Private Placement Offering Failures

US FINRA recently fined Pacific Cornerstone Capital and its former CEO, Terry Roussel, a total of $750,000 for failing to include full and complete information in private placement offering documents and marketing material. FINRA also charged Pacific Cornerstone and Roussel with advertising violations and supervisory failures.

Pacific Cornerstone agreed to make corrective disclosures to investors and to submit advertising and sales literature to FINRA for pre-use review for one year. Roussel was suspended in all capacities for 20 business days and in a principal capacity for an additional three months.

From January 2004 to May 2009, Pacific Cornerstone sold private placements in two affiliated companies using offering documents and accompanying sales literature that contained targets as to when investors would receive the return of their principal investment and the yield on their investment. The offering documents included statements that the affiliated entities targeted returns of principal in two to four years and targeted a yield on a $100,000 investment in excess of 18%. FINRA found no reasonable basis for those statements.

Further, Pacific Cornerstone and Roussel continued to use a similar targeted time period for return of capital and rate of return in successive offering documents, although those targets were not supported by prior performance. The offering documents failed to disclose the complete financial condition of one or both of the companies.

Pacific Cornerstone also offered private placement units of the two affiliated entities, Cornerstone Industrial Properties, LLC and CIP Leveraged Fund Advisors, LLC, to other broker-dealers and investment advisors, which in turn sold the units to the investing public. A total of approximately $50 million worth of units were sold to approximately 950 accredited investors over a period of almost six years. Pacific Cornerstone continued to use the same targeted two-to-four year return of principal and 18% rate of return in successive offering documents, despite not having met those targets.

During the same period, Roussel periodically sent letters to the private placement investors to update them on the progress of their investment that painted a positive — but unrealistic — future, without providing required risk disclosures. Roussel's letters also failed to disclose the complete financial picture of the two companies.

In Hong Kong, we rarely witness that offering to private placement investors and professional investors are so adequately supervised by SFC.

Displaying Fictitious Trades and Misleading Customers

US SEC recently charged a US subsidiary of the world's largest inter-dealer broker, U.K.-based ICAP plc, with fraud for engaging in deceptive broking activity and making material misrepresentations to customers concerning its trading activities.

As an inter-dealer broker, ICAP Securities USA LLC (ICAP) matches buyers and sellers in OTC markets for various securities, such as US Treasuries and mortgage-backed securities, by posting trade information on computer screens accessed by its customers who make trading decisions based in part on such information. Inter-dealer brokers with greater trade activity on their screens often are better positioned to attract customer orders and earn more commissions than those whose screens reflect little or no trading activity.

SEC's enforcement action finds that ICAP, through its brokers on its U.S. Treasuries (UST) desks, displayed fictitious flash trades also known as "bird" trades on ICAP's screens and disseminated false trade information into the marketplace in order to attract customer attention to its screens and encourage actual trading by these customers. ICAP's customers believed the displayed fake trades to be real and relied on the phony information to make trading decisions.

ICAP agreed to settle SEC's charges by, among other things, paying $25 million in disgorgement and penalties. SEC additionally charged five ICAP brokers for aiding and abetting the firm's fraudulent conduct and two senior executives for failing reasonably to supervise the brokers. The individuals have each agreed to pay penalties to settle SEC's charges.

According to SEC's order, ICAP's UST brokers displayed thousands of fictitious flash trades to ICAP's customers between December 2004 and December 2005. ICAP represented to its off-the-run UST customers that its electronic trading system would follow certain workup protocols in handling customer orders. Such ICAP customers therefore expected that their orders, once entered onto ICAP's screens, would be filled according to the workup protocols. However, ICAP's brokers on the UST desks used manual tickets to bypass such protocols and close out of thousands of positions in their ICAP house accounts, thereby rendering ICAP's representations concerning the workup protocols false and misleading. In some instances, ICAP's customers' orders received different treatment than the customers expected pursuant to the workup protocols.

ICAP held itself out as a firm that did not engage in trading that subjected its own capital to risk. ICAP's regulatory filings routinely made this point, noting specifically in one instance that the firm "does not engage in proprietary trading." During the relevant period, however, two former ICAP brokers on the voice-brokered collateral pass-through mortgage-backed securities (MBS) desk routinely engaged in profit-seeking proprietary trading that rendered ICAP's representations regarding proprietary trading false and misleading. ICAP failed to make and keep certain required books and records on the UST desks and the MBS desk.

Many individual and institutional investors in HK incurred losses from buying the shares of Asian Citrus (73.hk) based on the misleading information in the listing document and SEHK's trading system. Could SFC do something for them?

SDI Breach

In an article SDI breaches go dark at SFC dated 6 October 2009, David Webb voiced out that SFC has quietly stopped disclosing details of successful prosecutions for breaches of the securities disclosure-of-interests (SDI) provisions of SFO, including the name of the offender and the company whose shares are involved. Probably "alerted" by this article, SFC has recently resumed the practice of disclosing prosecution for SDI breaches.

On 26 November 2009, SFC announced that the High Court has dismissed an appeal by Mr Liu Su Ke against his conviction in June 2009 for failing to disclose his interest in shares in Warderly International Holdings Ltd (607.hk). Liu had earlier appealed against his conviction on two counts of failing to notify both SEHK and Warderly within three business days of becoming aware that he had acquired an interest in 231.8 million Warderly shares. Liu was convicted on 2 June 2009 in Eastern Magistracy on two summonses and fined the sum of $5,000 in respect of each summons.

On 28 December 2006 Liu received, from Mr Yeung Kui Wong, the chairman and an executive director of Warderly at the time, a deposit of certificates for 231.8 million Warderly shares together with share transfer documents as security for a loan of $6 million to a subsidiary of Warderly. As part of the arrangement, Liu obtained an irrevocable right to sell the shares to the extent of any failure by the subsidiary to repay the loan. On that basis, SFC contended and the Court found that Liu acquired a notifiable interest in the shares which he failed to disclose within three business days after becoming aware of his interest as required under SFO. Accordingly, the judge has dismissed the appeal and upheld the convictions.

In delivering the judgement, the judge considers a number of important legal issues concerning the enforcement of the obligation to disclose notifiable interests in listed securities including whether the absence of a reasonable excuse for not disclosing is an element of the offence, whether the offence is one of strict liability and the presumption of innocence.

SFC has successfully prosecuted 70 charges of failing to disclose a notifiable interest or change of interest so far this financial year against 11 individuals.

Email Supervision Failures

Last month US FINRA fined MetLife Securities and three of its affiliates a total of US$1.2 million for failing to establish an adequate supervisory system for the review of brokers' email correspondence with the public. The fine also resolves charges of failing to establish adequate supervisory procedures relating to broker participation in outside business activities and private securities transactions.

From March 1999 to December 2006, MetLife Securities and its affiliate broker-dealers had in place written supervisory procedures mandating that all securities-related emails of brokers be reviewed by a supervisor. However, the firms did not have a system in place that enabled supervisors to directly monitor the email communications of brokers. Instead, the firms relied on the brokers themselves to forward their emails to supervisors for review. To monitor compliance with the email-forwarding requirement, the firms encouraged — but did not require — managers to inspect brokers' computers for any emails that had not been forwarded as required. But brokers were able to delete their emails from their assigned computers, thus rendering spot-checks unreliable.

The firms also conducted annual branch audits, which were likewise ineffective because they did not allow for timely detection of email-forwarding failures. Moreover, the method employed by the auditors to identify email-forwarding deficiencies (prior to July 2005) was itself flawed, consisting mainly of a review of hard-copy files for any correspondence (including emails) that had not been forwarded. Brokers were therefore able to withhold emails without detection by the firm and conceal evidence or "red flags" of misconduct contained in their emails.

During the period from March 1999 through December 2006, two MetLife Securities brokers engaged in undisclosed outside business activities and private securities transactions without detection by the firm, although the misconduct was reflected in more than 100 separate emails that the brokers sent or received using their MetLife Securities email addresses. MetLife Securities did not discover the misconduct of either broker through supervisory review of emails because the brokers did not forward their emails to their respective supervisors.

MetLife Securities ultimately discovered that one of those brokers, Mark Salyer, stole nearly US$6 million from his customers in connection with his participation in numerous private securities transactions to raise capital for real estate development companies with which he had a relationship. In January 2009 SEC barred Salyer from association with any broker, dealer or investment adviser. FINRA's investigation of the misconduct of the other MetLife broker is continuing.

FINRA also found that the firms' inability to ensure compliance with the email-forwarding requirement meant they could not adequately enforce their own supervisory procedures relating to outside business activities and private securities transactions.

Monitoring of staff emails is not a simple matter. Apart from corporate email accounts, dealing malpractices may also be detected from webmail accounts. How could such monitoring be done without infringing privacy?

