Failures to Monitor Suspicious Trading Activities

SFC announced that it reprimanded and fined China Industrial Securities International Brokerage Limited $3.5 million for internal control failures relating to monitoring of suspicious trading activities and recording of client order instructions. I am more interested in reviewing the following issues described in the SDA.

Failures to ensure all identified unusual transactions were properly examined and the relevant examination findings and outcomes were adequately documented

• Since June 2015, China Industrial has been using a third-party post-trade surveillance system to detect suspicious trading activities.
• China Industrial’s post-trade monitoring policy provided that Compliance Department would circulate daily reports on the alerts generated by the surveillance system to the ROs of the relevant departments that handled client accounts for review on a daily basis. Each department would receive and assess alerts that were relevant to the client accounts they handled and the ROs were required to make specific enquiries with the relevant AEs and/or clients for different types of alerts.
• However, the evidence shows that:
• prior to May 2018, the daily reports were not sent to 2 of the 4 Frontline Departments that handled client accounts;
• between 29 Mar and 7 Sep 2016, there were a total of 1,607 alerts. However, there is no review record for these alerts; and
• during the periods from 1 Aug 2017 to 31 Jul 2019 and from 1 Jun to 31 Oct 2020, there were a total of 18,008 alerts. However, there are review records for only around 5,000 alerts.
• According to China Industrial’s former ROs, the surveillance system generated many false alerts, which they would discuss, review and remark on the list of alerts. Nevertheless, China Industrial failed to properly maintain the ROs’ alert review records and/or to ensure that the ROs adequately record their examination remarks.

Failure to implement effective compliance procedures in relation to the alert reviews

• Compliance Department would select 5 to 8 sample alerts per month for review and the review findings and follow-up actions were recorded in writing.
• However, the monthly check records show Compliance Department focused on examining the actual sample alerts (e.g. comparing the specific trade and client profile covered in each sample alert), and never reviewed the adequacy of the records kept and whether the steps taken by the ROs to examine the unusual transactions flagged by the alerts were compliant with the post-trade monitoring policy.

Many firms may have the misconception that putting in place a surveillance system which generate a lot of daily alerts is adequate. But now the regulatory is getting more concerned about the quality of monitoring. Unless RegTech facilitated by AI has become mature and reliable, human efforts in screening out false alerts and following up true alerts remain critical.

Misleading Share Placement

On 18 May 2023, SFC announced that it reprimanded and fined China On Securities Limited $6 million over its failures as the placing agent in a share placement between 25 Nov and 6 Dec 2019.

Summary of facts in this case:

• On 25 November 2019, China On entered into a share placing agreement with the then majority shareholder (vendor) of Hon Corp (with GEM listing cancelled on 22 Jun 2022), under which it agreed to procure, as the vendor’s agent, not less than 6 placees to subscribe for shares representing up to 45% of Hon Corp’s total issued share capital. The agreed total placing price for the shares would amount to HK$57.24 million (i.e. HK$0.265 per share).
• When completion takes place, (i) China On should pay, or procure the placees to pay, to the Vendor the aggregate placing price; and (ii) the Vendor should allot the shares to the placees. The vendor deposited the shares into its account with China On thereafter.
• In the meantime, China On entered into a subscription agreement with each of the placees on 27 November 2019. Subsequently, on 28 November 2019, without the vendor’s specific authority, China On entered into a bought and sold note relating to the shares on behalf of the vendor with each of the placees, in which the transaction prices were inconsistent with the placing price agreed with the vendor.
• On 6 December 2019, in the absence of the vendor’s consent or any funds deposited by the placees to settle the placing price, China On arranged to transfer the shares from the vendor’s account to the placees’ accounts. Such arrangements were made by China On in the mere hope that the placees would sell the shares on the market and the sale proceeds from such disposal would be sufficient to settle the placing price with the vendor, without even considering that the sale proceeds might fall short of the agreed placing price, not to mention other settlement risks which had not been accepted by the vendor.
• China On’s then responsible officer (RO) handling the placement claimed that he carried out the above arrangement because he had received instructions from two individuals (including a consultant of China On and a person associated with the minority shareholder of China On, both were not licensed representatives or employees of China On), that the vendor had agreed to allot the shares to the placees and receive payment from the placees only after the placees successfully sold the shares on the market. Whilst the RO had no idea how these "associates" communicated with the vendor, he did not seek written or any other direct confirmation from the vendor before effecting the above arrangement.
• Almost all the shares were immediately sold by the placees on the market on 6 December 2019, and the account statements issued by China On show that HK$53 million was credited from the placees’ accounts to the Vendor’s account on the next business day (9 December 2019). This amount fell short of the total agreed placing price for the shares of HK$57.24 million because the RO was under the unverified and unsupported belief that the vendor had agreed with one of the placees for the placing price of HK$4.24 million to be settled “off market” (i.e. not through China On).
• On 9 and 10 December 2019, China On was informed by law enforcement agencies that the placees were suspected to be involved in market manipulation. On 21 January 2020, SFC issued a restriction notice on China On, prohibiting it from disposing of or dealing with any assets in the placees’ accounts up to the total value of HK$170 million. Since the placees did not have any additional funds in their accounts, China On refused to make payment of the agreed price for the shares to the vendor.

