Q&A: equity derivatives in Hong Kong – Lexology

Overview

Typical types of transactions

Other than transactions between dealers, what are the most typical types of over-the-counter (OTC) equity derivatives transactions and what are the common uses of these transactions?

Typical types of OTC equity derivatives transactions in Hong Kong include the following (together with common uses):

• options and swaps: commonly used for hedging purposes or to monetise an equity stake and for synthetic or physical share repurchases; in the convertible debt context, call spread transactions are entered into to effectively increase the conversion price of convertible debt; 
• margin loans: commonly used to monetise or leverage large equity stakes held by shareholders (usually involving the granting of security over the underlying shares);
• collars, prepaid forward contract and collar loans: used to monetise a position, and as a hedge to limit the range of possible positive or negative returns; and
• stock borrowing transactions and economic equivalents: often entered into between a shareholder of the issuer and the underwriter of the issuer’s convertible debt (and, separately, between such an underwriter and the holders of such convertible debt) to enable the holders of such convertible debt to hedge their equity exposure by short selling in the market.

Borrowing and selling shares

May market participants borrow shares and sell them short in the local market? If so, what rules govern short selling?

Yes, market participants may borrow shares and short sell them in the local market provided that:

• the securities are on the list of designated securities eligible for short selling published by The Stock Exchange of Hong Kong Limited (SEHK); and
• they comply with the relevant trading rules of the SEHK.

Under the Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong) (SFO), naked short selling of shares in Hong Kong is prohibited. Under section 170 of the SFO, a person shall not sell securities at or through a recognised stock market unless, at the time that person sells them: that person has or, where that person is selling as an agent, that person’s principal has; or that person believes and has reasonable grounds to believe that he or she has or, where selling as an agent, that his or her principal has, a presently exercisable and unconditional right to vest the securities in the purchaser of them. Separately:

• under the Securities and Futures (Short Position Reporting) Rules, any person who has a reportable short position is required to notify the Securities and Futures Commission by making a submission through the Short Position Reporting Service; and
• any short selling is subject to the general provisions on market misconduct in the SFO.

Applicable laws and regulations for dealers

Describe the primary laws and regulations surrounding OTC equity derivatives transactions between dealers. What regulatory authorities are primarily responsible for administering those rules?

While there is no single unified regulatory framework on OTC equity derivatives transactions between dealers in Hong Kong, the Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong) (SFO) is the legislation of primary relevance. Among other things, it sets out:

• the licensing requirements for dealers in Hong Kong and the framework for mandatory clearing, reporting, record-keeping and trading requirements in Hong Kong;
• the authorisation requirements for advertisement, invitation or document in respect of the offering of structured products or equity derivatives products to the public in Hong Kong; and
• civil and criminal liabilities in respect of insider dealing, false trading, price rigging, stock market manipulation, disclosure of information about prohibited transactions and disclosure of false and misleading information inducing transactions.

The Securities and Futures Commission (and, in certain respects, the Hong Kong Monetary Authority (HKMA)) are responsible for administering the SFO. Moreover, the HKMA plays a role in the OTC equity derivatives transactions by regulating authorised institutions and approved money brokers in respect of capital, liquidity and other relevant requirements under the Banking Ordinance (Cap. 155 of the laws of Hong Kong), together with subsidiary legislation, regulations and guidelines.

In addition to the above, OTC equity derivatives transactions that reference shares of a listed company are subject to the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited.

Entities

In addition to dealers, what types of entities may enter into OTC equity derivatives transactions?

There are no specific prohibitions on the types of entities that may enter into OTC equity derivatives transactions. Subject to the memorandum and articles of association, charters or other constitutional documents of the relevant entities (as applicable), corporates, funds and private companies, as well as individuals, may enter into OTC equity derivatives transactions.

Applicable laws and regulations for eligible counterparties

Describe the primary laws and regulations surrounding OTC equity derivatives transactions between a dealer and an eligible counterparty that is not the issuer of the underlying shares or an affiliate of the issuer? What regulatory authorities are primarily responsible for administering those rules?

The Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong) (SFO) is the primary regime governing OTC equity derivatives transactions in Hong Kong between a dealer and an eligible counterparty that is not the issuer of the underlying shares or an affiliate of the issuer. The SFO sets out the licensing requirements for dealers in Hong Kong and the laws relating to advertisement, invitation and offering document made in respect of the offering of structured products or equity derivatives products to the public in Hong Kong. The Securities and Futures Commission is the regulatory authority primarily responsible for the administering of the SFO.

