The Securities and Futures Commission (“SFC”) has recently published the much anticipated conclusions (“Consultation Conclusions”) to the Consultation Paper on the Proposed Guidelines on Online Distribution and Advisory Platforms (“Consultation Paper”).
Amongst other things, the SFC will adopt its controversial proposal to require that Platform Operators ensure the suitability of unsolicited online transactions in complex products (subject to certain limited carve-outs) (“Online Complex Products Suitability Requirement”). This will be disappointing to various segments of the industry who expressed strong objections during the public consultation.
This bulletin summarizes the key points from the Consultation Conclusions (with a particular focus on the implications of the Online Complex Products Suitability Requirement) and sets out the next steps which Platform Operators may need to consider. The Guidelines will become effective on 6 April 2019.
The SFC has also commenced a two-month consultation on its proposal to extend the Online Complex Products Suitability Requirement to complex products in the offline context, which is also covered in this bulletin.
Terms used herein which are undefined have the same meaning as assigned under the Consultation Paper and/or the Consultation Conclusions.
Key points from the Consultation Conclusions
Sale of complex products on online platforms on an unsolicited basis
The new requirement
- The SFC will adopt its proposal to introduce the Online Complex Products Suitability Requirement. Please see Paragraph 197 of the Consultation Conclusions.
- Intermediaries are currently responsible for ensuring suitability whenever they solicit or recommend a financial product to a client. In the future, they will also be responsible for ensuring suitability whenever a client transacts in “complex products” (regardless of whether there has been any solicitation or recommendation). In other words, intermediaries will be held responsible for transactions which result from their actions (i.e. because they have made solicitations and recommendations), as well as transactions which arise from the independent decision-making of their clients (which they have had no prior involvement in). This is a fundamental change to the concept of when (and why) suitability is triggered in Hong Kong. It will first apply in the online context and (as mentioned) is proposed to be further extended to the offline context in due course (“Offline Complex Products Suitability Requirement”).
- The Online Complex Products Suitability Requirement is out of line with other jurisdictions. Whilst the underlying concern about an investor’s potential lack of understanding of a complex product may be valid, the proposed solution (i.e. requiring intermediaries to ensure suitability) may not fully address that issue. The investor may still not understand how the product works and may still not know when to take certain actions (e.g. where there are options to exercise), or when to hedge or exit their position. Other alternative solutions could have been considered (e.g. barriers to access). For example, the SFC could have required that intermediaries ensure that a client have the right level of knowledge and experience before giving them access to the platform (or before allowing them to execute online transactions in the products they intend to trade). In any event, intermediaries may consider implementing these barriers as a practical risk management measure (see “Next steps”, below).
What is a complex product?
- An investment product is a complex product if, objectively, it is not reasonably likely that retail investors (i.e. general members of the public) will understand its terms, features and risks. The assessment is not dependent on the personal circumstances of a particular client (e.g. the knowledge of a client). In other words, a Platform Operator should determine whether a product is complex or non-complex generally, and this determination should not change in respect of individual clients. Please see Paragraphs 135 and 137 of the Consultation Conclusions. Although an objective test is to be applied, Platform Operators will each need to assess for themselves whether a product is a complex product or a non-complex product.
- The SFC is aware that different Platform Operators may classify products differently. The SFC will provide further guidance to the industry by way of FAQs and a non-exhaustive list of investment products which are considered to be complex or non-complex. Please see Paragraph 151 of the Consultation Conclusions. The aforementioned non-exhaustive list was proposed in the Consultation Paper and has been amended pursuant to the Consultation Conclusions. Both the FAQs and the non-exhaustive list will be updated from time to time.
- In the Consultation Paper, the SFC had previously defined “complex product” to mean a product whose terms, features and risks are not reasonably likely to be understood by a retail investor because of their complex structure, and which are difficult to value. The SFC has now clarified that a product does not need to be difficult to value before it is classified as a complex product. “Difficult to value” is not necessarily a pre-requisite as to whether a product is complex or not, but is now a factor to take into account when determining that issue. Please see Paragraph 135 of the Consultation Conclusions.
Exceptions to the requirement
- The Online Complex Products Suitability Requirement will not apply in the case of exchange-traded derivative products which are traded on an exchange in Hong Kong or in one of the twenty-nine specified jurisdictions (together, “Specified Exchanges”). Where an exchange-traded derivative product is not traded on a Specified Exchange, the Online Complex Products Suitability Requirement will apply, unless the product can reasonably be treated on the same basis as exchange-traded derivative products that are traded on a Specified Exchange (herein, together with exchange-traded derivative products which are traded on a Specified Exchange, “Exempt Complex Products”). Please see Paragraph 198 of the Consultation Conclusions. There does not appear to be any guidance on when an exchange-traded derivative product that is not traded on a Specified Exchange can reasonably be treated on the same basis as an exchange-traded derivative product that is traded on a Specified Exchange
- A Platform Operator is exempt from the Online Complex Products Suitability Requirement when dealing with clients that are Institutional Professional Investors or qualified Corporate Professional Investors (i.e. clients in respect of which the Platform Operator has complied with Paragraphs 15.3A and 15.3B of the Code of Conduct). A Platform Operator is also exempt from the requirement to provide certain minimum information and warning statements to those clients. Please see Paragraphs 209 and 221 of the Consultation Conclusions. This is consistent with the SFC’s approach to intermediaries that deal with Institutional Professional Investors and qualified Corporate Professional Investors. For example, note that the mandatory suitability clause under Paragraph 6.2(i) of the Code of Conduct is not applicable to such professional investors.
