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9 January, 2017
As foreshadowed in the Consultation Conclusions on the Proposed Amendments to the Professional Investor Regime and Further Consultation on the Client Agreement Requirements issued by the Securities and Futures Commission (SFC) on 25 September 2014, the SFC has conducted a detailed study (including the gathering of industry views) of the requirement under paragraph 5.2 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code) that persons licensed by or registered with the SFC (collectively, Intermediaries) should, when making a recommendation or solicitation, ensure the suitability of the recommendation or solicitation for the client is reasonable in all the circumstances (Suitability Requirement).
In light of that study, the SFC issued the following further guidance to Intermediaries on 23 December 2016:
Circular to Intermediaries – Frequently Asked Questions on Compliance with Suitability Obligations (informs Intermediaries that the SFC has published an updated set of FAQs on compliance with the suitability obligations under the Code, which include the Suitability Requirement (collectively, the Suitability Obligations));
Frequently Asked Questions on Compliance with Suitability Obligations by Licensed or Registered Persons (Updated Suitability FAQs) (updates the suitability FAQs issued by the SFC in May 2007 (2007 Suitability FAQs) and sets out some practical considerations that Intermediaries should take into account (at a minimum) in the conduct of their business);
Circular to Intermediaries – Frequently Asked Questions on Triggering of Suitability Obligations (Suitability Triggers Circular) (clarifies the scope of application of the Suitability Obligations and provides guidance and illustrations on whether and when they would be triggered under certain scenarios); and
Frequently Asked Questions on Triggering of Suitability Obligations (Suitability Triggers FAQs) (provides guidance on whether the Suitability Obligations will be triggered where Intermediaries (i) have interactive communications with their clients on investment products; or (ii) provide discretionary account services to their clients).
In an SFC announcement that was also issued on 23 December 2016, Ms Julia Leung, the SFC’s Executive Director of the Intermediaries Division, said that the Suitability Obligations are “the cornerstone of investor protection” and that the circulars “aim to provide clarity on what may trigger the Suitability Obligations, particularly when brokers or distributors deal with clients in person, by telephone or by other direct means of communication, and on what needs to be done when such obligations are triggered”.
On 28 December 2016, the Hong Kong Monetary Authority (HKMA) also issued a circular to draw the attention of authorised institutions (AIs) to the SFC circulars above and to remind them of their own suitability obligations.
This e-bulletin summarises the new guidance under the Updated Suitability FAQs (as compared to the 2007 Suitability FAQs), the Suitability Triggers Circular and the Suitability Triggers FAQs.
Updated Suitability FAQs
Suitability Obligations (question 1)
The Suitability Obligations that Intermediaries are expected to comply with have not changed under the Updated Suitability FAQs, ie, the SFC continues to expect that Intermediaries should:
(a) know their clients;
(b) understand the investment products they recommend to clients (product due diligence);
(c) provide reasonably suitable recommendations by matching the risk return profile of each investment product with the personal circumstances of each client to whom it is recommended (Suitability Requirement);
(d) provide all relevant material information to clients and help them make informed investment decisions;
(e) employ competent staff (including appointment of agents, consultants, contractors and similar arrangements) and provide appropriate training; and
(f) document and retain the reasons for each investment recommendation made to each client.
However, as set out below, the Updated Suitability FAQs provide further guidance as to how these obligations might be complied with.
Updates to “know your client” (KYC) obligation (question 2)
In respect of the KYC obligation, the Updated Suitability FAQs provide some examples of the information from clients that Intermediaries might consider obtaining, eg:
(a) annual income, liquid assets or net worth in order to assess the client’s financial situation;
(b) the types of investment products in which the client has invested and the period over which investment in such products has occurred in order to assess the client’s investment experience; and
(c) the purposes of investment, such as income generation or capital preservation, in order to assess the client’s investment objectives.
The Updated Suitability FAQs also provide that where Intermediaries have used reasonable efforts to obtain information about clients, they may rely on that information in discharging the KYC requirement unless they are aware, or should be reasonably aware, that such information is inaccurate or out of date. To the extent that conflicting or incomplete information is provided by a client, Intermediaries should alert the client and seek clarification from the client before performing the suitability assessments.
New guidance in respect of assessing clients’ attitude to risk (question 3)
The Updated Suitability FAQs include a new section regarding how Intermediaries might assess a client’s attitude towards
risk for the purpose of suitability assessments. Where Intermediaries use a risk-scoring questionnaire to support their assessment, the SFC expects them to pay particular attention to the design of the questions and the underlying scoring mechanism, so as to ensure that the client’s personal circumstances are accurately reflected and to avoid producing results skewed towards high risk tolerance. Also, a client should not be asked to answer assessment questions in a particular way so as to produce a risk tolerance level that is commensurate with the risk of a product that is being recommended to that client.
Updates to product due diligence guidance (question 4)
The Updated Suitability FAQs provide that Intermediaries may adopt a proportionate approach in conducting due diligence and documenting the due diligence work done by having regard to the nature, complexity, opaqueness, risks and liquidity of the investment products.
For non-exchange traded products, the SFC expects due diligence to involve Intermediaries developing a thorough understanding of the products, eg, the structure of investment products, how they work, the nature of underlying investments, the level of risks they bear, the experience, financial condition and reputation of product issuers, guarantors (if any) and service providers, fees and charges, the relative performance and liquidity of investment products, lock-in periods, termination conditions, valuation and unit pricing, and safe custody arrangements.
For exchange traded products, the SFC again expects Intermediaries to have developed a thorough understanding of the investment products they recommend to their clients, including an understanding of the risks and features of different types of exchange traded products as some may have a higher level of risk than others.
Overall, Intermediaries should conduct their own product due diligence and arrive at their own assessment of the products by taking into account all relevant information that is appropriate and reasonably available for a fair and balanced assessment.
Updates to guidance on providing reasonably suitable recommendations (question 5)
The Updated Suitability FAQs provide that Intermediaries should take into account and give due consideration to all relevant circumstances specific to the client when performing suitability assessments. Merely mechanically matching a product’s risk rating with a client’s risk tolerance level may not be sufficient to discharge an Intermediary’s obligation and it should consider, among other things, risk concentration and the overall effect of the recommended investment product on the client’s portfolio.
Update to documentation standards (question 7)
Intermediaries are required to maintain records documenting the rationale for underlying investment solicitations or recommendations made to a client. However, as per the Updated Suitability FAQs, they now only have to provide a copy of the rationale to the client upon his/her request.
In its circular of 28 December 2016 referred to above, the HKMA informed AIs that in applying the same standard, the HKMA now updates its similar requirement on AIs, ie, AIs also now only have to provide a customer with a copy of the rationale for investment solicitations and recommendations at the customer’s request. AIs that adopt a portfolio-based approach in assessing suitability when providing services to private banking customers should continue to observe the requirements stipulated in the HKMA’s circular of 12 June 2012 titled “Selling of Investment Products to Private Banking Customers" in respect of providing customers with (i) a copy of the investment mandate; (ii) a copy of the rationale of recommendations for the investment mandate; and (iii) a copy of the rationale for any change in the investment mandate; and (iv) a copy of the rationale for any deviation from the agreed investment mandate.
The Updated Suitability FAQs provide that Intermediaries may choose to fulfil their documentation obligations by maintaining a written or audio record having regard to their mode of operations. Such records should be retained for at least 7 years in respect of non-exchange traded products and at least 2 years for exchange traded products.
As referred to in the “Updates to product due diligence guidance” section above, the level of documentation of product due diligence work done can be proportionate to the complexity, opaqueness, risk and liquidity of the different types of products.
Suitability Triggers Circular
Scope of application of the Suitability Obligations
The Suitability Triggers Circular clarifies that the Suitability Obligations are applicable to all recommendations or solicitations concerning investment products, whether or not the products involved are traded on an exchange. The SFC acknowledges that solicitations may cover a wide range of acts on the part of Intermediaries, which has always been a concern of Intermediaries.
The Suitability Triggers Circular also provides that whether an Intermediary has made a solicitation is a question of fact which should be assessed against the circumstances of each case.
Guidance and illustrations on whether and when the Suitability Obligations would be triggered under certain scenarios
The Suitability Triggers Circular states that the posting of an advertisement for an investment product or the provision to clients of research reports and other product-specific materials such as stock commentaries (Research and Marketing Materials) may or may not trigger the Suitability Obligations, depending on whether they are relevant to the selling or advisory process, ie, the direct communications with the client. In the absence of direct communications with the client, the Suitability Obligations are unlikely to be triggered by the mere posting of an advertisement for an investment product in newspapers, magazines or television programmes, or by the wide dissemination of research reports.
