HKSI Licensing Examination Paper 1 (Regulation) — All Questions

General Principle 1 of the SFC Code of Conduct requires a licensed person, in conducting business, to act:

• a.So as to maximise commission income
• b.In the firm's own commercial interest first, provided the client is not deliberately deceived during the process
• c.Honestly, fairly, and in the best interests of clients and the integrity of the market✓
• d.Only within the letter of the law, ignoring fairness

General Principle 1 (Honesty and fairness) requires licensed persons to act honestly, fairly and in the best interests of their clients and the integrity of the market. It is the foundational conduct principle of the Code of Conduct.

Before providing services, the Code of Conduct requires an intermediary to take reasonable steps to establish the client's identity, financial situation, investment experience and objectives. This 'know your client' duty is found in:

• a.The tipping-off offence in the AMLO
• b.The Listing Rules
• c.Part XV of the SFO
• d.Paragraph 5.1 of the Code of Conduct (Know your client)✓

The know-your-client duty is set out in paragraph 5.1 of the Code of Conduct, supporting General Principle 4 (Information about clients). It underpins the suitability obligation in paragraph 5.2.

A licensed representative recommends a complex derivative product to a retail client. The Code of Conduct's suitability obligation (para 5.2) requires that the recommendation be:

• a.Treated as suitable only where the client signs a waiver giving up all rights and protections under the Code of Conduct
• b.Approved by HKEX in advance
• c.Reasonably suitable for the client given their financial situation, investment experience and objectives✓
• d.The product carrying the highest commission

Paragraph 5.2 requires that when making a recommendation or solicitation, the intermediary ensures its suitability for the client in all the circumstances. The suitability obligation is also incorporated into the client agreement through the mandatory Suitability Clause.

An intermediary that trades as principal against a client's order must, under General Principle 6 of the Code of Conduct:

• a.Conceal its principal position from the client so as not to discourage the client from proceeding with the transaction
• b.Manage the conflict fairly, disclose its capacity, and give priority to the client's interests✓
• c.Always refuse the trade
• d.Charge the client a penalty

General Principle 6 (Conflicts of interest) requires a licensed person to avoid conflicts where possible and, where they arise, to ensure clients are fairly treated, including disclosing whether it acts as principal and giving client orders priority.

The Code of Conduct requires an intermediary to enter into a written client agreement. That agreement must:

• a.Be filed with, and individually approved by, the SFC before the intermediary executes any trade for the client
• b.Waive the firm's duty of suitability
• c.Be in a form the client can understand and must not contain terms inconsistent with the Code✓
• d.Be signed only by the responsible officer

A client agreement must be clear, fair and not misleading, and cannot contain provisions inconsistent with the Code. Clauses that purport to override the suitability obligation are unenforceable.

General Principle 2 of the SFC Code of Conduct requires a licensed person, in conducting business activities, to act with:

• a.A view to prioritising the transactions that generate the highest commission for the firm
• b.A guarantee that every recommended transaction will be profitable for the client
• c.Due skill, care and diligence, in the best interests of clients and the integrity of the market✓
• d.Diligence only when dealing with professional investors, applying a lower standard of care to retail clients

General Principle 2 (Diligence) of the SFC Code of Conduct requires a licensed or registered person to act with due skill, care and diligence, in the best interests of its clients and the integrity of the market. The standard does not vary by client type or commission.

General Principle 3 of the SFC Code of Conduct requires a licensed person to have and to employ effectively:

• a.Only such staff and systems as are required to maximise trading volume, regardless of its compliance obligations
• b.The resources and procedures needed for the proper performance of its business activities✓
• c.A guaranteed minimum level of annual profitability
• d.The largest possible sales team

General Principle 3 (Capabilities) requires a licensed person to have and employ effectively the resources and procedures needed for the proper performance of its business activities. Adequate systems, staffing and controls are a licensing and ongoing obligation.

General Principle 4 of the SFC Code of Conduct (Information about clients) requires a licensed person to:

• a.Seek from clients information about their financial situation, investment experience and investment objectives relevant to the services to be provided✓
• b.Publish each client's portfolio on the firm's public website
• c.Collect a client's information once at account opening and never update it, even after becoming aware that the client's circumstances have materially changed
• d.Share client information freely with other brokers to improve overall market liquidity

General Principle 4 (Information about clients) requires a licensed person to seek from clients information about their financial situation, investment experience and investment objectives relevant to the services provided. It underpins the know-your-client duty in para 5.1 and suitability in para 5.2.

General Principle 5 of the SFC Code of Conduct (Information for clients) requires a licensed person to:

• a.Withhold risk information so as not to alarm clients
• b.Make adequate disclosure of relevant material information in its dealings with clients✓
• c.Provide product information only to professional investors
• d.Disclose fees only after a transaction has been completed

General Principle 5 (Information for clients) requires a licensed person to make adequate disclosure of relevant material information in its dealings with clients, including product features, risks, fees and its own capacity where relevant.

General Principle 8 of the SFC Code of Conduct (Client assets) requires that client assets be:

• a.Available to the firm as an interest-free source of working capital
• b.Promptly and properly accounted for and adequately safeguarded✓
• c.Pooled with the firm's own proprietary assets to simplify record-keeping
• d.Held only where the client is a professional investor

General Principle 8 (Client assets) requires that client assets be promptly and properly accounted for and adequately safeguarded. It is supported by the Securities and Futures (Client Money) Rules and (Client Securities) Rules requiring segregation from the firm's own assets.

General Principle 7 of the SFC Code of Conduct (Compliance) requires a licensed person to:

• a.Comply with all regulatory requirements applicable to its business✓
• b.Follow the Code of Conduct only when dealing with retail clients
• c.Comply with the law only where non-compliance would be detected
• d.Comply only with those Hong Kong requirements that its overseas parent has separately chosen to adopt, disregarding the rest

General Principle 7 (Compliance) requires a licensed person to comply with all regulatory requirements applicable to the conduct of its business so as to promote the best interests of clients and the integrity of the market.

Under the SFO, an intermediary that makes an unsolicited (cold) call to sell securities to a member of the public:

• a.May do so freely to anyone at any time
• b.Is generally prohibited from doing so, subject to limited exceptions such as calls to existing clients or professional investors✓
• c.May cold-call any prospective retail client provided the call is recorded and a contract note is issued within seven days afterwards
• d.May do so only after 10 p.m.

SFO s.174 restricts unsolicited calls: a person must not make an unsolicited call to induce another to enter into certain agreements, subject to prescribed exceptions (for example calls to existing clients or professional investors made in permitted circumstances).

When executing a client order, the SFC Code of Conduct requires an intermediary to:

• a.Aggregate the client's order with the firm's proprietary orders and give the firm's own fills priority whenever the market moves favourably
• b.Execute the order on the best available terms (best execution)✓
• c.Delay execution in order to obtain a better commission
• d.Always route the order to its own affiliated broker

The Code of Conduct's best-execution requirement obliges a licensed person to execute client orders on the best available terms, taking reasonable care to act in the client's best interests. Client orders take priority over the firm's own orders in the same security.

A dealer places the firm's own buy order ahead of a large client buy order that is likely to move the price. This is:

• a.Front running, which is prohibited✓
• b.A legitimate hedging technique, provided the firm later discloses the practice in its annual return to the SFC
• c.Best execution
• d.Permitted proprietary trading

Dealing ahead of a client order to profit from the anticipated price impact is front running. The Code of Conduct's customer-priority rule requires client orders to be given priority over the firm's and its staff's own orders in the same security.

Effecting excessive transactions in a client's account primarily to generate commissions is known as:

• a.Scalping
• b.Best execution
• c.Churning, which the Code of Conduct prohibits✓
• d.Portfolio rebalancing, which is expressly encouraged by the Code of Conduct regardless of the client's objectives

Churning — trading a client's account excessively to generate commission rather than to serve the client's interests — breaches the Code of Conduct's obligations to act in the client's best interests and not to place volume of business ahead of the client.

Before operating a client's account on a discretionary basis, an intermediary must obtain:

• a.The client's prior written authorisation, confirmed at least annually✓
• b.The SFC's written approval
• c.A verbal instruction only
• d.Nothing further, because discretion is automatically granted once a client agreement of any kind has been signed

Para 7 of the Code of Conduct (Discretionary accounts) requires prior written authorisation from the client before an account is operated on a discretionary basis, with the authority confirmed at least annually and operation of the account properly supervised.

When dealing with an 'institutional professional investor' (such as a bank or an SFC-defined institution), an intermediary under the Code of Conduct:

• a.Must treat the client exactly as a retail client
• b.Cannot provide any services at all
• c.Is exempt from certain conduct requirements, such as the suitability and client-agreement obligations, for that client✓
• d.Must always issue a risk disclosure statement

Para 15 of the Code of Conduct and the Securities and Futures (Professional Investor) Rules allow certain conduct requirements (e.g. the client agreement and suitability obligations) to be dispensed with for institutional professional investors, who are treated as needing less protection.

Before a corporate customer may be treated as a professional investor and lose certain protections, the Code of Conduct requires the intermediary to:

• a.Simply take the client's word that it qualifies
• b.Treat all companies as professional investors automatically
• c.Obtain the SFC's approval for each such client
• d.Assess the client against the prescribed criteria and follow the prescribed procedures, including a written explanation of the protections being given up and the client's written agreement✓

For corporate professional investors, para 15 of the Code of Conduct requires the intermediary to be satisfied the client meets the qualifying criteria, to assess the client's knowledge and experience, and to follow the prescribed opt-in procedures, including explaining in writing the protections being waived.

Before a client who is not a professional investor enters into a derivative product transaction, para 5.3 of the Code of Conduct requires the intermediary to:

• a.Do nothing extra, since derivative products are treated identically to ordinary shares under the Code
• b.Guarantee the client against loss
• c.Assess the client's knowledge of derivatives and characterise the client accordingly✓
• d.Obtain the SFC's consent to the trade

Para 5.3 of the Code of Conduct requires an intermediary to assess a non-professional client's knowledge of derivatives before effecting a derivative transaction, and to provide appropriate advice or warnings where the client has no such knowledge.

Before a client deals in futures or options, the Code of Conduct requires the client to be provided with and to acknowledge:

• a.A copy of the firm's audited accounts
• b.A risk disclosure statement describing the nature and risks of the products✓
• c.A written promise from the responsible officer that the client's capital is fully protected against market losses
• d.A guaranteed rate of return

The Code of Conduct requires an intermediary to provide a risk disclosure statement and obtain the client's acknowledgement before dealing in derivatives such as futures and options, so the client understands the leverage and potential for loss.

Every client agreement must incorporate the mandatory 'suitability clause', which provides that:

• a.The firm need not consider suitability for any professional investor
• b.The client waives all rights against the firm
• c.The firm may vary the agreement at any time without notice
• d.If the firm solicits the sale of or recommends a financial product, the product must be reasonably suitable for the client, and this term may not be derogated from✓

Since the 2017 reforms, the Code of Conduct requires a mandatory suitability clause in client agreements: where the firm solicits or recommends a financial product, it must be reasonably suitable for the client having regard to the client's circumstances. The clause cannot be contracted out of.

When recommending an investment product, para 8.3A of the Code of Conduct requires an intermediary to disclose to the client:

• a.Nothing about its own remuneration
• b.The home addresses of the firm's directors
• c.The monetary and non-monetary benefits it will receive, and whether the product is a 'complex product' or has been independently reviewed✓
• d.Only the client's own tax position

Para 8.3A of the Code of Conduct requires disclosure, at the point of sale, of the monetary and non-monetary benefits the intermediary receives, whether it is independent, and (for complex products) additional information, so the client understands the firm's incentives.

After executing a transaction for a client, an intermediary must:

• a.Promptly confirm the transaction and provide a contract note in accordance with the notification and record-keeping requirements✓
• b.Wait until the client next visits the office
• c.Provide confirmation only on request and only to professional investors
• d.Notify only the SFC

The Code of Conduct and the Securities and Futures (Contract Notes, Statements of Account and Receipts) Rules require prompt confirmation of executed transactions and issue of a contract note, so clients have a timely and accurate record.

The Securities and Futures (Contract Notes, Statements of Account and Receipts) Rules generally require an intermediary to provide a client with a statement of account:

• a.Once every ten years, or whenever the client demands one in writing and pays a fee for its preparation
• b.At least monthly where there has been activity, and otherwise periodically✓
• c.Only if the client is a professional investor
• d.Only when the account is closed

The Contract Notes, Statements of Account and Receipts Rules require monthly statements where there has been activity in the account during the month, and periodic statements otherwise, so clients can monitor their holdings and balances.

The Code of Conduct requires a licensed corporation to handle client complaints by:

• a.Ignoring complaints from retail clients
• b.Referring every complaint directly to the police
• c.Ensuring complaints are handled promptly and properly, keeping proper records and, where a complaint is not resolved, informing the client of further avenues✓
• d.Charging the client a fee to lodge a complaint

The Code of Conduct requires firms to handle client complaints promptly and fairly, maintain proper records, and, where a complaint cannot be resolved, advise the client of other avenues (such as the Financial Dispute Resolution Centre) available to them.

To control conflicts of interest, the Code of Conduct requires a firm's controls over staff personal-account dealing, typically requiring employees to:

• a.Trade freely without disclosure, provided they do not use the firm's own trading terminals to place the orders
• b.Trade only through competitor firms
• c.Deal through accounts of which the firm is aware and can monitor, with pre-clearance where appropriate✓
• d.Never own any securities at all

The Code of Conduct requires firms to have controls over employees' personal dealing — typically requiring staff to deal through accounts the firm can monitor and to obtain pre-clearance — so the firm can detect front running, insider dealing and other conflicts.

A licensed representative is offered a substantial personal gift by a fund manager whose products she sells. The Code of Conduct's conflict principles require her to:

• a.Accept it privately without any disclosure
• b.Accept the gift automatically, because benefits received from product issuers are always outside the scope of the Code of Conduct
• c.Avoid or manage the conflict, following her firm's inducements policy, and not let it impair her duty to clients✓
• d.Demand an even larger gift

General Principle 6 (Conflicts of interest) and the Code's inducements provisions require gifts and benefits that could compromise a representative's duty to clients to be avoided or properly managed and disclosed under firm policy.

Information a client provides to an intermediary in the course of the relationship should be:

• a.Kept confidential and used only for proper purposes, subject to legal or regulatory disclosure obligations✓
• b.Posted publicly in the interests of transparency
• c.Shared with any third party who asks, provided that third party is also a licensed intermediary somewhere in the world
• d.Sold to data brokers to offset costs

The Code of Conduct and the Personal Data (Privacy) Ordinance require client information to be kept confidential and used only for the purposes for which it was collected (or directly related purposes), except where disclosure is required by law or regulators.

A licensed representative tells a client, 'I personally guarantee you won't lose money on this trade.' This is:

• a.Prohibited — intermediaries must not guarantee clients against loss or make misleading assurances✓
• b.Permitted, provided the representative also promises to share half of any profits the client makes on the trade
• c.Required by the suitability rule
• d.Acceptable if the client is a professional investor

Guaranteeing a client against loss, or making misleading assurances about performance, breaches General Principle 1 (honesty and fairness) and the Code of Conduct. Firms and representatives must not give such guarantees.

General Principle 1 and the Code of Conduct prohibit a representative from:

• a.Declining to execute an unsuitable trade
• b.Explaining a product's risks to the client
• c.Making any false or misleading representation to a client in order to induce a transaction✓
• d.Recording a client's telephone order

General Principle 1 (Honesty and fairness) prohibits false or misleading representations to induce a client to transact. Honest, fair dealing in the client's best interests is the foundational conduct standard.

When aggregating and allocating a block order across several client accounts, an intermediary must:

• a.Allocate the best prices to the largest commission-payers
• b.Give the best fills to the firm's proprietary account
• c.Allocate all favourable fills to whichever client complains most frequently, so as to reduce future complaints
• d.Allocate fairly and not favour one client (or itself) over another✓

The Code of Conduct requires fair allocation of aggregated orders, with a pre-determined and fair basis of allocation, so that no client (or the firm itself) is unfairly preferred over others.

In dealing with elderly or otherwise vulnerable clients, SFC guidance and good conduct expect an intermediary to:

• a.Take extra care to ensure the client understands the product and that it is suitable, with additional safeguards for higher-risk or complex products✓
• b.Refuse all business from clients over 60
• c.Apply no special care
• d.Automatically place every such client into the highest-risk products available, on the assumption they need higher returns

SFC guidance on vulnerable clients expects heightened care to ensure understanding and suitability, including additional steps (such as more thorough explanation and, for complex or higher-risk products, extra safeguards) when serving elderly or vulnerable investors.

Before recommending an investment product, the Code of Conduct expects an intermediary to conduct product due diligence so that it:

• a.Can rely solely on the issuer's marketing brochure without any independent assessment of the product's risks
• b.Knows only the product's sales commission
• c.Understands the product's nature, features and risks well enough to assess its suitability for clients✓
• d.Can advertise the product as widely as possible

The Code of Conduct requires an intermediary to conduct due diligence on the products it recommends (know your product), understanding their features and risks, as a precondition to assessing suitability under para 5.2.

Under SFC requirements, order instructions received by telephone should generally be:

• a.Written down from memory by the dealer at the end of the trading week, without any contemporaneous audio record
• b.Recorded, with the recordings retained for the prescribed period✓
• c.Recorded only for professional investors
• d.Never recorded, in order to protect client privacy

SFC requirements expect telephone order instructions to be recorded and the recordings retained for the prescribed period, providing an audit trail that helps resolve disputes and detect misconduct.

In a Hong Kong IPO, an applicant who lodges multiple applications for the same shares in their own name and through nominees:

• a.Increases their allocation legitimately
• b.Is rewarded with a guaranteed allocation
• c.Is acting properly, because the prospectus rules positively encourage each investor to lodge as many separate applications as possible
• d.Breaches the terms of the offer; such applications are liable to be rejected and may constitute an offence✓

Public-offer terms prohibit multiple or duplicate applications for the same shares. Such applications are liable to rejection, and making them (for example using false or nominee identities to obtain more shares) can constitute an offence.

Where an intermediary solicits the sale of, or recommends, an investment product to a client, the SFC expects it to:

• a.Document the rationale for the recommendation and the information relied on, and retain the records✓
• b.Destroy the supporting documents immediately after the transaction settles, to conserve storage space
• c.Keep no records of the advice given
• d.Record only the commission earned

SFC suitability guidance expects firms to document the rationale for a recommendation and the client information relied on, and to retain those records, so that suitability can later be demonstrated.

To manage conflicts of interest, a firm that publishes investment research must:

• a.Pay analysts based on specific investment-banking deals they help win
• b.Let analysts trade freely ahead of their own reports
• c.Suppress negative research on the firm's own clients
• d.Disclose the firm's interests and manage analysts' personal dealing so that the objectivity of research is not compromised✓

General Principle 6 (Conflicts of interest) and the Code's analyst provisions require firms to disclose relevant interests and manage analysts' personal dealing and remuneration so that research is not improperly influenced by the firm's other business.

When an intermediary executes a client order as agent, it should disclose:

• a.Only its total annual revenue, but never the specific commission charged on the individual transaction
• b.Its capacity as agent, and any commission or fee charged for the service✓
• c.Only the counterparty's identity
• d.Nothing, since its capacity is irrelevant

General Principle 6 and the Code of Conduct require an intermediary to disclose the capacity in which it acts (agent or principal) and the commission or charges applied, so the client understands the cost and any conflict.

Before providing securities margin financing to a client, an intermediary should:

• a.Enter a written agreement, explain the risks (including forced liquidation), and assess the client's ability to meet the obligations✓
• b.Guarantee that the client will not receive margin calls
• c.Lend against the client's shares without any agreement, adjusting the interest rate afterwards at the firm's sole discretion each day
• d.Extend unlimited credit to the client

The Code of Conduct requires margin lending to be governed by a written agreement, with the risks (including the risk that collateral may be sold to meet margin calls) explained, and the client's financial situation and ability to meet obligations assessed.

Where a firm holds client securities in a pooled account and wishes to rely on a standing authority to deal with them, the authority must:

• a.Be in writing, specify its scope, be subject to a maximum period (renewable), and be revocable by the client✓
• b.Be given orally each morning
• c.Allow the firm to transfer the securities to its own account without any limit
• d.Be permanent and irrevocable

Under the Securities and Futures (Client Securities) Rules, a standing authority permitting a firm to deal with pooled client securities must be in writing, limited in scope and duration (renewable, e.g. up to 12 months), and revocable by the client on notice.