Hong Kong proposes a tax concession on carried interest earned from private equity funds qualified for exemption under the Unified Funds Exemption
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The Securities and Futures Commission has introduced new rules intended to enhance the regulation of the asset management industry in Hong Kong. These rules will affect not only how pooled investment funds are formed, operated and distributed but also how segregated account management mandates are operated. In this article, we provide guidance on these changes.
Over the course of this year, asset managers will need to implement changes to their policies and procedures, their service agreements and fund offering documentation, to comply with amendments to the Fund Manager Code of Conduct (“FMCC”) and the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (“Code of Conduct”). The amendments will impact all licensed fund managers – including retail and institutional, hedge and private equity – as well as managers of discretionary accounts. There are significant changes, also, for financial advisers and fund distributors.
The amendments are in essence the regulatory response of the Securities and Futures Commission (“SFC”) to the Global Financial Crisis, ten years after it occurred and at a time when contrarian commentators are arguing that the lessons of the crisis have been forgotten.
After the 2008 crisis, regulatory bodies around the world published numerous reports and recommendations about how to avoid its repetition. The International Organisation of Securities Commissions (“IOSCO”), for example, promulgated standards for functionally independent custody of fund assets, while the Financial Stability Board published recommendations on “shadow banking” risks arising from securities lending and repos.
Some of those recommendations eventually found their way into the SFC’s Consultation Paper on Proposals to Enhance Asset Management Regulation and Point-of-sale Transparency, issued in November 2016, and then the SFC’s conclusions to that consultation, issued a year later. The Conclusions stipulate amendments to the FMCC, to become effective on November 17, 2018, and the Code of Conduct, effective on August 17, 2018. In this article, we provide our perspective on how these developments will impact the industry.
Many of the financial policy reforms recommended by IOSCO and others after the 2008 crisis relate to the activities of funds, rather than fund managers. While retail funds must be authorized by the SFC before distribution in Hong Kong, the SFC has no authority to regulate private funds which are sold in Hong Kong pursuant to applicable statutory exemptions. To reach the asset management industry more broadly, the SFC is endeavouring to implement the reforms by imposing new requirements on fund managers, through the updated FMCC and Code of Conduct.
In this way, the SFC is imposing regulatory standards and conduct requirements on fund managers with respect to the impact of their activities on fund investors. These standards are superimposed on the fiduciary duties that fund managers owe only to their clients, i.e., the funds. A difficulty with this approach is that fund managers are merely service providers to the funds, which are owned by the investors. As a matter of a law, ultimate responsibility for the management of a corporate fund lies with the fund’s board of directors. The fund appoints a manager and can overrule it. For a unit trust, the fund manager typically requires the trustee’s agreement on important matters.
However, the SFC argues that fund managers typically establish the fund and choose its directors or trustee. Therefore, managers that are “responsible for the overall operation of a fund” (which in this article we call “ROOF”) will be expected to implement various dictates regarding how funds themselves are structured and operated. The SFC says a fund manager cannot cite the existence of a governing body to conclude that it is not “responsible for the overall operation of the fund” just because it does not formally make final decisions or enter into legal agreements. Fund managers should use “due skill, care and diligence to comply with the FMCC requirements to the extent this is within the fund manager’s control”. For example, if a Hong Kong fund manager advises an offshore fund manager that is its subsidiary, it should ensure that the offshore manager complies with the FMCC.
The SFC has conceded that a Hong Kong subsidiary of an overseas fund manager cannot dictate how its parent operates a fund. Arguably, this blows a big hole in the intended regulatory reach of the FMCC, as private offshore funds are very frequently structured with an offshore fund manager advised by a Hong Kong subsidiary with the offshore fund manager holding all the management shares of the fund. In this case, it seems that the SFC accepts that the Hong Kong subsidiary cannot dictate how its parent, the offshore fund manager, operates the fund.