Other regulatory compliance issues
- Notwithstanding the exception relating to Exempt Complex Products, a Platform Operator must still comply with Paragraphs 5.1A and 5.3 of the Code of Conduct (i.e. it must assess a client’s knowledge of derivatives, warn the client of the risks associated with purchasing derivatives, and assure itself that the client has sufficient net worth to bear any potential losses). Please see Paragraph 198 of the Consultation Conclusions.
- The Online Complex Products Suitability Requirement is a regulatory obligation – not a contractual obligation. It is distinct from the mandatory suitability clause set out in Paragraph 6.2(i) of the Code of Conduct, which is not applicable in the case of unsolicited sales of complex products. Please see Paragraph 201 of the Consultation Conclusions. The mandatory suitability clause will continue to apply where an intermediary solicits or recommends a financial product to a client (whether online or offline and whether complex or non-complex).
Application and discharge of Suitability Requirement in the online context
- Under Paragraph 5.2 of the Code of Conduct, an intermediary is required to ensure that any recommendation or solicitation to a client is reasonable in all the circumstances, having regard to information about that client of which the intermediary is or should be aware through the exercise of due diligence (“Suitability Requirement”).
- It appears that (given its nature) the threshold for triggering the Suitability Requirement in a given online scenario may be different from the threshold for the equivalent offline scenario. For example, the SFC seems to have acknowledged that the Suitability Requirement is triggered when an advertisement which includes product-specific incentives is posted on an online platform, whereas the posting of the same advertisement in newspapers, magazines or on television would not trigger the Suitability Requirement. The SFC has justified this difference on the basis that in the offline context, whether the Suitability Requirement is triggered depends on whether the advertisements or materials are relevant to the selling or advisory process in the direct communications with a client. Whereas in the online context (without human interaction), the “selling or advisory process” centres on the materials which are posted on the platform. Please see Paragraphs 104 and 110 of the Consultation Conclusions.
- There does not appear to be any clarity on the application of the Suitability Requirement where there are both offline and online elements (e.g. where a relationship manager has recommended an investment product to a client during an offline conversation, but the client only later decides to execute the transaction online). Please see Paragraphs 130 and 131 of the Consultation Conclusions. However, this will only be relevant to non-complex products and Exempt Complex Products in the future (assuming that the Offline Complex Products Suitability Requirement is also implemented).
- In the Consultation Paper, the SFC had previously referred to robo-advice as including: (1) full automation (i.e. fully-automated investment advice via an online platform with no human intervention); (2) adviser-assisted (i.e. the online platform provides an option for clients to contact an adviser depending on their needs); and (3) guided advice (i.e. investment advice is provided by an adviser who is assisted and supported by technology tools). The third scenario is now out of scope as the SFC has clarified that the scope of robo-advice under the Guidelines only applies to the provision of investment advice using client-facing technology tools. Intermediaries using technology tools to assist and support them in providing investment advice to clients are outside the scope of the Guidelines. Please see Paragraph 74 of the Consultation Conclusions.
Core principles for the operation of online platforms
- The SFC has clarified that Platform Operators should act with due skill, care and diligence in the selection, appointment and on-going monitoring of third-party service providers so that they are reasonably satisfied that information provided by the service provider is accurate and reliable. However, this does not require monitoring the accuracy of each and every news feed item or stock price update. Nevertheless, if the Platform Operator becomes aware of incidents which suggest that a third party service provider may no longer be competent, the Platform Operator should consider whether to continue to engage its services. Please see Paragraph 55 of the Consultation Conclusions.
Further consultation on the Offline Complex Products Suitability Requirement
The SFC has launched a further consultation to extend the Online Complex Products Suitability Requirement to the offline context as well. In other words, if implemented, intermediaries would need to ensure the suitability of unsolicited offline transactions in complex products. The same exceptions which are applicable to the Online Complex Products Suitability Requirement are proposed to apply to the Offline Complex Products Suitability Requirement. There will be a two-month consultation period (ending on 28 May 2018). The SFC appear keen to ensure that there is a level playing field between the online and offline sales processes. Notwithstanding this, we would encourage intermediaries to voice any concerns or observations, as the proposal will fundamentally change the way in which they are able to provide execution-only services in complex products.
There are a number of next steps which Platform Operators may need to consider, including the following:
- reviewing all products traded on the platform to determine whether they are complex or non-complex products;
- reviewing the online sales flow and systems, to ensure that the suitability checking process is built in to all transactions in complex products which are subject to the Online Complex Products Suitability Requirement. For these purposes the following would be excluded:
- transactions in complex products by Institutional Professional Investors and qualified Corporate Professional Investors; and
- transactions in Exempt Complex Products.
- reviewing the online sales system to see if access or trading barriers should be applied;
- reviewing any online-specific terms and conditions, to ensure that there are no disclaimers or carve-outs where the Online Complex Products Suitability Requirement applies (note: even though the Online Complex Products Suitability Requirement is not a contractual requirement, generally speaking, intermediaries should not include any term or provision which is contrary to their regulatory obligations or misrepresent the services provided);
- reviewing the website in general, to determine whether and when the Suitability Requirement arises (and if so, addressing that, e.g. making changes to the website or by building in the suitability checking process);
- devising guidelines for online advertisements to mitigate the risk of triggering the Suitability Requirement; and
- reviewing the scenarios where there could be both online and offline elements, to determine if and when the Suitability Requirement arises (and appropriately communicating that to clients and reflecting that in the terms and conditions). Note: in the future, this will only be relevant to non-complex products and Exempt Complex Products (assuming that the Offline Complex Products Suitability Requirement is also implemented).