Disclosure of False or Misleading Information Inducing Transactions

SFO has defined 6 types of market misconduct offences. What we have frequently heard are insider dealing, false trading and price rigging. Until recently there is the first criminal prosecution of another kind of market conduct called "disclosure of false or misleading information inducing transactions".

SFC has commenced criminal proceedings against David Vong Tat Ieong, CEO of Vongroup Ltd (318.hk), alleging that he disclosed or was concerned in the disclosure of false or misleading information issued by Vongroup, which was likely to induce transactions in the shares of Vongroup or maintain or increase its share price. The case may be prosecuted by the Department of Justice as an indictable prosecution.

On 15 May 2007, Vongroup issued an announcement to SEHK and a press release disclosing that Vongroup Holdings Ltd, a company wholly owned by Vong through which he held 72% of the issued share capital of Vongroup, was selling a 9.9% stake in Vongroup to ABN AMRO Bank. The share price of Vongroup rose 31.25% on the following day. However, unknown to the investing public, Vong is alleged to have simultaneously executed two additional agreements with ABN AMRO. Under the first agreement, ABN AMRO secured the right to sell the shares back to Vongroup Holdings Ltd at the same price within three years. Under the second agreement, the proceeds were retained in an escrow account pending either ABN AMRO selling the shares to an independent third party or the expiry of the put option.

SFC alleges that the announcement on 15 May 2007 was false or misleading because it omitted the existence of the two additional agreements. In effect, the announcement failed to properly disclose the whole transaction and the investing public were likely to have been misled into believing ABN AMRO had decided to support Vongroup in buying 9.9% of the issued share capital when, effectively, the deal did not expose ABN AMRO to the same investment risks as other shareholders and was a virtually risk-free one.

SFC further alleges that (i) Vong knew that the announcement, which was likely to induce the investing public to purchase shares in Vongroup or maintain or increase the market price of Vongroup shares, was false or misleading because, to his awareness, the two additional agreements were not disclosed or (ii) he was reckless as to whether that would be the case.

If SFC won this case, I think those directors of Hong Kong listed companies would have one more nightmare. I am also interested to know if ABN AMRO would be implicated in this case.

Kickback Scheme

US SEC recently charged a former New York state political party leader and a former hedge fund manager in connection with a multi-million dollar kickback scheme involving New York's largest pension fund.

SEC alleged that Raymond Harding (a former leader of the New York Liberal Party) and Barrett Wissman (a former hedge fund manager) participated in a scheme that extracted kickbacks from investment management firms seeking to manage the assets of the New York State Common Retirement Fund. SEC previously charged Henry "Hank" Morris and David Loglisci for orchestrating the fraudulent scheme to enrich Morris and others with close ties to them. Specifically, Wissman arranged some of the payments made to Morris, and Wissman was rewarded with at least US$12 million in sham "finder" or "placement agent" fees. Harding received approximately US$800,000 in sham fees that were arranged by Morris and Loglisci.

The payments to Morris, Wissman, Harding and certain others were kickbacks that resulted from quid pro quo arrangements or that were otherwise fraudulently induced by the defendants. Loglisci ensured that investment managers that made the requisite payments - to Morris, Wissman, Harding, and certain other recipients designated by Morris and Loglisci - were rewarded with lucrative investment management contracts, while investment managers who declined to make such payments were denied fund business. Morris, Wissman, Harding and the others who received the payments at issue did not perform bona fide placement or finder services for the investment management firms that made the payments.

SEC additionally charged three entities through which Wissman perpetrated the fraud - Flandana Holdings, Tuscany Enterprises and W Investment Strategies — as well as two investment management firms with which he was affiliated at the time, HFV Management and HFV Asset Management. Wissman was a longtime family friend of Loglisci and a key participant in the kickback scheme. Wissman worked with Loglisci and Morris to extract sham finder fee payments for Morris and for himself from investment managers. Wissman received millions of dollars in sham fees and other illicit payments, and arranged millions of dollars in additional payments for Morris. In addition, Wissman caused HFV Management and HFV Asset Management to pay sham finder fees to Morris in one New York State Common Retirement Fund transaction.

Harding was a political ally who was allegedly inserted by Morris and Loglisci into at least two fund transactions for the sole purpose of compensating Harding, and Harding received a total of approximately US$800,000 in sham "finder" fees. In one of those transactions, the investment management firm already had a finder and Morris arranged for that finder to secretly split his fee with Harding. In another transaction, Morris and Loglisci simply inserted Harding as a finder on an investment solely for the purpose of directing money to Harding.

