SFC Proposed Guidelines for Online Platforms and their Implementation

Delivery of financial services through online platforms is becoming a norm and is further facilitated by extensive penetration of smart phones in Hong Kong. This means, like any other social situation, the face to face interaction is replaced by electronic information and communication. So, the question arises whether Securities and Futures Commission’s (the “SFC”) current regulations are robust enough to protect investors when the service delivery is through faceless online channels. SFC believes that though its conduct guidelines are principle based, it would still be appropriate to state specific operational parameters for online platforms. Therefore, SFC has issued a consultation paper for the proposed guidelines (the “Guidelines”) for online platforms.

The purpose of the Guidelines is to provide clarity on the design and operations of the online platforms. These Guidelines will apply to all licensed or registered entities conducting their regulated activities whether order execution or distribution or advisory. The Guidelines will apply to all forms of online presence i.e. websites, platforms, and other channels like social media. SFC has also clarified that the Guidelines are in addition to any other applicable principles and standards to a particular type of service to which a service provider is required to comply with.

The Guidelines focus on three critical areas of operations / services of licensed or registered entities using online platforms. These areas are governance and control including Robo-advice, suitability requirement and complex products.

Governance and control will be driven through certain Core Principles which are unique to online service providers. The Core Principles are:

·       Proper design: this means the online platform should restrict and control access rights, and should operate it with due skill, care and diligence.  Clients would have access to only that information which is relevant to them as a client.

·       Information for clients: The platform should make adequate disclosure of the relevant information on the products offered as well as the services provided and the limitations thereof, if any.

·       Risk management: The platform should have high level of reliability, cybersecurity, data protection, business continuity plan (the “BCP”), and the periodic testing of the BCP, etc.

·       Governance, capabilities and resources: the platform to have robust governance process to manage its operations including adequate human, technology and financial resources.

·       Review and monitoring: It will be mandatory to conduct periodic review of the operations of the platform.

·       Record keeping: Proper record of its online services rendered, audit trail of the transactions and suitability assessment should be kept.

The Guidelines will also cover the so called Robo-advisers i.e. automated portfolio construction or model portfolios based on a client’s personal circumstances. The challenge for the platforms is to ensure that while providing Robo-advice all regulatory provisions applicable to distribution of investment products including Suitability Requirement are fully complied with.

The second area pertains to compliance with Suitability Requirement (Paragraph 5.2 of the Code of Conduct for Persons Licensed by or Registered with SFC) i.e. when does Suitability Requirement get triggered and how to discharge these obligations. The position taken for trigger is that mere posting of factual, fair and balanced materials on the online platform will not in itself amount to recommendation or solicitation and will not trigger the Suitability Requirement. However, in case the client seeks Robo-advice on the platform, the suitability Requirement obligations will become active.

Finally, offering complex products through online platform will require the online service provider to comply with some additional regulatory provisions. Certain basic and key information on the complex product along with very clear and prominent warning statements should be displayed. Further, it is proposed that the platform operator shall ensure that any transaction in such products is suitable for the client in all circumstances.

What shall the online platforms do to comply with the proposed guidelines?

The Core Principles delineated by SFC are pretty standard provisions which are used by any other transaction based platform. It is our understanding that all of these should already be available in a platform. If not, the platform should without any loss of further time put together the IT and business team to implement these Core Principles.

Providing Robo-advice and complex products will attract the obligation associated with Suitability Requirement. The platform should mandatorily undertake risk profile, factual assessment of the risk profile and verification of each client availing these two services.  It is advisable that the process and procedure for these products is broken down in multiple steps so that information at each step is captured and verified with the supporting documents before generating the final Robo-advice or execution of the complex product transaction.

Further, an online platform should check the authenticity of the material on their website and ensure that the material posted there is factual, fair, and balanced.  A robust internal system must be put in place to ensure that any update or new material posted on the online platform passes the test of factual, fair and balanced.  Besides, an audit trail of the process followed for each update has to be maintained.

Emerging Legislative Trends for Beneficial Owners’ Register

Crown territories and other off-shore jurisdictions were not inclined to enact legislation on disclosure of beneficial owners (the “BO”) of certain legal and other entities. However, they came under relentless pressure of United Kingdom (UK) and other international bodies forcing them to take steps to bring relevant legislation.  However, the legislation passed by these jurisdictions have few loopholes which have the potential to undermine the effectiveness of the disclosures. In this paper we examine the trend-setting legislation of UK and not-so-effective legislation of Cayman Island and Singapore.

