Article by Richard Mazzochi, Minny Siu and Angela Kwan
On 25 March 2009, the Hong Kong Monetary Authority (HKMA) issued a circular setting out implementation measures and timeframes in relation to recommendations regarding the offering and distribution of structured products in Hong Kong (the "HKMA Circular"). The measures have important and immediate implications for distributors and manufacturers of structured products in Hong Kong and signal the start of a new wave of regulatory changes.
Scope of the HKMA Circular
Hong Kong's Securities and Futures Commission (SFC) and the HKMA issued separate reports in December 2008 setting out their recommendations for regulatory reform in response to the public controversy and claims of mis-selling by distributors of Lehman's 'mini-bonds' (respectively, the "SFC's Report" and the "HKMA's Report", and together the "Lehman Reports"). The HKMA Circular implements guidelines about some of the issues set out in the Lehman Reports.
The HKMA Circular applies to all Registered Institutions (as defined in the Banking Ordinance) which includes all authorised financial institutions which are licensed to carry on regulated activity under the Securities and Futures Ordinance (SFO).
The broad themes covered in the HKMA Circular are more systematic investor protections, more prescriptive disclosure rules and more stringent scrutiny of the independence and adequacy of the sales process. Most of the new rules directly affect distributors only. However, the additional operational requirements imposed on distributors will also place pressure on manufacturers to assist with the compliance process.
You can view the HKMA's Circular and the corresponding press release here.
The new rules
Annex 1 to the HKMA Circular sets out the following new rules.
1. Inclusion of a "health warning" statement on sales materials of all structured investment products
The HKMA (with the agreement of the SFC) has decided on the specific wording for English and Chinese language versions of a "health warning" statement that must be printed in reasonable font size on the marketing materials and offering documents of all derivative products and structured products with embedded derivatives. For existing products, the "health warning" statement can be included on a separate sheet attached to the materials.
This requirement was to be implemented immediately.
A few issues to consider include:
- The wording of the "health warning" statement implies that structured products should not be bought by an investor unless the intermediary selling the product has explained to that investor that the product is suitable. Stock trading is explicitly excluded from this requirement. The HKMA has recently confirmed that other popular types of listed structured products (such as warrants and CBBCs) which are traded using mechanisms similar to listed stocks are to be carved out from this requirement.
- Whether the "health warning" statement applies to offering materials for exempt offers is unclear. There have been previous suggestions that the health warning should be given when there is a sale to any individual (whether on an exempt basis or otherwise). The HKMA Circular makes no mention of sales made on an exempt basis. The HKMA Circular states that Registered Institutions may wish to apply the "health warning" statement to other investments which are not structured products and may adapt the wording accordingly.
- The requirement also applies to phone banking transactions in which the "health warning" statement must be provided verbally during the sales process and audio recorded.
2. Establishment of appropriate risk assessment procedures and adequate record retention including audio recording and separation of risk assessment and sales processes
Risk assessments of customers should be conducted by non-sales staff. Where it is not practicable for risk assessments to be conducted by non-sales staff, customers with risk assessments with below medium risk profiles should be independently reviewed by non-sale staff. The HKMA may also audit the effectiveness of a Registered Institution's investor risk assessment processes. Customers should be provided with copies of, and be asked to confirm, their risk profile and assessment processes should be audio recorded. The audio records of customer risk assessments must be retained for seven years.
This requirement was to be implemented by no later than the end of March 2009.
3. Maintenance of adequate records and audit trials to demonstrate that selling process is being followed for all investors
Adequate records and audit trails of sales processes, including mandatory audio recordings, must be made by distributors and retained for seven years.
This requirement was to be implemented by no later than the end of March 2009. Given the system changes that may be required to implement these new record keeping policies, the HKMA may allow Registered Institutions more time to comply. However, full implementation should be achieved by the end of June 2009 unless a longer lead time is negotiated with the HKMA.
4. Imposition of ongoing customer disclosure obligations if risk rating of product changes
Registered Institutions should notify customers (through monthly statements or a separate letter) if the risk ratings attributed to a purchased structured product becomes higher.
This requirement is already in place and was set out in an HKMA circular dated 28 October 2008. Registered Institutions are expected to achieve full implementation of this recommendation as soon as practicable but no later than 30 June 2009 (unless a longer lead time is negotiated with the HKMA).
Important issues which are not addressed in the HKMA Circular are the lack of explicit guidance in relation to risk rating standards and the possibility for inconsistency in the allocation of, or assessment of a change in risk ratings on, the same structured product by different distributors.
5. Increased responsibilities to ensure product suitability and clear explanations to customers of risk mismatches in the sales process
Distributors have stricter responsibilities to clearly and adequately explain the risks of structured products sold and their suitability to a customer's risk profile. Where there is a mismatch between the product and the customer's risk profile, the product may still be sold to the customer if there is written acknowledgment by the customer of the risk mismatch and audio records and adequate written records of the sales process are retained.
This requirement was to be implemented immediately and the related obligations for audio recordings were to be met by no later than the end of March 2009.
