Contents
Overview
Introduction
Objectives
1.0 The Investment Management Agreement
1.1 Contents of the Investment Management Agreement
1.2 What is an Investment Mandate?
1.3 Contents of the Investment Mandate
1.4 Use of Derivatives
1.5 Delegation to Other Investment Managers
2.0 Duties to Clients
2.1 The Prudent Investor Rule
2.2 Conflicts of Interest
2.3 Personal Account Trading
2.4 Crossings between Clients
2.5 Allocation
2.6 Soft Dollar Dealings
2.7 Dealing through Related Party Stockbrokers
3.0 Records and Segregation of Assets
3.1 Trust Accounts and the Custodian
3.2 Client Records and Accounts to be Maintained by a Fund Management Company
3.3 Reporting to Clients
4.0 Substantial Shareholder Notices
5.0 Insurance Cover
6.0 Summary
Suggested Answers to Activities
Overview
Introduction
In this topic we examine several practical aspects relating to the conduct of a fund management company’s business.
We start by looking at the Investment Management Agreement which describes the contractual arrangement between a fund management company and its client. We review the important elements of the Investment Mandate including the use of derivatives in relation to client portfolios. The ability to delegate to other investment managers is important following the relaxation of rules relating to the management of international portfolios.
We examine the duty owed by a fund management company to its client and the Prudent Investor Rule. We also look at the potential conflicts of interest that may arise, including several contentious areas — personal account trading, crossings between clients, allocation, soft dollar dealings, and related party transactions.
We then examine the important rules relating to the keeping of records and accounts by a fund management company, including the requirement to segregate client assets, and the obligations to report to clients on the progress of their portfolios. The semi-annual reports required by the Securities Commission are also examined.
Finally we look at substantial shareholder notices and the insurance cover that a prudent fund management company should hold.
Objectives
At the end of this topic you should be able to:
• describe the purpose of an Investment Management Agreement and Investment Mandate and list the contents of each
• understand that conflicts of interest between a fund management company and a client are likely to arise and how they may be resolved
• understand how personal account trading can give rise to a conflict of interest
• list the principles that may be applied by a fund management company to avoid conflicts arising from personal account trading and the compliance issues involved
• describe the conflict between clients that may arise in relation to allocation of stock
• define what is meant by ‘soft dollar dealings’, how a conflict of interest may arise in relation to such transactions, and how it can be properly dealt with
• appreciate the need for a fund management company to keep proper records and accounts and to clearly segregate client assets
• understand and be able to apply the Securities Commission’s requirements relating to client reports.
1.0 The Investment Management Agreement
In Topic 5 we stressed the importance of the Investment Management Agreement (IMA) between the fund management company and the client. Clearly, every Investment Management Agreement ill be different. However, a number of provisions will be common to all such agreements. As the Investment Management Agreement is the key to many aspects of a fund management company’s business, we will review the contents of a typical Agreement.
The Investment Management Agreement between the fund management company and the client should contain the client’s investment instructions in relation to the investment portfolio. This is because the fund management company must manage the portfolio in accordance with the client’s instructions. A client, such as the trustee of a pension fund, must set his or her own investment objectives and investment strategy — albeit, perhaps, with input provided by the fund management company (or other experts such as an asset consultant) — taking into account the requirements laid down in the trust deed. This responsibility cannot be simply abrogated to the fund management company who must manage the investment portfolio subject to the instructions of the client. The fund management company must therefore receive written investment instructions from the client. Such instructions form part of the Investment Management Agreement.
