and convincing” standard, CBP has issued guidance regarding the detailed evidence importers may need to provide to obtain the release of goods detained pursuant to certain WROs. A similar high bar of documentation — if not higher — will likely be required under the UFLPA. In addition to the required Certificate of Origin and importer’s detailed statement,[31] CBP has highlighted the following forms of evidence as helpful to importers seeking the release of shipments detained pursuant to a WRO:

  • An affidavit from the provider of the product;
  • Purchase orders, invoices, and proof of payment;
  • A list of production steps and records for the imported merchandise;
  • Transportation documents;
  • Daily manufacturing process reports;
  • Evidence regarding the importer’s anti-forced labor compliance program; and
  • Any other relevant information that the importer believes may show that the shipments are not subject to the import ban.[32]

The exact contours of any guidance to be issued by the Forced Labor Enforcement Task Force remains uncertain. However, companies with supply chain exposure to the XUAR should expect compliance with the UFLPA to require significant supply chain diligence and documentation obligations. These obligations may exceed the already high benchmarks on diligence established by the FLETF and CBP through years of sustained engagement with non-governmental organizations and other standard-setting stakeholders who are focused on eradicating forced labor from supply chains globally.

b. Due Diligence

The Act instructs the FLETF to issue guidance on “due diligence, effective supply chain tracing, and supply chain management measures” aimed at avoiding the importation of goods produced with forced labor in the XUAR within 180 days of the UFLPA’s enactment.[33]

Until the FLETF issues this guidance, companies importing goods into the U.S. should look to recognized international standards to conduct due diligence of their supply chains to identify potential ties to the XUAR. For example, the “Xinjiang Supply Chain Business Advisory” identifies the following standards as providing useful guidance on best practices for this due diligence:[34] the UN Guiding Principles on Business and Human Rights,[35] the OECD Guidelines on Multinational Enterprises,[36] and the ILO Tripartite Declaration of Principles Concerning Multinational Enterprises and Social Policy.[37] The Advisory warns, however, that third-party audits alone cannot guarantee credible information for due diligence purposes, both because of official harassment of auditors and because of workers’ fear of reprisals for speaking to these auditors.[38] To combat this information gap, the Advisory encourages businesses to collaborate within industry groups to share information and build relationships with Chinese suppliers.[39]

The unique circumstances of the forced labor crisis in the XUAR may render due diligence efforts insufficient, however. In 2020, the Congressional-Executive Commission on China warned that “due diligence in Xinjiang is not possible” because of official repression and harsh reprisals against whistle blowers, which is made possible by extensive state surveillance in the XUAR.[40] (Notably, this warning coincided with the introduction of the first versions of the bills that would later become the UFLPA.) Moreover, China enacted a series of “blocking statutes” in 2021 authorizing, inter alia, countersanctions and civil liability for Chinese nationals who comply with attempts to enforce foreign laws extraterritorially in China.[41] This threat of liability, coupled with the already-existing reprisals, limits the ability of companies to obtain reliable information about their supply chain activity in the XUAR.

VI. Timeline for Enforcement

The Act’s rebuttable presumption against the importation of goods produced in the XUAR or by entities identified by the FLETF is set to take effect 180 days after the UFLPA’s enactment, on June 21, 2022.

The Act provides that the process for developing the enforcement strategy will proceed as follows:

  1. Within 30 days of enactment (by Jan. 22, 2022): The FLETF will publish a notice soliciting public comment on how best to ensure that goods mined or produced with forced labor in China — and particularly in the XUAR — are not imported into the United States.[42]
  2. No less than 45 days after notice is given (by Mar. 8, 2022): The public, including private sector businesses and non-governmental organizations, will submit comments in response to the FLETF’s notice.[43]
  3. Within 45 days of the public comment period closing (by Apr. 22, 2022): The FLETF will hold a public hearing, inviting witnesses to testify regarding measures that can be taken to trace supply chains for goods mined or produced in whole or in part with forced labor in China and to ensure that goods made with forced labor do not enter the United States.[44]
  4. No later than 180 days after enactment (June 21, 2022): The FLETF, in consultation with the Secretary of Commerce and the Director of National Intelligence, must submit to Congress a strategy for supporting CBP’s processes for enforcing the Act. This strategy must include guidance to importers regarding due diligence and supply chain tracing, as well as the nature and extent of evidence required to show that goods originating in China were not mined or produced with forced labor.The Forced Labor Enforcement Task Force must thereafter submit an updated strategy to Congress annually.[45]

Notably, the FLETF’s enforcement strategy need only be submitted by the day the Act’s rebuttable presumption takes effect. Therefore, importers may have little or no advance notice as to what evidence they must submit to rebut the presumption against importation.

VII. Global Efforts to Address Forced Labor in the XUAR

The U.S. is far from the only country targeting forced labor through new executive and legislative actions. In the past year, jurisdictions around the globe have developed a variety of new strategies for eliminating the importation of goods produced with forced labor in the XUAR. These global efforts vary in scope, and many have not yet taken effect. Companies with supply chain exposure to the XUAR should, however, prepare for an increasingly complex international regulatory landscape in coming years.

a. The European Union (“EU”)

On September 15, 2021, the European Commission (“EC”) President Ursula von der Leyen announced plans for a ban on products made by forced labor to be proposed in 2022.[46] While the XUAR was not named, the proposed measure has been viewed to directly target forced labor in this region.[47] Recent reports, however, have highlighted disagreements within the EC as to which department is to spearhead the proposal due to trade sensitivities.[48] Therefore, little progress has been made. Most recently, in December 2021, the EU Executive Vice-President for Trade, Valdis Dombrovskis, warned the EC of the risks of a ban targeting only forced labor in the XUAR being deemed as “discriminatory”. He further noted that the UFLPA “cannot be automatically replicated in the EU,”[49] and argued instead that including the ban within the EU’s proposed Sustainable Corporate Governance Directive (“SCG Directive”) would be more effective.[50]

The EU has sought to address forced labor more generally via its proposal — in the form of the SCG Directive — for EU-based companies to undertake mandatory human rights due diligence to increase their accountability for human rights and environmental abuses in their supply chains. After lengthy delays, the EC’s proposal for the SCG Directive is now due in early 2022.[51]

At the moment, it remains unclear whether the EU will follow the U.S. in imposing a stand-alone ban on imports from the XUAR, or whether the proposed measures will be weakened by incorporating them into the SCG Directive proposal.

b. United Kingdom

The U.K. does not currently have legislation equivalent to the UFLPA. However, officials within the Foreign Office and the Department for International Trade have suggested that similar efforts to address imports made with forced labor in the XUAR may be imminent.[52] These efforts would build on the U.K.’s ongoing “review of export controls as they apply to Xinjiang . . . to prevent the exports of goods that may contribute to human rights abuses in the region.”[53]

c. Canada

In coordination with the United Kingdom and other international partners, the Canadian government released a statement in January 2021 addressing its concerns with the situation in the XUAR. The government announced that it would adopt a number of measures to combat the alleged human rights violations in the XUAR, including:[54]

  1. Prohibition on Imports of Goods Produced by Forced Labor: On November 24, 2021, Sen. Housakos introduced Bill S-204, an act to amend the “Customs Tariff (goods from Xinjiang).”[55] Currently at the second reading stage in the Canadian Senate, this bill is intended to prevent the importation of goods believed to be produced through forced labor.[56] Consistent with Canada’s obligations under the USMCA, this prohibition would prevent the importation of goods believed to be produced using forced labor in the XUAR.
  2. Xinjiang Integrity Declaration for Canadian Companies: Following the amendments made to the Customs Tariff, the Canadian Government established an Integrity Declaration on Doing Business with Xinjiang Entities to guide Canadian companies’ business practices in the region. The Integrity Declaration is mandatory for all Canadian companies that (i) source goods, directly or indirectly, from the XUAR or from entities that rely on Uyghur, (ii) are established in the XUAR, or (iii) seek to engage in the XUAR market. If any such company fails to sign the Integrity Declaration, they will be ineligible to receive support from the Trade Commissioner Service.[57]
  3. Export Controls: The Canadian government stated that it will deny export licenses for the exportation of goods or technologies if it determines that there is a substantial risk that the export would result in a serious violation of human rights under the Export and Import Permits Act 1985.[58]

d. Australia

In June 2021, Sen. Patrick introduced the Customs Amendment (Banning Goods Produced by Forced Labour) Bill 2021 to the Australian Senate. The introduction of this bill follows the growing concerns in Australia that the Australian Modern Slavery Act 2018 does not adequately address the issue of state-sanctioned forced labor. Rather limited in its scope, the Modern Slavery Act 2018 requires certain companies to submit annual statements reporting on the risks of modern slavery in their operations and supply chains, as well as any steps they are taking to address such risks. Other entities based or operating in Australia may report this information voluntarily.[59]

Sen. Patrick’s bill would go a step further in combatting state-sanctioned forced labor by amending the Customs Act 1901 to prohibit the importation into Australia of goods that are produced in whole or in part by forced labor.[60] Although the bill makes no specific reference to China, human rights abuses in the XUAR were repeatedly cited as the proposal’s impetus during the Senate debate. Moreover, if passed, the bill would have the effect of banning the importation of goods made with Uyghur forced labor.[61] The bill was passed through the Australian Senate with cross-party support and the endorsement of the Australian Council of Trade Unions. The bill must now pass the House of Representatives to become law.[62]

e. New Zealand

New Zealand has taken a notably softer stance than the U.S. Although New Zealand’s parliament unanimously declared in May 2021 that severe human rights abuses against the Uyghur ethnic minority group were taking place in the XUAR, the motion merely expressed the parliament’s ‘grave concern’[63] over these human rights abuses. The Uyghur community in New Zealand have requested for parliament to take stronger action, such as declaring the oppression of Uyghurs in China a ‘genocide’ and placing a ban on the importation of products made by forced labor in the XUAR.[64]

_________________________

   [1]   Pub. L. 117-78 (2021).

   [2]   Pub. L. 116-145 (2020).

   [3]   Pub. L. 117-78, § 1(2) (2021).

   [4]   Department of Homeland Security Strategy to Combat Human Trafficking, the Importation of Goods Produced with Forced Labor, and Child Sexual Exploitation (Jan. 2020), U.S. DEPARTMENT OF HOMELAND SECURITY, https://www.dhs.gov/sites/default/files/publications/20_0115_plcy_human-trafficking-forced-labor-child-exploit-strategy.pdf.

   [5]   Xinjiang Supply Chain Business Advisory (Jul. 2, 2020, updated Jul. 13, 2021), U.S. Department of the Treasury, https://home.treasury.gov/system/files/126/20210713_xinjiang_advisory_0.pdf.

   [6]   United States-Mexico-Canada Agreement art. 23.6, Jul. 1, 2020, available at https://ustr.gov/trade-agreements/free-trade-agreements/united-states-mexico-canada-agreement.

   [7]   Exec. Order No. 13923, 85 Fed. Reg. 30587 (2020).

   [8]   19 U.S.C. § 4681 (2020).

   [9]   Uyghur Forced Labor Prevention Act, H.R. 6210, 116th Cong. (2019–2020).

  [10]   Uyghur Forced Labor Prevention Act, S. 3471, 116th Cong. (2019–2020).

  [11]   Id. (House bill’s co-sponsors included Dan Crenshaw, Rashida Tlaib, and Ilhan Omar.). Uyghur Forced Labor Prevention Act, S. 3471, 116th Cong. (2019–2020). (Senate bill’s co-sponsors included Tom Cotton, Marsha Blackburn, Dick Durbin, and Elizabeth Warren.).

  [12]   Zachary Basu, House unanimously passes Uyghur forced labor bill, Axios (Dec. 15, 2021), https://www.axios.com/congress-uyghur-forced-labor-bill-d4699c95-16ea-4b42-bda4-eb5baa29326a.html.

  [13]   Pub. L. 117-78 § 3(a) (2021).

  [14]   Id. at § 2(d)(2)(B)(ii).

  [15]   The PRC government has established large-scale “mutual pairing assistance” programs, wherein companies from other provinces of China are incentivized to open satellite factories in the XUAR. See Xinjiang Supply Chain Business Advisory, supra note 5 at 6. The State Department has raised concerns that pairing-assistance programs and other poverty alleviation measures have served as a cover for forced labor and the transfer of Uyghurs and other persecuted minorities to other parts of the country. Forced Labor in China’s Xinjiang Region: Fact Sheet, U.S. Department of State (Jul. 1, 2020), available at https://www.state.gov/forced-labor-in-chinas-xinjiang-region/.

  [16]   Pub. L. 117-78 § 2(d)(2)(B)(v) (2021).

