Hong Kong: Anatomy of a structured product sale in Hong Kong - are you missing anything?

Last Updated: 9 June 2012
Article by Richard Mazzochi and Minny Siu

Hong Kong boasts an impressive structured products market. However, overlapping regulators, a labyrinth of rules, vocal investors, a new disputes umpire and certain legislators' continued irritation with the financial services industry do not make it easy.

In this alert, we dissect a sale into its critical parts and provide a refresher on the key requirements. We also flag some of the upcoming developments that may, once again, change the way structured products are sold in Hong Kong.

Background

Speak to front desk and they will tell you that compliance gets in the way of a good sale. Speak to compliance and they will tell you that front desk does the same. So "good" means different things to different people. For front desk, it means high value and fast. For compliance, it means the sale will stick if the market turns sour or a regulator starts pointing fingers.

Many high value sales involve derivatives. "Derivative" is the concept most relevant to the actual sales process for a product (whereas the term "structured product" is relevant to the statutory product regulatory pre-approval requirements). Hong Kong regulators have not defined "derivative" so it has its ordinary meaning – roughly, an arrangement linked to a some dynamic (changing) underlying. It is fairly safe to assume that any investment product is a derivative product unless it is a classic collective investment scheme, bond or share.

So how do you sell derivatives efficiently and effectively? By knowing the rules and the traps to avoid.

The rules are changing continually, but they are not difficult once decoded. This alert puts the key selling requirements for a dual-regulated institution into context.

"Hi, what can I do for you today?"

Onboarding / KYC

It is fine to have a conversation with a prospective investor without putting them through the know-your-client (KYC) grinder. However, it must be completed before a transaction takes place or a business relationship (eg account) is established.

KYC involves a complex set of overlapping regulation. For a relationship manager (RM), it means following internal protocols and making clear to new customers that any potential trade is subject to completing KYC.

For compliance teams, it means staying on top of regulatory changes - for example, see our 7 May 2012 alert on the new anti-money laundering and counter-terrorist financing regime.

Recording phone calls

Client orders must be recorded if they are taken by telephone. Those records must be retained for at least three months under the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (SFC Code of Conduct). That period is set to increase to six months.

The Hong Kong Monetary Authority (HKMA) also requires audio recording of the customer risk profiling process and all telephone sales processes. Those records must be retained for at least seven years.

Mobile phones

For now, mobile phones can still be used to take client order instructions, but they are "discouraged" and if used, must be followed up with a verbal or written recording of the instructions.

However, that will probably change soon. The Securities and Futures Commission (SFC) proposes to "strongly" discourage the use of mobile phones to receive instructions, ban mobile phone orders (at least on trading floors, in trading rooms and in usual places of business) and to require verbal (not written) recordings of instructions, as part of the variety of amendments recently proposed.

Cold calling

Unsolicited calls should be avoided. The Securities and Futures Ordinance (Cap. 571) (SFO) and related rules substantially restrict their use. The key principles are as follows:

  • "Unsolicited calls" are those made without the express invitation of the person being called upon. They are generally banned in respect of investment product sales.
  • "Call" is defined broadly and captures phone calls, visits and emails. Assume other communications (eg instant messaging) are also caught.
  • A number of exclusions apply. For example, the following are permitted:
    • Calls to other regulated institutions, professional investors and existing clients (to whom regulated services have been provided in the last 3 years).
    • Calls about securities to existing holders of those securities.
    • Non-interactive promotions by HKMA-regulated banks and other "authorized institutions" (AIs) in relation to leveraged foreign exchange contracts, in accordance with HKMA guidelines.

Speak to us if we can assist with compliance protocols.

Care is also required in relation to contacts provided by others - the Personal Data (Privacy) Ordinance (Cap. 486) and associated regulatory rules restrict the transfer of personal data to unrelated third parties for marketing purposes. A number of recent high profile cases underscore the need for a stringent approach to privacy, including a personal information collection statement.

Vulnerable customers

"Golden Age" (65+) and other vulnerable customers must be given the choice to have the sale conducted in the presence of a companion and/or to have a second sales staff member involved. The customer's choice must be documented.

"I'm looking for an ELN on HSBC – what do you have?"

Essential steps

Equity-linked notes (ELNs) are structured products. Before offering any structured product, there are 7 essential questions that need to be answered:

  1. Has the product been screened and approved internally?
  2. Is it restricted to professional investors only? For many structured products these days (including ELNs), the answer is yes (see our 12 May 2011 alert for further details).
  3. What is the risk rating of that product?
  4. Does that risk rating match the customer's risk profile?
  5. Is the product otherwise suitable for this investor?
  6. Does the customer understand, and are they able to bear, the risks involved?
  7. Have the requirements for sales of derivative products been met?

