UK: Obligations And Responsibilities Of Investment Managers Under The Draft SCA

In February, the Securities and Commodities Authority published on its website a draft resolution regulating the activities of investment managers in the UAE. The draft resolution proposes to regulate the activities of firms managing portfolios of securities for the benefit of others as well as the activities of investment managers of mutual funds. This note provides a summary of the obligations and responsibilities of investment managers vis-à-vis their clients contemplated by the SCA within the draft resolution. It also considers the consequences to the relevant investment manager in the event of a breach.

The Draft Resolution proposes to regulate the activities of firms managing portfolios of securities for the benefit of others as well as the activities of investment managers of mutual funds. For the first category, the Draft Resolution does not consider the "discretionary or not" distinction. For the second category, the Draft Resolution provides that its provisions shall apply cumulatively with those set out in the SCA Board of Directors' resolution no. 37 of 2012 on the Regulation of Investment Funds (mainly in articles 31 and 32).

This note will provide a summary of the obligations and responsibilities of investment managers vis-à-vis their clients contemplated by the SCA within the Draft Resolution. It will also consider the consequences to the relevant investment manager in the event of a breach.

Regulatory obligations outside of contractual arrangements

Obligation to put in place adequate internal procedures

These obligations are concerned with the administrative and technical procedures to be implemented by investment managers. They include the establishment of an investment committee, an obligation to put in place accounting, risk, anti-money laundering and complaints handling procedures, as well as a requirement to use appropriate software and data processing systems.

Investment managers are also required to appoint skilled administrative and technical staff. Such staff must adhere to internal codes of professional conduct. Further, an internal observer must be appointed. The duties of such internal observer include making sure that no conflicts of interest arise and that there is a separation between portfolio management and fund management activities if both types of activities are conducted by the investment manager.

Working on achieving the clients' investment objectives, complying with principles of honesty and integrity, avoidance of conflicts of interest and non discrimination

The Draft Resolution lays out a set of broad principles, without giving specific instructions as to how to implement them. This means, in practice, that there would be latitude for independent judgment. It also means that courts will potentially be called upon to interpret the meaning of each principle. The courts' interpretation of the principles could extend beyond the standards originally intended to be imposed by the SCA. The SCA's role in supervising the good application of the Draft Resolution should, nevertheless, guarantee a minimum standard of compliance with the principles expressed.

Typically, a client's investment objectives (long term / short term, regular income requirement or none, risk profile) will be stated in the investment management agreement as a target only with no guarantee of performance. The Draft Resolution does not clarify whether the investment manager will be required to consider suitability of investments for customers. Issues can arise where the investment objectives are complex, opaque, or inadequately defined. It is common in other jurisdictions for claims for breach of duties by the investment manager to centre on the client's investment objectives and portfolio risk profile.

Obligations of honesty and integrity are intended to restrict certain behaviours, which usually include unauthorised trading through a client's investment portfolio, covering losses on one client's portfolio by transferring funds from other clients' portfolios (without authorisation), misappropriating client funds by creating fictitious trading entries, supplying confidential client information to third parties to facilitate fraud. The investment manager must avoid churning and aim to achieve "best execution" according to the Draft Resolution. This means that transactions must be executed on the best possible terms, without any excessive or unnecessary operations for clients.

Avoiding conflicts of interest practically means refraining from recommending that a client purchase or sell a specific security where the investment manager or a particular client of the investment manager has a personal interest in relation to that security. It also means implementing policies prohibiting the acceptance or solicitation of benefits by members of staff (and the disclosure of any gratuities or benefits received). Where there is a realised or potential conflict, the investment manager must notify the relevant client(s) in writing and notify the SCA where the conflict relates to a mutual fund. Conflicts of interests between clients within the UAE and clients abroad must also be avoided.

Lastly, the Draft Resolution includes an obligation of non discrimination (equal treatment) between clients. In the portfolio management sense, this could mean handling all customer requests in the same way and giving equal treatment to all portfolios with similar objectives. In the investment fund context, this could mean that "late trading" is likely to be deemed illegal.

Due diligence on investments and diversification to reduce risk

The Draft Resolution provides that an investment manager shall "spare no effort" in analysing the financial position of companies and assets where clients' funds are invested and shall diversify investments to minimise risks. This is comparable to the "prudent investor rule" in other jurisdictions and to the related duty of diversification and avoidance of concentration of investment in one particular security or asset. It is unclear under the Draft Resolution whether parties are able to contract out of the duty to diversify, although the text seems to suggest that any diversification must be justified by, or at least accord with, the investment objective contractually agreed by the client.

Segregation of client accounts

Worthy of note is the obligation of investment managers to establish procedures which ensure the segregation of accounts of different clients and segregation vis-à-vis the accounts of the investment manager. The effect of this obligation is that securities and cash held by an investment manager should be ring fenced and protected in an insolvency provided, as a practical matter, the investment manager does comply with the obligation to segregate.

Confidentiality

The Draft Resolution creates an obligation that investment managers maintain the confidentiality of data and information pertaining to clients' investments, and refrain from disclosing the same except to the competent authorities or with the relevant client's written consent.

Roles and responsibilities under client agreements

The obligation to enter into a client agreement

Appropriate client agreements must be concluded. Client agreements must include the minimum terms prescribed by the Draft Resolution. The client agreement will set out the investment manager's mandate and establish the process of making investment decisions and receipt of client instructions.

Ambiguities in a client agreement are likely to be construed against the investment manager. Also, it is common practice for securities portfolio managers to stipulate in the client agreement that representations given outside the agreement (eg in promotional material) shall not be binding, although this is usually challenged before the courts. The Draft Resolution does not consider those two particular issues.

Reporting obligations and record keeping

A client agreement must specify the types and details of reports to be provided to the relevant client. According to the Draft Resolution, reports must be sent to the client at least on a monthly basis and must include, at a minimum, details of the securities in the portfolio, size of transactions executed, a valuation of the portfolio, fees payable to the investment manager and any important event that may influence the portfolio's risk profile.

Records (and adequate backups) should be kept by the investment manager for each client for no less than ten years.

Control, inspection and penalties imposed by the SCA

The Draft Resolution establishes a right to the SCA to "periodically and without prior notice" control and inspect locally licensed investment managers to verify compliance and investigate irregularities. Such irregularities could come to the attention of the SCA through complaints from clients.

Breach of the regulatory provisions within the Draft Resolution by the investment manager will result in a penalty imposed by the SCA. Penalties include the issuance of a warning notice and rectification order, the imposition of a financial fine, and being precluded from engaging in the investment management business for a period not exceeding one year. The flagrant breach of an obligation can result in the cancellation of the investment manager's licence.

If you would like further information on any issue raised in this update please contact Niall O'Toole.