Impact of SFC's client agreement requirements on private fund managers

Introduction

On 25 September 2014, the Securities and Futures Commission (SFC) published the Consultation Conclusions on the Proposed Amendments to the Professional Investor Regime and Further Consultation on the Client Agreement Requirements, where the SFC proposed measures to reform the existing Professional Investor (PI) regime and the Suitability Requirement enshrined in the Code of Conduct for Persons Licensed by or Registered with the SFC (the Code) to enhance investor protection.

Following further public consultation, the SFC published, on 08 December 2015, the Consultation Conclusions on the Client Agreement Requirements (Consultation Conclusions), where the SFC laid down the requirement for licensed intermediaries to include a contractual clause into client agreements to confirm their assessment that any financial product recommended or solicited for sale is reasonably suitable for that client having regard to their financial situation, investment experience and investment objectives (the New Clause). Forming part of the contract with investors, the New Clause is intended to provide aggrieved clients with recourse to contractual damages (which was previously unavailable) when an intermediary breaches the suitability obligation under the Code. Where applicable, it should be included in all client agreements on or before 09 June 2017.

This Article explores the impact of the Consultation Conclusions, the effect of the New Clause on private funds in Hong Kong, and in particular, whether licensed fund managers of private funds in Hong Kong need to incorporate the New Clause into their fund documents.

The existing regulatory regime and the suitability requirement

The Code sets out guidelines governing the conduct of licensed persons regulated by the SFC in Hong Kong. Among the various standards and practices in the Code, the Suitability Requirement forms a cornerstone of investor protection, working in synergy with other positive obligations (eg know-your-client requirements) to ensure that financial institutions properly assess investors and ensure suitability when recommending or soliciting any financial product.

The Suitability Requirement is contained in paragraph 5.2 of the Code, which reads as follows:

“Having regard to information about the client of which the licensed or registered person is or should be aware through the exercise of due diligence, the licensed or registered person should, when making a recommendation or solicitation, ensure the suitability of the recommendation or solicitation for that client is reasonable in all the circumstances.”

While the Code’s scope of regulation is broad and comprehensive, it is nevertheless a piece of regulatory guideline without the force of law. Where a breach of the Code is detected, the SFC may take action through internal investigations and impose disciplinary actions or other enforcement measures on the relevant intermediaries. However, owing to its nature, the Code ultimately cannot be relied on by aggrieved investors to claim compensation for financial institutions’ misconduct in the courts of Hong Kong.

The new client agreement requirements

In various financial mis-selling and misrepresentation cases that arose since the global financial crisis in 2008, it has become apparent that licensed intermediaries, including various financial institutions, would often require clients to sign declarations disclaiming the financial institution’s potential liabilities and negating the client’s right to resort to common law remedies in relation to the selling of financial products or the making of investment recommendations. In most cases, courts have been in favour of upholding express contractual provisions, even if it goes against the licensed intermediaries’ obligations set out in the Code, including the Suitability Requirement. As a result, investors are often left without any remedy for the alleged misconduct of the financial institutions.

Wary of the above conundrum, the SFC has, with the aim of further enhancing and protecting investors’ interests, drafted and proposed the inclusion of the New Clause in client agreements that licensed intermediaries enter into with individual professional investors and corporate professional investors that do not meet the assessment criteria under the new PI regime1. The New Clause reads as follows:

“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 objectives. 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.”

In essence, the New Clause incorporates the Suitability Requirement, elevating it into a contractual duty that intermediaries must abide by when recommending or soliciting the sale of financial products to investors. It brings the spirit of investor protection in this respect from the Code into the common law. Such a contractual right exists independently and in addition to the SFC’s right of enforcement over financial intermediaries based on the Suitability Requirement. As such, where licensed intermediaries are alleged to have breached their duty in this regard, they could potentially face a double layer of investigation from regulators and investors alike.

Furthermore, the New Clause specifically compels licensed intermediaries not to derogate from the suitability obligation. In doing so, licensed intermediaries regulated by the SFC would no longer be able to contract out of their obligations, and must ensure that the financial products being sold are suitable to the specific client.

