Introduction

In the report “Report on the review of licensed corporations providing online brokerage, distribution and advisory services” (the “Report”) issued by the Securities and Futures Commission (the “SFC”) in August 2022, the SFC observed that 98% of the licensed corporations (the “LCs”) surveyed provide online trading. The SFC also observed an increasing trend to use social media platforms for marketing and communication purposes with over 86% of surveyed LCs using self-developed or third-party operated social media platforms, such as Weibo, Wechat and Facebook, to interact with their clients. In view of the increasing demand and adoption of online platforms for brokerage, distribution and advisory services of investment products, the SFC issued “Guidelines on Online Distribution and Advisory Platforms” (the “Guidelines”) in July 2019  which, among the others, provide guidance to the industry on the relevance of the sales suitability regime in the context of online selling.

Suitability of recommendation in an online environment

The suitability requirement applicable to licensed or registered persons are set out in paragraph 5.2 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “Code of Conduct”). It denotes a regulatory standard requiring a licensed or registered person in its recommendation of an investment product to a client, or solicitation of a client in relation to an investment product to ensure that the recommendation or solicitation is reasonably suitable for the particular client.

In making that assessment, the licensed or registered person must have regard to information about the client of which he or she is, or should be, aware through the exercise of due diligence.

In the Guidelines, the SFC makes clear that the sale of investment products on online platforms are subject to the suitability requirement set out in paragraph 5.2 of the Code of Conduct. The Guidelines apply to all LCs who conduct regulated activities via online platforms including all online channels at which the LCs transact and use for presenting information on investment products targeted at Hong Kong investors (hereinafter referred to as “Platform Operators”).

Triggering of suitability requirement on online platforms

Generally, whether a communication regarding an investment product between LCs and their clients trigger the suitability requirement will depend on whether there is a “solicitation” or a “recommendation” having regard to the facts and circumstances of each interaction. In an online environment, the context (such as the manner of presentation) and content of product specific materials posted on an online platform coupled with the design and overall impression created by the content of the online platform would determine whether the suitability requirement is triggered. However, the SFC explained in the Guidelines that the posting of factual, fair and balanced product-specific materials would not in itself amount to a solicitation or recommendation and will not trigger the suitability requirement, whereas the posting of advertisements which include product-specific incentives such as cash rebates and fee discounts would trigger the suitability requirement. This is so in the absence of other circumstances that amount to a solicitation or recommendation in a particular investment product. The suitability requirement would be triggered, for example, where the online platform emphasizes some investment products over others or there have been interactive one-to-one communications involving solicitations or recommendations through the online platform. The SFC sets out in the Guidelines[1] some situations in which the suitability requirement is or is not triggered:

Situations when the Suitability Requirement is triggered

Situations when the Suitability Requirement is not triggered

·         Posting of advertisements with product-specific incentives (such as cash rebates or fee discounts) for transactions in any specific product; ·         Posting of product-specific research reports on any investment product with words such as “Don’t Miss Out!” or “Act Now!”; ·         Persistent pop-ups or flashing in connection with a specific investment product; ·         Presenting a specific list of investment products with an accompanying statement such as “product of risk rating X or below may suit you or match your risk tolerance level” or “these products may suit you or match your risk tolerance level” to clients immediately after the online platform conducts a risk profiling of clients; ·         Upon a client completing the KYC process or provision of information through a client profiling tool, or providing updates to his or her information, the generation of a specific model portfolio with a list of investment products or generating a list of selected investment products which could be perceived to be based on a consideration of the client’s information; ·         Presenting a model portfolio that allocates a percentage of the portfolio to a class of products (e.g., bonds) but there is only one product in that class of product offered by the platform; and ·         Showing the performance of a model portfolio offered by the platform against the performance of the client’s current portfolio held with the platform without the client requesting such a comparison.

·         Providing a direct facility to input stock codes to place orders for exchange-traded products for secondary market trading on the relevant exchange; ·         Posting lists of, and providing access to, investment products and posting factual information such as listed issuers’ corporate information (e.g., announcements, circulars or annual reports) or providing links to such information on the Stock Exchange of Hong Kong Limited’s website or other factual information (e.g., offering documents, notices to investors, annual reports, fact sheets, etc.); ·         Posting lists of investment products that are selected using objective criteria (e.g., performance data, sales figures, research data); ·         Posting advertisements of fee discounts not tied to any specific investment product (e.g., lower subscription fees during a client’s birthday month, time-limited reduced rates or loyalty discounts to reduce transaction fees in general); ·         Provision of objective filters for self-directed research on funds (e.g., geographical location, underlying assets, performance data, risk categories and third party or in-house risk ratings); ·         Posting of non-product specific information such as market news or updates, industry and sector trends, and educational materials; ·         The simple flashing of a “new” icon next to newly published research reports (which may contain views on buy, hold or sell with target prices) or newly issued investment products; ·         Posting model portfolios constructed using objective criteria (e.g., research data, performance data, asset allocation strategies / models) which are not linked to or generated based on information provided by the client; ·         Posting statistics or trends in customer activities involving a particular product that are factual and based on objective criteria and do not put pressure on a client to proceed with a transaction (for example, setting out a list of investment products with a description that “Other clients who bought product A also looked at these products”); and ·         Posting educational materials that are product-specific as long as such materials do not include (standing alone or in combination with other communications) a recommendation of the specific investment product.

