Regulatory Issues of Private Equity

In November 2007 IOSCO published a report on its review of private equity markets. This report identified seven specific issues relating to private equity markets that have been raised as potential risks to financial markets.

Increasing Leverage

• Growth in lending associated with leveraged buyout (LBO) activity may enhance the chance of financial distress and default, creating potential detriment to the secondary marktes if the debt is traded.

Market Abuse

• Flow of price sensitive information in relation to private equity trnsactions, creates potential for market abuse (like insider dealing).

Conflicts of Interest

• Private equity transactions involve a number of parties including private equity firms, investors, target portfolio companies and market intermediaries. Some parties can take on multiple roles with respect to the same transactions, presenting material conflicts of interest.

Transparency

• Industry standards (e.g. International Private Equity and Venture Capital Guidelines) have been widely used but not adopted consistently across the industry, making investors difficult to make objective comparisons among private equity firms.
• The wider market receive relatively little information on the activities and performance of funds, portfolio companies and private equity firms.

Overall Market Efficiency

• Public investors may lose access to firms during their development period with maximum growth before they are returned to public ownership.
• Existence of private equity investors may ensure that management of public companies are competent and seek to maximize shareholder value.
• High volumes of private equity activity may have a detrimental effect on the quality, size, depth and even fair and efficient operation of public markets.
• Governance in public firms may focus on short term share price levels, rather than long term strategic growth, in order to protect against becoming a takeover target.

Diverse Ownership of Economic Exposure

• Extensive use of opaque and complex risk transfer practices, such as assignment, sub-participation and credit derivatives, could damage the timeliness and effectiveness of workouts following credit event or downturn.

Market Access

• Some investment entities have sought public listings, providing some retail exposure to the market risks these firms undertake.

In HK, there is basically no securities regulation covering the private equity market because it has not approached retail investors. Similar to the case of hedge funds, I don't think HK retail investors are sufficiently sophisticated to invest in private equity products.

Octopus Cards Ltd

Last week I read Next Magazine (#932) and found a short comment from the column 中環人語 talking about Octopus Cards Ltd (OCL). The author said OCL, as a "Restricted Licence Bank" (RLB), is not complying with the banking regulations when issuing the Octopus cards to the cardholders (as depositors), including:

• Taking only deposits with a minimum amount of HK$500,000;
• Taking only fixed deposits; and
• Performing adequate know-your-client (KYC) procedure on the cardholders to prevent money laundering.

Then the author (who is used to critizing HKMA) concluded that HKMA (led by Mr Joseph Yam) is not enforcing the law. If you are a laymen of Hong Kong banking regulations (like most of the other citizens), you may think that the author's allegation is valid. Unfortunately, in fact the author is the same as you but being a laymen he dared to mislead you. Nevertheless, by exercising common sense, you may wonder how could HKMA make such an obvious and serious mistake? Let me point out the flaws in the short comment.

First of all, OCL is not a RLB, but a deposit-taking company (DTC). Banking Ordinance requires a DTC to take only deposits with a minimum amount of HK$100,000 (instead of HK$500,000) and a minimum maturity of 3 months. OCL has definitely been exempted by HKMA from following these restrictions, so that you don't need to deposit HK$100,000 to obtain a Octopus card and you can "withdraw" your deposit (by using the card for spending) at any time. Where is the legal basis?

You can find the answer from Chapter 10 of the Guide to Authorization issued by HKMA. OCL is not a normal DTC, but only authorized by HKMA as a special purpose vehicle (SPV) DTC whose principal businss is the issue of multi-purpose stored value cards (i.e. Octopus cards). Such a SPV DTC should be subject to a condition of authorization that it will not engage in other types of deposit-taking or lending business. Considering the nature and purpose of Octopus cards, it is self-defeating to impose the requirements of minimum deposit size and maturity on OCL. Simplifying the KYC procedure is also acceptable because the maximum amount that can be stored on the Octopus cards is quite small. How could money laundering happen by using such a payment tool?

I don't know if the author has consulted any legal or compliance practitioner before making this unsubstantiated comment. But I strongly recommend HKMA or OCL to issue a letter to Next Magazine for clarifying the actual compliance issues.

Improper Soft Dollars to Hedge Funds

FINRA recently fined SMH Capital Inc. US$450,000 for procedural failures to address its prime brokerage and soft dollar services to hedge funds.

