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23 November, 2017
The Securities and Futures Commission (the “SFC”) issued its Consultation Conclusions on Proposals to Enhance Management Regulation and Point-of-sale Transparency and Further Consultation on Proposed Disclosure Requirements Applicable to Discretionary Account (the “Conclusions”) on 16 November 2017. The Conclusions introduce changes to the Fund Manager Code of Conduct (the “FMCC”) and the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “Code of Conduct”). These changes will become effective on 17 November 2018 and 17 August 2018 respectively.
The SFC also initiated a further consultation on disclosure requirements applicable to discretionary accounts. Submissions on this further consultation should be made by 15 January 2018.
Amendments to the Fund Manager Code of Conduct
Further to the Conclusions, the revised FMCC largely adopts the amendments proposed by the SFC in its Consultation Paper issued on 23 November 2016 (the “Consultation”). The amended FMCC will become effective on 17 November 2018 (i.e. within 12 months of its publication in the Gazette).
The main changes introduced in the FMCC relate to: (i) the scope of its application; (ii) securities lending and repurchase agreements (“repos”); (iii) custody of fund assets; (iv) liquidity risk management; and (v) leverage disclosure.
Scope of application of the FMCC
The scope of the revised FMCC is considerably broader than that of the FMCC currently in force. As suggested in the Consultation, the revised FMCC applies not only to licensed and registered persons (and their representatives) whose businesses involve the management of collective investment schemes (whether authorised or not) but also to intermediaries that manage discretionary accounts (in the form of an investment mandate or pre-defined portfolio).
This is made clear in the introductory paragraph to Appendix 1 of the revised FMCC (Requirements for licensed or registered persons conducting discretionary accounts management). The rationale for expanding the scope of the FMCC to discretionary account managers is that investment functions performed by discretionary account managers and fund managers are broadly similar.
The SFC clarified that the revised FMCC applies to public and private funds as well as offshore and local funds.
It was proposed in the Consultation that some of the enhancements to the FMCC would only be applicable to those responsible for the overall operation of a fund or having “de facto control” of the oversight or operation of the fund. In light of the comments received on the Consultation, the SFC decided to retain the reference to fund managers that are “responsible for the overall operation of a fund” (which is in line with relevant IOSCO principles) and to remove the reference to “de facto control” in the revised FMCC. Whether a person is “responsible for the overall operation of a fund” is a factual question but the mere existence of a governing body will not be sufficient to conclude that the fund manager does not have such responsibility. The SFC announced that it would issue further guidance on the meaning of this expression in FAQs which will be updated from time to time.
In the Conclusions, the SFC also stressed that the FMCC applies generally to the outsourcing of a fund manager’s functions. Therefore, where functions are delegated to service providers, a fund manager should: (i) exercise due skill, care and diligence in the appointment of the provider; and (ii) monitor its competence on an ongoing basis to ensure that the principles in the revised FMCC are followed.
Requirements for intermediaries conducting discretionary accounts management
Following the SFC’s proposal in the Consultation, the revised FMCC includes a new Appendix 1 which specifies requirements in the FMCC that are not applicable to discretionary account managers and lays out additional requirements for such managers.
FMCC requirements not applicable to discretionary account managers
Pursuant to Appendix 1, a number of requirements in the revised FMCC do not apply to discretionary account managers as the SFC acknowledges that these are not relevant to the services they provide. These relate to: (i) liquidity management; (ii) the termination of funds; (iii) side pockets; (iv) audit of financial statements of funds and accounting information in funds’ annual report; (v) frequency of valuation of fund assets; (vi) net asset value calculation and pricing of different unit and share classes; and (vii) compliance with statutory requirements regarding offers of investments.
Additional requirements imposed on discretionary account managers
However, further to Appendix 1 to the revised FMCC, discretionary account managers are subject to a couple of additional requirements:
(i) Client agreements –discretionary account managers are required to enter into a written discretionary client agreement before providing services to or entering into transactions on behalf of, a client. Appendix 1 specifies the minimum content requirements for such discretionary client agreement. The FMCC includes exemptions from the discretionary client agreement requirement where clients are Institutional Professional Investors and Corporate Professional Investors in respect of which the discretionary account manager has complied with paragraph 15.3A and 15.3B of the Code of Conduct (but not Individual Professional Investors). The SFC is of the view that grandfathering provisions are not necessary in light of: (i) the SFC’s Management, Supervision and Internal Control Guidelines which already require discretionary account managers to execute a discretionary account agreement setting out the investment objectives and strategies of the client; and (ii) the 12-month transition period prior to the revised FMCC coming into force; and (ii) Performance review and valuation reports –under Appendix 1 the discretionary account managers are required to undertake a performance review at least twice a year and to provide valuation reports to clients on a monthly basis or at such shorter interval prescribed in the discretionary client agreement.
Securities lending and repos
The amendments to the FMCC on securities lending and repos proposed in the Consultation were by and large adopted in the Conclusions save that the references to “similar OTC transactions” in the Consultation were replaced by “reverse repos” to align the wording of the revised FMCC with the Financial Stability Board (“FSB”) recommendations.
