SFC’s circular on deficiencies and substandard conduct noted in the management of private funds and discretionary accounts

View PDF

Authored by: Jeremy Lam and Sarah Lau

On 9 October 2024, the Securities and Futures Commission (SFC) issued an important reminder to licensed asset managers regarding deficiencies and substandard conduct identified by the SFC during routine inspections (Circular).

The SFC’s Circular highlights four specific areas of regulatory concern covering (i) conflicts of interest; (ii) risk management and investment within mandate; (iii) disclosure of information to investors; and (iv) valuation methodologies (collectively, Key Areas). It serves to forewarn private asset managers of the SFC’s intention to step up its disciplinary action and to impose harsher penalties on licensed entities and their senior management engaging in the type of misconduct discussed in the Circular as well as previous SFC circulars and guidelines published in recent years highlighting inappropriate conduct and compliance weaknesses in the management of private funds and discretionary accounts.

In this article we provide our insight into some of the key concerns raised by the SFC in the Circular.

Key Areas highlighted by the SFC and their Expectations of Licensed Managers

Examples of substandard conduct in respect of the Key Areas identified by the SFC are as follows:

1. Conflicts of Interest:  failure to prevent and manage potential or actual conflicts of interest arising from transactions and internal practices such as:
“(a) using fund assets to provide financing to related entities;
(b) providing financing to funds and failing to justify charging fees higher than prevailing commercial rates;
(c) unfairly allocating trades in favour of the asset manager’s key personnel;
(d) receiving monetary benefits from the funds’ transactions; and
(e) failing to act fairly in handling redemption payments to fund investors by giving priority to redemptions from its staff over those of other clients.”

The SFC reiterated that it is essential for asset managers to take appropriate measures to identify, prevent, address and oversee any actual or potential conflicts of interest and ensure that all transactions are conducted in good faith at arm’s length and on normal commercial terms.

When faced with material conflicts, asset managers should consider available alternatives and where material conflicts cannot be prevented, be able to justify that such transactions are nonetheless in the best interests of the fund and its underlying investors. Appropriate and specific disclosure of material interests or conflicts should be made to investors in accordance with applicable laws and regulations supported by proper documentation.

2. Risk management and investment within mandate:  failure to implement appropriate risk management or conduct investment due diligence to ensure transactions carried out on behalf of clients were in accordance with investment objectives and restrictions and inadequately addressing risks associated with transactions.

The SFC expects sufficient and appropriate risk management procedures to be in place to identify, measure, manage and appropriately monitor the risk exposure of funds and discretionary accounts managed by asset managers and to ensure investments are made in compliance with investment mandates and risk parameters. Proper records of risk assessments should be maintained to demonstrate compliance.

3. Information for investors:  failure of asset managers to provide fund investors with adequate information such as disclosures on concentrated risks, significant exposures (such as majority of fund assets being exposed to a single issuer or issuers of related parties), significant events (such as major investment losses and significant defaults in investments) and modified opinions issued by auditors or material delays in issuing audited financial statements.

The SFC reminds asset managers that they should provide fund investors with adequate information on the funds to enable them to make informed investment decisions.

4. Valuation methodologies: inappropriate use of valuation methodologies to conceal investment losses from its investors (such as valuing investments at cost without justifying why no adjustments are made in the face of defaults on debt payments).

The SFC reminds asset managers that they have a responsibility to ensure the valuation policies and procedures are appropriate and in line with the requirements of the FMCC. In practice, asset managers should conduct regular reviews of their valuation policies and consider any write-down or impairment requirements with fund auditors in light of market and specific investment conditions.

Key take-aways

The recent Circular demonstrates the SFC’s determination to root out substandard and inappropriate conduct in the management of private funds and discretionary accounts. Asset managers must comply with expected regulatory standards in order to safeguard investors’ interests and to maintain the integrity of Hong Kong’s asset management industry. The SFC has indicated its intention to commence thematic on-site inspections of asset managers to detect material breaches of non-compliance, to step up disciplinary actions and to impose harsher penalties on entities and individuals who fail to comply with the required standards of conduct and regulation.

In recent years, we have observed that the SFC has issued a number of circulars and guidelines dealing with misconduct targeted at the management of private funds and discretionary accounts. Our recent experience in assisting clients navigate SFC inspections and our observations from recent SFC enforcement actions reiterates the SFC’s continued focus on dealing with misconduct.

The Board of directors and senior management of asset managers, including Managers-In-Charge of Core Functions and Responsible Officers should critically review the areas of concern highlighted by the Circular and ensure and maintain appropriate standards of conduct within their organisation to avoid the risk of regulatory action.

How can Deacons help?

In view of the Circular, asset managers should revisit their existing compliance policies and procedures, offering documents or discretionary account agreements and investor communications to assess its exposure to the Key Areas highlighted by the Circular.

Deacons regularly advises asset managers on regulatory and compliance issues, such as preparing and reviewing policies and procedures, compliance health-checks and preparing for SFC inspections. Please reach out to our team for further information as to how we might help.

Key Contacts

Jeremy Lam

Partner | Financial Services

Email or call +852 2825 9732