By Philippa Allen, Managing Director, Regulatory Compliance, Asia
On 9 October 2024, the Securities and Futures Commission of Hong Kong (SFC) issued a Circular summarising deficiencies and substandard conduct identified from its supervision of Type 9 managers of private funds and discretionary accounts. Beyond breaching the Code of Conduct (CoC), Fund Manager Code of Conduct (FMCC) and Internal Control Guidelines, such deficiencies pose significant risks to assets under the firms’ management, jeopardising investor interests and undermining the integrity of the market in Hong Kong.
The Circular applies to asset managers who manage private funds and discretionary accounts in the form of an investment mandate or a pre-defined model portfolio. In this article, we outline the context of the Circular before diving into the specific failings identified by the SFC, including example case studies for each and guidance on how to prevent them.
Compliance audit requirements
- The board, Responsible Officers (ROs) and Managers-in-Charge (MICs) of asset managers bear primary responsibility for ensuring the maintenance of appropriate standards of conduct and are expected to critically review the areas of concern set out in the Circular and Appendix
- Senior managers must strengthen their supervisory and compliance programmes, including their policies, procedures and controls to ensure compliance with applicable regulatory requirements
- Where practicable, an independent and objective audit should be conducted on asset managers’ compliance with the existing obligations discussed in the Circular
- If asset managers become aware of a material breach, infringement or non-compliance with any regulatory requirements they must report to the SFC immediately, providing details and supporting documents required under 12.5 of the CoC
- Asset managers’ initiative in self-reporting breaches of regulatory requirements identified are taken into consideration when the SFC decides on potential disciplinary action
Upcoming SFC thematic inspections
The SFC is determined to combat asset management misconduct and is commencing a thematic on-site inspection of asset managers managing private funds to detect any material breaches or non-compliance with applicable regulatory requirements.
As the SFC has issued many circulars on controls for asset managers, it will step up its disciplinary actions and impose harsher penalties against similar or persistent misconduct to send a strong deterrent message.
Below, we highlight the key failings identified in the latest SFC Circular.
Failure to manage conflicts of interest
The SFC identified widespread failures to prevent and manage potential or actual conflicts of interests arising from their transactions or practices including:
- Using fund assets to provide financing resulting in the continuous extensions of loans to loss-making related entities that could not fulfil repayment obligations, exposed the funds to significant credit risks and resulted in significant losses for the investors
- Providing financing to funds and not justifying fees higher than prevailing commercial rates
- Unfairly allocating trades in favour of the manager’s key personnel
- Receiving monetary benefits from the funds’ transactions
- Failing to act fairly in handling redemption payments to fund investors by giving priority to redemptions from its staff over those of other clients
Example case studies
Manager of fund investing in loans used assets to grant loans to listed Hong Kong parent
Manager used funds’ assets to provide loans to holding company, affiliates, and connected parties
Manager extended loans to several private funds and charged interest at higher rates than execution brokers on margin loans extended to funds
Fund had investment objective of capital appreciation through investing in wide range of instruments, but only invested in senior notes issued by subsidiary of listed company
Manager did not specify intended allocation of trades when placing order for two funds
Manager acted as lead manager and joint bookrunner in offering of senior notes
Fund had significant exposure to illiquid high-yield bonds
Fund had significant portion of assets in illiquid high-yield bonds
Meeting the requirements for managing conflicts of interest
Managers must take all reasonable steps to identify, prevent, manage and monitor actual or potential conflicts, which should be documented. Effective implementation must be demonstrable to the SFC.
Where a material interest in a transaction gives rise to a conflict of interest, managers must prevent such conflicts by considering other counterparties when deciding on financing arrangements for the fund from itself or its affiliates and conducting objective assessments of all financing sources available and proceeding with the best available option.
Where material conflicts of interest cannot be prevented, managers must consider whether it is in the best interest of the fund to conduct such transactions.
Managers must ensure transactions are conducted in good faith at arm’s length and on normal commercial terms.
