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The First SFC Compliance Bulletin on Conflicts of Interests of Intermediaries

Written by: Ms. Agnes Chan – Risk Consultant

In recent years, there has been strong growth in the number of intermediaries and licensed corporations (“LC”s). For the sake of highlighting the importance of managing conflicts of interest in selling practices and asset management and enhancing the communication with Managers-in-Charge of core functions in LCs, the Securities and Futures Commission (“SFC”) has published the first issue of its Compliance Bulletin on 19 December 2017 which focuses on four supervisory cases identified in on-site inspections and off-site monitoring. The four supervisory cases relating to conflicts of interests are summarized as follows:

Managing private funds
The SFC has performed an inspection of managers of private funds. It was discovered that the fund manager, in a case, heavily invested in concentrated positions of illiquid stocks, and then unfairly arranged loans from other funds and favorable terms. In this circumstance, the arrangements were unfair to the lending funds’ investors and the lending funds were exposed to default risks.

Rebates
Another private fund manager was found to have unusually large amount of cash rebate. In that case, the private fund manager passed majority of its fund transactions to execution brokers who could rebate as much as 85% of their commissions back to that fund manager. These cash rebates are treated as fund assets belonging to fund investors, so the private fund manager is required to make full disclosure, obtain consent and report continuously to the fund investors. However, the private fund manager was not able to explain to the SFC the reasons of its high trading volume with execution brokers who offered high cash rebates. The SFC was concerned about the exceptionally high stock turnover as the private fund manager may have the intention to generate the rebates for personal interests.

Selling practices
In an inspection, the SFC noted that a LC sold the same unlisted bonds to three investors which were issued on the same day at the same price, but at different annual coupon rates. It is found that the LC can earn a higher placing commission for those bonds with a lower coupon rate. Therefore, the SFC believed that the LC had put itself into a position of material conflict of interest by selling the same bonds to different investors with lower coupon rate in order to earn more commission. Besides, the SFC has reason to believe that the LC had no intention to take reasonable measures to ensure fair treatment of clients or disclose such material conflicts of interest to clients.

Selling “in-house” products
The SFC and the Hong Kong Monetary Authority (“HKMA”) conducted joint thematic reviews of large financial groups. It is noted that some large financial groups in Hong Kong conduct business through different Registered Institutions (“RI”s) and LCs. LCs may act as the manufacturer of investment products which are distributed to end-clients by the RIs within the same group. During the reviews, the SFC and the HKMA found that some RIs mainly offered sales to their clients by selecting financial products issued by another LC within the same financial group.

The joint thematic reviews highlighted some issues of the above arrangements as follows:

  • conducting sales of structured products issued by the same financial group without proper product due diligence or comparison of prices of third-parties
  • not disclosing the conflict of interest to their clients and not executing the client orders at the best prevailing price
  • not disclosing to clients that lower fees and charges were applicable to some “in-house” products
  • investing client funds substantially in “in-house” products


As the SFC will not tolerate intermediaries and LCs treating clients unfairly or getting benefits at the expense of clients’ interest, conflict of interest has always been the key area of concern for the SFC. In this bulletin, the SFC identified cases of conflicts of interest, providing guidance and clarifications on regulators' expected standards in respect of conflicts of interests through real life examples. Therefore, it is of top priority for intermediaries and LCs to examine their related controls and act honestly and fairly for the best interests of their clients.


Source:
SFC Compliance Bulletin: Intermediaries. The Securities and Futures Commission, December 2017.



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