HKSI LE Paper 6 Past Paper (2)

HKSI LE Paper 6 (Dec 2006) - Q&A 21~40 (with explanations):

21(D) - (III) is wrong because the required paid-up capital and reserves is HK$1 million instead.

22(D) - All of those persons should be checked in accordance with the Client Identity Rules under the Code of Conduct.

23(D) - (I) is wrong because a code of conduct is not statutory and thus any breach would not lead to judicial proceedings.

24(B) - (I) & (III) are most related to the principle of honesty and fairness. (II) is related to the principle of information for clients. (IV) is related to the principle of information about clients.

25(C) - (I) & (II) are wrong because entering into a written agreement with a client is necessary. For subscription of authorized CIS, the investor enters into the agreement by the application form accompanied by the offering document.

26(D) - (III) is wrong because the Code does not require the keeping of all allocation records permanently.

27(D) - (I) is wrong because staff of a fund manager may not deal for his personal account within one trading day before a forthcoming recommendation in any circumstance.

28(C) - (I) & (IV) are requirements set out in the UT Code in respect of trustees/custodians. (II) is wrong because there is no requirement that the review must be carried out by qualified members of AIMR. (III) is wrong because the terms of reference is incorporated in the review engagement letter instead.

29(B) - (III) is wrong because it is not reasonable to require trustees to indemnify the MPF scheme against loss.

30(D) - (II), (III) & (IV) are typical examples of suspicious transactions. (I) is wrong because there is no ground to pinpoint property deals in such OECD countries like Australia, Canada and the United States.

31(A) - Both (I) and (III) make sense. (II) is wrong because executive share option scheme may create corporate governance problem. (IV) is wrong because the ICG does not specify such detailed requirement.

32(D) - (I) & (II) are good corporate governance standards. (III) & (IV) describe what MPFA is doing.

33(C) - (III) is wrong because no specific threshold for transactions subject to JFIU reporting has been specified.

34(D) - If only two options could be chosen, then (I) & (II) are least essential as features of corporate governance which is more grounded on independent supervision (say, by non-executive directors or audit committee).

35(C) - (II) is wrong because it can't be an initiative taken by the Government and the SFC.

36(C) - (A), (B) & (C) are under the general considerations of the Guidelines, but (C) is considered by SFC as more serious. (D) is under the specific considerations as one of the "other circumstances", which appears to be less serious than (C).

37(D) - Only (III) & (IV) are included in the definition of market misconduct under the SFO.

38(B) - This question is examining common sense. Obviously if one of the options has to be dropped out (all answers contain only 3 options), it should be (III) - pursuing short term returns is usually not a good practice.

39(B) - Only (I) & (III) are defined as offences of "market misconduct" under Part XIV of the SFO.

40(D) - Directors, employees, substantial shareholders (holding 5% or above) of and persons having access to relevant information through business / professional relationship with a listed corporation and its related corporation are all defined as "connected persons".

HKSI LE Paper 6 Past Paper (1)

Besides Paper 1, so far HKSI has only released the past Q&A for another regulatory exam Paper 6 (Regulation of Asset Management). Again let me provide my own explanations in this blog in 2 parts:

HKSI LE Paper 6 (Dec 2006) - Q&A 1~20 (with explanations):

1(A) - SFC is only responsible for authorizing MPF products and licensing MPF fund managers. (III) & (IV) are handled by MPFA instead.

2(A) - (A) is incorrect because because Insurance Authority does not regulate MPF products.

3(D) - (A) is wrong because advertisements made only to professional investors are exempt from SFC authorization. (B) & (C) are wrong because referring to securities in the ordinary course of media business do not constitute advertisements.

4(A) - Insurance Authority only directly regulate insurers. Insurance agents are directly regulated by the Insurance Agents Registration Board.

5(B) - (IV) is wrong because SFC does not aim at protecting overseas investors as well.

6(C) - (C) is wrong because MPF can't ensure "maximizing investment returns" by regulating MPF schemes.

7(D) - (A) is wrong because no forecast of a scheme's performance is allowed. (B) is wrong because performance data must be actual rather than simulated results. (C) is wrong because use of past records are subject to certain restrictions (e.g. minimum track period).

8(B) - (I) is wrong because reference to past performance of SFC CIS managed by the investment managers may only be made on a restrictive basis and successful past records would not assist in predicting future performance. (IV) is wrong because the Code requires all client payments to be made payable to the trustee of the scheme.

9(B) - Leverage foreign exchange funds are definitely not permissible investment for a MPF constituent fund, but now MPFA has already permitted investment in REITs. The answer is outdated.

10(B) - (I) is wrong because warning statements should be audibly read out at the end of each broadcast (only in printed form are not acceptable). (III) is wrong because there is no such requirement.

11(D) - Simply speaking, both (I) and (II) are not requirements specified in the UT Code in respect of hedge fund authorization.

12(D) - "Insurance linked hedge fund" is not mentioned in this Code. Hedge fund should be covered by the UT Code instead.

13(B) - (II) is wrong because superiority of returns is supported by facts, not opinions. (IV) is wrong because it is not a requirement specified in the Code.

14(A) - (II) is wrong because the average portfolio maturity should not exceed 90 days instead. (IV) is wrong because the fudn may only hold up to 30% value in Government securities in the same issue.

15(C) - (I) is wrong because an executive director must be a responsible officer, but not the reverse. (IV) is wrong because this is not a requirement specified by SFO.

16(C) - (I) & (II) are requirements specified by SFO, but (IV) is not the case because the financial statements and auditor's reports of a licensed corporation must be filed with SFC within 4 months of the year end instead. The answer is wrong.

17(A) - (I) & (II) are items that must be reported to SFC under the Rules because they would materially affect an intermediary's financial soundness which is highly concerned by SFC.

18(D) - A person licensed or registered to deal in securities, as per (III) & (IV), is not deemed as engaging in asset management if his asset management activity (w.r.t. securities only) is wholly incidential to dealing in securities. A person licensed or registered to deal in futures contracts, as per (II), is also not deemed so if his asset management activity (w.r.t. futures contracts only) is wholly incidental to dealing in futures contracts.

19(A) - (III) & (IV) refer to advice not specific to the underlying fund investments of a MPF scheme and thus do not fall within Type 4 regulated activity.

20(B) - (I) and (III) are not requirements specified by MPFA.

Facilitation Trading

Yesterday SFC issued a reprimand to Deutsche Securities Asia Ltd (DSAL) and fined it HK$6m. This case is definitely a serious one in terms of financial penalty (the maximum fine under SFO is HK$10m), involving the issues of "facilitation trading".

As explained by SFC, facilitation trading involves brokers and clients executing transactions on a principal to principal basis rather than on an agency basis, which can give advantages to clients by providing them with liquidity and more certain execution. As the nature of the relationship with client may change in a facilitation transaction (because the broker is no longer an agent but dealing with the client as principal), conflicts of interest may arise. Therefore, brokers offering facilitation services need systems in place to identify, manage and control any conflicts that may arise in the provision of facilitation services.

SFC's investigation into DSAL's services provided to institutional clients through its facilitation trading desk found that, from May 2001 to Sep 2005, DSAL failed to:

• put in place an adequate system to identify and resolve potential conflicts of interest arising from commingled proprietary and client trades executed by the facilitation trading desk;
• maintain an appropriate and effective compliance function to detect and manage the risks to clients involved in dealing with clients as principal; and
• keep adequate audit trails of client order instructions.

In issuing the reprimand and imposing a fine of HK$6m, SFC has taken into account all the circumstances of the case including:

• as a result of DSAL's report to SFC in Nov 2005, the control deficiencies were discovered; and
• DSAL has been co-operative with SFC and has agreed to accept the reprimand and fine.

While there were many overseas enforcement cases in respect of failures to monitor facilitation trading, DSAL's case was probably the first one in Hong Kong. I wish SFC could also disclose the following details:

• Did clients of DSAL suffer any losses from the mis-managed facilitation trading?
• How was the fine of HK$6m determined?
• Would any responsible officer or other regulated persons (e.g. compliance officer) be penalized?

Investor Education or Client Solicitation?

