Regulation of the financial sector in Hong Kong does not properly protect retail investors and should be tightened, said a lawmaker who oversaw the drafting of the relevant legislation more than a decade ago.
Sin Chung-kai, who was chairman of the legislative committee responsible for the Securities and Futures Bill, published in late 2000 and enacted in 2003, says the city's two-tier system of regulation has created gaps, leaving the potential for unlicensed products to be sold undetected.
"I do not have any intention to escape my responsibilities. Supervising these selling activities seems to be insufficient," Sin told the South China Morning Post when asked about a clutch of mis-selling scandals that have reverberated through the expatriate-focused wealth management industry in recent years.
Some US$10.3 billion in new money was invested in licensed funds last year, according to data from the Hong Kong Investment Funds Association, which does not track unlicensed funds.
Many unlicensed funds are marketed directly to retail investors by firms that take advantage of a two-tier regulatory structure that gives investors different types of protection depending upon which regulator oversees their adviser and investment account
Hong Kong's rules assign supervision of certain investment products, known as investment-linked assurance schemes, to self-regulated insurance bodies with limited authority, rather than the Securities and Futures Commission, which has search and seizure powers.
This means the SFC's safeguards governing the sale of unlicensed funds to ordinary retail investors do not apply to savers using an investment-linked assurance schemes account, known as a portfolio bond.
Some HK$7.4 billion was invested in single premiums, including portfolio bonds, in 2012, according to the Insurance Commissioner. Many investors were unknowingly exposed to the risk of near total loss without any regulatory defence to help them get back their cash.
One such example is the collapse last year of Australian fund house LM Investment Management, which had a reported A$3 billion (HK$21.7 billion) in assets before its implosion. Its flagship Managed Performance Fund is now valued at 5 Australian cents on the dollar. The firm is under investigation as Australian authorities work out what happened.
LM products were sold in Hong Kong via investment-linked vehicles, exempting them from the regulatory scrutiny they would have received if they were marketed to ordinary investors.
SFC rules require Hong Kong resident investors to sign a form and prove they have HK$8 million in liquid assets before buying such a fund. These rules do not apply to portfolio bonds.
ILAS products combine insurance, investment, and estate planning structures and are especially targeted at expatriate investors.
"ILAS are expressly captured as insurance contracts under the Insurance Companies Ordinance," SFC senior director Stephen Tisdall said.
"The regulatory design is clear and deliberate, with the Securities and Futures Commission neither having the power to license intermediaries conducting ILAS business, nor having the powers to inspect, investigate or discipline them in connection with the manner in which they conduct that business."
Since the financial crisis, more than 80 unlicensed funds marketed via ILAS products have been suspended. Affected are fund houses including LM, Glanmore, Frontier Investments, Castlestone and Capricorn, as well as student accommodation funds from Brandeaux and Mansion.
In several cases, investors said they were not told the funds were unlicensed before sale, a breach of insurance regulations.
While a fund's suspension does not always denote problematic behaviour by fund managers, it can result in investors waiting years to get their money back.
LM's collapse is especially pertinent, as its funds were marketed as low-risk and sold to savers approaching retirement. The Managed Performance Fund paid 9 per cent commission to advisers and started delaying payouts to clients from 2009 - four years before its collapse - advisers and LM founder Peter Drake said.
The firm's generous commissions, roughly three times the industry average for similar products, encouraged financial planners to promote the fund, advisers said.
Investors were never told about the redemption problems, said Graham Smith, founder of the LM Investor Victim Centre, which helps represent LM investors in Hong Kong and overseas, many of whom had large holdings in the fund house, with little or no diversification.
In many cases, the advisers disappeared the moment LM failed, Smith said.
Hong Kong's rules put the responsibility for completing due diligence checks on such products squarely on the advisory firm. This assumes each firm has the capabilities to do the legwork needed to review an unlicensed fund.
"You have to go in and kick the tyres," said Mark Konyn, the chief executive of Hong Kong-based institutional investment firm Cathay Conning Asset Management.
"If it's a company you have not really heard of and it's a long way away, the onus is to do extra due diligence at the outset to make sure you are not buying a lemon."
A beefed-up Insurance Authority is set to take over regulation of the insurance sales sector by next year.
Sin welcomes the move but encourages the government to look again at the regulation of investment advice in the insurance sector. "After 13 years, it is time the government should review," Sin said.
HK's two-tier regulation puts some investors at risk, especially with insurance-linked funds, says lawmaker who helped set up framework.