Financial Services Quarterly Report - Second Quarter 2017: Hong Kong Consultation on Guidelines on Online Distribution and Advisory Platforms

by Dechert LLP
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The use of online platforms for distribution of financial products has become increasingly popular in Hong Kong. In May 2017, the Hong Kong Securities and Futures Commission (SFC) issued a Consultation Paper inviting comments on investor protection measures with respect to financial products offered on online platforms.1 The Consultation Paper aims “to introduce a specific set of guidelines (Proposed Guidelines) applicable to all SFC-licensed or registered persons when conducting their regulated activities in providing order execution, distribution and advisory services in respect of investment products via online platforms (Platform Operators).” The Proposed Guidelines potentially affect a broad variety of fund managers and distributors. If the consultation proposals are adopted, Platform Operators will need to conduct a review of their current operations and make appropriate changes in order to comply with the requirements in the Proposed Guidelines.

Core Principles

The Proposed Guidelines focus on governance and controls, suitability, and sale of complex products on online platforms on an unsolicited basis. The Proposed Guidelines identify six core compliance principles for Platform Operators, relating to their online platform’s:

(i)      Proper design;

(ii)     Provision of clear and adequate disclosures;

(iii)    Risk management regarding reliability and security;

(iv)    Governance and operational control;

(v)     Ongoing supervision and monitoring; and

(vi)    Maintenance of proper records.

In addition to these core principles, the Proposed Guidelines clarify when suitability requirements are triggered and how such requirements may be discharged by Platform Operators.

Suitability Requirements

Platform Operators currently providing execution-only services need not conduct suitability assessments of users who access product information on the online platform. However, after the implementation of the Proposed Guidelines, suitability requirements may be triggered even without the Platform Operator’s provision of investment recommendation or advice. Given the degree of reliance investors place on product information and materials posted on the online platform, the SFC proposes to consider the overall design and impression created by the online platform to determine whether suitability requirements are triggered.

The Proposed Guidelines clarify that suitability requirements are not triggered by the mere posting of factual, fair and balanced materials by online platforms of non-complex financial products (as defined below). However, where product-specific materials are not factual, fair and balanced, or where there are circumstances that may reasonably be expected to influence investors to purchase a specific investment product (e.g., where the platform emphasizes some investment products over others), then suitability requirements will be triggered.

Robo-Advice

Apart from product distribution and order execution, the SFC is aware that Platform Operators may also provide investment advice using automated portfolio construction or model portfolios based on clients’ personal circumstances (Robo-Advice) generated by algorithms and other technology.

Where advice is given, the existing suitability requirements under the SFC’s Code of Conduct2 continue to apply. The Proposed Guidelines clarify that providers of Robo-Advice (Robo-Advisers) should ensure that the description of their services is accurate and that sufficient information is made available to investors prior to client-onboarding. The Proposed Guidelines aim to assist investors to make informed decisions regarding the use of Robo-Advisers. This might include, for example, requiring disclosure of: (i) information as to the limitations and risks of Robo-Advice; (ii) how underlying algorithms operate; (iii) how portfolio rebalancing mechanisms work; and (iv) the degree of human involvement.

In addition to the above, the Proposed Guidelines set out issues to which Robo-Advisers should pay particular attention, such as: the way in which client profiles are assessed; the design and development of the system used in provision of financial advice; supervision and testing of algorithms; and operation of the rebalancing process.

Sale of Complex Financial Products

The Proposed Guidelines introduce additional requirements applicable to the sale of complex financial products on online platforms where no solicitation, recommendation or advice has been provided by the Platform Operator. Complex financial products refer to products whose terms, features and risks are not reasonably likely to be understood by retail investors because such products are not “plain-vanilla” or are difficult to value.

Complex financial products are not necessarily riskier than simple financial products. However, the SFC takes the view that because of their complexity, suitability requirements are triggered even though no investment advice will be provided to potential clients. The SFC notes that in a traditional offline environment, sales of complex financial products would typically involve solicitations or recommendations triggering suitability requirements, whereas in an online environment, an investor’s understanding of a financial product depends mainly on his or her ability to comprehend the posted information.

Accordingly, the Proposed Guidelines require Platform Operators to take steps to ensure that any transaction in a complex financial product (other than derivative products traded on an exchange) is suitable for purchase by the client accessing the information. Suitability requirements would apply even where the materials posted on an online platform would not otherwise trigger such requirement and no recommendation or advice is offered.

Currently, under the Code of Conduct, intermediaries are not required to comply with the suitability requirements for clients that fall within the categories of “institutional professional investors” or “corporate professional investors” (as defined in the Code of Conduct). This exemption from suitability requirements will continue to apply where the information is provided via the online platform, but (similar to the current Code of Conduct position) suitability requirements would apply where the information is provided to “individual professional investors” (as defined in Code of Conduct).

The Proposed Guidelines would require Platform Operators to provide certain basic and key information, which includes:

  • The nature of the product;
  • Key terms and features;
  • Key risks;
  • Whether the product is available only to professional investors;
  • Whether there may be a risk of losing more than the amount invested;
  • Any penalties for early exit; and
  • Availability of a secondary market.

Set out below is a non-exhaustive list of examples of financial products currently categorized by the SFC as complex or non-complex:

Non-complex financial products:

  • Shares traded on the Stock Exchange of Hong Kong (SEHK) or overseas exchanges, which are subject to the oversight of a regulator that is a signatory to the IOSCO Multilateral Memorandum of Understanding Concerning Consultation and Cooperation and the Exchange of Information;
  • Non-complex bonds;
  • Funds authorized by the SFC under the Code of Unit Trusts and Mutual Funds (UT Code) (including exchange-traded funds) that do not use financial derivatives extensively for investment or non-hedging purposes; and
  • Real-estate investment trusts authorized by the SFC.

Complex financial products:

  • Futures contracts;
  • Equity derivatives listed on the SEHK;
  • Synthetic exchange-traded funds and futures-based exchange-traded funds authorized by the SFC and listed on the SEHK;
  • Leveraged and inverse products authorized by the SFC and listed on the SEHK;
  • Complex bonds – these include (among others): bonds with special features (e.g., perpetual, subordinated or callable bonds); bonds with variable or deferred interest payment terms or extendable maturity dates; bonds that are convertible or exchangeable or with contingent write down or loss absorption features; and bonds with multiple credit support providers and structures;
  • Funds authorized by the SFC under the UT Code that use financial derivatives extensively for investment or non-hedging purposes;
  • SFC-authorized hedge funds;
  • SFC-authorized unlisted structured investment products; and
  • Collective investment schemes and other structure products not authorized by the SFC (this would include retail funds from other jurisdictions unless the funds have been authorized by the SFC).

Implications of the Proposed Guidelines

Platform Operators providing execution services for financial products should review the materials they currently make available to users via online platforms to determine whether such products fall within the SFC’s definition of complex or non-complex financial products. Where execution-only services of non-complex financial products are provided, Platform Operators should assess whether product information is presented in a factual, fair and balanced manner so as not to trigger suitability requirements.

Robo-Advisers should consider whether the platform’s design includes a comprehensive methodology for risk profiling of clients and investment products that would comply with the Proposed Guidelines.

Timeline and Implementation

The Consultation Paper is open for comments until 4 August 2017. The SFC will review responses and release consultation conclusions. Once the Proposed Guidelines are finalized and adopted, there will be a 12-month transition period before full implementation.

Footnotes

1) Consultation Paper on the Proposed Guidelines on Online Distribution and Advisory Platforms (8 May 2017) (Consultation Paper). In some instances, this article tracks the Consultation Paper without the use of quotation marks.

2) Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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