Investment Banking Malpractices

Investment banking is a dream job of many people. Even investment bankers are highly paid, they are too greedy to earn even more by cheating their clients.

FINRA recently fined GunnAllen Financial, Inc. US$750,000 for its role in a trade allocation scheme conducted by the firm's former head trader, as well as for various Anti-Money Laundering (AML), reporting, record-keeping and supervisory deficiencies.

In 2002 and 2003, the firm, acting through Rivera, the former head trader, engaged in a "cherry picking" scheme in which Rivera allocated profitable stock trades to his wife's personal account instead of to the accounts of firm customers. Rivera garnered improper profits of more than US$270,000 through this misconduct. Rivera was barred in December 2006. Kelley McMahon, Rivera's supervisor, was suspended for six months from association with any FINRA-registered firm in any principal capacity and fined $25,000, jointly and severally with the firm.

In connection with the firm's investment banking business, prior to March 2005, GunnAllen never put any stock of a company on a restricted or watch list even though the firm was conducting investment banking business with these companies. During the same period, GunnAllen failed to inform its own compliance department of the investment banking activities in which the firm was involved.

GunnAllen also failed to report to FINRA that its parent firm had entered into a consulting contract with an individual who had been previously barred by FINRA. In addition, the firm was sanctioned for:

• failing to preserve e-mails and instant messages;
• failing to implement an adequate AML compliance program; and
• supervisory and complaint reporting deficiencies.

Supervisory deficiencies included a failure to ensure that markups and commissions charged on equity transactions were reasonable. In reviewing markups on equity transactions, the firm did little more than ensure that commission charges did not exceed 5%.

Breach of Placing Guidelines

In a bull stock market, placing is not just a profitable business for brokerage houses, but also a temptation to personal trading through secret accounts.

SFC recently reprimanded Wintech Securities Ltd and fined it $450,000 by finding that:

• Wintech failed to act in the best interests of market integrity when a number of Wintech staff, including a former director and responsible officer (Tsap Wai Ping), subscribed for shares and received their allocations in an IPO through the accounts of two clients;
• the allocations breached the Placing Guidelines for Equity Securities under Appendix 6 of the Main Board Listing Rules, where no consent was sought or given for an allocation to directors or employees of a placing agent.

Apart from hiding his IPO subscription, Tsap had also:

• signed new client agreements as a witness when he was not present at the time of execution by the clients; and
• accepted instructions from an unauthorised third party to withdraw funds from a joint client account without receiving any valid withdrawal instruction from the clients or properly verifying the clients' signatures.

Tsap has been banned from re-entering into the industry for one year and fined $180,000.

Back to the basics - If the account opening process is robust enough, there would not be so many loopholes for improper personal trading.

AIG Distribution

In many misconduct cases of the financial industry, the wrongdoers are penalized but the victims (investors) may not be adequately compensated. Could the regulatory system be enhanced to offer more investor protection?

Still remember the accounting scandal of American International Group (AIG) a few years ago, which caused the former CEO Greenberg to step down from AIG?

On 9 Feb 2006, SEC filed a complaint alleging that from at least 2000 until 2005, AIG materially falsified its financial statements through a variety of sham transactions and entities and that AIG reported materially false and misleading information about its financial condition. On 17 Feb 2006, the court entered a final judgment against AIG, to which AIG consented without admitting or denying the allegations in the complaint and paid a total of US$800 million on 3 Mar 2006 (US$700 million in disgorgement and US$100 million in penalties). On 14 Jun 2007, the court entered an order authorizing SEC to establish a Fair Fund to include all of the funds paid by AIG.

On 14 Apr 2008, the U.S. District Court for the Southern District of New York approved a distribution plan for the Fair Fund. The court-appointed Distribution Agent will administer the distribution of the Fair Fund to eligible current and former shareholders of AIG.

The AIG distribution is expected to be completed by the beginning of 2009. The funds are on deposit in the court's registry earning interest. Potentially eligible claimants include:

• Any person or entity that purchased AIG common stock during the period from 8 Feb 2001 to 31 Mar 2005 who (1) sold at a loss on or after 14 Feb 2005; and/or (2) held after 31 Mar 2005.
• Any person or entity who purchased certain AIG-affiliated fixed-income securities during the period from 8 Feb 2001 to 31 March 2005 who (1) sold on or after 24 Mar 2005; and/or (2) held after 31 Mar 2005.

The Sarbanes-Oxley Act of 2002 provided the SEC with authority to increase the amount of money returned to injured investors by allowing civil penalties to be included in Fair Fund distributions. Prior to SOX, only disgorgement could be returned to investors.

Is it a role model for Hong Kong?

Protection of Customer Data

In today's financial world where IT is indispensable, protection of client assets and client information are equally important.

Recently FSA is urging firms to change their attitude to data security and do more to help prevent their customers falling victim to identity fraud and other types of financial crime, following a review of systems and controls for data security at 39 firms including banks, building societies, insurance companies and financial advisers.