In recent years, there are so many "financial actors" working in intermediary firms but at the same time maintaining public exposures through media or investment courses. Their employers may not be able to adequately monitor their activities outside their employment.

SFC has recently banned Mr Law Chun Pon from re-entering the industry for 32 months and fined him $260,000. The case arose from complaints by Law's clients alleging improper trading of foreign exchange contracts by Law in the clients' accounts. SFC found that Law, while acting as an account executive of Delta Asia Credit Ltd (once a DTC regulated by HKMA):

• contravened the law by cold calling the students of his investment course and inducing them to trade leveraged foreign exchange contracts;
• improperly provided discretionary account services to his clients against his employer's policies; and
• failed to act in the interests of his clients by churning their accounts and holding simultaneously equal long and short positions in the same foreign exchange contracts without any reasonable justifications when trading for his clients.

In deciding to ban Law for 32 months, SFC considered the fact that he had caused his clients to suffer significant trading losses in a relatively short period of time. SFC also fined him $260,000 which is the profit he made from his (mis)conduct.

Many trainers of investment course actually aim at soliciting clients rather than providing investor education.

Money Laundering Reporting Officer

Anti-money laundering (AML) is one of the key initiatives of financial regulators who are keen on penalizing firms with lax AML controls. But it is rare that even the money laundering reporting officer (MLRO) would also be fined.

UK FSA recently fined Sindicatum Holdings Limited (SHL) £49,000 and its MLRO, Michael Wheelhouse, £17,500 for not having adequate AML systems and controls in place for verifying and recording clients' identities. This is the first time the FSA has fined a MLRO.

FSA found a number of failings including:

• the firm failed to implement adequate procedures for verifying the identity of its clients;
• it failed to verify adequately the identity of a significant number of its clients;
• it failed to keep adequate records with regard to the verification of the identity of its clients; and
• Wheelhouse failed to take reasonable steps to implement adequate procedures for controlling money laundering risk.

SHL and Mr Wheelhouse have taken robust steps to review and improve the firm's systems and controls in relation to financial crime. FSA did not find any evidence of money laundering at the firm (otherwise I believe the penalty would be much more severe).

More details about Wheelhouse are found at FSA's Final Notice against him:

• Mr Wheelhouse jointly founded SHL and has been a director of the firm since it commenced regulated activities in Aug 2002.
• SHL is a corporate advisory firm with approximately 35 clients for whom it has periodically advised and arranged dealing in investments. Its clients are predominantly small and medium corporates based overseas. During the relevant period, SHL provided 26 of these clients with services which constituted the carrying on of regulated activities and were thus subject to the identification requirements of FSA's AML regime.
• Although Wheelhouse set up a New Business Committee in Nov 2006 to monitor the introduction of new business and took advice from independent consultants, this was insufficient to ensure or improve compliance with SHL's procedures and FSA's requirements.
• In respect of 13 clients (who were not low risk), although some customer due diligence ("CDD") evidence was available, Wheelhouse failed to ensure that the documentation was adequate to verify their identity.
• Wheelhouse did not ensure that all client acceptance checklists were completed. In 7 cases, client acceptance checklists were not fully completed for significant periods of time (up to 3 years) after client take-on and in some cases they were not completed at all.
• On one occasion, Wheelhouse applied an exemption from identification to a deposit-taking bank in Lithuania, despite Lithuania not appearing on the "equivalence" list for regulated entities. On this occasion, Mr Wheelhouse acted as the account executive collecting the identification evidence and also as the officer reviewing and signing off the account. Such an arrangement decreased the likelihood of this failure being identified.

I really suspect if Wheelhouse was a competent and independent MLRO.

HKSI LE Paper 1 Past Paper (4)

HKSI LE Paper 1 (Dec 2006) - Q&A 46~60 (with explanations):

46(D) - The function of stock borrowing & lending is similar to money borrowing & lending.

47(C) - (I) is right because over-concentration of securities collaterals is a margin control risk. (II) is wrong because the written agreement must be completed before the provision of margin service. (III) and (IV) are standard requirements for securities margin financing.

48(B) - (A), (C) & (D) are wrong as there are no such requirements under the rules of SEHK.

49(C) - (A), (B) & (D) are the functions performed by the clearing house. Market maker's role is to provide market liquidity by quoting both bid & ask prices.

50(D) - All options are services provided by the HKSCC.

51(C) - Offer for sale is not a recognized method of listing for already listed securities.

52(C) - Meetings of the Takeovers & Mergers Panel are definitely not open to public. The role of Takeovers Appeals Committee is to review disciplinary rulings of the Takeovers and Mergers Panel for determining whether any sanction imposed is unfair or excessive, rather than setting aside the entire proceedings of the Panel. The Takeovers Appeals Committee is a regulatory committee under the SFC, thus not independent.

53(C) - (A) is wrong as both codes have no force of law. (B) is wrong as both codes have impact on a person's fitness & properness in case of non-compliance. (D) is wrong as the Code on REITs has been promulgated by the SFC instead of the HKMC.

54(A) - Management of mutual funds, collective investment schemes and discretionary portfoliios are all related to asset management (Type 9 regulated activity). Securities margin financing is only Type 8 regulated activity.

55(B) - Recognized counterparty is not regarded as a "client" of a leveraged foreign exchange trader. This is an exemption under the SFO.

56(D) - All options are within the 6 Data Protection Principles under the Personal Data (Privacy) Ordinance.

57(B) - Covered short selling is not a misconduct. Corporate misgovernance is a misconduct but not market misconduct. (I) & (III) are market misconducts defined under the SFO.

58(C) - Rat trading and churning are misconducts but they are not defined under the SFO. (III) & (IV) are market misconducts defined under the SFO.

59(A) - Actually only price rigging is an offence of market misconduct in those options, but the answer "(II) only" is not available. This question is wrongly designed by treating also (I) as a market misconduct.

60(D) - By common sense all options are examples of good internal control measures.

HKSI LE Paper 1 Past Paper (3)

HKSI LE Paper 1 (Dec 2006) - Q&A 31~45 (with explanations):

31(A) - (I) & (III) are the risk disclosure statements set out in Schedule 1 of the Code of Conduct. (II) is wrong as the true risk of holding assets outside assets is that such assets are not protected by the Client Securities Rules. (IV) is wrong as the true risk of margin trading is the financial leverage which may cause the margin collaterals to be liquidated by the intermediary.

32(B) - (I) is the Client Identity Rules. (III) is a standard know-your-client requirement. (II) is not chosen because it may not be a problem if the client's cash settlement is a small amount. (IV) is not chosen because obtaining the client's latest tax return is not specified by SFC's codes & guidelines. Intermediary has flexibility to evaluate the client's financial position by different means.

33(D) - All of them are requirements specified in the Fund Manager Code of Conduct.

34(D) - (D) is wrong because the Code of Conduct allows the intermediary to set its own restrictions on staff dealings.

35(D) - (I) is wrong because complete reliance on internet for communication is too risky. When the server is out of order, clients should be allowed to contact the service provider by other means. (III) is wrong because shifting all responsibilities for errors and omissions to the client is unreasonable.

36(B) - Segregation of duties is a control requirement. (III) & (IV) are obviously not for this purpose.

37(D) - Receiving trade instructions from clients is definitely a front office function. Trade confirmations with clients may be performed by back office.

38(D) - The Code of Conduct does not encourage, but not strictly prohibit, taking client orders by mobile phone. Since mobile phone can't create central tape records, the dealer should record the order details in writing or on the office telephone recording system.

39(D) - (A) is wrong as the Guidance Note is not applicable to AFIs. (B) is wrong as the Guidance Note is not statutory and thus can't make offences or prescribe sanctions. (C) is wrong as the Guidance Note lets the licensed corporations decide whether trading for high risk clients.

40(D) - (I) is not chosen because it should not be an intermediary to check the credit worthiness of its counterparty's client. This should be done by its counterparty instead.

41(B) - (I) is wrong because senior management is ulitmately responsible for internal controls and can't delegate all of their supervisory functions to line management. (II) is wrong because the major focus of line staff (e.g. dealers) should be the regulated activities rather than compliance and audit.

