Submission to the Securities and Futures Commission on the Proposed Amendments to the Professional Investor Regime and the Client Agreement Requirements

1. The Consumer Council (CC) takes the opportunity to submit views to the Securities and Futures Commission (SFC) on the consultation paper on proposed amendments to the Professional Investor (PI) Regime and the Client Agreement Requirements in the Code of Conduct (Code) for Persons Licensed by or Registered with the SFC.
2. As an advocate of consumer welfare, CC takes interest in the review of the PI Regime because the definition of PI which serves to distinguish between professional and retail investors, triggers issues of investor protection in relation to financial services and products.
3. This submission provides an overview of what CC considers to be practical concerns to the investing public, as well as response to the specific questions posed in the consultation paper, for consideration of the SFC.

Overview

4. Broadly, CC supports the SFC’s PI review and its efforts to improve, clarify and update the distinction between professional and retail investors. Implementing changes can bring about greater protection and enhance the level of trust that investors/consumers have in the financial industry, given concerns which surfaced during the Lehman Brothers (LB) incident. Of particular concern was whether investors had been inappropriately classified as ‘experienced’ investors and treated as professionals who therefore fell outside the protection mechanisms.
5. For investor protection purpose, CC believes it is necessary to reassess what it is that investors need protection from, whether the retail/professional investor framework actually provides adequate protection to those investors who need to be protected, and how the Suitability Requirement (SR) could address the issue of mis-selling exposed by the LB incident.
6. CC is also very concerned about the apparent lack of balanced views in the consultation paper which throughout stresses the economic benefits brought about by the PI segment of the financial market, and the need to afford more sophisticated investors a greater level of flexibility in their financial arrangements.
7. CC believes that the need of vulnerable and inexperienced investors, who are in less of a position to assess and absorb risk, to receive adequate regulatory protections to foster market confidence should not be taken lightly or overlooked.
8. With regard to the PI regime, CC is of the view that solely applying a monetary threshold in determining PI status is untenable. Such measure excludes from participating in the private placement market a segment of possibly financial illiterate or inexperienced investors while allowing certain investment activities to remain within reach of PIs who are taken to be highly literate in financial matters. Yet increasing the existing monetary threshold do little to differentiate those investors who may require protection, but instead focuses attention on putting boundaries around wealthier investors who might not be financially sophisticated and could be vulnerable. On the other hand, relying on applying the SR would increase regulatory risks as a mechanism inherently carries with it the risk of misuse.
9. Therefore, CC considers that it is necessary for the PI regime to apply both quantitative and qualitative criteria that have regard for investors’ knowledge and investment experience, investors’ wealth and assets, plus an opt-in procedure. This requires the application of appropriate threshold as well as the application of SR. An important condition is that intermediaries can make a proper assessment of an individual’s personal circumstances and find matching investment products of appropriate risk return profile.
10. In our view, the following combination of changes to the existing PI regime would achieve a more desirable outcome in terms of investor protection –
    1. That the monetary threshold be reviewed periodically and increased as appropriate.
    2. That a person who fits the definition of PI be provided with the choice to ‘opt-in’ rather than be informed of (or asked to acknowledge) the status of PI, and be made aware of the ramification of being treated as a PI (that certain investor protection aspects are no longer available).
    3. That the SR be made applicable for both retail and professional investors, but strengthened to ensure compliance of intermediaries in providing appropriate product recommendations, as well as to examine the application of SR for the sale of complex products.
    4. That a feasibility study be conducted to explore the introduction of a product risk categorization regime to improve disclosure standards and facilitate the assessment of risk.
11. Bearing in mind that the majority of the investing public in Hong Kong tends to be relatively unsophisticated and unskilled in financial service matters, CC submits that consideration should be given to examining an investor's ability to acquire specific products as a PI, rather than limiting efforts to assessing what monetary threshold to apply and what investors to apply the SR.
12. Following are CC responses to the specific questions set out in the consultation paper.

Responses to Specific Questions

Question 1: Should Corporate and Individual Professional Investors continue to be allowed to participate in private placement activities?

13. In principle, yes. Investors, who qualify as PIs should be expected to possess sufficient experience, knowledge and expertise to make their own investment decisions and properly assess the related risks, and thereby be capable to look after their own interests and not require the protections given to retail investors.
14. In practice however this argument may not be strong. PIs who qualify solely by meeting the prescribed monetary threshold cannot be taken as more financially literate and have a greater understanding of the operation of the private placement market. Investors should be able to choose to be treated as retail investor or PI, notwithstanding that they meet the monetary threshold.
15. CC believes that an opt-in mechanism (not by way of an acknowledgment at the request of intermediaries) is more empowering to investors and should be incorporated in the PI regime. The opt-in decision would not be a simple matter of ticking a box on a form, but would involve real consideration of the risks involved in deeming an investor to be professional. That is, it embeds a risk management process into the decision. While it would not prevent bad decision making or fraud, it can provide signposts to investors to consider the implications of being treated as a PI.
16. By electing to be treated as PI, investors should also be made sufficiently aware of the consequences of their choices and actions, i.e. they understand the differences in being treated as a PI compared to their rights as a retail investor, prior to any investment being made.