FINRA also penalized the two brokers who helped manage SMH's prime brokerage services business while at the same time serving as the managers of a hedge fund that executed trades at SMH. They improperly received compensation from a profit pool derived, in part, from commissions on trading by their fund. This was obviously a conflict of interest, contrary to the fund's private placement memorandum (PPM) and a separate contractual agreement.

SMH commenced its hedge fund services business in July 2000 and eventually established relationships with more than 15 different hedge funds, making the hedge fund business an important part of the firm's overall operations. It provided a platform of services to hedge fund managers including office space and facilities, marketing assistance and capital introduction, with the fund managers paying for such services through commissions earned on trades directed to SMH.

The firm also operated soft dollar accounts for hedge funds that opted not to join SMH's prime brokerage services platform. These accounts collected a portion of the commissions earned when SMH executed trades for each fund. Fund managers could then submit invoices for goods and services. SMH then paid the providers from the balances accumulated in the soft dollar accounts.

FINRA found that SMH sent two improper soft dollar payments totaling $325,000 to a hedge fund manager. The manager had submitted an invoice to SMH requesting that SMH issue one cheque for US$75,000 to an individual for "consulting services" and a second check for just under US$250,000 to the manager for "research expense reimbursement".

The invoice raised several red flags because:

• it requested SMH to pay the hedge fund manager directly for expenses that had purportedly been provided by a third party;
• it did not describe what research had been provided to the manager or who had provided the research; and
• it failed to describe the "consulting services" the individual provided.

The hedge fund manager did not provide SMH with any invoice or backup documentation from the individual consultant or from any research provider to support the invoice.

A hedge fund could become an investment scam if there is no proper control procedure in place.

Front-running of Client Transactions

Front-running is a malpractice which arises when a person misuses confidential information about another person's trading intentions to make a profit, often at the latter's expense. For example, a broker who knows the client is going to buy a lot of shares in a stock may buy up that stock first at a lower price to sell on to the client at a higher price. If the broker is acting as a portfolio manager of discretionary clients, then the front-running problem would become more serious.

SFC recently revoked the licences of Mr Chung Yu Kit and Mr Ding Lai Leung for front-running. A

t the material time, Chung was accredited to J.P. Morgan Broking (Hong Kong) Ltd.

SFC found that:

• Chung gave confidential information about his clients' instructions to buy four listed securities to fellow trader, Ding, before placing those clients' orders;
• Ding bought shares in the four listed securities on five occasions between Sept 2006 and Oct 2006;
• Ding sold the shares for profit and, in the vast majority (94%) of selling transactions, he sold the shares to Chung's clients;
• Chung's clients ended up paying more for the shares than they would have otherwise; and
• Ding reaped a profit before transaction costs of approximately $128,000.

Ding was therefore fined $128,000, being the amount of profit made from his front-running activities. It appears that Chung got no benefit by giving the information of client orders to Ding, then why did he do so?

Breach of Chinese Walls

"Chinese Walls" are information barriers implemented by firms to restrict the flow of inside information from certain departments (e.g. ECM) to other "public side" departments (e.g. sales and trading) within the firm. The major purpose of Chinese Walls is of course prevention of insider dealing.

Chinese Walls become vulnerable when certain employees (e.g. analysts) are "wall crossed" by the firm to provide assistance to those sensitive departments. In this situation, restrictions should be imposed on the business activities of the wall crossed employees, e.g. they should not discuss or recommend those companies of which they have inside information, until such information becomes public or immaterial. Compliance officers should also closely monitor the flow of information from the sensitive department to the wall crossed employee. The employee's personal account trading of the relevant stock should be prohibited.

SFC recently banned Mr Ho King Man Justin, a former licensed representative of J.P. Morgan Broking (Hong Kong) Ltd, from re-entering the industry for four months. Ho was a staff member of the equity sales department of JPMorgan.

In March 2006, after he was "wall crossed" by his employer in relation to a listed company, Ho:

• disclosed information about the listed company to his colleagues in the equity sales department without authorisation from his employer; and
• continued to recommend the listed company to his clients.

SFC remarked that "there was no trading based on this information". Does it mean that even Ho's colleagues and clients had not traded by relying on such inside information? My further questions are:

• Why was Ho, as an equity sales, wall crossed by JPMorgan?
• How did SFC find out Ho's breaches of Chinese Walls?