Gatekeeper Approach

Regulation of hedge funds remains a controversial issue. Since investors of hedge funds are typically at non-retail level, direct regulation of hedge funds may not be appropriate. However, no regulation is also not desirable as hedge funds pose systemic risk to the markets.

Hennessee Group, an adviser to hedge fund investors, released its opinion recently on how to improve hedge fund investors’ protection and reduce systemic risk related to hedge funds. It supports recent SEC action to increase the accredited investor level and recommends further considerations related to “gatekeepers”.

Despite the recent decision not to directly regulate hedge funds, proactive indirect monitoring through coordination with “gatekeepers”, including prime brokers, accountants, administrators, investment banks and commercial banks (many of which are already under regulatory oversight or influence), can be a cost-effective alternative.

According to Hennessee Group research:

• The largest 100 hedge funds account for more than 50% of the industry’s total assets and pose the greatest threat to systemic risk.
• Over 90% of U.S. hedge funds currently utilize one of 10 prime brokers who are registered broker dealers and regulated by the SEC and NASD. Information about leverage and concentration can be gathered from this source.
• Over 90% of all U.S. hedge funds use one of six accounting firms to perform annual financial audits, and more than half of U.S. offshore hedge funds currently use one of the top five administrators. The uncertainties about the size of the hedge fund industry (in assets and leverage) can be answered by polling these accounting firms.

Hennessee Group concluded that by capturing information from the gatekeepers, regulatory authorities and government agencies can gain transparency into the hedge fund industry in a cost-effective and timely manner without inhibiting the entrepreneurial spirit of the industry that provides liquidity, contrarian research and pricing efficiency to the markets.

However, when hedge funds are distributed at retail level, a mix of direct supervision and gatekeeper approach would become necessary. Yesterday FSA set out proposals that would allow UK retail consumers to invest in funds of hedge funds and other alternative investments sold by firms authorised in UK. A key element in FSA's approach is its expectation that the fund manager will operate with "due diligence". FSA has accompanied the Consultation Paper with a case study illustrating the respective responsibilities of providers and distributors of these products.

Illegal Trading of Self-Service Customers

In recent years there are securities firms providing their customers with some direct market access platforms which enable brokers to execute larger volumes of trades more quickly and efficiently for their customers. However, direct access does not obviate a broker's own responsibilities to detect and prevent illegal trading by its customers.

SEC and NYSE recently settled separate enforcement proceedings against a prime broker and clearing affiliate of Goldman Sachs Group for its violations arising from in an illegal trading scheme carried out by customers through their accounts at the firm.

Both proceedings find Goldman's customers carried out the illegal short-selling scheme by placing their orders to sell through the firm's REDI System© - Goldman's direct market access, automated trading system - and falsely marking the orders "long". Relying solely on the way its customers marked their orders, Goldman executed the transactions as long sales.

In addition, because the customers had sold the securities short and did not have the securities at settlement date, Goldman delivered borrowed and proprietary securities to the brokers for the purchasers to settle the customers' purported "long" sales. Obviously Goldman's exclusive reliance on its customers' representations that they owned the offered securities was unreasonable.

For more than two years, beginning in March 2000, the customers' pattern of trading and Goldman's own records reflected that they were selling the securities short. The customers did not deliver to Goldman in time for settlement the securities they purported to sell long, but rather, had to borrow the securities from Goldman to settle all of their sales.

Goldman's records also reflected that its customers covered their short positions with securities purchased in follow-on and secondary offerings after executing their sales. Had Goldman instituted and maintained procedures reasonably designed to detect these significant trading disparities, it could have discovered the pattern of unlawful trades by its customers.

This case clearly indicated that a broker can't turn a blind eye to the "self-service" trading of customers.

Equity Research

In the past few years, compliance controls over equity research has been strengthened as a result of enhanced regulatory standards. Beforehand, we can find many cases where research integrity is compromised by conflicts of interest. Last week SEC settled enforcement action against Banc of America Securities LLC (BAS) for failing to safeguard its forthcoming research reports and for issuing fraudulent research.

