The Hong Kong Securities and Futures Commission (SFC) on 16 November 2017 published its Conclusions on its one-year consultation in relation to enhancement of asset management regulation and point-of-sale transparency (Conclusions). The SFC largely adopted its initial proposals, with a few modifications and clarifications as to regulatory intent. Further, in order to align with recommendations of the International Organisation of Securities Commissions (IOSCO) and the Financial Stability Board (FSB), the Conclusions introduced new requirements and enhanced existing requirements in the Fund Manager Code of Conduct (FMCC) and Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct).
These amendments will significantly impact discretionary account managers, as such managers will be required to comply with both the FMCC and the Code of Conduct after full implementation. The amendments to the FMCC and Code of Conduct will become effective on 17 November 2018 and 17 August 2018, respectively. The SFC also published Frequently Asked Questions (FAQs) with respect to the amendments.
This article provides an overview of key amendments to the FMCC and the Code of Conduct.
Overview of Key Amendments
The new and enhanced FMCC requirements pertain to: (i) the FMCC’s scope; (ii) securities lending, repurchase agreements (repos) and reverse repo transactions; (iii) custody of fund assets; and (iv) liquidity management. There are additional amendments related to the disclosure of leverage, fund portfolio valuation and risk management.
The Code of Conduct amendments pertain to: (i) expansion of its scope to cover SFC-licensed or registered persons acting as a management company that provides discretionary management to collective investment schemes; and (ii) implementation of a two-pronged approach to address potential conflicts of interest related to the receipt of benefits by intermediaries in connection with the sale of investment products. The two-pronged approach involves amendments to: the definition of “independence” of such SFC-licensed or registered persons; and disclosure requirements regarding monetary and non-monetary benefits received at the point-of-sale by such intermediaries
Amendments to the Fund Manager Code of Conduct
Revised Scope of Overall Application
The SFC recognises that fund managers may not formally make decisions for the fund (e.g., pertaining to appointment of custodians or the manner of handling pricing errors and fair valuations) or enter into legal agreements on behalf of the fund. However, fund managers nevertheless may be responsible for the overall operation of the fund (in circumstances where the fund confers them with complete discretion). To better protect investors and monitor any systemic risks potentially arising out of asset management activities, the SFC expects all fund managers to comply with the requirements of the FMCC, to the extent within the control of the fund manager.
Application of FMCC
The provisions of the FMCC apply to a fund manager and its representatives (where appropriate) when the business involves the management of collective investment schemes and/or discretionary accounts. To the extent a fund manager (including its representatives) is not responsible for the day-to-day operation and management of a fund, certain provisions of the FMCC do not apply.
Under the revised FMCC, the SFC may consider fund managers to be responsible for the overall operation of the fund where representatives of the fund manager and its affiliates constitute a majority of the fund’s board. In cases where there is such a majority, fund managers will need to comply with the FMCC regardless of whether the fund is private or public and whether the fund is domiciled in Hong Kong or overseas.
Implications of the Revised Scope of Application
Fund Managers. Parent offshore management companies may need to observe the requirements of the FMCC in their management and operation of an offshore fund, if they delegate investment management responsibilities to a Hong Kong licensed fund manager, even though such parent companies are in compliance with the offshore jurisdiction’s conduct and fund-level requirements. However, it is unclear what the implications would be for those parent offshore companies.
Discretionary Account Managers. Discretionary account managers are required to comply with the general principles and requirements applicable to fund managers, to the extent relevant to the functions and powers of the discretionary account manager. Appendix 1 to the revised FMCC sets out requirements that are, and are not, applicable to managers of discretionary accounts.
New Requirements as to Securities Lending and Repurchase Agreements
The revised FMCC sets out new requirements for fund managers that engage in securities lending, repos and reverse repo transactions on behalf of the funds they manage (New Requirements). The New Requirements aim to address shadow banking risks in the funds industry, as well as associated threats to financial stability of the market.
Fund Managers Subject to the New Requirements
The New Requirements will apply: (i) where the fund manager decides that securities lending should be a fund activity; or (ii) where the fund manager is materially involved in determining a securities lending mandate on behalf of the fund or in actual lending activities with/on behalf of the fund.
Where a third party is engaged (for example, as a prime broker or custodian), the fund manager must act with due skill, care and diligence in the selection, appointment and ongoing monitoring of the third party, including being satisfied that the third party’s policies and procedures are consistent with the FMCC requirements.