  [17]   19 U.S.C. § 1307.

  [18]   Pub. L. 117-78 § 3(b) (2021).

  [19]   Id. at § 3(c).

  [20]   Id.

  [21]   Id. at § 2(d)(2)(B)(viii)–(ix).

  [22]   CBP Issues Region-Wide Withhold Release Order on Products Made by Slave Labor in Xinjiang, U.S. Customs and Border Protection (Jan. 13, 2021), https://www.cbp.gov/newsroom/national-media-release/cbp-issues-region-wide-withhold-release-order-products-made-slave.

  [23]   China Renewables: The Stretched Ethics of Solar Panels from Xinjiang, The Financial Times (Jan. 9, 2022), available at https://on.ft.com/3ndq1NE.

  [24]   Press Release, Solar Industry Statement on the Passage of the Uyghur Forced Labor Prevention Act, Solar Energy Industries Association (Dec. 16, 2021), available at https://www.seia.org/news/solar-industry-statement-passage-uyghur-forced-labor-prevention-act.

  [25]   Solar Industry Forced Labor Prevention Pledge, Solar Energy Industries Association (Nov. 23, 2021), available at https://www.seia.org/sites/default/files/Solar%20Industry%20Forced%20Labor%20Prevention%20Pledge%20Signatories.pdf.

  [26]   Solar Supply Chain Traceability Protocol 1.0: Industry Guidance, Solar Energy Industries Association (Apr. 2021), available at https://www.seia.org/sites/default/files/2021-04/SEIA-Supply-Chain-Traceability-Protocol-v1.0-April2021.pdf.

  [27]   Pub. L. 116-145 § 6(a)(1) (2020).

  [28]   50 U.S.C. 1701 § 5(c)(1)(A) (1977).

  [29]   Pub. L. 116-145 § 6(a)(1) (2020).

  [30]   Pub. L. 117-78 § 2(d)(6) (2021).

  [31]   19 C.F.R. § 12.43 (2017).

  [32]   See Hoshine Silicon Industry Co. Ltd Withhold Release Order Frequently Asked Questions, U.S. Customs and Border Protection (Nov. 10, 2021), https://www.cbp.gov/trade/programs-administration/forced-labor/hoshine-silicon-industry-co-ltd-withhold-release-order-frequently-asked-questions.

  [33]   Pub. L. 117-78 § 2(d)(6)(a) (2021).

  [34]   Xinjiang Supply Chain Business Advisory, supra note 5 at 7–8.

  [35]   Guiding Principles on Business and Human Rights, Office of the United Nations High Commissioner for Human Rights (2011), available at https://www.ohchr.org/Documents/Publications/GuidingPrinciplesBusinessHR_EN.pdf.

  [36]   OECD Guidelines for Multinational Enterprises, Organisation for Economic Co-operation and Development (2011), available at https://www.oecd.org/daf/inv/mne/48004323.pdf.

  [37]   Tripartite Declaration of Principles Concerning Multinational Enterprises and Social Policy, International Labour Organization (2017), available at https://www.ilo.org/wcmsp5/groups/public/—ed_emp/—emp_ent/—multi/documents/publication/wcms_094386.pdf.

  [38]   Xinjiang Supply Chain Business Advisory, supra note 5 at 9.

  [39]   Id.

  [40]   Staff of Cong.-Exec. Comm’n on China, Global Supply Chains, Forced Labor, and the Xinjiang Uyghur Autonomous Region (2020), https://www.cecc.gov/sites/chinacommission.house.gov/files/documents/CECC%20Staff%20Report%20March%202020%20-%20Global%20Supply%20Chains%2C%20Forced%20Labor%2C%20and%20the%20Xinjiang%20Uyghur%20Autonomous%20Region.pdf.

  [41]   See MOFCOM Order No. 1 of 2021 on Rules on Counteracting Unjustified Extra-territorial Application of Foreign Legislation and Other Measures, People’s Republic of China Ministry of Commerce (Jan. 9, 2021), available at http://english.mofcom.gov.cn/article/policyrelease/announcement/202101/20210103029708.shtml.

  [42]   Pub. L. 117-78 § 2(a)(1) (2021).

  [43]   Id. at § 2(a)(2).

  [44]   Id. at § 2(b)(1).

  [45]   Id. at § 2(c)–(e).

  [46]   2021 State of the Union Address by President von der Leyen, European Commission (Sep. 15, 2021), available at https://ec.europa.eu/commission/presscorner/detail/en/SPEECH_21_4701.

  [47]   Coalition Statement on European Commission’s Proposed Ban on Products Made with Forced Labour, End Uyghur Forced Labour (Sep. 21, 2021), available at https://enduyghurforcedlabour.org/news/coalition-statement-on-european-commissions-proposed-ban-on-products-made-with-forced-labour/.

  [48]   Sarah Anne Aarup, Ban on Uyghur imports becomes EU’s hot potato, Politico (Oct. 15, 2021), https://www.politico.eu/article/uyghur-china-europe-ban-imports-europe-trade-hot-potato-forced-labor/; Mehreen Kahn, EU urges caution on any ban on imports made with forced labour, The Financial Times (Dec. 23, 2021), https://www.ft.com/content/748a837b-ac51-4f2e-9a5d-3af780ec8444.

  [49]   EU urges caution on any forced labor import ban, The Washington City Times (Dec. 23, 2021), https://thewashingtoncitytimes.com/2021/12/23/eu-urges-caution-on-any-forced-labor-import-ban/.

  [50]   Id.

  [51]   Legislative Proposal on Sustainable Corporate Governance, European Parliament, Legislative Train (Dec. 17, 2021), https://www.europarl.europa.eu/legislative-train/theme-an-economy-that-works-for-people/file-legislative-proposal-on-sustainable-corporate-governance; see also Sustainable Corporate Governance, About this initiative, European Commission, available at https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12548-Sustainable-corporate-governance_en.

  [52]   See Emilia Casalicchio, UK hints at banning Chinese imports with forced labor links, Politico (Dec. 20, 2021), https://www.politico.eu/article/uk-could-impose-chinese-forced-labor-import-ban/.

  [53]   Press Release, UK Government announces business measures over Xinjiang human rights abuses, U.K. Government (Jan. 12, 2021) (U.K.), https://www.gov.uk/government/news/uk-government-announces-business-measures-over-xinjiang-human-rights-abuses; see also Fifth Special Report, Never Again: The UK’s Responsibility to Act on Atrocities in Xinjiang and Beyond: Government’s Response to the Committee’s Second Report, U.K. Parliament (Nov. 1, 2021) (U.K.), available at https://publications.parliament.uk/pa/cm5802/cmselect/cmfaff/840/84002.htm.

[54]  Canada Announces New Measures to Address Human Rights Abuses in Xinjiang, China, Government of Canada (2021) (Can.), available at https://www.canada.ca/en/global-affairs/news/2021/01/canada-announces-new-measures-to-address-human-rights-abuses-in-xinjiang-china.html.

[55]  See s-204 An Act to amend the Customs Tariff (goods from Xinjiang), Parliament of Canada (Can.) (2021) https://www.parl.ca/legisinfo/en/bill/44-1/s-204.

[56]  Integrity Declaration on Doing Business with Xinjiang Entities, Government of Canada (2021) (Can.), available at https://www.international.gc.ca/global-affairs-affaires-mondiales/news-nouvelles/2021/2021-01-12-xinjiang-declaration.aspx?lang=eng.

[57]  Id.

[58]  Global Affairs Canada advisory on doing business with Xinjiang-related entities, Government of Canada (2021) (Can.), available at https://www.international.gc.ca/global-affairs-affaires-mondiales/news-nouvelles/2021/2021-01-12-xinjiang-advisory-avis.aspx?lang=eng.

[59]  See Modern Slavery Act 2018, Federal Register of Legislation (Austl.), https://www.legislation.gov.au/Details/C2018A00153.

[60]  See Customs Amendment (Banning Goods Produced by Forced Labour) Bill 2021 (Austl.), https://www.aph.gov.au/Parliamentary_Business/Bills_Legislation/Bills_Search_Results/Result?bId=s1307

[61]  Daniel Hurst, Australia Senate passes bill banning Imports made using Forced Labour, The Guardian, (Aug. 23, 2021), https://www.theguardian.com/australia-news/2021/aug/23/australian-senate-poised-to-pass-bill-banning-imports-made-using-forced-labour.

[62]  Australian Senate Passes Forced Labour Bill, Freedom United (Aug. 23, 2021), https://www.freedomunited.org/news/australian-senate-passes-forced-labor-bill/.

[63]  China slams New Zealand parliament’s motion on Uighur abuses, Al Jazeera (May 6, 2021), https://www.aljazeera.com/news/2021/5/6/china-slams-new-zealand-parliaments-uighur-concerns.

[64]  Julia Hollingsworth, New Zealand is a Five Eyes outlier on China. It may have to pick a side, CNN (June 4, 2021), https://edition.cnn.com/2021/06/03/asia/new-zealand-xinjiang-china-intl-hnk-dst/index.html.

 

The following Gibson Dunn lawyers assisted in preparing this client update: Judith Alison Lee, Selina Sagayam, Susanne Bullock, Michael Murphy and Christopher Timura, with Sean Brennan, Ruby Taylor, Natalie Harris, and Freddie Batho, recent law graduates working in the firm’s London and Washington, D.C. offices who are not yet admitted to practice law.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the above developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s International Trade practice group:

United States:
Judith Alison Lee – Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com)
Ronald Kirk – Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, rkirk@gibsondunn.com)
Jose W. Fernandez – New York (+1 212-351-2376, jfernandez@gibsondunn.com)
Nicola T. Hanna – Los Angeles (+1 213-229-7269, nhanna@gibsondunn.com)
Marcellus A. McRae – Los Angeles (+1 213-229-7675, mmcrae@gibsondunn.com)
Adam M. Smith – Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com)
Stephanie L. Connor – Washington, D.C. (+1 202-955-8586, sconnor@gibsondunn.com)
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, ctimura@gibsondunn.com)
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, cmbrown@gibsondunn.com)
Laura R. Cole – Washington, D.C. (+1 202-887-3787, lcole@gibsondunn.com)
Chris R. Mullen – Washington, D.C. (+1 202-955-8250, cmullen@gibsondunn.com)
Samantha Sewall – Washington, D.C. (+1 202-887-3509, ssewall@gibsondunn.com)
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, asyarief@gibsondunn.com)
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, stoussaint@gibsondunn.com)
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, szhang@gibsondunn.com)

Asia:
Kelly Austin – Hong Kong (+852 2214 3788, kaustin@gibsondunn.com)
Fang Xue – Beijing (+86 10 6502 8687, fxue@gibsondunn.com)
Qi Yue – Beijing – (+86 10 6502 8534, qyue@gibsondunn.com)

Europe:
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Nicolas Autet – Paris (+33 1 56 43 13 00, nautet@gibsondunn.com)
Susy Bullock – London (+44 (0)20 7071 4283, sbullock@gibsondunn.com)
Patrick Doris – London (+44 (0)207 071 4276, pdoris@gibsondunn.com)
Sacha Harber-Kelly – London (+44 20 7071 4205, sharber-kelly@gibsondunn.com)
Penny Madden – London (+44 (0)20 7071 4226, pmadden@gibsondunn.com)
Steve Melrose – London (+44 (0)20 7071 4219, smelrose@gibsondunn.com)
Matt Aleksic – London (+44 (0)20 7071 4042, maleksic@gibsondunn.com)
Benno Schwarz – Munich (+49 89 189 33 110, bschwarz@gibsondunn.com)
Michael Walther – Munich (+49 89 189 33-180, mwalther@gibsondunn.com)
Richard W. Roeder – Munich (+49 89 189 33-160, rroeder@gibsondunn.com)

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As the COVID-19 pandemic continued into 2021, lawmakers and regulators around the world faced the dual-pronged challenge of reversing the slowdown in enforcement seen in 2020 while working to combat new forms of bribery and corruption that emerged as a result of the pandemic. This webcast will explore the approach taken by emerging markets in addressing these challenges and examine the trends seen in FCPA and local anti-corruption enforcement. In China, companies face increased scrutiny over their compliance programmes as the country introduces its first pilot programme for corporate criminal compliance and non-prosecution. Chinese regulators have continued their assault on key industries, such as big tech and healthcare, and sweeping reforms to data protection laws have had seismic effects on the conduct of cross-border investigations. In Russia, the topic of corruption remains a source of great tension while the complexity of sanctions regimes increases and cybercrime activities become the latest driving force behind white-collar enforcement. In Latin America, anti-corruption efforts have struggled to gain a strong foothold amid the practical challenges caused by COVID-19 and political instability in key markets.