Greed is everywhere. In Hong Kong, I guess ICAC is also actively investigating into those kickback schemes prevailing in the securities market.

Late Delivery of Statements

FINRA recently fined Edward D. Jones & Co. US$900,000 for its failure to timely deliver official statements to customers who purchased new-issue municipal securities and related supervisory and recordkeeping failures. With limited exceptions, broker-dealers selling a new-issue municipal securities are required to deliver a copy of the official statement to the customer on or before settlement date. New-issue securities are those sold during the initial distribution of bonds to the public.

FINRA found that Edward Jones' late deliveries occurred when the firm was conducting retail transactions but was not a member of the underwriting syndicate for a new issue. The firm's failures from 2002 through 2006 were systemic. During that time period, Edward Jones engaged in approximately 100,000 new-issue municipal bond transactions in which it was not an underwriter. For a significant number of those transactions, the firm was late in delivering official statements to its customers. The firm's systemic late deliveries had multiple causes, including lack of training for employees, incorrect instructions to employees, limited photocopying capacity and errors by employees of the firm, including trading supervisors.

The late deliveries continued. In September 2008 alone, the firm was late in mailing official statements to customers in over 6,200 transactions, which represented 19% of the firm's municipal bond transactions. Edward Jones's own internal communications repeatedly referenced that it was not timely delivering official statements. Nevertheless, the firm failed to take reasonable and sufficient steps to comply with its delivery obligations. Edward Jones also failed to keep required records, did not have written supervisory procedures addressing the requirements for delivery of official statements until May 2006, and that those procedures contained incorrect guidance.

In Hong Kong, SFC licensed / registered intermediaries are required by the S&F (Contract Notes, Statements of Account and Receipts) Rules to provide official transaction and account statements to their customers within specified time frame. I did also witness the above systemic problems resulting in late delivery of statements, but (touch wood) so far SFC has not imposed a heavy penality for such problems.

Market Abuse by Market Maker

UK FSA has won its market abuse case at the Financial Services and Markets Tribunal (the Tribunal) against Winterflood and two of its traders, Mr Sotiriou and Mr Robins.

Winterflood is an FSA authorised firm and the largest market maker in AIM securities. In June 2008, FSA found that Winterflood and its traders had played a pivotal role in an illegal share ramping scheme relating to Fundamental-E Investments Plc (FEI), an AIM listed company. In particular, the market maker had misused rollovers and delayed rollovers thereby creating a distortion in the market for FEI shares and misleading the market for about six months in 2004.

In May 2003, Mr Eagle was seeking to secure control of an AIM shell company as an investment vehicle to acquire electronic technology companies, and he identified FEI as suitable for this purpose. He agreed with the two shareholders of 85% of the shares in FEI to arrange for their shares to be sold and then he arranged with Winterflood for executing the deal. Mr Eagle thereafter instituted a share ramping scheme in FEI shares, the effect of which was to inflate the share price of FEI shares.

The key elements of the share ramping scheme were as follows:

1. Acquisition of SP Bell: Mr Eagle proposed to buy a 10% stake in FEI himself but had to find buyers for the remaining 75%. To do so, he needed to generate significant demand for its shares. On 27 May 2003, Mr Eagle acquired SP Bell Limited, an agency-only stockbroking firm, using an investment vehicle. He intended to find buyers for the remaining 75% of FEI shares and to maintain demand thereafter by, for the most part, selling to clients of SP Bell. By acting as middleman, Winterflood helped Mr Eagle to conceal the full extent of his role and in particular the significant commission he stood to gain from the original shareholders.
2. Rollover trades and delayed rollover trades: In order to procure sufficient purchasers for the 85% interest of the original shareholders, and to continue to buy FEI shares in the market following the initial sale, Mr Eagle introduced 50 new clients to SP Bell in the period from 18 July 2003 to 13 May 2004. However, a number of the Eagle clients did not have sufficient funds to pay for the shares, so in order to avoid those clients being required to make payment, Mr Eagle instituted a scheme whereby their FEI positions were purportedly rolled from one SP Bell client to another. From 5 January 2004, Mr Eagle refined the rollover scheme by the use of delayed rollover trades, whereby the size and price of the buy and sell legs of the rollover trade were agreed at the outset, but the two legs of the transaction were then executed at different times of day. The effect of the rollover scheme was to defer settlement, potentially indefinitely. However, it required a rising share price in order to operate successfully.
3. Consistent purchasing of FEI shares by SP Bell: In order to support and increase the FEI share price, SP Bell consistently purchased FEI shares (in particular, from Winterflood), regardless of market conditions. In many cases, this trading was not authorised by the underlying clients, and shares bought were not paid for but were simply added into the rollover scheme. The trading did not represent genuine market demand for the shares.
4. Involvement of Winterflood: The involvement of Winterflood, Mr Sotiriou and Mr Robins was critical to the success of the share ramping scheme. In addition to executing the trades referred to above, there were many untaped conversations between Mr Eagle and Winterflood, particularly Mr Sotiriou. On a number of occasions there was obvious pre-arrangement of trades where details were agreed on untaped lines before they were executed on taped lines.

