Leveling the playing field - SFC conclusions on professional investor regime and client agreements

Despite the ongoing political noise coming out of Hong Kong, commercial life and the operation of the financial markets continue unabated.

For example, the Securities and Futures Commission (the SFC) has recently issued its much-anticipated consultation conclusions on the professional investor regime and client agreement requirements[1].  Notwithstanding objections from some of the financial institutions that participated in the consultation, the SFC's conclusions will implement important measures which demonstrate its strong determination to enhance investor protection. The key points include:

• revisions to paragraph 15 (Professional Investors) of the SFC's Code of Conduct for licensed or registered intermediaries, which will require intermediaries to treat all individual and certain corporate professional investors as retail investors (and not as professional investors).

• amendments to the Code of Conduct which will require: (i) that client agreements include a new clause requiring an intermediary to confirm that a financial product is "reasonably suitable" for a client; and (ii) that no terms in the client agreement are inconsistent with obligations under the Code or misdescribe the services to be provided.

Background

Financial mis-selling claims have attracted attention globally in recent years following the financial crisis in 2008.  It is fair to say that the Hong Kong courts have not been particularly sympathetic to those investors whose claims have proceeded to trial.  In particular, the courts have been careful to uphold the principle of contractual estoppel and permit intermediaries to rely on contractual provisions which do not necessarily reflect the true factual position.

In response to concerns regarding the professional investor regime and client agreements, the SFC issued a Consultation Paper in May 2013 seeking views on various proposals designed to enhance the regulatory framework and better protect investors.

Professional investor regime

Under the Code of Conduct, intermediaries are exempt from certain customer due diligence requirements with respect to professional investors[2]. The SFC's Consultation Paper proposed that these exemptions should no longer apply with respect to individual professional investors or corporate professional investors that serve as investment vehicles wholly owned by individuals or family trusts.

The SFC has now concluded that the "suitability requirement" (its cornerstone of investor protection[3]) will apply with respect to all individual investors (whether regarded as professional or not) as from 25 March 2016.

As for corporate professional investors (including, investment vehicles wholly owned by individual professional investors or family trusts), these will be subject to a new "principles-based" assessment before an intermediary can rely on exemptions from the suitability requirement and related investor protections in the Code of Conduct[4].

Client Agreements

The SFC has decided not to pursue its most contentious proposal; that the suitability requirement be incorporated into client agreements as a contractual term.  In particular, the SFC agreed with comments that obligations under the Code of Conduct are distinct from contractual obligations under a client agreement.

Instead, the SFC has concluded that it will introduce a requirement that a new clause will be incorporated in all client agreements, the draft of which is 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."

Further, the Code of Conduct will be amended to require that client agreements should not contain any terms which are inconsistent with the Code nor should they misdescribe the actual services provided to clients. The SFC, however, determined not to require agreements to set out positively the actual services to be provided.

In reaching its conclusions, the SFC indicated that it had little time for arguments from the industry that these measures would increase compliance costs. The SFC also disagreed with the suggestion that prescribing terms in client agreements would be contrary to the legal principle of freedom of contract stating that "[f]reedom of contract simply does not apply in this regulated environment".

The SFC has requested interested parties comment on the proposed new clause by 24 December 2014. The new provisions for client agreements will only come into effect after the SFC concludes this further consultation exercise.

Some comment

The changes to the professional investor regime are relatively uncontroversial. Putting the onus on intermediaries to do more due diligence with respect to individual professional investors (and their investment vehicles) is understandable in the current regulatory environment.

The proposed new contractual provisions are a significant development.   The new clause is an attempt to address the bargaining position between investors and intermediaries; for example, by focusing more on the nature and standard of the services and/or the financial product provided by intermediaries (rather than on the operation and validity of intermediaries' disclaimer clauses).   The new provisions regarding contractual terms are an attempt to limit intermediaries' use, and reliance on, exclusion and non-reliance clauses that state, for example, that services are execution-only when, in fact, advice is given at the outset.

In part, these measures are a recognition of, and reaction to, the widening gulf between the clear expectations of regulators and the current position of the law.  Regulators in a number of common law jurisdictions have struggled with a situation in which they strongly encourage the behaviour of financial institutions to be whiter than white only to find that those institutions can simply require their clients to contract on the basis that black is white (and that position will be upheld by the courts).  This issue is amplified in Hong Kong as the SFC does not have the power to require an intermediary to pay compensation to a client for losses arising from a breach of the Code of Conduct, nor is there any statutory basis for a client to bring a private legal claim based on a breach of regulation (in contrast to other jurisdictions, such as the UK[5]).

Of course, while the new clause is intended to give investors more protection, there will still be a need for plaintiffs to prove a breach (for example, that the financial product or the solicitation or recommendation is not "reasonably suitable") and, just as importantly, to establish and quantify their loss.  However, the introduction of these measures should do much to assist those investors that have meritorious claims.

This blog is a summary of recent developments. It should not be regarded as a substitute for advice in any particular case. RPC is not responsible for the content of external websites.

[1]http://www.sfc.hk/web/EN/index.html. "Consultation Conclusions on the Proposed Amendments to the Professional Investor Regime and Further Consultation on the Client Agreement Requirements", 25 September 2014. 

[2]Paragraph 15.5.  In brief, professional investors include individuals with a portfolio of not less than HK$8 million or corporates with a portfolio of not less than HK$40 million (Securities and Futures (Professional Investors) Rules).

[3] Paragraph 5.2 of the Code of Conduct. In short, that an intermediary ensure the suitability of a recommendation or solicitation for a client is reasonable in all the circumstances.

[4]The principles-based assessment will replace the current "bright line" tests.  It will involve a new "Corporate Professional Investor Assessment" based on three criteria: namely, corporate structure and controls, investment background/experience and awareness of risks.

[5] Section 138D (formerly section 150) of the Financial Services and Markets Act 2000 (which is limited to claims by a "private person").