Risk Management for Fund Managers, Proposals of SFC, Hong Kong

Securities and Futures Commission (SFC), Hong Kong has put for public consultation certain proposals for enhancing asset management regulations. (the “Proposals”). These proposals can be seen as forced risk containment measures for the asset management industry.

The Proposals put the responsibility of compliance on the fund managers instead of the fund.   A distinction has been drawn between the fund managers with overall operational responsibility for the fund and those who manage only a portion of the fund. A fund manager with overall responsibility will have to comply with all the Proposals. Whereas, a fund manager managing a portion of the fund will not be required to comply with some of the Proposals (e.g. liquidity management policy and qualified custodian appointment). However, all fund managers acting in any capacity has to comply with generally-applicable Fund Manager Code of Conduct (FMCC) principles and requirements.

Thus, the Proposals cover all persons licensed or registered for Type 9 (asset management) regulated activity whether managing collective investment schemes (CIS) (whether authorized or unauthorized) and / or discretionary accounts. The objective is to govern the conduct of fund managers. The nature of fund is immaterial, that is, whether it’s a public or private or the domicile of the fund. Beware fund managers managing private funds!

Securities lending and repo:

The Proposals mandate that a fund manager engaged in securities lending, repo and similar OTC transactions on behalf of the fund should undertake these activities as per a predefined collateral management policy (CMP). What parameters a CMP shall cover? Many!

CMP should define eligible collateral, valuation, margin, hair cut i.e. very similar to what a clearing and settlement agency will do to protect its settlement fund. The CMP should identify the parameters for eligibility of collateral, the requirement to conduct a due diligence for determination of eligibility and a record should be kept before accepting a collateral. Depending on the nature of the collateral, a valuation methodology shall be pre-identified and used consistently (if not, necessary explanations to be made available). Liquidity of a collateral will also be factored in the valuation. Similarly, parameters for margin and hair cut will have to be defined and implemented consistently.

 Further, if the investment mandate of a fund allows for the reinvestment of the cash collateral, then the fund manager should have a cash collateral reinvestment policy. For this policy, the critical factor is to subject the cash collateral to stress test to meet planned as well as unplanned calls for the return of cash collateral on an ongoing basis.

SFC-authorized funds are not allowed to re-hypothecate non-cash collateral. However, fund managers of non-SFC-authorized funds are required to make adequate disclosures to re-hypothecate non-cash collateral and the associated risk of this.

Other parameters pertain to disclosures in the offering document and reporting of such transactions on an annual basis.

Safe custody of fund assets:

A slew of measures are proposed for ensuring the physical and legal integrity of the assets. To meet this objective, the fund assets of a client should be segregated from the assets of the fund manager, assets of affiliates and assets of other clients. Further, it is mandated that the fund assets should be held with a custodian that is functionally independent from the fund manager. However, the scope of “functionally independent” has not been clarified. Whether an affiliate under a separate management but same owner qualifies to be functionally independent is not clear. The fund shall conduct a due diligence on the custodian before selection and the relationship between the fund and the custodian should be documented through an agreement.

If fund assets are kept in an omnibus account, a proper record of the assets and frequent reconciliation shall be done so that assets are at all times readily identifiable. For private funds, self- custody is acceptable provided the internal custody activity is functionally independent.

Liquidity management and disclosure of leverage:

The stand of SFC is that the liquidity issues apply to all funds and therefore SFC will not provide exemption to anyone on the ground of private fund, close-ended fund etc. The policy on this should have a robust stress testing features and this cannot be a periodic exercise. Since the market fluctuates on a continuous basis it is understandable that SFC wants liquidity parameters to be assessed on a continuous basis. It is also proposed that in case of any provision on redemption restrictions in the offer document, the fund manager shall use liquidity management tools and exceptional measures.

 In addition, impact of leverage whether financial or synthetic and the basis of calculation shall be disclosed to the investors.

It is apparent the intent behind these provisions is to safe guard the interest of the investors and to force the actual decision maker i.e. the fund manager to introduce robust risk containment measures supported with documented policies. Moreover, any inspection by SFC is likely to be quite extensive and thorough. To comply with the rigor of the inspection, fund manager will have to keep audit trails for the decisions made on these parameters. To implement the Proposals, fund manager will have to invest in human capital, system applications and third party service providers. Needless to mention, the cost of fund management will increase for the fund manager and so the fund management fees for the investors.

Steps to comply with Suitability Obligations issued by SFC, Hong Kong

The regulatory trend is only in one direction. Consumer protection and enhanced disclosures. Mis-selling and mis-allocation are the most often complained incidents observed by SFC. It is imminent that SFC is going to come down heavily on such violations. It is better to take corrective actions now. How to do that? Where to begin?