In India, enforcement has fallen as a result of the COVID-19 pandemic and new legislation which has made it more difficult to commence investigations. State governments have also withdrawn the general consent previously provided to authorities to investigate corruption allegations, which has caused delays in resolving cases. Nevertheless, while anti-corruption enforcement remains inconsistent, recent cases highlight the heightened risks for multinationals doing business in the country. Across Africa, companies and individuals face significant fines, bidding suspensions, and other sanctions as investigations by authorities from the United States, the United Kingdom, the World Bank, and African authorities concluded in several countries in the region. Meanwhile, high-profile trials of former heads of state, including Benjamin Netanyahu and Jacob Zuma, resumed after delays due to the pandemic and claims of bias and political interference.

Join our team of experienced international anti-corruption attorneys to learn more about how to do business in China, Russia, Latin America, India and across Africa without running afoul of anti-corruption laws, including the Foreign Corrupt Practices Act (“FCPA”).

Topics to be Discussed:

  • An overview of FCPA enforcement statistics and trends for 2021;
  • The corruption landscape in key emerging markets, including recent headlines and scandals;
  • Lessons learned from local anti-corruption enforcement in China, Russia, Latin America, India, and across Africa;
  • Key anti-corruption legislative changes in China, Russia, Latin America, India, and across Africa;
  • The effect of COVID-19 on corruption and anti-corruption efforts; and
  • Mitigation strategies for businesses operating in high-risk areas

View Slides (PDF)

MODERATOR:

F. Joseph Warin is Co-Chair of Gibson Dunn’s global White Collar Defense and Investigations Practice Group, and he is chair of the over 200-person Litigation Department of the Washington, D.C. office.  Mr. Warin is ranked in the top-tier year after year by Chambers USA, Chambers Global, and Chambers Latin America for his FCPA, fraud and corporate investigations experience.  He has handled cases and investigations in more than 40 states and dozens of countries involving federal regulatory inquiries, criminal investigations and cross-border inquiries by international enforcers, including UK’s SFO and FCA, and government regulators in Germany, Switzerland, Hong Kong, and the Middle East.  Mr. Warin has served as a compliance monitor or counsel to the compliance monitor in three separate FCPA monitorships, pursuant to settlements with the SEC and DOJ.

PANELISTS:

Kelly Austin is Partner-in-Charge of Gibson Dunn’s Hong Kong office and a member of the firm’s Executive Committee.  Ms. Austin is ranked annually in the top-tier by Chambers Asia Pacific and Chambers Global in Corporate Investigations/Anti-Corruption: China.  Her practice focuses on government investigations, regulatory compliance and international disputes.  Ms.. Austin has extensive expertise in government and corporate internal investigations, including those involving the FCPA and other anti-corruption laws, and anti-money laundering, securities, and trade control laws.

Joel Cohen is Co-Chair of the firm’s global White Collar Defense and Investigations Practice Group and a partner in the New York office.  Mr. Cohen’s successful defense of clients has been noted in numerous feature articles in the American Lawyer and the National Law Journal, including for pretrial dismissal of criminal charges and trial victories.  He is highly-rated in Chambers and named by Global Investigations Review as a “Super Lawyer” in Criminal Litigation.  He has been lead or co-lead counsel in 24 civil and criminal trials in federal and state courts, and he is equally comfortable in leading confidential investigations, managing crises or advocating in court proceedings.  Mr. Cohen’s experience includes all aspects of FCPA/anticorruption issues, in addition to financial institution litigation and other international disputes and discovery.

Benno Schwarz is Co-Chair of the firm’s Anti-Corruption & FCPA Practice Group and a partner in the Munich office, where his practice focuses on white collar defense and compliance investigations. Mr. Schwarz is ranked annually as a leading lawyer for Germany in White Collar Investigations/Compliance by Chambers Europe and was named by The Legal 500 Deutschland 2021 and The Legal 500 EMEA 2021 as one of four Leading Individuals in Internal Investigations, and also ranked for Compliance. He is noted for his “special expertise on compliance matters related to the USA and Russia.” Mr. Schwarz advises companies on sensitive cases and investigations involving compliance issues with international aspects, such as the implementation of German or international laws in anti-corruption, money laundering and economic sanctions, and he has exemplary experience advising companies in connection with FCPA and NYDFS monitorships or similar monitor functions under U.S. legal regimes.

Patrick Stokes is Co-Chair of the firm’s Anti-Corruption and FCPA Practice Group and a partner in the Washington, D.C. office, where he focuses his practice on internal corporate investigations, government investigations, enforcement actions regarding corruption, securities fraud, and financial institutions fraud, and compliance reviews. Mr. Stokes is ranked nationally and globally by Chambers USA and Chambers Global as a leading attorney in FCPA. Prior to joining the firm, Mr. Stokes headed the DOJ’s FCPA Unit, managing the FCPA enforcement program and all criminal FCPA matters throughout the United States covering every significant business sector. Previously, he served as Co-Chief of the DOJ’s Securities and Financial Fraud Unit.

Karthik Ashwin Thiagarajan is of counsel in the Singapore office. He represents clients in transactional, compliance and anti-corruption matters across the South Asia and ASEAN regions. Mr. Thiagarajan advises multi-national corporations on acquisitions, joint ventures and divestments across key emerging markets in Asia, including India and Indonesia. He frequently assists clients with internal investigations, anti-corruption reviews and regulatory actions in these markets.

MCLE CREDIT INFORMATION:

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This course is approved for transitional/non-transitional credit. Attorneys seeking New York credit must obtain an affirmation form prior to watching the archived version of this webcast. Please contact CLE@gibsondunn.com to request the MCLE form.

Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 2.0 hours.

California attorneys may claim “self-study” credit for viewing the archived version of this webcast. No certificate of attendance is required for California “self-study” credit.

China’s Anti-Monopoly Law (“AML”) was adopted in 2007 and talks about possible amendments have regularly surfaced in the last few years. The State Administration for Market Regulation (“SAMR”)  released a draft amendment for public comments in early 2020. The process is now accelerating with a formal text (“AML Amendment”) submitted to the thirty-first session of the Standing Committee of the National People’s Congress for first reading on 19 October 2021. This client alert summarizes the main proposed changes to the AML, which have been published for comments.[1]

1.   Targeting the digital economy

Emphasis on the digital economy. Technology firms and digital markets have been the subject of a broad regulatory assault in China, including one that is based on the AML.  SAMR has published specific guidelines on the application of the AML to platforms in early 2021 and has imposed significant fines on these market players in the last months. For example, SAMR fined Meituan, an online food delivery platform provider, RMB 3.44 billion (~$534 million) for abusing its dominant position.[2]  The AML Amendment specifically refers to enforcement in the digital economy by making it clear that undertakings shall not exclude or restrict competition by abusing the advantages in data and algorithms, technology and capital and platform rules. At the same time, the objectives to the AML have also been updated to include “encouraging innovation.” Going forward, SAMR will need to tread the delicate line between encouraging digital innovation and curbing such advancement where it constitutes abusive market behaviour. In the most recent year, at least, in practice there has been an emphasis on enforcement rather than fostering innovation, a trend we anticipate will continue.

2.   Substantive changes

Cartel facilitators. The AML arguably does not cover the behaviour of undertakings facilitating anticompetitive conduct, in particular cartels. The AML Amendment fills the gap by extending the scope of the AML to the organisation or provision of material assistance in reaching anticompetitive- agreements. This effectively means that the AML will be extended to cover behaviour leading up to the conclusion of such agreements, and third parties may be found in breach by virtue of their role in aiding the conclusion of cartels.

Abandoning per se treatment of resale price maintenance. The application of the AML to resale price maintenance (“RPM”) is confusing. While SAMR seems to apply a strict “per se” approach, the courts have generally adopted a rule of reason analysis, only prohibiting RPM when it led to anticompetitive effects.[3]  The AML Amendment seems to favour the courts’ approach by providing that RPM is not prohibited if the supplier can demonstrate the absence of anticompetitive effects.

Safe harbour for anticompetitive agreements. The AML Amendment introduces a safe harbour for anticompetitive agreements. Agreements between undertakings that have a market share lower than a specific threshold to be set by SAMR will not be prohibited unless there is evidence that the agreement has anticompetitive effects. Given that this is not a complete exemption from the prohibition, it is very much the question whether this safe harbour will be at all useful to undertakings.

Merger review of sub-threshold transactions. The State Council Regulation on the Notification Thresholds for Concentrations of Undertakings already provides SAMR with the right to review transactions that do not meet the thresholds for mandatory review. This right would now directly be enshrined in the AML.

Stop-the-clock in merger investigations. SAMR will have the power to suspend the review period in merger investigations under any of the following scenarios: where the undertaking fails to submit documents and materials leading to a failure of the investigation; where new circumstances and facts that have a major impact on the review of the merger need to be verified; or where additional restrictive conditions on the merger need to be further evaluated and the undertakings concerned agree. The clock resumes once the circumstances leading to the suspension are resolved. It seems that this mechanism may be used to replace the “pull-and-refile” in contentious merger investigations.

3.   Increased penalties

Penalties on individuals. The AML Amendment would introduce personal liability for individuals. In particular, if the legal representative, principal person-in-charge or directly responsible person of an undertaking is personally responsible for reaching an anticompetitive agreement, a fine of not more than RMB 1 million (~$157,000) can be imposed on that individual. At this stage, however, cartel leniency is not available to individuals.

Penalties on cartel facilitators. As explained above, cartel facilitators will be liable for their conduct. They risk penalties of not more than RMB 1 million (~$157,000).

Increased penalties for merger-related conduct. One of the weaknesses of the AML is the very low fines for gun jumping (limited to RMB 500,000). The AML Amendment now states that where an undertaking implements a concentration in violation of the AML, a fine of less than 10% of the sales from the preceding year shall be imposed. Where such concentration does not have the effect of eliminating or restricting competition, the fine will be less than RMB 5 million (~$780,000).

Superfine. SAMR can multiply the amount of the fine by a factor between 2 and 5 in case it is of the opinion that the violation is “extremely severe”, its impact is “extremely bad” and the consequence is “especially serious.” There is no definition of what these terms mean and this opens the door to very significant and potentially arbitrary fines.

Penalties for failure to cooperate with investigation. Where an undertaking refuses to cooperate in anti-monopoly investigations, e.g. providing false materials and information, or conceals, destroy or transfer evidence, SAMR has the authority to impose a fine of less than 1% of the sales from the preceding year, and where there are no sales or the data is difficult to be assessed, the maximum fine on enterprises or individuals involved is RMB 5 million (~$780,000) and RMB 500,000 (~$70,000) respectively.

Public interest lawsuit. Finally, public prosecutors (i.e. the people’s procuratorate) can bring a civil public interest lawsuit against undertakings they have acted against social and public interests by engaging in anticompetitive conduct.

______________________________

   [1]   National People’s Congress of the People’s Republic of China, “Draft Amendment to the Anti-Monopoly Law” (中华人民共和国反垄断法(修正草案)) (released on October 25, 2021), available at http://www.npc.gov.cn/flcaw/flca/ff8081817ca258e9017ca5fa67290806/attachment.pdf.

   [2]   SAMR, “Announcement of SAMR’s Penalty To Penalise Meituan’s Monopolistic Behaviour In Promoting “Pick One Out Of Two” In The Online Food Delivery Platform Service Market” (市场监管总局依法对美团在中国境内网络餐饮外卖平台服务市场实施“二选一”垄断行为作出行政处罚) (released on October 8, 2021), available at http://www.samr.gov.cn/xw/zj/202110/t20211008_335364.html.

   [3]   Gibson Dunn, “Antitrust in China – 2018 Year in Review” (released on February 11, 2019), available at https://www.gibsondunn.com/antitrust-in-china-2018-year-in-review/.

The following Gibson Dunn lawyers assisted in the preparation of this client update: Sébastien Evrard, Bonnie Tong, and Jane Lu.

Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Antitrust and Competition Practice Group, or the following lawyers in the firm’s Hong Kong office:

Sébastien Evrard (+852 2214 3798, sevrard@gibsondunn.com)
Kelly Austin (+852 2214 3788, kaustin@gibsondunn.com)

Please also feel free to contact the following practice leaders:

Antitrust and Competition Group:
Rachel S. Brass – San Francisco (+1 415-393-8293, rbrass@gibsondunn.com)
Ali Nikpay – London (+44 20 7071 4273, anikpay@gibsondunn.com)
Christian Riis-Madsen – Brussels (+32 2 554 72 05, criis@gibsondunn.com)
Stephen Weissman – Washington, D.C. (+1 202-955-8678, sweissman@gibsondunn.com)

© 2021 Gibson, Dunn & Crutcher LLP

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Gibson, Dunn & Crutcher LLP is pleased to announce that the Asia Pacific Loan Market Association (APLMA) has released an English law term facilities agreement template for Indonesia offshore loans, which is available in the APLMA documentation library.