These questions arise from a combination of regulatory sources including the SFC Code of Conduct, the SFC's FAQ on suitability issued in May 2007 and the HKMA's 13 July 2009 Circular, which extends the suitability requirement to investment products that are not regulated by the SFO.

Most financial institutions have detailed policies and procedures to meet these requirements. The importance of following them cannot be overstated. Speak to any bank involved in the Legislative Council enquiry into Lehman Brothers products (the report is due out soon) and they will tell you why.

However, there is still confusion about when and how to apply the key SFC Code of Conduct requirements. The following flow chart boils down the questions you need to ask for all retail investors.

See our 12 May 2011 alert for more details for further details about the new Hong Kong structured products regime.

Professional investors

Following recent reforms to the SFO, most unlisted structured products - including ELNs - must be authorised by the SFC before being sold to retail investors. The key exceptions are interest rate and currency-linked structured products issued by AIs.

There are two key impacts:

  • An investor must either be a regulated institution or a high net worth investor that meets the requirements in the SFO and related rules to invest.
  • High net worth investors must also be accredited to additional standards set out in paragraph 15 of the SFC Code of Conduct. If not, they can still buy the product - but only if the sales process covers all the mandatory aspects of a sale to retail customers.

The following chart illustrates the two key questions that must be answered before selling to high net worth investors.

Our 16 September 2011 alert explains in detail the changes that have occurred to the high net worth professional investor test and to the accreditation standards in the SFC Code of Conduct.

We are also aware of a soft consultation being undertaken by the SFC with the Hong Kong financial services industry on the professional investor regime, which could further tighten the availability of derivative products to the investing public.

See below for further details.

"What about an accumulator on the same stock?"

Generally, the same principles apply, but there are additional requirements for accumulators and decumulators sold in Hong Kong.

Special requirements

Despite their popularity, accumulators are the current bête noire of the structured products space. They are perceived as highly risky - almost Machiavellian - investments designed as traps for the unwary; rather than the more mundane series of forward contracts (with fairly typical bells and whistles) that they are.

This is evident in the special rules for selling accumulators and decumulators imposed by the HKMA. They include:

  • risk rating - assigning the highest risk rating to those products;
  • investor restrictions - generally only selling them to professional investors with structured products / options experience;
  • concentration limits - not offering them to customers with high concentration levels in those products;
  • alternatives - suggesting alternative products with lower risks and/or less complex structures that address the customer's investment needs;
  • sign-off - having any "risk-mismatch transactions" (which are discouraged) "strongly justified" and subject to senior officer or independent non-credit control unit approval;
  • disclosure - disclosing material product features and risks – including those stated by the HKMA;
  • hedging suitability - verifying that the product is a suitable hedging tool, if that is the customer's intention; and
  • decumulator protections - for decumulators specifically, not giving the impression that they serve as a hedging tool for accumulators and ensuring no breach of the Hong Kong short selling restrictions.

In addition, an "Important Facts Statements" is required for foreign currency accumulators sold by HKMA-regulated institutions under an exemption from the SFO offer authorisation regime.

"I heard you can link a life insurance policy to the market?"

Investment-linked assurance schemes (ILAS) take a variety of forms but essentially involve an insurance policy linked to the performance of funds or other assets selected by the customer. They often have long tenors and lock-in periods.

ILAS are subject to specific regulatory requirements imposed by the SFC and, in the case of those sold by AIs, the HKMA. The selling requirements imposed by the HKMA cover a very wide range of areas including:

  • product due diligence and risk rating;
  • the use of gifts - banned unless for brand awareness or other general purposes, or in the form of a discount on fees and charges;
  • disclosure - product features, risks, fees and charges, cooling off period etc;
  • suitability;
  • sales to vulnerable customers;
  • record-keeping and management oversight; and
  • complaint-handling.

"I am also looking at ETFs"

One of the key issues in selling funds is whether or not they are "derivative products" for the purposes of the special sales requirements in the SFC Code of Conduct.

That question is fairly straightforward for most structured products, but rather difficult for funds that regularly use derivatives across a spectrum that ranges from hedging to achieving an investment outcome synthetically.

After months of industry discussions, the SFC has recently confirmed that it expects distributors of SFC-authorised funds to consider the role that derivatives play in their structure and the duration and extent to which they are being used. While information from the product issuer can be used, the onus remains on the distributor to determine whether or not the fund is a derivative.

Helpfully, the SFC has largely confirmed industry views, stating that:

"a fund that uses derivatives for hedging or cash flow management purposes, or where a fund uses derivatives to a limited extent to enter into a restricted market and does not create any leverage effect, would less likely be regarded as a derivative product."