Application to private funds

In Hong Kong, fund managers have to be licensed with the SFC, typically for conducting Type 4 (advising on securities) and/or Type 9 (asset management) regulated activities before they may carry out their respective functions. As such, they would fall into the category of licensed intermediaries that have to abide by the new client agreement requirements described above, where applicable.

In the private (non-retail) fund realm, however, Hong Kong private funds (the Fund) are usually established offshore – primarily in the Cayman Islands (the BVI is also another popular destination, albeit less so than the Cayman Islands). They are typically organised either as stand-alone funds, master-feeder funds, or umbrella funds (eg segregated portfolio companies). While these private funds may differ in their investment framework, they often adopt a similar two-tiered management structure, where the board of directors’ function is delegated to a manager (often a Cayman Islands exempted limited liability company) by means of a management agreement, and the investment and advisory functions are typically further delegated to an investment advisor/manager (usually a Hong Kong incorporated private company with limited liability - the HK Entity) by means of an investment advisory/management agreement.

In the above structure, the HK Entity would be the only entity required to be licensed as an intermediary under the SFO in order to carry on the various regulated activities in Hong Kong. Usually, the HK Entity’s sole relationship with the Fund would be limited to the Investment Advisory/Management agreement it has with the Fund - that is, a strictly contractual relationship.

The “client” of the HK Entity

In the Fund’s day to day operations, regardless of the investment structure that has been adopted, the HK Entity would not, under normal circumstances, interact with investors, be they individual, corporate or institutional. Rather, investors would normally only contract with the Fund itself, usually by entering into subscription agreements and/or side letters. As there is actually no direct contractual relationship between the HK Entity and the investors in the Fund (and the usual “suite” of documents constituting the Fund would not contain any contract between the HK Entity and the investors), the simple answer would appear to be that the New Clause is not relevant to a regulated entity in the context of a private fund.

Put another way, as the only relevant “client” of the HK Entity is the Fund itself (which, by definition under the Code, is an “institutional professional investor”)2, the New Clause should have no relevance to the HK Entity.

Looking beyond a strict contractual analysis

While technically correct, there is no assurance that the SFC would find such an approach acceptable. Afterall, in practice, there are clear instances where the SFC actually looks beyond the strict contractual relationship between a fund manager and the Fund, to the underlying investors in the Fund. For example, in relation to the intra-group exemption that is available for Type 9 (asset management) regulated activity3 (and which may be relied on by the HK Entity if it provides Type 9 services solely to its wholly owned subsidiaries, its sole holding company or other wholly owned subsidiaries of that holding company), the SFC takes the view that this exemption no longer becomes available in circumstances where the HK Entity is managing third party moneys4.

In another instance, consider the conditions that are imposed for certain managers in respect of their Type 9 licence, and in particular, the restriction in relation to dealing only with “professional investors”5. It is clear that in such cases, the SFC is contemplating the type of underlying investors who would be allowed to invest in the Fund, and is looking beyond the simple contractual relationship between the HK Entity and the Fund (otherwise, the condition would be redundant since the Fund would almost always qualify as a “professional investor”).

Other compelling reasons for not having to incorporate the new clause

It is clear, therefore, that merely relying on a strict contractual analysis of the relationship between the HK Entity and the Fund may not be a sufficiently compelling answer to not incorporating the New Clause, especially if the SFC decides that in the interest of investor protection, managers should “lift the veil” of the contractual arrangements and look to underlying investors in the Fund.

Nevertheless, the author remains of the view that the New Clause does not need to be incorporated, for the following reasons.  

First, in relation to Type 9 regulated activity, asset management is the primary service being provided by the manager. To the extent there is any solicitation or recommendation of financial products, that is a derivative activity, carried on as an incident of the asset management function6. Requiring the incorporation of the New Clause (which has an entirely different focus to investment management) would “miss the mark” as regards the core activity being undertaken by the HK Entity.

