Client Confidentiality

In today's world, protection of client information is eqaully important as protection of client assets, but the awareness of information security of some financial institutions has remained low.

FSA recently fined Norwich Union Life (one of the UK's largest life insurance businesses) £1.26m for not having effective systems and controls in place to protect customers' confidential information and manage its financial crime risks. These failings resulted in a number of actual and attempted frauds against Norwich Union Life's customers, where fraudsters are allowed to use publicly available information including names and dates of birth to impersonate customers and obtain sensitive customer details from its call centres.

The fraudsters were also, in some cases able to ask for confidential customer records such as addresses and bank account details to be altered. Then they used the information to request the surrender of 74 customers' policies totalling £3.3 million in 2006.

Norwich Union Life also failed to address the issues, highlighted by the frauds, in an appropriate and timely manner even after they were identified by its own compliance department. The failings happened at a time of increasing awareness across the UK about the importance of information security.

Norwich Union Life has taken a number of remedial actions including co-operating with the police to identify and arrest the fraudsters and carrying out a review of its information security processes. It has also reinstated all fraudulently surrendered policies in full.

New Approach of SFC Disciplinary Proceedings

This week SFC published their investigation findings that:

• South China Capital Ltd, in acting as a sponsor for a listing applicant, had failed to conduct adequate due diligence of its client and keep a proper audit trail of work done; and
• South China Research Ltd failed to adequately enforce its staff dealing policy which resulted in failures of two staff members to avoid conflict of interests.

Subsequently SFC entered into agreement with both companies, where they agree:

• to undertake to engage an independent audit firm to carry out an internal control review within three years of the agreement, with the time of the review and terms of reference to be determined by the SFC; and
• that the relevant entity be sanctioned if it is found to have committed failures similar to those which they are currently being sanctioned for within three years from the agreement.

In case of repeated breach, South China Capital would be suspended from sponsorship activities for 18 months and South China Research would be suspended for a minimum of three months.

This agreement reflects a new approach of SFC's disciplinary proceedings - "suspended sentence". Under this approach, the SFC will suspend or postpone the imposition of formal disciplinary sanctions if the firm agrees to an independently conducted review of its activities without prior notice (i.e surprise checking) and the same kind of misconduct is not repeated within a period time.

Independent reviews used by SFC before to resolve cases about internal control failures reviews have been conducted on a "with notice" basis. A surprise review is a more meaningful test of whether the firm is on top of its internal control systems. This kind of agreement is a positive and forward-looking one. South China's decision to accept this agreement is considered as a strong commitment to compliance and prevention of misconduct.

I am curious whether SFC would apply this new approach to individual licensees in future.

Insider Dealing Investigation

Recently SFC published two interesting cases about its insider dealing investigation, which indicate how the market practitioners are keen on challenging SFC's extensive powers of investigation under SFO.

Case 1

SFC obtained an interim injunction to freeze the disposal of about $46m by a person "A" (name suppressed by court order) who is under SFC's investigation for suspected insider dealing. HK$46m is the potential financial penalty calculated by SFC.

"A" bought shares of CITIC Resources Holdings (listed in HK) and Chinatrust Financial Holdings (listed in Taiwan) when he was working in HK for a SFC licensed firm which held confidential information concerning the shares. Accordingly, SFC commenced the investigation.

SFC applied for the interim injunction because of fears that "A" is likely to transfer his assets out of HK which would frustrate any financial penalty imposed on insider dealing, based the following concerns:

• Neither "A" nor his wife are employed an longer in HK;
• "A" told SFC that he is currently residing with his parents in a military residence in Beijing (he has been out of HK since July 2007);
• "A" had been trying to transfer or sell his liquid assets and refused to enter into any volunatry arrangements concerning his assets pending completion of the investigation.

"A" applied to the High Court to dismiss or vary the interim injunction but was rejected.

Case 2

This one is also about "A" in Case 1. "A" applied to the High Court to dismiss a search warrant obtained by SFC to search the residential address of "A" and seize some documents. "A" argued that the search warrant was too board and that SFC was obliged to provide "A" with notice of the investigation before executing the search warrant. The judge rejected both arguments.

Black Sheeps of HK Securities Industry

This year there were lots of cases where the account executives had abused client accounts for unauthorized and even illegal trading activities (such as market manipulation and insider dealing).

SFC has just banned Mr Suen Wai Hung, a former representative of Sun Hung Kai Investment Services, from re-entering the industry for three years. Suen conducted personal trading through the accounts of four of his clients without their authorisation.

In particular:

• he short sold derivative warrants through the accounts of three of those clients;
• he lied to his employer when questioned about the trading and the short sales in those accounts;
• his short sales in those accounts caused substantial losses;
• he earned commission from his personal trades in those accounts to which he would not otherwise be entitled; and
• he fabricated lies to persuade those clients to open accounts with him and persuaded them to provide false or misleading information in their account opening forms in order to secure higher trading limits, ultimately for his own benefit.

It is really hard to rescue the image of HK local brokers if there are so many black sheeps without any bottom line of integrity.

Cost Cutting for Structured Products

In recent years SFC is keen on marketing how its regulatory greenlight can facilitate market development. Last month SFC announced it had authorized the first Islamic fund in Hong Kong, even when the fund promotor (Hang Seng) had not yet launched the product. Very proactive!

Last week SFC announced a new measure which would reduce the compliance burden and costs of issuers of structured products, including derivative warrants. Currently under Part XV of SFO, substantial shareholders and directors of an issuer that lists structured products on HKEx are required to report changes in their shareholdings in the issuer.

However, unlike disclosures relating to shareholdings in listed companies, this information is generally not useful to investors. Structured products issuers therefore regularly apply to SFC for waivers to exempt them from this reporting obligation. In recent years the number of structured products listed on HKEx, in particular derivative warrants, has increased substantially and there are now many cases of the same issuer applying for multiple waivers, which are routinely granted.

SFC considers that these multiple applications and the accompanying fees, which impose an administrative burden and costs on the industry and indirectly to investors, can be more effectively dealt with by the issue of a single waiver. SFC has therefore decided that from 21 Dec 2007 waivers will be granted to an issuer upon application, which will exempt all structured products issued over a 12-month period from the statutory reporting obligations, subject to receiving certain standard assurances from the issuer.

It is so funny that somebody who has created an unnecessary burden in the first place could claim a credit for reducing the burden subsequently!

Deficient Disclosures in Research Reports

FINRA recently censured and fined Wachovia Capital Markets, LLC $300,000 for violations of FINRA's research analyst conflict of interest disclosure rules which require firms to provide investors with information about actual and potential conflicts of interest that could influence analysts' conclusions about investing in listed companies.

From Jun 2004 to May 2006, Wachovia failed to include in 40 research reports a total of 56 disclosures concerning Wachovia's financial relationships with subject companies. In 20 of those reports, Wachovia failed to disclose that it managed or co-managed a public offering of securities issued by the subject company. In other research reports, Wachovia failed to disclose that it received compensation from the subject company for investment banking services, that it owned an interest in the common stock of the company or that it was making a market in the securities of the company.

Additionally, from Mar 2004 to Jul 2007, in over 15,000 research reports, Wachovia included a disclaimer stating that the firm and its affiliates may own an interest in the securities of the subject company. This disclaimer is inconsistent with FINRA's requirement that firms affirmatively disclose whether they own one percent or more of the common equity stock of the subject company.

Even the rules governing analyst conflict of interest have been implemented for several years, some firms are still using "maybe" disclaimer to replace actual disclosure. This indicates the fact that these firms do not have any internal compliance monitoring of research disclosures.

Independent Pricing Verification

FSA recently fined the London branch of Toronto Dominion Bank (TD Bank) £490,000 for systems and controls failings in relation to one of its trading books. FSA has also prohibited a former employee of the firm, Mr Simon Richard Brignall, from performing any regulated activity.

Mr Brignall was employed as a senior fixed income trader at the firm. On 9 Mar, he resigned and revealed to TD Bank that he had been attributing false values to his trading positions for a period of almost two years. He had done this in order to hide significant losses on his trading book. He had also entered a number of fictitious trades during the two weeks leading up to his resignation.