The SFC acknowledges that fund managers that are not ROOF cannot dictate the terms of operation of the fund. But they should use “due skill, care and diligence to comply with the FMCC requirements to the extent this is within the fund manager’s control”. Sub-managers with day-to-day management of only a portion of the fund should comply with FMCC to the extent possible for that portion.
Provisions of the updated FMCC that could be applicable to fund managers even if they are not ROOF include the following.
A fund manager must take all reasonable steps to identify, prevent, manage and monitor any actual or potential conflicts of interest. This includes: (a) conducting transactions in good faith at arm’s length and in the best interests of the fund on normal commercial terms, (b) minimizing conflicts by appropriate safeguards and measures to ensure fair treatment of fund investors and (c) disclosing any material interest or conflict to fund investors. The level of disclosure required is uncertain. For example, would it be sufficient to include in the fund offering document an overriding generic disclosure that conflicts could arise? Or should specific potential conflicts be described? Or, most stringently, would it be necessary to specifically disclose every actual conflict as and when it arises?
Fund managers that are materially involved in a fund’s securities lending activities, or in determining its lending mandate, are expected to ensure there is a collateral valuation management policy and a cash collateral reinvestment policy governing securities lending, repo and reverse repo transactions. The policy should require, among other things, that collateral and lent securities are marked to market daily, wherever practicable, and variation margin is collected at least daily where amounts exceed a minimum acceptable threshold appropriate to the counterparty risk.
Fund managers involved in lending activities are generally expected to accept collateral types that they are able, following a counterparty failure, to value, risk manage, and hold without breaching applicable laws or the fund’s mandate. The haircut policy for collateral should properly manage counterparty risk and should be consistent with Financial Stability Board recommendations.
Assets held in a cash collateral reinvestment portfolio should be sufficiently liquid with transparent pricing. Fund managers should on an ongoing basis stress test the ability of the portfolio to meet foreseeable and unexpected calls for the return of cash collateral. They should regularly review any cash collateral reinvestment policy and communicate it to fund investors.
The SFC also expects fund managers to provide information on a fund’s securities lending, repo and reverse repo transactions to investors at least on an annual basis. The FMCC specifies minimum information to be provided, such as the amount of securities on loan, concentration data on collateral and counterparties, and aggregate data on such things as maturity tenor, geography of counterparties, and type of collateral.
Where a fund appoints a prime broker, the fund manager should show due skill, care and diligence in the selection, appointment and ongoing monitoring of the prime broker. This would include being satisfied that the prime broker’s policies and procedures are consistent with the FMCC.
The revised FMCC includes an appendix setting out “suggested risk-management control techniques and procedures for funds”.
Suggestions concerning market risk include that a fund manager should establish and maintain measures such as estimating potential losses from unspecified adverse market movements, and stress testing to determine the effect of abnormal market conditions.
Fund managers should establish a credit assessment system to evaluate the credit worthiness of the fund’s counterparties and the credit risks of the fund’s investments.
In designing controls to reduce operational risk, fund managers should consider segregation of incompatible duties, maintenance of proper records, information security and staffing adequacy. They should also establish and implement a business continuity plan, and review it at least annually.
Additional responsibilities of fund managers who are ROOF include the following.
Liquidity management principles include ongoing liquidity stress testing to assess the impact of plausible severe adverse changes in market conditions. Fund managers should manage liquidity risk through techniques such as setting concentration limits, monitoring liquidity mismatches between underlying investments and redemption obligations, and considering various specified factors to assess the liquidity of a fund’s assets.
Custody provisions of the FMCC include proper segregation of assets; due skill, care and diligence in the selection, appointment and monitoring of a custodian; and proper disclosure to investors of custody arrangements and material risks.
Usually, a fund’s custodian is appointed by the board of a corporate fund or by the trustee of a unit trust. However, the SFC has indicated that it expects fund managers that are ROOF, “even though they may not be the party which formally appoints custodians”, to ensure a fund’s compliance with the custody provisions of the FMCC. If the custodian is appointed by the trustee, the SFC says the fund manager in selecting the trustee should consider whether the trustee would exercise due skill, care and diligence in the selection, appointment and monitoring of a custodian.
