The Securities and Futures Commission (SFC) have recently taken enforcement action against a licensed fund manager for failures in its role as investment manager of a private fund. The recent enforcement action serves as a reminder that the SFC expects licensed corporations to exercise high standards of due diligence, independent judgement and compliance with agreed investment mandates.
Notably, the SFC has in this enforcement action made explicit reference to its November 2019 Circular on Dubious Arrangements, which provides guidance on expected standards of conduct in considering a dubious arrangement or transaction.
Asset managers are also reminded to refer to the October 2024 Circular on Deficiencies in Management of Private Funds, which outlines deficiencies and substandard conduct noted in the management of private funds and discretionary accounts.
Key Takeaways
The SFC’s recent enforcement action provides a practical example of how it applies the standards under the relevant Circulars, highlighting types of problematic transactions. Regulatory concerns arise when a structure appears designed to achieve an outcome that could have been achieved more simply and transparently. Examples include:
- a fund with a single investor, where the underlying investment exposure was to an instrument issued by a related party of the investor;
- the investment was made at the investor’s instruction;
- structured notes were used instead of direct investment, and subsequently transferred underlying investments into another private fund; and
- the investment was effectively concentrated in a single economic exposure whilst the profile of the securities held under the structured note differed from the fund’s overall investment objective.
The SFC considered such structures unnecessarily complex and lacking a clear commercial rationale, which raised concerns about the potential concealment of asset movements or connected party transactions.
Notably, the SFC did not state any single characteristic automatically renders a transaction impermissible. Rather, the regulatory significance arises from cumulative red flags. Accordingly, a manager should exercise particular caution when a plain-vanilla investment could be made directly, yet the investor proposes an unnecessarily complicated structured-product route. The critical question is whether such complexity has a credible and justifiable explanation.
The SFC’s criticism was not directed solely at the unusual features, but at the manager’s failure to identify red flags, conduct enhanced due diligence, and adequately address concerns before proceeding with the transactions. This demonstrates that the standards in the Circular on Dubious Arrangements are not merely abstract guidance – failure to comply may result in significant disciplinary consequences.
This case also serves as a caution to fund managers against simply following investor instructions without adequate due diligence and without demonstrating independent discretionary investment management functions. The SFC treats such conduct as a serious breach of duty to act with due skill, care and diligence, in the best interests of clients and the market integrity.
This case also highlights the importance of adhering to the fund’s investment objectives and restrictions, taking a “substance over form” approach. Managers must ensure that underlying investments align with the fund’s objective and comply with investment limits, considering actual economic exposure regardless of legal structure.
Recommended Compliance Enhancements
To mitigate regulatory risks, managers should review internal controls and procedures, including implementing robust screening and escalation procedures for dubious arrangements, with clear documentation. Managers should also strengthen risk management and conflict of interest controls.
Conclusion
The most significant lesson is not about complex fund structures. Rather, it pertains to the role of investment manager itself. A private fund manager is not merely an execution agent. Investment managers must retain independence, remain vigilant, and ensure that their procedures comply with the latest regulatory guidance.
When a transaction appears unnecessarily complicated, investor-driven, related-party connected, economically circular or difficult to explain, the appropriate response is to understand why it exists, test the explanation independently, escalate concerns where appropriate, and proceed only when satisfied that the transaction is legitimate, commercially rational and consistent with regulatory responsibilities.
At Deacons, our experienced team can help you navigate the complex regulatory landscape. Should you require bespoke advice, please contact us.
For further information, please contact:
Catherine Zheng, Partner, Deacons
catherine.zheng@deacons.com