TD Bank did not identify, through its own systems and controls, either the extent of the mispricing of the trades or the fictitious trades. FSA identified three main system and control failings in relation to Mr Brignall's trading book:

• the absence of a system of independent price verification;
• a lack of effective trading supervision; and
• a failure to implement effective trade break escalation procedures.

The most important of these was the failure to have in place a system of independent price verification in relation to Mr Brignall's trading book. This meant that there was no independent third party check on the valuations that Mr Brignall had attributed to his own trading positions. FSA regards this as a fundamental control.

The net total loss caused by Mr Brignall was CAD $8.8 million and this was borne by TD Bank. No client or third party suffered any loss and Mr Brignall made no personal gain.

This case appeared to be another Barings story. Lacking of independent pricing verification is hardly conceivable. Fortunately TD Bank was not killed by this trader.

Guidance on PEPs

Handling of politically exposed persons (PEPs) is a big challenge in the Customer Due Diligence (CDD) process for AML. Recently the Industry Working Group on Prevention of Money Laundering and Terrorist Financing (IWG) has issued a guidance paper about PEPs (in a FAQ format) to banks. Though the practices recommended in the paper do not form part of the formal regulatory requirements, HKMA would consider that the adoption of these practices would strengthen a bank's systems and procedures for AML and CFT.

Certain points of this guidance paper are highlighted below with comments:

• Some jurisdictions and groups have put forward differing definitions of PEPs. Definitions in US and EU only refer to "foreign" individuals. (Comment: If HK banking industry generally follows this approach, even Donald Tsang or Joseph Yam would not be classified as a PEP.)
• While the focus tends to be on senior functions at the national level, individuals serving in a public capacity at more local levels can still be considered as PEPs if their position brings with it sufficient prominence and influence. A bank may adopt a risk based approach, taking into consideration the political environment and other relevant information. (Comment: Usually when an ambiguous answer is given, the term "risk based approach" would be used, which is effectively an empty term.)
• It is irrelevant whether the PEP is serving in an elected or appointed position.
• Individuals who have been entrusted with prominent public functions are also considered as PEPs. There is therefore no set time frame, but by using a risk based approach, a bank can make an informed decision. (Comment: The term "risk based approach" has been abused.)
• Any parties closely connected to PEPs, whether by blood or otherwise, could be considered as PEPs themselves. How broad this definition becomes depends on the specific risk factors of each PEP. (Comment: Ditto)
• The PEP process will also apply whenever a PEP has power of disposal over the assets of the individual or entity with which the bank is dealing. (Comment: How does a bank ascertain the existence of such "power"?)
• Political parties do not necessarily fall within the definition of PEPs.

Perhaps the most practical guidence on handling PEPs is to subscribe for a powerful external database of PEPs.

Securities & Futures Appeal Tribunal

Under SFO, people who are not satisfied with SFC's certain decisions (e.g. disciplinary action) may appeal to the Securities & Futures Appeal Tribunal (SFAT). Usually SFAT upholds SFC's decisions to impose penalities on the applicant, but in some cases SFAT may reduce the penalty level.

SFAT recently upheld SFC's decision to ban Mr Lee On Ming Paul, formerly a Type 1 representative of Fullbright Securities Ltd, for life. SFC found that Lee had deceived his employer by opening two nominee accounts in false names and concealing his personal trades. In doing so, Lee also forged the signatures of his sister-in-law on the account opening documents as well as on cheques issued for settlement. Lee lodged an application to SFAT on 31 July 2007 to review SFC's decision against him. SFAT issued the Determination on 9 Nov 2007.

SFAT rejected the argument that Lee had merely been "foolish" or "sloppy" in the manner in which he had conducted his affairs. No kidding - many people would utter such argument after they are caught red-handed - just like children! SFAT was satisfied that SFC's findings plainly were borne out by the evidence, and could not reasonably be criticized, far less set aside by this tribunal.

Although SFAT upheld SFC's reasoning, it varied the period of Lee's ban from life to 18 months. This is a fundamental difference - it appears that SFC's original decision was considered "too harsh"!

SFC's Power to Audio Record an Interview

The High Court has made a ruling dismissing a challenge lodged by a person under investigation in respect of the SFC’s power to audio record an interview held under section 183(1)(c) of SFO.

SFC was seeking to audio record an interview with a person who can only speak in Putonghua under an insider dealing investigation because the SFC investigator is not a fluent Putonghua speaker. Initially SFC proposed to video record the interview. Given this person's objection, SFC proposed to audit record the interview but the person objected also to this and brought judicial review proceedings. The proceedings were held in chambers (not open to the public) and the name of the applicant is suppressed by order of the court.

The lawyer appearing for the person put through the following major arguments:

• There is no express power under SFO enabling the investigator to insist on audio recording the interview.
• Nothing in section 183 allows the investigator to insist on the person's "audio signature" to the interview record.
• Audio recording is "invasive" of a person's privacy.

However, the Judge concluded that the power to record an interview by audio means is reasonably incidental and necessary to the power under section 183(1)(c) of SFO to compel a person under investigation to attend an interview and answer questions and that in insisting upon an audio recording of an interview SFC and its investigators did not act ultra vires. An audio recording does not involve any kind of "signature". Audio recording is an important way of ensuring the integrity of the interview process and does not interfere illegally with any privacy right.

Late Reporting of Broker Information & Customer Complaints

Last week FINRA censured and fined UBS Financial Services, Inc. US$370,000, for making hundreds of late disclosures to FINRA's Central Registration Depository (CRD) of information about its brokers, including customer complaints, regulatory actions and criminal disclosures. Those reporting violations occurred over a three-year period, from Jan 2002 to Dec 2004. The firm also failed to disclose a significant number of customer complaints and filed late and inaccurate notices concerning the termination of certain brokers' relationships with the firm.

The violations may have hampered investors' ability to assess the background of certain brokers via Broker Check, FINRA's public disclosure program. They also may have compromised firms' ability to conduct background checks when making hiring decisions, reduced the ability of state securities regulators to review brokers' transfer applications and hindered FINRA from promptly investigating certain disclosure items.

Under FINRA rules, when a securities firm hires a broker it must ensure that information on the broker's registration application (Form U4) is updated and kept current in the CRD system. The firm must update that information whenever significant events occur, including regulatory actions against the broker, certain customer complaints, settlements involving the broker and certain criminal charges and convictions. Normally, those updates must be filed within 30 days of the event. A reportable event involving statutory disqualification (often the result of a criminal conviction) must be disclosed to CRD within 10 days. Firms also are required to notify FINRA within 30 days of the termination of a registered person's association with a member firm by filing a notice known as Form U5. Firms also must notify FINRA within 30 days of learning that information disclosed on a Form U5 filed for a broker has become inaccurate or is incomplete.

Regarding complaints, certain types of written, consumer-initiated, investment-related complaints made within the past 24 months must be disclosed on Forms U4 and/or U5. If a complaint alleges that a broker was involved in one or more sales practice violations and contains a claim for compensatory damages of US$5,000 or more, it must be disclosed. Additionally, complaints alleging broker involvement in forgery, theft, misappropriation or conversion of funds or securities must also be disclosed.

In HK, SFC has implemented a similar reporting system but enforced it more leniently. The chance of imposing severe penalties on securities firms for late reporting of broker information and customer complaints is relatively low.

Loophole of DoI System

Under the disclosure of interests (DoI) regime laid down in SFO, substantial shareholders (5% stake or above) of a listed company should make a disclosure for certain prescribed changes of interest (e.g. crossing a whole percentage number) within 3 business days, which is tighter than 5 days required by the Pre-SFO regime. The law permits such disclosure to be made by hand, post, fax or email. However, there is an underlying loophole.

In recent months Warren Buffet has gradually reduced his shareholdings in PetroChina (857.hk), triggering the disclosure obligations. However, he sent in the disclosure by regular mail, each time leaving Hong Kong investors in the dark for two weeks.

According to newspaper reports, even Martin Wheatley (SFC's CE) had to admit that:

• There is clearly a gap in our legal system.
• It was never intended that somebody could send their disclosure in by a very slow means of communication.
• It is allowed for in the SFO, but it's a deficiency we need to address.
• It will take time to amend the law because it requires primary legislation changes.

I wonder how many other substantial shareholders (esp. overseas investors not regulated by SFC) are taking advantage of this loophole.

