Circular

28 May 2010

Guidance to Licensed Corporations and Registered Institutions in relation to Investor Characterization and Professional Investors Requirements
The Commission issued the Consultation Conclusions on Proposals to Enhance Protection for the Investing Public (Consultation Conclusions) today. The consequential amendments to the Code of Conduct1 will be published in the gazette on 4 June 2010. The purpose of these notes is to provide guidance to intermediaries in complying with the requirements in relation to investor characterization and professional investors as set out in the Consultation Conclusions. Investor characterization 1. Under paragraph 5.1A of the Code of Conduct, an intermediary should, as part of the know your client procedures, assess a clients knowledge of derivatives and characterize the client (other than professional investors for the purpose of paragraph 15 of the Code of Conduct) based on such knowledge. Where a client who has been characterized as without knowledge of derivatives wishes to: (a) purchase a derivative product which is traded on an exchange and the intermediary has not solicited or provided a recommendation to the client, the intermediary should explain the risks associated with the product to the client; (b) purchase a derivative product which is not traded on an exchange and the intermediary has not solicited or provided a recommendation to the client, the intermediary should warn the client about the transaction and provide appropriate advice to the client as to whether or not the transaction is suitable for the client in all the circumstances. Criteria for assessing a clients knowledge of derivatives 2. An intermediary is expected to assess whether a client has general knowledge of the nature and risks of derivatives based on information obtained from the client during the know your client procedures. It is considered that general knowledge of derivatives could assist a client to understand the nature and risks of derivative products and so enable an intermediary to provide appropriate services in relation to such products to the client. Hence, the intermediary needs to explain the risks of derivative products traded on an exchange to those clients without knowledge of derivatives but no such explanation would be required for clients with knowledge of derivatives. 3. Where an intermediary does not have sufficient information to determine whether a client has knowledge of derivatives, it should adopt a conservative approach and regard that client as not having knowledge of derivatives.
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Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.

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4. The following are some criteria (which are not exhaustive) for assessing if a client can be regarded as having knowledge of derivatives: (a) undergone training or attended courses on derivative products; (b) current or previous work experience related to derivative products; or (c) prior trading experience in derivative products. 5. The training or courses on derivative products may take different forms, for instance online or classroom courses offered by academic institutions or financial institutions, so long as they provide clients with general knowledge of the nature and risks of derivatives. 6. A client will be considered as having knowledge of derivatives if he has executed five or more transactions in any derivative product (whether traded on an exchange or not), within the past three years. Explanation of risks associated with a derivative product traded on an exchange 7. Given that derivative products of the same type that are traded on an exchange will have standardised features and be subject to regulation, for the purpose of complying with paragraph 5.1A(b)(i) of the Code of Conduct, an intermediary can explain the risks associated with a type of derivative product traded on an exchange to a client without knowledge of derivatives at any stage prior to the point at which a transaction is entered into. 8. The types of product risks that an intermediary is required to explain may vary according to the nature of each type of derivative product. An explanation of product risks should be specific to a particular type of derivative product which would include, for example, the fact that derivative warrants would have no value upon expiry or that for Callable Bull/Bear Contracts or CBBC, once the underlying price reaches the knock-out price, trading will be terminated immediately. 9. An explanation of the risks of a particular type of derivative product traded on an exchange need only be provided once by the intermediary to the client. For repeat purchases by the client of the same type of derivative product traded on an exchange, an intermediary is not required to explain the product risks to the client again. 10. Where a client without derivative knowledge has previously purchased a type of derivative product traded on an exchange but wishes to buy a different type of derivative product traded on an exchange, the intermediary is required to explain the risks associated with the different type of derivative product to the client. 11. Any explanation to the client regarding the risks of derivative products traded on an exchange should be made in writing, whether by electronic means or otherwise. However, it is also acceptable if the explanation is audio recorded so long as a proper audit trail is maintained and the records are kept properly. It would be good practice for intermediaries to obtain the clients acknowledgement.

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Providing advice to a client without knowledge of derivatives 12. For the purpose of complying with paragraph 5.1A(b)(ii) of the Code of Conduct, where an intermediary is required to provide appropriate advice to a client as to whether or not a transaction is suitable for the client in all the circumstances, the intermediary should have regard to the factors set out in the Suitability FAQs2 issued by the Commission. Professional Investors 13. Under paragraph 15.3 of the Code of Conduct, intermediaries are required to consider all criteria set out in paragraph 15.3(a)-(e) of the Code of Conduct. Intermediaries may adopt a holistic approach in conducting the assessment and make a reasonable decision as to whether a client could be treated as a professional investor under the Code of Conduct in the particular product and/or market in question. 14. Intermediaries may take into account all relevant and reasonable considerations in assessing a clients knowledge and expertise under paragraph 15.3(d) of the Code of Conduct such as whether the client: (a) is currently working or has previously worked in the relevant financial sector for at least one year in a professional position that involves the relevant product; or (b) has undergone training or studied courses which are related to the relevant product. 15. Furthermore, when providing a written explanation to a person explaining the risks and consequences of being treated as Professional Investor under paragraph 15.4(a) of the Code of Conduct, intermediaries are reminded to include in that explanation that the intermediary will not be subject to the requirements of paragraph 5.1A of the Code of Conduct relating to know your client investor characterisation and paragraph 8.3A of the Code of Conduct relating to disclosure of sales related information. Should you have any queries regarding the contents of this circular, please contact Ms Jacquline Yip on 2840 9530.

Intermediaries Supervision Department Securities and Futures Commission

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SFO/IS/011/2010

Questions and Answers on Suitability Obligations issued by the Commission on 8 May 2007

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