Regular and comprehensive due diligence is the key. The Suitability Obligations (SO) apply both to solicitation and recommendation. Generally, when a licensed person tries to sell its services either to existing or prospective customer that is treated as solicitation. While a recommendation happens when someone asks for something and the licensed person gives suggestion in response.

The prerequisite to comply with SO for solicitation or recommendation is to take steps or seek answers to the following queries:

1.       Do I know the client? Do I understand the risk appetite of the client? 

The due diligence of the client is an important and necessary step. The licensee should ask for certain specific details on the client’s financial situation and investment experience through a questionnaire. These questions should cover information on income, savings, past investments, current investments, liquidity needs and the timing, ability to bear financial loss and margin calls, one time or regular investment preference, etc. It is suggested to collect supporting documents on the assertions made by a client on her financial situation and investment experience. It is also necessary to keep record for internal as well as external audit that the licensed person understands the needs of the client. 

The information given by the client will help in evaluating the risk appetite of the client and should be used to develop a conservative risk profile and the possible investment portfolio. At the same time, it is important for the licensed person to document the holistic assessment as to the accuracy and currency of the information provided by the client. In case, there are doubts either on the accuracy or currency or both, then further clarifications should be taken before finalizing the investment portfolio. And this is critical. The licensed person’s assessment should show an application of mind as a trained person to the information provided. If there is no application of mind, the whole exercise of conducting the due diligence on the client can be termed by the regulator or the court as an exercise in deception.

2.       Do I understand the technical features of the portfolio of products proposed for the client? 

Financial markets are in a constant state of flux. Therefore, it is of paramount importance to understand the impact of change in market conditions on a product in an investment portfolio. Though this is difficult to foresee but the aim of the due diligence is to evaluate variation in return / asset value with change in market conditions. This is like a stress test.  Therefore, due diligence of a product shall cover a thorough analysis on the basis of the documentation provided by the issuer, other third party recommendations on the same product, seeking clarifications from the issuer and research houses and own analysis on the product by the licensed person. Own analysis of the product is a critical factor. Reasonableness of the assumptions have to be analyzed and, if necessary, scenario analysis shall be conducted on revised assumptions. Further, the investment climate might have changed since the issuance of the product due to other economic and political factors which may have an impact on the returns from it. Therefore, assessment whether a product will meet the needs of the client has to be done on client specific situation and as and when solicitation or recommendation is made. It is advisable to have a product approval committee to approve licensed person’s portfolio of products. Further, the product approval committee shall also set parameters for nature of further assessment that needs to be done to determine suitability of a product for a client. An audit trail shall be maintained for product approval.

3.       Have I done a matching of the needs of the client and the features of the products proposed for the client? 

One prudent approach for matching client profile and the investment risk is to select portfolio of products on the basis of modern portfolio theory. The weight of different securities in the portfolio can be determined on the basis of the risk profile of the client. Such a portfolio, apart from being diversified, will also be lower in risk. It is easier to defend such a portfolio as it will be subject to broadly systematic risk and lower product specific risk. This approach should be used in case of discretionary portfolio management with a mandate. Even in other situations, it should be possible to suggest product on the basis of efficient frontier.  

4.       Have I given sufficient information on the product and the investment environment to enable the client to make a decision? 

It is necessary to give to the client the relevant literature and the risk-return profile of the proposed product portfolio. Along with the product literature, the client should also be given information on the portfolio construction, diversification, and reduction of risk by diversification etc. as a support for the selection of the portfolio vis-à-vis the risk profile of the client as determined by the licensed person. Further, a realistic assessment of the likely market scenarios during the investment horizon of the client and the risk profile of the client should be shared.  

Transactions to build the portfolio should be undertaken only after sufficient time to consider the information to assess its suitability and to seek clarification, if any, has been given to the client. The trail of communication with the client should be appropriately documented for any future audit purposes.

5.       Have I been trained on conducting due diligence on clients and understand the technicalities of the products?       

Licensed persons are advised to look into the existing training program and make a judgement whether it is sufficient to meet the obligations imposed on them. This should also be evaluated in the light of the new requirement of identifying Manager In-Charge (MIC). Whosoever is identified as MIC will carry heavy burden to prove the sufficiency of the training to meet the Suitability Obligations. However, in my view, this is an area which goes beyond training. This requires a relook at the transaction life-cycle from solicitation / recommendation to transaction to product approval to close all the gaps, if any.

Finally, Ownership Transparency in Hong Kong and Singapore!

