SFC cautions deficiencies and misconduct in asset management practices

Key areas of concerns

The Circular highlights a number of examples of serious breaches by asset managers of their obligations under the SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “Code of Conduct”), the Fund Manager Code of Conduct (the “FMCC”) and the Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the Securities and Futures Commission (the “Internal Control Guidelines”), which give rise to the key areas of concerns below.

1. Conflicts of interest

   The SFC has observed the failures of several asset managers in preventing and managing potential or actual conflicts of interests arising from their transactions or practices, which seriously jeopardised investors’ interests and invariably led to their substantial losses.  Examples include the provision of financing to related entities with fund assets, provision of financing to funds with unjustified charges, unfair allocation of trades in favour of own key personnel, receipt of monetary benefits from fund transactions and failure to act fairly to fund investors when handling redemption payments.

   In this regard, the SFC reminds asset managers of their obligation under paragraph 1.5 of the FMCC to take all reasonable steps to identify, prevent, manage and monitor any actual or potential conflicts of interests.  Where material conflicts of interests have been identified, this entails a duty to thoroughly and objectively consider other alternatives to prevent such conflicts of interests.  In the absence of other alternatives, asset managers should consider critically whether the transaction is conducted in good faith at arm’s length and on normal commercial terms as well as in the best interests of the fund.  Asset managers should also have adequate and appropriate safeguards and measures in place to ensure fair treatment of fund investors with a view to minimising and managing any conflicts of interests. 

   The SFC further points out that generic and non-specific conflicts of interest disclosures in a fund’s constitutive documents are not sufficient where material conflicts of interests are involved.  Instead, clear and specific disclosures in respect of the conflicts of interests (including the nature and source of conflicts, material interests of the asset manager and its connected persons, associated risks and mitigation measures taken) must be properly disclosed to investors prior to the transaction.

   Asset managers are also expected to maintain proper records of their assessment and justifications for any investment decisions which give rise to actual or potential conflicts of interest to demonstrate compliance with the FMCC and the Internal Control Guidelines.

2. Risk management and investment within mandate

   The SFC has noted instances where asset managers failed to implement adequate risk management or to ensure transactions carried out were in accordance with the specific investment objectives and restrictions (including failure to implement proper investment management process to conduct appropriate and adequate investment due diligence), thereby exposing their clients to significant concentration, liquidity and credit risks. 

   Asset managers are required to ensure transactions conducted are in accordance with the specific investment objectives and restrictions of the fund pursuant to paragraph 3.11 of the FMCC.  In this regard, the SFC has emphasised that asset managers should have in place proper investment management policies and procedures, which include conducting appropriate and adequate investment research and due diligence. The SFC also expects assets managers to implement adequate risk management policies and procedures to identify, measure, manage and monitor appropriately all relevant risks (including market, concentration, liquidity and credit risks) in accordance with paragraph 3.1 of the FMCC, with proper records of risk assessments commensurate with the nature, size, complexity and risk profile of the asset manager.

3. Information for investments

   The SFC has noted that in certain cases asset managers failed to provide investors with material information, including concentrated positions of aggregate exposure of the fund (such as significant exposure to single issuer or issuers of the same group), material adverse events (such as major investment losses, defaults by counterparties, large redemptions requests and redemption suspension), and issuance of modified opinion by fund auditors and material delays in the provision of audited financial statements.

   Asset managers responsible for the overall operations of their funds are reminded of their obligation under paragraph 6.2 of the FMCC to provide adequate disclosure of information on the fund (as well as any material changes to the information) which is necessary for investors to make an informed judgment about their investment into the fund.

4. Valuation methodologies

The SFC has also noted some asset managers failed to adopt appropriate valuation policies and procedures, and in some cases with an intention to conceal investment losses. For instance, one asset manager valued a defaulted loan at cost but failed to justify the lack of adjustment notwithstanding the trading suspension and subsequent delisting of the listed company which provided the collateralised shares as security for the loan.

In this regard, the SFC reminds asset managers responsible for the overall operations of their funds to ensure that appropriate policies and procedures for proper and independent valuation are established in line with the FMCC, in particular, with respect to unlisted or unquote securities that are not actively traded or suspended listed securities.