Navigating the SFC Circular of 9 October 2024: Ensuring Compliance and Safeguarding Your Asset Management Business

Staying abreast of regulatory developments is crucial – not just to avoid potential issues but also to deliver high-quality services to clients and maintain a competitive edge for your business. 

On 9 October 2024, the Securities and Futures Commission of Hong Kong (the "SFC") issued a circular to licensed corporations engaged in the asset management business, entitled "Deficiencies and substandard conduct noted in the management of private funds and discretionary accounts" (the "Circular")¹.   In the Circular, the SFC highlighted various deficiencies and substandard conduct identified during the course of its supervision of licensed corporations engaged in managing private funds and discretionary accounts (the "asset managers" for the purposes of this article).  The appendix to the Circular has set out various case examples together with detailed guidance from the SFC, which serve as useful but non-exhaustive references for asset managers in determining whether a particular transaction is acceptable and how it should be managed.

In this article, we will discuss the regulatory concerns set out in the Circular, together with our observations and suggestions.  

In the Circular, the SFC has made it clear that: 

• The board and senior management of asset managers (including the Managers-In-Charge of Core Functions and Responsible Officers) are expected to critically review the areas of concern discussed in the Circular (including the appendix) and give priority to strengthening their supervisory and compliance programmes (including policies, procedure, systems and controls) to ensure compliance with all applicable regulatory requirements.  Where practicable, an independent and objective audit should be conducted on the asset manager's compliance with the existing obligations discussed in the Circular.
• The SFC will not hesitate to take decisive action against asset managers and their senior management for any misconduct or supervisory failures.  This includes thematic inspections on asset managers managing private funds to detect material breaches, stepping up its disciplinary actions, and imposing harsher penalties for similar or persistent misconducts.

These are strong messages from the SFC, and it is imperative for asset managers to reinforce their policies and procedures promptly with reference to the Circular. 

Key takeaways from the Circular & our observations

The Circular sets out several key areas of concern that, if not adequately addressed, could pose substantial regulatory risks to asset managers.

Conflicts of interest 

The SFC noted that certain asset managers only made generic and non-specific conflicts of interest disclosures to investors and engaged in transactions that gave rise to actual conflicts of interest which could seriously jeopardise the interests of investors, for example:

• The asset manager used fund assets to provide financing to its related entities, which transactions could not be justified from the portfolio management perspective – such as making additional loans despite the borrower's deterioration in financial health and the loan not being on arm's length terms.
• The asset manager provided financing to funds and failed to justify charging fees higher than normal commercial rates.
• The asset manager unfairly allocated trades in favour of funds where the asset manager's key personnel had a substantial interest.
• The asset manager received monetary benefits from the funds' transactions without taking all reasonable steps to manage the conflicts of interest and providing adequate disclosures to the fund investors on such conflicts.
• The asset manager failed to act fairly in handling fund redemption payments by giving priority to certain investors and its staff over the other remaining investors without justification and failing to prevent its staff from front-running other investors with respect to redemption from the fund.

These transactions breached a number of requirements under the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the "Code of Conduct"), the Fund Manager Code of Conduct (the "FMCC") and the Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the Securities and Futures Commission, as the case may be.

The SFC noted the following key points:

• Asset managers should implement effective policies and procedures, take all reasonable steps to identify, prevent, manage and monitor actual or potential conflicts of interest, and document these steps as appropriate to demonstrate effective implementation.
• Where material interest in a transaction gives rise to conflicts of interest, an asset manager should consider other alternatives.
• When material conflicts of interest cannot be prevented, asset managers should critically consider whether proceeding with such a transaction is in the fund's best interest. 
• Specific disclosures should be made to fund investors, covering specific descriptions of the nature and source of conflicts, material interests of the asset manager and its connected persons, potential risks to investors, as well as the steps taken by the asset manager to mitigate the risks.
• Asset managers should conduct transactions with connected persons at arm's length, and reject any offers or inducements extended to them or their group companies which may pose a material conflict with their duties owed to clients.