Based on the facts summarised above, SFC found that China On was grossly negligent, if not reckless, in its disregard of its fundamental duties to safeguard its client’s assets and ensure that it was acting under its client’s instructions and authorities.

My comments/queries:

• It appears that the share placing arrangement was misleading, given that the actual transaction prices were lower than the agreed placing price.
• Whether or not the placees were really procured by China On is questionable.
• I suppose SFC had investigated the two "associates", the vendor and even Hon Corp; if yes, the investigation results had better been disclosed.
• Who were the "law enforcement agencies" informing China On? Were they including the PRC authorities (e.g. CSRC)?
• If the placees were suspected to be involved in market manipulation, does it mean this share placing was part of it?

Victims of a Stock Manipulation Scheme

SFC banned Peter Law Chi Kin from re-entering the industry for 10 years for taking part in a stock manipulation scheme.

In mid-2016, Wong Kwun Shing, Law’s colleague at Convoy Asset Management Limited (CAML), introduced to Law a scheme operated by certain unknown manipulators to offload the shares of a GEM listed company to retail investors who were willing to hold onto the same for one to three months in return for a cash rebate of 12% to 15% of the transaction value.

Between June and July 2016, Law solicited and arranged for the clients to buy the shares from the manipulators. Law represented that he had met the manipulators to discuss the plan to push up the share price, but in fact he neither knew nor had direct contact with the manipulators. The clients agreed to buy and hold the shares until Law gave them permission to sell.

Wong would agree the date, time, quantity and price of each transaction with the manipulators in advance and inform Law of the same. At the agreed date and time, the manipulators would place an ask order within one to two spreads of the prevailing nominal price. Upon receiving Wong’s confirmation, Law would instruct the client to place a corresponding bid order. After the transaction was completed, Wong would pay the cash rebate collected from the manipulators to Law for onward distribution to the client.

Before the clients were allowed to dispose of the shares, the share price of the company collapsed and they suffered substantial losses.

Law admitted that he received a "referral fee" from Wong / the manipulators for soliciting the clients to participate in the scheme, which was calculated on the basis of the value of the shares the clients purchased. He did not disclose to the clients his financial interest in the transactions.

Law repeatedly gave reckless advice to some of the clients in connection with their investment in the shares, e.g.

• He represented that the scheme was "100% safe" and riskless, or had a guaranteed return of 12%, without explaining that the clients might suffer losses if the share price were to drop.
• He suggested one of the clients sell all her existing holdings and use the proceeds to invest in the company, without analysing and warning her of the concentration risk.
• He suggested two of the clients make use of the overdraft facilities offered by a brokerage firm to acquire a larger quantity of the shares, without explaining to them the risk of "margin call". Instead, he assured one of them that the brokerage firm would not force sell the shares in his account, and advised the other to ignore the brokerage firm's demand for deposit of additional funds. In the end, both their shares were force sold by the brokerage firm when the share price plummeted.
• When the share price started to fall, he dissuaded the clients from offloading their shares and reassured them that they would recoup their losses or even make a profit by holding onto the shares. As a result, the clients missed the opportunities to mitigate their losses.

