Circular to Licensed Corporations Measures to deal with disruptions caused by financial distress and insufficient responsible officers

1.     Recent operational disruptions exposed some vulnerabilities in the ability of licensed corporations (LCs), particularly small- and medium-size LCs, to cope with stress events. These incidents included financial distress faced by LCs or their controlling shareholders and the sudden unavailability of key staff. The Securities and Futures Commission (SFC) is concerned that these kinds of incidents may result in the abrupt discontinuation of an LC’s business, with a significant impact on its clients.

2.     All LCs are expected to have adequate resources and establish effective procedures to properly carry out their business activities¹. These would include appropriate and robust contingency planning which would help an LC to prepare for, react quickly to and recover from risk events and shocks which undermine its financial soundness or operational capability. Where an LC has no reasonable prospect of restoring its financial strength or viability as a going concern, it should wind down its business in an orderly manner.

3.     Pursuant to the Securities and Futures (Licensing and Registration) (Information) Rules (Cap. 571S) (Information Rules), corporate licence applicants are required to provide information to the SFC regarding their business plans, covering, amongst other things, “contingency plans and related matters”². In addition, the SFC may request an applicant or an LC to provide any further information or documents in relation to its contingency plans.

4.     This circular sets out the SFC’s regulatory approach and expected standards in the following areas to mitigate the risks and impact of an abrupt discontinuation of business:
        (a) information about all controllers and the shareholding structure of an LC;
        (b) maintenance of a sufficient number of responsible officers (ROs);
        (c) maintenance of adequate financial resources;
        (d) financial and operational dependency on another person;
        (e) plans for the scenario of an orderly closure of business in any regulated activity (exit plans); and
        (f) responsibility of senior management.

Information about all controllers and the shareholding structure of an LC

5.     A corporate licence applicant is required to provide basic information³ to the SFC regarding “any person in accordance with whose directions or instructions it is, or its directors are, accustomed or obliged to act” (Controller) under the Information Rules⁴. During a stress event, an LC’s Controllers can be understood as any persons who can influence the prospects of the LC as a going concern (eg, making decisions about capital injections, appointing key personnel or restructuring, selling or closing the LC’s business). The SFC would be in communication with an LC’s Controllers as well as its senior management to manage a contingent situation in an efficient and timely manner. The SFC may also contact any of these individuals in the course of its supervision of the LC.

6.     Where relevant and necessary, the SFC will ask a corporate licence applicant for the identity and background of its Controllers for assessment. In addition, the SFC may seek confirmation of the identities of an LC’s Controllers from any of its directors, ROs or other management personnel. An LC is required to notify the SFC of any changes to information about its Controllers⁵. It is important to note that the provision of false or misleading information to the SFC may constitute a criminal offence under sections 383 and 384 of the Securities and Futures Ordinance (Cap. 571) (SFO).

7.     A corporate licence applicant or an LC is also required to provide the SFC with information regarding its shareholding structure and notify the SFC of subsequent changes⁶. As set out in the licensing forms⁷, the shareholding chart submitted to the SFC should identify, among other things, all corporate and individual shareholders as well as all ultimate beneficial owners of the applicant or the LC. 

8.     After reviewing the information about Controllers and shareholding structure, the SFC may require additional information or documents, such as certain licensing forms⁸ completed by the Controllers or any entities or persons identified in the shareholding chart, where necessary.

Maintenance of a sufficient number of ROs

9.     ROs play a vital role in supervising an LC’s business of regulated activities on a day-to-day basis. Pursuant to section 125(1)(b) of the SFO, an LC shall not carry on any regulated activity for which it is licensed unless not less than two individuals are approved by the SFC as ROs of the LC in relation to the regulated activity, and at least one of them is an executive director⁹ (ED) of the LC. It is a possible offence if an LC contravenes this requirement¹⁰.  

10.   A corporate licence applicant or an LC should critically assess the possibility and impact of its inability to maintain a sufficient number of ROs given the requirements under section 125(1)(b) of the SFO, and incorporate such a scenario into its business continuity and exit plans. 

11.   LCs, in particular those having only two ROs or one ED in respect of any regulated activity for which it is licensed, should implement risk mitigation measures including the following:
        (a) identify potential RO and ED candidates, such as experienced licensed representatives at the firm or other ROs within its group, who are willing and eligible to become additional ROs and EDs of the firm within a short period of time;
        (b) review notice periods for termination in the employment contracts of existing ROs to reduce the risk of an insufficient number of ROs; and
        (c) resources permitting, appoint additional ROs and EDs for that regulated activity.