42(D) - (I) doesn't make sense as it is not abnormal that a well-known very wealthy businessman trades through different accounts. (II), (III) & (IV) are all examples of suspicious transactions given by the Guidance Note.

43(D) - (I) is wrong as cash market means spot market. (III) is wrong as the definition of securities is set out in the SFO, which is not freely extended by SFC.

44(A) - (A) is wrong because a SEHK dealer must be registered as a trading (instead of clearing) participant.

45(D) - (II) is wrong because a speculator dealing for himself as principal (rather than as agent) is not subject to any licensing requirement.

HKSI LE Paper 1 Past Paper (2)

HKSI LE Paper 1 (Dec 2006) - Q&A 16~30 (with explanations):

16(C) - Code of Conduct is simply providing the standards of good practices for intermediaries and their representatives to follow.

17(D) - Unlike (II), (III) & (IV), (I) appears not to be an effort with the intention to frustrate an audit.

18(C) - Part III of SFO clearly states that exchange companies (i.e. SEHK & HKFE) and clearing houses should be recognized by SFC. Official Receiver is not an institution specific to securities industry and thus not regulated by SFC. Listed companies are approved by SEHK instead of SFC.

19(A) - (I) refers to the EO for a licensed corporation, while (IV) refers to the EO for an associated entity. An EO is not necessarily a designated compliance officer. An EO is supervising regulated activities of a licensed corporation and its licensed representations, but "marketing executives" is not mentioned in SFO.

20(A) - Client Securities Rules ("CSR") could only cover securities received or held in HK (not overseas). (III) is wrong because CSR would not regulate securities neither handled by an intermediary nor its associated entity.

21(B) - The general rule under S&F (Keeping of Records) Rules is that records should be kept for at least 7 (instead of 10) years. Under S&F (Contract Notes, Statements of Account & Receipts) Rules, contract notes should be retained for at least 2 years (instead of 2 months). Under Code of Conduct, telephone recording of order instructions should be retained for at least 3 months (instead of 2 years).

22(A) - (II) is wrong because compliance staff is not subject to any particular qualification requirement. (IV) is obviously irrelevant.

23(A) - (III) is definitely correct as SFC emphasizes that clients must know they have the right to revoke the standing authority. (II) & (IV) are wrong because standing authority must be renewed for every 12 months and the renewal notice should be given to the cliennt 14 days prior to the expiry date. Though (I) is regarded as correct in the answer, I have reservation on the phrase "with the written consent of the client" - standing authority may be renewed by negative consent.

24(C) - (I) is wrong because records should be kept for at least 7 years. (IV) is wrong because telephone records should be kept for at least 3 months.

25(D) - By common sense all of those negative factors should be considered by SFC in judging a person's character and integrity.

26(C) - (III) is factually wrong - the benchmark of indirect "control" should be 35% of voting power.

27(D) - (III) is wrong because any exclusion of legal rights of the client should not appear in the client agreement.

28(D) - (I) is wrong because a fund manager is not only subject to FMCC, but also other codes and guidelines, like Code on Unit Trusts & Mutual Funds, Management Supervision & Internal Control Guidelines, etc.

29(B) - Responsibities of senior management should be more "high level". If only two options could be taken, (I) and (IV) are the best choices.

30(D) - Simply by memory, diligence and conflicts of interest are 2 of the 9 General Principles.

HKSI LE Paper 1 Past Paper (1)

Recently Hong Kong Securities Institute (HKSI) has eventually released the past Q&A for certain papers of the Licensing Exam for Securities and Futures Intermediaries. Of course candidates are most concerned about Paper 1 because this paper is almost a must-take and its pass rate has been relatively lower.

You can download the only one past Q&A (Dec 2006) for Paper 1 (Fundamentals of Securities and Futures Regulation). While answers are provided at the end of the script, explanations are not. Let me try to provide my own explanations in this blog in 4 parts.

HKSI LE Paper 1 (Dec 2006) - Q&A 1~15 (with explanations):

1(A) - Serving public interest and helping another regulator are legitimate reasons for SFC to disclose confidential information, as permitted by the secrecy provisions of SFO (S.378). (II) is wrong as the disclosure is for private interest. (IV) is obviously nonsense - How come SFC work for a debt collection agency?

2(B) - Financing terrorist activities and international speculators attacking a currency are obviously the role of financial regulators in developed countries. Preventing the activities of (II) and (III) is against the principles of free economy.

3(C) - Provision of a loan is a financial service and thus should be regulated by a financial services regulator.

4(C) - Onsite visits are done by Intermediaries Supervision Department. Collective investment schemes are authorized by Policy, China & Investment Products Division. Licensing Department is responsible for reviewing annual returns submitted by licensed persons. I don't really agree that Licensing Department monitors CPT but I can't choose only (II). Given that (I) is definitely wrong, the best answer seems to be (II) & (IV).

5(A) - SFC has the legitimate powers to refer cases to CCB / ICAC and suspend licences for breach of codes & guidelines. It is not within the legal scope of SFC to seize and dispose an intermediary's property. (IV) is ridiculous - SFC can't exclude a person's right to appeal.

6(D) - This question is straighforward. All answers are correctly describing the nature of a company as a separate legal entity.

7(C) - In criminal law, the standard of proof should be "beyond reasonable doubt". "Balance of probabilities" is for civil law.

8(C) - This question tests only your memory - 18 months.

9(C) - Case law (common law) is derived from the doctrine of precedent. The principles of equity is for equity law.

10(B) - With independence of jurisprudence in Hong Kong, judges should not be politically appointed. Even the Chief Executive can't override the decision of the court in a case involving political matters.

11(C) - Such activity is obviously "boiler room operation" which makes use of slick, professional-sounding salespeople to "cold call" and use high pressure sales tactics to lure investors into lucrative-sounding investment opportunities. On the other hand, even the call is cold call, it may not be illegal if Bernard is an existing client.

12(C) - (A) refers to Type 7 regulated activity and (B) refers to Type 6. Both are subject to SFC's licensing regime. Registered institutions are registered with SFC. Trust companies are not deemed as carrying out any regulated activity.

13(B) - (I) and (II) are legitimate grounds to trigger an investigation by the Financial Secretary. (II) and (III) are unreasonable interventions of a company in a free economy.

14(A) - Each of (B), (C) and (D) seems to be too minor to trigger a special report.

15(C) - Licensed persons and professional investor are exempt from the prohibition on unsolicited calls.

Local Hedge Fund Managers

Recently SFC completed a theme inspection of 8 locally set up hedge fund managers, which were generally smaller firms employing between 3 and 30 staff with AUM ranging between US$5m and US$800m. They mainly adopted equity long/short investment strategy. Then SFC issued a circular to set out the standard of conduct and control procedures expected of licensed hedge fund managers in HK.

Risk Management and Controls

• In some firms the CIO also takes on the role of a risk manager because the business may not afford employing an independent risk manager. This is definitely a control weakness, especially when the CIO is monitoring the risk of portfolios under his management.
• In one case noted by SFC, the parameters used in a proprietary trading model had not been updated for many years. Then how could this model cope with the extremely dynamic financial markets today?

Information for Clients

• There were instances where inaccurate information was disclosed in the newsletters or monthly fact sheets distributed to investors, e.g. largest stock holding, gearing ratios, or even NAV.
• Some side letters entered into with certain fund investors (typically those with sigificant interest) contained preferential terms, e.g. preferential redemption rights or additional transparency. Such unfair arrangements are normally only disclosed to investors upon request.

Side Pockets

• Side pocket is a structure used by hedge fund managers to assist investment in comparatively illiquid or hard-to-value assets. In essence it is similar to a single-asset private equity fund. Once an asset held by the hedge fund is designated for inclusion in a side pocket, new fund investors do not share in it. When existing investors redeem from the hedge fund, they remain as investors in the side pocket until it is liquidated, typically on the sale of the side pocket asset, or an IPO that causes the side pocket to become more liquid.
• SFC has reminded hedge fund managers to critically assess the following factors when managing side pockets: (a) operational capacity and risk management competency; (b) valuation basis; and (c) control for transferring investments in and out of side pockets.
• In addition, existing and potential investors should be kept fully informed of the side pocket arrangement. Fund offering documents should clearly disclose: (a) how the redemption lock-up period for the side pocket would be different; and (b) the policies for transferring investments in and out of side pockets.