Though the clients were victims, they had in fact participated in this stock manipulation scheme in return for a remuneration. Would SFC prosecute them?

Summary Review of SFC's Disciplinary Action against Swiss-Asia

On 8 November 2022, SFC fined Swiss-Asia Asset Management (HK) Limited $3 million for internal control failings and regulatory breaches in relation to the monitoring of trading activities in discretionary accounts and record keeping.

In mid-April 2015, a client signed an asset management mandate granting Swiss-Asia full discretionary power to manage the account, subject to certain management restrictions, e.g.

• Swiss-Asia could sell covered call options on existing securities and option strategies which have defined risk.
• It should not include any option strategies that involved uncapped risk or purchase options as a speculative strategy for the portfolio.

In late August 2016, the client complained to Swiss-Asia that its licensed representative conducted option trading in the account which was much riskier than agreed.

From May 2015 to August 2016, the licenced representative placed a total of 869 options trades in the account. Swiss-Asia only submitted to SFC in April 2017 that it had identified 225 of these options trades to be outside the management restrictions.

Swiss-Asia asserted that its responsible officers would randomly select five to seven portfolios on a monthly basis and conduct rough high-level reviews on them, which is considered inadequate by SFC. It did not maintain records of such random sample checks.

As a result of this case, Swiss-Asia has revised its internal control policies and procedures such that post-trade checks would be conducted on all accounts on a weekly basis. Any breaches in investment strategies or exceptions in the investment restrictions would be documented and escalated to executive management.

Swiss-Asia claimed that it operated with the support of the three lines of defence, i.e. (1) management supervision, (2) oversight by the legal and compliance team, and (3) audit by external auditors. SFC questions how legal and compliance as well as external auditors could perform their functions properly and effectively without records of the sample checks. I also question if legal and compliance (rather than risk management) would have the expertise in option strategies to identify breaches of investment mandate.

SFC highlights that the monitoring of trading activities are important for the detection and prevention of potential market misconduct (i.e. not just breaches of investment mandate). If this case involved also market misconduct, the penalty would be much higher.

SFC's Statement of Disciplinary Action is found here.

Proposed Amendments to SFO: Advertisements of Investment Products

In June 2022, SFC published a consultation paper on proposed amendments to the SFO. The proposal contains 2 enforcement-related amendments and the other one relating to the professional investor (PI) exemption (PI amendment) under section 103 of the SFO. I discuss the PI amendment in this article.

The PI amendment is triggered by the Pacific Sun case happened many years ago, summarized as follows:

• SFC announced on 21 Mar 2013 that Pacific Sun Advisors Limited and its director Andrew Mantel were charged for issuing an advertisement on the corporate website promoting "Pacific Sun Greater China Equities Fund" (the Fund) without SFC's authorization. The defendants submitted that they intended to sell the Fund only to PIs and so the advertisements did not require SFC's authorization under the PI exemption. Surprisingly, the Magistrate accepted the defendants' argument and acquitted them.
• SFC announced on 10 Jun 2014 that following its appeal, the Court of First Instance (CFI) issued a ruling in Jan 2014 clarifying that the advertisements in question did not fall within the PI exemption and ordered the case to be returned to the Magistrate for reconsideration. The CFI made it clear that the exemption only applies where the advertisement states on its face that the terms of the offer are limited to PIs. As a result, the defendants were convicted at the Magistrate.
• SFC announced on 20 Mar 2015 that following the defendants' appeal, the Court of Final Appeal (CFA) overturned the ruling of the CFI in that the PI exemption applies even if the intention to sell the Fund only to PIs is not expressed in the advertisement, unless the Fund is subsequently sold to a retail investor. It follows that contravention of section 103 of the SFO can only be established well after the offer to the public has been issued.

SFC has definitely thought the CFA's ruling is not in line with the intention of the PI exemption. SFC expressed on 20 Mar 2015 that it will study the CFA's decision to determine whether there should be any proposal to amend section 103 of the SFO. However, SFC has not taken any action until Jun 2022.