UK was one of the first jurisdictions to implement beneficial owner register requirement from April 6, 2016. The UK legislation on the BO register is onerous both on the company and the beneficial owners (categorized as Person of Significant Control (PSC)). The main features of the UK legislation are that only individual can be a BO, the register is kept centrally by the Company House, both the BO and the company have obligations towards maintenance and update of the register information, covers companies as well as limited liability partnerships, punitive provisions are very strong and apply both to the BO and the directors and provides for restricting the rights of the shareholders, and the register is open to public. The exemption is limited to listed companies and companies subject to Financial Conduct Authority’s Disclosure and Transparency Rules.

Cayman legislation on BO register is on similar lines as the UK legislation with some exceptions. Only a natural person can be a beneficial owner. At the same time, both the natural person and the intermediate legal entity through which a natural person may have control on another entity are to be registered in the relevant register.

Though, no central registry of the beneficial owners is proposed, still the competent authority will have direct access to the BO register.  Cayman legislation has enhanced the role of the corporate service providers (CSP) by mandating that the BO register has to be established and maintained by the CSP. The responsibility to identify the BO, seeking confirmation and collecting the BO’s relevant information has been put on the company i.e. its directors. While the actual act of creating and maintaining the BO register has been given to the CSP on the basis of the written particulars provided by the company. The information on the BO will not be available to public but will only be accessible to competent authority through a searchable platform to be set-up by CSP.

Cayman legislation is strong with regard to punitive provisions, and imposes both fine and imprisonment.   For example, the legislation gives power to the company to put restriction on the shares in case the BO fails to provide or confirm the relevant information sought by the company. A company failing to comply with its obligations can be fined $25000 for each contravention. Similarly, a person who fails to respond to the notices issued by the company or knowingly provides false or misleading information is liable for conviction with provision for imprisonment or fine.

However, the legislation has exceptions which will exclude listed, and licensed companies as well as funds set-up as exempt companies whether licensed or registered from the applicability of maintenance of BO register. Therefore, most funds set-up in Cayman Island whether licensed or registered are excluded from this requirement. Not only this, any company managed, administered, arranged, operated or promoted by a person which is regulated, registered or licensed in Cayman Island is also excluded from complying with the requirement. Further, the legislation does not cover limited partnerships which are used in fund structuring.   

Singapore has also implemented the beneficial owner register provision from March 31, 2017. As per Singapore’s legislation, a BO can be an individual or a legal entity.  The BO register is to be maintained by the company or its filing agent. However, the register is not required to be filed with the company registry. The accessibility of the BO register to the regulatory authority is neither direct nor unhindered. For accessing the BO register, the regulatory authority has to make a request to the company. This process has the potential of creating delay or litigation. Further, the BO register information is not publicly available. With respect to punitive measures, the maximum penalty on the company or its officers and the controllers (i.e. the BO) in failing to maintain the register or update the information, failure to give notices, failure to respond or provide information is $5000. However, there is no provision to put restriction on the shares in case the BO fails to respond to the notice. The new requirement does not apply to listed and licensed companies. Overall the legislation appears to be quite lenient and the punitive provisions lack teeth.

The legislations of most of the countries lie within these three levels. The utility of these legislations will get evaluated in due course on the basis of   the correctness of the information, ease of flow of information and whether the authorities of the countries seeking information get the sufficient level of details to meet their objectives.

Listed Structured Product Market of Hong Kong, FSDC’s Recommendations

Financial Services Development Council (FSDC) is a high level cross sector platform which formulate proposals to promote the further development of Hong Kong’s financial services industry and map out the strategic direction for development. To meet its objectives, FSDC has recently issued a paper on ‘Optimizing Hong Kong’s Listed Structured Products Market’ (the “Proposal”).

The Proposal recognizes the fact that Hong Kong’s listed structure products market is limited to vanilla warrants and CBBCs (Callable Bull / Bear Contracts) but has the highest turnover by global standards. But, the market is not geared to meet the future challenges due to certain deficiencies like limited product range and underlying asset classes, outdated issuance and listing process, higher costs and strict liquidity provisioning requirements. These short-comings in comparison to other competitive markets tend to threaten future development of Hong Kong’s listed structured product market.

The Proposal summarizes corrective actions that should be taken for each of the short-coming so that Hong Kong’s listed structure product market continues to maintain its leading position and offers wide variety of investment options to investors, at the same time.

The main recommendations of the Proposal are on the product types, naming convention, shorter timeframe and streamlined process, change in the fee criteria, flexibility liquidity provisioning and investor education.

It is recommended to give easy access to non-leveraged and investment type products through the exchange platform. These products are Discount Certificates, (a Yield Enhancement Product) and Bonus Certificate (a Participation Product). The pay-out from these listed products will be similar to unlisted structured products offered by retails banks in Hong Kong.

FSDC has also recommended to change the naming convention for structured products. E.g. it is suggested to use the word “X” in a stock short name only to denote exotic products with high risk. Further, it wants the exchange should design a common naming convention which should be consistently applied for all listed structured products.

 The Proposal has extensively looked into the current listing procedure for structured products and has recommended multiple areas to improve to shorten the timeline and streamline the process. The framework to approve an application for structured product should identify the steps required, approval criteria, persons responsible, the timeframe for review etc. Also, electronic submission of documents for approval of a new product should be introduced. Further, the eligibility requirement for the underlying asset class for a listed structure product should be clearly formulated.

Analysis of the fees charged to the issuers and the investors show that the current fee structure is not supportive to introduce new structured product types. The Proposal recommends to lower the listing fees, issuance fee to be linked to volume and distribution reward schemes.

The current liquidity mechanism of Active Quote is suited for products which are traded frequently. However, for investment type of structured products, which are held to maturity and are not actively traded a quote request liquidity process shall be evaluated.

FSDC’s recommendations are very practical, farsighted and are timely. Hong Kong has not yet started losing its leadership position in structured product market. Implementation of these recommendation will create a robust structured product market in Hong Kong and all this continues to be within the existing regulatory framework. This will immensely benefit the retail investors since they will get the benefits and protection of a listed product.  

Proposal to Expand the Definition of Professional Investors by SFC, Hong Kong

Till now Securities & Futures Commission allowed certain waivers to the definition of professional investor under Section 134 of the Securities & Futures Ordinance to whom some of the customer protection related provisions do not apply. Now, it is proposing to codify those waivers or modifications to the definition of professional investors. SFC is seeking public comments on its proposals which will expand the base of investors who can be grouped/classified as professional investors.

These proposals can be grouped under three main categories:

Aggregation of assets

Currently, an individual to be classified as a professional investor has to meet certain monetary thresholds, either personally or jointly with his or her spouse or children. The proposal is that the investments held by an individual in corporations and investments held jointly with unrelated parties should also be counted towards meeting the monetary limit. This will cover situations where an individual holds investments in some investment vehicles or joint portfolios with unrelated parties like partners, business associates etc.

Expansion of the definition of corporation

As per the existing definition for a corporation to qualify as a professional investor, the corporation should itself hold the portfolio which fulfills the monetary limit. Also, a corporation whose sole business is to hold investments and is a 100% subsidiary of certain other professional investors also qualifies as a professional investor. Now, it is proposed that a corporation whose principal business comprises holding investments and is a 100% subsidiary of certain other professional investors can also be classified as a professional investor. This means that a subsidiary which may engage in some other business along with holding of investments will be treated as professional investor. In addition, a corporation which holds 100% shares of another corporation which is classified as a professional investor by fulfilling the monetary criteria of portfolio or total assets shall also be classified as a professional investor.

Expansion of evidence required for meeting monetary limits

Currently, the evidence to support the fulfillment of the monetary limit can be either an auditor or CPA certificate or a custodian statement for individuals. For other categories of professional investors the relevant documents are most recent audited financial statements or custodian statements. It is proposed to allow two alternate form of evidence i.e. public filings made pursuant to legal or regulatory requirements in Hong Kong or a place outside Hong Kong for trust corporations, corporations and partnerships. Further, the status of trust corporations, corporations and partnerships can also be ascertained on the basis of certificates issued by auditors or certified public accountants.  

These proposals will generally be supported/accepted by the industry as the proposals support the existing industry practice.

Compliance with Anti-Money Laundering and Combating the Financing of Terrorism Requirements of SFC, Hong Kong

It is of paramount importance for financial institutions to comprehend the operational aspect of applying anti-money laundering and combating the financing of terrorism (AML) guidelines issued by any regulator. It is no different in Hong Kong. Fortunately, Securities and Futures Commission, Hong Kong (SFC) has on 26 January 2017 issued practical suggestions for licensed corporations and associated entities to comply with their AML obligations. This write-up provides a synopsis of the suggestions made by SFC to help in practical application in a financial institution.  

Role of senior management

The senior management has the primary stake in ensuring that their organization maintains robust and effective AML processes and procedures. The attitude of the senior management towards AML determines how the staff down the line will view their responsibilities towards AML processes. It is now apparent that the regulators are taking a view that the tone for AML processes in a firm is set by the senior management. Therefore, senior management’s involvement in all major decisions like institutional risk assessment, on-boarding of high risk clients, regular monitoring and reporting should be apparent supported with documents to facilitate an audit, if necessary.  