1.1 Contents of the Investment Management Agreement
The Securities Commission (SC) in its Guidelines on Compliance Function for Fund Management Companies, requires fund management companies to ensure that a written agreement is entered into with each client before any fund management services are provided to, or transactions are carried out on behalf of a client. A fund management company must ensure that the written agreement includes:
• clients’ risk profiles and investment objectives including any investment limitations, restrictions or instructions
• notification of any significant changes to the investment policy or investment recommendation
• clear authorisation from the clients for discretionary mandate
• scope of services that will be provided by the fund management company including frequency of written statements and reports relating to the clients’ portfolios
• fees and charges to be paid by the clients or any other remuneration received by the fund management company from any other person in relation to services provided to the clients
• details of custodial arrangement
• basis of valuation to be used for any type of investment products
• terms and conditions relating to soft commission, where applicable
• liability of fund management company where there is a breach of the IMA
• conditions for alteration and termination to the IMA and its
implications thereof in respect of settlement, repayment obligations and surrender of documentation; and
• details of delegation of the fund management company’s function (if any)
In another one of its Guidelines on Unit Trust Funds, the SC requires an agreement between the management company or trustee and its delegate or service provider contain (among others) clear provisions in relation to:
• the services to be provided
• the fees, remuneration and other charges of the delegate
• any restriction or prohibition regarding the performance of the function to be delegated reporting requirements, including the line of reporting between the delegate and
• the management company or trustee and means of evaluating the performance of the delegate.
1.2 What is an Investment Mandate?
A fund management company’s duties include the management of the clients portfolio on the basis of specific instructions from the client described in the Investment Management Agreement.
An Investment Mandate sets out the client’s instructions concerning the asset allocation of the portfolio (perhaps incorporating maximum and minimum sector exposures) and may provide a benchmark by which the performance of the fund management company can be assessed. It may also incorporate prohibited investments.
A disadvantage of incorporating the Investment Mandate within the Agreement is that it may not be as readily amended by the client in response to variations in its investment objectives and investment strategy. Hence, the Investment Mandate may be included with the Agreement as a Schedule which the Agreement may allow to be altered by agreement of the parties. In this way, the Agreement itself need not be re-signed as circumstances change.
1.3 Contents of the Investment Mandate
The content of an Investment Mandate is the subject of negotiation between the client and the fund management company and clearly each Mandate will differ. An Investment Mandate will usually incorporate the following:
Investment
• a description of the fund management company’s investment style and investment approach
• identification of the type of mandate e.g. balanced or specialist sector (i.e. Malaysian equities, international equities, Malaysian fixed interest, international fixed interest)
• asset allocation ranges (where relevant to the type of mandate) including details of how exposure to each asset class is to be measured e.g. physical exposure and exposure through derivatives
• a description of the fund management company’s investment powers
• details of the authorised investments from which the fund management company is able to select appropriate investments e.g. shares listed on Bursa Malaysia Securities Berhad, foreign currency (as an asset class)
• details of any prohibited investments e.g. shares in companies related to the client, companies deemed not to conform with Syari’ah principles, holdings in excess of a specified percentage of the market value of the client’s portfolio or in excess of a specified percentage of the issued share capital of the company in which an investment is held
• the extent to which the fund management company may use derivatives e.g. ‘only for hedging purposes’, and the methods by which the fund management company monitors compliance with restrictions on the use of derivatives imposed by the client
• counterparty credit limits (cash, fixed interest, OTC derivatives)
[Note: A counterparty is the bank or other entity with whom a deposit or other transaction is made. Counterparty risk is the risk that the client would face if the other party failed to fulfil the terms of the arrangement.]
▪ gearing restrictions
• related party investments i.e. investment in entities related to the fund management company e.g. unit trusts whose management company is an associate of the fund management company, bank deposits with a fund management company’s parent company
• impact of taxation e.g. whether the tax effect of investment decisions is to be ignored by the fund management company
• foreign currency management
• securities lending and borrowing policy.
Performance Measurement
• benchmarks to be applied for the purpose of assessment of the fund management company’s performance e.g. benchmark asset allocation, relevant indices, inflation, peer group performance
• the inclusion or otherwise of fund management company’s fees in measuring performance
• performance attribution
• the impact of taxation on performance measurement.
