The Securities and Futures Commission (SFC) has concluded its consultation on proposals to enhance the professional investor regime in Hong Kong.

Commencing on 25 March 2016, the Code of Conduct for Persons Licensed by or Registered with the SFC (Code) will be amended so that for:  

  • Individual professional investors – intermediaries will need to comply with all Code requirements (with the exception of specified requirements which are more administrative in nature) when dealing with such individuals, without exception;  
  • Corporate professional investors (includinginvestment vehicles wholly owned by individual professional investors and family trusts) – a principles-based knowledge and experience assessment, rather than the existing bright-line tests, will need to be conducted on such investors before certain Code requirements can be waived.

The SFC will conduct a further consultation on a revised proposal relating to client agreement requirements. In response to comments received during its earlier consultation, the SFC has proposed the requirement that a specific clause relating to the suitability of solicitations and recommendations to clients (rather than the suitability requirement under the Code) be incorporated into all client agreements.

Background

The aftermath of the global financial crisis has seen a renewed focus on investor protection from regulators around the globe, including those in Hong Kong. In May 2013, the SFC published a consultation paper outlining a number of proposals to amend the professional investor regime and client agreement requirements (2013 Consultation Paper). A copy of the 2013 Consultation Paper can be accessed here.

The proposals focused on:

  • the conduct of intermediaries when serving professional investors;
  • content requirements for client agreements; and
  • participation in private placements.

Last Thursday (25 September 2014), the SFC published its conclusions from the consultation (September 2014 Paper) and, in the same paper, launched a further consultation on a new proposal relating to client agreement requirements. A copy of the September 2014 Paper is available here.

Code amendments on the professional investor regime to come into effect on 25 March 2016

The professional investor regime in Hong Kong distinguishes between (i) institutional professional investors, (ii) corporate professional investors and (iii) individual professional investors. The proposals set out in the 2013 Consultation Paper focussed on enhanced protections for the latter two types of investors.

The Code places various requirements on intermediaries when dealing in financial products, but allows for exemptions from some of those requirements for professional investors, in particular, the requirement to ensure the suitability of recommendations or solicitations to clients (Suitability Requirement). In essence, the 2013 Consultation Paper proposed that the exemptions should not apply in respect of individual professional investors, nor corporate professional investors which were investment vehicles wholly owned by individuals or family trusts. The SFC further proposed to replace the “bright-line tests” with a “principles-based” assessment for intermediaries to determine whether a corporate professional investor was sufficiently knowledgeable and experienced in the relevant financial products, to enable the intermediaries to be exempted from the relevant Code requirements.

The “principles-based” assessment approach received majority support during the consultation phase and the SFC has concluded that it will proceed with that enhancement. The existing “bright line tests” (which include assessing the investor’s dealing experience and the number of transactions completed per annum) were considered unrealistic, rigid and difficult to fulfil. The new “principles-based” assessment approach, which is aimed to be more holistic and flexible, involves three considerations:

  • whether the corporate professional investor has the appropriate corporate structure and investment process and controls;
  • whether those responsible for making investment decisions on behalf of the corporate professional investor have sufficient investment background; and
  • whether the corporate professional investor is aware of the risks involved.

Notwithstanding that a majority of the respondents to the Consultation Paper did not support the proposals in relation to individual professional investors, the SFC has concluded that it will proceed largely as proposed. As a result, once the amendments take effect, the Suitability Requirement and other Code requirements that are “inherently linked with the Suitability Requirement and/or have significant bearing on investor protection” will apply whenever an intermediary serves any individual in his/her individual capacity, regardless of whether he/she falls within the definition of a “professional investor”. Code requirements that are more administrative in nature will be able to be waived (subject to the requirement to seek the individual’s consent to be treated as a professional investor, and other related requirements).

Importantly, however, the SFC has accepted public concern regarding the proposals in respect of investment vehicles and has concluded that investment vehicles wholly owned by individual professional investors and by family trusts shall be treated in the same way as other corporate professional investors under the Code. Accordingly, subject to satisfying the “principles-based” assessment and obtaining the investment vehicle’s consent to be treated as a professional investor (and meeting related requirements), intermediaries which deal with such investment vehicles will continue to be eligible for exemptions from the Suitability Requirement and other relevant Code requirements.