 

Discharging the suitability obligations

Once the suitability requirement is triggered, LCs must discharge the suitability requirement at the point of sale or advice in accordance with the existing requirements under the Code of Conduct, which cover the following aspects[2]:

·         Know your client – take all reasonable steps to establish the true and full identity of each of its clients and their financial situation, investment experience and objectives. Examples include information about annual income, liquid assets or net worth in order to assess the clients’ financial situation, the types of investment products in which the clients have invested and the periods over which investments in such products have occurred in order to assess the clients’ investment experience, etc. LCs can discharge this requirement by making reasonable efforts to obtain information from clients;

·         Product due diligence – understand the investment products they recommend to clients and conduct due diligence work in selecting appropriate investment products for each client. When conducting product due diligence, apart from understanding the nature and extent of risks of the investment products, LCs may need to consider market and industry risks, economic and political environments, regulatory restrictions and any other factors which may directly or indirectly impact on risk return profiles and growth prospects of investments depending on the nature of the investment products;

·         Product matching – provide reasonably suitable recommendations to clients by matching the risk return profile of each investment product with the personal circumstances of each client. In doing so, LCs should use their professional judgement to assess diligently whether the characteristics and risk exposures of each recommended investment product (including transaction costs, effect of gearing and foreign currency risks, where appropriate) are actually suitable for the client and are in the best interests of the client, taking into account the client’s investment objectives, investment horizon, investment knowledge and experience, risk tolerance, and financial situation, etc.;

·         provide all relevant material information to clients and assist them in making informed investment decisions, for example, by providing each client with the recommended investment products’ up-to-date prospectuses or offering circulars and other up-to-date documents relevant to the investment, giving proper and fair explanations to client as to why the recommended investment products are suitable and the nature and extent of risks the investment products bear, etc.;

·         employ competent staff and provide appropriate training (the competency requirement also applies to the appointment of agents, consultants, contractors and similar arrangements); and

·         document and retain the reasons for each investment recommendation given to each client.

In discharging the suitability requirement in the context of online selling, Platform Operators should also note in particular (but not exclusively) the following obligations where applicable:

·         act diligently and carefully in providing any advice and ensuring that advice and recommendations are based on thorough analysis and take into account available alternatives (for example, availability of any similar investment products which may be less costly);

·         when providing investment advice to clients, Platform Operators should not take commission rebates or other benefits as the primary basis for soliciting or recommending particular investment products to client;

·         establish a proper mechanism to assess the suitability of investment products via their online platforms. Such mechanism should be holistic (i.e., all relevant factors concerning the personal circumstances of a client, including concentration risk, should be taken into account); and

·         have in place appropriate tools for assessing a client’s concentration risk and such an assessment should be based on the information about the client obtained by the Platform Operators through its know-your-client process and any investment portfolio held with the Platform Operators.

Other points to note

Robo-advice

It is important to note that the Guidelines apply to robo-advice (i.e. automated portfolio construction or model portfolios based on a client’s personal circumstances) provided directly to clients in an online environment using technology tools (i.e. client facing tools). Platform Operators giving robo-advice via client facing tool also need to comply with the suitability requirement at the point advice is given. Algorithms should not therefore be programmed to direct clients towards particular investment products for which the robo-adviser or its affiliates receive higher commissions or other types of compensation. Similar to the above, robo-advisers are subject to, among others, the following obligations:

·         Information for clients - ensure that the investment advisory services offered are accurately described and that sufficient information is provided to investors prior to client on-boarding to allow investors to make an informed decision on whether to employ the robo-adviser’s services. This should include information on the limitations, risks and how key components of its services are generated (e.g. a description of how underlying algorithms operate, any limitations on the algorithm, how a portfolio rebalancing mechanism works and the associated risks).  Investors should also be informed of the degree of human involvement provided (e.g. advice via web-chat);

·         Client profiling - design client profiling tools or questionnaires in order to obtain sufficient information (including, where appropriate, the opportunity for clients to provide additional explanatory and contextual information) to enable the robo-adviser to provide advice that is suitable based on clients’ personal circumstances and put in place proper mechanisms to identify and reconcile inconsistent information provided by clients (e.g., by alerting clients to inconsistencies through popup boxes and allowing the information to be altered, or internally flagging inconsistent information for review and follow-up);

·         System design and development -  effectively manages and adequately supervises the design, development, deployment and operations of algorithms used in digital-advice tools and maintain appropriate documentation concerning the design and development (including modifications) of all algorithms, including their rationale and maintain documented manuals concerning the scope and strategy for the testing of algorithms and records of testing conducted and test results; and

·         Supervision and testing of algorithms - supervise the operation and testing of the algorithms that form the basis of any investment advice it provides (for example, having a documented plan with details on the scope and strategy for the testing, having security measures in place to prevent and detect unauthorized access to the algorithms, etc.).

If client facing tools are not involved, Platform Operators should refer to the requirements applicable to their conduct of regulated activities under the Code of Conduct, etc.

Additional protective measures for unsolicited sales of
complex products on online platforms

The Guidelines require Platform Operators to ensure that any transaction in a complex product (which is defined as an investment product whose terms, features and risks are not reasonably likely to be understood by a retail investor because of its complex structure) is suitable for the client in all the circumstances[3].This obligation should be discharged to the standard applicable to paragraph 5.2 of the Code of Conduct. For the avoidance of doubt, the suitability requirement applies to complex products (except for derivatives traded on an exchange where paragraph 6.5 of the Guidelines is applicable) even where the materials posted online would not otherwise trigger the suitability requirement and no recommendation or advice is given or offered, though Platform Operators dealing with Institutional Professional Investors (as defined in the Code of Conduct) are automatically exempt from the suitability requirement.

Takeaway

Platform Operators or those considering digitalising parts of their business should take note and evaluate the current frameworks for compliance with the Code of Conduct and other relevant guidelines.

 

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.

Published by ONC Lawyers © 2023