Hong Kong SFC targets asset management misconduct – Are you ready for an inspection?

On 9 October 2024, the Securities and Futures Commission (SFC) issued a circular flagging various deficiencies and substandard conduct identified during its supervision of licensed corporations engaged in managing private funds and discretionary accounts (asset managers).

The SFC has issued a number of circulars in recent years highlighting the deficiencies observed during its supervision of asset managers, and provided guidance on how to strengthen internal controls and risk management processes (set out at the end of this bulletin). However, the SFC observed that misconduct has persisted in the industry (see case examples in the Appendix to the circular). This circular reminds asset managers of their existing obligations when managing unauthorised collective investment schemes (private funds) and discretionary accounts.

Senior management of asset managers, including the Managers-In-Charge and Responsible Officers, are expected to:

1. critically review the areas of concern highlighted in the circular;
2. prioritise strengthening their supervisory and compliance programmes, including their policies, procedures as well as systems and controls; and
3. where practicable, conduct an independent and objective audit on the asset manager’s compliance with the existing obligations discussed in the circular. Should an asset manager become aware of any material breach, infringement or non-compliance with any regulatory requirements in its review, it should report immediately to the SFC.

To combat asset management misconduct, the SFC will commence a thematic on-site inspection of asset managers managing private funds and will not hesitate to take decisive action against these asset managers and their management, including Managers-In-Charge and Responsible Officers, for their misconduct in asset management activities and failure to discharge their supervisory duties. Indeed, the SFC has said it will step up its disciplinary actions and impose harsher penalties against misconduct to send a strong deterrent message to preserve the integrity of the Hong Kong market and instil confidence in the investing public.

Areas of deficiencies and substandard conduct 

The circular highlights cases involving breaches of regulatory requirements in four areas, which centre on the obligations under the SFC's Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission, Fund Manager Code of Conduct (FMCC), and Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the Securities and Futures Commission.

1. Prevention and management of conflicts of interest

Examples of deficiencies and substandard conduct

The SFC highlights that some asset managers have failed to comply with their duty to take all reasonable steps to identify, prevent, manage and monitor actual or potential conflicts of interest arising from their transactions or practices. In particular, there have been instances where asset managers:

• used fund assets to provide financing to related entities and prioritised the interests of the related entities or key personnel over those of the fund investors;
• provided financing to funds and failed to justify charging fees higher than normal commercial rates;
• unfairly allocated trades in favour of the asset manager's key personnel;
• received monetary benefits from the funds' transactions without proper disclosure or management of the conflicts of interest; and
• failed to act fairly in handling redemption payments to fund investors by giving priority to redemptions from their staff over those of other clients.

Regulatory expectations

The circular reminds asset managers of their duty, pursuant to paragraph 1.5 of the FMCC, to take all reasonable steps to identify, prevent, manage and monitor any actual or potential conflicts of interest:

• Where material interest gives rise to conflicts of interest – asset managers should consider alternatives, such as conducting thorough and objective assessments of all financing sources available when considering any financing arrangement for the fund from themselves or their affiliates.
• Where material conflicts of interest cannot be prevented - asset managers should:

1. critically consider whether it is in the best interest of the fund to conduct such transactions;
2. ensure that all transactions (including transactions with connected persons) are conducted in good faith at arm’s length and on normal commercial terms;
3. ensure that fund investors are treated fairly, such as in allocating client orders and handling redemptions, and to consider using appropriate liquidity management tools and exceptional measures to ensure fair treatment of all fund investors;
4. make specific disclosures about the material interest or conflict to fund investors. Generic and non-specific conflicts of interest disclosures in the fund’s constitutive documents that the asset managers and their affiliates may have an interest in the investments or transactions of the funds would not amount to proper disclosure;
5. reject any offers or inducements extended to them or their group companies which may pose a material conflict with their duties owed to clients; and
6. maintain proper documentation of their management of conflicts of interest and its assessments and justifications for the investment decision despite the actual or potential conflicts of interest that arise.

2. Implementation of adequate risk management procedures

Examples of deficiencies and substandard conduct

The circular emphasises that some asset managers failed to implement adequate risk management procedures or appropriate investment due diligence in accordance with their investment objectives and restrictions, leading to exposures of investors to significant concentration, liquidity and credit risks and substantial losses. For instance, some asset managers:

• made investments in breach of concentration restrictions and caused liquidity mismatches between the fund's underlying investments and its own redemption obligations due to different lock-up periods;
• continued to invest in illiquid stocks or private notes without performing liquidity risk assessments, despite a significant amount of overdue redemption payables;
• provided unsecured loans or made investments without obtaining information for risk assessments, such as understanding the financial position of the borrower/issuer and the latest credit rating report of a bond issuer; and
• failed to conduct appropriate investment due diligence by using a product due diligence form and scoring system inappropriate for the type of investment made.