Persons of Significant Control (PSC) is becoming a standard phrase in the corporate world compliance to fight tax avoidance and money laundering. This initiative is driven by Global Forum on Transparency and Exchange of Information for Tax Purposes (GF) and Financial Action Task Force (FATF). The objective of the initiative is to improve the implementation of international standards on transparency of beneficial ownership information, including its availability and international exchange.

United Kingdom (UK) was one of the first countries which made extensive legislative provisions requiring all UK incorporated companies and partnerships to identify people exercising control on them. Detailed and unambiguous provisions marked the definition and the procedure to identify and classify PSC, who has to be a natural person. In addition, each entity is mandated to maintain a register capturing specific information on the PSC and this register is filed with the Company House on an annual basis. Not only this, the contents of the register are made public with few exceptions. The requirement w.r.t. PSC became effective from April 6, 2016.

Somewhat on similar lines, Hong Kong and Singapore are proposing to introduce and maintain a register capturing the details of the PSC. The new requirement in both the countries is likely to be finalized and implemented in the third or fourth quarter of the current year.

One of the main features of the proposal for PSC register in Hong Kong is that companies, except listed companies, incorporated in Hong Kong would obtain and hold up-to-date beneficial ownership information of the companies.. The definition of beneficial ownership is based on the similar lines as in FATF guidance i.e. where an individual owns or controls more than 25% of the legal entity through direct or indirect shareholding. It is also proposed to register the legal entity immediately above the HK company in case of successive layers of holding companies in a chain of ownership. This particular requirement differs from the UK provision where only the information on beneficial owner is recorded in the register. The information shall be made available for public inspection upon request.

There are also provisions for penalty against the company, its responsible persons and beneficial owners for not maintaining the register or for not making it available for public inspection. However, no final decision has been taken on restricting the voting rights in case the beneficial owner fails to respond to the notices sent by a company though such is the position in UK law.

However, the PSC register requirement will not apply to partnerships unlike in UK and as proposed in Singapore. Since many HK companies have no employee and or director in HK, it is proposed that the company shall nominate a third party who is a HK resident and who shall be responsible to provide information in this regard.

Singapore’s proposals are also on the similar lines except on few parameters. The register of PSC will not be in public domain, but there may be a central registry for this information. There is an exception for both listed companies and Singapore financial institutions. The exception of Singapore financial institutions is a major carve-out unlike in UK and HK. Further, the PSC can be an individual or a legal entity unlike in UK and HK.

These are significant developments for these two off-shore financial centres. The impact of such transparency on the competitiveness of these jurisdictions vis-à-vis other off-shore centres (which have not yet committed to impose similar obligations to companies incorporated there) is something to be closely watched.

Triggering of Suitability Obligations for SFC, Hong Kong licensed or registered person

The intent behind the circular issued by Securities and Futures Commission (SFC), Hong Kong on Triggering of Suitability Obligations is to infuse life in paragraph 5.2 of the Code of Conduct. Paragraph 5.2 obligates a licensed or registered person to ensure suitability of the recommendation or solicitation for the client is reasonable in all the circumstances, having regard to information about the client of which the licensed or registered person is or should be aware through the exercise of due diligence.

The circular emphasizes that the trigger for complying with suitability obligations commences at the point of sale or advice. What does it mean? It implies that the actions and statements of the licensed person made to a prospective or existing client in her conversation is a material factor. Conversations could be spread over a period of time. Also, conversations could be through physical presence of the parties or verbal or textual or any other means or a combination of them. This conversation would also include the acts of providing research and marketing material, of course these material themselves should have been issued in compliance with paragraph 2.3 of the Code of Conduct. In case, the conversation results in successful solicitation or recommendation leading to a transaction, the requirement to comply suitability obligations will be triggered from the initial conversation. However, if the conversation is general in nature and does not involve an invitation or inducement to act on it and invest in a particular product then suitability obligations are unlikely to trigger.

How are the suitability obligations discharged and an audit trail maintained to support it?

 For discretionary portfolio management with a pre-determined mandate, the suitability obligations will be complied with when a target portfolio is created that meets the risk profile of the client and is agreed with the client. It is necessary that the portfolio is developed on the basis of the findings from due diligence conducted on the client. Here it is critical that the assessment is reasonable and factors in all the parameters of investment like client’s objectives, need for liquidity, ability to bear loss, age, understanding of the market, investment horizon etc. An assessment which is not in line with the investment profile of the client may not pass the test of due diligence. It is necessary to document the assessment for the mandate and provide a copy of the rationale to the client in writing and keep a proof of the same. Present and future transactions in accordance with the mandate will be considered to be done in compliance with suitability obligations. It is also necessary to review the mandate at periodic intervals as well as in case of change in circumstances either of the client or the market.

