Circular Issued by the Securities and Futures Commission on Dubious Private Fund and Discretionary Account Arrangements or Transactions

Our Ref: B1/15C & G16/1C
22 November 2019
The Chief Executive
All Registered Institutions
Dear Sir / Madam,
Circular Issued by the Securities and Futures Commission (“SFC”) on Dubious Private Fund and Discretionary Account Arrangements or Transactions I am writing to draw your attention to the attached circular issued by the SFC (“the Circular”), which provides guidance to asset managers in (i) considering if a proposed private fund and discretionary account arrangement or transaction is dubious; and (ii) deciding if they should proceed with a proposed arrangement or transaction that has been considered dubious. Standards of conduct expected of asset managers and examples of red flags for dubious private fund and discretionary account arrangements or transactions are set out in the appendices to the Circular. Registered Institutions which engage in asset management, including discretionary account management, should have due regard to the Circular. Failures or breaches which may arise from disregarding dubious arrangements or transactions highlighted in the Circular may call into question the fitness and properness of a registered person. Yours faithfully, Alan Au Executive Director (Banking Conduct) Encl. c.c. SFC (Ms Julia Leung, Deputy Chief Executive Officer and Executive Director (Intermediaries))

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Circular
35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 1 of 4 21 November 2019 Circular to licensed corporations Dubious private fund and discretionary account arrangements or transactions This circular provides guidance to assist asset managers 1 in (i) considering if a proposed private fund and discretionary account arrangement or transaction is dubious and (ii) deciding if they should proceed with a proposed arrangement or transaction that has been considered dubious. In a Statement on the Disclosure of Actual Controllers or Beneficial Owners of Counterparties to a Transaction, also issued by the Securities and Futures Commission (SFC) today, listed issuers are reminded that they should not employ private fund structures, discretionary accounts or similar arrangements with a view to avoid or to contravene laws, rules or regulations. Background The SFC has identified a number of dubious arrangements and transactions involving private funds or discretionary accounts in its supervision of asset managers 2 . In these cases, asset managers did not act in the manner which would normally be expected of a conventional investment manager in exercising its discretion to make investment decisions for the funds or discretionary accounts under their management. They largely followed investors’ instructions when structuring private funds or discretionary accounts and effecting transactions. Many of these arrangements and transactions involved other red flags and together should have led to a reasonable suspicion on the part of asset managers that these might not be legitimate or proper. Asset managers should not disregard signs of dubious private fund and discretionary account arrangements or transactions, which may facilitate the following types of misconduct by their clients or other entities:
(a) avoiding or contravening any of the market misconduct provisions or disclosure obligations set out in Part XIII, Part XIV, Part XIVA or Part XV of the Securities and Futures Ordinance (SFO) or other laws, rules and regulations, such as the Codes on Takeovers and Mergers and Share Buy-backs and the Listing Rules 3 ;

1 This circular does not apply to licensed corporations which provide discretionary account services as an ancillary part of their brokerage services for clients without any formal investment mandates agreed with, or management fees charged to, clients. 2 These arrangements and transactions were previously referred to in the following circulars:
 HKMA and SFC adopt a coordinated approach to supervise banks and licensed corporations, 24 April 2019.  Circular to intermediaries – Use of “nominees” and “warehousing” arrangements in market and corporate misconduct, 9 October 2018.  Circular to licensed corporations – Margin financing activities disguised as investments, 3 August 2018.  Circular to licensed corporations engaged in asset management business – Irregularities and deficiencies in managing private funds and discretionary accounts, 31 July 2017. 3 The Rules Governing the Listing of Securities on the Stock Exchange of Hong Kong Limited (Listing Rules)

35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 2 of 4 (b) conducting unlicensed regulated activities; or (c) involvement in fraud or other serious misconduct or illicit activities. In disregarding dubious arrangements or transactions, an asset manager may have failed to act honestly, fairly or with due skill, care or diligence, in the best interests of its clients or the integrity of the market in accordance with General Principles 1 and 2 under the Code of Conduct 4 . Failure to report suspicious client transactions may also amount to a breach of paragraph 12.5(f) of the Code of Conduct. In addition, an asset manager may also be in breach of paragraphs 3.2, 4.1.4, 4.9 or 7.23 of the AML Guideline 5 by failing to:
(a) conduct customer due diligence (CDD) measures to verify the identity of the client or beneficial owner; (b) obtain information about the purpose and intended nature of the business relationship it has established; (c) adopt a risk-based approach in determining the extent of CDD measures and ongoing monitoring so that preventive or mitigating measures are commensurate to the risks identified; (d) comply with special requirements in a situation which by its nature may present a high risk of money laundering or terrorist financing; or (e) report suspicious transactions to the JFIU 6 . These failures or breaches will call into question whether the asset manager remains fit and proper to be licensed. Expected standards of conduct The senior management of a licensed firm bears the primary responsibility for ensuring the firm’s maintenance of appropriate standards of conduct and adherence to proper procedures 7 . As such, the senior management 8 of an asset manager should ensure that there are effective procedures and controls for the asset manager to (i) consider if a proposed private fund and discretionary account arrangement or transaction is dubious and (ii) decide if the asset manager should proceed with the relevant arrangement or transaction. This process should cover the following:
(a) Initial screening
(b) Detailed due diligence

