Oversight January 2017 - SFC FAQs on Client Agreement Requirements and on Suitability Obligations

Introduction

The Securities and Futures Commission (SFC) issued a set of frequently asked questions (FAQs) on Client Agreement Requirements to provide guidance on the application of the new paragraph 6.2(i) of the Code on 23 September 2016.  It issued two further sets of FAQs on 23 December 2016 on compliance with suitability obligations by licensed or registered persons, and on triggering of suitability obligations respectively.  This Oversight discusses the key points of these FAQs.

Background

On 25 September 2014, the SFC published its Consultation Conclusions on the Proposed Amendments to the Professional Investor Regime and Further Consultation on the Client Agreement Requirements (Further Consultation).  Please refer to our Oversight of November 2014 (available here) for a detailed discussion.

In the Further Consultation, the SFC sought to introduce a new paragraph 6.2(i) to the Code of Conduct for Persons Licensed by or Registered with the Securities Futures Commission (Code), under which the following new clause (New Clause) must be incorporated into all client agreements entered by intermediaries, ie licensed corporations or registered institutions under the Securities and Futures Ordinance (SFO):

“If we [the intermediary] solicit the sale of or recommend any financial product to you [the client], the financial product must be reasonably suitable for you having regard to your financial situation, investment experience and investment objective. No other provision of this agreement or any other document we may ask you to sign and no statement we may ask you to make derogates from this clause.”

Further, the SFC also proposed adding a new paragraph 6.5 to the Code as follows:

“A licensed or registered person should not incorporate any clause, provision or term in the Client Agreement or in any other document signed or statement made by the client at the request of the licensed or registered person which is inconsistent with its obligations under the Code.”

On 08 December 2015, the SFC released its Consultation Conclusions on the Client Agreement Requirements (Consultation Conclusions), confirming the aforementioned proposal.  These proposed amendments to the Code will take effect on 09 June 2017, eighteen months after the date of the Consultation Conclusions, by which time all intermediaries, where applicable, must include the New Clause in all client agreements.  This is to provide for a transitional period for intermediaries to review their client agreements.   The SFC expects intermediaries to be able to complete this exercise well before the end of the transitional period, save for some existing clients where there are practical difficulties in re-executing the relevant agreements.

Client Agreement

At present, the Code requires intermediaries to ensure that the suitability of the solicitation or recommendation for a client is reasonable in all circumstances having regard to information available about the client (Suitability Requirement), subject to exemptions when dealing with certain types of professional investors.  At present, a breach of the Suitability Requirement would only lead to regulatory consequences, ie investigation and possibly disciplinary actions taken by the SFC.  The SFC is of the view that the current regime offers insufficient protection to investors, as the aggrieved clients have no recourse to seek compensation from an intermediary in breach of the Suitability Requirement.

Moreover, investors are sometimes required to sign declarations giving up their rights to common law remedies in relation to the relevant intermediary’s misconduct in the selling of financial products.  

As such, the SFC proposed the mandatory New Clause to be included in all client agreements of SFC regulated entities to bridge this gap.  The New Clause will provide investors with a contractual basis to recover damages against intermediaries in the event of a breach of the Suitability Requirements by the relevant intermediary.

On 23 September 2016, in light of queries raised by the industry, the SFC issued a set of FAQs on client agreement requirements, to provide guidance on the application of the new paragraph 6.2(i) of the Code.  The key points of the FAQs are discussed below:

Applicability to intermediaries licensed or registered for Type 9 (asset management) regulated activity

Generally, all intermediaries, including fund managers licensed or registered for Type 9 (asset management) regulated activity, must comply with the new paragraph 6.2(i) and include the New Clause in all of their client agreements.  A client agreement in this circumstance would be the investment management agreement entered into with a fund or a trust deed or a discretionary segregated managed account agreement.