Operational Efficiency

• When a hedge fund manager has grown considerably in terms of size and complexity, it should ensure that there are adequate staff resources and the organization structure, reporting lines and systems and controls are commensurate with business needs.

Auction Rate Securities

While banks in Hong Kong are facing with the allegation of mis-selling of Lehman Minibonds, financial institutions in US are also being charged for mis-selling of "auction rate securities" (ARS).

According to Wikipedia, ARS typically refers to a debt instrument (corporate or municipal bonds) with a long-term nominal maturity for which the interest rate is regularly reset through a dutch auction, where broker-dealers submit bids on behalf of potential buyers and sellers of the bond. Based on the submitted bids, the auction agent will set the next interest rate as the lowest rate to match supply and demand. Since ARS holders do not have the right to put their securities back to the issuer, no bank liquidity facility is required. Auctions are typically held every 7, 28, or 35 days.

Recent Case 1

SEC charged two Wall Street brokers with defrauding their customers when making more than US$1 billion in unauthorized purchases of subprime-related auction rate securities. SEC alleges that Julian Tzolov and Eric Butler misled customers into believing that ARS being purchased in their accounts were backed by federally guaranteed student loans and were a safe and liquid alternative to bank deposits or money market funds. Instead, the securities that Tzolov and Butler purchased for their customers were backed by subprime mortgages, collateralized debt obligations (CDOs), and other non-student loan collateral.

Tzolov and Butler, while employed at Credit Suisse Securities (USA) LLC in New York, deceived foreign corporate customers in short-term cash management accounts by sending or directing their sales assistants to send e-mail confirmations in which the terms "St. Loan" or "Education" were added to the names of non-student loan securities purchased for the customers. They also routinely deleted references to "CDO" or "Mortgage" from the names of the securities in these e-mails. As a result, the complaint alleges that customers were stuck holding more than US$800 million in illiquid securities after auctions for ARS began to fail in Aug 2007. Those holdings have since significantly declined in value.

Recent Case 2

At early Oct 2008, SEC announced a preliminary settlement in principle with Banc of America Securities LLC and Banc of America Investment Services, Inc. (collectively, Bank of America) that would provide 5,500 individual investors, small businesses, and small charities the opportunity to sell back to Bank of America up to US$4.7 billion in ARS they purchased before the ARS market collapsed in Feb 2008.

The agreement also would require Bank of America to use its best efforts to provide up to US$5 billion in liquidity to other businesses, charities, and institutional investors. The proposed settlement would include charges alleging that Bank of America made misrepresentations to thousands of its customers when it told them that ARS were safe and highly liquid cash and money market alternative investments. The liquidity of these securities, however, was premised on Bank of America providing support bids for auctions when there was not enough customer demand, and Bank of America did not adequately disclose this support to customers. Bank of America continued to market ARS as cash and money market alternatives despite its awareness of the escalating liquidity risks in the weeks and months preceding the collapse of the ARS market. When Bank of America stopped supporting auctions in Feb 2008, there were widespread auction failures for Bank of America customers.

How could people restore confidence in the financial markets if there are so many scams?

Portfolio Pumping

Even before the current financial turmoil, some fund managers attempted various illegal means to hide their poor portfolio performance.

Last week SEC charged San Francisco investment adviser MedCap Management & Research LLC (MMR) and its principal Charles Frederick Toney, Jr. with reporting misleading results to hedge fund investors by engaging in a practice known as "portfolio pumping."

According to SEC's order, MedCap Partners L.P. (MedCap), a hedge fund run by MMR and Toney, was suffering from dramatic losses and facing increasing redemptions from fund investors by Sep 2006. Over the last four days of the month, Toney — through a separate fund that MMR managed — placed numerous buy orders for a thinly-traded over-the-counter stock in which MedCap already was heavily invested. Toney's buying pressure caused the stock price to more than quadruple, from US$0.85 to US$3.72.

Since the stock represented over one-third of MedCap's holdings, the brief boost in its price inflated MedCap's reported value by US$29m, masking what would otherwise have been a 40% quarterly loss for MedCap. Immediately after the quarter ended, Toney reported to MedCap's investors that the fund's investments had begun to "bounce" and that the fund's performance was improving. Toney failed to disclose that this "bounce" was almost entirely the result of his four-day purchasing spree. Following MMR's brief buying activity, both the stock price and MedCap's asset value declined to their previous levels. At the same time, MMR charged fees to the fund based on the inflated quarter-end asset value.

Toney and MMR, without admitting or denying the findings, have agreed to cease and desist from violating the antifraud provisions of the Investment Advisers Act of 1940. MMR also will disgorge the higher management fees it received due to the inflated fund asset value, plus interest — an amount totaling US$70,633.69 — and receive the censure. Toney also has agreed to a bar from association with any investment adviser with the right to reapply after one year, and to pay a US$100,000 penalty.

What's Wrong with Selling Minibonds?

Lehman Minibonds has remained a hot topic for several weeks because those "victims" keep on accusing banks of mis-selling and have made more than 10,000 complaints to HKMA & SFC. As a compliance practitioner, I would also like to provide my comments on the underlying issues.

Unlike equity-linked products like accumulators, investors of Minibonds have primarily suffered from credit risk arising from Lehman's bankruptcy. Of course, Minibonds are complex structured products carrying at least 3 dimension of credit risk - Lehman (as the guarantor), underlying CDOs (as security) as well as those referenced entities (under the credit default swap arrangement).

Are Minibonds high risk products? Before Lehman's bankruptcy, banks had a ground to argue that they were not because all of Lehman, CDOs and referenced entities had good credit ratings. After Lehman collapsed and the subprime crisis caused a substantial devaluation (market risk) of CDOs, of course we could say Minibonds are very dangerous. But is it a hindsight?

Undoubtedly Lehman's collapse was a rare disaster, same as an aeroplane accident. But could we logically deduct that taking an flight is a high risk behavior because they were aeroplane accidents in the past? If Minibonds are high risk products, then time deposits should also be so classified because banks could also collapse.

Of course I won't say banks had no mis-selling of Minibonds, but the problem is not so simply understood as selling of products with wrong risk classifications. The actual responsibilities which might not be fully discharged by those distributors of Minibonds are:

• To ensure that the investors fully understand ALL underlying risk factors of Minibonds;
• To alert the investors the increase in risk of holding Minibonds when the subprime crisis has burst; and
• To advise the investors that they should never put all or most of their stakes at one product or one counterparty.

I think ignorance and over-concentration are the true risks of investing in Minibonds.

Mortgage Contracts with Retention Clauses

Several months ago a Taiwan bank in Hong Kong was found to have under-paid interests to certain depositors. Another case happened in UK was relating to over-charge of mortgage interests.

UK FSA recently fined GE Money Home Lending £1.12m for systems and controls failings that resulted in 684 borrowers with a regulated mortgage contract suffering financial loss in excess of £2.3 million before redress was later paid to them by the firm.

This is the first time FSA has fined a mortgage lender in relation to its lending processes. It sends a clear signal that mortgage lenders should treat all their customers fairly and prevent them suffering detriment.

The customers affected were those whose mortgage contracts were subject to a "retention" clause whereby a sum of around £3,000 was withheld from the mortgage advance as a condition of the mortgage loan - typically where the borrower was required to carry out specified repairs to the mortgaged property. The firm's mortgage terms and conditions provided that these retention monies would be retained for six months and that during this time the borrower would be charged interest on the full mortgage loan including the retention monies. After six months the retention monies and accumulated interest should have been released to the borrower or applied to reduce the outstanding mortgage loan.

The firm's terms and conditions did not make it clear to all customers that they would be charged interest on the full mortgage loan, including the retention monies, during the six month retention period. Further, due to inadequate systems and procedures at the firm, retention monies and accumulated interest were not always paid to borrowers or applied to their outstanding mortgage loan after six months and the firm continued to charge some borrowers interest on retention monies beyond the six month retention period. When a mortgage with an outstanding retention was redeemed, the firm did not always deduct the retention monies and accumulated interest from the outstanding mortgage loan. This resulted in some borrowers overpaying the firm when redeeming their mortgage.