Gibson Dunn’s lawyers, together with members of the APLMA Indonesian Documentation Steering Committee, worked on the drafting of the English law APLMA template for Single Borrower, Single Guarantor, Single Currency Term Facility Agreement for Indonesia Offshore Loans (the “APLMA Indonesia Template”), to help achieve a degree of consistency amongst financial institutions that lend into Indonesia and facilitate growth of the secondary market there.

The APLMA Indonesia Template not only sets out Indonesia specific provisions that typically are seen in loan documents for Indonesian cross-border transactions, such as those relating to reporting obligations owed to Bank Indonesia and Law No. 24 of 2009 relating to the use of Bahasa Indonesia, but also includes detailed notes to help template users focus on these key Indonesia related issues.  A Bahasa Indonesia version of the APLMA Indonesia Template will be published shortly.

The APLMA Indonesian Documentation Steering Committee was founded and spearheaded by Gibson Dunn partner Jamie Thomas, who chairs the committee.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the above. Please contact the Gibson Dunn lawyer with whom you usually work, or the lawyers below who worked on the drafting of the APLMA Indonesia Template:

Jamie Thomas – Singapore (+65 6507.3609, jthomas@gibsondunn.com)

U-Shaun Lim – Singapore (+65 6507.3633, ulim@gibsondunn.com)

© 2021 Gibson, Dunn & Crutcher LLP

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

1.

INTRODUCTION

1.1

Singapore has become an increasingly popular destination for trust listings in the recent years. Real estate investment trusts (“REITs”), business trusts (“BTs”) and stapled trusts are some of the more popular vehicles that property players opt for to tap capital on Singapore Exchange Securities Trading Limited (the “SGX-ST”).

1.2

This primer provides an overview of the structure of such vehicles, the main regulations regulating them, the process to getting listed on the SGX-ST as well as the various ways of acquiring control of these vehicles post-listing. This primer also explores the lessons to be learnt from the controversy surrounding Eagle Hospitality Trust (“EHT”) and the failed merger between ESR REIT and Sabana REIT.

2.

STRUCTURE

2.1

REIT

 

2.1.1

A REIT may generally be described as a trust that invests primarily in real estate and real estate-related assets with the view to generating income for its unitholders.

 

2.1.2

It is constituted pursuant to a trust deed entered into between the REIT manager and the REIT trustee.

 

2.1.3

The REIT manager manages the assets of the REIT while the REIT trustee holds the assets on behalf of the unitholders and generally helps to safeguard the interests of the unitholders.

 

2.1.4

REITs are popular with investors as the income from the assets (after deducting trust expenses) is distributed to the unitholders at regular intervals. A REIT which distributes at least 90% of its taxable income to its unitholders in the same year in which the income is derived can enjoy tax transparency treatment under the Income Tax Act, Chapter 134 of Singapore. It is also not uncommon for REITs to pledge to distribute the entire of its annual distributable income in the initial period post-listing.

 

2.1.5

The typical roles in a REIT structure are as follows:

  

(a)

REIT Manager: The REIT manager manages the assets of the REIT and is responsible for the overall strategic direction of the REIT, including asset acquisitions and divestments as well as capital management. In return, the REIT manager charges a management fee which typically comprises a base fee and a performance fee. The REIT manager would typically also be entitled to an acquisition fee, divestment fee and development management fee;

(b)

Property Manager: The property manager manages and maintains the properties of the REIT in return for a property management fee;

(c)

REIT Trustee: The REIT trustee holds the assets of the REIT on behalf of the unitholders and generally ensures that the REIT complies with applicable rules and regulations. In return, the REIT trustee is paid a trustee’s fee; and

(d)

Sponsor: The sponsor is the party that injects the initial portfolio of assets into the REIT and will continue to provide the REIT with a pipeline of assets moving forward. Typically, the sponsor also holds a substantial stake in the REIT and/or the REIT manager.
 
 

Typical REIT Structure

 

2.1.6

SGX-ST-listed REITs typically adopt an external management model where the REIT manager is owned by the sponsor of the REIT. This is in contrast to an internal management model (adopted by a majority of REITs in the United States of America) where the REIT manager is instead owned by the REIT itself. Proponents of an internal management model in Singapore argue that an internal management model avoids conflicts of interest and lowers the fees payable to the REIT manager (which ultimately translates to better returns for unitholders). The success of the Hong Kong-listed internally managed Link REIT, Asia’s largest REIT in terms of market capitalization, may bear testament to this. However, whether an internal management model takes off in Singapore remains to be seen. Singapore investors could well prefer sponsor participation due to the various advantages that a sponsor can bring, such as marketability, expertise, support and pipeline of assets.

2.2

BT

 

2.2.1

A BT is a trust that can generally engage in any type of business activity, including the management of real estate assets or the management or operation of a business.

 

2.2.2

It is constituted pursuant to a trust deed entered into by the trustee-manager, a single entity that has the dual responsibility of safeguarding the interests of the unitholders of the BT and managing the business conducted by the BT.

 

2.2.3

BTs, unlike companies, can make distributions out of operating cash flows (instead of profits). They suit businesses which involve high initial capital expenditures with stable operating cash flows, such as real estate assets.

 

2.2.4

Compared to REITs, BTs are also more lightly regulated and may therefore be preferred for their flexibility. Property BTs often also pledge to provide REIT-like distributions to the unitholders.

 

2.2.5

The typical roles in a BT structure are as follows:

  

(a)

Trustee-Manager: The trustee-manager is both the trustee and the manager of the BT. As trustee, it holds the assets of the BT on behalf of the unitholders and helps to safeguard the interests of the unitholders. As manager, it manages the business and strategic direction of the BT. In return, the trustee-manager is paid a trustee’s fee as well as a management fee, which typically comprises a base fee and a performance fee. The trustee-manager would typically also be entitled to an acquisition fee, divestment fee and development management fee;

(b)

Property Manager: In the case of a property BT, a property manager is typically engaged to manage and maintain the properties of the BT in return for a property management fee; and

(c)

Sponsor: The sponsor is the party that injects the initial portfolio of assets into the BT and will continue to provide the BT with a pipeline of assets moving forward. Typically, the sponsor also holds a substantial stake in the BT and/or the trustee-manager.
 
 

Typical Property BT Structure

2.3

Stapled Trust

 

2.3.1

A stapled trust on the SGX-ST typically comprises a REIT and a BT. Pursuant to a stapling deed, units of the REIT and units of the BT are stapled together and cannot be traded separately. The REIT and the BT would continue to exist as separate structures, but the stapled securities would trade as one counter and share the same investor base.

 

2.3.2

A stapled trust structure may be preferred when an issuer wishes to bundle two distinct (but related) businesses into a single tradeable counter. Such stapled trust structure is commonly adopted for hospitality assets which provide both a passive (through the receipt of rental income from the lease of such assets) and an active (through the management and operation of such assets) income stream.

 

2.3.3

In such cases, the REIT will be constituted to hold the income-producing real estate assets and the BT will be constituted to either (a) be the master lessee of the real estate assets who will manage and operate these assets or (b) remain dormant and only step in as a “master lessee of last resort” to manage and operate these assets when there are no other suitable master lessees to be found. The presence of a BT also offers flexibility for the stapled trust to undertake certain hospitality and hospitality-related development projects, acquisitions and investments which may not be suitable for the REIT.

 

2.3.4

Investors who value the business and income diversification may therefore find such a model attractive.

 

2.3.5

The typical roles in a REIT and a BT have been discussed above.

 
 

Typical Stapled Trust Structure

3.

REGULATIONS

3.1

REIT

 

3.1.1

A REIT is regulated as a collective investment scheme under the Securities and Futures Act, Chapter 289 of Singapore (the “SFA”).

3.1.2

The REIT, the REIT manager and the REIT trustee must comply with the Code on Collective Investment Schemes issued by the Monetary Authority of Singapore (the “MAS”, and such Code on Collective Investment Schemes issued by the MAS, the “CIS Code”), which prescribes the many distinctive characteristics of a REIT.

3.1.3

For example, Appendix 6 of the CIS Code requires a REIT to, among others:
 

(a)

enshrine certain provisions in the trust deed constituting the REIT (such as the right of unitholders to remove the REIT manager by way of a resolution passed by a simple majority of unitholders present and voting at a general meeting, with no participant being disenfranchised);

(b)

generally have at least 75% of its deposited property invested in income-producing real estate;

(c)

not derive more than 10% of its revenue from sources other than (i) rental payments from the tenants of the real estate held by the REIT or (ii) interest, dividends and other similar payments from special purpose vehicles and other permissible investments of the REIT; and

(d)

not have a gearing ratio exceeding 50% (before 1 January 2022) and 45% (on or after 1 January 2022, except that such gearing ratio may exceed 45% (up to a maximum of 50%) if the REIT has a minimum adjusted interest coverage ratio of 2.5 times after taking into account the interest payment obligations arising from the new borrowings).

3.1.4

A REIT manager is required to hold a capital markets services licence (“CMS Licence”) for REIT management before it can engage in the regulated activity of REIT management.

3.1.5

The Guidelines to All Holders of a Capital Markets Services Licence for Real Estate Investment Trust Management (Guideline No. SFA04-G07) set out further guidance relating to, among others, minimum licensing criteria and corporate governance arrangements.

3.1.6

CMS Licence holders would also need to abide by the Securities and Futures (Licensing and Conduct of Business) Regulations, which set out, among others, requirements relating to licensing, representative notification and key appointments.

3.1.7

A REIT trustee must be an approved trustee under the SFA. Further requirements of an approved trustee are set out under the Securities and Futures (Offers of Investments) (Collective Investment Schemes) Regulations 2005 (the “SF(OI)(CIS)R”).

3.2

BT

 

3.2.1

Pursuant to the SFA, a Singapore-constituted BT must be registered by the MAS before its units can be offered to the public. The Business Trusts Act, Chapter 31A of Singapore (the “BTA”), and the Business Trusts Regulations (the “BTR”) are the chief regulations governing registered BTs.

3.2.2

Among others, the BTA and the BTR contain provisions regulating:
 

(a)

the responsibilities, powers and liabilities of a trustee-manager (including corporate governance arrangements);

(b)

the contents of the trust deed constituting a registered BT;

(c)

the rights of unitholders (such as the right to remove the trustee-manager by way of a resolution passed by unitholders holding in the aggregate not less than three-fourths of the voting rights of all the unitholders who, being entitled to do so, vote in person or where proxies are allowed, by proxy present at a meeting of the unitholders); and

(d)

the winding up of a registered BT.

3.2.3

The BTA stipulates certain requirements of a trustee-manager. For example, only a company (not being an exempt private company) shall act as trustee-manager of a registered BT. The trustee-manager of a registered BT shall also not carry on any business other than the management and operation of the registered BT as its trustee-manager.

3.2.4

The regulations governing a collective investment scheme do not apply to a collective investment scheme that is also a registered BT.

3.2.5

Accordingly, BTs can offer issuers with considerably more flexibility as compared to REITs since BTs have no statutory gearing limit and can engage in a wider scope of business activity.

3.3

Stapled Trust

 

3.3.1

A stapled trust that comprises a REIT and a BT would be subject to the respective rules and regulations set out above.

3.3.2

Under Appendix 6 of the CIS Code, a REIT may only staple its units with the securities of an entity with active operations only if that entity (a) has business operations that are in the same industry segment as the REIT or (b) is operating a business or providing a service that is ancillary to the assets held by the REIT.

4.

LISTING

4.1

Due Diligence

 

4.1.1

Due diligence is conducted to evaluate an issuer’s suitability for listing on the SGX-ST. Under the listing manual of the SGX-ST (the “Listing Manual”), the issue manager (who will manage the issuer’s listing application) is tasked with the responsibility to “conduct adequate due diligence on the applicant”.

4.1.2

Through the due diligence process, the issue manager (with the assistance of its advisers and other experts) identifies the necessary information for the preparation of a prospectus. Notably, the SFA imposes on certain persons criminal and civil liabilities for any false or misleading statement in or omission of material information from a prospectus.

4.1.3

The issue manager is guided by the due diligence guidelines issued by The Association of Banks in Singapore (the “ABS Listings Due Diligence Guidelines”), which the SGX-ST will have regard to when assessing the adequacy of due diligence conducted.

