Market Timing by Hedge Funds

In my previous blogs I mentioned that one of regulatory issues of hedge fund managers is the market timing practices. Actual incidents have happened frequently in UK and US but not in HK.

Last week NASD imposed its largest fine (US$2.25m) against Paul Saunders, a hedge fund manager of James River Capital Corporation (JRCC), for using deceptive practices to market time through variable annuities.

JRCC is general partner and trading manager of the Jazzman Fund, a hedge fund established specifically to engage in market timing. After personally investing in Jazzman, Saunders, through JRCC, created 19 limited partnerships under Jazzman to increase the hedge fund's ability to market time mutual fund sub-accounts of variable annuities. While each Jazzman partnership appeared to be a separate entity, with a different name and tax identification number, the partnerships all had common owners - a fact that Saunders did not disclose to insurance companies that offered the variable annuities.

From Oct 2001 to Sep 2003, Saunders used these Jazzman partnerships to engage in numerous deceptive practices to evade attempts by insurance companies to block or restrict his market timing in sub-accounts of variable annuities. Saunders opened 20 different accounts for the Jazzman partnerships at one broker-dealer and commenced market timing, sometimes simultaneously purchasing contracts and trading in the same annuity through several Jazzman partnerships. After receiving communications from insurance companies restricting further market timing, the Jazzman hedge fund used three deceptive practices to continue market timing:

• Saunders purchased contracts in the same variable annuity for other Jazzman partnerships and continued trading through those contracts;
• Saunders obtained additional contracts in the same variable annuity, but changed the name of the annuitant. All of the annuitants were actually employees of entities Saunders controlled; and
• When certain insurance companies rejected an annuity contract because it was purchased with a large initial investment, Saunders purchased another contract with a much smaller initial investment. When that contract was accepted, Saunders transferred funds from accounts of other related Jazzman partnerships to the accepted contract and then began market timing in the contract's sub-accounts.

These practices enabled Jazzman to execute approximately 1,000 variable annuity transactions, well in excess of insurance company limits for any single entity. Saunders personally made approximately US$750,000 in illicit profits from the deceptive conduct.

Compared with the overseas practitioners, the games played by the HK hedge fund managers are much more "simple and naive", typically misappropriation of client assets - e.g. the CSA Fund case (Mr Charles Lee Schmitt was finally sentenced an imprisonment of 4.5 years).

Take a Break

Since creating this blog from 10 Aug 2006, I have continuously added one article per working day. This is not easy for me as I am not a newspaper columnist. Compliance is an interesting topic but not so many people are really interested. Thanks Ban and Idol for your ongoing support by leaving your comments here.

It's time for me to take a short break (from tomorrow to Friday) for recharge. I will come back on 31 Oct 2006.

Taking a vacation by a compliance officer is sometimes difficult, especially if you are working as a one-man band. I remember when I was a compliance officer designated for one specialist area, my boss would get crazy for finding a poor guy (who didn't know about my work at all) to act as my "backup" during my annual leave. Actually this is useless. Whenever there is any so-called urgent matter, the business people would immediately dial my mobile no!

See you next Tuesday.

Regulation of Hedge Funds (3/3)

In Mar 2006, IOSCO released a survey report which studied the global regulatory environment for hedge funds, covering a number of jurisdictions (including HK). There are 4 significant conclusions:

1. No member country had adopted a formal, legal definition of "hedge fund".
2. Hedge fund managers were regulated in most of the jurisdictions.
3. Few jurisdictions reported any significant "retailization" of hedge funds.
4. There had been some incidents of fraud relating to hedge funds.

