Opt In vs Opt Out

As announced on 19 Dec 2013, SFC reprimanded HSBC Securities Brokers (Asia) Limited (HSBC Securities) and fined it $5 million for providing inaccurate information to the SFC during a licence application process.

HSBC Securities submitted a licence application to carry on business in Type 7 (providing automated trading services) regulated activity for its provision of matching and crossing services in Hong Kong (Crossing Service) in May 2010. During the licence application process, HSBC Securities represented to SFC that existing clients would be given the option of "opting in", by signing "opt in letters", if they wished to participate in the Crossing Service (the "opt in" approach). SFC granted HSBC Securities a Type 7 licence in Mar 2011.

In Jul 2011, the media reported that HSBC proposed to launch the Crossing Service to its retail clients, and that an "opt out" approach would be adopted, whereby clients would effectively be assumed to consent to their trades being matched and crossed on the Crossing Service unless they took the initiative to notify HSBC otherwise. This is contrary to the representations that HSBC Securities had made to SFC during the licence application process.

SFC's investigation found that:

• A preliminary decision by HSBC to change the enrolment approach for retail clients from "opt in" to "opt out" was made in mid-Oct 2010 but as a result of internal miscommunication, when SFC specifically queried HSBC Securities in Nov 2010 whether the "opt in" approach would apply to retail clients, HSBC Securities misrepresented to SFC that this would be the case.
• When the decision to change from "opt in" to "opt out" approach for retail clients was confirmed in around Dec 2010, HSBC Securities failed to notify SFC about the change as required by the S&F (Licensing and Registration) (Information) Rules.

SFC considers that HSBC Securities' failure to ensure the accuracy of information submitted to SFC in support of its licence application and its failure to notify SFC about the change from "opt in" to "opt out" approach for retail clients called into question its fitness and properness as a licensed person.

Change from "opt in" to "opt out" is too material to be ignored!

Facilitation of Suspicious Fund Transfers

As announced on 25 Nov 2013, SFC suspended Mr Stephen Cho Yu Kwan for 3 years and reprimanded his wife Ms Ju You Li and fined her $100,000.

Between Aug and Dec 2010, there were a number of suspicious fund transfers of significant amounts to and from the personal bank accounts of Cho and Ju, who were licensed representatives of different securities firms. These transfers involved funds that had been advanced to them by money changers in both Hong Kong and the Mainland on behalf of Mainland clients. Money for Cho’s clients was routed through Ju’s personal bank account to the securities accounts of Cho’s clients and funds for Ju’s clients were transferred to the securities accounts of Ju’s clients via Cho’s personal bank account.

The effect of the arrangement was to create an additional layer of the fund transfer process disguising the true source of the funds that were being used and prejudicing their employers’ obligations to know the origin of their clients' money, both of which constitute important information in the prevention and identification of money laundering activities.

According to Cho and Ju, the funds deposited to their accounts came from their Mainland-based clients. However, they had no actual knowledge to confirm their belief. Nor did they verify whether the money received in Cho’s account was provided by the money changers and whether the relevant clients had transferred the equivalent amount of RMB to the money changers' accounts in the Mainland.

Cho admitted that he received a service fee from some of these clients for the services he rendered. Cho also admitted that on some occasions the money received from the money changers might be kept in his personal bank account temporarily, if the clients’ securities trading accounts at his employer had not yet been opened.

Use of money changers for fund transfers is already a red flag. Use of personal bank accounts to facilitate these is even an alarm.

Email Fraud

As announced on 29 Jul 2013, SFC reprimanded A One Investment Company Limited and fined it $1.2 million for internal control failures relating to the unauthorized sales of client securities and the unauthorized transfers of more than $7 million in client funds held by A One to third party accounts. SFC also suspended Ms Alysia Ann Lee's RO approval and her licence for 8 months.

The disciplinary action follows an SFC investigation into a self report by A One about suspected fraudulent activities in the account of one of its clients.

Between 4 Jul 2012 and 10 Aug 2012, 538,000 shares of Li & Fung Limited in the relevant client's account were sold and a total of EUR676,000 and GBP160,000 were transferred out of the client's account in 13 transfers to third party bank accounts in Italy, Norway, Singapore and the United Kingdom. The sales and transfers were carried out pursuant to instructions that were sent to Lee at A One's email account (the Email Instructions) from an email account that the client had previously used in his communications with A One. The client denied that the instructions were given by him and claimed that his email account had been compromised.

