Can banks still rely on non-reliance clauses in transactions without "suitability clause" ?

August 2017

The appeal court’s judgment in Chang Pui Yin v Bank of Singapore Limited (CACV 194/2016), decided on 20 July 2017, has raised the question whether authorized institutions can still be contractually protected by non-reliance clauses in alleged mis-selling where the transactions were conducted well before the Securities and Futures Commissions (SFC) introduced the mandatory clauses to be incorporated into every client agreement pursuant to paragraphs 6.2(i) and 6.5 of the revised Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct), which took effect from 9 June 2017.

Before the SFC imposed the new requirement by revising the Code of Conduct, the legal principle established by case law was that banks and financial institutions were contractually protected by non-reliance clauses in case of allegation of mis-selling by their clients. In two Hong Kong cases, Kwok Wai Hing Selina v HSBC Private Bank (Suisse) SA (formerly known as HSBC Republic Bank (Suisse) SA) (HCCL 7/2010), and DBS Bank (Hong Kong) Limited v San-Hot HK Industrial Company Limited and Hao Ting (HCA 2279/2008), the court upheld the “execution-only” clauses in the contractual documents as effective. In one of the above cases, the court rejected the argument by the client that professional duties were expressly incorporated into contracts by reference to the Code of Conduct. The court explained that paragraph 5.2 of the Code of Conduct did not have any contractual effect. Hence, a well-drafted disclaimer in the client agreement should prevail over the suitability requirement in paragraph 5.2 of the Code of Conduct.

Revised Code of Conduct in June 2017

The SFC’s new requirement did not seek to change any legal principle recognized by case law. It simply requires that every bank and financial institution add an overriding contractual provision in every agreement with clients which will negate the legal effect of any disclaimers or non-reliance clauses if the institution solicits or recommends any financial product. The new requirement is applicable only to financial products as defined in the explanatory note to new paragraph 6.2(i) of the Code of Conduct, which means any securities, futures contracts or leveraged foreign exchange contracts as defined under the Securities and Futures Ordinance. Regarding leveraged foreign exchange contracts, the requirement is only applicable to those traded by persons licensed for Type 3 regulated activity (and hence, it does not apply to authorised institutions under the Banking Ordinance).

The overriding contractual provision also contains a non-derogation clause that no other provision of the client agreement or any other document the institution may ask the client to sign and no statement the institution may ask the client to make derogates from it.

The non-derogation clause, and the Code’s requirement (ie, “do not mis-describe your actual services”), together render any non-reliance clause or “execution-only clause” ineffective if the financial institution solicits or recommends any financial product.

The combined effect is that a client will have a cause of action against a financial institution for damages for mis-selling in court. The basis of the claim will be breach of contract. Licensed and registered persons are now under a contractual duty to solicit the sale of or recommend financial products that are reasonably suitable for a client having regard to his or her financial situation, investment experience and investment objectives. The SFC takes the view that “reasonably suitable” is an objective standard which is sufficiently clear and familiar for a Court to readily interpret and apply the standard in the prevailing circumstances.

Significance of the Court of Appeal’s decision

The appeal court in Chang Pui Yin overturned the judgment of the first instance that the non-reliance and non-advisory clauses in the agreements between the bank and the customer did not apply to the transactions in question, but it held that the bank could not rely on these clauses as they were unconscionable under the Unconscionable Contracts Ordinance (UCO) and an unreasonable exclusion of liability under the Control of Exemption Clauses Ordinance (CECO).

The approach of the appeal court in Chang Pui Yin stands in marked contrast to that in Kwok Wai Hing Selina, above, in which the UCO and CECO were just briefly mentioned without in-depth analysis. In San-Hot HK Industrial Company Limited, above, only the CECO was discussed, but not the UCO.

The change in approach hints that in future first instance courts will more actively take the UCO and the CECO into account. In interpreting client agreements, judges will be more inclined to look at the substance, rather than the face value of the provisions that seek to protect the banks.

