Use of Fake Transaction to Steal Client Money

Another licensed person has been "killed" by SFC for theft of client assets.

SFC has revoked the licence of Liu Ka Hin, a former licensed representative of Goldbond Securities Ltd and Goldbond Futures Ltd (now taken over by Piper Jaffray after the offences were committed) and banned him for life from re-entering the industry.

An SFC investigation revealed that from 5 Feb 2007 to 4 Oct 2007, Liu had opened trading accounts in his relatives' names to facilitate his own personal trading without the knowledge of his employer (once again "secret account"). After Liu lost money by investing through these accounts, he persuaded a client to invest in a financial product (what? accumulator?) through Piper Jaffray, knowing that Piper Jaffray did not sell such products to its clients.

Liu then used the money deposited by this client to settle the losses he incurred in his related accounts. In the process, he had:

• asked the client to fax the bank-in slips for the money to a fax number under his control;
• falsified written instructions on these slips in order to mislead Piper Jaffray's settlement department into diverting the funds into the related accounts he controlled; and
• sent fake confirmation notes to the affected client.

The misappropriated client assets were estimated to be at least $20m. On 29 Feb 2008, Liu was arrested by the HK Police and charged with one count of theft.

In this case, the fraudster had successfully cheated both the client and the employer. I wonder whether:

• the client had reviewed the statement of account (which should be independently delivered by Piper Jaffray's settlement department) to detect the "missing transaction"; and
• Piper Jaffray's settlement department had indepentently called the client to confirm the fund transfer (as it didn't directly receive the bank-in slips from the client).

GEM Sponsor

Last week SFC announced that it SFC has "resolved" a number of compliance issues with Core Pacific-Yamaichi Capital Limited (CPYC), Core Pacific-Yamaichi International (H.K.) Limited (CPYI) and Core Pacific-Yamaichi Securities (H.K.) Limited (CPYS).

What has been resolved?

• SFC fines CPYI, CPYC and CPYS $3.3m, $2.8m and $350,000 respectively.
• SFC reprimands CPYI and CPYS.
• CPYC will engage an independent audit firm to conduct a review of two sponsorship transactions completed by it within three years of the agreement, but the review timing and the transactions will be selected by SFC.
• If CPYC is found to have committed failures or breaches materially similar within the three-year period then CPYC's business in sponsorship activities will be suspended for at least 18 months.
• CPYC accepts the disciplinary action without admitting liability.

The CPY group and the South China group have faced the similar fate!

What's wrong with CPYC, CPYI and CPYS?

CPYC

SFC's allegations concern CPYC's role as sole sponsor and continuing sponsor of Tungda Innovative Lighting Holdings Ltd (Tungda). Tungda was listed on GEM on 26 Jul 2002. CPYC ceased to act as Tungda's continuing sponsor on 10 Oct 2003. Trading of Tungda's shares has been suspended since 29 Jul 2004 at the request of the company.

In particular, SFC alleged that CPYC failed to:

• conduct adequate due diligence on Tungda's top customers and sales;
• ensure that its responses to HKEx's enquiries about over-statement of Tungda's sales in its listing prospectus were complete and not misleading;
• report irregularities it had detected about Tungda's sales to HKEx; and
• diligently supervise persons employed by it to carry out the Tungda sponsorship.

The amount of the fine represents the fee earned by CPYC in acting as sponsor and continuing sponsor of Tungda.

CPYI

SFC's concerns about CPYI's conduct stemmed from CPYI's role as lead underwriter in the listing of Shaanxi Northwest New Technology Industry Limited (SNNT). SNNT was listed on GEM on 3 July 2003.

SFC found that CPYI caused the level of demand for the new shares to be misrepresented by:

• offering high margin facilities to employees of SNNT who had insufficient financial means to support their subscriptions;
• allowing CPYI employees to subscribe for the shares without properly disclosing or obtaining the consent of HKEx as required; and
• causing SNNT to announce to the market an inaccurate over-subscription rate and public float of its shares.

CPYS

SFC found that CPYS's internal control deficiencies directly contributed to its failing to:

• detect and remedy misconduct by staff members who issued false statements of account to clients to cover up unauthorised trading; and
• ensure it had adequate systems to verify the accuracy of its FRR returns.

In my very extreme opinion, GEM is a hotbed of sub-standard issuers and sponsors.

Address Proof for Personal Customers

In the Customer Due Diligence (CDD) process for personal customers, one of the hurdles is that customers have difficulties in providing proofs of residential or permanent address. The Industry Working Group (IWG) on Prevention of Money Laundering and Terrorist Financing has recently developed a guidance paper to banks on "Address Proof for Personal Customers".