Email Spam

Email spam is big issue globally. It is particularly harmful if it is relating to stock market "pump and dump" scheme.

US SEC recently announced that it had continued its assault on stock market email spam by suspending trading in the securities of three companies that haven't provided adequate and accurate information about themselves to the investing public.

The companies, all of which trade on the Pink Sheets, are susceptible to spam stock promotions because they have inadequately disclosed their assets, business operations and/or management, their current financial condition, and/or financing arrangements involving the issuance of the companies' shares.

The trading suspensions are part of SEC's Anti-Spam Initiative announced earlier this year that cuts the profit potential for stock-touting spam and is credited for a significant worldwide reduction of financial spam. A recent private-sector Internet security report stated that a 30% decrease in stock market spam was triggered by actions taken by the SEC, which limited the profitability of this type of spam. In addition, spam-related complaints to the SEC's Online Complaint Center have been cut in half.

Since the launch of its Anti-Spam Initiative in Mar 2007 to combat spam-driven stock market manipulations, SEC has suspended trading in the securities of 39 companies and has brought several spam-related enforcement actions.

SFC has also actively combating "boiler room" activities that are usually associated with email spam. But I think there would not be too many people in HK cheated by email spam.

Cross-Border Unlicensed Activities

Last week SFC suspended Ms Ng Suet Hing for one month for unlicensed activities. She is licensed to carry on Type 3 regulated activity, accredited to Hantec International Ltd.

SFC found that Ng assisted a HK resident to open an account at Cosmos Hantec Investment (NZ) Ltd, a New Zealand company not licensed by SFC, to trade leveraged foreign exchange contracts. Cosmos Hantec (NZ) is a related company of Hantec International Ltd. It carries on a business in financial services including leveraged foreign exchange trading which is currently not regulated in New Zealand. Ng subsequently attempted to notify Cosmos Hantec (NZ) that she was the client's account executive for the purpose of receiving commissions.

Some market practitioners have a false hope that if client transactions arising a regulated activity are booked in an overseas entity, there is no licensing requirement. They don't realize that if the clients are HK residents and the account opening process takes place in HK, SFC has to offer them investor protection.

In this case, even though Cosmos Hantec (NZ) is a related company of Hantec International Ltd, SFC fails to exercise further investigation power against this overseas company. As a result, HK investors who have opened an account with Cosmos Hantec (NZ) are now requested to contact SFC.

Hedge Fund Fraud

Hedge funds have the features of lower transparency and less regulation. Accordingly, it is no surprise that fraud cases could happen from time to time.

Last week SEC charged a San Francisco hedge fund manager with defrauding investors by dramatically overstating the fund's profitability and misusing fund assets. It alleged that Alexander James Trabulse sent account statements to investors in his Fahey Fund that inflated the fund's returns by as much as 200%, while using investor money to purchase cars and finance shopping sprees for his family members.

According to SEC, Trabulse founded the Fahey Fund in 1997 and raised about US$10m from approximately 100 investors. He told investors the fund invested in financial instruments like stocks, derivatives, and foreign currency. Trabulse lured investors by touting the fund's spectacular performance, when in reality the statements he provided to investors bore no relation to the fund's actual performance.

Trabulse also misused fund assets to pay for a wide variety of personal expenses, using the fund's bank account to pay for cars, a home theater system, and his ex-wife's overseas shopping allowance. He even gave one relative free reign to use the fund's bank accounts for personal use.

In the past participation in hedge funds was limited to high net worth individuals, where the regulators could find an excuse for not directly supervising them. While such kind of products has been prevailing in the retail market, this incident makes an alarm.

Misuse of Name & Logo

SEC recently settled enforcement proceedings against HSBC Bank USA, N.A., which will pay a US$10m civil penalty and US$500,000 in disgorgement for allowing its name and logo to be used in connection with a Florida-based offering fraud by Pension Fund of America, L.C. (Pension Fund).

SEC issued a settled cease-and-desist Order finding that from Aug 2003 to Mar 2005, HSBC served as trustee for the investment component of Pension Fund and its affiliated entities' trust plans. Since at least 1999, Pension Fund sold retirement and college "trust plans" that purportedly provided term life insurance and the opportunity to invest in one or more pre-selected mutual funds. However, Pension Fund failed to disclose, among other things, that it was taking up to 95% of the investors' funds to pay commissions and fees. Pension Fund raised at least $127 million from more than 3,400 investors, primarily from Central and South America.

In Mar 2005, SEC filed an emergency action in the U.S. District Court for the Southern District of Florida against Pension Fund and its principals to halt the offering fraud. The Court appointed a receiver over Pension Fund, who shut down its operations, marshaled its assets, and developed a claims process to distribute recovered funds to its investor victims.

It was found that HSBC allowed the use of its name and logo in Pension Fund's offering materials. HSBC also allowed Pension Fund to use marketing materials that falsely suggested that the trust plans were co-developed by HSBC and Pension Fund, and that investors' funds would be "totally safe" because the money would be deposited in a trust account at HSBC. In reality, Pension Fund deposited investors' funds in an ordinary checking account in its name at HSBC, and used up to 95% of such funds to pay its own undisclosed sales commissions, expenses and fees. Pension Funds' marketing brochures provided a list of mutual funds offered as part of the trust plans, but did not disclose any information about the sales commissions, administrative expenses, or the front-load mutual fund fees charged to investors. However, HSBC failed to follow its own internal procedures in reviewing and approving certain Pension Fund offering materials.

Additionally, HSBC actively participated in the selection of offshore, high front-load mutual funds to be offered to prospective investors under a negotiated fee arrangement between HSBC and Pension Fund. However, neither the amount of the funds' sales loads, nor HSBC's role in the funds' selection, were disclosed to investors. In Oct 2003, shortly after HSBC became trustee for Pension Fund's plans, HSBC drafted a letter on its own letterhead announcing the new relationship and inviting certain of Pension Fund's existing investors to transfer their funds to HSBC. Pension Fund sent the letter to approximately half of its existing investors, and enclosed a form bearing HSBC's logo that listed new mutual fund selections available upon transfer to HSBC. Neither the letter nor the enclosure disclosed that investors would incur new front-load fees in connection with such transfers, or the amounts of those prospective costs.

A globally known institution should be very cautious when associating its name & logo with a third party. Who in HSBC should ultimately bear the responsibility for this incident?

Records Kept at Overseas Premises

According to S.130 of SFO, a licensed corporation must obtain SFC's pre-approval before keeping records at a particular premise. In recent years, some firms have outsourced their back office functions to third parties located at overseas countries. However, SFC recently released a FAQ to clarify that it would not approve overseas premises for the keeping of records or documents under S.130.

The reason why the SFC will only approve premises located in Hong Kong is that while SFC is empowered by SFO to enter an intermediary's premises to inspect the records, it may be precluded from exercising this power in the event of the premises being located outside HK.

Accordingly, if an intermediary enters into an overseas outsourcing arrangement, it must ensure that all relevant records or documents, which are kept by an overseas third party, are also contemporaneously kept by the intermediary at the HK premises approved by SFC under S.130.

If records at overseas premises are maintained in electronic format, then it would not be a big problem making a copy to the intermediary's local office. But it could be a hardship for the overseas third party to remit hard copy records back to HK.

"Free Lunch" Investment Seminars

"There is no such thing as a free lunch" is a famous quote of the late economist Milton Friedman.

US securities regulators recently released a joint report summarizing the results of their examinations of "free lunch" investment seminars. The year-long examination was conducted by the SEC, FINRA and state securities regulators. They scrutinized 110 securities firms and branch offices that sponsor sales seminars and offer a free lunch to entice attendees.