Training and guidance

AML processes of a firm are as good as its AML training. Training does not necessarily mean only instructor led session(s). Training also involves feedback to the team on new situations and circumstances encountered and how those situations were handled and the reasons for the action i.e. sharing of the internal accumulated knowledge. It is often seen that ‘once a year’ training is not sufficient to equip employees to comprehend the complexities of the relevant AML issues. Every employee with some role on AML process should mandatorily be first tested on their AML skills and knowledge before being assigned to such a role. Further, the employees handling AML processes should be encouraged to do self-reading to enhance their knowledge and skill.

Further, the regulatory environment for AML is constantly evolving and the practical impact of such changes must be appropriately drilled down to the team. For example, the inter-linkages with other regulatory developments should also be shared with AML staff. The recent proposal for disclosure of persons with significant control of a company which will be a requirement as per Company Ordinance is directly linked to AML.

In addition, the in-house AML manual must contain appropriate policy level guidance and may also be updated with new insights gained from time to time. This will ensure that the knowledge gained through operational experience gets institutionalized and is available for future reference.

Completeness of due diligence to assess all AML risks

From operational perspective, due diligence is the most critical requirement comprising many parameters and numerous factors in each parameter. The vastness of the situations and circumstances likely to be faced necessitates a mandatory documentation of these parameters and factors. The documentation should take the form of policy guidelines rather than prescriptive document covering all possible scenarios. Further, this has to be a live document to be updated as and when necessary.

Due diligence is generally conducted from the perspective of four mandatory parameters i.e. customer, products and services, location / country of origin and delivery / distribution channel.

The documents collected for conducting due diligence like proof of identity, utility bill, source of wealth and funds, references must be analyzed for consistency. The source of wealth and funds must be counter-checked with independent sources, while proof of identity must be run through third party databases as well as random check on Google. Any information gathered by such analysis must then be counter checked with the client for his feedback. PEP status is a factor which must always be verified through independent source and every PEP to be categorized as high risk.

It is critical that the application of AML process for each client depicts an application of mind by AML responsible staff to all these parameters for reaching to a conclusion and the risk rating. It is fine to use automated risk rating applications to determine the overall risk rating for a client. But, sometimes, a single factor may enhance the risk rating and this can be achieved only through application of mind by AML staff and not through automated risk rating system.

The due diligence process has to be robust to capture and analyze all the relevant factors. Complex ownerships structures with a trust or a foundation or a fund or structures with entities in multiple jurisdiction without economic justification require detailed assessment to understand the motive. Other relevant factors like cash-intensive businesses, non-face to face clients, businesses like arms and ammunition, drugs, gambling, on-line gaming etc. require special attention.

Further, whether a case requires simplified or an enhanced due diligence should be determined on specific guidelines like PEP, jurisdiction, business, complexity etc. And as more information gets collected for a case, a holistic view needs to be taken to decide on the type of the due diligence. A periodic review of each client, the frequency of which is a function of risk rating, should be conducted. Any unusual pattern in the transactions undertaken by a client can also trigger an unscheduled due diligence review.

Transaction monitoring, evaluation and reporting

A firm should use red-flags to identify suspicious or unusual transactions requiring further investigation. Depending on the size of the institution, the identification of the red-flags can be done manually or through automated applications. Also, the red-flags themselves may also depend on the nature of services provided by a firm. However, it is critical that the red-flags are comprehensive enough to generate the trigger. It is important that every triggered transaction, irrespective of the reason for trigger, is brought to the notice of MLRO. And it is MLRO’s responsibility to further investigate, evaluate and determine, on the basis of all the parameters available for the client and the transaction, whether a suspicious transaction report to authorities is required or not.

One important red-flag requiring special attention is payment through third parties. This is something which should be enquired at the time of on-boarding each client. If a possibility exists, then identification of such third parties can be also be done at the on boarding stage itself. Any deviation should show application of mind to the request of the client and should have the approval of the senior management.

Audit trail

The main objective to comply with AML guidelines is to prevent the use of a firm’s services for money laundering. How do we prove that a firm has taken the required preventive measures? By maintaining an audit trail of the due diligence process and the transaction so that it can be reconstructed if necessary. The audit trail is kept by having physical or electronic records of each and every process and decision made thereof.

It is possible that a firm has best of the intention and has followed all the necessary processes. But for whatever reason if it failed to maintain the audit trail, all its efforts will come to naught.

Institutional risk assessment (IRA)

IRA should be a periodic exercise, the frequency of which can vary on the basis of the size of a firm.  Large multi-product and multi-service firms should involve all the relevant departments and an assessment for IRA should be made for the organization as a whole. The IRA should itself be categorized as low, medium and high and this will depend on the percentage of the clients in each of the three categories. The review should be of all relevant factors like products and services, due diligence process, location of clients, intermediaries, delivery of service and the risk categorization of the clients. It is necessary that the outcome of the IRA should be reviewed and approved by the senior management.