Under the FMCC requirements, fund managers should meanwhile ensure that custodians are “functionally independent” of the fund manager. Functional independence is possible even if the fund manager and the custodian are in the same corporate group (e.g., a bank with asset management and custody arms) provided there are policies, procedures and internal controls to ensure independence.
The FMCC says valuation methodologies should be consistent for similar types of fund assets. This is controversial, as there may be good reasons for a fund manager to adopt different valuation models for different funds managed by the same manager. For example, assets might need to be valued only upon acquisition and disposal for a closed-ended fund, but more frequently for an open-ended fund.
There should be an annual review by an independent party of valuation policies and procedures. A fund manager’s internal audit department or external auditor would be appropriate independent party for this purpose.
The revised FMCC says a fund manager should disclose the fund’s “expected maximum” leverage, and the basis of calculation of leverage, taking into account its investor base such that it is easy for investors to understand the calculation methodology. There is currently no consensus on how to calculate leverage, such as with respect to derivatives, and the methodologies can be complicated. However, the SFC asserts, “leverage is a key piece of information … therefore, the SFC believes that in practice there should not be any major difficulty for fund managers to comply with this disclosure requirement.”
Previously, the FMCC applied only to licensees “whose business involves the discretionary management of collective investment schemes.” The SFC appears to have expanded the scope of the FMCC by deleting the word “discretionary”. However, in the SFC’s usual practice, the term “asset management” implies authority to exercise investment discretion. Accordingly, the SFC’s intentions in making this change are unclear, as are the consequences for the private equity industry.
In the typical fund setup, private equity fund managers or sponsors do not exercise investment discretion. Instead, they identify and negotiate investment opportunities and advise the fund on those opportunities. The fund itself, through an investment committee or otherwise, decides whether to invest. Managers also monitor the fund’s portfolio of investments, take an active role in enhancing their value, and identify opportunities to exit from the investments. In industry parlance, these activities may be referred to as “management”. It remains to be seen whether the SFC will take the view that its revisions to the FMCC have (accidentally or intentionally) expanded its scope to private equity fund managers who do not exercise investment discretion but whose business is nonetheless typically regarded as involving the management of collective investment schemes.
A further complication is that there is significant inconsistency in the licensing of private equity fund managers. Some are not licensed. Some are licensed for Type 9 (asset management) regulated activity. Some are licensed for Type 1 (dealing in securities). Others are licensed for Type 4 (advising on securities). These inconsistencies may have arisen because of the specific structures adopted or because of changes in SFC practice over the years.
Where a private equity fund manager is licensed for Type 9, it would appear there has been an admission that the manager is involved in the management of a fund and is therefore subject to FMCC requirements. On the other hand, those that are not licensed or are licensed for Type 1 or Type 4 might be considered to fall outside the ambit of the FMCC, even if their functions in the private equity fund structure are identical to those of a Type 9 licensee.
The SFC has also expanded the scope of the FMCC to cover discretionary account managers, who should observe the FMCC provisions “to the extent relevant to [their] functions and powers”. This reflects the fact that the exercise of investment discretion on behalf of a client is fundamentally the same whether the client is a pooled vehicle or a segregated account.
However, the drafting of the FMCC leaves doubt as to whether it applies to all discretionary account managers (as implied in the main body of FMCC), including brokers offering discretionary services but charging a commission for each trade, or only to discretionary account managers that receive a management or performance fee (as implied in Appendix 1 of the FMCC).
The FMCC now prescribes minimum content of client agreements for discretionary account management, such as a statement of investment policy and objectives (including asset classes, geographical spread and risk profile), and consent to receive soft commissions or cash rebates (if applicable). The manager should also review the account’s performance at least twice a year and provide valuation reports at least once a month.
