30 March, 2016
Recently, the Hong Kong Court of First Instance handed down its judgment in the case Li Kwok Heem John v Standard Chartered International (USA) Limited (“Bank”). The case was brought by a victim of the infamous Bernard Madoff ‘Ponzi’ scheme against Standard Chartered Bank, where he invested in the fund that was ultimately found to be a fraud. This case has sparked much debate on the obligations banks owe their investors and what measures they need to start taking to better protect themselves from liability in the event they found themselves in the midst of a Ponzi scheme.
We spoke with Laracy & Co’s dispute resolution team in Part I of this Q&A to further examine the big lessons learned from this case, new and upcoming amended regulations bearing on the case’s issues, “suitability clauses”, and the effectiveness of a bank’s risk disclosure statements, updates and fact sheets.
Conventus Law: What lessons can be learned from this case?
Laracy & Co: As a starting point, it is important to review the facts and findings relevant to the case for each cause of action.
Issue 1: Misrepresentation
• The Bank did make representations to the client by adopting the representations made by the Fund (which turned out to be false).
• The client relied on the representations by the Bank when deciding to make his investment in the Fund.
• The Bank conducted its due diligence with reasonable skill and care.
• The Bank proved on the balance of probability that it had reasonable grounds to believe the representations it made to the client were true.
• The Bank was not negligent in by failing to discover in the initial due diligence that the Fund was part of the Bernard Madoff fraudulent Ponzi scheme.
In reviewing the aforementioned facts and findings, we feel that going forward, Banks may adopt a more “hands-off” approach when providing advice and recommending particular financial products.
Additionally, the Securities and Futures Commission’s (the “SFC”) recent amendment (to be given full effect on 9 June 2017) to the “Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code)” (the “Code of Conduct”) imposes a contractual obligation on financial institutions to ensure that any financial product “recommended” or “solicited” to clients is reasonably suitable for the client (paragraph 6.2(i) of the Code of Conduct). Thus, banks will have to be very careful to ensure that information provided to clients does not fall within the scope of the meaning of “recommend” or “solicit” otherwise they will have contractual (in addition to regulatory) obligations to ensure a financial product is “suitable” for an investor.
Issue 2: Negligence
Relevant facts and findings by the Court:
• The Bank did owe a duty of care to its client by adopting the information from the fund manager and making recommendations to the client. When the bank assumed responsibility, they had assumed responsibility to the client.
• The Bank knew the client would act on the information from the Bank when making his investment decision.
• The Bank had “endorsed” the representations from the fund manager.
• The Bank had acted with reasonable skill and care in conducting its own initial and on-going due diligence on the fund.
• The Bank was not negligent in carry to discover in the initial and on-going due diligence that the fund was in fact a Ponzi scheme.
The findings by the Court highlights that it’s still very difficult for an investor to prove misselling by a bank.
Issue 3: Non-reliance clauses
Relevant facts and findings by the Court:
• The risk disclosure statements related only to high risk investments and did not protect the bank against a claim by an investor in a low risk hedge fund as this type of investment was not referred to in the risk disclosure statements.
• The risk disclosure statements were not “reasonable” under the Control of Exemption Clauses Ordinance and the bank couldn’t rely on them.
Based on the conclusions on this issue by the Court, we have learned that is it possible that these non-reliance clauses may not afford any protection to financial institutions because of the recent changes to the SFC’s Code of Conduct.
Relevant to this issue, there is another amendment to the Code of Conduct (to be given full effect on 9 June 2017) that provides that no contractual term in any client agreement/document can be inconsistent with the Bank’s obligation to recommend or solicit “suitable” products for the client (paragraph 6.5 of the Code of Conduct). Henceforth, it will be very difficult for banks to contract out of potential liability for recommending “unsuitable” products by including a wide disclaimer in the client agreement.
CL: On the issue of false representations, the Bank claimed they merely relayed the same information to the client that was given to them by the fund manager by way of a Fact Sheet and Update provided by the fund manager. However, the Court did not agree with the Bank’s characterization of its role, and instead held that the representations about the fund in the Fact Sheet and Update were not just made by the fund manager, but had been adopted and made on behalf of the Bank to the claimant.
a. Will this ruling change the way banks and other financial institutions communicate the information pertaining to the funds they sell, and if yes, how?
L&C: The Court found that the Bank expected the client to gain the impression from the presentation that the Fund was a low risk fund. However, the Bank “knew” that the client wanted its advice on investment strategies before deciding which funds he should invest in.
Based on this, the Court determined that the Bank “endorsed” the representations in the Fact Sheet and Update because it “wanted the client to rely on them.” It “wanted the client to have such an impression on the fund,” i.e. that the fund was low risk.
In answer to the question, yes, this ruling could potentially change how financial product information is communicated by financial institutions to investors. For starters, banks may ensure their “investment advisers” take a more neutral stance/be less proactive when advising and recommending to clients how they should invest their funds. Banks should also avoid giving any opinion or recommendation regarding a particular fund to a client.
It is also important for banks to be careful not to “talk up” information they have received from fund managers on a particular fund (e.g. such as a Fact Sheet/Update) when presenting the information to a client. Moreover, ensuring that they spend equal amounts of time and provide equal analysis on any funds they try to sell to a client would be prudent.
