New Proposals to Regulate Mis-Selling of Investment Funds & Structured Products in Hong Kong: Right or Wrong?
January 21, 2009
By Timothy Loh, Gavin Cumming and Howard Burchfield III
The recent global financial crisis has resulted in an upswing in regulatory action throughout world markets. In Hong Kong, the Securities and Futures Commission (SFC) has proposed a slew of new requirements, some of which have already been implemented retroactively and without industry consultation. In this article we examine these ongoing developments in SFC policy and their effectiveness in reaching a fair balance between investor protection and costs to the investor and the financial industry.
TIMOTHY LOH | Financial Services & Law Review
Vol. 3 (2009) at p. 1
The past few months have seen major developments
in the approach taken by the Securities and Futures Commission ("SFC") in regulating the
sale of investment products, including mutual funds, unit trusts and structured
products. The developments
continue to crescendo:
- On October 3, 2008, the SFC issued a circular ("Retail Products Circular")
to issuers of retail investment products reminding them of various existing
regulatory duties;
- On December 5, 2008, the SFC issued a letter ("CIS Enhanced Disclosure Letter")
to issuers of SFC authorized collective investment schemes providing guidance
on marketing materials and, in effect, establishing enhanced disclosure
requirements; and
- On December 31, 2008, the SFC co-authored a Report
to the Financial Secretary on Issues Raised by the Lehman Minibonds crisis ("Mis-Selling Report") setting
out recommendations for major regulatory changes.
Regrettably, it seems that some of the proposals
have already been implemented retroactively by the SFC, in particular those
relating to product disclosures set out in the CIS Enhanced Disclosure Letter,
without industry consultation and without notice to the industry. As a result, the industry has been
forced to review all its marketing materials, including those previously
authorized by the SFC, with a view to compliance.
The remaining majority of the proposals have not,
however, yet been implemented.
Some will require legislative amendments, which will take some
time. Others may be effected by
changes in SFC regulatory requirements and thus, could be implemented on short
notice.
SALES PRACTICES
A major focus for the SFC now appears to be (i) to
reinforce and supplement the existing duty of issuers of investment products to
provide sufficient, balanced and understandable information to describe the
product and its risks, (ii) to reinforce the existing duty of intermediaries
selling investment products to ensure the products sold by them are suitable
for the investors who purchase them, and (iii) to more proactively enforce
existing regulatory duties relating to sales practices.
However, going forward the SFC offers a number of
possible proposals for consideration, including:
- tightening the definition of a "professional
investor",
- requiring disclosure of commissions received by
intermediaries,
- introducing a cooling off period, and
- introducing new ongoing disclosure requirements for
issuers of investment products.
PRODUCT DISCLOSURES: DO INVESTORS READ OR UNDERSTAND THEM?
In the Mis-Selling Report, the SFC proposes a
requirement for summaries to be prepared for all investment products which are
offered to the Hong Kong public.
These summaries will be no more than 4 pages of plain, concise, easily
understood language augmented by charts and diagrams, will include all key
information and will facilitate comparison with other products.
These proposals are consistent with regulatory
developments in the U.S., the U.K. and Australia and are in fact reflected in
the SFC's new authorization and enforcement practices.
In relation to SFC authorized investment funds, the
SFC already appears to be implementing the proposal, with the CIS Enhanced
Disclosure Letter requiring marketing materials to contain a summary of key
product features and risks upfront, prominently and in a few key bullet points. It requires the summary:
- to state what the product is and what it does,
what the key risks are and what
the worst case scenario is for an investor, and
- to remind investors not to invest in the product
unless they have been advised by the selling intermediary that the product is
suitable.
Content of Product Summaries
Preliminary feedback from the asset management
industry suggests confusion as to what is to be included in the summary as
opposed to the formal offering document and, consequently, a desire within the
industry to standardize the summaries for particular product classes. The industry appears to be experiencing
difficulties in describing a product accurately in abbreviated form.
As liability may follow on the occurrence of a risk
which was described in the offering document but was not described in the summary
because it was considered to be a low risk, there is a concern that issuers of
investment products will aim to over-disclose risks in the summary but, because
of length constraints, will be forced to generalize risk disclosures to the
point where they are all encompassing but meaningless.
Effect of Product Summaries on Investor Behaviour
It is not clear to what extent enhanced product
disclosures will benefit investors and whether any such benefit justifies the
additional costs of compliance.
In the case of the Lehman Minibonds, whilst a
product summary may have highlighted that these products were not traditional
fixed income instruments, it is doubtful that such a product summary would have
highlighted the bankruptcy of Lehman as a key risk. It is uncertain whether a product summary
disclosure highlighting a possible complete loss of principal would have
deterred investors as such a loss is possible for virtually every investment
product and is likely to be disclosed in all product summaries.
