8 December, 2016
The Securities and Futures Commission (SFC) has announced the launch of a three-month consultation regarding proposed enhancements to the regulation of the asset management industry and other amendments aimed at enhancing point-of-sale transparency and addressing conflicts of interest in the sale of investment products by intermediaries.
In its consultation paper, the SFC has proposed amendments to the Fund Manager Code of Conduct (FMCC) in the following four key areas:
- Securities lending and repurchase agreements (repos)
- Custodians and safe custody of fund assets
- Liquidity risk management
- Disclosure of leverage
The SFC also proposes to make it clear in the revised FMCC that the FMCC applies to all persons licensed by or registered with the SFC whose business involves the management of collective investment schemes (whether authorised or unauthorised) and/or discretionary accounts (in the form of an investment mandate or a pre-defined model portfolio), including, where appropriate, their representatives.
Full details of the proposed amendments to the FMCC are set out in Appendix A of the consultation paper.
In addition, the SFC proposes to regulate the circumstances in which an intermediary can represent itself as being “independent” or as providing “independent advice”, as well as require enhanced disclosure of monetary benefits received or receivable that are not quantifiable prior to or at the point of entering into a transaction. Changes in this regard are proposed to the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (COC). The proposed amendments to the COC are set out in Appendix B of the consultation paper.
The consultation period will end on 22 February 2017.
In response to some uncertainty regarding the applicability of the FMCC, the SFC proposes to clarify that the FMCC applies to all persons licensed by or registered with the SFC whose business involves the management of a collective investment scheme (whether authorised or unauthorised) and/or discretionary accounts (in the form of an investment mandate or pre-defined model portfolio) (ie, Type 9 (asset management) regulated activity). The particular FMCC requirements that are not applicable to and other additional requirements applicable to managers of discretionary accounts will be set out in Appendix 1 to the FMCC.
The SFC also proposes that the FMCC applies to all SFC licensed or registered fund managers, regardless of whether they manage public or private funds and whether the funds are domiciled in Hong Kong or overseas. To the extent a fund manager is not responsible for the overall operation of the fund (because, for example, the fund manager is a sub-manager), the SFC has indicated that certain FMCC principles and requirements would not be applicable under the amended FMCC.
Other key proposed changes to the FMCC are discussed below.
Securities lending and repos
To address so called “shadow banking risks”, the SFC has proposed certain amendments to the FMCC where a fund manager engages in securities lending, repos and similar over-the-counter (OTC) transactions on behalf of the fund it manages. The amendments include the following requirements:
- the establishment of a collateral valuation and management policy to address minimum collateral valuation and margin requirements;
- the establishment of an eligible collateral and haircut policy to address the eligible types of collateral and calculation of haircuts on collateral received in connection with securities lending, repos and similar OTC transactions;
- the establishment of a cash collateral reinvestment policy which ensures assets held in a cash collateral reinvestment portfolio are sufficiently liquid and low risk to meet recalls; and
- enhanced disclosure requirements in fund offering documents and annual reporting to clients/fund investors of information relating to securities lending, repos and similar OTC transactions.
Further details of the proposed requirements with respect to securities lending, repos and similar OTC transactions are set out in Appendix C of the consultation paper.
Custodians and safe custody of fund assets
The SFC proposes to adopt the latest standards established by the International Organisation of Securities Commissions (IOSCO) in relation to the custody of fund assets, as set out in IOSCO report, Standards for the Custody of Collective Investment Schemes' Assets (November 2015). In particular, fund assets must be segregated from the assets of the fund manager, and where fund assets are held in a client omnibus account, the fund manager must ensure that appropriate safeguards are put in place to ensure the fund assets belonging to each client are appropriately recorded and reconciled. Further, save in the case of private funds adopting self-custody arrangements, fund managers should appoint and entrust the fund assets to an independent custodian and should ensure that a formal custody agreement is entered into with the custodian. Such custodial arrangements, including any changes to the arrangements, should be disclosed to fund investors.
Liquidity risk management
Managing the liquidity risk of a fund is a critical aspect of fund management. Accordingly, the SFC proposes to require a fund manager to maintain and implement effective liquidity management policies, having regard to the investment strategy, liquidity profile, underlying obligations and redemption policy of the fund. The fund manager should also ensure that such policies are updated and reviewed as necessary. Such policies should provide for appropriate stress testing to be carried out by the fund manager on an ongoing basis, and the results of such assessments should be reviewed by a committee responsible for liquidity risk management or senior management to determine whether further action is warranted.