Securities registration issues

Do securities registration issues arise if the issuer of the underlying shares or an affiliate of the issuer sells the issuer’s shares via an OTC equity derivative?

No Hong Kong law securities registration issues arise if the issuer of the underlying shares or an affiliate of the issuer sells the issuer’s shares via an OTC equity derivative. However, the seller should comply with the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32 of the laws of Hong Kong), the Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong) and the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited when conducting such sale. Generally speaking, it is uncommon for the issuer of the underlying shares or an affiliate of the issuer to sell the issuer’s shares via an OTC equity derivative.

Repurchasing shares

May issuers repurchase their shares directly or via a derivative?

An issuer may repurchase their shares either directly or via a derivative. An issuer may engage in four different types of share buy-back:

• on-market share buy-back;
• off-market share buy-back;
• exempt share buy-back; and
• share buy-back by general offer.

The Code on Share Buy-Backs published by the Securities and Futures Commission (SFC) sets out the rules and procedures relating to share buy-backs. In particular, for an off-market share buy-back, approval must be granted by at least three-fourths of the votes cast on a poll by disinterested shareholders in attendance or by proxy at a general meeting of the shareholders of the issuer and such buy-back must be approved by the Executive Director of the Corporate Finance Division of the Securities and Futures Commission or his or her delegate. For on-market buy-backs, the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited also set out additional rules and regulations that an issuer must comply with, such as timing and price restrictions.

In the case where the issuer enters into a cash-settled equity derivatives transaction referencing its own shares, the buy-back rules set out above do not apply.

The general provisions of the Companies Ordinance (Cap. 622 of the laws of Hong Kong) and the SFO with respect to financial assistance and market misconduct, etc., will also need to be considered.

Risk

What types of risks do dealers face in the event of a bankruptcy or insolvency of the counterparty? Do any special bankruptcy or insolvency rules apply if the counterparty is the issuer or an affiliate of the issuer?

There are no special bankruptcy or insolvency rules that would apply to a counterparty if it is the issuer or an affiliate of the issuer.

However, more generally, in the case of a bankruptcy or insolvency of a counterparty, the key risk that a dealer would face is credit risk (its ability to recover any amounts and collateral owed to it by the counterparty). Generally speaking, a secured creditor may take enforcement action in respect of a validly granted and perfected security interest, irrespective of whether the counterparty is factually or legally insolvent.

For a counterparty that is a Hong Kong company, the principal insolvency legislation is the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32 of the laws of Hong Kong) (C(WUMP)O) (in the case of an authorised institution, the Banking Ordinance (Cap. 155 of the laws of Hong Kong) is also relevant and for an individual, the principal bankruptcy legislation is the Bankruptcy Ordinance (Cap. 6 of the laws of Hong Kong)). The C(WUMP)O sets out the primary statutory grounds upon which a liquidator of a counterparty being wound up may seek to challenge a transaction, including unfair preference, transaction at an undervalue, extortionate credit transactions, dispositions of property after commencement of winding up and floating charge created within the relevant hardening period.

The moratorium under section 186 of the C(WUMP)O that generally applies upon a winding-up order being made, or a provisional liquidator being appointed, in respect of a counterparty will not prevent a termination right against the counterparty being exercised (or an out-of-court of enforcement of security over the counterparty’s assets).

If the counterparty is a ‘within scope financial institution’ for the purposes of the Financial Institutions (Resolution) Ordinance (Cap. 628 of the laws of Hong Kong), certain obligations of the counterparty may be temporarily suspended and termination rights against the counterparty may be temporarily stayed, but set-off, netting, title transfer and security arrangements are generally protected in relation to partial property transfers and bail-in.

As regards OTC equity derivatives transactions documented using an ISDA Master Agreement, ISDA has commissioned Hong Kong legal opinions regarding the enforceability of, among other things, close-out netting under an ISDA Master Agreement and collateral arrangements constituted under standard ISDA documentation.

Reporting obligations

What types of reporting obligations does an issuer or a shareholder face when entering into an OTC equity derivatives transaction on the issuer’s shares?

