In the months following the collapse of Lehman Brothers in September 2008, governments and regulators around the world were forced to take drastic steps. In Europe and the United States, for example, there were unprecedented government "bailouts" of a number of financial institutions and the introduction of short-term measures, like the banning of short-selling of financial stocks.

In the midst of all of that, Hong Kong's financial sector proved to be resilient and robust. However, one issue in particular – the selling of certain financial products (particularly to the retail market) – generated a significant amount of public attention.

Over a number of years up to 2008, thousands of Hong Kong investors had bought unlisted structured financial products which were Lehman Brothers-related. Some of those products were issued by Lehman, but often they were issued by third party issuers who, for example, used Lehman (and others) as a reference entity.

After Lehman collapsed, many of those investors suffered significant losses. Complaints were made to the Hong Kong Monetary Authority ("HKMA") and the Securities and Futures Commission ("SFC"), the two primary regulators of the institutions that had sold/distributed those products; and many of those complaints alleged mis-selling. Inevitably, investigations ensued. The Hong Kong Legislative Council also commenced an inquiry. The spotlight fell on how certain products had been authorised by the SFC for retail distribution, and how products were assessed by financial institutions and sold to investors.

A year after Lehman collapsed, and following careful consideration of the issues, the SFC published two consultation papers in late 2009 which set out a number of proposed changes to (a) the investment product pre-sale, sale and post-sale processes; and (b) the regulatory regime governing the public offering of structured products.

The consultation process1 resulted in the announcement in 2010 of a number of changes, which seek to provide greater protection for investors and to prevent any future recurrence. This article looks at the key changes to the investment product pre-sale, sale and post-sale processes which are to be implemented from June 2011.

Pre-sale and sale

Identifying professional investors

Hong Kong's investor protection rules generally place greater emphasis on protecting retail investors than professional investors, so identifying who is or is not a professional investor is a crucial part of any selling process. Professional investors fall into one of two categories:

  1. "true" professional investors, like banks, insurance companies and licensed intermediaries; and,
  2. high net-worth investors who have a portfolio of at least HK$8 million2 and in reality may be more advanced than the average retail investor ("Sophisticated Investors").

A number of provisions of the SFC's Code of Conduct (for example, the requirement to have a written client agreement with relevant risk disclosure statements) may be waived for Sophisticated Investors. But before an intermediary may treat a client as a Sophisticated Investor and waive those requirements, it must assess the client's investment knowledge and experience and be satisfied that the client understands the risks involved in trading in the relevant products and markets. These rules have now been tightened, to require such assessments to (i) include an assessment about the client's knowledge of and expertise in the product(s) in question; (ii) be documented; and (iii) be repeated if the client wants to trade in a different product or market, or if the client has not been active for more than two years.

Know your client – knowledge of derivatives

The knowledge and sophistication of an investor can be crucial in determining whether he/she/it can make an informed decision.

From June 2011, enhanced "know your client" procedures3 will come into force. For each client who is not a professional investor, an intermediary must assess that client's knowledge of derivatives; and if the client is considered by the intermediary to be "without derivatives knowledge" but wishes to buy:

  1. an Exchange-traded derivative product, where the intermediary has not solicited the client or given the client a recommendation about the proposed transaction, the intermediary should explain to the client the risks associated with the product; or
  2. an unlisted derivative product, the intermediary should warn the client about the transaction and, based on what the intermediary knows or should know about the client, give the client appropriate advice about whether the transaction is suitable for him/her/it. Importantly, the intermediary must keep a record of the advice as well as related communications with the client; and if the transaction is considered to be unsuitable for the client, the intermediary can only effect the transaction if he/she/it believes that it would be in the client's best interests.

Enhanced product documentation

The clarity and consistency of product documentation can be crucial in determining whether an investor understands the product and can, therefore, make an informed decision about whether to invest in it.

In June 2010, the SFC published a consolidated authorisation "handbook", which brought together and updated the key rules relating to the authorisation of offering documentation and advertisements for unit trusts and mutual funds, investment-linked assurance schemes, and (through new rules) unlisted structured products. The aim was to clarify, modernise and unify documentation standards across products. Offer documents must now, for example, include easily understood summaries (called "Key Facts Statements") about the key features and risks of the product.

Enhanced disclosure to seek to manage potential conflicts of interest

Issuers of investment products remunerate their distributors in a variety of ways. Under certain arrangements, distributors may have an incentive to promote certain investment products that bring higher monetary benefits to them, giving rise to a potential conflict between the interests of the intermediary and the interests of his/her/its client, the investor.

From June 2011, before or when selling an investment product to a client, an intermediary must disclose to the client information about the monetary and nonmonetary benefits he/she/it will receive from the sale. Additionally, in respect of a client who is not a professional investor, the intermediary must also disclose:

  1. whether the intermediary is acting as principal or agent;
  2. any affiliation the intermediary may have with the product issuer; and
  3. the circumstances where the client may receive a discount of fees and charges from the intermediary.


Cooling-off period for investments in unlisted structured products

Unlisted structured products can have maturity dates falling many months or years after purchase. Under the SFC's new rules for such products, investors in such products with a scheduled term of more than one year must be given a cooling-off period of at least five business days post-sale. Investors may cancel their orders, sell the products back or otherwise unwind the transaction and receive a refund (less market value adjustments and handling fees). Distributors must disclose the coolingoff mechanism to clients before or at the point of sale.

Ongoing disclosure

The SFC's new rules4 require issuers of unlisted structured investment products to provide certain information to investors on an ongoing basis throughout the investment term of the relevant product. Such information includes financial updates, any "material adverse changes" which might affect the issuer, and any material failure of collateral to meet the relevant eligibility requirements.

The intent behind these provisions is to seek to ensure that, post-purchase, investors have available to them up-to-date information about the investment products that they have bought which should allow them to make informed investment decisions about them.


For intermediaries who sell/distribute investment products to clients, these changes will necessitate amendments to existing selling procedures as well as training of frontline sales staff, to ensure that they understand the new processes and the regulatory rationale underlying them.

In revising relevant procedures, it will be important for intermediaries to include rules requiring staff to document certain key steps in the selling process (including those identified above), so that if questions were later to arise about the process (for example, from the SFC or otherwise), there are contemporaneous records to indicate what happened. The SFC places heavy emphasis on documentation which demonstrates compliance. The absence of such documentation where specific rules require it may itself be grounds for the SFC to take action against an intermediary.