According to a testimony of SEC, there are 3 principal areas of regulatory concern over hedge funds:

• Fiduciary obligations
• Market abuse
• Risks to broker-dealers

Fiduciary Obligations

SEC has handled many enforcement against hedge fund managers, which involve:

• misappropriation of fund assets
• "portfolio pumping" (i.e. bidding up the value of a fund's holdings right before the quarter-end)
• side letter agreements (i.e. hedge fund managers give certain investors more favorable privileges than others receive, e.g. liquidity preferences or more portfolio information)
• improper valuation of fund assets in order to hide losses or boost performance

Market Abuse

The market abuse activities include insider dealing, illegal short selling, market manipulation, late trading and fraudulent market timing. We still remember how hedge funds attacked the Asian financial markets during 1997-1998. Such manipulative activities were facilitated by investment banks and prime brokers.

Risks to Broker-Dealers

One core service prime brokers offer their hedge fund clients is margin financing. Under the competitive business environment, some prime brokers may be tempted to relax their risk management and credit policy, thus creating unduly large exposure to hedge fund risks. Derivative is a 2-side sword. Amarthan was killed by natural gas futures. A recent article of Forbes alerted investors to the potential disaster of hedge funds for trading in credit derivatives. Nevertheless, Donald Tsang still mentioned in his policy address that the government would study for the development of a commodity futures market in HK. Is it an idea to attract more hedge funds to HK, or provide one more gambling tool to retail investors?

Hedge fund is definitely a growing business but the global regulators are still sorting out the best regulatory model for such a mix of devil and angel. While we are concerned about systemic risk and investor protection, we can't deny that hedge funds contribute substantially to market efficiency, price discovery, liquidity and financial innovation.

Regulation of Hedge Funds (2/3)

SFC may feel proud of Hong Kong becoming a leading hub for hedge funds in the Asian region. The survey report indicated that HK has achieved a high growth of hedge funds, managers and AUM over the past 2 years.

Details of the survey are not reproduced here. I just want to highlight the following findings:

• 74% of responends reported that they had 10 or less staff. It could be envisaged that they may not have a full time compliance officer. Quite probably one staff is required to oversee risk management, compliance and operations.
• Most of the hedge funds are offered only to institutional investors. This is normal as most of retail investors and even salespersons could not understand hedge funds well. However, I also wonder whether institutional investors like pensions could master hedge funds.
• While the textbook tells us there are so many alternative strategies adopted by hedge funds, the strategies used by HK hedge fund managers are occupied by equities long/short (34%), multi-strategies (25%) and FoHFs (20%). Only a very small portion is playing more fantastic strategies like global marco, event driven, distressed debts, etc.
• A majority of hedge funds used no or little leverage. This is because they mainly invested in equity markets and did not trade heavily in derivatives.

In HK, direct regulaton of hedge funds is not practical because most of them are unauthorized private funds. SFC can only indirectly supervise the licensed hedge fund managers. It seems that the hedge funds managed by HK managers are still far from sophisticated as the overseas ones. Therefore the corresponding compliance concerns are still limited to those basic topics such as internal controls and conflicts of interest.

Next Monday I will touch on the international arena of hedge funds.

Regulation of Hedge Funds (1/3)

Hedge funds has become an important regulatory agenda in the past few years, especially after the LTCM incident. The recent collapse of Amaranth Advisors has made this topic hot again. Hedge fund is attractive in terms of the pursuit of "absolute return", flexible investment strategies and the low correlation to the overall market. But it is sometimes viewed as a mysterious monster which could disturb the markets from time to time.

In US and UK, hedge funds are only made available to private and institutional investors. Therefore the regulatory concern is not investor protection but the market impact. In the case of Amaranth, despite the size of loss (US$6 bn), the financial markets were not extensively affected. This may reflect the improved risk management measures taken by the market practitioners.

In HK, though a segment of hedge funds are made available to retail investors, most of the hedge fund managers licensed by SFC are managing private hedge funds. Obviously SFC's focuses are put on the internal control and risk management issues of both hedge fund managers and prime brokers.

Yesterday SFC banned Mr Charles Lee Schmitt from re-entering the industry for life for misappropriating client assets and being convicted of false accounting. This is the well-known case initiated by the report of directors of Charles Schmitt & Associates that Schmitt was suspected of misappropriating client assets from the CSA Absolute Return Fund. SFC found that Schmitt diverted the investors’ subscription proceeds for the Fund for his own use. He was charged with offences under the Theft Ordinance and now waiting for sentence.

