As part of its continued drive to curb improper practices by private fund managers, the Securities and Futures Commission of Hong Kong (SFC) yesterday announced in a special circular to asset managers that it will commence a thematic on-site inspection of private fund managers to detect any material breaches or non-compliance with applicable regulatory requirements. This article summarizes the areas of regulatory concern together with the expected standards of conduct to which private fund managers must adhere.
Areas of Regulatory Concern
The common deficiencies noted by the SFC in the management of private funds or discretionary accounts include:
- Conflicts of interest: failure to manage potential or actual conflicts of interests when using fund assets to provide financing to related parties, or providing financing on preferential terms lower than the prevailing market rates (without security or inadequate collateral), or unfairly allocating trades in favor of a manager’s key personnel, or receiving monetary benefits from fund transactions arising from underwriting activities, or giving priority to staff redemptions over those of external investors.
- Risk management: failure to implement adequate risk management or conduct due diligence to ensure investments are in accordance with a fund’s stated investment strategy, objectives, restrictions and guidelines to avoid exposing investors to significant concentration, liquidity or credit risks.
- Investor disclosures: failure to make adequate disclosures to investors about concentrated positions or other significant events which impair net asset value or liquidity or delays in issuing (or modifications made to) an auditor’s opinion involving a fund’s audited financial statements (regardless of whether the fund’s constitutive documents have required the provision of audited financial statements to investors or upon request) which hinder the ability of investors to make informed decisions about their investments.
- Valuation methodologies: adopting valuation methodologies to conceal investment losses, especially for funds heavily invested in fixed income products, collateralized loans or unlisted securities that are not actively traded or have been suspended from trading.
Expected Standards of Conduct
The SFC urges private fund managers (including their senior management and managers-in-charge) to critically review the areas of concern and strengthen their supervisory and compliance programs, including policies and procedures as well as systems and controls to rectify any deficiencies ahead of its thematic on-site inspections. When scrutinizing these areas, managers are expected to consider the expected standards of conduct in the Fund Managers Code of Conduct (FMCC). This includes:
- the need to identify, prevent and manage actual or potential conflicts that arise from transactions to ensure fair treatment of fund investors. Specifically, managers should avoid prioritizing the interests of related parties over those of fund investors and properly evaluate and document objective counterparty/credit/collateral risk assessments. Reliance on generic or non-specific disclosures that managers and their affiliates may have an interest in investments or transactions that may conflict with the interests of investors is likely to be viewed as inadequate where material interest or conflict is involved.
- the need to identify, measure, manage and monitor appropriately all relevant risks to which each is exposed, including assessing the market, diversification, liquidity, concentration and credit risks of investment portfolios throughout the life cycle of the fund. However, the SFC cautioned that the use of credit rating agency ratings should not be “mechanistic nor lessen asset managers’ responsibility” to ensure credit exposures are based on robust risk assessments. It also reminded managers of the baseline requirements set out in the FMCC, including the duty to “integrate” liquidity management when making investment decisions.
- the need to make prompt disclosures to fund investors whenever significant events have a material adverse impact on the value of a fund’s assets or its ability to meet its liquidity needs, such as major investment losses, defaults in principal or interest for any significant position(s) with counterparties or related parties, large redemption requests that result in the majority of liquid assets being liquidated, or suspensions of redemptions. Further, the SFC also urged managers to adopt a “look-through” approach in determining a fund’s exposure to issuers where complex arrangements are involved or investments are held through other investment vehicles.
- the need to obtain independent quotes from suitably qualified third parties when valuing unlisted securities or quotes from brokers or market makers when valuing securities that are not actively traded or have been suspended from trading at their fair value (rather than at cost or last known market price). Specifically, managers are expected to identify when such a security ought to be written down or written off in the valuation of a fund account. However, the SFC noted that managers “remain responsible” for valuation of a fund’s assets notwithstanding the appointment of a third-party valuer and need to assess whether the valuation model and assumptions are appropriate.
What Happens Next?
The circular underpins the increased level of regulatory scrutiny facing private fund managers. It sends a clear message that senior management, including managers-in-charge of core functions and responsible officers, bear primary responsibility for ensuring appropriate standards of conduct. Managers who become aware of any material breach, infringement or non-compliance with any regulatory requirements are reminded to promptly comply with their self-reporting obligations to the SFC under paragraph 12.5 of the Code of Conduct. However, the SFC warns that it is ready to take enforcement action and impose harsher penalties for similar or persistent misconduct to the areas of concern identified in the circular.
If you would like to discuss the expected standards of conduct, revamp your written procedures or explore how we may be able to assist you, please do not hesitate to contact us.
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