Compliance Consultants

While small financial firms may not afford employing a full-time compliance officer, appointment of a compliance consultant sounds like a feasible solution. However, in HK usually the senior management of small firms prefer performing compliance by themselves or asking the ops / admin staff to double up this function rather than looking for an external consultant. Given that compliance is a professional job, reliance on part-time or inadequately trained staff to take it up is quite risky.

FSA recently issued a factsheet about using a compliance consultant for small personal investment, mortgage and general insurance firms. The following key messages are conveyed:

• The firm's compliance responsibility would not be "contracted out" by using the consultant.
• The compliance needs should be established in order to identify the right services (e.g. risk assessment, setting up procedures, training, etc.) from the consultant.
• Qualifications, experience and service standards of potential consultants should be assessed to ensure that they can meet the firm's needs.
• The firm should act on the recommendations made by the consultant.

FSA carried out work in late 2006 and early 2007 to see if, and how, compliance consultants were used in small mortgage, general insurance and financial advice firms. The project also looked into whether the firms that did use consultants used them effectively.

In particular FSA visited 22 small firms employing compliance consultants in early 2007 and found nearly half of them still had significant weaknesses in respect of their regulatory requirements. The work also showed over a third of these firms were not acting on recommendations from their consultants that would have improved their regulatory position.

Does this survey indicate that small firms have only employed compliance consultants for "window dressing" instead of protecting them against regulatory risk?

Commodities Markets

Last month FSA published a paper titled "Growth in Commodity Investment: risks and challenges posed for commodity market participants". After examining the recent growth in investment in commodity markets, the paper concludes that "markets have changed significantly bringing new issues which need to be understood and acted upon by participants". But how have markets changed?

The recent growth in commodity markets with record prices, high volatility, and the high returns to be gained have attracted a wave of new investors and firms into what was previously viewed as a specialist market. These new entrants include hedge funds, pension funds, high net worth individuals and even a small number of retail investors. The level of funds being invested is expected to grow and, unlike previous cycles, to remain. This has given rise to a number of risks and challenges for both established and newly arrived participants.

FSA as part of its oversight of commodity markets regulates both participant firms and infrastructure providers. In its assessment of the impact of the growth in the market, FSA has identified the risks and challenges facing the regulated community as including:

• Lack of skilled and experienced staff
• Insufficient system capacity to cope with large trading volume
• Failure to put apppropriate risk management systems and procedures in place
• No sharing of knowledge between new participants and traditional participants
• Deficient monitoring of market abuse

Although direct investment by retail investors is limited at present, financial firms are responding to growing consumer interest by developing products which will allow individuals to gain an element of exposure to commodity markets. These changes combined with a shortage of financial services professionals who understand the market could result in consumers buying products they don't fully understand. Indirect exposure of retail investors is also increasing through pension fund investment.

HK Government is also studying the feasibility to develop the commodities market. The above-mentioned risks and challenges should also form part of its agenda.

P.S. SFC has recently released a FAQ on commodities futures / commodities index funds.

Lying to SFC

Provision of false or misleading to SFC during its investigation is a serious offence under S.184 of SFO, but yet some market professionals have recklessly taken this risk.

Last year SFC revoked the licence of Mr Ng Ting Shag and banned him from re-entering the industry for life for stealing clients’ securities, giving false information to the SFC and conspiring to pervert the course of public justice.

Ng admitted that he had stolen his clients’ securities by forging their signatures on transfer forms, or using transfer forms pre-signed by the clients. On one occasion, Ng concealed the theft by giving forged copies of share certificates to his client and retaining the original certificates to facilitate the misappropriation.

Ng further admitted that he had conspired with another person to induce a complainant to withdraw her complaints against him and lie to the SFC during its enquiries.

During SFC’s investigation, Ng was represented by a solicitor, Ms Ha Pon Lin, Emily. As the investigation progressed, SFC became suspicious that Ha and Ng had invented a story and lied to cover up the suspected thefts. Subsequently SFC referred the case to ICAC.

In criminal proceedings brought by ICAC, Ha was convicted on one count of conspiracy to pervert the course of justice and sentenced today to 12 months' imprisonment. Ng was also convicted on one count of conspiracy to pervert the course of justice and several counts of theft and sentenced to 14 months' imprisonment.

How come a solicitor could be so unwise to act like this?

