Mis-Selling of Financial Products

Banks and Brokerage Firms on the SFC Radar Screen
After the collapse of Lehman Brothers in mid-September and the losses subsequently suffered by retail investors who had bought so-called "Lehman Minibonds" from banks¹ and brokerage firms² (as reported widely in the local and international press since then), questions have been raised about the extent of distributors' responsibility for assessing the suitability of investment products sold to investors.

Mark Steward, the Executive Director of Enforcement at the SFC, gave the key-note speech at the 4th Annual Wealth Management Conference in Hong Kong on 23 October, 2008 and he took advantage of this opportunity to remind all intermediaries (ie banks as well as SFC registered investment advisors) what the requirements are in relation to retail selling of financial products in Hong Kong.

He said (the underlining is ours):

The relevant standards of conduct are contained in the SFC Code of Conduct. The Code applies equally to banks and SFC licensees. The Code sets out nine general principles. These principles underpin the conduct of securities business in Hong Kong. They impose general requirements of honesty, fairness and due diligence. They stress in several places that banks and firms have obligations to act in the best interests of both clients and the market. They make it clear that the primary responsibility to ensure appropriate standards of conduct are maintained lies with senior management.

Under more detailed requirements, the Code obliges firms and banks to ensure staff are fit and proper, properly trained and supervised. The Code also makes it clear that banks and firms are responsible for the acts and omissions of their staff and agents.

The key obligation that relates to the risk of mis-selling is the need for banks and firms to ensure that products are suitable for their clients.

This means banks and firms must know their client's financial situation, investment experience and investment objectives (General Principle 4) and, having regard to that information, "..when making a recommendation or solicitation, ensure the suitability of the recommendation or solicitation for that client is reasonable in all the circumstances" (Para 5.2).

This is the cornerstone obligation for banks and firms engaged in the sale of financial products.

Let me be clear about the requirement of suitability. It does not mean banks and firms must make sure the client has received a copy of the prospectus, or that the client has been given a list of risks attached to the product or signed a form that says they have read the prospectus. These things might be relevant but they do not by themselves satisfy the requirement of suitability.

The onus is on the bank or the firm to ensure the product is an appropriate one for the client given the client's financial situation, investment experience and investment objectives. The Code casts the obligation on the bank or firm to know the product is suitable. The obligation is not on the client.

It goes without saying that the person making the suitability assessment must have appropriate expertise to perform that task; have adequate training and information about the product, understand the product properly and be properly supervised. After all, the client is relying on that expertise and experience when making his investment decision.

He also discussed the requirements in relation to complaint handling:

"[T]he Code requires banks and firms to have in place adequate systems to deal with complaints. In short, complaints must be handled in a timely and appropriate manner; steps must be taken to investigate and respond promptly to the complaint and, if the complaint cannot be remedied, the client needs to be told what to do next, e.g. referring the matter to the SFC or the HKMA (as applicable)",.

and referred the audience to the SFC circular of 19 September, 2008³.

Finally, he discussed what the SFC expects of intermediaries against whom complaints have been made:

"banks and firms should not wait for us to complete our investigations before discussing any potential misconduct issues with us. We encourage banks and firms to undertake their own internal inquiries into their selling practices, to speak to us about the scope of these inquiries and, if necessary, engage external consultants to conduct reviews."

The SFC has conducted two "thematic inspections" of SFC licensed investment advisors in recent years, and emphasised similar points in their reports ^4&5.

ACTION REQUIRED
As indicated in these extracts from Mark Steward's speech, senior management of banks and brokerage firms needs to formulate an action plan in anticipation of more heightened scrutiny of their retail selling operations moving forward.

In the course of our firm's due diligence / review / mock inspection work for clients, we find that most of the compliance manuals / internal rules we review for intermediary clients are usually fairly comprehensive in terms of describing what needs to be done to remain in compliance with the substantive regulatory requirements⁶.

However, senior management would be well advised to satisfy themselves that implementation is as robust as the paperwork.

Soon after the allegations of mis-selling first surfaced, the SFC issued a circular³ reminding brokerage houses and banks of their obligations under the Code of Conduct to ensure suitability of their recommendation or solicitation for investors. The SFC expects that senior management of all licensed corporations and registered institutions will maintain effective control procedures in this regard⁷ and issued a circular reminding senior management of their responsibilities on 29 October⁸, just after Mark Steward's speech.

In our Financial Services Newsletters of June 2007 and again in January 2008, we summarised the requirements of the SFC Suitability FAQs⁹. This document is key to understanding what the SFC expects of senior management.

In the context of retail selling, especially of complex products, this means that before any sales can be made, senior management should be satisfied and preferably verify:

• that the sales force has a very solid understanding of all the mechanical aspects of the products they are selling, including all the risks. Usually this will mean
  • compulsory internal training sessions
  • separate sign-off by a senior manager that each of those individuals involved in the sales process has this solid understanding of the product
• on a case by case basis that it is appropriate to treat a particular customer as a "professional investor"
  
• for retail customers (ie those who do not satisfy these criteria, or who do not wish to be treated as professional investors in any case), that the suitability assessment by the sales staff was thorough, reasoned and correct and in accordance with the guidance issued by the SFC.

In terms of ensuring compliance with the suitability obligations, there is no substitute for frequent, high-quality, interactive, internal training of staff using case examples. Senior management needs to remain vigilant in ensuring that no sales person is permitted to engage in any retail selling unless and until senior management is satisfied that the person is competent.

How can Deacons help Distributors?
Deacons can assist distributors as follows:

Compliance Reviews & Follow-up

• review of internal manuals, rules and procedures for compliance with requirements for retail investors buying complex products and complaint handling
• analysis of gaps between what is required and what is being done in practice by sales staff with retail sales and on complaint handling
• assistance in closing gaps including enhancements to internal approval and monitoring processes

Compliance Training

• creation of focussed training programs and training updates for sales staff

Specific Legal / Regulatory Issues

• advice as to whether there was mis-selling in the case of specific complaints or generally on sales of Lehman Minibonds or other products
• assistance in connection with the handling of formal investigations by the SFC into the conduct of distributors in selling investment products
• representation in any legal proceedings relating to sales of investment products

LegCo Subcommittee Enquiry

• assistance in connection with preparing for the LegCo subcommittee enquiry hearing generally
• preparation of senior management for appearances before the enquiry

Support with HKMA Lehman Brothers-related Products Dispute Mediation and Arbitration Scheme

• advice in preparation for / anticipation of proceedings brought by investors under the HKMA Lehman Brothers-related Products Dispute Mediation and Arbitration Scheme, set up to provide a dispute resolution platform for facilitating resolution of disputes between investors and banks arising out of investments in Lehman Brothers-related investment products, including training of staff to handle mediations

1 referred to by the SFC as "registered institutions"
2 referred to by the SFC as "licensed corporations"
3 Circular to All Licensed Corporations and Registered Institutions (19 September 2008)
4 Report on Selling Practices of Licensed Investment Advisers (February 2005)
5 Report on Findings of Second Round of Thematic Inspection of Licensed Investment Advisers (May 2007)
6 The Securities and Futures Ordinance and the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission and the Management, Supervision and Internal Control Guidelines For Persons Licensed By or Registered with the Securities and Futures Commission
7 Internal Control Guidelines For Persons Licensed By or Registered with the Securities and Futures Commission
8 Circular to all Licensed Corporations and Registered Institutions Regarding Supervision and Risk Management (29 October 2008)
9 Questions and answers on suitability obligations of licensed and registered persons who are engaged in financial planning and wealth management business activities. The full text of the FAQs and the Circular which was issued at the same time can be found on the SFC website