Additionally, any advice or recommendation that is given by the HK Entity as an incident to the exercise of its investment management discretion, is not a “true” recommendation or solicitation in the sense that underlying investors may be free to act or not act upon such advice. This is because in a Fund arrangement, the underlying investors have no voting power, and cannot veto any decision of the HK Entity (they can redeem out of the Fund). The investment discretion exercised by the HK Entity therefore breaks the chain of causation between any recommendation/analysis provided by it, and the impact such recommendation/analysis may have on underlying investors.

For this reason, it is also clear that in respect of Type 4 activity (where an investment advisor is solely advising a private fund which is separately managed by an investment manager), the investment discretion that is to be exercised by the investment manager would sever the link between the giving of such recommendation/solicitation by the advisor, and the ability of the underlying investors to act upon such recommendation. (The analysis would be different if we were dealing with a Type 4 advisor that was writing reports and analyses for third parties - in such cases, there is a far stronger argument for incorporation of the New Clause into any contract entered into by such an advisor and its clients for the provision of such advisory services.)

In a private fund context, however, it is clear that the New Clause would be neither necessary nor appropriate for a manager or advisor undertaking Type 4 or Type 9 regulated activity.

Finally, if we were to take the view that the New Clause should be incorporated into the suite of documents constituting a Fund arrangement, logistics aside7, we would, in effect, be imposing a regulatory burden on the Fund itself 8. As a general principle, a regulatory body should not be allowed to achieve, by way of subsidiary legislation (in this case amendments to the Code which by itself, has no force of law) matters which are not contemplated or provided for under the primary legislation. In the context of private funds, it is clear that they were never intended to fall within the purview of the SFC or any other regulatory body in Hong Kong. Allowing the New Clause to affect private funds in this way would cut across the demarcation between private and retail funds (with practical implications, including making Hong Kong a less attractive jurisdiction to base a private fund manager).

Conclusion

The New Clause has been criticised as encroaching upon the freedom of contract between institutions and investors by making the Suitability Requirement and non-derogation principle contractual duties. However, the applicability of the New Clause may not be as broad as it seems, and in the author’s view, there exist strong arguments against the imposition of the New Clause on private funds and their managers/advisors in Hong Kong.

In any case, fund managers are advised to undertake a review of the compliance procedures9 and (to the extent they exist) client agreements that are in place, to ensure that the relevant rules and procedures for determining the applicability of the Suitability Requirement and the New Clause are complied with.

2  See Appendix A, paragraph 15.2 of the Code and the definition of “professional investors” in Schedule 1, paragraph (e)(ii) of the SFO

3  See the definition of “securities or futures contracts management” in Schedule 5 to the SFO, in particular, paragraph (a).

4   http://www.sfc.hk/web/EN/faqs/intermediaries/licensing/other-topics-relating-to-the-sfo.html#8.

5  Usually expressed as the manager “shall only provide services to professional investors”.

6  See the definition of “advising on securities” under Schedule 5 of the SFO, where at paragraph (iva), a person who is licensed to carry out Type 9 regulated activity is exempt from obtaining a Type 4 licence if the provision of such investment advice is for the sole purpose of managing a portfolio of assets. 

7  As there is no actual agreement in existence between the HK Entity and underlying investors, we would either have to create a new contract (for example, in the form of an undertaking from the HK Entity), or make the HK Entity a party to the subscription agreement entered into between the Fund and the investors – either method being undesirable and rather cumbersome.

8  The HK Entity would be exposed to the possibility of a suit from underlying investors, who would, by reason of incorporation of the New Clause, have a direct claim against it.  In turn, the HK Entity would look to the usual indemnity that the Fund provides to it from Fund assets, and absent any fraud or wilful default, it would be the Fund and its assets that become exposed to any such claims. 

9  Funds that accept individual and corporate “professional investors” would need to have their compliance manuals updated to incorporate suitability requirements (for individual professional investors), and the corporate professional investor assessment for corporate professional investors.