The report's key findings include:

• 100% of the "seminars" were instead sales presentations. While many sales seminars were advertised as "educational", "workshops" and "nothing will be sold", they were intended to result in the attendees' opening new accounts and, ultimately, in the sales of investment products, if not at the seminar itself, then in follow-up contacts with the attendees.
• 59% reflected weak supervisory practices by firms. While some exams found effective supervisory practices, many examinations found indications that firms had poorly supervised these sales seminars, including failure to review seminar presentations or materials as required.
• 50% featured exaggerated or misleading advertising claims. Examples included "Immediately add $100,000 to your net worth", "How to receive a 13.3% return" and "How $100K can pay 1 Million Dollars to Your Heirs".
• 23% involved possibly unsuitable recommendations. In 25 of the 110 examinations, examiners found indications that unsuitable recommendations were made, for example, a risky investment recommended to an investor with a "conservative" investment objective, or an illiquid investment recommended to an investor with a short-term need for cash.
• 13% appeared to be fraudulent and have been referred to the most appropriate regulator for possible enforcement or disciplinary action. Examiners found indications of possible fraudulent practices in 14 examinations that involved apparent serious misrepresentations of risk and return, possible liquidation of accounts without the customer's knowledge or consent, and possible sales of fictitious investments.

Free lunch sales seminars are routinely targeted at senior citizens and are commonly held at upscale hotels, restaurants, retirement communities and golf courses. FINRA found that 78% of seniors received a free lunch seminar invitation and 60% received six or more invitations in the past three years.

In HK, such "free lunch" seminars are also prevailing. Has SFC conducted the similar examination?

Unauthorized Access

TSFC's control guidelines have emphasized the importance of preventing unauthorized access to a licensed firm's key systems and documents. Could you imagine how serious the case may be if such unauthorized access is made by an outsider for a prolonged period?

Last week SFC reprimanded Emperor Securities Ltd and fined it $130,000 for the reason that it had insufficient systems and controls to monitor the use of its equipment, confidential information and client assets. SFC found that an unauthorized person, the girlfriend of one of Emperor's authorized representatives, had been accessing Emperor's premises, equipment, confidential information and client assets. She had also been dealing directly with clients accepting orders and handling settlement instructions for about three years.

Her unauthorized handling of settlement instructions caused Emperor's settlement department in Apr 2003 to redirect a deposit of $120,000 from a client into an account controlled by her. She repaid the $120,000 and has since been prosecuted by the police. In addition, though not mentioned by SFC, she might have conducted unlicensed dealing in breach of SFO.

As a good security control, a licensed firm should strictly enforce the policy of restricting entrance into the office premise by outsiders, even they are relatives / friends of staff members. In Emperor's case, I wonder how the company could turn a blind eye to the physical existence of this "mysterious employee" in its office for such a long period.

Discretionary Account Service

Just within a few months, there was another relevant individual (RI) of Hang Seng Bank penalized by the regulator. Last time Ms Chu Lai Kwan was suspended by HKMA for concealing her personal account dealing. This time SFC banned Ms Hung Sum Yee, who should have already been deregistered as a RI, from re-entering the industry for five months.

The case of Ms Hung was a bit more complicated. First, she engaged in joint securities trading activities with another colleague (I wonder if this "another colleague" was Ms Chu) without disclosing the trading to Hang Seng. Second, HKMA found that Hung had accepted and mishandled investment order forms and time deposit forms that were signed by clients but were otherwise left blank.

As far as I know, signing blank forms by the clients is not uncommon in many banks. This arises from the clients' expectation that the bank officers could handle their investment orders with exercise of discretion. For example, the clients wish the bank officers could decide on their behalf the best timing of acquiring securities (shares or funds) and then making the disposal for either profit-taking or stop-loss. Some clients even rely on the bank officers to choose the "right" securities.

Unfortunately, banks' general policy is providing no discretionary account service at retail level. If the bank officers accepted clients' request for such service unofficially, they will violate SFC Code of Conduct. On the other hand, if they failed to exercise the discretion on behalf of clients subsequently, they would be complained for negligence or lack of diligence. So my advice to bank officers at retail level is: never pretending to be a nice guy!

Regulated Person

Under SFO, a "regulated person" is subject to SFC's disciplinary action including public reprimand and fine. Such a person may not be a licensed representative or responsible officer. He/she could only be the senior management of a licensed firm.

SFC recently reprimanded Mr Wong Ding Pong Allan, a responsible officer of South China Securities Ltd, and to Ms Yau Man Yuk Jabriel, a former financial controller of South China and fined them $65,000 and $93,000 respectively.

An SFC investigation that followed an inspection of South China found that the company:

• failed to maintain the required liquid capital on various dates between May 2002 to Oct 2003 (17 months) in breach of the Financial Resources Rules (FRR);
• failed to segregate clients' monies fully in accordance with Client Money Rules (CMR); and
• did not have in place adequate internal controls to ensure compliance with applicable laws and regulations.

As a responsible officer, Wong signed most of the FRR returns. He acknowledged it was his responsibility to supervise FRR compliance. Yau, as financial controller, had a role in ensuring South China complied with the FRR and CMR. More importantly, she arranged fund transfers that in fact caused South China's liquid capital deficiencies.

I wonder whether the Head of Compliance, who is also part of a licensed firm's management, would also be disciplined by SFC for not ensuring the adequacy of compliance procedures.

Charging Excessive Prices on Corporate Bonds

Financial Industry Regulatory Authority (FINRA), formerly NASD, recently fined Morgan Stanley & Co. Incorporated US$1.5m and ordered the firm to pay more than US$4.6m in restitution for rule violations relating to the sale of corporate bonds to retail customers at excessive prices. The firm was cited for charging excessive mark-ups in more than 2,800 transactions and for having an inadequate supervisory system for monitoring the pricing of corporate fixed income securities sold to customers.

The firm's corporate bond trader, who was responsible for setting the excessive prices, Kenneth S. Carberry III, was fined US$40,000 jointly and severally with the firm and suspended in all capacities for 15 business days.

FINRA found that during a five-month period in 2001, Morgan Stanley charged markups ranging from 5.88% to 17.86% on 2,807 sale transactions of Kemper Lumbermans Mutual Casualty Surplus Notes in the 9.15% and 8.30% series, with a face value totaling over US$59 million.

In pricing the securities, the firm's corporate fixed income securities trader, Carberry, established the offering price, to which a sales commission was added. However, the firm's procedures failed to provide for a review of the mark-ups charged using the prevailing market price at the time, which in this case was best evidenced by the firm's cost for acquiring the bonds that it later sold to customers. The pricing method used by Carberry and the firm resulted in excessive prices paid by its customers. These transactions were conducted out of the firm's main office in New York City.

In addition, FINRA found that the firm failed to have a supervisory system in place that would have allowed the firm to detect the excessive mark-ups, and failed to properly register the individual responsible for review of the trading activities.

Poor Practices in Sub-Prime Mortgage Market

While the global stock markets have been affected by the problem of sub-prime mortgages, the financial regulators are doing something to find out the root causes.

Last month FSA published its latest review of the behavior of intermediaries and lenders within the sub-prime mortgage market, which services consumers with impaired credit histories. It has found weaknesses in lending practices and in firms' assessments of a consumer's ability to afford a mortgage. As a result the regulator has started enforcement action against five firms.

The thematic work reviewed 11 lender firms, representing more than 50% of the sub prime market by volume of sales. It also included 34 intermediary firms covering 485 customer files, of which 90 were tracked from the contact made with an intermediary through to the lender's decision.

While the research found no significant evidence of sub-prime mortgages being sold incorrectly to prime customers, several other issues were identified for both intermediaries and lenders when selling to sub-prime customers.

For Intermediaries:

• In a third of the files reviewed there was an inadequate assessment of consumers' ability to afford the mortgage.
• In almost half of the files there was an inadequate assessment of customers' suitability (e.g. needs and circumstances) for the mortgage.
• In over half of the files customers had self certified their income but it was not clear in many cases why they had been advised to do this.
• Significant numbers of consumers were advised to re-mortgage, thereby incurring early repayment charges, without the adviser being able to demonstrate that this was beneficial to the customer.

For Lenders the main weaknesses were found in their lending policies:

• None of the lenders adequately covered all relevant lending considerations in their policies. For example, some firms' lending policies contained unclear affordability or self-certification requirements.
• In many cases, lenders did not apply their own policies in practice. For example, some firms failed to check the plausibility of information, as required by their own lending policy.
• There were also failings by lenders to monitor the application of their policies, which resulted in the approval of potentially unaffordable mortgages.

While the suitability requirements have been applied to selling of investment products, they are also relevant to selling of high risk sub-prime mortgage products.

Secret Accounts

Perhaps owing to the stock market boom in recent two years, there have been many SFC licensed representative engaged in personal trading via "secret accounts", i.e. dealing accounts not maintained in their own names. If such misconduct is done by a responsible officer, then the penalty is definitely more severe.