During 1999 through 2001, in breach of the firm's stated policies, BAS sales and trading employees were on multiple occasions able to obtain access to forthcoming BAS research (including analyst upgrades and downgrades) before the public release. BAS failed to track the actual release times and monitor for potential misuse of such information.

Prior to mid-1999, BAS traders received advance access to material non-public research information but were prohibited to establish or accumulate proprietary positions while unreleased research information were pending. Subsequently BAS erected an information wall between research and trading departments and thus allow BAS traders to trade notwithstanding that research changes were pending. However the above breakdown of research dissemination lead to "front-running" by the proprietary traders.

In BAS, there was a Marketing Director who acted as a "sounding board" for the firm's analysts (therefore in possession of material non-public information concerning forthcoming research), liaised with sales department and regularly provided trading advice to the traders. BAS knew that he was one of the most active personal traders at the firm but failed to address the conflicts created by his multiple roles.

Also during 1999 through 2001, BAS intertwined research with investment banking and rewarded analysts for their support of investment banking activities. By compromising independence and objectivity, the firm's analysts published research reports on three companies (Intel, TelCom and E-Stamp) that did not reflect their true views.

Each BAS research report included an investment rating. In early 1999, BAS utilized a three-tier rating system of Buy, Hold and Sell. In mid-1999, BAS changed to a five-tier system of Strong Buy, Buy, Market Perform, Underperform and Sell. During 1999 through 2001, BAS analysts rarely rated companies an Underperform and almost never a Sell, in part to avoid aggravating current or prospective investment banking clients.

Don't you think the above story you are so familiar with? Yes, of course, the same story happened in so many firms during 1999 through 2001.

Hedge Fund Portfolio Valuation

Valuation of hedge fund portfolios has become a hot topic in the international regulatory platform. Last week IOSCO published a consultation paper which proposes nine principles to ensure that hedge funds' financial instruments are appropriately valued and these values are not distorted to the disadvantage of fund investors.

The drivers of IOSCO's focus on hedge fund portfolio valuation:

• Increasing importance of hedge funds to global capital markets
• Complexity of certain hedge fund portfolio strategies and their underlying complex & illiquid instruments
• Central role of financial instrument valuations to hedge funds' NAV pricing & performance presentation
• Conflicts of interest arising from fund managers' active role in the valuation process
• Different structures & governance systems of hedge funds organized in different jurisdictions

The nine principles mentioned in IOSCO's paper are quite high level and stereotypical:

1. Documented valuation policies & procedures
2. Identificatio of valuation methodologies
3. Consistency of valuation
4. Periodic review of policies & procedures
5. Independent application and review of policies & procedures
6. Independent review of individual values (in particular those influnced by the fund managers)
7. Independent review of price overrides
8. Initial & periodic due diligence on third parties providing valuation services
9. Transparency of valuation to investors

Since valuation of complex & illiquid instruments is readily and objectively ascertainable, the regulators are concerned with abuse of the valuation process by the fund managers. I think the most difficult issue not addressed in IOSCO's paper is whether qualified and independent "valuation experts" are adequately available. Academics and industry practitioners should work together to develop more well recognized valuation models.

Business Premises

Last week SFC released a FAQ about business premises. The question is whether SFC allows licensed firms to carry out their business in business centres or shared offices.

This is an interesting question. I immediately recalled S.130 of SFO regarding suitability of business premises. SFC replied that in general the firm should satisfy itself that the premises are reasonably secure and that confidential / non-public information (such as price sensitive information) and client privacy will be sufficiently safeguarded against unauthorized access or leakage.

SFC further specified the following factors suggesting that the premises are not suitable for a firm’s business:

• There does not exist any secured and properly segregated office area (under lock), which is designated for the corporation’s own use.
• Its essential office equipment and telecommunication systems are not situated within an enclosed area accessible only by its staff and authorized personnel.
• No or insufficient actions / measures are taken to prevent confusion to its clients that might be caused by the co-existence of other corporations in the same premises.
• The nature of business of the firm demands frequent face-to-face dealings / meetings with clients at the premises where clients’ information and instructions will be exchanged and there are practical difficulties for the firm to preserve secrecy in respect of clients’ information.
• The firm has not ensured that its office premises will always be accessible for all regulatory visits and investigatory searches conducted under the law.