Risk Management for Fund Managers, Proposals of SFC, Hong Kong

Securities and Futures Commission (SFC), Hong Kong has put for public consultation certain proposals for enhancing asset management regulations. (the “Proposals”). These proposals can be seen as forced risk containment measures for the asset management industry.

The Proposals put the responsibility of compliance on the fund managers instead of the fund.   A distinction has been drawn between the fund managers with overall operational responsibility for the fund and those who manage only a portion of the fund. A fund manager with overall responsibility will have to comply with all the Proposals. Whereas, a fund manager managing a portion of the fund will not be required to comply with some of the Proposals (e.g. liquidity management policy and qualified custodian appointment). However, all fund managers acting in any capacity has to comply with generally-applicable Fund Manager Code of Conduct (FMCC) principles and requirements.

Thus, the Proposals cover all persons licensed or registered for Type 9 (asset management) regulated activity whether managing collective investment schemes (CIS) (whether authorized or unauthorized) and / or discretionary accounts. The objective is to govern the conduct of fund managers. The nature of fund is immaterial, that is, whether it’s a public or private or the domicile of the fund. Beware fund managers managing private funds!

Securities lending and repo:

The Proposals mandate that a fund manager engaged in securities lending, repo and similar OTC transactions on behalf of the fund should undertake these activities as per a predefined collateral management policy (CMP). What parameters a CMP shall cover? Many!

CMP should define eligible collateral, valuation, margin, hair cut i.e. very similar to what a clearing and settlement agency will do to protect its settlement fund. The CMP should identify the parameters for eligibility of collateral, the requirement to conduct a due diligence for determination of eligibility and a record should be kept before accepting a collateral. Depending on the nature of the collateral, a valuation methodology shall be pre-identified and used consistently (if not, necessary explanations to be made available). Liquidity of a collateral will also be factored in the valuation. Similarly, parameters for margin and hair cut will have to be defined and implemented consistently.

 Further, if the investment mandate of a fund allows for the reinvestment of the cash collateral, then the fund manager should have a cash collateral reinvestment policy. For this policy, the critical factor is to subject the cash collateral to stress test to meet planned as well as unplanned calls for the return of cash collateral on an ongoing basis.

SFC-authorized funds are not allowed to re-hypothecate non-cash collateral. However, fund managers of non-SFC-authorized funds are required to make adequate disclosures to re-hypothecate non-cash collateral and the associated risk of this.

Other parameters pertain to disclosures in the offering document and reporting of such transactions on an annual basis.

Safe custody of fund assets:

A slew of measures are proposed for ensuring the physical and legal integrity of the assets. To meet this objective, the fund assets of a client should be segregated from the assets of the fund manager, assets of affiliates and assets of other clients. Further, it is mandated that the fund assets should be held with a custodian that is functionally independent from the fund manager. However, the scope of “functionally independent” has not been clarified. Whether an affiliate under a separate management but same owner qualifies to be functionally independent is not clear. The fund shall conduct a due diligence on the custodian before selection and the relationship between the fund and the custodian should be documented through an agreement.

If fund assets are kept in an omnibus account, a proper record of the assets and frequent reconciliation shall be done so that assets are at all times readily identifiable. For private funds, self- custody is acceptable provided the internal custody activity is functionally independent.

Liquidity management and disclosure of leverage:

The stand of SFC is that the liquidity issues apply to all funds and therefore SFC will not provide exemption to anyone on the ground of private fund, close-ended fund etc. The policy on this should have a robust stress testing features and this cannot be a periodic exercise. Since the market fluctuates on a continuous basis it is understandable that SFC wants liquidity parameters to be assessed on a continuous basis. It is also proposed that in case of any provision on redemption restrictions in the offer document, the fund manager shall use liquidity management tools and exceptional measures.

 In addition, impact of leverage whether financial or synthetic and the basis of calculation shall be disclosed to the investors.

It is apparent the intent behind these provisions is to safe guard the interest of the investors and to force the actual decision maker i.e. the fund manager to introduce robust risk containment measures supported with documented policies. Moreover, any inspection by SFC is likely to be quite extensive and thorough. To comply with the rigor of the inspection, fund manager will have to keep audit trails for the decisions made on these parameters. To implement the Proposals, fund manager will have to invest in human capital, system applications and third party service providers. Needless to mention, the cost of fund management will increase for the fund manager and so the fund management fees for the investors.

Steps to comply with Suitability Obligations issued by SFC, Hong Kong

The regulatory trend is only in one direction. Consumer protection and enhanced disclosures. Mis-selling and mis-allocation are the most often complained incidents observed by SFC. It is imminent that SFC is going to come down heavily on such violations. It is better to take corrective actions now. How to do that? Where to begin?