Our observations:

• Under the general law, asset managers owe a fiduciary duty to their clients to act in their best interest.  With respect to any actual or potential conflict of interest, an asset manager needs to obtain "informed consent" from its client before proceeding with the transaction.  As a prerequisite for obtaining informed consent, there must be sufficient disclosures provided to the client – often in the form of conflicts of interest disclosures in the fund documents or the client agreements.  Therefore, an asset manager should not treat conflicts of interest disclosures as boilerplate provisions but should review its disclosures carefully and provide specific details having regard to the nature of business of its group of companies and the types of transactions contemplated for the fund or the discretionary account.  Specifically, the SFC emphasised that the disclosures should also include the steps taken by the asset manager to mitigate the risks.  This part is often overlooked or otherwise omitted by asset managers.
• When conducting the regulated activity of asset management, asset managers are expected to act independently from their connected persons.  When it is proposed that a fund will transact with its asset manager or a connected person of the asset manager, one should ensure that the transaction will be on arm's length terms, and document in detail relevant matters, including, without limitation, (a) the reason and justification for entering into a transaction with a connected person as counterparty, (b) other alternatives or counterparties considered, (c) the measures undertaken to ensure the transaction will be on arm's length terms, and (d) the measures undertaken to manage the conflicts of interest.
• With respect to funds that will acquire warehoused investments, the disclosures on conflicts of interest and the purchase price should be very detailed and specific, and will vary on a case-by-case basis.  Please consult us if you require further information.
• Asset managers should always bear in mind the requirements of the FMCC and the general principles set forth in the Code of Conduct – in particular, the overarching need to act in the best interest of investors and clients and to ensure fair treatment of fund investors.  Irrespective of how detailed and specific the conflicts of interest disclosures are, there are certain types of transactions that give rise to a high degree of conflicts of interest, such that asset managers should not enter into these transactions.

Risk management and investment within the mandate

The SFC noted that certain asset managers failed to implement adequate risk management measures (including ensuring that transactions were in accordance with the fund's or the client's investment objectives and restrictions) or to address the risks associated with the transactions properly.  Consequently, the investors were exposed to significant concentration, liquidity and credit risks, leading to substantial losses. 

In one of the cited examples, despite having a significant amount of overdue redemption payables, the asset manager continued to invest the assets of a fund into illiquid stocks or private notes that were estimated to take 6 to 18 months to liquidate, and could not demonstrate that liquidity risk assessments were made prior to making the investment decisions.  The liquidity problem of the fund aggravated, resulting in further delays in redemption payments to the investors.

Omission regarding the application of appropriate investment risk management procedures by asset managers appeared to be not uncommon.  In most of the cited examples, including the one above, certain asset managers disregarded glaring "red flags", and failed to address them before such risks turned into real issues adversely affecting the investors.  The SFC also noted that certain asset managers failed to ensure that the transactions were carried out on behalf of the funds in accordance with the stated investment restrictions or objectives.  This issue is evident in an enforcement case earlier this year² , where an asset manager was reprimanded and fined by the SFC for failing to invest within the mandate and in accordance with the fund's investment objective and strategy.  One of the observations by the SFC was that the said asset manager placed too much reliance on the portfolio manager to manage the fund and the associated risks.  Whilst it may be convenient to delegate all fund management duties to the portfolio managers, asset managers, particularly those with sizeablemore extensive operations, are still expected to actively supervise all investment activities.  

The SFC noted the following key points:

• Asset managers should design and implement proper policies and procedures for the investment management process, which are formulated to ensure that transactions carried out on behalf of the funds and discretionary accounts are in accordance with their stated investment strategies, objectives, restrictions and guidelines, whether in terms of asset class, geographical spread or risk profile, as set out in the respective constitutive and relevant documents.
• Asset managers should implement adequate risk management procedures (including risk measurements and reporting methodologies) to identify, measure, manage, and monitor appropriately all relevant risks to which each fund or account is or may be exposed.
• Asset managers should integrate liquidity management into the investment decision process and set concentration limits with respect to the funds' exposures, taking into account the respective liquidity profiles and the funds' liquidity risk policies.
• In situations where the risk exposures of the funds are significant, the risk assessments should be reviewed by a qualified and experienced person of the asset manager.
• Asset managers should keep proper records of their assessments of the portfolios' risks.  The records should be commensurate with the asset manager's nature, size, complexity and risk profile and the investment strategy adopted by each of the funds and accounts.

Our observations:

• Understandably, many asset managers prefer to set the investment program of a fund or a discretionary account to be extremely wide with no or minimal investment restrictions for flexibility.  Do note that (a) the actual portfolio constructed should at least somewhat resemble the substance of the investment program as presented, (b) asset managers should not overpromise or use overly ambiguous words in the investment program, and (c) the investment restrictions should be precisely defined.
• It is critical for the investment process to be documented in detail.  Ideally, the record should cover matters including, without limitation, (a) the rationale or basis for making the investment, (b) the assessment for compliance with the terms of the investment program, (c) the risk management considerations, (d) the liquidity risk management considerations, (e) the climate-related risk considerations (if applicable), and (f) any specific remark for post-investment monitoring.

