Repurchase of Minibonds

The most shocking compliance news immediately before the Chinese New Year should be the "agreement" entered into by Sun Hung Kai Investment Services Ltd (SHK) with SFC under s201 of SFO to resolve disciplinary cases without completing the formal hearing process. Simply speaking, Sun Hung Kai agrees with SFC to repurchase Lehman Brothers Minibonds from its clients. This case is comparable to the ex-gratia payments made by Towry Law in 2004.

SFC also issued a reprimand to Sun Hung Kai in respect of internal systems and controls relating to its sales since 2002 of Lehman Brothers Minibonds to its clients, following SFC's investigation. Sun Hung Kai has agreed to make a voluntary offer to purchase all outstanding Minibonds bought by eligible Sun Hung Kai clients at original value, with the following exceptions:

• those clients who purchased Minibonds only from the secondary market on an execution only basis and had not previously purchased Minibonds through Sun Hung Kai in primary offerings
• professional investors (PIs), including financial institutions, insurers and other corporations falling under paragraphs (a) to (i) of the definition of "professional investor" in Part 1 of Schedule 1 to SFO [Then how about those PIs defined under S&F (Professional Investors) Rules?]
• those clients who had already commenced legal action against Sun Hung Kai unless the clients are willing to stay or end the legal action
• those clients who had concluded a settlement with Sun Hung Kai and already received payments that exceeded the principal they invested

SFC estimates the total amount of the repurchase offer will be up to $85 million.

The decision follows an investigation by SFC which raised a number of concerns with Sun Hung Kai, specifically with respect to:

• the adequacy of product due diligence on Minibonds before they were distributed to eligible clients;
• the adequacy of training given to Sun Hung Kai retail sales staff on Minibonds to enable them to understand the product and all its material risks;
• the assessment of the level of risk for each particular series of Minibonds, the communication of those risk ratings to its retail sales staff and the measures that ought to have been taken to ensure that its sales staff gave reasonably suitable advice by matching the risk-return profile of each series of Minibonds with the personal circumstances of each eligible client; and
• the record-keeping of investment advice given to eligible clients and any queries raised by them.

Sun Hung Kai does not admit any liability or wrongdoing arising from these matters but acknowledges the seriousness of these concerns. Given the high public interest in resolving these issues quickly, to avoid unnecessary costs and expenses and to affirm its commitment to the highest standards of conduct, Sun Hung Kai has also agreed with SFC to the following:

• to offer to its eligible clients to purchase all outstanding Minibonds bought through Sun Hung Kai at a price equal to the principal amount invested by those clients (the eligible clients will retain all coupon payments received to date) with payments to be made within 30 days of the date of acceptance, and each eligible client who accepts this offer will be required to transfer their Minibonds (or entitlement thereto) to Sun Hung Kai and sign a release and waiver of claims they may have against Sun Hung Kai;
• to engage an independent audit firm to conduct a review of Sun Hung Kai's internal control and compliance systems;
• if, within 18 months from the completion of Sun Hung Kai's current enhancement exercise (which shall be completed within 6 months from the date of this agreement), SFC finds the same concerns of a materially serious nature as those identified by it in this investigation, Sun Hung Kai's licence will be partially suspended for a period of three years to the extent that Sun Hung Kai will not be allowed to sell or distribute unlisted or structured products to clients and provide advice to clients in relation to these products; and
• continue to support and cooperate fully with SFC.

Let's wait and see what actions HKMA and SFC will take against those retail banks which had distributed Minibonds.

SFC Lehman Report

At the end of 2008 SFC has made a report to the Financial Secretary on issues raised by Lehman Minibonds crisis. Then it released the report but has removed certain contents to avoid prejudicing the investigation and enforcement work that is under way. This report is in fact quite a good summary of the existing regulatory framework and requirements governing the selling of investment products to retail investors. Compliance officers working in this area should read through it in detail.

This report has made a number of recommendations to further strengthen the regulatory system. Let me summarize my initial thoughts as follows:

• I tend to agree with SFC in adopting the Twin Peaks Approach. That means, HKMA continues to oversee safety and soundness of banks, while SFC will cover the business conduct of both banks and non-banks in respect of regulated activities. This will attain a more consistent enforcement of securities regulations.
• It may not be practical and useful to requre securities activities of banks to be conducted by separate entities. Instead, the professional standards of bank staff providing wealth management services should be substantially uplifted.
• Mystery shopping sounds like a useful technique to identify problems, but SFC needs to clarify how it would use the findings.
• SFC sticks to disclosure-based approach rather than merit-based approach in authorizing products sold to retail investors. This regulatory philosophy can of course increase Hong Kong's competitiveness in attracting product issuers. However, when SFC is adopting merit-based approach in licensing of intermediaries, why can't it do the same for product authorization? I won't fully this philosophy until the average investor education level was sufficiently high.
• I strongly suggest SFC streamline the existing product authorization regime to make it less complex and fragmented.
• Developing summaries for different products in plain language is definitely a good idea, but SFC should act as the central coordinator in this project to avoid duplicate efforts made by intermediaries.
• Ongoing disclosure obligations should be introduced for all types of investment products (securities, CISs and RIAs).
• SFC's recent efforts of consolidating the advertising guidelines for all different CISs in one document is a reasonable first step. It should further enhance the advertising guidelines to cover all types of investment products.
• The term "professional investor" should be renamed by not using the "professional" label to avoid unnecessary confusion.
• If other countries like Australia, the UK and Singapore have no problem of mandating disclosure of commission rebates at the pre-sale stage, what is Hong Kong waiting for?
• Cooling off clause provides a kind of investor protection, but would it be implemented with practical difficulties for unlisted and illiquid investment products?
• Setting up the dispute resolution procedure and a financial ombudsman seems necessary for Hong Kong, but where comes the funding?
• I support the establishment of an Investor Education Council operated by SFC. We can't really the intermediaries to do a good IE job given their conflicts of interest problem.
• Giving SFC the power to impose a compensation order as a disciplinary sanction is desirable as this can directly benefit the investors but forming a proper basis for computing the compensation amount in each case is not simple.