[Note: In Malaysia it is not current practice to include aspects of performance measurement in an Investment Mandate — rather, this aspect would be discussed with the asset consultant appointed by the client (as would the taxation aspects of the client’s portfolio). For further discussion of this important area, refer to Topical Issues in Fund Management Regulation)
Other Issues
• fund management company’s policies in relation to corporate governance and proxy voting, related party dealings e.g. transactions through a related party stockbroker, soft dollar arrangements (again, this aspect is not currently included in Malaysian mandates)
• restrictions imposed on the investment portfolio by legislation, trust deeds etc.
• time limit for remedying non-compliance with investment restrictions applicable to the portfolio.
Not all the elements of an Investment Mandate described above may be appropriate for use in the Malaysian funds management industry at its current stage of development. However, as the industry grows, it is highly likely that Malaysian mandates will move toward international standards of content.
1.4 Use of Derivatives
A fund management company may, in accordance with the Investment Mandate, use derivatives as part of a client’s portfolio.
A derivative instrument is a contract derived from a fundamental security (such as a share) which allows one party exposed to an unwanted risk to pass that risk to another party and assume a different risk, or pay cash, in return. Derivatives allow investment risk to be managed in a way that is not possible using the underlying assets alone. Fund management companies may, in respect of a client’s investments,
identify, isolate, and manage separately the fundamental risks and other characteristics that are bound together in traditional investments.
The use of derivative instruments by fund management companies provides benefits to clients by way of:
• Increased execution efficiency. For example, an asset allocation decision to transfer exposure from the fixed interest market into the share market may be effected more quickly using futures without affecting the market significantly and at a fraction of the cost of the equivalent physical transactions.
• Improved investment returns. The mispricing of derivatives can frequently lead to the enhancement of portfolio returns. For example, options are often overpriced and excess returns may be realised through a judicious option selling program.
• Reduced costs. For example, share transactions attract stamp duty which can be avoided with equivalent stamp duty exempt futures transactions.
• Risk separation. Foreign currency risk associated with international shareholdings can, for example, be separated from the equity risk through the use of forward foreign exchange contracts.
However, there are risks involved in the use by fund management companies of derivatives:
• Market risk refers to the risk inherent in a position that arises from market price movements.
• Credit risk refers to the risk associated with entering into a transaction with a specific counterparty. It is generally considered to be significant only with OTC derivative transactions.
• Operational risk refers to the risk associated with inadequate systems and controls, human error or management failure.
• Legal risk refers to the enforceability of a derivatives contract and includes risks arising from insufficient documentation and insufficient capacity or authority of the counterparty. With exchange traded derivatives this risk is minimal.
1.5 Delegation to Other Investment Managers
A fund management company may, with the approval of its client, appoint third party investment managers to be responsible for investment of a part of a client’s portfolio. The third party investment manager may be a related party of the fund management company. For example, a Malaysian-domiciled fund management company jointly owned by local interests and an international joint venture partner may delegate responsibility for a client’s international equity component of a balanced portfolio to its joint venture partner.
A fund management company acting in relation to a unit trust should be aware of the SC’s requirements set out in the Guidelines on Unit Trust Funds. The terms of any agreement between the fund management company and the delegate would be agreed with the client.
2.0 Duties to Clients
In Topics 4 and 5 we looked at the fiduciary duties of a fund management company and the duty and standard of care. In this section we will examine some aspects of the conduct of a fund management company’s business that require particular consideration.
In addition to the discussion of duties to clients in this subtopic, reference also needs to be made to the Guidelines on Compliance Function for Fund Management Companies, which provides for the conduct of fund management companies pertaining to various aspects including portfolio management, trading practices and safeguard of clients’ interests.
2.1 The Prudent Investor Rule
Where funds are managed on behalf of others (i.e. as a fiduciary) we have seen that the fund management company has a duty of care in relation to how those funds are invested. This duty of care has been articulated over many years — usually as a result of court decisions involving the activities of trustees of funds and become known as the Prudent Investor Rule’. In its modern form and in the context of a fund management company acting on behalf of a client, the Rule suggests that a fiduciary must:
• Adhere to the fundamental fiduciary duties of loyalty, impartiality, and prudence.