12.   Separately, where a corporate licence applicant or an LC is wholly owned by an individual, who also acts as the sole director of the firm, the SFC expects that the firm put in place control measures, such as appointing a reserve director¹¹ or additional directors, in order to mitigate the risk that the firm becomes incapacitated in the event of the sudden unavailability of the sole director (due to illness, death or other circumstances) and the firm has no shareholder to appoint new directors. Where applicable, the SFC may seek information from a corporate licence applicant or an LC about how the firm will effectively manage the key person risk concerning its operations.

13.   When an LC becomes aware that it will have less than two ROs or no ED in respect of any regulated activity for which it is licensed, it should immediately activate its business continuity plan and notify the SFC of the situation. It should also provide information regarding its remedial actions to appoint additional ROs or EDs, with a concrete timeframe. Whilst the LC should submit related RO applications to the SFC as a matter of urgency, the competence of the RO candidates should not be compromised and the quality of the application materials should comply with all the relevant application requirements. 

14.   If an LC lacks a concrete and feasible solution to maintain the minimum number of ROs required, it should initiate its exit plan to ensure an orderly closure of business and submit the plan to the SFC (see paragraphs 29 to 33 of this circular).

Maintenance of adequate financial resources

15.   Pursuant to sections 6(1) and 55(1)(a) of the Securities and Futures (Financial Resources) Rules (Cap. 571N) (FRR), an LC must at all times maintain its required liquid capital and notify the SFC in writing within one business day when it becomes aware that its liquid capital falls below 120% of the required amount. Under sections 146(1) and (2) of the SFO, an LC shall 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, unless otherwise permitted by the SFC.  It is an offence if an LC contravenes sections 146(1) and (2)¹².

16.   A corporate licence applicant is required to submit a projection of its major operating expenses to the SFC to illustrate that its existing financial resources are reasonably adequate to run its proposed business for at least six months (without taking into account any projected income). If the applicant’s excess liquid capital (ELC) cannot cover its projected total major operating expenses for at least six months, it is required to submit a funding plan, together with supporting documents relating to additional liquidity sources, to demonstrate its financial strength to operate should it be licensed. The funding plan, which must be approved by the applicant’s board of directors and endorsed by its substantial shareholders (SSH) and Controllers, must clearly set out the sources of additional funds and the identity of the sponsoring parties as detailed in Appendix A.

17.   The SFC may impose conditions on an SSH pursuant to section 132(3) of the SFO to reflect the SSH’s funding commitments to the applicant as represented to the SFC. Depending on the circumstances of each case, conditions may be imposed in the following areas:
        (a) provision of financial support and other resources to the LC for maintaining its ongoing operations;
        (b) notification to the SFC regarding stress events or other circumstances which suggest the potential for the support to be discontinued; and
        (c) provision of information to the SFC upon request.

18.   The SFC monitors the adequacy of each LC’s liquid capital on an ongoing basis. Adopting a risk-based approach and taking into account the LC’s business activities, client interests and other specific circumstances, the SFC may make enquiries with an LC when it has not been generating sufficient income to cover its operating expenses for a period of time and its ELC is projected to run out in less than 12 months. The SFC may ask the LC, its SSHs and Controllers to improve the LC’s financial position by, for example, injecting share capital and adopting cost-cutting and risk mitigation measures. If the financial position of the LC continues to deteriorate, the LC will be asked to provide a detailed funding plan (see Appendix A), a detailed exit plan (see Appendix B) or both, approved by its board of directors and endorsed by its SSHs and Controllers.

19.   Depending on the situation, the SFC may ask an LC, its management, SSHs and Controllers to provide written confirmation and undertakings for the purposes of risk mitigation and to protect client interests. The terms of the confirmation and undertakings may include ceasing to accept new clients and new buy orders, notifying clients of the risk mitigation measures undertaken by the LC and returning client assets. Where the SSHs are also in financial distress, eg, having net liabilities or subject to a winding-up petition, the SFC may ask the LC to undertake other appropriate measures, such as not to provide any financing or guarantee to the SSHs or its affiliates.

