SFC issues guidance on what triggers suitability obligations and updates suitability compliance FAQs

On 23 December 2016, Hong Kong’s Securities and Futures Commission (SFC) issued two new circulars which take effect immediately. The first contains long-awaited guidance on when the suitability obligations are triggered (and when they are not) and includes three FAQs. The second circular covers ten FAQs on compliance with the suitability obligations, which replace the suitability FAQs issued in 2007. The SFC also advised market participants to check its website for updates to the FAQs from time to time. Both circulars have been drafted with the asset management industry in mind.

To read the circulars and FAQs, please see:

Triggering of suitability obligations:

• Circular
• FAQs

Compliance with suitability obligations:

• Circular
• FAQs

When are the suitability obligations triggered?

The first circular is generally helpful and those market participants who prefer clear regulatory guidance will appreciate the 12 examples of when the obligations are and are not triggered in the context of interactive communications with investors. The examples do not reveal any real surprises in the SFC’s approach.

The question as to whether the suitability obligations are triggered will depend on what happens in the lead up to and at the point of sale or advice. One of the key factors is whether the SFC licensed corporation (LC) has any relevant direct / interactive communication with the investor during the selling or advisory process. In the absence of any direct / interactive communication, the posting of an advertisement or other product-specific materials relating to an investment product in a newspaper or on the television is unlikely to trigger the suitability obligations.

Also, the provision of factual information about an investment product at the request of the client (and without any accompanying solicitation / recommendation) is also unlikely to trigger the need for a suitability assessment.

The carve-out for execution-only transactions has been specifically confirmed but its scope remains very narrow.

The Annex to the FAQs contains the examples of when the suitability obligations are triggered including communications which may be perceived to have taken into account the circumstances of the client, such as their risk appetite to invest in a particular product.

The FAQs clarify that the suitability obligations apply in the context of discretionary account services but the SFC has, helpfully, set out different requirements for discretionary mandates and the transactions conducted under discretionary mandates.

LCs may adopt a holistic approach in assessing whether the terms of a mandate are suitable for the client which means that the LC has the discretion to invest in products with a lower or higher risk profile than that of the investor, provided that the overall risk profile of the portfolio is maintained. Transactions need to be in accordance with the agreed mandate, and do not have to be suitable for the investor on a standalone basis. The assessment needs to be documented however and a copy of the rationale must be provided to the investor in writing.

LCs are also required to document any material queries from the investor about specific products in the mandate or about the portfolio’s composition, and its responses to the client.

LCs need to review mandates regularly (e.g. annually or when there have been significant market movements) taking into account the client’s latest circumstances and, where necessary, recommend revisions to the terms of the mandate. If the mandate needs to be revised, LCs should provide a written copy of the rationale for the recommendation to the investor.

What’s in the revised suitability FAQs?

The SFC has not completely rewritten the 2007 FAQs, but instead has revised the language here and there to make it clear that the suitability obligations apply not just to investment advisors but to all LCs and registered persons whether making an investment recommendation or solicitation. There is only one new FAQ, covering the assessment of a client’s attitude towards risk. Nothing of significance has been removed and no new substantive obligations have been added although some points have been clarified.

The SFC points out that the FAQs are not exhaustive, and that breaches of the FAQs can affect the SFC’s assessment of whether an LC is “fit and proper” to keep its licence.

The SFC has clarified that references to “recommendations” in the FAQs should be interpreted to include references to “solicitations”. It did not however take the opportunity to discuss the difference between the two concepts or the scope of activities caught by “solicitation”, which remains an area of uncertainty in the industry.

The SFC has elaborated on how to ensure a solicitation or recommendation is reasonably suitable for an investor and included in Q2 a helpful list of examples of relevant KYC information:

• Annual income, liquid assets or net worth
• Previous investment products experience and holding periods
• Investment purposes

For the first time, the SFC has provided examples as to how to assess a client’s risk tolerance. Verbal discussions with clients can be supplemented by questionnaires with a risk-scoring mechanism (Q3) but the SFC insists that matching a client’s risk tolerance with the product’s risk rating should not be merely mechanical. LCs need to exercise professional judgement and take into account all relevant circumstances including the concentration risk in the client’s portfolio. Risk-scoring mechanisms must be tested to ensure the results are not overly aggressive.

The product due diligence requirements in Q4 are much more extensive than in the 2007 version. The FAQ distinguishes the due diligence requirements for exchange traded and non-exchange traded products and emphasises the responsibility of the distributor to do its own due diligence and not rely on that of a third party (including the product provider).

Q5, which addresses how to provide reasonably suitable recommendations, is key, and is also much more detailed this time. The SFC has emphasised portfolio concentration risk, and again helpfully makes it clear that an LC may solicit / recommend a high risk product to a low or medium risk tolerance client provided this is commensurate with the risk return profile of the entire portfolio of the client and meets the investment objectives and other personal circumstances of the client.

Commission rebates and other benefits must not be the “primary” reason for recommending an investment product and where the available product range is limited this needs to be properly disclosed.

Records documenting the rationale for an investment recommendation (solicitation) need to be kept but only need to be provided to the client on request (Q7).

FAQs 8 and 9 are largely unchanged.

Q10 also remains unchanged but should be noted in light of the impending introduction of the SFC’s measures for augmenting the accountability of senior management (known as the MIC Regime, see our Legal Alerts: New senior management accountability regime for SFC licensed corporations Manager-In-Charge regime: What licensed corporations need to do).

This FAQ covers senior management responsibility for compliance with the suitability obligations. It requires that LCs and senior management personnel ensure on an ongoing basis that sample transactions and documents (which would include suitability assessments) are reviewed by qualified and competent personnel. In determining which transactions to select, a risk-based approach needs to be taken and in particular senior management needs to ensure that sufficient attention is paid to complex investments by elderly, unsophisticated or vulnerable clients.

The suitability obligations are still only relevant to retail investors, Individual Professional Investors, and Corporate Professional Investors that cannot be treated as Professional Investors, as described in the SFC’s Code of Conduct.

LCs need to consider their existing practices and procedures in light of the two new circulars, and enhance their systems and controls as soon as possible to ensure they are in compliance with this updated guidance. They also need to update their compliance manuals and new investor take-on procedures.

The SFC plans to launch a consultation in the first quarter of 2017 on proposed guidelines on online distribution and advisory platforms which aim to provide tailored guidance on complying with conduct requirements including the suitability obligations.