• Maintain overall portfolio risk at a reasonable level (i.e. risk and return objectives and trade-off must be reasonable and suitable to the client on whose behalf the fund is being managed).
• Provide for a reasonable level of investment diversification. Note that although the investment by the fiduciary in a particular asset may be high risk, in the context of the overall portfolio that investment may be justified. Hence the Rule in its modern form has moved away from the prescriptive or restrictive list of prudent investments as is currently found in the Trustee Act 1949 and toward a form that reflects modern portfolio theory.
• Act with prudence where delegation occurs and in the selection and supervision of agents.
• Be cost conscious when making investments and particularly in relation to the expected level of returns from those investments.
2.2 Conflicts of Interest
As part of its duty of loyalty to a client, a fund management company must be aware of the potential for conflicts of interest between it and the client.
A fund management company should appreciate that potential conflicts of interest will arise as part of its normal business activities. It is important that these are recognised. Many areas of potential conflict, and the fund management company’s proposed treatment of such conflict, will be incorporated within the Investment Management Agreement. Clients are therefore made fully aware of both the potential for such conflicts to arise and of the fund management company’s procedures and practices for handling such conflicts when they do arise.
Risk separation. Foreign currency risk associated with international shareholdings can, for example, be separated from the equity risk through the use of forward foreign exchange contracts.
However, there are risks involved in the use by fund management companies of derivatives:
• Market risk refers to the risk inherent in a position that arises from market price movements.
• Credit risk refers to the risk associated with entering into a transaction with a specific counterparty. It is generally considered to be significant only with OTC derivative transactions.
• Operational risk refers to the risk associated with inadequate systems and controls, human error or management failure.
• Legal risk refers to the enforceability of a derivatives contract and includes risks arising from insufficient documentation and insufficient capacity or authority of the counterparty. With exchange traded derivatives this risk is minimal.
1.5 Delegation to Other Investment Managers
A fund management company may, with the approval of its client, appoint third party investment managers to be responsible for investment of a part of a client’s portfolio. The third party investment manager may be a related party of the fund management company. For example, a Malaysian-domiciled fund management company jointly owned by local interests and an international joint venture partner may delegate responsibility for a client’s international equity component of a balanced portfolio to its joint venture partner.
A fund management company acting in relation to a unit trust should be aware of the SC’s requirements set out in the Guidelines on Unit Trust Funds. The terms of any agreement between the fund management company and the delegate would be agreed with the client.
2.0 Duties to Clients
In Topics 4 and 5 we looked at the fiduciary duties of a fund management company and the duty and standard of care. In this section we will examine some aspects of the conduct of a fund management company’s business that require particular consideration.
In addition to the discussion of duties to clients in this subtopic, reference also needs to be made to the Guidelines on Compliance Function for Fund Management Companies, which provides for the conduct of fund management companies pertaining to various aspects including portfolio management, trading practices and safeguard of clients’ interests.
2.1 The Prudent Investor Rule
Where funds are managed on behalf of others (i.e. as a fiduciary) we have seen that the fund management company has a duty of care in relation to how those funds are invested. This duty of care has been articulated over many years — usually as a result of court decisions involving the activities of trustees of funds and become known as ‘the Prudent Investor Rule’. In its modern form and in the context of a fund management company acting on behalf of a client, the Rule suggests that a fiduciary must:
• Adhere to the fundamental fiduciary duties of loyalty, impartiality, and prudence.
• Maintain overall portfolio risk at a reasonable level (i.e. risk and return objectives and trade-off must be reasonable and suitable to the client on whose behalf the fund is being managed).
• Provide for a reasonable level of investment diversification. Note that
• although the investment by the fiduciary in a particular asset may be high risk, in the context of the overall portfolio that investment may be justified.
