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.