For a listed issuer, the key reporting obligations arise under Part XIVA of the Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong) (SFO) and the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (SEHK Listing Rules). Under Part XIVA of the SFO, a listed issuer is required to disclose specific material price sensitive information (about the issuer, a shareholder or officer of the issuer, or listed securities of the issuer or their derivatives) to the public as soon as reasonably practicable. A similar requirement is also set out in Rule 13.09(2) of the SEHK Listing Rules, which requires a listed issuer to simultaneously announce the information when the listed issuer is required to do so under Part XIVA of the SFO. Moreover, listed issuers are required to disclose certain ‘notifiable transactions’ and ‘connected transactions’ under the SEHK Listing Rules.

Under Part XV of the SFO, directors, chief executives and substantial shareholders of a listed issuer are required to disclose their interests in voting rights in the listed company. Generally speaking, a director or a chief executive of the listed company must disclose all interests and short positions in any shares of the listed company as well as all dealings in respect of such interests and positions. In contrast, the disclosable obligations of a shareholder are triggered when such person holds a long interest of 5 per cent or above and applies to any changes in such interest that cross a whole percentage point above the 5 per cent threshold. More generally, the disclosure obligations:

• take into account parties acting in concert;
• are applicable to OTC equity derivatives transactions on a gross basis (no netting of long and short positions); and
• apply regardless of whether a transaction is cash or physically settled.

Obligations under the Securities and Futures Commission Code of Takeovers and Mergers to disclose certain dealings during an offer period should also be taken into account.

Restricted periods

Are counterparties restricted from entering into OTC equity derivatives transactions during certain periods? What other rules apply to OTC equity derivatives transactions that address insider trading?

The Model Code For Securities Transactions By Directors Of Listed Issuers (ie, the required standard that The Stock Exchange of Hong Kong Limited requires all listed issuers and their directors to meet, any breach of which is regarded as a breach of the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited) provides that, in essence, a director of a listed company is prohibited from dealing in the securities of such company:

• at any time when he or she possesses inside information in relation to those securities;
• on any day on which its financial results are published;
• during the period of 60 days immediately preceding the publication date of the annual results; and
• during the period of 30 days immediately preceding the publication date of the quarterly results (if any) and half-year results.

This restriction on dealings also extends to dealings by, among others, a director’s spouse and minor children.

In addition, the Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong) (SFO) has civil and criminal regimes (Parts XIII and XIV of the SFO) in respect of market misconduct. In particular, the SFO defines various categories of ‘insider dealing’ in relation to a listed company including:

• a person connected with the issuer who has information that he or she knows is inside information in relation to the issuer:
  • deals in the issuer’s listed securities or their derivatives (or those of a related corporation); or
  • counsels or procures another person to deal in such securities or derivatives, knowing or having reasonable cause to believe that the other person will deal in them; and
• a person connected with the issuer and knowing that any information is inside information in relation to the issuer, discloses the information, directly or indirectly, to another person, knowing or having reasonable cause to believe that the other person will make use of the information for the purpose of dealing, or of counselling or procuring another person to deal, in the listed securities of the issuer or their derivatives (or those of a related corporation).

There are various defences available under the SFO for insider dealing, such as the ‘market information’ defence, the ‘Chinese wall’ defence and where the use of inside information was not for the purpose of securing or increasing a profit or avoiding or reducing a loss, whether for him or herself, or another person.

In addition to insider dealing, the SFO also contains provisions relating to other forms of market misconduct, including false trading, price rigging, stock market manipulation, disclosure of information about prohibited transactions and disclosure of false and misleading information inducing transactions.

Legal issues

What additional legal issues arise if a counterparty to an OTC equity derivatives transaction is the issuer of the underlying shares or an affiliate of the issuer?

An OTC equity derivatives transaction entered into between an issuer of the underlying shares and an affiliate of the issuer over the issuer’s shares may also rise to ‘connected transaction’ issues. A connected transaction is a transaction entered into between the listed company and its ‘connected person’ (which includes, among others, a director, chief executive or substantial shareholder of the listed company or any of its subsidiaries as well as any connected subsidiary of the issuer). Unless such transaction falls within certain exemptions that are available under Chapter 14A of the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited, disclosure requirements may apply to such transaction and approvals of the shareholders of the listed company may be required.

More generally, where an issuer is entering into an OTC equity derivatives transaction that provides it with a long position over its own shares, it should be mindful of any share repurchase issues. Further, there are often public policy considerations in relation to issuers entering into derivatives over their own shares. As such, an issuer would generally discuss the transaction structure with The Stock Exchange of Hong Kong Limited before entering into such a transaction.

