SFC sets out standards expected of asset managers in considering private fund and discretionary account arrangements and transactions

On 21 November 2019, the Securities and Futures Commission (SFC) published a circular to licensed corporations regarding dubious private fund and discretionary account arrangements and transactions. This is part of the SFC’s ongoing efforts to tackle market and corporate misconduct.

The circular provides guidance to asset managers in considering if a proposed private fund and discretionary account arrangement or transaction is dubious, and if so, whether it should be proceeded with. The Hong Kong Monetary Authority has drawn the circular to the attention of registered institutions which engage in asset management and discretionary account management.

This circular does not apply to licensed corporations or registered institutions which provide discretionary account services as an ancillary part of their brokerage services for clients, without any formal investment mandates agreed with or management fees charged to clients.

The SFC reminds firms that their senior management (including managers in charge) bears primary responsibility for ensuring that there are effective procedures and controls to consider if a proposed private fund and discretionary account arrangement or transaction should be proceeded with.

As part of its ongoing efforts to tackle market and corporate misconduct, the SFC has simultaneously issued a statement reminding listed companies of their disclosure obligations, focusing on the need to adequately disclose information about counterparties and, where appropriate, their beneficial owners (see our recent bulletin regarding this statement).

Background

In its supervision of asset managers, the SFC has in recent years identified a number of dubious arrangements and transactions involving private funds or discretionary accounts. These have been noted in various circulars issued in July 2017, August 2018, October 2018 and April 2019, and include (among others) investments with irregular features, margin financing disguised as investments, nominee and warehousing arrangements, and complex arrangements to finance risky investments.

The SFC notes that the asset managers in many of these cases largely followed investors’ instructions when structuring private funds or discretionary accounts and effecting transactions, even where there were red flags which should have been looked into.

Failure to detect or act on red flags

Asset managers which do not make proper enquiries or adequately deal with red flags may risk:

• facilitating misconduct by their clients or other parties, such as fraud, unlicensed regulated activities, market misconduct, and breach of other laws and regulations;
• breaching the obligation to act honestly, fairly or with due skill, care or diligence, in the best interest of their clients, under the SFC’s main code of conduct;
• breaching guidelines relating to anti-money laundering and counter-terrorist financing, such as client due diligence and suspicious transactions reporting requirements.

These may give rise to disciplinary, civil or even criminal action by the SFC.

Expected standards of conduct and procedures

The SFC circular provides guidance to asset managers in considering if a proposed private fund and discretionary account arrangement or transaction is dubious, and if so, whether it should be proceeded with. The steps and expected standards (set out in Appendix 1 of the circular) should include those below, and should be adopted in substance rather than in form.

The senior management of firms should assume responsibility for developing and implementing the procedures and controls in an effective manner. These procedures and controls should be in writing, supplemented by staff training and subject to compliance reviews and internal audits as appropriate.

Asset managers are expected to be familiar with the (non-exhaustive) examples of potential red flags set out in Appendix 2 of the circular, which may indicate that arrangements or transactions are unduly complex or lack a commercial rationale, or facilitate corporate or market misconduct or breaches of legal or regulatory requirements.11

1. Initial screening

• An asset manager should perform an initial screening of any proposed arrangement or transaction which deviates from generally accepted market practices (such as special purpose vehicles for tax purposes), before accepting a new mandate, executing an investor directed or suggested investment transaction, or accepting the injection of an investment by the investor into the private fund or discretionary account.
•  If there is any reason to suspect that it is or will be required or expected to make investment decisions (apart from mere execution or operational decisions), the asset manager should review the details of the proposed arrangement or transaction and ask itself further questions, such as whether the proposed arrangement or transaction makes commercial sense, and whether it involves one or few investors investing significant amounts in one or a few illiquid stocks or unsecured loans (see section (A) paragraph 2 of the expected standards for more examples).
• If the asset manager is not satisfied with the answers to any of the above questions, the proposed arrangement or transaction should be considered dubious.

2. Detailed due diligence

• Any proposed arrangement or transaction which is considered dubious at the initial screening should be logged and subject to detailed due diligence.
• Due diligence should be conducted on the investors, the set up and structure of the fund and discretionary account, and the transactions directed by the investor (recommended steps are set out in section (B) of the expected standards).
• The asset manager should then escalate the proposed arrangement or transaction and its due diligence report to senior management for review and a decision as to whether to proceed.

3. Senior management assessment and decision

• Senior management should consider the due diligence report and any necessary additional factors (such as those set out in section (C) of the expected standards), and seek professional advice if necessary, to determine whether to proceed with the proposed arrangement or transaction. It should only decide to proceed if all of its concerns have been sufficiently addressed.

4. Documentation

• An asset manager should keep full documentation of all aspects of any proposed private fund or discretionary account arrangement or transaction which has been determined to be dubious at the initial screening.
• This should include:
  • a log of all such arrangements and transactions;
  • details of the initial screening and enhanced due diligence, and any additional steps taken by the senior management together with the results; and
  • the senior management’s review and decision, with its stated reasons for approval.