SFC circular to asset managers on dubious arrangements or transactions

On 21 November 2019, the Securities and Futures Commission (the "SFC") issued a circular on dubious private fund and discretionary account arrangements or transactions.

The circular provides guidance to asset managers ("AM") in considering if a proposed private fund and discretionary account arrangement or transaction is dubious; and deciding if they should proceed with such arrangement or transaction before accepting a new mandate, executing a new investment suggested by an investor or accepting the injection of new investment by the investor into a fund or discretionary accounts[1].

The circular follows a number of similarly themed circulars recently issued by the SFC and represents another step in the SFC's ongoing efforts to tackle potentially problematic transactions and investment arrangements, including concentrated, illiquid and interconnected investments with irregular features, margin financing disguised as investments, nominee and warehousing arrangements, and complex arrangements to finance risky investments and deficient lending practices[2].

Expected standards of conduct

Senior management of AM, who bears the primary responsibility for ensuring compliance, is expected to put in place effective procedures and controls in writing for AM to identify dubious arrangements or transactions and decide if they should proceed with them. These procedures and controls should cover the matters set out in the table below. AM are also expected to familiarise themselves with the non-exhaustive examples of red-flags set out in Appendix 2 of the circular and be vigilant where a proposed arrangement bears features same as or similar to those red-flags.

1. Initial screening

AM should perform initial screening to determine whether a proposed arrangement or transaction is dubious.

Assessment

AM are expected to:

assess whether the proposed arrangement or transaction deviates from generally accepted market practice before accepting a new mandate, executing an investor directed or suggested transaction, or accepting the injection of an investment by the investor into a private fund or discretionary account; and
if there is any reason to suspect that AM are not, or will not be, required or expected to make any investment decisions (apart from mere execution or operational decisions), review the details of the proposed arrangement or transaction and conduct further assessment, e.g. assess whether the structure looks unduly complex, whether the proposed transaction makes commercial sense, and whether the proposed transaction involves the investment of significant amounts by one or a few investors.

Reporting

If AM are not reasonably satisfied with the assessment outcome, the proposed arrangement or transaction should be considered dubious. The responsible staff should escalate the proposed arrangement or transaction and the initial screening result to the MIC of the Key Business Line (i.e. asset management) and compliance staff for a decision about whether to proceed.

2. Detailed due diligence

All proposed arrangements or transactions which are considered dubious at the initial screening should be logged and subject to detailed due diligence (DD) on investors and investors' instructions.

Detailed DD on investors

AM should assess:

the relationship (if any) between the investor and other parties relevant to the same fund, discretionary account or the proposed investment, e.g. other investors in the same fund or discretionary account, the proposed investment, or the person from which the investment was directly acquired; and
the investor's source of funding, e.g. whether the amount injected is commensurate with the investor's background and assets, and whether there are indications that the fund is from other parties.

Detailed DD on investors' instructions

AM should:

Set up and structures of funds or discretionary accounts

understand the purpose of setting up the fund or the discretionary account;
understand the rationale behind multiple or complex layers of arrangements or transactions; and
assess whether the fund or discretionary account might have been set up for improper purposes.

Transactions directed by investors

take a cautious approach if instructed by an investor to make a certain investment or use structured products or derivatives;
make enquiries to determine whether the investor has set up similar arrangements with or made similar investments through other asset managers or brokers and whether such investments (if any) appear suspicious;
assess whether the source of investments may involve any untoward arrangement or transaction; and
assess whether the investment is relatively illiquid or involves investing in private companies or making sizable unsecured loans to persons with obscure backgrounds or poor financial standing, or whether the investor has suggested a convoluted, risky or expensive way of making the investment.

3. Senior management review and decision

Senior management of AM should exercise due skill, care and diligence in reviewing each proposed arrangement or transaction which was determined to be dubious and take additional steps such as seeking professional advice if necessary. It should only proceed if all of its concerns have been sufficiently addressed.

4. Documentation

AM should maintain full documentation covering all aspects of any proposed private fund or discretionary account arrangement or transaction which has been determined to be dubious at the initial screening.

Scope

Documentation should include:

a log of all such arrangements and transactions;
details of the initial screening and detailed due diligence as well as any additional steps taken by the senior management, with the corresponding results; and
the senior management's review and decision, with its stated reasons for approval.

Consequences of failing to meet the expected standards of conduct

Misconduct by AM's clients

In disregarding signs of dubious private fund and discretionary account arrangements or transactions, AM may have facilitated the following types of misconduct by clients or relevant entities:

1. avoiding or contravening any of the market misconduct provisions or disclosure obligations or other laws, rules and regulations, such as the Codes on Takeovers and Mergers and Share Buy-backs and the Listing Rules;
2. conducting unlicensed regulated activities; or
3. involvement in fraud or other serious misconduct or illicit activities.

Regulatory action against AM and their senior management

1. If AM fail to detect or report dubious arrangements or transactions or they facilitate illegal or improper conduct due to inadequacies in their procedures and controls, there is a risk that AM may be construed to be in breach of certain regulatory requirements including the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission, or the Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Corporations).
2. These breaches and failures to meet the expected standards of conduct will also call into question whether the AM remain fit and proper to be licensed.

Next steps

AM must at all times remain vigilant in their asset management activities and particularly when dealing with potentially dubious or complex arrangements or transactions. If you have any queries in relation to any of your existing or potential new asset management activities, please do not hesitate to contact us.

[1] Please note that the circular does not apply to licensed corporations and registered institutions which provide discretionary account services as an ancillary part of their brokerage services for clients, without any formal investment mandates agreed with or management fees charged to clients.

[2] See previous SFC circulars: