Circular to Product Providers of SFC-authorized unit trusts and mutual funds, SFC-authorized investment-linked assurance schemes and SFC-authorized unlisted structured investment products Guidance on Internal Product Approval Process

1. The purpose of this circular is to introduce a set of guidance on internal product approval process (“Guidance”) applicable to Product Providers (as defined in the Overarching Principles Section of the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products (the “SFC Products Handbook”)) in respect of SFC-authorized unit trusts and mutual funds, SFC-authorized investment-linked assurance schemes, and SFC-authorized unlisted structured investment products (collectively, “SFC-authorized products”).

   Background

2. The global regulatory trend¹ is increasingly focused on the early stages of the product life-cycle, as well as the product governance of the Product Providers throughout the product life-cycle.

3. In line with such global regulatory trend, the Commission is introducing this set of Guidance to further concretize the principles in the SFC Products Handbook.  This set of Guidance will:

   (a)   explain the requirements for a robust internal product approval process for Product Providers;

   (b)   cover the entire chain from inception of the product to post-sale; and

   (c)   remind Product Providers of their duty to consider investors’ interests as part of the product-design process.

4. This set of Guidance is built upon certain existing requirements under the SFC Products Handbook, in particular the requirement that Product Providers shall act honestly, fairly and professionally (GP1 under Chapter 3 of the Overarching Principles Section).

   The Internal Product Approval Process Guidance

5. Product Providers are expected to comply with this set of Guidance in respect of each SFC-authorized product.

6. This set of Guidance comprises 14 general principles as follows:

   (a)   Accountability– To ensure accountability of Product Providers and require Product Providers to consider investors’ interests as part of their internal product approval process –

   (i)   Product Providers are required to put in place an internal product approval committee;

   (ii)   all new products should go through an internal product approval process, with sign-offs from the internal product approval committee;

   (iii)   there should be proper documentary record for any approval or disapproval of products; and

   (iv)   to ensure accountability throughout the product life-cycle, all products should be subject to regular review after issuance by the internal product approval committee.

   (b)   Infrastructure– To ensure each new product goes through proper due diligence and an approval process with checks and balance –

   (i)   the internal product approval committee should comprise senior management and all key relevant functions covering both front-office and back-office functions of the Product Provider; and

   (ii)   in particular, risk and control functions of the Product Provider should include credit, market and operation risks, product control, legal and compliance functions.

   (c)   Target market identification – Product Providers should identify the target market and consider investors’ interests, and design their products accordingly. A Product Provider should conduct market assessments and identify the target market by considering carefully –

   (i)   the target market’s profile (including the target market’s investment objectives, knowledge and experience; risk appetite; expected investment return; and expected tenor²) having regard to the age and life expectancy of the target market;

   (ii)   whether the product and its risks would be generally understood by the target market; and

   (iii)   whether the product’s investment objectives and risk/return profile match the needs of the target market.

   (d)   Product design – Product Providers should conduct a detailed assessment of the product risks and features in order to be generally satisfied with the fairness of their products, taking into consideration any other alternatives for achieving the same investment objective and risk/return profile. In particular, a Product Provider should be generally satisfied that –

   (i)   the product is designed fairly, delivers a fair outcome to the target market and reasonably meets the needs of the target market;

   (ii)   the product payout is determined in a clear and transparent manner;

   (iii)   the product’s risks are generally commensurate with its return;

   (iv)   assumptions used in designing the product are market-driven, fair and unbiased;

   (v)   the product has gone through proper back-testing (if applicable); and

   (vi)   any material tax implications of the product are properly identified, reviewed and assessed, so that the associated tax risks are effectively disclosed and appropriately managed.

   (e)   Risk monitoring and stress testing – Product Providers should use their best efforts to assess all relevant risks of the products, and be generally satisfied that any product risk is properly managed such that –

   (i)   potential risks have been identified and will be managed throughout the product life-cycle;

   (ii)   extensive stress testing under different scenarios have been properly conducted to identify corresponding risks;

   (iii)   regular reviews of assumptions and product viability will be conducted; and

   (iv)   back-office risk functions use market data obtained from an independent source (instead of market data provided by the front office) for product risk assessment, in order to provide for checks and balance and to mitigate conflicts of interest.

   (f)   Termination/de-authorization – Product Providers should ensure that the termination/de-authorization process of a product is carried out fairly. In particular –

   (i)   any reasons or justifications for the termination/de-authorization should be fair and reasonable;

   (ii)   alternatives (if available) to investors should be fair and should not materially prejudice the rights or interests of investors;

   (iii)   notice contents and advance notification period given to investors must meet relevant regulatory and contractual requirements; and

   (iv)   the amount payable to investors upon any termination/de-authorization should be determined in good faith and in a commercially reasonable manner, including appropriate treatment of:

    
   • any accrued but unpaid interest/benefits;
   • any market value adjustments; and
   • any termination/de-authorization costs (if applicable).

   (g)   Modification of contract terms/constitutive documents – Product Providers should ensure that the following will be taken into account when making modification(s) or adjustment(s) to a product or its contract terms/constitutive documents –  

   (i)   any reasons or justifications for the modification should be fair and reasonable; and

   (ii)   notification period given to investors must meet relevant regulatory and contractual requirements.

   (h)   Fees – Product Providers should ensure that the fees are fair and proportionate. When considering the fee structure at launch (and, if applicable, throughout the life-cycle of the product), the following should be taken into account –

   (i)   whether the fees and charges payable by the investor for the product are fair, proportionate and commensurate with the investment objectives and risk/return profile;

   (ii)   the charging mechanism should be simple and transparent so that investors can easily identify and be able to assess the fees and charges, particularly in the case of a packaged product; and

   (iii)   whether the product is cost-efficient, taking into consideration the profiles and features of any comparable substitute products.

   (i)   Distributor selection – Product Providers are encouraged to exert control over the distribution process with regard to the specific target market.  As such, Product Providers should –  

   (i)   ensure the following when choosing the distribution channel:

   • the distributors chosen are appropriate for covering the target market identified; and
   • the distributors have the necessary product knowledge to understand the product and advise investors accordingly;

   (ii)   provide sufficient, on-going training to the selected distributors; and

   (iii)   obtain regular feedback from distributors throughout the product life-cycle.

   (j)   Investor education – Product Providers should consider the need and, where necessary, devise appropriate plans for conducting investor education programmes for their products.

   (k)   Disclosure – Product Providers should ensure that the disclosures relating to the products comply with all applicable laws and regulations, including any relevant codes and guidelines.

   (l)   Legal and compliance – Product Providers should ensure that –

   (i)   the legal and compliance functions play a role throughout the product life-cycle;

   (ii)   the contractual terms are clear; and

   (iii)   each product and its issuance comply with all applicable requirements throughout the product life-cycle.

   (m)   Conflicts of interest – Product Providers should avoid/manage any actual or potential conflicts of interests by conducting all transactions at arm’s length and establishing and maintaining necessary “Chinese walls”.  In particular, where such a conflict cannot be avoided, and provided that investors’ interests can be sufficiently protected, the conflict shall be managed and minimized by appropriate safeguards, measures and product structure and these measures and safeguards shall be properly disclosed to investors.

   (n)   Post-sale obligations – Product Providers should ensure that they will continue to serve the following functions after product issuance –

   (i)   establish procedures to monitor product performance and review product viability;

   (ii)   review distribution strategy;

   (iii)   ensure ongoing disclosure of information relating to the product to keep investors informed;

   (iv)   handle investors’ requests and review complaints; and

   (v)   provide valuation and market-making, if applicable.

   Compliance procedures
   
   

7. Subject to the transitional arrangement as set out in paragraph 12, all applicants making applications for authorization of SFC-authorized products under section 104 or 104A of the Securities and Futures Ordinance (“SFO”) are required to submit a written confirmation (in the form set out in Appendix 1 to this circular) (“Confirmation”) to the Commission that this set of Guidance has been and will be fully complied with.  Such Confirmation should be submitted with the relevant application form and other application documents.

8. The Confirmation must be signed by a person of sufficient seniority with the necessary authority to sign on behalf of the applicant³ acceptable to the Commission.

9. The Commission reserves the right to request information, records and documents from the applicants in respect of the product or the internal product approval process as the Commission deems appropriate in pursuing its regulatory objectives and performing its functions under the SFO.

10. As a general reminder, applicants should note that any representation in, or referred to in, an application, and any representation made from time to time in support of the application which is false or misleading in a material particular, the provision of any information to the Commission which is false or misleading in a material particular or the provision of any record or document which is false or misleading in a material particular constitutes an offence under either section 383(1), 384(1) and/or 384(3) of the SFO.

    Effective Date and Transitional Arrangement

11. This set of Guidance will take effect on 1 May 2014 (“Effective Date”).

12. In respect of applications for authorization of SFC-authorized products received on or after the Effective Date but before 31 July 2014, being the date falling three months after the Effective Date, applicants are granted a transitional period so that they may submit the Confirmation to the Commission before final authorization of the relevant product(s) is granted.

13. All applicants of applications for authorization of SFC-authorized products submitted on or after 31 July 2014 are required to submit the Confirmation to the Commission as part of the application documents package.

14. Product Providers of existing SFC-authorized products (in respect of which authorization remain in force as of the date of this circular) will not normally be required to submit a Confirmation to the Commission for any post-authorization applications (e.g. a scheme change application).  However, so long as these products remain authorized⁴, the Product Providers are expected to comply with the general principles on their product governance during the product life-cycle.  The Commission reserves the power to request for a Confirmation during a post-authorization application should there be any doubt on the Product Provider’s compliance with this set of Guidance.

15. To provide further guidance and clarification to market practitioners on the application of this set of Guidance, we have updated the Frequently Asked Questions in respect of the relevant types of SFC-authorized products posted on our website (www.sfc.hk).

16. Please contact the relevant case officers in charge if you have any questions. 

Investment Products Division
Securities and Futures Commission

Revised as of 4 March 2016

Appendix 1

Form of confirmation to be submitted to the Commission regarding compliance with this set of Guidance

To: Securities and Futures Commission

From: [Name of the applicant]

Date: [Date of application⁵]

Subject of application: [*] (“Application”)

We hereby confirm and undertake that all requirements set out in the Circular to product providers of SFC-authorized unit trusts and mutual funds, SFC-authorized investment-linked assurance schemes and SFC-authorized unlisted structured investment products entitled “Guidance on Internal Product Approval Process”, as amended from time to time, have been and will be complied with in respect of the product(s) under the Application.

Signed on behalf of the applicant:

Name of applicant:                                                                  

Name of authorized signatory:                                                

Position of authorized signatory⁶:                                            

Signature: