Distribution of fixed-income and structured products – have you reached the regulator’s standards?

2 February 2018

LCs

The SFC published a circular on 25 January 2018 on the topic of distribution of complex bonds and structured products by Licensed Corporations (LCs), setting out the results of the SFC’s recent on-site inspections of a number of LCs.

The circular lists out a number of compliance failures when distributing these complex products, which provides a useful starting point for conducting your own in-house review. The SFC also sets out their expectations of the standards that must be met, thereby assisting LCs and their senior management to understand the SFC’s requirements thoroughly.

The areas which LCs have failed to fulfil their responsibilities are further elaborated below, and the circular should be viewed as a call to action for any firms which distribute complex products and undertake a review as necessary, and should take immediate actions to rectify any compliance deficiencies.

Common Areas of Failures

  1. Product Due Diligence
  • Some LCs failed to consider the special or complex features of certain bonds, for example contingent convertible bonds (CoCo Bonds), while some others failed to take the complex features of some bonds into account when selling them to clients, including common ones such as bonds that are listed under Chapter 37 of the Main Board Listing Rules (Chapter 37 Bonds).
  • An LC classified some bonds with contingent write-down or loss absorption features as low risk based on the credit ratings assigned by credit rating agencies solely.
  • Some LCs failed to maintain adequate records to demonstrate they conducted proper due diligence on clients and/or investment products.
  • An LC treated accumulators and decumulators as simple products with the lowest rating for product complexity without considering their specific features or risks to investors.
  1. Triggering of Suitability Obligations
  • Some LCs relied heavily on their licensed persons to determine whether an investment recommendation constitutes a solicitation without having in place proper systems or procedures to check whether suitability obligations have been triggered.
  • Some licensed persons of an LC sent recommendations of bonds to certain clients based on their preferences, but the LC claimed that they do not recommend bonds to clients, thereby demonstrating inconsistencies/discrepancies between the LC’s policies and the licensed persons’ actions.
  1. Suitability Assessment Framework
  • One licensed person recommended high risk bonds to an elderly client, but the client’s preference was to invest in “prudent or safe” products.
  • One client’s investment objectives were recorded as both “capital preservation” and “capital appreciation”, but the licensed person did not clarify this apparent inconsistency with the client.
  • One licensed person did not highlight the possibility of the bond’s book value being written off in certain scenarios to an elderly client.
  • Another licensed person recommended equity accumulators and decumulators to a client whose preference is to invest in mutual funds and bonds, and the rationale for this was documented as “product aligns with the client’s target asset allocation”, which was manifestly incorrect.

Expected Standards from the Regulators

The SFC has reiterated the importance of complying with the suitability obligations, and LCs are reminded to fulfil the SFC’s expectations, where they have been regularly mentioned in SFC’s circulars and enforcement news.

Some explicit expectations from the SFC include:-

  • LCs should not treat all bonds or structured products as plain vanilla and assign the same low risk rating to all of them.
  • LCs should educate and train their sales staff about the investment products they distribute and how to appropriately disclose product features and risks to clients.
  • LCs and their licensed persons should conduct proper due diligence on their clients and the investment products that they recommend.
  • LCs should have in place appropriate monitoring systems to identify transactions which resulted from a solicitation or recommendation.
  • LCs should establish proper systems and controls to ensure compliance with suitability obligations.

Chapter 37 Bonds

Chapter 37 Bonds are debt securities that can only be offered to professional investors in Hong Kong. It is important to note that the listing documents of Chapter 37 Bonds have not been vetted by the Hong Kong Exchange (HKEx). Thus, the listing status of Chapter 37 Bonds should not be taken as an endorsement of their commercial merit and credit quality.

As mentioned in the beginning of this article, some Chapter 37 bonds may contain complex features, as a majority of them have substantial inherent risks including high illiquidity. LCs that are distributing these kind of bonds should ensure that suitability obligations are fulfilled, in full consideration of their customers objectives and risk tolerance, and should not provide potentially misleading or inaccurate information to clients about the nature and risks of the bonds.

LCs are also reminded to carry out sufficient due diligence in order to sufficiently understand the risk return profile of the bonds they distribute or sell before recommending them to clients. LCs must not ask clients to sign declarations that the LCs or licensed persons of the LCs did not solicit or recommend the bonds to the clients, as these declarations are not in the best interests of clients are would be in breach of the SFC’s Code of Conduct.

Know Your Client (KYC)

LCs are required to duly fulfil their KYC obligations as they are fundamental to an LC’s operations and businesses, and LCs should at all times act in the best interests of their clients.

Senior Management

Directors, MICs and Heads of the relevant departments must keep abreast of regulatory changes and be mindful of the relevant requirements and obligations. It must be stressed that senior management bears the primary responsibility for ensuring appropriate standards of conduct and adherence to proper procedures by the LC.

Senior management of LCs should therefore at all times ensure that the distribution of investment products are diligently supervised. The SFC will not hesitate to take enforcement actions against LCs, their senior management and licensed persons if compliance deficiencies and/or failures are found.

We Can Help

Here at Bovill we have deep experience gained through conducting suitability reviews and reviews of the mis-selling of complex products. We can help you in reviewing client files post sale on a sample basis to identify errors, but also assist with preventative measures such as specialist training for the sales force/relationship managers. Also we can help revise your existing compliance systems and controls and your firms management policies and procedures in order to enable you to be in full compliance with the SFC’s rules and regulations.a

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