Illegal Share Offer

Under S.103 of SFO, it is illegal to advertise an offer to acquire or dispose shares in HK, unless you are subject to certain specified exemptions (e.g. you are a Type 1/4/6 intermediary). In the past there were people prosecuted by SFC for making such illegal offers via newspapers or other mass media.

On 13 Nov 2006, an Australian company Empowernet International Ltd published an advertisement in SCMP offering its shares for sale to investors in Hong Kong. No prospectus was registered with SFC for the offer nor was the advertisement authorised by SFC.

SFC investigated the matter and found that no Hong Kong investor had accepted the offer. Upon SFC’s request, the company had retracted the offer and undertaken not to offer any shares to investors in HK. It has also published a correction in SCMP on 12 Apr 2007.

As explained by SFC, given the steps taken by the company to rectify the matter and that there was no harm or damage caused to investors, SFC will take no further action. I think if SFC would probably prosecute this company if it was within HK's jurisdiction.

For curiosity, I checked with websites and found that Empowernet International is going to be listed on ASX. Interestingly, it is a provider of personal development seminars and associated products and services based upon intellectual property produced by the famous motivational speaker Anthony Robbins!

Unliensed Securities Business of Bank

Over the past couple of years, we had witnessed enforcement cases of SFC in cooperation with HKMA against unlicensed dealing of staff in two banks, namely, Wing Lung Bank and DBS Bank (HK). However, in none of these cases the concerned bank was disciplined. The latest case published by SFC about ICICI Bank is somewhat special.

According to its website, ICICI Bank is India's second largest bank. It is a HKMA licensed bank but not a SFC registered institution. SFC has prosecuted ICICI Bank and several senior officers of the bank for carrying on a securities business and dealing in securities without an SFC licence.

ICICI Bank established a securities business in HK through some of its employees in approximately Jun 2004, selling securities and unauthorised investment products to HK investing public. The unlicensed business was then carried on by ICICI Bank since Oct 2005 until it was detected by HKMA and referred to SFC for investigation in Mar 2006.

SFC has also prosecuted ICICI Bank's former CEO and its former Head of Private Banking, for aiding and abetting the bank in carrying on the unlicensed securities business. Five current and former staff have also been charged by the SFC with unlicensed dealing in securities. ICICI Bank and four staff were fined and ordered to pay the investigation costs.

I know that ICICI Bank was granted the banking licence by HKMA in Oct 2005. If the Bank established the securities business in Jun 2004, I wonder if it had also engaged in unlicensed banking business before Oct 2005.

In recent years, more and more financial institutions (banks and non-banks) from emerging markets have established their business in HK. Without conducting a sufficient research into HK's regulatory regime, they are indeed running a high risk of breaching the law.

P.S. I heard from a source that last year this bank had urgently looked for a compliance officer. Hopefully nobody has joined this "pirate ship"!

Selective Disclosure by Analyst

We've heard about cases where senior management of listed companies selectively disclosed non-public material information to equity analysts. The same kind of misconduct would also be done by analysts.

FSA recently fined Roberto Casoni, a former equity analyst, £52,500 for deliberately disclosing his valuation methodology, his recommendation and target price to external parties prior to research publication.

Casoni was a research analyst for Citigroup's Global Equity Research (Citigroup) in London, where he was head of the Italian small-mid cap team whose areas of coverage included the Italian leasing sector.

During late 2005 Casoni became interested in the Italian leasing and factoring bank, Banca Italease (BI). By Jan 2006 he was considering using a different method to that normally used to value companies in the Italian leasing sector to value BI.

On 9 Jan Casoni began the internal Citigroup process of arranging for Citigroup's Stock Steering Committee (SSC) to consider his publication of research on BI with an intended publication date of 20 Jan. His draft report showing a target price of €35 was circulated to the SSC on 18 Jan and at a meeting at 10am on 20 Jan was cleared for publication.

Citigroup initiated coverage on BI on Monday 23 Jan at 5:40pm with a buy recommendation, with medium risk and a target price of €39 per share (BI had been trading at €25.70).

