On the heels of one of the most volatile periods in recent market history, politicians and commentators have questioned whether some investment products are too risky or too complex for retail investors. In response, regulators in Hong Kong, Thailand and Singapore have proposed new "suitability" rules— requirements that sales intermediaries evaluate the knowledge and sophistication of their retail investors and attempt to classify investment products according to the risk or complexity of such products.
Hong Kong – "Derivatives" Products and Retail Investors
The Hong Kong Securities and Futures Commission (the "SFC") recently put into place new suitability rules, effective 4 September 2011.1 Licensed sales intermediaries in Hong Kong already had been required to "ensure the suitability of [an investment] recommendation or solicitation" for a client.2 Under the new rules, licensed intermediaries must specifically evaluate their retail clients' knowledge of derivatives and then separate clients into two categories based on whether or not the investor is knowledgeable regarding derivatives.3 If a client without knowledge about derivatives wishes to purchase a derivative product, the licensed intermediary is required to explain the risks and/or take additional steps to ensure that the client understands the risks involved in investing in that product.
A problem arises when attempting to determine whether a fund is a "derivative product." Without additional guidance, some industry participants wondered whether funds with limited derivatives exposure might be considered derivative products. Given the widespread use of derivatives, such an interpretation would result in additional scrutiny in the sale of nearly all funds. In response, the SFC, in a letter to the Hong Kong Investment Fund Association, outlined factors that could be used to determine whether a fund is a derivative product, including "the function derivatives play in the structure of the fund, the duration, and the extent of derivatives" used and whether the use of derivatives creates leverage.4 But, even taking this guidance into account, the "derivative product" determination is not a bright line test. The responsibility for making this determination lies solely with the sales intermediary. In a recent FAQ, the SFC reminded intermediaries that, while fund managers could provide information in an offering document about a fund's use of derivatives, the intermediary must rely on its own "independent" evaluation of a fund.5
The requirement for such an independent evaluation is a significant departure from current practice where distributors rely heavily on "product training sessions" conducted by product issuers to educate distributors about the relevant products. It remains to be seen how these arrangements and evaluations will play out in practice. In the absence of further SFC guidance, there may be no consensus whether a particular fund should be considered a "derivative product". Furthermore, the rules may create tension between the independent evaluations by distributors and the desire of issuers to have their shares sold to the broadest possible retail client base.
Thailand SEC and Investor Suitability
The Securities and Exchange Commission of Thailand (the "SEC") recently amended its rules on sales of investment funds to retail investors, effective 1 July 2011. Under these amended rules, "investment unit" sellers, including securities firms, asset management companies, "limited brokers", dealers and underwriters (collectively,"Covered Institutions"), are required to perform "know your customer" and suitability tests before making sales to retail investors. Using this information, Covered Institutions are required to develop a risk profile for each retail investor (and update such profile at least bi-annually), and attempt to match the investor to suitable funds in eight categories (described below). In addition, Covered Institutions are required to distribute a prospectus to potential unitholders. Finally, Covered Institutions must apply their procedures to meet these requirements, in all electronic securities distribution channels.
For purposes of the suitability and "know your customer" tests, funds are to be classified in eight categories of increasing perceived risk:
- domestic money market funds;
- foreign money market funds;
- government fixed income funds;
- other fixed-income funds;
- balanced funds;
- equity funds;
- sector funds; and
- alternative funds.
The suitability process for a particular investor will depend in part on the types of funds about which the investor requests information. For example, suitability tests will not be required for investors interested in only domestic money market funds. In contrast, investors who wish to purchase higher-risk products must agree that they understand the risks of such products. Investors whose risk profiles do not match the investment products they wish to purchase would not be prohibited from buying higher risk products, but would have to sign a waiver in order to do so.
The new rules form part of a broader initiative by the SEC to develop Thailand's capital markets. The success of these rules will depend on how the rules are implemented. The eight categories may require substantial refinement to adequately reflect actual investment risk. For example, it is unclear whether a domestic Thai money market fund would be safer than a diversified international money market fund. Similarly, some higher-yield fixed-income products may be riskier than equity funds. Finally, the paperwork required to comply with these regulations could prove burdensome for potential investors and slow the growth of the domestic Thai fund market, which has nearly doubled since 2005 to nearly $70 billion as of May 2011.6
Singapore – "Delivering Fair Dealing Outcomes to Customers"
In Singapore, the suitability process also depends on the nature of the investment product.7 Under recently approved guidelines, there are two broad categories used to determine whether additional scrutiny is needed for retail investor purchases of more complex products.8
For less complex products, known as "excluded investment products" or "EIPs", intermediaries are not required to conduct various due diligence procedures. A product may be classified as an EIP if it is "established in the market" and has terms and features that are generally understandable by retail investors. The Singapore MAS specifically noted certain products that it believes may not be understood by retail investors, including products that contain derivatives or "innovative features" or that require customers to put up margins that vary depending on the market value of the investment. Products that do not meet the criteria to be considered EIPs will be instead considered "non-excluded investment products or "NEIPs". The MAS has determined that collective investment schemes, other than real estate investment trusts, do not qualify as EIPs.
