In these FAQs on SFC License Type 9, we provide guidance on SFC asset management regulation
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January 2, 2019
By Timothy Loh
In April, 2019, the Securities and Futures Commission will require intermediaries to ensure that any transaction in a complex product is suitable for their clients. This is so even if an intermediary neither solicits nor recommends the transaction. The new requirement is an unduly paternalistic attempt to protect investors who choose to invest in products they do not understand and diminishes the responsibility of investors for losses they incur from poor investment choices. At the same time, the new requirement interferes with the ability of intermediaries to define their own role and to decide whether or not they wish to give investment advice.
Since the Lehman Brothers mini-bond debacle in 2008, the Securities and Futures Commission (“SFC”) has prioritized regulatory efforts to combat mis-selling of financial products. These efforts have resulted in an increasing emphasis on requiring brokers, investment advisers and other intermediaries to ensure the suitability of investment products for their clients.
Under the SFC’s latest proposal (“Enhanced Suitability Proposal”), the suitability obligation will apply to any transaction in a complex product. In other words, an intermediary cannot effect a transaction in a complex product unless they can demonstrate that it is suitable for a client. This is so even if the intermediary neither solicits nor recommends the transaction. This has at least 2 consequences. First, no intermediary can effect a transaction, even an unsolicited one, unless they have conducted due diligence on the product, first to understand whether or not it is complex and secondly, to determine whether it is suitable for the client. Secondly, the flexibility for an intermediary to limit their role to one of an “execution-only” agent and to refrain from advising is much more limited.
The Enhanced Suitability Proposal will be implemented through changes to the Code of Conduct for Persons Licensed by or Registered with the SFC (“Code of Conduct”) and will take effect on April 6, 2019.
Historically, the requirement to ensure suitability was triggered where an intermediary recommended or solicited a transaction. In this case, the recommendation or solicitation was required to be suitable. In the absence of any recommendation or solicitation, no suitability obligation arose.
However, the financial crisis in 2008 led the SFC to question whether the traditional basis for suitability, namely a recommendation or solicitation, was sufficient. The crisis saw a number of investors suffer substantial losses which they allege arose as a result of mis-selling. While some of these investors sought to recoup their losses through the courts, arguing that banks had mis-sold products to them, almost universally, the investors lost.
The failure of the investors to obtain redress from the courts stemmed from the fact that the banks in almost each of these cases had limited their role in the client agreements to acting as an “execution only” agent. In other words, the banks expressly provided in their client agreements that they owed no duty to advise these investors and that any advice provided to these investors could not be relied upon as such. The courts upheld these limitations even though the investors argued that the banks had recommended products to them which were unsuitable for them.
As many of the complaints arising from the 2008 financial crisis related to the sale of derivatives, in 2011 the SFC introduced a new suitability requirement for derivatives. Under this new requirement, even in the absence of a recommendation or solicitation, where an intermediary dealt in a non-exchange traded derivative on behalf of a client who had no knowledge of derivatives, the intermediary was required to advise the client whether the transaction was suitable for the client and if the transaction was unsuitable, the intermediary was prohibited from effecting the transaction unless it could show that to do so would be in the best interests of the client.
Dissatisfied with the reach and scope of the new suitability requirement for derivatives, in 2017 the SFC mandated the inclusion of a suitability clause (“Suitability Clause”) into client agreements. The Suitability Clause requires intermediaries to ensure the suitability of the recommendations or solicitations made to the client, thereby imposing a contractual responsibility to ensure suitability where a recommendation or solicitation is made even if no duty to advise otherwise arises.
In essence, the Suitability Clause is intended to prevent intermediaries from limiting their liability through contractual provisions which seek to cast their role as being one of “execution-only” even though financial advice is provided. It introduces regulatory requirements into the legal framework governing the relationship between intermediaries and their clients.
Amidst uncertainty regarding how courts would react to the new Suitability Clause and whether the Suitability Clause would or would not be an effective means of protecting investors, this year, the SFC will forge ahead with its Enhanced Suitability Proposal.
Under the Enhanced Suitability Proposal, intermediaries must assess whether a product is or is not “complex”. If a product is complex, then intermediaries must comply with 3 requirements (“Enhanced Suitability Requirements”):
They must ensure that any transaction in that product is suitable for the client in all the circumstances.
They must ensure that information on the key nature, features and risks of the product is provided to enable the client to understand the product before making an investment decision.
They must provide warning statements in a clear and prominent manner.