6. Establishment of internal and market-wide "mystery shopper" programmes to test sales procedures
"Mystery shopping" involves the testing of the quality of sales processes through customer surveys. The HKMA and SFC will jointly conduct "mystery shopper" programmes and Registered Institutions are also expected to put in place similar programmes internally.
This requirement is to be implemented as soon as possible but no later than the end of March 2009.
7. Review of and greater scrutiny over sales staff remuneration structures
Registered Institutions must have adequate procedures and controls to ensure sales staff are not solely remunerated with volume-based or financial-performance based incentives.
This requirement was to be implemented immediately.
Annex 2 to the HKMA Circular outlines the need for Registered Institutions to have formulated plans for discussion with the HKMA by the end of March 2009 as follows.
1. Requirements for a clearer separation between general banking and investment product sales activities within retail banks through physical segregation and operational changes
Separate "investment corners" that sell investment and wealth management products must be clearly sign-posted and physically and operationally distinct from general banking areas. All sales of investment products must be conducted in the investment corner by qualified staff. New investment customers must provide consent for Registered Institutions to access their deposit information for investment or wealth management purposes.
Registered Institutions are expected to implement these separation measures by 30 September 2009 although individual institutions requiring more implementation lead time may request for additional time if justification is given.
2. Segregation between a Registered Institution's insurance activities and other investment activities
Segregation should apply to a Registered Institution's insurance activities and other investment activities except in respect of a prescribed list of general insurance and traditional insurance products that may be sold in the general banking area if cooling-off periods apply for those products. Life insurance products must include a designated risk disclosure statement that sets out the customer's cooling-off rights.
Issues which have not been resolved
Several issues remain uncertain including:
- A number of recommendations raised in the Lehman Reports were not addressed in the HKMA Circular, notably:
- requirements for 'Key Fact Statements' or a four page short form document setting out the key risks and features of a structured product as part of disclosure documentation. The SFC is continuing to consider this issue. A key aspect of this proposal is whether the Key Facts Statement is part of a prospectus or is a separate document expressly stated to be read together with the prospectus. If it is to be considered a separate document, there will need to be a statutory exclusion of liability similar to that set out in Article 5(2)(d) of the EU Prospectus Directive
- plans for consolidation of the disclosure standards through the Third Phase Reform of the Companies Ordinance (CO) and clear and concise disclosure requirements (see our previous article, which touches on this issue)
- ongoing disclosure requirements in relation to secondary market prices of, and change in circumstances affecting, structured products. We have concerns about these proposals in the context of an offer of structured products which are designed as 'hold-to-maturity' investments. It is difficult to set a market standard for both elements of this proposal
- amendments to rules surrounding marketing materials and the offer of gifts in relation to structured products. We hope there will be rationalisation of the marketing guidelines that currently apply to several different types of marketing material. We also hope the SFC will move to post-vet advertisements
- imposition of cooling-off for structured products. Comparable jurisdictions exclude the operation of cooling-off to structured products because any market related costs incurred during the cooling-off period need to be borne by investors
- new requirements in relation to the disclosure of commissions as suggested in the SFC's Report, and
- potential reforms to dispute resolution processes and regulatory enforcement powers.
- Are exempt offers (that is, offers of certain types of structured products which are currently exempt from direct regulation such as offers to "Professional Investors" [as defined under the SFO] or offers which fall within the CO "safe harbours") subject to the requirements set out in the HKMA Circular? For example, must offering documents and marketing materials in relation to exempt offers contain the specified "health warning" statements?
- The future roles and regulatory responsibilities of the HKMA and SFC are unclear. Will the SFC be separately issuing guidelines or policies in relation to the requirements under the HKMA Circular or other recommendations in the Lehman Reports?
- Do the recommendations on risk assessment and the explanation on risk mismatches apply to corporate customers? The HKMA Circular does not draw a clear distinction between individual and corporate customers. The HKMA Report focuses on the protection of individual retail customers but the terms "retail client" or "retail customer" might also include corporate customers.
Comparisons to regulatory reforms taking place in other jurisdictions
It must be remembered the problems facing the financial markets and the pressure for reform are not exclusive to Hong Kong and other jurisdictions are undergoing similar periods of regulatory flux. The reform agenda proposed in Singapore by the Monetary Authority of Singapore in its March 2009 Consultation Paper and regulatory experiences in markets such as Australia and the United Kingdom may provide valuable insights and have practical comparative value.
Notwithstanding the practical challenges and remaining uncertainties poised by the guidelines set out in the HKMA Circular, distributors and manufacturers of structured products in Hong Kong need to understand the new requirements and update their compliance and operational systems accordingly. In light of the current financial and political climate, the general direction and pace of the reform process initiated by the HKMA and SFC is unlikely to change and Registered Institutions should be prepared for greater scrutiny of their products and selling practices. We hope that the future regulatory regime will be decided promptly and efficiently so that there can be a timely return to confidence and activity in the Hong Kong retail structured products market.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.