While transactions conducted after 9 June 2017 should supposedly be handled by banks and institutions pursuant to a new workflow to ensure that the solicitation and recommendation of the financial products are “reasonably suitable” for the client in question, the appeal court’s decision could spur dormant mis-selling claims regarding transactions conducted before that back to life. If the fact of a potential claim falls squarely on that in Chang Pui Yin, the customer will likely succeed in recovering the loss in the investment suffered from the bank or financial institution even if the financial product was subscribed well before 9 June 2017. Banks and financial institutions with any pre-existing claims should carefully assess the underlying facts to determine whether the customers may be able to successfully rely on the reasoning in Chang Pui Yin. They are no longer treat the non-advisory or non-reliance clauses in client agreements as fool-proof.

The new approach of the Court of Appeal also highlights the implications of the revised Code of Conduct’s “suitability requirement”, which should no longer be viewed in isolation. The interplay between the mandatory contractual provision under the Code and the statutory provisions in the UCO and the CECO may give rise to potential claims in a wider range of factual matrix.

Factual background of the case

In Chang Pui Yin, the customers were an elderly couple and a company owned by one of them, Nextday International Limited (“NIL”). The couple had lived a modest lifestyle. One of them had worked as a factory manager and sandwich maker and the other as a primary school teacher and cashier at the sandwich shop.

In 1997 the couple received a windfall of about HK$120 million and opened a private banking account in 2004. A couple of years later they opened an account using NIL as the corporate vehicle. They suffered extensive loss during the financial crisis and commenced the proceedings against the bank for recovering the loss.

The trial judge found that the couple were not experienced or knowledgeable investors. According to the risk assessments and client suitability questionnaire they did with the bank, they had a “medium” investment risk profile. The questionnaires were completed by the account manager, whom the couple had followed from her previous employer, which were not verified by the couple. The trial judge found that the questionnaires were completed inaccurately so as to enable the sale of high risk products to the couple and NIL. The court of first instance accepted expert evidence that the customers’ portfolios were “extremely risky”, and also found that they had trusted and relied entirely on the account manager, who had not explained the risks of the products properly.

The client agreements that the customers had signed with the bank contained clauses to the effect that they were responsible for making their own investment decisions, that the bank was assuming no advisory duties towards them and that it would not be responsible for any loss arising from products it had recommended or sold to them.

The trial judge held that despite the non-reliance clause, the bank had in fact provided an advisory service through the account manager and that she was effectively managing the accounts. Significant weight was also placed on the bank’s marketing materials, which referred to “investment advice” and “quality advice” being part of the services provided by the bank. The court of first instance held that the non-reliance and non-advisory clauses did not apply to the accounts of the transactions in question, as they were not “pure custody accounts”.

The Court of Appeal’s decision

The Court of Appeal overturned the trial judge’s interpretation of the client agreements. The appeal judges unanimously held that the trial judge erred in finding that, because advisory statements had been made, the bank had assumed responsibility for them. The trial judge also erred in holding that because there had been an assumption of responsibility, any clauses in the agreements that were inconsistent with that must be inapplicable. While the appeal court’s judgment might seem to relieve the bank’s potential liability in this context, the bank’s defence remains failed because the appeal judges held that the non-reliance and non-advisory clauses were unenforceable under the UCO and the CECO.

To successfully argue that a contract is unconscionable under the UCO, a plaintiff must deal as a “consumer” as defined. The trial judge held that the plaintiffs’ claim failed on the third limb of this definition, as the services were not “of a type ordinarily supplied for private use or consumption” under the UCO. The Court of Appeal rejected that analysis, holding that even though private banks’ customers are often wealthy, they can still “purchase goods and services for private consumption”.

