Oversight February 2017 - Hong Kong Fund Manager Code of Conduct set to change

Introduction

Since 2003 with the introduction of the single license under the Securities and Futures Ordinance (SFO) there have been few direct changes to the approach of the Securities and Futures Commission (SFC) to the oversight and supervision of fund managers, in particular those whose focus is on the non-retail market ie whose funds were sold to or invested by professional investors or offered on a non-retail basis (private funds). Indeed there was a degree of satisfaction in Hong Kong that in the aftermath of the global financial crisis Hong Kong’s regime was adjudged to need no significant revision. This contrasts with Singapore’s overhaul of its ‘exempt fund manager’ regime and the new licensing regime under “Dodd-Frank” in the United States as well as the Alternative Investment Fund Managers Directive (AIFMD) in the European Union (EU).

Once a fund manager is licensed in Hong Kong under the SFO, it is subject to various SFC guidelines and circulars, compliance with which goes to the fund manager’s fitness and properness. The key rules governing a fund manager’s conduct are set out in the Fund Manager Code of Conduct (FMCC). The FMCC is not "heavy" regulation in any sense and to date has confined itself to the fund manager’s obligations to clients and general guidance as to the SFC’s expectations with regard to a fund manager licensed and operating in Hong Kong. Product specific requirements for retail funds are set out in the SFC’s Code on Unit Trusts and Mutual Funds (UT Code). To date there have been no attempts to set requirements for offshore funds managed from Hong Kong. There are at the moment no structural or prescribed disclosure requirements on offshore funds arising from the fact that the fund manager is licensed under the SFO. In addition, unlike AIFMD in the EU, there is no filing, notification or registration requirement to offer interests in an offshore fund on a non-public basis in Hong Kong.

At the end of November 2016 the SFC launched a Consultation Paper on Proposals to Enhance Asset Management Regulation and Point-of-sale Transparency (Consultation). The point-of-sale transparency initiative are proposals to amend the Code of Conduct for Persons Licensed on Registered with the Securities and Futures Commission (Code), the set of rules governing all intermediaries (at present only those holding a Type 9 (asset management) license under the SFO in relation to the discretionary management of funds are not subject to the Code). The point-of-sale proposals address similar issues around independent advice addressed by the Retail Distribution Review in 2013 in the United Kingdom and the Markets in Financial Instruments Directive II (MiFID II) in the EU. These proposals are not covered by this Oversight.

The Consultation, as it affects the FMCC, is material and is therefore significant for fund managers in particular of private funds. The driving force behind the changes to the FMCC suggested by the SFC - which will effect all Type 9 (asset management) licensed fund managers in Hong Kong, seems to be the perceived need for Hong Kong to comply with broader international initiatives such as those of the International Organisation of Securities Commissions (IOSCO). In the Consultation the SFC says that it is mindful of the need to balance market development and competiveness on the one hand and protecting investors interests on the other. The SFC’s proposed enhancements relate specifically to (i) securities lending and repurchase agreements (repos); (ii) custody, (iii) liquidity risk management and (iv) disclosure of leverage. In addition the scope of the FMCC will be widened although this is described as housekeeping. A key aspect and thrust of the proposals is that fund managers will have explicit responsibility under the FMCC for the funds they manage. In effect the SFC is stipulating minimum requirements for offshore and onshore private funds where the fund manager has (in the SFC’s view) de facto control.

Responsibility for funds

The FMCC has always governed fund managers in respect of their management of funds. Paragraph 1.4 of the Code has historically stated that to the extent a licensed person is managing a fund then the FMCC, not the Code, applies to that activity. The proposed revisions to the FMCC make it clear that to the extent applicable, the Code will apply as well as the FMCC. Paragraph 1.4 of the Code will be deleted. The present drafting in the FMCC is not concise and simply refers to “client”, where appropriate.

