The SFC's proposals on the sale of complex products shift responsibility to the financial sector, writes Chris Davis

The Lehman Brothers bankruptcy and resulting wave of defaults forced banks to change the way they sell investment products. It also prompted the Securities and Futures Commission (SFC) to review the processes used to clarify who qualifies as a professional investor.

More than 40,000 Hong Kong investors lost more than HK$15 billion when Lehman collapsed and their credit derivative products, or minibonds, became worthless. Questions have since been raised over the rules governing the sale of complex investment products - particularly over who is qualified to buy them.

After a consultation with the finance sector, the SFC recommended a principles-based approach to allow licensed intermediaries to use whatever method they deem appropriate to decide who qualifies as a professional investor. The action subtly shifted the balance of responsibility for overseeing this screening process from the regulator to the financial sector.

By signing on as a professional investor, an individual gets access to a wide range of complex financial instruments. It also means that person has fewer avenues for legal redress if the investment goes bad.

Commenting soon after the minibond incident became global news, SFC chief executive Martin Wheatley said: "I think everyone understands the process for selling structured products, and the documentation that goes with it, had got to a stage where the products were not always ending up in suitable hands. It is generally recognised there is an issue that needs to be addressed."

The SFC says the proposals listed in its consultation paper aim to create flexibility by adopting a principles-based approach. This allows licensed intermediaries to decide for themselves whether an investor meets the relevant assets or experience threshold to qualify as a professional investor.

The principles-based approach does not define what these methods should be, although it does note that firms should maintain proper records of their assessment process.

This will enable any bank or finance firm to show they made a reasonable decision in declaring, after exercising professional judgment, that their clients satisfy the relevant thresholds. The revised rules are expected to be gazetted following a review by the Department of Justice.

"The SFC's recommendations are more of a 'tweak' than a complete revision of the existing rules governing who qualifies as a professional investor. The conclusions might have a small impact on banks selling products to retail investors, but I cannot see it will make any difference to the way private banks operate," said a relationship manager at a Swiss private bank.

"Our clients are not only very wealthy, they are extremely knowledgeable about the different risks involved with different types of investment products."

The SFC recommendations also allow firms to continue with existing practices under the Professional Investor Rules. In the case of high-net-worth individuals, current methods may require accounting certificates or custodian statements showing the investor has sufficient funds and investing experience to meet the professional investor requirements.

Phil Neilson, an industry watcher and chief executive at Elite Capital Solutions Hong Kong, said the SFC's recommendations are forward looking, but could go further. "The SFC paper does a good job of reaffirming the responsibility of licensed intermediaries on matters of accountability, maintaining proper documentation and establishing suitability, but it could go further with the addition of guidance notes," Neilson said.

"For example, there is no position on the amount of assets a client should hold to qualify as a professional investor."

He said the SFC paper leaves intermediaries to make their own decisions on whether an individual qualifies as a professional investor.

"In today's world we are all accountable as licensed practitioners. The industry needs to stand by its duty of care to clients."

Neilson also noted that the investing public needs to shoulder a degree of personal responsibility.

"If someone makes a declaration saying they have assets and the necessary experience and understanding of making investments to qualify them as a professional investor, they should stand by the declaration. It would be helpful to the industry and the public to have SFC guidelines covering these issues," Neilson said.

He said establishing an investor's experience is another area where the SFC recommendations could include guidelines. "You are not able to define if someone is a professional investor without learning about their experience. Establishing a level of investment experience is probably one of the most important single issues," he said. "There are people that receive inheritance money every day, they may have US$5 million to invest, but this doesn't make them an experienced investor."

Ian De Witt, a Hong Kong-based lawyer who successfully represented a client in a highly publicised duty of care and negligence case involving a financial adviser, said he is not a big fan of the professional investor category. "I cannot see what having money has to do with being a professional investor. To me, a professional is one who engages in a job as part of their livelihood, and has real experience. Whether you are wealthy or not is, to me, irrelevant. You can be the richest man in the world, but still not have a clue about the markets," he said.

De Witt added that he is not a keen advocate generally of regulation. "I believe strongly in a free market without government interference. Rather, I would like to see mandatory professional indemnity insurance for all advisers. I also believe that it is up to the investor to ensure he or she understands the advice being given, I am sure that is one of the biggest problems," he said.

While welcoming the SFC's proposals as a "step in the right direction", the Institute of Financial Planners of Hong Kong said low standards in professional knowledge of frontline staff have not been adequately addressed in the SFC's recommendations.

The institute said that the effectiveness of the proposed reforms would be significantly jeopardised without initiatives to improve the professional standards of frontline sales staff.

"Insights from the Lehman minibond investigations suggested that many responsible for selling these products had little understanding of the risk/reward profile of the product and did not appear to have the technical financial skills required to establish suitability of the products being offered to their clients," according to the institute.

"As there is nothing in the consultation paper which is directed at raising professional standards of frontline sales staff, we are concerned that mis-selling of complex products by sales staff may continue despite the proposed rule changes."

People in the industry also say that the SFC recommendations lack clarity. And given that intermediaries may now be required to apply ambiguous standards to vet individuals for the professional investors designation, that might be a problem.

Kerry Ching, a managing director of Fidelity, said characterisation measures included in the SFC's modified regulatory framework require an intermediary to assess a client's knowledge of derivatives.

"In cases where an unsolicited client without knowledge of derivatives wishes to purchase a listed derivative product, an intermediary must explain the relevant risks of the product to the client. If the product is unlisted, an intermediary must warn and advise the client as to the suitability of the transaction," Ching said.

She noted that mutual funds routinely use derivatives for hedging purposes, and might therefore be considered derivative products.

As such, a strict reading of the SFC proposals might mean that investors would have to be defined as a professional investor before they could buy such funds.

24 Apr 2011