In the consultation paper, SFC proposes an amendment to section 103(3)(k) to restore the PI exemption to the original point in time when the advertising materials are issued. Therefore, following the proposed amendments, unauthorized advertisements of investment products which are intended to be sold only to PIs may only be issued to PIs who have been identified as such in advance by an intermediary through its know-your-client and related procedures, regardless of whether or not such an intention has been stated on the advertisements.

My views:

• The CFA's ruling was weird. Even the CFA made it clear that the burden of establishing the PI exemption applies rests on the defendants, it didn't say expressing the intention to sell the Fund only to PIs was a must.
• SFC's proposed amendments overshoot. It sounds impractical to require an intermediary to identify the PIs (esp. corporate and individual clients) in advance before issuing unauthorized advertisements of investment products.
• My stance is close to the Magistrate's decision in 2014. Section 103 should be amended to require an intermediary to express prominently in the advertisements that the unauthorized product is intended to be sold only to PIs, otherwise the PI exemption won't apply. SFC can subsequently sample check if the intermediary has sold the product to retail investors.

Customer Supplied Systems

On 30 Dec 2021, SFC announced that it reprimanded and fined Grand International Futures Co., Limited (GIFCL) $8,000,000 and suspended the licence of GIFCL's responsible officer, Mr Liang Benyou for 8 months.

Liang has been accredited to GIFCL and approved to act as its responsible officer for RA2 and RA5 since 3 October 2017. Liang has been GIFCL's MIC of the OMO, OCR, Compliance and IT since 1 Sep 2017, and MIC of KBL since 4 Apr 2018. This is probably the first time a MIC of Compliance was sanctioned by SFC, though obviously Liang was not a full-time compliance professional.

Summary of Facts

• SFC received a complaint against various LCs, including GIFCL, for allowing clients to place orders to their broker supplied systems (BSS) through a software called Xinguanjia (XGJ). XGJ was developed and/or provided by Hengxin Software Limited.
• The complainant alleged that XGJ permitted the LCs' clients to create sub-accounts under their accounts maintained with the LCs, and the clients had solicited investors in Mainland China to trade through the sub-accounts via XGJ without having to open separate securities accounts with the LCs in Hong Kong.
• Between Oct 2017 and Oct 2018 (Relevant Period), GIFCL has permitted 103 clients to use their designated customer supplied systems ("CSSs", including XGJ) for placing orders. From Dec 2017 to Oct 2018, the number of futures contracts transacted by GIFCL clients through orders placed via CSSs accounted for 93.92% to 99.25% of its monthly trading volume.

Failure to perform adequate due diligence on the CSSs and assess and manage the associated ML/TF and other risks

• Before allowing its clients to connect their CSSs to its BSS, GIFCL would require its clients to: (a) complete an application form and risk disclosure statement; and (b) apply for authorisation from its BSS Supplier. But GIFCL did not perform any due diligence or testing on the CSSs used by its clients.
• While GIFCL claimed that it relied on the BSS Supplier to conduct due diligence on the CSSs, the BSS Supplier stated that GIFCL had never instructed it to, and it did not, conduct any due diligence or test on the CSSs to examine their design and functions.
• In the absence of proper control over the use of CSSs by its clients, GIFCL has exposed itself to the risks of improper conduct such as unlicensed activities, money laundering, nominee account arrangement and unauthorized access to client accounts.

Failure to conduct proper enquiries on client deposits which were incommensurate with the clients' financial profiles

• SFC's review of the fund movements in sample client accounts showed that the amounts of deposits made into the accounts of four clients (Four Clients) were incommensurate with their financial profiles declared in their account opening documents, which were unusual and/or suspicious (Anomalies).
• GIFCL claimed that it was aware of the Anomalies during the Relevant Period. As part of its monthly monitoring measure, it had contacted the top clients (including the Four Clients) via WeChat to understand the client situation (Monthly Monitoring).
• However, the Monthly Monitoring was inadequate:
• GIFCL did not document the policies and procedures governing the Monthly Monitoring.
• The scope of the Monthly Monitoring was limited to top 10 clients with the highest number of transactions and top 10 clients with the highest amount of deposits.
• GIFCL has not maintained any record of the Monthly Monitoring, including its enquiries allegedly made with the Four Clients and their responses to the enquiries.