Concealment of Unauthorised Trading Losses

UK FSA recently fined UBS AG £8million for systems and controls failures that enabled employees to carry out unauthorised transactions involving customer money on at least 39 accounts.

The unauthorised activity, which took place between January 2006 and December 2007 at UBS' London-based wealth management business, only came to light when a whistleblower raised concerns internally.

Upon further investigation, it was discovered that UBS employees had taken part in the trading of foreign exchange and precious metals using customer money without authorisation and allocated losses to customers' accounts. An internal UBS investigation estimated that as many as 50 unauthorised transactions a day were taking place at the operation's peak.

FSA investigation found that UBS had failed to:

• manage and control the key risks, and the level of risk, created by its international wealth management business model;
• implement effective remedial measures in response to several warning signs that suggested the business' systems and controls were inadequate; and
• provide an appropriate level of supervision over customer-facing employees.

Further details disclosed by FSA's Final Notice:

• The services UBS provides to its international wealth management customers in the UK include, amongst other things: bank account services, investment advisory, portfolio management, trade execution, and the safekeeping of documents and assets.
• International wealth management customers are typically non-UK resident individuals who have substantial assets to invest, and are sophisticated, active and performance-driven investors.
• The London Branch afforded the Desk Heads a high degree of autonomy and authority. Each Desk Head supervised the Client Advisers operating on that specific International Business Desk. Desk Heads’ responsibilities included preparing investment documentation, contributing to technical discussions and liaising with Legal, Compliance and ‘Back Office’ functions. Where appropriate, Desk Heads were also expected to meet clients with the Client Advisers.
• During the Relevant Period, UBS’ control framework was designed to operate on the basis of a ‘Three Lines of Defence’ model. The ‘First Line of Defence’ was the business itself (i.e. Client Advisers and Desk Heads). The ‘Second Line of Defence’ was UBS’ Risk and Compliance department, which, amongst other things, undertook monitoring and risk assessments. The ‘Third Line of Defence’ was the Group Internal Audit function and external auditors.
• On 31 December 2007, a UBS employee reported to UBS’ Money Laundering Reporting Officer a concern regarding a proposed transfer of funds from a customer’s account to a particular Desk Head’s (“Desk Head ‘A’”) personal account. As a result, the Risk & Compliance department announced it would undertake a review of the International Business Desk headed by Desk Head ‘A’ (“Desk X”). The announcement of this review prompted another employee on Desk X to escalate a concern regarding an unauthorised inter-customer transfer of a structured product at a non-market price.
• In response to these concerns, UBS suspended relevant employees on the Desk and conducted a comprehensive investigation. The investigation established that Desk Head ‘A’ and certain other employees on Desk X had engaged in and/or facilitated unauthorised FX and precious metals transactions by using certain customers’ money without their authorisation and allocating any resulting profit or loss to the affected customers’ accounts. There was a high volume of FX transactions during the Relevant Period; UBS’ investigation identified approximately 50 such trades per day during 2006, which continued (at a reduced rate) throughout 2007.
• UBS’ investigation established that losses arising from the Unauthorised Trades were allocated to the accounts of other affected customers on the same Desk by exploiting the following failings in the control environment: (a) FX transactions could be executed by providing UBS’ FX traders with only an identifier for the trade and the details of the amount and the currency to be traded. Full details of the transaction, including the account number, could be provided to UBS’ FX traders up to 24 hours later. This allowed the performance of the trade to be assessed before Desk Head ‘A’ decided how any losses (or profits) should be allocated; (b) FX trades that had already been executed and booked could be cancelled and then subsequently re-booked onto another customer’s account; and (c) FX trades made nominally on behalf of a number of customers could be consolidated into a single trade with an ‘averaged’ price, thereby hiding the number of deals and the patterns of price.
• UBS’ investigation identified that losses resulting from the Unauthorised Trades were concealed by Desk Head ‘A’ and certain other individuals on Desk X from UBS’ customers by adopting the following techniques: (a) unauthorised transactions were made on the accounts of customers on the Desk who utilised UBS’ ‘retained mail’ facility. Customers using the ‘retained mail’ facility did not receive timely statements and updates on their accounts; as such, it was less likely that such customers would discover in a timely way the unauthorised activities on their accounts in comparison to those customers receiving periodic statements; (b) customers with significant liquid funds in their accounts were persuaded by the Desk to “lend” funds to other customers on the Desk who had incurred losses as a result of the Unauthorised Trades. These “loans” were documented on UBS headed notepaper by way of purported ‘UBS Guarantee Letters’. This procedure was intended by the employees on Desk X to give the lending customers the impression that the loan had been approved by UBS; however, no such approval had been given; and (c)a number of internal transfers were routed inappropriately through one of UBS’ internal ‘suspense’ accounts. The use of the suspense account enabled the true origin of the funds to be concealed as the source would not be displayed on the customers’ statements.
• Desk Head ‘A’ and other individuals working on Desk X were able to deploy these techniques without effective challenge from UBS’ systems and controls.
• UBS reported the findings of its investigation to the FSA on 30 January 2008. In February 2008, UBS commissioned an independent third party to assist it in identifying those customers who had been affected by the Unauthorised Trades. This work identified that 39 clients of “Desk X” had been affected by the Unauthorised Trades.

This case again reveals the highly risky control environment of private banking.

Dark Pools

Recently Martin Wheatly, CEO of SFC, delivered a speech about regulating alternative trading venues, in particular dark pools and direct market access (DMA). Some major points are summarized below:

• Whatever term is used to describe them, be it dark pools or alternative trading venues, they are really just facilities that allow dealing activities outside traditional exchanges without prices being disclosed publicly.
• The proliferation of dark pools has been phenomenal during the last few years but the pace of development varies across the regions. According to US SEC, the number of active dark pools transacting in stocks that are tradedon major U.S. stock markets has increased from approximately 10 in 2002 to approximately 29 in 2009.
• In Asia, dark pools are still at an infancy stage. Some of the more prominent American and European firms have explored the prospects of setting up similar operations in the major markets in Asia, including Hong Kong. In Hong Kong, we have seen the number of dark pools, mainly brokers' internalisation pools, increased from just a handful several years ago to more than 10 currently.
• There have been discussions about the implication of dark pools for the integrity of the market. The main issue being debated is that a lack of transparency in dark pool operations deprives the public of fair access to information about the best available prices to some market participants and thus results in a two-tiered market. The dark pool is an institutional market. Regulators should carefully study the pros and cons of integrating this institutional trading venue and the trading venue offered by stock exchanges before making any policy changes. The primary focus here should be whether the two-tiered market has created difficulties for regulators to conduct market surveillance.
• Another unintended consequence of dark pools is the fragmentation of pricing data, thus making it difficult for investors to know where they are likely to get the best price for their orders. In some markets, there are rules requiring an exchange to route an order to another exchange or liquidity pool if there is a better price. But such order routing usually incurs costs to investors. The growth of dark pools calls for a review of the best execution policy.
• Price discovery is a major function of an exchange market and the efficiency with which it is carried out depends on whether orders from a diverse set of participants are properly integrated so as to achieve reasonably accurate price discovery and reasonably complete quantity discovery. Most of the dark pools determine execution prices with reference to exchange produced prices. If dark pools continue to grow and account for a significant portion of market share, it will affect the price discovery function currently performed by the exchange market.
• To bring about greater market transparency and fairness, US SEC has recently mooted three changes to enhance the transparency of dark pools: (a) dark pools in the U.S. are currently required to publicly display stock quotes if their trading volume exceeds 5% of the volume of a particular stock, but the new plan would reduce the threshold to 0.25%;(b) the second change would require actionable indications of interests to be displayed in the public quotation system; and (c) the third proposal requires real time reporting from dark pools for their executed trades, making the dark pools' identity visible to the public.
• Dark pools can offer something exchanges cannot, e.g. a wide range of order types including algorithmic trading tools. Thus, it is arguable that dark pools are not competing with the exchanges, they are in fact offering a different type of service or servicing a different segment of the market.
• Along with the emergence of dark pools or alternative trading pools, we have also seen a rapid development of advanced trading tools, in particular algorithmic trading or DMA in general. DMA allows institutional investors to trade faster and to have direct control of their order execution. The increase in trading speed can amplify any unintentional errors in the execution process. DMA also enables institutional investors to send a large amount of order flow to the market within a very short period of time, which may have a systemic impact on the market. For example, the use of DMA facilitates the automatic generation of time-sensitive orders based on the changing market conditions. In the past, we have seen a number of occasions when DMA users sent large orders to the exchanges merely based on the pre-set algorithmic formula without giving sufficient consideration to the prevailing liquidity level in the market. As a result, the stock prices fluctuated wildly triggered by the arrival of these large orders. It is therefore important that brokers who provide DMA services ensure that there is sufficient pre-trade monitoring and control of orders using DMA.
• Broker-sponsored access has raised more challenges for us to monitor DMA orders. Some brokers have offered their institutional clients direct access to the market without going through the brokers' trading systems. This kind of DMA provides market participants unfiltered access to the market and makes it difficult for brokers to conduct any meaningful pre-trade monitoring. The term "naked access" can better describe this type of trading activity. Some regulators have been looking into this issue.

