合規行者

Ponzi Scheme at Citi Asia

2011-10-03T18:04:00.001+08:00

Today SFC announced in a press release that it has reprimanded Citigroup Global Markets Asia Limited, fined it $6 million, and suspended the approval granted to Ms Lisa Chan Sin Man, to act as a responsible officer. Her licence has also been suspended for 8 months.

Citi Asia has also agreed to offer to pay compensation to customers affected by a fraudulent scheme operated by a former licensed representative in the amount of any principal lost by such customers.

The disciplinary action follows an investigation into suspected misconduct of a former licensed representative of Citi Asia, Mr X, who was responsible for operating what appears to have been a fraudulent scheme involving 13 Citi Asia wealth management clients who invested through Mr X on the basis their money would be pooled and used to purchase US Treasuries and other products.

It appears Mr X promised the affected customers that their principal was protected and returns were guaranteed. Instead, returns were funded wholly or partly from other affected clients induced by Mr X's representations. In effect, Mr X appears to have been operating a Ponzi or Madoff-style scheme in which high returns are paid to investors out of the contribution by new investors. Ponzi Scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk.

Mr X's scheme operated from 2004 until February 2009 when Citi Asia suspended Mr X while investigating the suspected misconduct. Shortly thereafter, Citi Asia dismissed Mr X for gross misconduct. However, Citi Asia failed to report Mr X's activities to SFC in a timely manner as required by the Code of Conduct.

After initially reporting to the SFC that Mr X had been dismissed for gross misconduct, Citi informed the SFC that an internal investigation was in progress, when in fact a preliminary report was already available which revealed important information in relation to Mr X's apparent fraudulent scheme. Citi Asia did not provide the report to SFC until after a follow-up investigation by Citi Asia's external auditor was completed.

By the time these reports were provided to the SFC, Mr X had left Hong Kong. He has not returned since then. While this was not Citi Asia's intention, the consequence of the delay in reporting details of the fraudulent scheme to SFC meant SFC and other law enforcement agencies had no opportunity to interview Mr X or to secure his whereabouts pending the completion of the investigation.

SFC also found that Mr X was insufficiently supervised by Citi Asia and Chan (as Mr X's supervisor) with the result that his fraudulent scheme was undetected despite a number of "red flags" which should have caused those supervising Mr X to instigate inquiries. For example, Mr X issued correspondence under Citi Asia's name referring to guaranteed returns contrary to Citi Asia's internal guidelines. Some of this correspondence was brought to Chan's attention but Chan accepted Mr X’s explanations and did not conduct any probative inquiry into the true nature of Mr X's dealings on behalf of Citi Asia’s clients. The reference to guaranteed returns in Mr X's correspondence was a very clear red flag. A quick check to verify the existence of the US Treasuries and other products supporting Citi Asia's clients' investments should have been conducted.

Citi Asia has agreed that it will pay for an external auditor, to be appointed by SFC, to audit the accounts of affected customers and assess the amount of compensation required to make them whole. Citi Asia will also pay for an external expert to conduct a review of the internal and external detection, escalation and notification practices and policies in Citi Asia's private banking division in relation to compliance with all applicable regulatory and legal requirements in its securities business, including:

the identification and handling of red flags by all staff involved in regulated activities; and
performance management of all staff engaged in supervision of staff conducting regulated activities, including calculation of compensation in respect to supervisory functions.

Citi Asia will implement all recommendations by the external expert and submit to a surprise audit of all detection, escalation, notification, red flag practices and policies at a time to be selected by SFC within two years of today’s date.

My questions:

Why can't the identity of Mr X be disclosed?
Did the compliance head of Citi Asia survive from this case?

SFC Records Historically High Fine

2011-09-15T16:33:00.003+08:00

Today SFC publicly reprimanded Oasis Management (Hong Kong) LLC and its Chief Investment Officer, Mr Seth Hillel Fischer, and fined each of them $7,500,000 for their trading in the shares of Japan Airlines Corporation (JAL) on the Tokyo Stock Exchange (TSE) in 2006.

This disciplinary action relates to trading by Oasis in JAL shares on the TSE on 19 July 2006 on behalf of two investment funds after JAL announced a plan to issue new shares via a public offer. Under JAL’s plan, the offering price for the new shares would be priced between 90%-100% of the closing price of JAL’s shares on one of the days from 19 July 2006 to 21 July 2006. This type of pricing mechanism is common in the Japanese market and usually the offering price determination day is the first day of the selected range which was 19 July 2006 in this case.

Oasis entered a series of orders for JAL shares in the last 15 minutes before the market closed on 19 July 2006, including:

market-on-close buy orders and cancelling them subsequently; and
a large volume of short sell orders during the last five minutes before market closed on the TSE (some orders were incorrectly labelled as short sell exempt orders, such that the funds were able to enter sell orders at prices lower than the latest executed prices).

On the settlement day for the short sell orders, Oasis failed to deliver shares in nearly 70% of the shares they had short sold with approximately 50% of these transactions having to be covered by new shares issued by JAL in the public offer.

Oasis' trading strategy, which originated in Hong Kong and was executed by Fischer, appeared to have been designed to drive down the closing price of JAL on 19 July 2006 to the detriment of the market for JAL shares. A lower closing price would benefit the funds as subscribers for the new shares.

Oasis and Fischer do not admit their strategy was designed to mislead the market for JAL shares. However, they have agreed to accept these sanctions which SFC regards as a sufficient expiation for SFC's concerns about their conduct on 19 July 2006.

This was actually a market manipulation case happened in Japan, referred by Japanese Securities and Exchange Surveillance Commission to SFC for cross-border enforcement.

http://www.sfc.hk/sfcPressRelease/EN/sfcOpenDocServlet?docno=11PR108

Streamlined Sales Process for Investment Products

2011-04-06T22:00:00.002+08:00

Today HKMA issued a circular to announce the streamlining of the sales process for investment products as follows:

Sales of investment products to vulnerable customers (VCs)

The implementation of the Pre-Investment Cooling-off Period since 1 January 2011 has further strengthened the protection provided to VCs during the sales process. Taking this into account, it is appropriate to allow VCs the flexibility in choosing whether they wish to continue to enjoy the safeguards mentioned below.

For all investment products, banks should allow VCs to choose during the initial transaction
whether they would like to

bring along a companion to witness the sales process; and/or
have a second front-line staff member to handle the sales.

The VC can choose to have either, neither or both safeguards. Banks should adopt the VCs' choices and maintain proper audit trails of the choices.

Streamlined sales process for plain vanilla investment products

Where there is no risk mismatch, and subject to the exceptions set out in the next paragraph, audio recording is not required for the face-to-face sales process in respect of:

plain vanilla investment products (without embedded derivatives and without leverage) where the products or product documents have been authorized by SFC;
sovereign bonds issued by Ministry of Finance of PRC; or
bonds issued by HKSAR Government.

Certain categories of bonds are not common investment products and their risks and nature are substantially different from other plain vanilla bonds. Therefore, audio-recording is still required for bonds that have the following features:

either the issue or the issuer, or both, have a credit rating below an investment grade;
both the issue and the issuer are unrated;
perpetual bonds; or
subordinated bonds.

Banks should ensure that their frontline staff have ready access to clear and comprehensive lists of individual products whose sales process does not require audio recording (e.g. through system enquiry) so that there is clarity and consistency in applying the above framework.

As always, banks are required to provide a clear explanation of the product nature and risks to the customers during the sales process. Banks are also reminded to consider each customer's personal circumstances (such as his/her financial situation, investment objectives, experience, knowledge, horizon and risk tolerance before making any recommendation or solicitation to the customer) and to maintain proper documentary records of the recommendation, including the underlying rationale. For transactions involving risk mismatch, banks should follow the existing regulatory requirements, including audio recording the sales process.

Jack's comment: After the Lehman Minibonds incident, HKMA has more actively and frequently fine-tuned the regulation of investment sales, even performing risk assessment of different products.

Fraudulent Conduct at Advisory Firm

2011-03-30T08:22:00.017+08:00

Last week US SEC charged Houston-area businessman Daniel Frishberg with fraudulent conduct in connection with promissory note offerings made to clients of his investment advisory firm.

SEC alleges that Frishberg's firm Daniel Frishberg Financial Services (DFFS) advised clients to invest in notes issued by Business Radio Networks (BizRadio), a media company founded by Frishberg where he hosts his own show under the nickname "The MoneyMan."

Frishberg agreed to the SEC's charges by paying a $65,000 penalty that will be distributed to harmed investors. He will be barred from future association with any investment adviser.

According to the SEC's complaint, at least $11 million in promissory notes were issued by BizRadio and Kaleta Capital Management (KCM), which is owned by Frishberg's associate Albert Fase Kaleta. Frishberg and Kaleta jointly controlled BizRadio.

SEC charged Kaleta and his firm with fraud in 2009, and the court appointed a receiver to marshal the assets of KCM and relief defendants BizRadio and DFFS.

Frishberg authorized Kaleta to recommend the notes to DFFS clients, and clients were not provided with critical disclosures. Investors were not told of BizRadio's poor financial condition and the likely inability of KCM and BizRadio to repay the notes. Nor were investors informed about Frishberg's significant conflicts of interest in the note offerings because the proceeds funded his salary as a BizRadio talk show host.

Frishberg chose Kaleta to recommend the BizRadio notes even though he was aware of complaints about Kaleta's lack of truthfulness in sales presentations regarding other investments.

Jack's comment: This guy is really a great "financial actor"!

Listed RMB Securities Business

2011-03-23T08:34:00.019+08:00

Last week SFC issued a circular to SEHK Exchange Participants and CCASS Participants by attaching a checklist to facilitate their review of readiness to conduct listed RMB securities business. The checklist recaps the key areas that Participants should consider during their readiness review.

Participants conducting the RMB Readiness Test are advised to summarize in the checklist the conclusions of their review of readiness in those applicable areas set out in the checklist. Participants should also keep a copy of the completed checklist for record.

Participants are reminded to prudently assess their readiness and be satisfied that they have already prepared themselves properly before confirming their readiness to HKEx.

Brokers providing currency conversion service to their clients should ensure the relevant exchange rate and / or basis of fixing the exchange rate has been clearly disclosed to and agreed with the clients. Brokers should also clearly disclose to the client their role in the transaction (as agent or principal) and ensure compliance with the Code of Conduct's requirements relating to conflicts of interest and compliance.

Those brokers who fail to ensure their readiness should refrain from dealing in RMB securities to be listed on the SEHK or clearing transactions in such securities. They should put in place measures to prevent inadvertent trading of, or acceptance of client trading instructions on, listed RMB securities. For example:

Notify all staff in writing that no client trading instructions on listed RMB securities should be accepted
Explain to clients clearly that no services in listed RMB securities are offered by your firm currently upon clients' enquiries
Closely monitor trading activities. If inadvertent transaction in listed RMB securities is identified, contact HKEx immediately to discuss any need for taking remedial action

Brokers conducting trading / clearing activities in RMB securities to be listed on the SEHK without having ensured their readiness for conducting such activities shall be liable to regulatory scrutiny of their conduct.

Jack's comment: The checklist provided by SFC, asking only a lot of general questions, is basically useless. But SFC would claim they have got their job done.

Enhanced Regulatory Requirements on Selling of ILAS

2011-03-16T08:20:00.091+08:00

This week HKMA issued a circular to state the necessity to further enhance the regulatory requirements for the sale of Investment-Linked Assurance Scheme (ILAS) products by the banks. The following control measures are set out in the Annex of this circular:

Competence of staff and registration

Banks and their staff who sell ILAS products should ensure that they are properly registered as insurance agencies and technical representatives of the principal insurance companies respectively.
Banks should provide sufficient training to ensure that staff engaged in the selling of ILAS products (i) have adequate knowledge and skills to provide explanations, recommendations or advice to customers about such products; (ii) are conversant with the selling procedures and relevant controls; and (iii) are aware of the relevant regulatory requirements that they need to comply with.

Product due diligence

Banks should develop sufficient understanding of the nature and structure of ILAS products, including the underlying investments, the insurance protection, lock-in periods, fees and charges, penalty for early encashment, the credibility and capability of the insurance companies issuing the ILAS products, and other factors that may have an impact on the risk and benefit profiles of the ILAS products.
The independent risk management function should be involved in the product approval and review processes to ensure that the risks of ILAS products are well understood and adequately assessed. All relevant departments, e.g. risk control, legal and compliance, should be consulted as appropriate.
Banks should conduct their own product due diligence and not to merely rely on the risk assessment conducted by the issuing insurance company. Banks should also perform a continuous review of the risk ratings it has assigned to the underlying investment options of ILAS products and make revisions to such risk ratings as appropriate. Where a review results in a higher risk rating, the affected customers should be notified through a monthly statement or a separate letter.
Banks should assess and determine the tenor of an individual ILAS product, and match it with a potential customer's preferred investment horizon. In general, ILAS products are longer-term products designed to be held by the policyholder for a relatively long period (e.g. at least five years or above). Banks should take into account, among other things, the lock-in period (the period during which penalties or charges will apply in the event of early encashment) for determining the tenor of an ILAS product.

Use of gifts

To avoid distracting customers' attention from the nature and risks associated with ILAS products, banks should not offer financial or other incentives (e.g. gifts) for promoting ILAS products. Discount of fees and charges, and the offering of any gifts for brand promotion, relationship building or other purposes not directly related to the promotion of ILAS products will not fall foul of this requirement.

Selling activities to be conducted inside investment corner

Any solicitation, recommendation, discussion on ILAS products and sale of ILAS products to customers should be carried out only inside banks' investment corners.

Product disclosure

Banks should make adequate disclosure to customers through proper explanation of the nature and risks of ILAS products, including, among other things:

Product nature – Banks should make it clear to customer at the outset that the product is an investment-linked insurance product. ILAS products should not be misrepresented, for example, as savings plans or deposits, or investment funds without any insurance element. Both the investment and insurance elements should be properly disclosed. Any description that disguises the insurance element, e.g. describing ILAS as "investment funds with complimentary insurance or life protection", is inaccurate and unacceptable.
Investment options and risks – Banks should disclose and explain the nature and risks of the investment options under each ILAS product. Banks should make it clear, where applicable, that there is no guarantee of the repayment of principal.
Credit risk – Banks should disclose the name of the insurance company, the fact that the premiums the customer pays will become part of the assets of the insurance company and that the customer will not have any rights to or ownership of the underlying investment assets, and thus he or she is subject to the credit risk of the insurance company.
Insurance protection – Banks should disclose and explain the amount and/or the basis of determining the death benefit, including the fact that the amount is subject to the market risk and the foreign exchange risk of the ILAS product, where applicable, and that the death benefit payable may be significantly less than the premiums paid and may not be sufficient for the customer's estate planning purpose.
Premium payment – Banks should disclose the amount, frequency and duration of premium payments. Banks should also explain the circumstances under which a premium holiday can be exercised and its consequence (e.g. the value of the ILAS product may be reduced due to the continuing fees and charges; the entitlement to loyalty bonus may be affected; and the ILAS product may be terminated and the policyholder may be subject to a surrender penalty if he or she fails to resume making the premium payments). Where the ILAS product allows policyholders to take out policy loans, Banks should disclose and explain how the policy loans operate (e.g. whether the loans will be automatically given when the policyholder does not pay a premium payment that is due), the interest and charges on the loans, and the possible termination of the ILAS when the account value is insufficient to cover the outstanding loans and accumulated loan interest.
Lock-in periods – Banks should disclose and explain that ILAS products are designed to be held for a medium/long-term period and that early surrender of the product may be subject to a heavy financial penalty, and disclose the level of penalty. Banks should also explain to customers the restrictions on cash withdrawal, if any.
Fees and charges – Banks should disclose and explain the fees and charges at both the scheme level and the underlying investment asset level, and that due to the fees and charges, the return on the ILAS product as a whole may be lower than the return of the underlying investment assets. Banks should also explain that part of the fees and charges paid will be used to cover the charges for the life insurance coverage. The insurance charges will reduce the amount that may be applied towards investment in the underlying assets selected. The insurance charges may increase significantly during the term of the ILAS product due to factors such as age and investment losses. This may result in a significant or even total loss of the premiums paid.
Cooling-off period – Banks should draw to the attention of the customer his or her right to cancel the policy, how he or she may exercise the right and how the refund will be calculated.

Banks should provide to customers the ILAS offering documents and Product Key Fact Statements (if issued). When explaining or recommending ILAS products to customers,
banks should give balanced views. Where direct investment in the underlying investment assets (e.g. unit trusts and mutual funds) can be the alternative of indirect investment through ILAS products, banks should explain to customers the pros and cons of ILAS products compared with direct investment in the underlying investment assets and taking out a life insurance policy separately.

Banks must distribute HKFI's education pamphlet entitled "Questions you need to ask before taking out an ILAS product" to potential policyholders of ILAS products at the point-of-sale. Where appropriate, banks may also refer their potential customers to other ILAS-related public education materials, e.g. those issued by SFC or HKFI.

Ensuring customer suitability

Banks should take all reasonable steps to ensure that the recommended ILAS product is suitable for a customer having regard to the customer’s circumstances, such as investment objectives and horizon, investment experience, risk tolerance level, affordability and asset concentration, etc. In general, customer risk profiling and needs analysis should be performed prior to making any solicitation or recommendation in respect of any ILAS products. In this respect, banks should ensure compliance with HKFI's "Updated Requirements Relating to the Sale of ILAS Products following the Introduction of the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products".
Banks should avoid exerting any undue influence on or the manipulation of the risk profiling result. Banks should guard against any acts, before, during or after the profiling process, that may defeat the purpose of these measures.
While ILAS products can take various forms, those currently available in Hong Kong mostly offer a wide range of investment options with varying risk levels which a customer can choose from. It is also a common feature of ILAS products that subsequent switching between investment options and a top-up investment are allowed. At the point-of-sale of ILAS products, banks should explain to the customer the possible risks of switching to or top-up investment in investment options that are inconsistent with his or her risk profile. Banks should remind the customer to discuss with relevant staff before making a subsequent switching or top-up investment.
Where a customer indicates that he or she does not need/want insurance/investment products, banks should not recommend ILAS products. Further, in view of the long lock-in period of ILAS products, banks should ensure that due regard is paid to a customer's risk tolerance, financial situation, liquidity needs, investment horizon and retirement plan (if any) in considering whether ILAS products are suitable for him or her. In particular, when dealing with elderly customers or customers in need of liquidity, banks should alert them of the lock-in period and ensure that the product is suitable for the customer. Banks should allow sufficient time for these customers to consider the product or seek advice from their relatives or friends where necessary.
Banks should exercise extra care in selling investment products to vulnerable customers. Among other things, there should be more than one front-line staff member handling the sale to such a customer, unless the customer opts out of this arrangement and proper audit trail is maintained on this opt-out decision.
More stringent control measures should be adopted for transactions involving a risk mismatch. Whenever any of the investment options selected by a customer in an ILAS transaction has a risk rating higher than the customer’s risk tolerance level, before accepting this transaction, the bank staff should (i) remind the customer of the risk mismatch and that the investment option(s) may not be suitable for him or her; (ii) document the reasons of any product recommendations as well as the reasons for the customer’s choice of investment option(s); (iii) ensure the customer's acknowledgement of the risk mismatch; and (iv) appropriately audio-record the relevant conversation in respect of these arrangements. In the event of inconsistent answers given by the customer, the bank staff should seek clarification and document the reasons given by the customer. Endorsement should be sought from supervisory staff.
Banks should have proper audit trail, including audio-recording, of every switching transaction or top-up investment processed by the bank to capture either (i) the customer's acknowledgement that the switching or top-up investment did not involve solicitation / recommendation by the bank or its staff; or alternatively (ii) the rationale for any solicitation/recommendation by the AI or its staff. If the switching transaction or top-up investment processed by the AI involves the customer choosing risk-mismatched investment option(s), the control measures set out in the previous paragraph should also be adopted. Similarly, there should be appropriate warnings, alert messages and audit trail for transactions conducted through channels other than bank branches such as phone banking or Internet banking.

Records maintenance and audio-recording

Banks should ensure that adequate records and an audit trail (including audio records) are in place to show that the proper selling process has been followed. Banks should ensure the salient parts of the sales process and ancillary arrangements relevant to the ILAS application are properly audio-recorded. This should cover the salient parts of the customer risk profiling, relevant information for suitability assessment obtained from financial needs analysis5, provision of alternatives and rationales of the recommendation (e.g. covering why the ILAS product was recommended instead of direct investment in funds and separate life insurance policy), disclosure of product features and risks, Applicant’s Declarations, and Customer Protection Declaration.

Management oversight

Banks should have adequate management oversight of the sale of ILAS products. Banks should establish proper management information system reports for management to assess its business and identify risks or non-compliance. High risk areas and exceptions (such as transactions with vulnerable customers, tenor and/or risk mismatch transactions, affordability issues or high asset concentration) related to the sale of the ILAS products should be monitored. There should also be regular independent reviews of the selling process of ILAS products, covering test-checks of ILAS transactions including those identified as high risk areas and exceptions. The "mystery shopper" programme of banks should include a test of the ILAS product selling process. Appropriate follow-up actions should be taken if any irregularity is identified.

Complaints handling

Banks should ensure that complaints relating to ILAS are handled in a proper and timely manner. Banks should report to the relevant principal insurers all complaint cases and keep the insurers informed during the complaint handling process, as appropriate. Given the principal-agent relationship, the complaints may also be handled by the principal insurers and reviewed by OCI or HKFI.

Notifications to regulators

Banks should promptly report to the HKMA and other relevant regulator(s) any material breach, infringement of or non-compliance with any applicable law, regulations and codes.

Disciplinary proceedings

Disciplinary proceedings under the Banking Ordinance may be taken against a relevant individual (ReI) if his or her conduct in the sale of ILAS products raises concerns about his or her fitness and properness to be an ReI. Banks should clearly communicate to all ReIs involved in the sale of ILAS products the potential risk of disciplinary proceedings being taken against them for any acts or omissions that raise concerns about their fitness and properness to be an ReI.
Similarly, disciplinary proceedings may also be taken by IARB against technical representatives for non-compliance or misconduct under the Code of Practice for the Administration of Insurance Agents issued by HKFI. Banks are advised to report, via their principal insurers, to IARB any disciplinary proceedings taken on an ReI for any acts or omissions that raise concern about his or her fitness and properness to remain as an ReI.

Jack's comment: Such "parental guidance" note should also be provided by SFC or OCI to those insurance agents who are not working for banks.

Evidential Requirements for Professional Investors

2011-03-09T08:30:00.034+08:00

SFC recently published the Consultation Conclusions regarding proposals to refine the requirements for evidencing whether a person qualifies as a high-net-worth professional investor under the Securities and Futures (Professional Investor) Rules.

THE NEW REGIME

The Principles Based Approach

SFC's new regime is founded upon a principles based approach to the consideration of whether an investor meets the relevant assets or portfolio threshold, at the relevant date, to qualify as a professional investor. This flexible approach is designed to permit companies to employ whatever method seems most appropriate to them, in the circumstances at hand, when making this consideration.

SFC will not prescribe what these methods should be, although it does note that firms should maintain proper records of their assessment process. This will enable any firm to show that they have made a reasonable decision in declaring, after the appropriate exercise of professional judgement, that their clients satisfy the relevant thresholds.

Some issues were raised during the consultation process which merit examination:

Assessment Methods

A number of market participants requested advice from SFC on the standards and processes which should be employed when evaluating the assets and portfolio levels of potential professional investors. More detailed instruction was also appealed for, as market participants wished to know whether specified types of documents or data (such as a company search on corporate client) are acceptable evidence when investigating an investor's potential status as a professional investor. Some respondents called on SFC to release a non-exhaustive list of such acceptable documentation.

However SFC stated that although guidance on the standards to be utilized when assessing potential professional investors may increase market certainty, the concept of issuing lists of acceptable documentation for making such assessments ran contrary to the principle based approach on which the new rules are founded. SFC reiterated its intention to leave maximum flexibility to market participants in their determination of an investor’s status, so long as the means availed of are appropriate in the circumstances and records are maintained.

