The Securities and Futures Commission (SFC) recently issued two circulars to licensed corporations engaged in asset management business. The circulars were issued following routine inspection by the SFC of corporations licensed for such activity.
Irregularities identified relating to private funds and discretionary accounts
The first circular was issued by the SFC on 31 July 2017 (July Circular) in respect of concerns identified from inspections of licensed corporations engaged in managing private funds and discretionary accounts (PD Asset Managers).
The SFC noted that there were certain private funds and discretionary accounts with concentrated, illiquid and interconnected investments. These private funds and discretionary accounts were found to have the following irregularities:
- discretionary account holders having large concentrated stock positions in their accounts and PD Asset Managers acting solely at the direction of their clients without exercising investment discretion;
- related-party acquisition or disposal of shares in listed companies by bought and sold notes (e.g., a substantial shareholder of a listed company sells the company’s shares to a fund managed by a PD Asset Manager by bought and sold notes, and the substantial shareholder in turn invests in the fund through a discretionary account);
- fund investors or discretionary account holders being related (e.g., as a substantial shareholder, director or affiliate) to the listed companies invested by the PD Asset Manager; and
- a director of a PD Asset Manager was also a director or chief executive officer of listed companies in which funds under the management of the PD Asset Manager were invested.
The nature and commercial substance of the above practices are regarded by the SFC as questionable as they may conceal the shareholding of the fund investors or discretionary account holders in the listed companies.
The SFC also identified situations which called into question whether the relevant PD Asset Managers were acting consistently with the Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct) general principles to act fairly and avoid conflicts of interest. These situations included:
- where a fund was unable to meet margin calls on leveraged stock trading, accordingly, loans were arranged to be made by the PD Asset Manager’s other funds. This exposes the investors in the lending funds to risks, especially if the lending funds also needed cash to meet outstanding redemption requests and the borrowing fund was not able to repay uncollateralised loans. In this case, a party related to the PD Asset Manager made a loan to the borrowing fund with an extremely high one-off financing charge; and
- where a fund investor related to a PD Asset Manager was given preferential treatment and was allowed to redeem his holdings before negative adjustment was applied to the fund, thereby minimising his own investment losses.
Other common instances of non-compliance in managing funds and discretionary accounts
Further to the July Circular, the SFC on 15 September 2017 issued a further circular (September Circular) which covers other regulatory issues noted from the SFC’s inspection of corporations licensed for asset management activity (Asset Management). These issues include:
- inappropriate receipt of cash rebates giving rise to apparent conflicts of interest;
- failure to ensure suitability of funds or discretionary account mandates when making solicitations or recommendations of funds under their management, or providing discretionary account management services, to clients;
- failure to put in place a proper liquidity risk management process to ensure that liquidity risks of funds and discretionary accounts under management are adequately addressed;
- deficiencies in setting up a proper governance structure and implementing comprehensive policies and procedures for fair valuation of assets;
- deficiencies in systems and controls to ensure best execution;
- failure to ensure fair order allocation;
- inadequate systems and controls in relation to protection of client assets;
- inadequate systems and controls for ensuring compliance with investment restrictions and guidance; and
- inadequate systems and controls to address the risk of market misconduct.
What Asset Managers should do
Asset Managers with discretionary management authority are advised to perform their roles with due skill, care and diligence, in the best interests of their clients and the integrity of the market. The SFC warns that an Asset Manager should critically examine arrangements and transactions proposed by their clients and should not turn a blind eye to dubious arrangements, otherwise, they may risk being implicated in any associated market misconduct or other illicit activities. If an Asset Manager suspects that their clients have committed any market misconduct, they should report to the SFC in accordance with their obligation under the Code of Conduct.
Asset Managers should have in place and maintain effective risk management policies and procedures in order to identify and manage risks to which their portfolios are exposed, especially liquidity risk, to ensure that investors’ redemption requests can be met in accordance with the terms set out in the relevant offering documents. Further, Asset Managers are advised to review their existing internal control procedures and operational capabilities, and enhance them as needed so as to ensure that standards of conduct and control procedures meet the expectations of the SFC.
It should be emphasised that the SFC expects the board and other senior management (including the managers-in-charge of core functions) of Asset Managers to maintain adequate oversight of their firm’s business activities. Senior management should have primary responsibility for ensuring the maintenance of appropriate standards of conduct (including, amongst other requirements, acting fairly and in the best interest of their clients and the integrity of the market) as well as ensuring adherence to proper procedures and the maintenance of proper risk management measures. The SFC recommends senior management review the areas of concern mentioned above and give priority to strengthening their supervisory and compliance programmes to ensure compliance with all applicable regulatory requirements.