Greenmail

Every time after experiencing a financial crisis, many people would dream for recovering their capital losses by making some innovative investments. In 1999 they put their stakes at IT stocks, in 2009 they have faith on "green" investments.

SEC recently charged four individuals and two companies involved in perpetrating a US$30 million Ponzi scheme in which they persuaded more than 300 investors nationwide to participate in purported environmentally-friendly investment opportunities.

Wayde and Donna McKelvy, who were previously married and living in the Denver area, particularly targeted elderly investors or those approaching retirement age to finance such "green" initiatives of Pennsylvania-based Mantria Corporation as a supposed "carbon negative" housing community in rural Tennessee and a "biochar" charcoal substitute made from organic waste. The McKelvys promoted Mantria investment opportunities through their Denver-based company Speed of Wealth LLC. With the help of two other promoters who are Mantria executives — Troy Wragg and Amanda Knorr of Philadelphia — they convinced investors attending seminars or participating in Internet "webinars" to liquidate their traditional investments such as retirement plans and home equity to instead invest in Mantria.

The "green" representations were laced with bogus claims, and investors were falsely promised enormous returns on their investments ranging from 17% to "hundreds of percent" annually. In fact, Mantria's environmental initiatives have not generated any significant cash, and any returns paid to investors have been funded almost exclusively from other investors' contributions. They overstated the scope and success of Mantria's operations in several ways to solicit investors. For instance, they claimed that Mantria was the world's leading manufacturer and distributor of biochar and had multiple facilities producing it at a rate of 25 tons per day. In fact, Mantria has never sold any biochar and has just one facility engaged in testing biochar for possible future commercial production. Furthermore, Mantria's only source of revenue has been from its resale of vacant lots for its purported residential communities in rural Tennessee, but those did not generate cash with which to pay investor returns because Mantria provided 100% financing for almost all of its vacant lot sales to buyers using other investors' funds.

Speed of Wealth has frequently advertised its events through television, radio and print advertising as well as Internet marketing. At seminars and webinars sponsored by Speed of Wealth, Wayde McKelvy along with Wragg or Knorr generally conduct a two-part presentation in which they urge investors to liquidate all of their traditional investments, including individual retirement accounts, employer-sponsored 401(k) plans, mutual funds, stocks, bonds, and savings accounts. McKelvy also encourages investors to borrow as much as possible against home equity, parents' home equity, and business lines of credit. He then recommends that investors use all of their funds to invest in what he describes as the "consistent and safe" high-yield securities offered by Speed of Wealth and Mantria.

After Wragg or Knorr describe Mantria's purported operations and corresponding securities being offered, they market Speed of Wealth and Mantria securities with high-pressure tactics. They frequently offer short-term incentives and bonuses in various programs to induce investors to "pledge" their investments, or to induce those who have pledged to send in their money immediately. In seminars, webinars, and conference calls, Wayde McKelvy often calls upon past investors to provide "testimonials" about their receipt of high returns from past programs. McKelvy and Wragg also tout the safety and security of Mantria's securities based on collateral consisting of deeds of trust given to investors on Mantria's Tennessee rural land holdings. Wragg even tells potential investors that because of the valuable collateral, investors may make more money on their investments if Mantria defaults than if Mantria makes the promised payments. The promoters frequently allude to Mantria's imminent closing of sales worth hundreds of millions of dollars, initial public offerings of securities that are "sure to come" and "sure to be a very huge Wall Street hit", or upcoming investments by "Wall Street."

Mantria and Speed of Wealth used investor funds to pay returns to other investors in typical Ponzi scheme fashion. Mantria and Speed of Wealth also did not tell investors that they kept a significant amount of their funds to generously pay commissions of 12.5% to the McKelvys.

The word "greenmail" could be redefined now.

Insider Trading by Lawyers and Traders

Last week SEC charged a pair of lawyers for tipping inside information in exchange for kickbacks as well as six Wall Street traders and a proprietary trading firm involved in a US$20 million insider trading scheme.

SEC alleges that Arthur J. Cutillo, an attorney in the New York office of international law firm Ropes & Gray LLP, had access to confidential information about at least four major proposed corporate transactions in which his firm's clients participated. Through his friend and fellow attorney Jason Goldfarb, Cutillo tipped this inside information to Zvi Goffer, a proprietary trader at New York-based firm Schottenfeld Group. Goffer promptly tipped four traders at three different broker-dealer firms and another professional trader Craig Drimal, who each then traded either for their own account or their firm's proprietary accounts.

Goffer was known as "the Octopussy" within the insider trading ring due to his reputation for having his arms in so many sources of inside information. Cutillo, Goldfarb, and Goffer at times used disposable cell phones in an attempt to conceal the scheme. For example, prior to the announcement of one acquisition, Goffer gave one of his tippees a disposable cell phone that had two programmed phone numbers labeled "you" and "me." After the announcement, Goffer destroyed the disposable cell phone by removing the SIM card, biting it, and breaking the phone in half, throwing away half of the phone and instructing his tippee to dispose of the other half.

This is a real case, not a TV drama.

HKMA Guideline on Sound Remuneration System

HKMA has recently developed this Guideline on the basis of the recommendations issued by the Financial Stability Board (FSB), which have been endorsed by the G20 as an international standard on sound remuneration practices. This Guideline serves to provide broad guidance on the governance and control arrangements for, and operations of, banks' remuneration systems. It is intended to apply to both locally incorporated banks and local branches of foreign banks.

The Guideline covers the following areas:

1. Governance – formulation of remuneration policy; board oversight (including the establishment of a remuneration committee); and the role of risk control functions (including, but not limited to, risk management, financial control, compliance, and internal audit) in respect of an bank's remuneration system.
2. Structure of remuneration – proportionate balance of fixed and variable remuneration; use of instruments for variable remuneration; and exceptional use of guaranteed minimum bonuses.
3. Measurement of performance for variable remuneration – pre-determined criteria for performance measurement; adjustments to performance assessment in respect of current and potential risks and the overall performance of a bank and relevant business units; and the exercise of judgement in the process of determining variable remuneration.
4. Alignment of remuneration payouts to the time horizon of risks – deferment of variable remuneration (including minimum vesting period and pre-defined performance conditions); claw-back provision and restriction on hedging exposures in respect of the unvested portion of deferred remuneration.
5. Adequate disclosure on remuneration – disclosure in respect of the design and implementation of remuneration systems; and aggregate quantitative information on remuneration broken down by senior management and by other employees whose activities could have a material impact on the risk exposure of a bank.

HKMA intends to finalize the Guideline by the end of 2009 and expects all banks to fully implement it within 2010.

It appears that even last year's financial tsunami has not caused a disaster affecting the stability of Hong Kong's banking industry, HKMA is more proactively intervening in the banking industry by following the international recommendations. If banks' remuneration system has to be regulated, how about insurance companies and the securities industry?

As a compliance practitioner, I am also interested to know how the remuneration policy would be formulated for the compliance function.

Online Securities Fraud

SFC recently charged a securities broker from Merrick, N.Y., with securities fraud for repeatedly creating and then distributing fake press releases to manipulate the stock prices of multiple publicly traded companies.

Lambros Ballas, a registered representative of NYSE firm Global Arena Capital Corporation, purported to announce good news regarding the companies, including that Google was buying one of them at a substantial premium. Ballas then posed as an investor on Internet message boards, touting the announcements he had fabricated. In one instance, his scheme caused the stock price to increase by nearly 80% within a few hours of the issuance of his phony press release.

According to SEC's complaint and other court documents filed in the case:

• Ballas issued a phony press release the evening of 29 September 2009, announcing that Pennsylvania biotech company Discovery Laboratories had obtained approval from the U.S. Food and Drug Administration for a drug under development. Ballas then posted a message on a stock message board with a link to what he described as the company's "official press release." In his post, Ballas claimed to have called his "personal broker" who "says it's been confirmed." The next morning, Discovery Laboratories shares opened significantly higher.
• The next day, Ballas issued another press release falsely claiming that IMAX Corporation had been acquired by Disney. Once again, he followed up by posting links to the phony release on a stock message board, telling other potential investors that he had bought 10,000 IMAX shares and that his broker "just called me to tell me at the crack of dawn."
• Ballas continued his scheme on 1 October 2009, issuing a phony press release stating that California search engine company Local.com was being acquired by Microsoft. Ballas again followed up by posting messages and links to the Local.com release on stock message boards. In one posting he stated: "Local just bought out by Microsoft, at $12.50 per share including patent ownership." In after-market trading, Local.com's stock price rose nearly 80%.
• Later that night, Local.com issued a corrective release saying that the Microsoft release had been false — there was no Microsoft acquisition. Undeterred, the next day Ballas issued another phony release, this time stating that it was Google, and not Microsoft, that was acquiring the company.