SFC has just released a survey report on hedge funds managed by SFC licensed fund managers. I will comment on it tomorrow.

Supervisory System

Many firms have a misconception that once a perfectly written compliance manual is put in place then everything will be under control. They ignore the fact that a good supervisory system should at least include ALL of the following:

• Written compliance procedures which are properly communicated to all relevant staff
• Effective and consistent enforcement of compliance procedures by regular monitoring and disciplinary action for non-compliance
• Keeping of adequate records to demonstrate compliance

NASD recently fined CCO Investment Services Corp. US$850,000 for failing to establish, maintain and enforce a reasonably designed supervisory system and written procedures relating to a series of issues. Some violations are highlighted below:

• CCO failed to maintain business-related email and records of compensation given to its brokers by issuers of variable contracts or mutual funds.
• CCO's suitability reviews of variable annuity contract sales were not reasonably designed to prevent and detect sales practice violations. For example, although the firm utilized surveillance reports and its operations personnel reviewed variable annuity applications before the transactions were completed, it inconsistently provided for reasonable follow-up and review to ensure that noted exceptions were adequately addressed.
• Although the firm had some policies related to variable annuity sales to elderly clients, it failed to provide for reasonable follow-up and review to ensure that those policies were implemented for these clients. To the extent that the firm had customer suitability review procedures, such as mandating the use of customer financial profile forms, it did not consistently enforce those procedures. As a result, customer information that could have assisted registered persons and the firm in assessing suitability was not always available.
• CCO made telephone calls to prospective customers during "call nights". The firm required affiliated bank employees, who were not registered representatives, to use pre-approved scripts and not to discuss specific financial products with customers. But the firm had no supervisory system or written procedures for monitoring compliance with its supervisory procedures in this area. The firm had no reasonable way of even tracking the occurrence of call nights or otherwise monitoring compliance with its procedures.

Compared with dealing operations, sales operations is more difficult to monitor. The audit trails are usually maintained by human efforts (instead of automatic capture by computer systems), thus the probability of misuse and abuse is higher.

Ponzi Scheme

A "Ponzi scheme" is a fraudulent investment operation that involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. It was "invented" by the notorious Charles Ponzi in early 20th century.

Nowadays the Ponzi schemes are often more sophisticated but the underlying formula is quite similar. They continue to prevail because greed is a human nature.

Last week US SEC filed emergency securities fraud charges against a promoter (Pinnacle) to halt a Ponzi scheme that raised at least US$30m from around 2,000 investors in fraudulent "real estate development partnerships".

SEC alleged that from at least Oct 2006 to present Pinnacle has:

• sold interests in such scheme through a nationwide advertising campaign (including solicitation for investors in magazines & newspapers)
• promised investors a 25% return in 45 or 60 days, and a second 25% return and the return of capital after 90 days
• represented that the profits would be earned by purchasing foreclosed real estate, making minor repairs and reselling the property within 45 to 60 days.

Without disclosure to investors, Pinnacle in fact purchased property from third parties and sold it to investors at high mark-ups. The exorbitant returns promised to investors were generated by selling the property to other "fooled" investors.

Under the SFO, the above Ponzi scheme may be regarded as a collective investment scheme or regulated investment agreement. Marketing of it to the HK investing public without SFC authorization is illegal. But from time to time I've received those suspicious advertisements from different sources.

People could not eliminate greed, but at least they should learn to be smart investors. In their new book "Why We Want You To Be Rich", Donald Trump and Robert Kiyosaki even alleged that middle classes in developed countries would eventually become poor if they don't have financial education!

Manipulation of Futures Market

Last week SFC suspended the licence of a futures dealer (Tsoi Bun) for 15 months due to manipulation of the futures market. This is a rare case because usually people are caught by SFC for manipulation of the stock market.

