The final word from the SFC on structured product reform - 1 June 2010

The final word from the SFC on structured product reform - 1 June 2010

Hong Kong’s Securities and Futures Commission (SFC) has issued its consultation conclusions on the rules by which it will regulate structured products and the conduct of intermediaries selling those products. The new rules significantly effect the way that products are designed and sold.

The SFC adopted most of what it proposed initially. Issuers owe new obligations to investors during the tenor of a structured investment product.

They will come into effect on a date yet to be published, but issuers will only need to comply with documentation requirements at the time their product programmes are renewed.

Background

The SFC issued its “Consultation Conclusions on Proposals to Enhance Protection for the Investors Public” (Conclusions) on Friday evening, 29 May 2010. The Conclusions follow a consultation paper issued in September 2009 and several months of consultation with industry participants. A summary was set out in our alert - Reform of the sale of unlisted structured products in Hong Kong - the devil is in the detail - 29 September 2009.

This Alert examines the key changes and the departures that the SFC has made from what it proposed in its earlier consultation paper. The changes are complex. They affect:

■the exercise by the SFC of its approval of structured products offered to retail investors;
■the way distributors sell those products to their clients; and
■the obligations of issuers to provide information to investors after the issue of those products.
The Conclusions:

■apply to unlisted structured products (including equity linked deposits), unit trusts, mutual funds and investment-linked assurance schemes;
■do not apply to listed structured products (such as warrants and CBBCs) except that intermediaries must now explain the risks involved as part of enhanced know-your-client (KYC) procedures - see below; and
■include the final version of a Handbook that will govern the SFC’s approval, and after-sale supervision, of unlisted structured investment products, funds and investment linked assurance schemes.
Just to recap

The Conclusions detail the mechanics of a public offer of each category of product. The Conclusions run parallel with another set of conclusions that will remove the statutory regulation of structured products from the Companies Ordinance (CO) to the Securities and Futures Ordinance (SFO). Those parallel conclusions are described in our previous alert - SFC takes tough line on structured product reform - 27 April 2010.

Key features of the Handbook

SFC approval and breaches of the Handbook

The Handbook codifies the principles the SFC will apply in its approval of structured investment products (SIP Code). “Structured investment product” is defined in the Handbook to include a product which is required to be authorised by the SFC under the SFO, or which involves derivative arrangements and is regarded in the market as an equity, index, commodity or credit-linked investment product.

Issuers are required to notify the SFC of all “material” breaches of the Handbook. It does not matter that the breach is of a short duration or caused by factors outside the control of the issuer.

Issuers must cease to issue structured products if they fail to comply with the Handbook and take remedial action. The SFC’s suggested requirement that compensation be paid to investors for any such failure has been removed.

Qualification of an issuer, guarantor and product arranger

The SFC requires a locally licensed dealer to be appointed as product arranger when a structured product is issued by:

■a special purpose vehicle; or
■when neither the issuer nor guarantor is regulated in Hong Kong.
The product arranger must take responsibility for compliance by the issuer with the Handbook.

The second appointment is surprising in the situation where the issuer or a guarantor is regulated by an internationally recognised regulator. The local arranger is likely to be a much smaller, related entity of the issuer or guarantor.

The SFC has clarified that an issuer and guarantor will only be disqualified from acting if any disciplinary hearings “materially affect” the issuer’s or the guarantor’s financial condition, status as a licensed or regulated entity, or ability to perform its licensed on regulated activity.

The SFC will accept financial information being prepared in accordance with internationally recognised financial reporting standards. It will not insist on the use of International or Hong Kong Financial Reporting Standards.

The SFC will not insist that issuers undertake to the SFC that the product is “fair” and “appropriate” or that, the structured product continues to comply with the SIP Code.

There appears to be growing support from the SFC for incorporating by reference information available outside the offering documents. The key is to ensure that investors are notified of, and have access to, such information.