Shortly before he sent the hoax press release about Discovery Laboratories, Ballas’s brokerage clients purchased shares of the company and thus stood to profit by any price rise Ballas’s fake release created. Similarly, Ballas bought shares of Local.com stock just before he sent out the fake Local.com-Microsoft release so that he could capitalize on the fraudulent share price inflation he intended to trigger.

SEC’s complaint charges Ballas with violations of the antifraud provisions of the federal securities laws. The SEC seeks injunctive relief, disgorgement of ill-gotten gains, and monetary penalties against Ballas.

Employee Fraud

UK FSA recently fined London-based investment bank and stockbroker Seymour Pierce Limited (SPL) £154,000 for failing to establish effective controls to guard against employee fraud. As a result of SPL's failings, an employee was able to steal approximately £150,000 completely undetected from the firm's internal and private client accounts in 36 separate transactions over a three year period.

A number of the illicit transactions involved making unauthorised changes to static data (such as the client's name, address, bank account and payment instructions) on existing client accounts or taking advantage of dormant accounts. In one instance the employee transferred a personal trading loss into one of SPL's internal accounts. The employee was dismissed prior to the discovery of the misdemeanours which only came to light when his replacement noticed serious accounting discrepancies.

At the start of the relevant period (from December 2001 to February 2007), SPL's private client business consisted of only a small number of legacy private clients who had remained with the firm after the closure of the private client department in 1997. In May 2005, SPL rebuilt its private client business operations following the transfer to SPL of a private client team from a related company.

Settlements

Throughout the relevant period, trades executed by SPL on behalf of its institutional clients and private clients were settled by a third party firm pursuant to a settlements, clearing and custody arrangement. This involved a tripartite contractual relationship between SPL, the third party firm and each client. Under this arrangement, SPL retained responsibility for all aspects of the client relationship and Settlements department (Settlements) continued to play an important role in the administration of accounts set up on the third party firm's settlement system (System B), which SPL was licensed to use.

Settlements was a small team which consisted of Mr A and one or two other members of staff. Settlements staff had access rights to System B which enabled them to manually enter details of executed trades, and change static data on client accounts in accordance with clients' instructions.

Relevant Accounts

Monies and assets belonging to SPL's institutional and private clients were held in bank accounts in the name of the third party firm, and responsibility for reconciling all accounts held by SPL's institutional and private clients rested with the third party firm. The holdings and related trades were administered by SPL via client accounts set up on System B.

SPL also operated a number of its own 'internal' accounts set up on System B, including: an 'Errors Account' used for booking trades when there had been a dealing error; a 'Warehouse Account' used for administrative convenience to aggregate trades where an institutional client gave the firm an order which needed to be executed in tranches; a 'Corporate Account' used for allocating new stock holdings to client accounts; and a 'Placing Account' used for allocating stock relating to a corporate finance placing to a party that was not an existing client of the firm. SPL also had use of a 'Trading Account' established and maintained by the third party firm for all correspondent broker firms that used System B. The Trading Account was used for posting trades that various SPL institutional clients executed with the firm on a 'riskless principal' basis.

The Frauds

Between May 2003 and April 2006, Mr A stole a total of £149,165 by way of thirty-six separate transactions. Around half of this amount was from SPL and around half from SPL’s legacy private clients.

Three transactions involved Mr A stealing a total of £73,884 from SPL's legacy private clients between December 2004 and February 2005. The three legacy private client accounts involved were all dormant:

1. One account held the proceeds of securities that had been sold in November 1998. The proceeds remained on the account accruing interest at six-monthly intervals. In December 2004, Mr A manipulated payment instructions on the account so that the total balance of £4,426 was automatically paid out to his personal bank account by the third party firm.
2. A second account held a balance that had been accruing interest at six-monthly intervals since March 1998. In December 2004, Mr A manipulated payment instructions on the account so that the total balance on the account of £16,787 was automatically paid out to his personal bank account.
3. A third account held securities since November 1999. In 2004, Mr A changed details on System B to transfer the securities initially to a dormant institutional client account that he had converted in October 2002 for his own use and then to his personal dealing account. Staff personal dealing accounts were set up to pay away cleared funds automatically. Therefore, when the securities were redeemed in February 2005, the proceeds of £52,670 were automatically paid to Mr A's personal bank account.

Thirty-three transactions involved Mr A stealing a total of £75,281 from SPL between May 2003 and April 2006:

1. Twenty-four transactions related to 'riskless principal' trading profits that the firm had earned. Trading on a riskless principal basis involved SPL buying stock from (or selling to) a client in the firm’s own name (as opposed to acting as an agent) at one price and simultaneously selling the stock to (or buying from) another client at a different price. SPL traded on this basis when clients insisted that they did not want to pay agency broking commission and that instead SPL should make its profit from the difference between the buying and selling price. These trades should have been booked onto the Trading Account. However, instead Mr A booked the trades onto the dormant institutional client account. Mr A had manipulated payment instructions on this dormant account in October 2002 so that the monies were automatically paid out by the third party firm via cheques sent to his home address. Mr A stole a total of £39,127 from the firm in this way between May 2003 and March 2005. After this date Mr A was deterred from diverting any further riskless principal trading profits for his own benefit due to the implementation by SPL of a computerised front office order management system.
2. Seven transactions related to interest that was due to the firm. Institutional clients normally settled their transactions on a delivery-versus-payment basis. This meant that balances would not normally be left on their accounts and no interest would accrue. However, where interest did accrue on these accounts, SPL's terms of business made it clear that it would be due and payable to SPL. Mr A was able to commit six of the seven frauds by manipulating payment instructions on client accounts where interest had accrued. This resulted in the monies being automatically paid either directly to his personal bank account or by cheque sent to his home address. The other fraud involved the diversion of interest that had accrued on SPL's internal Placing Account to Mr A’s personal bank account. Mr A stole a total of £22,257 from the firm in this way between October 2004 and September 2005.
3. One transaction involved Mr A transferring, into the firm's Warehouse Account, a loss that he had incurred on his personal dealing account. SPL employees were permitted to be SPL clients and to maintain accounts set up on System B through which they could buy and sell securities, in accordance with the firm’s personal dealing procedures. Mr A sold stock in his own name in March 2005, incurring a loss of £2,883 on a corresponding purchase trade that he had instructed the firm's front office to effect but which he had not settled. He then transferred both trades (and the resulting loss) from his personal dealing account into the firm's internal Warehouse Account by misleading an employee at the third party firm and misusing his access rights to System B.
4. One transaction related to dealing commission that SPL had earned on the sale of an institutional client's shares. Mr A was able to commit this fraud by incorrectly booking the dealing commission to the client's account and manipulating payment instructions so that the monies were automatically paid to his personal bank account. Mr A stole a sum of £11,015 from the firm in this way in April 2006.

Static Data Monitoring

Static data is information held on a client account which does not often change, such as the client's name and address and the client's payment instructions. SPL's Settlements team was responsible for making changes to static data on accounts set up on System B in accordance with client instructions. There was therefore a material risk that static data might be improperly altered by Settlements staff and it was necessary for SPL to mitigate this risk.

Static data on client accounts could be set up to facilitate payment in one of two ways: 'Pay away funds' – accounts set up to pay out cleared funds arising on the account automatically either as they arose or at pre-set intervals; or 'Retain funds' – accounts set up to retain any cleared funds arising on the account indefinitely.

For accounts set up on System B to retain funds, SPL sought to control payments out by requiring payment instructions to be authorised by a member of the firm’s Finance department (Finance). However, this control by Finance did not apply where an account was set up to pay away funds automatically. A dishonest member of staff in Settlements might therefore circumvent this control by improperly changing the status of the account from 'retain funds' to 'pay away funds' and changing the payee’s details to those of an account that he controlled. It was therefore important that SPL monitored changes to payment instruction static data on client accounts.

A daily exception report was generated which detailed all changes to static data made on accounts set up on System B. This report was accessible to members of SPL's Compliance department (Compliance) and Settlements for monitoring purposes. However, prior to February 2004 it was only accessed by Mr A at SPL. After February 2004, Compliance also accessed the report to carry out sample checks of the client's categorisation on the system and to ensure that all new accounts had received Compliance sign-off. After SPL's new private client department opened in May 2005, these reviews were extended to include sample checks against details contained in the application forms of new clients. However, during the Relevant Period Compliance's reviews of the daily exception reports did not focus on changes made to static data on existing accounts. As a result, if Settlements staff manipulated static data on older client accounts, it was unlikely that this activity would be discovered by Compliance.