• Hence the Rule in its modern form has moved away from the prescriptive or restrictive list of prudent investments as is currently found in the Trustee Act 1949 and toward a form that reflects modern portfolio theory.
• Act with prudence where delegation occurs and in the selection and supervision of agents.-
• Be cost conscious when making investments and particularly in relation to the expected level of returns from those investments.
2.2 Conflicts of Interest
As part of its duty of loyalty to a client, a fund management company must be aware of the potential for conflicts of interest between it and the client.
A fund management company should appreciate that potential conflicts of interest will arise as part of its normal business activities. It is important that these are recognised. Many areas of potential conflict, and the fund management company’s proposed treatment of such conflict, will be incorporated within the Investment Management Agreement. Clients are therefore made fully aware of both the potential for such conflicts to arise and of the fund management company’s procedures and practices for handling such conflicts when they do arise.
In the following sections we examine several areas of potential conflict of interest and review proposals for handling them.
2.3 Personal Account Trading
One area of activity where there is a prospect of conflict between the interests of the fund management company (and its employees) and the fund management company’s clients is that of personal account trading.
Personal trading in securities by the staff of fund management companies (or their family, related parties and associates including corporations, or by those who rely on the investment advice of staff) is common. In addition to the fiduciary obligations, there are requirements imposed upon such dealings under the CMSA (e.g. insider dealing, requirement to maintain a register of securities).
However, from an ethical perspective (and since legal requirements can sometimes be avoided) it is generally considered good practice for a fund management company to provide guidelines to directors and staff (particularly those members of staff who provide advice, receive instructions from or act on behalf of clients, or have access to information generated by the provision of services to clients) in relation to personal share dealings. (It should be noted that some fund management companies simply prohibit personal trading.)
2.4 Crossings between Clients
The Rules of Bursa Malaysia Securities Berhad has a series of rules applying to the crossing of transactions through the market. A particular issue that should concern fund management companies, however, is the potential for conflict when acting on behalf of two separate clients in relation to a crossing.
While the transaction may be of benefit to both clients involved in the transaction it would be advisable that full disclosure of the transaction be made to each client prior to the crossing being disclosed to Bursa Malaysia Securities Berhad. It may not be necessary to disclose to each client the name of the other party.
2.5 Allocation
A fund management company is unlikely to act on behalf of only one client. Commonly, a fund management company will have several clients of which some may be subject to similar or broadly similar Investment Mandates.
A potential conflict may therefore arise in that one client may be favoured over another’, for example, in relation to a limited supply of stock in an Initial Public Offering, or in relation to the earliest allocation of stock purchased at lower prices following an investment recommendation.
The Investment Management Agreement may allow a client’s portfolio to be invested with funds managed on behalf of other clients of the fund management company. The client may consent to the fund management company acting in the acquisition and disposal of assets on behalf of other clients and may authorise the fund management company to deal with the client’s portfolio and any other clients funds as an undivided whole where this is necessary for the efficient management or administration of the portfolio. This authorisation will generally be subject to a condition that the fund management company maintain systems and records that distinguish one client’s portfolio from that belonging to others.
A potential conflict may also arise where an investment is purchased ‘on market on behalf of one client while being sold on behalf of another.
The Investment Management Agreement will generally incorporate recognition of such problems and potential for conflict in its dealings with more than one client. By signing such an Agreement a client acknowledges that the fund management company may perform similar portfolio management services for others, and that the fund management company has ‘no obligation to purchase or sell, or recommend for purchase or sale, for the account of the client, any investment which the fund management company purchases or sells for its own account or for the account of any other client of the fund management company’.
The client may also acknowledge that the fund management company may give advice and take action in the performance of its duties for other clients which differ from advice given and action taken in relation to the client’s portfolio’.
2.6 Soft Dollar Dealings
Soft dollar dealings refer to arrangements in which the brokerage generated by transactions made on behalf of clients by a fund management company is used by the broker to supply various products and services that are produced by a third party to the fund management company.
