Hong Kong's new approach to individual accountability in regulatory investigations - Implications for licensed corporations

An analysis of the key short, medium, and long term risks and implications of Hong Kong's new Manager in Charge regime for licensed institutions.

Introduction

In December 2016, Hong Kong’s Securities and Futures Commission (the SFC) issued a circular to introduce measures to heighten the accountability of senior management of licensed corporations (the Circular).  The Circular tracks a similar measure introduced in the UK in March 2016, the Senior Managers Regime (SMR), and reflects an established global trend towards enhanced scrutiny of individual conduct in regulatory enforcement.

In this note we provide a short overview of the Circular, explain the likely short, medium, and long term implications, and conclude with our three key points for licensed corporations.

Overview of the Circular

The Circular sets out the SFC’s view on who should be regarded as members of senior management of licensed corporations under Hong Kong’s existing regulatory framework .  It also sets out a timetable for licensed corporations to submit organisational charts and other information to the SFC.  In so doing the Circular seeks to clarify the scope of each senior manager’s duties and responsibilities under Hong Kong’s regulatory regime and to promote awareness of the existing regulatory obligations and potential liabilities.

The SFC considers senior management to include directors, ROs, and individuals whom the SFC terms “Managers in Charge” (MIC).  Licensed corporations are required to appoint a MIC for each of what the SFC refers to as the eight “Core Functions”:  (1) overall management oversight, (2) key business lines, (3) operational control and review, (4) risk management, (5) finance and accounting, (6) information technology, (7) compliance, and (8) anti-money laundering and counter-terrorist financing .  To be an MIC the relevant individual must:

  • Occupy a position within the corporation which is of sufficient authority to enable the individual to exert a significant influence on the conduct of the Core Function
  • Have authority to make decisions (eg assume business risks within pre-set parameters or limits) for that Core Function
  • Have authority to allocate resources or incur expenditures in connection with the particular department, division, or functional unit carrying on that Core Function
  • Have authority to represent the particular department, division, or functional unit carrying on that Core Function, eg in senior management meetings or in meetings with outside parties, and
  • Generally speaking, report directly to the Board and be accountable for the performance or achievement of business objectives set by the Board.

Annex 1 of the Circular sets out examples of individual positions which could be identified as MICs for the eight Core Functions, and will be a useful starting point for licensed corporations.

Implications for licensed corporations

Short term:  time required to identify and map senior management responsibility

In the short term, considerable time and effort will be required to identify and map senior management responsibilities during the first half of 2017 in order to meet the timetable prescribed by the Circular.

Information on MICs, together with organisational charts showing management and governance structures, business and operational units, as well as key human resources and their reporting lines must be provided to the SFC between 18 April and 17 July 2017.  The final form of this initial submission has not yet been gazetted and licensed corporations must inform the SFC of any changes to the appointment or particulars of MICs on a continuing basis.  Licensed corporations then have a further three months, ie until 16 October 2017, to apply to the SFC for at least one MIC for each of the overall management oversight and key business lines “Core Functions” to become ROs.

The SFC will likely take note of the UK financial regulator’s experience with the SMR and be wary of any overlapping or unclear divisions of responsibility between MICs, or efforts to put more junior employees forward to limit the responsibility of senior management.

Medium term:  responding to challenges around employee engagement and training

The medium term challenges for licensed corporations are likely to be more employee-focused.  Licensed corporations may find that they experience different demands during the recruitment process for senior management roles (particularly from potential non-executive directors) about the extent of their exposure.  For example potential MICs may request higher compensation packages in response to the heightened risk of enforcement activity, or a right to receive free and independent legal advice during any internal investigations into potential failures in risk management within their reporting lines.  Firms should consider whether to extend D&O insurance coverage to more members of senior management which may address some of these perceived concerns.

With the prospect of enhanced supervision and enforcement activity in mind, licensed corporations should take steps in the medium term to engage with their current senior management teams to ensure that they understand the scope of their regulatory obligations.  In particular, senior managers should be trained on how they should respond to material failures in risk management or misconduct which are escalated to them, and specifically what steps they should take to document their decision making and upwards escalation to other senior managers or risk committees.  This will be particularly important in the context of remediation exercises, where the committee-based nature of such projects can leave senior managers exposed to criticism should issues not be progressed in a timely way.