In Jun 2000, HKFE introduced the pre-market opening period (30 minutes before the normal trading hours) as a price discovery mechanism. An indicative calculated opening price (COP) is calculated every time an order is placed, changed or cancelled. Orders are received, ranked and ultimately matched at the last indicative COP.

During the pre-market opening periods of 2 trading days in 2002, Tsoi artificially increased the COP of the HSI futures contracts by 160 points and 76 points respectively, and made a profit of $510,000 through his net short positions.

When Tsoi committed such market manipulation, the SFO was not yet implemented. But even Tsoi had appealed to SFAT, how could SFC take 4 years to conclude this case?

SOX Compliance

Following the accounting scandals in such companies as Enrol, Tyco and WorldCom, SOX has become a new challenge to the compliance field and also created many career opportunities for compliance officers.

SOX stands for the Sarbanes-Oxley Act of 2002, also known as the Public Company Accounting Reform and Investor Protection Act of 2002, is the US federal law for the listed companies. The more remarkable provisions of SOX include:

• Certification of financial reports by CEO and CFO
• Independence of auditor and audit committee
• Significantly longer maximum penalties for corporate executives who knowingly and wilfully misstate financial statements
• Employee protections for corporate fraud whistleblowing
• Establishment of internal controls over financial reporting

IT plays a key role in the financial reporting process and thus SOX compliance. Recently a software company Approva conducted a survey of more than 200 high-level finance and IT executives at listed companies. The purpose of this survey explored how executives at leading listed companies view their compliance-related investments.

Major findings of this survey are set out below:

• The vast majority of companies who currently use software to automate their controls think their investment will provide business value beyond SOX compliance.
• Despite the recognized value of automation, most companies have yet to automate the testing of their IT controls.
• ERP systems alone are not adequately equipped to support proper monitoring of controls to ensure regulatory compliance.
• Open, cross-application controls automation and monitoring solutions are critical in the audit process.
• Most companies who currently do not have a software solution for controls automation are planning to invest in one in the next year.
• Investment in audit preparation continues to rise.
• Most companies expect to realize measurable returns on their IT controls and compliance investents.
• Many companies believe SOX has been successful in helping to prevent corporate fraud and increase investor confidence.

In forseeable future, we can expect compliance monitoring to be more automated (therefore less labor-intensive), then the role of compliance officers would turn into being more analytical and advisory.

Dual Filing System

The dual filing system has been launched since the commencement of SFO in 2003, which represents the mechanism taken by SFC to supervise the due diligence work done by sponsors. It also indirectly helps SFC oversee the listing approval function of SEHK.

Every quarter SFC issues an update on the operation of the dual filing system by illustrating those listing applications with disclosure problems. One of the typical issues is the insufficient disclosure of risk factors, particularly legal risk (e.g. compliance with the PRC's social insurance requirements). Another common issue is the concealment of business models and key business relationships.

In one case illustrated in the latest update of SFC:

• The company's principal supplier is also its principal customer, which on-sells the products to an ultimate customer.
• The sales to this principal supplier/customer are apparently priced above market prices and contributed substantially to the company's impressive increases in historical profits.
• There were unusual settlements and fund transfers between two parties.

It is quite obvious that certain artifical arrangements have been made to window address the company's financial performance disclosed in the prospectus. But the sponsor may have turned a blind eye to this problem, or even advised its client to play these tricks.

I've heard that many sponsor firms rely only on the lawyers or accountants to perform the due diligence work which requires both business sense and regulatory knowledge. Under the new sponsor guidelines, they are required to employ more human resources to discharge their duties. Compliance officers need also to do more jobs to assess the competency of the transaction teams.

Responsible Officer

Responsible officer (RO) is a risky position. Being a RO means that you are required to supervise the regulated activities and then bear the responsibility of regulatory breaches (even not directly committed by you).

Based on SFC enforcement actions, I've noted that a RO would most probably be penalized for non-compliance incidents incurred by other staff if:

• There is no well documented compliance policy/procedure in place; or
• The compliance policy/procedure is not effectively enforced.