However, when dealing with Institutional Professional Investors (Institutional PIs, as defined under paragraph 15.2 of the Code), being professional investors as defined in Schedule 1 to the SFO, or Corporate Professional Investors (Corporate PIs, as defined under paragraph 15.2 of the Code) being professional investors as defined in the Securities and Futures (Professional Investor) Rules, save for individuals, who pass certain assessment requirements under the Code, intermediaries may rely on certain Code exemptions, including the discretion to waive the need to enter into a client agreement.  

In the FAQs, the SFC clarifies that, given that the requirement for a client agreement can be waived under the Code in the first place, even when an intermediary chooses to enter into a client agreement with an Institutional PI or Corporate PI who passes the requisite assessment, it would not be required to include the New Clause in the client agreement.  In other words, fund managers will not typically be required to include the New Clause in the relevant agreements they enter unless the counterparty is an individual or a Corporate PI who does not pass the assessment required under the Code.

Applicability to discretionary investment management agreements

The SFC clarifies that all intermediaries that provide discretionary investment management services to their clients and enter into agreements with their clients must incorporate the New Clause in the agreements, unless they are entitled to certain exemptions.

As explained in the Consultation Conclusions, cases where an intermediary may be exempted from compliance with new paragraph 6.2(i) of the Code include (i) intermediaries serving Institutional PIs or Corporate PIs who are entitled to waive the requirement to enter into client agreements, and (ii) standard corporate finance mandates (eg advising on new share placements or rights offering, merger and acquisition advisory, corporate restructuring, financing activities, underwriting and sponsor activities) which do not involve the solicitation of sale of, or recommendation of, financial products.

Applicability to intermediaries dealing with an unregulated fund, a hedge fund or a sovereign wealth fund

In the consultation, the SFC was asked whether intermediaries can treat their clients who are unregulated funds, hedge funds or sovereign wealth funds as Institutional PIs, and as such be exempted from incorporating the New Clause by relying on the exemption relevant to Institutional PIs (as explained above).  The SFC in response stated the obvious view that intermediaries should determine the statuses of their clients having regard to the definition of “professional investor”, which means persons falling under paragraph (a) to (i) of the definition of “professional investor” in the SFO.

Relevant to funds is paragraph (e)(ii) of the definition which includes as a “professional investor”:

“(e) any scheme which-

(i) is a collective investment scheme authorized under section 104 of this Ordinance; or

(ii) is similarly constituted under the law of any place outside Hong Kong and, if it is regulated under the law of such place, is permitted to be operated under the law of such place,

or any person by whom any such scheme is operated.”

Given the strange language used in this part of the definition, it is likely that most funds will constitute an Institutional PI.

Compliance with the new paragraph 6.2(i) of the Code

In the FAQs, the SFC stated that the New Clause must be incorporated verbatim with no modification to the wording used in the Code, save for minor and inconsequential drafting amendments eg replacing “we” with “the Firm”, “you” with “the Customer”, and “agreement” with “ Terms” etc.

The SFC also reiterated that intermediaries are expected to ensure that the New Clause is incorporated in all client agreements, including those with existing clients.  These existing agreements may be amended by negative consent or by re-execution, depending on the circumstances and the provision of each agreement.  All intermediaries will therefore need to ascertain which, if any, of their client agreements need to be updated and to update those where required.

Complying with Suitability Obligations

On 23 December 2016 the SFC issued a set of FAQs regarding compliance in practice with the suitability obligations by licensed or registered persons as contemplated in the New Clause. The FAQs set out a list of six of such suitability obligations (and other miscellaneous ones), and provides guidance on how to comply with each of these duties. 

The FAQs also clarify that the duties and guidance continue to attach whether the licensed or registered person is making a “recommendation” or a “solicitation”. Any use of either term in this Oversight will, accordingly, be a reference to both terms. 

