Updated SFC Guidance on Management of Regulatory Capital

Overview

The Securities and Futures Commission (“SFC”) published a circular on July 3, 2024 setting out its expectations regarding the governance and internal control standards of SFC licensed corporations for monitoring the adequacy of financial resources and compliance with the Securities and Futures (Financial Resources) Rules (“FRR”).

The circular noted that as part of the SFC’s monitoring of licensed corporations financial resources adequacy, it had observed various undesirable practices that led to abrupt declines in excess liquid capital (“ELC”), or breaches of the liquid capital requirement under the FRR. In some cases, those required liquid capital deficits (“RLC deficits”) had remained outstanding for months. These observations are not surprising given the difficult economic conditions which have challenged the securities and futures industry over the past months.

Common Deficiencies and Causes

Common deficiencies identified by the SFC included:

• inadequate or ineffective controls over liquid capital monitoring;

• failure to make proper accruals or accounting provisions; and

• incorrect treatments of certain assets or liabilities for liquid capital computation.

The SFC attributed these deficiencies were mainly to (a) ineffective management oversight; and (b) failure to employ competent and qualified persons to calculate and monitor liquid capital and to prepare and review the relevant financial resources returns (“FRR returns”).

It noted that some licensed corporations were late in reporting their RLC deficits to the SFC, thus also contravening the relevant notification requirements under the Securities and Futures Ordinance (“SFO”), the FRR and the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission. While such problems were mainly found in those licensed corporations with smaller operations and/or weaker governance, the SFC nevertheless reminded all licensed corporations that they should comply with the FRR and ensure adequate resources are employed to properly carry out their business activities in a compliant manner.

Expected Standards

Under the FRR, an SFC licensed corporation must at all times maintain liquid capital which is not less than its required liquid capital and under the SFO, a licensed corporation must notify the SFC in writing and immediately cease carrying on any regulated activity for which it is licensed if it becomes aware that it is unable to maintain, or to ascertain whether it maintains, the financial resources required of it.

Under the General Principles of the Code of Conduct, an SFC licensed corporation is required to have the resources and effectively employ procedures which are required for the proper performance of its business activities, including the need for sufficient liquid capital to enable the corporation to operate in the normal course of business as a going concern.

Having inadequate internal controls in respect of FRR compliance can lead to an abrupt cessation or interruption of an LC’s regulated activities and impact its clients’ interests. Poor controls may also expose an LC to the risk of theft, fraud, other dishonest acts, and professional misconduct.

Management Oversight

Every SFC licensed corporation is required to designate at least one responsible officer (“RO”) or manager-in-charge (“MIC”) to be responsible for each of the following areas: (a) ensuring the availability of the financial resources needed for the proper performance of the LC’s business activities; and (b) ensuring full compliance with the financial resources requirements under the FRR at all times.

The designated RO or MIC should have the following responsibilities: (a) overseeing the calculation, monitoring and reporting of liquid capital; and (b) establishing and enforcing policies, procedures and internal controls to ensure the adequacy of financial resources and compliance with the FRR; and (c) identifying the root cause of any FRR compliance failure and implementing appropriate remedial measures promptly.

If the designated RO or MIC delegates or outsources the calculation, monitoring or reporting of liquid capital, they should ensure that any person employed or appointed for these duties is competent and possesses the relevant qualifications, knowledge and experience. In all cases, the licensed corporation will remain responsible for compliance with the FRR and the SFC circular notwithstanding any such outsourcing.

Internal Control Standards

Under the Internal Control Guidelines, SFC licensed corporations must establish and maintain policies and procedures to ensure compliance with all applicable legal and regulatory requirements including:

• sound accounting policies and procedures,

• a maker and checker mechanism for liquid capital calculation,

• procedures for ongoing liquid capital monitoring,

• regular liquid capital projections,

• a liquidity management framework for dealing with thin ELC situations,

• procedures to comply with all relevant notification requirements, and

• an allocation of responsibilities between the licensed corporation and its external service providers.

The frequency of liquid capital monitoring should be in line with the operational complexity of the business of a licensed corporation and a licensed corporation should therefore consider the potential fluctuation of its ELC to set the monitoring frequency. If the operations of a licensed corporation are simple with a substantial liquid capital buffer and proper liquid capital projections, the monitoring frequency can be reduced.

Remedial Measures

Under the FRR and pursuant to the SFO, where an SFC licensed corporation notifies the SFC that it has failed to maintain the minimum required liquid capital, it must include in its notice full details of the matter, the reasons and any steps to redress the shortfall. An SFC licensed corporation that incurs an RLC deficit is expected to complete and submit an incident report within three weeks from the date of first identifying the RLC deficit.

Financial Distress

SFC licensed corporations must comply with all relevant regulatory requirements until their licence has been revoked. This is so even where the licensed corporation has ceased business operations. In cases of financial distress, a licensed corporation should ensure sufficient financial, human and operational resources to handle the return of client assets and the winding down its regulated business in an orderly manner.

SFC Monitoring of Capital Adequacy

The SFC monitors the adequacy of each licensed corporation’s liquid capital on an ongoing basis and may make enquiries where it appears that the licensed corporation is not generating sufficient income to cover its operating expenses so that its ELC is projected to run out in less than 12 months.

Remedial Measures to Address Capital Concerns

The SFC may ask licensed corporations to improve their financial position, including, for example, by arranging for substantial shareholders or controllers to inject share capital or by adopting cost-cutting measures. If it appears a licensed corporation will be unable to meet its capital requirements, the SFC may ask the corporation to provide a detailed exit plan, to provide undertakings to cease to accept new clients or new orders or to return client assets or to undertake other measures such as not providing any financing or guarantee to substantial shareholders or affiliates.