Regular and comprehensive due diligence is the key. The Suitability Obligations (SO) apply both to solicitation and recommendation. Generally, when a licensed person tries to sell its services either to existing or prospective customer that is treated as solicitation. While a recommendation happens when someone asks for something and the licensed person gives suggestion in response.

The prerequisite to comply with SO for solicitation or recommendation is to take steps or seek answers to the following queries:

1.       Do I know the client? Do I understand the risk appetite of the client? 

The due diligence of the client is an important and necessary step. The licensee should ask for certain specific details on the client’s financial situation and investment experience through a questionnaire. These questions should cover information on income, savings, past investments, current investments, liquidity needs and the timing, ability to bear financial loss and margin calls, one time or regular investment preference, etc. It is suggested to collect supporting documents on the assertions made by a client on her financial situation and investment experience. It is also necessary to keep record for internal as well as external audit that the licensed person understands the needs of the client. 

The information given by the client will help in evaluating the risk appetite of the client and should be used to develop a conservative risk profile and the possible investment portfolio. At the same time, it is important for the licensed person to document the holistic assessment as to the accuracy and currency of the information provided by the client. In case, there are doubts either on the accuracy or currency or both, then further clarifications should be taken before finalizing the investment portfolio. And this is critical. The licensed person’s assessment should show an application of mind as a trained person to the information provided. If there is no application of mind, the whole exercise of conducting the due diligence on the client can be termed by the regulator or the court as an exercise in deception.

2.       Do I understand the technical features of the portfolio of products proposed for the client? 

Financial markets are in a constant state of flux. Therefore, it is of paramount importance to understand the impact of change in market conditions on a product in an investment portfolio. Though this is difficult to foresee but the aim of the due diligence is to evaluate variation in return / asset value with change in market conditions. This is like a stress test.  Therefore, due diligence of a product shall cover a thorough analysis on the basis of the documentation provided by the issuer, other third party recommendations on the same product, seeking clarifications from the issuer and research houses and own analysis on the product by the licensed person. Own analysis of the product is a critical factor. Reasonableness of the assumptions have to be analyzed and, if necessary, scenario analysis shall be conducted on revised assumptions. Further, the investment climate might have changed since the issuance of the product due to other economic and political factors which may have an impact on the returns from it. Therefore, assessment whether a product will meet the needs of the client has to be done on client specific situation and as and when solicitation or recommendation is made. It is advisable to have a product approval committee to approve licensed person’s portfolio of products. Further, the product approval committee shall also set parameters for nature of further assessment that needs to be done to determine suitability of a product for a client. An audit trail shall be maintained for product approval.

3.       Have I done a matching of the needs of the client and the features of the products proposed for the client? 

One prudent approach for matching client profile and the investment risk is to select portfolio of products on the basis of modern portfolio theory. The weight of different securities in the portfolio can be determined on the basis of the risk profile of the client. Such a portfolio, apart from being diversified, will also be lower in risk. It is easier to defend such a portfolio as it will be subject to broadly systematic risk and lower product specific risk. This approach should be used in case of discretionary portfolio management with a mandate. Even in other situations, it should be possible to suggest product on the basis of efficient frontier.  

4.       Have I given sufficient information on the product and the investment environment to enable the client to make a decision? 

It is necessary to give to the client the relevant literature and the risk-return profile of the proposed product portfolio. Along with the product literature, the client should also be given information on the portfolio construction, diversification, and reduction of risk by diversification etc. as a support for the selection of the portfolio vis-à-vis the risk profile of the client as determined by the licensed person. Further, a realistic assessment of the likely market scenarios during the investment horizon of the client and the risk profile of the client should be shared.  

Transactions to build the portfolio should be undertaken only after sufficient time to consider the information to assess its suitability and to seek clarification, if any, has been given to the client. The trail of communication with the client should be appropriately documented for any future audit purposes.

5.       Have I been trained on conducting due diligence on clients and understand the technicalities of the products?       

Licensed persons are advised to look into the existing training program and make a judgement whether it is sufficient to meet the obligations imposed on them. This should also be evaluated in the light of the new requirement of identifying Manager In-Charge (MIC). Whosoever is identified as MIC will carry heavy burden to prove the sufficiency of the training to meet the Suitability Obligations. However, in my view, this is an area which goes beyond training. This requires a relook at the transaction life-cycle from solicitation / recommendation to transaction to product approval to close all the gaps, if any.

Finally, Ownership Transparency in Hong Kong and Singapore!

Persons of Significant Control (PSC) is becoming a standard phrase in the corporate world compliance to fight tax avoidance and money laundering. This initiative is driven by Global Forum on Transparency and Exchange of Information for Tax Purposes (GF) and Financial Action Task Force (FATF). The objective of the initiative is to improve the implementation of international standards on transparency of beneficial ownership information, including its availability and international exchange.

