The Obligations and Duties of Investment Advisors Licensed by the SFC. 24 February 2005

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1 The Obligations and Duties of Investment Advisors Licensed by the SFC 24 February 2005 Speech by Alexa Lam Executive Director Intermediaries and Investment Products Thank you for inviting me here this afternoon. Today I wish to talk about how the SFC s mission ties in with promoting the standards of the investment advisory market. Financial Planning Industry Overview The investment advisory industry is a growth industry and a profitable one. There are various factors that support growth. Demographics In terms of demographics, the Government predicts that 25% of Hong Kong s population will be aged 65 or above by the year According to report issued by the Census and Statistics Department 2004, the total fertility rate of HK in 2003 was 925 per 1,000 women, i.e. there will be fewer children to support their aged parents. There is an urgent need for people to plan for their children s education, and their retirement. Investing trends In the past, Hong Kong investors mainly invested in property, shares and foreign currency. However, the low interest rate environment in the past several years and the stock market volatility have encouraged many investors seeking better returns or planning for their retirement, to invest in a wide range of financial products. These include the traditional equity and bond funds, newer funds such as guaranteed funds, exchange traded funds, or even hedge funds. We have also seen a multiplicity of structured products as well as investmentlinked insurance policies (ILAS). Over time, these financial products have become more complex, cutting across traditional boundaries between securities investment, banking and insurance. This trend emphasizes the increasing need for professional investment advice and the important role that investment advisers play in giving their clients suitable advice when selling financial products. 1

2 Market environment The rapid development in IT and information transmission significantly reduces opportunities for arbitrage. The market is becoming more competitive with banks making their considerable presence felt. We also notice a gradual trend that some brokers are diversifying their business to include investment advisory or asset management services in order to adapt to changing market conditions, investor appetite and market trends. Since 1 April 2003, more than 130 brokers have applied to diversify into investment advisory or asset management activities. The upside of this is that a competitive market fosters greater innovation, choice and value-added for investors. The growth of our products market is apparent in the wide range of both authorised and unauthorised products available. There are now over 2,500 SFC-authorised collective investment schemes (including 13 hedge funds) and over 170 investment linked insurance products (ILAS). As the market becomes more sophisticated, and therefore more unforgiving to the average retail investor, investors need investment advisors to guide them through the complex range of financial products to find those that are reasonably suitable and appropriate for them. Let me now talk about our approach to policy and supervision The SFC s approach is to work in partnership with the industry. In regulating, we follow four guiding principles: First, our first and primary mission is investor protection. Investors look to the regulator for maintaining integrity in the market (where market crimes and misconduct is punished) and good transparency of information. So, our job is to regulate the market, and the intermediaries, in such a way as to deliver these results. Second, in regulating the market, we believe in dialogue and understanding. The market is necessarily ahead of us, smarter than we are. We can travel the world and shop for the best regulatory model and rules. But they are not our rules unless the market understands them and a broad consensus is built around them. That s why we put emphasis on working in partnership with the industry. Of course, different market people have different interests and biases. These may or may not coincide with the public interest, the larger needs of Hong Kong. Our job is to seek to balance these interests fairly and responsibly, without fear or favour. 2