4.1.4

Among others, the ABS Listings Due Diligence Guidelines recommend that an issue manager should:
 

(a)

review the educational and professional qualifications, experience and expertise of the proposed directors and executive officers of the issuer to assess their suitability;

(b)

achieve a thorough understanding of the issuer and its business through reasonable due diligence and with the assistance of advisers, carry out reasonable checks and make enquiries as are reasonable in the circumstances to satisfy itself that the information contained in the prospectus (subject to reasonable reliance on experts) is compliant with law; and

(c)

where there is reliance on the reports and opinions of experts, take measures to satisfy itself that such reliance is reasonable in the circumstances and there are no reasonable grounds to believe that the information in such reports and opinions is untrue or misleading in any material respect or contains any material omission.

4.1.5

In the context of a REIT, property BT or stapled trust listing, due diligence on the initial portfolio of properties is of utmost importance. In this regard, due diligence will generally involve:
 

(a)

on-site visits to the properties;

(b)

the engagement of independent property valuer(s) to conduct a valuation of the properties as well as provide a thorough analysis of the properties;

(c)

the engagement of legal advisers to conduct legal due diligence to, among others:
 

(i)

confirm that good title to the properties will be obtained;

(ii)

identify key approvals;

(iii)

confirm that material contracts (such as leases) are legal, binding and enforceable;

(iv)

identify ongoing and past litigations and investigations;

(v)

identify scope of insurance coverage;

(vi)

identify caveats, security interests, easements, covenants and licenses;

(vii)

assess compliance with zoning and planning permissions; and

(viii)

obtain information on road line plans, survey plans and property boundaries;

(d)

the engagement of technical consultants to assess the structural integrity of the properties and identify material defects; and

(e)

the engagement of environmental consultants to assess the environmental conditions of the properties in order to identify actual and potential environmental liabilities.

4.1.6

Financial due diligence should be conducted with the assistance of reporting accountants to analyze the financial health of the issuer and to prepare the pro forma financial information as well as the profit forecast and profit projection sections, which are to be included in the prospectus.

4.1.7

Taxation experts should also be engaged to identify and assess the taxation issues in connection with a listing. To the extent necessary, favorable tax rulings may need to be obtained from the relevant authorities.

4.2

Listing Process

 

4.2.1

There are quantitative requirements (such as minimum profit, minimum operating track record, operating revenue and minimum market capitalization), among others, which must be met before an issuer can list on the Mainboard of the SGX-ST.

4.2.2

As it is not uncommon for REITs and BTs to only be constituted shortly prior to listing, the Listing Manual allows REITs and BTs who have a market capitalization of not less than S$300 million based on the issue price and post-invitation issued unit capital to apply for listing even if they do not have historical financial information, provided they are able to demonstrate that they will generate operating revenue immediately upon listing.

4.2.3

To list on the Mainboard of the SGX-ST, the issue manager, on behalf of the issuer, submits the listing application (including Section (A) of the listing admissions pack of the SGX-ST (the “LAP”), which sets out the general information of the issuer and key issues for listing) to the SGX-ST for review.

4.2.4

Upon completion of such review, the issuer then submits Section (B) of the LAP (which includes the draft prospectus) to the SGX-ST for review.

4.2.5

To shorten time-to-market, Sections (A) and (B) of the LAP may also be submitted together. A pre-lodgment submission to the MAS for the concurrent review of the draft prospectus is typically also made during the submission of Section (B) of the LAP.

4.2.6

Prospective cornerstone investors are then approached at this juncture. A typical cornerstone process involves having the prospective investors execute non-disclosure agreements before they are provided with copies of the draft prospectus. Prospective cornerstone investors may also be given the opportunity to meet with the management team.

4.2.7

During the review process, the regulators may raise queries which the issuer will need to resolve to the regulators’ satisfaction. Upon completion of such review (which generally takes at least four weeks from the submission of Section (B) of the LAP ), the SGX-ST will issue an eligibility-to-list letter (containing certain conditions) (the “ETL Letter”). The MAS will also inform the issuer to proceed with the lodgment of its preliminary prospectus once it has completed its review.

4.2.8

The issuer will thereafter lodge its preliminary prospectus (along with the accompanying documents, such as the product highlights sheet) with the MAS, upon which the preliminary prospectus will be subject to public exposure. Institutional book-building commences at this juncture.

4.2.9

The public offer commences only upon the registration of the prospectus by the MAS, which takes place between the seventh and 21st day (both days inclusive) from the date of lodgment of the preliminary prospectus. This may also be extended to a maximum of 28 days if the MAS gives notice of such extension. Pursuant to the Listing Manual, a public offer is required to be open for at least two market days.

4.2.10

Upon the close of the public offer and provided the SGX-ST is satisfied that the conditions set out in the ETL Letter have been met, the units or stapled securities will be allotted and listing and quotation of the units or stapled securities may commence.

4.2.11

In the case of a REIT, a Singapore-constituted REIT must be authorized by the MAS prior to an initial public offering of units to investors in Singapore. Further, a REIT manager is required to hold a CMS Licence for REIT management before it can engage in REIT management.

4.2.12

In the case of a BT, a Singapore-constituted BT would also need to be registered by the MAS prior to an initial public offering of units to investors in Singapore.

4.2.13

These applications are made concurrently during the listing process.

4.3

Prospectus

 

4.3.1

The prospectus is the primary offering document on which investors base their investment decisions. It should generally include all the information that investors and their professional advisers would reasonably require to make an informed assessment of the matters specified under the SFA and the matters prescribed by the MAS.

4.3.2

The contents of the prospectus of a REIT, BT and stapled trust are prescribed by, among others, the SFA, the Securities and Futures (Offers of Investments) (Securities and Securities-based Derivatives Contracts) Regulations 2018, the SF(OI)(CIS)R, the CIS Code and the Listing Manual (such rules and regulations regulating the contents of such prospectus, the “Prospectus Regulations”).

4.3.3

The prospectus of a REIT, property BT or stapled trust will generally include, among others, the following information:

 

(a)

overview of the issuer’s business and organizational structure;

(b)

risk factors;

(c)

use of proceeds;

(d)

ownership of the units;

(e)

capitalization and indebtedness;

(f)

unaudited pro forma financial information;

(g)

management’s discussion and analysis of financial condition and results of operations;

(h)

profit forecast and profit projection;

(i)

business and properties;

(j)

formation and structure of the issuer;

(k)

overview of the material agreements relating to the issuer and its properties;

(l)

overview of relevant laws and regulations; and

(m)

expert reports (such as the reporting accountants’ reports on the unaudited pro forma financial information and the profit forecast and profit projection, the independent taxation report(s), the independent property valuation summary report(s) and the independent market research report).

4.3.4

With respect to risk factors, the Prospectus Regulations generally require risks specific to the issuer to be disclosed. Risk factors which are typically included in the prospectus of a REIT, property BT or stapled trust include:

 

(a)

risks relating to the properties (such as certain properties being subject to restrictions, concentration risk and risk that due diligence on the properties may not have uncovered all material defects);

(b)

risks relating to the issuer’s operations (such as risk of failure in implementing investment strategy, the lack of an operating track record of the REIT manager and/or the trustee-manager and risk of breach of obligations by the lessees);

(c)

risks relating to the jurisdiction(s) in which the issuer operates;

(d)

risks relating to investing in real estate (such as the relative illiquidity of real estate investments and risk that the rate of increase in rentals of the properties may be less than the inflation rate); and

(e)

risks relating to an investment in the units or stapled securities (such as the risk that substantial unitholders or substantial stapled securityholders could sell a substantial number of units or stapled securities and risk of change in taxation laws).

4.4

Continuing Listing Obligations

 

Post-listing, REITs, BTs and stapled trusts are subject to continuing listing obligations under the Listing Manual, such as the requirement to announce specific and material information, requirements relating to secondary offerings, interested person transactions and significant transactions, as well as requirements relating to circulars and annual reports.

4.5

Case Study of EHT

 

4.5.1

Despite the safeguards in the listing framework put in place by the SGX-ST, the case of EHT has illustrated that the continued success of a REIT, property BT or stapled trust which adopts a master lease arrangement will ultimately depend on the commitment and financial strength of the master lessees (who will typically be affiliates of the sponsor).

4.5.2

EHT is a stapled trust, comprising Eagle Hospitality Real Estate Investment Trust (“EHREIT”) and Eagle Hospitality Business Trust (“EHBT”), which made its debut on the Mainboard of the SGX-ST in May 2019 with an initial portfolio of 18 hotel properties. EHREIT was established with the principal investment strategy of investing in income-producing real estate used primarily for hospitality and/or hospitality-related purposes while EHBT will initially remain dormant.

4.5.3

EHT adopted a master lease arrangement under which affiliates of its sponsor (collectively, the “Master Lessees”), Urban Commons, would lease the hotels from EHREIT. The Master Lessees would in turn enter into (a) franchise agreements with various hotel franchisors to operate under their brands and (b) hotel management agreements with third-party hotel management companies to manage the day-to-day operations of each hotel.

4.5.4

Indications that things may be less than perfect surfaced shortly post-listing in October 2019 when an article appeared in the press that EHT had been served with a notice of default by the City of Long Beach in respect of one of its properties, The Queen Mary (a hotel operated aboard a historic British ocean liner which had been leased from the City of Long Beach), as a result of failure to make repairs. The same article also quoted a marine survey conducted in 2017 (the “2017 Marine Survey”) which alleged that The Queen Mary was in deteriorating condition and in need of substantial repairs (collectively, the “Queen Mary Allegations”).

4.5.5

The Queen Mary Allegations were swiftly disputed by EHT, which clarified that there was no default and that the supposed notice of default was merely a “formal request for information by the City”. EHT also called the 2017 Marine Survey’s estimate of the scope of work and costs “grossly inaccurate”. To substantiate its claims, EHT further relied on an independent structural engineer’s report by John A. Martin & Associates, Inc. (which was commissioned by Urban Commons prior to EHT’s listing) which concluded that The Queen Mary “remains in excellent structural condition”. Despite the assurances from EHT, the price of its stapled securities reportedly fell 14%.

4.5.6

In late 2019 to early 2020, EHT’s financial resources started to deplete due to the impact of Coronavirus Disease 2019 and various delinquencies by the Master Lessees. Among others, the Master Lessees (a) breached the master lease agreements by failing to pay rent on time, (b) received notice of default from various hotel managers due to, among others, failure to provide and/or maintain sufficient working capital for the hotels’ operations and failure to pay management fees and (c) received notice of termination from various hotel managers due to failure to cure the default of maintaining sufficient working capital for the hotels’ operations. During this period, EHT received a notice of default and acceleration in respect of a US$341 million loan it had taken out in connection with its listing.

4.5.7

In March 2020, EHT called for a voluntary suspension of trading. In April 2020, EHT established a special committee to safeguard value and conduct a strategic review. EHT subsequently appointed a financial adviser and implemented caretaker arrangements at the hotels which were the subject of the notice of termination by the relevant hotel managers.

4.5.8

In May 2020, the strategic review uncovered that the founders of Urban Commons (in their capacity as directors of various subsidiaries of EHREIT) had, on behalf of these subsidiaries, entered into certain interested person transactions which were prejudicial to the interests of EHT and its minority stapled securityholders. This discovery prompted their resignations from the board of directors of the manager of EHREIT (the “EHREIT Manager”) and the trustee-manager of EHBT (the “EHBT Trustee-Manager”).

4.5.9

In June 2020, EHT announced that an initial request for proposal (“RFP”) process conducted by its financial adviser was interrupted by Urban Commons’ entry into a letter of intent with Far East Consortium International Limited (“FECIL”) in relation to FECIL’s proposed acquisition of a 70% interest in each of the EHREIT Manager and the EHBT Trustee-Manager. Against this, the MAS and the Commercial Affairs Department of the Singapore Police Force commenced a joint investigation into current and former directors and officers responsible for managing in EHT in connection with suspected breach of disclosure requirements under the SFA.

4.5.10

Discussions with FECIL, however, collapsed and the trustee of EHREIT (the “EHREIT Trustee”) restarted the RFP process in late 2020, which culminated in the selection of SCCPRE Hospitality REIT Management Pte. Ltd. as the replacement manager of EHREIT (the “SCCPRE Proposal”). The SCCPRE Proposal was contingent on a number of resolutions being passed at an extraordinary general meeting (“EGM”) to be held on 30 December 2020. On or around the same period, EHT terminated the master lease agreements and the EHREIT Trustee also received a directive from the MAS to remove the EHREIT Manager.

4.5.11

On 30 December 2020, the EHREIT Manager was removed. However, not all the requisite resolutions for the SCCPRE Proposal were passed at the EGM held on the same day. In view of the absence of a replacement manager and inability to continue as a going concern because of the depletion of funds, EHT filed for insolvency protection under Chapter 11 of the United States Bankruptcy Code.

4.5.12

As at the time of writing of this primer, EHT has disposed 15 of its 18 hotel properties and also surrendered The Queen Mary back to the City of Long Beach. Stapled securityholders are, however, not expected to receive the sale proceeds as the cash is insufficient to repay all the claims on EHT.

4.5.13

The case of EHT has shown that the continued success of a REIT, property BT or stapled trust which adopts a master lease arrangement will ultimately depend on the commitment and financial strength of the master lessees. Where a master lease arrangement is adopted, concentration risk is at its highest (given the lack of diversity in lessees) and the ability of the master lessees to keep up with timely rental payments becomes even more important. Rental income is ultimately the chief source of income for a REIT, property BT or stapled trust. As seen in the case of EHT, in certain cases, rental defaults could even result in the REIT, property BT or stapled trust defaulting on its debt obligations and ultimately wind up.

4.5.14

The case of EHT has also resulted in the public calling for the authorities to review the current disclosure regime. In particular, it has been questioned if the rules should also require disclosure of the financials of a sponsor (especially if a master lease arrangement with the sponsor is adopted). Where a master lease arrangement is adopted, valuations of the properties and financials presented in the prospectus would be based on the rental income received under such master lease arrangement. For these figures to remain accurate, the master lessees need to be able to perform their end of the bargain. Requiring such disclosures would allow investors to better assess a sponsor’s financial strength.

4.5.15

Short of any amendment to the disclosure regime, issuers will do well to treat the required disclosures as the minimum standard and aim to go above and beyond in the interests of investors.

5.

Acquiring Control of a REIT, BT or Stapled Trust

5.1

An acquisition of all the units of a REIT or BT or all the stapled securities of a stapled trust listed on the SGX-ST (“Target Entity”) may be effected in various ways, such as a take-over offer, a trust scheme of arrangement (“Trust Scheme”) and a reverse take-over (“RTO”).

5.2

Any merger or acquisition involving a Target Entity would be subject to the Listing Manual, the CIS Code (in the case of a REIT) and the Singapore Code on Take-overs and Mergers (the “Take-over Code”). The Take-over Code is enforced by the Securities Industries Council (the “SIC”), which is part of the MAS.

5.3

Take-over Offer

 

5.3.1

Take-over offers of a Target Entity generally take three forms under the Take-over Code – a mandatory offer, a voluntary offer and a partial offer. A mandatory offer is triggered by an acquiror’s holdings in a Target Entity. A voluntary offer occurs where the acquiror makes an offer for all the units or stapled securities of a Target Entity and this offer does not trigger the mandatory offer rules in the Take-over Code. A partial offer is a voluntary offer for less than 100% of the outstanding units or stapled securities in a Target Entity.

5.3.2

The acquiror can stipulate objective conditions for a voluntary offer such as a particular level of acceptances, unitholders’ or stapled securityholders’ approval and certain regulatory approvals. However, no conditions should be imposed in a mandatory offer other than the mandatory offer being conditional upon the acquiror obtaining acceptances which, together with the units or stapled securities carrying voting rights acquired or agreed to be acquired before or during the offer, will result in the acquiror and parties acting in concert with it holding units or stapled securities carrying more than 50% of the voting rights of the Target Entity.

5.3.3

The acquiror can also seek irrevocable undertakings from the unitholders or stapled securityholders of a Target Entity to accept its offer. Such undertakings must be publicly disclosed.

5.3.4

The consideration for a mandatory offer should be in cash or accompanied by a cash alternative, while the consideration for a voluntary offer may be in cash or securities or a combination thereof.

5.3.5

Steps

The principal steps of a take-over offer are as follows:

 

(a)

Due Diligence: The acquiror may request that it be allowed to conduct due diligence on the Target Entity by notifying the board of directors of the REIT manager or trustee-manager or their advisers;

(b)

Offer: The acquiror announces that it wishes to make an offer for the Target Entity, the consideration and any conditions for the offer;

(c)

Offer Document: The acquiror issues an offer document in compliance with the Take-over Code to all the unitholders or stapled securityholders of the Target Entity;

(d)

Target Entity Circular: The Target Entity issues a circular to the unitholders or stapled securityholders containing the advice of the independent financial adviser to the independent directors of the REIT manager or the trustee-manager on the offer and the recommendation of such directors whether or not to accept the offer; and

(e)

Close of the Offer: At the close of the offer, if the conditions of the offer are met, the offer is declared unconditional in all respects, and payment for the units or stapled securities must be made.

5.3.6

Examples of Take-over Offers
 

(a)

Take-over of Forterra Trust
 

(i)

In 2015, New Precise Holdings Limited (“New Precise Holdings”), an indirect wholly owned subsidiary of Nan Fung International Holdings Limited, triggered the requirement to make a mandatory offer under the Take-over Code to acquire all the units (other than the units that were already owned, controlled or agreed to be acquired by New Precise Holdings and the parties acting in concert with it) in Forterra Trust, a SGX-ST-listed BT, at an offer price of S$2.25 per unit.

(ii)

Prior to the announcement of the offer, New Precise Holdings had exercised 3,050,000 options in respect of 3,050,000 units in Forterra Trust (the “Options Exercise”). After the issuance of the units to New Precise Holdings pursuant to the Options Exercise, the total number of issued units in Forterra Trust was 257,019,717, and New Precise Holdings and the parties acting in concert with it held units that represented approximately 30.79% of the total number of issued units in Forterra Trust. Accordingly, New Precise Holdings was required under the Take-over Code to make a mandatory offer.

(iii)

At the close of the offer, New Precise Holdings and the parties acting in concert with it owned units representing approximately 97.11% of the total number of issued units in Forterra Trust. New Precise Holdings thereafter exercised its right to acquire the remaining units pursuant to the BTA. Forterra Trust was subsequently delisted from the SGX-ST.

(b)

Take-over of Perennial China Retail Trust (“PCRT”)
 

(i)

In 2015, Perennial Real Estate Holdings Limited (“PREH”) proposed to acquire all the units (other than the units that were already owned, controlled or agreed to be acquired by PREH and the parties acting in concert with it) in PCRT, a SGX-ST-listed BT, by a voluntary offer at a consideration per unit of (A) S$0.70 and (B) 0.52423 ordinary shares in the capital of PREH.

(ii)

At the close of the offer, PREH and the parties acting in concert with it owned units representing approximately 96.32% of the total number of issued units in PCRT. PREH thereafter exercised its right to acquire the remaining units pursuant to the BTA. PCRT was subsequently delisted from the SGX-ST.

5.4

Trust Scheme

 

5.4.1

In a Trust Scheme, the acquiror typically acquires all the units or stapled securities of a Target Entity in consideration for cash and/or the issuance of new securities of the acquiror to the existing unitholders or stapled securityholders of the Target Entity. A Trust Scheme will typically be adopted in a situation where the acquiror wishes to acquire all the units or stapled securities of a Target Entity.

5.4.2

A Trust Scheme will typically require:

 

(a)

the approval by the unitholders or stapled securityholders of the Target Entity to amend the trust deed constituting the Target Entity to include provisions that will facilitate the implementation of the Trust Scheme;

(b)

the approval by a majority in number of the unitholders or stapled securityholders of the Target Entity representing at least three-fourths in value of the units or stapled securities held by the unitholders or stapled securityholders present and voting either in person or by proxy at the meeting of the unitholders or stapled securityholders to be convened to approve the Trust Scheme; and

(c)

the grant of the order of the High Court of the Republic of Singapore (the “High Court”) sanctioning the Trust Scheme.

5.4.3

All Trust Schemes are subject to compliance with the Take-over Code although the SIC may, subject to conditions, exempt a Trust Scheme from selected provisions of the Take-over Code, such as those relating to the timetable of the offer.

5.4.4

Steps

The principal steps of a Trust Scheme are as follows:
 

(a)

Implementation Agreement: The acquiror and the Target Entity will typically enter into an implementation agreement setting out the terms and conditions on which the Trust Scheme will be implemented;

(b)

Trust Scheme Announcement: The Target Entity announces that it wishes to propose the Trust Scheme to its unitholders or stapled securityholders;

(c)

Court Application to Convene Meeting: The Target Entity files with the High Court an application for an order to convene a meeting for its unitholders or stapled securityholders to approve the Trust Scheme (the “Trust Scheme Meeting”);

(d)

Trust Scheme Document: The Target Entity issues a scheme document to its unitholders or stapled securityholders which typically sets out the terms and conditions of the Trust Scheme, its rationale and gives notice of (i) the EGM to approve amendments to the trust deed constituting the Target Entity to include provisions that will facilitate the implementation of the Trust Scheme and (ii) the Trust Scheme Meeting. The EGM and the Trust Scheme Meeting are typically convened on the same day;

(e)

EGM and the Trust Scheme Meeting: The unitholders or stapled securityholders approve (i) the amendments to the trust deed constituting the Target Entity at the EGM and (ii) the Trust Scheme at the Trust Scheme Meeting;

(f)

Court Application to Sanction the Trust Scheme: The Target Entity files with the High Court the results of the Trust Scheme Meeting and an application for the High Court to sanction the Trust Scheme; and

(g)

Court Order Sanctioning the Trust Scheme: The High Court grants an order sanctioning the Trust Scheme.

5.4.5

Examples of Trust Schemes
 

(a)

Merger of CapitaLand Mall Trust (“CMT”) and CapitaLand Commercial Trust (“CCT”)
 

(i)

In 2020, CMT merged with CCT by a Trust Scheme (the “CMT-CCT Trust Scheme”) where CMT acquired all of the units of CCT at a consideration per unit of (A) S$0.259 and (B) 0.72 units in CMT.

(ii)

At CCT’s Trust Scheme Meeting, the CMT-CCT Trust Scheme was approved by approximately 90.31% of the CCT unitholders who were present and voting either in person or by proxy, which represented approximately 98.23% in value of the total number of units held by the CCT unitholders who voted.

(iii)

The High Court sanctioned the CMT-CCT Trust Scheme and CCT was subsequently delisted. Following CCT’s delisting, the enlarged trust was renamed CapitaLand Integrated Commercial Trust and had a market capitalization of approximately S$11.4 billion and a total portfolio property value of approximately S$22.4 billion.

(b)

Merger of OUE Commercial REIT (“OUE C-REIT”) and OUE Hospitality Trust (“OUE HT”)

 

  

(i)

In 2020, OUE C-REIT merged with OUE HT by a Trust Scheme (the “OUE C-REIT-OUE HT Trust Scheme”) where OUE C-REIT acquired all of the stapled securities in OUE HT at a consideration per stapled security of (A) S$0.04075 and (B) 1.3583 units in OUE C-REIT.

(ii)

At OUE HT’s Trust Scheme Meeting, the OUE C-REIT-OUE HT Trust Scheme was approved by approximately 89.47% of the OUE HT stapled securityholders who were present and voting either in person or by proxy, which represented approximately 96.19% in value of the total number of stapled securities held by the OUE HT stapled securityholders who voted.

(iii)

The High Court sanctioned the OUE C-REIT-OUE HT Trust Scheme and OUE HT was subsequently delisted. This was the first merger in Singapore between a SGX-ST-listed BT and a SGX-ST-listed REIT, and the enlarged trust had a market capitalization of approximately S$2.9 billion and a total portfolio property value of approximately S$6.9 billion.

5.5

RTO

 

5.5.1

In a RTO, the acquiror transfers to a Target Entity certain assets in consideration for new units or stapled securities in the Target Entity, following which the acquiror may be required to make, or may decide to make, a take-over offer for all the remaining units or stapled securities of the Target Entity that it does not hold. The acquiror will thereafter hold all the units or stapled securities of the Target Entity.

5.5.2

A RTO will typically require the approval of the SGX-ST and the unitholders or stapled securityholders for (a) the acquisition of the assets from the acquiror and (b) the issuance of new units or stapled securities in the Target Entity to the acquiror and listing of such units or stapled securities on the SGX-ST.

5.5.3

The principal steps of a RTO are the same as a take-over offer (as set out in paragraph 5.3.5 above) with a preliminary step of the Target Entity (a) acquiring the assets from the acquiror and (b) issuing new units or stapled securityholders in the Target Entity to the acquiror.

5.5.4

As at the time of writing of this primer, there has only been one instance of an acquiror attempting to carry out a RTO of a Target Entity, which was eventually aborted.