4 Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct) 5 Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Corporations) (AML Guideline) 6 Joint Financial Intelligence Unit (JFIU) 7 General principle 9 (Responsibility of senior management) of the Code of Conduct 8 Senior management should include, but not be limited to, the Manager-in-Charge (MIC) of Overall Management Oversight, MIC of Key Business Line (ie, asset management), MIC of Compliance and MIC of Anti-Money Laundering and Counter￾Terrorist Financing

35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 3 of 4 (c) Senior management assessment and decision (d) Documentation Asset managers should observe substance over form throughout the entire process. For more details about the expected standard of conduct, please refer to Appendix 1. (a) Initial screening 9 Once an initial screening determines that a proposed arrangement or transaction is dubious, asset managers should not proceed without prior written approval from senior management with the reasons clearly stated. Asset managers should be familiar with the red flags included in Appendix 2 and be able to recognise them. However, as they are non-exhaustive and practices evolve over time to avoid regulatory scrutiny, asset managers should not adopt a box-ticking approach. Instead, they should:
(i) perform an initial screening of each proposed arrangement or transaction which appears to deviate from generally accepted market practices, such as setting up master-feeder fund structures or special purpose vehicles for tax purposes, using derivative instruments for making an investment for a fund under the Qualified Domestic Institutional Investor program and having multiple funds or special purpose vehicles in private equity funds; and (ii) assess if there is any reason to suspect that the asset manager is not, or will not be, required or expected to make any investment decisions (apart from mere execution or operational decisions), and if there is, look more closely at the details and consider the proposed arrangement or transaction to be dubious unless these reasons can be addressed. See paragraph 2 in Appendix 1 for examples of the types of questions asset managers should ask when reviewing the details of proposed arrangements and transactions. (b) Detailed due diligence All proposed arrangements or transactions which were considered dubious at the initial screening should be logged and subject to detailed evaluation. Asset managers should conduct enhanced due diligence on the investor, the set up and structure of the fund and discretionary account and transactions directed by the investor. The asset manager should then escalate the proposed arrangement or transaction and its due diligence report to senior management for review and a decision. (c) Senior management review and decision Senior management should exercise due skill, care and diligence in reviewing each proposed arrangement or transaction which was considered dubious at initial screening.

9 For the avoidance of doubt, initial screening should generally not be necessary where asset managers do not know the identity of the end investors of private funds under their management, for example, where they have appointed another party to distribute these private funds to end investors and the identity of these end investors is not disclosed to asset managers.

35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 4 of 4 Additional steps should be taken as needed. In particular, senior management should critically assess if it has any remaining doubts about the investor’s explanations, the investor’s sources of funding and whether the transaction is at arm’s length. Senior management should only decide to proceed if it is satisfied that the suspicions (for example, of misconduct) have been sufficiently addressed. (d) Documentation The asset manager should maintain full documentation covering all aspects of every proposed private fund or discretionary account arrangement or transaction which was considered dubious in the initial screening. If asset managers fail to detect dubious arrangements or transactions or they facilitate illegal or improper conduct due to inadequacies in their procedures and controls, the SFC would not hesitate to take regulatory action against them and their senior management. Should you have any questions regarding the contents of this circular, please contact your case officers. Intermediaries Supervision Department Intermediaries Division Securities and Futures Commission Enclosure End SFO/IS/056/2019

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35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 1 of 5
Appendix 1
Standards of conduct expected of asset managers considering dubious private fund and discretionary account arrangements or transactions The senior management 1 of an asset manager should have procedures and controls so that the asset manager could reasonably (i) consider if a proposed private fund or discretionary account arrangement or transaction is dubious and (ii) decide if the asset manager should proceed with the arrangement or transaction. This process should cover the following:
(a) Initial screening
(b) Detailed due diligence
(c) Senior management assessment and decision
(d) Documentation
The senior management should assume responsibility for developing and implementing the procedures and controls in an effective manner. These procedures and controls should be in writing, supplemented by staff training and subject to compliance reviews 2 and internal audits as appropriate. Where it is necessary to delegate any functions, the senior management should only appoint personnel who are suitably qualified to perform the work and ensure that they are properly supervised. The asset manager should be familiar with the examples of red flags included in Appendix 2, which are intended to serve as non-exhaustive guidance. It should also observe substance over form throughout the entire process. (A) Initial screening 3 Once an initial screening determines that a proposed arrangement or transaction is dubious, the asset manager should not proceed without prior written approval from the senior management with the reasons clearly stated, after having conducted detailed due diligence.

