Distribution of Fixed Income and Structured Products

Our Ref: B1/15C
G16/1C
8 February 2018
The Chief Executive
All Authorized Institutions
Dear Sir / Madam,
Distribution of Fixed Income and Structured Products I am writing to share some key observations and good practices in relation to distribution of fixed income and structured products identified during the course of our supervision. In view of the increase in the sale of investment products and increased market volatility recently, Authorized Institutions (“AIs”) are reminded to comply with the expected standards governing the selling of investment products, especially complex and high-risk bonds and structured products as set out below. Further guidance is elaborated in Annex 1.  AIs should maintain effective management oversight and compliance monitoring to ensure product due diligence is properly conducted, and put in place appropriate systems and controls to ensure that the local circumstances and regulatory requirements, as well as other relevant information, are duly considered.  AIs should ensure that sufficient disclosure is made to customers during the selling process, particularly when the product involves special features or complex structure (e.g. high-yield bonds, Chapter 37 Bonds1 ). Staff should be provided with sufficient training and guidance to enable them to appropriately disclose and explain key product information and risks to customers.  AIs should implement proper systems and controls to ensure compliance with suitability obligations, including know your clients, suitability assessment and selling process, and the relevant regulatory requirements and standards applicable to distribution of specific products (such as Chapter 37 Bonds). 1 Referring to bonds listed under Chapter 37 of the Main Board Listing Rules.

 AIs should adopt a cautious approach in selling accumulators and ensure that accumulators are only sold to customers who can fully understand the structure and risks, have the risk appetite for acquiring the underlying assets with leverage (where applicable), and have the ability to withstand the potential financial loss. AIs should provide adequate disclosure and explanation of material information to customers, particularly the worst case scenario and margin requirements, and conduct proper suitability assessment, including assessment of concentration risk2 . AIs are also reminded to be vigilant in selling debt instruments that may be converted to common equity or written down on the occurrence of a trigger event, in particular loss-absorbing capacity (“LAC”) debt instruments that would absorb loss when the issuer is likely to reach or has reached the point of non-viability. AIs should have an adequate understanding of the nature and risks of these products, assign appropriate risk rating, identify suitable target market, and provide adequate training to staff. AIs may wish to note that the HKMA issued a consultation paper on 17 January 2018 on “Rules on LAC requirements for AIs” which suggests that LAC debt instruments are not suitable for retail investors due to the complex nature and riskiness, and proposes that distribution of LAC debt instruments and related products should be restricted to Professional Investors3 that are not retail banking customers. Subject to the outcome of the consultation, the HKMA will introduce appropriate selling restrictions and enhanced investor protections on distribution of LAC debt instruments and related products. Taking this opportunity, your attention is also drawn to the attached circular issued by the Securities and Futures Commission (“SFC”) to licensed corporations (“LCs”) on compliance failures identified in the SFC’s onsite inspections and investigations of LCs’ distribution of complex bonds and structured products (Annex 2). AIs should review the areas of concern as discussed in this circular and the two annexes, and take prompt action to rectify any deficiencies to ensure compliance with the relevant regulatory requirements and standards. AIs are also encouraged to adopt the good practices where appropriate. The HKMA will continue to monitor AIs’ selling practices and follow up with individual AIs concerned. 2 HKMA’s circular “Selling of accumulators” of 22 December 2010 3 as defined in section 1 of Part 1 of Schedule 1 to the Securities and Futures Ordinance

If you have any questions on this circular, please contact Ms Ada Au at 2878-8814 or Ms Florence To at 2878-1582. Yours faithfully, Alan Au Executive Director (Banking Conduct) Encl. c.c. SFC (Attn: Ms Julia Leung, Executive Director (Intermediaries)

---

Annex 1
Key observations and good practices noted in respect of distribution of fixed income and structured products

1. Product due diligence (“PDD”)
    In conducting due diligence of certain bonds, an AI overly relied on the PDD assessment of its Head Office without implementing appropriate measures to ensure that all relevant factors, including local regulatory requirements, were duly taken into account. In certain cases, the assessment of the Head Office was fully adopted without review. For some Chapter 37 Bonds, another AI overly relied on external credit ratings without proper assessment of the complexity and special features of the bonds.  Some AIs failed to adequately consider key product features and risks of some complex and/or high-risk bonds, and assigned unduly low risk ratings to such bonds. Examples include bonds that are subordinated, contingent convertible, below investment grade or unrated, or Chapter 37 Bonds that are complex, risky or illiquid. In some cases, the AIs did not take into account some fundamental factors such as the higher risk associated with the business nature of the issuer and the financial position of the issuer or the credit enhancement provider(s).  A few private banks originally intended to sell certain products (such as contingent convertible bonds) to customers only on an “unsolicited” basis, and therefore did not perform PDD on those products. Nevertheless, this intention was not specified in the policies and procedures, and some sales staff made investment recommendation or solicitation to customers in respect of such products. In another case, the AI’s practice of distributing bonds with extendable or loss absorption features to Professional Investors only was not set out in its policies and procedures.  Relevant functional units, such as Risk and Compliance, were not involved in the PDD process of an AI in respect of individual complex or high-yield bonds.  A few AIs did not maintain adequate records to demonstrate the consideration made during the PDD assessment. For example, they did not maintain documentation to reflect the factors that had been considered or the rationale for modifying the target customers of Chapter 37 Bonds. Good practices  An AI designed a template which included checkpoints to remind staff to identify whether a bond had any special features (e.g. perpetual, Chapter 37 Bonds) and consider imposition of any relevant selling restrictions to facilitate its PDD process.

Annex 1
Regulatory standards
 AIs should establish and implement appropriate and effective systems and controls to ensure that PDD assessment of the investment products should be fair and balanced, taking into account the local circumstances and regulatory requirements, as well as other relevant information that is reasonably available. While AIs may make reference to risk ratings published by independent research companies or credit ratings assigned by credit rating agencies, such ratings should not be the sole factors to be considered1 , and AIs should arrive at their own assessment. Relevant functions, including Risk and Compliance, should be involved in the PDD process.  AIs should put in place robust methodologies for assessing product risk and assigning product risk ratings, with particular attention to factors that may warrant assigning a higher product risk rating2 . In respect of debt securities, any special features or complex structure and the applicable local regulatory requirements should be taken into account.
2. Disclosure of product information
 During the selling process of some bonds, several AIs failed to highlight and explain the key features and risks of the products to the customers (e.g. whether the bond is unsecured, subordinated, callable; any deferred interest payment; priority of repayment; any non-viability loss-absorption mechanism; creditworthiness of the issuers, guarantors and credit enhancement providers). Similar findings were identified in respect of selling of accumulators by a private bank (e.g. worst case scenarios and margin requirements).  Some AIs did not provide any bond offering or product documents to customers during the selling process, or provided such documents only upon customers’ request.  A private bank provided explanatory materials on the features and risks of accumulators to the customers before their first transactions. Nevertheless, it did not require its sales staff to explain the content of the materials to the customers. For some customers who had not invested in a product for several years, the bank did not explain to them the risks and features to ensure the customers well understand the related risks before conducting the transactions.  An AI provided to customers with an integrated set of product materials or fact sheets which contained generic description of the features and risks of different types of products only. The sales staff did not highlight the relevant parts or explain those features and risks applicable to the specific type of product to be distributed. 1 Question 4 of the SFC’s FAQs on Compliance with Suitability Obligations updated on 23 December 2016 2 HKMA’s circular “Product Risk Rating of High-yield Bonds and Related Products” of 9 August

Annex 1
Good practices
 An AI provided sales script to guide sales staff to disclose the key risks associated with different types of bonds (e.g. high-yield bonds and contingent convertible bonds, etc.). Regulatory standards  Where available, AIs should provide customers with up-to-date prospectuses, offering documents/ circulars and other up-to-date documents relevant to the investment products recommended to the customers3 .  AIs should also make adequate disclosure of relevant information in its dealing with customers4 . Among others, this includes disclosure and explanation of key product features and risks to help customers make informed investment decisions.
3. Suitability assessment and selling practices
 In respect of bonds which were perpetual or bonds with long tenor, a few AIs did not take into account customers’ investment horizon when making a recommendation or solicitation of such bonds with low liquidity.  A private bank did not require its sales staff to assess the concentration risk of its customers’ exposure to bond issuers of high credit risk. Another private bank did not have sufficient guidance and controls to ensure that its staff adhere to concentration threshold. As a result, some sales staff solicited customers to enter into new accumulator contracts even though the customers’ exposure had already exceeded the internal concentration threshold. In some other cases, concentration assessment was only performed after the transactions were executed.  For some risk-mismatched Chapter 37 Bond transactions conducted over the phone, no adequate documentation had been maintained to support an AI’s representation that suitable alternatives had been recommended to the customers. Regulatory standards  AIs should ensure that the suitability of an investment solicitation or recommendation for a customer is reasonable in all the circumstances5 . The customer’s personal circumstances that should be considered in the suitability assessment include, among others, investment objectives, investment horizon, risk tolerance and concentration risk. 3 Question 6 of the SFC’s FAQs on Compliance with Suitability Obligations updated on 23 December 2016 4 General Principle 5 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission 5 Paragraph 5.2 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission

Annex 1
 AIs should have rationale underlying investment recommendations made to the customers. Proper records documenting the rationale should be maintained by AIs, and this is applicable irrespective of the channels of communication with the customers. AIs should provide a copy of the rationale for the recommendations made to the customer upon the request of the customer6 .  AIs should properly document the alternative investment products considered or recommended, if any, as records to demonstrate that they have acted with due skill, care and diligence, and in the best interests of the customers7 .  Chapter 37 Bonds, which are meant to target at Professional Investors, are generally unsuitable for sale to retail investors. While a few Chapter 37 Bonds may be high-quality plain vanilla bonds and are reasonably liquid, many are complex, risky and illiquid. The listing documents of Chapter 37 Bonds are not vetted by the Hong Kong Exchanges and Clearing Limited. In distributing such complex bonds, AIs are required to demonstrate that they have performed proper PDD and complied with the suitability obligations. AIs should also refer to the HKMA’s circular on “Circular Issued by the SFC on Distribution of Bonds Listed under Chapter 37 of the Main Board Listing Rules and Local Unlisted Private Placement Bonds” of 1 April 2016.
4. Staff knowledge and training
 An AI did not provide sufficient training to staff and did not implement effective controls to ensure that only staff who were equipped with the requisite knowledge (e.g. through completion of relevant training) could engage in distribution of certain investment products, in particular complex products like LAC debt instruments. Regulatory standards  AIs should not launch new products or engage in new business activities unless they are satisfied that their staff have adequate knowledge of the relevant products, markets and associated regulatory requirements8 .  AIs should provide adequate and timely training and guidance to their staff, and ensure that their staff have a thorough understanding of and are equipped with the necessary knowledge of the products and the relevant internal and regulatory requirements governing the selling process. Additional training may be needed for staff who perform PDD, or sales staff who have to explain to customers the product features and risks of and conduct suitability assessment on complex and risky products. 6 Question 7 of the SFC’s FAQs on Compliance with Suitability Obligations updated on 23 December 2016 7 HKMA’s circular “Guidance on Selling of Investment Products and Handling of Client Securities” of 23 February 2017 8 Paragraph 3.7.4 of the Supervisory Policy Manual module CG-6 “Competence and Ethical Behaviour”

---

Circular
Tel: (852) 2231 1222 Fax: (852) 2284 4660 Website: www.sfc.hk 25 January 2018 Circular to all licensed corporations Compliance failures in the distribution of fixed-income and structured products The Securities and Futures Commission (SFC) has identified a number of compliance failures during its on-site inspections and investigations of the distribution of complex bonds and structured products by licensed corporations (LCs). The SFC reminds LCs to comply with the following expected standards, which are further elaborated in the Appendix. (a) Maintain adequate management oversight and effective compliance monitoring to ensure product due diligence is properly conducted and put in place appropriate measures, systems and controls to ensure that the features and risks of each investment product are duly considered. (b) Provide staff with adequate training on the investment products they distribute and how to appropriately disclose the products’ features and risks to clients, particularly for complex and risky products. (c) Implement proper policies and procedures, ensure sufficient guidance is provided to staff and put in place appropriate monitoring procedures in order to identify when suitability obligations 1 have been triggered. (d) Regularly perform a holistic assessment of the suitability framework to ensure compliance with suitability obligations, which includes management supervision, know your client, product due diligence, suitability assessment, the sales process, record retention and staff training. (e) Maintain adequate records to ensure compliance with suitability obligations and to enable reviews or investigations to be carried out by the LCs, their auditors and the SFC. Suitability assessment is important for investor protection and reviewing compliance with suitability obligations is an SFC priority. The SFC expects the board and other senior management of each LC, including the Managers-In-Charge of Core Functions, to maintain effective oversight of the firm’s business activities and to put in place appropriate systems and controls to ensure full compliance with the relevant regulatory requirements governing the distribution of investment products. LCs should review the areas of concern discussed in this circular and the Appendix and take immediate action to rectify any deficiencies. The SFC will continue to monitor selling practices and will take action against delinquent LCs. Paragraph 5.2 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.
Annex 2

Tel: (852) 2231 1222 Fax: (852) 2284 4660 Website: www.sfc.hk Should you have any queries regarding the contents of this circular, please contact Ms Pauline Chan at 2231 1952. Intermediaries Supervision Department Intermediaries Division Securities and Futures Commission Enclosure End SFO/IS/003/2018
Annex 2

Tel: (852) 2231 1222 Fax: (852) 2284 4660 Website: www.sfc.hk
Appendix
Compliance failures and expected standards in the distribution of fixed-income and structured products Product due diligence To fulfil the suitability obligations 1 , it is crucial that licensed corporations (LCs) conduct proper due diligence to understand the investment products they recommend to clients, taking into account the features and risks of the products. Our inspections and investigations found the following deficiencies. (a) Some LCs failed to consider the special or complex features of certain bonds, for example, by ignoring the contingent write-down or loss absorption features of contingent convertible bonds. Specifically, a number of bonds listed under Chapter 37 of the Main Board Listing Rules (Chapter 37 Bonds) had multiple credit support providers with no material operations or other complex structures 2 the aim of which were to subordinate the bondholders’ rights to those of the credit support provider 3 , and some LCs failed to take these features into account. (b) Some LCs assigned risk ratings to bonds based solely on credit ratings assigned by credit rating agencies. For example, an LC classified some bonds with contingent write-down or loss absorption features as low-risk solely on the basis of credit ratings. (c) Some LCs failed to maintain adequate records to demonstrate they conducted proper due diligence. (d) An LC treated a wide array of structured products, including accumulators and decumulators, as “simple” products (representing the firm’s lowest rating for product complexity) without due consideration of their specific features. Failure to properly perform product due diligence casts doubt on the LCs’ capability to provide appropriate training to their account executives (AEs) who make solicitations or recommendations to clients. In such circumstances, AEs may not be able to provide sufficient and accurate product information. Expected standards (a) Proper product due diligence Among the wide variety of bonds and structured products, some may have complex or opaque features and involve substantial risks, including liquidity risk. LCs should put in place appropriate measures, systems and controls to ensure that the features See paragraph 5.2 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct). Some bonds have both. We have seen structures with up to 100 guarantors with no material operations where if an event of default were triggered, the bondholders’ rights would effectively be subordinated to most of the obligations of the issuer and guarantors jointly and severally.
Annex 2

Tel: (852) 2231 1222 Fax: (852) 2284 4660 Website: www.sfc.hk and risks of each investment product are duly considered 4 . In particular, LCs should not treat all bonds or structured products as plain vanilla and assign the same low risk rating to all of them. LCs should conduct their own due diligence, properly document the work performed and arrive at a fair and balanced assessment by taking into account all appropriate and reasonably available information. (b) Sufficient staff training LCs should be able to demonstrate that they have educated their sales staff about the investment products they distribute and how to appropriately disclose product features and risks to clients 5 . They may want to provide additional training to staff who perform due diligence on complex and risky products and to sales staff who must explain such products to their clients. LCs should not solely rely on having sales staff review offering documents on their own to develop an understanding of such investment products. Triggering of suitability obligations The SFC noted that some LCs did not implement proper policies and procedures to identify when suitability obligations had been triggered and therefore failed to fulfil them when they were triggered. The following deficiencies were noted. (a) Some LCs relied heavily on AEs to determine whether an investment recommendation or solicitation had been given or made to clients and failed to put in place sufficient measures to monitor and assess whether a recommendation or solicitation had in fact been given or made. (b) An LC advised that its AEs generally would not actively solicit or recommend bonds to clients. However, some of its AEs periodically sent lists of bonds to selected clients based upon the clients’ preferences, which amounted to solicitation. Expected standards Solicitation may cover a wide range of acts on the part of LCs. Whether an LC has made a solicitation is a question of fact which should be assessed in each case 6 . The SFC reminds the senior management of LCs that they should ensure staff are provided with sufficient guidance and training and should put in place appropriate monitoring to identify transactions which resulted from a solicitation or recommendation. 4 Answer to question 4 of the Circular on Frequently Asked Questions on Compliance with Suitability Obligations dated 23 December 2016 (2016 Suitability FAQs). 5 Answers to questions 4, 6 and 10 of 2016 Suitability FAQs. Circular on Frequently Asked Questions on Triggering of Suitability Obligations dated 23 December 2016.
Annex 2

Tel: (852) 2231 1222 Fax: (852) 2284 4660 Website: www.sfc.hk Suitability assessment framework The SFC’s inspections noted cases where there were gaps and anomalies in the suitability framework. In other cases, management supervision was inadequate and compliance monitoring was insufficient to ensure that the policies and procedures governing the suitability framework were properly implemented and regularly reviewed and updated. Certain AEs failed to properly explain product features when recommending them. Below are some examples of deficiencies noted. (a) An AE recommended high risk bonds issued by a commercial firm to an elderly client but the client’s preference was to invest in “prudent or safe” products, eg, products issued by government-owned entities. (b) A client indicated her investment objectives as both “capital preservation” and “capital appreciation”, but the AE did not clarify this apparent inconsistency with the client. (c) An AE incorrectly explained a bond’s loss absorption features to an elderly client and did not highlight the possibility of the bond’s book value being written off in certain scenarios. (d) An AE recommended equity accumulators and decumulators to a client and documented the rationale underlying this recommendation as “product aligns with the client’s target asset allocation”. There was no further explanation despite the fact that the client previously indicated a preference to invest in mutual funds and bonds. Further, some LCs distributed Chapter 37 Bonds to clients. The SFC considers that Chapter 37 Bonds, which are meant to target professional investors, are generally unsuitable for sale to retail investors.While a few Chapter 37 Bonds may be high-quality plain vanilla bonds and reasonably liquid, many are highly complex, risky and illiquid. The listing documents of Chapter 37 Bonds are not vetted by the Hong Kong Exchanges and Clearing Limited 7 . In distributing such complex bonds, LCs are required to demonstrate that they have performed proper product due diligence and complied with the suitability obligations. LCs should also refer to the SFC’s circular issued on 31 March 2016 8 when distributing Chapter 37 Bonds 9 . Expected standards Each LC should establish proper systems and controls to ensure compliance with suitability obligations. It is expected to regularly perform a holistic assessment of its suitability LCs need to bear in mind that listing documents of Chapter 37 Bonds are not publicly available, nor are such bond products subject to detailed disclosure requirements under the Main Board Listing Rules. Circular on Distribution of bonds listed under Chapter 37 of the Main Board Listing Rules and local unlisted private placement bonds. In particular, LCs should not take the listing status of Chapter 37 Bonds to denote any commercial merit, a low product risk rating or high credit quality and should not represent the listing status as an endorsement of the offer or the Chapter 37 Bond during the
selling process. They should draw clients’ attention to the prescribed disclaimer in the listing document to assist clients to make an informed decision.
Annex 2

Tel: (852) 2231 1222 Fax: (852) 2284 4660 Website: www.sfc.hk framework and adopt measures to evaluate and ensure adherence to it. The key components of the suitability framework 10 include:
(a) management supervision (eg, corporate governance structure and transaction monitoring); (b) know your client (eg, collecting information about clients and identifying clients who require extra care); (c) product due diligence (eg, new product approval and product removal); (d) suitability assessment (eg, consideration of clients’ profiles as well as the features and risks of recommended products); (e) the sales process (eg, providing all relevant material information to clients and helping them make informed investment decisions, determining whether suitability obligations are triggered, properly explaining why recommendations are suitable and the nature and extent of the risks and taking into account available alternatives when providing advice to clients 11); (f) record retention (eg, retaining proper records to ensure compliance with the suitability obligations 12 and to enable the firm, its auditors and the SFC to carry out reviews or investigations); and (g) staff training (eg, covering internal policies and procedures and the relevant regulatory requirements governing selling practices). The senior management of LCs, including relevant Managers-In-Charge of Core Functions, are reminded that they bear primary responsibility for ensuring appropriate standards of conduct and adherence to proper procedures. They should diligently supervise the distribution of investment products to their clients and enforce prudent policies and rigorous controls to safeguard their business operations and the interests of clients. 10 See 2016 Suitability FAQs. 11 Paragraph 3.4 of the Code of Conduct 12 In particular, as specified in 2016 Suitability FAQs, records should be maintained documenting the product due diligence work, the rationale underlying investment recommendations, information given to clients and responses to material queries raised by clients.
Annex 2