Expired Standing Authority

As required by the Client Securities Rules ("CSR") under the SFO, a broker firm is only allowed to repledge its clients' securities collateral to banks if it has obtained their valid standing authority (but exemption is applicable to professional investors).  The CSR also requires annual renewal of the standing authority, where the broker firm must send a renewal notice to clients 14 days prior to the expiry date.  Negative consent is allowed (i.e. if a client doesn't object, the standing authority is automatically renewed for another 12 months).

Yesterday SFC reprimanded China Everbright Securities (HK) Limited ("CESHK") and fined it $2.5 million for pledging its clients’ securities with banks for financial accommodation without valid authorization.

Between 1 April 2018 and 19 August 2018, CESHK relied on expired standing authority given by around 6,841 clients to pledge their securities as collateral in obtaining credit line from three banks in Hong Kong.  The standing authority in question had expired on 31 March 2018.

Details of the incident leading to the breach:

• Starting from late 2017, China Everbright Securities International Group (of which CESHK is a member) and Everbright Sun Hung Kai Group (EBSHK Group) were going through an amalgamation.
• In late February 2018, the Compliance Department of the EBSHK Group (EBSHK Compliance) was instructed to take over CESHK’s compliance function.
• At CESHK, the standing authority renewal exercise was handled by its compliance team in or around March every year.  At EBSHK, the same process was handled by its operations team in or around August every year.
• It was not highlighted to EBSHK Compliance that the standing authority of CESHK’s clients should be handled by the compliance team.
• In mid-August 2018, when EBSHK Group began the process of renewing the standing authority of its clients, it discovered that CESHK had not delivered standing authority renewal notices to its clients at least 14 days before 31 March 2018 in respect of standing authority that had expired on 31 March 2018 pursuant to section 4(3) of the CSR.
• On 20 August 2018, CESHK made a self-report to SFC regarding its failure to renew its clients’ standing authority which expired on 31 March 2018.

It appears that this incident was caused by internal miscommunication, i.e. CESHK wrongly believed that the standing authority renewal exercise would be handled by EBSHK Compliance.  But in my opinion, it is not appropriate for the compliance team to take over such operational duties.  I reproduce below the following paragraph from SFC's Internal Control Guidelines:

Management ensures that, where practicable, policy formulation, supervisory and other internal review or advisory functions, including where applicable compliance and internal audit, are effectively segregated from line operational duties. Such segregation serves to ensure the effectiveness of supervisory and other internal controls established by Management.

Basic Mistake, Silly Belief

Yesterday SFC publicly reprimanded The Bank of East Asia, Limited (BEA) and fined it HK$4.2 million due to BEA’s failure to segregate its client securities from proprietary securities into separate accounts maintained at two external custodians as required by the Client Securities Rules ("CSR").

Section 5(1) of the CSR requires an intermediary (or its associated entity) to ensure client securities it receives are deposited in safe custody in a segregated account which is designated as a trust account or client account established or maintained in Hong Kong with an authorized financial institution, an approved custodian or other intermediaries licensed for dealing in securities, asap.

Between Nov 2015 and Jan 2016, HKMA conducted an on-site examination on BEA and expressed concerns regarding BEA’s non-compliance with the CSR.  In Dec 2016, following further enquiries from the HKMA, BEA made a report to SFC and HKMA regarding its failure to deposit client securities in a designated segregated account in accordance with the CSR.

SFC conducted an investigation and found that BEA failed to segregate its client securities and proprietary securities in accounts maintained at two external custodians, CCASS and Sumitomo Mitsui Banking Corporation ("SMBC"), from Apr 2003 to Dec 2016.

According to BEA, its failure to segregate client securities and proprietary securities was caused by its belief that the identification and segregation of client securities and proprietary securities in its internal electronic accounting records was sufficient to comply with section 5(1) of the CSR.

BEA had made a basic mistake, which was caused by a silly belief.  Who in BEA made the non-segregation decision?  Did they consult their lawyers or compliance team in advance?  Why such problem had not been detected by BEA's auditors (internal and external) over 13 years?

Listed Brokerage Houses Halted to Disclose Operating Data

Disclosure-based approach is a key regulatory philosophy.  Listed companies are usually required by regulatory authorities to publicly and regularly disclose their financial and operating information to enhance market transparency.