But if the non-compliance situation is in fact plotted by the RO, then of course he can never escape the liability.

Yesterday SFC announced that it has suspended the licence of a RO (Steven Chan) of Peace Town Forex for 3 years. He holds a licence of Types 1, 2, 3, 4, 5, 6 & 9. This is quite a severe penalty. What happened?

As disclosed by SFC:

• PT Forex used a dormant company to fund commission payments to individuals carrying on leveraged FX trading without a licence.
• Chan knew about the arrangements and even suggested how they could be made to avoid suspicion.
• PT Forex continued the unlawful activity despite internal documents revealing the true nature of the payments.

I've heard that many firms had made use of similar arrangements to conceal the compensations for unlicensed dealing activities. This case may just be part of the iceberg.

Referring to the history of this RO, I noted that he had also been suspended by SFC for 2 years in 2002 for misconduct under the Takeover Code. For wilful contravention of law, a 3-year suspension should not be too harsh.

Prevention of Money Laundering & Terrorist Financing

Since the implementation of the revised guidelines about AML & CTF, HKMA has put many efforts to enforce the rules, including the demand for self-assessments and the conduct of onsite examinations. This topic is really a heavy compliance burden to the banks.

Last Friday HKMA issued a letter which set out its approach to "formalise" the use of supervisory measures against serious AML deficiencies in individual banks. Simply speaking, HKMA has broadly categorised the following three levels of available measures, namely Level I (emerging concern), Level II (significant concern) and Level III (severe concern).

HKMA will deal with Level I and Level II situations largely through the use of the use of "administrative or prudential measures", and Level III situations mainly through the exercise of "statutory powers".

Examples of supervisory measures taken by HKMA for each level are given below.

Level I:

• Issue of a warning letter to the bank
• Direct communication to the bank's board, head office or host supervisor
• Requiring the bank to submit a remedial action plan
• Conduct of a follow-up examination asap

Level II:

• Downgrade of CAMEL rating
• Increase of minimum CAR
• Referral of violation cases to law enforcement authorities for investigation or prosecution

Level III:

• Suspension or revocation of the bank's authorization
• Withdrawal of prior consent given for appointment of director or chief executive

If we have confidence on the banking supervision in HK, we can expect Level III situations would rarely happen. Needless to say, more and more compliance resources have been allocated to the AML agenda, thus increasing the workload of compliance officers in other areas.

HKSI Paper 1 Exam

In HK, no matter how you are well educated and experienced, you need to take the HKSI Paper 1 exam in order to get the SFC license. This paper had been a nightmare to many people. I remember when I first taught a course about this paper in 2003, the pass rate was sometimes within the range of 20~30%. Now the average pass rate is much higher, but the deviation is significant (from 40% to 70%).

A few years ago I read an article from Finance Asia, which reported that even a Harvard graduate had failed the Paper 1 exam for several times! Some senior executives of banks had expressed grievance to me that they were "too old" to take this exam.

Is this paper so difficult to the new entrants to the financial industry? I would say "yes" due to the following reasons:

• Some beginners have too little knowledge about investment products & markets, thus would feel even harder to understand the underlying regulations. They may take Papers 1, 7 & 8 at the same time. In the Paper 1 classes, it is no surprise that some people would ask me "what ordinary share is".
• Securities regulations per se is quite a boring subject and there are too many trivial requirements to memorize. Unless you are a legal or compliance practitioner, how come you would be motivated to study the ordinances and codes?
• The HKSI's study manual for Paper 1 is the most relevant stuff for studying. But unfortunately, in my opinion, the manual is not written in a user-friendly way. It has covered (or copied) too many regulatory materials but not effectively digested them for the readers.

So my usual advice to those people who want to pass this paper in one go is to take a preparation course.
(Note on 2008.11: HKSI has recently released one (and only one) past paper (Dec 2006) of the Paper 1 exam. You may download the paper from HKSI's website and refer to my explanations of the answers from this blog.)