Self-certification

A number of respondents expressed a desire for guidance on the matter of when it would be acceptable to permit a client to self certify as a professional investor. However SFC refused to issue such specific guidance, noting that firms should have sufficient knowledge of their clients' affairs, under the know-your-client requirements in the Code of Conduct, to make such a determination for themselves. SFC also explicitly stated that it was not ruling out self-certification as an acceptable method of evaluating the assets and portfolio levels of potential professional investors, but that it must be used in appropriate situations.

Incorporation of Modifications

Over the last few years SFC has made several Modifications, under section 134 of SFO, to the requirements under the Professional Investor Rules. Some respondents requested that SFC insert those Modifications which are applicable to a wide spectrum of market participants into the Professional Investor Rules. However SFC declined to act on these propositions, calling attention to the fact that these Modifications were permitted on the basis of particular sets of facts being presented by applicants to the SFO and stating that it had no inclination to alter the manner in which such modifications are granted. Additionally, SFC declared that the need for Modifications to alleviate the rigidity of the old regime in this area had been addressed by the flexible nature of the new principles based system of assessing an investor’s status.

PRESERVATION OF EXISTING METHODS

In the Consultation Paper the SFC recommended retaining the current methods of appraising whether or not a client qualifies as a professional investor, a recommendation which received the approval of the majority of respondents. SFC confirm that market participants may choose to continue to use the existing practices or to avail of the new more flexible system presented in the Consultation Conclusions.

USE OF "RELEVANT DATE" AS THE TIME REFERENCE FOR ASCERTAINING WHETHER AN INVESTOR MEETS THE RELEVANT ASSETS OR PORTFOLIO THRESHOLD TO QUALIFY AS A PROFESSIONAL INVESTOR

The majority of respondents approved of SFC's proposal to use "relevant date" as the time reference for evaluating whether a high net worth professional investor satisfies the relevant assets or portfolio threshold. However a number contended that it is extremely difficult, from a practical standpoint, to procure evidence permitting the appraisal of an investor's assets or portfolio value on a specific date. Requests were made to SFC to ease the strictness of this rule, in recognition of these difficulties. However these were rebuffed by SFC, who reiterate in the Consultation Conclusions that although an investor must adhere to the relevant assets or portfolio threshold at the relevant date to qualify as a professional investor, the new principles-based approach imposes no process or evidence that market participants are obliged to follow or acquire on any particular date.
Furthermore, SFC note that any market participant experiencing complications when attempting to determine an investor's status on the relevant date may employ the current methods outlined in sections 3(a) to 3(c) of the Professional Investor Rules, which permit the assembling of specific documentary evidence prior to the relevant date, when making said determination.

EXTENSION OF THE SCOPE OF SECTION 3 (D) OF THE EXISTING PROFESSIONAL INVESTOR RULES

Most respondents agreed with SFC's proposal to broaden the application of section 3(d) of the existing Professional Investor Rules, with the effect that any corporation which is wholly owned by one or more individuals or corporations/partnerships, where each of those individuals or corporations/partnerships would qualify as a professional investor under section 3(b) or section 3(c) (as the case may be) of the Professional Investor Rules, will qualify as a professional investor. However some market participants felt that the scope of section 3 (d) should be extended further and include more forms of corporations as professional investors.

SFC considered the responses of the market and in the Consultation Conclusions agreed to further extend the operation of section 3 (d) of the Professional Investor Rules, so that any corporation which is wholly owned by one or more trust corporations, individuals or corporations/partnerships where each of those trust corporations, individuals or corporations/partnerships would qualify as a professional investor under section 3(a), section 3(b) or section 3(c) (as the case may be) of the Professional Investor Rules, will qualify as a professional investor.

However SFC refused to extend the application of section 3(d) any further, as to do so would be unnecessary and exceed the ambit of the current consultation. SFC also repeats the argument here that "the flexibility provided by the proposed principles-based approach has effectively addressed market participants' concerns with the practical difficulties in ascertaining their clients as professional investors under the current Professional Investor Rules."

MISCELLANEOUS MATTERS

Suggestions from market participants outside the scope of the current consultation

A number of recommendations were received by SFC from respondents with regard to aspects other than the evidential requirements of the professional investor regime. As these were not relevant to the current consultation, SFC did not consider them.

Status of existing Modifications / Future applications for Modification

One market participant queried whether Modifications granted prior to the amendment of the Professional Investor Rules will remain in force after the amendment and whether an application for a Modification or waiver of the requirements of the Professional Investor Rules, under section 134 of the SFO, will be permissible subsequent to the amendment of the Professional Investor Rules.

In response to the first query, SFC stated that the amendments would not affect any existing Modifications. SFC then noted that if a Modification application concerns sources or types of information and the remedy sought is in fact consistent with the revised Professional Investor Rules, there is no need to make such an application and to do so would be inappropriate. However, SFC will continue to consider granting modifications in relation to other requirements of the Professional Investor Rules under section 134 of the SFO.

IMPLEMENTATION

SFC will now take steps to implement the proposals discussed in this newsletter, via the making of the necessary amendments to the Professional Investor Rules. The revised rules will be gazetted in due course following review by the Department of Justice.

Jack's comment: More flexibility is at the expense of less "parental guidance".

2011-03-02T08:27:00.048+08:00

Yesterday SFC and HKMA announced that an agreement has been reached with Standard Chartered Bank (Hong Kong) Limited in relation to the bank's distribution of equity linked structured notes issued and guaranteed by Lehman Brothers (LB ELNs). Standard Chartered sold over HK$5 billion worth of LB ELNs between August 2006 and June 2008 of which HK$2.19 billion worth remains outstanding. The 2,515 outstanding LB ELNs are held by 2,234 individual customers.

Without admitting liability, Standard Chartered has agreed to make a repurchase offer to eligible customers holding an outstanding LB ELN distributed by Standard Chartered. The total value of the repurchase offer is estimated to be approximately HK$1.48 billion and will cover over 95% of the outstanding transactions in LB ELNs by Standard Chartered customers.

The repurchase offer is available to all retail customers holding outstanding LB ELNs who invested more than 5% of their Available Assets in not principal protected LB ELNs or 10% of their Available Assets in principal protected LB ELNs at the time of the purchase of the LB ELNs. The offer will exclude corporations (other than a corporation where the suitability assessment was based on an individual's circumstances rather than the corporation's, charities and not for profit organisations), professional investors, customers of the private banking division of Standard Chartered and those who did not purchase the LB ELNs from Standard Chartered.

Following an investigation by SFC and HKMA, both regulators were concerned that Standard Chartered may have exposed LB ELN customers to higher levels of risk than were suitable for them by not adequately considering concentration risk when assessing the suitability of LB ELNs for customers.

Under the repurchase scheme, Standard Chartered has agreed to make the repurchase offer at a price equal to the total value of each eligible customer's investment in outstanding not principal protected LB ELNs less 5% (or less 10% in the case of customers holding principal protected LB ELNs) of each customer's total assets held at or with Standard Chartered at the end of the month immediately preceding the date of the purchase of the outstanding LB ELNs or, the amount invested in LB ELNs (whichever is higher) (Available Assets).

The repurchase offer price will exclude the amount of coupons already paid to the customer but include an additional amount representing the interest that would have been earned if the amount invested in LB ELNs that is over 5% or 10% of the customer’s Available Assets (as the case may be) had been invested with Standard Chartered on a fixed term deposit instead of being invested in LB ELNs.

Under the repurchase scheme, Standard Chartered will also pay top-up payments to those customers with whom Standard Chartered has already entered into settlement agreements but would otherwise have been eligible to receive a repurchase offer to the extent that such payments are needed to ensure those customers are treated in the same way as other customers participating in the repurchase scheme.
In entering into this agreement under section 201 of the Securities and Futures Ordinance, SFC took into account that:

the total value of the repurchase offers under the repurchase scheme that will be made available to eligible customers who invested in LB ELNs at levels in excess of 5% or 10% of their Available Assets;

although LB ELNs were high risk products, they were less complex than Minibonds and likely to have been suitable products for most customers as part of a diversified portfolio;

unlike Minibonds, there is no distributable collateral for the LB ELNs;

as unsecured creditors there is little chance LB ELN holders will receive a substantial payment or dividend in the Lehman Brothers bankruptcy so the payments from Standard Chartered may be the only possible return for eligible customers.

the repurchase offer will enable the vast majority of Standard Chartered's LB ELN customers to obtain a reasonable recovery without the costs and associated risks of separate litigation;

the agreement will bring the LB ELN matter to an appropriate end for the benefit of Standard Chartered and its customers who participate in the repurchase scheme;

a result on these terms could not have been achieved through disciplinary action by SFC against Standard Chartered and/or its officers and employees; and

Standard Chartered has undertaken to engage an independent reviewer, to be approved by SFC and HKMA, to review its systems and processes relating to the sale of unlisted structured investment products, to report to SFC and the HKMA and will commit to the implementation of all recommendations of the independent reviewer.

In view of the repurchase scheme, SFC will not take disciplinary action against Standard Chartered and its current or former officers or employees in relation to the distribution of LB ELNs, save for any acts of dishonesty, fraud, deception or conduct that is criminal in nature. HKMA has also informed Standard Chartered that it does not intend to take any enforcement action against their executive officers and relevant individuals in connection with the sale of LB ELNs to customers who have accepted the repurchase offers or the top-up payments under the repurchase scheme, except for any acts of dishonesty, fraud, deception or conduct that is criminal in nature.

Jack's comment: This case highlights the importance of concentration risk in the suitability process, which seems to be a hindsight after the Lehman Minibond incident. This case implicitly delivers a regulatory message that "over-concentration" means above 5% (of Available Assets) for non-principal protected products and over 10% for principal-protected products. Are such percentages too restrictive? Also, the so-called "Available Assets" count only assets maintained by the customers with the bank, then over-concentration is almost inevitable. Seriously speaking, if SFC does not intend to take this case as a benchmark to define over-concentration, it should issue a guideline in this respect as soon as possible.

Failure to Protect Confidential Customer Information

2011-02-23T08:49:00.007+08:00

US FINRA recently imposed fines of $450,000 against Lincoln Financial Securities, Inc. (LFS) and $150,000 against an affiliated firm, Lincoln Financial Advisors Corporation (LFA), for failure to adequately protect non-public customer information. In addition, LFS failed to require brokers working remotely to install security application software on their own personal computers used to conduct the firm's securities business.

SEC and FINRA rules require every broker-dealer to adopt written policies and procedures that address safeguards for the protection of customer records and information. FINRA found that for extended periods of time – seven years for LFS and approximately two years for LFA – certain current and former employees were able to access customer account records through any Internet browser by using shared login credentials. From 2002 through 2009, between the two firms, more than 1 million customer account records were accessed through the use of shared user names and passwords. Since neither firm had policies or procedures to monitor the distribution of the shared user names and passwords, they were not able to track how many or which employees gained access to the site during this period of time. As a result of the weaknesses in access controls to the firms' system, confidential customer records including names, addresses, social security numbers, account numbers, account balances, birth dates, email addresses and transaction details were at risk.

The Web-based system both firms used combined non-public customer account information from various sources and allowed employees to view the customer account information within a single site. Home office personnel from both firms could access the system either by clicking on a link on the firm's website or could gain access through any Internet browser by going directly to the system's website and logging in with one of the shared user names and passwords.

FINRA also found that LFS and LFA did not have procedures to disable or change the shared user names and passwords on a recurring basis even after a home office employee had been terminated. Many individuals left the two firms during the relevant time period, yet the shared user names and passwords were never changed, and the firms had no way of determining whether former employees continued to access confidential customer information using those same user names and passwords.

In assessing sanctions, FINRA took into consideration the firms' efforts to notify all customers whose account information was or had been potentially exposed on the firms' Web-based system, and offered those customers credit monitoring and restoration services for a period of one year.

Jack: The affected clients in this horrible case were almost naked! Should the IT Head (if any) be held liable?

Library Resources for Financial Education

2011-02-16T08:58:00.000+08:00

US FINRA Investor Education Foundation and the American Library Association (ALA) have announced $1.4 million in grants to 20 recipients as a part of the Smart investing@your library® initiative.

Smart investing@your library is administered jointly by the Reference and User Services Association – a division of ALA – and the FINRA Investor Education Foundation. The program funds library efforts to provide patrons with effective, unbiased financial education resources. Now in its fourth year, the program has awarded a total of more than $4.6 million to public libraries and library networks nationwide.

The new grant recipients will use the funds to implement a variety of programs designed to increase patrons' access to and understanding of financial information. The grants target a diverse group of library patrons – among them youth, seniors, English-language learners, local employment counselors, members of the military and their spouses, and low-income families. Participating libraries will use a variety of technologies and outreach strategies to connect library users to the best financial education and information available. These strategies include gaming, online learning, classroom formats, one-on-one clinics, storytelling and staff training.

The grantees will partner with community organizations, schools, universities and local governments to expand the impact of the services and resources the grants enable. Library patrons will be empowered to make educated financial choices for both long-term investing and day-to-day money matters.

The grantees, which serve urban, suburban and rural communities across the country, will receive one to two years of funding, in addition to assistance with program marketing, outreach and evaluation provided by ALA. For more information about Smart investing@your library®, visit www.smartinvesting.ala.org.

Jack's comment: Providing more financial education to the society is equally important as regulating the financial industry.

Expert Network Insider Trading Scheme

2011-02-09T08:44:00.001+08:00

US SEC just charged a New York-based hedge fund and four hedge fund portfolio managers and analysts who illegally traded on confidential information obtained from technology company employees moonlighting as expert network consultants. The scheme netted more than $30 million from trades based on material, nonpublic information about such companies as AMD, Seagate Technology, Western Digital, Fairchild Semiconductor, and Marvell.

The charges are the first against traders in SEC's ongoing investigation of insider trading involving expert networks. SEC filed its initial charges in the case last week against technology company employees who illegally tipped hedge funds and other investors with material nonpublic information about their companies in return for hundreds of thousands of dollars in sham consulting fees.

In its amended complaint filed today in federal court in Manhattan, SEC alleges that four hedge fund portfolio managers and analysts received illegal tips from the expert network consultants and then caused their hedge funds to trade on the inside information.

SEC's ongoing investigation is focusing on the activities of expert networks that purportedly provide professional investment research to their clients. While it is legal to obtain expert advice and analysis through expert networking arrangements, it is illegal to trade on material nonpublic information obtained in violation of a duty to keep that information confidential.

The technology company insiders who tipped the confidential information were expert network consultants to the firm Primary Global Research LLC (PGR).

Jack's comment: This case can be the blueprint for a commercial firm!

Gray Areas in Jobs After an SEC Ban

2011-02-02T08:09:00.003+08:00

(Source: WSJ 2011.01.28)

Jason Galanis describes his job as doing "M&A work" for a subsidiary of Gerova Financial Group Ltd., where he is chief executive. The insurer has a stock-market value of about $600 million and trades on the New York Stock Exchange.

The 40-year-old Mr. Galanis, who also is a manager of the unit called Gerova Advisors LLC, agreed in 2007 with another person accused of accounting fraud related to a false quarterly report to a five-year ban by the Securities and Exchange Commission from "serving as officers or directors of public companies."

The ban has resurfaced in a war of words between the insurer and some investors who are betting against the company's share price. But it isn't clear if Mr. Galanis's current job duties violate the settlement. SEC spokesman John Nester declined to comment, and the language in Mr. Galanis's settlement and a related court filing are murky, with no reference to subsidiaries of public companies.

Earlier this month, research and investment firm Dalrymple Finance asserted in a report about the insurer that it was "likely fraudulent," contending its assets were overvalued. Mr. Galanis's past also was cited as a red flag because of the SEC enforcement action.

Dalrymple has an incentive to criticize Mr. Galanis, saying in the report that it is shorting Gerova shares, meaning it would make money if they fell.

Mr. Galanis said the SEC charges against him were "clearly regrettable" and "a black eye. It's embarrassing." He also paid a $60,000 fine to end the agency's civil lawsuit alleging he "prepared and filed" a false quarterly report for magazine publisher Penthouse International Inc. Penthouse, which didn't admit or deny wrongdoing, settled the case by promising not to violate securities laws.

In an interview, Mr. Galanis said his current job is clearly allowed under the settlement because Gerova Advisors isn't a public company. Gerova Financial Group said in a statement that he is a "valuable employee," adding that his "responsibilities to the company are clearly defined" and his duties "limited." Mr. Galanis isn't a member of the parent company's board.

The court filing signed by Mr. Galanis includes his promise to avoid "acting as an officer or director of any issuer that has a class of securities registered" with the SEC or "that is required to file" financial reports with the agency. The five-year ban is to end in May 2012. Some securities lawyers say his job raises questions about the effectiveness of bans, an important tool used by regulators to protect investors.

In the past five years, the SEC has sought to bar more than 500 people from being officers or directors of a public company. Most of those efforts succeeded, often as a result of settlements with defendants in civil lawsuits filed by the SEC, though the agency couldn't provide exact figures.

Jacob Frenkel, a former SEC enforcement lawyer who now is a partner at law firm Shulman Rogers Gandal Pordy & Ecker in Potomac, Md., said comebacks following such bans occur "with great frequency," adding that being a director or officer of a unit of a public company is a grey legal area.

The question of whether a comeback by someone booted out of the securities industry or barred from being an officer or director of a public company crosses the line has long been controversial.

In 1998, Michael Milken, the former junk-bond king who spent nearly two years in prison for securities-law violations, agreed to pay $47 million to settle SEC charges that he violated a lifetime ban from the securities business. Mr. Milken didn't admit or deny wrongdoing. The SEC claimed Mr. Milken violated the ban by acting as a consultant in two transactions.

In November, financier Steven Rattner agreed as part of a settlement with the SEC over alleged influence-peddling at New York's flagship pension fund to not associate with any investment adviser or broker dealer for two years. Mr. Rattner didn't admit or deny wrongdoing. A December agreement with then-New York Attorney General Andrew Cuomo bans Mr. Rattner from appearing "in any capacity" before New York pension funds for five years.

Barry Goldsmith, a partner at law firm Gibson, Dunn & Crutcher LLP who was the SEC's chief litigation counsel from 1993 to 1996, said it is "unusual" for someone barred from running a public company to work as a director of a wholly owned subsidiary of a public company, as Mr. Galanis said he is doing.

Mr. Galanis got a Ferrari when he was 16 years old. Two years later, his father, John Peter Galanis, went to federal prison after being convicted of racketeering, tax-fraud, bank-fraud and securities-fraud charges. The five-year ban agreed to by the younger Mr. Galanis came when he owned about an 8% stake in Penthouse. The SEC said the alleged fraud boosted revenue and made a quarterly loss look like a profit. He didn't admit or deny wrongdoing.

Deal-making is a major part of the parent company's growth strategy. Launched in 2007 as a "blank check" operation to make acquisitions, Gerova has gobbled up loans and insurance assets. Last month, the company announced plans to buy Seymour Pierce Holdings Ltd., a London brokerage firm with roots dating back to 1803, and New York brokerage firm Ticonderoga Securities LLC.

Gerova said it will change its name to Seymour Pierce when the London deal is completed. The takeovers must be approved by U.S. and U.K. regulators.

The Dalrymple report claimed the company is vastly overvaluing its real-estate assets, which investors can't fully assess because Gerova hasn't filed financial statements since it became a public company last year.

A May 2010 company spreadsheet reviewed by The Wall Street Journal calculates that Gerova's real-estate holdings are worth 41% less than their stated book value of $274 million. The analysis of more than 30 investments includes a high-rise condominium in West Palm Beach, Fla., and 253 single-family homes in Ohio.

Jack Doueck, a Gerova director, said the document was an informal estimate that was "rife with errors." The book values are out of date, and "there is no $112 million discrepancy," he said. And as a "foreign private issuer," Gerova is required to disclose results only annually, Mr. Doueck added. The annual report for 2010 is due by June.

Gerova said earlier this month that it hired investigative firm Kroll, a unit of Altegrity Inc., to probe "possible market manipulation and collusion aimed at driving down the price" of Gerova shares. The company accused Dalrymple, the research firm that questioned Mr. Galanis's role at the insurer, of using "materially false information" to support a "series of speculative and unsupported conclusions."

Keith Dalrymple, managing director of Dalrymple, declined to comment.

Jack's comment: When there is a regulation, there are lots of loopholes.

Improper Marketing of YieldPlus Bond Fund

2011-01-26T08:54:00.000+08:00

US FINRA recently ordered Charles Schwab & Company, Inc., to pay $18 million into a Fair Fund to be established by SEC to repay investors in YieldPlus, an ultra short-term bond fund managed by Schwab's affiliate, Charles Schwab Investment Management. The $18 million consists of the $17.5 million in fees that Schwab collected for sales of the fund, plus a fine of $500,000, both of which will have been designated as restitution to customers.

FINRA's investigation found that despite changes in YieldPlus' portfolio that caused the fund to be disproportionately affected by the turmoil in the mortgage-backed securities market, Schwab failed to change its marketing of the fund. In written materials and in conversations with customers, some Schwab representatives omitted or provided incomplete or inaccurate material information relating to the fund's characteristics, risk and diversification, and continued to represent YieldPlus as a relatively low-risk alternative to money market funds and other cash alternative investments that had minimal fluctuations in NAV.

Between Sep 2006, and Feb 2008, Schwab sold over $13.75 billion in shares of YieldPlus to customers, which accounted for approximately 98% of the amount Schwab customers invested in ultra short-term bond funds. During this time period, Schwab's solicited sales of YieldPlus totaled approximately $3.36 billion, approximately 40% of which were to customers 65 years of age or older.

In late August 2006, Schwab Investment's Board of Trustees approved a proposal from YieldPlus' fund manager to no longer classify non-agency mortgage-backed securities as an "industry" for purposes of the fund's concentration policies. This change purportedly allowed the fund manager to increase the amount of non-agency mortgage-backed securities in the portfolio to greater than 25% of the fund's assets. As a result, by February 2008, YieldPlus held over 50% of its assets in mortgage-backed securities, and about 40% in non-agency mortgage-backed securities.

Schwab was or should have been aware of the fund's significant exposure to mortgage-backed securities in light of the increasingly unfavorable financial markets. As YieldPlus' NAV declined in the latter part of 2007, Schwab acknowledged internally that YieldPlus was a higher-risk investment than it had been in the past. Internally, some Schwab employees even began referring to YieldPlus as "Yield Minus." Schwab nevertheless continued to describe to investors YieldPlus as being very low risk with minimal fluctuations in share price. Schwab also was aware that YieldPlus was being marketed improperly. The firm's product manager for YieldPlus advised others that the firm needed "to get away from saying YieldPlus is equivalent to a money market fund," but the firm failed to stop this practice.

Schwab's investment management unit was aware of the changes in the fund's portfolio and the significant increase in the percentage of the fund's mortgage-backed securities holdings, but it failed to appreciate the concomitant increase in the risk of the fund and price volatility. Meanwhile, Schwab's retail brokerage division did not change the way it marketed YieldPlus or the internal guidance it provided to its registered representatives.

In its advertisements and sales literature, Schwab described YieldPlus as a cash alternative investment. Schwab initiated marketing campaigns during the second half of 2006 and continued into 2007, one of which was internally called the "Cash" campaign, which compared the performance of YieldPlus to a money market fund and promoted YieldPlus as an alternative to money market funds. In the campaigns, Schwab did not disclose that the higher returns resulted from the greater risk in the portfolio. Other advertisements emphasized the "minimal risk" and "high degree of price stability" in YieldPlus.

The increased concentration in mortgage-backed securities caused YieldPlus to be severely impacted by the decline in the mortgage-backed securities market that began in the summer of 2007. YieldPlus' NAV dropped significantly, falling from a high of $9.69 on 26 Feb 2007 to $8.79 on 29 Feb 2008, a decline of 9.3%.

Jack's comment: It is again a case about the conflict between product due diligence and product marketing. Investors should be educated to appreciate that bond, or bond fund, is not necessarily safe.

Analyst Fined for Disclosing Misleading Information

2011-01-19T08:15:00.000+08:00

Last week UK FSA fined Christopher Gower £50,000 for making misleading and inaccurate disclosures to the market about Enterprise Inns plc (ETI) to clients via Bloomberg instant messenger, substantially impacting ETI share price.