The six suitability obligations are that intermediaries should:

• know their clients (know your client)
• understand the investment products they recommend to clients (product due diligence)
• provide reasonably suitable recommendations by matching the risk return profile of each investment product with the personal circumstances of the client (reasonably suitable recommendations)
• provide all relevant material information to clients to help them make informed investment decisions (informed decisions by client)
• employ competent staff and provide appropriate training, and
• document and retain the reasons for each investment recommendation made to each client (standard of documentation). 

The SFC’s expectations on compliance can be summarised as follows. 

Know Your Client (KYC)

KYC is a positive obligation on intermediaries to actively seek information from clients about their financial situation, investment experience, and investment objectives. Examples of such information include the client’s annual income and net worth (financial situation), the types of investment products in which the client has invested in the past (investment experience), and the purposes of the client’s current investment (investment objectives).

Intermediaries should also actively seek out supporting information such as the client’s investment knowledge, investment horizon, risk tolerance and capacity to make regular financial contributions or meet extra collateral requirements. 

The standard of duty is reasonableness: after having made reasonable efforts to obtain such information, the licensed or registered person is entitled to rely on the information, unless there are inconsistencies or errors therein that are reasonably apparent. They should also reach out to clients to rectify and update such inconsistent, out-of-date, or wrong information. 

Where the client himself or herself is unwilling to disclose sufficient information, the licensed or registered person should explain the consequent limitations on his assessment to the client. 

In general, any assumptions regarding the client, such as his appetite for risk, should also be explained to the client, especially if information is not forthcoming.

Any information so collected should be stored and updated continuously. 

Client’s attitude towards risk

As part of KYC, intermediaries should assess their clients’ attitude towards risk. The SFC suggests having verbal discussions with clients and supplementing the discussions with questionnaires with a risk-scoring mechanism. Particular care must be taken to ensure the questionnaires are neutral and designed to acquire the most accurate picture of the client’s personal circumstances, and not skewed to produce results indicating a high tolerance for risk. 

Due diligence

Intermediaries should not recommend investment products which they do not understand. Further, in selecting an investment product for clients, they must conduct product due diligence.

Product due diligence involves understanding (i) the nature and risks of a certain investment product, and also (ii) broader market and industry risks such as the relevant economic and political environment, regulatory restrictions and any other facts which may directly or indirectly impact the risk return profiles and growth prospects of investments. 

Depending on the nature and risks of a certain investment product, intermediaries may adopt a proportionate approach in conducting and documenting product due diligence. The FAQs provide an example by contrasting the greater level of due diligence required in recommending non-exchange traded products with the laxer standard expected in the case of exchange traded products. 

There is also a duty to be independent in conducting the due diligence. The SFC indicates that it is not acceptable to rely solely on the risk ratings published by research companies or credit ratings assigned by credit ratings agencies. They may however be taken into account. 

Reasonably suitable recommendations

Intermediaries must match the risk return profile of each recommended investment product with each client’s personal circumstances.  

Therefore, intermediaries should use their professional judgement to assess diligently whether the characteristics and risk exposures of each recommended investment product (including transaction costs, effect of gearing and foreign currency risks) are actually suitable for the client, taking into account the client’s investment objectives, investment horizon, investment knowledge and experience, risk tolerance, and financial situation, and any other relevant circumstances of a client.  Therefore, for intermediaries that have assigned risk ratings to products, merely mechanically matching a product’s risk rating with a client’s risk tolerance level assessed by the intermediaries may not be sufficient to discharge the obligation.  

In assessing the client’s personal circumstances and risk tolerance and whether to recommend a certain investment product, intermediaries should consider concentration risk based on available information of the client (eg the investment portfolios of the client, or the portfolio held with the licensed or registered person, and the client’s financial situation), and they should also consider the overall effect of their recommended products would have on their client’s portfolio (eg, recommending a portion of high risk products to a client with a low risk profile, given that the overall risk return profile of the portfolio still matches the personal circumstances and risk tolerance of the client). 

