On 24 November 2017, the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) issued a circular outlining their observations from their joint thematic reviews on the potential conflicts of interest arising from the sale of in-house investment products (ie, investment products that are manufactured and distributed by different entities within a single financial group). The scope of the HKMA's and the SFC's joint reviews included order execution, product due diligence, selling processes, the management of discretionary accounts, management supervision, and controls and monitoring. Without naming any intermediaries, the HKMA and the SFC have required certain intermediaries involved in the reviews to undertake remedial actions.
The HKMA's and the SFC's circular demonstrates that conflicts of interest are a major regulatory focus for both the HKMA and the SFC. On 19 December 2017, the SFC published the first issue of its SFC Compliance Bulletin: Intermediaries to provide guidance to intermediaries and market practitioners on the SFC's regulatory and supervisory priorities. In its bulletin, the SFC stresses that it will continue to focus on conflicts issues in its supervisory work. The SFC notes that it will not hesitate to take action against licensed corporations and their senior management for failing to properly handle conflicts of interest, or otherwise failing to act honestly, fairly, and in the best interests of their clients.The HKMA's and the SFC's circular is useful for intermediaries as it sets out the regulators' expected standards in respect of conflicts of interest. In this e-bulletin, we highlight the key points in the circular and set out recommended next steps.
WHO DOES THIS HKMA AND SFC CIRCULAR AFFECT?
The circular is relevant to licensed corporations and registered institutions which manufacture, manage or sell in-house investment products. For example, these may include:
- registered institutions which provide wealth management or private banking related services to their clients (Registered Institutions); and
- licensed corporations which provide asset management related services, as well as execution and investment banking services to Registered Institutions.
The circular will be of interest to different parts of these businesses including boards, senior management, compliance, risk, internal audit, heads of distribution and front office staff.As stated by Ms Julia Leung, the SFC's Executive Director of Intermediaries, "Senior management bear the primary responsibility for ensuring appropriate standards of conduct and adherence to proper policies and procedures. Both the HKMA and the SFC strive to deliver a clear, unified message to financial institutions about exercising management supervision and putting in place sound internal controls".
WHAT ARE THE HKMA'S AND SFC'S EXPECTED STANDARDS ON CONFLICTS OF INTEREST?
The following are the key points from the HKMA's and SFC's expected standards on the areas reviewed (as set out in the circular):Order execution and related disclosures
- Intermediaries should execute client orders on the best available terms when acting for or with clients (paragraph 3.2 of the Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct)).
- Intermediaries should implement proper controls and monitoring to ensure compliance with their established policies and procedures, including requiring staff to obtain and compare quotes from external market participants. Where no external quote is obtained or is not available, intermediaries should sufficiently disclose to clients that fact.
- Intermediaries should disclose monetary and non-monetary benefits and affiliation with the product issuer in accordance with paragraphs 8.3 and 8.3A of the Code of Conduct.
- Intermediaries should disclose material interests in a transaction with or for a client and take all reasonable steps to ensure fair treatment of the clients, and should not advise or deal in relation to the transaction unless it has done so (paragraph 10.1 of the Code of Conduct).
- Intermediaries should perform regular reviews of disclosure of information, and place effective controls to ensure sufficient disclosure to clients in relation to conflicts of interest arising from sale of in-house products. Intermediaries should provide an appropriate level of training and guidance to staff on such disclosure.
Product due diligence
- Intermediaries should have a thorough understanding of their in-house products before they solicit investment from or recommend such products to clients.
- The HKMA and the SFC accept that intermediaries may take into account the due diligence work of related entities. However, intermediaries should establish proper policies and procedures to ensure that product due diligence is adequately and independently conducted to identify if bias exists.
- There should be due consideration of actual or potential conflicts of interest. The mechanism for assessing actual or potential conflicts of interest should be reasonable, taking into consideration all relevant factors such as the relationship between the product issuers and the distributors, as well as the benefits received for distributing the in-house products.
- Relevant control functions should ensure that conflicts of interest have been adequately identified and assessed.
- Approval from senior management should be obtained and proper documentation of product due diligence should be maintained.
Selling process and discretionary portfolio management
- Intermediaries should implement appropriate policies and procedures to ensure that clients are fairly treated and actual or potential conflicts of interest in the sale of in-house products and investment in such products by discretionary accounts are properly addressed, monitored and disclosed to clients. Intermediaries should not advise or deal in relation to the transaction unless it has done so.
The following is applicable to advisory models:
- Intermediaries should take steps to ensure that their solicitations or recommendations for in-house and third-party products for clients are reasonable in all circumstances having regard to all relevant information about the clients available to the intermediaries.
- Intermediaries should ensure that the general course of dealing or advising a client, and the application of charges, mark-ups or fees should be fair and reasonable in the circumstances, and be characterised by good faith (paragraph 2.2 of the Code of Conduct).
The following is applicable to discretionary management models:
- Intermediaries should ensure the selection of in-house and third party products match with the investment strategies and risk expectations agreed with clients.
- Intermediaries should demonstrate in a sufficiently clear manner that due consideration has been given to third party products as an alternative to in-house products having regard to the clients' personal circumstances.
Management supervision, and controls and monitoring
- Intermediaries should review from time to time, and enhance where appropriate, their practices, controls and monitoring.
- Intermediaries should establish proper policies and procedures in relation to conflicts of interest arising from the sale of in-house products.
- Intermediaries should review the scope, coverage and frequency of monitoring carried out by control functions to assess whether conflicts of interest are properly addressed, monitored and managed.
- Intermediaries should provide regular training and guidance to ensure that staff are equipped with adequate knowledge and skills to handle actual or potential conflicts of interest in the sale of in-house products.
Intermediaries should at the earliest opportunity consider how their own arrangements, practices and controls meet the HKMA's and SFC's expected standards as set out in the circular and enhance them as appropriate.
Senior management of intermediaries should keep in mind that they bear the primary responsibility of managing risks on a group basis, assessing holistically the robustness and effectiveness of systems and controls which identify and manage potential conflicts of interest arising from the sale of in-house products, and ensuring compliance with all applicable legal and regulatory requirements across the financial group. Despite this, it is important to note that the entire firm, from the board to frontline staff, has a part to play in ensuring that policies and procedures are implemented effectively.