A major practical problem in the SFC’s latest proposal is recognizing a “complex product”. The SFC defines a “complex product” as “an investment product whose, terms, features and risks are not reasonably likely to be understood by a retail investor because of its complex structure”. The SFC identifies 6 criteria to determine whether an investment product is complex:1
whether the investment product is a derivative product;
whether a secondary market is available for the investment product at publicly available prices;
whether there is adequate and transparent information about the investment product available to retail investors;
whether there is a risk of losing more than the amount invested;
whether any features or terms of the investment product could fundamentally alter the nature or risk of the investment or pay-out profile or include multiple variables or complicated formulas to determine the return; and
whether any features or terms of the investment product might render the investment illiquid and/or difficult to value.
It is unclear how these criteria work in practice. For example, is a product necessarily complex because it meets one of these criteria? In this case, would all private equity funds be regarded as “complex” because they are illiquid or difficult to value? Given the SFC view that a “complex product” is one that is difficult to understand, this would appear to be a strange conclusion given that the nature of a private equity fund is quite readily understandable to the average person.
By way of guidance to the industry, the SFC has indicated that certain products are non-complex. These include:
shares traded on the Stock Exchange of Hong Kong (“SEHK”) and other specified exchanges;
non-complex bonds, and
funds authorized by the SFC which do not employ derivatives and which are not hedge funds.
It will be self-evident that in the absence of SFC guidance, different intermediaries may classify some products differently, one intermediary perhaps classifying a product as being “complex” and another classifying the same product as “non-complex”.
Derivative products which might be regarded as being complex are exempted from the Enhanced Suitability Requirements if they are traded on an exchange in Hong Kong or other specified exchanges. However, this exemption is in effect limited to dealings with clients with knowledge of such derivatives as, under current regulatory requirements, dealings with clients who lack such knowledge are in any event subject to the suitability obligation, whether or not a recommendation or solicitation is made.
The Enhanced Suitability Requirements will not apply to dealings with institutional professional investors and corporate professional investors. There is no exemption for dealings with individual professional investors.
The Enhanced Suitability Proposal may well mark the death knell of intermediaries acting as “execution only” agents whose sole role is to effect a dealing rather than to provide advice. This is because, for any product other than exchange traded shares and simple SFC authorized funds, there is a real possibility that an intermediary has a duty to advise on suitability. As will be self-evident, the proposal thus represents a potential paradigm shift in the market, denying intermediaries the opportunity to define their role and the range of services which they choose to offer.
At the same time, though the SFC’s goal of improving protection for investors is laudable, it is not clear whether this goal comes at an even potential greater cost of limiting Hong Kong investor access to financial products. The Enhanced Suitability Requirements mean that intermediaries cannot deal in a product on an unsolicited basis for a client without first conducting due diligence. Where the economics do not justify such due diligence, an intermediary is unlikely to undertake this due diligence.
Perhaps, ironically, the Enhanced Suitability Proposal may, at times, undermine investor protection. It is not clear that investors will accept that products are too complex for them to understand. There may well be a temptation for investors to overstate their own investment experience and financial situation to self-qualify themselves for products which they believe will generate superior returns for them but which otherwise might be regarded as being unsuitable for them. Attempts by investors to do so may expose them to even greater risk as their risk profiles so enhanced may allow for dealings in a wider range of unsuitable products. Equally, there may well be a temptation for investors to seek out products which they believe will generate superior returns for them through intermediaries outside of Hong Kong, thereby potentially exposing them to greater risks in dealing with intermediaries subject to different regulatory oversight. In this regard, for many years, investors in foreign jurisdictions have sought to deal with Hong Kong intermediaries to access products and avoid restrictions in their home jurisdictions from dealing in those products.
In the end, the Enhanced Suitability Requirements appear to be a heavy-handed approach to investor protection that is unduly paternalistic to the extent that it seeks to protect investors from their own blindness to their own limitations and to the extent that it seeks to preclude investors from making the investment choices which they believe will best serve them. Investment losses are a natural part of investing and there is no reason why investors who lose money investing in products which they do not understand should not assume responsibility for the losses they incur on these investments. Regulatory reinforcement of the perception that any product available to an investor is suitable for him or her will tend to diminish the investor’s sense of responsibility for his or her own choices.
At the same time, intermediaries should be free to choose whether they wish to undertake a duty to advise. Rather than forcing them to advise, regulations should prohibit them from holding out that they are “advisers” (e.g. an independent financial adviser) or that they play a role in which they act in the best interests of their clients (e.g. wealth manager). In other words, regulations should require intermediaries who provide “execution-only” services to describe themselves as such. In turn, the regulators should seek to educate the investing public on the economic incentives given to intermediaries to distribute investment products. Recent changes to regulations requiring intermediaries to declare whether or not they are independent are steps in the right direction.
1Guidelines on Online Distribution and Advisory Platforms, para 6.1
In these FAQs on SFC License Type 9, we provide guidance on SFC asset management regulation
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