Ponzi Scheme at Citi Asia

Today SFC announced in a press release that it has reprimanded Citigroup Global Markets Asia Limited, fined it $6 million, and suspended the approval granted to Ms Lisa Chan Sin Man, to act as a responsible officer. Her licence has also been suspended for 8 months. 


Citi Asia has also agreed to offer to pay compensation to customers affected by a fraudulent scheme operated by a former licensed representative in the amount of any principal lost by such customers.


The disciplinary action follows an investigation into suspected misconduct of a former licensed representative of Citi Asia, Mr X, who was responsible for operating what appears to have been a fraudulent scheme involving 13 Citi Asia wealth management clients who invested through Mr X on the basis their money would be pooled and used to purchase US Treasuries and other products.


It appears Mr X promised the affected customers that their principal was protected and returns were guaranteed. Instead, returns were funded wholly or partly from other affected clients induced by Mr X's representations. In effect, Mr X appears to have been operating a Ponzi or Madoff-style scheme in which high returns are paid to investors out of the contribution by new investors. Ponzi Scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk.


Mr X's scheme operated from 2004 until February 2009 when Citi Asia suspended Mr X while investigating the suspected misconduct. Shortly thereafter, Citi Asia dismissed Mr X for gross misconduct. However, Citi Asia failed to report Mr X's activities to SFC in a timely manner as required by the Code of Conduct.


After initially reporting to the SFC that Mr X had been dismissed for gross misconduct, Citi informed the SFC that an internal investigation was in progress, when in fact a preliminary report was already available which revealed important information in relation to Mr X's apparent fraudulent scheme. Citi Asia did not provide the report to SFC until after a follow-up investigation by Citi Asia's external auditor was completed.


By the time these reports were provided to the SFC, Mr X had left Hong Kong. He has not returned since then. While this was not Citi Asia's intention, the consequence of the delay in reporting details of the fraudulent scheme to SFC meant SFC and other law enforcement agencies had no opportunity to interview Mr X or to secure his whereabouts pending the completion of the investigation.


SFC also found that Mr X was insufficiently supervised by Citi Asia and Chan (as Mr X's supervisor) with the result that his fraudulent scheme was undetected despite a number of "red flags" which should have caused those supervising Mr X to instigate inquiries. For example, Mr X issued correspondence under Citi Asia's name referring to guaranteed returns contrary to Citi Asia's internal guidelines. Some of this correspondence was brought to Chan's attention but Chan accepted Mr X’s explanations and did not conduct any probative inquiry into the true nature of Mr X's dealings on behalf of Citi Asia’s clients. The reference to guaranteed returns in Mr X's correspondence was a very clear red flag. A quick check to verify the existence of the US Treasuries and other products supporting Citi Asia's clients' investments should have been conducted.


Citi Asia has agreed that it will pay for an external auditor, to be appointed by SFC, to audit the accounts of affected customers and assess the amount of compensation required to make them whole. Citi Asia will also pay for an external expert to conduct a review of the internal and external detection, escalation and notification practices and policies in Citi Asia's private banking division in relation to compliance with all applicable regulatory and legal requirements in its securities business, including:

• the identification and handling of red flags by all staff involved in regulated activities; and
• performance management of all staff engaged in supervision of staff conducting regulated activities, including calculation of compensation in respect to supervisory functions.

Citi Asia will implement all recommendations by the external expert and submit to a surprise audit of all detection, escalation, notification, red flag practices and policies at a time to be selected by SFC within two years of today’s date.


My questions:

• Why can't the identity of Mr X be disclosed?
• Did the compliance head of Citi Asia survive from this case?

SFC Records Historically High Fine

Today SFC publicly reprimanded Oasis Management (Hong Kong) LLC and its Chief Investment Officer, Mr Seth Hillel Fischer, and fined each of them $7,500,000 for their trading in the shares of Japan Airlines Corporation (JAL) on the Tokyo Stock Exchange (TSE) in 2006.


This disciplinary action relates to trading by Oasis in JAL shares on the TSE on 19 July 2006 on behalf of two investment funds after JAL announced a plan to issue new shares via a public offer.  Under JAL’s plan, the offering price for the new shares would be priced between 90%-100% of the closing price of JAL’s shares on one of the days from 19 July 2006 to 21 July 2006.  This type of pricing mechanism is common in the Japanese market and usually the offering price determination day is the first day of the selected range which was 19 July 2006 in this case.


Oasis entered a series of orders for JAL shares in the last 15 minutes before the market closed on 19 July 2006, including:

• market-on-close buy orders and cancelling them subsequently; and
• a large volume of short sell orders during the last five minutes before market closed on the TSE (some orders were incorrectly labelled as short sell exempt orders, such that the funds were able to enter sell orders at prices lower than the latest executed prices).

On the settlement day for the short sell orders, Oasis failed to deliver shares in nearly 70% of the shares they had short sold with approximately 50% of these transactions having to be covered by new shares issued by JAL in the public offer.


Oasis' trading strategy, which originated in Hong Kong and was executed by Fischer, appeared to have been designed to drive down the closing price of JAL on 19 July 2006 to the detriment of the market for JAL shares.  A lower closing price would benefit the funds as subscribers for the new shares.


Oasis and Fischer do not admit their strategy was designed to mislead the market for JAL shares.  However, they have agreed to accept these sanctions which SFC regards as a sufficient expiation for SFC's concerns about their conduct on 19 July 2006.


This was actually a market manipulation case happened in Japan, referred by Japanese Securities and Exchange Surveillance Commission to SFC for cross-border enforcement.


http://www.sfc.hk/sfcPressRelease/EN/sfcOpenDocServlet?docno=11PR108

Streamlined Sales Process for Investment Products

Today HKMA issued a circular to announce the streamlining of the sales process for investment products as follows:


Sales of investment products to vulnerable customers (VCs)


The implementation of the Pre-Investment Cooling-off Period since 1 January 2011 has further strengthened the protection provided to VCs during the sales process. Taking this into account, it is appropriate to allow VCs the flexibility in choosing whether they wish to continue to enjoy the safeguards mentioned below.


