December 05, 2017
Securities Law/Asia-Pacific Alert
Author(s): James Griffiths
After a year-long period of consultation, the Hong Kong Securities and Futures Commission (SFC) has issued its Consultation Conclusions on Proposals to Enhance Asset Management Regulation and Point-of-sale Transparency and Further Consultation on Proposed Disclosure Requirements Applicable to Discretionary Accounts (Conclusions). We now provide a summary of the key changes contained in the SFC’s original November 2016 Consultation Paper as amended by the Conclusions, and pointers to what action Hong Kong licensed fund managers need to take.
On November 16, 2017, the Hong Kong Securities and Futures Commission issued its Consultation Conclusions on Proposals to Enhance Asset Management Regulation and Point-of-sale Transparency and Further Consultation on Proposed Disclosure Requirements Applicable to Discretionary Accounts incorporating proposals for changes to the regulation of fund managers in Hong Kong under the Commission’s Fund Manager Code of Conduct and Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.
After a year-long period of consultation, the Hong Kong Securities and Futures Commission (SFC) has issued its Consultation Conclusions on Proposals to Enhance Asset Management Regulation and Point-of-sale Transparency and Further Consultation on Proposed Disclosure Requirements Applicable to Discretionary Accounts (Conclusions).
Below, we provide a summary of the key changes contained in the SFC’s original November 2016 Consultation Paper (Consultation Paper) as amended by the post-consultation Conclusions.
The changes are intended to bring existing regulation of fund managers in Hong Kong in line with international regulatory developments—notably policy reforms promulgated by the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB). The changes fall into three parts, as follows.
Part I sets out the enhancements to be made in the SFC’s Fund Manager Code of Conduct (FMCC) relating to the key areas of securities lending and repurchase agreements (repos), safe custody of fund assets, liquidity risk management and disclosure of leverage. It also clarifies how the FMCC applies to different types of fund managers.
Part II sets out amendments to be made to the SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct) to enhance point-of-sale transparency and to deal more effectively with the potential conflicts of interest in the sale of investment products, following principles aimed at:
The changes to the FMCC are targeted to come into effect in November 2018 and changes to the Code of Conduct are targeted to come into effect in August 2018. Clarifications will be given in Frequently Asked Questions (FAQs) yet to be issued by the SFC.
Part III, as set out in the Conclusions, contains a further consultation on the disclosure requirements that will be applicable to discretionary accounts under the Code of Conduct.
Where necessary, intermediaries will need to take action during the transitional period to make changes to their operations, and to amend counterparty contracts, client agreements and marketing materials. In doing so, they will need to take account of points of elaboration in the Consultation Paper and Conclusions that are not specifically contained in the revised FMCC or Code of Conduct, and review relevant FAQs when these are issued.
Changes are being made to the Fund Manager Code of Conduct across a wide range of issues. Key issues highlighted by the SFC are set out below.
The FMCC will apply as follows:
Responding to reports from the FSB, to address shadow banking risks the revised FMCC will place express obligations on a Hong Kong licensed fund manager where a fund under its management “engages” in securities lending, repo and reverse repo transactions. The Conclusions clarify that a fund manager would be engaging in such transactions if it decides that securities lending should be a fund activity, or is materially involved in determining a securities lending mandate or in actual lending activities. Except where the FMCC provides otherwise, these proposals apply to all fund managers, not only those responsible for the overall operation of a fund. They also apply to managers of private as well as public funds. Specifically, the fund manager will need to:
Where a fund manager outsources its functions to a third party (such as a prime broker), the fund manager is expected to act with due skill, care and diligence in the selection, appointment and ongoing monitoring of the third party. This would include checking that the service provider’s policies and procedures are consistent with the FMCC.
In addition, where a fund manager is responsible for the overall operation of a fund, it will need to disclose to fund investors a summary of the securities lending, repo and reverse repo transactions policy and the risk management policy, but there is now no requirement for this to be set out in the fund’s offering document. Fund managers responsible for the overall operation of a fund will also need to provide certain reports on an annual basis as to such transactions, including at a minimum certain specified global data, concentration data, aggregate transaction data, re-use and re-hypothecation data and data as to returns, as well as information as to custodians used and the proportion of collateral posted by funds held in various types of accounts.
To meet the disclosure requirements, the fund manager will need to ensure that mechanisms are put in place to allow it to obtain the information for such reports where the fund appoints a third-party agent to conduct securities lending and repo activities on its behalf.
In the Conclusions, the SFC has clarified that the changes regarding custodians and safe custody only apply to fund managers who are responsible for the overall operation of the fund. Adopting the latest principles under IOSCO standards, the current FMCC custody requirements are supplemented with respect to:
These requirements will similarly apply where the fund is a unit trust, so that the duties of the fund manager will relate to the appointment of the trustee and the ongoing monitoring of the trustee’s performance of its custodial functions.
