Securities firms can defend against investor suitability disputes

One of the most common claims by investors in margin trading disputes is that a securities company failed to fulfil its suitability obligation – ensuring that the product it was selling to the client was appropriate to their needs and risk profile.

The obligation of securities companies to manage investor eligibility in margin financing and securities lending is stipulated under article 88 of the Securities Law and article 12 of the Administrative Measures on Margin Financing and Securities Lending by Securities Companies. The Provisions of the Supreme People’s Court on Several Specific Issues concerning Current Trial of Commercial Cases, issued on 24 December 2015, emphasised that “the duty of disclosure is the core of the suitability obligation”, while the Minutes of the National Court Work Conference for Civil and Commercial Trial also defines the duty of notification and explanation as an integral part of the suitability obligation.

Since the suitability obligation adopts the principles of presumption of fault and reverse onus, securities companies should first submit standard basic materials, such as documents and videos recording the process of obtaining customer information and conducting risk assessment and risk disclosure during the account opening process. In addition, or in the event of difficulty in providing some of the materials owing to time passed since the account opening, they may also consider collecting material or mounting a defence based on the following aspects.

Proof of investors’ risk identification ability, such as previous investment experience. Performance of the duty of illustration and explanation is based on subjective standards. According to article 78 of the National Court Work Conference minutes, if evidence can be presented to prove that investors have extensive investment experience, or conclusions can be made based on investors’ education level that they have the ability to identify the risks in margin trading, whether such risk disclosure is made by securities companies does not affect investors’ decisions or assumption of losses.

Such evidence includes whether such investors’ securities accounts were opened and used for the first transaction at a much earlier time, whether they had engaged in margin trading activities or other leveraged investments with other securities companies, whether they had any practice qualification or working experience in the securities industry or other financial industries, or whether they can be defined as professional investors.

In many cases, the courts also refer to an investor’s “repeated purchases of relevant financial products”, “investment experience in high-risk financial products”, and “many years of securities trading” as important reasons for exempting or mitigating financial institutions’ liability. However, courts may also consider whether the relevant experience is applicable to margin trading.

In one case, in which the investor was a judge responsible for hearing financial cases, the court did not exempt the financial institution from its suitability liability.

The Implementing Guidelines for the Management of Investor Suitability by Securities Operations (for Trial Implementation) stipulates the process for securities companies to identify a professional investor and requires the provision of the Letter of Notice and Confirmation of Professional Investors. However, failure to perform the process does not preclude a claim in litigation or arbitration that an investor is a professional investor.

In judicial practice, the determination of professional investors tends to be substantive, that is, both the courts and arbitration tribunals may be more concerned about whether the risk identification ability of an investor is substantively appropriate for a particular product, and may not necessarily regard the financial institution’s implementation of professional investor identification process as the prerequisite.

Alternative proof of investors’ risk tolerance. In addition to risk assessment at the time of opening the account, if an investor has undergone risk assessment for a product with higher risk or at the same level of risk as margin trading, the results of such assessment can also reflect the investor’s risk tolerance for margin trading.

The Provisions on Strengthening the Administration of Securities Brokerage Business require that after the initial risk tolerance assessment, follow-up assessments should be conducted at least every two years based on the investment profile. Therefore, the documents of such subsequent assessments may also indicate investors’ risk tolerance and prove securities companies’ fulfillment of the suitability obligation.

Proof of investors’ knowledge of the business rules through their act of performance. If an investor has carried out a large number of margin trading transactions since opening the account, or has even increased or maintained the guarantee ratio by adding collateral when the guarantee ratio fell below the minimum margin, this may reflect the investor’s knowledge of the transaction rules. In Huatai Securities v Liu Xin (2020), the court stressed that the investor had been operating the margin trading account for many years, personally overseeing all investments. This was presented as one of the arguments that the securities company did not violate the suitability obligation.

Exemption from liability in the event of malicious deception by investors. Article 78 of the minutes also stipulates that if the product purchased or service received by a financial consumer is unsuitable as a result of the consumer’s own action, such as intentional provision of false information, or refusal to follow the suggestions of the product or service provider, the financial institution may claim exemption from such liability.

Therefore, for investors with subjective malice, deliberately providing false information or deceiving securities companies, such as an investor deliberately opening a credit account with false information to engage in illegal stock speculation, securities companies may claim liability exemption within the corresponding scope according to the specific circumstances.

The suitability obligation may also give rise to other thorny issues, including forced liquidation and contract extension, such as whether securities companies have special suitability obligations for contract extension. However, at the core of all these debates is the division of the duty of care between securities companies and investors. Naturally, the fundamental prerequisite for conducting business and mounting a defence in the case a dispute arises remains unchanged: the business activity itself must fulfil all necessary compliance requirements.