United Kingdom (UK) was one of the first countries which made extensive legislative provisions requiring all UK incorporated companies and partnerships to identify people exercising control on them. Detailed and unambiguous provisions marked the definition and the procedure to identify and classify PSC, who has to be a natural person. In addition, each entity is mandated to maintain a register capturing specific information on the PSC and this register is filed with the Company House on an annual basis. Not only this, the contents of the register are made public with few exceptions. The requirement w.r.t. PSC became effective from April 6, 2016.

Somewhat on similar lines, Hong Kong and Singapore are proposing to introduce and maintain a register capturing the details of the PSC. The new requirement in both the countries is likely to be finalized and implemented in the third or fourth quarter of the current year.

One of the main features of the proposal for PSC register in Hong Kong is that companies, except listed companies, incorporated in Hong Kong would obtain and hold up-to-date beneficial ownership information of the companies.. The definition of beneficial ownership is based on the similar lines as in FATF guidance i.e. where an individual owns or controls more than 25% of the legal entity through direct or indirect shareholding. It is also proposed to register the legal entity immediately above the HK company in case of successive layers of holding companies in a chain of ownership. This particular requirement differs from the UK provision where only the information on beneficial owner is recorded in the register. The information shall be made available for public inspection upon request.

There are also provisions for penalty against the company, its responsible persons and beneficial owners for not maintaining the register or for not making it available for public inspection. However, no final decision has been taken on restricting the voting rights in case the beneficial owner fails to respond to the notices sent by a company though such is the position in UK law.

However, the PSC register requirement will not apply to partnerships unlike in UK and as proposed in Singapore. Since many HK companies have no employee and or director in HK, it is proposed that the company shall nominate a third party who is a HK resident and who shall be responsible to provide information in this regard.

Singapore’s proposals are also on the similar lines except on few parameters. The register of PSC will not be in public domain, but there may be a central registry for this information. There is an exception for both listed companies and Singapore financial institutions. The exception of Singapore financial institutions is a major carve-out unlike in UK and HK. Further, the PSC can be an individual or a legal entity unlike in UK and HK.

These are significant developments for these two off-shore financial centres. The impact of such transparency on the competitiveness of these jurisdictions vis-à-vis other off-shore centres (which have not yet committed to impose similar obligations to companies incorporated there) is something to be closely watched.

Triggering of Suitability Obligations for SFC, Hong Kong licensed or registered person

The intent behind the circular issued by Securities and Futures Commission (SFC), Hong Kong on Triggering of Suitability Obligations is to infuse life in paragraph 5.2 of the Code of Conduct. Paragraph 5.2 obligates a licensed or registered person to ensure suitability of the recommendation or solicitation for the client is reasonable in all the circumstances, having regard to information about the client of which the licensed or registered person is or should be aware through the exercise of due diligence.

The circular emphasizes that the trigger for complying with suitability obligations commences at the point of sale or advice. What does it mean? It implies that the actions and statements of the licensed person made to a prospective or existing client in her conversation is a material factor. Conversations could be spread over a period of time. Also, conversations could be through physical presence of the parties or verbal or textual or any other means or a combination of them. This conversation would also include the acts of providing research and marketing material, of course these material themselves should have been issued in compliance with paragraph 2.3 of the Code of Conduct. In case, the conversation results in successful solicitation or recommendation leading to a transaction, the requirement to comply suitability obligations will be triggered from the initial conversation. However, if the conversation is general in nature and does not involve an invitation or inducement to act on it and invest in a particular product then suitability obligations are unlikely to trigger.

How are the suitability obligations discharged and an audit trail maintained to support it?

 For discretionary portfolio management with a pre-determined mandate, the suitability obligations will be complied with when a target portfolio is created that meets the risk profile of the client and is agreed with the client. It is necessary that the portfolio is developed on the basis of the findings from due diligence conducted on the client. Here it is critical that the assessment is reasonable and factors in all the parameters of investment like client’s objectives, need for liquidity, ability to bear loss, age, understanding of the market, investment horizon etc. An assessment which is not in line with the investment profile of the client may not pass the test of due diligence. It is necessary to document the assessment for the mandate and provide a copy of the rationale to the client in writing and keep a proof of the same. Present and future transactions in accordance with the mandate will be considered to be done in compliance with suitability obligations. It is also necessary to review the mandate at periodic intervals as well as in case of change in circumstances either of the client or the market.

