Comment

• Author: LOW Kee Yang LLB (National University of Singapore), LLM, PhD (King's College London); Associate Professor of Law, Singapore Management University.
• Date: 01 December 2012
• Published date: 01 December 2012
• Citation: (2012) 24 SAcLJ 298

PRODUCT SUITABILITY, DUE DILIGENCE AND MANAGEMENT RESPONSIBILITY

The New Regime of Regulation 18B of the Financial Advisers Regulations

In response to the structured products crisis of 2008, many changes were made to the Singapore regulatory landscape over the past three years. More recently, in July 2011, the Financial Advisers Regulations (Cap 110, Rg 2, 2004 Rev Ed) were amended and an important new provision – reg 18B – was added. Regulation 18B requires a financial adviser and its senior management to conduct a comprehensive due diligence exercise before selling a new product. This comment considers reg 18B's overall scheme, its interpretational difficulties, the demands of the diligence requirements, its interrelation with s 27 of the Financial Advisers Act (Cap 110, 2007 Rev Ed) and the extent to which the regulatory regime has been altered.

I. Introduction

1 It was not so long ago that the global financial crisis triggered by the collapse of Lehman Brothers rocked the world. In Singapore, the structured products saga involving Lehman Minibonds, DBS High Notes and other derivative instruments brought substantial losses to more than 10,000 investors. The ensuing period witnessed an array of actions and responses by the Monetary Authority of Singapore (“MAS”), some involving the participation of industry stakeholders. The developments resulted in significant changes to the regulatory landscape, the foremost of which were:

(a) the extension in April 2009 of the Consumer Protection (Fair Trading Act)1 regime to financial products;

(b) the issuance in April 2009 by MAS of the Guidelines on Fair Dealing2 (“FDG”);

(c) the issuance in October 2010 by MAS of the Guidelines on the Product Highlights Sheet;3

(d) the issuance in November 2010 by MAS of various new or revised notices and guidelines on miscellaneous matters;

(e) the July 2011 amendments to the Financial Advisers Regulations4 (“FAR”) in July 2011; and

(f) the issuance in July 2011 by MAS of a revised Notice on Recommendations on Investment Products and a Notice on the Sale of Investment Products.5

2 Regulation 18B of the FAR, the focus6 of our attention, was introduced against the backdrop of all these changes made to enhance due diligence by financial advisers and the protection of investors.

3 As a side note, it is observed that the new measure – the essence of which is to require enhanced due diligence for new financial products – was introduced by way of a provision in a piece of subsidiary legislation (the FAR) rather than through an amendment to the Financial Advisers Act7 (“FAA”) itself, such as by amending s 27 – which basically requires a financial adviser to have a reasonable basis for making recommendations as to financial products – or adding a s 27A. Neither was it encapsulated in an MAS Notice (which curiously is supposed to have statutory force),8 guideline or some other circular.

II. Regulation 18B

A. Overall scheme of reg 18B

4 The intent of reg 18B is clear enough – financial advisers should do due diligence before selling new products. The overall scheme is as follows:

(a) a financial adviser must do due diligence to ascertain suitability before allowing a new product to be sold: reg 18B(1);

(b) the requisite due diligence exercise includes product due diligence, client due diligence and other aspects of the overall system to support the sale of the product: reg 18B(2);

(c) the due diligence exercise requires the personal attention of every member of the financial adviser's senior management: reg 18B(3);

(d) delegation of the due diligence tasks is permitted but with qualifications: reg 18B(4);

(e) a financial adviser must not sell a new product which the due diligence exercise indicates is not suitable: reg 18B(8); and

(f) the contravention of reg 18B without reasonable excuse is an offence: 18B(10).

B. Due diligence prerequisite

5 The basic prerequisite is set out in ostensibly simple and clear terms in reg 18B(1):

Before selling or marketing any new product in Singapore to any targeted client, a financial adviser shall carry out a due diligence exercise to ascertain whether the new product is suitable for the targeted client.