Thirty-three of the frauds committed by Mr A between May 2003 and April 2006 involved unauthorised changes to static data made by Mr A on twelve client accounts. In this way, SPL's failure to adequately monitor static data changes facilitated the theft of £92,107.

Dormant Account Monitoring and Control

A dormant account is an account on which there has been no trading activity for a period of at least two years or that is otherwise known to be inactive. Dormant client accounts carry an increased risk of fraud because they are not likely to be monitored by the clients who hold them. The risk of misuse applied to all dormant accounts, whether they were institutional client accounts or private client accounts.

SPL did not adequately control dormant client accounts to prevent them being misused. The majority of the legacy private client accounts that remained open during the Relevant Period were dormant. This was therefore a particularly high risk category of accounts that required SPL's attention. Significant efforts were made by SPL to contact legacy private clients and return any balances on their accounts following the closure of the old SPL private client department in 1997. However, SPL was unable to close thirty-eight legacy private client accounts, some of which continued to hold client money or assets. SPL was unable to locate and obtain instructions from those legacy private clients, and accordingly those legacy accounts remained. Despite the fraud risks posed by these legacy accounts, SPL allowed them to be left open on System B without putting in place a process for monitoring any activity on them.

Twenty-six of the frauds committed by Mr A between May 2003 and March 2005, involved the misuse of a total of four dormant institutional client and/or legacy private client accounts. In this way, SPL's failure to adequately monitor and control dormant accounts facilitated the theft of £108,891.

Reconciliation of Internal Accounts

It was necessary for SPL to monitor its internal accounts in order to identify any errors in the booking of entries onto System B by Settlements staff and to identify any manipulative practices involving these accounts. However, there was no process in place at SPL to adequately govern this area.

As part of his responsibilities, SPL expected Mr A to regularly reconcile the firm’s internal accounts. However, for at least fifteen months he did not reconcile these accounts at all. He was not challenged by SPL over the fact that he had not been reconciling these accounts until around October 2005. The fact that the reconciliations had not been completed for a substantial period of time then made it difficult and time-consuming for him to complete them. This gave Mr A an apparently plausible excuse to delay further, which SPL accepted.

Two of the frauds committed by Mr A involved the misuse of SPL internal accounts, namely the Placing Account (theft of £1,505 interest in October 2004) and the Warehouse Account (transfer of a £2,883 personal dealing loss in March 2005).

Twenty-four of the frauds (theft of riskless principal trading profits of £39,127 between May 2003 and March 2005) involved monies that should have been booked to the Trading Account. This was not one of SPL's internal accounts, but SPL should have taken steps to ensure that the booking of entries that should have been posted to this account by Settlements was being monitored. SPL introduced an electronic order management system in 2005. However, before this system was introduced, SPL should have mitigated fraud risk in this area, for example, by independently reconciling trades executed by its front office against those booked by Settlements.

If SPL had taken proper steps to ensure that such reconciliations were completed during the Relevant Period, it is likely that Mr A would have been deterred from committing some of the frauds. Effective and independent monitoring of internal account reconciliations would have also led to his fraudulent activity being detected earlier.

Discovery of Issues

In July 2006, SPL dismissed Mr A. The replacement that SPL recruited in August 2006 was asked to reconcile the firm's internal accounts as a priority. In January 2007, when reconciling the Warehouse Account, Mr A's replacement discovered one of the frauds. Further investigations by SPL in the following months uncovered the remaining frauds.

MMT Case Against Sun Hung Kai

This week the talk of the town in the compliance field is the report issued by Market Misconduct Tribunal (MMT) on the case of QPL International Holdings Ltd.

SFC publicly reprimanded Sun Hung Kai Investment Services Ltd (SHKIS) and fined it $4,000,000 for internal control failures that contributed to market misconduct (false trading and price rigging). Following an inquiry into dealing in the shares of QPL in 2003, MMT found on 22 January 2009 that Mr Edmond Chau Chin Hung (a former responsible officer of SHKIS) and Ms Connie Cheung Sau Lin (a former account executive of SHKIS) engaged in false trading and price rigging, contrary to SFO, for the period from 6 May to 10 June 2003.

MMT further found that:

• the misconduct of Chau was attributable to SHKIS of whom he was an executive director and responsible officer, and to Cheeroll Ltd (now renamed Sun Hung Kai Strategic Capital Ltd) for whom Chau was authorised to trade; and
• SHKIS was vicariously liable for the misconduct of Cheung.

On 25 February 2009, MMT made certain orders including recommending that disciplinary action be taken by SFC against SHKIS, Chau and Cheung. SFC found that there were internal control failures at SHKIS that contributed to the market misconduct because:

• despite policies to segregate proprietary trading and client trading, SHKIS gave Chau the authority to conduct both types of trading which gave him the opportunity to misuse information gathered on the client trading side of the business to engage in unlawful activities in a proprietary account;
• at material times, SHKIS allowed Chau and Cheung to place orders in the same dealing room by open "outcry", which was inconsistent with SHKIS' formal policy to physically separate proprietary and client trading functions; and
• SHKIS did not detect Chau and Cheung's misconduct for five weeks until brought to its attention by SFC.

Further details disclosed in MMT's report:

• In October 2002 and February 2003, Chau arranged two placements of QPL's shares on behalf of Sun Hung Kai International Limited to two clients, namely Chinacal Limited and Honest Opportunity Limited, generating total commissions of around $8 million.
• Since 1997, Chau had been authorized to operate the house account of Cheeroll. Between 6 May and 10 June 2003, he made numerous "buy", "cancel" and "reduce" orders for Cheeroll in its account with SHKIS to trade QPL shares. Not a single share was acquired in the course of those orders.
• During the same period, Cheung (direct subordinate of Chau) sold through SHKIS substantial quantities of QPL shares on behalf of Chinacal and Honest Opportunity.
• Since Chau had suggested Chinacal and Honest Opportunity take substantial tranches of QPL shares, he was motivated to "scaffold" in the account of Cheeroll in order to enable them to sell those shares more easily and quickly.

Let's wait and see how SFC would discipline Chau and Cheung as well.

Failure to Prevent Insider Dealing

We all know insider dealing is illegal, and so Du Jun (former investment banker of Morgan Stanley) was imposed a 7-year imprisonment term. But don't you think broker firms should be obliged to report insider dealing of their clients to the regulatory body (like the reporting of money laundering)?

Recently FSA fined Mark Lockwood, a former trading desk manager at a retail stockbroking firm, £20,000 for failing to observe proper standards of market conduct. Lockwood failed to identify and act on a suspicious client order that allowed the firm to be used to facilitate insider dealing. As a result of his failings the firm failed to identify the trade as suspicious and report it to the FSA.

Lockwood's misconduct related to his dealings with a client who sold shares in oil and gas exploration company Amerisur on 23 May 2007 - ahead of an announcement by the company of a placing of shares the next day. The client has been subject to separate FSA enforcement action for market abuse in relation to Amerisur shares. Lockwood was aware of the client's possession of inside information by means of telephone conversations with him.

Lockwood failed to identify that the transaction was being conducted on the basis of inside information, despite his own knowledge of the impending transaction and clear warning signals from the client. He failed to prevent the trade or alert his firm to the possibility that the trade was being conducted on the basis of inside information. As a result no Suspicious Transaction Report (STR) was submitted to the FSA and the trading only came to light because of a report submitted by another broker.

For details of the story, please refer to FSA's Final Notice.

I wonder if SFC would consider implementation of the STR regime for insider dealing and market manipulation in future.

SFC Proposals to Enhance Investor Protection

Last week SFC released the Consultation Paper on Proposals to Enhance Protection for the Investing Public as the regulatory response to last year's financial crisis triggered by the collapse of Lehman Brothers.

This consultation is premised on Hong Kong continuing to adopt the "disclosure-based approach" coupled with conduct regulation on intermediaries who sell products. It proposes additional measures to provide investor protection, which are briefly summarized and commented below.

Documentation

• The criteria for authorizing offering documentation and advertisements will be consolidated into a single SFC handbook, covering unit trusts/mutual funds, ILAS and unlisted structured products. (Comment: It is desirable to provide a Code for unlisted structured products, but would it be as comprehensive as the UT Code?)
• SFC is working with Government to bring forward legislative amendments to transfer the authorization of offering documentation in relation to structured products out of the CO prospectus regime. (Comment: Actually this issue had been consulted and concluded a few years before. Why is SFC still working with Government?)
• All offering documents should include concise and easily-understood summaries, or product Key Facts Statements. (Comment: That's good for investor education. Such product KFS may be produced by SFC for standardization.)

