Wash Trade Arranged by Fund

As announced on 27 Dec 2018, SFC reprimanded and fined Ardon Maroon Fund Management (Hong Kong) Limited (now known as China Silver Asset Management (Hong Kong) Limited) $800,000 for cross-trade related failures in managing Ardon Maroon Asia Master Fund (AM Fund).

On 8 Aug 2014, Ardon Maroon gave instructions to one of its brokerages to execute

a cross trade for 15 million shares of a listed company on SEHK, which resulted in AM Fund conducting a wash trade and incurring transaction costs totalling $133,056. In respect of the cross trade ordered by Ardon Maroon, AM Fund was both the buyer and seller of the relevant shares.

Ardon Maroon then instructed another brokerage, which received 48 million shares of the same company, to deliver 15 million of such shares to settle the wash trade. 

Ardon Maroon claimed that the cross trade was conducted for the purposes of moving

shares between the two brokerages so as to reduce margin requirement at the

brokerage receiving the 48 million shares and achieve better financing at the

brokerage conducting the cross trade.

Use of wash trade for share transfer purpose is ridiculous!

Failure to Timely Disclose Inside Information

Recent SFC has commenced proceedings in the Market Misconduct Tribunal against CMBC Capital Holdings Limited (1141.hk, formerly known as Mission Capital Holdings Limited) and its former directors for failing to disclose inside information as soon as reasonably practicable.

On 13 Oct 2014, CMBC Capital's Company Secretary sent an email to inform the board of directors that the company had recorded a significant improvement in financial performance in the sense that:

• Interim result up to 30 Sep 2013 – Loss HK$12m
• Annual result up to 31 Mar 2014 – Profit HK$417m
• 5-month unaudited result up to 31 Aug 2014 – Profit HK$838m (mainly contributed by securities investment)

SFC has considered the 5-month profit as inside information.  However, CMBC Capital did not issue any profit alert announcement as such until 7 Nov 2014 (i.e. late for less than one month since the email issued on 13 Oct 2014). As a result, SFC has commenced the MMT proceedings.

This case is alarming to Hong Kong listed companies because many of them may not think unaudited result of less than 6 months could still be deemed as inside information and slightly late disclosure would be a big problem. I also wonder how CMBC Capital's Company Secretary advised the board during Oct 2014.

Email Monitoring System

As announced on 20 Sep 2018, SFC banned Mr Ngo Wing Chun, a former relationship manager of HSBC, from re-entering the industry for 12 months for unauthorized transfer of customer data.

Ngo sent an email containing personal data of approximately 995 customers from his HSBC email account to his two personal email accounts on 19 Nov 2015, his last working day at HSBC.

The customer data leakage was immediately detected by HSBC's email monitoring system before Ngo joined another bank in a similar capacity the following day. Ngo agreed to delete the email upon HSBC's request from his personal email accounts. There is no evidence that the customer data had been disclosed to any third parties.

Ngo's conduct was in breach of HSBC's internal policies, the PDPO and SFC's Code of Conduct.

Implementation of email monitoring system for detecting deliberate leakage of customer data and inside information has deserved a higher priority.

Ineffective AML Procedures

As announced on 17 Aug 2018, HKMA reprimanded Shanghai Commercial Bank Limited (SCOM) for contravening S.19(3) of Schedule 2 to the AMLO by failing to establish and maintain effective procedures for the purpose of carrying out its duty to continuously monitor business relationships. It also SCOM to pay a pecuniary penalty of HKD5,000,000 and submit to HKMA a report prepared by an independent external advisor assessing whether the remedial measures implemented by SCOM are sufficient to address the contraventions and the effectiveness of the implementation.

In summary, SCOM did not:

• continuously monitor its business relationship with 33 customers by examining the background and purposes of their transactions that were identified as (i) complex, unusually large in amount or of an unusual pattern and (ii) having no apparent economic or lawful purpose, and setting out its findings in writing;
• establish and maintain effective procedures for the purpose of carrying out its duty under S.5 of Schedule 2 to the AMLO to continuously monitor business relationships; and
• carry out customer due diligence (CDD) measures in respect of certain pre-existing customers when a transaction took place with regard to each of the customers that (i) was, by virtue of the amount or nature of the transaction, unusual or suspicious, or (ii) was not consistent with SCOM's knowledge of the customer or the customer's business or risk profile, or with its knowledge of the source of the customer's funds.

