COVID-19 reminder by SFC of suitability and client information obligations

On 27 March 2020, the Securities and Futures Commission (SFC) issued a circular (Circular) to remind the industry of the importance of complying with the suitability obligations prescribed in the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct). The Circular provides useful reminders and guidance concerning matters which particularly need to be taken into account during the COVID-19 outbreak, in view of its potential impact on market volatility and liquidity, as well as credit quality.

Separately, the SFC has recently made clear to the market that, notwithstanding the current circumstances arising out of the COVID-19 outbreak, it expects licensed firms (i.e. licensed corporations and registered persons) to make all reasonable efforts to maintain “business as usual”. This means that the SFC expects continuing market compliance with relevant legal and regulatory obligations, including the suitability obligations.

In addition to emphasizing the overarching obligation of licensed firms to act in the best interests of their clients, the Circular also reiterates that compliance with the suitability obligations is not only required when marketing investment products, but also when managing investment portfolios. The Circular further advises that the SFC will continue to assess compliance with the suitability obligations provided for in the Code of Conduct during its ongoing monitoring of licensed corporations.

The Circular does not impose new regulatory obligations on licensed firms and, therefore, is intended to be a timely reminder to the market of the existing obligations arising out of the suitability requirements prescribed in the Code of Conduct.

In the following paragraphs, we will provide a general discussion of the well-established suitability requirements and the various sources of these requirements, and will highlight the guidance provided by the SFC in the Circular, which it considers to be important in light of the COVID-19 outbreak.

Sources

The obligation to ensure suitability is stipulated in paragraph 5.2 of the Code of Conduct in the following terms:

“Having regard to information about the client of which the licensed or registered person is or should be aware through the exercise of due diligence, the licensed or registered person should, when making a recommendation or solicitation, ensure the suitability of the recommendation or solicitation for that client is reasonable in all the circumstances.”

This generally-stated obligation has been further elaborated by guidance that the SFC has issued from time to time and, in particular, by two key sets of frequently asked questions (FAQs), each of which was released by the SFC on 23 December 2016:

  • Compliance with Suitability Obligations by Licensed or Registered Persons (Suitability FAQs) – this supersedes the previous 2007 Suitability FAQs.
  • Triggering of Suitability Obligations – this explains when suitability obligations are triggered, including how to comply with such obligations in the context of discretionary account services.

There is now a dedicated page on the SFC’s website which provides consolidated guidance concerning suitability, including these FAQs and other relevant guidance (available here).

Suitability obligations and new guidance provided in the SFC’s Circular

The Suitability FAQs set out the following six key obligations:

1.

Know your client (KYC)

Licensed firms need to know all the relevant and current circumstances of their clients, including their financial situation, investment experience and objectives, risk tolerance, investment horizon and liquidity needs, as well as the risk profile and concentration risk of their existing investment portfolio (if available). Although the SFC’s Circular does not add anything new to the already well established KYC obligations, we suggest that extra effort now be expended to obtain up-to-date information concerning clients’ investment portfolios in order to better assess their suitability in the current volatile market condition.

2.

 Product due diligence

Licensed firms need to ensure that due diligence is conducted on investment products on the current approved product lists on a continual basis at appropriate intervals, having regard to the natures, features and risks of the investment products, and other factors which may have an impact on the risk return profiles and growth prospects of the investments. With reference to the current circumstances, the Circular identifies these other factors as including any deterioration in credit quality or liquidity and any market or industry risk associated with the COVID-19 outbreak.

3. 

 Suitability assessment

Licensed firms are required to provide reasonably suitable investment recommendations, taking into account the personal circumstances of the client. Although the Circular does not specifically touch on this point, we warn against merely mechanically matching a product’s or portfolio’s risk rating with a client’s risk tolerance level based on the client’s investor profile questionnaire. In the current circumstances we recommend that consideration be given to the provision of refresher training to remind frontline managers that mere reliance on mechanical matching might not be sufficient and that they must be alert to any other factors, which should be taken into account and which might well call into question the reliability of mechanical matching. In our view, mere mechanical matching should not solely be relied on to satisfy the suitability obligations (Suitability FAQ #5).

4.

 Information for client

When making a recommendation, licensed firms should present a balanced view and alert clients to the disadvantages and downside risk. In the Circular, the SFC issues a reminder that the focus should not solely be on advantageous terms, such as high coupon rates or yields, and that clients must also be alerted to downside risk, such as credit deterioration and illiquidity.

It can sometimes be forgotten that the provision of information to clients is not only confined to the time when clients make their initial investment decisions. With this in mind, the SFC has issued a reminder in its Circular concerning ongoing post-sale obligations. Where licensed firms hold investment products on behalf of clients (directly or indirectly), they should promptly disseminate to their clients any product information received by them from product issuers, product arrangers or management companies, to enable their clients to make informed investment decisions whether to continue to hold such products. This reminder is based on paragraph 4(f) and (g) of the SFC Circular on Obligations Relating to Selling/Distribution of Investment Products issued on 28 May 2010.

These notices or communications may include material information or updates crucial for investment decisions, for example, untoward circumstances relating to a fund which may include the use of liquidity risk management tools by a fund manager. In this regard, it is noteworthy that, on 27 March 2020, the SFC also issued a Circular to management companies and trustees and custodians of SFC authorized funds, to remind them to manage risk, including market and liquidity risk, during the COVID-19 outbreak.

5.

 Staff and training

Although not discussed in the Circular, the senior management of licensed firms should recruit staff who are fit and proper and who have an adequate level of knowledge and skills to provide recommendations to clients. Senior management should also ensure that regular and appropriate training is provided to their staff and ensure that they keep abreast of developments in the industry.

6. 

 Document and retain reasons for recommendation

Although not mentioned in the Circular, licensed firms need to document the reasons for each investment recommendation made to a client and keep such records for seven years (non-exchanged traded funds and portfolio strategy recommendations) and provide them to a client upon request.

Finally, we wish to highlight a matter which is not dealt with in the Circular, but which can be overlooked by senior management in respect of compliance with the suitability obligations (Suitability FAQ #10). Senior management is required to sample transactions on a regular basis and monitor whether the recommendations given to clients are suitable. They should also ensure that complaints are handled promptly. On 23 February 2009, the SFC issued a Circular Regarding Self Examination of Controls and Procedures on Suitability Obligations to remind licensed firms to conduct self-examination of their controls and new investment take-on procedures to ensure compliance with the suitability obligations. In addition, they should ensure that their responses to the SFC in the section titled “Distribution of Investment Products and/or Provision of Investment Advisory Services” (Section B9) in the Business Risk Management Questionnaire, are consistent with the controls and monitoring carried out by them.