For all investment products, banks should allow VCs to choose during the initial transaction
whether they would like to

• bring along a companion to witness the sales process; and/or
• have a second front-line staff member to handle the sales.

The VC can choose to have either, neither or both safeguards. Banks should adopt the VCs' choices and maintain proper audit trails of the choices.


Streamlined sales process for plain vanilla investment products


Where there is no risk mismatch, and subject to the exceptions set out in the next paragraph, audio recording is not required for the face-to-face sales process in respect of:

• plain vanilla investment products (without embedded derivatives and without leverage) where the products or product documents have been authorized by SFC;
• sovereign bonds issued by Ministry of Finance of PRC; or
• bonds issued by HKSAR Government.

Certain categories of bonds are not common investment products and their risks and nature are substantially different from other plain vanilla bonds. Therefore, audio-recording is still required for bonds that have the following features:

• either the issue or the issuer, or both, have a credit rating below an investment grade;
• both the issue and the issuer are unrated;
• perpetual bonds; or
• subordinated bonds.

Banks should ensure that their frontline staff have ready access to clear and comprehensive lists of individual products whose sales process does not require audio recording (e.g. through system enquiry) so that there is clarity and consistency in applying the above framework.


As always, banks are required to provide a clear explanation of the product nature and risks to the customers during the sales process. Banks are also reminded to consider each customer's personal circumstances (such as his/her financial situation, investment objectives, experience, knowledge, horizon and risk tolerance before making any recommendation or solicitation to the customer) and to maintain proper documentary records of the recommendation, including the underlying rationale. For transactions involving risk mismatch, banks should follow the existing regulatory requirements, including audio recording the sales process.


Jack's comment: After the Lehman Minibonds incident, HKMA has more actively and frequently fine-tuned the regulation of investment sales, even performing risk assessment of different products.

Fraudulent Conduct at Advisory Firm

Last week US SEC charged Houston-area businessman Daniel Frishberg with fraudulent conduct in connection with promissory note offerings made to clients of his investment advisory firm.

SEC alleges that Frishberg's firm Daniel Frishberg Financial Services (DFFS) advised clients to invest in notes issued by Business Radio Networks (BizRadio), a media company founded by Frishberg where he hosts his own show under the nickname "The MoneyMan."

Frishberg agreed to the SEC's charges by paying a $65,000 penalty that will be distributed to harmed investors. He will be barred from future association with any investment adviser.

According to the SEC's complaint, at least $11 million in promissory notes were issued by BizRadio and Kaleta Capital Management (KCM), which is owned by Frishberg's associate Albert Fase Kaleta. Frishberg and Kaleta jointly controlled BizRadio.

SEC charged Kaleta and his firm with fraud in 2009, and the court appointed a receiver to marshal the assets of KCM and relief defendants BizRadio and DFFS.

Frishberg authorized Kaleta to recommend the notes to DFFS clients, and clients were not provided with critical disclosures. Investors were not told of BizRadio's poor financial condition and the likely inability of KCM and BizRadio to repay the notes. Nor were investors informed about Frishberg's significant conflicts of interest in the note offerings because the proceeds funded his salary as a BizRadio talk show host.

Frishberg chose Kaleta to recommend the BizRadio notes even though he was aware of complaints about Kaleta's lack of truthfulness in sales presentations regarding other investments.

Jack's comment: This guy is really a great "financial actor"!

Listed RMB Securities Business

Last week SFC issued a circular to SEHK Exchange Participants and CCASS Participants by attaching a checklist to facilitate their review of readiness to conduct listed RMB securities business. The checklist recaps the key areas that Participants should consider during their readiness review.


Participants conducting the RMB Readiness Test are advised to summarize in the checklist the conclusions of their review of readiness in those applicable areas set out in the checklist. Participants should also keep a copy of the completed checklist for record.


Participants are reminded to prudently assess their readiness and be satisfied that they have already prepared themselves properly before confirming their readiness to HKEx.


Brokers providing currency conversion service to their clients should ensure the relevant exchange rate and / or basis of fixing the exchange rate has been clearly disclosed to and agreed with the clients. Brokers should also clearly disclose to the client their role in the transaction (as agent or principal) and ensure compliance with the Code of Conduct's requirements relating to conflicts of interest and compliance.


Those brokers who fail to ensure their readiness should refrain from dealing in RMB securities to be listed on the SEHK or clearing transactions in such securities. They should put in place measures to prevent inadvertent trading of, or acceptance of client trading instructions on, listed RMB securities. For example:

• Notify all staff in writing that no client trading instructions on listed RMB securities should be accepted
• Explain to clients clearly that no services in listed RMB securities are offered by your firm currently upon clients' enquiries
• Closely monitor trading activities. If inadvertent transaction in listed RMB securities is identified, contact HKEx immediately to discuss any need for taking remedial action

Brokers conducting trading / clearing activities in RMB securities to be listed on the SEHK without having ensured their readiness for conducting such activities shall be liable to regulatory scrutiny of their conduct.


Jack's comment: The checklist provided by SFC, asking only a lot of general questions, is basically useless. But SFC would claim they have got their job done.

Enhanced Regulatory Requirements on Selling of ILAS

This week HKMA issued a circular to state the necessity to further enhance the regulatory requirements for the sale of Investment-Linked Assurance Scheme (ILAS) products by the banks. The following control measures are set out in the Annex of this circular:


Competence of staff and registration

• Banks and their staff who sell ILAS products should ensure that they are properly registered as insurance agencies and technical representatives of the principal insurance companies respectively.
• Banks should provide sufficient training to ensure that staff engaged in the selling of ILAS products (i) have adequate knowledge and skills to provide explanations, recommendations or advice to customers about such products; (ii) are conversant with the selling procedures and relevant controls; and (iii) are aware of the relevant regulatory requirements that they need to comply with.