To the extent a fund's constituent documents allow the use of liquidity management tools which affect the redemption rights of investors, an explanation of such tools and exceptional measures should be included in the fund offering documents. The SFC has indicated that fund managers should generally consider the appropriateness of using such tools and the interests of investors should take priority to the fund manager's own interest.
Disclosure of leverage
To aid disclosure and transparency of risks to investors, the SFC has proposed that fund managers should disclose the maximum level of leverage which it may employ on behalf of each fund it manages. In calculating leverage, the SFC proposes that fund managers should take into account financial leverage arising from borrowings and synthetic leverage arising from the use of derivatives. The basis of calculation should be disclosed to investors in fund offering documents.
Other amendments to the FMCC
In its consultation paper, the SFC has proposed a range of other amendments to the FMCC which largely codify existing requirements and practices in the fund management industry. Significant amendments include:
- the valuation of fund assets in accordance with the principles published by IOSCO in Principles for the Valuation of Collective Investment Schemes (May 2013);
- the requirement to appoint an independent auditor to audit the financial statements of a fund;
- new risk management requirements;
- enhanced disclosure requirements regarding side pockets; and
- more detailed reporting requirements to the SFC.
Further details of those requirements are contained in the consultation paper.
PROPOSED AMENDMENTS REGARDING INTERMEDIARY CONDUCT
Representations regarding independence
Building on recent regulatory focus regarding conflicts of interest and transparency, the SFC proposes to regulate under the COC the circumstances in which an intermediary can represent itself as being “independent” or use any other term(s) with a similar inference (for example, “independent financial advisers”, “impartial”, “neutral”, “objective” or “unbiased”), where monetary or non-monetary benefits from other parties (including product issuers) are received.
The SFC has indicated that a licensed or registered person would generally not be regarded as independent if such person receives fees, commissions or any monetary or non-monetary benefits in relation to the distribution of the investment product, or if the person has any links or relationships with the product issuers.
Enhanced disclosure of monetary benefits
In Hong Kong, intermediaries are currently required to disclose monetary and non-monetary benefits received or receivable by it in relation to distribution of an investment product. Such disclosure was introduced back in 2010 and became effective in 2011 as one of the key proposals to enhance protection for the investing public following the global financial crisis.
In relation to monetary benefits received or receivable by intermediaries that are not quantifiable prior to or at the point of entering into a transaction (eg, the ongoing commission payable by product issuers to intermediaries for distribution (in the context of funds, trailer fees)), the COC currently requires the licensed or registered person to disclose the existence and nature of such monetary benefits. The SFC has observed that there are varied disclosure practices which may not help investors compare costs and fees amongst different intermediaries.
In the consultation paper the SFC notes that both the UK and Australia have adopted a “pay-for-advice” model to help eliminate the inherent conflict of interest in receiving benefits from product providers in the sale of investment products to clients. However, the SFC notes that this model may have unintended consequences such as the emergence of an “advice gap” where investors who are without the resources to pay for or are unwilling to pay for advice for any reason could be left with no or very limited access to investment products.
The SFC considers that a pay-for-advice model with a complete ban on the receipt of commissions by intermediaries may not be appropriate for Hong Kong in light of survey results referenced in the consultation paper which show that, for example, the majority of persons surveyed (55%) are only willing to pay HK$5,000 or less for financial planning services. Accordingly, rather than adopting a pay-for-advice model, the SFC proposes to enhance the disclosure of monetary benefits received or receivable that are not quantifiable prior to or at the point of entering into a transaction. Under the proposed amendments, intermediaries will be required to disclose the following, in addition to disclosing the existence and nature of the relevant monetary benefits:
- the range of such monetary benefits receivable on an annualised basis; and
- the maximum dollar amount of such monetary benefits receivable per year.
The SFC has indicated that the disclosure should be made by intermediaries on a transaction basis and the SFC sets out in the consultation paper a sample disclosure using trailer fees as an example. Proposed amendments to the COC are found at Appendix B of the consultation paper.
CONCLUSION
If implemented, the SFC’s proposed amendments to the FMCC and the enhanced disclosure requirements in the COC will increase the compliance burden for Hong Kong asset managers and intermediaries alike. That said, the amendments are aligned with the general regulatory shift towards greater transparency in financial markets, particularly in relation to fees and conflicts of interest.
The consultation paper sets out a series of questions on which the SFC invites comments from the industry and the public at large. Interested parties are invited to submit their comments to the SFC on or before 22 February 2017.
For further information, please contact:
William Hallatt, Partner, Herbert Smith Freehills
William.Hallatt@hsf.com
