14 December 2015 - Post by:Cliff Chow
Suitability is a well-established regulatory concept and an on-going supervisory priority in the UK and Hong Kong among other jurisdictions. Hot off the press is the news that the Securities and Futures Commission (SFC) has issued its conclusions on a consultation that has significant implications for the financial services sector in Hong Kong. The decision is controversial and important for any firm with suitability obligations.
A new clause required in client agreements
On 8 December 2015, the SFC published its conclusions on the Further Consultation on the Client Agreement Requirements. In summary, the SFC has decided to require (by an amendment to the SFC Code of Conduct) licensed corporations or registered institutions to incorporate a new clause into their client agreements.
The clause reads:
“If we [the intermediary] solicit the sale of or recommend any financial product to you [the client], the financial product must be reasonably suitable for you having regard to your financial situation, investment experience and investment objectives. No other provision of this agreement or any other document we may ask you to sign and no statement we may ask you to make derogates from this clause.”
For this purpose, “financial product” means any securities, futures contracts or leveraged foreign exchange contracts as defined under the SFO (the term “leveraged foreign exchange contracts” does not apply to sales or recommendations of those products by Hong Kong banks, although watch this space as the HKMA recently disciplined bank staff for not complying with the provisions of the SFC Code of Conduct relating to these products, even though the provisions did not apply to that bank).
Why? A desire to give aggrieved investors a contractual right to claim damages
The SFC’s intention underlying this change is clear; the clause will enhance investor protection by filling an obvious gap in current investor protection, giving aggrieved investors a contractual right to claim damages if there is a breach of the suitability obligation under the clause.
The consultation follows the SFC’s express disapproval of recent High Court decisions where an alleged breach of the suitability requirement in the SFC Code of Conduct did not give rise to any claim in damages. In both DBS Bank (Hong Kong) Limited v San-Hot HK Industrial Company and Hao Ting HCA 2279/2008, in which Allen & Overy acted for DBS Bank, and Kwok Wing Hai Selina v HSBC Private Bank (Suisse) SA HCCL 7/2010, claimants alleged that certain professional duties (including the suitability requirements) set out in the SFC Code of Conduct had been incorporated into their contractual relationship with the bank and had been breached. The High Court determined (in both cases) that the SFC Code of Conduct did not have the force of law, and that there was no scope for the SFC Code of Conduct to be implied in contract should it contradict any express terms, such as non-advisory and non-reliance clauses, between the parties.
A significant development
The significance of this development should not be underestimated.
- For the first time under Hong Kong law clients of regulated intermediaries may have a claim for breach of contract for an alleged breach of the suitability requirement. In essence the regulatory requirement to ensure a financial product is reasonably suitable will now be a legal obligation.
- The clause will only apply if a solicitation or recommendation is made – and yet the definition of “solicit” or “recommend” under the clause is unclear and could potentially be very broad. Such concerns expressed by respondents to the consultation were put aside by the SFC; “[t]he New Clause is derived from the Suitability Requirement under the Code, which… has been in place for many years and intermediaries should be fully aware of their compliance obligations under it.”
- Given that the clause provides that no other provision of the client agreement or any other document the client may sign derogates from the obligation under the clause, it will likely present significant difficulties for a bank wishing to run a contractual estoppel defence on the basis of non-advisory and non-reliance clauses (“bases clauses”) typically found in client agreements.
To allow time for the regulated intermediaries to review, redraft and re-execute the client agreements, the proposed changes will come into effect after a 18-month transitional period. However, intermediaries are expected to make available revised client agreements for new clients, and make arrangements for existing clients to enter into revised client agreements, as soon as possible. Intermediaries should now start working on incorporating the new clause in their client agreements; the SFC expects the process to complete “well before the end” of the transitional period.
There are other steps that intermediaries could consider taking to mitigate the risks that will arise from these changes.
- Intermediaries could seek express representations and warranties from their clients as to the alleged facts and matters upon which the intermediary has relied in order to assess the client’s suitability to the products concerned. This would not affect the analysis of whether a product or recommendation was suitable, but it would allow the intermediary to bring a counterclaim for damages should the factual matters upon which the intermediary relied prove to be incorrect.
- Any amendments to the client agreement can be expressly stated to apply from the date of the amendments, to make clear that the new clause does not apply to any products sold before then.
- Intermediaries should make clear (and ensure that client facing staff are well aware) that the suitability requirement will only have effect to the extent that any recommendation or solicitation is in fact made.
- Intermediaries should undertake an intensive training and operational exercise to ensure that relationship managers and the sales team do not make any recommendation or solicitation throughout the course of their relations with their clients unless a finding of suitability has been made.
- Intermediaries should re-emphasise the importance of keeping thorough and accurate notes of correspondence with clients, and ensure that the same are properly recorded and archived.
Last thought: is it in any event necessary?
The Control of Exemption Clauses Ordinance and the Misrepresentation Ordinance both provide statutory controls to ensure that any term in a client agreement which seeks to exclude or restrict liability for breach of contract or for misrepresentation is reasonable. Importantly, the former expressly provides that to the extent the Ordinance prevents the exclusion or restriction of liability, it also prevents the exclusion or restriction of liability by reference to terms and notices that exclude or restrict the relevant obligation or duty (i.e. bases clauses).
In other words, the court already has a statutory basis to conclude that bases clauses are unreasonable, and, therefore, that a claim for misrepresentation or breach of duty on the basis that the investment was not suitable could be pursued. Against this statutory background, there is a debate whether there was any alleged gap in investor protection. That debate will shortly become academic.
 The Code of Conduct sets out certain circumstances where no client agreement is necessary e.g. in the case of Professional Investors (15.5) (although these circumstances will change as from March 2016).