Regulatory Alert - October 2024
2024-10-25

Bite the Bullet: The SFC reminds asset managers to ramp up their efforts to protect investors and maintain market integrity

 

On 9 October 2024, the Securities and Futures Commission of Hong Kong (“SFC”) issued a circular (the “Circular”) which identified various deficiencies and substandard conduct of licensed asset managers in managing private funds and discretionary accounts.

 

It is clear from the Circular that effective internal controls, fair information disclosure to investors and robust risk management remain priorities. With reference to existing codes, regulations and guidelines (including the SFC’s Code of Conduct, Fund Manager Code of Conduct, and Internal Control Guidelines), the SFC reiterates its expectation for asset managers to take various actions to better protect investors and maintain market integrity.

 

This article summarises the deficiencies and substandard conduct identified by the SFC and actions that asset managers should take.

 

Areas of concern

 

Conflicts of interest

 

Deficiencies and substandard conduct

Actions that asset managers should take

  • Use of fund assets to provide financing to related entities;

 

  • Financing to funds and failing to justify charging fees higher than prevailing commercial rates;

 

  • Unfair allocation of trades in favour of the asset manager’s key personnel;

 

  • Receipt of monetary benefits from the funds’ transactions; and

 

  • Failure to act fairly in handling redemption payments to fund investors by giving priority to redemptions from its staff over those of other clients.

 

  • Document steps taken to identify, prevent, manage and monitor actual or potential conflicts of interest;

 

  • Prevent conflicts by considering other alternatives;

 

  • Conduct thorough and objective assessments of all financing sources available and proceed with the best available option;

 

  • If material conflicts cannot be prevented, critically consider whether it is in the best interest of the fund to conduct such transactions;

 

  • Ensure that transactions are conducted in good faith at arms’ length and on normal commercial terms;

 

  • Make specific disclosures about material interest or conflict, e.g.  in respect of loan arrangements, specific disclosures should be made prior to the transaction such as the counterparty, loan amount, material interests of the asset manager and its affiliate, how conflicts will be managed and mitigated, etc.; and

 

  • Maintain proper documentation of their management of conflicts of interest.

 

Risk management and investment within mandate

 

Deficiencies and substandard conduct

Actions that asset managers should take

  • Failure to implement adequate risk management procedures, and conduct appropriate investment due diligence, to ensure transactions conducted are in accordance with investment objectives and restrictions; and

 

  • Failure to adequately address the risks associated with the transactions.

 

  • Implement adequate risk management procedures to identify, measure, manage and monitor appropriately risks;

 

  • Ensure investment is made in accordance with investment objectives, restrictions and risk profiles; and

 

  • Maintain effective record retention policies and keep proper records of risk assessment.

 

Information disclosure

 

Deficiencies and substandard conduct

Actions that asset managers should take

  • Failure to provide adequate information about concentrated positions and significant exposure 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;

 

  • Failure to disclose significant events impacting the funds such as major investment losses or significant defaults with substantial adverse impact on the funds’ net asset value or the funds’ ability to meet their liquidity needs; and

 

  • Failure to inform investors about modified opinions issued by the funds’ auditors or material delays in issuing audited financial statements to the funds’ investors.
  • Provide fund investors with adequate information on the funds to allow them to make informed judgment about investments.

 

Valuation methodologies

 

Deficiencies and substandard conduct

Actions that asset managers should take

  • Adoption of inappropriate valuation methodologies to hide investment losses, e.g. valuing investments at cost despite defaults on debt payments at investment level without any justification why no adjustments were made.
  • Ensure valuation policies and procedures are appropriate; and

 

  • Pay special attention to the valuation of securities that are not actively traded or have been suspended from trading.

 

Given the ongoing expansion of asset management businesses, we expect the SFC to step up its disciplinary actions and impose harsher penalties on asset managers and their personnel to send a strong deterrent message. By way of an example, in February 2024, the SFC publicly reprimanded and fined an asset manager HKD 2.8 million over its failures to discharge duties as the manager of a Cayman-incorporated fund between May 2018 and May 2020. The breaches in that case included (i) failure to comply with the fund’s investment objective and strategy (where there were only one to three stocks in the fund’s portfolio at the material time and the fund held highly concentrated positions in stocks that were not permitted); (ii) inadequate internal controls to ensure the fund’s adherence to the investment mandate and compliance with stop loss procedure; and (iii) significant reliance on the investment manager to manage the fund and failure to supervise the investment manager’s activities. The portfolio manager in question was also subsequently reprimanded and suspended for a period of seven months as a result of his involvement in the breaches.

 

Conclusion

 

The SFC remains determined to combat asset management misconduct to protect investor interests and maintain market integrity. The board and senior management of asset managers, including Managers-In-Charge of Core Functions and Responsible Officers, should critically review the areas of concern discussed in the Circular and strengthen their supervisory and compliance programmes.

 

 

Recent recognition

 

We are pleased to share with you that the Regulatory Team at Howse Williams and its members have been recognised in the IFLR1000 2024 ranking, including:

 

  • “Notable Firm” in the Financial Services Regulatory practice
  • “Rising Star Partner” in the Financial Services Regulatory category (Partner William Wong)
  • “Rising Star Partner” in the Investment Funds category (Partner Jason Chan)

 

These accolades are a reflection of the dedication, expertise, and client-centric approach that defines the Regulatory, Funds and Virtual Assets practice at Howse Williams. We are honoured by the trust and support of our valued clients, which has been instrumental in our continued success and growth in this specialised area of law. The HW Regulatory team now consists of two Partners, two Consultants and four Associates (many of whom joined from international law firms), and is one of the largest dedicated financial services regulatory practices in Hong Kong.

 

The Regulatory team at Howse Williams advises on both contentious and non-contentious matters, and often in both capacities for the same clients; therefore making us unique in our ability to work with clients on all of their regulatory and compliance needs. Our clients include banks, brokers, listed companies, asset managers, financial advisors, financial investors, insurance companies and established businesses. We also advise senior management such as directors, responsible and executive officers, chief executives and licensed individuals.

 

 

About Us

 

Howse Williams is a leading, full service, Hong Kong law firm. We combine the in-depth experience of our lawyers with a forward thinking approach.

 

Our key practice areas are corporate/commercial and corporate finance; commercial and maritime dispute resolution; clinical negligence and healthcare; insurance, personal injury and professional indemnity insurance; employment; family and matrimonial; trusts and wealth preservation; wills, probate and estate administration; property and building management; banking; fraud; distressed debt; investment funds; virtual assets; financial services/corporate regulatory and compliance.

 

As an independent law firm, we are able to minimise legal and commercial conflicts of interest and act for clients in every industry sector. The partners have spent the majority of their careers in Hong Kong and have a detailed understanding of international business and business in Asia.

 

Disclaimer: The information contained in this article is intended to be a general guide only and is not intended to provide legal advice. Please contact [email protected] if you have any questions about the article.