Typical products and services ‘purchased by a fund management company with soft dollars include performance measurement analysis, external research services, software (e.g. for portfolio modelling and technical analysis), economic analysis and stock quotation systems.
Soft dollar dealing has become common within the funds management industry worldwide. In the US, soft dollar dealing accounts for 20% of total institutional commissions; in the UK it represents 15%.
Clause 11.33 and 11.34 of the SC’s Guidelines on Unit Trust Funds states the following:
“A management company, a trustee or its delegate should not retain any rebate from, or otherwise share in any commission with, any broker/dealer in consideration for directing dealings in a fund’s property. Accordingly, any rebate or shared commission should be directed to the account of the fund concerned.
Notwithstanding the above clause, goods and services (“soft commission”) provided by any broker/dealer may be retained by a management company or its delegate, but only if the goods and services are of demonstrable benefit to unit holders and-
(a) dealings with the broker/dealer are executed on terms which are the best available for the fund; and
(b) the management company’s or delegate’s soft commission practices are adequately disclosed in the prospectus and fund reports (including a description of the goods and services received by the management company or delegate).”
In other situations, whether the practice of soft dollar dealing is appropriate or not is an issue to be decided between a fund management company and its client. From a fund management company’s perspective, soft dollar dealings allows products and services to be obtained in substitution for broker research that may not be needed,
the cost of which continues to be borne by the client through brokerage on transactions. Ultimately, the receipt of more focused and relevant products and services is to the benefit of the client. An alternative would be to raise the investment management fees charged to clients to pay for such products and services.
Soft dollar dealings have the potential for abuse by a fund management company where there is no direct benefit to the client. Such products and services therefore represent a benefit to the fund management company that may lie outside the terms of the Investment Management Agreement.
In this regard, reference also needs to be made to the Guidelines on Compliance Function for Fund Management Companies, which makes provisions for soft commission arrangements.
Pursuant to the guidelines, fund management companies must not accept or receive, any rebates arising from transactions or orders on behalf of clients. Any rebates received must be directed to the account of the relevant clients.
However, a fund management company may accept or receive soft commission arising from transactions or orders on behalf of a client provided that the-
(a) client’s prior consent has been obtained;
(b) goods and services are of demonstrable benefit to the client; and
(c) goods and services are in the form of research and advisory services that assist in the decision-making process relating to the client’s investments.
In the US, soft dollars may only be used to purchase those products and services which provide ‘…lawful and appropriate assistance to the money manager in the performance of his investment decision making responsibilities’. In the UK, soft dollars can be used to purchase products and services ‘._which can reasonably be expected to assist in the provision of investment services to the firm’s customers’.
The Australian Investment Managers’ Association provides guidance to its members as follows:
An Investment Manager may enter into a soft dollar arrangement on behalf of a client providing:
1. The goods or services acquired are of demonstrable benefit to the client.
2. The cost of dealing will not disadvantage the client compared with similar dealing otherwise than under the soft dollar arrangement.
3. When a broker acting under soft dollar arrangements acts as principal, the notional brokerage charged should be at the same rate as a similar size transaction on an agent basis.
4. There are no cash or money rebates involved which could be constituted to be a secret commission. •
5. The total commitment made on behalf of all clients of the
Investment Manager for such arrangements does not jeopardise the Manager’s ability to continue to maintain adequate financial resources. This brokerage limit should be prudent and reflect the nature of the Manager’s business, its level of capital and reasonable changes in market circumstances which could be expected. The Manager’s policy towards its limit should be expressed as a maximum percentage of the total brokerage generated on each of its client’s funds and stated in
submissions.
6. Details of the manager’s policy regarding soft dollars should be contained in all submissions and management mandates. A statement of compliance with the stated policy should be contained in all reports to clients on an annual basis or as required by the clients.
7. On request any information relating to how the manager’s soft dollar policy affects clients individually should be made available to the client’.