However, this week I read a shocking news from the PRC media  第一财经, where the key points are reproduced below:

• 券商8月单月经营数据目前尚未发布。按照惯例，证券公司在每月10号前会披露上一个月的经营数据简报。但目前已进入9月中旬，全部上市券商的8月月报却都迟迟未至。
• 记者以投资者身份电话询问了部分上市券商，有中小型券商投资者关系部人士表示，于上周接到相关通知要求暂不披露8月经营数据。
• 上市券商按月公布经营数据的规定于2010年出台，当年7月，上市券商首次公布月度经营数据。
• 据证监会官网，证监会2010年6月发布了《关于修改〈关于加强上市证券公司监管的规定〉的决定》，其中规定，上市证券公司在向监管部门报送综合监管报表的同时，应当以临时公告的形式在交易所网站公开披露公司月度经营情况主要财务信息，包括当期营业收入、当期净利润、期末净资产等数据，以及公司认为应当披露的其他财务信息。

We may have a reasonable belief that last week PRC listed brokerage houses were requested by CSRC to halt the monthly disclosure of their operating data.  But why did CSRC make such seemingly "anti-regulatory" request?  Would the disclosure create a chaotic market?

I wish such black-box operation won't be adopted by regulatory bodies in Hong Kong.

Retail Investor Convicted of False Trading

Last week Hong Kong Police arrested 15 people on suspicion of conspiracy to defraud and money laundering by manipulating shares of Next Digital (282.hk), inducing a lot of criticisms. 

This week SFC demonstrated how it professionally sanctioned a retail investor who manipulated the market.

Yesterday SFC announced that the Eastern Magistrates’ Court has convicted Mr Ke Wen Hua of false trading in the shares of Carry Wealth (643.hk) following a prosecution by SFC.

Let's have a look at SFC's investigation findings:

• Ke began accumulating Carry Wealth shares in May 2011 and acquired most of his holdings in Carry Wealth shares at a price between $0.48 and $1.30 until Sep 2011.
• On 4 Sep 2012, Ke conducted trading in Carry Wealth shares through 6 securities accounts under his control.  In doing so, the share price of Carry Wealth was pushed to reach as high as $0.6 which was 50% higher than the preceding day’s closing price of $0.4.  On the same day, Ke’s trading generated a trading volume of 58.6 million Carry Wealth shares, approximately 3,000 times the average daily trading volume of Carry Wealth shares during the previous 10 trading days.
• Consequently, Ke was able to dispose of Carry Wealth shares at artificially inflated prices through his false trading and reduce the total of his trading losses by approximately $887,220.

Ke's trading had created extreme results (soaring price and turnover), otherwise SFC's prosecution would be an uphill battle.  He pleaded guilty to the offence and was fined only $30,000 (and also ordered to pay SFC’s investigation cost), not very punitive.  More importantly, Ke's market misconduct happened 8 years ago but SFC commenced criminal proceedings against him in July 2020.  This case seems like a delayed justice.

SFC Bypassed by Hong Kong Police

Yesterday Hong Kong Police ("HKP") arrested 15 people on suspicion of conspiracy to defraud and money laundering by manipulating shares of Next Digital (282.hk).  There have been lots of online discussions with some misconceptions.

Some laymen criticized HKP for accusing stock market speculators or prohibiting "buy low sell high" (profit making).  Stock market speculation is of course not illegal, but manipulation is another matter.  Stock market manipulation refers to fraudulent activities aiming at distorting the actual demand and supply  in order to create a false or misleading appearance of the price or turnover of a stock.  It is indeed a financial crime specified under the Securities and Futures Ordinance ("SFO").

If a securities firm has identified such fraudulent activities from its clients, it is obliged to report them to Securities and Futures Commission ("SFC").  A suspicious transaction report ("STR") would also be filed to Joint Financial Intelligence Unit ("JFIU") under HKP's Narcotics Division because the use of proceeds from a financial crime has the implication of money laundering.  Usually HKPF would not take any action until SFC has concluded that a serious offence was committed.