Where a fund manager merely engages in securities lending and repo transactions on behalf of the fund, but is not responsible for the overall operation of the fund, the fund manager is nevertheless expected to have adequate arrangements in place to receive and access information from third-party agents.
Discretionary account managers generally are not subject to the above requirements if they do not have any authority under an investment mandate to use securities lending or repos on behalf of a client, or are not materially involved in determining the securities lending mandate for a client.
In order to manage counterparty risks, fund managers that engage in securities lending and repo transactions must create and implement: (i) a collateral valuation and management policy (CVM Policy); (ii) an eligible collateral and haircut policy (ECH Policy); and (iii) a cash collateral reinvestment policy (CCR Policy).
Collateral Valuation and Management Policy
The CVM Policy should:
- Enable the fund manager to determine the acceptability of certain collateral, and manage collateral in default situations (in particular, to liquidate where necessary).
- Require that collateral and loaned securities are marked to market daily, to the extent practicable.
- Enable the fund manager to monitor counterparty risk, and to determine a minimum acceptable threshold by collecting daily information on variation margin.
Eligible Collateral and Haircut Policy
An ECM Policy should enable the fund manager to determine the types of acceptable collateral and the corresponding haircuts in connection with the securities lending, repo or reverse repo transactions. The determination should take into account various risk considerations, such as market risk, counterparty credit risk, foreign exchange risk, and other risk factors applicable to the specific characteristics of the collateral.
The haircut methodology should cover the maximum expected decline in the market price of the collateral asset before a transaction can be closed out, according to a conservative liquidation horizon. The calculation of the maximum price decline should be based on a long-term series of price data, covering at least one stress period. Where such data is unavailable or unreliable, stress simulations should be conducted for at least one stress period. The liquidation horizon should reflect the expected liquidity or illiquidity of the assets in stressed market conditions.
Cash Collateral Reinvestment Policy
A CCR Policy should:
- Ensure that assets held in the cash collateral reinvestment portfolio are sufficiently liquid, with transparent pricing and low risk, to meet reasonably foreseeable recalls of cash collateral. Ongoing stress test should be conducted to ensure the portfolio is able to meet foreseeable and unexpected calls for the return of cash collateral.
- Require a minimum portion of the cash collateral to be kept in short-term deposits, held in highly liquid short-term assets, or invested in short-tenor transactions.
- Set specific limits for the weighted average maturity and/or weighted average life.
In respect of non-cash collateral rehypothecation, a fund manager must disclose re-use and re-hypothecation data to investors.
Fund managers that are responsible for the overall operation of a fund must disclose to fund investors, at least annually, information regarding the fund’s securities lending, repo and reverse repo transactions. The revised FMCC sets forth the types of information to be provided.
Custody of Fund Assets
The amendments incorporate current principles under the IOSCO standards, and aim to ensure that:
- Fund assets, assets of fund managers (and their affiliates, if any) and assets of other clients of fund managers are properly segregated.
- Where fund assets are held in an omnibus account, those assets are readily identifiable on the custodian’s books and records through implementation of appropriate safeguards and record-keeping.
- A custodian is functionally independent from the fund manager, and a fund manager responsible for the overall operation of the fund exercises due skill, care and diligence in appointing the custodian.
- A fund manager responsible for the overall function of the fund monitors the custodian on an ongoing basis.
- Where self-custody arrangements are adopted, the custodial function is independent from the fund’s management and administration functions.
- Custody arrangements, and changes of such arrangements, are administered by a custody agreement or trust deed (as the case may be) and properly disclosed to the fund’s investors.
Under the revised FMCC, with respect to liquidity management (LM), all licensed or registered fund managers will be required to ensure that the activities of the funds they manage (e.g., trading activities, receipt of subscription monies, payment of redemption proceeds) are commensurate to the funds’ liquidity profiles.
In addition, fund managers must conduct ongoing liquidity stress tests to assess the impact of plausible severe adverse changes in market conditions. The frequency of such tests depends on the nature and liquidity profile of each fund. Test results are to be reviewed by an LM committee and/or the senior management to determine: (i) whether further actions are required; and (ii) if not, the action plans to meet the fund’s liquidity needs should any stress scenarios materialise.