The firm identified retentions failings in 2004, but despite this the failings persisted over a significant period of time and the firm did not promptly remediate all customers.

In setting the fine the FSA has taken account of the following mitigating factors. The firm:

• reported the issue to the FSA;
• conducted a remediation programme to ensure that customers who suffered financial loss as a result of the retentions failings were properly compensated;
• commissioned an external review of the issue and shared the report with the FSA;
• has stopped using the retentions mechanism.

The firm has also reviewed non-regulated mortgage contracts with retention clauses entered into before 31 Oct 2004 when mortgage regulation began. In total, including both regulated and non-regulated mortgage contracts, it has paid 5,245 customers redress of £7.04 million in relation to their mortgage retentions.

The firm agreed to settle an early stage of the proceedings and therefore received a 30% reduction in penalty. Were it not for this FSA would have sought to impose a financial penalty of £1.6 million on the firm.

Disqualification & Compensation Orders Against Listed Company's Directors

SFC has recently commenced proceedings in the High Court to seek disqualification and compensation orders against the current chairman, Mr Cheung Keng Ching, a current executive director, Ms Chou Mei, and a former executive director, Mr Lau Ka Man Kevin, of Rontex International Holdings Ltd (Rontex), a Hong Kong-listed company engaged in the trading of garments and premium products.

SFC alleges that the three directors:

• breached their fiduciary duty and/or duty of care owed to Rontex;
• failed to ensure Rontex fully complied with disclosure requirements under the Listing Rules; and
• failed to exercise reasonable skill, care and diligence in entering into a number of transactions, resulting in Rontex suffering losses and damages of about $19m.

The alleged breaches are centred on four investments involving:

• the acquisition of 3.62m shares in Grandtop International Holdings Ltd, a company listed on SEHK, for $9.263m, which represented an unjustifiable premium of 45% over the prevailing market price for such shares;
• the acquisition of $15m in options for shares in Macau Asia Investments Ltd, a United States-incorporated company listed as a Pink Sheet stock on the American Stock Exchange;
• three payments totalling $27.7m to a Mainland Chinese citizen named Wan Lin; and
• an investment of $8.454m in Beijing Kut Ka Lok Fashion Apparels Ltd.

SFC alleges Rontex suffered losses and damages of about $19m as a consequence of the alleged misconduct by the three directors. SFC is seeking orders that the three directors be disqualified as company directors and that they pay compensation to Rontex.

I am interested to know:

• What did trigger SFC's investigation into Rontex's transactions before commencing the legal proceedings?
• Why didn't SFC refer this case to CCB or ICAC?

SEC Halts Short Selling of Financial Stocks

We all experienced the US financial turmoil last week. Finally the US government has made the rescue plan to recover investor confidence. Prohibition of short selling is probably a consideration for bailing out those financial entities suffering from subprime mortgages.

On 19 Sep 2008, US SEC, acting in concert with the UK FSA, took temporary emergency action to prohibit short selling in financial companies. SEC's action applies to the securities of 799 financial companies. As explained by SEC's chairman, the temporary emergency order is expected to restore equilibrium to markets and would not be necessary in a well-functioning market.

Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets. At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation. Financial institutions are particularly vulnerable to this crisis of confidence and panic selling because they depend on the confidence of their trading counterparties in the conduct of their core business.

The emergency order will terminate on 2 Oct 2008 but SEC may extend it beyond 10 days if it deems an extension necessary in the public interest and for the protection of investors, but will not extend the order for more than 30 calendar days in total duration.

SEC has also taken the following steps to address the recent market conditions:

• Temporarily requiring that institutional money managers report their new short sales of certain publicly traded securities. These money managers are already required to report their long positions in these securities.
• Temporarily easing restrictions on the ability of securities issuers to re-purchase their securities. This change will give issuers more flexibility to buy back their securities, and help restore liquidity during this period of unusual and extraordinary market volatility.

Of course SEC intervenes the markets (by prohibiting short selling of financial companies and taking up their bad debts) only in a very special circumstance, I am concerned about the abuse of such measures which could create more moral hazard. In 1998 Milton Friedman heavily criticized the HK government's intervention of stock markets. Ten years from 1998 the US government is doing the same. What would Milton Friedman think if he was still alive?

SFC v Styland

SFC challenges the senior management of another listed company by commencing proceedings in the High Court against the former chairman, a former executive director, and two current executive directors of Styland Holdings Ltd. Styland, well-known to many retail investors, was listed in 1991. The group's business includes securities dealing, property investment, general trading and infrastructure development. SFC ordered suspension of trading in Styland's shares on 23 Dec 2002. Trading resumed in Jun 2003 but was suspended again at Styland's request on 21 Apr 2004 pending an announcement of a possible rights issue. Trading remains suspended.

SFC alleges the four directors breached their duties to the company resulting in Styland incurring substantial losses in a number of transactions. SFC is seeking orders that the four directors (or any of them):

• be disqualified as company directors; and
• pay compensation to Styland for losses allegedly caused by their misconduct.

The four directors are former chairman, Mr Kenneth Cheung Chi Shing, current executive directors, Ms Yvonne Yeung Han Yi and Ms Miranda Chan Chi Mei and former executive director Mr Steven Li Wang Tai (the four directors).

SFC also alleges that Cheung breached his duty to the company in a number of transactions in which he is alleged to have received (directly or indirectly) financial benefits totaling $79m. These transactions should have been disclosed to shareholders (and the market) and required shareholder approval which was not sought or given. SFC also alleges Yeung breached her duty through connected transactions not authorised by the company's shareholders (which should have been authorised by shareholders), receiving financial benefits totaling $6.95m.

This is the first time SFC has commenced action seeking compensation for a listed company or sought orders for the commencement of compensation proceedings by the listed company against company directors for alleged misconduct. This action is concerned with three important issues:

1. The obligations of listed company directors to ensure shareholders are given a proper opportunity to scrutinise transactions that require their authorisation;
2. The extent to which Hong Kong law recognises the special responsibilities entrusted to a chairman of a listed company; and
3. The ambit of the court's jurisdiction under S.214 of SFO to order compensation to be paid to a listed company.

If SFC could win this case, then the perceived protection of investors in HK listed companies would be better.

Court Order Against Ex-CEO of Wah Sang

Last week SFC commenced proceedings in the High Court against Mr Shum Ka Sang, the former chairman, CEO and executive director of Wah Sang Gas Holdings Limited (Wah Sang Gas), and one other former company director seeking an order to disqualify them from acting as company directors or being involved, directly or indirectly, in the management of any corporation for a period to be specified by the court. Listed in GEM since March 2000, the company is engaged principally in providing gas connection service through its subsidiaries on the Mainland.

Under S.214 of SFO ("Remedies in case of unfair prejudice, etc. to interests of members of listed corporations, etc."), the court may make such orders for up to 15 years if it finds those persons are wholly or partly responsible for the company's affairs being conducted in a manner involving defalcation, fraud or other misconduct.

These proceedings follow an SFC investigation of the company into suspicions that the company's accounts had been falsified and asset values were overstated for the financial year ended 31 Mar 2004. On SFC's order, the company's shares were suspended from trading on 6 Apr 2004.

SFC alleges that Shum, who resigned as a director of the company on 22 Oct 2007, knew or was involved in falsifying the accounts or was otherwise responsible by failing to exercise reasonable skill, care and diligence and to act in the company's best interests. The same allegations are also made against another former director, who is named in the proceedings but who has not yet been located and notified of these proceedings.

An independent audit led to the reconstruction of the company's accounts. In new financial results finally filed with SEHK on 11 Jul 2007 (following new management being appointed to run the company), the company reported a reduction in the value of net assets as at 31 Mar 2004 of approximately $720m.

Trading in Wah Sang Gas shares remains suspended and resumption of trading is subject to SFC's approval. The company announced to the market on 29 May 2008 a Restructuring Proposal, which will be the subject of a Circular that it must issue to shareholders no later than 30 Sep 2008.

Once again SFC has demonstrated that it has more teeth to bite the wrongdoers of listed companies than SEHK.

