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.