In considering the factors under section 6 of the UCO as to whether the clauses should not be enforced, the Court of Appeal focused on the fact that (i) there was no scope in reality for the plaintiffs to negotiate the terms and conditions, even though they could have gone to another bank, (ii) there was no legitimate interest in the bank having absolute protection from client losses and (iii) it would “make a mockery” of the bank’s compliance with its regulatory duties under the SFC’s Code of Conduct if it could rely on the clause. The three appeal judges considered that the entire arrangement adopted by the bank was to deprive the plaintiffs of the ability to make informed risk decisions and that conduct in question was “so aberrant from commercial norms” that it would be unconscionable for the bank to be able to rely on the protections provided by the non-reliance and non-advisory clauses.

To defend the argument based on the CECO, the bank submitted that the non-advisory and non-reliance clauses were not clauses excluding or restricting liability, but that they were instead terms defining the scope of obligations owed that were not subject to the CECO. They tried to distinguish between what are referred to as exclusion clauses and “basis” clauses. The Court of Appeal held that such argument was not applicable to cases involving comparatively unsophisticated investors such as the couple and NIL, which was just their corporate vehicle. The court should look at the substance of the clause rather than its form, as to do otherwise would emasculate the CECO by allowing well-advised commercial parties to draft their way around it. As the bank had operated the accounts by advertising to the plaintiffs that it would recommend and select suitable products for the couple, it would not be fair or reasonable to allow the bank to rely on the non-advisory and non-reliance clauses to avoid liability.

Lesson to learn

The court of first instance in this case sought to dis-apply a clearly worded contractual provision on the ground that the bank had in fact provided an advisory service. Such approach in contractual interpretation would have caused confusion and uncertainty. The Court of Appeal's decision to overturn this point followed the well-established approach in contractual interpretation and should be welcomed.

On the other hand, the Court of Appeal’s reasoning based on the UCO and CECO would probably cause some concern among the banking industry. In this case two sets of accounts were involved, one belonging to the couple personally and the other NIL. The sole business of NIL was undoubtedly investment of private wealth products for the benefit of the couple. There is no detailed analysis in the Court of Appeal’s judgment as to whether in this context a company can be operating other than “in the course of business” within the meaning of the UCO, even though NIL was just a private corporate vehicle, rather than a “business” in the normal sense.

The Court of Appeal’s reliance on the SFC’s Code of Conduct when assessing unconscionability also has the potential to take Hong Kong law into a new direction. In reaching this conclusion the Court relied heavily upon Australian legislation that specifically provides that industry codes of practice can be taken into account, a factor that was not expressly provided for in the UCO. Arguably, this in effect imports the Code of Conduct as an implied contractual term, something that previous Hong Kong decisions have been unwilling to do. Although the Court of Appeal recognised in its decision that it is arguable “not every breach of the Code would give rise to unconscionability” under the UCO, its reasoning will likely encourage plaintiffs to rely on this piece of legislation in future.

The application of a substance over form analysis when considering the potential application of the CECO also marks a departure from English cases such as JP Morgan Chase v Springwell Navigation and Titan Steel Wheels v RBS. The Court of Appeal no doubt shared the same concerns about contractual limitations of liability that led to the SFC’s introduction of the suitability clause in June 2017. That amendment to the Code of Conduct requires licensed or registered intermediaries to include a term in their client agreements that any products recommended or solicited must be “reasonably suitable” for the client having regard to their financial situation, investment experience and investment objectives. Had such a clause been present in the plaintiffs’ customer agreements in this case, it would likely have enabled them to pursue a contractual claim against the bank without the need to rely on either the UCO or CECO.

An even more important question is the impact of the Court of Appeal’s rationale on the pending mis-selling complaints about the transactions that took place before the implementation of the suitability requirement as amended in June 2017. Customers who already gave up their complaint based on the previous decisions of Kwok Wai Hing Selina and San-Hot HK Industrial Company Limited (above) may reactivate their complaints and reply on the Court of Appeal’s judgment to side-step the non-reliance clauses. Banks should review their position in all pre-June 2017 cases.

For future transactions, banks should enhance their compliance procedures to ensure that customers’ financial situation, investment experience and investment objectives are adequately analysed and recorded, and more importantly the information must be updated from time to time.