Gower, a former senior research analyst employed by MF Global Securities Limited and MF Global UK Limited, attended a meeting with the CEO of Punch Taverns plc on 7 May 2008. In the course of the meeting they discussed an application made by ETI to Her Majesty’s Revenue and Customs (HMRC) for approval to convert to a REIT. This discussion concerned solely information which was in the public domain.

Following the meeting, Gower sent a Bloomberg instant message to 14 clients of MF Global, a Bloomberg reporter and MF Global equity salesmen in the following terms:

"*** HOT OFF PRESS*** Just had meeting with CEO of PUNCH TAVERNS. They have heard from HM Revenue & Customs that it is highly likely Enterprise Inns has been granted REIT status and ETI are due to announce this on 13th May at interims. Expect ETI to bounce (was up 10% on previous HMRC news) BUT then fall back as mkt realises it will take time to implement.... MORE on my meeting to follow.... Chris"

This instant message did not accurately reflect the conversation Gower had had. It gave the impression of containing inside information although, in fact, Gower had no such information. The message was misleading and inaccurate. It was rapidly circulated widely in the market and contributed to a substantial increase in the volume of ETI shares traded.

Gower gave no apparent consideration to the consequences to the market of his message. His conduct was careless and fell below proper standards of conduct in the circumstances.

Jack's comment: Pretending to be an insider would not commit an offence of insider dealing, but market abuse.

Promotion of Unauthorized Investment Fund

2011-01-12T08:00:00.026+08:00

Investment fund promoter, Ms Kwok Sau Ping, was convicted last week at the Eastern Magistrates Court of issuing documents in relation to a collective investment scheme without the authorization of SFC and not disclosing interests in listed securities on time. Kwok was fined a total of $12,000 and ordered her to pay SFC investigation costs of $ 80,000.

The Court found that on 13 and 20 October 2007, Kwok held a series of public presentations to promote a collective investment scheme called Reliance China Hong Kong Opportunity Fund. Kwok conducted the presentations using Powerpoint slides, which were not authorized by SFC. A total of 120 investors subscribed to the Fund.

Kwok, who controlled the Fund, was deemed to be interested in the Fund's investments which included an indirect interest in 60 million shares of Hong Kong-listed Bel Global Resources Holdings Limited, and she failed to disclose it within three business days.

Jack's comment: Some people may think that only displaying but not distributing Powerpoint slides about an unauthorized investment product would not constitute a breach of SFO. I don't think so, because the document is still "issued" (the term "issue" is broadly defined under S.102 of SFO) as an invitation to the public for inducing investment.

Expert Immunity

2011-01-05T18:10:00.000+08:00

Today I read this interesting article published by a law firm about "expert immunity":

Keeping up with the Jones case – will expert immunity survive?

If you have ever acted, currently act, or contemplate acting as an expert for litigants, then you ought to be aware of an interesting case before the English Supreme Court. The pending decision could abolish the long-standing doctrine that provides experts with immunity from suit for almost all work done in relation to litigation proceedings (expert immunity). This extends to oral evidence given at trial and preliminary steps undertaken in connection with giving evidence, such as the creation of expert reports.

The subject case on appeal from the English High Court is Jones v Kaney [2010] EWHC 61 (QB). Justice Blake of the English High Court summarily struck out a negligence claim against an expert witness on the basis that he was bound by the leading English case on point, Stanton v Callaghan (Stanton). Stanton upheld the absolute immunity from suit conferred on witnesses (including experts) with respect to testimony in court or work otherwise intimately related to court proceedings.

Since the Court of Appeal would also be bound by Stanton, Blake J granted the claimant, Mr Jones, a 'leapfrog' certificate for the Supreme Court to decide whether or not to allow an appeal, under s.12(1) of the Administration of Justice Act. The Supreme Court has granted permission, and the appeal will be heard on 11 and 12 January 2011.

Although it seems likely that the ordinary 'witness immunity' will be left unaltered, it is not inconceivable that expert immunity could be removed, particularly in view of:

attacks on the public policy underpinning the doctrine of expert immunity;
the fact that these days many experts derive income or indeed make a full-time career acting as an expert witness; and
the judgment of Lord Hoffman in Arthur JS Hall & Co v Simons (Hall v Simons) which overruled the long standing principle that advocates, whether solicitors or barristers, were immune from suit for things done or omitted in the course of conducting a case in court.

It remains to be seen whether the Supreme Court will take the opportunity on this appeal to revisit the case law and the public policy considerations behind the immunity. If, however, expert immunity is abolished, experts who derive fees advising litigants should pay careful attention. The decision could well reverberate across all common law jurisdictions.

HKMA Securities Enforcement Senior Manager

2010-12-29T18:00:00.002+08:00

金融管理局高級經理錢曾珙〔Brian Chin Tsang-kung〕，因被航空公司拒絕登機，一怒之下，打傷國泰航空一名地勤人員，早上在荃灣裁判法院，判簽保守行為三年，以及罰款五千元。

裁判官指被告的教育程度，應該清楚什麼是規矩，應為自己行為感到羞恥。國泰本地職員工會主席劉玉光，滿意裁決，認為被告的行為應受譴責。

金管局說，錢曾珙已就事件通知局方，局方會按既定的人事處理機制跟進事件，但發言人現階段不願評論會否對事主進行處分。

案情指被告今年八月，與三名家人乘搭國泰航機往吉隆坡，但因家人遲到，他們在航機起飛前幾分鐘才抵達閘口，地勤人員拒絕四人登機，被告情緒激動，拍打一名地勤人員，對方後來報警將他拘捕。

Hong Kong still has law and order!

I wonder if this "poor guy" can still work in HKMA.

Good News: Chief Executive Officer to leave SFC

2010-12-08T17:00:00.001+08:00

SFC just announced that its Chief Executive Officer, Mr Martin Wheatley will be leaving next summer.

The following are standard BS in the press release...

Chairman of the SFC, Dr Eddy Fong said: "It has been a great pleasure working with Martin, whose leadership has helped the Commission ride out many challenges and strengthen its position as a globally respected regulator. I am thankful to him and I wish him all the best in his future endeavours."
"My six years with the SFC – hectic and demanding at times – have been very fruitful. The Commission has taken in its stride the many challenges that confronted the financial markets and regulators and we have been able to adopt a pragmatic and sensible approach in our regulation. I am also encouraged to see the work that we have done in tackling market misconduct," Mr Wheatley said.
"I am very grateful for the support, dedication and professionalism of our staff who carried out their duties conscientiously under very trying circumstances at times. I would like to thank them for their commitment and hard work and I wish the SFC continuing success," he added.
Mr Wheatley joined the SFC in June 2005 and was appointed as the Commission’s first Chief Executive Officer in 2006.
Mr Wheatley is a member of the Standing Committee for Standards Implementation of the Financial Stability Board as well as the International Organisation of Securities Commissions (IOSCO) Technical Committee. He currently chairs the IOSCO Technical Committee Task Force on Short Selling.
Prior to joining the SFC, Mr Wheatley was Deputy Chief Executive of the London Stock Exchange. He was also Chairman of the FTSE International and sat on the Listing Authority Advisory Committee of the Financial Services Authority of England.

Jack's comment: My Xmas wish is that the key personnel change will lead to a much more robust and fair regulatory culture. There are too many power-abusing and irresponsible officials in the world!

Criminal Procedures Not Applicable to SFC Disciplinary Process

2010-12-01T08:13:00.001+08:00

This week SFC announced that the Court of Appeal has allowed SFC's appeal against a decision of the Securities and Futures Appeals Tribunal (SFAT) and decided that criminal procedures are not applicable to SFC disciplinary proceedings.

On 19 March 2010, the SFAT altered SFC's decision to revoke the licence of Asser Li Kwok Keung and ban him for 10 years to a suspension for 18 months for lying to SFC and breaching his undertaking to co-operate. In addition, in its determination, the SFAT equated the obligations of the SFC in disciplinary proceedings with that of a prosecutor in criminal proceedings.

SFC appealed to the Court of Appeal against both the penalty imposed by the SFAT and its analogy drawn between SFC's disciplinary process and criminal procedures.

The Court of Appeal, comprising Madam Justice Kwan JA, Mr Justice Stone and Mr Justice Bharwaney, unanimously allowed the SFC’s appeal and increased the penalty for Li from a suspension of licence for 18 months to a prohibition order for three years.

Jack's comment: Many market practitioners believe that SFC's disciplinary process is a kind of "private punishment" and should be subject to the rigidity of criminal procedures. Unfortunately, the Hong Kong court usually supports SFC, especially when SFC can use taxpayers' monies to extend its power.

Synthetic ETFs

2010-11-24T08:13:00.000+08:00

Last week SFC and HKEx a new effort to raise investors' awareness of Exchange Traded Funds (ETFs) that primarily adopt synthetic replication strategy (synthetic ETFs). A traditional ETF (also known as physical ETF) invests in securities that replicate or represent the composition of the index it tracks, and a synthetic ETF uses financial derivative instruments to track index performance.

A manager of an ETF may adopt one or more of the following strategies to achieve the fund's index tracking objective:

full replication by investing in a portfolio of securities that replicates the composition of the underlying index;
representative sampling by investing in a portfolio of securities featuring a high correlation with the underlying index, but not exactly the same as those in the index; or
synthetic replication through the use of financial derivative instruments (such as swaps and performance-linked structured products issued by counterparties) to replicate the index performance.

Synthetic ETFs' managers have agreed to adopt new measures aimed at helping investors to better differentiate between index tracking strategies of ETFs. The new measures, supported by the SFC, HKEx and the industry following extensive discussions, are in line with ongoing efforts to strengthen protection for investors.

Addition of marker to stock short names of synthetic ETFs

Effective from 22 November, 2010, a marker X will be placed at the beginning of the English and Chinese stock short names of all synthetic ETFs listed on SEHK.

The marker will make synthetic ETFs more visible on the stock pages of HKEx's securities trading system and on the HKEx website and the HKExnews website. The stock short names of traditional ETFs will remain the same.

Annotation of names of synthetic ETFs

Building on the preceding measure, by 16 January 2011, managers of synthetic ETFs will be required to put an asterisk (*) and an annotation in English "(*This is a synthetic ETF)" and in Chinese "(*此基金為一隻合成交易所買賣基金)", as the case may be, right after the name of a synthetic ETF whenever it appears in offering documents and marketing materials for a synthetic ETF issued by the manager or on the manager’s behalf to investors in Hong Kong.

This requirement will also be applicable to all notices and other communications with Hong Kong investors in respect of synthetic ETFs whenever the name of the synthetic ETF is mentioned, including information on the corporate websites for Hong Kong investors run by or on behalf of synthetic ETFs' managers.

Investor education initiatives

SFC will continue its investor education efforts to help investors better understand synthetic ETFs.

HKEx is updating its product education material to explain the purpose of the stock short name marker and the risks of ETFs using synthetic replication.

HKEx will also enhance the HKEx website to highlight disclosure of ETF product features. For example, it will indicate which ones use synthetic replication and which ones do not. This will help investors find ETFs by their product features more easily.

HKEx has enhanced the hyperlinks to ETF websites from the HKEx website to provide easier navigation to ETF websites.

Other measure to enhance transparency of ETFs

To assist managers of ETFs in complying with the ongoing disclosure obligations under the Code on Unit Trusts and Mutual Funds and/or Listing Agreement, SFC and HKEx today jointly issued a circular containing a list of potential events that may trigger such disclosure obligation.

Jack's comment: Retail investors should thank Next Magazine's article published several months ago for reporting the danger of synthetic ETFs. SFC is often working on hindsight when handling products.

False Portfolio Valuation Report to Conceal Stealing

2010-11-17T08:02:00.000+08:00

This week SFC banned Ms Pauline Ellen Cousins, a former managing director and responsible officer of Crown Asset Management Limited, from re-entering the industry for life.

Between 2002 and 2006, Cousins produced four false portfolio valuation summaries to a client. The portfolio valuation summaries belonged to other clients and Cousins used them to mislead her client into believing that he had invested a lump sum of $1.75 million in an investment-linked assurance scheme. Instead Cousins had, without her client's authority, invested the lump sum in the shares of a hi-tech company, which was subsequently put into administration.

The disciplinary action follows Cousins' conviction in the District Court on four counts of furnishing false information. Cousins was sentenced to 21 months' imprisonment in December 2009 in proceedings commenced by the police’s Commercial Crime Bureau following referral by SFC.

Jack's comment: In the age of web 2.0, we shouldn't trust any paper produced by intermediaries.

Whistleblower Program

2010-11-10T08:38:00.021+08:00

Last week the US SEC voted unanimously to propose a whistleblower program to reward individuals who provide the agency with high-quality tips that lead to successful enforcement actions.

Rules Requirements

Under the proposed rules, a whistleblower is a person who provides information to the SEC relating to a potential violation of the securities laws.

To be considered for an award, a whistleblower must …

Voluntarily provide the SEC …

In general, a whistleblower is deemed to have provided information voluntarily if the whistleblower has provided information before the government, a self-regulatory organization or the Public Company Accounting Oversight Board asks for it.

… with original information …

Original information must be based upon the whistleblower’s independent knowledge or independent analysis, not already known to the Commission and not derived exclusively from certain public sources.

… that leads to the successful enforcement by the SEC of a federal court or administrative action …

A whistleblower's information can be deemed to have led to successful enforcement in two circumstances: (1) if the information results in a new examination or investigation being opened and significantly contributes to the success of a resulting enforcement action, or (2) if the conduct was already under investigation when the information was submitted, but the information is essential to the success of the action and would not have otherwise been obtained.

… in which the SEC obtains monetary sanctions totaling more than $1 million.

The proposed rules further define and explain these requirements.

Key concepts would include …

Avoiding unintended consequences:

Certain people would generally not be considered for whistleblower awards under the proposed rules. These include:

People who have a pre-existing legal or contractual duty to report their information.

Attorneys who attempt to use information obtained from client engagements to make whistleblower claims for themselves (unless disclosure of the information is permitted under SEC rules or state bar rules).

Independent public accountants who obtain information through an engagement required under the securities laws.

Foreign government officials.

People who learn about violations through a company's internal compliance program or who are in positions of responsibility for an entity, and the information is reported to them in the expectation that they will take appropriate steps to respond to the violation.

This last exclusion — which is intended to prevent company personnel from "front running" legitimate internal investigations — ceases to be applicable if the company does not disclose the information to the Commission within a reasonable time or acts in bad faith. In these circumstances, such people can become whistleblowers.

Certain other people — such as employees of certain agencies and people who are criminally convicted in connection with the conduct — are excluded by Dodd-Frank.

The SEC also would not pay culpable whistleblowers awards that are based upon either the monetary sanctions that such people themselves pay in the resulting SEC action, or on sanctions paid by entities whose liability is based substantially on conduct that the whistleblower directed, planned, or initiated. The purpose of this provision is to prevent wrongdoers from benefitting by, in effect, blowing the whistle on themselves.

Providing Information to the SEC and Seeking a Reward:

The proposed rules also would describe procedures for submitting information to the SEC and for making an award claim after an action is brought. The claim procedures would provide opportunities for whistleblowers to fairly present their case before the Commission makes a final award determination.

The SEC also would pay an award based on amounts collected in related actions brought by certain agencies that are based upon the same original information that led to a successful SEC action.

Supporting Internal Compliance Programs:

The proposed rules include provisions to discourage employees from bypassing their own company’s internal compliance programs.

For instance, the proposed rules:

Would treat an employee as a whistleblower under the SEC program as of the date that employee reports the information internally — as long as the employee provides the same information to the SEC within 90 days. Through this provision, employees will be able to report their information internally first while preserving their “place in line” for a possible award from the SEC.

Permit the SEC to consider higher percentage awards for whistleblowers who first report their information through effective company compliance programs.

What’s Next?

The proposal seeks public comment and data on a broad range of issues relating to the whistleblower program. After careful review of the comments, the Commission will consider what further action to take on the proposal.

Jack's comment: I can hardly imagine such a whistle-blowing program would be implemented in any Chinese society!

Medical Researcher Charged With Tipping Inside Information

2010-11-03T08:10:00.010+08:00

We often see directors of listed companies or investment bankers being charged with insider dealing. Recently there is a US case involving a doctor.

This week US SEC charged a French medical doctor and researcher with breaking securities laws by tipping a hedge fund manager with confidential information about a clinical trial that he was involved in.

SEC alleges that Yves M. Benhamou, M.D., breached his duty of confidentiality to Human Genome Science, Inc. (HGSI) when he illegally tipped non-public negative details about a clinical trial for the drug Albumin Interferon Alfa 2-a (Albuferon) ahead of a public announcement by the company.

Benhamou was a member of the Steering Committee overseeing HGSI's clinical trial of Albuferon, a potential drug to treat Hepatitis C. Benhamou learned about two serious adverse events, including one death, occurring during the third phase of the trial. HGSI consequently decided to reduce the dosage for the patients in that arm of the trial and publicly announce the changes.

Benhamou tipped material, non-public information about the trial to the hedge fund portfolio manager upon learning of each new negative development. While serving on the Steering Committee, Benhamou provided consulting services to the portfolio manager with whom he had developed a friendship over the years.

The portfolio manager, based on the confidential information provided by Benhamou, ordered the sale of the entire position of HGSI stock held by six health care-related hedge funds that he co-managed (approximately 6 million shares). These sales occurred during the six-week period prior to HGSI's public announcement on Jan. 23, 2008, that it was reducing the dosage in one arm of the trial. Two million shares were sold in a block trade just before the markets closed on January 22. HGSI's share price dropped 44 percent by the end of the day on January 23. As a result of the sales, the hedge funds avoided losses of at least $30 million.

Fraud in Valuing Side Pocket

2010-10-27T08:00:00.012+08:00

Last week SEC charged two hedge fund portfolio managers and their investment advisory businesses with defrauding investors in the Palisades Master Fund, L.P. by overvaluing illiquid fund assets they placed in a "side pocket."

SEC alleges that the hedge fund managers Paul Mannion and Andrews Reckles placed the Palisades hedge fund's investments in World Health Alternatives Inc. in a side pocket and valued those investments in a manner that was inconsistent with fund policy and contrary to an undisclosed internal assessment. They also stole investor money to pay for their own personal investments and made material misrepresentations in connection with a private securities transaction.

A side pocket is a type of account that hedge funds use to separate particular investments that are typically illiquid from the remainder of the investments in the fund. SEC's Asset Management Unit has been probing whether funds have overvalued assets in side pockets while charging investors higher fees based on those inflated values.

According to SEC's allegations:

Mannion and Reckles stole more than approximately $1.6 million worth of warrants belonging to the fund. They also improperly used investors' cash on at least two occasions to make personal investments, and they deceived a securities issuer by making false representations about their trading positions in order to participate in a private offering by the issuer.
Mannion and Reckles defrauded investors for at least a three-month period in 2005 through PEF Advisors LLC and PEF Advisors Ltd., two investment adviser entities they controlled. The fraudulent valuations of a convertible debenture, restricted stock, and bridge loans enabled Mannion and Reckles to report to investors misleadingly inflated net asset values, allowing them to take excessive management fees from the fund.

Jack's comment: That is one of the reasons why hedge fund managers are richer than their clients!

SEC's Largest-Ever Financial Penalty Against a Public Company's Senior Executive

2010-10-20T08:00:00.001+08:00

Last week SEC announced that former Countrywide Financial CEO Angelo Mozilo will pay a record $22.5 million penalty to settle SEC charges that he and two other former Countrywide executives misled investors as the subprime mortgage crisis emerged. The settlement also permanently bars Mozilo from ever again serving as an officer or director of a publicly traded company.

Mozilo's financial penalty is the largest ever paid by a public company's senior executive in an SEC settlement. Mozilo also agreed to $45 million in disgorgement of ill-gotten gains to settle SEC's disclosure violation and insider trading charges against him, for a total financial settlement of $67.5 million that will be returned to harmed investors.

Former Countrywide chief operating officer David Sambol agreed to a settlement in which he is liable for $5 million in disgorgement and a $520,000 penalty, and a three-year officer and director bar. Former chief financial officer Eric Sieracki agreed to pay a $130,000 penalty and a one-year bar from practicing before the Commission. In settling SEC's charges, the former executives neither admit nor deny the allegations against them.
The penalties and disgorgement paid by Sambol and Sieracki will also be returned to harmed investors.

SEC filed charges against Mozilo, Sambol and Sieracki on June 4, 2009, alleging that they failed to disclose to investors the significant credit risk that Countrywide was taking on as a result of its efforts to build and maintain market share. Investors were misled by representations assuring them that Countrywide was primarily a prime quality mortgage lender that had avoided the excesses of its competitors. In reality, Countrywide was writing increasingly risky loans and its senior executives knew that defaults and delinquencies in its servicing portfolio as well as the loans it packaged and sold as mortgage-backed securities would rise as a result.

SEC's complaint further alleged that Mozilo engaged in insider trading in the securities of Countrywide by establishing four 10b5-1 sales plans in October, November, and December 2006 while he was aware of material, non-public information concerning Countrywide's increasing credit risk and the risk regarding the poor expected performance of Countrywide-originated loans.

Jack's comment: Don't invest in financial stocks until their risks taken are sufficiently transparent to you.

Proposed Establishment of an Independent Insurance Authority

2010-10-13T08:50:00.002+08:00

During August 2010, FSTB issued the Consultation Paper on Proposed Establishment of an Independent Insurance Authority. This Monday (11 October 2010) was the due day for submission. I provided the comments to FSTB on behalf of the International Academy of Financial Management - Hong Kong Chapter ("IAFMHK"), which are set out as follows:

Consultation Questions

1. Do you agree that an independent IA should be established along the principles set out in paragraph 2.6?

IAFMHK: We agree to the establishment of an independent IA for more effective regulation of the insurance industry. This is in line with the regulatory practices of banking and securities industries in Hong Kong.

2. Do you think that there are other important principles in addition to those set out in paragraph 2.6 that the Administration should adopt in working out the detailed legislative proposals for the establishment of the independent IA? If so, what are they?

IAFMHK: We think that the independent IA should also adopt two more principles: (a) protection of the interests of insurance agents working for insurance companies; and (b) education of the general public about insurance products and industry practices.

3. Do you agree that the independent IA should have an expanded role beyond the existing functions of the IA as set out in paragraph 3.1? If so, do you agree that the independent IA should assume the additional functions as proposed in paragraphs 3.3 and 3.4?

IAFMHK: Agree, especially the independent IA should be able to directly supervise insurance intermediaries.

4. Do you agree the independent IA should also have a duty to enhance the competitiveness of the insurance industry, which will help to reinforce Hong Kong’s status as an international financial centre?

IAFMHK: The fundamental responsibility of the independent IA remain the enforcement of insurance regulations. However, it should adopt a pragmatic regulatory approach to avoid hindering the industry from product innovation and business versatility.

5. Do you agree that the independent IA should be vested with additional powers as proposed in paragraph 4.7 to enable it to regulate insurers more effectively?

IAFMHK: Agree. The additional powers are necessary for the independent IA to enforce the relevant laws and regulations.

6. Do you consider that the existing self-regulatory arrangements for insurance intermediaries should be changed, and if so, do you support that Option 2 (i.e. direct supervision of insurance intermediaries by the independent IA) should be pursued? If not, why?

IAFMHK: We support Option 2.

7. Do you consider that in relation to the sale of insurance products in banks, the HKMA should be vested with powers similar to those for the independent IA to allow HKMA to regulate bank employees selling insurance products given the different client profile and sale environment in banks?

IAFMHK: Different client profile and sale environment is not a sufficient reason to justify that sale of insurance products in banks should be regulated by the HKMA. For avoidance of regulatory arbitrage, sale of insurance products by insurance companies, insurance brokers, independent financial advisors and banks should be regulated by a single and specialist regulatory body.

8. Do you agree that the recommendations as set out in paragraphs 6.5 to 6.8 should be pursued for the independent IA to operate as an independent entity? Any other views?

IAFMHK: We largely agree to the recommendations but suggest that the incentive pay should be linked to the meeting of certain objective performance pledges.

9. Do you agree with the proposed checks and balances and governance arrangements for the independent IA as set out in this Chapter?