Some respondents submitted that existing discretionary account mandates should be grandfathered, to avoid having to renegotiate them. Others submitted that clients may wish to use their own standard investment management agreements (“IMA”), and that some of the FMCC provisions, such as liquidity requirements, are not appropriate for some bespoke investment mandates. The SFC concluded, not quite convincingly, that no grandfathering is required because managers should already comply with the SFC’s Internal Control Guidelines, any standard IMA that clients may use should include protections additional to the minimum requirements in FMCC, and discretionary account managers should integrate liquidity management into investment decisions and to regularly assess liquidity irrespective of the mandate. Moreover, the SFC decided that the 12-month transition period will give discretionary account managers and their clients sufficient time to renegotiate if necessary.
A significant feature of the Code of Conduct has been its paragraph 1.4, which says the code does not apply to the discretionary management of collective investment schemes. The rationale, after publication of the FMCC in 2003, was that fund managers’ conduct should be guided by that instead. However, the FMCC does not cover all aspects of conduct regulation, and in practice the SFC and industry often looked selectively to the Code of Conduct to fill the gaps.
Now, the SFC has decided that paragraph 1.4 will be deleted, meaning that fund managers must comply both with the Code of Conduct and the FMCC. This introduces two problems. First, there is overlap between the Code of Conduct and the FMCC, and their duplicative provisions are not entirely consistent. They may also conflict with other codes and guidelines, whether issued by the SFC or other regulatory authorities. For example, managers of mandatory provident fund schemes are licensed by the SFC but also subject to regulatory requirements of the Mandatory Provident Fund Schemes Authority. The SFC has dismissed this problem, asserting that the FMCC requirements are principles-based and therefore unlikely to conflict with other applicable codes and guidelines. In the event of conflict, “the more stringent provision will apply”.
The second problem arises from the Code of Conduct having been first published in 1994, at a time when the financial services industry was dominated by small brokerage firms. For the last decade or two, the number of brokerage firms has remained relatively static, while asset management firms have proliferated, and in 2016 finally surpassed brokerage firms in number. Despite frequent amendment – the latest Code of Conduct will be the 19th edition – large parts of it remain that were evidently drafted only with brokerage firms in mind. How those parts will apply to asset managers is a mystery that the SFC has not yet sought to elucidate.
Code of Conduct provisions that may be problematic for asset managers include requirements that client agreements include prescribed risk disclosure statements and a suitability clause (“if we recommend a product it must be reasonably suitable for you”). In the fund management context, the client agreement will typically be an IMA between the fund manager and its fund client. IMAs typically do not include such statements or clauses, and their relevance is dubious, but it appears that IMAs must now be revised to include these. The client agreement provisions do not apply in respect of “institutional professional investors” as defined in the Code of Conduct, which includes SFC authorized funds, but it is by no means certain that private funds (or any of their offshore managers) fall within the definition.
Similarly, it may be the case that asset managers will now be expected to comply with Code of Conduct provisions relating to opening of client accounts, such as assessment of a client’s knowledge of derivatives and certification by a licensee or JP of client identification and signing of account opening documents. In a brokerage context these measures are intended to ensure the intermediary carries out prudent know-your-client (KYC) procedures. It is unclear what regulatory benefit these provisions would impart in the asset management context.
The Code of Conduct also includes a requirement for annual confirmation of discretionary authority granted by clients. This may make sense in relation to discretionary accounts operated by brokers, but the requirement seems pointless when applied to managers of funds and segregated accounts. Similarly, requirements for prompt confirmation after effecting a transaction for a client (unless otherwise agreed in writing), and for disclosure of monetary benefits on a transaction basis, are generally inappropriate in a fund management context.
In Hong Kong, fund sales are highly concentrated through a few banks and distribution fees are relatively high. Moreover, while distributors typically purport to provide “financial advice”, most are remunerated through commissions payable by third parties. As a result, there is low investor awareness of fees, and distributors are incentivized to recommend products based on the benefits payable to them by the product issuers. While ensuring a product’s suitability for the client is a regulatory requirement (client agreements must now include a clause: “If we [the intermediary] solicit the sale of or recommend any financial product to you [the client], the financial product must be reasonably suitable for you having regard to your financial situation, investment experience and investment objectives”), this is often at odds with commercial incentives.