Liquidity risk has been of international concern since the global financial crisis, especially with respect to the meeting of redemption requests. The SFC has already responded to this in a July 2016 circular on liquidity risk management for public funds authorized by the SFC, but is now adopting certain IOSCO principles in the FMCC. These only apply to fund managers who are responsible for the overall operation of the fund, but apply whether the fund is a public or private fund and whether it is open-ended or closed-ended:
Helpfully, the SFC has confirmed that a fund manager will not be deemed to be responsible for the overall operation of a fund (and thus subject to the above provisions) simply by virtue of having responsibility for managing liquidity risk.
There has been international concern as to the contribution of the use of leverage by funds to the build-up of systemic risk or disorderly markets. In the USA and Europe, managers may now be subject to reporting obligations regarding the use of leverage. The FMCC will require a fund manager responsible for the overall operation of a fund to disclose to fund investors the expected maximum level of leverage that it may employ on behalf of each fund it manages and the basis of calculation of leverage that should be reasonable and prudent.
Supplementing the major issues highlighted above, the original Consultation Paper contained a raft of additional amendments and updates to the FMCC to codify existing requirements or practices and improve clarity. These include:
The Conclusions have refined these proposals among other things as follows:
The FMCC will generally apply to Hong Kong SFC licensed managers of discretionary accounts (Discretionary Account Managers) where (a) the Discretionary Account Manager provides discretionary management services to a client in the form of an investment mandate or a pre-defined model investment portfolio, and (b) the Discretionary Account Manager receives a management fee and/or a performance fee as remuneration for managing discretionary accounts for its clients. It will not apply to brokers providing management services ancillary to brokerage services where there is no investment mandate or pre-defined model investment portfolio and the broker does not receive a management fee and/or performance fee in addition to commission fees.
A new Appendix 1 will be introduced in the FMCC clarifying which FMCC requirements do and do not apply to Discretionary Account Managers. This will include specific requirements that only apply to Discretionary Account Managers.
In the Conclusions, the SFC rejected most of the comments made in the consultation period. Relevant points arising are:
Two key regulatory concerns over past years have been the inherent conflict of interest in the receipt of inducements and commissions by financial advisers and distributors and the lack of transparency in the monetary benefits received or receivable that are not quantifiable at the point of sale of an investment product. One solution to alleviate these concerns might be a “pay for advice” model favoured in the UK and Australia, which bans commissions for the sale of fund products. The SFC has confirmed its view that this model is not currently appropriate for Hong Kong but will keep it under review.
The Consultation Paper introduced proposals for new rules supplementing existing protections under the Code of Conduct (which among other things already requires intermediaries to act in the best interests of clients and to disclose affiliations with product issuers and (where applicable) limitations of recommendations to products issued by related companies). Under the revised Code of Conduct, the SFC will apply the following principles:
Notably, an exemption from compliance with the proposed disclosure requirements may be available for intermediaries when dealing with corporate professional investors and institutional professional investors under paragraph 15 of the Code of Conduct.
The Code of Conduct is also amended to make it clear that it and its general principles will apply to all Hong Kong licensed fund managers.
In the consultation period, questions were raised as to how the disclosure requirements for point of sale transparency would apply to discretionary accounts. The SFC is now seeking comments on its proposals for the following disclosure options for discretionary accounts:
Option 1—Specific disclosure by type of investment product. Under this model, the intermediary would disclose the maximum percentage of monetary benefits receivable by it and its associates by type of investment product.
Option 2—Specific disclosure of the aggregate amount in percentage terms. Under this model, the intermediary would disclose the estimated maximum percentage of monetary benefits receivable by it and its associates, calculated by aggregating the maximum monetary benefits receivable from each product type according to the proportion such product type represents in a client’s investment portfolio.
Where there is no explicit remuneration arrangement between the intermediary and the product issuer, the intermediary would need to make a generic disclosure that it will benefit from purchasing in-house products for a client under a discretionary portfolio. Where the intermediary will receive non-monetary benefits from a product issuer when purchasing an investment product for a client, it would need to make a similar generic disclosure.
These disclosure requirements will apply where the intermediary deals with clients who are “individual” professional investors, but may be exempt where the intermediary deals with “institutional” or “corporate” professional investors.
The SFC has invited comments on these proposals by January 15, 2018.
Although lengthy transition periods apply before these changes become effective, to the extent they have not already done so Hong Kong fund managers licensed by the SFC will now need to begin a process of reviewing what changes should be made to their operational procedures, counterparty contracts, client agreements and marketing materials to meet these additional compliance obligations. Among other things:
Fund managers may also wish to provide comments to the SFC before January 15, 2018 under the further consultation concerning the application of disclosure requirements for point-of-sale transparency to discretionary accounts.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.
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