Accredited Investor Definition to be Amended

Recently US SEC voted to propose amendments to the definition of accredited investor, one of the principal tests for who is eligible to participate in our private capital markets. The proposal seeks to update and improve the definition to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in our private capital markets.

SEC expressed that the current test for individual accredited investor status takes a binary approach to who does and does not qualify based only a person's income or net worth. Modernization of this approach is long overdue. The proposal would add additional means for individuals to qualify to participate in our private capital markets based on established, clear measures of financial sophistication.

The proposed amendments would allow more investors to participate in private offerings by adding new categories of natural persons that may qualify as accredited investors based on their professional knowledge, experience, or certifications. The proposal would also expand the list of entities that may qualify as accredited investors by, among other things, allowing any entity that meets an investments test to qualify.

"Professional investor" (PI) defined under the SFO is akin to accredited investor. In particular, Category-B PIs (corporate and individual) are subject only to the asset test, which is totally unrelated to "professionalism". I strongly recommend SFC to adopt SEC's proposal by amending the PI definition as well.

PWM Regulation Needs Improvement

In Oct 2019, PWMA and KPMG jointly published the Hong Kong Private Wealth Management Report 2019. I want to reproduce certain key contents about regulation from this report below:

• A key challenge faced by PWM institutions is the large number of circulars issued – some of which cover common areas between the HKMA and SFC – which have created complexity in the interpretation of regulations and difficulties in effectively updating processes and controls to remain compliant.
• Interviewed PWM executives have observed conflicting approaches between the 'principles-based' regulatory guidelines which infer greater flexibility in interpretation and implementation, and the findings from on-the-ground regulatory examinations which take a more prescriptive approach.
• Clients most commonly cited 'providing evidence for source of wealth', 'trade by trade disclosure requirements' and 'trade by trade investment suitability requirements' as the biggest pain points in their Hong Kong PWM experience in terms of time and administrative effort.

I share the view that the above issues would place Hong Kong at a disadvantage compared to other key PWM hubs.

Use of Cloud Services for Record Keeping

Under S.130 of the SFO, a licensed corporation shall not, without SFC’s prior written approval, use any premises for keeping records or documents relating to the carrying on of the regulated activity for which it is licensed. Basically SFC would not approve a premise outside Hong Kong because SFC can only conduct onsite inspection in Hong Kong.

But how about a LC makes use of cloud storage services to keep records?

On 31 Oct 2019, SFC issued the circular "Use of external electronic data storage", which states that when using external electronic data storage providers (EDSPs) for keeping Regulatory Records, LCs should remain in full compliance with the existing regulatory requirements. LCs should ensure that SFC’s access to Regulatory Records, in a legible form, pursuant to the exercise of its regulatory powers is not restricted or otherwise undermined, and that these Regulatory Records have not been deleted or tampered with. 

The authenticity, integrity and reliability of Regulatory Records, as well as the ability to access them promptly, are paramount if such records are required to be produced in legal proceedings initiated by SFC or DoJ.

Please refer to the circular for technical details. Simply speaking, if a LC wishes to keep any Regulatory Records exclusively with an EDSP, it should ensure compliance with the those requirements in the circular, including but not limited to the following:

• The EDSP (i) is either a company incorporated in HK or a non-HK company registered under the Companies Ordinance, in each case staffed by personnel operating in HK, and (ii) provides data storage to the LC at a data centre located in HK.
• As an alternative, if the EDSP is not a Hong Kong EDSP, the LC must obtain an undertaking by the EDSP to provide Regulatory Records and assistance as may be requested by SFC.
• The LC should seek approval for the premises used for keeping Regulatory Records under S.130 of the SFO.

However, the above requirements do not apply to:

• a LC which keeps Regulatory Records with an EDSP if the LC contemporaneously also keeps a full set of identical Regulatory Records at premises used by the LC in HK approved under section 130 of the SFO, for example when cloud storage is only used for the purposes of data backup or ensuring data availability; or
• a LC which uses computing services without keeping any Regulatory Records with an EDSP, for example where cloud computing services are only used for computations and analytics while Regulatory Records are kept at the premises of the LC.

Regulators are naturally prudent towards cloud-based systems due to security concerns, but in today's technology world they have to embrace fintech for maintaining financial market efficiency.

Client Interfacing as Regulated Function

As announced on 3 Oct 2019, SFC reprimanded and fined SEAVI Advent Ocean Private Equity Limited (SAOPEL) $1 million for breach of the Code of Conduct.

SFC's investigation found that SAOPEL had allowed its director and an investment manager, both of whom were not licensed by the SFC, to perform regulated functions for its business in regulated activities between Mar 2013 and Apr 2014. They introduced clients to invest in the fund managed by SAOPEL, answered clients' queries and arranged for the execution of the subscription agreements for the fund.