Disclosure

• There are various options to address potential intermediary conflicts of interest issues regarding monetary and non-monetary benefits received. (Comment: Disclosure of commission rebates received by intermediaries from product issuers to the clients could at least partially resolve the conflicts of interest issues.)
• The single SFC handbook requires ongoing disclosure to investors of material information in relation to unlisted structured products in addition to the existing ongoing disclosure requirements already imposed on unit trusts/mutual funds and ILAS. (Comment: Ongoing disclosure is particularly important for long term unlisted structured products.)
• Distributors of these products are obliged to pass on to ultimate investors the information that they receive from the issuers. (Comment: Simply "passing on" the information may not be enough. Distributors should highlight material issues to the clients.)
• The minimum content to be provided in a sales disclosure document is specified. (Comment: Standardization of content in sales disclosure documents is necessary.)

Sales Process

• An intermediary should not act in a way that distract the client's attention from the product features by offering certain types of gifts as a marketing tool. (Comment: Actually this is the problem of retail investors. Even though product specific gifts are prohibited, intermediaries may still offer account specific gifts depending on the sales turnover.)
• Audio recording requirement should be extended to cover all intermediaries selling investments to the public. (Comment: Implementation of audio recording by intermediaries meeting with clients outside office is a difficulty. It may be more feasible for audio recording only the deal closing stage.)
• Intermediaries should only promote unlisted derivative products to clients (other than professional investors) who have been characterized as "clients with derivative knowledge". (Comment: The more objective way to characterize clients with derivative knowledge is asking them to pass an assessment quiz.)
• The minium portfolio requirement and the ways of assessing the knowledge, expertise and investment experience of a professional investor in a relevant market/product should be adjusted. (Comment: Increasing minimum portfolio requirement is of no use. SFC should give more guidelines for intermediaries to assess a PI's knowledge or experience in a so-called "relevant" market/product.)

Post-Sale Arrangements

• Cooling-off period should only be considered for products where the investment is long-term, and where there is no ready (and realistic) secondary market. (Comment: This requirement creates operational difficulties. Product issuers might have to delay the investment/trading process to cater for the refund request.)

This consultation has raised a number of controversial issues with far-reaching impact on intermediaries selling investment products. It is anticipated that SFC will receive a large amount of comments or counter-proposals.

Investment Courses

Last week the Eastern Magistracy convicted RC Trading Education Ltd and its director, Mr Rickey Cheung Wing On of two counts of issuing unauthorised advertisements and one count of carrying on regulated activities when they do not hold a licence to do so from SFC.

SFC alleged that between June and July 2008, RC Trading advertised three courses about trading S&P500 index futures. The advertisements promoted free seminars which were followed by practical training sessions, at a cost of $2,500, or coaching sessions on day trading the S&P500 index, for a monthly fee of $7,800.

The defendants represented the coaching courses would guarantee performance or students would receive 110% of their money back (thus they issued unauthorized investment advertisements). Students who enrolled in the course received trading instructions, tips and real time advice from Cheung (thus he was advising on futures contracts), some of whom suffered losses.

When the stock and futures markets are hot, there are a lot of so-called "financial coaching" courses available to people who are keen on getting trading tips instead of learning the investment tools. This is not a healthy phenomenon. When I conduct the Chartered Wealth Manager (CWM) program, I would emphasize that this is not a course offering any investment advice or "lucky stock codes" to the participants.

City of Greed

There is always an annoying voice surrounding the Central branch of Citibank during office hours. What's wrong with this bank?

Last month FINRA has barred Tamara Lanz Moon from the securities industry for wrongfully taking over US$850,000 in funds from at least 22 customers, including her own father. Moon was also charged with falsifying numerous account records, engaging in unauthorized trades in customer accounts and related recordkeeping violations.

Moon's misconduct occurred over an eight-year period ending in March 2008, while she was working as a sales assistant for Citigroup Global Markets at the firm's Palo Alto, CA, branch office. Citigroup has compensated customers for losses resulting from Moon's misconduct.

FINRA found that Moon targeted elderly, ill or otherwise vulnerable customers whom she believed were unable to monitor their accounts. Victims of Moon's scheme included elderly customers (including a senior with Parkinson's disease), an American diplomat and even her own father. Moon forged signatures on letters of instruction requesting unauthorized address changes, trades and transfers between and to accounts controlled by Moon for the purpose of paying her personal expenses, remodeling her home and making personal investments in other real estate properties.

In one case, FINRA found that Moon misappropriated approximately US$26,000 belonging to an elderly widow. In November 2006, following the death of the customer's husband, Moon helped the widow consolidate her holdings into one Citigroup account. In June 2007, when the widow was 83 years old, Moon began moving money from the widow's Citigroup account — without the widow's authorization — to accounts owned by Moon and to accounts owned by other Citigroup customers to replace funds Moon had previously stolen from those accounts.

To further her scheme, Moon falsified documents requesting address changes. On May 21, 2007, the widow's account appeared on an internal report that indicated a discrepancy between the address on the widow's account and her address in government and telephone directories. Moon explained the discrepancy to Citigroup by falsely stating that the "client moved into a nursing home."

Moon's misconduct was not limited to taking funds belonging to elderly widows. Moon misappropriated approximately US$55,000 belonging to an American diplomat working overseas, who held custodial accounts at Citigroup for his two daughters, and forged his signature on authorizations to change his address so account statements wouldn't reach him.

Moon also misappropriated funds belonging to her own father. In January 2006, Moon created a phony account for her father, without his knowledge or consent, and used this account to misuse approximately US$30,000 belonging to her father and approximately US$250,000 belonging to other Citigroup customers. On 20 January 2006, Moon forged her father's signature on a letter of authorization to Citigroup, changing the address on the account to keep account statements from being sent to her father. From August 2006 to March 2008, Moon requested and processed unauthorized cash transfers into her father's phony account from other Citigroup customers totaling over US$250,000. During this same timeframe, Moon — again forging her father's signature — disbursed the funds from the account for her own personal use.

Another bastard!

HKSI LE Paper 2 Past Paper (2)

HKSI LE Paper 2 (Dec 2006) - Q&A 21~40 (with explanations):

21(A) - (I) and (II) are the facts and thus (III) and (IV) must be wrong.

22(D) - ATS provider should be either authorized by SFC or licensed by SFC for Type 7. Firms whose business is principal dealing is exempt from being licensed for Type 1. Trust companies registered under Trustee Ordinance are exempt from being licensed for Type 1 when acting as an agent for a collective investment scheme.

23(A) - Without the quotation rules, the share price fluctuations may not fluctuate in an orderly way.

24(D) - (A) is wrong because following the demutualization of SEHK an exchange participant has no longer been required to be a shareholder of SEHK. (B) is wrong because the transfer of exchange participantship is approved by SEHK. (C) is wrong because a SFC licensed corporation should separately make an application for exchange participantship to SEHK.

25(D) - (I) is wrong because individual investors may also open accounts with HKSCC.

26(C) - (C) is incorrect because such marking to market is only required on at least daily basis.

27(C) - (C) is incorrect because some other securities listed on Main Board (e.g. illiquid stocks, warrants) may also not be short sold.

28(D) - (I) is wrong because there is no such requirement. In fact, it would be inconvenient to combine the annual standing authority with the client agreement.

29(B) - (B) is incorrect because such a journalist, even not licensed by SFC, may still be prosecuted by SFC for "disclosure of false or misleading information" (one kind of market misconduct).

30(C) - Both (A) and (B) are unfavorable to the clients without reason. (D) is wrong because such requirement does not exist and is not practical.

31(C) - An approved introducting agent is not subject to the Rules per (I), (II) and (IV) because it would never hold client assets, while contract notes and statements are issued by the execution broker instead.

32(A) - (II) is wrong because the offer and distribution as part of a listing is covered by SEHK's Listing Rules instead. (III) is wrong because not all kinds of securities are covered by CO for offering.

33(D) - (I) is wrong because only eligible an options exchange participant can become a market maker. (III) is wrong because there is no market maker system for equity securities.

34(D) - (D) is wrong because the use of modeling techniques is for risk monitoring, not risk reduction.

35(A) - (III) is wrong because there is no such thing as "independent clearing participant". (IV) is wrong because self-dealing participant can't clear the transactions of other participants.

36(C) - Retaining even the balance of any proceeds after meeting in full the client's obligations is obviously not a reasonable step.

37(B) - (B) is exactly describing the behavior of front-running. (A) is cold calling. (C) is churing. (D) is wash sale.

38(A) - (B) is wrong because the Investment Compensation Fund covers only investors who have suffered from defaults of certain intermediaries. (C) is wrong because an investor has no such right. (D) is wrong because such insurance is not claimed for dealing misconduct.

39(C) - Possession of professional qualifications is not relevant to the misconduct.

40(C) - MMT can only impose civil sanctions and thus imprisonment is not available.