Information for investors

Under paragraph 6.2 of the FMCC, asset managers responsible for the overall operation of the funds are required to provide fund investors with "adequate information" on the funds to allow them to make informed judgements about their investments in the funds.  Whilst the Circular has not set out a definitive list of matters that will constitute "adequate information", from the cited examples, the SFC noted that the following disclosures should be made: 

• concentrated positions and significant exposures that pose significant risks to the funds, such as the majority of the fund's assets being exposed to a single issuer or issuers of the same group – a look-through approach should be employed in determining the exposures to issuers;
• significant events impacting the funds, such as major investment losses, significant defaults in investments with substantial adverse impact on the funds' net asset value or the funds' ability to meet their liquidity needs; and 
• modified opinion issued by the funds' auditors or material delay in issuing of audited financial statements. 

Asset managers are also expected to notify fund investors if the stipulated information is not provided to them according to the fund documents, explaining why the information is not available and the expected time when such information will become available.  Asset managers should also keep proper records of the disclosures made to fund investors.

Our observations:

• Except for the specific instances noted in the Circular, the SFC has not been more prescriptive on the types of information to be disclosed and the method of disclosure, and has left room for a case-by-case determination as to what constitutes "adequate information".  In this regard, asset managers can seek guidance from the prevailing market practice.   
• It is expected that the method of disclosure will continue to comprise (a) the fund documents, (b) the reports stipulated in the fund documents, such as the annual reports, and (c) the periodic newsletters.  Where the circumstance requires due to urgency or otherwise, asset managers can also consider issuing an investor notice.
• A rule of thumb for determining whether additional disclosure should be made is "whether the already published information has become misleading in material respects".
• Disclosures should be made promptly, taking into account the time required for gathering the necessary information and preparing the disclosure materials. 

Valuation methodologies 

The SFC identified instances where asset managers adopted inappropriate valuation methodologies, and attempted to hide investment losses of the funds from investors.  The valuation of securities that are not actively traded (including unlisted or unquoted) or have been suspended from trading is the main area of concern.

In some instances, the asset managers valued their investments at cost but failed to justify why no adjustments were needed when defaults had occurred.  In another cited example, the asset manager chose to value a defaulted loan based on the estimated value of the collateralised shares (the loan was collateralised by a majority stake in a Hong Kong-listed company), despite the fact that trading of the said shares was suspended due to litigation and winding up petitions against the said company.  Deliberately adopting this valuation method to conceal investment losses, the asset manager calculated the estimated value using the closing prices of the shares at different points of time before the suspension without providing any adjustments or justifications despite the company's situation. 

Under paragraph 5.3.1 of the FMCC, asset managers are required to establish appropriate policies and procedures to ensure that a proper and independent valuation of the fund assets can be performed and valuation methodologies are consistently applied to the valuation of similar types of fund assets.  Paragraph 5.3.6 of the FMCC provides detailed guidance on the valuation of fund assets.  The SFC noted that even when the responsibility of valuation is delegated to a third-party valuer, asset managers should exercise due skill, care and diligence in the selection of a third-party valuer, and remain primarily responsible for the valuation of a fund's assets to ensure that the valuation is conducted in compliance with the relevant requirements.  

Our observations:

• The SFC has been scrutinising the valuation of securities that are not actively traded (including unlisted or unquoted) or have been suspended from trading, and we expect such scrutiny to continue.
• Generally, the valuation methodologies to be used for a fund should be consistent with the valuation policy adopted by the asset manager.  If the asset manager wants to adopt a different valuation methodology for a particular asset type, it must be specifically stated in the fund documents.  If such valuation methodology comes with certain risks, the relevant risks should be stated in the fund documents as well.
• Deliberate manipulation or cherry-picking of valuation is clearly a no-go.  Valuation methodologies must be applied consistently across similar types of assets within the fund. 
• Essentially, valuation of fund assets is an exercise based on information available.  When new information becomes available in the market or to the asset manager (e.g. a default by an issuer), the asset manager should react and revisit the valuation made for the relevant securities.   
• In relation to the valuation of securities that are not actively traded (including unlisted or unquoted) or have been suspended from trading, asset managers should clearly document the basis for determining the valuation, including, without limitation, the types of information taken into account and the pricing sources (e.g. brokers) consulted.

Conclusion

In light of the SFC's intensified focus on compliance and enforcement, it is imperative for asset managers to reassess and reinforce their policies, procedures and operational practices.  Should you have any questions, please contact our lawyers for a consultation.