Question 2: Do you think that the minimum monetary thresholds for Corporate and Individual Professional Investors should be increased?

17. Yes, CC supports increasing the monetary threshold limits from their current levels.
18. In our view, the current threshold limits may have become too easy to satisfy, potentially creating perverse outcomes where high net worth investors can be treated as PIs, not because they provide their consent and are sophisticated and knowledgeable, but because they fall within the arbitrary limits relating the size of their investments.
19. While CC acknowledges that wealth is not necessarily an accurate proxy for financial literacy, the monetary threshold can serve as initial objective criteria by which PIs are identified. In any case, CC is of the view that the current threshold limits should be increased as they have not been updated for over 10 years (therefore failure to keep pace with inflation) and is generally not comparable with thresholds in other jurisdictions (the minimum portfolio threshold for individual PIs is lower than that in Australia and Singapore but higher than that in the United Kingdom as noted in the consultation paper). More importantly, because the review is to provide enhancements to the existing PI regime for better investor protection, there is merit from a protection perspective to increase the thresholds.
20. CC is also of the view that it is better to err on the side of caution given the dire consequences which can follow from inexperienced investors who in need of higher levels of investor protection being treated as PIs.
21. As the increases would not prevent investors with low financial literacy from being classed as PIs and therefore not receiving the protection given to retail investors, CC considers that the threshold criteria should be supplemented by a requirement for the investor to opt-in (as mentioned above) to treatment on a PI basis. This would be appropriate to ensure the investors are not unknowingly included within the definition of a PI and understand the consequence of the choice.
22. CC also submits that the monetary threshold should be adjusted to ensure that it reflects level of individual wealth by today’s standards and other factors as appropriate, and be reviewed periodically, for example every 5 years, to continue to remain adequate in the future.

Question 3: Do you agree that intermediaries should observe the Code without exception when they deal with individuals?

23. CC supports this proposal. Our community is changing with growing demand for greater investor protection.
24. In our view, applying the requirement to ensure the suitability of investments to all investors may ensure that the provision of additional protection and disclosure is appropriate regardless of the investor type. CC therefore supports that all Code requirements, including the SR, should be observed by intermediaries without exemption when they deal with individual PIs.
25. As a fundamental requirement, CC believes that intermediaries should assess a client’s personal circumstances to determine whether any investment products they recommended to their clients are suitable and the clients have sufficient financial literacy to understand the recommended products.
26. While the responsibility to assess the individual circumstances of the client relies on an intermediary’s own judgment, CC considers the ability to deliver appropriate recommendation and to have effective governance i.e. verifying the suitability of investments for client, is necessary.
27. Furthermore, it is our view that intermediaries would, however, have a duty of care not to simply allow any investor seeking “PI” status to be classified as such. They would need to be able to demonstrate that they have not acted negligently in agreeing a client “PI” status.

Question 4: Do you agree that investment vehicles wholly owned by individuals and by family trusts should be treated on the same basis as individuals under the Code?

28. CC has no strong views on whether the same protection afforded to the individual should equally apply to corporations that operate as investment vehicles wholly owned by individual PIs and by family trusts.
29. However, CC believes that Code protections should only be dis-applied when intermediaries deal with sufficiently sophisticated investors. It should therefore cater for situations in which ‘corporations’ (particularly small business owners who are generally less sophisticated investors) are clearly disadvantaged under circumstances in which retail investors in a precisely similar position are included in the protection.

Question 5: Do you agree that a principles-based Knowledge and Experience Assessment should dispense with bright line tests concerning dealing experience?

30. CC believes that a more accurate indication of financial literacy would likely involve a detailed assessment of the state of each investor’s knowledge and investment experience, rather than through some rigid bright line tests (e.g. the number of transactions per annum and years of activeness in the relevant market). The proposed change would require intermediaries be satisfied that an investor is adequately equipped with relevant knowledge, and have sufficient investment experience in relevant products and/or markets to be determined a PI, which may help address circumstances where investors be inappropriately classified as PIs.
31. Nevertheless, significant consideration should be given to how best this principles-based test would be properly conducted by intermediaries to make correct assessment of an individual’s personal circumstances. In our view, the uncertainty inherent in a subjective and uncertain test will lead less careful and prudent intermediaries to exploit such a test.
32. To demonstrate our point, the Study Report of the Legislative Council Subcommittee related to the issues arising from Lehman Brothers-related mini-bonds and structured financial products (June 2012) made the following observations:

    “8.5(f) Notwithstanding the policies and procedures put in place by individual RIs [registered institutions], there was evidence that not all the requisite procedures on KYC [know your client] and suitability assessment had been followed in every transaction (e.g. suitability assessment not done before the transaction, special arrangements not carried out in respect of golden age customers, questions in the risk-profiling questionnaires not understood by the investor).”

