With the introduction of the Suitability Clause on June 8, 2017, financial intermediaries are required to include the clause, as set out below, in their client agreements, according to the amended Code of Conduct for Persons Licensed by or Registered (Code of Conduct) with the Securities and Futures Commission of Hong Kong (SFC).
“If we [the intermediary] solicit the sale of or recommend any financial product to you [the client], the financial product must be reasonably suitable for you having regard to your financial situation, investment experience and investment objectives. No other provision of this agreement or any document which we ask you to sign and no statement we may ask you to make derogates from this clause”.
Under the Suitability Clause, financial intermediaries are contractually liable to their clients for ensuring that financial products solicited or recommended are “reasonably suitable”, and financial intermediaries are prohibited from inserting any provision in the client agreement which derogates from this requirement.
Background
Since the financial crisis in 2008, mis-selling claims have attracted the attention of many regulators around the world, including the SFC. However, in many of the Hong Kong cases, courts held that “non-reliance clauses” and “exclusion of liability clauses” could be relied upon by the financial intermediaries, and therefore duties set out in the Code of Conduct could not be implied into the agreement between the financial intermediary and the client.
The Suitability Clause was introduced as part of the reform by the SFC to enhance investor protection and to allow for the compensation of investors if financial intermediaries breach their obligations on suitability.
Suitability on clients of asset managers
On its face, the Suitability Clause will only apply where a solicitation or recommendation is made by a financial intermediary. The bigger issue however is whether an asset manager should also be subject to the suitability requirement, and therefore the requirement to include the Suitability Clause into its client agreements, given that:
- An asset manager providing discretionary investment management services to its clients does not solicit or recommend any products to the clients (they made that decision for the client); and
- An asset manager providing discretionary investment management services to collective investment schemes (whether authorised or unauthorised) is not subject to the Code of Conduct (and therefore the suitability requirements), but the SFC’s Fund Manager Code of Conduct (which does not impose any suitability obligations).
The application of the suitability requirements for asset managers remain debatable. Yet, in late December 2016 the SFC confirmed that suitability obligations are applicable where financial intermediaries are providing discretionary account services to their clients (which involves the making as well as execution of recommendations).
In that FAQ (frequently asked questions), the SFC further provided that, where the financial intermediary is managing a client’s portfolio in accordance with a mandate or a predefined model investment portfolio established or chosen by the client, the suitability assessment could be conducted on a holistic basis (rather than on each transaction), provided that a rationale of the suitability of the mandate or portfolio in writing is given to the client.
The requirement to conduct suitability assessment and include a Suitability Clause is not needed where the client is an “institutional professional investor” or a “corporate professional investor” (according to Code of Conduct definitions). In the context of an asset manager managing a fund, the client of the asset manager will be typically either the fund or an offshore asset manager acting on behalf of the fund. In order not to trigger the suitability requirements, the asset manager should ensure that the fund or the offshore asset manager is an “institutional professional investor” or a “corporate professional investor”.
Suitability on fund investors
Another common issue is whether the suitability requirements are extended to investors in funds that are managed by asset managers that also market and distribute those funds. The market appears to be divided on this question. Some participants take the view that suitability is required because the asset manager solicited or recommended the fund to investors, and others take the view that suitability is not required because the fund investors are not clients of the asset manager.
The aforementioned views seem to revolve around whether the fund investors are regarded as clients of the asset manager, which depends on definitions contained in the Securities and Futures Ordinance. Regardless of this technical analysis, recent SFC disciplinary action against Benedict Ku Ka Tat (a former employee of The Pride Fund Management Limited) appears to suggest that licensed individuals who fail to conduct suitability assessments when recommending an investor to invest in a fund managed by the licensed corporation to which the person is accredited, would be subject to suitability requirements. Accordingly, asset managers should act cautiously and consult with professional advisers to ensure minimising their regulatory risks.
*Michael Wong is a partner at international law firm Dechert