However the Consultation proposes to broaden the scope of the FMCC so that it imposes greater formal responsibilities on Hong Kong fund managers for the funds which they manage. To this end, the SFC wishes to differentiate between a fund manager’s various types of clients. In the context of funds, the FMCC will be changed to refer either to “fund” alone or to refer to funds where the fund manager is responsible for the overall operation of the fund or has de facto control of the fund. In the SFC’s view, certain duties should attach to the fund manager where it has, in substance, responsibility for the fund’s operation notwithstanding that legally the fund manager may not have such responsibility. Whilst this is in effect the approach long adopted by the SFC with regard to managers of SFC authorised funds under the UT Code, this will be a departure for private funds which historically have had no such oversight. Regardless of, say, a corporate fund’s board of directors, the Consultation says that the fund manager should be responsible for setting liquidity management policy and the appointment of the custodian of any fund it operates. Similarly, for example, the proposed FMCC says a fund manager must ensure fair treatment of fund investors when managing conflicts of interest despite fund investors not being the fund manager’s client. A fund manager’s decision to terminate a fund will be required to take into account the best interests of investors in the fund. The fund manager must also provide fund investors with information about itself. The SFC indicates a view that where a fund manager’s and/or its affiliates’ appointed representatives constitute a majority of the board of a fund, then the fund would be controlled by the fund manager for this purpose. Where a fund manager is appointed as a sub-investment manager, by contrast, the client of the fund manager would be the delegating primary manager. In that case, these additional requirements will not be imposed.

Specifically with regard to private funds (being funds (open-ended or closed-end) which are not authorised by the SFC pursuant to the SFO) the SFC acknowledges that its “proposed enhancements” may be perceived as more relevant to fund level regulation (and therefore not be subject to SFC regulation at all). However the SFC excuses itself by noting that IOSCO and other international regulations applicable to funds do not distinguish in their application as between private and public funds. The SFC adds that, because its focus at the fund level remains on public funds, the FMCC changes are more principles-based. Further changes, in respect of SFC authorised fund, are planned for the UT Code. It will be interesting to see how these changes are applied - often overseas managers of SFC authorised funds are excused certain UT Code and related requirements.

Managed accounts

In addition to extending fund level regulation on private funds via the FMCC, the SFC is also proposing to expand the scope of the FMCC to managers of discretionary accounts. Although many Type 9 (asset management) licensed persons regard the FMCC as being applicable to their dealings with managed account clients, the FMCC only refers at present to persons whose business involves the management of funds. The SFC is therefore proposing to clarify the applicability with a new Appendix 1 to the FMCC. Appendix 1 proposes that the FMCC provisions in respect of (i) liquidity management, (ii) termination, (iii) side pockets, (iv) auditors, (v) valuation frequency, (vi) net asset value calculation and pricing, and (vii) offers of investments, that will apply to funds, will not apply to managed accounts and managed account clients as appropriate.

However the new Appendix to the FMCC if adopted will prescribe certain minimum contents requirements (in addition to those already set out for client agreements under paragraph 6.2 of the Code) where the manager’s client is not an “Institutional Professional Investor”, being a financial institution or a “Corporate Professional Investor”, being a non financial institution having passed the requisite suitability assessment per the Code (see the Oversight on this topic of February 2015).

Securities lending and repos

Taking its cue from the Financial Stability Board (FSB), the Consultation proposes to adopt certain FSB recommendations to address what it refers to as shadow banking risks in respect of securities lending and repos transactions by funds:

• Collateral valuation and management policy: It is proposed that the fund manager must put such a policy in place to include certain minimum valuation and margin requirements.
• Eligible collateral and haircut policy: It is proposed that the fund manager must also adopt a policy re the types of acceptable collateral and the methodology used to calculate ‘haircuts’ with due consideration to the specific nature of the fund it manages. The SFC says in the Consultation that it will issue frequently asked questions (FAQs) on the standards it will expect for designing the methodologies in this regard. From the SFC’s perspective FAQs are a useful way of promulgating rules without requiring any public 3 consultation process. It will be interesting to see if the FAQs are as prescriptive as those for SFC authorized funds under Chapter 8.8(e) of the UT Code.
• Reinvestment of cash collateral: It is proposed that the fund manager must also have in place a cash collateral reinvestment policy to ensure sufficient liquidity with transparent pricing and low risk to meet potential recalls. Although most private placement memoranda (PPMs) of hedge funds will already disclose non-cash re-hypothecation, the fund manager will have to ensure this is the case going forward. In addition, the SFC clarifies that for SFC authorised funds, non-cash collateral should not generally be rehypothecated.
• Reporting to fund investors: With regard to each of the foregoing, the fund manager must ensure that a summary of those policies are disclosed in the PPM of each fund it “controls”. In addition, it is proposed that at least annually and upon request, these policies be provided to fund investors. Where a third party agent conducts securities lending and repo activities on behalf of a fund, the SFC say that it will expect a fund manager to obtain access to such information (via a fund’s board or a unit trust’s trustee by agreement). It is not clear if, should the FMCC changes be made, the SFC expects all fund documentation to be revisited for such contractual permissions to be given.