The FEI share ramping scheme had the effect of misleading the market as to the supply, price or value of and demand for FEI shares and of distorting the market in FEI shares. It caused the positioning of the FEI share price at an artificially high level, and resulted in an almost five-fold increase in the share price of FEI between May 2003 and July 2004.

On 15 July 2004, the share price of FEI fell sharply from 11.75p to 7.5p as a result of sustained selling. The London Stock Exchange also received information that substantial unsettled positions in FEI shares had accumulated within SP Bell. At 10:35am, the Exchange temporarily suspended trading in FEI shares because it was of the view that the market was disorderly. The suspension of trading caused the unsettled positions in FEI shares at SP Bell to crystallise. Neither the clients of SP Bell nor SP Bell itself had sufficient funds to settle the resulting debt of over £9 million. On 23 July 2004, SP Bell ceased trading and was placed into administration.

FEI was the single most profitable stock for each of Winterflood, Mr Sotiriou and Mr Robins. Winterflood received £204,403 from the sale of the interest of the original shareholders and approximately £941,133 from its trading in FEI shares between January and July 2004. The profitability of trading in FEI also had a direct impact on the level of bonus awarded to Mr Sotiriou and Mr Robins. As a result of their conduct, FSA decided to impose fines of £4 million, £200,000 and £50,000 on Winterflood, Mr Sotiriou and Mr Robins respectively.

Regulation of Short Selling

In more mature stock markets, short selling is usually permitted, but it could be prohibited during a financial crisis (like the one in 2008). Recently the Technical Committee of IOSCO released the Consultation Paper on Regulation of Short Selling.

The Technical Committee believes that short sellling have important functions such as providing more efficient price discovery, mitigating market bubbles, increasing market liquidity, facilitating hedging and other risk management activities. However, there is also a general concern that during extreme market conditions, certain types of short selling may contribute to disorderly markets.

Short selling is typically defined based on two factors: (i) a sale of stock that (ii) the seller does not own at the point of sale. Some jurisdictions (like Hong Kong) do not directly define short selling but prohibiting "naked" short selling.

The Consultation Paper has developed the following high level principles for effective regulation of short selling, briefly highlighted below:

Principle 1 - Short selling should be subject to appropriate controls to reduce or minimize the potential risks that could affect the orderly and efficient functioning and stability of financial markets.

• The Technical Committee recommends the imposition of a strict settlement (e.g. compulsory buy-in) of failed trades. Having a short settlement cycle (no later than T+3) can help to reinforce settlement discipline. Other measures such as price restriction rules (e.g. uptick rule), "locate" requirement (e.g. stock borrowing) and "flagging" of short sales are also useful for preventing abusive short selling.

Principe 2 - Short selling should be subject to a reporting regime that provides timely information to the market or to market authorities.

• There are two models that are commonly used by various markets for short selling reporting: (i) flagging of short sales and (ii) short positions reporting. While transparency of short selling information should be promoted, the Technical Committee recognizes that such information may mislead the market and subject short sellers to potential short squeeze.

Principle 3 - Short selling should be subject to an effective compliance and enforcement system.

• The Technical Committee encourages market authorities to consider extending their power to require information parties suspected of breach, beyond the scope of licensed or registered persons if they lack such power. Market authorities should also review whether their cross-border information sharing arrangements are sufficient to facilitate cross-border investigation.

Principle 4 - Short selling regulation should allow appropriate exceptions for certain types of transactions for efficient market functioning and development.

• Legitimate short selling should not be prohibited. Activities falling under category may include bona fide hedging, market making and arbitrage activities. Short selling regulation should consider building in flexibility. For example, failed trades arising from market making activities are not subject to strict settlement requirements but rather allow more time to close out the positions.

Based on my observations, Hong Kong is to a large extent fulfilling the above four principles for regulation of short selling.