I think the above list of unsuitable factors in substance prohibit the use of business centres or shared offices.

Wall Street Professionals

Are you dreaming of become a Wall Street professional earning high salaries and bonuses? What do you think if in reality some of them are even more greedy and shameless than you can imagine?

SEC recently charged 14 defendants in an insider trading scheme that netted US$15m on thousands of illegal trades, using information stolen from UBS and Morgan Stanley.

UBS

Mitchel Guttenberg, an ED in UBS research department, provided material non-public information about upcoming UBS analyst upgrades and downgrades to two traders Eric Franklin and David Tavdy in exchange for sharing in the illicit profits from their trading on that information personally, for the hedge funds Franklin managed, and for the registered broker-dealers where Tavdy was a trader.

The traders had a network of downstream tippees, including another hedge fund, a day-trading firm and three registered representatives at Bear Stearns. Such illegal activities are hid through a clandestine meeting at Manhattan's famed Oyster Bar and eventually the use of disposable cell phones, secret codes and cash kickbacks.

Morgan Stanley

Randi Collotta, an attorney in Morgan Stanley's global compliance department, together with her husband Christopher Collotta (an attorney in private practice), provided material non-public information about upcoming corporate acquisitions involving Morgan Stanley's investment bank clients to Marc Jurman, a registered representative at a Florida broker-dealer. Jurman traded on that information and share his illicit profits with the Collottas.

Jurman also tipped Robert Babcock, a registered representative at Bear Stearns, who traded on that information and tipped Franklin, a hedge fund managed by Franklin, and another registered representative at Bear Stearns.


SEC made very severe comments on this insider trading scheme and stated that "we will do everything possible to make sure that, in addition to any other remedies or sanctions imposed, none of these individuals ever works in the securities industry again".

I am quite curious how SEC can unravel this scheme. Did they send a secret agent 007 to UBS and Morgan Stanley?

Investment Advisory Activities of Banks

HKMA has recently completed a thematic exam of investment advisory activities of both retail and private banks. This exercise was done concurrently with SFC's inspections on its licensed investment advisers.

Overall, all banks examined had implemented the baseline control requirements. The following issues, largely expected, were identified:

Retail Bank

• Information on clients' investment experience by types of products was not kept in written form.
• No specific procedures were put in place to require frontline staff to properly compare investment horizons of clients and the product tenors.

Private Bank

• Only product term sheets of mutual funds were provided to clients. Prospectuses and annual reports were only provided upon client request.
• No formal procedures were carried out to classify clients as professional investors (PI).
• No central log for keeping track of sale of unauthorized investment products to PI clients was maintained.
• No regular compliance reviews on investment advisory activities were performed.

On the other hand, certain "good practices" of banks were also highlighted in HKMA's findings:

• A risk tolerance level was assigned to each client for matching against product risk ratings.
• Specific criteria for classifying clients into "vulnerable clients" (e.g. elderly) subject to special handling procedure were established.
• Specific MIS reports to detect potential mis-selling were generated for management review.
• Mystery shopping inspections and post-transaction surveys were conducted.
• Formal sales compliance checklists were established for frontline staff.
• Frontline staff were required to pass an internal competence test on an annual basis.

Compared with five years ago, the investment sales compliance procedures of banks have substantially improved. Look forward to reading SFC's report on its second round theme inspections.

Listing Rules with Teeth

Following a lengthy consultation process, SFC eventually concluded on the proposals to extend the market misconduct regime to cover breaches of new statutory listing requirements.

