The HKMA and the SFC permit relaxation of suitability and other regulatory requirements while dealing with high-net-worth and experienced investors.
On 28 July 2023, the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) issued a joint circular (Joint Circular) outlining a new streamlined approach for compliance with the suitability and related obligations when dealing with sophisticated professional investors, alongside guidance and FAQ on how to apply the new approach.
When dealing with individual professional investors (Individual PIs), i.e., high-net-worth individuals with a portfolio of at least HK$8 million (around US$1 million), intermediaries are required to comply with the “suitability obligation” when (1) making a recommendation or solicitation to the client or (2) entering into a transaction in a “complex product” for the client. The HKMA and the SFC have supplemented this suitability obligation, contained in the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct), with additional guidance over the years.
Since the bar for qualifying as an Individual PI in Hong Kong is set at a relatively low level and therefore captures a relatively large number of people, this group includes both individuals who have a sophisticated understanding of financial products and markets, and others who do not. Regulatory policy generally has sought to protect individual investors of all types, and the current rules are calibrated such that individual professional investors are treated quite similarly to retail investors. Intermediaries dealing with Individual PIs are therefore not formally exempt from suitability and other investor protection obligations. This exemption currently applies to certain types of corporate professional investors and institutional professional investors who are assumed to have a sophisticated understanding of financial products and markets.
That said, the regulators have recognised that a nuanced approach is needed to account for differing levels of financial sophistication between individual professional investors. In assessing suitability, the intermediaries can take a risk-based and proportionate approach rather than adopting a mechanical exercise of matching the risk return profile of a product to the customer’s assessed risk rating.
However, market participants — particularly from the wealth management and private banking industry — have requested further guidance and a formal approach to granting intermediaries greater flexibility when dealing with extremely high-net-worth and sophisticated Individual PIs.
The Joint Circular introduces a new “Streamlined Approach” to allow intermediaries to benefit from certain relaxations in the regulatory requirements when dealing with such sophisticated Individual PIs.
Eligibility Criteria of Sophisticated Individual PIs
The Joint Circular introduces a new concept of “Sophisticated Individual PI” (SPI), i.e., individuals who meet the following three criteria:
(a) Financial situation
The SPI should have:
- a portfolio of at least HK$40 million (around US$5 million) or its equivalent in any other currency; or
- net assets (i.e., total assets minus total liabilities), excluding primary residence, of at least HK$80 million (around US$10 million) or its equivalent in any other currency.
This can be met looking at the SPI’s own or joint account with their spouse and children, and any investment holding companies they wholly own.
(b) Knowledge or experience
The SPI should have a degree of sophistication to understand the risks of being treated as an SPI by meeting at least one of the following:
- holding a degree or post-graduate diploma in accounting, economics or finance, or a related discipline;
- having attained a professional qualification in finance (e.g., CFA, CIIA, CPWP, CFP, or other comparable qualifications);
- having at least one year of relevant work experience in a professional position in the financial sector in Hong Kong or elsewhere (e.g., being licensed for conducting relevant regulated activities); or
- having executed at least five transactions within the past three years in the same category of investment products as categorised based on their terms and features, characteristics, and nature and extent of risks (Product Category).
(c) Investment objectives
The SPI should not be categorised as a conservative client (e.g., whose investment objective is capital preservation and/or seeking regular income).
Transactions Subject to the Streamlined Approach
Intermediaries can execute investment transactions for an SPI under the Streamlined Approach which meet the Product Category and the Streamlining Threshold requirements (Eligible Investment Transactions):
(a) Product Category
Intermediaries should devise Product Categories to classify investment products based on the terms and features, characteristics, and nature and extent of risks of investment products. These features should be explained to the SPI in a “Product Category Information Statement” (which could take the form of an information booklet or hyperlinks) that the intermediary must provide.
The Product Categories should be differentiated based on the characteristics, nature and extent of risks, and/or to comply with existing product specific regulatory requirements, e.g., (1) accumulators/decumulators, (2) collective investment schemes whose investment objective or principal investment strategy is investing in insurance-linked securities, (3) debt instruments with loss-absorption features and related products, and (4) virtual assets and virtual asset-related products.
The SPI should specify the Product Categories that investment transactions can be executed under a Streamlined Approach. Intermediaries are required to document the choice of the SPI.
Intermediaries should not apply the Streamlined Approach to investment transactions within a Product Category for an SPI, unless the SPI:
- has met the criteria specified under limb (a), (b), or (c) of the “Knowledge or experience” section above; or
- has executed within such Product Category at least five transactions within the past three years (i.e., the limb (d) of the “Knowledge or experience” section above).