Fit & Proper Assessment

Before 2001, banks in HK had enjoyed the "exempt dealer" status when engaging in securities business, where the bank staff were not subject to the "fit & proper" assessment. This was of course unfair. To attain a level playing field, HKMA has imposed the assessment requirements on banks since 2001 and required the registration of bank staff since the implementation of SFO in 2003. This is a historical issue.

However, after a few years some banks have not yet fully equipped themselves to cope with this regulatory burden. They may have employed unqualified compliance officers (internally transferred from other functions) or under-trained HR staff to handle the registration matters. Either of them are not knowledgable about the fit & proper requirements and then they have made a lot of mistaken judgments.

Following the unlicensed dealing incidents in Wing Lung and DBS, last week HKMA issued a circular to highlight some internal control measures about fit & proper assessment. I have the following observations or comments:

Regular internal audit of the controls is required.

• This seems to cast a vote of distrust to the compliance function.

A suitably qualified designated unit is assigned to perform the assessment before registration. The assessment is approved by an independent reviewer at a reasonable level of seniority.

• The assessment should first be done in the recruitment process. That's why in some banks HR is responsible for this task.
• I had witnessed those independent reviewers (at a manager level) who were still ignorant and negligent in discharging their duties.

Banks should establish due diligence steps to verify the individuals' relevant industry experience with previous employers to the extent practicable instead of solely relying on their CV or self-declaration.

• But some banks (as previous employers) are not quite cooperative in providing the information for verification of relevant industry experience.

Banks should de-register the staff who have failed to pass the local regularoy framework paper upon expiry of the six-month grace period.

• Some staff registered by using the grace period concession would "forget" about the exam if they are not regularly reminded.

Banks should seek the potential employees' specific confirmation on whether his employment has ever been terminated by any previous employer.

• An individual who is being investigated by SFC when working in a licensed corporation may be fired and then get a job in a bank.

Registration of bank staff based on the internal assessment could shorten the processing time, but the banks is facing a higher risk of mis-registration. This is a two-edge sword.

Beware of Your Emails

Email is an inevitable communication tool today. Some executives have even become addicted to blackberry. But email does not pose a risk of unintentional leakage of your "secrets" (no matter with public concern or not). Certain firms have installed the email surveillance system for their compliance officers to detect "offending emails" of the staff.

Last week the market was shocked when Morgan Stanley announced that its highly ranked Asia economist, Andy Xie (謝國忠), had "suddenly" resigned. The announcement did not explain why he was going or where he was going. Given such a strange time (the bonus period is coming) for resignation, the market was speculating why Xie had left.

Yesterday Finance Asia released an article, which may give us an insight about Xie's leave. It was said that Xie wrote an email about Singapore on 18 Sep 2006. Then this email has been spreaded around by the region’s fund management and banking community.

Under the subject "Observations on the IMF/ World Bank conference", Xie commented on that event recently hosted in Singapore. The following remarks in this email attracted most attention.

• "I tried to find out why Singapore was chosen to host the conference. Nobody knew. Some said that probably no one else wanted it. Some guessed that Singapore did a good selling job. I thought that it was a strange choice because Singapore was so far from any action or the hot topic of China and India. Mumbai or Shanghai would have been a lot more appropriate. ASEAN has been a failure. Its GDP in nominal dollar terms has not changed for 10 years. Singapore's per capita income has not changed either at $25,000. China's GDP in dollar terms has tripled during the same period."
• "Actually, Singapore's success came mainly from being the money laundering centre for corrupt Indonesian businessmen and government officials. Indonesia has no money. So Singapore isn't doing well. To sustain its economy, Singapore is building casinos to attract corrupt money from China."

This email was intended to be circulated internally within Morgan Stanley but eventually got leaked. As Singapore is one of the firm's key investment banking markets in Asia, the above remarks would make it very embarassing.

