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?