IAFMHK: We agree to the proposed checks and balances and governance arrangements. In addition, we suggest the establishment of a mediation and arbitration mechanism to resolve the commercial disputes among insurance companies, insurance intermediaries and/or insurance policyholders.

10. Do you agree that the Government should provide a lump sum to support the independent IA in its initial years of operation and the independent IA should seek to reach full cost recovery in six years?

IAFMHK: We agree that the Government should provide financial assistance to the support the independent IA in its initial years of operation. However, we suggest a longer period (say, 10 years) for full cost recovery to reduce the burden of the insurance industry.

11. Do you agree with the proposed fee structure as set out in paragraphs 8.2 and 8.6?

IAFMHK: We agree to the proposed fee structures.

Regulatory Framework for Pre-Deal Research

2010-10-06T08:12:00.097+08:00

Last week SFC started a two-month public consultation on proposals to expand the scope of the present requirements governing conflicts of interest for analysts so that not only research reports on listed securities but also those on IPOs are covered.

The proposed changes to existing regulatory requirements are summarized in SFC's consultation questions below. My initial comments are also provided.

1.   Do you agree that the requirements in paragraph 16 of the Code of Conduct should be extended to cover research analysts in relation to Pre-deal Research reports?

Jack: It makes sense for paragraph 16 to cover analysts issuing pre-deal research reports as well.

2.   Do you agree that the requirements of paragraph 16 of the Code of Conduct should be extended to cover research analysts covering proposed listings of and listed SFC-authorised REITs in Hong Kong?

Jack: It makes sense for paragraph 16 to cover research reports on REITs as well.

3.   Do you agree that the firm employing research analysts preparing pre-deal research reports on a Applicant should be required to establish, maintain and enforce a set of written policies and control procedures to ensure that these analysts are not provided by the firm with any material information or forward looking information (whether qualitative or quantitative), concerning the Applicant that are not: (a) reasonably expected to be included in the prospectus; or (b) publicly available?

Jack: Agree, but SFC should issue some guidelines on (i) the benchmark for such policies and control procedures (e.g. additional Chinese Wall procedure); and (ii) what constitutes material information or forward looking information that will not be included in the prospectus or publicly available. Also, SFC should specify which party can make the final judgement on such unprovided information.

4.   Do you agree that a research analyst preparing a research report on an Applicant should not seek to obtain from the Applicant or its advisers, any material information or forward looking information (whether qualitative or quantitative), that are: (a) not reasonably expected to be included in the prospectus; or (b) publicly available?

Jack: Ditto

5.   Do you agree that the proposed amendments to Paragraph 16 of the Code of Conduct set out in Appendix 1 implement the above proposals?

Jack: The proposed amendments are not adequate. See above comments.

6.   Do you agree that sponsors should take steps to ensure that all material information or forward looking information (whether qualitative or quantitative), disclosed or provided to analysts is contained in the relevant prospectus or where the proposed listing does not involve a prospectus the relevant listing document, offering circular or similar document?

Jack: Agree in principle, but what steps should be taken by sponsors? Shall a sponsor review the pre-deal research reports to ensure that all material or forward looking information provided to analysts is contained in the prospectus. If the reports contain information gathered by the analysts through their own due diligence, how can the sponsor confirm that such information is not obtained from the Applicant? If the sponsor reviews the research reports, would the independence of analysts be compromised?

7.   Do you agree that the proposed amendments to the CFA Code of Conduct set out in Appendix 2 implement the above proposal?

Jack: The proposed amendments are not adequate. See above comments.

Scripless Securities Market

2010-09-29T08:20:00.036+08:00

Last week SFC announced the plan to introduce a scripless securities market in Hong Kong after the consultation. The key features of the proposed scripless model are summarized below:

Dual system : The existing paper-based system will be retained for the time being so that it runs in parallel with the proposed scripless system. Investors will be allowed to dematerialise securities held in paper form into uncertificated form and also to rematerialise them back into physical form, as long as the dual system exists. The duration of maintaining the dual system will be kept open for now.
Full dematerialisation ultimately : Dematerialisation will be made compulsory eventually i.e. the paper-based option will be removed altogether.
Phased approach : Existing securities will be dematerialised in batches starting with shares of companies incorporated in Hong Kong.
Register to comprise two parts : The register of holders will consist of a certificated sub-register which is maintained by the share registrar and an uncertificated sub-register which is maintained by HKSCC. To facilitate inspection, corporate action processing and corporate entitlements calculation, HKSCC will provide the respective share registrars with a day-end record of the uncertificated sub-register. The day-end record will also allow share registrars to reconcile the two sub-registers.
Removal of the immediate credit arrangement : One of the consequences of the register of holders comprising two sub-registers is the removal of the immediate credit arrangement by HKSCC.
Account types to hold uncertificated securities : Investors will be able to hold their uncertificated securities through four different account types. Only one of these, namely the Issuer Sponsored Account (ISA), is a new account type under the proposed model. The other three are essentially modified versions of the existing CCASS Participant Account (CPA), Stock Segregated Account and Investor Participant Account (IPA).
Name on register : Investors will be able to hold securities in CCASS in their own names i.e. they will have the option of becoming the legal owner of the securities and of enjoying the full benefits of legal ownership.
Unique identification numbers : Currently, investors who hold securities within CCASS are required to provide an identity proof (such as their HKID) during the account opening process with a broker/bank/custodian or HKSCC, as the case may be. Building on this practice, we propose that investors' identification numbers be made available to both HKSCC and the relevant share registrar.
Attending and voting at shareholders' meetings : The Working Group is keen to preserve the status quo of allowing beneficial owners to attend and vote at shareholders' meeting and considers that the better way to achieve this may be to simply allow the appointment of multiple proxies. This way, brokers / banks / custodians who hold shares on behalf of clients will be able to appoint their clients as proxies to attend and vote at meetings. For clients who merely wish to vote but not to attend the meeting, their interest can be represented by brokers / banks / custodians through appointing the chairman of the meeting as a proxy to vote on their behalf.
Disseminating corporate communications and providing corporate action services to securities holders : As HKSCC Nominees will no longer be the registered holder of uncertificated securities in CCASS, there will be changes in the dissemination of corporate communications and provision of corporate action services to holders of uncertificated securities. Accordingly, we propose that share registrars will disseminate corporate communications to all registered holders (both certificated and uncertificated) and HKSCC will continue to provide additional services like providing receivable notices to uncertificated holders who hold their securities through a CPA, Participant Sponsored Account (PSA) or IPA.
Regulation of share registrars : Share registrars will be able to become a new category of participants in CCASS (if they meet the admission criteria). This will allow them to use the existing CCASS infrastructure to communicate electronically with other CCASS Participants and to handle instructions relating to uncertificated securities. Additionally, in view of their more active and involved roles and functions in the scripless environment, share registrars will be more directly and robustly regulated.
IPOs : In the scripless environment, the existing four ways to apply for an IPO (applications via a white form, a white form eIPO, a yellow form and CCASS eIPO) will remain largely unchanged. The main difference will be that applicants under the white form and white form eIPO options will be able to choose if their securities should be issued in uncertificated or physical form.
Scope : Pending resolution of certain practical issues, the scripless proposals will be implemented in relation to shares of listed companies - starting first with those incorporated in Hong Kong and then those incorporated overseas.
Shares and debentures of companies incorporated overseas and listed in Hong Kong : We will focus first on companies incorporated in Bermuda, Cayman Islands, Mainland China and UK mainly because companies incorporated in these four jurisdictions make up the vast majority of overseas companies listed on the SEHK and will therefore have a greater impact on the scripless initiative.
Roll-out plan for implementing a scripless securities market : There will be two distinct implementation timelines which are independent of one another - one for existing securities and the other for IPOs. In both cases however, there will first be a pilot run.

Jack's comment: There are so many advantages of the scripless model. It should have been implemented since ten years ago!

RMB Products

2010-09-22T08:20:00.032+08:00

RMB products are getting hot in our city. Therefore HKMA recently issued a circular to remind all banks to ensure that the material features and risks of such products are adequately taken into account in the product due diligence process and the suitability assessment of customers. Key points are summarized below:

Proper disclosure of the nature of RMB products

Banks should ensure that customers understand the nature of the RMB product including any underlying investments and whether any deposit protection is available.

Proper disclosure of the risks of RMB products

The following paragraphs highlight some of the key risks relevant to RMB products.

RMB currency risk

When a customer opens a RMB deposit account, the bank should disclose to the customer the RMB exchange rate risk and the fact that RMB is currently not freely convertible and conversion of RMB through banks in Hong Kong is subject to certain restrictions. Such risks should also be disclosed to its customers during the marketing and selling process of RMB investment and insurance products. In particular, for personal customers, the bank should explain that as the conversion of RMB is subject to a daily limit, the customer may have to allow time for conversion of RMB from/to another currency of an amount exceeding the daily limit.

For RMB products which are not denominated in RMB or with underlying investments which are not RMB-denominated, banks should disclose to their customers that such products will be subject to multiple currency conversion costs involved in making investments and liquidating investments, as well as the RMB exchange rate fluctuations and bid/offer spreads when assets are sold to meet redemption requests and other capital requirements (e.g. settling operating expenses).

Other risks associated with RMB products

Limited availability of underlying investments denominated in RMB – For RMB products that do not have access to invest directly in Mainland China, their available choice of underlying investments denominated in RMB outside Mainland China may be limited. Banks should explain to the customers that such llimitation may adversely affect the return and performance of the RMB products.
Projected returns which are not guaranteed – If the RMB investment product (e.g. RMB ILAS) is attached with a statement of illustrative return which is (partly) not guaranteed, banks should clearly disclose to their customers that the return which is not guaranteed and the assumptions on which the illustrations are based, including, e.g. any future bonus or dividend declaration.
Long term commitment to investment products – For RMB products which involve a long period of investment (e.g. RMB ILAS), banks should remind customers that if they redeem their investment before the maturity date or during the lock-up period, they may incur a significant loss of principal where the proceeds may be substantially lower than their invested amount. Customers should be reminded of the early surrender/withdrawal fees and charges as well as the loss of bonuses as a result of redemption before the maturity date or during the lock-up period.
Credit risk of counterparties – Banks should disclose to their customers the credit risk of counterparties involved in the RMB products. To the extent that the RMB products may invest in RMB debt instruments not supported by any collateral, AIs should ensure customers' understanding that such products are fully exposed to the credit risk of the relevant counterparties. Where a RMB product may invest in derivative instruments, counterparty risk may also arise as the default by the derivative issuers may adversely affect the performance of the RMB product and result in substantial loss.
Interest rate risk – For RMB products which are, or may invest in, RMB debt instruments, banks should disclose to their customers that such instruments are susceptible to interest rate fluctuations, which may adversely affect the return and performance of the RMB products.
Liquidity risk – Banks should remind customers of the liquidity risk associated with the RMB products, and where applicable, the possibility that the RMB products may suffer significant losses in liquidating the underlying investments, especially if such investments do not have an active secondary market and their prices have large bid/offer spreads.
Possibility of not receiving RMB upon redemption – For RMB products with a significant portion of non-RMB denominated underlying investments, banks should disclose to their customers that there is a possibility of not receiving the full amount in RMB upon redemption. This may be the case if the issuer is not able to obtain sufficient amount of RMB in a timely manner due to the exchange controls and restrictions applicable to the currency.
Additional risks associated with leveraged trading – Banks should note that leveraged trading facilities should not be offered to personal customers and Designated Business Customers (DBCs) in respect of RMB products. While banks may extend RMB loans to corporate customers, prior to conducting leveraged trading of RMB products for corporate customers, banks should ensure that the customers understand and are willing to accept the risks and the terms and conditions of the borrowing arrangement. Banks should explain to customers that leveraging heightens the investment risk by magnifying prospective losses. Customers should be properly informed of the circumstances under which they will be required to place additional margin deposits at short notice and that their collateral may be liquidated without their consent. Banks should also ensure their customers' understanding of the risk that market conditions may make it impossible to execute contingent orders, such as "stop-loss" orders. In addition, customers should be reminded of their exposure to interest rate risk, and in particular, their cost of borrowing may increase due to interest rate movements.

Jack's comment: HKMA almost treats RMB products like Lehman minibonds. My concern is that people buying RMB products are too distracted by the expectation of RMB appreciation, ignoring the scene behind these products.

Basel III

2010-09-15T08:30:00.020+08:00

(Extracted from BIS Basel Committee's Press Release 2010.09.12)

At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010. These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the Seoul G20 Leaders summit in November.

The Committee’s package of reforms will increase the minimum common equity requirement from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%. This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative and securitisation activities to be introduced at the end of 2011.

Increased capital requirements

Under the agreements reached today, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments. This will be phased in by 1 January 2015. The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period.

The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions. This framework will reinforce the objective of sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and high dividends, even in the face of deteriorating capital positions.

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above. In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt. In addition, work is continuing to strengthen resolution regimes. The Basel Committee also recently issued a consultative document Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability. Governors and Heads of Supervision endorse the aim to strengthen the loss absorbency of non-common Tier 1 and Tier 2 capital instruments.

Transition arrangements

Since the onset of the crisis, banks have already undertaken substantial efforts to raise their capital levels. However, preliminary results of the Committee’s comprehensive quantitative impact study show that as of the end of 2009, large banks will need, in the aggregate, a significant amount of additional capital to meet these new requirements. Smaller banks, which are particularly important for lending to the SME sector, for the most part already meet these higher standards.

The Governors and Heads of Supervision also agreed on transitional arrangements for implementing the new standards. These will help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy. The transitional arrangements include:

National implementation by member countries will begin on 1 January 2013. Member countries must translate the rules into national laws and regulations before this date. As of 1 January 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs): 3.5% common equity/RWAs; 4.5% Tier 1 capital/RWAs, and 8.0% total capital/RWAs. The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015. On 1 January 2013, the minimum common equity requirement will rise from the current 2% level to 3.5%. The Tier 1 capital requirement will rise from 4% to 4.5%. On 1 January 2014, banks will have to meet a 4% minimum common equity requirement and a Tier 1 requirement of 5.5%. On 1 January 2015, banks will have to meet the 4.5% common equity and the 6% Tier 1 requirements. The total capital requirement remains at the existing level of 8.0% and so does not need to be phased in. The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 and higher forms of capital.
The regulatory adjustments (ie deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, would be fully deducted from common equity by 1 January 2018.
In particular, the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014, 40% on 1 January 2015, 60% on 1 January 2016, 80% on 1 January 2017, and reach 100% on 1 January 2018. During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.
The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.
Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.
Existing public sector capital injections will be grandfathered until 1 January 2018. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10 year horizon beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.
Capital instruments that do not meet the criteria for inclusion in common equity Tier 1 will be excluded from common equity Tier 1 as of 1 January 2013. However, instruments meeting the following three conditions will be phased out over the same horizon described in the previous bullet point: (1) they are issued by a non-joint stock company1; (2) they are treated as equity under the prevailing accounting standards; and (3) they receive unlimited recognition as part of Tier 1 capital under current national banking law.
Only those instruments issued before the date of this press release should qualify for the above transition arrangements.

Phase-in arrangements for the leverage ratio were announced in the 26 July 2010 press release of the Group of Governors and Heads of Supervision. That is, the supervisory monitoring period will commence 1 January 2011; the parallel run period will commence 1 January 2013 and run until 1 January 2017; and disclosure of the leverage ratio and its components will start 1 January 2015. Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

After an observation period beginning in 2011, the liquidity coverage ratio (LCR) will be introduced on 1 January 2015. The revised net stable funding ratio (NSFR) will move to a minimum standard by 1 January 2018. The Committee will put in place rigorous reporting processes to monitor the ratios during the transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary.

Deficient AML Controls Over Omnibus Accounts

2010-09-08T08:40:00.026+08:00

US SEC charged Pinnacle Capital Markets LLC with failing to comply with an anti-money laundering (AML) rule that requires broker-dealers to identify and verify the identities of its customers and document its procedures for doing so. SEC also charged Pinnacle's managing director Michael A. Paciorek with causing Pinnacle's violations.

Pinnacle is a broker-dealer based in Raleigh, N.C., with more than 99% of its customers residing outside the United States. Pinnacle's business primarily involves order processing with direct market access (DMA) software for foreign institutions comprised mostly of banks and brokerage firms and foreign individuals.

SEC found that Pinnacle established, documented and maintained a customer identification program (CIP) that specified it would identify and verify the identities of all of its customers. However, during a six-year period, Pinnacle failed to follow the identification and verification procedures set forth in its CIP.

Many of the firm's foreign entity customers hold omnibus accounts at Pinnacle through which the entities carry sub-accounts for their own corporate or retail customers. Pinnacle treats the sub-account holders of the foreign entity omnibus accounts in the same manner as it does its regular account holders. The vast majority of Pinnacle's regular account holders, as well as the omnibus sub-account holders, use DMA software to enter securities trades directly and instantly through their own computers. As a result, these account holders have direct, unfiltered control over how securities transactions are effected in the accounts. The foreign entity holding the omnibus account does not intermediate these trades. The DMA software allows the omnibus sub-account holders to route their securities transactions directly to the relevant market centers without intermediation.

From October 2003 to August 2006, Pinnacle did not verify the identities of 34 out of a sample of 55 corporate account holders. The Commission also finds that from October 2003 through November 2009, Pinnacle did not collect or verify identifying information for the vast majority of the beneficial owners of sub-accounts maintained by Pinnacle's omnibus brokerage accounts. Consequently, the order finds that Pinnacle's documented procedures differed materially from its actual procedures.

Pinnacle and Paciorek agreed to settle SEC's enforcement action without admitting or denying the allegations, and Pinnacle will pay $25,000 in financial penalties. As part of an action taken by FINRA in February 2010, Pinnacle also has agreed to certain undertakings, including extensive AML training for its employees, as well as the hiring of an independent consultant to review its AML compliance program.

Jack's comment: DMA plus omnibus account is really a perfect mix for not only keeping privacy, but also money laundering. KYC is always the No.1 fundamental compliance issue.

Sales of Inverse Floater CMOs

2010-09-01T08:50:00.000+08:00

FINRA recently fined HSBC Securities (USA) Inc. $375,000 for recommending unsuitable sales of inverse floating rate Collateralized Mortgage Obligations (CMOs) to retail customers. HSBC failed to adequately supervise the suitability of the CMO sales and fully explain the risks of an inverse floating rate or other risky CMO investment to its customers.

As a result of HSBC not implementing an adequate supervisory system and procedures relating to the sale of inverse floating rate CMOs to retail customers, six of its brokers made 43 unsuitable sales of inverse floaters to retail customers who were unsophisticated investors and not suited for high-risk investments.

In addition, HSBC's procedures required a supervisor's pre-approval of any sale in excess of $100,000; FINRA found that 25 of the 43 CMO sales were in amounts exceeding $100,000 and that in five of these instances, customers lost money in their inverse floating rate CMO investments. HSBC has paid these customers full restitution totaling $320,000.

A CMO is a fixed income security that pools mortgages and issues tranches with various characteristics and risks. CMOs make principal payments throughout the life of the security with the maturity date being the last date by which all of the principal must be returned. The timing of the return of principal payments can vary depending on interest rate changes.

One of the more risky CMO tranches is the inverse floater, a type of tranche that pays an adjustable rate of interest that moves in the opposite direction from movements of an interest rate index, such as LIBOR. Since 1993, FINRA has advised firms that inverse floating rate CMOs "are only suitable for sophisticated investors with a high-risk profile."

HSBC did not provide its brokers with sufficient guidance and training regarding the risks and suitability of CMOs. In particular, the firm did not inform its registered representatives that inverse floaters were only suitable for sophisticated investors with a high-risk profile. In addition, the firm did not provide its registered representatives with information regarding the risks associated with the specific inverse floaters that were available to be sold.

HSBC also failed to comply with a FINRA rule, adopted in November 2003, which requires firms to offer certain educational materials before the sale of a CMO to any person, other than an institutional investor. The educational materials must include, among other things, the characteristics and risks of CMOs, in general, and the specific characteristics and risks associated with the different tranches of a CMO.

During the relevant time period, HSBC did not advise its registered persons that they were required to offer written educational material to their customers before they sold them CMOs. Although HSBC provided its brokers with a CMO brochure, the brokers did not offer the brochure to every CMO investor, nor did they know that they were required to give the materials to all potential CMO investors before selling them a CMO. Moreover, the brochures did not comply with FINRA's content standards. In particular, the brochure failed to discuss inverse floaters and failed to include a section on risks associated with purchasing CMOs.

Jack's comment: Investor floater is a highly risky product, no matter it is associated with CMOs or not. Such kind of product should not be offered to retail investors unless they can demonstrate full understanding of its risk profile. Distribution of education materials to retail investors is certainly not enough.

Review of Insider Dealing Sentence

2010-08-25T08:00:00.032+08:00

Last week The Eastern Magistracy today sentenced Mr Pablo Chan Pak Hoe, who was earlier convicted of insider dealing in a proposed takeover, to serve 240 hours of community service. Chan was also ordered to pay the SFC investigation costs totalling $44,478.

Magistrate Anthony Yuen Wai Ming (who recently put Amina Mariam Bokhary on one year's probation with respect to her third conviction for assaulting a police officer) had earlier found Chan guilty of one count of insider dealing in the shares of Universe International Holdings Ltd between 2 May 2008 and 19 June 2008 when he acted as a representative of the controlling shareholder in a proposed acquisition.

SFC had informed the Magistrate that Chan made a profit in the order of $120,000 when he sold the shares following the announcement of the acquisition. Under the community service order, Chan does not have to repay or disgorge any profit from his insider dealing and is able to retain it.

SFC is seeking a review of this sentencing decision.

Jack's comment: Compared with previous cases of insider dealing, the sentence in this case was really "exceptional"...no imprisonment, and even no disgorgement of profit. I am not informed that the defendant in this case has also suffered from bipolar disorder!

Morgan Stanley Breached the Research Rules Again

2010-08-18T08:40:00.023+08:00

Recently FINRA censured and fined Morgan Stanley & Co., Inc. $800,000 for failing to make public disclosures required by FINRA's rules governing research analyst conflicts of interest. The firm also failed to comply with a key provision of the 2003 Research Analyst Settlement by failing to disclose the availability of independent research in customer account statements.

In addition to the censure and fine, Morgan Stanley must review a sample of its research reports and certify to FINRA that they comply with FINRA's research analyst conflict-of-interest rules. These reviews and certifications must take place every six months for two years.

FINRA found that from April 2006 to June 2010, Morgan Stanley issued equity research reports that failed to disclose accurate information about the relationships Morgan Stanley, or its analysts, had with companies covered in its research reports. Overall, these inaccuracies resulted in approximately 6,836 deficient disclosures in about 6,632 equity research reports and 84 public appearances by research analysts. Among the deficient disclosures were:

Securities holdings of an analyst, or a member of the analyst's household, in a subject company;
Morgan Stanley's receipt of investment banking and non-investment banking revenue from subject companies;
Morgan Stanley's role as a manager, or co-manager, of a public offering of securities for subject companies;
Morgan Stanley's role as a market maker for certain subject companies' securities; and
Price charts for securities covered in equity research reports and the valuation method used to support published price targets.

Morgan Stanley also did not disclose in approximately 127,600 monthly account statements sent to customers from August 2007 to February 2008 that it had available independent, third-party research. The requirement to provide customers with this notification was part of SEC's final agreement with Morgan Stanley as part of the 2003 Research Analyst Settlement and was incorporated into a separate agreement with FINRA.

In determining the appropriate sanctions in this matter, FINRA considered Morgan Stanley's self-review and self-reporting of some of its disclosure violations and remedial steps taken by the firm, as well as a prior FINRA settlement in 2005 that found the firm violated FINRA's research analyst disclosure rules.In settling this matter, Morgan Stanley neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

Jack's comment: The credibility problem of research analysts has not fundamentally changed since the burst of the IT bubble. The financial penality is just a piece of cake to a giant investment bank.