Morgan Stanley spokesman made this remark on the email: "This is an internal email based on personal suppositions and aimed at stimulating internal debate amongst a small group of intended recipients. The email expresses the views of one individual and does not in any way represent the views of the firm. Morgan Stanley has been a very strong supporter of Singapore and has a great deal of respect for Singapore's achievements."

The lesson learnt from this story: Don't use emails to express your "sensitive comments" and trust the recipients would keep confidentiality for you! Learning to use emails tactfully is a must for many senior executives.

Bad Habits of Compliance Officers

I have critically commented on how the compliance function is abused by the business people. But there are two sides of the same coin. We, as compliance officers, should also have a self-reflection on our practices.

With years of observation & experience, I would like to point out the following 5 typical "bad habits" of a compliance officer (CO). Such habits are bad because either they add no value on compliance effectiveness or they expose compliance officers to undue risk.

Copycat

When addressing the regulatory risk of a particular product or conduct, the CO simply quotes the relevant legislaton or code without explaining how the text is relevant or applicable to the situation. For example, he would list out SFO S.xxx, HKMA SPM SB-1, SFC Code of Conduct, etc. in the compliance comment section of a new product paper, but never derive any implications for breach of those regulatory pieces.

Intuition

This is another extreme - The CO simply says "I feel uncomfortable (by intuition) with such practice" without specifying a breach of any requirement or highlighting any regulatory concern. When tackling a compliance problem initially, it is acceptable that you rely on your intuition (of which the accuracy depends on your experience) and make a prudent comment. But eventually you have to support your intuition by reasoning and evidence.

Editor

The CO pretends to be an editor or language teacher (even if his literacy is so-so) when reviewing the documents prepared by business people (e.g. marketing materials, operating manuals, etc). He may have forgotten his role is to pick out compliance concerns (e.g. misleading statements, insufficient risk disclosure, etc.) from the documents instead of correcting typos or grammatical mistakes.

Beyond Expectation

This is not a compliment. I mean the CO is doing something beyond others' expectation of his compliance scope or expertise. If you are not a lawyer, should you review a legal T&C and give "legal opinions"? Of course not, otherwise you will put youself in an unfavorable position.

I remember this story. Many years ago a lady working in a bank branch called me and asked whether I could give a "tax advice" to her customer.

After I told her that this should not be a CO's job, she said: "Our bank should endeavor to offer the 'best service' to our customers." Then I replied: "If your customer is now asking for a dish of lobster noodle, would you immediately cook it for him!?"

Paperwork Monitoring

Some CO, especially those previously working in regulatory bodies, like to use "self-assessment" as a compliance monitoring tool. They would draft up a very comprehensive checklist which sets out the major regulatory requirements and distribute it to different business units for completion (i.e. to confirm "comply or not" for each item). But after collecting back the checklists, the CO would not perform any serious verification work. If self-discipline & self-censorship really work, why should a firm recruit a CO?

Compliance is a respectable job. But certain bad habits of CO have undermined the image of this profession. Let's work hard & smart!

Fund Administrator Fraud

We know funds involve all sorts of expenses, but the general principle is that the fund assets should not be abused to pay for those expenses not for the benefit of investors.

Last week SEC instituted an enforcement action against BISYS Fund Services, a mutual fund administrator. BISYS aided and abetted 27 mutual fund advisers' improper use of fund assets for fund marketing and other expenses.

BISYS entered into "side agreements" (either verbal or written) with those fund advisers, which obliged BISYS to rebate a portion of its fund administration fee to the advisers so that they would continue to recommend BISYS as an administrator to the fund board of trustees. Fund advisers used the money to pay for marketing expenses and even non-marketing expenses such as:

• check fraud losses
• seed capital for new mutual funds
• settlement of disputes with third parties

From Jul 1999 to Jun 2004, BISYS provided over US$230m from its administration fees to the fund advisers!

This fraud case is quite shocking because of its massive scale in terms of the number of advisers, amount involved and the long duration. It is sometimes hard to correct some people's impression that fund investing is cheating. Even the fund manager has done a great job, the fund performance could be eroded by those unnecessary expenses.