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.