Product due diligence

• Banks should develop sufficient understanding of the nature and structure of ILAS products, including the underlying investments, the insurance protection, lock-in periods, fees and charges, penalty for early encashment, the credibility and capability of the insurance companies issuing the ILAS products, and other factors that may have an impact on the risk and benefit profiles of the ILAS products.
• The independent risk management function should be involved in the product approval and review processes to ensure that the risks of ILAS products are well understood and adequately assessed. All relevant departments, e.g. risk control, legal and compliance, should be consulted as appropriate.
• Banks should conduct their own product due diligence and not to merely rely on the risk assessment conducted by the issuing insurance company. Banks should also perform a continuous review of the risk ratings it has assigned to the underlying investment options of ILAS products and make revisions to such risk ratings as appropriate. Where a review results in a higher risk rating, the affected customers should be notified through a monthly statement or a separate letter.
• Banks should assess and determine the tenor of an individual ILAS product, and match it with a potential customer's preferred investment horizon. In general, ILAS products are longer-term products designed to be held by the policyholder for a relatively long period (e.g. at least five years or above). Banks should take into account, among other things, the lock-in period (the period during which penalties or charges will apply in the event of early encashment) for determining the tenor of an ILAS product.

Use of gifts

• To avoid distracting customers' attention from the nature and risks associated with ILAS products, banks should not offer financial or other incentives (e.g. gifts) for promoting ILAS products. Discount of fees and charges, and the offering of any gifts for brand promotion, relationship building or other purposes not directly related to the promotion of ILAS products will not fall foul of this requirement.

Selling activities to be conducted inside investment corner

• Any solicitation, recommendation, discussion on ILAS products and sale of ILAS products to customers should be carried out only inside banks' investment corners.

Product disclosure

Banks should make adequate disclosure to customers through proper explanation of the nature and risks of ILAS products, including, among other things:

• Product nature – Banks should make it clear to customer at the outset that the product is an investment-linked insurance product. ILAS products should not be misrepresented, for example, as savings plans or deposits, or investment funds without any insurance element. Both the investment and insurance elements should be properly disclosed. Any description that disguises the insurance element, e.g. describing ILAS as "investment funds with complimentary insurance or life protection", is inaccurate and unacceptable.
• Investment options and risks – Banks should disclose and explain the nature and risks of the investment options under each ILAS product. Banks should make it clear, where applicable, that there is no guarantee of the repayment of principal.
• Credit risk – Banks should disclose the name of the insurance company, the fact that the premiums the customer pays will become part of the assets of the insurance company and that the customer will not have any rights to or ownership of the underlying investment assets, and thus he or she is subject to the credit risk of the insurance company.
• Insurance protection – Banks should disclose and explain the amount and/or the basis of determining the death benefit, including the fact that the amount is subject to the market risk and the foreign exchange risk of the ILAS product, where applicable, and that the death benefit payable may be significantly less than the premiums paid and may not be sufficient for the customer's estate planning purpose.
• Premium payment – Banks should disclose the amount, frequency and duration of premium payments. Banks should also explain the circumstances under which a premium holiday can be exercised and its consequence (e.g. the value of the ILAS product may be reduced due to the continuing fees and charges; the entitlement to loyalty bonus may be affected; and the ILAS product may be terminated and the policyholder may be subject to a surrender penalty if he or she fails to resume making the premium payments). Where the ILAS product allows policyholders to take out policy loans, Banks should disclose and explain how the policy loans operate (e.g. whether the loans will be automatically given when the policyholder does not pay a premium payment that is due), the interest and charges on the loans, and the possible termination of the ILAS when the account value is insufficient to cover the outstanding loans and accumulated loan interest.
• Lock-in periods – Banks should disclose and explain that ILAS products are designed to be held for a medium/long-term period and that early surrender of the product may be subject to a heavy financial penalty, and disclose the level of penalty. Banks should also explain to customers the restrictions on cash withdrawal, if any.
• Fees and charges – Banks should disclose and explain the fees and charges at both the scheme level and the underlying investment asset level, and that due to the fees and charges, the return on the ILAS product as a whole may be lower than the return of the underlying investment assets. Banks should also explain that part of the fees and charges paid will be used to cover the charges for the life insurance coverage. The insurance charges will reduce the amount that may be applied towards investment in the underlying assets selected. The insurance charges may increase significantly during the term of the ILAS product due to factors such as age and investment losses. This may result in a significant or even total loss of the premiums paid.
• Cooling-off period – Banks should draw to the attention of the customer his or her right to cancel the policy, how he or she may exercise the right and how the refund will be calculated.

Banks should provide to customers the ILAS offering documents and Product Key Fact Statements (if issued). When explaining or recommending ILAS products to customers,
banks should give balanced views. Where direct investment in the underlying investment assets (e.g. unit trusts and mutual funds) can be the alternative of indirect investment through ILAS products, banks should explain to customers the pros and cons of ILAS products compared with direct investment in the underlying investment assets and taking out a life insurance policy separately.

Banks must distribute HKFI's education pamphlet entitled "Questions you need to ask before taking out an ILAS product" to potential policyholders of ILAS products at the point-of-sale. Where appropriate, banks may also refer their potential customers to other ILAS-related public education materials, e.g. those issued by SFC or HKFI.

Ensuring customer suitability

• Banks should take all reasonable steps to ensure that the recommended ILAS product is suitable for a customer having regard to the customer’s circumstances, such as investment objectives and horizon, investment experience, risk tolerance level, affordability and asset concentration, etc. In general, customer risk profiling and needs analysis should be performed prior to making any solicitation or recommendation in respect of any ILAS products. In this respect, banks should ensure compliance with HKFI's "Updated Requirements Relating to the Sale of ILAS Products following the Introduction of the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products".
• Banks should avoid exerting any undue influence on or the manipulation of the risk profiling result. Banks should guard against any acts, before, during or after the profiling process, that may defeat the purpose of these measures.
• While ILAS products can take various forms, those currently available in Hong Kong mostly offer a wide range of investment options with varying risk levels which a customer can choose from. It is also a common feature of ILAS products that subsequent switching between investment options and a top-up investment are allowed. At the point-of-sale of ILAS products, banks should explain to the customer the possible risks of switching to or top-up investment in investment options that are inconsistent with his or her risk profile. Banks should remind the customer to discuss with relevant staff before making a subsequent switching or top-up investment.
• Where a customer indicates that he or she does not need/want insurance/investment products, banks should not recommend ILAS products. Further, in view of the long lock-in period of ILAS products, banks should ensure that due regard is paid to a customer's risk tolerance, financial situation, liquidity needs, investment horizon and retirement plan (if any) in considering whether ILAS products are suitable for him or her. In particular, when dealing with elderly customers or customers in need of liquidity, banks should alert them of the lock-in period and ensure that the product is suitable for the customer. Banks should allow sufficient time for these customers to consider the product or seek advice from their relatives or friends where necessary.
• Banks should exercise extra care in selling investment products to vulnerable customers. Among other things, there should be more than one front-line staff member handling the sale to such a customer, unless the customer opts out of this arrangement and proper audit trail is maintained on this opt-out decision.
• More stringent control measures should be adopted for transactions involving a risk mismatch. Whenever any of the investment options selected by a customer in an ILAS transaction has a risk rating higher than the customer’s risk tolerance level, before accepting this transaction, the bank staff should (i) remind the customer of the risk mismatch and that the investment option(s) may not be suitable for him or her; (ii) document the reasons of any product recommendations as well as the reasons for the customer’s choice of investment option(s); (iii) ensure the customer's acknowledgement of the risk mismatch; and (iv) appropriately audio-record the relevant conversation in respect of these arrangements. In the event of inconsistent answers given by the customer, the bank staff should seek clarification and document the reasons given by the customer. Endorsement should be sought from supervisory staff.
• Banks should have proper audit trail, including audio-recording, of every switching transaction or top-up investment processed by the bank to capture either (i) the customer's acknowledgement that the switching or top-up investment did not involve solicitation / recommendation by the bank or its staff; or alternatively (ii) the rationale for any solicitation/recommendation by the AI or its staff. If the switching transaction or top-up investment processed by the AI involves the customer choosing risk-mismatched investment option(s), the control measures set out in the previous paragraph should also be adopted. Similarly, there should be appropriate warnings, alert messages and audit trail for transactions conducted through channels other than bank branches such as phone banking or Internet banking.

Records maintenance and audio-recording

• Banks should ensure that adequate records and an audit trail (including audio records) are in place to show that the proper selling process has been followed. Banks should ensure the salient parts of the sales process and ancillary arrangements relevant to the ILAS application are properly audio-recorded. This should cover the salient parts of the customer risk profiling, relevant information for suitability assessment obtained from financial needs analysis5, provision of alternatives and rationales of the recommendation (e.g. covering why the ILAS product was recommended instead of direct investment in funds and separate life insurance policy), disclosure of product features and risks, Applicant’s Declarations, and Customer Protection Declaration.

Management oversight

• Banks should have adequate management oversight of the sale of ILAS products. Banks should establish proper management information system reports for management to assess its business and identify risks or non-compliance. High risk areas and exceptions (such as transactions with vulnerable customers, tenor and/or risk mismatch transactions, affordability issues or high asset concentration) related to the sale of the ILAS products should be monitored. There should also be regular independent reviews of the selling process of ILAS products, covering test-checks of ILAS transactions including those identified as high risk areas and exceptions. The "mystery shopper" programme of banks should include a test of the ILAS product selling process. Appropriate follow-up actions should be taken if any irregularity is identified.

Complaints handling

• Banks should ensure that complaints relating to ILAS are handled in a proper and timely manner. Banks should report to the relevant principal insurers all complaint cases and keep the insurers informed during the complaint handling process, as appropriate. Given the principal-agent relationship, the complaints may also be handled by the principal insurers and reviewed by OCI or HKFI.

Notifications to regulators

• Banks should promptly report to the HKMA and other relevant regulator(s) any material breach, infringement of or non-compliance with any applicable law, regulations and codes.

Disciplinary proceedings

• Disciplinary proceedings under the Banking Ordinance may be taken against a relevant individual (ReI) if his or her conduct in the sale of ILAS products raises concerns about his or her fitness and properness to be an ReI. Banks should clearly communicate to all ReIs involved in the sale of ILAS products the potential risk of disciplinary proceedings being taken against them for any acts or omissions that raise concerns about their fitness and properness to be an ReI.
• Similarly, disciplinary proceedings may also be taken by IARB against technical representatives for non-compliance or misconduct under the Code of Practice for the Administration of Insurance Agents issued by HKFI. Banks are advised to report, via their principal insurers, to IARB any disciplinary proceedings taken on an ReI for any acts or omissions that raise concern about his or her fitness and properness to remain as an ReI.

Jack's comment: Such "parental guidance" note should also be provided by SFC or OCI to those insurance agents who are not working for banks.

Evidential Requirements for Professional Investors

SFC recently published the Consultation Conclusions regarding proposals to refine the requirements for evidencing whether a person qualifies as a high-net-worth professional investor under the Securities and Futures (Professional Investor) Rules.



THE NEW REGIME


The Principles Based Approach


SFC's new regime is founded upon a principles based approach to the consideration of whether an investor meets the relevant assets or portfolio threshold, at the relevant date, to qualify as a professional investor. This flexible approach is designed to permit companies to employ whatever method seems most appropriate to them, in the circumstances at hand, when making this consideration.


SFC will not prescribe what these methods should be, although it does note that firms should maintain proper records of their assessment process. This will enable any firm to show that they have made a reasonable decision in declaring, after the appropriate exercise of professional judgement, that their clients satisfy the relevant thresholds.


Some issues were raised during the consultation process which merit examination:


Assessment Methods


A number of market participants requested advice from SFC on the standards and processes which should be employed when evaluating the assets and portfolio levels of potential professional investors. More detailed instruction was also appealed for, as market participants wished to know whether specified types of documents or data (such as a company search on corporate client) are acceptable evidence when investigating an investor's potential status as a professional investor. Some respondents called on SFC to release a non-exhaustive list of such acceptable documentation.


However SFC stated that although guidance on the standards to be utilized when assessing potential professional investors may increase market certainty, the concept of issuing lists of acceptable documentation for making such assessments ran contrary to the principle based approach on which the new rules are founded. SFC reiterated its intention to leave maximum flexibility to market participants in their determination of an investor’s status, so long as the means availed of are appropriate in the circumstances and records are maintained.


Self-certification


A number of respondents expressed a desire for guidance on the matter of when it would be acceptable to permit a client to self certify as a professional investor. However SFC refused to issue such specific guidance, noting that firms should have sufficient knowledge of their clients' affairs, under the know-your-client requirements in the Code of Conduct, to make such a determination for themselves. SFC also explicitly stated that it was not ruling out self-certification as an acceptable method of evaluating the assets and portfolio levels of potential professional investors, but that it must be used in appropriate situations.


Incorporation of Modifications


Over the last few years SFC has made several Modifications, under section 134 of SFO, to the requirements under the Professional Investor Rules. Some respondents requested that SFC insert those Modifications which are applicable to a wide spectrum of market participants into the Professional Investor Rules. However SFC declined to act on these propositions, calling attention to the fact that these Modifications were permitted on the basis of particular sets of facts being presented by applicants to the SFO and stating that it had no inclination to alter the manner in which such modifications are granted. Additionally, SFC declared that the need for Modifications to alleviate the rigidity of the old regime in this area had been addressed by the flexible nature of the new principles based system of assessing an investor’s status.


PRESERVATION OF EXISTING METHODS


In the Consultation Paper the SFC recommended retaining the current methods of appraising whether or not a client qualifies as a professional investor, a recommendation which received the approval of the majority of respondents. SFC confirm that market participants may choose to continue to use the existing practices or to avail of the new more flexible system presented in the Consultation Conclusions.


USE OF "RELEVANT DATE" AS THE TIME REFERENCE FOR ASCERTAINING WHETHER AN INVESTOR MEETS THE RELEVANT ASSETS OR PORTFOLIO THRESHOLD TO QUALIFY AS A PROFESSIONAL INVESTOR


The majority of respondents approved of SFC's proposal to use "relevant date" as the time reference for evaluating whether a high net worth professional investor satisfies the relevant assets or portfolio threshold. However a number contended that it is extremely difficult, from a practical standpoint, to procure evidence permitting the appraisal of an investor's assets or portfolio value on a specific date. Requests were made to SFC to ease the strictness of this rule, in recognition of these difficulties. However these were rebuffed by SFC, who reiterate in the Consultation Conclusions that although an investor must adhere to the relevant assets or portfolio threshold at the relevant date to qualify as a professional investor, the new principles-based approach imposes no process or evidence that market participants are obliged to follow or acquire on any particular date.
Furthermore, SFC note that any market participant experiencing complications when attempting to determine an investor's status on the relevant date may employ the current methods outlined in sections 3(a) to 3(c) of the Professional Investor Rules, which permit the assembling of specific documentary evidence prior to the relevant date, when making said determination.


EXTENSION OF THE SCOPE OF SECTION 3 (D) OF THE EXISTING PROFESSIONAL INVESTOR RULES


Most respondents agreed with SFC's proposal to broaden the application of section 3(d) of the existing Professional Investor Rules, with the effect that any corporation which is wholly owned by one or more individuals or corporations/partnerships, where each of those individuals or corporations/partnerships would qualify as a professional investor under section 3(b) or section 3(c) (as the case may be) of the Professional Investor Rules, will qualify as a professional investor. However some market participants felt that the scope of section 3 (d) should be extended further and include more forms of corporations as professional investors.


SFC considered the responses of the market and in the Consultation Conclusions agreed to further extend the operation of section 3 (d) of the Professional Investor Rules, so that any corporation which is wholly owned by one or more trust corporations, individuals or corporations/partnerships where each of those trust corporations, individuals or corporations/partnerships would qualify as a professional investor under section 3(a), section 3(b) or section 3(c) (as the case may be) of the Professional Investor Rules, will qualify as a professional investor.


However SFC refused to extend the application of section 3(d) any further, as to do so would be unnecessary and exceed the ambit of the current consultation. SFC also repeats the argument here that "the flexibility provided by the proposed principles-based approach has effectively addressed market participants' concerns with the practical difficulties in ascertaining their clients as professional investors under the current Professional Investor Rules."


MISCELLANEOUS MATTERS


Suggestions from market participants outside the scope of the current consultation


A number of recommendations were received by SFC from respondents with regard to aspects other than the evidential requirements of the professional investor regime. As these were not relevant to the current consultation, SFC did not consider them.


Status of existing Modifications / Future applications for Modification


One market participant queried whether Modifications granted prior to the amendment of the Professional Investor Rules will remain in force after the amendment and whether an application for a Modification or waiver of the requirements of the Professional Investor Rules, under section 134 of the SFO, will be permissible subsequent to the amendment of the Professional Investor Rules.


In response to the first query, SFC stated that the amendments would not affect any existing Modifications. SFC then noted that if a Modification application concerns sources or types of information and the remedy sought is in fact consistent with the revised Professional Investor Rules, there is no need to make such an application and to do so would be inappropriate. However, SFC will continue to consider granting modifications in relation to other requirements of the Professional Investor Rules under section 134 of the SFO.


IMPLEMENTATION


SFC will now take steps to implement the proposals discussed in this newsletter, via the making of the necessary amendments to the Professional Investor Rules. The revised rules will be gazetted in due course following review by the Department of Justice.




Jack's comment: More flexibility is at the expense of less "parental guidance".

Guideline on "Over-concentration"?

Yesterday SFC and HKMA announced that an agreement has been reached with Standard Chartered Bank (Hong Kong) Limited in relation to the bank's distribution of equity linked structured notes issued and guaranteed by Lehman Brothers (LB ELNs). Standard Chartered sold over HK$5 billion worth of LB ELNs between August 2006 and June 2008 of which HK$2.19 billion worth remains outstanding. The 2,515 outstanding LB ELNs are held by 2,234 individual customers.


Without admitting liability, Standard Chartered has agreed to make a repurchase offer to eligible customers holding an outstanding LB ELN distributed by Standard Chartered. The total value of the repurchase offer is estimated to be approximately HK$1.48 billion and will cover over 95% of the outstanding transactions in LB ELNs by Standard Chartered customers.