The SFC has published a revised paragraph 15 of the Code which captures the amendments outlined above. The amended paragraph 15 will take effect on 25 March 2016 (18 months from the issue of the September 2014 Paper).

Separately, in response to requests from the respondents to the consultation, the SFC will conduct a detailed study of the Suitability Requirement (including gathering industry views), with the objective of providing further guidance on such requirement in due course.

As indicated above, dealings with institutional professional investors are out of the scope of the reform and will continue to be automatically exempted from the Suitability Requirement and other relevant Code requirements. Institutional professional investors include banks, insurance companies and other financial institutions and are taken to be financially sophisticated.

Further consultation on content requirements for client agreements

In response to the practices of some intermediaries in drafting client agreements and the strict contractual approach favoured by Hong Kong Courts, the SFC proposed in the 2013 Consultation Paper that:

  • the Suitability Requirement be incorporated into client agreements as a contractual term;
  • client agreements should accurately describe the actual services to be provided to the client; and
  • client agreements should not contain any terms which are inconsistent with Code obligations or misdescribe the actual services to be provided to the client.

A key objective of the SFC’s proposals was to ensure that a client of an intermediary could sue the intermediary for breach of the Suitability Requirement (which is considered a key investor protection measure) and claim compensation. The SFC has noted that some intermediaries, for example, state in client agreements that they provide an “execution only” service (although they may in fact provide advisory services) to avoid the application of the Suitability Requirement to the intermediary-client contractual relationship. Although the SFC may nonetheless take regulatory action for breaches of the Suitability Requirement under the Code, aggrieved clients are left with no redress under the contractual relationship.

The majority of the respondents to the Consultation Paper did not support the proposals. Notwithstanding that feedback, the SFC remains of the view that any increased administrative or compliance burden is outweighed by the benefits of enhanced investor protection.

After considering other specific concerns raised by the respondents, the SFC now proposes that, instead of requiring the Suitability Requirement under the Code to be incorporated by reference into client agreements, it will instead require the following self-contained clause be inserted into client agreements:

“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.”

The SFC considers that the objective standard of “reasonably suitable” introduced in this clause is appropriately amenable to judicial interpretation, addressing one of the matters raised by the respondents during the consultation.

The SFC has launched a further 3-month consultation (ending on 24 December 2014) to receive feedback on the proposed new clause.

In the meantime, the SFC has determined that:

  • it will introduce a requirement that client agreements should not contain any terms which are inconsistent with the Code and must not misdescribe the actual services to be provided to clients,
  • but it will not proceed with the proposal to require client agreements to set out in clear terms the actual services to be provided to the client.

The first mentioned requirement will not come into effect until the SFC has reached its conclusion in respect of the further consultation on the self-contained clause set out above.

No change to the current private placement regime

In the 2013 Consultation Paper, the SFC sought views on:

  • whether individual and corporate professional investors should continue to be permitted to participate in private placements (based on the amount of their portfolio/total assets); and
  • whether the current portfolio/total asset thresholds should be increased.

In response to feedback received during the consultation, the SFC has concluded that individual and corporate professional investors should continue to be able to participate in private placements and that the current monetary thresholds should remain unchanged.

Amongst other things, the SFC agreed that preventing such investors from participating in private placements would have an adverse impact on the private placement market. The SFC also acknowledged that the regime in place in Hong Kong is well established and comparable to those employed elsewhere, such as the United States, Australia and Singapore, which allow access to the private placement market solely based on monetary criteria.

Conclusion

Although the Code amendments to the professional investor regime will not come into effect until 25 March 2016, intermediaries should take steps to prepare for the implementation of the amendments. This will include updating policies and documentation for the purposes of complying with the relevant Code requirements relating to individual professional investors and implementing the new “principles-based” knowledge and experience assessment for corporate professional investors.

Client agreements will also need to be reviewed and amended for compliance with the proposed content requirements, pending conclusion of the further consultation.

In addition, intermediaries should assess whether they will require additional resources to implement the new requirements, particularly in light of the increased compliance work relating to individual professional investors. Training should be provided to officers and employees who will be affected by the new requirements.