10.1 of the CoC and 1.5 of the FMCC require specific disclosures about any material interest or conflict to be made to investors including specific descriptions of the nature and source of conflicts, material interests of the manager and its connected persons, potential risks to investors and the steps taken to mitigate the risks. Key points to note:
- Generic and non-specific conflicts of interest disclosures in the fund’s constitutive documents are insufficient where material conflicts are involved
- Where a manager plans to use a material portion of the fund’s assets to provide loans to its affiliates, it is insufficient to provide generic disclosure in the constitutive documents that there may arise future instances where the interests of the fund conflict with interests of the manager and its affiliates. The manager must make specific disclosure to investors prior to the transaction about the loan arrangements, including details of the affiliated counterparty of the loan arrangements, the loan amount, material interests of the manager and its affiliate, risks of the material conflicts of interest and the loan, and how the conflicts will be managed and mitigated through a prescribed monitoring mechanism
Inadequate risk management and investment DD within mandate
The SFC identified managers who did not implement adequate risk management procedures or conduct appropriate investment due diligence to ensure transactions for clients were in line with their investment objectives and restrictions. There were also cases identified where the managers did not adequately address the risks associated with the transactions, which exposed investors to significant concentration, liquidity and credit risks, leading to substantial losses due to defaults by the issuers or borrowers.
Example case studies
Manager invested more than 40% and 25% of NAV of fund managed into two third-party funds
Manager had significant overdue redemption payables but continued to invest fund into illiquid stocks or private notes estimated to take six to 18 months to liquidate
Manager used most of fund NAV to provide unsecured loans to private company
Manager purchased senior notes worth US$35 million issued by subsidiary of Mainland listed company
Fund had investment objective to achieve attractive stable returns with capital preservation
Manager of discretionary account invested 90% of AUM into debt and shares of unlisted company, using product due diligence form to score each investment
Meeting the requirements for risk management
Managers must implement adequate risk management procedures to identify, measure, manage and monitor appropriately all risks to which the fund or account is exposed, and ensure investment is made in accordance with their investment objectives, restrictions and risk profiles.
5.1(a) of the FMCC and IV.6 of the Internal Control Guidelines require managers to maintain effective record retention policies and keep proper records of their risk assessments to demonstrate compliance with legal and regulatory requirements.
Failure to disclose risks to clients
Instances were found where managers did not provide fund investors with adequate information, including failing to disclose:
- Concentrated positions and significant exposures that subject the fund to significant risk, such as the majority of the fund’s assets being exposed to a single issuer or issuers of the same group
- Significant events impacting the funds such as major investment losses, significant defaults in investments with substantial adverse impact on the funds’ NAV or the funds’ ability to meet their liquidity needs
- Modified opinion issued by the funds’ auditors or material delay in the issuing of audited financial statements
Example case studies
Debt fund invested HK$100 million (75% of NAV) in loan to private company that is major shareholder of listed company
Stop-loss mechanism requires fund to secure additional subscriptions from designated investors to maintain NAV level or consider rejecting redemption requests when NAV drops to certain levels
Fund with quarterly redemption had a default of significant loan holding
Offering memoranda stated audited financial statements of funds should be provided within six months of financial year, but audited financial statements were issued seven and nine months after year-end, exceeding timeframe
Meeting the requirements for risk disclosure
6.2 of the FMCC requires responsible for the overall operation of a fund (ROOF) managers to provide fund investors with adequate information on the funds to allow them to make informed judgement about their investments into the funds.
Valuation methodologies
The SFC noted some managers adopted inappropriate valuation methodologies to hide investment losses of funds including valuing investments at cost but not justifying why no adjustments were needed when issuers and guarantors of the investments defaulted on the payments for their debts.
Example case studies
Manager valued defaulted loan at cost which accounted for 75% of NAV
Fund heavily invested in high-yield bonds issued by companies and obtained guarantees from the bond issuers or their related parties
Meeting the requirements for valuation methodologies
ROOF managers must ensure the valuation policies and procedures adopted by the funds are appropriate and comply with .3.1 of the FMCC. Managers must comply with 5.3.6 of the FMCC to value not actively traded or suspended securities unless dealt with in the constitutive documents.
How IQ-EQ can help?
IQ-EQ has a 20-year track record in undertaking SFC mock inspections, compliance health-checks and inspection remediation, providing recommendations for improvements and supporting clients through the regulatory inspection, improvement and remediation process.
IQ-EQ drafts, reviews and customises all types of compliance and internal control manuals, operational and procedural manuals and risk management frameworks including valuation methodologies, liquidity risk frameworks and conflicts of interest assessments, mapping and registers.
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About the author
Philippa is IQ-EQ’s Managing Director of Regulatory Compliance, Asia, with over 30 years’ extensive business and regulation experience in Asia. Prior to founding ComplianceAsia, which is now part of IQ-EQ, Philippa was the Head of Compliance, APAC for Dresdner Bank and GT Asset Management (LGT Asset Management). She was one of the drafters of the original Fund Manager Code of Conduct in Hong Kong and is involved in numerous submissions to regulators and lobbying efforts with financial industry bodies.
