Circular to intermediaries
Distribution of complex and high-risk products

7 Dec 2018



The Securities and Futures Commission (SFC) reminds intermediaries to observe the requirements governing selling practices, including the suitability obligations under the Code of Conduct1, when they distribute structured products and corporate bonds with complex features or high risks2.  The SFC noted from its recent survey3 that sales volumes of these products by licensed corporations have increased.

One example is equity-linked accumulators, which are derivative products with significant investment risks.  Investors are bound by contract to take up units of the underlying assets at the strike price when the market moves against them, crystallising losses.  This downside risk is magnified when a “multiplier” condition is included.

Another example is bonds with non-viability loss-absorption features (NVLA Bonds).  These may have contingent equity conversions or write-down features which are triggered when the issuers’ regulatory capital ratio drops to a certain level or upon specific government or regulatory action in the event the issuers face financial difficulties.  Triggering events are complex and difficult to predict.  If one occurs, it could fundamentally alter the nature of the products or pay-out profiles.  This could make it difficult for investors to assess the likelihood and amount of potential losses.

In light of the complexity of these types of products, they are considered complex products for the purpose of compliance with the Guidelines on Online Distribution and Advisory Platforms and the new paragraph 5.5 of the Code of Conduct.  Under these requirements, with effect from 6 April 2019, intermediaries will be required to ensure that a transaction in a complex product is suitable for the client in all circumstances irrespective of whether a solicitation or recommendation is made.  Intermediaries will also be required to provide information and warning statements about the complex products to the client4.

The SFC has also noted that high-yield corporate bonds are being distributed to investors. These bonds come with an increased risk of issuer default5 and are more vulnerable during an economic downturn6

When distributing complex products, intermediaries should:

(a) conduct product due diligence taking into account, amongst other factors, their features7, risks and any restrictions on their sale or target customers, and in what aspects they are considered suitable for clients;

(b) ensure that the products’ risk-return profiles match the client’s financial situation, investment objectives, investment experience, risk tolerance and other specific circumstances8;

(c) provide clients with sufficient and accurate information about the products, including their features and risks, and always present balanced views and not focus solely on the products’ advantages; and

(d) provide staff with adequate training on the products they distribute and how to appropriately disclose the products’ features and risks to clients.

The SFC uses a range of supervisory tools, including inspections, to monitor compliance and takes regulatory action against licensed corporations found to have breached the requirements.

Should you have any queries regarding the contents of this circular, please contact Ms Pauline Chan at 2231 1952 or the case officer.

Intermediaries Supervision Department
Intermediaries Division
Securities and Futures Commission

End

SFO/IS/069/2018


1 The Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.
2
 The selling practice requirements, including the suitability obligations, are set out in the Code of Conduct, Frequently Asked Questions on Compliance with Suitability Obligations and other guidance issued or updated by the SFC from time to time. 
3
 Please refer to the Survey on the Sale of Non-exchange Traded Investment Products released on 7 December 2018.
4
  A list of examples of the minimum information and warning statements for a complex product is issued and updated by the SFC from time to time.
5
The issuers may be companies which are highly leveraged or experiencing financial difficulties.
6
During an economic downturn, high-yield bonds typically fall more in value than investment-grade bonds as investors become more risk-adverse and default risks rise.
7
 For example, the conditions under which investors take up underlying assets of accumulator contracts; and the conditions under which the contingent equity conversions or write-down features of an NVLA Bond may be triggered.
8
 For example, whether: a) a client has adequate knowledge to understand the non-viability loss-absorption features and risks involved in NVLA Bonds; b) the client is able to financially assume the risks and bear the potential losses of investing in the products; and c) the products meet the investment objective of the client, including his or her risk profile.


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Page last updated : 7 Dec 2018