Key Facts Statements (KFS)

The KFS should form part of the offering document “although they may be produced as physically separate documents”. Issuers will be reluctant to detach the KFS from the fuller disclosure in the offering document for fear of being accused that the KFS summary is incomplete. It would be usual to qualify reliance on the KFS issued on its own but the SFC has said “it will not consider it an acceptable practice…to insert disclaimers…with a view to minimising or avoiding liability…”.

It would appear that publishing the KFS separately to the offering document runs the serious risk of criminal and/or civil liability for misrepresentation.

The SFC is prepared to be flexible and permit the KFS to exceed four pages if that is useful for investors.

Helpfully, the SFC has removed its earlier requirement that English and Chinese versions of the offering document be of equivalent standing.

SPV structures

Lehman Minibonds were issued by a special purpose vehicle (SPV). Investors took risk on:

■Lehman as a swap counterparty;
■highly rated credit linked notes (CLNs);
■the credit of a number of local banks and corporations.
There is on-going controversy as to the effectiveness of the mechanism by which payments to Lehman as a defaulting swap counterparty were expressly deferred to payments to the SPV/investors.

Following the Conclusions, a structure of that type would now require:

■extensive disclosure about the swap counterparty (in SFC terminology, the “Key Product Counterparty”) and the swap. It is now clear that a Key Product Counterparty is a party on whom the issuer relies in order to make payments. It does not apply to a “balance-sheet” hedge;
■SFC approval of the asset which secures the obligations of the SPV. The asset must be “liquid and tradeable” - unlisted CLNs are unlikely to qualify. The SFC expects that the collateral will normally be diversified. Investors must be informed of any default in the collateral; and
■SFC approval of the reference asset. A key factor in determining whether a reference asset is eligible is the availability of information about the asset in English and Chinese. Again, it is unlikely the SFC will approve credit as a reference asset.
For these reasons, a structure similar to Lehman Minibonds is unlikely to receive approval.

The SFC has agreed however not to insist that investors in structures of this type must always rank first in right of payment to all other creditors (such as the swap counterparty) of the SPV.

Payment waterfalls will require extensive disclosure, as will any other matter that might impede investors recovering their investment (such as the laws of another country). Lehman Minibonds provide a lesson as how the laws of the United States (which govern the liquidation of Lehman) conflict with the laws of England (which govern the Minibond documents).

Transitional

The Handbook will become effective upon its publication in the Government Gazette but issuers of existing authorised structured products will only need to comply with the Handbook at the time their product programmes are renewed.

The SFC has reserved the right to obtain specific undertakings from issuers when it approves offering documents.

Distribution of structured investment products

KYC - investor characterisation

Except in the case of professional investors, distributors are required to assess their client’s knowledge of derivatives and characterise the client based on their knowledge of derivatives. Factors relevant to determining such knowledge include training, work experience and trading experience.

In the case of an execution only sale of a derivative structured product, if the client does not have derivatives knowledge:

■if the product is listed, the distributor must provide a written or audio-recorded explanation of the risks associated with the structured product to the client; and
■in case of unlisted structured products, the distributor must warn the client and determine whether the transaction is suitable for the client. The distributor should not proceed with an “unsuitable” transaction for the client unless that is the best interests of the client.
This requirement is new and must be satisfied in addition to other existing KYC procedures set out in the Code of Conduct.

Professional Investors

The SFC agrees not to change the existing HK$8 million portfolio requirement.

In determining whether to classify an investor as a “professional”, a distributor may, in addition to the existing factors set out in the Code of Conduct, adopt a holistic approach and take into account the investor’s knowledge and expertise in each different type of product. Helpfully, the SFC recognises that the factors set out in the Code of Conduct are examples only of what is to be taken into account in determining whether to treat an investor as a professional. That assessment is to be updated when the investor ceases to trade in the relevant product for more than two years.

Disclosure of monetary and non-monetary benefits

Distributors must disclose:

■the receipt of any monetary benefit from an issuer (directly or indirectly) as a percentage ceiling of the investment amount (eg “up to x%”);
■the trading profit made on a transaction where the distributor purchases a structured product from an issuer and then sells the structured product to the investor as a percentage ceiling of the investment amount; and
■all other benefits by a making generic disclosure of the existence and nature of the benefits.
The SFC acknowledges that the disclosure of benefits and other mandated information such as the capacity in which the distributor is acting, may be set out in an account opening form or subscription form.

