Hong Kong Official Lists Results of SEC-SFC Inspection of Hedge Fund Managers

A senior Hong Kong securities regulator recently detailed the results of the joint inspection of hedge fund managers carried out with the SEC on a sample of hedge fund managers registered with both regulators. Alexa Lam, executive director of the Securities and Futures Commission, noted that the joint inspections revealed areas of concern, particularly the use of side letters. Her remarks were delivered at a recent Investment Company Institute seminar.

The inspections revealed that some fund managers give preferential treatments to certain investors through side letters without adequate disclosure to other investors, which can lead to unfairness and conflicts of interest. These undisclosed side letters often offer enhanced liquidity and other preferential benefits to selected investors. Disclosure could be one of the solutions to this problem, emphasized the executive director, who advised fund managers to disclose to investors the existence of side letters and their material terms, such as preferential redemption rights and portfolio transparency rights.

The UK Financial Services Authority is also concerned about undisclosed side letters. The FSA believes that the failure of UK-based hedge fund managers to make adequate disclosure is a breach of the principle that a firm must conduct its business with integrity. As a minimum, the FSA also expects that, as an acceptable market practice, managers will ensure that all investors are informed when a material side letter is granted.

The SEC-SFC inspections also revealed that some managers did not have clear valuation policies, such as the valuation methods for complex and illiquid products.