Sales representatives must conduct additional steps prior to selling NEIPs to retail customers, including requirinig such customers to complete a Customer Knowledge Assessment (for listed NEIPs) or Customer Account Review (for unlisted NEIPs). In particular, customers would be required to disclose their education levels, and any relevant investment experience or work experience with the desired product or similar products. If a sales representative, using information obtained during this process, determines that a desired product is not suitable for a customer, the representative must inform the customer in writing and request confirmation in writing that the customer still wishes to proceed. If the customer proceeds, the representative must inform the customer that various civil law remedies will no longer be available if the customer suffers losses.9 In the case of listed NEIPs, a member of "senior management" who is independent of the account opening process would also be required to sign off on the transaction.10 The MAS views this requirement as more procedural than substantive, noting that it is "unnecessary for the senior management . . . to have in-depth knowledge of the product or the customer to enable them to . . . ensure that appropriate safeguards have been imposed".11 Nonetheless, the potential consequences to senior management are unclear in the case of an investor who may subsequently claim to have been misled during the product selling process.
Unless regulators provide further guidance, distributors in each of these jurisdictions may feel that they have been left to their own devices. It would not be unreasonable for industry participants in such jurisdictions to expect to receive supplemental guidance from the respective local regulator as the new regimes come into effect. The "derivative product" classification in Hong Kong is inherently subjective and may prove difficult to apply. Similarly, in Singapore, the determination of what constitutes an EIP is dependant upon an opinion of what products are "established in the market". In contrast, the framework in Thailand for classifying funds is prescriptive and detailed, although the eight recommended categories may not adequately reflect the relative risks or complexity of the full range of investment products available. In each case, the best approach may be to develop a suitability process that focuses on risks to investors regardless of the regulatory classification of an investment, while at the same time attempting to implement the new suitability regimes.
1 The effective date was extended by the SFC from 4 June 2011.
2 Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission, paragraph 5.2.
3 Professional investors are subject to another regime and would not be subject to the categorisation requirement. For more information on professional investors, please see the DechertOnPoint available at http://www.dechert.com/Financial_Services_Quarterly_Report_-_Asia_03-30- 2011.
4 Stephen Po, Securities and Futures Commission to the Hong Kong Investment Funds Association, dated April 6, 2011.
5 Securities and Futures Commission, "Frequently Asked Questions on the Code of Unit Trusts and Mutual Funds", updated June 11, 2011 available at http://www.sfc.hk/ sfc/doc/EN/faqs/products/FAQs%20on%20UT%20 Code%20_updated%20on%2010%206%2011_%20%20 qs%2027A%20_2_.pdf.
6 "Net asset value and growth of mutual funds 1992- May 2011" as calculated by the Association of Investment Management Companies, available at http://www.aimc.or.th/en/21_overview_detail.php?nid=14&subid=0&ntype=2.
7 The Monetary Authority of Singapore ("MAS") indicated on October 21, 2010 that it would proceed with the requirements discussed herein, but it has not yet indicated when formal implementing guidance will be released. Nonetheless, the MAS stated that it expected that market participants would begin implementing procedures to comply with such requirements immediately, as a best practice.
8 As in Hong Kong, these requirements do not apply to certain sophisticated investors: "accredited investors, institutional investors, expert investors and high net worth individuals who are clients of private banks".
9 Specifically, the representative must inform the customer that he or she cannot rely on Section 27 of the Financial Advisers Act to file a civil claim. Section 27 provides that financial advisers must have a reasonable basis for making any of their investment recommendations.
10 The MAS notes that "senior management" refers to the Chief Executive Officer, Principal Officer or executive directors of the intermediary. MAS, Response to Feedback Received – Policy Consultation on Regulatory Regime for Listed and Unlisted Investment Products, 21 October 2010.
11 MAS, Response to Feedback Received – Policy Consultation on Regulatory Regime for Listed and Unlisted Investment Products, 21 October 2010.
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