Hong Kong – Regulators Warn Of Common Instances Of Non-Compliance In Asset Management.

 

14 November, 2017

 

 

The SFC has recently conducted around 250 inspections of licensed corporations engaged in asset management business, and has identified a number of common instances of regulatory non-compliance among them, which it has set out in its circular of 15 September 2017 (with appendix). In the circular, the SFC also sets out its expectations and calls on asset managers to review their internal control procedures and operational capabilities and enhance them (if necessary) to meet the SFC’s expectations. The HKMA has also issued a circular to bring the SFC circular to the attention of registered institutions engaging in asset management business.
 
The above follows earlier circulars from the SFC and the HKMA on 31 July and 2 August 2017 respectively, which covered a number of potential regulatory concerns identified in the course of the SFC’s supervision of licensed corporations engaged in managing private funds and discretionary accounts (see our earlier e-bulletin here). The SFC's latest circular of 15 September 2017 highlights various other issues noted among asset managers in general.
 
In view of the recent measures by the SFC and the HKMA to heighten the accountability of senior management at licensed corporations and registered institutions, the issues highlighted in the SFC circular should be brought to the attention of the senior management at asset managers. The SFC has expressly stated that it will continue to monitor compliance by asset managers and will not hesitate to take action against any asset managers and/or their management for non-compliance. 
 

COMMON INSTANCES OF REGULATORY NON-COMPLIANCE 

 

The SFC recently conducted around 250 inspections which covered asset managers forming part of overseas groups of companies (based in the United States, Europe, and on the Mainland) of varying sizes, as well as local asset managers operating on a smaller scale. In the course of these inspections, the SFC identified many instances of non-compliance with the Fund Manager Code of Conduct (FMCC), the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (COC) and the Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the Securities and Futures Commission. 

 

The issues and deficiencies have been grouped into nine areas: 

 

1. Cash rebates – Inappropriate receipt of cash rebates from execution brokers, giving rise to potential or perceived conflicts of interest. 
2. Suitability – Failure to ensure suitability of funds or discretionary account mandates when (a) making solicitations or recommendations of funds under their management to clients, or (b) providing discretionary account management services to clients in accordance with agreed mandates, for example, as a result of inappropriately treating clients as professional investors. Suitability obligations are the cornerstone of investor protection and such obligations and related requirements were updated in March 2016 as part of the enhanced professional investor regime (see our e-bulletin and other e-bulletins referenced therein regarding the implementation of the regime). 
3. Liquidity risk management – 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, and lack of oversight by senior management and risk personnel. This may result in an inability to meet redemption or withdrawal requests. 
4. Valuation of assets – Deficiencies in setting up a proper governance structure and in implementing comprehensive policies and procedures for fair valuation of assets, particularly assets for which there are no current or reliable market prices. Proper valuation of assets is critical to investors as it has a direct impact on matters such as subscription and redemption prices, performance reporting and calculation of fees. 
5. Best execution – Deficiencies in systems and controls to ensure best execution, which is critical in ensuring that transactions are executed in the best interest of clients.
6. Order allocation – Failure to put in place proper governance structures, policies and procedures to ensure fair allocation of orders, especially where the orders involve both proprietary and client accounts. 
7. Client assets – Inadequate systems and controls to protect client assets against potential theft, fraud and other acts of misappropriation, and to ensure that records relating to client assets are accurate. 
8. Investment compliance – Inadequate systems and controls for ensuring compliance with the stated objectives, investment restrictions and guidelines of the relevant mandates, whether in terms of asset class, geographical spread or risk profile. 
9. Market misconduct controls – Inadequate systems and controls to address the risk of market misconduct, for example, procedures and controls relating to material non-public information and ensuring that staff are aware of the prohibition against insider dealing. 

 

Examples of non-compliance in the above areas are set out in the appendix to the SFC circular. 

 

Through the examples, the SFC has highlighted asset managers’ duties to:

 

• perform their role responsibly, with due skill, care and diligence;
• act in the best interests of their clients and the integrity of the market; and
• be vigilant and report to the SFC any material breach, infringement or non-compliance with the market misconduct provisions of the Securities and Futures Ordinance which they reasonably suspect may have been committed by their clients. 

 

The SFC also notes that some asset managers have stated during inspections that they only provide investment advisory and trade execution services to clients in practice (ie, they do not exercise any discretion over asset management). If such is the case, they will not be regarded as conducting asset management activities and will therefore not be eligible for the incidental exemption for dealing in securities (eg, distribution of funds and placing orders with brokers for funds under their management). 

 

In addition, when asset managers assist their clients in executing transactions, they must take care and critically examine those transactions, so that they are not implicated in market misconduct or other illicit activities by assisting their clients in suspicious transactions, such as those highlighted in the SFC’s circular of 31 July 2017. 

 

INCREASED FOCUS ON GOVERNANCE AND SENIOR MANAGEMENT RESPONSIBILITY 

 

The examples in the circular illustrate the importance of:

 

• establishing and maintaining robust policies and procedures;
• ensuring that the policies and procedures are supported by effective governance and operational capabilities;
• putting in place adequate systems and controls; and
• putting in place proper governance structures. 

 

The SFC has stated that it will continue to monitor asset managers’ compliance with applicable regulatory requirements and will not hesitate to take action against any asset managers and/or their management (including Managers-in-Charge of Core Functions) for non-compliance. 

 

The emphasis on senior management responsibility follows the introduction of measures by the SFC earlier this year to heighten the accountability of senior management at licensed corporations (see our e-bulletin here), as well as corresponding measures by the HKMA announced last month in respect of registered institutions (see our e-bulletin here). 

 

FOCUS ON THE ASSET MANAGEMENT INDUSTRY 

 

The latest SFC circular is also in line with the SFC’s broader initiative to enhance Hong Kong’s position as a major international asset management centre. In November 2016, a consultation was launched on proposed changes to the FMCC and the COC to enhance the regulation of the asset management industry, as well as increase point-of-sale transparency and address conflicts of interest in the sale of investment products by intermediaries (see our e-bulletin here). Conclusions on this consultation are expected to be published in the near future.

 

NEXT STEPS 

 

Asset managers should at their earliest opportunity review their policies, internal control procedures and operational capabilities, and enhance them as needed to ensure compliance with applicable regulatory requirements, particularly with regards to the issues highlighted in the nine areas identified by the SFC. 

 

 

For further information, please contact:

 

William Hallatt, Partner, Herbert Smith Freehills

William.Hallatt@hsf.com