Clarification on regulatory expectations and enforcement actions by the Hong Kong Securities and Futures Commission
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On 21 November 2017, the Hong Kong Securities and Futures Appeal Tribunal (Tribunal) issued a much awaited determination in respect of a private bank’s review of disciplinary action taken against it by the Hong Kong Securities and Futures Commission (SFC) in July 2015. The determination clarifies the murky area of fines and sanctions by the SFC and also throws light on the heightened enforcement of financial product suitability regulations by the SFC. This blog post highlights aspects of the determination of interest to us.
The disciplinary action centred on the marketing and sale of accumulators and Lehman Brothers issued or guaranteed financial products between 2003 and 2008. The Tribunal in large measure upheld the SFC’s findings, while reducing the fine by one third and replacing the sanction of a revocation of licence to suspension. The SFC’s position about the determination can be found here.
The Tribunal accepted the multiplier approach – a number of culpable acts or omissions of the same generic nature may attract multiple penalties – used by the SFC in coming to the amount of the fine to be imposed. The Tribunal observed that an institution contravening, say, paragraph 5.3 of the Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct) on three separate occasions in respect of three separate clients, may be penalised for each of those three contraventions. Importantly, the Tribunal was prepared to look at the essence of the failures; if different failures are of the same generic nature they may be consolidated for calculating penalty.
This is where the Tribunal differed from the SFC. The SFC, for penalty purposes, broke down the misconduct in the sale and marketing of accumulators into four discrete areas: “know-your-client” failure, “sufficient-net-worth” failure, “risk profile” failure and “lack of explanation” failure. The SFC took “4” as the multiplier. For each contravention the SFC imposed a HKD5 million fine. With 13 accumulator complaints, the SFC sought to impose a fine of HKD260 million (HKD5 million x “4” x 13). The Tribunal determined, instead, that the four failures were, when considered as a whole, essentially of the same generic nature and came to the same thing: a failure to ensure the suitability of a product. The Tribunal substituted “1” for “4” as the multiplier, accepted HKD5 million for each contravention, and then determined the appropriate penalty to instead be HKD65 million (HKD5 million x “1” x 13).
Standard of Proof in Intermediary Enforcement
The Tribunal’s determination clarified that in intermediary enforcement, and in any corresponding review proceedings before the Tribunal, the SFC needs to establish its case “on a balance of probabilities”, and not the criminal standard of beyond reasonable doubt.
Private Contracts and Regulatory Codes: Can you contract out of regulatory obligations?
The Tribunal accepted the distinction between matters of private contracts and those of a regulatory nature. Acknowledging the judicial sentiment that regulatory codes cannot unilaterally impose a contractual duty on a bank, the Tribunal accepted that non-reliance contractual provisions may provide commercial certainty in contractual relationships, serving a commercial purpose in private law. The Tribunal however noted that its concern was with issues of a regulatory nature; in other words, whether an intermediary has or has not failed to meet regulatory obligations which the entity had accepted pursuant to relevant legislative provisions. For regulatory purposes, it is not permissible to diminish regulatory obligations including those in the Code of Conduct by way of a private contract.
Professional Investors entitled to the same level of prudent advice
Similarly, the characteristics of a bank’s client has no impact on the regulatory obligations imposed on a bank by the Code of Conduct. Even clients who hold out that they have experience in investment matters are entitled to the same levels of prudent advice as clients who do not. The Tribunal further observed that regardless of a client’s classification as a “professional investor” by reference to his worth, the standards of professionalism owed by a bank to him remain the same.
Risk Assessment: Sufficiency of Rating by Credit Agencies
The Tribunal accepted that, when there is little or no turbulence in the market, relying on the “investment grade” of the issuer, as rated by credit agencies, of a derivative product may well be sufficient when assessing its risk. However, this may be insufficient in times of very heightened turbulence – as was the case in mid-2008. Financial institutions are required, in the interests of their clients, to have an understanding of and monitor changes in the market, to be possessed of a certain nimbleness that enables them to give timely advice and information.
The SFC has since the global financial crisis heightened enforcement of financial product suitability regulations. The determination is a helpful reminder of various system and control checkpoints for ensuring suitability and the need to monitor and, where appropriate, update the information and recommendation provided in the sales process, to reflect changing market conditions and increased risks arising in the products, although we believe that they will not be new to financial institutions which have been continually enhancing their systems, controls and processes for better investor protection.
The point about pecuniary penalties is particularly important. It offers some much awaited clarification in this otherwise murky area. The SFC’s Disciplinary Fining Guidelines are generic in nature, and its approach as explained in statements of disciplinary actions are generally high level. While one accepts that the calculation of fines is not a matter of exact science, a clear methodology (such as that found in this determination) should be articulated to guide market expectations.
Prompted by this Tribunal determination, a further explanation by the SFC of its approach to sanctions in different scenarios would be welcome.