SFC found that:

• A One did not have any manual, written policy or procedure for handling client requests to transfer funds to third party accounts.
• A One claimed that clients who requested to transfer funds to third party accounts were required to provide a signed authorization letter, so that the client's signature could be verified by comparing it against the signature on his/her account opening documents. However, A One never received the original signed authorization letters for the above 13 transfers. It received a scanned copy of the signed authorization letter on the day it processed the client's request for only one of the transfers. In all other cases, scanned copies of the signed authorization letters were received only after the transfers had been completed.
• A One did not take any other step to verify the identity of the person who gave instructions for the sales and the transfers, or to verify the authenticity of the instructions.
• Although two ROs were required to endorse the remittance application form (which gives the bank instructions to effect a remittance), it does not appear that they bore any responsibility for verifying the authenticity of the client's instructions.
• The circumstances of the transfers did not accord with the historical pattern of transfers from the relevant client's account to third party bank accounts, but A One made no enquiries to satisfy itself that the transfers were reasonable.

SFC also found that in response to the Email Instructions, Lee set in train the chain of events that facilitated the unauthorized transfers from the relevant client's account. She acted negligently in handling the relevant transfers and failed to properly discharge her managerial duties. Therefore, A One's failures are attributable to her.

Taking of client instructions by email is not unacceptable, but authentication of client identity is a headache. In this case, there were too many alarms to be ignored by a reasonable man.

Apex Horizon

On 13 May 2013, Cheung Kong (Holdings) Limited, Cheung Kong Property Development Limited, Pearl Wisdom Limited (PWL) and Horizon Hotels & Suites Limited (collectively the Cheung Kong parties) entered into an agreement with SFC to unwind the sale of hotel room units at Apex Horizon.

Apex Horizon (雍澄軒) is a development in Kwai Chung comprising 360 hotel room units. On 18 Feby 2013, Cheung Kong announced at a press conference that its subsidiary PWL was offering 65 of the 360 hotel room units in the development at an average selling price of $5,200 per sq. ft. On offer were 660 sq. ft. 2-bedroom hotel room units and 909 sq. ft. 3-bedroom hotel room units. All 65 units were sold on the same day with the rest of the units sold shortly afterwards.

SFC has been investigating whether the offer to purchase hotel room units at The Apex Horizon development constituted an offer to acquire an interest in or to participate in a Collective Investment Scheme (CIS) under the SFO. A total of 360 hotel room units were individually sold to purchasers by the vendor, PWL, in Feb 2013.

PWL will issue a letter to all purchasers informing them that it wishes to cancel each contract and, in return, it will:

• reimburse every purchaser the deposit and any part payments together with interest at the rate of 2% p.a. above the prime rate specified by HSBC for the period from the date each amount was paid respectively until 30 May 2013; and
• offer an amount of $10,000 as reimbursement of any reasonable legal and other expenses.

SFC formed the view that the offer to purchase hotel room units at Apex Horizon appeared to be an invitation to acquire an interest in or to participate in a CIS as defined in the SFO.

A CIS has 4 relevant elements:

• it must involve an arrangement in respect of property;
• participants do not have day-to-day control over the management of the property even if they have the right to be consulted or to give directions about the management of the property;
• the property is managed as a whole by or on behalf of the person operating the arrangements; and
• the purpose of the arrangement is for participants to participate in or receive profits, income or other returns from the acquisition or management of the property.

In this case, SFC considered the fact that day-to-day management of the hotel was to be in the hands of a separate operator appointed to operate the hotel on behalf of the purchasers and the hotel operator would control key functions necessary to manage and supervise the hotel including allocation of guests to rooms.

The Cheung Kong parties do not agree with SFC’s view and contend that the purchasers have effective day-to-day control of their rooms and that it is an investment in real estate. However, SFC informed the Cheung Kong parties that it intended to commence proceedings under S.213 of the SFO in the Court of First Instance to seek orders unwinding the sale and returning all deposit moneys and part payments to purchasers. The agreement avoids these proceedings being commenced at this stage.

This is an important case illustrating the very wide scope of CIS under the SFO.

Issue of Advertisements of Unauthorized Fund

As announced by SFC on 21 Mar 2013, the Eastern Magistracy acquitted Pacific Sun Advisors Limited (Pacific Sun) and its director Mr Andrew Mantel for 4 counts of issuing advertisements to promote a collective investment scheme (CIS) without SFC's authorization, in contravention of S.103 of the SFO.

SFC alleged that between Nov and Dec 2011, the defendants issued an advertisement on the corporate website of Pacific Sun promoting a CIS called "Pacific Sun Greater China Equities Fund" (the Fund) without SFC's authorization. On or around 2 and 3 Nov 2011, the defendants issued an advertisement regarding the launch of the Fund to the public by email without SFC's authorization.

During 3 days of evidence, the defendants submitted that they intended to sell interests in the units of the Fund only to professional investors and so the advertisements did not require SFC's authorization under a statutory exemption. But SFC submitted that the exemption did not permit advertisements that had not been authorized by SFC to be issued to the public and that in this case there was no evidence that the interests in the Fund had only been sold to professional investors.

The Magistrate accepted the defendants' argument and ruled also that the advertisements did not constitute invitations to the public to invest in the Fund. SFC will consider an appeal of the decision.

This case is interesting. For my previous interpretation of S.103 of the SFO, advertising an unauthorized fund without SFC's authorization is no doubt illegal, even if the promoter has the "intention" of selling the fund to PI only. The court judgement has overturned this thought!


Subsequent update on 10 Jun 2014:

• Following SFC's appeal concerning the acquittal in which the Court of First Instance in Jan 2014 issued a ruling clarifying that the advertisements in question did not fall within the exemption and ordered the case to be returned to the Magistrates’ Court for reconsideration.
• The Court of First Instance made it clear that the exemption only applies where the advertisement states on its face that the terms of the offer are limited to professional investors. SFC considers this ruling protects retail investors from the risks of direct marketing of inappropriate or risky investment products.
• As a result, Pacific Sun and Andrew Mantel were convicted at the Tsuen Wan Magistrates' Court on 4 charges of issuing advertisements to promote a CIS without SFC's authorization. Pacific Sun was fined $20,000 and Andrew Mantel was sentenced to 4 weeks' imprisonment suspended for 12 months.

Subsequent update on 20 Mar 2015:

• The Court of Final Appeal (CFA) upheld an appeal by Pacific Sun and Andrew Mantel in relation to issuing advertisements to promote a CIS without SFC's authorization. The ruling of the CFA overturned a decision by the Court of First Instance on the interpretation of S.103 of the SFO.
• The CFA decided the Court of First Instance erred in its ruling in that the exclusion applies even if the intention to dispose of the securities or interests in a CIS only to professional investors is not expressed in the advertisement, invitation or document. The CFA made it clear that the burden of establishing the exclusion applies rests on the defendant and not on SFC.
• The CFA also stated that the professional investor exemption would not apply if a person published an unauthorized offer to the public and sold the advertised securities to a retail investor.
• This ruling means advertisements of unauthorized CIS can be issued to the general public if the issuer only intends to sell them to PI. It also means a contravention of S.103 of the SFO can only be established well after the offer to the public has been issued.
• SFC alleges that it will study the CFA's decision to determine whether there should be any proposal to amend S.103 of the SFO.

Inadequate Investor Profiling

As announced on 4 Mar 2013, SFC reprimanded Manulife Asset Management (Hong Kong) Limited (MAM) and fined it HK$24 million for inadequate internal controls in relation to the distribution of Manulife Global Fund (authorized by SFC) from 2007 to 2012.

SFC's findings focus on MAM's systems and processes for understanding its customer’s financial situation, investment experience, and investment objectives in soliciting or recommending the sale of the Fund to them.

Between 2007 and 2009, Manulife Asset Management obtained this information by performing an investor profile for each customer. However, 73% of the customers in 2009 were not profiled or their information was either incomplete or outdated for at least 12 months.

Needless to say, "not profiled" is more severe than "incomplete" which is in turn more severe than "outdated". However, SFC gave only the total percentage (73%) of all these deficiencies but did not provide the breakdown.

After 2010, MAM introduced a questionnaire to assess each customer's risk profile. By Feb 2012, the new process had not been fully implemented to all customers and MAM still had not secured a completed risk profile questionnaire from 70% of the Fund's customers.

Together with concerns about the quality and extent of its record-keeping, these failures have jeopardised MAM's capacity to ensure that recommended securities are suitable for each customer.

Despite these failures, SFC said there has been no default in any of the sub-funds of the Fund nor has any customer complained about the performance or suitability of the fund. Then how did SFC come up with such a huge amount of penalty? Of course, MAM is a big firm. If it was a small IFA incurred with the same deficiencies, I don't think SFC could impose a fine of $24 million.