SFC recently banned Mr Yeung Hon Fat from re-entering the industry for life for operating secret accounts while acting as a responsible officer of KGI Futures (Hong Kong) Ltd. The SFC investigation found that in late 2005, Yeung:

• concealed from KGI his personal options trading through an account under his brother-in-law's name, resulting in a margin deficit of over $13m;
• conducted unauthorized trading in two other clients' accounts, resulting in a total margin deficit of over $1.5m;
• coached one of these two clients to assume responsibility for Yeung's unauthorized trades and to lie to KGI about these unauthorized trades in order for Yeung to evade his own liability; and
• coaxed a subordinate to become the nominal account executive of these clients.

Obviously Yeung's behaviors are dishonest and deceptive. But the comment made by Mark Steward (SFC's Executive Director of Enforcement) that Yeung's conduct is viewed as a form of market misconduct is problematic. Prima facie I don't think Yeung has committed any market misconduct (e.g. insider dealing, false trading, etc.) as defined under SFO.

Stealing of Insider Information

In most insider trading cases, the wrongdoers were the listed company’s directors and senior management. However, IT specialists who have the access right to sensitive information should not be ignored.

US SEC recently filed insider trading charges against a former MDS Inc. employee who allegedly stole confidential information about MDS's impending tender offer for the shares of Molecular Devices Corp. (Molecular) and, along with his wife, used that information to trade in Molecular securities ahead of the merger's public announcement.

SEC alleges that Shane Bashir Suman, of Toronto, learned about secret merger negotiations through access he had to electronic data in his job as an information technology specialist at MDS, then gave that information to his wife, Monie Rahman. In the days before the tender offer became publicly known, Suman and Rahman made just over US$1m by trading in the securities of Molecular.

Suman's job gave him access to a vast amount of secret corporate information. In particular, he was able to read the contents of confidential e-mails and other electronic data without detection. For example, the circumstances in which Suman was called to restore an electronic document on Jan. 23, 2007, the day before he and his wife started trading, suggested the code name for the MDS-Molecular merger and the sensitivity associated with that project. Later that day, Suman conducted internet searches for both that code name and for "Molecular Devices". Just after running those searches, Suman called Rahman and spoke to her for 100 minutes, much longer than their phone records indicate they usually spoke.

Between 24 Jan and 26 Jan 2007, Suman and Rahman bought 12,000 Molecular shares and 900 Molecular call options. Brokerage account records indicate that a portion of the Molecular securities purchases were financed with a margin loan of approximately US$200,000, and the couple previously did not have a position in Molecular securities. On 29 Jan 2007, MDS and Molecular jointly announced the tender offer for Molecular's shares. The stock price immediately rose from almost US$24 to roughly US$35, making Rahman and Suman's trades worth more than US$1m.

Enhanced Stock Segregated Account with Statement Service

Following the initiatives taken early this year, HKEx has recently introduced additional features to the Stock Segregated Account (SSA) with Statement Service. Investors who choose to entrust their shares to their brokers or custodians can ask their brokers or custodians to open an SSA in HKEx's CCASS for them.

An SSA is owned and operated by the broker or custodian. In using the SSA service, investors can receive statements directly from CCASS or check any share movement and the balance in their accounts through the CCASS Phone / Internet System. The following new services are made available now.

Electronic Voting

Investors who open an SSA through their brokers or custodians can now enjoy access to an electronic voting service in CCASS. Through the CCASS Phone / Internet System, they can choose to attend corporate meetings, appoint a corporate representative or request HKEx to vote on their behalf through HKSCC Nominees Ltd. Investors can also request CCASS to alert them of any upcoming shareholder votes by sending them messages via SMS or email.

Share Movement Affirmation

Investors using the SSA can opt to use the affirmation function via the CCASS Phone / Internet System to confirm transfer of shares out of the SSA. They can also elect to receive notifications via SMS or emails whenever there are share transfer transactions requiring their affirmation.

Money Settlement

Investors using the SSA can now enjoy the CCASS money settlement service. Through their brokers, investors are able to request settlement on a DvP basis when shares are moved out of the SSA. CCASS will issue electronic payment instructions to the bank account designated respectively by the broker and investor. The money will be credited into the investor's bank account on the next business day.

Removal of Limit on Number of SSAs

To assist brokers and custodians to cater for their clients' demand for SSAs, the number of SSAs that can be opened by each broker or custodian is now removed.

With these further enhancements on the SSA service, the Investor Participant Account will become less attractive.

Human Rights in Securities Regulation

I recently attended a seminar presented by Laurence Li, who is currently a Barrister-at-Law and the ex-SFC director in Corporate Finance Division. He talked about an interesting topic: the conflict between HK's securities regulatory regime and protection of human rights. Over the past years, many challenges to SFC's enforcement action on human rights grounds were not successful until the recent legal case of Koon Wing Yee. Laurence Li published an article about this case in July 2007's "Hong Kong Lawyer". Here I just give a summary.

As the public knows, Koon Wing Yee was the chairman of Easyknit International Holdings and Easy Concepts International Holdings. There had been heavy turnover and substantial price increases in both stocks in the few days before their suspension on 31 Jan 2000. The companies announced that a third party was taking over Easy Concepts on 18 Feb 2000. Upon that announcement, the share prices of them soared by several times.

SFC commenced an investigation into suspected insider dealing and exercised its statutory powers by compelling Koon and others to answer questions during the interviews. Then Financial Secretary directed the Insider Dealing Tribunal (IDT) to initiate the proceedings. IDT admitted SFC's interview records into evidence. In 2005, IDT found that Koon had engaged in insider dealing (including "tipping") and thus imposed heavy penalties (about $48m) on him. Koon was also disqualified to act as a director or take part in the management of any company for 5 years.

Koon appealed to the Court of Appeal. The Court held that IDT proceedings involve the determination of a criminal charge within the meaning of the Bill of Rights Ordinance. That means:

• Evidence obtained by SFC by compulsion from a suspected insider dealer is inadmissible in IDT proceedings.
• IDT can't require a suspected insider dealer to appear before it to give evidence.
• IDT shall apply the criminal standard of proof (i.e. beyond reasonable doubt).

After the commencement of SFO in Apr 2003, SFC can establish the Market Misconduct Tribunal (MMT) to replace the old IDT. MMT can cover market misconducts other than insider dealing, like false trading, price rigging, disclosure of false or misleading information. MMT has the advantages of requiring less restrictive rules of evidence and lower standard of proof. However, the Koon Wing Yee case indicates that MMT's sanction powers are subject to human rights challenges. As Laurence Li said: for the dog to bite civilly, it cannot have teeth.

Whistle Blowing

Since the Enron incident, whistle blowing has become a controversial topic in corporate governance. With whistle blowing arrangement, staff of an organization should be encouraged to report any serious malpractices that they observe, first to their supervisors within the organization and, if that way is not feasible, to external authorities.

This arrangement would alert senior management to malpractices committed by lower levels of the organization, the board to malpractices committed by senior management, and even the outside stakeholders (e.g. shareholders, creditors, regulators, etc.) to malpractices committed by the board.

So how should the whistle blowing policy of an organization be formulated? The UK Corporate Governance Committee of the Commerce & Industry Group (the Law Society’s recognised body for in-house lawyers) has just published a report which seeks to provide such guidance to in-house lawyers on corporate governance.

This report, "Blowing the Whistle", aims to:

• provide an overview of the law on whistleblowing, including: whether employees have a legal obligation to blow the whistle; and if they do so, what protection the law provides them with against victimization or other detrimental treatment by their organizations;
• provide some guidance on how to help their organization to implement a good whistle blowing policy;
• examine the in-house lawyer’s own position as a whistle blower, especially: whether they have a greater legal or ethical obligation to blow the whistle than other staff members? how effectively will the law protect them if they blow the whistle? how should the extent of such legal protection affect their decision whether to blow the whistle? and
• identify gaps in the law protecting whistle blowers.

The report finds that there are some gaps in the law to protect the whistle blowers. In some cases in-house lawyers may have greater obligations than other staff to blow the whistle, but may have less (or no) protection. Compliance officers and money-laundering reporting officers are particularly exposed, because they may have to make disclosures outside of their organisations, and this was not contemplated when the whistle blowing legislation was drafted.