Custody

In the Consultation, the SFC proposes to adopt the latest relevant principles under IOSCO standards which it considers mostly enhancements to the current FMCC requirements. As drafted in the Consultation, the relevant provisions (as before) only refer to “custodians”. Given the fact that the FMCC applies to fund managers of both private funds and SFC authorised funds, the FMCC requirements are clearly intended to cover trustees of unit trusts (who under the UT Code have responsibility for all custody of the relevant SFC authorised fund). However it is to be hoped that this drafting will be clarified.

Regardless of the legal structure of the relevant fund, the SFC proposes to expressly require that, in cases where a fund manager “controls” a fund, it must arrange for the appointment of a functionally independent custodian. In other words, regardless of necessity, a private fund managed from Hong Kong must appoint a custodian unless the fund or fund manager adopts a “selfcustody” arrangement. In a self-custody arrangement (the meaning of which is unclear), the SFC will require the fund manager to have policies and internal controls to ensure that the persons managing custody are functionally independent from those managing the fund. Although the requirement for an independent custodian or trustee to perform safe keeping of fund assets is embodied in the UT Code, this is a new requirement applicable to private funds which may prove difficult in practice and expensive for many smaller private equity funds in Hong Kong.

As the FMCC is only binding on Type 9 (asset management) licensed corporations, most fund managers operating in Hong Kong have an express licensing condition prohibiting the holding of client assets. Where the SFC allows a fund manager to hold client assets, the licensed corporation must, amongst other things, satisfy the HK$5m paid up capital and the HK$3m liquid capital requirements under the SFC’s financial resources rules. Client assets must also be segregated. The existing FMCC provisions are consistent with this but the proposed changes may make it difficult for a fund manager to hold its private fund’s assets. Moreover the proposed changes do not appear to anticipate a private equity fund holding assets directly or through a nominee special purpose vehicle.

The Consultation proposes to amend the FMCC to explicitly require a fund manager to exercise due skill, care and diligence in the selection, appointment and ongoing monitoring of the relevant fund’s custodian. The fund manager will also have to ensure a formal written custody agreement is entered and ensure its contents are sufficient. Aside from the lack of clarity as regards unit trusts (is the trust deed the custody agreement?), this new FMCC duty, if implemented, cuts across the usual responsibilities of directors and trustees in most fund structures. It goes beyond the requirements of the UT Code.

The SFC also wishes to require that fund managers ensure proper disclosure of custody arrangements and material risks associated with those (including any changes) to fund investors.

The custody changes to the FMCC are also intended to also apply to managed accounts. Where a manager is allowed to hold client assets, as indicated above, it should be able to self-custody subject to a separation of function within it. However in many cases, custody of managed accounts rests with a bank that appoints the manager. The changes in the FMCC seem to suggest that the manager will be responsible for monitoring the bank which may be difficult to achieve in “EAM” arrangements with banks.

Liquidity risk

On 04 July 2016 the SFC issued the Circular to Management Companies of SFC-authorised Funds on Liquidity Risk Management (Liquidity Circular). As the name suggests the Circular was directed at SFC authorised funds and again seeks to implement IOSCO recommendations. Managers of SFC authorised funds in Hong Kong were required to enhance internal liquidity risk management 4 processes in view of the Liquidity Circular by 01 January 2017 (please see the Oversight on this topic of October 2016). In the Consultation, the SFC now proposes to extend these requirements to fund managers of private funds and incorporate these into the FMCC. The key proposals are as follows:

• Liquidity management policy: It is proposed that all fund managers must maintain such policies and monitor the liquidity risk of the relevant fund or funds with reference to its obligations and redemption policy (if any). Regardless of whether or not a fund is closed-ended or open-ended the SFC will expect a fund manager in Hong Kong to have a compliant policy regarding liquidity. This points up the problematic approach the SFC is adopting in redrafting the FMCC in making the FMCC applicable to all types to fund. Private equity, hedge and retail funds are all very different.
• Stress testing: This will be required to be undertaken by the fund manager to assess and monitor liquidity risk. Although the SFC indicates in the Consultation that the extent and frequency of such testing may vary depending on the nature of the relevant fund, the SFC does expect that such testing will be ongoing. For a closed end private equity fund with a term of ten years it is unclear what the SFC would expect to see in this regard.
• Tools: The SFC suggests that where fund documentation provides tools, such as redemption deferral or suspension, to assist with liquidity management, the fund manager will be under a positive duty to consider the appropriateness of using such tools at all times. In a footnote, the proposed revised FMCC states that where side letters have been entered into, a fund manager should disclose this fact and the material terms in relation to redemption in the side letters to all potential and existing fund investors.