5.5.5

In 2016, following a Lone Star Funds’ affiliate’s acquisition of all the real estate assets in Saizen REIT’s portfolio in Japan, Saizen REIT announced that it had entered into an implementation agreement with Sime Darby Property Singapore Limited (“SDPSL”), Sime Darby Eastern Investments Private Limited and Perpetual Corporate Trust Limited (in its capacity as trustee of Sime REIT Australia) in respect of Saizen REIT’s proposed acquisition of some of SDPSL’s industrial properties in Australia (the “Properties Acquisition”). The Properties Acquisition was part of a proposed RTO of Saizen REIT by SDPSL.

5.5.6

However, this transaction was eventually aborted as Saizen REIT, without delving into the specifics, announced that “it [was] not possible to complete the [Properties Acquisition and the RTO] by the long-stop date of the implementation agreement”.

5.6

Which method to adopt?

 

5.6.1

Whether a take-over offer, a Trust Scheme or a RTO should be adopted ultimately depends on the commercial objective of the acquiror. If the acquiror wishes to acquire all of the units or stapled securities of a Target Entity, a Trust Scheme may be preferable, evident in how almost all the mergers involving REITs or BTs in Singapore till date were implemented by a Trust Scheme.

5.6.2

However, if the acquiror wishes to acquire only some of the units or stapled securities of a Target Entity, a partial offer would be preferable. A RTO is generally not adopted as the acquiror will have to provide certain assets prior to the take-over.

5.6.3

The composition of unitholders or stapled securityholders of the Target Entity would also be a relevant consideration, such as whether there are any minority unitholders or stapled securityholders which could potentially reject the take-over offer or vote against the Trust Scheme at the Trust Scheme Meeting. If so, it would be prudent for the REIT manager or the trustee-manager to engage with these minority unitholders or stapled securityholders and require them to sign irrevocable undertakings to accept the offer or vote in favor of all resolutions relating to the Trust Scheme prior to the announcement of the take-over offer or the Trust Scheme. If there is any resistance, the REIT manager or the trustee-manager should also work together with the potential acquiror to sweeten the deal.

5.6.4

An example of minority unitholders derailing the implementation of a Trust Scheme could be seen in the failed merger between ESR REIT and Sabana REIT.
   

(a)

In 2020, ESR REIT and Sabana REIT issued a joint announcement of ESR REIT’s intention to merge with Sabana REIT by a Trust Scheme (the “ESR-Sabana Trust Scheme”) with ESR REIT acquiring all the units in Sabana REIT for a consideration per unit of 0.94 units in ESR REIT (the “ESR Consideration”). The ESR-Sabana Trust Scheme required the approval by, among others:
 

(i)

the unitholders of Sabana REIT holding in aggregate 75% or more of the total number of votes cast for and against the resolution to approve the amendments to the trust deed constituting Sabana REIT to include provisions that will facilitate the implementation of the ESR-Sabana Trust Scheme (the “Sabana REIT Trust Deed Amendments Resolution”); and

(ii)

a majority in number of the unitholders of Sabana REIT representing at least three-fourths in value of the units held by the unitholders of Sabana REIT present and voting either in person or by proxy at the Trust Scheme Meeting (the “Sabana REIT Trust Scheme Resolution”).
 

The Sabana REIT Trust Scheme Resolution was contingent upon the approval of the Sabana REIT Trust Deed Amendments Resolution. This meant that in the event that the Sabana REIT Trust Deed Amendments Resolution was not passed, Sabana REIT would not proceed with the Trust Scheme Meeting.

(b)

At the EGM convened by Sabana REIT to pass the Sabana REIT Trust Deed Amendments Resolution (the “Sabana REIT EGM”), approximately 66.67% of the total number of votes for and against the resolution voted for the Sabana REIT Trust Deed Amendments Resolution. As less than 75% of the votes were cast in favor of the Sabana REIT Trust Deed Amendments Resolution, the Sabana REIT Trust Deed Amendments Resolution was not passed and, accordingly, Sabana REIT did not proceed with the Trust Scheme Meeting and the ESR-Sabana Trust Scheme was not implemented.

(c)

The failure of the Trust Scheme however did not come as a surprise.

Prior to the Sabana REIT EGM, Black Crane Investment Management Limited (“Black Crane”) and Quartz Capital Management Ltd (“Quartz Capital”), who collectively hold approximately 10% of the issued units in Sabana REIT, were vocal of their objections to the merger and embarked on a bruising campaign against the merger, which included:
 

(i)

Black Crane and Quartz Capital issuing a letter to the manager of Sabana REIT (the “Sabana REIT Manager”) on 7 August 2020 which stated that:
 

(A)

both Black Crane and Quartz Capital intend to vote against the merger of ESR REIT and Sabana REIT as, among others:
 

(I)

the ESR Consideration was at a substantial discount to the book value of Sabana REIT and “in the 18-year history of the Singapore REIT market with multiple takeovers/mergers, there has never been a single takeover/merger of a REIT target at such a substantial discount to book value”; and

(II)

the merger was a “bold attempt by ESR to potentially solve [a] conflict of interest issue at the expense of Sabana [REIT] unitholders”;

(B)

a conflict of interest existed as (I) ESR Cayman Limited was the ultimate controlling shareholder of the manager of ESR REIT (the “ESR REIT Manager”) and the Sabana REIT Manager and (II) ESR Cayman Limited, together with the parties acting in concert with it, were “top unitholders of both REITs with overlapping investment mandates”; and

(C)

the “substantial undervaluation” of the ESR Consideration “raises concerns on whether the fiduciary duty of [the Sabana REIT Manager’s] board and management to act and protect all unitholders’ interest has been potentially compromised”;

(ii)

Black Crane and Quartz Capital issuing a letter to the MAS and the SGX-ST on 17 August 2020 highlighting, among others, the “significant conflict of interest and corporate governance issues resulting from ESR Cayman Limited controlling [the ESR REIT Manager and the Sabana REIT Manager]”;

(iii)

Black Crane and Quartz Capital issuing a letter to the trustee of Sabana REIT on 3 September 2020 highlighting, among others, the “corporate governance and potential conflicts of interests of the [Sabana REIT Manager] due to: (A) the controlling ownership of ESR [Cayman Limited] in both [the ESR REIT Manager and the Sabana REIT Manager]; (B) the overlapping investment mandate of Sabana REIT and ESR REIT; and (C) ESR [Cayman Limited] together with its concert parties being substantial unitholders of both Sabana REIT and ESR REIT”;

(iv)

Black Crane and Quartz Capital requisitioning an EGM under the CIS Code relating to (A) the appointment of Ms. Ng Shin Ein as an independent director despite Ms. Ng Shin Ein having had “substantial business relationships with ESR Cayman [Limited] and its affiliates” and (B) the employment of three ex-ESR employees to senior management roles at the Sabana REIT Manager;

(v)

Black Crane and Quartz Capital requisitioning an EGM under the CIS Code relating to (A) the proposed removal of the Sabana REIT Manager and (B) the appointment of an “internal REIT manager owned by and for all unitholders”;

(vi)

Black Crane and Quartz Capital hosting a zoom webinar on 25 November 2020 relating to their vote against the merger;

(vii)

Black Crane and Quartz Capital issuing a letter to the Sabana REIT Manager on 15 December 2020 stating, among others, that the Sabana REIT Manager “is fully responsible for the failure of the disastrous and value destructive proposed merger between Sabana and ESR REITs”; and

(viii)

Black Crane and Quartz Capital creating the website, <www.savesabanareit.com> “to enable visitors to carefully monitor how sincerely the board and management of Sabana REIT address unitholders’ proposals, listen to unitholders’ views and endeavour to increase the value of the Sabana REIT units in the best interest of all unitholders”.

(d)

Both the ESR REIT Manager and the Sabana REIT Manager attempted to put out the fire created by Black Crane and Quartz Capital through a series of announcements which in summary:
 

(i)

acknowledged that there was a discount to the net asset value (“NAV”) of Sabana REIT, but the merger of ESR REIT and Sabana REIT would create an enlarged REIT, which “offer[ed] the best opportunity for re-rating and for reducing the NAV discount in the long term as part of a larger, more liquid and scalable REIT”;

(ii)

stated that (A) there were “strict internal controls” in both ESR REIT and Sabana REIT, (B) ESR Cayman Limited’s stake in the Sabana REIT Manager is held through an independent third party trustee licensed in Singapore, (C) there are no overlaps in the management teams of both the ESR REIT Manager and the Sabana REIT Manager and (D) there is no sharing of information between both the ESR REIT Manager and the Sabana REIT Manager; and

(iii)

stated that Black Crane’s and Quartz Capital’s claims were unsubstantiated and they “owe it to unitholders to act responsibly and justify their statements”.

(e)

Suffice to say both the ESR REIT Manager’s and the Sabana REIT Manager’s efforts were not successful against Black Crane’s and Quartz Capital’s onslaughts on the merger.

(f)

If the Sabana REIT Manager had engaged with Black Crane and Quartz Capital prior to the announcement of the Trust Scheme, perhaps this debacle would not have occurred, with no ink spilled and no sharp exchanges between both sides.

Even if the Sabana REIT Manager was not able to engage with Black Crane and Quartz Capital prior to the announcement of the Trust Scheme due to perhaps confidentiality reasons, it should have done so the moment the first signs of resistance surfaced. Instead of going on the defensive, the Sabana REIT Manager could have engaged with Black Crane and Quartz Capital, while simultaneously working with the ESR REIT Manager to sweeten the deal.

It is crucial to note that Quartz Capital had on 14 November 2019 proposed that ESR REIT merge with Sabana REIT “in a cash and unit transaction where 0.92 units of ESR REIT and S$0.067 of cash will be exchanged for one unit of Sabana REIT” so as to “solve the critical issue of overlapping investment mandates between the two trusts”. This may suggest that the minority unitholders’ principal objection lay in the offer price and if there were any sweeteners to the deal, such as revising the offer price, the minority unitholders’ could likely be struck by cupid’s arrow and agree to the merger. After all, no one is entirely immune from cupid’s arrow.

Introducing deal sweeteners is not uncommon. In the merger of CMT and CCT, the respective REIT managers worked together and sweetened the deal by ensuring a higher accretion to their respective distribution per unit and the manager of CMT also waived the acquisition fees due from CMT that amounted to approximately S$111.2 million. In the take-over of Forterra Trust, New Precise Holdings raised its cash offer from S$1.85 to S$2.25 per unit.

If the foregoing actions were taken, the merger could perhaps have succeeded. More importantly, the Sabana REIT Manager would not be caught in the situation it is in after the failed merger – dealing with the reputational fallout arising from the failed merger and the adversarial stance of Black Crane and Quartz Capital, as well as the increased public scrutiny on its management of Sabana REIT.

Black Crane and Quartz Capital, perhaps emboldened by the failed merger, have repeatedly opposed certain management decisions of the Sabana REIT Manager since the failed merger. Recently, after Mr. Chan Wai Kheong was appointed as an independent non-executive director of the Sabana REIT Manager, Black Crane and Quartz Capital requisitioned an EGM on 2 August 2021 to pass a resolution that the appointment of Mr. Chan Wai Kheong “be endorsed by the independent unitholders”. Black Crane and Quartz Capital highlighted that Mr. Chan Wai Kheong was arguably not independent and there exists a “real and significant risk” of a conflict of interest as he “had received a substantial premium of approximately S$22 million over market price from ESR Cayman [Limited] and is also a substantial unitholder of AIMS APAC, a major competitor to Sabana REIT”.

The Sabana REIT Manager rejected convening the EGM stating, among others, that (i) the unitholders have “the opportunity to vote in relation to the endorsement of Mr. Chan Wai Kheong as an independent director by the next annual general meeting” and (ii) “it would be in the best interest of unitholders for the [Sabana REIT Manager] to be allowed to focus on improving Sabana REIT’s performance and results instead of convening [the EGM]”.

(g)

Whether the failed merger is a victory or pyrrhic victory for the unitholders of Sabana REIT remains to be seen. It is nevertheless a cautionary tale of the importance of considering the composition of the unitholders or stapled securityholders and engaging any minority unitholders or stapled securityholders prior to announcing any take-over offer or Trust Scheme. Where necessary, deal sweeteners should be introduced.