Intermediaries should be independent and disclose any relevant interests. Where they receive commission rebates or other benefits for transacting in particular investment products for clients, the intermediaries must not take such benefits as the primary basis for recommending particular products to clients. Further, where they only recommend products which are issued by related companies, they must disclose this limited availability of products to their clients.

A higher standard is expected of intermediaries when they make recommendations to elderly or unsophisticated clients who may not be able to make independent investment decisions and rely on the intermediaries for recommendation, especially when clients invest in products that have a long maturity period and attract hefty penalty charges upon early termination or withdrawal. 

Informed decisions by clients

To help clients make informed decisions about their investments, intermediaries should not only furnish clients with up-to-date prospectuses, offering circulars, and/or other relevant documents relating to recommended investment products, but should also give clients proper explanations of the nature and risks of the investment products and why these recommended investment products are suitable for the client. It is important to use plain, simply and lay language. Intermediaries should also be neutral by discussing disadvantages and risks of the products recommended. 

It is improper to pressurise, entice, or otherwise unfairly induce clients to make hasty investment decisions. Clients should be given sufficient time to consider and raise queries with the intermediaries.

Standard of documentation

Intermediaries should maintain records documenting the rationale of the underlying investment recommendations and provide a copy of the rationale for the recommendations to the client upon his or her request.

Intermediaries should also record contemporaneously the information given to each client, including any material queries raised by the client and the responses given.

In addition, intermediaries should keep sufficient documentation on all client transactions including orders placed to product providers.

Records may be in writing or in audio format. For non-exchange traded products, such records should be retained for at least seven years.  For exchange traded products, they should be retained for at least two years.

Computer models

Intermediaries may assist clients in making investment decisions by using computer models which make reference to specific client information input into a computer to generate investment recommendations. They are also subject to the same suitability obligations outlined above. This means there is an obligation to ensure the computer models satisfy the suitability obligations by fairly matching product recommendations with a client’s personal circumstances and risk tolerance. 

Nature and scope of services in client agreements

Intermediaries should establish and define their relationships (such as the rights, obligations, and responsibilities of each party, as for instance in the New Clause) with each client by way of a client agreement. The client agreement should be reviewed and updated on an ongoing basis.

Senior management

The duties that attach to senior management of intermediaries are similar to those normally expected of senior managers or directors. They are expected to maintain a good corporate governance structure, review and upkeep adequate systems and controls to ensure continued compliance with laws, appoint and delegate responsibilities to fit and competent staff and provide continued training, ensure ongoing reviews by competent personnel of transactions and related records and documents. There should be an adequate procedure to receive client complaints and effect remedial measures. There should also be a procedure so that senior management is kept informed of all issues that may affect compliance with applicable laws and client interests.

Triggering Suitability Obligations

This set of FAQs clarifies the types of interactions or relationships in which suitability obligations may arise. The SFC takes a broad view such that any communication or relationship which in some way involves a solicitation or recommendation of an investment product will automatically trigger suitability obligations. It provides certain examples of interactions that are likely or unlikely to so trigger the obligations, but the overarching message is that intermediaries should always attempt to observe such obligations whenever there is a possibility that their communication may be perceived as a recommendation, either implicitly or explicitly. 

Types of interactions

Whether an interaction (no matter face-to-face, via the phone, or electronically) between an intermediary and its client triggers suitability obligations depends on whether there is a recommendation, having regard to all the facts and circumstances of each case. 

To do so, the SFC opines that there are three non-exhaustive factors to consider: (i) the content or context of the communication (whether the communication is the provision of neutral information about a product or the market, or if it involves a representation inviting or inducing investors to invest in a product); (ii) whether the communication is delivered to targeted clients; and (iii) the series of actions taken (ie if the communication is part of a multiple-step recommendation). 