The paper sets out the some common cases where a personal customer is unable to provide acceptable address proof:

• Business people staying in HK for a short
• New immigrants or expatriates who reside in a serviced apartment or the home of a relative
• Individuals living in an overseas country where utility bills are not in English or Chinese
• Individuals (esp. celebrities) who normally use their office address or a PO box as correspondence address
• Individuals living in a village type property with address proof showing the village's lot number only

To handle these situations, banks may consider expanding their list of acceptable address proofs to cover the following documents:

• utility, rates or tax bills
• bank or credit card statements
• management fee bills
• letters issued by government or other public bodies
• correspondence received from banks, MPF providers, insurance companies or professional bodies
• mobile phone or pay TV statements
• rental agreements showing the address of the customer and having the customer as one of the contracting parties
• ID card, passport or driving licence which shows the customer's address in the home country

In cases where the customer is unable to provide the address proof, banks may consider accepting the following documents as address proof:

• correspondence received from the customer's employer which shows the residential address of the customer
• letters issued by a qualified intermediary confirming the address of the customer
• up-to-date annual returns which contain the customer's residential address
• address proof of an immediate family member plus a written confirmation from the immediate family member that the customer is living at that address
• an acknowledgement of receipt duly signed by the customer in response to a letter sent by the bank to the address provided by the customer
• a land search report on the address provided by the customer which confirms that the customer is the owner of the property
• a copy of the statement which is sent by the bank to the address provided by the customer and is returned by the customer during his visit to the bank

The above alternative ways to verify a customer's residential or permanent address sound pragmatic. I suggest SFC acknowledge this guidance paper for reference by licensed intermediaries.

Rogue Trader Risk

When talking about "rogue trader", in the past you will associate it with the Barings incident, now new scene has been played by Societe Generale. I never believe that a rogue trader could really kill a firm if he is not "empowered" by the blind management and lax controls.

Recently FSA published a Market Watch paper which focuses on firms' reviews of their systems and controls in light of SG's rogue trader incident. The paper highlights the measures firms should consider to protect them against rogue trader risk. In the current volatile market environment, with the risk of inappropriate practices quickly leading to significant losses, early discovery and remedial action are even more important than in more benign conditions.

The following suggestions made by the Market Watch are remarkable:

• If a trader has a high number of cancelled and amended orders in a period, firms should consider if this would be brought to the attention of senior trading management and control functions through routine reporting.
• Traders should be encouraged (or required) to take two-week continuous holidays (i.e. block leave policy).
• Use of suspense accounts should be understood by middle and back office, and challenged when used inappropriately by front office.
• Firms should monitor those risks that may be difficult to capture as part of a portfolio or firm level risk measure, e.g. exotic and higher order risks, basis risks and liquidity risk.
• A number of "yellow" flags in different areas should be aggregated to produce a "red" flag if there are common control concerns with a particular trader across different areas.
• Transactions done at an "off-market" rate should be checked because an attempt to alter profit and loss may require the trader to enter trades at an off-market rate.
• Confirmations or valuations should be sent directly from external counterparties to the middle or back office, not via the front office.
• Location checks should be performed to detect whether a front office person is logging into a computer in the back office.

In substance, I think rogue trader risk is a risk resulted from a poor corporate governance environment.

Grey Market

SFC has recently commenced a proceeding in the Court of First Instance seeking orders restraining certain unlicensed persons from dealing in grey market securities and seeking a declaration that such dealings are a regulated activity under SFO. SFC's action concerns the activities of two unlicensed individuals, Chow Ngai Keung Alex and Siu Sum Fung Christopher and an unlicensed company, Mega Dragon Group Ltd (now deregistered and not a party to the proceedings).

They had been involved in a scheme offering H shares of Bank of China Ltd (BoC) since Mar 2006 up to 1 Jun 2006 when BoC H shares were listed on SEHK. This kind of alleged trading of securities prior to the time when they are traded publicly on a stock exchange is called "grey market" trading.

SFC contends that any person carrying on a business of offering shares in a "grey market" must be licensed by the SFC and comply with the obligations of a licensee under the SFO and under the Code of Conduct.

The regulatory issues surrounding grey markets were raised recently in a Court of Appeal case, Woo Hing Keung Lawrence v CEF Brokerage Ltd (CACV148/2007) in a judgment published (but not yet found from the online Legal Reference System) on 19 March 2008. This case has provided judicial guidance on the validity as between client and broker of grey market trades.

However, the decision in this case did not deal with the issue of unlicensed persons engaging in grey market activity. Under SFO, IPO shares "soon-to-be-listed" during the grey market period would also fall within the definition of "securities". Accordingly, persons not licensed for Type 1 are prohibited from arranging such grey market trades.

I also wonder if the requirement for providing a "written document" under S.175 of SFO would apply to the offer to acquire or dispose of "unlsted securities" in the grey market.