SFC has recently resolved its compliance concerns with Julius Baer (Hong Kong) Ltd. Under the resolution, SFC reprimands and fines Julius Baer $3 million.
An SFC investigation revealed that Julius Baer, which is licensed to provide services only to professional investors, failed:
- to take adequate steps to identify clients as professional investors before treating them as such;
- to conduct an annual confirmation as to whether its clients continued to fulfil the professional investor requirements; and
- to maintain adequate written records of its investment advice given to clients.
In deciding the disciplinary sanction, the SFC took into account that:
the failures took place between October 2006 and July 2008 when they were detected;
- Julius Baer has a clean disciplinary record;
- Julius Baer co-operated in resolving these disciplinary proceedings;
- Julius Baer does not admit to the failures as identified by SFC; and
- Julius Baer will engage an independent reviewer to review its internal controls in relation to its compliance with the regulatory requirements for treating clients as professional investors and the provision of investment advice.
Jack's comment: The implication of this case seems alarming. It may indicate that certain non-eligible clients had been mis-classified as professional investors but recommended to purchase unauthorized investment products without reasonable care being taken by their relationship managers.
Last week SFC reprimanded Christfund Securities Ltd (CSL), Christfund Futures Ltd (CFL) (collectively referred to as Christfund) and their respective responsible officers, and fined them a total of $2.5 million over internal control deficiencies in handling Mainland clients' accounts.
CSL and CFL were fined $1,200,000 and $700,000 respectively while responsible officers Ng Kam Shing and Chow Yuen Tung were fined $300,000 each in relation to Christfund’s internal control deficiencies in handling Mainland clients’ accounts.
An SFC investigation covering the period from August 2007 to July 2008 found that a Shenzhen-based company, Hang Fung Investment Consultants (Shenzhen) Co Ltd (HF Shenzhen) -- an affiliate of Christfund -- provided marketing services for Christfund on the Mainland.
HF Shenzhen made available account opening forms for Mainland investors to open accounts with Christfund. In handling the account opening process for these Mainland individuals, SFC found that:
- Christfund had not performed sufficient know-your-client procedures with respect to Mainland clients;
- Christfund took insufficient steps to establish the full identities and addresses of each of these Mainland individuals, thereby failing to establish the accuracy of such information;
- Christfund allowed 22 and 44 such Mainland clients of CSL and CFL respectively to use the office address of HF Shenzhen as their correspondence address. Also, 51 such Mainland clients of CSL were permitted to use the address of one of Christfund’s clients as their correspondence address;
- Christfund allowed about 1,000 clients at CSL to authorise one individual amongst them to operate their accounts on their behalf;
- Christfund had taken insufficient steps to check the operation of two accounts of clients emanating from HF Shenzhen for a prolonged period of time, thereby allowing these accounts to be used to transfer funds to facilitate settlement of transactions in the Mainland clients' accounts at Christfund, although each transfer is supported by written transfer authorisation by the respective clients; and
- in allowing these matters to occur, Christfund had taken insufficient steps to address the potential regulatory issues arising from inadequate records and the safe custody of client assets, including cash.
In deciding the sanction, SFC took into account that:
- Christfund was acting in good faith and there is no evidence of any dishonesty on its part or its senior management in its business activities;
- Christfund has co-operated with the SFC by readily accepting responsibility for the above breaches;
- Christfund has agreed to engage an independent audit firm to review the relevant aspects of its internal controls system and account opening procedures. The audit firm will also verify that remedial steps had been taken since the deficiencies were identified;
- Christfund has also agreed that CSL shall: (i) cease operating those Mainland individuals’ client accounts apart from taking those clients’ sell order instructions and returning their securities and remaining balances to those clients; and (ii) cease opening accounts for any Mainland individuals referred by or through HF Shenzhen or any other persons or corporations on the Mainland, unless such practice is in compliance with applicable Mainland laws; and
- CFL, Ng and Chow have not previously been disciplined by the SFC.
Jack's comment: Obviously Christfund's consent to cease the Mainland business is made under the pressure of the watchdog. However, even Christfund's internal controls were inadequate, why should an indefinite "show-stopper" be imposed? Who is the judge to determine whether "such practice is in compliance with applicable Mainland laws"?
Last week US SEC approved the new stock-by-stock "circuit breaker" rules. The rules, which were proposed by the national securities exchanges and FINRA and published for public comment, come in response to the market disruption of May 6.
SEC anticipates that the exchanges and FINRA will begin implementing the newly-adopted rules as early as Friday, June 11.
Under the rules, trading in a stock would pause across U.S. equity markets for a five-minute period in the event that the stock experiences a 10% change in price over the preceding five minutes. The pause, which would apply to stocks in the S&P 500 Index, would give the markets the opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion. Initially, these new rules would be in effect on a pilot basis through December 10, 2010.