Tax issues

What types of taxation issues arise in issuer OTC equity derivatives transactions and third-party OTC equity derivatives transactions?

Stamp duty will be payable upon physical settlement of an equity derivatives transaction in respect of Hong Kong stock. The rate of stamp duty payable is 0.2 per cent on the higher of the consideration or the value of the shares. An additional amount of HK$5 is payable on the instrument of transfer.

The Financial Secretary proposed in the 2021/22 Hong Kong Budget for an increase to the rate of stamp duty payable in respect of Hong Kong stock transfers from 0.2 per cent to 0.26 per cent on the higher of the consideration or the value of the shares. According to the Revenue (Stamp Duty) Bill gazetted on 5 March 2021, the new rate will come into effect on 1 August 2021.

Stamp duty relief is available for securities lending and borrowing transactions provided that such transactions fall within the conditions set out in the Stamp Duty Ordinance (Cap. 117 of the laws of Hong Kong).

Liability regime

Describe the liability regime related to OTC equity derivatives transactions. What transaction participants are subject to liability?

Issuances and marketing of structured products are subject to the Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong) (SFO). Under section 103 of the SFO, a person commits an offence if he or she issues, or has in his or her possession for the purposes of issue, whether in Hong Kong or elsewhere, an advertisement, invitation or document that to his or her knowledge is or contains an invitation to the public to enter into or offer to enter into an agreement to acquire, dispose of, subscribe for or underwrite any structured products, unless the issue is authorised by the Securities and Futures Commission under section 105 of the SFO or an exemption applies (eg, offers solely to persons outside of Hong Kong and offers to professional investors).

For unlisted structured investment products offered to the public in Hong Kong, the Code on Unlisted Structured Investment Products (including the content requirements for offering documents in respect of an offering of Unlisted Structured Investment Products) must also be complied with.

Various offences and civil liabilities set out in the SFO are also relevant to the issuance of structured products. Examples are given below.

Civil liability

• section 108: civil liability for inducing others to invest money;
• section 277: disclosure of false or misleading information inducing transactions;
• section 281: civil liability for market misconduct;
• section 305: civil liability for contravention of Part XIV of the SFO; and
• section 391: civil liability for false or misleading public communications concerning securities and futures contracts.

Criminal offences

• section 107: offence to fraudulently or recklessly induce others to invest money;
• section 298: offence of disclosure of false or misleading information inducing transactions;
• section 300: offence involving fraudulent or deceptive devices;
• section 384: provision of false or misleading information; and
• section 390: liability of officers of corporations for offences by corporations, and of partners for offences by other partners.

Liability for an issuer of structured products may also arise under common law, for example, on the basis of misrepresentations.

Market misconduct such as insider trading can also incur civil and criminal liability, and directors of listed issuers and connected persons are prohibited from dealing in the company’s securities in certain circumstances.

Stock exchange filings

What stock exchange filings must be made in connection with OTC equity derivatives transactions?

Listed issuers are required to disclose certain ‘notifiable transactions’ and ‘connected transactions’ under the SEHK Listing Rules.

Under Part XV of the SFO, directors, chief executives and substantial shareholders of a listed issuer are required to disclose their interests in voting rights in the listed company. Generally speaking, a director or a chief executive of the listed company must disclose all interests and short positions in any shares of the listed company as well as all dealings in respect of such interests and positions. In contrast, the disclosable obligations of a shareholder are triggered when such person holds a long interest of 5 per cent or above and applies to any changes in such interest that cross a whole percentage point above the 5 per cent threshold. More generally, the disclosure obligations:

• take into account parties acting in concert;
• are applicable to OTC equity derivatives transactions on a gross basis (no netting of long and short positions); and
• apply regardless of whether a transaction is cash or physically settled.

Obligations under the Securities and Futures Commission Code of Takeovers and Mergers to disclose certain dealings during an offer period should also be taken into account.

Typical document types

What types of documents are typical in an OTC equity derivatives transaction?

For OTC equity derivatives transactions, parties typically use standard derivatives documentation published by ISDA, being either the 1992 or the 2002 ISDA Master Agreement (entered separately or incorporated via a long-form confirmation) and its related credit support documentation, and the 2002 ISDA Equity Derivatives Definitions.

