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).