Under the revised FMCC, enhanced requirements apply to fund managers which engage in securities lending, repos and reverse repos on behalf of the funds managed by them (whether or not the fund manager is responsible for the overall operation of the fund).
In particular, fund managers are required to:
- establish a collateral valuation and management policy as well as a cash collateral reinvestment policy;
- establish an eligible collateral and haircut policy determining the eligible types of collateral and corresponding haircuts. Such policies should be consistent with FSB recommendations; and
- make enhanced disclosures to clients/fund investors on securities lending, repos and reverse repos –in light of the comments received on the Consultation, the SFC deleted the proposed requirement to disclose a summary of the fund’s transaction and risk management policies in the fund’s offering document. The SFC also removed the requirement to provide information on the fund’s securities lending, repo and reverse repo transactions to fund investors upon request. However, the obligation to provide such information to fund investors on an annual basis was maintained in the revised FMCC. Further to the Conclusions, the revised FMCC also includes guidance on the minimum disclosures expected of fund managers in this respect. Such disclosure requirements are aligned with the relevant FSB recommendations.
Custody of fund assets
The revised FMCC largely follows the proposals in the Consultation relating to the custody of fund assets. The SFC retains its proposal that custody requirements only apply to fund managers that are responsible for the overall operation of the fund (despite the fact that they may not formally appoint the custodians). In addition, it is made clear in the revised FMCC that, where funds adopt a unit trust structure, references to a “custodian” should be read as references to the “trustee”.
Under the revised FMCC, fund managers are required to exercise due skill, care and diligence in the selection, arranging for the appointment and ongoing monitoring of the custodian. The custodian should (among other things) be functionally independent from the fund manager. The SFC clarifies in the Conclusions that “functional independence” can be achieved despite the custodian being part of the same group as the fund manager if there are policies, procedures and internal controls in place to this effect. A fund manager is also required to ensure that a formal custody agreement is entered into with the custodian. Custodial arrangements (and any changes thereto) should be disclosed to fund investors.
The revised FMCC also imposes segregation requirements between fund assets and the fund manager’s assets. Where fund assets are held in a client omnibus account, the fund manager must ensure that appropriate safeguards are put in place to ensure that the fund assets belonging to each client are appropriately recorded and reconciled.
The Conclusions also introduce a new requirement, namely that where fund assets are not capable of being held in custody, they should be identified in records as being owned beneficially by the fund and not by the fund manager or the custodian.
Liquidity risk management
The proposals in the Consultation were largely incorporated into the Conclusions. They key changes introduced in the FMCC are:
- all fund managers, regardless of whether the fund is open-ended or closed-ended, must maintain liquidity management policies and monitor the liquidity risk of relevant fund or funds with reference to its obligations and redemption policy (if any). The SFC expects a fund manager of any type of fund to adopt a proportionate approach to liquidity management and to consider the extent of the applicability of the proposed liquidity risk management requirements to the specific funds it manages and to ensure that its activities are commensurate with the liquidity profiles of those funds;
- a fund manager should perform liquidity stress testing on its funds on an ongoing basis to assess the impact of plausible severe adverse changes in market conditions. The extent or frequency of the testing may vary depending on the nature of the fund;
- a fund manager is not deemed to be responsible for the overall operation of a fund simply by virtue of its responsibility in managing liquidity risk; and
- the fund manager should disclose the liquidity risks involved in investing in a fund, the liquidity management policies and an explanation of any tools or exceptional measures that could affect redemption rights in the fund’s offering documents or otherwise made freely available to fund investors.
Leverage disclosure
In line with the suggested amendments in the Consultation, under the revised FMCC, fund managers are to disclose to investors the expected maximum leverage to be employed by the fund manager. There is no prescribed method on how leverage should be calculated, although fund managers should ensure that the disclosure is based on a reasonable and prudent calculation methodology and that the disclosure is fair and not materially misleading.
Other amendments
The revised FMCC also introduces a number of other amendments, including (among other things):
- house orders –under the revised FMCC, client orders retain priority where they have been aggregated with other orders and where all orders cannot be filled, unless the client is an Institutional Professional Investor which requested a different allocation priority; and
- separation –strict separation is not required between the investment decision-making process and the dealing process if this is not reasonably practicable in light of the small size of the fund manager or the nature of the investments.
Amendments to the Code of Conduct
The SFC proposed in the Consultation to amend the Code of Conduct to: (i) prescribe the circumstances in which an intermediary can represent itself as being “independent” (or other words to this effect); and (ii) introduce enhanced disclosures of monetary benefits. Both suggested amendments were introduced in the revised Code of Conduct and will become effective on 17 August 2018 (i.e. 9 months from the date of the publication of the revised Code of Conduct in the Gazette).
However, the SFC has decided not to adopt a pay-for-advice model at this stage although it indicated that it would keep under active consideration the merits of such model, taking into account local as well as international developments in this space.
Independence
Use of the term “independent”
A new paragraph 10.2 was added to the Code of Conduct which prescribes the circumstances in which an intermediary may represent itself as being independent (or use any other term(s) with similar inference).