There were examples of good practice across the industry, but many firms still underestimate the risk of data loss and fraud to their businesses, and especially to their customers. This includes senior management at firms not recognising the value of their customers' data to fraudsters or that staff could pose a similar threat to data security as that posed by computer hackers and burglars. Also on occasions of significant data loss, firms seem more concerned about adverse media coverage than on being open and transparent with their customers. Following the review, one firm has been referred to enforcement.

The findings showed that:

• Many firms are not proactively checking that third party suppliers vet their employees or have adequate security arrangements in place to prevent unnecessary access to customer data;
• Many large and medium sized firms devote adequate resources to data security risk but placed too much emphasis on IT controls and not enough on staff awareness and training or regular risk assessments;
• Many small firms were wholly reliant on compliance consultants, who did not understand the importance of data security within the firm.

Examples of good practice found at the firms visited included:

• Encrypting laptops and transferring data via secure internet links to third parties;
• Masking financial details where they are not necessary for staff to do their jobs;
• Appointing a senior manager with overall responsibility for data security.

I think all of the above are also applicable to Hong Kong financial market. The recent incident of HSBC for losing the customer data server is again a warning signal.

Worldwide Injunction

SFC is again showing its teeth by obtaining an interim "worldwide injunction" from the Court to freeze assets of up to HK$43m held by two individuals involved in suspected insider trading of Asia Telemedia (ATML) shares. The original application made by SFC on 16 Apr 2008 was made in chambers (not open to public). This is the third application made by the SFC since 27 Jul 2007 freezing proceeds of suspected insider trading.

So far SFC has identified approximately HK$31.2m held in the bank accounts of two individuals, "C" and "D" (the Court has suppressed their identities) as well as in the bank accounts of two BVI companies controlled by "C". These bank accounts are now frozen under the terms of the interim worldwide injunction. SFC is continuing to make inquiries to identify more assets up to HK$43.7m.

SFC's action was based on evidence and suspicions that "C" sold 100 million shares through his own and suspected nominees' accounts between 27 Apr and 30 May 2007. These transactions occurred before ATML informed the market that a winding up petition had been served on the company and that winding up proceedings had commenced.

The sum of money frozen by the injunction is the loss that appears to have been avoided by "C" in selling 100m ATML shares before news of the statutory demand and winding up petition became generally known. The injunction serves to prevent the dissipation of assets pending the finalisation of the SFC's investigation and to ensure there are sufficient assets to satisfy any financial penalty, compensation or disgorgement orders, if relevant proceedings are commenced and orders are made against "C". SFC calculated the amount of HK$43.7m by comparing the amount realised from the shares sold and the market value of the shares after the market learned and absorbed the relevant information.

"C" is a PRC resident who did not appear to be residing in HK. SFC suspected "C" had transferred most of the sales proceeds through "D" to overseas bank accounts. SFC sought the interim worldwide injunction on an ex parte basis (i.e. on the absence of notification to any of the defendants). The case returned to the High Court this morning where legal representatives appeared for "C", "D" and the two BVI companies. The Court gave directions for filing further material with the court and adjourned the hearing of the case to a date to be fixed being not less than 10 weeks from today.

SFC will not disclose any further details about the investigation, which is continuing. Let's wait and see.

"Expert" Advice

There are so many people claiming themselves to be a "god of stock market", no matter they are licensed by SFC or not.

A man was convicted of placing a series of advertisements in newspapers promoting unlicensed securities advice business and for conducting that business without an SFC licence.

Mr Cheng Chun Lung Mondy pleaded guilty to 19 charges in the Eastern Magistracy. He received a jail term of four months suspended for two years and a fine of $10,000 on one count of conducting an unlicensed securities advice business. He was also fined a total of $36,000 in respect of 18 separate offences of issuing advertisements promoting an unlicensed securities advice business. The Court also ordered Cheng to pay total investigation costs of $7,192 to SFC.

SFC prosecuted Cheng after an investigation which found that he placed a total of 18 advertisements in three newspapers -- Apple Daily, Oriental Daily News, and The Sun --between Aug and Nov 2007, offering to provide advice on the buying and selling of specified stocks for a fee.

The advertisements, many with bold headings promising "sure wins", invited investors to pay $5,000 per month, or a trial fee of $500 for two days, in return for tips on one or two "must trade stocks" every day.

Cheng's advertisements were also misleading because they represented that:

• his advice provided investors with a "sure win";
• he could provide investors with a 90% chance of making intraday profits;
• he could predict the market trend;
• he could guarantee profits in the long run;
• profits are guaranteed or investors can get their money back.

SFC also found that Cheng had no expertise in advising clients about stock trading.

I think the advice given by Cheng is equally sub-standard and unreliable as that given by "Uncle 4"? The differences are:

1. Uncle 4 would not be prosecuted for conducting an unlicensed securities advice business;
2. Uncle 4's advice has a more far-reaching impact on the investing public (Shall SFC follow up on this issue?).