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.