2.7 Dealing through Related Party Stockbrokers
A potential conflict of interest between a fund management company and its client may also arise in relation to the completion of transactions made on behalf of the client through a stockbroker that is a related party of the fund management company.
The Guidelines on Unit Trust Funds, while it relates only to transactions made by management companies and trustees in relation to a unit trust, nevertheless provides relevant guidance on this issue.
The guidelines state that the management company and trustee should take all reasonable steps to ensure that:
• Any related party transaction, dealing, investment and appointments involving parties to a fund must be made on terms which are the best available for the fund and which are no less favourable to the fund than an arm’s length transaction between independent parties.
• In approving the broker/dealer, the investment committee-
(a) should be satisfied that the dealings in the fund’s property will be effected by the broker/dealer on terms which are the best available for the fund (“best execution” basis); and
(b) should prescribe a limit in terms of proportion of dealings (in percentage) executed with each broker/dealer.
• “…the use of any broker/dealer for a fund should not exceed 50% of the fund’s dealings in value in any one financial year of the fund”.
• The Guidelines also require disclosure in the annual report to unitholders, of total commissions paid and the proportions and amounts paid to related party stockbrokers.
While the practice of a fund management companies retaining rebates from stockbrokers (based on commissions charged to the fund management company’s client) is not in accordance with the SC’s Guidelines where the client is a unit trust, it is also considered by some fund management companies to be improper in relation to other types of client.
Certainly authority from the client to retain such rebates should be obtained in advance and the amount retained should be disclosed to the client at regular intervals.
The practice of retaining rebates is often linked to the frowned-upon practice of “churning”. Churning relates to an excessive level of transactions in a client portfolio made with a view to generate additional commissions (in the case of a stockbroker) or rebates (where a fund management company is also involved). Any transactions made primarily to benefit the fund management company — rather than being in the client’s best interest — is likely to be a breach of the fund management company’s fiduciary duty.
3.0 Records and Segregation of Assets
The requirements of a fund management company relating to the keeping of records and the segregation of assets are laid down in the Investment Management Agreement and in the CMSA.
3.1 Trust Accounts and the Custodian
An Investment Management Agreement will generally refer to the appointment by the client (perhaps after consultation with the fund management company) of an external custodian.
A custodian safeguards and maintains assets which comprise the portfolio (e.g. shares, liquidity etc.) on behalf of the client. It holds the assets in its own name but on behalf of the client who retains beneficial ownership. The custodian makes settlements for securities bought and sold, collects income arising from the portfolio, and pays expenses as instructed by the client. Amounts may be transferred into and out of the portfolio in accordance with the client’s instructions.
An external custodian, such as a trustee company, provides the client with an additional layer of protection. Since special skills are required of a custodian — especially where international investments are held or where there are a large number of client portfolios to be separately maintained — it is generally uncommon for a fund management company to provide this service. However, a trustee company need not be appointed as a custodian in all cases.
The Investment Management Agreement will prescribe the arrangements for dealing with client assets; for example, allowing for authorised employees of the fund management company to initiate settlements and for the timely provision to the fund manager of the amount of available liquidity held by the custodian.
The CMSA requires a fund management company to maintain a trust account for client monies and property and to make arrangements for a licensed custodian to maintain that account (s.122). A separate record is to be maintained for each Went (s.123(1)(c)) — not to do so is an offence.
The holder of a CMSRL who carries on the business of fund management may not accept nor hold client monies or property unless the representative does so on behalf of a fund management company and in the course of the representative’s employment with that fund management company (s.122(7) of the CMSA).
Read s.122 of the CMSA and list the obligations of holder of a CMSL who carries on the business of fund management in relation to deposits and withdrawals from its trust account.
The penalties for breach of s.122 are severe. A fund management company is liable to a fine of up to RM500,000 for contravention or failure to comply with the provisions of s.122. Where the breach is made with intent to defraud, the fine is a maximum of RM1 million and/or imprisonment for a term of up to 10 years.
