Managing conflicts of interest
17 January 2018
The SFC published a brand new compliance bulletin for intermediaries on 19 December 2017, on the topic of conflicts of interest in selling practices and asset management, setting out the results of the SFC’s supervision of Licensed Corporations (LCs) as well a joint thematic review with the Hong Kong Monetary Authority (HKMA).
The Bulletin provides guidance to LCs through real life examples, and aims to give some clarity of the SFC’s rules, regulations and their expectations, thereby assisting LCs and their senior management to understand the SFC’s requirements thoroughly.
Conflicts of Interest
Conflicts of interest can arise in many situations and in different forms, and without a proper policy or robust system to manage conflicts of interest, LCs may be jeopardizing their clients’ interests.
1. Conflicts in Managing Private Funds
An SFC inspection found that a manager of private funds did not have appropriate risk management policies to address concentration and liquidity risks, which was crucial to the fund’s operation. The funds invested heavily in concentrated positions and illiquid stocks, where investors’ interests could be at risk in a volatile market. Another fund manager even arranged loans between different funds under its management, where collateral was not provided and the lending fund was subjected to default risks.
The lack of robust risk management policies, particularly liquidity risk, may result in the funds’ inability to meet the clients’ redemption or withdrawal requests. Fund managers should therefore act in the best interests of their clients by having in place a proper and effective liquidity risk management system in order to address these issues so as to ensure that their clients are being treated fairly.
2. Conflicts in Rebates
Another fund manager was found to have received unusually large cash rebates from an execution broker, and could not explain to the SFC the reason of its high trading volume with that broker. The SFC was concerned with the exceptionally high stock turnover, as the fund manager could be churning (trading more frequently than needed for own benefit), which was not in accordance with the clients’ expectations and investment objectives.
Cash rebates are often related to potential conflicts of interest. Therefore, fund managers should have in place a robust conflict of interest management policy, where transactions carried out on behalf of the funds should be in accordance with the pre-determined investment strategies and objectives, whether in terms of asset class, geographical spread or risk profile.
3. Conflicts in Selling Practices
An LC sold unlisted bonds to three retail clients on the same date at the same price, but with different annual coupon rates. The SFC found out that the lower the coupon rate, the higher the placing commission earned by the LC from the bond-issuing company, and this was clearly a material conflict of interest.
LCs should take reasonable measures to ensure fair treatment of clients, proper disclosure of all material conflicts of interest, and the provision of all relevant material information to clients to help them make informed investment decisions so as to fulfil their suitability obligations.
4. Conflicts in Selling “In-house” Products
Following the joint thematic reviews by the SFC and the HKMA of large financial institutions, it was discovered that some Registered Institutions (RIs) mainly selected financial products issued by another LC within the same financial group and offered them for sale to their clients, without conducting proper product due diligence or comparing prices from third-parties. Further, these arrangements within the same financial group were not disclosed to their clients and client orders were not executed at the best prevailing price. There was also an instance where an LC did not disclose to clients that lower fees and charges were applicable to some “in-house” products.
Another RI, acting as a discretionary account manager, invested substantially in “in-house” products manufactured by an LC within the same financial group which amounted to over 90% of its portfolio size, and a proper system to monitor conflicts of interest was not in place to address these issues.
LCs within large financial groups should ensure that their solicitations or recommendations for “in-house” products and third-party products are reasonable at all times having regard to all relevant information about the clients that are available, and that the selection of different “in-house” and third-party products should match with the pre-determined investment strategies and risk appetite of their clients. LCs should also ensure that when dealing with clients, the application of any fees or charges should be fair and reasonable in the circumstances, be characterised by good faith and in the best interests of their clients.
The SFC explicitly stressed the importance of the senior management of LCs, including their MICs, being aware of the SFC’s Compliance Bulletin and also the relevant circulars regarding the irregularities, deficiencies and common instances of non-compliance in managing funds and discretionary accounts.
The Bulletin closed with a strong message about possible enforcement actions for non-compliance.
“The SFC will not tolerate intermediaries treating clients unfairly or benefiting at the expense of clients’ interests.”
SFC Compliance Bulletin: Intermediaries pg. 6
Bovill can help you in reviewing and revising your existing compliance systems and controls, and can assist in drafting the conflicts of interest management policies and procedures in order to enable you to be in full compliance with the SFC’s rules and regulations.