SFC Quarterly Report (2Q/2008)

Last week SFC released the first Quarterly Report for the second quarter of 2008 to enhance its transparency and accountability of its operation. The following activities of SFC during this quarter highlighted in the Report are remarkable:

• SFC is concentrating on completing investigations within 7 months and it did so in 76% of all completed investigations. It seems that Enforcement has become more efficient now.
• SFC has sent a strong message to deter market misconduct. It used all the tools available to tackle insider dealing (e.g. sought an interim worldwide injunction to freeze assets of suspected insider dealers in one case).
• SFC has encouraged good compliance and deterred wrongdoing by reaching agreements with ICEA and Core Pacific-Yamaichi such that repeated material breaches of the same kind would trigger an accelerated enforcement response.
• SFC received 329 complaints, compared with 258 in the same period of last year. I wonder whether the significant increase in complaint figure was caused by "accumulators".
• SFC issued a joint consultation paper with HKEx to seek public feedback on allowing paper application forms to be handed out for public offers of shares, debentures and authorized CISs, without also having to hand out paper offer documents if electronic offer documents are available from websites. Comments are being reviewed by SFC. Given that most of the HK people have regular access to the internet, this proposal seems highly feasible.
• Companies can now list in HK by way of depository receipt after SFC approved proposed changes to the main board listing rules. SFC has also approved the re-positioning of the GEM board as a secondary board and a stepping stone to the main board. I doubt if this could "rescue" the GEM board if it is labelled as a platform for "inferior" companies.
• SFC approved HKEx's proposal to introduce gold futures in HK. Trading of gold futures is expected to start in Oct 2008. Would one more "gambling" tool be made available to the retail investors?
• SFC also approved HKEx's proposed amendments to relax the tick rule. It is said the current stock market has suffered from substantial short selling activities. Would relaxation of the tick rule worsen the situation?
• Two teams have been assigned to handle licensing applications by Mainland fund managers. Would SFC offer any "special treatment" to them?

The staff length of SFC has not increased when compared with one year ago. It seems that the workloads of SFC staff have become heavier.

Shortage in Compliance Profession

During this sluggish financial market environment, does the excess demand for compliance practitioners remain? Recently HKSI released a research report titled "Grooming of Talent in the Financial Industry", which is an industry research conducted on the manpower gap in the financial sector. I've got the following insights relevant to the compliance profession from this report:

• Competition for talent is keen in the financial industry, though the shortage has been relieved after the sub-prime crisis. So this year the turnover rate of compliance officers has been lower.
• There is an acute shortage in compliance because this area requires specialized knowledge that can't be easily nurtured through universities. Many firms, particularly smaller companies, prefer not to hire inexperienced people. They are willing to train existing staff but less willing to train new hands from scratch. It follows that fresh graduates or laymen may encounter barriers to entry for the compliance profession.
• Two rapid areas of growth are private banking and wealth management. These areas require people with good interpersonal skills and other soft skills as much as hard skills. This happens to be the area in which Hong Kong's new university graduates appear to be the weakest. Soft skills are not only important for relationship managers but also for compliance officers.
• There is a big gap between self-rated ability and employer-rated ability. While employers are generally satisfied with employees' technical skills, they are not so satisfied with their general lack of creativity, problem solving skills, management skills, and languages skills. Compliance officers spending time only on technical knowledge may lose competiveness in the future.
• Many employees have a strong desire to pursue a career in the financial industry and have the motivation to learn. But they will need to be more proactive, instead of being reactive. They should also develop a global perspective and have a good sense about the financial markets. Some compliance officers, especially those trained up by a regulatory body, have remain bureaucratic and narrow-minded in facing with the rapid changes of the world.

Mis-Pricing of Asset-Backed Securities

FSA recently fined the UK operations of Credit Suisse (the subsidiaries) £5.6 million for breaching FSA Principles 2 and 3 by failing to conduct their business with due skill, care and diligence and failing to organise and control their business effectively.

Credit Suisse announced its financial results for 2007 on 12 Feb 2008. On 19 Feb 2008, Credit Suisse announced that it had identified mismarking and pricing errors by a small number of traders and that it was repricing certain asset-backed securities. The re-pricing involved a write down of revenues by US$2.65 billion. In relation to the write down, Credit Suisse disclosed in its 2007 Annual report in Mar 2008 that a SOX 404 material weakness had existed in its internal controls over financial reporting as at 31 Dec 2007.

The breaches related to the pricing of certain asset-backed securities held by the Structured Credit Group (SCG) within Credit Suisse's Investment Banking Division. The principal activities of the SCG are structuring and issuing securities based on underlying pools of assets, including CDOs and credit correlation trades. These are often highly complex, high risk, leveraged products. The subsidiaries were responsible for ensuring the adequacy and effective operation of their systems and controls, including those provided in part by other companies within the group.

Credit Suisse's senior management commissioned a detailed review of the causes of the write down which identified serious failings in the design, implementation, operation and management of controls over the SCG. The principal failings identified in that review were set out as follows:

• The systems and controls of the subsidiaries for the supervision of traders in the SCG and for the pricing of highly complex products within the SCG were not effective and were not applied consistently. The systems and controls in place, such as a complex matrix structure for the supervision of traders in the SCG, were too complicated and fragmented. Some individuals within control functions lacked a clear understanding of the responsibilities that had been assigned to them.
• There were failures to respond adequately to a number of warning signals or "red flags" and to translate identified concerns about price testing variances in CDO positions within the SCG into tangible or timely actions.
• Certain personnel within control functions with responsibility for recording or checking prices were overly deferential in challenging certain SCG traders and do not appear to have had sufficient seniority or management support to challenge effectively.
• Undue reliance was placed on the technical ability and revenue contribution of certain front office staff, who were highly influential in down-playing price testing variances and in influencing the price testing methodology used, and did not take appropriate action to control and manage such staff effectively.
• Certain control functions failed to escalate in a timely manner price testing variances that were identified, owing to issues such as the complex booking structure used for the CDO trading business, a lack of effective supervision over price verification processes and an over-reliance on assertions made by certain front office staff.

One of the key lessons learnt from this case is the over-reliance on front office staff because they have more technical knowledge of complex deals than the control function staff. As a matter of risk management, firms may assign some front office staff to work at control functions for a period of time to bridge the knowledge gap. Of course front office staff may not always be willing to sacrifice their high pay to become a "coach", but how about such job rotation is arranged during a bear market (like the present)?

Exempt Principal Trader

Recently the Takerovers and Mergers Panel has reported a decision relating to Lehman Brothers Asia Ltd, which cast some light on the issues of Chinese Walls.

From April 2008, Lehman worked specifically on a proposal which would result in the privatization of CITIC International Financial Holdings Ltd ("CIFH") (183.hk) listed on SEHK. On 3 Jun 2008, CIFH announced that it had received a proposal from Gloryshare Investment Ltd, a wholly-owned subsidiary of the CITIC group, regarding the proposed privatization. It envisaged that Banco Bilbao Vizcaya Argentaria S.A. ("BBVA"), presently a substantial shareholder of CIFH, would increase its shareholding in CIFH from 15% to 30%, the balance being held by Gloryshare or members of its group.

By 10 Jun 2008 Lehman was formally retained by Gloryshare as its adviser and on that date Glorysky and CIFH jointly announced the terms of the privatization proposal. In summary, members of CIFH will receive, in consideration for the cancellation of their shares, one "H" share of China CITIC Bank Corporation Ltd ("CNCB") (998.hk) and HK$1.46 in cash for every share in CIFH. In anticipation of resumption of trading on the following day, the Lehman group instituted a restriction on all proprietary trading, but not agency trading, in the shares in CIFH and CNCB.

However, on 11 Jun 2008 the Lehman group:

• purchased 31,000 shares in CIFH for the purpose of rebalancing a hedge against existing swaps with a client on the MSCI HK Index;
• purchased 179,000 shares in CIFH for the purpose of unwinding a short position resulting from OTC sales to clients; and
• purchased 72,000 shares in CIFH for the purpose of executing a "Lehman Performance Swap" for a client through its direct market access (DMA) system.