Advertisements

The SFC Code codifies the existing market practice for advertisements. A new requirement is that advertisements must be reviewed by a senior manager of the issuer. The SFC has confirmed its intent that the senior manager will not be personally liable for the accuracy of advertisements. It is unclear how senior managers will avoid liability (it is not proposed to expressly give any comfort in the Handbook). The reality is that there will be considerable focus on the senior manager if any error is found in an advertisement he approves.

Gifts

Distributors may offer to an investor discount fees and charges but not gifts such as supermarket gift coupons and audio visual equipment for the purpose of promoting any investment product.

Audio recording

Audio recording is not mandatory. The SFC has confirmed that the existing record keeping requirements are sufficient.

Transitional

The timing for the changes to the Code of Conduct is:

■restrictions on the use of gifts - three months following the publication of the amendments to the Code of Conduct in the Government Gazette;
■commission refund obligation - when the SIP Code takes effect; and
■all other requirements - 12 months following publication in the Government Gazette.
After-sale supervision

Ongoing disclosure

Issuers, guarantors and Key Product Counterparties must disclose:

■annual and interim financial statements - only summaries of those statements need to be translated into Chinese (if not in Chinese); and
■if published, quarterly financial statements and other financial information that is required to be publicly filed - no translation is required if made available in English.
This reflects the existing practice for issuers and guarantors of listed structured products. It can be a time consuming (and, in the case of translations, costly) process.

An issuer and guarantor must keep the SFC and investors informed of changes in their financial condition which would reasonably be expected to have a material adverse effect on their ability to perform their obligations under the structured product. The SFC does not propose to make available to issuers a website for the dissemination of information to investors. Issuers must instead determine how to efficiently disseminate that information in a timely manner.

Cooling-off - two regimes

Under the Handbook, cooling-off:

■must be provided for all SFC-approved unlisted structured products with a scheduled tenor of more than one year;
■applies during the period commencing five business days after the investor places an order for the structured product; and
■entitles the investor to receive a refund of the principal invested and sales commissions paid less a market value adjustment (including any swap break costs) and a reasonable handling fee to cover the administrative costs of the issuer and distributor.
The Hong Kong Monetary Authority (HKMA) issued on 20 May 2010 its own pre-sale cooling-off rules for implementation by all banks no later than 1 January 2011. The HKMA’s rules differ from those of the SFC in that they apply:

■to all unlisted derivative products (whether or not approved by the SFC);
■only in the two calendar day window before the investor buys the structured product. The SFC’s rules apply after the structured product is purchased; and
■only to retail customers aged 65 or above and to first-time buyers. Even then, the rules may not apply if the investor’s investment in structured products is less than 20% of his aggregate investments. The SFC’s post-sale cooling-off rules apply to all retail customers.
Market-making and indicative valuations

The SFC will not require issuers to provide daily indicative valuations of the structured product. The Issuer must instead provide indicative bids on a bi-weekly basis for all structured products with a scheduled tenor of more than six months. Bids are not required if the pricing is affected by market disruption or suspension of trading. Bids may be subject to intra-day change.

Firm bids must be provided upon request made by an investor on a market-making day. The issuer may set reasonable maximum order sizes or a maximum aggregate buy-back limit on a given market-making day.

Issuers are to decide whether to use websites or other means by which to communicate bid prices to investors.

Summary

All the changes have been expected for some time and have been extensively debated. There are welcome modifications to the SFC’s original stance including:

■flexibility concerning the length of the KFS;
■clarification about the obligation of an issuer and guarantor to disclose changes in financial condition and the need to translate financial information;
■clearer rules as to the obligation to make a market in the structured product; and
■recognition of existing practices concerning KYC.
Mallesons Stephen Jaques will shortly conduct client seminars explaining the proposals in detail.