Indian budget for the year 2017-18 and its impact on capital markets

In 2012 the Income Tax Act (ITA) was amended to tax transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. This amendment adversely impacted the fund industry because the investors of India based funds located abroad were subject to tax on transfer of their shares in such funds. It is heartening to note that the government has finally agreed not to tax the capital gains earned by investors abroad on transfer of their shares in India based funds. In addition, for multi-tier structures redemption in Indian market and upstream distribution of the redemption proceeds will not be subject to tax in India. However, this exemption is offered only to Category I and II Foreign Portfolio Investors (FPI). But it is not clear whether Category III FPI, PE and VC investors will get the benefit of this exemption or not. Further, in spite of this move, certain associated issues related with such taxation like reorganization, reporting and disclosure still continue to be the areas of concern.In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

A new regime was created under section 9A of ITA to promote fund management activity in India. However, this regime did not pick up due to onerous conditions like minimum number of investor (broad based criteria), minimum corpus (INR 1 billion), restriction on investment in a single entity (not to exceed 20% of the corpus), arms-length fee etc. Now, there is a proposal to remove the requirement for a fund to consistently maintain a minimum corpus of at least INR 1 billion in case the fund is wound up during the previous year. However, the other onerous conditions continue to remain and therefore the use of this regime is unlikely to pick-up.

It has been a long pending demand of the industry to provide a single window registration for Foreign Portfolio Investors. Now, it is proposed that application for registration, demat account and PAN will be handled through a common application form. Though different variants of this has been tried in the past, the new proposal will ease the administrative burden at the initial stage.

The proposal to allow the listing of Security Receipts (SR) issued by asset reconstruction companies (ARC) will induce much needed liquidity in this industry. Currently, the pool of investors in SR is restricted to qualified buyers (i.e. financial institutions, insurance companies and FPI), it is not clear whether this pool will be expanded or not. It is expected that the regulatory framework and the operational guidelines to implement this proposal will be expedited by SEBI.  

Another relevant budget provision is to allow certain systemically important NBFCs to participate in IPOs as qualified institutional buyers (QIB) will bring in one more investor category to sustain an IPO market and should give a boost to capital market. It is not clear whether these NBFCs will be allowed to participate in other QIB related issuances.

There is also the usual mention of disinvestment policy and PSU listing. However, it is difficult to comprehend the long-term policy on PSU listing and disinvestment since there is hardly any action taken on it so far. Though there are conscious efforts to move towards market economy but there seems to be reluctance on the part of the government to let go of their control on the PSUs.    

Further, the proposal to link individual demat accounts with Aadhar is one more step towards creating an integrated information system. May be it’s time to analyse the possibility of switching to a single card for all government related transactions.

Some of these proposals are either a continuation of earlier policies (like listing of PSUs) or are meant to rectify a situation created by earlier amendment. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

169. In order to remove this difficulty, I propose to exempt Foreign Portfolio Investor (FPI) Category I & II from indirect transfer provision. I also propose to issue a clarification that indirect transfer provision shall not apply in case of redemption of shares or interests outside India as a result of or arising out of redemption or sale of investment in India which is chargeable to tax in India. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

169. In order to remove this difficulty, I propose to exempt Foreign Portfolio Investor (FPI) Category I & II from indirect transfer provision. I also propose to issue a clarification that indirect transfer provision shall not apply in case of redemption of shares or interests outside India as a result of or arising out of redemption or sale of investment in India which is chargeable to tax in India. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

169. In order to remove this difficulty, I propose to exempt Foreign Portfolio Investor (FPI) Category I & II from indirect transfer provision. I also propose to issue a clarification that indirect transfer provision shall not apply in case of redemption of shares or interests outside India as a result of or arising out of redemption or sale of investment in India which is chargeable to tax in India. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

169. In order to remove this difficulty, I propose to exempt Foreign Portfolio Investor (FPI) Category I & II from indirect transfer provision. I also propose to issue a clarification that indirect transfer provision shall not apply in case of redemption of shares or interests outside India as a result of or arising out of redemption or sale of investment in India which is chargeable to tax in India. In 2012, Income-tax Act was amended to provide for taxation of those transactions of transfer of shares or interest in a foreign entity deriving its value substantially from Indian assets. Apprehensions have been raised about some difficulties which arise because of this provision in case of transfer of stake of investors of India-based funds located abroad but investing in India-based companies.

169. In order to remove this difficulty, I propose to exempt Foreign Portfolio Investor (FPI) Category I & II from indirect transfer provision. I also propose to issue a clarification that indirect transfer provision shall not apply in case of redemption of shares or interests outside India as a result of or arising out of redemption or sale of investment in India which is chargeable to tax in India.The proposals w.r.t. ease of doing business are not significant or are only relevant at the initial stage. The ease of doing business should also be incorporated in the activities carried on to run the business after the registration.