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.