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Regulatory focus on the suitability obligation

The suitability principle is one of the cornerstones of investor protection. It has been an area of increasing focus for regulators around the world. The suitability principle simply imposes an obligation on people selling investments to ensure that the investment is suitable for the person buying the investment. It derives from the mis-selling scandals of the 1980s and 90s, but the global financial crisis triggered intense regulatory focus on the issue.

The SFC’s focus

The Securities and Futures Commission (SFC) is particularly focused on the issue as they have not forgotten being picketed by angry investors in 2008. The SFC conducted a survey at the end of last year which showed that sales to individual investors of derivatives and complex products have returned to levels prior to the global financial crisis, far outstripping sales of retail funds, which is likely to have generated significant concern.

Total transaction amount by product type (2018)


Non-authorized investment products continued to account for more than 90% of the aggregate transaction amount. Nearly all of the authorized investment products sold to individual investors were collective investment schemes. In terms of the number of transactions, collective investment schemes were the most frequently traded products.

Last week, on 6 December 2019, the SFC issued a circular announcing the launch of a joint product survey together with the Hong Kong Monetary Authority (HKMA). The findings will enable the regulators to understand current market trends and in particular, to identify risks associated with the selling activities of intermediaries for the period from 1 January to 31 December 2020. Intermediaries will be required to report on their selling practices in relation to non-exchange traded investment products to all types of investors for which the suitability obligation applies.

The SFC has conducted numerous thematic inspections on the investment sales process and issued a plethora of circulars to intermediaries drawing attention to common deficiencies in establishing suitability. There is currently a ‘mystery shopper’ programme in operation in Hong Kong and it is likely that there will be enforcement actions in the coming year.

The HKMA’s findings

The HKMA issued a circular on 22 November 2019 (Circular) drawing attention to the findings of its recent thematic review of banks’ sales practices in respect of the selling of investment funds. The Circular identified high frequency trading of investment funds by investors as a continuing concern. The Circular referred back to the HKMA’s previous circulars of 8 April 2016 and 21 December 2018. The 2016 circular drew attention to a number of failings in the sales process of banks it had inspected, including KYC deficiencies, inadequate product due diligence, inadequate suitability assessments, inadequate monitoring and staff training, and unacceptable sales practices, including high frequency trading. The 2018 circular focused on high frequency trading, so it is a serious concern that this continues to be an issue. Both the 2018 circular and the Circular focus on sales remuneration models and inadequate staff training as root causes of the problem. Hong Kong continues to adopt a commission driven sales model for most forms of investment product distribution. Whilst the commission model has been put under the microscope on several occasions, particularly since it has been abandoned in other markets such as the UK and Australia (on whose experience the SFC frequently draws in formulating regulations), thus far it has survived on the basis that the Hong Kong market is not yet ready for fee based advice; investors prefer to pay commission on the products they buy rather than paying fees for advice.

In light of the HKMA’s repeated findings of frequent trading, it is likely that intermediaries in Hong Kong will come under pressure to change their remuneration model, if not for the corporation as a whole, at least for their sales staff, so that they are not incentivised by commission based remuneration to churn investors’ portfolios. The Circular cites as an example of good practice a bank which offers a type of investment account which charges a single monthly account fee based on average net asset value (i.e. no initial, subscription or switching charges are made on transactions within the account). Frequent trading activities in the account do not generate commissions for sales staff.

The FCA’s ban on mini-bonds

The Financial Conduct Authority (FCA) in the UK has recently announced that it will place a temporary ban on the sale of mini-bonds to retail investors. The FCA is introducing the restriction without consultation, using its product intervention powers. The restriction will come into force on 1 January 2020 and last for 12 months while the FCA consults on making permanent rules. The term mini-bond refers to a range of investments. The ban will apply to more complex and opaque arrangements where the funds raised are used to lend to a third party, invest in other companies or purchase or develop properties. There are various exemptions including for listed mini-bonds, companies which raise funds for their own activities (other than the ones above) or to fund a single UK property investment.

The FCA ban will mean that unlisted mini-bonds can only be promoted to investors that firms know are sophisticated or high net worth, and will further consumer protection of investors who may not have the experience to assess and manage the risks involved.

The IOSCO review

The International Organization of Securities Commissions (IOSCO) recently published a report on its thematic review on suitability requirements with respect to the distribution of complex financial products. The review examined the implementation of the nine principles it established in its 2013 report. The principles were developed in response to the global financial crisis, and called into question investors’ understanding of the risks associated with complex products, the conduct of intermediaries in selling financial products and their responsibility for assessing the suitability of investments for their customers.

The IOSCO report concludes that Hong Kong is one of only five jurisdictions of the 29 surveyed in the review which is fully compliant with the nine principles. The major European jurisdictions and the US were also found to be broadly compliant. This means that Hong Kong has in place the key regulatory requirements for intermediaries to ensure suitability, and (critically) that the SFC supervises and enforces those requirements. Accordingly, it seems unlikely that there will be significant changes to the Hong Kong suitability regime in the near future.

Action points

Nevertheless, suitability is likely to be a hot topic in upcoming Hong Kong inspections, particularly where intermediaries are selling complex products. Accordingly, here are some key points for intermediaries to consider:-

  1. Do I know enough about the people I’m selling to?
  2. Do I know enough about the people who are selling my product?
  3. Am I providing clear and complete information about the product?
  4. If I’m a distributor, do I know enough about the product?
  5. Do my sales staff understand the suitability obligation and how to assess if a product is suitable for a customer?
  6. Do I have adequate compliance checks and supervision systems?
  7. Do I keep adequate records?

Many of our clients have benefited from a ‘mock inspection’ which can be tailored to focus on particular areas, such as client take-on procedures and the suitability assessment process.

If you have not already done so, you should conduct an internal review of your sales process, taking into account the above points. The importance of maintaining written procedures, and records of the implementation of those procedures, cannot be over-emphasised: you must be able to demonstrate to the SFC that you have adequate systems and controls, and that they are being implemented effectively. The SFC has given multiple warnings to the financial services industry about its concerns over how investments are sold, so no one should be surprised if they follow up with tough enforcement action.

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Investment Funds, Regulatory

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