Perhaps owing to cultural differences, whistle blowing is not a phenomenon in Chinese societies. In-house lawyers and compliance officers usually choose to quit for self-protection after identifying serious malpractices within the organization.

Analyst's Employment with Covered Company

Analyst conflicts of interest remains one of the key regulatory issues. Neutrality of research reports is often undermined when the research analyst is under the pressure of investment banking unit. But the problem is more prominent if the analyst receives a direct benefit from the covered company.

NASD censured and fined Wells Fargo Securities US$250,000 and imposed a US$40,000 fine and 60-day supervisory suspension against its former Director of Research, Douglas van Dorsten - for failing to disclose in a research report that the lead analyst on the report had accepted a job at Cadence Design Systems, a San Jose, CA company that was the subject of the report.

NASD also announced that it filed a complaint against Jennifer Jordan, the former Wells Fargo research analyst, for failing to disclose in a series of three research reports that she was pursuing employment and then had accepted a job with Cadence, which was the subject of all three reports. As part of her compensation package with Cadence, Jordan was to receive 15,000 shares of Cadence stock, along with the option to purchase an additional 75,000 shares, once she started working at Cadence.

NASD's disciplinary actions concern three research reports issued by Wells Fargo in February, March, and April of 2005. The subject of the research reports, Cadence, designs semi-conductors for use in the global electronics market. In each report, Jordan was listed as the lead analyst.

From Jan to Apr 2005, Jordan applied for, interviewed for, and then accepted a job at Cadence. On 4 Feb 2005, after Jordan had applied for a job at Cadence, Wells Fargo issued a research report covering Cadence that increased the price target for the company from US$16 per share to US$18 per share. The report did not disclose that Jordan had applied for a job at Cadence. On 2 Mar 2005 - after Jordan had met with Cadence senior management twice to interview for a job with the company - Wells Fargo issued a research report reiterating the $18 per share price target. That report did not disclose that Jordan had applied for a job at Cadence or that she was in employment discussions with the company.

After Wells Fargo issued the 2 Mar 2005 report, Jordan was offered a position at Cadence as Corporate Vice President of Investor Relations. As part of the offer, Cadence agreed to pay Jordan over US$300,000 in salary and bonuses, provide her with 15,000 shares of Cadence stock and an option to purchase 75,000 additional shares, and provide her a US$1m interest-free loan. Shortly after she accepted the offer on 9 Apr 2005, Jordan told van Dorsten and others at Wells Fargo that she had accepted a job at Cadence.

On 28 Apr 2005, Wells Fargo published another research report concerning Cadence. That report raised revenue estimates for Cadence for the second quarter of fiscal year 2005 and increased both revenue and price-per-share estimates for the company for fiscal years 2005 and 2006. On the morning the report was issued, Jordan flew to Cadence's offices to attend a management meeting as a future employee of the company.

Although Wells Fargo and van Dorsten had learned nearly three weeks prior to the 28 Apr report that Jordan had accepted a position at Cadence as Vice President of Investor Relations, that information was not disclosed in the report. In his position as Director of Research, van Dorsten approved the 28 Apr report without requiring that the report disclose that Jordan had accepted a position with Cadence.

Having learnt the lesson from this case, shall analysts be subject to a cool-off period for changing job to a previously covered company?

Fee-Based Acccount

Fees & charges for investment accounts are becoming more complicated in recent years as a result of versatility of products and services. If retail investors do not spend time to understand fees & charges thoroughly, they will pay a "premium" for relying on their service providers.

NASD recently fined Wachovia Securities LLC US$2 million for failing to adequately supervise its fee-based brokerage business between 2001 through 2004. In addition, NASD ordered Wachovia to identify and pay restitution to approximately 1,300 customers who were inappropriately allowed to continue maintaining fee-based accounts, or who were inappropriately charged account fees on Class A mutual fund share holdings for which they had already paid a sales load.

In fee-based brokerage accounts, customers are charged an annual fee that is either fixed or a percentage of the assets in the account, rather than a commission for each transaction, as in a traditional brokerage account.

Wachovia began offering a fee-based brokerage account, now called "Pilot Plus," to its customers in 1999. In 2001, Wachovia had just over 18,000 Pilot Plus customers who paid more than US$55 million in Pilot Plus fees. By the end of 2004, that number had grown to more than 41,000 customers who paid more than US$110 million in Pilot Plus fees.

During 2001 through 2004, while Wachovia informed its brokers that a Pilot Plus account was not appropriate for customers who made a limited number of trades, buy-and-hold customers, and customers with assets below US$50,000, it failed to put in place a system and procedures reasonably designed to determine whether Pilot Plus accounts were appropriate for its customers.

NASD's investigation revealed that 594 Wachovia customers, who conducted no trades in their Pilot Plus accounts for at least two consecutive years, paid the firm approximately US$1.9 million in fees. Also, 620 Pilot Plus customers held assets of less than US$25,000 for at least one full year and paid at least the minimum annual fee of US$1,000. This fee represented twice the firm's stated top rate of 2% allowed under the Pilot Plus agreement. During the time that these customers' eligible assets averaged below US$25,000 for at least one full year, they paid a total of about US$1m in Pilot Plus fees.

In addition, Wachovia failed to protect Pilot Plus customers from being assessed both an initial sales charge and an on-going asset-based fee on the purchases of Class A shares of mutual funds. Ordinarily, when a customer purchases Class A shares, the customer pays a front end sales charge or "load" at the time of purchase. Under Wachovia's procedures, customers who purchased Class A shares outside of a Pilot Plus account and paid a front end sales charge on the purchase were not allowed to transfer those shares into a Pilot Plus account for at least 13 months so as to avoid duplicative charges for the fund shares. But Wachovia failed to enforce these procedures. Consequently, Wachovia charged more than 110 customers both a load and Pilot Plus fees on the purchase of Class A shares.

Wachovia also failed to adequately supervise certain high revenue-producing brokers, who were members of the firm's "Red Carpet Club." The Red Carpet Club members were exempted from some of the firm's review and approval processes. Whereas most Pilot Plus accounts were opened only after review and approval by both a branch manager and a representative from the unit responsible for the oversight of all of the firm's fee-based programs, only branch manager approval was required for customers of Red Carpet Club members. This less vigorous review resulted in Red Carpet Club members opening Pilot Plus accounts for customers with total assets which were below the firm's stated US$50,000 minimum account balance. This resulted in Red Carpet Club members' customers constituting approximately 99% of those accounts in Pilot Plus that held less than US$25,000 in assets for at least one full year.

Additionally, two brokers, who were recruited from another firm and immediately became Red Carpet Club members, brought more than 340 of their customers to Wachovia and opened Pilot Plus accounts for them. In recommending Pilot Plus accounts to these customers, the two brokers incorrectly told them that Pilot Plus was an advisory account rather than a fee-based brokerage account. Wachovia failed to adequately supervise these brokers' communications with their customers. Moreover, once the firm discovered that these brokers had incorrectly described Pilot Plus as an advisory account, it failed to respond in a timely manner to correct the inaccurate representations made to these customers.

NASD also determined that Wachovia violated NASD rules governing communications with the public by providing its brokers with an optional letter they could send to customers which inaccurately stated at one point that Pilot Plus was "a fee-based, investment advisory service." In fact, Pilot Plus was not an advisory service or advisory account, which would be subject to a different regulatory regime, but was in fact a fee-based brokerage account.

The facts are complex but the lesson is simple: A firm's sales compliance standard was blinded by profit motive.

Wash Trade

SFC prosecuted Mr Li Kam Shing for creating a false and misleading appearance of active trading in the shares of Sino Technology Investments Ltd and for misleading SFC in its investigation. He pleaded guilty to six summonses at Eastern Magistracy. The Court adjourned sentencing to 28 Jun 2007 pending probation order and community service order suitability reports.

SFC investigation revealed that between Aug and Nov 2002, Li used four securities accounts with four different broker firms using the name Ms Wan Wai Chi Katherine to buy and sell his own shares in Sino Technology. These transactions did not involve any change of ownership of the shares because Li set up the transactions to ensure he traded with himself at all times through the four accounts. This kind of trading, which is called wash trading, manipulated the market for Sino Technology shares by inflating turnover and volume, and ultimately fixing an artificial price.