The precise scope of senior managers’ responsibilities will inevitably be brought into sharper focus in 2017 and 2018, and licensed corporations should take the opportunity now to mitigate the risks associated with increased supervisory and enforcement action in this area.

Long term:  increase in parallel investigations and enforcement activity in relation to senior management accountability

The Circular heralds a renewed focus by the SFC on individual accountability and its role in setting the culture of licensed corporations.  This reflects a well-established global trend in regulatory enforcement, and underscores the SFC’s commitment to ensuring that the ‘tone from the top’ within licensed corporations is appropriate.

The primary long term consequence of the Circular for licensed corporations will be closer scrutiny of individual decision making and judgment.  This will be particularly so where material failures of risk management or misconduct are identified within an MIC’s reporting line.  In practical terms this will mean that licensed corporations, to the extent they do not already do so, may need to adjust their investigations protocols in order to conduct parallel or consequential factual investigations into individual accountability.

As part of those investigations licensed corporations will need to undertake careful and detailed assessments of the scope of responsibility set out in any information previously provided to the SFC, and to critically assess whether the relevant individuals have discharged their responsibilities appropriately.  The SFC will likely wish to see clear evidence that MICs and their senior subordinates have exercised appropriate judgment when presented with difficult facts.  In particular the SFC will wish to see how issues have been identified and escalated within their relevant reporting lines and beyond. 

The fact that a licensed corporation has carried out such an investigation, together with its findings and the management response in terms of the approach to individual accountability, will likely influence the SFC’s view as to whether enforcement action against the licensed corporation (now or in the future) is necessary to correct any perceived cultural failings.  Compliance teams and other relevant control functions should be aware of this new reality.  This is particularly so in terms of assessing the need to sanction senior management in light of failures identified during internal investigations, and more specifically, how the failure to sanction such an individual may be interpreted by the SFC in the context of the SFC’s ongoing assessment of the culture of the licensed corporation.

Conclusion and three key points

The introduction of the Circular underscores the SFC’s focus on culture and senior management conduct.  While the SFC has stopped short of seeking to introduce wholesale changes to achieve its objective of linking individual accountability to cultural change, by requiring licensed corporations to clearly delineate responsibility between senior managers the Circular goes some way towards addressing what has for some time been considered a missing link in Hong Kong’s enforcement landscape.

For licensed corporations, the immediate challenge will be to meet the deadlines imposed for the completion and submission of the organisational charts and finalising information on the MICs.  The long term challenges, flowing from increased scrutiny of senior management conduct and ensuring continuing compliance with the Circular, however, are more demanding, and will require ongoing engagement and focus from senior management and compliance as well as from other control functions.

The three key points for licensed corporations to take on board at this stage are as follows:

  1. The Circular does not impose any additional civil or criminal liability on senior management of licensed corporations.  Instead the Circular sets out the SFC’s current powers to take action in response to individual misconduct.  While in that sense the SFC’s CEO, Mr Ashley Alder, is correct when he said in announcing the Circular that senior management should be “well aware of the obligations currently imposed on them as well as their potential liability if they fail to discharge their responsibilities” , licensed corporations should consider providing additional training to their senior management given the SFC’s renewed focus on individual accountability.
  2. Although the substance of the regulatory framework is unchanged, it is clear that the SFC intends to cast a wider net for enforcement in terms of individual accountability than has been the case to date.  Arguably this is particularly so for compliance teams, who the SFC has previously considered to be outside the scope of the licensing regime, given their role as an independent control function.  All members of senior management of licensed corporations (even if they are not licensed) are regulated persons because of their involvement in the management of the licensed corporation’s business.  Their actions, and not only those of the Board, are likely to be subject to heightened regulatory attention.  To the extent that licensed corporations do not already review and assess individual accountability in parallel with or as a consequence of internal investigations, they should adjust their internal processes to do so in order that they may respond appropriately to the SFC’s renewed focus on individual accountability.
  3. The Circular confirms the SFC’s focus on conduct and culture and clears the path for the SFC to identify and hold to account those individuals who are responsible for material failures in risk management or misconduct.  In his first substantive speech since arriving in Hong Kong, the new SFC Director of Enforcement, Thomas Atkinson, announced that the SFC will “vigorously exercise” its powers where it considers it appropriate to do so.  Licensed corporations should keep Mr Atkinson’s words in mind when considering their response to the Circular in terms of training and any adjustments they may need to make to their investigations protocols.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.