Para 12.1 and 4.1 of the Code of Conduct provide that a licensed corporation (LC) should comply with the relevant law and regulations, and ensure that any person it employs or appoints to conduct business is fit and proper and otherwise qualified to act in the capacity so employed or appointed.

From time to time people ask me whether a LC's employee should be licensed by SFC. I typically advise that if any activity conducted by such employee involves client interfacing, licensing requirement would highly likely be triggered.

Mishandling of Client Money

As announced on 10 Jul 2019, SFC reprimanded Celestial Commodities Limited (CCL) and Celestial Securities Limited (CSL) and fined them $4.9 million and $1.4 million, respectively for regulatory breaches and internal control failures relating to mishandling of client money.

SFC found that for the purpose of operational convenience, CCL transferred approximately $44 million on about 180 occasions between Jan 2009 and Dec 2016 from its client accounts to pay monthly commission rebates to its account executives. The amounts involved in each transfer ranged from $249,000 to over $1 million.

CCL often replenished the shortfalls in the client funds days after the initial withdrawals from the relevant client trust accounts, and on one occasion it only replenished the shortfall 41 days after the withdrawal. CCL is unable to trace the exact time when such practice commenced, but the evidence suggests that the arrangement had likely prevailed for more than 20 years.

CSL effected payments totalling $40 million on 8 Jul 2015 from its client trust accounts into CCL's client trust accounts in an intra-day fund swap arrangement so that CCL could meet various margin calls from the HKEx on time.

CCL and CSL had failed to implement proper controls to safeguard client money and supervise its staff in handling it in that their accounting and treasury staff were effectively given a free reign in handling client money with little supervision, instructions or guidance.

How come the external auditors failed to detect the above malpractices for such a long period of time? Would the MICs of OCR and F&A be held accountable?

Unidentified Research Analysts

On 24 Jun 2019, Securities and Futures Appeals Tribunal (SFAT) affirmed the decision of SFC to reprimand FT Securities Limited (FTSL) and fine it $3.5 million for regulatory breaches and internal control failures in relation to preparation and publication of research reports.

FTSL published 3 equity research reports on its website between July 2012 and April 2013. SFC found that, during the relevant period:

• FTSL's research reports, which were published in the name of its research analyst, were in fact prepared and written by 2 unidentified individuals who were not its employees. FTSL did not know their identities, background or contact details, nor did it take any steps to ascertain whether they were related to or had any financial interests in the companies covered in the research reports;
• FTSL falsely disclosed in one of the research reports that it did not provide any investment banking services to the company covered in the research report in the 12 months preceding the publication of the report when in fact it had been appointed as the placing agent for the placing of the company’s convertible bonds;
• FTSL had no formal policies or procedures governing the preparation and publication of research reports;
• FTSL did not segregate its research and corporate finance functions to avoid any actual or apparent conflicts of interest. Staff members responsible for handling the placing activities of the company covered in the research report were concurrently involved in the preparation and publication of the report; and
• FTSL failed to demonstrate that there was a reasonable basis for the analyses and recommendations in the research reports.

SFAT accepted that FTSL was culpable of egregious failures to comply with the regulatory requirements addressing analyst conflicts of interest, and its failure to ensure independence and objectivity of research reports might damage investor confidence in the research sector and in the financial services industry more broadly.

Para. 16 of SFC Code of Conduct has taken effect for over 10 years, but many firms are yet to establish effective compliance monitoring on the research function. This case is remarkable that unidentified research analysts were used.

Serious Breaches of Client Money Rules

SFC reprimanded China Merchants Securities (HK) Co., Limited (CMSHK) and fined it $5 million for regulatory breaches and internal control failings related to mishandling of client money.

In Sep 2014, CMSHK self-reported to SFC regarding its failure to segregate client money in accordance with Client Money Rules.  Subsequently, CMSHK performed a look-back review to examine its operational processes and controls governing the segregation of client monies during the 3-year period from 1 Oct 2011 to 30 Sep 2014.

The review identified around 800 incidents of non-compliance with the Client Money Rules with individual transaction amounts ranging from HK$68,000 to HK$308 million.

These incidents were classified into 6 categories:

1. Transfer of funds from client trust accounts to house accounts during client money segregation process.
2. Transfer of funds from client trust accounts for repayment of CMSHK’s bank loans.
3. Transfer of funds from client trust accounts for granting term loans to CMSHK’s clients.
4. Transfer of funds from client trust accounts for purposes of funding proprietary investments of CMSHK’s fellow subsidiary company.
5. Transfer of funds from client trust accounts for purposes of paying CMSHK’s expenses.
6. Transfer of a rounded amount from a client trust account for purposes of facilitating potential client withdrawal requests, settlement of securities dealing in overseas markets and fee payments for stock lending/borrowing.

Even if clients’ funds improperly transferred out were subsequently returned to the client trust account on the same day, the above misconducts (obviously arising out of deliberate or reckless decisions) can't be tolerated.

