Keeping track of the changes
Category: Asia, Global
By David Macfarlane
Essential for Asian law firms to keep a finger on the financial pulse
The current regulatory environment has investment management firms grappling with a growing number of requirements and expectations from both regulators and investors. So, how are financial law firms assisting them to accommodate these demands?
Mark Shipman, partner, Hong Kong and global head of investment funds and management sector and co-head of financial services regulatory, Asia-Pacific at law firm Clifford Chance says that post the global financial crisis (GFC), a raft of regulations have been introduced by the US and European regulatory agencies “which we’ve termed ‘the sea of change’. Less invasive (arguably!) regulations are also being adopted in Asia. In response to this, the firm has launched a “Sea of Change” initiative, aimed at educating its clients on how these regulatory changes will affect them both locally and on a cross-border basis – in particular, how it affects their business, their clients and the products and services they offer.”
Mr. Shipman explains that the firm has provided briefing and seminars, and presented at industry associations to ensure that its clients understand these changes and prepare their businesses accordingly to deal with these changes, including the SFC’s new Product Handbook Dodd-Frank, Volcker Rule, OTC clearing, AIFMD, MiFID2, Basel 3, etc…
Philippa Allen, CEO and managing director of ComplianceAsia, which focuses solely on providing compliance advice, consulting and solutions for the financial industry, points out that firms are overwhelmed by the sheer volume of proposed changes, particularly Asian firms as there is less appreciation in Asia that party politics is the driver for many of these changes rather than a real need for reform. “From a compliance consultant’s point of view, one of the biggest services that we offer clients is to keep them up to date with the practical implications of these changes and help client prioritise what items they need to deal with in any one financial quarter,” she says, adding: “The EU proposals are interesting, for example, but they do not come into effect until 2015, so for Asian managers the Dodd Frank changes and short selling reporting changes are more pressing.”
Jason Ng, a Hong Kong-based partner who heads up law firm Baker & McKenzie’s Asia-Pacific funds practice group avers that as the regulations in Hong Kong have come under closer scrutiny, the increased regulatory expectations on areas ranging from systemic risk management and transparency, to product disclosure and sales processes, have placed additional pressure on asset management firms. “As legal advisers to asset managers, law firms like Baker & McKenzie are expected to understand the totality of the regulatory requirements and to assist clients to address compliance issues and manage their regulatory risk effectively. Beyond this, there is a growing expectation for legal advisers to have specific industry expertise in order to help clients better appreciate the strategic implications of regulatory change for their business,” he says.
In regard to detecting emerging challenges for the fund industry in terms of legalities, compliance and risk management, Ms. Allen says ComplianceAsia is concerned for its clients about the disparities emerging between different markets in the move to more regulation. “This creates the risk of inadvertent breaches at an individual firm level but more importantly from a macro stance, the rush to require registration and more reporting from managers particularly of hedge funds creates a real risk of over reporting to regulators. If governments over-estimate the systemic risk to stability posed by the asset management industry there will be a push to introduce even more regulation,” she opines. Another macro issue, she notes, is the rush to prosecute being seen in many regulators at the moment which is dramatically increasing the risk of doing business for many firms.
Karen Man, a Hong Kong-based Partner at law firm Baker & McKenzie whose practice focuses on financial services regulatory advice, mergers and acquisitions, corporate restructuring and general commercial matters, claims that regulation across the Asia-Pacific region is fragmented and the approaches taken by the various regulators with respect to product regulation and distribution can differ significantly in many cases. “Some markets seek to attract overseas investment managers whereas other regulators focus on strengthening the domestic investment management sectors. This may be one of the reasons why the Asian markets have not achieved greater integration in this area,” she divulges. “We keep abreast of emerging challenges domestically by tracking regulatory policy, reform proposals, consultation conclusions and enforcement actions and outcomes on a regular basis. We also commit considerable resources to engaging in regulatory consultations and to strengthening our relationship with industry regulators.