5.6.5

If the acquiror wishes to gain control of the management of a Target Entity, a more cost effective alternative to acquiring the units or stapled securities in the Target Entity would be to acquire the shares of the REIT manager and/or trustee-manager of the Target Entity. As a REIT manager manages the business of a REIT and a trustee-manager manages the business of a BT, such an acquisition allows the acquiror to effectively control the Target Entity. Additional approvals (such as approval from the MAS in relation to an acquisition of shares of a REIT manager) may however be required.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please feel free to contact the Gibson Dunn lawyer with whom you usually work, or the authors of this primer in the firm’s Singapore office:

Robson Lee (+65.6507.3684, RLee@gibsondunn.com)
Kai Wen Chua (+65.6507.3658, KChua@gibsondunn.com)
Zan Wong (+65.6507.3657, ZWong@gibsondunn.com)

© 2021 Gibson, Dunn & Crutcher LLP

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On 21 May 2021, the Hong Kong government published the Consultation Conclusions[1] on legislative proposals to enhance anti-money laundering and counter-terrorist financing (“AML/CTF”) regulations in Hong Kong, including a proposal to introduce a licensing regime for virtual asset services providers (“VASPs”). This client alert discusses the proposed scope of the licensing regime, the proposed regulatory requirements for licence holders, implications for cryptocurrency trading platforms, and opportunities for the future development of such trading platforms in Hong Kong.

Note that the discussions in this alert are based on the Consultation Conclusions. While unlikely, there could still be further changes in the drafting of the legislation before the laws are passed. Importantly there will be further public consultation before the detailed regulatory regime for licence holders, including applicable guidelines, are published, as discussed below.

I. Why introduce a licensing regime for VASPs?

In recent years, the world has seen tremendous growth in the trading of virtual assets (“VAs”) including cryptocurrencies like bitcoin. This drew the attention of the Financial Action Task Force (“FATF”), which expressed concern about the perceived money laundering and terrorist financing (“ML/TF”) risks arising from the growing use of VAs. To address these ML/TF risks, the FATF updated the FATF Standards in February 2019[2] to require jurisdictions to subject VASPs to the same range of AML/CTF obligations as financial institutions. To fulfil its obligations as a member of FATF, the Hong Kong government launched a public consultation on 3 November 2020.[3] Amongst other things, the consultation proposed amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (“AMLO”) to introduce a licensing regime for VASPs. The public consultation period ended on 31 January 2021, and the Consultation Conclusions were published on 21 May 2021.

II. Scope of proposed licensing regime for VASPs

The proposed licensing regime for VASPs would designate the business of operating a VA exchange as a “regulated VA activity”. As such, any person seeking to operate a VA exchange in Hong Kong would be required to apply for a licence[4] from the Hong Kong Securities and Futures Commission (“SFC”) to become a licensed VASP under the AMLO. The granting of the licence would be subject to meeting the SFC’s fit-and-proper test and other regulatory requirements, which we discuss further below.

The proposed definition of a “VA exchange” is any trading platform which:

  • Is operated for the purpose of allowing an invitation to be made to buy or sell any VA in exchange for any money or any VA; and
  • Comes into custody, control, power or possession of, or over, any money or any VA at any time during the course of its business.

Accordingly, a peer-to-peer trading platform would not fall within the definition of a VA exchange provided that the actual transactions in VAs are conducted outside the platform and the platform is not involved in the underlying transaction by coming into possession of any money or any VA at any point in time (i.e. platforms that only provide a forum for buyers and sellers to post their bids and offers, where the parties themselves transact outside the platform). As such, on the basis of the current drafting, it is possible that decentralised exchanges (“DEXs”) that operate on the basis of non-custodial storage (as opposed to centralised exchanges where users give up custody of their assets to the exchange) and without a centralised entity in charge of the order book, may not ultimately be caught by the definition of a VA exchange.

The proposed definition of “VA” means a digital representation of value that:

  • Is expressed as a unit of account or a store of economic value;
  • Functions (or is intended to function) as a medium of exchange accepted by the public as payment for goods or services or for the discharge of debt, or for investment purposes; and
  • Can be transferred, stored or traded electronically.

The definition of “VA” is therefore likely to include cryptocurrencies such as bitcoin and VAs backed by another asset for the purpose of stabilising its value (i.e. stablecoins). On the other hand, the definition of VA would not cover:

  • Digital representations of fiat currencies (such as digital currencies issued by central banks);
  • Financial products already regulated under the Securities and Futures Ordinance (“SFO”);
  • Closed-loop, limited purpose items that are non-transferable, non-exchangeable and non-fungible (e.g. air miles, credit card rewards, gift cards, customer loyalty points, gaming coins, etc.); and
  • Stored value facilities which are regulated under the Payment Systems and Stored Value Facilities Ordinance.

Depending on the final drafting of the legislative amendment to introduce the licensing regime for VASPs, it appears that non-fungible tokens (“NFTs”) may fall outside the definition of “VA”. In that scenario NFT trading platforms would also fall outside the scope of the licensing regime

III. Implications for non-Hong Kong cryptocurrency exchanges

The proposed licensing regime for VASPs would also extend to VA exchanges which operate outside of Hong Kong, but which actively market to the public of Hong Kong. This means that a cryptocurrency exchange that is based outside of Hong Kong will be prohibited from ‘actively marketing’ regulated VA activity (i.e. operating a VA exchange) to the public of Hong Kong unless they are a licensed VASP. This would be similar to existing prohibitions under the SFO[5] on actively marketing regulated activities to the public of Hong Kong (see below). In the context of the SFO, the meaning of actively markets is potentially broad, with some guidance available from the SFC[6] and in case law on its interpretation.

IV. Crypto assets which are securities or futures contracts are already regulated under the SFO

It is important to note that financial products which are already regulated under the SFO would not fall within the definition of “VA”, and therefore trading platforms which enable trading in such products would not fall within the licensing regime for VASPs.  An example of such financial products is bitcoin futures which, depending on its terms and features, would likely either fall within the definition of “securities” or “futures contracts” under the SFO (and therefore would not be considered VAs).[7]

However, such trading platforms may already fall within the SFO regulatory regime for providing automated trading services, if it operates in or from Hong Kong, or actively markets to the public in Hong Kong (even if the platforms are based outside of Hong Kong). In this respect, in November 2019, the SFC published a position paper[8] which outlined the regulatory standards for the licensing of trading platforms that enable trading of crypto assets which have “securities” features.

V. Proposed licensing requirements for licensed VASPs

  • Eligibility: applicants must either be incorporated in Hong Kong, or non-Hong Kong incorporated companies which are registered in Hong Kong under the Companies Ordinance.
  • Fit-and-proper test: in considering whether or not an applicant is fit-and-proper to be granted a VASP licence, the SFC will take into account, among other matters, whether or not the applicant has been convicted of an ML/TF offence or other offence involving fraud, corruption or dishonesty, their experience and qualifications, their good standing and financial integrity, etc. This fit-and-proper test is likely to be very similar to, if not derived from, the well-established fit-and-proper test which applicants are required to satisfy to be granted a regulated activity licence under the SFO.
  • Two responsible officers: as with any firm currently licensed by the SFC, applicants will need to appoint at least two responsible officers to assume the responsibility of ensuring compliance with AML/CTF and other regulatory requirements, who may be held personally accountable in case of non-compliance.

VI. Regulatory requirements for licensed VASPs

Licensed VASPs will be subject to the AML/CTF requirements stipulated in Schedule 2 of the AMLO (i.e. the same as financial institutions), including customer due diligence and record-keeping requirements.

In addition to AML/CTF requirements, licensed VASPs will also be subject to regulatory requirements designed to protect market integrity and investor interests. These requirements will be set out in codes and guidelines to be published by the SFC. Licensed VASPs would be required to comply with these requirements under licensing conditions imposed by the SFC. These requirements are likely to be wide-ranging in scope, with prescribed requirements covering, among other things, financial resources, risk management, segregation and management of client assets, financial reporting, prevention of market manipulative and abusive activities, prevention of conflicts of interest, etc.

Notably, licensed VASPs will only be able to provide services to professional investors, i.e. high net worth and institutional investors. This means that after the commencement of the licensing regime for VASPs, licensed VASPs cannot provide services to retail investors.

VII. Supervisory powers of the SFC over licensed VASPs

The SFC will be given broad powers to supervise the AML/CTF and regulatory compliance of licensed VASPs. This will include powers to enter business premises, to request the production of documents and records, to investigate non-compliance and to impose sanctions (including orders for remedial actions, civil penalties and suspension or revocation licence) for non-compliances. The SFC will also have intervention powers to impose restrictions and prohibitions against the operations of licensed VASPs and their associated entities where the circumstances warrant, such as to prohibit further transactions or restrict the disposal of property. These powers enable the SFC to protect client assets in the event of emergency and to prevent the dissipation of client assets in the case of misconduct by a licensed VASP.

VIII. Timing

The Hong Kong government aims to introduce the AMLO amendment bill into the Legislative Council in the 2021-22 legislative session, which is due to commence in October 2021. The SFC will also prepare and publish for consultation the regulatory requirements for licensed VASPs, before commencement of the licensing regime for VASPs. Considering the above, the licensing regime is unlikely to commence before 2022. In any event there will be a 180-day transitional period from the commencement of the licensing regime to facilitate licence applications by interested parties.

IX. Conclusion

While the primary motivation for introducing the licensing regime for VASPs is to ensure that Hong Kong meets the latest FATF Standards, the Hong Kong authorities are also focused on promoting the protection of market integrity and investor interests, and the regulatory requirements for licensed VASPs extend beyond AML/CTF requirements by seeking to regulate matters including customer type (i.e. professional investors only), prevention of market manipulative and abusive activities, and prevention of conflicts of interest.

As Mr. Christopher Hui, Secretary for Financial Services and the Treasury, recently said in his remarks at a fintech forum,[9] the introduction of the licensing regime for VASPs is intended to facilitate the development of such an industry by providing a clear regulatory framework for the industry to operate within. Notably, the original proposal for the licensing regime has now been amended to allow non-Hong Kong companies to apply for a VASP licence[10] which may help to attract overseas crypto asset trading platforms that wish to develop their business within the Hong Kong regulatory framework.

For current VASPs contemplating applying for a VA licence when the licensing regime commences, we would recommend starting by reviewing their existing AML/CTF policies and systems and controls to identify gaps with the requirements under Schedule 2 of the AMLO. This is because these requirements are unlikely to be significantly modified during the legislative process, and it may take time and resources to design and implement. VASPs should also be alert to future consultations by the SFC on the codes and guidelines for licensed VASPs in order to identify the detailed regulatory requirements which licensed VASPs would need to comply with. Implementing these requirements will likely require preparing written policies and procedures, upgrading systems and controls, and potentially restructuring aspects of their business and operations to address potential conflicts of interest.

__________________________

   [1]   Consultation Conclusions on Public Consultation on Legislative Proposal to Enhance Anti-Money Laundering and Counter-Terrorist Financing Regulation in Hong Kong (May 2021), published by the Financial Services and the Treasury Bureau, available at: https://www.fstb.gov.hk/fsb/en/publication/consult/doc/consult_conclu_amlo_e.pdf

   [2]   Public Statement – Mitigating Risks from Virtual Assets (22 February 2019), published by FATF, available at: https://www.fatf-gafi.org/publications/fatfrecommendations/documents/regulation-virtual-assets-interpretive-note.html

   [3]   Government launches consultation on legislative proposal to enhance anti-money laundering and counter-terrorist financing regulation (3 November 2020), Hong Kong government press release, available at: https://www.info.gov.hk/gia/general/202011/03/P2020110300338.htm

   [4]   There will be an exception for a VA exchange that is already regulated as a licensed corporation in the voluntary opt-in regime supervised by the SFC pursuant to the SFO.

   [5]   Section 115 of the SFO.

   [6]   “Actively markets” under section 115 of the SFO (last updated 17 March 2003), published by the SFC, available at: https://www.sfc.hk/en/faqs/intermediaries/licensing/Actively-markets-under-section-115-of-the-SFO#9CAC2C2643CF41458CEDA9882E56E25B

   [7]   Circular to Licensed Corporations and Registered Institutions on Bitcoin futures contracts and cryptocurrency-related investment products (11 December 2017), published by the SFC, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=17EC79

   [8]   Position paper: Regulation of virtual asset trading platforms (6 November 2019), published by the SFC, available at: https://www.sfc.hk/-/media/EN/files/ER/PDF/20191106-Position-Paper-and-Appendix-1-to-Position-Paper-Eng.pdf

   [9]   Secretary for Financial Services and the Treasury, Mr. Christopher Hui, remarks at StartmeupHK Festival – Virtual FinTech Forum on 27 May 2021, available at: https://www.news.gov.hk/eng/2021/05/20210527/20210527_131949_094.html

  [10]   The non-Hong Kong incorporated company would need to be registered in Hong Kong under the Companies Ordinance.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you would like to discuss further, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Financial Institutions practice group, or the following authors:

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