The assessment should be made at the point of sale or advice and should focus on the communications between the client and the Intermediary leading up to and including the point of sale or advice, taking into account the content and context of any Research and Marketing Materials and the extent to which they created an environment in which the client was induced or recommended to enter into the transaction.
Suitability Triggers FAQs
Triggering of Suitability Obligations – interactive communications with clients on investment products
Whether interactive communications with a client about an investment product trigger the Suitability Obligations depends on whether there is a solicitation or recommendation having regard to the facts and circumstances of each case.
In determining the facts and circumstances, the general guiding principles set out in the Suitability Triggers FAQs provide that an analysis of the content and context of each interactive communication (eg, message and materials (if any) sent to the client) as well as other relevant factors should be taken into consideration. Some of the relevant (and possibly interrelated) factors that might be taken into account and which should be considered in totality by an Intermediary include:
(a) the content and context of the communication with the client, eg, whether the communication is limited to the provision of factual, fair and balanced information about a product, information about a market or an industry, or whether it contains a representation involving an invitation or inducement to act on it and invest in a particular product;
(b) whether the communication is delivered to targeted clients; and
(c) the series of actions taken, eg, whether the communication forms part of a multiple step solicitation or recommendation process and hence triggers the Suitability Obligations.
To facilitate the application of the general guiding principles referred above, the Suitability Triggers FAQs helpfully set out a non-exhaustive list of scenarios illustrating when the Suitability Obligations are likely or unlikely to be triggered during interactive communications with a client about investment products.
From the illustrations, scenarios such as the following are likely to trigger the Suitability Obligations:
(a) recommendations made directly to clients to buy or sell stock;
(b) discussions involving the merits of a particular investment product/portfolio or presenting the investment product/portfolio implicitly or explicitly as being suitable for the client;
(c) conversations that may be perceived to be based on consideration of the client’s circumstances;
(d) shortlisting investment products based on the circumstances of the client (eg, risk appetite) and providing factual
information about those shortlisted products; and
(e) having regard to the personal circumstances of the client, finding or structuring an investment product based on
parameters or specifications provided by the client.
The illustrations also provide that the Suitability Obligations would likely be triggered if, during any fund raising activity of a listed company or listing applicant, an Intermediary calls a client and recommends the client to buy the company’s stock.
Triggering of Suitability Obligations – providing discretionary account services to clients
The Suitability Triggers FAQs clarify that Intermediaries that provide discretionary account services to their clients (which involve the making and execution of recommendations) should comply with the Suitability Obligations.
Where an Intermediary provides discretionary account services to a client in accordance with an agreed mandate (Mandate) or a predetermined model investment portfolio established or chosen by the client (Investment Model), the Suitability Triggers FAQs helpfully set out how the Intermediary’s Suitability Obligations could be discharged, including by:
(a) ensuring the Mandate or Investment Model is suitable for the client, based on the client’s personal circumstances of which the Intermediary is aware through the exercise of due diligence;
(b) conducting transactions in accordance with the Mandate or Investment Model (it is not necessary to record and provide to clients the rationale of each transaction subsequently effected in accordance with the Mandate or Investment Model);
(c) documenting any material queries raised by the client about specific products in the portfolio or the portfolio's composition after the Mandate or Investment Model is agreed and during the course of the investment management relationship; and
(d) reviewing the Mandate or Investment Model on a regular basis, having regard to the client’s latest circumstances and where appropriate recommending revisions and agreeing them with the client, ensuring that the rationale for recommending the revised Mandate or Investment Model is documented and a copy is provided to the client upon request.
Where an Intermediary provides discretionary account services to a client as an ancillary part of their brokerage services for clients without an agreed mandate, they are required to follow the documentation requirements set out in the Updated Suitability FAQs (see question 7) for compliance with the Suitability Obligations.
It was also announced on 23 December 2016 that the SFC plans to launch a consultation in the first quarter of 2017 on proposed guidelines on online distribution and advisory platforms which aim to provide more tailored guidance to the industry in complying with the applicable conduct and other regulatory requirements, including the Suitability Obligations.
We have been doing a lot of work with Intermediaries in relation to the revised professional investor regime, the new client agreement requirements (including the new suitability clause) (see our e-bulletin regarding the same) and the Suitability Obligations, and we would be happy to assist should Intermediaries have any questions in relation to such matters, this e- bulletin or the latest guidance issued by the SFC in relation to the Suitability Obligations.
For further information, please contact:
William Hallatt, Partner, Herbert Smith Freehills
William.Hallatt@hsf.com