When it comes to identifying, assessing, and controlling business, operational, and compliance issues in an efficient and cost-effective manner, Mr. Shipman says that this is something investment management companies must look at, and adds: “Where they require legal advice, we’re there to help them. We spend a lot of investment time getting familiar with the changes and new rules with a view to delivering an efficient and cost-effective service to our clients.”
In terms of asset management clients’ changing expectations during the current economic furore, Ms. Allen observes that senior management is significantly more aware of and worried by regulation and compliance. “There is general anxiety now about “grey areas” whereas in the past the possibility of using these regulatory gaps was never discounted,” she says.
Mark Shipman reveals that his firm’s asset management clients have become much more aware of the regulatory changes outside of the immediate jurisdiction that affects their business. “However,” he says, “while all fund managers are suffering more from the surfeit of regulations, in being able to meet the day to day compliance requirements, this is particularly challenging for the smaller managers that don’t have the resources or support structures in place.”
Ms. Man states that clients are becoming more aware of the need to invest in risk and compliance functions and infrastructure, and to be able to demonstrate to key stakeholders that their compliance and internal controls are robust. “This has clearly come at a cost, and asset managers are more conscious than ever of how to allocate their resources,” she says, adding: “It is possible that increasingly more of the non-core middle and back office functions of asset managers will be outsourced in the future.”
Rules and regulations
Proposed regulatory changes and recently introduced regulations will have an undoubted impact on distribution and fund raising from asset managers in a legal sense. Ms. Man says the recent amendments to the Securities and Futures (Professional Investor) Rules may have impacted distribution to some extent, by providing market participants with a higher degree of flexibility to establish the professional investor status of investors. “Being able to treat a client as a professional investor allows an institution to fall outside the public offering requirements under the Hong Kong regime in relation to securities, funds and structured products,” she notes.
“In particular, the adoption of a principles-based (rather than a prescriptive) approach allows market players, including asset managers, to use different methods to determine whether a person qualifies as a professional investor,” says Ms. Man. “In fact,” she claims, “the SFC does not explicitly rule out the use of self-declarations – that is, a declaration given by the investor that they have the necessary assets or portfolio – in appropriate circumstances (e.g., by having regard to knowledge obtained about their clients when complying with the “know your client” requirements).”
Notwithstanding the greater flexibility this might provide in the context of distribution, Ms. Man explains that the accreditation requirements for high net worth professional investors under the SFC Code of Conduct have also become more onerous. “The difficulties inherent in meeting these standards, which relate to the exemption from certain know-your-client and other requirements, have led to many industry players choosing to treat such investors as retail investors, rather than accrediting them as high net worth professional investors for the purposes of the SFC Code of Conduct,” she states.
According to Mr. Shipman, asset managers now have to deal with additional disclosures in compliance with new regulations. They’ve also needed to make further filings such as registration with the SEC or applications for exemption. There will also be additional reporting requirements such as the US form PF which has added more administrative burden for many of these firms. In Europe, he says, it’s still too early to tell what impact these changes will have on asset manager’s business. “In six-to-12 months, we should get a better feel for this as AIFMD becomes closer to reality,” he declares. “The biggest difficulty right now is the lack of certainty on what the final position will look like, and whether there will be consistency across jurisdictions e.g. rules for OTC Clearing.”
Ms. Allen goes on to say that this is probably the most difficult distribution and capital raising environment from a legal view she has seen in Asia in the last 22 years. “Regulators are showing aversion to authorising simple vanilla products and the risks attached to raising capital via private placements even to institutional investors are very high. The confusion around the future of capital raising in Europe under the proposed AIFMD is adding to the complexities,” she says.
As today’s regulatory environment is driving towards greater transparency and compliance, what are some of the rules that have a legally-binding effect on asset managers? And what will be the cost of compliance (or non-compliance)?
Ms. Man of Baker & McKenzie says protecting investors from unnecessary risk by enhancing transparency has been at the heart of regulatory change since the financial crisis. “Underpinning this is the requirement for asset management firms which carry out regulated activities in Hong Kong, to be licensed by the SFC, and to comply with SFC filing and capital requirements, and regulatory rules and guidelines on an ongoing basis,” she says. “The recent enactment of the Dodd Frank Act has also led to a large number of non-US investment management firms with interests in the US, being required to register with the US SEC and take on additional reporting and compliance obligations.”
