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Hong Kong Regulator Finds a Back Door to Fund Regulation

SFC has no authority to regulate private funds. Unable to touch these funds directly, the SFC has instead imposed new regulatory requirements on licensed asset managers, financial advisers and fund distributors, through amendments to the Fund Manager Code of Conduct (“FMCC”) and the Code of Conduct for Persons Licensed by or Registered with the SFC (“Code of Conduct”).

The amendments are in essence the SFC’s response 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. While investors, again exuberant, began the year by piling into equities, the sharp correction in early February served as a reminder that the world’s financial system might again be dangerously stretched and, some predict, heading for another meltdown.

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 FMCC and the Code of Conduct.

Codes of conduct do not have the force of law – courts sometimes ignore them – but the SFC and industry typically treat their provisions as if they are mandatory. That is because the SFC has broad discretion in licensing decisions and disciplinary actions, and in forming a view of an intermediary’s fitness and properness will consider its compliance with all manner of SFC pronouncements, including codes, guidelines, FAQs and circulars.

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. 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” (“ROOF”) will be expected to ensure that funds themselves comply with the revised codes. 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. 

The SFC has conceded that a Hong Kong subsidiary of an overseas fund manager cannot dictate how its parent operates a fund. This would appear to blow 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. Nonetheless, the SFC expects fund managers that are not ROOF to use “due skill, care and diligence to comply with the FMCC requirements to the extent this is within the fund manager’s control”.

FMCC provisions applicable to fund managers generally

Provisions of the updated FMCC that could be applicable to fund managers even if they are not ROOF include the following.

Conflicts of interest

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, (b) minimising conflicts 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.

Securities lending

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 policies should require, among other things, that collateral and lent securities are marked to market daily, wherever practicable, assets held in a cash collateral reinvestment portfolio should be sufficiently liquid, and collateral haircuts should properly manage counterparty risk. The SFC also expects fund managers to provide detailed information on a fund’s securities lending to investors at least annually.

Risk management

The revised FMCC says a fund manager should establish and maintain measures to estimate potential losses from unspecified adverse market movements, and a credit assessment system to evaluate the credit worthiness of the fund’s counterparties. In designing controls to reduce operational risk, fund managers should consider maintenance of proper records, information security, staffing adequacy and segregation of incompatible duties.

FMCC provisions applicable to fund managers that are ROOF

Additional responsibilities of fund managers that are ROOF include the following.


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.


Fund managers should manage liquidity risk through techniques such as setting concentration limits and monitoring liquidity mismatches between underlying investments and redemption obligations.


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, depending on whether the fund is closed or open-ended.


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.

Discretionary account managers

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”. 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.

Code of conduct

An unusual 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 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. The second problem is that large parts of the Code of Conduct were 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.

Regarding fund distribution, due to limited retail investor familiarity with pay-for-advice models and limited availability of independent fund advisory services, there is currently little appetite in Hong Kong to ban commission-based distribution models. Instead, the SFC has amended the Code of Conduct to require better disclosure of benefits payable to fund distributors. Also, distributors will need to disclose whether or not they are independent, and the basis for that determination. The Code of Conduct now says 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 should not claim to be independent financial advisers if they receive commissions for distributing a financial product.


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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