SFC investigation also revealed that Li had provided misleading information to an SFC investigator. He falsely denied during an interview with SFC that he knew Wan. SFC was ready to issue six summonses against Li in Feb 2005. At this point Li disappeared and proceedings could not be served on him. Li was believed to be in China. He was eventually tracked down in Apr 2007 after he opened a new mobile phone account in HK. SFC then issued the six summonses heard at Eastern Magistracy.

As stated by SFC, it would not give up pursuing offenders who think they can evade justice by leaving HK and returning when they think the coast is clear.

Overseas Hedge Fund Managers

In recent years, there have been more and more overseas hedge fund houses setting up their offices in HK. In many cases the funds managed by these firms are not marketed in HK but only distributed to overseas investors or professional investors (PIs). However, they are required to get a licence from SFC and observe SFC's licensing and conduct requirements. Given that they would not approach the HK retail investors, it seems unduly burdensome for them to comply with certain licensing requirements like local institutions.

Recently SFC issued a circular to provide guidance on a few licensing issues. This initiative was obviously made for encouraging more hedge fund managers to establish their businesses in HK.

Licensing exemption for providing intra-group investment advice

• Some overseas hedge funds managers only set up a research team in HK to provide securities advice to their group companies outside HK. In this case, they are exempt from licensing for Type 4 or 5 under SFO.

Streamlined licensing process for UK or US licensed hedge fund managers

• This is a privilege granted to players in more advanced securities markets. Firms licensed by SEC or FSA, with a good compliance track record and which serve only PIs, would benefit from an expedited licensing process.

Competence requirements for Responsible Officers (ROs)

• Each firm should appoint 2 ROs for each regulated activity and one of them should be always available. For overseas fund houses, some ROs may not be physically located at HK. SFC clarified that at least one RO should be based in HK and then at least another one is immediately contactable at all times by SFC and the HK office's staff.
• SFC would impose the "non-sole" condition on those ROs who have no direct hedge fund management experience.
• ROs may be exempt from taking the local regulatory exam if they have substantial industry experience and take a post-licensing refresher course on local regulations, given that the firm serves only PIs and confirm providing compliance support to the ROs. But in my experience would not easily be granted by SFC.

Office space

• Just like the previously issued FAQ, SFC softly reject the ideas of overseas firms for using business centres or serviced offices as business premises.

Connected Brokers

There is a potential conflict of interests when a securities firm has the discretion to direct client orders to its affiliated brokers. This issue is also compounded by the best execution problem.

NASD recently fined New York's HSBC Brokerage (HBI) $250,000 for failure to have adequate systems in place to supervise government securities transactions to ensure best execution.

In addition, the firm routed orders to HSBC Securities (HSI), an affiliated firm, without taking adequate steps to ensure that customers would not be harmed in the pricing of these securities. HBI's inability to provide documentary evidence of its supervisory review for best execution of trades inhibited NASD's ability to review transactions for best execution.

HBI's retail brokerage business was largely located in HSBC bank branches. To support the retail business, HBI operated a trading desk to handle orders that were placed by brokers who had direct contact with HBI's clients. One desk was devoted to filling orders for fixed income products. When a client order was placed, HBI required traders on the fixed income desk to call several broker-dealers on the "street" in an effort to get the best price for a client's transaction.

Toward the end of 2003, there were discussions between HBI and HSI about increasing business between the two affiliated firms and efforts were undertaken by HBI to increase its order flow to its institutional affiliate. In late 2003, HBI began to increase its order flow to HSI, and in May 2004, HBI directed its fixed income traders to route all government securities orders to HSI for execution. As a result, the dollar volume of U.S. Treasury transactions that HBI sent to HSI rose from approximately 24% in Oct 2003 to approximately 79% in Apr 2004, and to close to 100% from Jun through Dec 2004. While its traders were required to "shop" an order for a government securities transaction before placing it with the affiliate, HBI had inadequate systems to monitor this process by its traders.

NASD also found that while several HBI officers recognized the increased risk associated with directing all government securities orders to a single, affiliated broker-dealer, the firm failed to put reasonable policies and procedures in place to ensure that clients received best execution for these orders. The firm had minimal systems in place to supervise for best execution prior to May 2004, and no further steps were taken to monitor for best execution after the directive to send all customer orders to the affiliated firm.

HBI was unable to provide documentary evidence of supervisory review for best execution for any of the trades requested by NASD as part of its review. This, combined with the fact that the firm did not have a system for recording competitive bids, severely limited NASD's ability to review transactions for best execution. NASD identified several transactions in which the firm violated its best execution obligations, but the firm lacked the records needed for a thorough best execution review.

Disqualification of Director

Though the process of codifying certain provisions in Listing Rules is yet to be finished, SFC is not a teethless tiger. Under S.214 of SFO, SFC may make an application to the Court where it appears that the business or affairs of a listed company have been conducted in a manner that:

1. is oppressive to the shareholders;
2. involves defalcation, fraud, misfeasance or misconduct towards the listed company or its shareholders;
3. results in shareholders not receiving all the information with respect to its affairs or business that they might reasonably expect; or
4. is unfairly prejudicial to the shareholders.

Last week SFC obtained orders in the High Court against Mr Yick Chong San, a former director and CFO of Riverhill Holdings Ltd, a company previously listed on GEM. The orders disqualify Yick from being a director or involved in the management of any listed company, subsidiary or affiliate, without the leave of the Court, for 4 years.

This is the first time SFC has applied to the High Court seeking a disqualification order based on misfeasance or misconduct.

SFC’s allegations concerned a decision by Yick to pledge $10m of Riverhill’s money (raised by Riverhill in the IPO) to secure a loan for a third party. This was a misuse of the funds because it was contrary to representations made in Riverhill’s prospectus and no information was given to shareholders about any changes in the use of the IPO funds.Yick failed to take proper skill and care in entering into the deal and did not ensure the company’s funds were recoverable or properly secured on commercial terms. The third party defaulted on the loan and Riverhill lost the entire $10m reducing its net asset value by more than 20%.

There were also similar breaches in relation to unsecured loans totalling about $25 million authorised by Yick to employees of Riverhill and other third parties, again not disclosed to shareholders. The moneys loaned to the employees were used to open accounts with brokers through which Yick then directed trading in securities for Riverhill.

Given the seriousness of the above misconduct, I don't think the disqualification order is sufficient to create a deterrent effect.

Relevant Individual Suspended by HKMA

A couple of years ago the Banking Ordinance was amended to empowered HKMA to disclose details of disciplinary action taken against securities staff of banks. But in many cases disciplinary action was not taken because the concerned individuals had left the banking industry. This week HKMA issued the first press release (in a similar style to SFC's) about its enforcement action against a relevant individual.

HKMA has suspended all the particulars of Ms Chu Lai Kwan, a relevant individual employed by Hang Seng Bank, from the register maintained by the HKMA under S.20 of Banking Ordinance for one month from 5 Jun 2007 to 4 Jul 2007 for her concealment of her securities trading from her employer.

It was found that Chu conducted joint securities trading with her colleague through the accounts of a client and another colleague with her employer during the period from 2 April 2003 to 30 April 2004. She failed to declare her beneficial interests in these two accounts in accordance with the requirements of the staff dealing policy of her employer. She therefore breached SFC's Code of Conduct and was guilty of dishonesty and misconduct.

HKMA also disclosed that Ms Chu took the initiative to report her concealed securities trading activities to the Internal Audit (not Compliance?) of her employer during its investigation of a complaint (about what?).

I expect HKMA will announce more enforcement actions against relevant individuals in future. Although over the past years some securities staff of banks attempted to avoid HKMA's disciplinary action by jumping from banking industry to securities industry, HKMA could share their "bad records" with SFC.

2nd SFC Report on Investment Advisers

In 2004 SFC conducted the first round of thematic inspection on the selling practices of investment advisers (IAs) and issued a report of findings. Last week SFC issued a further report for its second round of such inspection.

Overall speaking, the deficiencies identified from those IAs in both rounds of inspections are similar, e.g. KYC, product due diligence, suitability, management supervision, documentation and management supervision. Investigation has commenced on some cases with more serious breaches of SFC regulations.