Failure to maintain effective ongoing monitoring system to detect and assess suspicious trading patterns in client accounts

• SFC’s review of the transactions in sample client accounts showed that there were 100,989 self-matched trades (i.e. the client’s order matched with his/her own order in the opposite direction) (Matched Trades) in nine client accounts during the Relevant Period. But GIFCL was not aware of the Matched Trades at the material time.
• During the Relevant Period, GIFCL relied on its dealing department to monitor client trading activities. However, it did not provide its staff with any guidelines or procedures for such monitoring.

As a result, SFC remarked that LCs should assess the risks of any new products and services (especially those that may lead to misuse of technological developments or facilitate anonymity in ML/TF schemes) before they are introduced and ensure appropriate additional measures and controls are implemented to mitigate and manage the associated ML/TF risks. Approving the use of CSSs by clients is indeed a new challenge to LCs.

In addition, as SFC said, the LCs' clients had solicited investors in Mainland China to trade through the sub-accounts via XGJ without having to open separate securities accounts with the LCs in Hong Kong. This may even facilitate the breach PRC's regulations which restrict cross-border online brokers.

Provision of False Client Documents and Information

On 30 Aug 2021, SFC announced that it suspended Mr Cheung Man Chit, a former licensed representative of Emperor Securities Limited and Emperor Futures Limited (collectively, Emperor), for two years. The facts are summarized below.

Submission of false client documents and information to Emperor

• Cheung received two sets of client agreements from Client L and H in around Aug 2013 for the opening of Client L's accounts at Emperor, but submitted to Emperor the one received from H. Further, he falsely certified and claimed to have witnessed Client L's signing of the submitted client agreement.
• In around Jan 2014, Cheung received three payment forms authorising fund transfer from Client L to H, one from Client L and two from H. He submitted to Emperor the two payment forms received from H and not signed by Client L, one of which resulted in the $300,000 Transfer which Client L alleged was not authorised by her.
• He handled and submitted to Emperor six other account documents of Client L which were not signed by her between Nov 2013 and Jun 2014.
• Cheung provided his own addresses, and an email address he created, to state as the residential addresses and email address of another client (Client Y) in her client agreement and a change of particulars form which he submitted to Emperor.

Transfer of funds for clients

• Between Jun 2014 and Jan 2017, the accounts of Client Y and another client (Client C) at Emperor recorded transfers totalling around $3.2 million to/from Cheung's bank account or the bank account of a company solely owned by him (Company U) on 15 occasions. Ten of the 15 transfers were made pursuant to third party deposit/payment request forms (Third Party Forms) of the clients signed by Cheung as the handling account executive.
• Cheung admitted that he helped the clients transfer money to/from the Mainland using his and Company U's bank accounts, and claimed that he did not receive any benefit for transferring money for the clients. He accepted that the money transferred from the Emperor accounts of the clients had been mingled with the money in his and Company U's bank accounts.
• To secure Emperor's approval of the third party fund transfer requests of the clients and get around the need to provide supporting documents required under the firms' then policy, he falsely stated in the clients' Third Party Forms that they were directors of Company U, he and Client C were business partners, and the reason for payment was capital recovery by Company U.

Using a client's password to place trade orders in her online trading account

• Client C opened an option account at Emperor in May 2014. Based on the records of internet service providers, 84 orders were placed in her option account via internet from IP addresses subscribed by Cheung or situated at the offices of Emperor and his new employers between Jun 2014 and Aug 2017.
• Cheung stated that he placed orders for Client C via internet as a friend and did not receive any personal benefit from her. Client C only paid commission to Emperor for the trades.

Failure to inform SFC and Emperor of directorship / proprietorship

• Cheung has been the sole proprietor of Company U and the director of another company since their incorporation in around 2010 and January 2018.
• He did not report to SFC his directorship and proprietorship of the two companies in his licence application and throughout the period when he was licensed with SFC.
• Cheung did not notify Emperor of his proprietorship of Company U during his accreditation with the firms pursuant to their internal policy.

My comments on this case:

• In terms of variety, severity and duration of Cheung's misconducts, licence suspension of two years seems too lenient.
• Emperor's account opening, trading and settlement procedures had been abused by Cheung. The relevant internal controls and monitoring should be strengthened.