Market participants must treat clients fairly and exercise care when recommending potentially volatile or illiquid products.
By Simon Hawkins and Kenneth Y.F. Hui
In response to ongoing volatility in local and international markets caused by the COVID-19 pandemic, on 27 March 2020, the Hong Kong Securities and Futures Commission (SFC) published two circulars reminding fund industry participants and SFC-licensed intermediaries of their obligations to safeguard client interests.
The first circular, directed at fund managers, trustees, and custodians of SFC-authorized funds (i.e., retail funds), reminded market participants of their obligations to properly manage the liquidity of funds and to ensure investors are fairly treated at all times.
The second circular, reminded all licensed intermediaries to act with extra care when soliciting or recommending investment products to, or managing investment portfolios on behalf of, clients, as global markets continue to experience turbulence.
The obligations described in the SFC’s circulars do not reflect any new regulatory requirements or regulatory policy changes, but rather that the SFC has stepped up monitoring of SFC-authorized funds and market participants. The SFC is restating the importance of some key regulatory requirements that are intended to enhance investor protection and are more important than ever in the context of current market dynamics.
Fund management obligations
Fund managers of SFC-authorized funds are reminded of their obligations to:
- Closely monitor the dealing and trading of funds under their management and keep investors informed at all times
- Ensure the fair and accurate valuation of fund assets in accordance with the fund’s offering documents and consider performing fair value adjustment if necessary (particularly in respect of less liquid securities), as well as to review fair value adjustment policies regularly to ensure they remain effective
- Exercise due care, skill, and diligence in managing liquidity of funds, in particular, ensuring that actions taken in meeting redemption obligations should not have any material adverse impact on the fund and its remaining investors (g., trying to meet a fund’s redemption requests primarily by using the fund’s cash or by selling the fund’s most liquid assets may have an adverse impact)
- Use appropriate liquidity risk management tools (g., swing pricing or anti-dilution levy) to properly allocate redemption costs to redeeming investors and to ensure the fair treatment of remaining fund investors
Trustees and custodians of SFC-authorized funds are reminded of their duty to safeguard fund assets and to provide independent oversight of fund management (e.g., on valuation of the funds and use of liquidity risk management tools).
Fund managers, trustees, and custodians of SFC-authorized funds are also reminded to warn the SFC promptly about any material issues affecting their funds, including any intention to increase or apply any swing factor (or anti-dilution levy) exceeding the one that is disclosed in the fund’s offering documents and any serious contemplation of suspension of dealings and significant decrease in the value of the fund (e.g., a drop of 10% or more in a fund’s net asset value in a single day). Managers, trustees, and custodians are strongly encouraged to consult the SFC if in doubt.
Product suitability obligations
SFC-licensed intermediaries are reminded of their obligations under the Code of Conduct for Persons Licensed or Registered with the SFC (Code of Conduct) when distributing investment products.
In particular, to fulfil their suitability obligations under the Code of Conduct, SFC-licensed intermediaries are reminded to:
- Ensure that due diligence is continually conducted on investment products, having regard to factors such as an investment product’s liquidity and credit quality, market risks relating to COVID-19, and a client’s profile and financial situation.
- Give due consideration to a client’s specific circumstances when assessing the suitability of an investment product for that client, including current financial situation, investment objectives, risk tolerance, investment horizon and liquidity needs, as well as the risk profile and concentration risk of the client’s existing investment portfolio.
- Explain to the client the risks and features of the investment product, including its credit quality, liquidity, termination conditions, and transaction costs.
- Present balanced views when recommending an investment product to a client. Staff of intermediaries should not focus solely on advantageous terms such as high coupon rates or yields, and should explain the potential disadvantages and downside risks, such as credit deterioration and illiquidity.
Additionally, SFC-licensed intermediaries that hold investment products directly or indirectly on behalf of their clients are reminded of the importance of disseminating to their clients notices and other communications prepared or issued by the investment products’ issuers, product arrangers, or management companies on a timely basis upon receipt.
These notices or communications may include material information or updates that are crucial for the client to make investment decisions (e.g., untoward circumstances relating to a fund that may include use of liquidity risk management tools by a fund manager).
Should you have any questions on the SFC’s circulars or any other Hong Kong regulatory issues, please contact the authors of this post.
This post was prepared with the assistance of Bianca Lee in the Hong Kong office of Latham & Watkins.
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