The repurchase offer is available to all retail customers holding outstanding LB ELNs who invested more than 5% of their Available Assets in not principal protected LB ELNs or 10% of their Available Assets in principal protected LB ELNs at the time of the purchase of the LB ELNs. The offer will exclude corporations (other than a corporation where the suitability assessment was based on an individual's circumstances rather than the corporation's, charities and not for profit organisations), professional investors, customers of the private banking division of Standard Chartered and those who did not purchase the LB ELNs from Standard Chartered.


Following an investigation by SFC and HKMA, both regulators were concerned that Standard Chartered may have exposed LB ELN customers to higher levels of risk than were suitable for them by not adequately considering concentration risk when assessing the suitability of LB ELNs for customers.


Under the repurchase scheme, Standard Chartered has agreed to make the repurchase offer at a price equal to the total value of each eligible customer's investment in outstanding not principal protected LB ELNs less 5% (or less 10% in the case of customers holding principal protected LB ELNs) of each customer's total assets held at or with Standard Chartered at the end of the month immediately preceding the date of the purchase of the outstanding LB ELNs or, the amount invested in LB ELNs (whichever is higher) (Available Assets).


The repurchase offer price will exclude the amount of coupons already paid to the customer but include an additional amount representing the interest that would have been earned if the amount invested in LB ELNs that is over 5% or 10% of the customer’s Available Assets (as the case may be) had been invested with Standard Chartered on a fixed term deposit instead of being invested in LB ELNs.


Under the repurchase scheme, Standard Chartered will also pay top-up payments to those customers with whom Standard Chartered has already entered into settlement agreements but would otherwise have been eligible to receive a repurchase offer to the extent that such payments are needed to ensure those customers are treated in the same way as other customers participating in the repurchase scheme.
In entering into this agreement under section 201 of the Securities and Futures Ordinance, SFC took into account that:

• the total value of the repurchase offers under the repurchase scheme that will be made available to eligible customers who invested in LB ELNs at levels in excess of 5% or 10% of their Available Assets;

• although LB ELNs were high risk products, they were less complex than Minibonds and likely to have been suitable products for most customers as part of a diversified portfolio;

• unlike Minibonds, there is no distributable collateral for the LB ELNs;

• as unsecured creditors there is little chance LB ELN holders will receive a substantial payment or dividend in the Lehman Brothers bankruptcy so the payments from Standard Chartered may be the only possible return for eligible customers.

• the repurchase offer will enable the vast majority of Standard Chartered's LB ELN customers to obtain a reasonable recovery without the costs and associated risks of separate litigation;

• the agreement will bring the LB ELN matter to an appropriate end for the benefit of Standard Chartered and its customers who participate in the repurchase scheme;

• a result on these terms could not have been achieved through disciplinary action by SFC against Standard Chartered and/or its officers and employees; and

• Standard Chartered has undertaken to engage an independent reviewer, to be approved by SFC and HKMA, to review its systems and processes relating to the sale of unlisted structured investment products, to report to SFC and the HKMA and will commit to the implementation of all recommendations of the independent reviewer.

In view of the repurchase scheme, SFC will not take disciplinary action against Standard Chartered and its current or former officers or employees in relation to the distribution of LB ELNs, save for any acts of dishonesty, fraud, deception or conduct that is criminal in nature. HKMA has also informed Standard Chartered that it does not intend to take any enforcement action against their executive officers and relevant individuals in connection with the sale of LB ELNs to customers who have accepted the repurchase offers or the top-up payments under the repurchase scheme, except for any acts of dishonesty, fraud, deception or conduct that is criminal in nature.



Jack's comment: This case highlights the importance of concentration risk in the suitability process, which seems to be a hindsight after the Lehman Minibond incident. This case implicitly delivers a regulatory message that "over-concentration" means above 5% (of Available Assets) for non-principal protected products and over 10% for principal-protected products. Are such percentages too restrictive? Also, the so-called "Available Assets" count only assets maintained by the customers with the bank, then over-concentration is almost inevitable. Seriously speaking, if SFC does not intend to take this case as a benchmark to define over-concentration, it should issue a guideline in this respect as soon as possible.

Failure to Protect Confidential Customer Information

US FINRA recently imposed fines of $450,000 against Lincoln Financial Securities, Inc. (LFS) and $150,000 against an affiliated firm, Lincoln Financial Advisors Corporation (LFA), for failure to adequately protect non-public customer information. In addition, LFS failed to require brokers working remotely to install security application software on their own personal computers used to conduct the firm's securities business.

SEC and FINRA rules require every broker-dealer to adopt written policies and procedures that address safeguards for the protection of customer records and information. FINRA found that for extended periods of time – seven years for LFS and approximately two years for LFA – certain current and former employees were able to access customer account records through any Internet browser by using shared login credentials. From 2002 through 2009, between the two firms, more than 1 million customer account records were accessed through the use of shared user names and passwords. Since neither firm had policies or procedures to monitor the distribution of the shared user names and passwords, they were not able to track how many or which employees gained access to the site during this period of time. As a result of the weaknesses in access controls to the firms' system, confidential customer records including names, addresses, social security numbers, account numbers, account balances, birth dates, email addresses and transaction details were at risk.

The Web-based system both firms used combined non-public customer account information from various sources and allowed employees to view the customer account information within a single site. Home office personnel from both firms could access the system either by clicking on a link on the firm's website or could gain access through any Internet browser by going directly to the system's website and logging in with one of the shared user names and passwords.

FINRA also found that LFS and LFA did not have procedures to disable or change the shared user names and passwords on a recurring basis even after a home office employee had been terminated. Many individuals left the two firms during the relevant time period, yet the shared user names and passwords were never changed, and the firms had no way of determining whether former employees continued to access confidential customer information using those same user names and passwords.

In assessing sanctions, FINRA took into consideration the firms' efforts to notify all customers whose account information was or had been potentially exposed on the firms' Web-based system, and offered those customers credit monitoring and restoration services for a period of one year.

Jack: The affected clients in this horrible case were almost naked!  Should the IT Head (if any) be held liable?