For repo transactions, parties typically use the standard form Global Master Repurchase Agreement published by the International Capital Markets Association, while for stock borrowing and lending transactions, the standard form Global Master Securities Lending Agreement is commonly used in Hong Kong.

Institutional lenders typically document margin loan transactions using their internal form of loan documentation. Such documentation is usually based on the standard forms published by the Loan Market Association or the Asia Pacific Loan Market Association.

Legal opinions

For what types of OTC equity derivatives transactions are legal opinions typically given?

Opinions relating to the capacity and authority of the counterparties are typically given for OTC derivatives transactions. Enforceability opinions are also typically given for transactions that are not based on ISDA documentation (for transactions that are based on ISDA documentation, enforceability opinions are generally only given in relation to material bespoke aspects that are not covered by the ISDA commissioned opinions). Additional opinions and memoranda may also be given regarding specific regulatory issues and enforcement scenarios.

Hedging activities

May an issuer lend its shares or enter into a repurchase transaction with respect to its shares to support hedging activities by third parties in the issuer’s shares?

It is not possible for an issuer to lend its own shares in Hong Kong and any repurchase of shares carried out by an issuer must comply with the laws and regulations relating to share repurchases.

Securities registration

What securities registration or other issues arise if a borrower pledges restricted or controlling shareholdings to secure a margin loan or a collar loan?

Rule 10.07 of the SEHK Listing Rules prohibits a ‘controlling shareholder’ from, among other things:

• within six months of listing, creating security over any shares of such listed company; and
• in the subsequent six months, creating security over shares of such listed company if, immediately following the enforcement of such security, that person would cease to be a controlling shareholder.

A ‘controlling shareholder’ is any person who is or group of persons:

• entitled to exercise or control the exercise of 30 per cent or more of the voting power at general meetings of the issuer; or
• in a position to control the composition of a majority of the board of directors of the issuer.

Certain exemptions apply to Rule 10.07. For example, a ‘controlling shareholder’ may pledge the shares of such listed company owned by him or her in favour of an AI for a bona fide commercial loan, provided that certain conditions and disclosure requirements are complied with.

Separately, under Rule 13.17 of the SEHK Listing Rules, where a ‘controlling shareholder’ has pledged all or part of its interest in the shares of the listed company to secure such company’s debts or to secure guarantees or other support of its obligations, such company must announce certain information, including:

• the number and class of shares being pledged;
• the amounts of debts, guarantees or other support for which the pledge is made; and
• any other details that are considered necessary for an understanding of the arrangements.

A ‘controlling shareholder’ should also be mindful of any contractual restrictions or lock-up arrangement imposed on the shares.

Borrower bankruptcy

If a borrower in a margin loan files for bankruptcy protection, can the lender seize and sell the pledged shares without interference from the bankruptcy court or any other creditors of the borrower? If not, what techniques are used to reduce the lender’s risk that the borrower will file for bankruptcy or to prevent the bankruptcy court from staying enforcement of the lender’s remedies?

Broadly, yes. An enforceable and properly perfected first ranking Hong Kong law governed fixed security interest created by a Hong Kong incorporated borrower over shares located in Hong Kong can be enforced by the secured party (for example, by exercising its out-of-court power of sale) notwithstanding the commencement of Hong Kong law governed insolvency proceedings in respect of the borrower.

The impact of other jurisdictions should be considered (for example, whether a Hong Kong incorporated borrower may be wound up under the laws of another jurisdiction and the impact of local law requirements on the enforcement of security over Hong Kong shares held in an account outside of Hong Kong).

Market structure

What is the structure of the market for listed equity options?

All listed equity options in Hong Kong are traded on the SEHK (by or through an exchange participant) and are cleared through The SEHK Options Clearing House Limited, a wholly owned subsidiary of Hong Kong Exchanges and Clearing Limited.

Listed equity options (both puts and calls) are American-style and physically settled.

Governing rules

Describe the rules governing the trading of listed equity options.

The trading of listed equity options are governed by the SEHK listing rules, the Options Trading Rules of the SEHK and the Operational Trading Procedures for Options Trading Exchange Participants of the SEHK. The clearing of listed equity options is governed by the Options Clearing Rules and the Operational Clearing Procedures of The SEHK Options Clearing House Limited.

Law stated date

Correct on

Give the date on which the information above is accurate.

30 June 2020