The listing requirements which will be removed from SEHK's Listing Rules to the subsidiary legislation under SFO comprise:

• Periodic financial reporting
• Disclosure of price sensitive information
• Notifiable and connected transactions which require shareholders' approval

In balancing legal certainty against flexibility, SFC has taken a revised approach to address the market concerns that a breach of minor detailed requirements might attract statutory sanctions. SFC's revised approach is actually a principles-based approach with the following features:

• A set of general principles enshrined in SFO
• A new schedule to SFO to explain the general principles, including the definitions and factors in determining compliance
• A non-statutory Listing Code to set out the detailed and technical provisions

Non-compliance with the general principles will then be regarded as market misconduct. Serious cases are subject to either SFC disciplinary action, MMT proceedings or criminal prosecutions. Non-compliance with relatively detailed and technical provisions would not of itself lead to enforcement action, but may be of evidential value in any proceedings for a breach of general principles.

Certain administrative arrangements to facilitate a smooth transition to the new regime are mentioned in the Consultation Conclusions:

• Grant of statutory waivers under SFO
• Issue of rulings on interpretation which will be binding on SFC
• Provision of informal consultation on a non-binding basis in order to assist compliance
• Pre-vetting of announcements and circulars on a voluntary basis
• Publication of written rulings and waivers to enhance transparency of decisions and provide guidance to the market

Overall, I think SFC's revised approach to giving statutory backing to major listing requirements are quite considerate and flexible. Unfortunately, such a user-friendly approach is not extended to the intermediary supervision regime!

Self-Supervision

How can you believe that self-supervision can effectively detect and prevent malpractices?

NASD recently fined Raymond James Financial Services, Inc. (RJFS) US$2.75m for failing to maintain an adequate supervisory system to oversee the sales activities of its branch managers. In a related action, NASD permanently barred one of those branch managers for making unsuitable sales recommendations and misleading statements.

From early 2000 to Sep 2004, RJFS employed over 1,100 branch managers, most of whom worked in small, geographically dispersed offices. These branch managers were allowed to act as the primary supervisors of their own business activities. They approved their own transactions, opened and accepted new accounts, and reviewed their own correspondence.

RJFS relied on an electronic transaction surveillance system maintained by its Compliance Department, and a series of exception reports, to flag transactions that required further review. It also assigned supervisory responsibility for these 1,100 branch managers to three sales managers. The activities commonly associated with daily supervision, however, were conducted by the branch managers, who in many cases, in effect, supervised themselves. By permitting these principals to engage in self-supervision, RJFS's supervisory system was not reasonably designed to achieve compliance with securities rules and regulations.

Donna Vogt was one of those branch managers and the only registered person working in her office in Wisconsin. She maintained hundreds of customer accounts and sold mainly mutual funds and variable annuities. Many of her customers were of retirement age or older. In determining which products to recommend, Vogt treated her customers as a homogeneous group, regardless of age, financial status, investment experience and objectives. Of her approximately 700 accounts, more than 90% listed their primary investment objective as "growth" and risk tolerance as "medium". RJFS never questioned the fact that Vogt listed these objectives and strategies for almost all of her customers. In fact, the person who reviewed and accepted the customer account documents was Vogt herself.

Vogt recommended unsuitable purchases and concentrations of aggressive mutual funds and variable annuities to at least five customers who were elderly, retired or nearing retirement. These transactions were unsuitable due to the over-concentration in aggressive growth funds, and because access to their funds was limited by the variable annuity surrender charges.

RJFS failed to detect or prevent these unsuitable transactions by Vogt for approximately four years. The firm also failed to prevent Vogt from sending misleading communications to some of her customers, in part because the firm allowed all of its branch managers, including Vogt, to review their own incoming and outgoing correspondence.

RJFS's Compliance Department screened variable annuity purchases using only three exception reports which did not screen transactions for suitability based on customer net worth, annual income, investment experience or concentration of variable annuity holdings as a percentage of net worth. In addition, there was no system in place at the firm for reviewing the suitability of variable annuity sub-account transactions recommended by branch managers, nor was there any system for ensuring that a record of sub-account recommendations and transactions was maintained.

In HK, many financial planners are working like self-employed persons. Remote control of their sales activities is more difficult, especially if the supervisory system is too lax.