Introducing Non-SFC Authorised Fund to Clients

2010-08-11T08:33:00.000+08:00

SFC has just suspended the licence of Ms Kou Sao Peng for three months from 4 August 2010 to 3 November 2010. SFC's investigation found that Kou, while acting as a consultant of TTG (HK) Ltd, an investment adviser, introduced a non-SFC authorised fund to several clients in 2008.

The introduction of the fund preceded the completion of due diligence process by TTG. As such, the fund was not yet approved by TTG for recommendation to clients. In order to sell the fund to her clients, Kou asked her clients to sign a form acknowledging themselves as "execution only" clients who specifically requested to purchase the fund. Kou should not have done so given the fund was actually introduced by her to the clients.

An "execution only" transaction usually means a transaction executed by a firm upon the specific instructions of a client without solicitation or recommendation by the firm, where the firm does not, and is not expected to give investment advice relating to the merits and suitability of the transaction.
Moreover, Kou did not consider TTG’s due diligence on the fund before introducing it to the clients and ignored an instruction from her supervisor to monitor the fund for a longer period before introducing it to any clients.

In suspending Kou, SFC did not consider that Kou had acted dishonestly. Had there been a finding of dishonesty, the SFC would have imposed a more severe sanction.

Jack's comment: In the past, there were many investment consultants who attempted to deny solicitation of clients for purchasing non-authorized products by asking the clients to sign the "execution only" acknowledgement. This case reveals that such arrangement may not work.

Breach of Money Laundering Checks

2010-08-04T08:00:00.002+08:00

This week FSA fined members of the Royal Bank of Scotland Group (RBSG) £5.6m for failing to have adequate systems and controls in place to prevent breaches of UK financial sanctions. FSA's Decision Notice

UK firms are prohibited from providing financial services to persons on the HM Treasury sanctions list. The Money Laundering Regulations 2007 (the Regulations) require that firms maintain appropriate policies and procedures in order to prevent funds or financial services being made available to those on the sanctions list.

During 2007, RBSG processed the largest volume of foreign payments of any UK financial institution. However, between 15 December 2007 and 31 December 2008, RBS Plc, NatWest, Ulster Bank and Coutts and Co, which are all members of RBSG, failed to adequately screen both their customers, and the payments they made and received, against the sanctions list. This resulted in an unacceptable risk that RBSG could have facilitated transactions involving sanctions targets, including terrorist financing.

FSA considers that RBSG’s failings in relation to its screening procedures were particularly serious because of the risk they posed to the integrity of the UK financial services sector. This is the biggest fine imposed by the FSA to date in pursuit of its financial crime objective. It is also the first fine imposed by the FSA under the Regulations.

As RBSG agreed to settle at an early stage of the FSA investigation, it qualified for a 30% reduction in penalty. The FSA would have otherwise imposed a financial penalty of £8m.

Jack's comment: It appears that many financial institutions in the world (especially private banks) have not yet changed their lax attitude towards the compliance with money laundering rules.

Regulation of Life Settlements

2010-07-28T08:00:00.026+08:00

Last week US SEC released a staff report recommending that life settlements be clearly defined as securities so that the investors in these transactions are protected under the federal securities laws.

A life settlement is a transaction in which an individual with a life insurance policy sells that policy to another person, who then assumes responsibility for paying the premiums. Typically, the seller no longer wants the policy or can no longer afford to pay the premiums. In exchange, the insured party typically receives a lump sum payment that exceeds the policy's cash surrender value, but is less than the expected payout in the event of death.

The staff report by SEC's Life Settlements Task Force, which SEC Chairman Mary Schapiro established in August 2009, notes that the market for life settlements has grown over the past decade, raising questions about its regulation and oversight.

In particular, the report notes that there is inconsistent regulation of participants in the life settlements market, including those who arrange for the buying and selling of policies and those who provide estimates of an insured's life expectancy. In addition, the report notes that investors in individual life settlement transactions, or pools of life settlements, would benefit from the application of baseline standards of conduct to market participants.

In the report, the staff outlines the Task Force's findings about the life settlements market and recommends ways to improve market practices and regulatory oversight. It recommends that the Commission should:

Consider recommending to Congress that it amend the definition of security under the federal securities laws to include life settlements as securities.
Instruct the staff to continue to monitor that legal standards of conduct are being met by brokers and providers.
Instruct the staff to monitor for the development of a life settlement securitization market.
Encourage Congress and state legislators to consider more significant and consistent regulation of life expectancy underwriters.

SEC also issued an investor bulletin regarding investments in life settlements, consistent with one of the recommendations of the Task Force.

Amending the federal securities laws to define life settlements as securities could have several benefits:

The amendment would clarify the status of life settlements under the federal securities laws and provide for a more consistent treatment of life settlements under both federal and state securities laws.
The amendment would bring intermediaries in the life settlement market within the regulatory framework of SEC and FINRA. This would subject them to regulatory requirements designed to protect investors from abusive practices and to promote business conduct that facilitates fair, orderly and efficient markets.
The amendment would give SEC and FINRA clear authority to police the life settlements market, which could lead to early detection of abuses and help deter fraud.

Jack's comment: It appears that life settlement is not regarded as securities under SFO, but would they be treated as regulated investment agreement, or structured product in future?

Responsible Lending

2010-07-21T08:30:00.002+08:00

Last week UK FSA has today outlined proposals to ensure all mortgages are carefully assessed to make sure borrowers can afford them.

Reflecting FSA's enhanced consumer protection strategy and intensive day-to-day supervision, the proposed changes aim to ensure all lenders get back to the basics of responsible lending and that problems are prevented before they can develop or get out of control.

Some of the key proposals include:

Imposing affordability tests for all mortgages and making lenders ultimately responsible for assessing a consumer's ability to pay;
Requiring verification of borrowers' income in every case to prevent over inflation of income and to prevent mortgage fraud;
Extra protection for vulnerable customers with a credit-impaired history.

The tough new proposals, published in the consultation paper, form part of a major review by FSA into the UK mortgage market and are based on detailed analysis of past lending decisions, looking at the causes of arrears and repossessions since 2005.

FSA found that:

46% of households either had no money left, or had a shortfall after mortgage payments and living costs were deducted from their income;
Almost half of new mortgages between 2007 and the first quarter of 2010 were provided without a customer having to verify their income;
The share of interest-only mortgages has been increasing. At the peak of the market, over 30% of all mortgages were interest-only;
Many consumers with no repayment vehicle count on future house price rises or uncertain life events to repay their mortgage and some have no plan at all;
Borrowers with a credit-impaired history are particularly vulnerable.

Jack's comment: While FSA is enforceing responsible lending, it may have failed to ensure responsible borrowing.

Manipulating Stock Price Downward to Benefit Hedge Fund Client

2010-07-14T08:30:00.020+08:00

A FINRA hearing panel has permanently barred a former Deutsche Bank broker from the securities industry for manipulating the price of Monogram Biosciences (MGRM) stock in an effort to enrich a hedge fund client, himself and his family.

The panel found that Edward S. Brokaw, who worked in the Greenwich, CT branch office of Deutsche Bank Securities, engaged in a pattern of trading designed deliberately to drive the value of MGRM stock down and, in turn, drive up the value of contingent value rights (CVRs) on that stock. Included in the evidence against Brokaw were tape recordings of his phone calls to his firm's trading desk to place sell orders.

The MGRM CVRs were created and issued in December 2004, in connection with the merger of two firms to form MGRM. The CVRs were to be valued during a 15-day pricing period scheduled for 18 months after the merger – beginning on May 19, 2006, and ending on June 9, 2006.

The value of the CVRs was to be determined by the volume weighted average price (VWAP) of MGRM shares trading during that 15-day period. At the end of the pricing period, CVR holders were to receive a payment from MGRM, most or all of which would be in cash. If the final VWAP was at or above $2.90, the CVRs would be worthless. But if the final VWAP was below $2.90, CVR holders would receive a penny-for-penny payment for the amount below $2.90, down to $2.02. The maximum of $.88 per CVR would be paid if the final MGRM VWAP was at or below $2.02.

Brokaw's hedge fund client held approximately 18.5 million CVRs – nearly 30% of the 64.8 million MGRM CVRs outstanding. For every penny the final VWAP dropped below $2.90, the value of the hedge fund's CVRs increased by $185,000. If the maximum payout of $.88 per CVR were achieved, the hedge fund would receive approximately $16 million. Brokaw and his family owned 217,000 of the CVRs, with a potential maximum payout of $188,000.

The hedge fund owned 3 million shares of MGRM and told Brokaw that it wanted to sell off all of those shares during the pricing period. Prior to market open on the first day of the pricing period, the hedge fund placed an order with Brokaw to sell 50,000 MGRM shares close to the open and another 50,000 shares close to the close. In a tape-recorded phone call that morning, Brokaw told a Deutsche Bank sales trader, "Take 50,000 MGRM at the market. Sell it down. Sell it as low as you want. Sell it hard, 50,000." According to the panel decision, the sales lasted little more than a minute – and MGRM shares dropped from $2.06 to $1.94.

The panel decision quotes another phone call from Brokaw to the sales trader that afternoon, in which he explained the pricing of the CVRs and the strategy behind the hedge fund's instructions to sell close to the market's open and close, saying, "Just so you know what the target price is … So yeah, understand the game that's being played for the next 15 days."

The hedge fund's orders and Brokaw's aggressive placement of those sell orders continued for three trading days. But when Deutsche Bank's compliance personnel reviewed those orders, the firm decided it would no longer execute MGRM sales for the hedge fund's account. Deutsche Bank first suspended, then terminated Brokaw based on his MGRM sales orders for the hedge fund.

The hearing panel concluded that "the objective of the selling strategy was to drive down the price of MGRM shares rather than to obtain the best price … (Brokaw) placed the orders to artificially depress the price of MGRM to impact the pricing of the CVRs." The panel noted that for every penny MGRM stock dropped, the hedge fund lost $29,000 in value on its shares but gained more than $180,000 in value on its CVRs.

The panel also found that Brokaw violated Deutsche Bank's policy requiring the individual accepting a client order to create an order ticket "immediately upon receipt of an order." Instead, Brokaw's sales assistant completed one "booking ticket" each day, each showing a single 100,000-share order to sell, each with a false notation that the order was given by the client directly to the trading desk rather than to Brokaw – thus circumventing automatic branch office compliance review of the orders.

Unless the hearing panel's decision is appealed, its ruling will resolve charges filed in a FINRA complaint against Brokaw filed in December 2008.

Jack's comment: Actually the design of CVR motivated this kind of "arbitrage" activities, but were incidentally regarded as "market manipulation".

Fraudulently Touting Penny Stocks on a Website, Facebook and Twitter

2010-07-07T08:50:00.012+08:00

US SEC has recently obtained an emergency asset freeze against a Canadian couple who fraudulently touted penny stocks through their website, Facebook and Twitter. It also charged two companies the couple control and obtained an asset freeze against them.

According to SEC's complaint, the defendants profited by selling penny stocks at or around the same time that they were touting them on www.pennystockchaser.com. The website invites investors to sign up for daily stock alerts through email, text messages, Facebook and Twitter.

Since at least April 2009, Carol McKeown and Daniel F. Ryan, a couple residing in Montreal, Canada, have touted U.S. microcap companies. They received millions of shares of touted companies through their two corporations, defendants Downshire Capital Inc., and Meadow Vista Financial Corp., as compensation for their touting. McKeown and Ryan sold the shares on the open market while PennyStockChaser simultaneously predicted massive price increases for the issuers, a practice known as "scalping."

McKeown and Ryan used all the modern methods to communicate with investors including the PennyStockChaser website, e-mail, text messages, Facebook, and Twitter yet failed to adequately communicate that their rosy predictions for touted stocks were accompanied by their sales of those very same stocks.

McKeown, Ryan together with their corporations failed to disclose the full amount of the compensation they received for touting stocks on PennyStockChaser, and they have realized at least $2.4 million in sales proceeds from their scalping scheme.

Jack's comment: If such scalping practice happened in Hong Kong, probably SFC would charged those scalpers for violating Section 300 of SFO - Offence involving fraudulent or deceptive devices, etc. in transactions in securities, futures contracts or leveraged foreign exchange trading.

Treatment of Professional Investors

2010-06-30T08:24:00.001+08:00

SFC has recently resolved its compliance concerns with Julius Baer (Hong Kong) Ltd. Under the resolution, SFC reprimands and fines Julius Baer $3 million.

An SFC investigation revealed that Julius Baer, which is licensed to provide services only to professional investors, failed:

to take adequate steps to identify clients as professional investors before treating them as such;
to conduct an annual confirmation as to whether its clients continued to fulfil the professional investor requirements; and
to maintain adequate written records of its investment advice given to clients.

In deciding the disciplinary sanction, the SFC took into account that:
the failures took place between October 2006 and July 2008 when they were detected;

Julius Baer has a clean disciplinary record;
Julius Baer co-operated in resolving these disciplinary proceedings;
Julius Baer does not admit to the failures as identified by SFC; and
Julius Baer will engage an independent reviewer to review its internal controls in relation to its compliance with the regulatory requirements for treating clients as professional investors and the provision of investment advice.

Jack's comment: The implication of this case seems alarming. It may indicate that certain non-eligible clients had been mis-classified as professional investors but recommended to purchase unauthorized investment products without reasonable care being taken by their relationship managers.

Internal Control Deficiencies in Handling Mainland Clients’ Accounts

2010-06-23T08:40:00.016+08:00

Last week SFC reprimanded Christfund Securities Ltd (CSL), Christfund Futures Ltd (CFL) (collectively referred to as Christfund) and their respective responsible officers, and fined them a total of $2.5 million over internal control deficiencies in handling Mainland clients' accounts.

CSL and CFL were fined $1,200,000 and $700,000 respectively while responsible officers Ng Kam Shing and Chow Yuen Tung were fined $300,000 each in relation to Christfund’s internal control deficiencies in handling Mainland clients’ accounts.

An SFC investigation covering the period from August 2007 to July 2008 found that a Shenzhen-based company, Hang Fung Investment Consultants (Shenzhen) Co Ltd (HF Shenzhen) -- an affiliate of Christfund -- provided marketing services for Christfund on the Mainland.

HF Shenzhen made available account opening forms for Mainland investors to open accounts with Christfund. In handling the account opening process for these Mainland individuals, SFC found that:

Christfund had not performed sufficient know-your-client procedures with respect to Mainland clients;
Christfund took insufficient steps to establish the full identities and addresses of each of these Mainland individuals, thereby failing to establish the accuracy of such information;
Christfund allowed 22 and 44 such Mainland clients of CSL and CFL respectively to use the office address of HF Shenzhen as their correspondence address. Also, 51 such Mainland clients of CSL were permitted to use the address of one of Christfund’s clients as their correspondence address;
Christfund allowed about 1,000 clients at CSL to authorise one individual amongst them to operate their accounts on their behalf;
Christfund had taken insufficient steps to check the operation of two accounts of clients emanating from HF Shenzhen for a prolonged period of time, thereby allowing these accounts to be used to transfer funds to facilitate settlement of transactions in the Mainland clients' accounts at Christfund, although each transfer is supported by written transfer authorisation by the respective clients; and
in allowing these matters to occur, Christfund had taken insufficient steps to address the potential regulatory issues arising from inadequate records and the safe custody of client assets, including cash.

In deciding the sanction, SFC took into account that:

Christfund was acting in good faith and there is no evidence of any dishonesty on its part or its senior management in its business activities;
Christfund has co-operated with the SFC by readily accepting responsibility for the above breaches;
Christfund has agreed to engage an independent audit firm to review the relevant aspects of its internal controls system and account opening procedures. The audit firm will also verify that remedial steps had been taken since the deficiencies were identified;
Christfund has also agreed that CSL shall: (i) cease operating those Mainland individuals’ client accounts apart from taking those clients’ sell order instructions and returning their securities and remaining balances to those clients; and (ii) cease opening accounts for any Mainland individuals referred by or through HF Shenzhen or any other persons or corporations on the Mainland, unless such practice is in compliance with applicable Mainland laws; and
CFL, Ng and Chow have not previously been disciplined by the SFC.

Jack's comment: Obviously Christfund's consent to cease the Mainland business is made under the pressure of the watchdog. However, even Christfund's internal controls were inadequate, why should an indefinite "show-stopper" be imposed? Who is the judge to determine whether "such practice is in compliance with applicable Mainland laws"?

New Stock-by-Stock Circuit Breaker Rules

2010-06-16T08:05:00.013+08:00

Last week US SEC approved the new stock-by-stock "circuit breaker" rules. The rules, which were proposed by the national securities exchanges and FINRA and published for public comment, come in response to the market disruption of May 6.

SEC anticipates that the exchanges and FINRA will begin implementing the newly-adopted rules as early as Friday, June 11.

Under the rules, trading in a stock would pause across U.S. equity markets for a five-minute period in the event that the stock experiences a 10% change in price over the preceding five minutes. The pause, which would apply to stocks in the S&P 500 Index, would give the markets the opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion. Initially, these new rules would be in effect on a pilot basis through December 10, 2010.

The markets will use the pilot period to make appropriate adjustments to the parameters or operation of the circuit breakers as warranted based on their experience, and to expand the scope to securities beyond the S&P 500 (including ETFs) as soon as practicable.

At Chairman Schapiro's request, the SEC staff also will:

Consider ways to address the risks of market orders and their potential to contribute to sudden price moves.
Consider steps to deter or prohibit the use by market makers of "stub" quotes, which are not intended to indicate actual trading interest.
Study the impact of other trading protocols at the exchanges, including the use of trading pauses and self-help rules.
Continue to work with the exchanges and FINRA to improve the process for breaking erroneous trades, by assuring speed and consistency across markets.

SEC staff is working with the markets to consider recalibrating market-wide circuit breakers currently on the books — none of which were triggered on May 6. These circuit breakers apply across all equity trading venues and the futures markets.

Jack's comment: When the market is getting more "emotional", the circuit breaker may be an effective way to let investors cool down, especially if the emotion is triggered by error or manipulative orders.

SFC Concluded the Proposals to Enhance Investor Protection

2010-06-09T08:26:00.062+08:00

Two weeks ago SFC has concluded the consultation on those proposals to enhance investor protection. The new measures include a consolidated product handbook with revised product codes for unit trusts and mutual funds and for investment-linked assurance schemes as well as a new product code for unlisted structured investment products. There are also requirements for product key facts statements to summarise the key features and risks of investment products, issuers to provide a post-sale "cooling-off" or "unwind" right for certain unlisted structured investment products to give investors a window to exit these investments, and conduct requirements for intermediaries to enhance selling practices relating to the sale of investment products.

In December 2009, I summitted the comments on the consultation paper on behalf of the Hong Kong Chapter of the International Academy of Financial Management (IAFM). The finalized measures relating to conduct of intermediaries are largely conforming to my expectations. My brief comments on the conclusions are set out as follows:

Investor Characterization: It remains a subjective process for intermediaries to judge whether the client has derivative knowledge. In order to solicit more new clients for structured products, I expect the intermediaries will organize or sponsor "derivative training courses" for retail investors.
Professional Investors: As I've said, the proposal of increasing the portfolio requirement for professional investors is useless and finally scrapped by SFC. To ensure that a professional investor has the relevant product knowledge, again intermediaries had better provide free training sessions to them.
Pre-Sale Disclosure of Monetary and Non-Monetary Benefits: As expected, SFC has compromised by requiring only the disclosure of the percentage ceiling, between the two extremes of specical disclosure in exact percentage and generic disclosure.
Use of Gifts by Distributors in Promoting a Specific Investment Product: Non-bank intermediaries should have raised strong objection to the use of gifts for product promotion and SFC has no pressure to impose this restriction.
Sales Disclosure Document: This proposal is probably the least controversial one.
Audio Recording: Again non-bank intermediaries should have raised strong objection to mandatory audio recording as this is not practical. Banks are unfortunately forced by HKMA to do so.
Post Sale Arrangements – Refund by Distributors Under a Cooling-Off Period: SFC has quite insisted on implementing the post-investment cooling-off period even though it is costly. Again banks are unfortunately required by HKMA to implement pre-investment cooling-off period as well.

SFC fines Merrill Lynch for systems and controls failings

2010-06-02T08:28:00.001+08:00

SFC recently fined Merrill Lynch (Asia Pacific) Limited and Merrill Lynch Futures (Hong Kong) Limited (collectively Merrill Lynch) $3,500,000 for systems and controls failings associated with the mis-marking activities in a trading book. Such kind of cases has been common in overseas countries over the past years but appears to be the first one in Hong Kong.

SFC's investigation found that during the period from December 2007 to October 2008, a managing director of Merrill Lynch had mis-marked a trading book in exotics options (Book) by manipulating the volatility marks in the valuation model, and accessed the computer system without authority to alter pricing parameters on various occasions. The mis-marking activities, which did not apply to any other books, resulted in the value of the Book being inflated by approximately US$25 million and caused the actual loss in the Book to be wrongly reported internally.

SFC found that Merrill Lynch did not have adequate internal controls procedures in place to manage the risks associated with mis-marking, in that:

there was uncertainty as to supervisory responsibilities over the trader and the Book;
the price verification mechanism applied to other trading books was not applied to the Book;
there were inadequate checks and balances over the Book to mitigate operation risks including risks associated with fraud and dishonest activities;
there was insufficient safeguard over information security and integrity as regards the Book;
trading and valuation policies were not sufficiently implemented over the Book; and
senior management failed to adequately manage the risks associated with the Book.

Merrill Lynch accepts that its systems and controls fell short of those expected in respect of the Book. SFC accepts that Merrill Lynch's misconduct was not intentional (!) and Merrill Lynch has taken remedial steps to address the compliance weaknesses.

This case is no doubt a scandal in Hong Kong's risk management industry. Would the managing director and other key personnel of Merrill Lynch be personally liable?

Pre-Investment Cooling-off Period

2010-05-26T08:42:00.046+08:00

Last week HKMA eventually announced the implementation of pre-investment cooling-off period (PICOP) in the sales of non-listed derivative products to retail investors since 1 January 2011.

Under the PICOP arrangements, after a bank has ensured that a non-listed derivative product is suitable for an eligible customer and adequately disclosed material product information to the customer, it should allow the customer at least 2 calendar days (of which the last day should be a business day) to understand the product, consider the appropriateness of the investment and consult with family members and friends. The price and terms of transaction will be fixed on the day when the customer gives instruction to the bank to confirm placement of an order (i.e. upon the end of the PICOP). The bank must arrange the customer to give specific confirmation of order placement on the execution day, supported by proper audit trail. Under no circumstances should the bank allow the customer to confirm the order before the execution day. Taking T as the sales day, execution day should be a business day on T+2 at the earliest.

It appears that if the customer keeps silent (i.e. no confirmation of the order) upon the end of the PICOP, the order would not be placed.

In determining whether PICOP should be applied to a particular dealing with a retail customer, the bank should consider the customer's age, asset concentrationand whether he/she is a first-time buyer of the same type of product as follows:

For an elderly customer (aged 65 or above), PICOP should be mandatory except that the customer will be allowed to opt out from the PICOP arrangement if (i) the customer's asset concentration is below 20% and (ii) he/she is not a first-time buyer of the type of product in question.
For a non-elderly customer, PICOP is not necessary except if (i) the customer's asset concentration is 20% or above and (ii) he/she is a first-time buyer of the type of product in question.

Asset concentration is the percentage of the customer's total net worth (excluding real estate properties) to be invested in the relevant transaction. The bank may rely on the customer's self-declaration to ascertain asset concentration.

Even one particular transaction does not exceed 20%, how about if the customer's total portfolio has been occupied by more than 20% by non-listed derivative products (including his/her previous transactions)?

In determining whether a customer is a "first-time buyer" of a particular type of product, a bank may take into account his/her actual investment(s) executed through the bank or another intermediary. If the customer has such investment experience with another intermediary, the bank should gather from the customer the relevant documentary proof (e.g. contract notes or monthly statements) and retain a copy for record purpose. Moreover, the bank should obtain the customer's signed declaration that he/she has such investment experience.

Systemic Short Sale Violations

2010-05-19T08:27:00.008+08:00

Recently US FINRA fined FINRA fined New York's Deutsche Bank Securities $575,000 and Boston's National Financial Services (NFS) $350,000 for executing numerous short sale orders in violation of Regulation SHO and for related supervisory violations.