Regulatory expectations

The SFC notes that asset managers should:

• implement adequate risk management procedures to identify, measure, manage and monitor appropriately all risks to which the fund or account is or may be exposed;
• ensure that risk assessments are reviewed by a qualified and experienced person of the asset manager where risk exposures of the funds are significant;
• ensure investment is made in accordance with their investment objectives, restrictions and risk profiles; and
• maintain effective record retention policies and keep proper records of their risk assessments.

3. Provision and disclosure of adequate information

Examples of deficiencies and substandard conduct

The SFC has noted instances where asset managers failed to provide fund investors with adequate information, including disclosures about:

• concentrated positions and significant exposures that subject the fund to significant risk, such as the majority of the fund’s assets being exposed to a loan made by a private company which subsequently defaulted;
• significant events impacting the funds, such as major investment losses and significant defaults in investments; and
• modified opinion issued by the funds' auditors and material delay in issuing audited financial statements.

Regulatory expectations

The SFC notes that asset managers responsible for the overall operation of the funds should provide fund investors with adequate information (including any material changes to the information) on the funds to allow them to make informed decisions about their investments.

In the above cases of deficiencies and substandard conduct, the asset managers should have disclosed to the fund investors promptly the following information, amongst other things:

• concentrated positions of aggregate exposure, which may subject the fund to significant risk and materially affect the value of the fund. Where complex / opaque arrangements are involved or investments are held through other investment vehicles, asset managers should employ a look-through approach in determining the exposure to the issuers;
• significant events that have had a material adverse impact on the value of the fund assets or the fund’s ability to meet its liquidity needs;
• modified opinion on audited financial statements, other material information issued by the fund auditors, or if there are material discrepancies in the year-end fund valuation information between the fund’s audited financial statements and the information provided to fund investors for the relevant period. This is irrespective of whether the fund’s constitutive documents have required the provision of its audited financial statements to fund investors or upon request; and
• where stipulated information is not provided to the fund investors according to the fund's constitutive documents, a notification with the reasons why the information is not available, and the expected time when such information will become available.

4. Adoption of appropriate valuation methodologies

Examples of deficiencies and substandard conduct

The circular notes that in certain cases, asset managers adopted inappropriate valuation methodologies with an intention to hide investment losses of the funds under their management from investors. For instance, some asset managers:

• valued their investments at cost but failed to justify why shares of a company which has been suspended from trading were valued using closing prices at different points of time prior to the suspension; and
• failed to identify when the fund's asset should be written down or written off when the issuers and guarantors of investments defaulted on the payments for their debts.

Regulatory expectations

The SFC reminds asset managers responsible for the overall operation of the funds under their management that they have a responsibility to ensure the valuation policies and procedures adopted by the funds are appropriate, particularly in respect of unlisted or unquoted securities that are not actively traded and suspended securities.

If a third party is appointed to perform valuation services, asset managers should exercise due skill, care and diligence in the selection of a third-party valuer – noting that asset managers will remain responsible for the valuation of a fund’s assets. The asset managers should:

• ensure that the third-party valuer possesses the appropriate level of knowledge, experience and resources that align with the investment strategy, size, and complexity of the funds under their management; and
• periodically review the third-party valuer’s activities and assess whether the valuation model and assumptions adopted by the third-party valuer continue to be appropriate and effectively implemented.

Conclusion

The SFC stresses that the board and senior management of asset managers bear primary responsibility for ensuring the maintenance of appropriate standards of conduct.

Asset managers should critically review this circular, take actions to strengthen their supervisory and compliance programs, and where practicable, conduct an independent and objective audit on their compliance with the obligations discussed in the circular, in order to be ready for the upcoming thematic on-site inspection.

For reference:

Recent enforcement actions against asset managers and their personnel referred to in the circular

1. SFC suspends a former licensed representative for seven months for failures in managing a private fund (20 Jun 2024)
2. SFC reprimands and fines a licensed corporation $2.8 million for fund management failures (5 Feb 2024)
3. SFC reprimands and fines a licensed corporation $5.2 million for fund management and account opening failures and suspends its responsible officer (4 Dec 2023)
4. SFAT affirms SFC decision to fine a licensed corporation $1.5 million and imposes a heavier suspension on its responsible officer for failures in managing private funds (30 Jan 2023)
5. SFC reprimands and fines a licensed corporation $3.2 million for failures in managing private funds (27 Jun 2022)

The SFC's guidance referred to in the circular

6. Dubious private fund and discretionary account arrangements or transactions (21 Nov 2019)
7. Managing the liquidity risk of funds (23 Aug 2019)
8. HKMA and SFC adopt a coordinated approach to supervise banks and licensed corporations (24 Apr 2019)
9. Use of “nominees” and “warehousing” arrangements in market and corporate misconduct (9 Oct 2018)
10. Margin financing activities disguised as investments (3 Aug 2018)
11. Common instances of non-compliance in managing funds and discretionary accounts (15 Sep 2017)
12. Irregularities and deficiencies in managing private funds and discretionary accounts (31 Jul 2017)
13. Circular to all licensed corporations engaged in hedge funds management business (27 Oct 2008)