SFC also said CMSHK failed to employ fit and proper staff to conduct its business and have proper internal controls and procedures in place to ensure compliance with the Client Money Rules and safeguard client assets.  Which senior management member(s) of CMSHK would be held liable?

I don't think $5 million fine is commensurate with the seriousness of this case.

Repledge of Securities Collateral

Recently someone asked me if a Type 1 broker providing securities margin financing (SMF) can repledge clients' securities collateral to another Type 1 broker. I answered NO. Then he argued that Section 8 of Client Securities Rules (CSR) permits this. He had a misinterpretation of CSR.

In fact, Type 1 intermediaries are only allowed by Section 7 of CSR to repledge margin clients' securities collateral to authorized financial institutions ("AFI", i.e. banks in Hong Kong), but Type 8 intermediaries (licensed for SMF) are allowed by Section 8 to repledge securities collaterals to either AFI or Type 1 intermediaries.

Having said the above, I also want to highlight Section 3 of CSR:

"…these Rules apply to client securities and securities collateral of an intermediary that are—
(a) either—
(i) listed or traded on a recognized stock market [i.e. SEHK]; or
(ii) interests in a collective investment scheme authorized by the Commission under section 104 of the Ordinance; and
(b) received or held in Hong Kong by or on behalf of—
(i) the intermediary in the course of the conduct of any regulated activity for which the intermediary is licensed or registered; or
(ii) an associated entity of the intermediary in relation to the conduct of such regulated activity."

Therefore, if the securities collateral is not listed on SEHK (e.g. US stocks) or even unlisted (e.g. an OTC bond), Type 1 / 8 intermediaries are implicitly allowed by CSR to repledge such collateral to any third party.

Licensing Fraud

As announced on 4 Feb 2019, SFC revoked the licence of W. Falcon Asset Management (Asia) Limited (Falcon) for window-dressing its liquid capital, breaching the terms of a restriction notice and failing to provide timely notification of the resignation of its director who engineered the window-dressing scheme.

Falcon provided SFC with false or misleading information in its licence application and financial returns between Jun 2014 and Jun 2017.

Falcon window-dressed its month-end liquid capital by including in its liquid capital computation the amount of certain cheques, which were subsequently dishonoured.  This practice was adopted from the time of Falcon's SFC licence application. Had the amount of these cheques been excluded, Falcon would have been denied a licence to carry on regulated activities due to a liquid capital deficit at the time of its licence application and at each of the month-ends over a three-year period.

In May 2017, the director of Falcon guaranteed a loan taken out in the name of Falcon. Two months later, SFC issued a restriction notice against Falcon after a self-report by Falcon that its liquid capital had dropped below the required level. Subsequently, Falcon defaulted on repayment of the loan and proceeded to enter into a debenture with the lender, thereby subjecting its assets to a floating charge, contrary to the terms of the restriction notice.

The director resigned from Falcon on 23 Oct 2017, but both the director and Falcon failed to provide SFC with written notification of such resignation within 7 business days as required.

This was indeed a fraud case. SFC must chase those fraudsters.

Subsequent update on 19 Dec 2019:

• SFC banned Mr Ang Wing Fung, the former chairman of Falcon, and its former CFO and company secretary Mr Chan Kam Wah, from re-entering the industry for life and 3 years, respectively, in connection with their roles in window-dressing the liquid capital of Falcon.

• Ang was the mastermind of the window-dressing scheme and its operation was facilitated by Chan.

• Chan, who reported to Ang, had full access to various bank accounts of which Ang was a signatory. As the person in charge of accounting, he was fully aware of the true financial condition of Falcon. He was also aware that cheques signed by Ang would certainly be dishonored upon presentation due to insufficient funds in the bank accounts on which they were drawn and closure of some of these accounts. But he continued to take part in the window-dressing scheme to disguise Falcon's failure to maintain sufficient capital.

Key Personnel Requirements

As announced on 8 Jan 2019, SFC reprimanded and fined FWD Life Insurance Company (Bermuda) Limited (FWD Life) $2.4 million for failures in complying with the key personnel requirements under the SFC Code on MPF Products and the Fund Manager Code of Conduct.

FWD Life (licensed for RA9) failed to ensure there were at least 2 key personnel who met the minimum 5-year investment experience requirement in managing retirement funds or public funds under the MPF Code at all times.

Specifically, from Dec 2012 to Nov 2016, FWD Life had only one key personnel in place who met the minimum investment experience requirement. FWD Life only discovered it had insufficient key personnel when MPFA made enquiries in Jan 2017.

FWD Life also failed to implement policies and procedures for the designation and monitoring of key personnel and to communicate to relevant staff members of their designation as key personnel. FWD Life's failure in this respect contributed to the duration of its breach of the MPF Code.

Whenever a management member (no matter RO/MIC/director/key personnel) is going to leave a licensed corporation, a compliance officer should naturally check if the minimum threshold will be breached and then alert the senior management. This is a basic duty.