On 13 Jun 2008 the Lehman group purchased a further 41,000 shares in CIFH for the purpose of covering a short position created as a result of a client facilitation trade. HK$6.27 was the highest price paid by the Lehman group for purchases of shares in CIFH during the offer period. When the Compliance and Control divisions of the Lehman group were aware of these purchases, they immediately informed SFC.

Under the Takeovers Code, the Lehman group is treated as a person "acting in concert". The Code places strict disciplines on a financial adviser to an offeror in respect of in shares of the offeree. In the case of a securities exchange offer, purchases made by the Lehman group above the offer price will result in that offer being accompanied by a full cash alternative at the highest price paid. This would increase the cash element of the offer from HK$2.6 bn to between HK$10.92 bn and HK$11.16 bn!

Nevertheless, the Code recognizes that for a multi-service financial group the disciplines it imposes on a financial adviser and its group may have an impact on other activities which are unrelated to the provision of advice to an offeror. Therefore the Code contains provisions for exemptions for principal traders. But the Lehman group failed to apply for the exempt principal trader status.

The Panel finally decided to exercise its discretion to waive the requirement for a cash alternative for the following reasons:

• the size of the purchases were very small relative to the size of the offer and the total volume of shares in CIFH traded;
• the purchases had a negligible impact on public shareholders;
• the imposition of the cash alternative requirement would have a substantial and adverse impact on Gloryshare who had no knowledge of the purchases; and
• the remedy would be disproportionate to the scale of the purchases if the primary obligation for the offer fall on the Lehman group.

If the Panel did not give a leeway to this case, then I think the Lehman group would get into great trouble!

Socially Responsible Investing

Socially responsible investing (SRI) describes an investment strategy which seeks to balance the pursuit of financial return and social merit. In general, socially responsible investors favor corporates that promote environmental protection, consumer protection, human rights, etc., while avoiding businesses involving in alcohol, tobacco, gambling, weapons, etc. Some investment funds (e.g. Islamic fund) are characterized by SRI, but we seldom hear about incidents of serious breaches of SRI rules.

SEC recently charged New Hampshire-based Pax World Management Corp. with violating investment restrictions in socially responsible mutual funds that investors were told would not contain securities issued by companies involved with producing weapons, alcohol, tobacco or gambling products.

Pax World, the SEC-registered investment adviser to several socially responsible mutual funds, including the Pax World Growth Fund and Pax World High Yield Fund, purchased at least 10 securities that the Funds' SRI restrictions prohibited them from buying — contrary to representations it made to investors and the boards of the Funds. Pax World agreed to settle SEC's charges and was ordered to pay a penalty of US$500,000.

Pax World violated the Funds' SRI restrictions by making purchases in the securities of companies that derived revenue from the manufacture of alcohol or gambling products, derived more than 5% of their revenue from contracts with the U.S. Department of Defense, or failed to satisfy the Funds' environmental or labor standards. Pax World Funds held at least one security that violated their SRI restrictions at all times from 2001 through early 2006. For example:

• In 2003, Pax World purchased for the Growth Fund securities issued by an oil and gas exploration company that had failed its three most recent screens.
• In 2004, Pax World purchased for the High Yield Fund securities issued by a conglomerate primarily engaged in the shipping industry but which derived revenue from gambling and the manufacture of liquor.

Pax World failed to consistently follow its own internal SRI-related policies and procedures that required that all new securities be screened by Pax World's Social Research Department prior to purchase to ensure compliance with the funds' SRI disclosures. Pax World failed to screen 8% of all new security purchases from 2001 to 2005.

SRI funds are surging in Asia and thus SRI compliance monitoring would become a new agenda to the compliance function.

Insurer Treated Customers Unfairly

There have been complaints to media from time to time against HK insurance companies for not treating their customers fairly, but seldom we've seen disciplinary actions taken by the Insurance Authority and made known to the public.

FSA recently fined Hastings Insurance Services Ltd £735,000 for failing to treat its customers fairly in relation to cancelling around 4,550 incorrectly priced car insurance policies.
During two separate periods between Jul and Sep 2007, Hastings discovered that due to an internal system error, inaccurate insurance quotations were given to customers, which resulted in some of them paying significantly lower premiums than they should have. Hastings cancelled the policies but in doing so failed to give sufficient consideration to paying the premium shortfall to the insurance provider or investigating other possible remedies.

FSA found that the firm had invoked a cancellation clause to cancel the policies which FSA considers was not generally intended to be used in circumstances such as these. The way in which the policies were cancelled and the service that the firm gave to its customers following the cancellation showed the firm focussed on the financial cost to itself and did not properly consider the alternatives or the detrimental effect on customers.

Following these incidents the firm has now strengthened the controls surrounding customer treatment and agreed with FSA to write to all affected customers and review the compensation it offered to ensure that its customers are treated fairly.

It is indeed quite ridiculous that customers have to suffer from an internal system error in this way.

Good Practices on Transaction Monitoring

HKMA has recently developed a guidance paper "Good Practices on Transaction Monitoring" in consultation with the Industry Working Group on Prevention of Money Laundering and Terrorist Financing (IWG). The purpose of transaction monitoring is to alert banks to unusual or suspicious activities for further examination and investigation. Banks should put in place effective monitoring systems to identify and report suspicious transactions for AML/CFT.

During 2007, HKMA completed a round of thematic examinations of selected banks focused on transaction monitoring. While banks have generally established appropriate MIS reports for transaction monitoring, the systems and procedures of certain banks are not considered to be sufficiently effective, having regard to the types of business activities they engage.

The guidance paper seeks to highlight the essential features of an effective transaction monitoring system. Some of those major detailed guidances are set out below:

• Good understanding of customers and updating of their risk profiles on a risk-sensitive b basis are important elements of an effective transaction monitoring system.
• The monitoring system should comprise two components: (a) monitoring by front-line staff; and (b) monitoring of past transactions.
• Front-line staff are in the best position to identify unusual activities because they know most about the customers. They should be well trained to perform this function.
• Periodic MIS reports should at a minimum cover the following transactions: cash transactions, wire transfers, cheque transactions, loan payments and prepayment, and reactivation of dormant accounts followed by unusually large or frequent transactions.
• The current transaction should be compared with the past transaction patterns and risk profile of the customer.
• Suspicious transactions identified by the system should be carefully investigated and followed up.
• An automated transaction monitoring system should be used but it can't replace human awareness in detecting unusual or suspicious activities.
• Parameters or criteria used to generate monitoring reports require regular review and updating.

This guidance paper may not be very practical but at least it alerts us to a more serious attitude towards transaction monitoring.

Insider Dealer Arrested

A recent big news in the HK compliance field is that a former managing director at Morgan Stanley Asia Ltd has been arrested and charged for insider dealing and counselling or procuring another person to deal in a listed company's shares prior to the announcement of an acquisition deal.

Mr Du Jun was detained at the Hong Kong International Airport last Thursday after arriving from Beijing and appeared at the Eastern Magistracy last Friday. He is no longer employed by Morgan Stanley and has been residing mainly in Beijing since last year. No plea was taken and the case was adjourned to 5 Sep 2008 for transfer to the District Court. He was granted bail but was ordered to surrender all travel documents and report to the Police twice a month.

The arrest was made following an SFC investigation with Morgan Stanley's cooperation (by reporting Du's trading to SFC in May 2007). The charges allege that on nine occasions between 15 Feb 2007 and 30 Apr 2007, Du dealt in the shares of CITIC Resources Holdings Ltd (CITIC Resources), a company listed on SEHK, whilst in possession of material and price sensitive information not known to the market. The information related to a proposed deal by CITIC Resources to acquire oil field assets, which was announced on 9 May 2007.

It is alleged that Du obtained the information while he was part of a Morgan Stanley team involved in advising CITIC Resources. The charges relate to a total of 26.7 million shares in CITIC Resources allegedly acquired by Du at a cost of about $86 million. On 30 Apr 2007, the last day Du was alleged to have bought CITIC Resources shares, the share price of CITIC Resources closed at $3.68. The price rose by 13.86% to $4.19 on the day of the announcement. Du is also alleged to have counselled or procured his wife Ms Li Xin, who is not facing any charges, to deal in CITIC Resources shares on 27 Feb 2007.