The FAQs also provide practical examples in its Annex to illustrate when the suitability obligations might be triggered. For instance, any communication that may be perceived to be based on the consideration of the circumstances of the client, such as his or her risk appetite, to invest in a product, or any discussion with a client about a product or portfolio of products with the implication that it is a suitable investment for the client will certainly trigger the obligations. In contrast, providing alerts to the client when there are updates on information about a listed company upon his or her request, without any prior or post-hoc communication which seeks to recommend the stock, or other standalone provision of factual information about stocks, markets, or industries without any prior or post-hoc communication that might be perceived as a recommendation or solicitation, will not, in the SFC’s view, attract the suitability obligations. 

Discretionary account services

Intermediaries that provide discretionary account services to their clients, which the SFC clarifies as involving both the making and execution of a recommendation, will trigger the suitability obligations. 

The SFC also describes how an intermediary who provides such discretionary account services might in practice comply with the suitability obligations. 

The discretion granted depends on the client agreement, which may augment or restrict the scope within which the intermediary may make investment decision on the client’s behalf. There are two main types of discretionary account services: intermediaries may manage a client’s portfolio in accordance with a mandate (sets out, for example, risk, product type, and concentration parameters) or a predefined model investment portfolio (sets out the proportion of asset classes, markets, and risk profile of a portfolio) established or chosen by the client, while others may only provide discretionary account services as an ancillary part of their brokerage services for clients without any such mandate.

Where an intermediary provides discretionary account services to a client in accordance with an agreed mandate or a predefined model investment, the suitability obligations can be discharged as follows:

1. The intermediary should ensure that the mandate or predefined model investment portfolio established or chosen by the client is suitable for that client based on information about the client’s personal circumstances.  Whether or not the portfolio or mandate is suitable is considered holistically: for instance, a predefined investment portfolio with a low risk profile may still be satisfied by a mixture of low and high risk products so long as the overall risk profile is maintained. The intermediary should document its assessment and provide a copy of the rationale to the client in writing. 
2. For any transaction effected in accordance with the mandate or predefined model portfolio, it would not be necessary to record contemporaneously the rationale of each transaction or to provide the clients with the rationale of its recommendation for that particular transaction.
3. If during the course of the investment management relationship, the client raises any material queries about specific products in the portfolio or the portfolio’s composition, the intermediary should document such queries and its responses.
4. The intermediary should review the mandate or predefined model investment portfolio on a regular basis, having regard to the client’s latest circumstances and, where appropriate, recommend revisions to the mandate or predefined model portfolio and agree them with the client.  The intermediary should also document the rationale for recommending the revised mandate or predefined model portfolio and provide a copy of the rationale to the client in writing.

Where intermediaries provide discretionary account services to a client as an ancillary part of their brokerage services without any agreed mandate, they are required to follow the documentation requirements set out in the Suitability FAQs for Compliance (set out in the section above).

As indicated, in dealings with Institutional PIs and Corporate PIs that have passed the assessment, the New Clause is not required and the suitability obligations do not apply.

Conclusion

Intermediaries should note that, subject to limited exemptions, any agreement between an intermediary with a client must comply with paragraph 6.2(i) on or before 9 June 2017. The inclusion of the New Clause mandated by this paragraph entails a host of suitability obligations that seeks to protect investors, particularly unsophisticated ones. 

Intermediaries should bear in mind that the SFC, based on its FAQs on triggering the suitability obligations, will be disposed to find that a certain communication, interaction, or relationship involves or is part of a wider effort to recommend an investment product, and so attracts the suitability obligations. Intermediaries should therefore be heedful of the obligations whenever the possibility arises that an interaction might be construed as a, or part of a, recommendation. 

In terms of actual compliance, an intermediary should perform proportionate due diligence both for the investment products it recommends and particularly on the clients to whom it is recommending, and ensure that compliance is ongoing and regularly reviewed. Senior management should actively involve itself by implementing rules, controls, and systems in place to ensure continuing compliance with the suitability obligations. Further, documentation is important, not only for compliance with the suitability obligations, but also to keep clients informed and to protect intermediaries themselves by keeping a clear record of the reasons that underpin their recommendations. 

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