1. The asset manager should perform an initial screening of each proposed arrangement
   or transaction which deviates from generally accepted market practices, such as setting up master-feeder fund structures or special purpose vehicles for tax purposes, before:
   (a) accepting a new mandate for a private fund or discretionary account;

1
Senior management should include, but not be limited to, the Manager-in-Charge (MIC) of Overall Management Oversight, MIC of Key Business Line (ie, asset management), MIC of Compliance and MIC of Anti-Money Laundering and Counter￾Terrorist Financing. 2 For example, the asset manager should select mandates and transactions which were not considered dubious for review to assess the reasonableness of the initial screening. 3 For the avoidance of doubt, initial screening should generally not be necessary where the asset manager does not know the identities of the end investors of private funds under its management, for example, where it has appointed another party to distribute private funds and the identities of the end investors are not disclosed to it.

35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 2 of 5 (b) executing an investor-directed or suggested investment transaction for a new or existing private fund or discretionary account under its management; or (c) accepting the injection of an investment (for example, stocks or bonds) by the investor into a private fund or discretionary account under its management.
2. The asset manager should first assess if there is any reason to suspect that the asset
manager is not, or will not be, required or expected to make any investment decisions (apart from mere execution or operational decisions). If there is, then the asset manager should review the details of the proposed arrangement or transaction and ask itself further questions, such as:
(a) Does the fund set up or structure look unduly complex or does it link back to the same investor or small group of investors? (b) Does the proposed transaction make commercial sense? (c) Is it logical to make the proposed investment in this way? (d) Does the proposed transaction involve one or a few investors investing significant amounts in one or a few illiquid stocks or unsecured loans? (e) Is the proposed transaction part of a series of transactions and, if so, what are the implications of the series of transactions as a whole? (f) To what extent have the underlying investments been identified or pre-arranged by the investor? (g) Where a proposed investment does not have a market value, how can the asset manager gauge the reasonableness of the consideration to be paid?
3. If the asset manager is not reasonably satisfied with the answers to any of these
questions 4
, the proposed arrangement or transaction should be considered dubious. The responsible staff should report the arrangement or transaction and the initial screening result to the MIC of the Key Business Line (ie, asset management) and compliance staff for a decision about whether to proceed.
4. Unless a decision is made not to proceed, the asset manager should log the case and
perform enhanced due diligence (please see Section B below).
(B) Detailed due diligence
5. The asset manager should perform enhanced due diligence as follows:
(a) Enhanced due diligence on investors

4 For example, when the use of derivative instruments for making an investment may generally be a red flag indicator, using them for a fund under the Qualified Domestic Institutional Investor program should not, in most cases, be considered dubious. Similarly, a private equity fund should generally not appear dubious just because its fund or investment structure involves multiple funds or special purpose vehicles.

35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 3 of 5 The asset manager should:
(i) make reasonable efforts, for example, by making enquiries and conducting its own research (such as a public records search), to assess whether the investor in the private fund or discretionary account is related, in any way, to:
 other investors in the same fund or discretionary account;  the investments made or to be made by the fund or discretionary account, for example, whether the investor is a substantial shareholder, director or affiliate of the investee company;  the person or entity from which an investment in or by the fund or discretionary account was directly acquired; or  the borrower under a loan which is an investment of the fund or discretionary account; (ii) assess whether the amount of funds or assets injected by the investor into the private fund or discretionary account is commensurate with the investor’s background and declared net assets; and (iii) understand the investor’s source of funding. For example, if there are indications that funding may be from other parties, this should be a red flag that the investor may not be the beneficial owner. (b) Enhanced due diligence on investors’ instructions (i) Set up and structures of funds or discretionary accounts The asset manager should:
 make enquiries with the investor to understand the purpose of setting up the fund or discretionary account, the rationale behind the structure or, where relevant, the reason for channelling money into the fund or discretionary account through multiple or complex layers of arrangements or transactions; and  assess whether the fund or discretionary account might have been set up for improper purposes, such as concealing beneficial ownership or forming part of a dubious “nominee” or “warehousing” arrangement as referred to in the Circular to intermediaries – Use of “nominees” and “warehousing” arrangements in market and corporate misconduct dated 9 October 2018. (ii) Transactions directed by investors The asset manager should:
 take a cautious approach when an investor directs or suggests that the asset manager effects a specific transaction, purchase a particular