The ruling probably won’t change how financial institutions communicate information to professional investors that are highly experienced with the type of funds being offered to them by the bank as such clients will be less reliant on the Bank’s advice and the Bank has less obligations to such clients under the Code of Conduct (certain requirements are waived for professional investors).
Relevant to this issue, it important to consider the two new clauses that have recently been incorporated into the SFC’s Code of Conduct which will have full effect on 9 June 2017. The SFC confirmed the implementation of these clauses in its Consultation Conclusions on the Client Agreement Requirements dated 8 December 2015 (“Consultation Conclusions”). The most significant clause introduced into client agreements is the mandatory “suitability clause”.
The clause states as follows:
“6.2 Minimum Content of Client Agreement
… a Client Agreement should contain at least provisions to the following effect:
(i) the following clause: “If we [the intermediary] solicit the sale of or recommend any financial product to you [the client], the financial product must be reasonably suitable for you having regard to your financial situation, investment experience and investment objectives. No other provision of this agreement or any other document we may ask you to sign and no statement we may ask you to make derogates from this clause.”
This suitability clause imposes a legal obligation on financial institutions to only recommend or solicit the sale of a financial product that are deemed to be “reasonably suitable” for the client. Clients will have a contractual right to claim damages against the financial institution if they are recommended an “unsuitable” financial product. Previously a breach of the “suitability requirement” in the Code of Conduct (paragraph 5.2) would only potentially result in disciplinary action by the SFC against the financial institution.
It is not clear at this stage how the Courts will interpret the meaning of “suitability” in the context of a claim by an investor for breach of contract for failing to recommend a “suitable” product. However, guidance can be found in the Questions and Answers on Suitability Obligations of Investment Advisers (“the Q&A”) published by the SFC in May 2007 which provides guidelines on how to satisfy this “suitability” obligation.
This includes the following:
• Complying with the KYC provisions of the Code of Conduct (paragraph 5.1) where the Bank would have to take all reasonable steps to understand a client’s financial situation, investment experience and investment objectives;
• Developing a thorough understanding of the structure of investments products they recommend to clients; and
• Using professional judgment to match the risk return profile of each investment product with the personal circumstances of the client.
It would seem likely that the Court might adopt a similar criteria based approach in determining whether there has been a breach of the suitability clause. It is also helpful that the SFC is currently completing an internal study of the suitability requirement which will hopefully provide regulatory guidance on the scope of the Banks’ obligations to ensure that they comply with this clause.
Given the suitability clause will have the force of law, financial institutions may be more wary as to how they relay information to their clients so that communications do not fall within the scope of “recommend” or “solicit, which would trigger the suitability clause. Banks may react by either ensuring that any information relayed to a client is confined to purely factual information and descriptions of the financial product, or if they continue to “recommend” or “solicit” financial products to clients (which seems more likely), they will have to be more diligent in ensuring their internal compliance procedures and risk management are sufficiently robust to defend any claims that a product is “unsuitable” and that the bank has breached the suitability clause.
This clause exposes the Banks to greater risks as it now faces potential liability in the form of contractual claims being pursued by aggrieved investors, where liability was previously limited to sanctions from the SFC. Accordingly, Banks will be accountable to two disciplinary bodies on the suitability requirements– the Courts and the SFC – and may face two sanctions instead of one.
Although this clause does not come into full effect until 9 June 2017, the SFC: “expects all financial institutions to commence reviewing and revising their current and future client agreements immediately, and they are expected to make these revised client agreements available as soon as possible so that new clients can execute them and existing clients can amend or replace their existing agreements” (comment from SFC’s Chief Executive Officer, Mr. Ashley Alder).
In addition, the SFC has stated in its Consultation Conclusions that, “the New Clause should retain the same main features that are in the Suitability Requirement, with which the market is familiar, including the same trigger for applicability, i.e., making a “solicitation” or “recommendation”.
Accordingly, it appears that financial institutions should adopt their current interpretation and practice as to what might constitute a “recommendation” and “solicitation” under the “suitability requirement” in the Code of Conduct as regards the new “suitability clause”.
b. Will the banks have to do more than just rely on a Fact Sheet and Update from a fund manager moving forward to avoid being liable for misrepresentations made on them?
Banks cannot rely “blindly” on information received from a fund manager in a Fact Sheet and Update. They will need to show on the balance of probabilities that they had reasonable grounds to believe at the relevant time that the representations were true. If the Bank can show that it did its own due diligence with reasonable skill and care, then this should be enough to show it had reasonable grounds to believe the representations were true.
More risk disclosure statements/exemption clauses?
Banks may want to state that it is only relaying information given to them by the Fund Manager and that it does not warrant that the information is true or correct. Nevertheless, this may not be effective in protecting the Bank from liability in negligence if the Bank has assumed responsibility for giving advice and recommendations as they would still need to satisfy the Court that the clauses are “reasonable,” which may be difficult if the Bank has clearly given advice and recommendations. This will require an examination of the particular circumstances and the statements made by the Bank.
Banks may want to obtain more detailed information/documents from the Fund Manager to corroborate/support the statements in a Fact Sheet and Update. This would help the Bank show “reasonable grounds to believe” the representations and perhaps help show that the investor was not relying on the Banks’ advice and recommendations, but instead relying on information provided by the fund manager.
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