3.2 Client Records and Accounts to be Maintained by a Fund Management Company
Both the Investment Management Agreement and the CMSA require fund management companies to keep certain records and accounts.
The records maintained in accordance with the Investment Management Agreement will have the objective of providing information for the purposes of proper monitoring of a client’s portfolio, for the purposes of reporting to the client on the progress of the portfolio, and for reconciliation with custodian and portfolio accounting records.
The CMSA (s.108(1)(a)) requires a fund management company to keep accounting and other records which will explain the transactions and financial ‘position of its business and enable true and fair profit and toss accounts and balance sheets to be prepared. Section 108(1)(b) requires such records to be kept in a manner as will enable them to be conveniently and properly audited. Failure to comply with these requirements is also an offence.
The accounts of a fund management company are to be audited, and the auditor is given special responsibilities to report on irregularities that jeopardises (or may jeopardise) the funds or property of clients (s.130 and s.131).
Directors and officers of a fund management company are required to provide information to an auditor. The SC may itself appoint an independent auditor where it is alleged that a fund management company has failed to account to the SC for monies or securities held on behalf of a client (s.130 and s.131). The independent auditor may examine the records of the fund management company and examine on oath any director, executive officer, secretary or employee in relation to those records (s.133). Section 135 of the CMSA requires such persons (and others) to produce any records held by them and to answer any questions. Failure to comply with these requirements is an offence and on conviction a fine not exceeding RM1 million and/or imprisonment not exceeding five years may be imposed.
Section 136 makes it an offence to destroy, conceal or alter records or to send them outside the country with an intention of preventing, delaying or obstructing any examination or audit of a fund management company’s business activities. On conviction, a fine of up to RM1 million and/or up to 10 years applies. The onus of proving that the records were not destroyed, concealed, altered or transferred overseas with intent to prevent, delay or obstruct an examination or audit lies on the person charged.
3.3 Reporting to Clients
In relation to reporting to clients, the SC requires that a fund management company provide statement relating to a client’s portfolio directly to each client, at least on monthly basis. Such statement must, among others, include a statement of account showing the client’s actual portfolio position and the fees and charges payable by the client.
A fund management company must also provide, at least on quarterly basis, reports to its clients on the performance of each client’s portfolio against appropriate benchmarks, any changes in risk (if any) which will affect the client’s investments and any impact on the client’s capital and earning of the client’s investment arising from the change in risk.
4 Substantial Shareholder Notices
A fund management company is not the beneficial or legal owner of securities under its management. A custodian will generally be the legal owner and the client is the beneficial owner.
However, it is advisable that the fund management company be aware of the requirements in relation to substantial shareholdings.
5 Insurance Cover
As part of its risk management program, every business should ensure that it has appropriate levels of insurance cover. A funds management business .should, in addition to policies of insurance applicable to all businesses, maintain some or all of the following insurances:
• fidelity guarantee insurance
• electronic and computer crime insurance
• professional indemnity insurance.
The level of insurance cover required by clients of a fund management company may reflect the type of investment management and other services offered, the identity of the manager, and the amount of funds under management. A fund management company, particularly where it is part of a banking or insurance group, may offer to clients a related company guarantee in place of external insurance – effectively
self-insurance.
6.0 Summary
In this topic we have looked in detail at some practical aspects of the fund management company’s business. We have seen how some everyday situations faced by a fund management company should be handled in order to avoid an actual or potential conflict of interest and a duty to act in a client’s best interest at all times.
In the next topic we will examine arguably one of the most important aspects of the conduct of a fund.
Suggested Answers to Activities
Activity 1
Read s.122 of the CMSA list the obligations of a holder of a CMSL who carries on the business of fund management in relation to deposits and withdrawals from the trust account.
Answer:
Section 122(3) requires a holder of a CMSL to deposit client’s assets into a trust account maintained by a custodian not later than the next bank business day following receipt.
Withdrawals can only be made for the following purposes (s.122(5)):
• to make a payment to the person entitled thereto
• to make a payment authorised by law.