6 The provision, it seems, desires financial advisers to sell products that are suitable to its clients and to conduct due diligence to ascertain suitability. The notions of suitability and due diligence are reinforced by reg 18B(8), which provides:

For the avoidance of doubt, no financial adviser shall sell or market any new product to any targeted client if the due diligence exercise required to be and carried out under paragraph (1) indicates that the new product is not suitable for the targeted client.

So if the due diligence exercise results in the financial adviser finding the product unsuitable, the financial adviser must not sell or market the product.

7 Let us take a closer look at some of the terms used in the above provisions.

C. “New product”

8 Firstly, “new product” is defined as any investment product9 that “has not previously been sold or marketed” by the financial adviser or any of its representatives. Regulation 18B therefore does not apply to existing products, that is, products which at the coming into force of the provision (ie, 28 July 2011)10 were already being sold or marketed by the financial adviser or any of its representatives. One consequence of this definition is that existing products are unaffected by the new due diligence requirements even if the products had never been assessed and approved by the senior management of the financial adviser; reg 18B is forward looking, and presumably it was considered too much of an imposition to require enhanced due diligence for existing products.11 It should be noted that “new product” is defined to include a product which “varies in any manner (other than in respect of the maturity date)” from any existing product.

9 A second consequence, probably unintended, is that technically speaking a product may be new in that it had not been sold or marketed before 28 July 2011 but once it is sold or marketed at any time thereafter, even if that were done without complying with the new due diligence requirements, it is not a new product within the meaning of reg 18B. The first instance of selling or marketing the product is an offence but the subsequent instances do not appear to be.12 A formulation which would have avoided the anomaly is one which provides that the enhanced due diligence is required for “any product” rather than “any new product”, and to add the qualification that reg 18B does not apply to products that have been sold or marketed by the financial adviser or any of its representatives before 28 July 2011.

D. “Targeted client”

10 Regulation 18B(9) defines “targeted client” as “any client … to whom the financial adviser intends to sell or market the new product” but excludes from its ambit the accredited investor, the expert investor and the institutional investor13– categories of investors who are regarded (although the point is debatable) as being able to look after their own interests.

11 It should be noted that the term repeatedly used in reg 18B is “targeted client” and not “targeted client segment” which raises the vexed question of whether the financial adviser is liable for due diligence in respect of the particular sale to an individual client, an issue which will be taken up later in this comment.

E. Details of due diligence requirement

12 Regulation 18B elaborates upon the due diligence exercise required by reg 18B(1) and recites that it includes an assessment of a whole spectrum of matters:

(a) the type of targeted client the new product is suitable for and whether the product matches the client base of the financial adviser;14

(b) product details: investment objectives,15 key risks16 and costs and fees;17

(c) processes in place for a representative to determine whether the product is suitable for the targeted client;18

(d) how the product is to be marketed or sold19 and whether additional measures are necessary to mitigate any conflict of interest between the representative and the client;20

(e) qualifications and training required for a representative;21 and

(f) whether the current systems of the financial adviser support the sale of the new product to the client.22

13 Broadly speaking, the due diligence matters fall into three categories.

14 The first is product due diligence, which involves product assessment23 and market segmentation.24 Paragraph 2.2.1 of the FDG sets it out more clearly:

The financial institution should undertake formal due diligence on any investment product it intends to distribute, in order to: (a) assess and fully understand the features and risk-reward characteristics of the product; and (b) identify customer segments for which the product is suitable, and customer segments for which the product is clearly not suitable.[25]

15 It is significant that with reg 18B, there is now a statutory requirement of product due diligence, which hitherto was only required by the FDG.

16 The second is client due diligence, often referred to as the “KYC” (know your client) process conducted by representatives to ascertain the client's background so as to enable the representative to recommend a suitable product.26

17 The third category concerns a wide variety of matters which fall within the expression in reg 18B(2)(i) –“whether the current systems of the financial adviser adequately support the sale of the product”. Whilst the words “adequately support” may be rather vague, one should be mindful of the regulator's expectation, enunciated in the FDG, that

board and senior management should...