Indian budget for the year 2017-18 and its impact on capital markets

In 2012 the Income Tax Act (ITA) was amended to tax transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. This amendment adversely impacted the fund industry because the investors of India based funds located abroad were subject to tax on transfer of their shares in such funds. It is heartening to note that the government has finally agreed not to tax the capital gains earned by investors abroad on transfer of their shares in India based funds. In addition, for multi-tier structures redemption in Indian market and upstream distribution of the redemption proceeds will not be subject to tax in India. However, this exemption is offered only to Category I and II Foreign Portfolio Investors (FPI). But it is not clear whether Category III FPI, PE and VC investors will get the benefit of this exemption or not. Further, in spite of this move, certain associated issues related with such taxation like reorganization, reporting and disclosure still continue to be the areas of concern.In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

A new regime was created under section 9A of ITA to promote fund management activity in India. However, this regime did not pick up due to onerous conditions like minimum number of investor (broad based criteria), minimum corpus (INR 1 billion), restriction on investment in a single entity (not to exceed 20% of the corpus), arms-length fee etc. Now, there is a proposal to remove the requirement for a fund to consistently maintain a minimum corpus of at least INR 1 billion in case the fund is wound up during the previous year. However, the other onerous conditions continue to remain and therefore the use of this regime is unlikely to pick-up.

It has been a long pending demand of the industry to provide a single window registration for Foreign Portfolio Investors. Now, it is proposed that application for registration, demat account and PAN will be handled through a common application form. Though different variants of this has been tried in the past, the new proposal will ease the administrative burden at the initial stage.

The proposal to allow the listing of Security Receipts (SR) issued by asset reconstruction companies (ARC) will induce much needed liquidity in this industry. Currently, the pool of investors in SR is restricted to qualified buyers (i.e. financial institutions, insurance companies and FPI), it is not clear whether this pool will be expanded or not. It is expected that the regulatory framework and the operational guidelines to implement this proposal will be expedited by SEBI.  

Another relevant budget provision is to allow certain systemically important NBFCs to participate in IPOs as qualified institutional buyers (QIB) will bring in one more investor category to sustain an IPO market and should give a boost to capital market. It is not clear whether these NBFCs will be allowed to participate in other QIB related issuances.

There is also the usual mention of disinvestment policy and PSU listing. However, it is difficult to comprehend the long-term policy on PSU listing and disinvestment since there is hardly any action taken on it so far. Though there are conscious efforts to move towards market economy but there seems to be reluctance on the part of the government to let go of their control on the PSUs.    

Further, the proposal to link individual demat accounts with Aadhar is one more step towards creating an integrated information system. May be it’s time to analyse the possibility of switching to a single card for all government related transactions.

Some of these proposals are either a continuation of earlier policies (like listing of PSUs) or are meant to rectify a situation created by earlier amendment. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

169. In order to remove this difficulty, I propose to exempt Foreign Portfolio Investor (FPI) Category I & II from indirect transfer provision. I also propose to issue a clarification that indirect transfer provision shall not apply in case of redemption of shares or interests outside India as a result of or arising out of redemption or sale of investment in India which is chargeable to tax in India. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

169. In order to remove this difficulty, I propose to exempt Foreign Portfolio Investor (FPI) Category I & II from indirect transfer provision. I also propose to issue a clarification that indirect transfer provision shall not apply in case of redemption of shares or interests outside India as a result of or arising out of redemption or sale of investment in India which is chargeable to tax in India. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

169. In order to remove this difficulty, I propose to exempt Foreign Portfolio Investor (FPI) Category I & II from indirect transfer provision. I also propose to issue a clarification that indirect transfer provision shall not apply in case of redemption of shares or interests outside India as a result of or arising out of redemption or sale of investment in India which is chargeable to tax in India. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

169. In order to remove this difficulty, I propose to exempt Foreign Portfolio Investor (FPI) Category I & II from indirect transfer provision. I also propose to issue a clarification that indirect transfer provision shall not apply in case of redemption of shares or interests outside India as a result of or arising out of redemption or sale of investment in India which is chargeable to tax in India. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

169. In order to remove this difficulty, I propose to exempt Foreign Portfolio Investor (FPI) Category I & II from indirect transfer provision. I also propose to issue a clarification that indirect transfer provision shall not apply in case of redemption of shares or interests outside India as a result of or arising out of redemption or sale of investment in India which is chargeable to tax in India.The proposals w.r.t. ease of doing business are not significant or are only relevant at the initial stage. The ease of doing business should also be incorporated in the activities carried on to run the business after the registration.