As regards the deficiencies in monitoring business relationships, although the relevant transactions were identified through SCOM's Management Information System (MIS) reports, which took into account different customer risk levels and transaction types, and were selected by SCOM's Compliance Department at the material time for further enquiry or investigation, SCOM had not adequately examined the background and purposes of those transactions and set out the findings in writing.

SCOM also lacked effective policies and procedures for monitoring the handling of MIS alerts including properly recording the follow-up actions taken and monitoring the review time, resulting in significant delay in alert clearance. As for carrying out CDD measures in respect of pre-existing customers, while one of the customers conducted the relevant transactions as early as in May 2012, SCOM failed to identify those transactions at the material time as unusual or suspicious or not consistent with its knowledge of the customer and had not conducted CDD measures accordingly.

It is the first time HKMA took a high profile action against a bank for contravention of the AMLO. This case reveals that putting in place surveillance systems and recruiting a team of compliance officers is no guarantee of compliance standards, effective implementation is critical.

Margin Financing Disguised as Investments

On 3 Aug 2018, SFC issued the circular "Margin Financing Activities Disguised as Investments". SFC said it had observed that some LCs carrying on asset management activities may have aided and abetted unlicensed affiliates or third parties to provide securities margin financing in the guise of investments.

SFC warns that the provision of margin financing in the guise of investments under such an arrangement is illegal. Parties involved in the illicit activities may have avoided certain capital, conduct or disclosure requirements aimed at protecting investors and market integrity.

These suspected margin financing arrangements are set up or operated in different forms. For example, they may operate through discretionary accounts or private funds with the following features:

• jointly with a LC's clients (note), the unlicensed affiliates or third parties appear to fund the acquisition and holding of sizeable, concentrated positions in one or more securities;
• the clients are required to provide additional capital or collateral when the value of these investments falls below a pre-determined level, similar to a margin call;
• the unlicensed affiliates or third parties are entitled to receive a guaranteed or predetermined yield from these investments, similar to margin interest; and
• the LC does not have actual investment discretion as the listed securities to be acquired were previously agreed between its clients and the unlicensed affiliates or third parties.

Note: In the context of a private fund, these refer to a particular class of investor of the fund whereas the unlicensed affiliate or third party belongs to another class of investor of the fund.

Arrangements which involve the provision of financial accommodations to facilitate the acquisition and holding of listed securities may constitute "securities margin financing" (i.e. RA8). The unlicensed affiliates and third parties in the examples above are not licensed by the SFC in any capacity and they may be in breach of S.114 of the SFO.

Persons conducting business activities which constitute securities margin financing are also subject to other regulatory requirements, including the capital requirements under the FRR and the risk management requirements governing margin lending under the Code of Conduct. Obviously such kind of dubious arrangement aims at evading all of these requirements.

Taking of Client Orders by Instant Messaging

On 4 May 2018, SFC issued the circular "Receiving client orders through instant messaging" to intermediaries to provide guidance on the statutory and regulatory requirements for the use of instant messaging (IM) applications to receive orders from clients.

IM is a form of electronic communication which allows two or more users to immediately transfer text messages and electronic files, such as images, audio, video and textual documents, across a network connection of mobile devices or computer platforms. Examples of major IM tools include WhatsApp and WeChat.

This circular encourages firms to take adequate measures to ensure compliance with the requirements, which include keeping proper records of messages relating to client orders and ensuring they are accessible for monitoring and audit purposes, as well as validating client identities and maintaining adequate safeguards to prevent unauthorised account access and cybersecurity attacks.

The key requirements of this circular is centralised record keeping:

• Messages relating to client orders (order messages) and the IM accounts and devices for storing and processing them should be properly maintained and centrally managed to reduce the possibility of error and minimise the risk of record tampering.
• Appropriate arrangements should be in place and sufficient capacity should be available to store and back up order messages in a form which could not be inappropriately modified or erased.
• All order messages should be fully recorded and properly maintained for a period of not less than 2 years (as required by the Keeping of Records Rules).