At the same time, investors may not be inclined to
read or to take the time and make the effort to understand product
disclosures. They may discount
written risk disclosures as standardized disclosures without more considered
thought.
In this regard, it is possible that at some point,
there may be a point of diminishing returns beyond which further risk
disclosures may incrementally decrease the effectiveness of individual
disclosures. It is not uncommon
for investors who have lost money investing to complain that they did not
understand a product even after having signed a written declaration that they
understood the product.
In any event, it is unclear whether investors are
in a position to assess the probability and consequences of disclosed risks
materializing. Indeed, many hedge fund managers, regarded as sophisticated
investors, failed to successfully assess the counterparty risk of dealing with
Lehman Brothers.
The Case Against Product Summaries
It is difficult for product regulations to protect
investors in these circumstances.
Investment losses, including severe investment losses, are a natural
part of investing. In the absence
of evidence that investors would modify behaviour appropriately (i.e. to a degree
commensurate to the disclosed risks) in light of disclosures contained in marketing
materials, there is a danger of over-regulating product disclosures with little
investor protection benefits.
Ongoing Disclosure Obligations
In the Mis-Selling Report, the SFC recommends the
introduction of statutory requirements for product issuers to provide relevant
information to investors including changes in circumstances that may have a
significant effect on the value of the investment and for intermediaries to
take appropriate steps to ensure that such information is brought to the
attention of investors.
The SFC suggests that the SFC website become a
central repository for such information in respect of SFC authorized investment
products much like the website of the Stock Exchange of Hong Kong is a central
repository for such information in respect of listed companies.
The recommendation raises significant potential
compliance burdens. Take for
example the case of a structured product linked to an underlying listed company
and for which the issuing bank serves as counterparty.
- The bank may issue press releases regularly to
disclose material developments which affect its share price and which may be
material to the creditworthiness of the bank.
- The underlying listed company may issue press
releases regularly to disclose material developments which affect its share
price or creditworthiness.
- Third parties may produce research which may
materially affect the perceived value or creditworthiness of the bank or listed
company.
Would the bank now be required to collate,
summarize and disseminate information from these press releases and from such
research to all intermediaries selling the product?
Alternatively, take for example a mutual fund with
a wide ranging portfolio of securities.
- Is the fund company required to disseminate all
public information which may reasonably be available to it in respect of each
significant portfolio company as it becomes publicized?
- Is the fund company required to monitor the
custodian bank's creditworthiness on an ongoing basis and disseminate all
public information which may reasonably be available to it in respect of the
custodian bank which may affect the creditworthiness of the custodian bank as
it becomes publicized?
At the same time, would selling intermediaries be
required to disseminate such information to clients who purchased the
product? Would investors welcome
the receipt of such information on a regular basis and would they appreciate
the significance of this information?
SUITABILITY: CAN INVESTORS EXPECT OBJECTIVE ADVICE
FOR FREE?
Many investors rely upon their banker or financial
adviser to recommend investment products to them. Consequently, it has been a long standing regulatory
requirement that intermediaries must ensure that the advice they provide is
suitable for their clients given the clients' individual circumstances.
In the Mis-Selling Report, the SFC proposes to
supplement existing suitability obligations by requiring intermediaries:
- to adopt suitable criteria for characterizing investors
with a view to assisting in ensuring that investment advice and products
offered are suitable for investors;
- to ensure products are only sold by staff who have
demonstrated a sufficient understanding of the particular product;
- to document and provide a copy to each client of the
rationale underlying the recommendations or solicitations made to the client; and
- to conduct product due diligence on a continuous
basis at appropriate intervals having regard to the nature, features and risks
of investment products.
At the same time, the SFC proposes to use
undercover enforcement officials as part of a programme to enforce compliance
with suitability obligations.
In like vein, in the CIS Enhanced Disclosure
Letter, the SFC requires product issuers to place a reminder in the front of
their marketing materials that they should not invest in the product unless the
intermediary who sells it to them has advised them that the product is suitable
and has explained how it is consistent with their investment objectives.
Commercial Realities
At base, any discussion on regulation of sales
practices should recognize that selling intermediaries are generally in the
business of selling investment products rather than advising clients. This is because clients generally
do not pay intermediaries for advice.
Rather, product issuers pay intermediaries to distribute products.
Unless the economic interests of selling
intermediaries are more closely aligned with the economic interests of their
clients, a requirement for selling intermediaries to ensure that product
recommendations are suitable may simply encourage intermediaries to justify
recommendations in their own economic interests as being suitable for clients
rather than to encourage intermediaries to make recommendations based on the
economic interests of clients.
Reinforcing regulations for selling intermediaries to ensure product
recommendations are suitable does not align the economic interests of intermediaries
and their clients.
Disclosure of Commissions
Recognizing the possible misalignment of economic
interests, in the Mis-Selling Report, the SFC also proposes a requirement for
selling intermediaries to disclose at the pre-sale stage commissions payable to
and other benefits receivable by them.