3 Thirdly, once these rules and standards are set, we expect the industry to comply with them. In enforcing these rules and standards, we must be fair and consistent. Fourthly, regulation should not stand in the way of market innovation and competition, thus, we must be vigilant on market development and needs, and be open minded enough to recognize that if certain regulations become obstacles to progress, we should change them. Similarly, if there are loopholes, we must plug them. We listen closely to what the market says, and any significant regulatory changes we make are subject to rigorous market consultation. You all have an important voice in Hong Kong and we appreciate your views. Our doors and phone lines are always open. Regulatory Landscape In Hong Kong, three groups of investment advisors provide financial advisory services to the public: (1) SFC licensed investment advisers (2) banks (3) insurance intermediaries. The SFC directly supervises SFC licensed investment advisers only, and therefore my talk today will focus only on this segment. Where we are now Two recent cases in Hong Kong have exposed specific areas of concern. The first is the Court case of Barber Asia Limited v. Susan Field ( Barber Asia ). The second is the SFC s disciplinary action against Towry Law (Asia) HK Limited ( Towry Law ). The Barber Asia case is significant because it is the first time in Hong Kong that an investor has successfully sued an investment adviser for negligent investment advice. Cases like this provide useful guidance in helping investment advisers understand their responsibilities to their clients. They also point to a possible decline in the standards in parts of the investment adviser industry, and highlight the need for investment advisers to adhere to high conduct standards so as to maintain investor confidence. The SFC s role in fighting fraud and mis-selling Theme inspection The SFC conducted a theme inspection last year on a good mix of 15 investment advisory firms with SFC licence, roughly 10% of the total number of firms (about 150) that we license. We focused on looking at the selling 3

4 practices of investment advisers and assessing their compliance with the relevant rules and regulations. A number of deficiencies were detected. In particular: Insufficient work on know-your-client Inadequate due diligence on products being sold lack of proper basis for the investment recommendation the explanation given to the client was not sufficient to enable the client to make an informed decision on the investment Interestingly, our inspection, together with our other investigations, have shown that most of the problematic regulatory issues identified could have been avoided if investment advisers had strictly observed the standards that are already set out in the existing codes and guidelines. Thus, one of the primary objectives of the SFC report published yesterday is to remind investment advisers to follow these requirements very closely. Before I go into the findings, let me stress here that while we found deficiencies among the 10% that we inspected, we cannot and do not draw any inference that the same deficiencies existing among the other 90%. However, the report will serve to remind everyone that the principles of the code and guidelines must be adhered to. The obligations and duties of investment advisors Acting in the clients best interests The Code and Guidelines have set out the following principles: 1. Know your client Collect and record sufficient information of the client s financial situation, investment experience, and investment objectives. If the investment adviser maintains an ongoing relationship with the client, the client s profile should be updated periodically. 2. Product due diligence - Ensure that all material aspects of a product are understood before recommending the product to the client. This duty is more onerous when it is an unauthorized product. 3. Reasonable recommendation - Make recommendations that are reasonably suitable given the client s specific circumstances. Document the basis of recommendation and how the recommended investments would match the client s investment objectives and risk profile. 4

5 4. Help the client make informed decisions - Give the client a proper explanation of the basis of the investment recommendation, as well as the nature and extent of the risks. The consequences of early encashment should be clearly explained. It is not enough to hand over a product brochure and treat it as self-explanatory for the client. 5. Competency - Employ competent staff and provide appropriate training. The overriding principle is to act with due skill, care and diligence in the client s best interest. And in this, we expect management to take responsibility and to play a greater role in ensuring that proper standards of conduct and compliance are adhered to. We call on those who have strayed outside the parameters of the Code and Guidelines to move back to the centre. Next year, 2006, we will do another theme inspection to see if standards have improved. If not, more drastic action may be required. Three areas for further study 1. Client agreements As part of their client management, investment advisers should ensure that they enter into client agreements with all their clients at the outset, setting out the terms, obligations and scope of the services. Our inspection reveals that there are generally insufficient details as to whether the services provided to the client are confined to a one-off trade execution, or whether there would be ongoing review and advice from the IA. We plan to seek the industry s view on the best way to communicate such difference to the investors. 2. Commission Rebates While some investment advisers disclose to clients that they receive commission rebates from product providers, the current market practice is that Investment advisers usually do not disclose to clients the quantum of their remuneration or soft dollar benefits which they receive from product providers. During the theme inspection, we noted that a number of IA firms and/or their staff tended to sell more financial products that rewarded Investment advisers with higher commission rebates. While we cannot conclude that these firms or their staff had put their interests ahead of their clients, it does however raise conflicts of interest issues. We intend to further study the issues involved and then to consult the market regarding the disclosure of commission rebates (including soft dollar rebates) received by investment advisers when selling financial products. There are at least two compelling reasons why we intend to pursue this matter: 5