20.   The SFC may also impose new conditions or amend or revoke any conditions on an LC’s licence as may be reasonable in the circumstances pursuant to section 116(6) of the SFO or take other regulatory actions as it considers appropriate in order to protect the interest of the LC’s clients. Any licensing conditions imposed by the SFC will be published in the public register of licensed persons and registered institutions on the SFC’s website.

21.   A breach of licensing conditions or any confirmation and undertakings provided to the SFC may call into question the fitness and properness of an LC and other licensed persons concerned to remain licensed.

Financial and operational dependency on another person

22.   Some LCs have arrangements in place for another party, eg, their SSHs or group company, to pay for their key operating expenses, such as staff costs and rental expenses. In some cases, these payments are not charged back to the LCs as expenses or management fees and therefore the financial positions of the LCs reported in the financial returns do not fully reflect their actual financial and operational capability.

23.   Where a paying party encounters financial difficulty and is unable to continue to pay for an LC’s operating expenses, the LC may be in financial and operational stress, which may result in regulatory breaches. For example, the office premises of the LC may need to be vacated, making it unable to keep records properly as required under the Securities and Futures (Keeping of Records) Rules (Cap. 571O). The staff of the LC may depart at short notice if the paying party fails to pay salaries on time. When the LC is suddenly required to bear these expenses itself, it may have funding problems and may be unable to meet the minimum liquid capital requirement under the FRR.

24.   Therefore, in the SFC’s assessment of the adequacy of an LC’s liquid capital mentioned in paragraph 18 above, after considering the risks and specific circumstances of the LC, the SFC may assume that the LC has to bear the key operating expenses itself. Unless the LC is able to demonstrate that the paying party or its SSHs have adequate resources independent of the LC to continue to pay for these expenses on its behalf, or the LC is able to support its operations for at least 12 months should it have to bear these expenses itself, the SFC may require the LC, the paying party and the SSHs to undertake to adopt measures in addition to those mentioned in paragraphs 18 to 20 above. These additional measures may include:
        (a) provision of financial information of the paying party and the SSHs to the SFC upon request; and
        (b) notification to the SFC should the paying party cease or intend to cease bearing the LC’s key operating expenses.

25.   An LC may also be required to provide:
        (a) a detailed business continuity plan covering the scenario where the paying party ceases to pay for the LC’s key operating expenses and the LC’s proposed actions to minimise disruptions to its operations and clients; and
        (b) a detailed exit plan for an orderly closure of its business and return of all client assets assuming the worst-case scenario that the LC cannot continue its operations.

26.    The SFC may also consider imposing conditions on an LC and its SSHs as discussed in paragraphs 17 and 20 above.

27.   In view of the issues that may arise from an LC’s financial and operational dependency on another person as discussed above, LCs are strongly encouraged to take appropriate measures to mitigate the risk of such dependency, such as increasing its share capital buffer and establishing a business continuity plan described in paragraph 25(a) above. The SFC will request information about an LCs’ financial and operational dependency regularly and on ad-hoc basis for assessment. 

28.   When applying for a licence, a corporation should provide information regarding its key operating expenses which are paid by another person and not by the corporation itself. The SFC may request these other persons to provide a written undertaking, confirming their financial soundness and intention to provide continuous support to the applicant in maintaining its operations. Such a confirmation is relevant to the SFC’s consideration of whether the applicant is fit and proper to be licensed. The SFC may also consider imposing conditions on the applicant’s SSHs as discussed in paragraph 17 above. 

Exit plans

29.   There are various reasons, which may or may not be related to any stress event, for an LC to discontinue its regulated activities and surrender its licence. For instance, its regulated activities are no longer viable or it makes a strategic decision to cease them. Where an LC does not carry on any regulated activity for which it is licensed, it should request the SFC to revoke or suspend its licence for such regulated activity under section 195(1)(d) of the SFO.

30.   The process of winding down an LC’s business can be lengthy and costly, particularly if it involves the handling of client assets held or managed by the LC. In order to minimise the potential impact of an LC’s business cessation on its clients and the market, it is prudent for an LC to plan ahead for such a scenario even when business cessation may not be imminent or anticipated. In formulating its exit plan, an LC should take into account the financial, human and operational resources required to complete the process and ensure that client interests are protected.