As suggested in the Consultation, an intermediary will not be able to describe itself as being “independent” where it receives fees, commissions, or any monetary benefits by any party in relation to the distribution of an investment product.
Although the SFC remains of the view that non-monetary benefits may also affect an intermediary’s independence, pursuant to the Conclusions, whether this will be the case will depend on whether such benefits are likely to impair the independence of the intermediary to favour an investment product (or class of investment product) or a product issuer.
The SFC also clarified in the Conclusions that an intermediary is prevented from describing itself as being “independent” only in circumstances where links or other legal or economic relationships are likely to impair the independence of the intermediary to favour a particular investment product (or class thereof) or product issuer.
Entities which are within the same group of companies will be regarded as having “close links” to one another. The SFC will provide further guidance on the meaning of “other legal or economic relationships” in FAQs.
Disclosure of independence
Under the revised paragraph 8.3A of the Code of Conduct, an intermediary is required to disclose prior to or at the point of entering into a transaction whether or not it is independent and the basis for such determination. The Conclusions stress that non-independent intermediaries are therefore subject to this disclosure requirement. The prescribed disclosures are set out in the new Schedule 9 to the Code of Conduct.
The SFC adopted the proposal in the Consultation that disclosures under paragraph 8.3A (other than disclosures of monetary and non-monetary benefits) be made, at a minimum, on a one-off basis prior to or at the point of entering into a transaction and upon any changes to such disclosure. Subsequent disclosure of changes can be either in the form of an update or a specific disclosure for each transaction in respect of which there is a change from the one-off disclosure.
Enhanced disclosure requirements
As proposed in the Consultation, the disclosure requirements in respect of monetary benefits in paragraph 8.3 of the Code of Conduct are no longer restricted to monetary benefits “received” by and intermediary and/or its associate but are extended to those which are “receivable” by them.
Where the monetary benefits receivable per year are not quantifiable prior to or at the point of entering into a transaction (e.g. trailer fees), the maximum percentage receivable per year should be disclosed. Although it is possible for intermediaries to disclose the range of such monetary benefits on an annualised basis, the maximum percentage receivable must be disclosed in each case. In addition, while intermediaries may choose to also disclose amounts receivable in dollar amounts, if they do, the maximum dollar amount receivable each year must be disclosed to ensure fair and comparable disclosure to investors. Further guidance will be provided by the SFC on this point in FAQs. The SFC also stressed that such enhanced disclosure requirements are not restricted to trailer fees but also covers other non-quantifiable monetary benefits receivable for the distribution of funds (e.g. volume-based service fees).
Further consultation on disclosure requirements applicable to discretionary accounts
The SFC also launched a further consultation on disclosure requirements applicable to discretionary accounts, which will close on 15 January 2018. In this further consultation, the SFC proposes two disclosure options for disclosure of monetary benefits under explicit remuneration arrangements for discretionary accounts:
- option 1: “specific disclosure by type of investment product” –under this option, an intermediary will disclose the maximum percentage of monetary benefits (e.g. initial commission rebates and trailer fees) received by it and/or any of its associates by type of investment product; and
- option 2: “specific disclosure of the aggregate amount in percentage terms” –under this option, an intermediary will disclose an estimated maximum percentage of monetary benefits receivable by it and/or any of its associates, calculated by aggregating the maximum monetary benefits receivable from each product type according to the proportion such product type represents in a client’s investment portfolio.
For disclosure of monetary benefits under non-explicit remuneration arrangements, and in relation to non-monetary benefits, the proposal is for the intermediary to make a generic disclosure that it will benefit from purchasing the products for a client under a discretionary portfolio.
The proposed disclosure should be made in writing to investors at the account opening stage or prior to entering into a discretionary client agreement (whether in writing, electronically or otherwise). It is also proposed that exemptions will apply to Institutional and Corporate Professional Investors but not to Individual Professional Investors.
How we can help
Managing the implementation of the revised FMCC and Code of Conduct will be a complex task. In particular, discretionary account managers which were not previously subject to the FMCC will need to introduce changes to their policies and procedures to ensure full compliance with the revised FMCC from day one. Managers of discretionary accounts should also start amending their client agreements or entering into new client agreements as soon as possible to ensure that they meet the 17 November 2018 deadline.
Changes to the disclosure requirements under paragraph 8.3A of the Code of Conduct may also prove challenging to implement in due course as this will require firms to undertake an assessment of their independence and the monetary benefits receivable (as well as received) by them and/or their associates for all relevant transactions.
Updates may also need to be made to client facing documentation to take into account these new disclosure requirements.
Choosing the right legal adviser brings significant advantages to your implementation project. We have extensive expertise in advising financial institutions on wide-ranging regulatory implementation projects, including in revising contractual agreements to ensure compliance. We worked, for example, on numerous mandates initiated as a result of the changes introduced by the SFC to paragraph 6 of the Code of Conduct and our experience will be instrumental in completing these projects within the timelines set by the SFC.
For further information, please contact:
Annabella Fu van Bijnen, Partner, Linklaters
annabella.fu@linklaters.com