35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 4 of 5 investment or use structured products or derivatives to make an investment, even if the investment is within the private fund or discretionary account’s investment mandate;  make enquiries to determine whether the investor has set up similar arrangements with or made similar investments through other asset managers or brokers, and assess whether all these arrangements, when viewed in their totality, appear suspicious;  determine the source of the investments, ie, from where the investments are acquired or are to be acquired, and assess whether this may involve any untoward arrangement or transaction; and  conduct its own research and exercise independent judgement by assessing whether:
o the investment is relatively illiquid (for example, a listed equity that is thinly traded or has a high shareholding concentration as identified by the SFC); o the investment involves investing in private companies or making sizable unsecured loans to individuals or corporates with obscure backgrounds or poor financial standing; or o the investor has suggested a convoluted, risky or expensive way of making the investment. (C) Senior management review and decision
6. Senior management of the asset manager should exercise due skill, care and diligence
in reviewing each proposed arrangement or transaction which was determined to be dubious in the initial screening and take additional steps (such as obtaining professional advice) as needed. Senior management should exercise judgement in determining, among other things, whether:
(a) the investor has provided a valid explanation (for example, tax efficiencies, capital savings or access to markets) with supporting documentation (such as correspondence with the relevant authority or expert tax advice); (b) there remains any reason to suspect that the proposed transaction was illegitimate or improper; and (c) there remains any doubt about the investor’s source of funding or that transactions are at arm’s length.
7. Senior management should only decide to proceed with the arrangement or transaction
if it is satisfied that its concerns have been sufficiently addressed.

35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 5 of 5 (D) Documentation
8. The asset manager should maintain full documentation covering all aspects of every
proposed private fund or discretionary account arrangement or transaction which was determined to be dubious in the initial screening. This should include: (i) a log of all such arrangements and transactions; (ii) details of the initial screening and enhanced due diligence as well as any additional steps taken by the senior management, with the corresponding results; and (iii) the senior management’s review and decision, with its stated reasons for approval.

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35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 1 of 2
Appendix 2
Red flags for dubious private fund and discretionary account arrangements or transactions The following examples of red flags in private fund and discretionary account arrangements or transactions were noted in the SFC’s supervision of asset managers. These examples are intended to serve as non-exhaustive guidance. Asset managers should be wary of arrangements or transactions which exhibit similar characteristics. (a) Arrangements or transactions which are unduly complex or lack a commercial rationale Some arrangements did not appear to have a commercial rationale, were unduly complex or were not the most logical or convenient means to acquire an investment as they would increase costs or counterparty risks. These included:
(i) Investors using structured products and derivatives to channel money into a private fund, disguising one financial institution’s lending to another. For example, investment into a preferential stock issued by a Hong Kong listed company or a bond issued by an overseas financial institution via convoluted methods, such as fund-linked notes; and (ii) The subsidiary of Asset Manager A setting up a discretionary account with Asset Manager A and then issuing a note linked to the performance of the discretionary account. This note was then subscribed by Asset Manager B for another discretionary account it managed. (b) Arrangements or transactions which may facilitate corporate or market misconduct or breaches of legal or regulatory requirements Some private funds or discretionary accounts only invested solely or mainly into a single investment, often selected or suggested by the investor. In some of these cases, “nominees” and “warehousing” arrangements were suspected to be involved. In other cases, these arrangements appeared to be used to mask connected party transactions or to circumvent legal or regulatory requirements 1 . For example:
(i) Multiple private funds were set up with the same fund manager which invested all or most of each such fund’s assets in a single investment or subscribed to a single initial public offering; (ii) A private fund subscribed to other multiple private funds all of which made the same investment and together held a sizeable stake in that investment; (iii) A private fund was set up by a single investor for investing in a single project or providing a loan to a single person or entity;

1
Including the Rules Governing the Listing of Securities on the Stock Exchange of Hong Kong Limited and the Codes on Takeovers and Mergers and Share Buy-backs

35/F, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong 香港皇后大道中二號長江集團中心三十五樓 +852 2231 1222 www.sfc.hk Page 2 of 2 (iv) A private fund was set up for an investor, but apart from a transfer of shares owned by the investor into the fund, no other transactions, or only minimal transactions, were carried out by the asset manager for the fund; (v) An investor instructed a fund manager to set up multiple funds which invested in a single stock, but these funds were only subscribed by persons who were related to the investor or with funds provided by the investor; (vi) The fund investors were connected to the listed stocks in which the fund invested, for example, the investors were substantial shareholders, directors or affiliates of the listed companies; (vii) Listed companies (or their subsidiaries or affiliates) invested in different private funds which cross-invested in one another’s shares; and (viii) Some asset managers facilitated the setting up or operation of the arrangements as covered in the Circular to licensed corporations – Margin financing activities disguised as investments dated 3 August 2018.