Hong Kong Licensed Investment Advisers’ Duty to Protect Investors Extends Beyond Their Mandate

With the Asian fund management industry burgeoning and Hong Kong being well positioned to support private fund managers investing into China, the Hong Kong Securities & Futures Commission (SFC) has published guidance on the licensing obligations of private equity firms that conduct business in Hong Kong on 7 January 2020. Further, the SFC also revamped the Fund Manager Code of Conduct on 14 November 2018, heightening the SFC’s expected standards of business conduct applicable to discretionary fund managers in Hong Kong. In view of the enhanced regulatory scrutiny over private fund managers, private fund industry players have critically reassessed their business models, and some fund managers have changed gears to become licensed investment advisers in Hong Kong to advise fund managers operating and managing funds from outside Hong Kong.

The affirmation by the Securities and Futures Appeals Tribunal (SFAT) of the SFC decision against Cardinalasia Consulting Limited (CCL), a Hong-Kong-licensed investment adviser to five private funds, and its responsible officer (collectively the “Applicants”) serves to remind the fund industry that the SFC takes its supervisory role seriously. Investment advisers (not only fund managers) are reminded to act independently and with due skill, care and diligence in the best interests of fund investors when using their financial knowledge and acting in a delegated capacity. The paramount importance of protecting investors’ interests extends beyond an investment adviser’s delegated capacity, and the SFC takes the view that the investment adviser is obliged to raise concerns over the fund manager’s investment decisions (i.e., in the case of CCL, the entry into inter-fund loans among the five private funds) if such decision is not made in the best interests of the fund and/or its investors.

Though CCL was appointed by the funds’ non-HK-regulated fund manager to act as the principal investment adviser responsible for providing investment advisory services with respect to each fund (incorporated in the Cayman Islands), the SFAT’s conclusions provide insights as to the SFC’s regulatory stance on the standard of conduct expected of licensed investment advisers that are delegated with extensive powers:

1. Scope of delegated powers

The investment adviser’s obligations arise from the terms of its Investment Advisory Agreement (IAA) entered between the adviser, the manager and/or the fund. As the IAA does not mandate the investment adviser to remain passive and only act until required by the manager or the fund, the clear intent would be the opposite effect, that the onus is on the investment adviser to provide effective and professional advice in a timely manner. The investment adviser, being a professional and experienced party, should remain cognizant of market movements and provide effective and professional advice in a timely manner in the best interests of each fund.

2. Advising on the entry of a loan

The loans were entered into among the private funds solely for the purpose of addressing the liquidity needs of the borrowing funds. Specifically, the loan terms had the following features:

a. The loans were not backed by any collateral or guarantee and offered limited protection to the lending funds in the event of default or late repayment;
b. One of the loans was interest free, and the interest rates for some of the loans fell far below margin loans offered by execution brokers; and
c. One lending fund did not have sufficient liquidity when granting the loan, and another had an immediate liquidity issue after granting a loan.

The investment adviser and especially its responsible officer, who is described as a seasoned industry participant, is expected to have knowledge of basic and reasonable protective measures accompanying a loan arrangement, for example, collateral protections or security, and regular repayment provisions. The failure to advise regarding the need for such terms and conditions/safeguards on behalf of the lending funds constitutes a blatant disregard of the investment adviser’s fiduciary obligations with respect to the lending funds and their investors.

3. Breach of General Principle 9 of the SFC Code of Conduct and the importance of keeping adequate documentary evidence

Licensed persons (both the corporation and individuals accredited thereto) are expected to have regard for the SFC’s published guidance including the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code) when conducting regulated activities. The SFC will be guided by the Code’s requirements, including the general principles when assessing whether licensed persons are “fit and proper” to remain licensed. Specifically, the SFC considers that it is fundamental for senior management (i.e., responsible officers) to bear primary responsibility for the maintenance of appropriate standards of conduct and adherence to proper procedures by licensed corporations. Even though the Code does not have the force of law and would not override any statutory provision, it is recommended that licensed persons should still act in a manner that meets the Code’s requirements at all times.

Failure by the investment adviser to maintain documentary evidence (electronically or physically), recording the rationale for the advice given and considerations of fairness to each fund/its investors, risks falling short of the standard of fairness and places the investment adviser at a disadvantage when seeking to demonstrate compliance to the SFC. The SFAT criticized a lack of contemporary documentary materials to support the case for the Applicants. The SFC argued, which the SFAT accepted, that the lack of supporting documentary evidence must cast doubt on whether the Applicants had properly conducted any detailed and balanced assessment of the internal loan arrangements and submitted those assessments to the managers of the funds for consideration.

Independent investment advisers have an independent obligation to protect the legitimate interests of the investors when giving their advice, regardless of the fact that their advisory engagement and mandate flows from the IAA entered with the manager and/or the fund. The SFAT made it clear that this obligation should be upheld even if “in giving advice, that advice is contrary to the intended wishes, or decisions actually made, of those higher in the delegated chain of management.” It is therefore crucial for the investment adviser to consider the relative positions of all relevant stakeholders and to exercise their duties with care and integrity to avoid falling afoul of the Code’s requirements.

Sidley’s Insight

The SFAT’s affirmation reinforces the basic tenets of the SFC’s regulatory approach that the Code’s requirements serve as the benchmark for intermediaries’ conduct when dealing with investors. As a licensed person, the SFC’s expectation of an intermediary’s standard of conduct transcends beyond mere contractual obligations. The expectation is that the intermediary would fully play its part in facilitating and achieving the SFC’s statutory objective of providing protection for the investing public.

An investment adviser to a private fund should (i) critically assess the terms of its IAA to ensure that it has a mutual understanding between itself and the delegating manager with regard to its roles and obligations; and (ii) undergo a review of its compliance program to ensure that its internal policies and procedures are sufficiently robust and are applicable to and enforced by senior management personnel. Further, funds investing in loans are expected to critically review the loan arrangements to ensure that they have built-in reasonable safeguards to afford basic protection to the funds’ investors.

Finally, the SFAT, as a review body that considers the SFC’s regulatory decision on appeal, is empowered to make a range of orders under the Securities & Futures Ordinance, which may even extend any suspension order against an intermediary originally proposed by the SFC. In this appeal case, the SFAT considered that an extension of the suspension order against CCL’s responsible officer from seven to nine months was warranted. The SFAT’s imposition of an even longer suspension period forewarns the asset management community at large that the regulator will not shy away from exercising its enforcement powers to police undesirable behaviour at the senior management level. More severe penalties may be imposed to deter misconduct, and responsible officers will be held individually accountable for their regulatory breaches. Likewise, this trickles down to delegates of the fund manager who are responsible for providing investment advisory services.

Investment advisers are reminded to ensure that their responsible officers are fully trained and aware of their obligations and duties in supervising the provision of investment advisory services. This includes their supervisory role in assessing the basis for, and execution terms of, any proposed trades to ensure they are in the best interests of the funds and investors. Where there is any doubt in this regard, the matter should be escalated to the manager accordingly. It is also imperative that proper records and documents of such steps are kept so that the investment adviser will be well positioned to demonstrate its compliance to the regulator should the need arise.