Regulation SHO requires that a broker or dealer may not accept or effect a short sale order in an equity security without reasonable grounds to believe that the security can be borrowed, so that it can be delivered on the date delivery is due. Identifying a source from which to borrow such security is generally referred to as obtaining a "locate." Locates must be obtained and documented prior to effecting a short sale.

Both Deutsche Bank and NFS implemented Direct Market Access trading systems for their customers that were designed to block the execution of short sale orders unless a "locate" had been obtained and documented. But FINRA found that Deutsche Bank disabled its system in certain instances and NFS created a separate system for certain customers – so that in both instances, the systems no longer blocked some short sale orders that did not have valid, associated locates.

FINRA's review of a sample of short sale orders at both firms revealed that some short sale orders entered through the Direct Market Access trading systems were released for execution without any evidence that a locate had actually been obtained.

In Deutsche Bank's case, the firm's systems sometimes experienced outages that prevented the importing of locate data and, as a result, short sale orders placed for execution were automatically rejected, even when a client had already obtained a valid and properly documented locate. FINRA found that during these system outages, Deutsche Bank disabled the system's automatic block, permitting client short sale orders to automatically proceed for execution without first confirming the presence of an associated locate.

In addition to its automated process, NFS created a separate manual locate request and approval process for approximately 12 of the firm's prime brokerage clients, which preferred to obtain locates in multiple securities prior to commencement of the trading day. Requests for, and approvals of, the multiple simultaneous locates were transmitted via email exchanges with account representatives on the firm's Prime Services Desk, and were not required to be entered into the firm's stock loan system at the time of approval. Further, prime clients were allowed to enter and execute their orders through automated platforms that did not have the functionality to automatically block execution of a short sale order that did not have a valid and documented locate.

Neither Deutsche Bank nor NFS performed a meaningful post-trade date review of short sale orders to identify short sale orders executed without a valid, associated locate having been obtained or documented.

Further, both firms implemented inadequate supervisory systems in connection with their Regulation SHO compliance. Deutsche Bank was aware that its system to block short sale orders in the absence of locates was periodically disabled over a period of more than four years (from January 2005 through September 2009), but failed to devise or implement a replacement procedure. Similarly, NFS created a flawed system for certain customers that failed to ensure that certain short sale orders had valid and timely locates associated with them. NFS's flawed system operated for nearly four years (from January 2005 through August 2008).

Churning and Other Trading Malpractices

2010-05-12T08:30:00.001+08:00

Last week US FINRA has ordered Westpark Capital, Inc. to pay a total of $400,000 for supervisory system failures, and has suspended two officers for failing to supervise brokers in two now-closed Long Island branches who churned customer accounts and engaged in unauthorized and unsuitable trading in multiple accounts. The monetary sanction includes a $100,000 fine and $300,000 in restitution to affected customers.

FINRA suspended Westpark's former Chief Compliance Officer, William A. Morgan, for four months in any principal capacity and ordered him to pay a $5,000 fine. Chief Operations Officer Jason S. Stern has been suspended for three months in any principal capacity and fined $20,000.

In related actions, FINRA has barred and/or fined two brokers and a branch manager who were previously employed in Westpark's Long Island branch offices, and has filed a complaint against another former broker involved in the misconduct, charging him with churning accounts and other violations. Two additional former brokers involved have already been barred, by FINRA or SEC, for misconduct at other firms prior to or after their employment with Westpark.

Several of the brokers involved came to Westpark from broker-dealers that had lengthy disciplinary records and that FINRA has expelled from the securities industry, such as Stratton Oakmont, Inc., LH Ross & Co., Salomon Grey Financial Corp. and Continental Broker-Dealer Corp. When Westpark hired them, several of the brokers themselves had histories that included multiple customer complaints and/or disciplinary actions.

In its action against Westpark, Morgan and Stern, FINRA found that between February 2006 and July 2007, the firm failed to establish and maintain an adequate system for supervising its brokers. Among the supervisory system's deficiencies:

Westpark failed to restrict the activities of certain Long Island brokers and failed to monitor their customer account activities, even though they had disciplinary histories and customer complaints that included unauthorized, unsuitable and excessive trading;
The firm performed inadequate monitoring of excessive trading, failed to have standards for what constituted excessive trading and failed to prescribe any steps that would be taken if excessive trading were suspected; and
The firm's system assigned front line supervisory responsibility to branch office managers, even though the Long Island managers were inexperienced or had previously been disciplined for failure to supervise.

Ddespite the fact that Westpark had placed all of the brokers in question on "heightened supervision," Morgan and Stern failed to supervise several brokers who committed serious sales practice violations – including unauthorized, unsuitable and excessive trading involving at least 19 customer accounts.

Morgan and Stern failed to adequately scrutinize the conduct of the Long Island brokers and to address red flags, including disciplinary and employment histories, customer complaints and questionable account activity, such as evidence of excessive trading, a high level of margin and frequent concentration of customer accounts in a single security.

In related actions, FINRA has taken the following actions against a former branch manager and former brokers at Westpark's former Long Island branches:

Robert A. Bellia, Jr., a former branch manager, was barred permanently from association with any securities firm in a principal capacity and ordered to pay a $10,000 fine. Bellia failed to supervise three Westpark brokers who churned and executed unsuitable and unauthorized trades in at least 12 customer accounts.
Dale R. Menendez, Jr., a former broker, was barred permanently from the industry by a FINRA Hearing Officer and ordered to pay over $110,000 in restitution to his customers. Menendez engaged in excessive and unauthorized trading, mischaracterized customer transactions to his firm and failed to appear for testimony during the FINRA investigation of his conduct.
Michael Quattalaro, a former broker, was barred permanently from the securities industry. Quattalaro churned and engaged in excessively unsuitable trading in two customer accounts and exercised discretion in those accounts without prior written customer authority.
Chanse K. Menendez, Sr., a former broker, has been charged in a FINRA complaint with excessive trading and churning activity in two customer accounts. Menendez mischaracterized "solicited" trades as "unsolicited" trades in an apparent attempt to conceal his misconduct in those accounts, as well as in a third account. In addition, the complaint alleges that Menendez failed to appear for testimony and provide documents during the FINRA investigation of his conduct. The case is pending.

Failure to Protect Clients from Hackers

2010-05-05T08:15:00.001+08:00

Recently US FINRA fined D.A. Davidson & Co., $375,000 for its failure to protect confidential customer information by allowing an international crime group to improperly access and hack the confidential information of approximately 192,000 customers.

Prior to January 2008, D.A. Davidson did not employ adequate safeguards to protect the security and confidentiality of customer records and information stored in a database housed on a computer Web server with a constant open Internet connection. The unprotected information included customer account numbers, social security numbers, names, addresses, dates of birth and other confidential data. Furthermore, the firm's procedures for protecting that information were deficient in that the database was not encrypted and the firm never activated a password, thereby leaving the default blank password in place.

On 25 and 26 December 2007, D.A. Davidson's database was compromised when an unidentified third party downloaded confidential customer information through a sophisticated network intrusion. To breach D.A. Davidson's system, the hacker employed a mechanism called "SQL injection," an attack in which computer code is repeatedly inserted into a Web page for the purpose of extracting information from a database. The hacker was able to access and download the affected customers' confidential information. While these attacks were visible on Web server logs, the firm failed to review those logs.

Between April 2006 and October 2007, the firm had retained independent auditors and outside security consultants to review and/or audit its network security. During the course of those consultations, the firm received recommendations for enhancements to its security systems. Although the firm implemented the majority of those recommendations, it failed to implement a recommendation, made in or about April 2006, that it install an intrusion detection system. The firm had not implemented such a system at the time the hack occurred in December 2007.

The breach was discovered through an email that was sent by the hacker on 16 January 2008, blackmailing the firm. Upon receiving the threat, D.A. Davidson reported the incident to law enforcement and assisted the Secret Service in identifying four members of an international group suspected of participating in the hacking attack of the firm. Three of those individuals have been extradited from Eastern Europe, arrested and are facing charges in federal court in Montana.

FINRA took into consideration the firm's quick response to protect its customers and cooperation with law enforcement authorities and the fact that do date, no customer has suffered any instance of identity theft when assessing the fine in this matter.

IT security risk is quite high today. Recently SFC also issued a circular on IT management to all licensed corporations, suggesting some control techniques and procedures in respect of the following key ideas:

Information security policy;
Access control;
Encryption;
Change management;
User activities monitoring; and
Data backup and continuity planning

Trading Ban Against Tiger Asia

2010-04-28T08:12:00.014+08:00

SFC is beating the "tiger" again by seeking court orders to prohibit New York-based asset management company, Tiger Asia Management LLC, from dealing in all listed securities and derivatives in Hong Kong in the light of further insider trading allegations concerning the shares of another bank -- Bank of China Limited (BOC). This is the first time SFC has taken this kind of action.

SFC has also amended the current proceedings against Tiger Asia and three of its senior officers, Mr Bill Sung Kook Hwang, Mr Raymond Park and Mr William Tomita (collectively the "Tiger Asia parties") to include the new allegations and is seeking to freeze an additional amount of up to $8.6 million of Tiger Asia’s assets, equivalent to the notional profit Tiger Asia has allegedly made in one of the new claims.

This is on top of the $29.9 million that SFC has applied to freeze when it first commenced proceedings in August 2009 against the Tiger Asia parties in relation to dealings by Tiger Asia in the shares of China Construction Bank Corporation (CCB) on 6 January 2009.

The proceedings were commenced under section 213 of SFO. Tiger Asia was founded in 2001 and is a New York-based asset management company that specialises in equity investments in China, Japan and Korea. All of its employees are located in New York. Tiger Asia has no physical presence in Hong Kong. Park joined Tiger Asia in April 2006 and, at all times since, his job title has been Managing Director, Head of Trading, and his responsibilities include managing the trading desk, supervising orders and managing broker relationships. Tomita joined Tiger Asia in April 2008 and is charged with supporting the trading activities led by Park. Both Park and Tomita report to portfolio manager, Hwang, whom SFC alleges made the trading decisions for the CCB and BOC trades.

SFC alleges that in the case concerning BOC shares:

Tiger Asia was given advance notice and was invited to participate in two placements of BOC shares by UBS AG and Royal Bank of Scotland (RBS) on 31 December 2008 and 13 January 2009 respectively;
Tiger Asia was provided with details of both placements after being told and agreeing the information was confidential and price sensitive;
Tiger Asia also agreed not to deal in BOC shares after receiving the information;
Tiger Asia short sold 104 million BOC shares before the placement by UBS AG on 31 December 2008 making a notional profit of $8.6 million; and
Tiger Asia sold 256 million BOC shares before the placement by Royal Bank of Scotland on 13 January 2009 (of which 251 million shares were short sales) making a notional loss of around $10 million.

SFC contends that these transactions constitute illegal insider trading in shares of BOC.

These allegations will be heard by the court in the same proceedings involving similar allegations against the Tiger Asia parties involving dealings in shares of CCB, at a date yet to be fixed.

SFC is also seeking orders to unwind the transactions if the court finds they contravened SFO and to restore affected counterparties to their pre-transaction positions. The amount of assets that SFC is seeking to freeze is to ensure there are sufficient funds to satisfy any restoration orders that may be made by the court.

(Jack's comment: Cross-border enforcement of SFO would be a challenge to SFC. Would UBS AG and RBS be implicated as well?)

Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages

2010-04-21T08:03:00.048+08:00

Last week US SEC charged Goldman Sachs & Co. and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter.

SEC alleges that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.

"The product was new and complex but the deception and conflicts are old and simple," said Robert Khuzami, Director of the Division of Enforcement. "Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party."

SEC alleges that one of the world's largest hedge funds, Paulson & Co., paid Goldman Sachs to structure a transaction in which Paulson & Co. could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events.

The marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.

After participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.'s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.

Goldman Sachs Vice President Fabrice Tourre was principally responsible for ABACUS 2007-AC1. Tourre structured the transaction, prepared the marketing materials, and communicated directly with investors. Tourre allegedly knew of Paulson & Co.'s undisclosed short interest and role in the collateral selection process. In addition, he misled ACA into believing that Paulson & Co. invested approximately $200 million in the equity of ABACUS, indicating that Paulson & Co.'s interests in the collateral selection process were closely aligned with ACA's interests. In reality, however, their interests were sharply conflicting.

The deal closed on 26 April 2007, and Paulson & Co. paid Goldman Sachs approximately $15 million for structuring and marketing ABACUS. By 24 October 2007, 83% of the RMBS in the ABACUS portfolio had been downgraded and 17% were on negative watch. By 29 January 2008, 99% of the portfolio had been downgraded.

Investors in the liabilities of ABACUS are alleged to have lost more than $1 billion.

(Jack's comment: I agree that Goldman Sachs was wrong for failing to disclose Paulson & Co.'s short interest and involvement in the collateral selection process; but in order to charge Goldman Sachs and Tourre for fraud, SEC must justify that investors' losses were caused by such misrepresentation. Those CDO investors are all institutional rather than retail. They were capable of performing an independent valuation of the CDO, which would not be affected by knowing that they were betting with Paulson & Co.)

Fraud Related to Subprime Mortgages

2010-04-14T08:13:00.002+08:00

US SEC recently announced administrative proceedings against Morgan Keegan & Company and Morgan Asset Management and two employees accused of fraudulently overstating the value of securities backed by subprime mortgages.

SEC alleges that Morgan Keegan failed to employ reasonable procedures to internally price the portfolio securities in five funds managed by Morgan Asset, and consequently did not calculate accurate "net asset values" (NAVs) for the funds. Morgan Keegan recklessly published these inaccurate daily NAVs, and sold shares to investors based on the inflated prices.

James Kelsoe, the portfolio manager of the funds and an employee of Morgan Asset and Morgan Keegan, arbitrarily instructed the firm's Fund Accounting department to make "price adjustments" that increased the fair values of certain portfolio securities. The price adjustments ignored lower values for those same securities quoted by various dealers as part of the pricing validation process. Kelsoe actively screened and manipulated the pricing quotes obtained from at least one broker-dealer. With many of the funds' securities backed by subprime mortgages, Kelsoe's actions fraudulently prevented a reduction in the NAVs of the funds that otherwise should have occurred as a result of the deterioration in the subprime securities market.

Morgan Keegan priced each portfolio's securities and calculated its daily NAV through its Fund Accounting Department. Each fund held various amounts of securities backed by subprime mortgages and lacked readily available market quotations. Therefore, the securities were internally priced using fair value methods to determine the amount that the funds would reasonably expect to receive on a current sale of the security. The funds stated that the fair value of securities would be determined by a valuation committee using procedures adopted by the funds. In fact, the responsibility was essentially delegated to Morgan Keegan, which along with the valuation committee failed to comply with the funds' procedures in several ways.

From at least January to July 2007, Kelsoe had his assistant send approximately 262 "price adjustments" to Fund Accounting. In many instances, these adjustments were arbitrary and did not reflect fair value. Despite the lack of any supporting documentation, Kelsoe's price adjustments were routinely entered into a spreadsheet used to calculate the NAVs of the funds. Kelsoe also routinely instructed Fund Accounting to ignore month-end quotes from broker-dealers that were supposed to be used to validate the prices the firm had assigned to the funds' securities.

Joseph Weller, a CPA who was head of the Fund Accounting Department and a member of the Valuation Committee, did nothing to remedy the deficiencies in Morgan Keegan's valuation procedures, nor did he otherwise make sure that fair-valued securities were being accurately priced and NAVs were being accurately calculated.

(Jack's comment: Can we still trust the accountants? "Fair value" is kidding.)

Insider Dealer subject to "Life Sentence"

2010-04-07T08:34:00.021+08:00

Last week SFC announced that it has banned Mr Steve Luk Ka Cheung (once a famous fund manager) from re-entering the industry for life following a Market Misconduct Tribunal (MMT) determination that Luk had engaged in market misconduct. Steve Luk's licence was revoked in November 2006.

MMT determined that Luk, a former vice-president and fund manager of JF Asset Management Ltd, and two other parties had engaged in insider dealing in respect of the shares of China Overseas Land and Investment Ltd (COLI). MMT made certain orders against Luk, including orders that he should not, without the leave of the court, take part in the management of any company and acquire, dispose of or otherwise deal in any securities for nine months.

During the period from 7 to 26 January 2004, Mr David Tsien Pak Cheong, then an equity salesman of JP Morgan Securities (Asia Pacific) Ltd, disclosed to Mr Edmond Leung Chi Keung and Luk relevant information in respect of negotiations between JP Morgan and COLI in relation to a top-up placement of the latter's shares. Leung and Luk then separately sold COLI shares held by funds they managed to avoid the loss to those funds in the value of those shares, flowing from what they believed would be a fall in the market price of COLI shares following disclosure of the relevant information to the market.

Let's have a look at the following remarks on Steve Luk extracted from MMT's report:

In common with the other Specified Persons, Mr Steve Luk was a man of considerable experience in the financial services industry at the time of the commission of his acts of insider dealing. In 1990, he obtained an MBA degree from Columbia University. In 2004, he was a Vice-President of JFAM and manager of two of its funds, having been employed by that organisation for 14 years. At the time of the insider dealing one of the funds, JPM China Fund, held shares to a value of US$600 million whilst the other fund, JF Greater China Open Fund, held shares to the value of US$250 million. He was permitted to trade in the funds without requiring the permission of others. Clearly, Mr Steve Luk was a man in whom JFAM reposed considerable trust and who bore considerable responsibility. His insider dealing was a breach of that trust.
Although Mr Steve Luk's acts of insider dealing were committed in a period of not much more than an hour on the afternoon of 26 January 2004, it is to be noted that, having placed the original order to sell COLI shares in the two funds that he managed, a little later he intervened to reduce the price limit at which they could be sold and placed a third sell order for the fund of a colleague. In all, he sold 9.1 million COLI shares in the three funds.
The Tribunal accepts that Mr Steve Luk received no direct benefit of having succeeded in avoiding loss in the three funds by his sale of COLI shares. However, in so far as the two funds that he managed benefited from his market misconduct in avoiding loss, that was to be reflected in the assessment of his performance as a fund manager, measured by the funds outperforming the MSCI China Index, and ultimately in monetary terms in the bonus he received.

It is your judgement on whether the penalty for Steve Luk is too harsh or not, but definitely this case tells you again how a momentary slip (一念之差) can ruin one's life.

Guidelines on Disclosure of Inside Information

2010-03-31T08:36:00.042+08:00

This week SFC issued a draft set of guidelines to explain "inside information" and its application, in parallel with FSTB's publication of proposals to make it statutory for listed corporations to make timely disclosure of "price-sensitive information" (PSI).

FSTB's Consultation Paper proposes to include in SFO a statutory requirement for a listed corporation to disclose to the public as soon as practicable PSI that has come to its knowledge.

As part of the proposals, SFC has drafted guidance on what constitutes "inside information", a new term used in the proposed legislation to mean PSI. "Safe harbours" and how they would apply are also described in the "Draft Guidelines on Disclosure of Inside Information".

Key contents of the Draft Guidelines include:

What may constitute inside information?
Examples of possible inside information concerning the corporation
When and how should inside information be disclosed?
Responsibility for compliance and management controls
Safe Harbours that allow non-disclosure of inside information
Guidance on particular situations and issues

Listed companies should carefully read through the Consultation Paper and Draft Guidelines to understand the new "minefield" set by SFC!

Director Qisqualification Over Timely Disclosure

2010-03-24T08:02:00.001+08:00

SFC has recently obtained orders in the High Court to disqualify two former executive directors of Warderly International Holdings Ltd for failing to ensure timely disclosure of material information to the company's shareholders. This is the first time directors have been disqualified for this type of misconduct.

The orders disqualify Ms Ellen Yeung Ying Fong and Mr John Lai Wing Chuen, from being directors or being involved in the management of any corporation, without leave of the court, for five years, effective 7 April 2010.

Both Yeung and Lai accepted they had breached their duties to Warderly by failing to manage the company with appropriate care. In particular, they agreed they failed on a number of occasions to ensure Warderly complied with the disclosure requirements under the Listing Rules and to give shareholders all the information they might reasonably expect. SFC is also taking similar action against four other former directors of the company.

SFC directed trading to be suspended in the company's shares in May 2007 and consequently, focused its investigation on events between July 2006 and April 2007. SFC alleged that the company should have disclosed its substantially depleted financial position to the market:

there were legal proceedings underway in Hong Kong and the Mainland against Warderly and its subsidiaries by banks and creditors to recover overdue loans;
Warderly’s operations were substantially disrupted by labour strikes in its Mainland factory;
the company had appointed a financial adviser in respect of a proposed debt restructuring and re-organisation;
a management committee had been appointed to solve Warderly’s financial problems;
an external firm of accountants had been appointed at the request of a bank loan syndicate and had reported on the company’s deteriorating financial position; and
the company was forced to raise money by way of loans at penalty interest rates to stay afloat.

(Jack's comment: In the future, when certain disclosure requirements of the Listing Rules have been codified under the SFO regime, those directors who fail to make timely disclosure of material information may even bear criminal liability.)

Lehman Brothers Examiner Report

2010-03-17T08:24:00.043+08:00

Last week the Examiner appointed by the bankruptcy court released a 2,200-page report on a year-long investigation into the failure of Lehman Brothers, which has addressed the following three topics:

Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure?
Are There Administrative Claims or Colorable Claims for Preferences or Voidable Transfers?
Are There Colorable Claims Arising Out of the Barclays Sale Transaction?

I am of course most interested in the first topic, for which the Executive Summary is partially reproduced below:

Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure?

Lehman failed because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity to meet its current obligations. Lehman was unable to maintain confidence because a series of business decisions had left it with heavy concentrations of illiquid assets with deteriorating values such as residential and commercial real estate. Confidence was further eroded when it became public that attempts to form strategic partnerships to bolster its stability had failed. And confidence plummeted on two consecutive quarters with huge reported losses, $2.8 billion in second quarter 2008 and $3.9 billion in third quarter 2008, without news of any definitive survival plan.

The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule. But the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements – Lehman's CEO Richard S. Fuld, Jr., and its CFOs Christopher O'Meara, Erin M. Callan and Ian T. Lowitt. There are colorable claims against Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements.

Although Repo 105 transactions may not have been inherently improper, there is a colorable claim that their sole function as employed by Lehman was balance sheet manipulation. Lehman's own accounting personnel described Repo 105 transactions as an "accounting gimmick" and a "lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end." Lehman used Repo 105 "to reduce balance sheet at the quarter‐end."

In 2007‐08, Lehman knew that net leverage numbers were critical to the rating agencies and to counterparty confidence. Its ability to deleverage by selling assets was severely limited by the illiquidity and depressed prices of the assets it had accumulated. Against this backdrop, Lehman turned to Repo 105 transactions to temporarily remove $50 billion of assets from its balance sheet at first and second quarter ends in 2008 so that it could report significantly lower net leverage numbers than reality. Lehman did so despite its understanding that none of its peers used similar accounting at that time to arrive at their leverage numbers, to which Lehman would be compared.

Lehman defined materiality, for purposes of reopening a closed balance sheet, as "any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion)." Lehman's use of Repo 105 moved net leverage not by tenths but by whole points.

Lehman's failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those "low" leverage numbers to investors as positive news, created a misleading portrayal of Lehman’s true financial health. Colorable claims exist against the senior officers who were responsible for balance sheet management and financial disclosure, who signed and certified Lehman’s financial statements and who failed to disclose Lehman's use and extent of Repo 105 transactions to manage its balance sheet.

In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties; in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet and quarter end. The next day ‐ on June 13, 2008 ‐ Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee's assertions, despite an express direction from the Committee to advise on all allegations raised by Lee. Ernst & Young took virtually no action to investigate the Repo 105 allegations. Ernst & Young took no steps to question or challenge the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions. Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee's allegations and in connection with its audit and review of Lehman's financial statements.

(Jack's comment: Arthur Anderson died with Enron. Would Ernst & Young go with Lehman?)

New Short Selling Reporting Regime

2010-03-10T08:08:00.032+08:00

(Last week SFC announced its consultation conclusion on the introduction of a short-position reporting regime to enhance transparency of short-selling activities in Hong Kong. I am quite annoyed by the idiotic proposal of 0.02% reporting trigger level. Let's read David Webb's comments on this new regime and vote against it!)

