In these FAQs on SFC License Type 9, we provide guidance on SFC asset management regulation
Enhanced Suitability Requirements for the Sale of Complex Products: A Pullback?June 19 , 2019
June 24, 2019
By Timothy Loh and Gavin Cumming with Daphne Chung
New enhanced suitability requirements applicable to the sale of complex products will come into force on July, 6 2019. Though heavy-handed and paternalistic on their face, recent guidance issued by the Securities and Futures Commission appears to soften the impact of these requirements. In this article, we discuss the major changes.
On June 13, 2019, the Securities and Futures Commission (“SFC”) issued frequently asked questions (“FAQs”) clarifying the enhanced suitability requirements (”Enhanced Suitability Requirements”) applicable to the sale of complex products. These requirements are set to be implemented through an update to the Code of Conduct for Persons Licensed by or Registered with the SFC (“Code of Conduct”) on July 6, 2019. The FAQs appear to water down the Enhanced Suitability Requirements for complex products.
The Enhanced Suitability Requirements require that, in the context of a sale of a complex product, a licensed or registered person (i.e. an intermediary) must:
Ensure that any transaction in that product is suitable for the client in all the circumstances (even in the absence of making any solicitation or recommendation in respect of the transaction).
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.
Provide warning statements in a clear and prominent manner.
Solicitations and Recommendations
Perhaps most significantly, the FAQs clarify that if an intermediary (a) solicits the sale of or recommends a complex product, or (b) provides discretionary account services (which involves the making, as well as execution, of a recommendation on a complex product) to a client, Enhanced Suitability Requirements will not apply, meaning that it will only need to comply with the normal suitability requirements under paragraph 5.2 of the Code of Conduct.
It is unclear what is intended by this clarification. For practical purposes, it appears that where a client requests an intermediary on an unsolicited basis to execute a transaction in a complex product, the intermediary can push a recommendation to that client ahead of execution to bring himself within the normal suitability requirements and avoid the Enhanced Suitability Requirements. In this respect, it is significant to note that, because the product is complex, the intermediary would in any event be required to pause execution to establish suitability. It is just that, assuming the product is suitable, the intermediary can dispense with the requirement to provide product information and risk disclosures by making a recommendation.
Provision of a Loan
Where an intermediary provides a loan to its clients to buy a non-complex product (e.g. shares listed and traded on the Stock Exchange of Hong Kong), the FAQs clarify that the provision of such a loan would not transform the non-complex product to a complex product, thus triggering Enhanced Suitability Requirements. This is because the provision of such a loan does not alter the terms, features and risks of the underlying product.
Obligations of Execution Brokers
The FAQs clarify that execution brokers may be exempt from Enhanced Suitability Requirements where they merely execute orders placed by an investment adviser (“IA”) or asset manager (“AM”) (as the case may be) on behalf of the client and the following conditions are satisfied:
IA or AM Regulated - The IA or AM is licensed by or registered with the SFC or is regulated by the banking or securities regulator in the overseas jurisdiction where the investment advisory or discretionary portfolio management services are provided;
No Advisory Relationship Between Executing Broker and Client - The execution broker merely provides order execution and custody services to the client and has no day-to-day contact or direct communication with the client (e.g. the execution broker does not do any of the following: advises on the client’s trades, manages the client’s investment portfolio, handles the client’s enquiries on complex products or the client’s requests to trade complex products);
IA or AM Compliance with Point of Sale Requirements - The execution broker has agreed in writing with the IA or AM that:
in respect of an IA or AM which is a regulated entity in the overseas jurisdiction, the IA or AM is responsible for complying with the applicable requirements of the overseas jurisdiction before transmitting the client’s order to be executed; or
in respect of an IA or AM which is licensed by or registered with the SFC, the IA or AM is responsible for ensuring the suitability of a transaction in a complex product for the client and providing sufficient product information and warning statements in respect of the complex product to the client before transmitting the client’s order to be executed; and
the execution broker is not responsible for ensuring suitability of the order transmitted by the IA or AM or providing product information and warning statements to the client; and
Client Disclosure - The execution broker has ensured that the client has been informed in writing of the arrangement referred to in paragraphs (b) and (c) above.
Once the client has been informed of the arrangement pursuant to (d) above, the arrangement and the notification do not need to be repeated for each applicable transaction executed for the same client. Where there is any change to the arrangement (e.g. termination of the arrangement among the parties), the execution broker should ensure that an update is provided to the client in writing as soon as possible.
For practical purposes, since execution brokers often have no direct contractual relationship with the client of an IA or AM, it will need to receive confirmation from the IA or AM confirming that the client is apprised of the arrangements.
In relation to repeat purchases of the same complex product or complex products of the same product category, the SFC noted in the FAQs that an intermediary is generally required to disclose product information and provide warning statements to a client on a “transaction-by-transaction basis”.
However, in what appears to be a retreat from the “transaction-by-transaction” requirement, the SFC clarified in the FAQs that an intermediary may adopt a risk-based approach having regard to the circumstances, such as the client’s trading pattern, level of sophistication and investment experience, and product complexity and risk in providing the disclosure to clients. Under this clarification, an intermediary could design its own risk disclosure procedures for repeat transactions provided that it can be reasonably satisfied that a client has sufficient understanding of the product.
In its circular announcing the FAQs, the SFC classified security tokens as a type of complex product and thus, the distribution of such tokens is subject to Enhanced Suitability Requirements. The classification of security tokens appears to be an aggressive move given that there is considerable uncertainty as whether security tokens are in fact “securities” under the Securities and Futures Ordinance. Though the Statement on Security Token Offerings issued by the SFC on March 28, 2019 suggests that security tokens are “likely” to be securities, the statement provides no basis whatsoever for this suggestion and indeed, references in the statement to the use by such tokens of blockchain and digital technology appear entirely irrelevant to the issue of whether such tokens are "securities".