Generally speaking, the use of WhatsApp or WeChat for receiving client orders is unable to meet the above requirements. Broker firms may have to create their own IM tools. But then would the use of WhatsApp or WeChat be strictly prohibited?

Centralized record keeping is the core concept of para 3.9 of the Code of Conduct. This paragraph restricts, but not prohibits, the use of mobile phone for receiving client orders. In today's IT world, use of mobile phone should include both phone call and phone apps. Therefore, if orders are accepted by IM, the account executive / dealer should immediately call back to their firm's telephone recording system and record the time of receipt and the order details. Mere provision of screen capture of the IM chat history is not acceptable.

No Compliance Control Over Staff Dealing in a Fund House

As announced on 24 Apr 2018, SFC reprimanded CN Capital Management Limited (CN Capital) and fined it $1,000,000 for failing to maintain an effective compliance function and satisfactory internal controls concerning employee account dealing.

SFC also reprimanded its RO, Mr George Chan Yee Lee and Mr Stephen Ng Wing Leung and fined them $100,000 each for failing to comply with the employee account dealing requirements under the Fund Manager Code of Conduct, breaching the basic principle that persons engaged in fund management business, when transacting for themselves, must give their clients priority and avoid conflicts of interest.

SFC’s investigation revealed that, between January 2011 and October 2016:

• none of the staff members of CN Capital had disclosed their personal investment holdings to CN Capital in writing;
• Chan and Ng conducted a total of 3,188 personal trades without obtaining any written pre-clearance from the designated officer of CN Capital;
• in 619 incidents, Chan or Ng held their personal investments for less than 30 days without prior written approval from the designated officer; and
• a total of 996 personal trades of Chan and Ng were conducted in the same stock and on the same day as the transactions conducted for the fund managed by CN Capital.

It appears that this asset management firm had no compliance control over staff dealings at all.

Market Disruption Caused by Algo Trading

As announced on 14 Feb 2018, SFC reprimanded and fined Interactive Brokers Hong Kong Limited (IBHK) $4.5 million after resolving concerns over IBHK's breaches of the Code of Conduct in its execution of market orders using electronic and algorithmic trading systems.

SFC's disciplinary action followed two market disruption incidents in 2015 and 2016 where the share prices of HK-listed O-Net Communications (Group) Limited and AAG Energy Holdings Limited were ramped up by 48.7% and 126% respectively, in less than two minutes.

In light of the incidents, SFC and IBHK jointly engaged an independent reviewer to review IBHK's electronic and algorithmic trading systems, in particular, the controls to monitor and prevent the generation of or passing to the market for execution order instructions which may interfere with the operation of a fair and orderly market.

The review found that, in the two incidents, IBHK executed market orders by placing the entire order volume to the market and repeatedly submitting the unexecuted part of the order at the next available price until the entire order was completed. It also found that IBHK did not take into account the liquidity of the market when executing the market orders. Furthermore, IBHK failed to put in place effective price and volume controls to prevent its execution of market orders from disrupting the market.

Para 3.3.1 of Schedule 7 to the CoC provides that a licensed person should have controls that are reasonably designed to monitor and prevent the generation of or passing to the market for execution order instructions from its algorithmic trading system which may interfere with the operation of a fair and orderly market.

In respect of IBHK's electronic and algorithmic trading systems, the review indicated that:

• IBHK's electronic trading system was developed by its head office in the United States, where its programming function was responsible for both development and quality assurance of the system. IBHK did not conduct adequate user acceptance testing on the system; and
• the technical design documents of the systems were high level and did not provide a detailed explanation of the components of the trading systems. A specific example is that IBHK did not keep adequate records in relation to the design, development, deployment or operation of the order cancellation functionality in its electronic trading system.

Para 3.2 of Schedule 7 to the CoC provides that a licensed person should ensure that the algorithmic trading system and trading algorithms it uses are adequately tested to ensure that they operate as designed. Para 1.3 and 3.4 provide that a licensed person should keep proper records on the design, development, deployment and operation of its electronic trading system.

This was a rare enforcement case against algo trading. For more technical details, please refer to the SDA.