Proposed law sells HK short

7th March 2010

Imagine, if you will, a consultation paper on road speed limits, in which the Government proposes introducing a 50km/h speed limit, and after collecting responses, they decide that because traffic moves slower here, they will introduce a 4km/h speed limit instead, 10 times lower than other countries decide to do at the same time.

That, in essence, is what Hong Kong's Securities and Futures Commission has just decided to do with short-position disclosures to the regulator. The change needs subsidiary legislation which is subject to Legislative Council negative vetting, so there is still time to stop this madness. It puts HK way out of line with international rules, including those announced by Europe the same day, as we explain below. If we don't stop this then for institutional investors, it will impose a high administrative burden for no public benefit, and many private investors or institutions selling dual-listed stocks overseas will likely just ignore it.

Don't get us wrong: Webb-site has always advocated transparency in every aspect of governance, but only where it results in meaningful disclosure and the benefit to the public interest justifies the costs. We need well-designed regulation, not just regulation for the sake of it.

Background

If you understand short selling in HK then skip this section.

A "short sale" is when a person sells shares he has borrowed, betting that the share price will go down rather than up, creating a "short position". If he can buy them back at a lower price, then he makes a profit. If he has to buy them back at a higher price, he makes a loss. All short sales are tagged as such, and the aggregate amount of short sales in each stock is disclosed twice daily by HKEx. There is no disclosure when the short position is closed with a purchase, so the total short interest is not known.

Not all short sellers are betting against the market direction. Often, the short-seller will be making a relative-value bet, by buying something else as a hedge. For example, in a "pair trade", he might buy the shares of a listed company and short the shares of its listed subsidiary, betting that one will out-perform the other, or in a "merger arbitrage" trade during a takeover offer, he might buy the shares of the target and sell short the shares of the offeror, or vice versa. These are known as "market neutral" positions.

Since all short sales must result in delivery of stock (or compulsory buy-in) on settlement day, the aggregate of all long minus short interests in a company must be 100% at all times. If there are 120% long positions, then there are 20% short. There is no theoretical limit to how many times borrowed shares can be resold - shares don't have a label on them saying "I am borrowed". So in theory (but seldom if ever in practice), the long interests could be 300% and the short interests would then be 200%. The net total is still 100%.

Under archaic SEHK Rules, not all stocks can be sold short. They publish a list of Designated Securities Eligible for Short Selling (DSESS), currently including 520 stocks. This includes 7 stocks in the ill-fated Nasdaq pilot program, 6 Real-Estate Investment Trusts and 52 Exchange-Traded Funds (ETFs), leaving about 455 ordinary shares. This restrictive list is probably honoured in the breach by borrowing the stock offshore and not tagging the sale as short. As long as you deliver, nobody here will know. One asset manager told us the other day how he was able to borrow shares in a stock he regarded as overvalued (all his HK orders are placed through a New York head office) before realising that the stock was not on the DSESS list, so he didn't sell.

SFC research and consultation

In a research paper published on 23-Oct-08, the SFC found that short selling in HK from 22-Sep-08 to 22-Oct-08 (during the crisis) accounted for only 7.6% of market turnover, compared to 7.4% in the second quarter and 8.5% from 1-Jul-08 to 19-Sep-08. The SFC estimated that the aggregate short position was about 1% of market capitalisation, well below that of New York (4.7%) and about the same as Australia (1.0%).

In a further research paper on 17-Apr-09, on the liquidity effect of short-selling, the SFC concluded that:

"trading volume rose as short selling increased. Short selling improves market efficiency and increases turnover, be it directly or indirectly. As short selling helps price discovery, it encourages trading in the overall market...Short-selling activity helped narrow bid-ask spreads."

Given all those benefits, you might wonder why short selling isn't allowed on all stocks. So do we. A free-market approach would allow it.

On 31-Jul-09, the SFC issued a consultation paper on increasing transparency of short positions. It mentioned that during the financial crisis, the UK had introduced a temporary requirement for public disclosure of short positions of 0.25% (in financial stocks and companies conducting rights issues) and was consulting on a permanent one with a 0.5% trigger. In the US, there was an emergency requirement for weekly disclosure of 0.25% short positions, applicable only to discretionary managers holding more than US$100m of certain classes of equities, which expired on 1-Aug-09.

As the SFC noted in its consultation paper (but failed to follow):

"A threshold that is too low would be overly burdensome and may render the threshold meaningless."

Given the relatively low levels of short positions in HK, the consultation paper was a solution in search of a problem which doesn't exist. On p13, the SFC looked at stock loan estimates as a proxy for short positions (because you can't short shares without borrowing them to deliver). Looking at about 320 HK stocks, it found that in late Feb-2009, about half of them had total stock loans below 0.50% of market value, so no single holder could have been short more than 0.50%. In other words, in half the cases, the long positions were between 100.0% and 100.5%, and the short positions were between 0% and 0.5%. Even if you only count the free float of 25% as long, you have long positions outweighing short positions by 51 to 1. How is that a problem for market stability? Furthermore, About 36% of the 320 stocks had total short positions less than 0.25%. The SFC stated that:

"if we adopt a threshold approach to capture significant short positions, the threshold level should not be higher than 0.25% of the issued share capital which is the level adopted currently in London and New York."

The giant flaw in the SFC's reasoning is that they decided that if short positions were not significant relative to other markets (let alone relative to long positions), then they should make them significant by adopting lower disclosure thresholds. That is rather like saying that, if speeding is not a problem in HK, then we should make it a problem by having lower speed limits than other territories.

The gap in HK law

Although we oppose the new requirements, there is a problem with the law, and this is where the SFC and Government should focus its efforts.

The Securities and Futures Ordinance requires shareholders to publicly disclose long interests of 5% or more (i.e. 250 times larger than the proposed private short position threshold), but the only statutory requirement for short positions is that, if someone has a long position over 5%, then they must disclose any short position over 1% in the same stock. This would almost never happen, because anyone who wanted a long position would not want a short position, and vice versa. It is cheaper to buy 4% than to buy 5% and short 1%. So short disclosures are only made by a few quirky participants such as operators of stock lending pools. Because of this omission in the law, in a stock with a 30% free float, you could have a short position of 6% of the company or 20% of the float, and you would not have to disclose it publicly.

Directors of the issuer must disclose all positions however small.

The obvious question here is this: if a long position is only significant enough to be publicly disclosed at the 5% threshold, then why is a short position significant, even to the regulator, at the 0.02% threshold? Why not have symmetric, public disclosure obligations for long and short positions, including derivatives, at the same threshold, whether at 5% (the HK and US standard) or 3% (the UK standard)?

Spotlight pressure

The SFC is not proposing any public disclosure by holders, only private filing to the SFC, which will disclose aggregated data without names. This opens the possibility of the SFC being privy to price-sensitive information on individual large short interests, where the short shareholder itself might also be listed, and the consequent risk of illegal leakage. The public might be told that there is a 10% short interest in a stock, but they wouldn't know whether that was 50 holders averaging 0.2% each, or 1 big player who is short 10%. Inevitably investors would speculate and try to find out whether there was a single big player and who the player was. So the disclosure of aggregated data would put the spotlight on the SFC.

We emphasise that the SFC is pretty good at maintaining its statutory secrecy, but that's partly because the public doesn't know anything about what the SFC knows on pending takeovers or secret investigations, so there is no pressure for leaks. That would not be the same if there are aggregate public disclosures derived from SFC filings. These would be the "known unknowns" rather than the "unknown unknowns", in Rumsfeld-speak. If you tell us half of the data, we'll want the rest.

The regulatory principles

The global regulatory scrutiny of short-selling is apparently aimed at stocks allegedly being "pushed down" by short sellers, which regulators and politicians say "causes panic" and makes the firms "more likely to fail". But in an efficient market, if the stock was not over-priced then why wouldn't buyers come in to meet short sellers? If the stock is a bank, and investors have confidence in it, they will buy. Buyers have unlimited upside and limited downside. For short-sellers, it's the opposite - they have unlimited downside and limited upside, because the stock can only go to zero (on bankruptcy), not negative. If anyone has to be certain about their analysis, it is short-sellers. They take more risk.

The global regulators are confusing cause and effect - banks collapsed during the crisis because of over-leverage and reckless lending (facilitated by lax regulation) and the consequent busting of the property bubble, not because of short-sellers. After short-selling of financial stocks was briefly banned in the USA and UK, banks continued to collapse. Don't shoot the messenger - the global markets' price discovery mechanisms were working.

As regards the circulation of false information about a listed company, whether positive or negative, there are laws against that, and those laws operate independently of disclosure of short or long positions. There are just as many incentives to circulate false positive news about a profit boost or a takeover (or in HK, some Chinese/Mongolian mining injection), and the upside on that is greater than false negative news.

Despite the overwhelming lack of evidence that short-selling causes companies to fail, regulators, including those in Europe, seem hell-bent on imposing far more stringent disclosure requirements on short positions than they do on long positions.

There is no other aspect of the HK law which requires shareholders to make private disclosure to the regulator but not make public disclosure. We do not, for example, have to tell the SFC when we own 0.02% of a company. Indeed, almost all of your editor's holdings exceed 0.02% and several are disclosed above 5%. He has never had a short position, but may in future. Why introduce a law on private disclosure of short positions? Why not just decide on the public disclosure requirements for both long and short positions (5%, or lower) and leave it at that?

The SFC's conclusion

The SFC's conclusion paper issued on 2-Mar-2010 is draconian. The SFC will require holders of short positions exceeding just 0.02% (that is, 1/5000th) of a company's issued shares, and any short position which exceeds HK$30m, to report their position privately to the SFC weekly. The $30m threshold only kicks in above $150bn, so that only relates to 19 companies (as of Friday). In the largest case, $30m of China Mobile Ltd (0941) is just 0.002%. To put this in sporting terms, it is equivalent to a 2 millimetre bump in a 100 metre-long soccer pitch. It may be significant to an ant, but not to a soccer player.

The reporting requirement will apply to stocks in the Hang Seng Index (43 stocks) and the H-share Index (40 stocks, of which several are in the HSI) and "other financial stocks" which are not in the index. They haven't defined what they mean by "other financial stocks", but it is safe to assume it includes (but is not limited to) any company which derives a majority of its activity from banking, and probably insurance underwriting. Does it include listed stockbrokers and asset management firms? Insurance brokers? Only time will tell.

The criteria for inclusion in the DSESS list include companies with a market cap (at the time of admission) of at least HK$1bn and an aggregate 12-months turnover of at least 40% of market capitalisation. Therefore, for the smallest stocks, the disclosure threshold of a 0.02% short interest would amount to just HK$200k (US$26k) - not even enough to buy a board lot of Rusal with the proceeds.

The warped logic of the SFC is reflected in paragraph 30 of the conclusions:

"While 0.25% is used in triggering the short position reporting requirement in several overseas jurisdictions...we note that not many reporting obligation is triggered (sic) each day...This implies that if a similar trigger level is used in Hong Kong, only very large short positions in the shares of very few companies might exceed the threshold..."

So they appear to define "very large" based on the frequency or size relative to other short positions, rather than relative to market cap. The goal seems to be to meet some quota of disclosures, rather than to disclose what is meaningful. And there's more:

"0.02% of the issued share capital of a large-cap company may have a very large value (e.g. 0.02% of the issued share capital of the top three constituent stocks of the Hang Seng Index is about HK$300m each)."

So what? This is just a banal truism, rather like saying 0.02% of Li Ka Shing's net worth is a lot of money. Would it be news if his net worth had changed by that amount? Of course not. Would it be at all meaningful if the long position of say, Fidelity in HSBC had changed by 0.02%?

At the same time as setting such a low disclosure threshold, the SFC decided to exclude derivative interests, such as put options, short futures contracts, or contracts for differences. That is not an acceptable compromise, as it is likely to shift activity from the underlying stock to the derivative market, particularly contracts for differences.

Europe

Ironically, just a few hours after the SFC announced its decision on 2-Mar-2010, the Committee of European Securities Regulators (CESR), which includes representatives of the regulator in each EU member state, also announced its recommendations and issued a report to the European Commission to introduce a pan-European short-selling disclosure regime. The recommendation is that interests of 0.2% (10 times the proposed HK level) would trigger private disclosure to the regulator, while short interests of 0.5% would require public disclosure. Market-makers would be exempt, but all derivative interests would be included.

Apart from leaving HK with much stricter filing requirements, it also results in likely partial disclosure for dual-listed stocks. For example, do you really think that a firm based in the UK with no HK presence, which has short-sold 0.02% of Standard Chartered or HSBC shares in London, is going to report their short interest to the HK regulator? Highly unlikely - they may not even be aware of the obligation, much less comply with it.

The proposed law will incentivise short sellers to use London rather than HK. It puts HK at a competitive disadvantage. Put simply, it sells HK short.

Where's the external force?

After observing regulatory developments here for over 18 years (11 on this site), we can't help but notice that consultation exercises usually conclude in either abandoning the proposed reforms, or doing something no stricter than was proposed. Like Newton's first law of motion, a regulatory body moves at constant velocity unless some external force acts upon it.

This time, the SFC's "conclusion" is 12.5 times stricter than what their consultation paper suggested. It seems likely to us that the Government, through the Financial Services and Treasury Bureau, and/or through the Non-executive Directors who form a majority on the Commission, has pushed them to go far further than they had proposed.

The Legislative Council should push back.

We call on the SFC to look to Europe and withdraw or amend the proposals. The requirements should be no more stringent than Europe's, if and when implemented.
We call on Government to legislate a public disclosure threshold for short positions, including derivative interests, at the same level as long positions (currently 5%)

While they are at it, the should amend the SFO to remove Saturday from the definition of business days, which is largely honoured in the breach when it comes to calculating 3-day deadlines for disclosures of interests. Most of HK is now on a 5-day week, and the Exchange hasn't opened on Saturdays in our living memory, but the law seems to think we will all be busy filing disclosures on Saturdays.

Minimum Mortgage Rates

2010-03-03T08:05:00.002+08:00

(Source: Bloomberg 2010.03.03)

HKMA Set Minimum on Home Mortgage Rates, ICBC Says

The Hong Kong Monetary Authority told lenders to price new home loans above its "reference rate," as concerns grow that a price war may further erode their profit margins, a bank executive said.

At meetings with the city’s lenders last week, the HKMA set the reference levels at 0.7 of a percentage point above the one-month Hong Kong interbank offered rate and 3.1 percentage points below the prime mortgage rate, Stanley Wong, deputy general manager at ICBC Asia Ltd., said in an interview today. The Hibor is 0.07964 percent at present.

Hong Kong banks have cut mortgage rates to the lowest in at least 20 years, fueling an almost 30 percent gain in home prices last year, as capital inflows into the city kept interbank lending rates down. The HKMA said in a statement yesterday risks linked to mortgages must be "vigilantly managed."

"They're expecting banks to follow these guidelines fully," Wong said. "When they brought that up in September it was more like a friendly reminder, but this time their tone was much firmer."

The HKMA met and discussed reference rates with lenders last week, Peggy Lo, a spokeswoman, said. She declined to say what the levels were.

The HKMA in September said that "intense price competition" isn't sustainable and may erode the industry’s profit margins and increase risks.

HSBC Holdings Plc, Hong Kong’s biggest bank by deposits and assets, said February 18 it will offer mortgage rates as low as 0.65 of a percentage point above the one-month Hibor until April 30, the first time it has priced new mortgages based on interbank rates. The bank has the fourth-biggest mortgage market share in Hong Kong, according to mReferral Mortgage Brokerage Services. BOC Hong Kong (Holdings) Ltd. is the biggest.

Hang Seng Bank Ltd., the city’s second-biggest provider of such loans, said the profitability of the mortgage business in Hong Kong will erode if borrowing costs drop further.

"Mortgage rates are already at a very low level and banks need to be able to make a reasonable profit," Hang Seng Chief Executive Officer Margaret Leung said at a briefing March 1.

New mortgage loan approvals in Hong Kong rose 22.3 percent to HK$29.6 billion in January from December, the HKMA said last week.

(Jack's comment: What the hell HKMA is doing? Price control!)

Diploma in Investment Compliance

2010-02-24T08:50:00.014+08:00

Last week the Chartered Institute for Securities & Investment (CISI), the ICMA Centre at the Henley Business School and the FINRA of the US announce that they have joined forces to support and enhance education, training and certification in financial compliance.

The CISI is the largest and most widely respected professional body for those who work in the securities and investment industry in the UK and abroad and has developed a suite of well recognized and supported programs centered around product knowledge and regulation to support practitioners in the financial services industry. Since 2006, the ICMA Centre and FINRA have developed and offered a highly regarded Diploma in Capital Markets Regulation and Compliance aimed at mid-level securities professionals. With the development of the CISI 's Diploma in Investment Compliance, the industry was faced with two separately recognized routes to certification,and it was agreed that, by joining forces, the parties can work together to better enhance the professional credentials of capital markets practitioners in the UK.

The agreement will mean that those who have already achieved the Diploma in Capital Markets Regulation and Compliance will become members of the CISI and those with a partially completed qualification will receive appropriate exemptions from the jointly supported Diploma in Investment Compliance. In addition, the ICMA Centre will work with the CISI to deliver advanced certification for those who have completed the Diploma in Investment Compliance and whose needs are for expanded coverage of topics required by senior compliance staff in financial institutions.

(Jack's comment: Hong Kong financial industry doesn't have such kind of compliance qualification for the practitioners. Why don't SFC and HKSI work with CISI to promote the Diploma in Investment Compliance?)

Mystery Shopping Programme

2010-02-17T08:42:00.058+08:00

Following the Minibond incident, both HKMA and SFC have proposed the use of mystery shopping to detect sales malpractices. Last week they jointly issued an invitation to tender for the Mystery Shopping Programme (MSP) for the sale of unlisted securities and futures investment products in Hong Kong.

Scope:

The MSP is a market wide exercise focusing on the retail market and capturing experiences from different types of Intermediaries in the banking sector and the securities sector selling investment products.
The regulators want to ascertain if the sales consultants follow their rules and regulations during the sales process, including but not limited to making of recommendations and/or solicitation on investment products. The MSP will focus on a number of areas, including "know your client" procedures, risk disclosure and suitability of investment recommendation.In addition to the audio recordings, all completed questionnaires and materials received by the shoppers must be handed over to the service provider, which will in turn, be provided by the service provider to the regulators at the conclusion of the MSP. No copies may be retained by the shoppers or the service provider. The regulators may require the service provider to certify that all the audio recordings, completed questionnaires and materials received by the shoppers have been returned to the Regulators. During the MSP, the regulators may request for documents and audio-records of particular samples for testing or review purpose.
The MSP will cover shoppers of various age groups and with specific investment objective, investment experience, financial position and attitude to risks.

Sample size:

The target Intermediaries will be determined by the regulators and the sample size will cover (i) the banking sector which includes large, medium and small banks; and (ii) the securities sector which includes securities brokers and investment advisers.
The exact number of target Intermediaries and sample size are to be determined but tenderers should give separate quotations in multiples of 50 samples starting from 400 up to 700 samples (total for both banking and securities sectors).

Methodology and main duties of the MSP service provider:

All shoppers are to be sourced, recruited and trained by the MSP service provider. It is expected that the shoppers will use their real personal identity and act as potential clients. In relation to the method of initial approaches to the sales consultants within targeted Intermediaries, it is expected that there will be a mix of approaches from "walk in", telephone and/or responding to advertising or marketing.
The regulators may request all mystery shopping interviews to be audio-recorded and the recordings to be handed over to the regulators. No copies may be retained by the shoppers or the service provider.
The service provider will undertake to comply with the Personal Data (Privacy) Ordinance in performing the MSP.
A shopper questionnaire will be designed by the regulators and mandatory for shoppers to complete and to submit the same to the regulators upon request. This questionnaire will document the shoppers' experiences and consist mainly of closed-end questions requiring yes/no answers with some open-end questions requiring opinions from the shoppers.
Training provided by the service provider should cover posing as potential clients. The service provider should also provide training and simulations on how to audio-record mystery shopping interviews, carry out assessment process, complete questionnaire, etc.
All the mystery shopping meetings must be face-to-face. It is expected that a number of meetings may be conducted before reaching a point where investment recommendation on investment products will be provided, and the shoppers would not be required to make any investment. In the event that a shopper makes an investment out of his own volition, the shopper has to bear his own costs and risks. The regulators will under no circumstances be liable for any investment and related expenses and for any loss or damage incurred by the shopper.
During the mystery shopping exercise, the service provider will perform on a regular basis quality control on the completed questionnaires, which will include reviewing samples of completed questionnaires by checking the answers of the completed questionnaires against the relevant audio-recordings and provide the regulators with statistics of the answers in the completed questionnaires.
The service provider will administer the mystery shopping interviews (e.g. follow up with the shoppers on completion of the questionnaire, debrief the shoppers after the first few mystery shopping interviews to resolve any unanticipated problems and perform quality control on data gathered, which includes but is not limited to an independent review on the completeness and accuracy of all the completed questionnaires).
After the first two weeks of commencement of interviews conducted by the mystery shoppers, the regulators will select samples conducted during that period, review the documents received by, and questionnaires (if any) completed by, the shoppers and listen to the audio recordings to test the adopted working approach carried out by shoppers and other elements of the MSP and provide feedback to the service provider.
The service provider should establish and maintain such measures and procedures to provide for the safe custody and proper handling of information (including audio recordings and materials received by the shoppers) obtained in the MSP and to prevent unauthorised access to, or use of, such information. The service provider shall also comply with all instructions of the regulators relating to the handling and storage of the information obtained in the MSP.
The service provider will provide bi-weekly status report to the regulators summarising issues identified, and task progress, etc.
The service provider will analyse the results of the completed questionnaires and summarise the findings for the purpose of preparing reports to the regulators.

(Jack's comment: Thanks HKMA and SFC for creating employment opportunities. I am interested in assisting the service providers for training the mystery shoppers.)

Misleading Investors About Subprime Mortgage Investments

2010-02-10T08:56:00.004+08:00

SEC recently charged Boston-based State Street Bank and Trust Company with misleading its investors about their exposure to subprime investments while selectively disclosing more complete information to specific investors. State Street has agreed to settle SEC's charges by paying more than $300 million that will be distributed to investors who lost money during the subprime market meltdown in 2007. This payment is in addition to nearly $350 million that State Street previously agreed to pay to investors in State Street funds to settle private claims.

According to SEC's complaint, State Street established its Limited Duration Bond Fund in 2002 and marketed it as an "enhanced cash" investment strategy that was an alternative to a money market fund for certain types of investors.

By 2007, however, the fund was almost entirely invested in subprime residential mortgage-backed securities and derivatives that magnified its exposure to subprime securities. But State Street continued to describe the fund to prospective and current investors as having better sector diversification than a typical money market fund, and failed to disclose the extent of the fund's concentration in subprime investments.

State Street sent investors a series of misleading communications beginning in July 2007 concerning the effect of the turmoil in the subprime market on the Limited Duration Bond Fund and other State Street funds that invested in it. At the same time, however, State Street provided particular investors with more complete information about the fund's subprime concentration and other problems with the fund. These other investors included clients of State Street's internal advisory groups, which provided advisory services to some investors in this fund and related funds.

Based on this more complete information, State Street's internal advisory groups subsequently decided to recommend that all of their clients including the pension plan of State Street's publicly-traded parent company (State Street Corporation) redeem their investments from the fund and the related funds. State Street sold the fund's most liquid holdings and used the cash it received from these sales to meet the redemption demands of better informed investors, leaving the fund and its remaining investors with largely illiquid holdings.

(Jack's comment: Packaging subprime investments as a money market fund is no different from telling investors that Minibond is equivalent to time deposit.)

SFC and Minibond Fiasco

2010-02-03T08:54:00.002+08:00

(Reproduced from SCMP 2010.01.27)

The Lehman Brothers minibond mess could have been avoided had the Securities and Futures Commission imposed the measures needed to properly vet their sale and suitability to investors, a former senior manager with the regulator said.

