SFC Fund Manager Code of Conduct Workshop (Clifford Chance - Jan 2018)

MORGAN STANLEY PRIME BROKERAGE WORKSHOP:
THE SFC’S REVISED FUND MANAGER CODE OF CONDUCT
MARK SHIPMAN, MATT FELDMANN

19 JANUARY 2018
BACKGROUND
November 2017
November 2016 SFC conclusions on
asset management 17 November 2018
Consultation Paper on
Soft consultation with regulation and point-of-
Proposals to Enhance
the industry sale transparency and Effective date of FMCC
Asset Management
further consultation on provisions
Regulation and Point-of-
disclosure requirements
sale Transparency
for discretionary
accounts
MORGAN STANLEY PRIME BROKERAGE WORKSHOP: THE SFC’S REVISED FUND MANAGER CODE OF CONDUCT CLIFFORD CHANCE | 2
SCOPE OF APPLICATION
Applies to all licensed corporations or registered institutions whose business involves:

 the management of collective investment schemes (authorized or private); and/or
 discretionary accounts (in the form of an investment mandate or pre-defined model portfolio)
Why applicable to private funds?
 The international benchmarks on which the SFC’s proposals are based (IOSCO principles and FSB
recommendations) do not distinguish between public and private funds
 FMCC is applicable to all SFC licensed/registered fund managers, regardless of whether the funds
they manage are public or private funds and whether the funds and their investors are domiciled in
Hong Kong or overseas
 FMCC is intended to be principles-based. More detailed requirements are separately prescribed in
Code on Unit Trusts and Mutual Funds (UT Code) for funds seeking the SFC’s authorization for public
offering
CLIFFORD CHANCE | 3
FUND MANAGER RESPONSIBLE FOR OVERALL
OPERATION OF A FUND
While FMCC generally applies to all licensed/registered fund managers and their delegates, certain
requirements are only applicable to a fund manager that is responsible for the overall operation of a
fund.
 Needs fact-based review to ascertain whether fund manager in substance is responsible for the day-
to-day operation and management of the fund
 Further guidance in SFC FAQs published in November 2017
 No intention to give legal effect to “de facto control” concept
FUND MANAGER RESPONSIBLE FOR OVERALL
OPERATION OF A FUND (CONT’D)
Examples when the fund manager IS Examples when the fund manager IS NOT
considered to be responsible for the overall considered to be responsible for the overall
operation of the fund operation of the fund
 Where the senior management or shareholders  A Hong Kong fund manager appointed by an
of a fund manager constitute a majority of the overseas management company as sub-
board of directors of the fund. manager to manage a fund or an allocated
 Where the representatives of the fund manager portion of the fund.
or its subsidiaries constitute a majority of the  Senior management of Hong Kong fund
board of directors of the fund. manager’s overseas affiliate sits on the board
 Where the fund is in the form of a limited of directors of the fund while the Hong Kong
partnership and the fund manager is the fund manager acts as sub-manager.
general partner, and the general partner has
the responsibility in law to serve as the
governing body of the fund.
 Where the fund manager is responsible for
day-to-day management of the fund despite
having to seek the agreement of the trustee on
significant matters.
RISK MANAGEMENT CONTROL TECHNIQUES
A fund manager should maintain satisfactory risk management governance structure and procedures
commensurate with the nature, size, complexity and risk profile of the firm and the investment strategy
adopted by each of the funds under its business management.
General risk management:
 The fund manager should establish and maintain effective policies and procedures as well as a
designated risk management function to identify and quantify the risks, whether financial or
otherwise, to which the fund manager and, if applicable, the funds are exposed. The fund manager
should take appropriate and timely action to contain and otherwise adequately manage such risks
 Also need to comply with SFC Internal Control Guidelines
 Review the risk management policies and procedures with appropriate frequency and enhance
such policies and procedures whenever necessary
(CONT’D)
Fund specific risk management:

Fund manager should implement adequate risk management procedures (including risk measurements
and reporting methodologies) in order to identify, measure, manage and monitor appropriately all risks:
 relevant to each investment strategy
 to which each fund is or may be exposed, such as market, liquidity and counterparty risks, and
other risks, including operational risks, which may be material for each fund it manages taking into
account the nature, scale and complexity of its business and of the investment strategy of each of
the funds it manages
Need to:
 Identify and manage potential risks of a fund throughout the fund life cycle
 Ensure that risk profile of the fund is consistent with the nature, size, portfolio structure and
investment strategies, restrictions and objectives of the fund as provided and represented to fund
investors in the constitutive and/or relevant documents
 Ensure ongoing and proper identification, measurement, management and monitoring of risks
associated with each investment of the fund and their overall effects on the fund’s portfolio
(including via the use of suitable stress testing procedures)
(CONT’D)
Fund specific risk management:

Fund managers should exercise professional judgement about which control techniques are
appropriate for the funds they manage. New Appendix 2 sets out some suggested risk management
control techniques and procedures.
Risk management
 The risk management policy for each fund should provide, for each fund, a system of limits
concerning the measures used to monitor and to control the relevant risks.
Market risk
 Fund manager should establish and maintain effective risk management measures to quantify the
impact on the fund (especially if the fund deals in derivative financial products) and, if applicable,
the impact from changing market conditions:
 using an appropriate value-at-risk or other methodology to estimate potential losses from
unspecified adverse market movements
 measuring the sensitivity of the fund’s risk exposure to specific market risk factors
 stress testing - determining the effect of abnormal and significant changes in market
conditions on the fund using various quantitative and qualitative variable assumptions
(CONT’D)
Liquidity risk
 Set and enforce concentration limits with respect to the funds’ investments, collateral, markets and
business counterparties
 Establish and regularly monitor measures of maturity liquidity mismatches between the funds’
underlying investments and their redemption obligations using quantitative metrics or qualitative
factors.
 Establish appropriate arrears and default procedures to alert staff member(s) responsible for
liquidity management to potential problems and to provide them with adequate time to take
appropriate action to minimise the impact of fund counterparty liquidity problems.
Issuer and counterparty credit risk
 Establish and maintain an effective credit assessment system to evaluate the creditworthiness of
the funds’ counterparties and the credit risk of the fund’s investments (or, if applicable, the relevant
issuers).
(CONT’D)
Operational risk
 In designing the policies, procedures, and internal controls to reduce operational risk, a fund
manager should consider, amongst other considerations, physical and functional segregation of
incompatible duties, maintenance and timely production of proper and adequate accounting and
other records, the security and reliability of accounting and other information, staffing adequacy and
prompt reconciliation of trading information.
 Fund manager should establish, implement and maintain a business continuity and transition plan.
The plan should include policies and procedures that ensure, in the case of a business disruption or
an interruption to the fund manager’s operations.
 The business continuity and transition plan, including the adequacy of the plan and the
effectiveness of its implementation, should be reviewed at least annually. Records of such reviews
should be maintained.
(CONT’D)
What it means for fund managers:

 Need to establish written risk management policies for both fund manager and each fund
 Regular review (and documentation of review)
 Stress testing
 Regular assessment of counterparty risk (both service provider and investment level)
 Ensure consistency with disclosures to fund investors
LIQUIDITY MANAGEMENT AND SIDE POCKETS
LIQUIDITY MANAGEMENT
Fund manager must:

 establish, implement and maintain appropriate and effective liquidity management policies and
procedures to monitor the liquidity risk of the fund, taking into account the investment strategy,
liquidity profile, underlying assets and obligations, and redemption policy of the fund
 integrate liquidity management in investment decisions
 regularly assess the liquidity of the assets and liquidity profile of liabilities of a fund
 regularly conduct assessments of liquidity in different scenarios, including stressed situations,
to assess and monitor the liquidity risk of the funds accordingly
 disclose the liquidity risks involved in investing in the fund, the liquidity management policies,
and an explanation of any tools or exceptional measure that could affect redemption rights in
the fund’s offering document or otherwise make such information freely available to fund
investors
LIQUIDITY MANAGEMENT (CONT’D)
 The extent of application of these liquidity management principles will depend on the nature,
liquidity profile and asset-liability management of the fund. Applies in principle to both closed-
ended and open-ended funds.
 liquidity stress testing on an ongoing basis to assess the impact of plausible severe adverse
changes in market conditions (part of general risk management controls).
 Investor liquidity terms: Need to disclose preferential treatment (e.g. side letters) and the
material terms in relation to redemption to all relevant potential and existing fund investors
SIDE POCKETS
Before any side pocket is introduced in a fund, a fund manager that is responsible for the overall
operation of a fund should disclose to the fund investors:
 limit of total assets to be put in the side pocket
 overall fee structure and charging mechanism
 that the redemption lock-up period for a side pocket would be different from ordinary
units/shares of fund
 how the fund manager defines and categorises investment products which are to be put into the
side pocket and the policies and rationale for transferring investments in and out of side pockets
 where the assets in side pockets are allowed to be transferred to another investment vehicle,
the circumstances under which transfers are allowed and the pricing mechanism for such
transfers.
SIDE POCKETS (CONT’D)
In setting up and managing side pockets in Where a fund manager decides to side pocket
respect of fund assets, a fund manager should any fund asset, it should arrange clear
ensure that it has: disclosure to fund investors of:
 risk management competency in managing  creation of the side pocket
side pockets  asset which has been side-pocketed
 valuation policy covering side-pocketed  how the asset has been valued at the time of
assets which complies with the fund side pocketing and the ongoing valuation of
portfolio valuation requirements the asset.
 operational checks and controls for
transferring investments in and out of side
pockets
LIQUIDITY MANAGEMENT AND SIDE POCKETS