31.   An LC should submit its exit plan which sets out the details (see Appendix B) of its orderly wind down and closure of business to the SFC when:
        (a) it intends to cease, or has ceased, to carry on regulated activities for which it is licensed;
        (b) it is required to suspend or cease to carry on regulated activities for which it is licensed, including but not limited to the SFC’s exercise of its power under section 146(5)(a) and section 195(1)(c) of the SFO; or
        (c) it is requested to do so by the SFC.

32.   The SFC may request an LC to provide updates on the activation and implementation of its exit plan, such as regular updates of the latest positions of the client interests connected with the LC. The LC should also inform the SFC immediately of any major changes in the exit plan, eg, changes in key milestones, timelines or designated personnel for executing the exit plan.

33.   Should an LC fail to formulate a concrete exit plan or act promptly according to its exit plan, the SFC will consider imposing conditions on the LC and other relevant persons, such as its SSHs and ROs, to require their immediate action to wind up the LC’s business of regulated activities in an orderly manner. The SFC may consider taking other regulatory action, such as issuing restriction notices¹³ and appointing an administrator¹⁴. The SFC may also take regulatory action against the LC and other regulated persons concerned if their conduct does not meet the standards expected of them, such as failure to act in the best interests of clients.

Responsibility of senior management

34.   The senior management of an LC¹⁵ assumes overall responsibility for the LC’s contingency planning, which should cover the areas and mitigation measures for stress events as set out in this circular. Among other things, they are expected to take reasonable steps to ensure that financial and other resources, such as manpower and professional services, required for the effective execution of the contingency plan, including the exit plan, are secured and will be available to the LC should the plans be activated.

35.   Senior management of an LC should also review the LC’s contingency planning, including any test results, at least annually to ensure that the plans are sufficiently robust and remain effective over time to allow the LC to mitigate stress events on an ongoing basis, taking into account the prevailing market conditions and the LC’s specific business mix, scale, operational model and clientele. 

36.   An LC’s contingency plan, including the exit plan, and any subsequent revisions should be properly documented. They should also be approved by the LC’s board of directors, endorsed by its SSHs and Controllers and communicated to all relevant personnel. The SFC may require an LC to submit related documents should circumstances warrant. 

37.   An individual (whether licensed or not) who is or was involved in the management of an LC’s regulated business is expected to ensure the LC’s orderly exit from the business of any regulated activity, particularly in regard to safeguarding the interests of clients and the investing public and upholding the integrity of the market. Failure to meet these expectations may affect an individual’s fitness and properness to be licensed or to be involved in the management of other LCs in the future.

38.   Should you have any questions regarding this circular, please contact your case officers in the Licensing Department or the Intermediaries Supervision Department.

Intermediaries Division
Securities and Futures Commission

 

Appendix A

Expected details in a funding plan

A funding plan for an LC or a corporate licence applicant should be approved by the firm’s board of directors and endorsed by its SSHs and Controllers, providing sufficient details of how and when the firm will obtain additional funds or liquidity to finance its ongoing operations and comply with the FRR. Such details include the following:

(a)   Identified sponsoring parties who are prepared to contribute additional funds to the firm;

(b)   Amount and form of the additional funds, eg, paid-up share capital, subordinated loan from shareholders;

(c)   Specific timing for providing the intended additional funds to the firm;

(d)   Projection of the firm’s ELC level, income and expenses¹⁶ for the 12 months immediately after the provision of the intended additional funds to the firm; 

(e)   Written undertakings signed by the identified sponsoring parties, confirming their intended funding commitments to the firm and related timing;

(f)    Background information and contact details of the identified sponsoring parties (if they are not the firm’s existing SSHs) and supporting documents relating to their financial strength to meet their funding commitments; and

(g)   Where the proposed funding arrangements involve the introduction of any new SSHs to the firm, the specific timing as to when the related application for regulatory approval under section 132 of the SFO will be submitted to the SFC.