Library Resources for Financial Education

US FINRA Investor Education Foundation and the American Library Association (ALA) have announced $1.4 million in grants to 20 recipients as a part of the Smart investing@your library® initiative.

Smart investing@your library is administered jointly by the Reference and User Services Association – a division of ALA – and the FINRA Investor Education Foundation. The program funds library efforts to provide patrons with effective, unbiased financial education resources. Now in its fourth year, the program has awarded a total of more than $4.6 million to public libraries and library networks nationwide.

The new grant recipients will use the funds to implement a variety of programs designed to increase patrons' access to and understanding of financial information. The grants target a diverse group of library patrons – among them youth, seniors, English-language learners, local employment counselors, members of the military and their spouses, and low-income families. Participating libraries will use a variety of technologies and outreach strategies to connect library users to the best financial education and information available. These strategies include gaming, online learning, classroom formats, one-on-one clinics, storytelling and staff training.

The grantees will partner with community organizations, schools, universities and local governments to expand the impact of the services and resources the grants enable. Library patrons will be empowered to make educated financial choices for both long-term investing and day-to-day money matters.

The grantees, which serve urban, suburban and rural communities across the country, will receive one to two years of funding, in addition to assistance with program marketing, outreach and evaluation provided by ALA. For more information about Smart investing@your library®, visit www.smartinvesting.ala.org.

Jack's comment: Providing more financial education to the society is equally important as regulating the financial industry.

Expert Network Insider Trading Scheme

US SEC just charged a New York-based hedge fund and four hedge fund portfolio managers and analysts who illegally traded on confidential information obtained from technology company employees moonlighting as expert network consultants. The scheme netted more than $30 million from trades based on material, nonpublic information about such companies as AMD, Seagate Technology, Western Digital, Fairchild Semiconductor, and Marvell.


The charges are the first against traders in SEC's ongoing investigation of insider trading involving expert networks. SEC filed its initial charges in the case last week against technology company employees who illegally tipped hedge funds and other investors with material nonpublic information about their companies in return for hundreds of thousands of dollars in sham consulting fees.


In its amended complaint filed today in federal court in Manhattan, SEC alleges that four hedge fund portfolio managers and analysts received illegal tips from the expert network consultants and then caused their hedge funds to trade on the inside information.


SEC's ongoing investigation is focusing on the activities of expert networks that purportedly provide professional investment research to their clients. While it is legal to obtain expert advice and analysis through expert networking arrangements, it is illegal to trade on material nonpublic information obtained in violation of a duty to keep that information confidential.


The technology company insiders who tipped the confidential information were expert network consultants to the firm Primary Global Research LLC (PGR).


Jack's comment: This case can be the blueprint for a commercial firm!

Gray Areas in Jobs After an SEC Ban

(Source: WSJ 2011.01.28)


Jason Galanis describes his job as doing "M&A work" for a subsidiary of Gerova Financial Group Ltd., where he is chief executive. The insurer has a stock-market value of about $600 million and trades on the New York Stock Exchange.


The 40-year-old Mr. Galanis, who also is a manager of the unit called Gerova Advisors LLC, agreed in 2007 with another person accused of accounting fraud related to a false quarterly report to a five-year ban by the Securities and Exchange Commission from "serving as officers or directors of public companies."


The ban has resurfaced in a war of words between the insurer and some investors who are betting against the company's share price. But it isn't clear if Mr. Galanis's current job duties violate the settlement. SEC spokesman John Nester declined to comment, and the language in Mr. Galanis's settlement and a related court filing are murky, with no reference to subsidiaries of public companies.


Earlier this month, research and investment firm Dalrymple Finance asserted in a report about the insurer that it was "likely fraudulent," contending its assets were overvalued. Mr. Galanis's past also was cited as a red flag because of the SEC enforcement action.


Dalrymple has an incentive to criticize Mr. Galanis, saying in the report that it is shorting Gerova shares, meaning it would make money if they fell.

Mr. Galanis said the SEC charges against him were "clearly regrettable" and "a black eye. It's embarrassing." He also paid a $60,000 fine to end the agency's civil lawsuit alleging he "prepared and filed" a false quarterly report for magazine publisher Penthouse International Inc. Penthouse, which didn't admit or deny wrongdoing, settled the case by promising not to violate securities laws.


In an interview, Mr. Galanis said his current job is clearly allowed under the settlement because Gerova Advisors isn't a public company. Gerova Financial Group said in a statement that he is a "valuable employee," adding that his "responsibilities to the company are clearly defined" and his duties "limited." Mr. Galanis isn't a member of the parent company's board.


The court filing signed by Mr. Galanis includes his promise to avoid "acting as an officer or director of any issuer that has a class of securities registered" with the SEC or "that is required to file" financial reports with the agency. The five-year ban is to end in May 2012. Some securities lawyers say his job raises questions about the effectiveness of bans, an important tool used by regulators to protect investors.


In the past five years, the SEC has sought to bar more than 500 people from being officers or directors of a public company. Most of those efforts succeeded, often as a result of settlements with defendants in civil lawsuits filed by the SEC, though the agency couldn't provide exact figures.


Jacob Frenkel, a former SEC enforcement lawyer who now is a partner at law firm Shulman Rogers Gandal Pordy & Ecker in Potomac, Md., said comebacks following such bans occur "with great frequency," adding that being a director or officer of a unit of a public company is a grey legal area.


The question of whether a comeback by someone booted out of the securities industry or barred from being an officer or director of a public company crosses the line has long been controversial.


In 1998, Michael Milken, the former junk-bond king who spent nearly two years in prison for securities-law violations, agreed to pay $47 million to settle SEC charges that he violated a lifetime ban from the securities business. Mr. Milken didn't admit or deny wrongdoing. The SEC claimed Mr. Milken violated the ban by acting as a consultant in two transactions.

In November, financier Steven Rattner agreed as part of a settlement with the SEC over alleged influence-peddling at New York's flagship pension fund to not associate with any investment adviser or broker dealer for two years. Mr. Rattner didn't admit or deny wrongdoing. A December agreement with then-New York Attorney General Andrew Cuomo bans Mr. Rattner from appearing "in any capacity" before New York pension funds for five years.


