With effect from 9 June 2017, all client agreements must include a new clause stating that any financial product which a Hong Kong licensed intermediary solicits to sell, or recommends to the client, must be reasonably suitable for the client, having regard to the client's financial situation, investment experience and investment objectives (New Clause)1 .
The objective of this new requirement is to enhance investor protection. The inclusion of the New Clause in client agreements effectively imposes a contractual obligation on the regulated intermediary, enabling an investor to claim for damages under the client agreement where the regulated intermediary solicits the sale of or recommends a financial product which is not reasonably suitable.
The New Clause further provides for "non-derogation", such that any disclaimers or terms in the client agreement (or any other document) that would defeat the purpose of the New Clause will not have any effect.
On 25 September 2014, the SFC launched a second consultation on client agreement requirements, seeking public views on the proposed New Clause. Please refer to our briefing of 30 September 2014 regarding such proposal and the SFC's conclusions on the earlier consultation on the professional investor regime and client agreement requirements here.
The SFC received 12 written submissions during the 3-month consultation period that followed, including one response that was made on behalf of 24 financial institutions. On 8 December 2015, the SFC published its consultation conclusions confirming the implementation of its proposal to require the incorporation of the New Clause into client agreements.
The New Clause builds on the suitability provisions in the SFC main code of conduct (Code)2 . Under the current regime, when making a recommendation or solicitation a licensed or registered person should ensure that the suitability of the recommendation or solicitation for a client is reasonable in all the circumstances (Suitability Requirement). Failing to do so constitutes a breach of paragraph 5.2 of the Code, which can lead to disciplinary action being taken by the SFC. At present this is solely a regulatory obligation – it does not entitle the SFC to compel the intermediary to compensate the client for losses arising from the breach of the Code, nor does it enable the aggrieved client to seek compensation from the intermediary. The introduction of the New Clause aims to close this gap by incorporating the Suitability Requirement into client agreements as a contractual term.
2. KEY FEATURES
- Applicability: The application of the New Clause will be triggered when there is "solicitation of the sale" or "recommendation" of any financial product by the intermediary to a client. This is consistent with the Suitability Requirement under Paragraph 5.2 of the Code.
- Definition of "Financial product": In response to public comments, the SFC has sought to clarify the meaning of the term "financial product", in the Code as "any securities, futures contracts or leveraged foreign exchange contracts3 as defined under the SFO". This is a relatively wide definition and as such, intermediaries are advised to ensure that it is clearly stated in their client agreements.
- "Reasonably Suitable": Whether or not the financial product is reasonably suitable for the client must be measured according to an objective standard, by reference to the client's financial situation, investment experience and investment objectives.
- Non-derogation: There is a component in the New Clause that provides that no other provision of the client agreement (or any other document or statement that the client may be asked to sign) derogates from the New Clause. This is to ensure that any disclaimers or terms which would defeat the purpose of the New Clause will not have any effect. To complement this, a new paragraph 6.5 will be added to the Code to disallow contractual terms in the client agreement or any other document which are inconsistent with the Code obligations, or which misdescribe the actual services to a client.
The inclusion of the New Clause as a mandatory term in all client agreements has the potential to fundamentally change the existing legal landscape. Intermediaries are currently able to limit their liability by seeking a declaration or acknowledgement signed by clients, or by incorporating a contractual term in client agreements to describe an investment account as an execution-only account. The Hong Kong court had previously held (on a number of occasions) that the express terms of the client agreement prevailed, such that an intermediary was not to be regarded as offering investment advice to its client in respect of an account which was expressly stated to be an execution-only account, even though the intermediary had made recommendations on investments to its client4.
Following the incorporation of the New Clause in client agreements, the above mechanism is no longer effective in limiting an intermediary's liability, because the New Clause contains a non-derogation component, such that any other provision which is inconsistent with, or purports to undermine the effect of, the New Clause will be disallowed or will have no effect.
Going forward, an intermediary which is in breach of the Suitability Requirement under the Code will face not only potential disciplinary action from the SFC, but will also be exposed to the risk of civil claims pursued by aggrieved clients for breach of the contractual obligation under the New Clause.
4. WAY FORWARD
While the client agreement requirements will only come into effect for all client agreements on 9 June 2017, the SFC expects all intermediaries to commence reviewing and revising their client agreements immediately to ensure this exercise is completed on time.
It is, therefore, important that intermediaries take immediate steps to comply with the new requirements as follows:
- Immediately revise all existing template client agreements to include the New Clause;
- Provide the necessary training to licensed persons on the new requirements to ensure ongoing compliance;
- Ensure that new client agreements are available for signing by new clients as soon as possible;
- Ensure that existing clients are repapered (by way of amendment or replacement of their existing agreements) as soon as practicable and in any event before June 2017.