Martin Tam, also Hong Kong-based Partner at law firm Baker & McKenzie, whose practice focuses on insurance and pension law and investment funds, points to the new SFC Handbook as an example, which he says contains revised and new product codes, which will apply to most investment products that are offered to the public in Hong Kong. “The product codes are designed to enhance product disclosure, increase transparency of investment products offered to investors, and update the regulatory framework for retail funds,” he notes. “In authorising the various investment products, the SFC will review the relevant disclosures and exercise its regulatory oversight to ensure that the risk disclosures are appropriate in light of the prevailing market conditions, and to allow investors to make an informed investment decision.”
The revised Code of Conduct has reinforced the obligations of licensed persons to ensure that investment products are suitable for their clients, and to supplement disclosure obligations to ensure that clients understand the risks of their investment decisions. Mr. Tam says: “As legal advisers, it is critical that we help our clients achieve transparency in all aspects of their asset management operations, and to ensure that their internal controls are effective and visible not just at financial year-end, but at any given time. There is no doubt that the increasingly sophisticated technology required to comply with emerging regulatory requirements will continue to be a considerable cost for asset managers.”
Following on from there, Mr. Shipman of Clifford Chance notes that asset managers may face breaches to the new regulations if they are not in compliance, which may possibly lead to criminal offences. “Furthermore,” he asserts, “regulators are looking at internal controls as part of the compliance requirements, and a lack of these controls may result in disciplinary action.”
As to where the demand for legal advice is coming from in regard to the asset/fund management industry, Ms. Man reveals that an area that often requires legal input is in the context of the disclosure obligations under the existing disclosure of interests regime. Inadvertent breaches of Part XV of the SFO may happen, and it is likely that most fund managers are not aware of how often the SFC prosecutes such cases.
“In particular, investment managers need to be aware of their filing obligations to disclose dealings during a takeover offer under the Hong Kong Takeovers Code,” she says. “This is an area that has attracted the SFC’s close attention recently. In a disciplinary action late last year, the SFC publicly criticised the Hong Kong office of a large global investment manager for late disclosure of its funds’ dealings in Little Sheep Group Limited during the takeover offer period.
She goes on to point out that this increased vigilance by the regulators in monitoring mis-selling practices by asset management firms – evidenced by the recent increased volume and severity of SFC enforcement actions – has also increased the demand for legal support and assistance. “In the context of retail investors, the post-Lehman environment has provided a platform for complaints by clients to regulators, who are increasingly more responsive and willing to investigate allegations,” notes Ms. Man.
According to Ms. Man, two issues facing the industry which will likely increase demand for legal services in the future are the impending short position reporting obligations and the OTC derivatives market reform.
She says the introduction of short positions reporting requirements, which are expected to commence in June 2012, could potentially increase the compliance burden of industry players, including those in the fund industry. In addition to the time and expense in developing systems which are compliant with the short position reporting obligations, one of the main concerns with the proposals are the penalty provisions (a maximum fine of HK$500,000 and imprisonment for two years) which effectively create a strict liability offence, thus adding an additional element of regulatory risk.
“The recent focus on systemic risk by regulators has led to the proposed development of a regulatory regime for the OTC derivatives market in Hong Kong. As fund managers continue to increase their use of derivatives, they will need to be aware of these changes and their impending compliance obligations. It is possible that we may see greater outsourcing of OTC derivative functions depending on the complexity of the requirements and the implementation timetable,” Ms. Man proclaims.
ComplianceAsia’s Ms. Allen observes that the organisation’s clients have been extremely focussed on the “hows” of distribution in Asia. “They focus down to the level of whether they can attend conferences, leave business cards, respond to reverse solicitations and so on.” Another area of growing concern she brings attention to is the mismatch between tax advice on efficient structures for both managers and funds to ensure funds are not on-shored for tax purposes and regulatory requirements for the manager to have substantive control contractually and in reality in the country in which it is licensed.
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