This is a high profile case for SFC to demonstrate its teeth to hunt a tiger. Morgan Stanley's surveillance system and whistle blowing also take the credit.

Beware of IT Guys

A listed company should have the policy of prohibiting certain employees from dealing in the company shares during the "blackout period" prior to results announcement because they are likely in possession of unpublished price sensitive information. Such employees usually comprise all directors and senior management as well as staff carrying out sensitive functions like finance, company seretary, etc. However, IT people may be missed out.

FSA recently fined John Shevlin £85,000 for market abuse. He was employed as an IT technician at the Body Shop International plc ("Body Shop"). On 10 Jan 2006 he established a short position equivalent to 80,000 Body Shop shares through a Contract for Difference ("CFD"), in effect betting that the share price would fall. This trade was made on the basis of inside information. He obtained the inside information by improperly accessing confidential emails which had been sent or received by senior Body Shop executives in connection with the company's Christmas trading announcement. The emails contained details of Body Shop's Christmas trading results and a draft announcement that the Body Shop had underperformed expectations.

Shevlin closed out his CFD position on 11 January 2006 after Body Shop announced its Christmas trading results to the market and made a profit of £38,472. He even borrowed £29,000 (more than his annual salary) to effect the trade.

FSA finds there is cogent and compelling circumstantial evidence against Shevlin, including that:

• He was able to log into the email accounts of certain senior executives from their computers, given that it would have been in the name of the account holder, such access is unlikely to be traceable as being by Mr Shevlin;
• He arranged substantial finance on an urgent basis to enable him to effect the CFD trade before the surprise announcement;
• He placed the CFD trade on the day before the announcement and was keen that his trade took place on that day;
• His CFD trade was of a considerable size, one which accounted for approximately 26.7% of the trading volume in that stock on that day;
• His CFD trade was significantly larger than any CFD he had previously traded. The underlying value of the trade was £213,536 which represented more than double Mr Shevlin's net assets;
• The level of financial risk undertaken by Shevlin was much higher than he had undertaken on previous trades and was such that it could have resulted in serious financial hardship if the trade had gone against him.

As a result, FSA does not accept Shevlin's assertions that he based his trading strategy on information obtained by research or analysis using public information; instead, his CFD trade was based on inside information obtained from the computers of Body Shop's senior executives.

QFII-Related Lawsuit in China

Today I've read a news article from Finance Asia about the first QFII-related lawsuit in China. Nanning Sugar, a company based in Guangxi province, has filed a lawsuit against Martin Currie Investment Management (MCIM) and Martin Currie Incorporated (MCI) with the Nanning Intermediate People's Court for alleged breaches of Article 47 under the PRC Securities Law. Nanning Sugar has successfully obtained court orders to freeze Martin Currie's assets in China, with a total of RMB 39.6 million under MCIM's QFII account, until the case is heard in court.

Article 47 stipulates that if a shareholder purchases and sells a stake of over 5% in a listed company within six months, the listed company is entitled to the proceeds of the trade. This rule was originally designed to deter short-term and insider trading. Nanning Sugar claims that Martin Currie should pay back the profit it made from trading the company's stock between Aug 2007 and Jan 2008, as well as accrued interested and incurred legal costs.

However, Martin Currie argues that:

• the action taken by Nanning Sugar is wholly unwarranted because Nanning Sugar has misunderstood how the current system works for foreign investors;
• the fact that Martin Currie companies owned more than 5% of the issued shares is clearly incorrect;
• MCIM has only held a maximum of 1.6% of Nanning Sugar's shares in the period of the alleged breach; and
• the rest of the stake that totals over 5% as Nanning Sugar has claimed belonged to four different clients and was invested across three different QFII accounts, some of which are advised by MCI (a separate legal entity from MCIM).

There is a widespread concern about its impact of this case on the further reforms amid expectation for a coming QFII scheme expansion. The PRC Securities Law in China was first adopted in 1999 and later revised in 2005. Given the short history of the asset management industry in China, most of the rules remain untested and are subject to regulators' interpretation and revision as the market expands. Market partitiorners have been concerned about the legal loopholes and overlapping regulations.

QFII investors are currently subject to regulation by the CSRC and rules on foreign exchange by SAFE. Given China's legal system is based on a civil law system, instead of case law, rulings follow the word of the law without reference to precedence. The inconsistencies between the securities law and the regulation on disclosure of equity interest could lead to potential conflicts when applied to foreign investors under the QFII scheme.

Let's see how this case is finally adjudicated by the PRC court.

Bear Stearns Hedge Fund Fraud

Bear Stearns is again under the spotlight. This time the subject is hedge fund fraud related to subprime crisis.

SEC recently charged two former Bear Stearns Asset Management (BSAM) portfolio managers for fraudulently misleading investors about the financial state of the firm's two largest hedge funds and their exposure to subprime mortgage-backed securities before the collapse of the funds in June 2007.

SEC alleges that when the hedge funds took increasing hits to the value of their portfolios during the first five months of 2007 and faced escalating redemptions and margin calls, then-BSAM senior managing directors Ralph Cioffi and Matthew Tannin deceived their own investors and certain institutional counterparties about the funds' growing troubles until they collapsed and caused investor losses of US$1.8 billion.

The Bear Stearns High-Grade Structured Credit Strategies Fund and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund collapsed after taking highly leveraged positions in structured securities based largely on subprime mortgage-backed securities. Cioffi acted as senior portfolio manager and Tannin acted as portfolio manager and chief operating officer for the funds, and they misrepresented the funds' deteriorating condition and the level of investor redemption requests in order to bring in new money and keep existing investors and institutional counterparties from withdrawing money.

For example, Cioffi misrepresented the funds' Apr 2007 monthly performance by releasing insufficiently qualified estimates — based only on a subset of the funds' portfolios — that projected essentially flat returns. Final returns released several weeks later revealed actual losses of 5.09% for the High-Grade Structured Credit Strategies Fund and 18.97% for the High-Grade Structured Credit Strategies Enhanced Leverage Fund.

Cioffi and Tannin also misrepresented their funds' investment in subprime mortgage-backed securities. Monthly written performance summaries highlighted direct subprime exposure as typically about 6% to 8% of each fund's portfolio. However, after the funds had collapsed, the BSAM sales force was ultimately told that total subprime exposure — direct and indirect — was approximately 60%.

Cioffi and Tannin continually exaggerated their own investments in the funds while using their personal stake as a selling point to investors. Tannin repeatedly told investors, directly and through the Bear Stearns sales force, that he was adding to his own stake in the funds in order to take advantage of the buying "opportunity" presented by the funds' losses. Tannin never actually added to his investment. He mocked as "silly" at least one investor who sought to redeem instead of following Tannin's supposed example. Meanwhile, Cioffi redeemed US$2 million, which was more than one-third of his personal investment in the funds at the end of March 2007. Cioffi transferred it to another BSAM fund that he described as "short subprime," which he knew was profitable at the time.

The real hazard of hedge funds is often operational risk rather than market risk. Subprime fund managers are more terrible than subprime securities.

Investment Adviser Fined

In the two reports on thematic inspections of investment advisers, SFC stated that it had identified certain malpractices of Hong Kong's investment advisers. So far not too many cases have been concluded and announced, thus the following one is remarkable.

This week SFC issued a reprimand to Mr Choy Kwong Wa Christopher, a former responsible officer of Pacific World Asset Management Ltd (then licensed for RA4 & RA9), and fined him $570,000.

SFC found that Choy:

• mis-stated in a fund's marketing materials the credit rating of the notes in which Pacific World invested through the fund;
• accepted commission from the notes issuer without disclosing this to his clients, which may create a potential conflict of interests in that Pacific World's advice as to the suitability of this fund may have been influenced by that commission;
• failed to ensure that Pacific World's clients received updated information about a reduction in the fund's net asset value and surrender price from the fund launchers;
• failed to ensure that Pacific World's investment advisers kept a record of advice they gave their clients; and
• did not supervise the suitability of investment advice given to clients.

Pacific World has already ceased businesses of regulated activities and therefore Choy alone bears the overall responsibility. The magnitude of the fine reflects the seriousness of this case. What other IA firms would follow?