Of course, a large grey area remains. We speak to clients regularly about this issue, so contact us if we can assist.

"I heard about iBonds – how quickly can you do a sale?"

Execution only?

Lehman Brothers Minibonds demonstrated the impact of a brand name investment. Interest is contagious. An investor may call up their RM and ask for the product by name. Some say this makes the sale an "execution only" trade and wash their hands of any further responsibilities. But is that right?

In the derivatives space, there is no such thing as an "execution only" trade.

Certainly, the requirements are less onerous if a customer asks for a very specific product without any solicitation or recommendation (also known as reverse-enquiry). For example, the suitability test in the SFC Code of Conduct does not apply.

However, a newly added provision in the SFC Code of Conduct requires a warning and suitability advice for all derivative product sales. The SFC Code of Conduct also has, for a long time, required financial institutions to assure themselves that a customer understands the nature and risks of derivative products and can bear those risks and potential losses.

Furthermore, the suitability assessment is increasingly seen as an important step for any complex product trade. For example, the HKMA expects advice on suitability to be given for any sale of accumulators to retail investors – even if it is on a reverse-enquiry basis.

This makes it worth considering a consistent sales process for all but the most vanilla products.

"Is now a good time to buy?"

Advice - licensing

Responding to this type of question is clearly advice and generally requires a Type 4 (dealing in securities) licence from the SFC, unless it can be said to be incidental to licensed dealing or some other exemption applies.

In this case, a short answer with brief reasons would probably be "incidental". However, we recommend telling the customer that:

  • the timing of any investment depends on their personal circumstances and market view; and
  • they should also only make a decision after reading all the offering documents and consulting their usual advisors.

Fiduciary duties

Giving advice can also result in a relationship of trust and give rise to questions of whether fiduciary duties exist. Such duties would substantially expand the role of a typical retail-facing RM. For example, the customer might expect to be contacted and told when to unwind an unfavourable trade or how to invest other assets. There may be difficulties if the financial institution takes a proprietary position contrary to that advice.

Terms and conditions that expressly disclaim a fiduciary relationship are not enough to prevent one from being created. Therefore, in practice, RMs must take extreme care in maintaining appropriate boundaries and making clear the scope of their services and responsibilities.

"Do I get supermarket vouchers?"

Gifts

As a general rule, gifts should not be mentioned during a sale and the answer to this question should be "no", unless there is a discount of fees and charges available.

The reason is that the SFC Code of Conduct prohibits gifts when promoting a specific investment product. Discounts of fees and charges are exempted. Gifts as part of general brand promotion are okay, but during this kind of conversation, it would be difficult to disconnect the gift from the product sales process.

"I don't have much time – just tell me what I need to know"

No one likes fine print. No one enjoys listening to risks. No one wants to hear that they have more work to do. But this is the most critical part of any sale. The trick is to know what needs to be covered and do it efficiently.

Product features

Key product features must be disclosed during a sale. It is not enough to rely on a customer to read the offering documents, although they must be advised to do so.

These features should include anything that is relevant and material to a customer's decision to invest. It is essential to tell the customer the issuer's name and affiliation. Loss scenarios should be illustrated.

There are very specific disclosure requirements for SFC-authorised products in Appendix C to the SFC's Code on Unlisted Structured Investment Products. The HKMA also expects AIs to disclose the following facts in relation to non-SFO regulated investment products:

  • The nature of the product.
  • Whether or not it includes any embedded derivatives or leverage.
  • The product is not equivalent to a time deposit and is not a protected deposit under the Deposit Protection Scheme in Hong Kong.
  • If applicable, it is not principal-protected.

Product features and risks must also be taken into account in the product due diligence process. Training must be provided to staff about each product issue and associated risks.

Risk disclosure

Risks must be disclosed in the offering documents and/or other documents such as general risk disclosure statements and product application forms. The standard of risk disclosure is substantially more prescriptive for retail customers, who receive the greatest protection during the sales process.

Both the SFC and the HKMA have provided sample risk disclosures about particular product types and services. There are specific disclosures required in relation to Renminbi investment, deposit and insurance products, and SFC-authorised products. Risks relating to the issuer and counterparties to embedded derivatives transactions must be explained. Risks associated with offshore transactions should be disclosed.

The standard is particularly high for sales of derivative products, because it does not stop at disclosure. The SFC Code of Conduct requires a financial institution to:

"...assure itself that the client understands the nature and risks of the products and has sufficient net worth to be able to assume the risks and bear the potential losses of trading in the products."

This applies to all customers - there is no exemption for professionals.