The markets will use the pilot period to make appropriate adjustments to the parameters or operation of the circuit breakers as warranted based on their experience, and to expand the scope to securities beyond the S&P 500 (including ETFs) as soon as practicable.
At Chairman Schapiro's request, the SEC staff also will:
- Consider ways to address the risks of market orders and their potential to contribute to sudden price moves.
- Consider steps to deter or prohibit the use by market makers of "stub" quotes, which are not intended to indicate actual trading interest.
- Study the impact of other trading protocols at the exchanges, including the use of trading pauses and self-help rules.
- Continue to work with the exchanges and FINRA to improve the process for breaking erroneous trades, by assuring speed and consistency across markets.
SEC staff is working with the markets to consider recalibrating market-wide circuit breakers currently on the books — none of which were triggered on May 6. These circuit breakers apply across all equity trading venues and the futures markets.
Jack's comment: When the market is getting more "emotional", the circuit breaker may be an effective way to let investors cool down, especially if the emotion is triggered by error or manipulative orders.
Two weeks ago SFC has concluded the consultation on those proposals to enhance investor protection. The new measures include a consolidated product handbook with revised product codes for unit trusts and mutual funds and for investment-linked assurance schemes as well as a new product code for unlisted structured investment products. There are also requirements for product key facts statements to summarise the key features and risks of investment products, issuers to provide a post-sale "cooling-off" or "unwind" right for certain unlisted structured investment products to give investors a window to exit these investments, and conduct requirements for intermediaries to enhance selling practices relating to the sale of investment products.
In December 2009, I summitted the comments on the consultation paper on behalf of the Hong Kong Chapter of the International Academy of Financial Management (IAFM). The finalized measures relating to conduct of intermediaries are largely conforming to my expectations. My brief comments on the conclusions are set out as follows:
- Investor Characterization: It remains a subjective process for intermediaries to judge whether the client has derivative knowledge. In order to solicit more new clients for structured products, I expect the intermediaries will organize or sponsor "derivative training courses" for retail investors.
- Professional Investors: As I've said, the proposal of increasing the portfolio requirement for professional investors is useless and finally scrapped by SFC. To ensure that a professional investor has the relevant product knowledge, again intermediaries had better provide free training sessions to them.
- Pre-Sale Disclosure of Monetary and Non-Monetary Benefits: As expected, SFC has compromised by requiring only the disclosure of the percentage ceiling, between the two extremes of specical disclosure in exact percentage and generic disclosure.
- Use of Gifts by Distributors in Promoting a Specific Investment Product: Non-bank intermediaries should have raised strong objection to the use of gifts for product promotion and SFC has no pressure to impose this restriction.
- Sales Disclosure Document: This proposal is probably the least controversial one.
- Audio Recording: Again non-bank intermediaries should have raised strong objection to mandatory audio recording as this is not practical. Banks are unfortunately forced by HKMA to do so.
- Post Sale Arrangements – Refund by Distributors Under a Cooling-Off Period: SFC has quite insisted on implementing the post-investment cooling-off period even though it is costly. Again banks are unfortunately required by HKMA to implement pre-investment cooling-off period as well.
SFC recently fined Merrill Lynch (Asia Pacific) Limited and Merrill Lynch Futures (Hong Kong) Limited (collectively Merrill Lynch) $3,500,000 for systems and controls failings associated with the mis-marking activities in a trading book. Such kind of cases has been common in overseas countries over the past years but appears to be the first one in Hong Kong.
SFC's investigation found that during the period from December 2007 to October 2008, a managing director of Merrill Lynch had mis-marked a trading book in exotics options (Book) by manipulating the volatility marks in the valuation model, and accessed the computer system without authority to alter pricing parameters on various occasions. The mis-marking activities, which did not apply to any other books, resulted in the value of the Book being inflated by approximately US$25 million and caused the actual loss in the Book to be wrongly reported internally.
SFC found that Merrill Lynch did not have adequate internal controls procedures in place to manage the risks associated with mis-marking, in that:
- there was uncertainty as to supervisory responsibilities over the trader and the Book;
- the price verification mechanism applied to other trading books was not applied to the Book;
- there were inadequate checks and balances over the Book to mitigate operation risks including risks associated with fraud and dishonest activities;
- there was insufficient safeguard over information security and integrity as regards the Book;
- trading and valuation policies were not sufficiently implemented over the Book; and
- senior management failed to adequately manage the risks associated with the Book.
Merrill Lynch accepts that its systems and controls fell short of those expected in respect of the Book. SFC accepts that Merrill Lynch's misconduct was not intentional (!) and Merrill Lynch has taken remedial steps to address the compliance weaknesses.
This case is no doubt a scandal in Hong Kong's risk management industry. Would the managing director and other key personnel of Merrill Lynch be personally liable?