To mitigate conflicts of interest, to increase competition and to promote fee transparency, some jurisdictions have banned commission-based distribution models. There is currently little appetite to do so in Hong Kong. With limited retail investor familiarity with pay-for-advice models, and limited availability of independent fund advisory services, an “advice gap” could emerge if commissions were to be banned. To fill the gap, other distribution models would need to develop, such as online distribution through exchange-based sales and robo-advising.
Consequently, instead of banning commissions, the SFC will require better disclosure of any one-off and ongoing benefits payable to a fund distributor. Where benefits are not quantifiable at the point of sale (for example where trailer fees are dependent upon a distributor’s total sales over a year), distributors will be required to disclose the maximum percentage of monetary benefits receivable each year. The SFC has published further consultation questions concerning how the disclosure requirements should apply for managers of discretionary accounts. The SFC proposed that discretionary account managers should disclose the maximum monetary benefits payable to the manager under an assumed allocation of assets. This would only make sense if declared as an estimate of maximum benefits, or if the presumptions in terms of asset allocation are specified; otherwise, the “maximum” benefits payable could be exceeded.
Also, distributors will need to disclose whether or not they are independent, and the basis for such determination. For example, a distributor may need to disclose that it is not independent, because it receives commissions for distributing a particular product. The Code of Conduct will be amended to state that an intermediary should not represent itself as being independent if it receives benefits “which are likely to impair its independence to favour a particular investment product”. Whilst ungrammatical, the intention of this provision is evidently that intermediaries now should not claim to be independent financial advisers if they are subject to conflicts of interest in the sale of financial products.
By August 17, 2018, fund managers will need to ensure compliance with various Code of Conduct provisions they might previously have considered inapplicable. They will also need to determine whether they are ROOF, in relation to each fund for which they have a mandate, and ensure compliance with applicable FMCC requirements by November 17, 2018.
Steps might include:
ensuring proper arrangements to identify, prevent, manage and monitor conflicts of interest;
reviewing collateral valuation and management policies;
ensuring adequate documentation in respect of risk management control procedures;
reviewing custody arrangements;
reviewing fund offering documentation to ensure that heightened disclosure requirements are implemented; and
for retail funds offered in multiple jurisdictions, seeking approval from other regulators for any amendments to of the amended offering documents that may be required.
By November 17, 2018, discretionary account managers will need to review and may need to renegotiate client agreements to ensure the agreements meet the prescribed minimum content requirements, including details of:
the investment policy and objectives, such as geographical spread, risk profile, and limitations on asset classes, markets or instruments;
client consent if soft commissions or cash rebates are to be received; and
Discretionary managers should also put in place systems and procedures to meet other new minimum requirements, including a twice-yearly review of the performance of each account and the monthly provision of valuation reports to the client.
From August 17, 2018, distributors will not be able to sell any funds to a client unless unless they have disclosed whether they are independent. Fund distributors will therefore need to decide whether they will be independent, and then consider how to disclose that. The revised Code of Conduct includes a schedule setting out the expected content of such disclosure. Distributors will also need to ensure they have processes in place for disclosure of benefits, if any, payable to the distributor by the product issuer, including maximum benefits payable where the actual benefit is not quantifiable at the point of sale. As some distributors will have positioned themselves historically as “trusted advisers” or the like, a disclosure of non-independence may be sensitive and the manner of disclosure may need to be considered with some care.
Although the SFC has characterized new FMCC and Code of Conduct requirements as high-level and principles-based, they will necessitate specific changes to fund structures and operations, including the nature of the services provided by fund managers and fund distributors. While the financial markets are likely to provide some interesting distractions this year, the asset management industry in Hong Kong will also need to keep a close eye on the evolving regulatory landscape.
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