(b) Streamlining Threshold
The SPI should specify an acceptable Streamlining Threshold, i.e., a maximum threshold of investment (as an absolute amount or a percentage relative to the SPI’s assets under management (AUM)), with the intermediary that can be executed under the Streamlined Approach.
The SPI should specify a Streamlining Threshold appropriate to the SPI’s circumstances. The intermediary is required to maintain proper records of setting any such threshold, including the SPI’s rationale that provides support for setting such a threshold.
Intermediaries are required to establish and maintain effective systems and controls to ensure compliance with the Streamlining Threshold, in particular:
- ensuring that the gross exposure arising from investment transactions executed under the Streamlined Approach remains at or below the Streamlining Threshold upon execution; or
- using designated accounts (or sub-accounts) to consolidate the SPI’s Eligible Investment Transactions executed under the Streamlined Approach (e.g., ensuring that the gross exposure from all positions remains below the Streamlining Threshold at all times).
Intermediaries should implement measures to detect outsize or material transactions, and issue warning statements to the SPI for these transactions.
They should also review compliance with the Streamlining Threshold at least on an annual basis and alert the SPI if the gross exposure arising from investment transactions executed under a Streamlined Approach, and/or positions maintained in the designated accounts, have exceeded the Streamlining Threshold.
Application of the Streamlined Approach
Before applying the Streamlined Approach, an intermediary should:
- ensure the Individual PI meets the eligibility criteria to be an SPI;
- maintain written records of how the eligibility criteria is met;
- maintain records of all correspondences with the SPI to support the choice of Product Categories and the setting of a Streamlining Threshold by the SPI;
- enter into a written agreement with each SPI for acknowledging and giving consent to be treated as an SPI;
- obtain a written acknowledgement from the client specifying how the SPI criteria is met and the Product Categories and the Streamlining Threshold within which investment transactions can be executed under a Streamlined Approach; and
- fully explain to the SPI the consequences of being treated as an SPI and the SPI’s right to withdraw from being treated as such at any time.
For transactions under the Streamlined Approach:
- in which the intermediary makes a recommendation or solicitation, the intermediary is not required to:
- match the SPI’s risk tolerance level, investment objectives, and investment horizon with Eligible Investment Transactions;
- assess the SPI’s knowledge, experience, and concentration risk in Eligible Investment Transactions;
- provide product explanation, except upon request and/or any material queries raised by the SPI (but should provide up-to-date product offering documents); and
- maintain records documenting the rationale underlying investment recommendations made to SPI.
- in which the intermediary executes transactions in a complex product without recommendation or solicitation, intermediaries:
- are not required to perform product due diligence for investment products falling within the Product Categories specified by the SPI (but for certain investments, should provide at least information related to the key terms);
- are not required to match the SPI’s risk tolerance level, investment objectives, and investment horizon with Eligible Investment Transactions;
- are not required to assess the SPI’s knowledge, experience, and concentration risk in Eligible Investment Transactions;
- are not required to provide product explanation, except upon request and/or any material queries raised by the SPI (but should provide up-to-date product offering documents); and
- can provide warning statements in relation to the distribution of a complex product on an annual basis, instead of a transaction-by-transaction basis.
Annually, the intermediary should also carry out a review to ensure that the SPI continues to fulfil the eligibility criteria and continues to agree that the intermediary executes investment transactions falling within the Product Categories and the Streamlining Threshold specified by the SPI under a Streamlined Approach.
The new Streamlined Approach will likely enable intermediaries dealing with SPIs — such as private banks and wealth managers — to adopt a more flexible approach when recommending or executing investments in complex products. While the Streamlined Approach will provide an avenue for private banks and wealth managers to service their more sophisticated clients in a more efficient manner, compliance with the new requirements will require significant effort to prepare the necessary documents, create internal compliance procedures, and conduct staff training. Intermediaries and their clients may particularly appreciate the flexibility not to provide product explanations or keep records documenting the rationale of investment recommendations, which, under the current suitability rules, led to some complaints regarding the deluge of paperwork required when dealing with highly experienced investors.
Intermediaries who wish to employ the Streamlined Approach will need to identify investors who will be able to meet the SPI eligibility criteria. They will also need to establish and maintain effective systems and controls to ensure compliance with these requirements. Intermediaries should carefully consider how the Streamlined Approach should be implemented under their existing terms of services (including in connection with their existing contractual suitability obligation) and sales procedures, and provide necessary training to staff on how to apply the new approach.