Key risks should also be verbally explained during the sales process. Plain language should be used. If the customer could lose all their money, the RM should say so. That warning must be equally prominent to any statement of the maximum expected return of the investment.

It is not enough to provide a "Key Facts Statement" or similar. Customers should also be directed to read the relevant offering documents applicable to the particular type of reference asset involved.

In its 13 July 2009 Circular, the HKMA offered limited relief from its risk disclosure requirements for roll-over and repeat transactions in "relatively simple" products. However, the conditions on that relief (eg timing restriction, waivers and ensuring the customer still understands risks previously disclosed) may make it easier and safer simply to repeat the usual process.

Overseas tax implications

For any overseas products, the RM should advise the customer to obtain tax advice to ensure they are aware of any overseas tax implications.

Commission and affiliations

The SFC Code of Conduct otdetails her information that must be disclosed to investors, including commissions earned on transactions and any affiliation with a product issuer. There are limited exceptions.

There are ways to make disclosure very efficient – for example, including appropriate language in terms and conditions, adopting commission schedules and adjusting term sheet templates. Contact us if we can assist.

"Let's go ahead"

Concentration risk

This is a flexible concept and Hong Kong regulators have not attempted to prescribe a particular threshold or methodology.

The HKMA has advised a "prudent approach" with factors including product type and nature, product risk rating, the customer's investment objectives and risk tolerance level. The requirements in the event of a risk mis-match are to:

  • alert the customer;
  • ask the customer to reconsider their investment (or its size);
  • if the customer chooses to proceed, "justify that the transaction is suitable for the customer in all the circumstances"; and
  • keep a paper trail.

Please also refer to our comments on concentration risk in our 12 May 2011 alert.

Documentation

All relevant offering documents, risk disclosure statements etc must be made available to the customer before any trade and noted on their file. We have seen time and time again that this is one of the strongest defences that an RM and their financial institution have to allegations of mis-selling.

Authority to bind

Any person purporting to act on behalf of a customer must be identified and have their identity and authority to act verified. Standing authorities must be reconfirmed annually.

Account documentation should also include terms and conditions that protect the firm in relation to relying on instructions given by such persons. Contact us if you need the language.

Cooling-off - does it apply to this sale?

There are two cooling-off regimes in Hong Kong:

  1. The mandatory five business day cooling-off period required for all SFC-authorised structured products with a tenor of more than one year.
  2. The "Pre-Investment Cooling-off Period" imposed by the HKMA in May 2010 on sales of unlisted derivative products to "Golden Age" (65+) retail customers and first time retail customers with 20%+ concentration levels, with limited opt-out rights available. This gives eligible customers a two-day window to reconsider their investment.

Customers should be told if they are entitled to cool-off and the process / deadline for doing so. This emphasises the importance of KYC, a clear sales process and promptly providing all the documentation that a customer needs to make an informed decision.

Upcoming developments

The Hong Kong Legislative Council (LegCo) subcommittee enquiring into the sale of Lehman Brothers-related structured products is due to issue its final report soon. That report is expected to recommend further regulatory changes to the sale of structured products - particularly to retail.

Hong Kong regulators may also choose to track overseas developments - for example, the European Commission is undertaking a significant review of the Markets in Financial Instruments Directive (better known as "MiFID"). Relevant proposals include:

  • more rigorous pre-sale assessment – excluding derivatives and other complex products from the presumption that a "professional client" has the necessary level of experience and knowledge to invest;
  • increased protection for certain institutions - preventing municipalities and local public authorities from being treated as "eligible counterparties" (ECPs) (those entitled to the least regulatory protection) and tightening the rules that apply to ECPs by extending information and reporting requirements and imposing a high-level standard of fair conduct to dealings; and
  • higher standards for advisors – requiring advisors to report to their clients about the advice they give (reasons and basis), the costs involved and the nature of the services provided.

As noted above, the SFC is consulting the Hong Kong financial services industry and LegCo on the professional investor regime, which could further tighten the availability of derivative products to the investing public.

The proposals are still at a very preliminary stage, but some of the ideas being debated by industry stakeholders include:

  • raising the bar - raising the monetary threshold for individuals to qualify for professional investor status from HKD8m to up to HKD12m. The transactional experience threshold could also be raised;
  • further protection for individuals – not allowing individuals to waive certain SFC Code of Conduct requirements despite meeting the asset, experience etc tests for professionals;
  • process overhaul - changing the professional investor assessment approach; and
  • licensing - introducing, in the long run, a licensing regime for professional investors in respect of different financial products and markets.

Next steps

Watch this space. The way that structured products are sold in Hong Kong may undergo a further seismic shift. Speak to us if we can help sharpen your policies and procedures, or answer any questions.

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.

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Authors
Richard Mazzochi
 
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