Harold Ko Ping-chung, the commission's former head of insurance-related policies and products, told lawmakers that he believed different standards used by the commission's investment products and corporate finance departments, and lax supervision and staff inexperience contributed to the Lehman minibond fiasco.

Minibonds were handled by the corporate finance department, which only required that necessary product information be disclosed, and not the investment products department, which looked at whether the various parties involved in the product were suitably qualified.

Since leaving the commission about five months ago, Ko has been keen for lawmakers to hear his evidence. He testified publicly yesterday for the first time before the Legislative Council subcommittee investigating what went wrong. He also met the subcommittee last week behind closed doors.

The collapse of Lehman Brothers in September 2008 left holders of minibonds linked to it virtually worthless. Minibonds are not corporate bonds, but are high-risk, credit-linked derivatives. They are marketed as a proxy investment in well-known companies.

Ko spent much of his two decades with the commission vetting investment products. His deep understanding of the regulator's work in authorising Lehman minibonds is seen as invaluable as lawmakers prepare to summon banking representatives to testify.
Ko is no stranger to politics. In the 1990s he was a core member of United Ants, a grass-roots human rights group. He also ran unsuccessfully for a seat in Legco in 1995.

(Jack's comment: This is not a unified regulatory body. It consists of different operating units pursuing their private interests by all means. This is the misfortune of the Hong Kong securities industry. Salute to Mr Harold Ko.)

Futures Trader Acquitted of Price Rigging Charges

2010-01-27T08:11:00.000+08:00

In recent years, SFC initiated a number of criminal prosecutions against stock market manipulators. Last week the Eastern Magistracy acquitted a futures trader, Mr Tsoi Bun, of five charges of manipulating the calculated opening prices (COP) of index futures contracts in the futures market. This was the first criminal prosecution for market manipulation in Hong Kong's futures market under SFO.

A COP is calculated during the Pre-Market Opening Period and serves as the market opening price for the corresponding product. It is calculated only if the highest bid price of the limit orders entered into the Automated Trading System of the Exchange (HKATS) is greater than or equal to the lowest ask price of the limit orders. If more than one price satisfies this criterion, the COP will be calculated according to the established formula set forth in Rule 4.84 of Trading Procedures for Stock Index Futures and Stock Index Options Traded on HKATS.

Tsoi was charged of manipulating the COP of HSCEI futures contracts and HSI futures contracts during the morning Pre-Market Opening Period on five trading days between February and September 2007.

The Deputy Magistrate ruled that there was insufficient evidence to prove beyond reasonable doubt that Tsoi had manipulated the calculated opening price on each of the trading days in question. SFC is reviewing the ruling to determine whether there should be an appeal and will continue to pursue civil proceedings against Tsoi.

In addition to the criminal charges, SFC has on 21 July 2009 sought orders in the High Court under section 213 of SFO stopping him from placing orders on the futures market during the Pre-Market Opening Period. In response to that application, Tsoi gave the court an undertaking that he would not place any order held in his name or in the name of another person on the futures markets during the Pre-Open Allocation Sessions. The undertaking remains in force.

The civil proceedings against Tsoi contains additional allegations that were not part of the criminal trial including allegations that Tsoi continued to manipulate the COP after the commencement of the SFC’s criminal proceedings.

I am quite interested to know how the evidence provided by SFC was insufficient to prove beyond reasonable doubt that Tsoi had manipulated the futures market.

Dual Filing Update (Jan 2010)

2010-01-20T08:06:00.044+08:00

SFC has recently released another newsletter to update market participants on the dual filing arrangements. During the 6 months ended September 2009, SFC received 64 listing applications via SEHK and found causes to comment on 53 applications. Some of the cases reviewed by SFC are highlighted below.

Understanding potential risks on business viability

In one case, the listing applicant breached certain regulatory provisions when entering into contracts with its customers which, in the worst case, might render the contracts illegal. The potential result could be the loss of its business licence, the very basis on which the listing was sought. The applicant did not appear to have followed the advice of its legal adviser to mitigate the effects of such breaches. The extent of the deficiencies raised substantial doubts as to whether the sponsors had critically assessed the applicant's business viability, of which disclosure alone might not necessarily be adequate to address the issues. The listing application was allowed to expire, leaving these issues unresolved.
In another case, a large part of the applicant's business was substantially derived from its connected persons and employees, although the proportion decreased from over 90% to 40% of its profit during the track record period. The reliance on these connected clients was expected to continue after listing. The applicant's ability to obtain third party funding for its business also depended on its ability to generate a sufficient level of revenue, which in turn was substantially derived from the transactions with the connected clients. It was questionable whether the applicant could carry on its business independently. In addition, some of these connected clients were directors of the applicant. Concerns were raised at the risk that they might override the internal control procedures to facilitate their own transactions or make decisions in favour of themselves at the expense of the interests of the shareholders. Even internal controls and corporate governance measures may not be sufficient to reduce or eliminate these inherent risks. The listing application was formally withdrawn after the regulators raised these concerns with the sponsors.

Inconsistent explanations on impact of the global financial crisis

In one case, the listing applicant, a Mainland property developer, claimed that the global financial crisis, uncertain economic prospects, and the tightened credit markets reduced the demand for its properties. However, it actually sold more properties in terms of square meters after the turmoil. In a similar case, the applicant claimed that the downturn in 2008 reduced property prices on the Mainland but the average selling price of its properties continued to increase by more than 20% in the same year.
In another case, the listing applicant attributed the decline in its net profit to the global financial crisis since the second half of 2008. However, its net profit for the second half of 2008 was actually more than double the net profit for the first half.

Disclosure of instances of regulatory non-compliance

The media have widely reported that the Chinese central government has introduced stringent measures against leaving land idle where property developers miss specified development deadlines. In one case, the listing applicant delayed construction and was in breach of land grant contracts signed with the local regulatory bodies. No analysis of the potential adverse financial and operational impact on its business was provided. Nor was there any basic information relating to the idle land, the amounts invested, any regulatory notices received or any measures taken to address the breach.
In another case, the listing applicant did not obtain the construction permit before commencing construction of a property project and in the worst case could be liable to penalty or forfeiture of the land. However, no disclosure was made relating to the length of the delay, when and whether the construction permit could be obtained, the estimated penalty and the total costs of investment or other information that was important for potential investors to assess the financial and operational impact on the listing applicant.
In another case, the draft prospectus omitted the applicant's past record of production without valid permits, which had led to the temporary suspension of operations during the track record period. In a similar case, the applicant’s various major litigation and regulatory breaches, which had exposed it to penalties and potential disruption of operations, were omitted from the draft prospectus.

Conduct of sponsors

In one case, the listing applicant consistently represented to the regulators that the reason why the ownership of a key asset had not been transferred from the parent, but had rather been entrusted to the company, was a prolonged regulatory approval process. However, it was later revealed that the parent's interest in the key asset was, in fact, subject to a lock-up, which prevented the parent from transferring ownership to the applicant in the near future. This rendered the previous reasons submitted by the sponsor for the entrustment arrangement potentially false and misleading. It also raised substantial concerns as to the adequacy of the due diligence performed by the sponsor to understand and verify the rationale behind the arrangement. The disclosure was rectified only after the regulators had persistently challenged the sponsor’s representation.
In another case, the listing applicant initially disclosed in the draft prospectus that all three of its executive directors remained as directors of a major subsidiary after its disposal. In fact, only one executive director remained as a director of this company, which was actually managed by the purchaser after the disposal. Had the regulators not enquired into the matter, the statement made could be false or misleading since the prospectus representation would mean that all three executive directors remained involved in the day-to-day management of the major subsidiary after its disposal to a third party.
In a similar case, the listing applicant sold its products to distributors which contributed more than 40% of its total revenue during the track record period. The sponsor failed to perform sufficient due diligence on the number of distributors provided by the listing applicant and the initial disclosure of the number of distributors was revised down by 20% upon enquiry by the regulators.
In another case, the initial draft prospectus failed to disclose the applicant's trading business. When we queried this point, it was revealed that this business segment actually contributed more than 30% of the applicant's total revenue throughout the track record period. As a result, the draft prospectus was substantially revised to rectify the misleading disclosure on the businesses of the applicant.

Enhanced Monitoring of Compliance with the Code of Banking Practice

2010-01-13T08:54:00.051+08:00

As a result of a recent review, last week HKMA announced that it will be introducing the following new measures for enhanced monitoring:

1. Annual self-assessments with revised reporting template

The current biennial self-assessment exercise will revert to a yearly basis. As a transitional arrangement, the forthcoming exercise will cover a reporting period from 1 June 2008 to 31 December 2009. This will enable HKMA to assess banks' full compliance with the current version of the Code which took effect on 2 January 2009.
In addition, the reporting template for the self-assessment has been revised so that banks set out their rationale for any deviation from the norm in certain areas. For instance, section 12.3 requires banks not to charge customers "extortionate interest rates". A bank might be charging over 48% (the level presumed under the Money Lenders Ordinance to be extortionate) in some cases but decide that it is in compliance with that section because it sees itself as having strong justification for doing so. Instead of reporting a simple "yes" as in the existing template, the revised template would require the bank to provide further information on its justification for cases where it charges in excess of 48%.
As in the past, all banks are required to commission their internal audit department, compliance department or other equivalent unit to conduct the self-assessment. The chief executive of the bank should co-sign the self-assessment report. Where an instance of non-compliance is identified, the bank concerned should provide details of the case including its plan to rectify the situation. A full account should be given if the instance of non-compliance is a recurrence of similar instances identified in previous exercises.

2. Exception reporting

Based on results from previous self-assessment exercises, most of the non-compliance cases concern subjects covered in Chapter 1 (Relationship between Banks and Customers) and Chapter 2 (Accounts and Loans) of the Code. These also tend to be areas that attract customer complaints and therefore call for priority attention. Henceforth, banks should notify HKMA as soon as practicable of any breach of any provision within Chapters 1 and 2 of the Code, adopting the standard format below. Such exception reporting will facilitate HKMA's timely monitoring of rectification action, and should also help focus banks' attention on measures needed to strengthen their compliance with the Code.

3. Mystery shopping

Both self-assessment and exception reporting inevitably reflect banks' own perspectives of their compliance with the Code. Drawing on the monitoring frameworks in other jurisdictions, including the UK and Australia, HKMA is proposing to introduce a trial mystery shopping scheme as a proactive approach to seek to assess compliance from the consumer's perspective. By testing customer experience against expectations set by the Code, this research technique may reveal useful information regarding levels of compliance with the Code and identify potential areas for improvement.
Starting from 2010, HKMA will engage the services of one or more organisations engaged in market research activities to undertake mystery shopping exercises. In determining the scope and frequency of such exercises, HKMA will be guided by any concerns or trends emerging from the self-assessment results or other sources regarding banks' compliance with the Code. A key area, by way of example, which lends itself to the mystery shopping technique is the use of mystery shoppers to assess the extent to which bank staff are able to provide clear and accurate information in accordance with requirements under the Code.
HKMA does not intend to take the findings of a particular mystery shopping exercise to be fully representative of a bank's general level of compliance with the Code. Nevertheless, where mystery shopping indicates possible compliance problems within a bank, it will prompt HKMA to consider follow-up work to establish why any failings occurred. The findings will also provide HKMA with insights to share with the AI concerned. In addition, examples of good and bad practice identified by any mystery shopping campaign can be shared with banks generally with a view to improving industry practice.

I particularly support extending mystery shopping to banking practices. Bank staff should understand that misleading customers is unacceptable in both banking and investment services.

新監管新財管

2010-01-06T08:25:00.002+08:00

(This article was published in Hong Kong Economic Journal on 30 December 2009. I also submitted to SFC the following responses to their proposals to enhance investor protection on behalf of IAFM Hong Kong Chapter.)

近日見到證監會在電視及報章大賣廣告，積極宣傳其建議加強投資者保障措施的公眾諮詢文件。該諮詢為期三個月（直至本年底），提出了多項建議，以優化現時適用於向公眾銷售非上市投資產品的規例。

去年雷曼兄弟的倒閉，引發金融海嘯，令香港不少投資者因購入「迷你債券」（Minibond）或雷曼相關產品而蒙受損失。事件引致大量公眾投訴及社會議論，而事後的檢討工作令人關注到過去若干非上市投資產品售予公眾的手法。後遺症是大眾因個別不良的銷售行為而對財富管理這個方興未艾的行業產生反感。筆者作為國際金融管理學會（IAFM）香港分會的會長，有責任大聲疾呼：「以往過分由銷售主導的財管行業是誤入歧途，而優質的財管服務應以客戶真正及全面的需要為本。」

證監會諮詢文件載有的建議，範圍涵蓋投資過程的每個階段【圖】，包括售前文件及廣告、銷售手法及利益披露，售後持續披露及冷靜期等課題。對於專業的財管人員來說，新的監管要求不應被視為工作上的負擔，反而是改善行業形象的契機。當然，某些建議在具體執行上有技術上的考慮。最近筆者跟部分IAFM的本地會員交換過意見後，想籍本文回應諮詢文件第三部分「中介人操守」中的建議。以下就以答問形式（根據諮詢文件列出的問題），扼要地向證監會提出對加強監管投資產品銷售的觀點。

問題：你是否同意，本部分的若干建議應只適用於非上市投資產品？請解釋你的意見。

回應：不完全同意。不少散戶投資者對上市的高風險投資產品（如窩輪、牛熊證等）其實認識不深。諮詢文件的部分建議亦應適用於上市投資產品，例如中介人在推介窩輪時，亦須評估投資者對衍生工具的認識，及披露有否收取發行商的利益等。另一方面，某些非上市投資產品(例如一般基金或傳統債券)較少產生系統性的銷售風險。建議證監會把監管力度集中在衍生工具及結構式產品上。

問題：你認為中介人在執行「認識你的客戶」程序時，應否向客戶查詢其對衍生工具的認識，並將具備相關知識的客戶（專業投資者除外）歸類為「對衍生工具有認識的客戶」，以協助中介人確保就非上市衍生產品所提供的投資意見及投資產品均適合客戶？請就中介人如何評估投資者是否對衍生工具有認識的建議措施發表意見。

回應：同意中介人應該在肯定客戶對衍生工具有足夠認識後，才向其提供有關產品的投資意見。至於如何評估投資者是否對衍生工具有認識，建議證監會設計並要求投資者完成一份測試問卷，在其獲得及格分數後才可被歸類為「對衍生工具有認識的客戶」。

問題：應否將符合以下條件的高資產淨值投資者，視為有具體的認識和專業知識：(a) 目前或曾經在相關的金融行業擔任專業職位至少一年，而該職位的工作涉及相關產品；或 (b) 曾就相關產品接受培訓或修讀相關課程？你有其他提議嗎？

回應：符合(a)的投資者恐怕人數不多，(b) 則相對地較為可行。建議由證監會或香港證券專業學會設定相關培訓或課程的內容及程度。

問題：投資組合最低總值規定應設定在甚麼水平？請說明理由。

回應：金融海嘯後，香港高資產淨值投資者的人數已大減。現時的投資組合最低總值規定（港幣八百萬）應足以區別高資產淨值投資者。況且再高的總值規定亦不能保證投資者具有足夠的投資知識。

問題：如分銷商及╱或其任何有聯繫者明確地從或將會從產品發行人（直接或間接）收取金錢利益，以下三個披露資料的方案中哪個較為合適？請解釋你的意見。
方案1.1 －披露金額或百分率
方案1.2 －披露百分率範圍或上限（即“x%至y%”或“不多於y%”）
方案1.3 －披露概括資料

回應：方案1.2比方案1.1較有彈性，同時亦已給予投資者足夠的利益披露。

問題：假設分銷商並非明確地就分銷投資產品收取任何利益，你認為以下哪種披露方案較為合適？請解釋你的意見。
方案2.1 －披露分銷報酬的具體資料
方案2.2 －披露概括資料

回應：方案2.1在計算上恐怕過於複雜，亦難以確立標準的計算方法。方案2.2似乎較為可行。

問題：假設分銷商通過背對背交易賺取銷售利潤，以下哪種披露方案較為合適？請解釋你的意見。
方案3.1 －披露銷售利潤的具體資料
方案3.2 －披露概括資料

回應：建議採用方案3.1，但只要求披露銷售利潤的百分率範圍或上限。這樣既能保障分銷商的商業秘密，亦能令投資者對交易費用有所預算。

問題：你認為應否限制分銷商不可為推銷個別投資產品而向投資者送贈超市禮券、影音器材等具現金價值的贈品（費用及收費折扣除外）？

回應：不同意證監會過分干預營商手法，但建議在風險披露聲明中加入警告，提醒投資者不應以贈品作為投資決定的主要考慮。

問題：證監會建議在銷售披露文件載述多項資料，包括 (a) 以主事人還是代理人身分行事；(b) 與產品發行人的聯繫；(c) 金錢利益及非金錢利益；及 (d) 投資者享有的費用及收費折扣。你對以上內容有何意見？

回應：同意以上的披露有助投資者了解分銷商在銷售過程中的利益衝突。

問題：你認為應否強制規定將客戶風險狀況評估及投資產品的建議或銷售過程錄音，或是現行的備存紀錄規定已經足夠？如將錄音定為強制規定，你認為錄音紀錄應保存多久？請解釋你的意見。

回應：將錄音定為強制規定在執行上有很多技術上困難。首先，證監會通常要求使用中央控制的錄音系統，這對於經常要在辦公室外跟客戶面談的非銀行投資顧問來說並不切實可行。另外，非銀行的客戶一般較為熟練，亦可能對言談之間錄音較為敏感。建議證監會中間落墨，要求銷售人員用書面形式記錄客戶的風險狀況及投資產品建議後，再由獨立之職員在辦公室以錄音系統致電客戶確認重點資訊，把錄音過程縮短在十分鐘之內。這樣安排應可平衡投資者保障及商業效率。

Private Placement Offering Failures

2009-12-30T08:25:00.002+08:00

US FINRA recently fined Pacific Cornerstone Capital and its former CEO, Terry Roussel, a total of $750,000 for failing to include full and complete information in private placement offering documents and marketing material. FINRA also charged Pacific Cornerstone and Roussel with advertising violations and supervisory failures.

Pacific Cornerstone agreed to make corrective disclosures to investors and to submit advertising and sales literature to FINRA for pre-use review for one year. Roussel was suspended in all capacities for 20 business days and in a principal capacity for an additional three months.

From January 2004 to May 2009, Pacific Cornerstone sold private placements in two affiliated companies using offering documents and accompanying sales literature that contained targets as to when investors would receive the return of their principal investment and the yield on their investment. The offering documents included statements that the affiliated entities targeted returns of principal in two to four years and targeted a yield on a $100,000 investment in excess of 18%. FINRA found no reasonable basis for those statements.

Further, Pacific Cornerstone and Roussel continued to use a similar targeted time period for return of capital and rate of return in successive offering documents, although those targets were not supported by prior performance. The offering documents failed to disclose the complete financial condition of one or both of the companies.

Pacific Cornerstone also offered private placement units of the two affiliated entities, Cornerstone Industrial Properties, LLC and CIP Leveraged Fund Advisors, LLC, to other broker-dealers and investment advisors, which in turn sold the units to the investing public. A total of approximately $50 million worth of units were sold to approximately 950 accredited investors over a period of almost six years. Pacific Cornerstone continued to use the same targeted two-to-four year return of principal and 18% rate of return in successive offering documents, despite not having met those targets.

During the same period, Roussel periodically sent letters to the private placement investors to update them on the progress of their investment that painted a positive — but unrealistic — future, without providing required risk disclosures. Roussel's letters also failed to disclose the complete financial picture of the two companies.

In Hong Kong, we rarely witness that offering to private placement investors and professional investors are so adequately supervised by SFC.

Displaying Fictitious Trades and Misleading Customers

2009-12-23T08:12:00.003+08:00

US SEC recently charged a US subsidiary of the world's largest inter-dealer broker, U.K.-based ICAP plc, with fraud for engaging in deceptive broking activity and making material misrepresentations to customers concerning its trading activities.

As an inter-dealer broker, ICAP Securities USA LLC (ICAP) matches buyers and sellers in OTC markets for various securities, such as US Treasuries and mortgage-backed securities, by posting trade information on computer screens accessed by its customers who make trading decisions based in part on such information. Inter-dealer brokers with greater trade activity on their screens often are better positioned to attract customer orders and earn more commissions than those whose screens reflect little or no trading activity.

SEC's enforcement action finds that ICAP, through its brokers on its U.S. Treasuries (UST) desks, displayed fictitious flash trades also known as "bird" trades on ICAP's screens and disseminated false trade information into the marketplace in order to attract customer attention to its screens and encourage actual trading by these customers. ICAP's customers believed the displayed fake trades to be real and relied on the phony information to make trading decisions.

ICAP agreed to settle SEC's charges by, among other things, paying $25 million in disgorgement and penalties. SEC additionally charged five ICAP brokers for aiding and abetting the firm's fraudulent conduct and two senior executives for failing reasonably to supervise the brokers. The individuals have each agreed to pay penalties to settle SEC's charges.

According to SEC's order, ICAP's UST brokers displayed thousands of fictitious flash trades to ICAP's customers between December 2004 and December 2005. ICAP represented to its off-the-run UST customers that its electronic trading system would follow certain workup protocols in handling customer orders. Such ICAP customers therefore expected that their orders, once entered onto ICAP's screens, would be filled according to the workup protocols. However, ICAP's brokers on the UST desks used manual tickets to bypass such protocols and close out of thousands of positions in their ICAP house accounts, thereby rendering ICAP's representations concerning the workup protocols false and misleading. In some instances, ICAP's customers' orders received different treatment than the customers expected pursuant to the workup protocols.

ICAP held itself out as a firm that did not engage in trading that subjected its own capital to risk. ICAP's regulatory filings routinely made this point, noting specifically in one instance that the firm "does not engage in proprietary trading." During the relevant period, however, two former ICAP brokers on the voice-brokered collateral pass-through mortgage-backed securities (MBS) desk routinely engaged in profit-seeking proprietary trading that rendered ICAP's representations regarding proprietary trading false and misleading. ICAP failed to make and keep certain required books and records on the UST desks and the MBS desk.

Many individual and institutional investors in HK incurred losses from buying the shares of Asian Citrus (73.hk) based on the misleading information in the listing document and SEHK's trading system. Could SFC do something for them?

SDI Breach

2009-12-16T08:26:00.004+08:00

In an article SDI breaches go dark at SFC dated 6 October 2009, David Webb voiced out that SFC has quietly stopped disclosing details of successful prosecutions for breaches of the securities disclosure-of-interests (SDI) provisions of SFO, including the name of the offender and the company whose shares are involved. Probably "alerted" by this article, SFC has recently resumed the practice of disclosing prosecution for SDI breaches.

On 26 November 2009, SFC announced that the High Court has dismissed an appeal by Mr Liu Su Ke against his conviction in June 2009 for failing to disclose his interest in shares in Warderly International Holdings Ltd (607.hk). Liu had earlier appealed against his conviction on two counts of failing to notify both SEHK and Warderly within three business days of becoming aware that he had acquired an interest in 231.8 million Warderly shares. Liu was convicted on 2 June 2009 in Eastern Magistracy on two summonses and fined the sum of $5,000 in respect of each summons.

On 28 December 2006 Liu received, from Mr Yeung Kui Wong, the chairman and an executive director of Warderly at the time, a deposit of certificates for 231.8 million Warderly shares together with share transfer documents as security for a loan of $6 million to a subsidiary of Warderly. As part of the arrangement, Liu obtained an irrevocable right to sell the shares to the extent of any failure by the subsidiary to repay the loan. On that basis, SFC contended and the Court found that Liu acquired a notifiable interest in the shares which he failed to disclose within three business days after becoming aware of his interest as required under SFO. Accordingly, the judge has dismissed the appeal and upheld the convictions.

In delivering the judgement, the judge considers a number of important legal issues concerning the enforcement of the obligation to disclose notifiable interests in listed securities including whether the absence of a reasonable excuse for not disclosing is an element of the offence, whether the offence is one of strict liability and the presumption of innocence.

SFC has successfully prosecuted 70 charges of failing to disclose a notifiable interest or change of interest so far this financial year against 11 individuals.