I just want to highlight the following more interesting issues / findings from the report:

• Clients were allowed to select all the available investment objectives, from "capital preservation" to "aggressive growth". They even selected "others" without giving further description. Sales staff failed to follow up on such inconsistency.
• When distributing an unauthorized CIS, the IA failed to spot the inconsistencies between OM and marketing materials. For example, marketing materials specified that the CIS is principal-protected although there was no such statement in OM.
• A retiree indicated in the client profile form that his investment objective as security of capital but subsequently switched his portfolio to higher risk funds (e.g. energy funds) without justification on the file.
• A client disclosed in the profile form a monthly income of $12k and personal net worth of $80m but was advised to invest a lump sum of $120k. No rationale for such advice was given.
• Investors signed off on confirmation forms that their advisers did not offer them advice but only carried out their orders. Of course this was not the fact.
• Most of the IAs do not disclose to clients the remuneration they receive from product providers. SFC is currently reviewing this issue and may consult the market on disclosure.
• A salesperson simply put down the words "good product" as the reason for recommending a fund to a client who did not indicate his risk attitude in the profile form.
• When reviewing the recommendations made by their sales staff, the management might not always detect and follow up on glaring exceptions and mismatches even though the had signed off for approving the recommendations.
• One firm had ignored the licensing condition that restricted it to only advise on funds and advised its clients on investing in equity linked financial instruments.

Misleading Sales Literature

Without sufficient investment knowledge, many retail investors are easily cheated by misleading sales literature. The risk is even higher If they do not spend time to study the stuff and ask the right questions.

NASD recently fined two Fidelity broker-dealers $400,000 for preparing and distributing misleading sales literature promoting Fidelity's Destiny I and II Systematic Investment Plans, which were sold primarily to U.S. military personnel.

Issuance and sales of new systematic investment plans (also known as periodic payment plans), which typically require investors to make a fixed number of monthly payments over a 10- to 15-year period, were prohibited by Congress last fall. Previously sold plans remain in force.

NASD found that the two broker-dealers violated NASD advertising rules by preparing and distributing various pieces of misleading sales literature. For instance, from May 2003 through Jan 2006, the Fidelity broker-dealers prepared and distributed a brochure entitled "Time is Money" that included misleading performance claims about the Destiny Plans. According to "mountain charts" contained in the brochures, Destiny Plans significantly outperformed the S&P 500 Index over a 30-year period. But during the most recent 10- and 15-year periods - the time frame most relevant to current and prospective investors - Destiny Plans substantially underperformed the S&P 500 Index. The 30-year time period masked the underperformance of the Destiny Plans over the most recent 15 years.

The brochures also showed Destiny Plans' average annual total returns for 1, 5 and 10 years as well as the life of the Plan, without showing comparable returns for the S&P 500 Index. Again, this created the misleading impression that Destiny outperformed the S&P 500 Index throughout the periods shown. The comparable S&P 500 Index average annual total returns would have shown that the S&P 500 Index significantly outperformed Destiny during the more current time periods.

Finally, the broker-dealers used the performance of Destiny Plan Class O shares in these charts, when new Plan investors could only purchase Class N shares. Class N shares did not perform as well as Class O shares because of higher ongoing expenses. The broker-dealers prepared and sent over 10,000 copies of these brochures to Destiny retail brokers or their registered representatives to use them with both prospective investors as well as current Plan holders.

NASD also found that in May 2003, the Fidelity broker-dealers prepared and distributed a misleading Destiny newsletter to over 325,000 Destiny Plan holders. The newsletter included a mountain chart showing Destiny I Plan performance. While the chart showed Plan performance, Fidelity disclosed the average annual total returns for the underlying mutual fund portfolio, rather than for the Plan. Because Plan holders paid a 50 percent upfront sales charge on each of the first year's payments and a continuing sales charge on each additional payment until plan payments were completed, the average annual total returns for the Plans were significantly lower than that of the underlying funds.

Fidelity did not adequately supervise the review of this Destiny sales literature in light of the unusual features of the Destiny products.

As part of the settlement, for the next five years, the two broker-dealers are required to notify Destiny Plan holders who want to increase their investments in existing Destiny Plans that additional shares of the underlying fund can be purchased outside the Destiny Plans without paying the additional creation and sales charges of up to 50% on the first year's payments.

Unauthorized Portfolio Management

In HK, there have been enforcement cases against financial consultants who mis-advised clients of frequent fund switching. The situation would be even worse if such switching activities are not authorized by clients.

FSA fined Charterhouse Consulting Wealth Management Ltd £122,500 for carrying out discretionary portfolio management without permission and for various conduct of business failings.

Charterhouse regularly switched a number of clients between funds although the firm did not have permission to operate in this way. It would often send clients an email before 6.30am in the morning proposing the switching of funds and requiring a response by 8.00 am. Switches would then take place without any further instruction from the client.

Charterhouse also failed to:

• record sufficient client information to demonstrate the suitability of its advice;
• ensure transactions were appropriate for its customers' attitude to risk; and
• communicate with its clients in a clear, fair and not misleading manner.

Charterhousethe has taken mitigating steps to regularize its business activities which included the cessation of business activities falling outside its permitted activities. As a result of agreeing to settle at the earliest opportunity Charterhouse has received the maximum 30%, discount afforded under FSA's "Discount Scheme". The fine would otherwise have been £175,000.

Anti-Fraud Controls of Private Bank

Private banking has long been perceived as a high risk area. Inherent risk (client profile, transaction nature, etc.) is one thing, control risk (lack of management oversight, inadequate procedures, etc.) is another thing.

FSA recently fined BNP Paribas Private Bank (BNPP Private Bank) £350,000 for weaknesses in its systems and controls which allowed a senior employee to fraudulently transfer £1.4 million out of clients' accounts without permission.

This is the first time a private bank has been fined for weaknesses in its anti-fraud systems. The 13 fraudulent transactions were carried out between Feb 2002 and Mar 2005 using forged clients' signatures and instructions and by falsifying change of address documents.

During its investigation, FSA found that BNPP Private Bank did not have an effective review process for large transactions, over £10,000, from clients' accounts. The bank's procedures were not clear about the role of senior management in checking significant transfers prior to payment. As a result, a number of fraudulent transactions were not independently checked.

In addition, a flaw in the bank's IT system allowed the senior employee to evade the normal Middle Office processes. This meant that basic authorisation and signatory checks were not carried out on internal cash transfers between different customer accounts.

The bank's failings were serious because they enabled significant fraud to take place and failed to detect subsequent transfers to cover it up for a long period of time. It also failed to improve its procedures for monitoring large transactions or carry out remedial action on a timely basis. This was despite the bank being aware that certain of its procedures required improvement as a result of an FSA visit in relation to money laundering systems and controls in Aug 2002 and subsequent internal reviews.

Best Execution

In SFC's Code of Conduct, "best execution" means when acting for or with clients, the intermediary should execute client orders on the best available terms. In actual world, under what circumstances would this principle be violated?

Last week SEC settled fraud charges against Morgan Stanley & Co. Inc. for its failure to provide best execution to certain retail orders for OTC securities. In particular, Morgan Stanley embedded undisclosed mark-ups and mark-downs on certain retail OTC orders processed by its automated market-making system and delayed the execution of other retail OTC orders, for which Morgan Stanley had an obligation to execute without hesitation.

Morgan Stanley will pay around US$7.9m in disgorgement and penalties to settle SEC's charges. All of Morgan Stanley's revenue from its undisclosed mark-ups and mark-downs will be distributed back to the injured investors through a distribution plan.

From Oct 2001 through Dec 2004, Morgan Stanley failed to obtain best execution for certain orders for OTC securities placed by retail customers of Morgan Stanley, Morgan Stanley DW, Inc. and third party broker-dealers that routed orders to Morgan Stanley for execution. As a result of this conduct, Morgan Stanley breached its duty of best execution with respect to these retail customers' orders.

Morgan Stanley failed to provide best execution to more than 1.2 million executions valued at approximately US$8 billion. Morgan Stanley recognized revenue of $5,949,222 through its improper use of undisclosed mark-ups and mark-downs. As stated by SEC, Morgan Stanley was recklessly programming its order execution system to receive amounts that should have gone to retail customers.