The SFC also recognises that specific tools or exceptional measures may be permitted by the constitutive documents of a fund for the purpose of LM. Where such tools or measures affect redemption rights, the fund manager should consider the appropriateness of using such tools or measures, taking into account the nature of assets held by the fund as well as the fund’s investor base. Accordingly, the fund manager must disclose such uses and provide relevant explanations of the effects on redemption rights, in the fund’s offering documents and/or side letters (as the case may be).
Fund managers should use their own professional judgment as to whether a liquidity target should be set and, if so, the appropriate level.
Disclosure of Maximum Leverage
A fund manager must disclose in the fund’s offering documents an expected maximum leverage, calculated based on: (i) financial leverage arising from borrowings; and (ii) synthetic leverage arising from the use of derivatives. The calculation methodology also must be disclosed in the offering documents.
Fund Portfolio Valuation
The SFC incorporates relevant IOSCO principles into the existing valuation requirements:
- Fund valuation processes. Fund managers should ensure that policies and procedures are in place for valuation.
- Independent valuation of fund assets. Fund managers must ensure that an independent valuation can be performed (by an internal auditor that is functionally independent from the valuation team or by an external auditor), and that valuation methodologies are consistently applied to the valuation of similar types of fund assets. The fund manager remains responsible for the valuation of fund’s assets, despite appointment of third-party delegates to perform valuation.
- Periodic review of valuation policies and procedures. A review is required to be performed by a competent and functionally-independent party (e.g., a person performing an independent audit function or an external auditor).
The SFC introduced a new Appendix 2 to the FMCC, which sets out recommended risk management (RM) techniques and procedures that a fund manager should take into account (where appropriate). These recommended best practices provide additional guidance on risk management at the fund level.
Appendix 2 sets out recommended measures regarding market risk, liquidity risk, issuer and counterparty credit risk and operational risk (with some elaboration on a business continuity and transition plan). However, it is important to note that the relevant sections of the revised FMCC do not supersede the SFC’s “Internal Control Guidelines”.
Additional Requirements for Discretionary Account Managers
The SFC introduced a minimum required content for discretionary account agreements, and allows clients of the discretionary account managers to add further terms and conditions. Provisions as to receipt of soft commissions or retention of cash rebates (as defined in the Code of Conduct) may be added via an addendum to the client agreement.
A performance benchmark must be included as part of the minimum content in cases where the client’s mandate requires this. If the client mandate does not contain such a provision, the discretionary account manager needs to employ an appropriate benchmark, taking into account the client’s investment objectives.
Amendments to the Code of Conduct
Revised Scope of Application of the Code of Conduct
The application of the Code of Conduct has been expanded to cover SFC-licensed or registered persons that act as a management company that provides discretionary management to collective investment schemes (whether such schemes are authorised by the SFC or unauthorised). As a result, providers of asset management services to a private or public fund (including its discretionary account management services) must comply with the Code of Conduct, in addition to the revised FMCC, as discussed above.
Two-Pronged Approach to Receipt of Benefits by Intermediaries in Connection with the Sale of Investment Products
The SFC concluded that, instead of adopting a pay-for-advice model (i.e., banning commissions), which is still uncommon among Hong Kong investors, it will adopt a two-pronged approach that:
- Restricts the circumstances in which intermediaries may represent themselves as “independent” or providing “independent advice” (First Limb); and
- Enhances the disclosure of monetary benefits received or receivable by an intermediary, which are not quantifiable prior to or at the point of entering into a transaction (e.g., trailer fees and commissions) (Second Limb).
However, this seems to be only a temporary approach. In the Conclusions, the SFC recognises the insufficiency of the enhanced disclosure requirements to facilitate competition and drive down fees. The SFC has indicated that it will actively monitor the impact of the new requirements and consider the merits of pay-for-advice models.
Restriction on Use of the Term “Independence” – First Limb
A licensed or registered intermediary cannot refer to itself as “independent” (or use other terms with similar inference), if it: (i) (directly or indirectly) receives fees, commissions or any monetary or non-monetary benefits from other parties in relation to the distribution of an investment product to clients; or (ii) has “close links or other legal or economic relationships” with product issuers, which are likely to impair the intermediary’s independence in respect of a particular investment product, class of investment products, or product issuer.
Monetary and Non-Monetary Benefits Received in Relation to Distribution of an Investment Product
The following situations might give rise to potential conflicts of interest:
- Where a distributor receives fees, commissions or any other monetary benefits from a third party for distributing an investment product; and
- Where a distributor is remunerated for selling a particular issuer’s products or for meeting a specified sales target set by the product issuer.