Leverage

In line with greater scrutiny of the use of leverage in the United States and in the EU under AIFMD, the SFC proposes in the Consultation that when a fund manager controls a fund, the fund manager should disclose the maximum level of leverage it may employ for the relevant fund to the fund’s investors. At this stage, the Consultation indicates that the SFC is not proposing to prescribe how leverage should be calculated although it expects the basis of calculation to be disclosed and to take into account synthetic leverage from the use of derivatives. The SFC will keep this under review and it is possible FAQs will be issued in future.

Other proposed changes

In addition to the key changes outlined above, the SFC is also proposing other updates to the FMCC which are intended to codify what it expects already and to clarify the drafting. These include:

• Fund valuation: The SFC proposes to require independent valuation of a fund’s portfolio, separate from a fund’s investment function.
• Auditors: Where a fund manager controls a fund, it must appoint an independent auditor (even if this is not required by the fund’s jurisdiction of domicile).
• Side pockets: The FMCC changes if adopted will required that fund investors are informed of the structure and operation of side pockets (including fees) before side pockets are created. As proposed, the Circular seems to suggest that in addition to generic disclosure, say in a PPM, there should be additional notifications to fund investors when illiquid assets are side pocketed.
• Reporting to the SFC: A more express requirement will be included in the revised FMCC under which all fund managers must provide appropriate information to the SFC on an ongoing basis upon request, for example with regard to leverage or securities lending and repo or OTC transactions on behalf of funds. Fund managers, the FMCC will state, must respond promptly and in an open and co-operative manner. Any mistake in data provided must also be notified to the SFC promptly.
• House accounts: The FMCC will be revised to state that aggregation of house orders with client orders should only be made if it is in the best interests of clients.

Conclusion

Whilst it would be difficult to argue that certain inconsistencies and out-dated drafting in the FMCC do not require improvement, the FMCC is admirable for its light touch regulation of Hong Kong based fund managers - who are not seriously considered by most observers to pose any systemic risk. The existing legal framework under the SFO and the SFC’s various codes as applicable to the fund management industry has worked well. Perhaps for this reason, there has been no political assault on hedge funds or private equity funds in Hong Kong post-2008. In the case of "retail" funds authorised by the SFC, the UT Code has continued to evolve and a rigorous vetting approach ensures high levels of investor protection. In the case of private funds, the tightening of the professional investor 5 regime under the Code means that interests in such funds are often restricted to Institutional Professional Investors which do not need SFC protection in their choice of investments.

The proposed changes to the Consultation therefore appear to be motivated by the desire to achieve equivalence with overseas regimes. This risks restricting the development of the fund management industry in Hong Kong especially as regards private funds. The proposals, which touch all funds managed from Hong Kong, potentially deter private fund launches from Hong Kong whilst increasing entry and compliance costs for new fund managers.

In the Consultation the SFC states that it has conducted extensive soft consultations and received general support for the proposed changes. However, if implemented, these will affect all fund manager’s operations in Hong Kong. If adopted, the changes in the FMCC will require a review and redrafting of private fund’s PPMs, adoption of additional policies and revision of compliance manuals by all fund managers as well as a revision of all managed account agreements entered by managers from Hong Kong. The Consultation asks if a six month period following the gazetting of the revised FMCC will be sufficient time for implementation - this suggests that at least the SFC is aware of the degree of regulatory change proposed.

Together with the new “manager-in-charge” regime (implemented by circular not revision to the Code - please see the Oversight on this topic of January 2017), the Consultation heralds an increase in regulation of Hong Kong based fund managers in 2017. It will be interesting to see whether, in the context of Brexit for the UK and the election of President Trump in the United States, Hong Kong’s regulation goes beyond what is needed to ensure international parity of regulatory standards. The Consultation calls for submissions to the SFC in response by 22 February 2017.

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