HKSI LE Paper 2 Past Paper (1)

HKSI has recently released also the past paper (December 2006) of licensing examination Paper 2, which is usually taken by people who intend to become a responsible officer for Types 1/4/8 regulated activities. Again, I provide my explanations of the answers here.

HKSI LE Paper 2 (Dec 2006) - Q&A 1~20 (with explanations):

1(A) - Even a stock has been suspended for trading, those transactions completed before the suspension should be settled as usual. There is not such thing called Securities & Futures (Suspension of Trading) Rules. Nobody is entitled to any compension due to trading suspension.

2(C) - (I), (II) and (IV) are correct based on common senses of law. (III) is wrong because PDPO does not require the provision of access to personal data free of charge.

3(A) - (C) and (D) are too serious to pass the fit and proper standards. When comparing (A) and (B), obviously (A) is less adverse.

4(A) - Listing of companies is covered by Listing Rules. Issue of contract notes is covered by Securities & Futures (Contract Notes, Statements of Account and Receipts) Rules.

5(D) - Institutional investor is typically subject to less investor protection under SFO and thus not protected by Securities & Futures (Investor Compensation - Claims) Rules.

6(C) - (A) is wrong because annual audited accounts must be submitted to SFC within 4 months of the financial year end. (B) is wrong because appointment of an auditor must be notified to SFC within 7 business days. (D) is wrong because financial year end must be notified to SFC within 1 month.

7(B) - In (I), (II) and (III), the client can confirm that the intermediary has received his assets in an alternative way, thus issue of a receipt by the intermediary is exempted by the Rules.

8(B) - For records which are orders and instructions from clients, the record retention period required by the Rules is only 2 years, while 7 years is applicable to all other records.

9(A) - (I) is incorrect because the Fund would not cover certain professional investors and clients of certain intermediaries. (II) is incorrect because the Fund cover all securities traded on SEHK.

10(B) - (I) is wrong because contract notes must be issued within T+2. (IV) is wrong because the two intermediaries must agree in writing as to who will provide contract notes to the client.

11(C) - Segregation of client money within 1 business day is specified by the Rules.

12(D) - It is not practical for the licensed person to notify the client before dealing in options through another intermediary, thus (D) would not be included in the options client agreement.
13(B) - (B) is correct because such goods and services are of demonstrable benefits to the clients.

14(A) - "Prompt execution" and "best execution" are obviously related to the broker's level of diligence.

15(C) - The dealer has failed to fulfil the "prompt execution" requirement under the diligence principle under the Code.

16(C) - (III) is a requirement under Securities & Futures (Client Securities) Rules and thus can't be waived.

17(D) - (D) is wrong because tape records must be kept for at least 3 months.

18(D) - (I) is wrong because a guideline can never override the Code.

19(A) - Simply speaking, there are no such requirements as (III) and (IV) in the Listing Rules.

20(A) - Exchange traded options are traded on the Hong Kong Futures Automated Trading System (HKATS).

Market Misconduct by Overseas Entity

Last week SFC commenced proceedings under S.213 of SFO ("Injunctions and other orders") in the High Court against Tiger Asia Management LLC, a New York-based asset management company, and three of its senior officers, Mr Bill Sung Kook Hwang, Mr Raymond Park and Mr William Tomita. Founded in 2001, Tiger Asia specialises in equity investments in China, Japan and Korea. All of its employees are located in New York. Tiger Asia has no physical presence in Hong Kong.

According to an article of Finance Asia, the Tiger Asia fund is one of many Tiger-branded funds that have been seeded by the original Tiger Fund daddy, Julian Robertson. Hwang's Tiger Asia fund is among the first of the "Tiger baby" funds that Robertson began to nurture in 2000, after he had closed his own, massively successful hedge fund.

SFC has applied for an injunction order to freeze assets of Tiger Asia and the three senior officers, including those located overseas, up to $29.9 million. The amount is equivalent to the notional profit made by Tiger Asia in alleged insider dealing and market manipulation activities.

The proceedings followed an SFC investigation into suspected insider dealing and market manipulation by Tiger Asia and the three senior officers in relation to dealings in the shares of China Construction Bank Corporation (CCB) on 6 January 2009.

SFC alleges that:

• on 6 January 2009, before the market opened, a placing agent in Hong Kong invited Tiger Asia to participate in a proposed placement of CCB shares in Hong Kong by the Bank of America Corporation (BOA);
• the placing agent told Tiger Asia about the size and the discount range of the proposed placement;
• this information was confidential and price sensitive and Tiger Asia and the three senior officers knew this;
• Tiger Asia then short-sold a total of 93 million CCB shares on 6 January 2009 ahead of the public announcement of the CCB placement;
• Tiger Asia covered its short sales out of the placement shares that it bought on 7 January 2009 at a discount to the prevailing market price; and
• Tiger Asia made a substantial notional profit of $29.9 million.

SFC also:

• alleges downward manipulation of CCB share price by Tiger Asia on 6 January 2009 at the time of the short sales;
• is seeking final orders against Tiger Asia and the three senior officers, including orders to unwind the relevant transactions if the court finds the transactions have contravened SFO and to restore affected counterparties to their pre-transaction positions;
• considers it necessary to seek a freezing order to ensure there are sufficient assets to satisfy any restoration orders that may be made by the court; and
• is seeking orders to prevent Tiger Asia and the three senior officers from trading in listed securities and derivatives in Hong Kong in similar circumstances.

Overseas entities might think that SFC can never taken any legal / regulatory action against their insider dealing and market manipulation because they are not located at Hong Kong. Let's see if SFC can "beat the tiger" this time.

Licensing Requirements for Selling ILAS

Last week SFC issued a circular to clarify the licensing requirements arising out the promotion, offering or sale of investment-linked assurance schemes (ILSA) by insurance intermediaries (agents and brokers) to the public.

Regulated activities relating to the sale of ILAS are Type 1 (dealing in securities) and Type 4 (advising on securities). ILAS by itself is defined as a collective investment scheme (CIS) but excluded from the definition of "securities" under SFO. The question is whether advising clients acquiring ILAS on the selection of underlying funds would constitute dealing in securities or advising on securities.

In its circular, SFC highlights that premium payments made by ILAS policyholders are first applied in respect of fees and commissions, with the balance being paid to the insurer and notionally invested in the underlying funds specified by policyholders. Although it is the performance of these underlying funds that determines the value of the ILAS policy from time to time, the policyholder's premium payments are not invested in these underlying funds for them. Instead, these investments, if made, are for the account of the insurer itself.

SFC takes the view that advising or making recommendations to policyholders concerning the selection by them of the underlying funds of ILAS, does not constitute advising on securities, even if those underlying funds are securities. The reasons are as follows:

• Advising on securities, within the meaning of SFO, is concerned with advice relating to the acquisition or disposal of securities by the person being advised. In the case of ILAS, the underlying funds are not acquired or disposed of.
• Advice given to ILAS policyholders is only concerned with selection of underlying funds whose performance will notionally be used to calculate the value of the ILAS policy from time to time.

SFC also takes the view that promoting, offering or selling ILAS to the public (including giving advice to policyholders concerning selection of underlying funds) does not constitute dealing in securities, which is defined as making an agreement with another person or inducing another person to enter into an agreement (a) for acquiring, disposing of, subscribing for or underwriting securities; or (b) the the purpose of which is to secure a profit from the yield of securities or by reference to fluctuations in the value of securities. The reasons are as follows:

• Units in ILAS are not securities.
• Underlying funds of ILAS are not acquired or disposed of for the policyholders.
• It can't be said that the purpose (or even the dominant purpose) of acquiring an ILAS policy is to secure a profit from fluctuations in the value of underlying funds.
• SFO definition of dealing in securities excludes the issue of any advertisement, invitation document authorized by SFC.

Even if advising concerning ILAS underlying funds were regarded as advising on securities or dealing in securities, SFC considers that there would be no carrying on of a business in these regulated activities. This is because advising concerning ILAS underlying funds:

• does not stand alone as a discrete business carried on its own right
• by itself does not generate any financial gain
• appears to occur haphazardly
• does not indicate the existence of an established and ongoing business principally involving that particular activity

Two important implications could be derived from this circular. First, insurance intermediaries would no longer be regulated by SFC when they are selling (or mis-selling) ILAS and advising (or mis-advising) ILAS underlying funds. Second, in future the number of licensed corporations and representatives would be substantially reduced because:

• Selling of direct funds (no matter by banks, brokers or so-called IFA) constitutes only dealing in securities, not advising on securities.
• Corporations / representatives licensed for Type 1 could advise on securities without Type 4 based on the "wholly incidental" exemption.
• Advising concerning ILAS underlying funds is no longer regarded as Type 4.