In each instance, the SFC will consider the relevant facts and circumstances to determine the likelihood of impairing the intermediary’s independence with respect to particular investment products or product issuers.
“Close Links or Other Legal or Economic Relationships” with Product Issuers; Controlling-Entity Relationship with Product Issuer
“Close links” may be established where a licensed or registered intermediary has a parent company or subsidiary relationship with a product issuer (e.g., a fund), or is in a controlling-entity relationship (as defined under the Securities and Futures Ordinance) with the product issuer.
A “legal or economic” relationship arises, for example, where the intermediary has a contractual agreement with a product provider whereby the intermediary may distribute only that provider’s investment products.
Disclosure of Monetary Benefits – Second Limb
An intermediary (e.g., a distributor) that deals directly with clients must disclose information on a transaction basis (i.e., on a per-fund basis). However, this obligation does not apply with respect to clients that are professional investors as defined under the Securities and Futures (Professional Investor) Rules (Chapter 571D of the Laws of Hong Kong) (Professional Investor Rules).
The SFC will seek a further two-month consultation on the relevant disclosure requirements with respect to monetary and non-monetary benefits received by licensed or registered persons from discretionary managed account clients (i.e., arrangements where the client has delegated authority to a manager to purchase investment products on the client’s behalf).
The following information must be provided under the enhanced disclosure requirements:
- Existence and nature of monetary benefits received or receivable that are not quantifiable prior to or at the point of entering into a transaction. To the extent an intermediary chooses to disclose additional information (e.g., actual monetary benefits received once they become quantifiable), the intermediary needs to ensure that such information is accurate and not misleading.
- Range of monetary benefits receivable on an annualised basis. This range must reasonably reflect the terms of any agreement with the party providing such monetary benefits. In the case of trailer fees in respect of funds, the intermediary should disclose both the range and maximum percentage of trailer fees receivable.
- Maximum dollar amount of monetary benefits receivable per year. In the case of trailer fees in respect of funds, the maximum dollar amount is calculated based on the assumption that the investor will remain invested in the fund for a 12-month period and there is no change in the net asset value per unit in the fund throughout that period.
- Determination of independence. Intermediaries must provide clear disclosures to investors, prior to or at the point of transaction, as to whether or not the intermediary is independent and the bases for such determination. Although one-off disclosures prior to or at the point-of-sale are sufficient, intermediaries must inform clients of any subsequent changes.
Disclosure Requirements Not Currently Applicable to Discretionary Accounts
At present, the enhanced disclosure requirements in relation to third-party benefits do not apply to discretionary accounts. These requirements remain open to further consultation until 15 January 2018.
The SFC notes the difficulty of providing details as to the nature and amount of the monetary benefits received or retained by discretionary account managers prior to each transaction on behalf of clients. As such, the SFC has proposed approaches requiring disclosure of:
- Monetary benefits (under explicit remuneration arrangement)
- Option 1 – disclosure by type of investment product
- Option 2 – disclosure of aggregate amount, expressed as a percentage of the invested amount
- Monetary benefits (under non-explicit remuneration arrangement) and non-monetary benefits
Where an intermediary purchases in-house products on behalf of its clients under a discretionary portfolio and there is no explicit remuneration arrangement between the intermediary and the related product issuer, the intermediary should make a generic disclosure of its benefit from purchasing in-house products. Similarly, the intermediary should make a generic disclosure about non-monetary benefits received from a product issuer arising from a purchase of an investment product on behalf of a client.
The proposed disclosures should be made by intermediaries to investors in writing, at the account opening stage or prior to entering into a discretionary client agreement.
Intermediaries would be exempted from these disclosure requirements only with respect to clients that are Institutional and Corporate Professional Investors as defined under the Professional Investor Rules. No exemptions would be available with respect to clients who are Individual Professional Investors.
The SFC has proposed a six-month transition period for disclosure requirements that are adopted.
Existing fund managers and discretionary account managers (i.e., regulated persons under Type 9 regulated activity) should carefully consider the wide-ranging amendments to the FMCC and the Code of Conduct. As a substantial amount of work and time may be needed to update policies and procedures to comply with these amendments, managers may wish to seek professional assistance as soon as possible.