Conduct of a Fund Management Company’s Business

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.


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