Barry Goldsmith, a partner at law firm Gibson, Dunn & Crutcher LLP who was the SEC's chief litigation counsel from 1993 to 1996, said it is "unusual" for someone barred from running a public company to work as a director of a wholly owned subsidiary of a public company, as Mr. Galanis said he is doing.


Mr. Galanis got a Ferrari when he was 16 years old. Two years later, his father, John Peter Galanis, went to federal prison after being convicted of racketeering, tax-fraud, bank-fraud and securities-fraud charges. The five-year ban agreed to by the younger Mr. Galanis came when he owned about an 8% stake in Penthouse. The SEC said the alleged fraud boosted revenue and made a quarterly loss look like a profit. He didn't admit or deny wrongdoing.


Deal-making is a major part of the parent company's growth strategy. Launched in 2007 as a "blank check" operation to make acquisitions, Gerova has gobbled up loans and insurance assets. Last month, the company announced plans to buy Seymour Pierce Holdings Ltd., a London brokerage firm with roots dating back to 1803, and New York brokerage firm Ticonderoga Securities LLC.


Gerova said it will change its name to Seymour Pierce when the London deal is completed. The takeovers must be approved by U.S. and U.K. regulators.


The Dalrymple report claimed the company is vastly overvaluing its real-estate assets, which investors can't fully assess because Gerova hasn't filed financial statements since it became a public company last year.


A May 2010 company spreadsheet reviewed by The Wall Street Journal calculates that Gerova's real-estate holdings are worth 41% less than their stated book value of $274 million. The analysis of more than 30 investments includes a high-rise condominium in West Palm Beach, Fla., and 253 single-family homes in Ohio.


Jack Doueck, a Gerova director, said the document was an informal estimate that was "rife with errors." The book values are out of date, and "there is no $112 million discrepancy," he said. And as a "foreign private issuer," Gerova is required to disclose results only annually, Mr. Doueck added. The annual report for 2010 is due by June.


Gerova said earlier this month that it hired investigative firm Kroll, a unit of Altegrity Inc., to probe "possible market manipulation and collusion aimed at driving down the price" of Gerova shares. The company accused Dalrymple, the research firm that questioned Mr. Galanis's role at the insurer, of using "materially false information" to support a "series of speculative and unsupported conclusions."


Keith Dalrymple, managing director of Dalrymple, declined to comment.

Jack's comment: When there is a regulation, there are lots of loopholes.

Improper Marketing of YieldPlus Bond Fund

US FINRA recently ordered Charles Schwab & Company, Inc., to pay $18 million into a Fair Fund to be established by SEC to repay investors in YieldPlus, an ultra short-term bond fund managed by Schwab's affiliate, Charles Schwab Investment Management. The $18 million consists of the $17.5 million in fees that Schwab collected for sales of the fund, plus a fine of $500,000, both of which will have been designated as restitution to customers.

FINRA's investigation found that despite changes in YieldPlus' portfolio that caused the fund to be disproportionately affected by the turmoil in the mortgage-backed securities market, Schwab failed to change its marketing of the fund. In written materials and in conversations with customers, some Schwab representatives omitted or provided incomplete or inaccurate material information relating to the fund's characteristics, risk and diversification, and continued to represent YieldPlus as a relatively low-risk alternative to money market funds and other cash alternative investments that had minimal fluctuations in NAV.

Between Sep 2006, and Feb 2008, Schwab sold over $13.75 billion in shares of YieldPlus to customers, which accounted for approximately 98% of the amount Schwab customers invested in ultra short-term bond funds. During this time period, Schwab's solicited sales of YieldPlus totaled approximately $3.36 billion, approximately 40% of which were to customers 65 years of age or older.

In late August 2006, Schwab Investment's Board of Trustees approved a proposal from YieldPlus' fund manager to no longer classify non-agency mortgage-backed securities as an "industry" for purposes of the fund's concentration policies. This change purportedly allowed the fund manager to increase the amount of non-agency mortgage-backed securities in the portfolio to greater than 25% of the fund's assets. As a result, by February 2008, YieldPlus held over 50% of its assets in mortgage-backed securities, and about 40% in non-agency mortgage-backed securities.

Schwab was or should have been aware of the fund's significant exposure to mortgage-backed securities in light of the increasingly unfavorable financial markets.  As YieldPlus' NAV declined in the latter part of 2007, Schwab acknowledged internally that YieldPlus was a higher-risk investment than it had been in the past. Internally, some Schwab employees even began referring to YieldPlus as "Yield Minus." Schwab nevertheless continued to describe to investors YieldPlus as being very low risk with minimal fluctuations in share price. Schwab also was aware that YieldPlus was being marketed improperly. The firm's product manager for YieldPlus advised others that the firm needed "to get away from saying YieldPlus is equivalent to a money market fund," but the firm failed to stop this practice.

Schwab's investment management unit was aware of the changes in the fund's portfolio and the significant increase in the percentage of the fund's mortgage-backed securities holdings, but it failed to appreciate the concomitant increase in the risk of the fund and price volatility. Meanwhile, Schwab's retail brokerage division did not change the way it marketed YieldPlus or the internal guidance it provided to its registered representatives. 

In its advertisements and sales literature, Schwab described YieldPlus as a cash alternative investment. Schwab initiated marketing campaigns during the second half of 2006 and continued into 2007, one of which was internally called the "Cash" campaign, which compared the performance of YieldPlus to a money market fund and promoted YieldPlus as an alternative to money market funds. In the campaigns, Schwab did not disclose that the higher returns resulted from the greater risk in the portfolio. Other advertisements emphasized the "minimal risk" and "high degree of price stability" in YieldPlus.

The increased concentration in mortgage-backed securities caused YieldPlus to be severely impacted by the decline in the mortgage-backed securities market that began in the summer of 2007. YieldPlus' NAV dropped significantly, falling from a high of $9.69 on 26 Feb 2007 to $8.79 on 29 Feb 2008, a decline of 9.3%.

Jack's comment: It is again a case about the conflict between product due diligence and product marketing. Investors should be educated to appreciate that bond, or bond fund, is not necessarily safe.