You may doubt whether this SFC circular is also relevant to promotion, selling or offering of MPF schemes (which are also regarded as CIS but not securities under SFO). My interpretation is that even selling of MPF schemes does not constitute Type 1, advising concerning constituent funds of MPF schemes may still fall within Type 4 because, unlike ILAS, constituent funds are acquired or disposed of for employee participants.

SFC had better issue a separate circular to clarify the licensing requirements for selling of MPF schemes. If MPF intermediaries were also exempt from licensing, then we may envisage that in future only equity research analysts need to be licensed for Type 4.

Flash Orders

Flash orders have been used for years but have become increasingly popular in recent months as more traders and exchanges adopted the approach. Last week WSJ reported that US SEC is considering a ban of flash orders. The Chairman Mary Schapiro said she has asked SEC's staff to develop a proposal to eliminate the inequity that results from flash orders.

Flash order technology means high-frequency trading, a lightning-fast, computer-based trading technique. It allows some traders to have a sneak peek at market activity, giving high-frequency traders an advantage over retail investors.

Flash orders were pioneered by the Chicago Board Options Exchange's stock exchange earlier this decade as that exchange looked for a way to improve execution speeds. Flash remained a niche part of the industry until around June 2006, when a small stock-trading platform, Direct Edge, owned by Knight Capital Group Inc., adopted the practice. Now, Direct Edge is the third-largest stock trading platform by matched volume in the country. Its success has helped prompt competitors to adopt their own versions of flash.

In a flash order, a firm wishing to buy or sell stock can elect to freeze the order on an exchange for as long as half a second. This move can have several effects, one of which concerns a system of rebates and fees on trading orders. Typically on trades, exchanges pay rebates to traders who post shares to buy or sell and charge fees to traders who respond to those offers. This setup creates an incentive to earn rebates. A flash order puts a trader in the position of poster, rather than responder. The hope is that another trader who needs to buy or sell quickly steps in on the other side of the trade. This dynamic boosts the chance the flash-order trader will complete the trade on the exchange and get the rebate.

The following diagram found from the internet explains how flash orders work:

Critics say that flash orders give the high-speed traders a window into the direction of the market, giving them the ability to trade at lightning speeds ahead of less fleet-footed investors. On the other hand, flash-order advocates say the orders help traders get better prices. They say a ban could cause trading volume to drop on the exchanges that permit flash as traders look for better execution in alternative, less-transparent venues.

Meanwhile, in a sign of regulators' growing concern about evolving electronic trading, SEC staff is also studying rules for so-called dark pools, private electronic-trading networks that match buyers and sellers anonymously. The pools have been gaining market share in recent years as more trading firms use them.

SEC staff is looking at requiring disclosure of post-trade information to show which dark-pool operator is executing which trades, according to people familiar with the matter. That would give investors a better idea of the liquidity and depth of a particular operator. SEC is also considering whether to have the information disclosed on a real-time basis or collected and disclosed in an aggregate form.

Another area under review is the "indications of interest," which are similar to flash orders. If an exchange can't execute an order, it will look at indications of interest from a number of dark pools. Rather than flash the order for a potential mate, the exchange can route it through the dark pools that expressed indications of interest.

Are you dazzled by the flash?

Inter-dealer Brokers

SFC recently issued a circular to clarify the licensing obligations of inter-dealer brokers. Typically, inter-dealer brokers carry on the business of facilitating transactions between institutional clients and financial institutions in relation to a wide range of financial instruments, including listed securities and futures contracts, listed structured products, unlisted fixed income products and OTC derivatives. Transactions in listed instruments may be effected by inter-dealer brokers OTC or through an exchange.

SFC's concern is that some inter-dealer brokers might be carrying on a business in a regulated activity in Hong Kong, without having been appropriately licensed under SFO. The licensing obligation is largely dictated by the nature of the financial instruments that they trade, their clients and the booking structures which they employ. However, it is likely in most cases that inter-dealer brokers are carrying on a business in Type 1 / 2 / 3 regulated activity. Accordingly, it must be appropriately licensed unless it can rely upon any of the exemptions stipulated in SFO.

Some inter-dealer brokers might take the view that they are not required to be licensed because they are able to rely upon the "as principal" exemptions provided for in the definitions of "dealing in securities" and "dealing in futures contracts". However, SFC points out that these "as principal" exemptions are quite narrow in their scope and that some of their business activities might well fall within the above definitions.

In particular, SFC does not interpret the "as principal" exemptions as being applicable to transactions such as back-to-back arrangements which involve the temporary interposition of a third party (such as an inter-dealer broker) between the parties who are, in the real sense, the buyer and the seller. Where a broker routinely facilitates or effects such transactions by entering into back-to-back contracts with the buyer and with the seller, it is not able to rely on the "as principal" exemptions. There is no "as principal" exemption provided for in the definition of "leveraged foreign exchange trading".

Some inter-dealer brokers which are approved money brokers under Banking Ordinance might take the view that they are not required to be licensed under SFO because they are able to rely upon the "money broker" exemptions provided for in the definitions of "dealing in securities" and "leveraged foreign exchange trading". Again, SFC states that these "money broker" exemptions are quite narrow in their scope. There is no "money broker" exemption provided for in the definition of "dealing in futures contracts".

In determining whether an inter-dealer broker is able to rely upon the licensing exemptions stipulated in SFO, SFC takes into account all of the relevant facts and circumstances and, in particular, whether the business model of the broker primarily involves agency brokerage.

SFC's clarification in this circular may be coming late because I've heard many inter-dealer brokers in Hong Kong are not aware of their licensing obligations.

Enhancement of AML Regulatory Regime for Financial Sectors

At mid-July 2009, FSTB has launched a 3-month public consultation on its legislative proposals to enhance the anti-money laundering (AML) regulatory regime for the financial sectors. The proposals include codifying the customer due diligence and record-keeping requirements for financial institutions in law and putting in place an AML regulatory regime for remittance agents and money changers. The aim of the proposals is to address the deficiencies indentified by the FATF its evaluation of Hong Kong.

Summary of the key proposals are set out below:

Proposed Scope of the Future Legislation

• The proposed legislation will apply to the following financial institutions:

1. Authorized institutions (banks/deposit-taking institutions)
2. Licensed corporations regulated by SFC
3. Insurance companies and intermediaries carrying on or advising on long term business (i.e. life insurance)
4. Remittance agents and money changers (RAMCs)

• SFC, HKMA, OCI and C&ED will be designated as regulatory authorities to supervise compliance in respect of the securities, banking, insurance and RAMC sectors respectively.

Obligations of financial Institutions, Powers of the Regulatory Authorities and Offences and Sanctions

• The financial institutions will be required to implement CDD and record-keeping requirements in accordance with international standards, which are not substantially different from the existing requirements set out in the guidelines issued by the financial regulators.
• The regulatory authorities will issue guidelines on the statutory obligations to facilitate compliance.
• The regulatory authorities will be empowered to supervise compliance. These powers will be modeled on relevant powers in SFO, including powers to:

1. access to financial institutions' business premises for routine inspections
2. access to, extract or make copies of books and records of the financial institutions
3. require information and answers from financial institutions, staff and counterparties in investigation into suspected breaches
4. enter into and search a premises and seize documents/records and other items upon warrants
5. impose supervisory sanctions, including fines, public reprimand, suspension or revocation of licence having regard to the fitness and properness of the regulatees, and issue directions on remedial actions to be taken
6. prosecute offences summarily
7. share and exchange information with local and foreign authorities

• There will be appropriate checks and balance in the system, including the establishment of an independent appeals tribunal to hear appeals lodged by financial institutions against regulatory authorities' decisions made under the proposed new legislation.
• A financial institution commits an offence under the proposed new legislation only if it breaches the statutory customer due diligence and/or record-keeping requirements without reasonable excuses.
• No one will commit an offence under the proposed new legislation solely due to inadvertence on his/her part. A member of the management of a financial institution will be personally liable in case of a breach by the financial institution only if the breach was committed with his/her consent, connivance of, or is attributable to any recklessness on his/her part. Other staff members of the financial institution commit an offence only if they willfully breach the statutory obligations.
• The maximum level of penalty of the criminal sanctions will be specified in the new legislation, which will be determined by drawing reference from sanctions for offences of similar nature.

Licensing of the Remittance Agents and Money Changers

• A licensing system for RAMCs to be administered by the C&ED will be put in place. It will provide "fit and proper" test and other licensing criteria. Granting of new or renewed licences will be subject to a specified fee, to be determined on the cost recovery principle. C&ED will make regulations to prescribe the application and processing matters.
• To tackle unlicensed activities, carrying on a remittance and money changing business without a licence would be a criminal offence with penalty of fine and/or imprisonment.
• C&ED would be conferred with appropriate powers to take enforcement action against unlicensed RAMCs, such as the power to arrest/seizure as the Police currently have in administering the registration system for RAMCs under the Organized and Serious Crimes Ordinance.