Hong Kong SFC Launches Massive Investor Protection Initiative; Starting with Proposed Code for Derivatives Investing

In light of the global financial crisis, the Hong Kong Securities and Futures Commission has launched a multi-pronged offensive to enhance investor protection and provide increased market transparency. The first prong of the offensive is a rulemaking proposal to enhance disclosure to investors about derivatives and other unlisted structured financial products. Later, there will be rulemaking and legislation authorizing the formation of an Investor Education Council and a Financial Ombudsman for dispute resolution. There will also be legislation governing the authorization of products sold to the public.

The proposals are nothing less than a Code intended to cover all unlisted structured products commonly offered to the public in Hong Kong, including equity, credit, and commodity-linked notes, equity-linked investments and equity-linked deposits. In future, where issuers seek authorization in respect of types of unlisted structured products that are new to the market, the Commission will consider these on a case-by-case basis and, where appropriate, consult the new Products Advisory Committee, which would comprise representatives of industry participants and other stakeholders with diverse knowledge and expertise. The Code would also introduce the concept of investors ``with derivative knowledge’’ as determined under criteria listed in the Code. The comment period ends December 31, 2009.

Where necessary, the Commission will engage in further public consultation and publish further guidance on requirements for these types of structured products. The common types of currency-linked and interest rate-linked products issued by banks would fall outside the scope of the Code. Also listed structured products would continue to be subject to the Listing Rules. They are not, and will not be, required to seek the Commission’s authorization.

A broad principle behind the proposed Code is that the investment life-cycle involves multiple parties, such as the product issuer, the selling intermediary and the investor, each of whom must bear some responsibility for the investment that is ultimately made. Issuers would be required to prepare concise and easily understandable summaries of their financial products, what the Commission calls "Key Facts Statements", which would form part of the offering documents. Designed to help investors better understand the products being considered, these would be only a few pages long, which is much shorter than an offering document

The ``Key Facts Statement’’ is a concept akin to the proposal by the Committee of European Securities Regulators (CESR) with respect to the key information document. Both CESR and the Commission intend for these documents to be concise, user friendly and standardized to facilitate comparison between securities products. In principle, noted SFC Chief Executive Martin Wheatly, the Key Facts Statement will comprise part of the offering documents of the product and have equal force and standing as the prospectus, yet it will be limited to only a few pages in length so as to highlight and facilitate investors’ appreciation of the key features and risks of the product.

At the same time, the Commission is aware that some UCITS schemes may already be using a specific form of key factsheet that satisfies their home regulator’s requirement. Since a large proportion of Hong Kong funds are UCITS funds, noted Mr. Wheatly, the SCF would accept these European key factsheet counterparts provided that they provide substantially the same information as required under the Key Facts Statements, and their format and presentation are user friendly and easy to understand.

Selling intermediaries often get incentives from issuers who want their products sold. While there is nothing wrong with salespeople being rewarded for their work, this commercial arrangement poses a potential conflict of interest between the seller and the buyer. The SFC therefore proposes that intermediaries disclose at the pre-sale stage any commissions, fees or other benefits they would earn from the sale of a product. Knowing the rewards or benefits to be received by the selling intermediaries provides greater transparency and provides the investor with relevant information in making investment decision.

The Commission is considering a cooling-off period for some derivative products. This would be a short period, immediately after committing to make an investment, during which investors could change their minds and exit the arrangement. However, to prevent any abuse of the process, investors would have to bear some costs attached to this exit option, such as administrative fees, applicable unwinding costs and any decline in underlying market value of the product during the cooling-off period. The SFC has suggested that the cooling-off period apply only to longer-term products with no ready secondary market. This is because these are the types of products where a cooling-off period might be of most benefit as an investor protection measure. Where products already have an active and liquid secondary market, such as mutual funds, investors could exit the investment if they subsequently change their minds.

Another proposal relates to investor profiling. As part of the know-your-client procedures, intermediaries would be required to seek each client's knowledge of derivatives and characterize those with such knowledge as clients with derivative knowledge. Additionally, the professional investors regime will be reviewed to consider whether or not the assessment criteria for qualifying as a professional investor should be revised.

The proposed Code provides three alternative avenues by which investors may be regarded as having knowledge of derivatives. First, they may have undergone training or attended courses on derivative products. Second, they may have prior trading experience in derivative products, or, third, they may have work experience related to derivative products.

Under the proposed Code, if an investor is not characterized as a client with derivative knowledge, the intermediary could not promote any unlisted derivative products to such a client under any circumstances. When clients who do not have derivative knowledge wish to purchase an unlisted derivative product on their own initiative, the intermediary should warn them about the proposed transaction and provide appropriate advice to them, including assessment of suitability of the transaction, taking into account the client’s personal circumstances such as total portfolio, asset concentration and exposure to a particular market or asset class. The warning and communications with the client should be recorded. However, intermediaries would not be required to seek information about a client’s knowledge of derivatives if no services with respect to unlisted derivative products are envisaged to be provided to that client.

Regarding valuation, the Commission believes that it would be helpful for investors assessing the performance of a structured product if they were provided with regular information about the prevailing market value of their investments. Thus, the Code would require that issuers or their agents make available indicative valuations of structured products on a daily basis throughout their terms. Such indicative valuations would be determined in good faith, on an independent basis, and must be fair and reasonable.

The Commission similarly proposes that, except for structured products with a short term of one month or less, issuers should provide liquidity by way of making firm price quotations for the structured product available to investors at least weekly. Such quotations should be fair and reasonable.

The Commission ensured that the enhanced proposed Code does not represent product or merit regulation, where the regulator judges the merits of an investment product before it is marketed. Similar to the SEC and the FSA, the SFC does not believe that the regulator should become the final judge of the soundness or suitability of a product. In an extreme case, product regulation could be obstructive to market innovation because the regulator may substitute its own preferences for those of investors. Limiting approvals of products to those judged suitable for all types of investors would result in a narrower selection of products available to investors and militate against Hong Kong’s reputation and status as an international financial center.

.