Customer Responsibility

Last year one of the main themes in HK's compliance field was "mis-selling". While the general public has attributed all the problems to the sales side, the voice of "buyer beware" is too little to hear. I won't say prevention of mis-selling is not critical, but prevention of "mis-buying" is also very important.

In Dec 2008 UK FSA released a discussion paper on customer responsibity in order to explore what steps the regulator or others could take to help financial consumers understand their own best interests more effectively. While FSA has no power to impose responsibilities on consumers, it is required by law to consider the general principle that consumers should take responsibility for their decisions when setting its consumer protection agenda.

The key findings of FSA's Financial Capability Baseline Survey indicate that:

• many people fail to plan adequately for retirement or for unexpected expenses or drops in income;
• while a relatively small proportion of the population experiences difficulties with debt, those problems are often severe;
• people do not take adequate steps to choose products that meet their needs - many do not shop around to find a good deal and people take risks without realising they are doing so; and
• under 40's are, on average, less financially capable than their elders (the greatest demands are placed on this younger group).

In a "better world" consumers should be empowered to engage and take on responsiblity. However, their relative lack of knowledge in potentially complex markets, behavioral constraints and firms' performance make this difficult and means that the balance of responsibilities currently operates in favor of consumers. FSA's current position on customer responsibility is summarized as follows:

If a firm fulfils its obligations and treats the customer fairly, then, even if the transaction turns out to be a disappointment to the consumer, this should not be blamed upon the firm.

SFC recently submited a report to Financial Secretary, suggesting how HK can improve its regulatory framework and enhance investor protection and education, following the events brought about by the collapse of Lehman Brothers during last Sep. I wish the issue of enhancing customer responsibility is adequately addressed in this report.

Unfair Treatment to Fund Clients

It is reasonably expected that retail banks in Hong Kong would experience a tough year when facing regulatory investigations of their investment product selling activities. Being the first case against a bank in 2009, yesterday SFC issued a reprimand to Standard Chartered Bank (Hong Kong) Ltd (SCB) for failing to act in the best interests of its clients and to exercise due skill, care and diligence to reasonably ensure that its clients who invested in the mutual funds from two fund houses were treated fairly.

The decision follows HKMA's investigation into SCB's mutual funds distribution and dealing operation between May 2001 and Sep 2003 (so long ago?). HKMA referred its findings to the SFC on 10 Jan 2008 for further action. The investigation centred on concerns that SCB gave preferential treatment to one client, Stone Castle Ltd (Stone Castle), over SCB's other clients investing in the mutual funds from two fund houses.

Stone Castle Ltd was a Cayman Island vehicle of Millennium International Ltd, which was owned by a US based hedge fund group, Millennium Partners. In Oct 2003, Steven B. Markovitz, a director and authorized signatory of Stone Castle, pleaded guilty to a charge of late trading of mutual funds in New York. In Dec 2005, Millennium settled with US SEC for abusive trading strategies. SCB was not an implicated party in the prosecution of Markovitz.

SCB allowed Stone Castle to get same day pricing for switching in and out of the relevant mutual funds. The same day pricing arrangement was not made known nor available to other clients of SCB who received next day pricing. The timing advantage given to Stone Castle was open to abuse and was potentially prejudicial to SCB's other clients because it might enable Stone Castle to trade ahead of those clients at better prices.

SCB has agreed with SFC to make payments to the eligible SCB clients who invested in the relevant funds and did not receive the same treatment SCB gave to Stone Castle. In entering into this agreement, SCB does not accept that it has done anything wrong and is making the payments voluntarily. Under the payment scheme, about 1,260 SCB clients who invested in the relevant funds will each be eligible to receive a total payment ranging between US$0.1 and US$12,739 plus interest, making a total amount available under the scheme of about US$320,000 plus interest.

In deciding on the appropriate action to take against and the resolution with SCB, SFC took into account the mitigating factors that SCB self reported the matter to HKMA and co-operated fully with both HKMA and SFC in agreeing to make these payments to clients.

Relative to the Lehman Brothers incident, this case was not very significiant in terms of the amount of client losses. But it is hardly acceptable that SCB had not done anything wrong (who facilitated Stone Castle's late trading?).