Such a requirement benefits investors as it places them on notice that
the advice which they receive may not be impartial advice. Indeed, the SFC notes that such
disclosure is required in Australia, the U.K and Singapore.
Nevertheless, a requirement for disclosure of
commissions and benefits does not align the economic interests of selling
intermediaries and their clients.
Its purpose therefore cannot lie in improving the suitability of advice
given but rather with reducing the degree of reliance placed by an investor on
advice.
The Extent to Which Disclosures Protect Investors
However, if a misalignment of economic interests
persists, it is not difficult to conceive of intermediaries selling products
with higher commissions which, whilst not unsuitable, may be less suitable for
clients, rather than selling products with lower commissions which may be more
suitable for clients.
To take a simplistic example, assume the universe
of investment products may be divided into 2 classes, "A" and "B". Intermediaries receive a $5 commission
on each unit of "A" sold but only $1 on each unit of "B" sold. In the short term, an intermediary may
wish to offer its clients a selection of "A" products, recommending one of them
in particular but without offering any "B" products. In this case, a client would not be aware of the "B"
products and may consider the commission disclosed to him as not affecting the
recommendation given to him to purchase the particular "A" product.
Investor Responsibility
In light of the foregoing, whilst it is clearly
beneficial for investors to receive advice that is suitable for them, it is
possible that it is counterproductive for the SFC to reinforce suitability
obligations on intermediaries as such obligations may perpetuate perceptions amongst
investors that advice they receive from intermediaries is premised on their own
best economic interests. Instead,
it may be more productive for the SFC to encourage investors to pay for
financial advice if they wish to obtain investment recommendations which are
premised on their own best economic interests. Unfortunately, investors have traditionally shown reluctance
to pay for financial advice and it may therefore be desirable for the SFC to
consider moving towards a regulatory framework biased towards such an
arrangement.
PROFESSIONAL INVESTORS
Broadly, in the Mis-Selling Report, the SFC
suggests that there is no general dissatisfaction with the current definition
of a "professional investor" under the regulatory framework and thus, by
implication, no general dissatisfaction with the circumstances in which
investment products may be sold without SFC authorization or without
appropriate advice as to suitability.
However, the SFC does propose further consultation on the matter as to
the necessity of raising the threshold for a person to qualify as a
professional investor.
COOLING OFF PERIOD
In the Mis-Selling Report, the SFC proposes the
introduction of a cooling off period on sale of investment products. It is not clear whether the SFC
proposals are limited to products sold to retail investors but presumably this
is the case.
Under a cooling off period, investors would have
the right to cancel an investment product purchase within a fixed period of
time following the purchase. The
SFC notes that a cooling off period already exists for Hong Kong insurance
contracts, for unlisted unit trusts in Singapore and for certain investment
products in the United Kingdom.
The SFC recognizes that in respect of investment products
where the value of the investment may fluctuate during the cooling off period, the price
refunded on cancellation should be adjusted to reflect any fluctuations.
To the extent that investors are already free to close out
any purchase made at any time after the purchase, the proposal does not represent a
significant change in current practices and it appears unlikely that such a cooling off
period would have been of any assistance to the majority of investors who purchased
Lehman Minibonds, as those investors were presumably satisfied with their investment
until the collapse of Lehman Brothers.
However, to the extent that investment products
are fixed term in nature, the proposal marks a significant change in practice.
It effectively eliminates the possibility of an investment product which is premised
on a short fixed term, as a product issuer will not be able to effectively hedge the
risk it bears on such products if the investor has the right to withdraw their
investment before the fixed term expires. For products with a longer fixed term,
it effectively limits a product issuer from relying upon the initial portion of the
fixed term, which may, in turn, affect product structure.
Notably, the SFC does suggest that selling costs
associated with cancellation should not be reflected in any adjustment, opening up
the possibility (which product issuers must take appropriate steps to guard against)
of selling intermediaries defrauding product issuers with fake investment purchases
which are cancelled immediately upon receipt of commissions.
CONCLUSION
Ultimately, investors must assume responsibility
for the losses they incur on their investments. Regulation of sales practices, both on product issuers and
selling intermediaries, is clearly desirable but at the macro level, the costs,
including compliance burdens on issuers and intermediaries and restrictions on
product options for investors, must be weighed carefully against investor
protection benefits.
The limits of regulation should also be
realistically appraised. To some
degree, the SFC must allow investors to suffer the consequences of their own
action where they have failed to use the regulatory protections and financial
product information which is already available to facilitate their
investment-making decisions. In
this regard, the SFC should be wary of allowing a climate of heightened
regulation to lure investors into the mistaken belief that it and other
regulatory authorities exist primarily as a means to insure them against the
results of their own folly.
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