Fri, Sep 22, 2017

SFC Identifies Common Control Failings Observed during On-site Inspections in the Asset Management Industry

The Hong Kong Securities and Futures Commission (“SFC”) issued a circular on 15 September 2017 identifying regulatory concerns noted in the course of SFC’s supervision of licensed corporations (“LCs”) engaged in managing funds and discretionary accounts.  This circular seeks to emphasise the importance of LCs complying with the Fund Manager Code of Conduct, Code of Conduct and the Internal Control Guidelines.   

Impact on Type 9 Firms
Now that the regulator has publicly highlighted the issues that it has identified during its recent on-site inspections, LCs would be well advised to review their control frameworks, focusing in particular on the areas outlined by the SFC.  By openly communicating these issues to the industry, the SFC is both offering guidance as to some key areas of focus during its inspections and additionally issuing a warning to LCs that they should not expect any lenience if they are found to have deficiencies in these areas going forward. 

The good news is that the areas identified are nothing new or ground-breaking.  What is perhaps of note is that this is the second time in approximately six weeks that the regulator has publicly discussed their concerns around discretionary accounts which are in reality not discretionary, indicating perhaps a certain area of discussion should you have an inspection in the near future. 

For Duff & Phelps clients, we will of course walk through all of these topics, and any others you have concerns about, at our next meeting.

The Failings
Through its inspections, the SFC identified nine areas where LCs had deficient controls, policies or procedures. We summarize these nine areas below.

1. Inappropriate receipt of cash rebates, leading to potential conflict of interest issues
As cash rebates may give rise to potential or perceived conflicts of interest, LCs are reminded to establish and maintain robust conflict of interest management policies and procedures and take all reasonable steps to ensure fair treatment of all clients.

2. Failure to ensure suitability of funds or discretionary accounts mandates
Suitability obligations, as a cornerstone of investor protection, require that LCs ensure the investment mandate of a fund/ discretionary account is reasonably suitable for the investors in all circumstances. The SFC also warn against reliance on the investor’s self-declaration without the LC conducting own assessments.

3. Lack of proper liquidity risk management process
LCs should implement effective liquidity risk management policies and procedures, taking into account the investment strategy, liquidity profile, underlying redemption obligations and withdrawal policies of the funds and discretionary accounts. Sole reliance on the investment team managing the liquidity risk built into the portfolio management system was not deemed sufficient.

4. Deficiencies in a proper governance structure and policies for fair valuation of assets
The SFC reminds LCs of the importance of proper governance structure and comprehensive valuation policies and procedures. Appropriate written methodologies are required in particular for stale prices so where the market price of an asset is not available, or its most recent market price does not reflect its fair value, LCs must have sufficient and demonstrable governance arrangements in place to value the price in a fair and reasonable manner.

5. Deficiencies in policies and controls on best execution
Best execution is a critical factor in ensuring transaction are executed in the best interest of clients. Hence, LCs should consider all relevant factors which may be as varied as price, cost, speed, likelihood of execution and settlement, size and the nature of the trade when executing trades. If the LC adopts a regular broker review process, it should be holistic and unbiased in nature, taking into account both qualitative and quantitative factors. Sound governance and policy is certainly required here. Note that best execution was also the subject of an SFC circular in November 2016, so here and globally it continues to be a focal point.

6. Lack of systems and policies in ensuring fair order allocation
The SFC reminds LCs that proper governance structure to govern order allocation is required. LCs should record the intended basis of allocation prior to order placement and ensure the executed transactions are allocated on such basis and any deviation is documented and approved by senior management. Allocation can be a complicated process depending upon a LC’s client portfolio and whether there are any proprietary considerations. This is certainly a topic for regular review and senior management visibility.

7. Inadequate protection of client assets
LCs should implement robust policies and controls to protect client assets from misappropriation. They should also perform regular reconciliations against third parties. Acting as agents, LCs need to make sure they are appropriately safeguarding their clients’ assets and have robust controls to prevent any client detriment, deliberate or otherwise.

8. Inadequate investment compliance systems and controls
Pre-trade controls have to be sufficient to ensure that all investments are executed in accordance with the investment objectives, restrictions, geographical spread and risk profile of the fund or the mandate of the managed account. Where pre-trade and post-trade compliance checks are automated, LCs should ensure accuracy of the net asset value being referenced by the system, as otherwise such automated controls are redundant.

9. Inadequate systems to address market misconduct
LCs should implement systems and controls to prohibit and prevent market misconduct. Even with a robust policy in the compliance manual, the SFC found firms did not conduct post-trade monitoring to identify irregular trades. Insufficient control around potential contamination of the investment process with material non-public information was also an area of concern, for instance in interactions with connected persons.

SFC also reminds asset managers that if they only provide investment advice when executing transactions directed by their clients, they are then not regarded as conducting asset management activities and hence are not eligible for the incidental exemption for dealing in securities.  Furthermore, if LCs fail to comply with regulatory requirements, including fitness and properness, the SFC may take action against the LCs and their management, including the relevant Managers In Charge. 

The SFC urges LCs to review their existing internal control procedures and operational capabilities, and ensure the standards of conduct meet the SFC requirements and expectations.  We are very happy to assist you in this and will be raising these issues during our next on-site meeting. For more details, please contact us. 

Financial Services Compliance and Regulation

End-to-end governance, advisory and monitorship solutions to detect, mitigate, drive efficiencies and remediate operational, legal, compliance and regulatory risk.