    “8.5(g) The fact that some individuals who could hardly be assessed as suitable for LB structured products had been sold such products demonstrated that not all RIs had effectively ensured that KYC and suitability requirements had been properly carried out by sales staff in all cases.”

33. CC considers the above mentioned practice is clearly in contrary to the Code under which intermediaries are required to act “honestly, fairly, and in the best interests of clients and the integrity of the market” and cannot demonstrate that, at the time of providing the recommendation, the intermediaries took adequate due diligence to ascertain that the investor understood the investment product and the risks attached to the investment.

Question 6: Do you have any views on the Suitability Requirement?

34. CC agrees that the SR is a cornerstone of investor protection. It is however crucial as to how intermediaries apply the SR and whether a genuine assessment of an investor’s knowledge and investment experience is conducted.
35. In our view, the SR is not easy to apply. For example, how intermediaries would interpret particular experience relevant to a recommended investment; whether an investor’s experience in investing in listed shares can be taken to have the level of sophistication to fully understand the risks of more complex investment products (e.g. collateralized debt obligations).
36. Furthermore, the difficulty with this is that it is very hard to ensure suitability of a product recommendation. Two intermediaries may form a different opinion about for the same investor, depending on the intermediaries’ subjective judgment as to individual investor’s particular circumstances, as well as their perception as to the risk levels of any particular investment products. While acknowledging that intermediaries are made to account for any product recommendation, the subjectivity surrounding the application of the SR may open to abuse or misuse by intermediaries rather than meeting client’s best interest obligations.
37. CC however, is not dismissing the importance of requiring intermediaries to apply the SR when dealing with investors. But what we are concerning is that the LB incident indicates problems which cannot effectively be addressed only by regulating the conduct of intermediaries or expanding the retail/professional investor boundaries in an effort to enhance consumer protections. A more solution should be considered to effectively regulating investment products, particularly those complex and high risk products, to be sold to consumers.

Question 7: Do you agree with the above proposals (i.e. the suitability requirement to be incorporated into client agreements as a contractual term and client agreements should not contain terms which are inconsistent with the Code and should accurately set out in clear terms the actual services to be provided to the client) in relation to the client agreement?

38. Yes. From the fairness point of view, CC considers it is totally inacceptable to have happenings that intermediaries mis-described the actual services to be provided in client agreements for the sake of escaping contractual obligations to clients or restricting the ability of clients to successfully seek compensation. CC therefore supports that intermediaries client agreements should set out in clear terms the actual services to be provided to clients, and that the inclusion of the SR in client agreement as a contractual term to enable clients of an intermediary to bring claims against the intermediary for breaches of the Code obligations.
39. In addition to these proposals, CC considers the recommendation of the LegCo Subcommittee about empowering the regulators to order RIs to pay compensation, should be further explored for enhancing the investor protection.

Other comments

40. An issue of great concern to CC is the failure of RIs to comply properly with relevant regulatory requirements in the sale process, as revealed from the large number of LB related complaints about mis-selling. CC believes that it does not suffice to rely solely on intermediaries to ensure suitability of an investment product for investors concerned.
41. CC is of the view that a feasibility study on introducing a product risk categorization regime should be conducted to assess appropriateness of its adoption in Hong Kong and to draw reference from the latest development in the international arena in order to strengthen the protection of investors. For instance, the Danish Financial Supervisory Authority implemented rules on risk categorization of investment products by color code in 2011. The risk labeling regime would be consistent with a disclosure regulation framework applicable across all investment products, and there are requirements for appropriate product disclosure and warnings to be provided to facilitate investors’ assessment of risk and easier comparison across products. This will help deal with the situation that RIs apply their own methodology for assigning risk ratings to different investment products.

Conclusion

42. In summary, CC considers that the proposals in the consultation paper could provide a greater level of investor protection if embedded with updates of the monetary threshold and application of effective SR on all investor types, as well as a client opt-in mechanism and better product regulations.
43. Last but not least, CC urges that further efforts is needed to educate investors with respect to the difference in the level of protection made available under the retail/professional regulatory framework.