 

Appendix B

Expected details in an exit plan

An LC’s exit plan should be approved by its board of directors and endorsed by its SSHs and Controllers, providing sufficient details in respect of the process, responsible personnel and funding sources to secure an orderly closing down of the business in any regulated activity of the LC, having due regard to the interests of its clients and the integrity of the market. Such details include, where applicable, the following:

(a)   Timetable with key milestones for an orderly closure of each of the LC’s business lines constituting regulated activities;
 
(b)   Communication and follow-up actions with the LC’s clients regarding:
        (i) the intended business cessation;
        (ii) the actions the clients will need to take (eg, transfer their investment holdings to another intermediary, withdraw client money, collect physical scrips or redeem their holdings in funds managed by the LC or other intermediaries)¹⁷;
        (iii) timeline and corresponding fees and charges, if any;
        (iv) consequences if the clients do not take any action within the timeframe (for example, if a client does not provide instructions to the LC for how to handle its assets despite the LC’s requests or when a client is not contactable, the LC may apply for payment of the client’s assets into the court under the Trustee Ordinance (Cap. 29). In this case, the client may need to submit claims for the assets to the court, which may take time and incur extra costs); and
        (v) contact information of the LC’s personnel to answer clients’ enquiries in relation to the intended business cessation;

(c)   Latest position of client interests connected with the LC (eg, the number of clients or ongoing deals engaged by the LC, the amount of client securities and client money held by the LC and its associated entities and information about the portfolios or funds it manages for clients or fund investors);

(d)   In the case of an LC which is a fund manager, additional information about its business cessation, such as:
        (i) liaising with governing bodies and other service providers (eg, administrators, custodians and auditors) of the fund it manages to formulate an exit plan in accordance with the fund’s constitutive documents;
        (ii) transferring the fund management role of the LC to another fund manager or liquidating investments in the fund and returning the proceeds to fund investors; and
        (iii) reminding fund investors about the risks associated with the redemption process (eg, it may be prolonged if the fund investments are illiquid and redemption proceeds may be in the form of specie instead of cash);

(e)   Where the LC holds client assets or manages funds, the actions, funding and human resources earmarked for returning client assets, including handling any unclaimed client assets (eg, engaging professional legal services with relevant expertise to arrange for the LC’s application for paying such assets into the court under the Trustee Ordinance), liquidating the funds it manages or transferring its fund management role to another fund manager;

(f)   Designated personnel, including at least one director of the LC, who have sufficient authority to act for the LC in executing the exit plan (including the operation of bank and custodian accounts, bearing in mind that any requests for changes to designated signatories could take months for banks and custodians to implement) and their names and contact information;

(g)   Financial forecasts including the estimated costs and the funding sources to finance the complete execution of the exit plan and to continue to comply with the minimum liquid capital requirement under the FRR until the LC’s licence is revoked;

(h)   Submission of the LC’s request to the SFC to revoke its licence under section 195(1)(d) of the SFO;

(i)   Arrangements to submit the LC’s financial statements and other documents, which shall be made up to (and including) the date of cessation, not later than four months after the date of business cessation under section 156(2) of the SFO and other regulatory filings, including financial returns, annual audited accounts and annual returns, before the LC’s licence is revoked by the SFC; and

(j)   Arrangements regarding the LC’s books and records (eg, where they will be kept after revocation of the LC’s licence and contact information of the persons in charge).

 

Notes: 

¹  General Principle 3 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.
²  Section 3(1)(a) of the Information Rules and item 12, Part 1, Schedule 2 to the Information Rules.
³  As defined in section 2 of the Information Rules, “basic information” means the information referred to in Part 1 of Schedule 1 to the Information Rules.
⁴  Section 3(1)(a) of the Information Rules and item 13 in Part 1 of Schedule 2 to the Information Rules.
⁵  Section 4 of the Information Rules and item 10 in Part 1 of Schedule 3 to the Information Rules.
⁶  See footnotes 4 and 5 above.
⁷  See licensing forms including Form 1, Form 7 and Form 8.
⁸  For example, Supplement 1 and Supplement 2 (as the case may be).
⁹  As defined in section 113(1) of the SFO.
¹⁰ Section 125(3) of the SFO.
¹¹ Pursuant to section 455 of the Companies Ordinance (Cap. 622).
¹² Sections 146(13) and (14) of the SFO.
¹³ Pursuant to sections 204, 205 and 206 of the SFO.
¹⁴ Pursuant to section 213 of the SFO.
¹⁵ Including the LC’s directors, ROs and Managers-In-Charge of Core Functions.
¹⁶ If the firm’s key operating expenses are paid by other persons without recharge to it, the SFC may request the firm to provide information about these expenses and take them into account when assessing the firm’s financial projection. 
¹⁷ When handling client assets, LCs should act in accordance with clients’ instructions and ensure compliance with relevant rules and regulations, including the Securities and Futures (Client Money) Rules and the Securities and Futures (Client Securities) Rules.