6 (a) (b) The SFC s Internal Control Guidelines for licensed persons already states that actual or apparent conflicts of interest should be avoided or minimized. Hence, disclosure of commission rebates and soft dollar benefits can address the conflicts of interest issue and enhance client confidence. Hong Kong may be lagging behind international standards in this regard. Such disclosure is mandatory in countries such as Australia and the UK. 3. Professional Insurance Cases such as Barber Asia and Towry Law underscore the duty of care that investment advisers owe to the clients. While we have kept to a minimum financial resources requirements for advisers (on the basis that they do not hold client assets), it is clear that in the event advisers were held liable to their clients for failure of duty, there may not be sufficient resources within the firm to pay compensation, which could be substantial (about 200,000 in Barber Asia, and US$37 million in Towry Law). This is where professional insurance comes in. Of course, this imposes an additional cost layer to the industry and the burden may well fall on the investor, ultimately. That is why we believe we should consult the market. Selling of unauthorized products I now turn to the serious issue of some Investment advisers offering unauthorized collective investment schemes to the public in Hong Kong. Doing so is a clear offence under the Securities and Futures Ordinance (the SFO ). Although there are exceptions under the law, for example, offering unauthorized products only to professional investors, the SFC cannot and will not condone any attempt to use this exception as a camouflage to sell unauthorized products to retail investors. To be more specific, it is not acceptable to simply classify clients as professional investors without having sufficient evidence that this is truly the case. The classic example is when an IA says, Look, we have obtained written confirmation that it is the client who has requested to invest in an unauthorized product. We accept that in some cases this may be the case, but getting client confirmation is not by itself conclusive proof that the IA has not made an offer to the public. The SFC will take enforcement action if we find incidents where an offer to the public has been made. Even where an unauthorized product is marketed to professional investors only, Investment advisers should pay particular attention to their duty to conduct proper due diligence before making a recommendation to their clients. When 6

7 dealing with a professional investor, even though the IA is exempted from complying with the SFO requirement to have prior SFC authorization of the product sold, such exemption does not free the IA from the obligation to provide reasonably suitable advice. This is all the more important for unauthorized products, where the products and the providers have not been vetted by the Commission. We have serious reservations against Investment advisers that try to get around the prohibition under section 103 of the SFO. Be very clear that a licensed IA commits serious misconduct, and a criminal offence if it sells unauthorized investment financial products to the retail public. We will not hesitate to take action against Investment advisers that are involved in such serious breaches. A number of cases already under investigation are likely to be publicized in due course. Going Forward Here is the roadmap (1) The report serves to remind Investment advisers to adhere closely to the requirements in the SFO, the Code of Conduct and the Internal Control Guidelines and provides specific guidance on certain high-level principles. Investment advisers following this guidance should be in a better position to provide Hong Kong investors with access to quality, affordable financial products, based on good advice and appropriate disclosure. We will be back in 2006 with another theme inspection to see where the industry is by that time. (2) Meanwhile we will study and consult the market on disclosure of rebates and commission, professional insurance, and disclosure of nature of services provided. (3) The SFC will continue its efforts to help investors know their rights, responsibilities and risks when seeking advice from Investment advisers. We will continue to educate investors through different channels via the media, workshops, publications and our comprehensive E-IRC (Electronic Investor Resources Centre) website. However, no amount of investor education can help careless investors who rush into seemingly attractive investments without first reading about the disclosed fees and obligations and without understanding the 7

8 Conclusion nature of the product and risks involved. We will be seeking to improve investors awareness in this regard. Change is always difficult. But our market is part of the global market. Investors today demand better service, and high quality intermediaries. If our licensed investment advisers can provide good quality advice, they will come out ahead in the competition. So let s focus on that ultimate objective towards higher standards, and a better market. Thank you. 8

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