In the period between beginning the process for gaining approval for his research and its publication, Casoni was in contact with a number of clients about different elements of his research:

• On 12 Jan he emailed a fund manager at Firm B, who held a large position in BI stock, saying "Itaplease a bomb". This contact continued and included Casoni inviting him to consider his model for BI and discussed his valuation methodology with the client on 16 Jan and later meeting with and showing the client a copy of his research on 20 Jan following its approval that morning;
• On 13 Jan he contacted one fund manager client at Firm A by email discussing some of his analysis and followed this up with an email on 23 Jan, following approval of his research, but ahead of publication, saying that "Banca Italease is still a strong buy, I initiate tomorrow with a +50 pc upside;
• On 13 Jan he emailed a draft spreadsheet of the valuation model for BI to a fund manager at Firm C who was knowledgeable about BI and they compared valuation models;
• On 16 January emailed the draft spreadsheet to a fund manager at Firm D, this contained a valuation and his valuation methodology.

By engaging in the above contacts, Casoni allowed the recipients the opportunity to pre-empt the conclusions of the published research ahead of the rest of the market. However, none of the recipients of Casoni's information traded in the shares of BI as a result of having received it! (Oh really?)

Viatical Settlement

Several years ago SFC began to raise the public awareness of an exotic product "viatical settlement" (保單貼現) when it was not yet commonly sold in HK.

A viatical settlement is a contractual arrangement under which the holder of a life insurance policy sells the rights to the death benefit under the policy to a viatical provider. The viatical provider in turn sells the death benefit from the discounted life insurance policy to investors as an investment opportunity. Generally, the viatical provider will provide a fixed return depending on the term of contract. However, the investor will not receive the death benefit until the death of the insured. Viatical settlement arrangements may be complex and investing in it could be risky.

This week SFC reprimanded and fine two financial consultants of Convoy Financial Services Ltd (which is not licensed by SFC). They are also Type 4 representatives of Convoy Asset Management Ltd. The disciplinary action followed SFC investigation into the complaints lodged by their respective clients who invested in viatical settlements as a result of their recommendation.

SFC found that these two financial consultants failed to:

• be conversant with the risks associated with the investment product as required by Convoy;
• adequately explain to the complaining clients all the material downside risks associated with the investment product; and
• sufficiently ensure the suitability of the investment product before giving his investment advice to clients.

SFC decided to impose a fine because the financial consultants did not use their SFC licence to conduct the business, and so suspension or revocation of the licence was insufficient to discourage them from repeating the misconduct.

Regulating the selling of viatical settlement is difficult because the product itself is not securities. It may be regarded as a regulated investment agreement and subject to SFC's authorization requirement. In this case, SFC did not indicate whether the viatical settlement had been authorized, and the financial consultants sold the product under a non-licensed firm. If they were not accredited to another licensed firm, I wonder how SFC could handle this case.

Market Cleanliness

According to the "Efficient Market Hypothesis", a stock market is most efficient when insider traders fail to make any profit. Then obviously the modern stock markets are still far behind from this kind of "strong form" efficiency.

FSA recently published the results of its latest work to measure the "cleanliness" of UK financial markets. The market cleanliness measure is the ratio of informed price movements to significant announcements. The methodology measures market cleanliness by looking at the extent to which share prices move ahead of the regulatory announcements that companies make to the market.

The research covered two types of market announcements:

• regulatory disclosures about the trading performance of FTSE 350 companies in the periods 1998-2000; 2002/03; and 2004/05; and
• takeover announcements for listed companies made in 2000 and 2002-2005

In both types of announcement the researchers looked for abnormal price movements around the time of the disclosure which would indicate the possible availability of information that may be of use to an insider trader. They then looked for the cases where these "significant announcements" were preceded by an apparent IPM that could suggest informed trading had occurred.

The analysis was also extended to examine the behaviour of trading volumes ahead of announcements and how changes in the sample could affect the measure over time.

The results show that in 2004/05 there was a significant decrease in the level of possible informed trading ahead of FTSE 350 companies' trading announcements, with only 2% of significant announcements being preceded by informed price movements compared to 11.1% in the period 2002/03 and 19.6% in 1998-2000.

For takeover announcements there was a decrease in the level of possible informed trading ahead of takeover announcements from 32.4% in 2004 to 23.7% in 2005. But the level still remains high and little changed from the situation in 2000 of 24% before the implementation of the FSMA.

Although a useful statistical study, it is important to recognise that the scope of the review does have some limitations. First, given the data and techniques at its disposal it focused only on insider trading – which is just one form of market abuse. Second, it only considered "cash" equities, rather than derivative or other instruments.