 Liquidity management policy highly fund-specific
 Documentation and regular review
 Liquidity stress-testing as part of general risk management controls
 Disclosure of preferential investor treatment on investor liquidity terms
Side pockets:
 Disclosure requirements in FMCC are standard for voluntary side pockets, but careful of
“involuntary” side pockets
CUSTODIAN AND THIRD PARTY DELEGATES
CUSTODIAN / SAFE CUSTODY OF FUND ASSETS
Safekeeping of fund assets and Selection and appointment of custodian and

independence custody agreement
A fund manager should ensure that any fund The fund manager responsible for the overall
assets are segregated from the assets of the operation of a fund should:
fund manager.
 exercise due skill, care and diligence in the
Where a fund manager is responsible for the selection, arrangement for the appointment
overall operation of a fund, it should: of and ongoing monitoring of the custodian
 select and arrange for the appointment of,  ensure a formal custody agreement is
and entrust the fund assets to, a custodian entered into with the custodian
that is functionally independent from it
 ensure the custody arrangements and any
 for self-custody, put in place policies, material risks associated with the
procedures, and internal controls to ensure arrangements are properly disclosed to the
independence fund investors and fund investors are
updated about any significant changes
DELEGATION
 Fund managers to exercise due skill, care and diligence in the selection and appointment of
third-party delegates
 Where functions are delegated to third parties, ongoing monitoring of the competence of
delegates to ensure that the principles of the FMCC are followed
 Although the investment management role of the fund manager may be sub-contracted, the
responsibilities and obligations of the fund manager to the funds it manages may not be
delegated
CUSTODY AND DELEGATION

Process for selecting and monitoring custodian is standard, but:
 Document selection and ongoing monitoring of custodian
 Ensure fund investors are updated about any significant changes to custodian arrangements
including material risks
Third party delegation:
 Document selection and ongoing monitoring
 Ensure compliance with FMCC
 Ultimate responsibility of fund manager cannot be delegated
PORTFOLIO VALUATION
FUND PORTFOLIO VALUATION
Where fund manager is responsible for overall operation of a fund (or is delegated responsibility for
fund valuation), it should ensure that:
 Appropriate policies and procedures are established so that a proper and independent valuation
can be performed.
 Detailed valuation requirements for different type of assets in FMCC
 Valuation methodologies to be consistently applied to the valuation of similar types of fund assets
 Valuation policies and procedures should describe process for deviating from valuation policies and
procedures:
 requiring the Fund Manager to document the reason for any price override or deviation
 ensuring an appropriate review of the price override or deviation by a functionally independent
party
 describing the method for determining the appropriate price
 All fund assets managed by a fund manager should be valued on a regular basis. Where a Fund
Manager is responsible for the overall operation of a fund it should disclose the frequency of
valuation and dealing and basis of valuation to fund investors.
FUND PORTFOLIO VALUATION (CONT’D)
 Fund manager should have regard to applicable generally accepted accounting principles as well
as best industry standards and practices in valuing fund assets, unless otherwise specified in the
fund’s constitutive documents.
 Valuation policies, procedures and process should be periodically reviewed (at least annually) by a
competent and functionally-independent party such as a qualified independent third party or a
person performing an independent audit function.
NET ASSET VALUE CALCULATION AND PRICING
AND RECONCILIATIONS
Net asset value calculation and pricing

Where fund manager is responsible for overall operation of a fund (or is delegated
responsibility for fund valuation):
 NAV calculation of different unit/share classes needs to be carried out in accordance
with the terms set out in the constitutive documents of the fund and the valuation
policies and procedures established by the fund manager.
 Valuation policies and procedures should seek to detect, prevent and correct pricing
errors and to compensate fund investors in respect of any material error. Action
should be taken to avoid further error.
FUND PORTFOLIO VALUATION AND NAV
CALCULATION

 Prescriptive valuation requirements where fund manager is responsible for overall
operation of a fund or is delegated responsibility
 Requirement for independent valuation:
 NAV override by fund manager?
 Pricing by fund manager?
 Fund board valuation committee with majority of independent directors?
 Annual review of valuation policy by functionally independent party
 Investor compensation where material pricing errors
OTHER AMENDMENTS
DISCLOSURE OF LEVERAGE
SFC considers leverage a key piece of information for investors in private funds.
Where the fund manager is responsible for the overall operation of a fund it should disclose to
fund investors:
 the expected maximum level of leverage which it may employ on behalf of the fund; and
 basis of calculation of leverage should be reasonable and prudent.
There is no prescribed method of calculation.
REPORTING OBLIGATIONS TO THE SFC
A new section on reporting. The fund manager should:

 Provide appropriate information to the SFC on an ongoing basis upon request.
 Respond to requests and enquiries from the SFC promptly in an open and co-operative manner.
 Ensure that all information provided to the SFC is in all material respects, complete and not
misleading.
SECURITIES LENDING AND REPOS
The securities lending requirements are only applicable to fund managers that engage in securities
lending, repos and reverse repo transactions on behalf of the funds managed by them.
Collateral valuation and management policy Reinvestment of cash collateral

 Need for a collateral valuation and  Assets held in the cash collateral
management policy and a cash collateral reinvestment portfolio should be sufficiently
reinvestment policy in respect of collateral liquid.
received by the funds. The collateral valuation  Fund manager that reinvests cash collateral
and management policy should include received by the funds needs to document and
contingency plans. regularly review the cash collateral
reinvestment policy and communicate the
Eligible collateral and haircut policy
policy to fund investors.
 Policy that determines the types of acceptable  For a fund that is the securities lender, the
collateral and their corresponding haircut. fund manager is required to stress test the
ability of a cash collateral reinvestment
portfolio to meet foreseeable and unexpected
calls for the return of cash collateral on an
ongoing basis.
SECURITIES LENDING AND REPOS (CONT’D)
Reporting to fund investors (applicable to Fund manager responsible for the overall
operation of a fund)
 Provide information on a fund’s securities lending, repo and reverse repo transactions to fund
investors at least on an annual basis.
 At a minimum, certain information should be provided to fund investors from time to time (e.g.
concentration data, aggregate securities lending, repo and reverse repo transaction data, re-use
and re-hypothecation data, number of custodians and the amount of collateral assets
received/held by each custodians).
 Disclose a summary of the securities lending, repo and reverse repo transactions policy and the
risk management policy to fund investors.
HOUSE ACCOUNTS AND AUDITED FINANCIAL
STATEMENTS
House accounts
 Aggregation of house orders with client orders should only be made if it is in the best interests of
clients.
 If a client which is an institutional professional investor requests otherwise, allocation can be
effected on the terms specified by the client.
Audited financial statements

Where a Fund Manager is responsible for the overall operation of a fund:
 Must ensure that independent auditor performs an audit of the financial statements of the fund
 The annual report for each of the funds should be made available to fund investors upon request.
REQUIREMENTS FOR DISCRETIONARY ACCOUNTS
REQUIREMENTS FOR LICENSED OR REGISTERED
PERSONS CONDUCTING DISCRETIONARY
ACCOUNTS MANAGEMENT
Not applicable Additional requirements

 Liquidity management: requirements in relation Unless otherwise agreed with the client:
to use tools or measures which could affect  Performance review against agreed benchmark
redemption rights at least twice a year
 Termination: requirements in relation to  Monthly valuation reports showing positions,
termination process value, all income received and charges levied;
 Side pockets: requirements in relation to side movements in value; open derivative positions
pocket arrangements Minimum content of client agreement (unless
 Auditors: requirements in relation to waivable under Code of Conduct):
independent audit and accounting information in  Details on client's investment policy and
annual report objectives, including asset classes,
 Valuation: requirements in relation to valuation geographical spread, risk profile and any
frequency performance benchmark
 NAV: requirements in relation to NAV calculation  Amount of all fees to be paid by the client to
of different unit/share classes manager or connected persons and description
of fees to be paid to third parties
 Consent to receive soft commission or cash
rebates
 Details of custody agreement
CONTACT
Mark Shipman Matt Feldmann

Partner Partner
Clifford Chance Hong Kong Clifford Chance Hong Kong
T +852 2825 8992 T +852 2825 8859
E mark.shipman@cliffordchance.com E matthias.feldmann@cliffordchance.com
Clifford Chance, 27th Floor, Jardine House, One Connaught Place, Hong Kong
© Clifford Chance 2018
Clifford Chance
WWW.CLIFFORDCHANCE.COM

SFC Fund Manager Code of Conduct Workshop (Clifford Chance - Jan 2018)

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MORGAN STANLEY PRIME BROKERAGE WORKSHOP:

THE SFC’S REVISED FUND MANAGER CODE OF CONDUCT

MARK SHIPMAN, MATT FELDMANN

Applies to all licensed corporations or registered institutions whose business involves:

Fund specific risk management:

Fund specific risk management:

What it means for fund managers:

Fund manager must:

What it means for fund managers:

Safekeeping of fund assets and Selection and appointment of custodian and

What it means for fund managers:

Net asset value calculation and pricing

What it means for fund managers:

There is no prescribed method of calculation.

A new section on reporting. The fund manager should:

Collateral valuation and management policy Reinvestment of cash collateral

Audited financial statements

Not applicable Additional requirements

Mark Shipman Matt Feldmann

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