Whether or not the share trading constitutes market manipulation should be the professional judgement exercised by SFC at the outset.  Typically SFC spends a long period of time on the investigation process by collecting tons of records from securities firms and questioning the suspects.  According to SFO's relevant provisions, SFC is able to mandate any person to answer questions (but their answers may not be admitted as evidences in criminal proceedings to avoid self-incrimination).

SFC can refer a potential market manipulation case to Department of Justice ("DoJ") to assess whether the case should be criminally prosecuted and, if so, whether the case should be prosecuted on indictment by the DoJ in the higher courts or summarily by SFC in the Magistrates’ Courts.  SFC seldom requests HKP to make an arrest unless the suspect has a high chance to flee.

Unfortunately, it appears that in Next Digital's case SFC has been bypassed by HKP.  The public is hardly convinced that HKP is more professional than SFC to conduct an investigation into a market manipulation case, not to mention it hastily completed the process within one month.  Moreover, HKP bypassed SFC only for Next Digital's case but not for numerous other suspected cases, why?

If Hong Kong still has separation of powers (already denied by the HKSAR Government), SFC should challenge HKP's reckless action.   But now SFC has chosen to keep silent.

Latest update:

Today's evening SFC eventually made a statement on HKPF's action.  Apart from those wishy-washy words (implying HKP is not professional), SFC left only such remark: As investigations are continuing, the SFC is not in a position to comment any further.

I am afraid Hong Kong would soon be transformed from an IFC into a NFC.into a NFC.

Licensing of Family Offices

Over the past 2 decades, family offices have become more influential in the wealth management industry. Ultra HNWIs are no longer satisfied with the services of traditional private banks. They need an in-house professional team.

But shall family offices in Hong Kong, which make investment decisions on behalf of one or more families, be licensed by SFC?

On 7 January 2020, SFC issued a circular on the licensing obligations of family offices. It provides general guidance for family offices intending to carry out asset management or other services in Hong Kong. On 8 September 2020, SFC published a FAQ to provide additional guidance on the implications of the licensing regime to single family offices and multi-family offices. I reproduce the questions (Q) and answers (A) and give my comments (C) below:

Q1:
Is there a definition for “family” or “family office” under the licensing regime?
A2:
No, the Ordinance does not define “family” or “family office”. It is noteworthy that the licensing regime does not hinge on whether an entity is called a family office or whether its clients are families. A family office operator will have more flexibility to determine its legal form and operational structure with respect to its services to be provided.
C1:
A family office ("FO") is most likely deemed as an asset management firm because it usually conducts discretionary trading for the client (family). Thus licensing for RA9 is required. But if the client occasionally places dealing orders to the FO, then licensing for RA1 or RA2 may also be required.

Q2:
What constitutes a single family office for the purposes of the Circular?
A2:
It typically refers to an arrangement (often structured through a corporate vehicle owned or controlled by the family) under which the assets, investments and long-term interests of members of a single family are managed. The SFC has not sought to define what relationships of blood or of law would constitute family membership because the licensing obligations under the Ordinance do not hinge on whether the clients of a family office are family members or not.
C2:
SFC reiterated that members of a single family don't need to be strict "family members". In the Circular, SFC stated that "the family office will not need a licence because it will not be providing asset management services to a third party". I wonder if such licensing exemption could be abused, e.g. a so-called FO attempts to group a number of actually unrelated clients into a "single family".

Q3:
Is a single family office required to be licensed under the Ordinance?
A3:
The issue of whether a single family office is required to be licensed under the Ordinance is determined by reference to three key factors, all of which must be present in order to give rise to a licensing obligation: firstly, the services provided by the family office constitute one or more regulated activity as defined under the Ordinance; secondly, the family office is carrying on a business in the provision of such services; and thirdly, the business is carried on in Hong Kong.
In determining whether certain asset management activities amount to a regulated activity, the definition of Type 9 regulated activity contains an intra-group carve-out for a single family office where it provides such services solely to its related entities, which are defined as its wholly owned subsidiaries, its holding company which holds all its issued shares or that holding company’s other wholly owned subsidiaries.
What amounts to “carrying on a business in Hong Kong” is not defined in the Ordinance and will need to be determined by reference to the facts of each case, including whether the person is performing an occupation or a duty which requires attention; the activity involves continuity; the activity is capable of making profit; and the activity was carried out for the purpose of making profit. A genuine single family office arrangement, established to serve the investment needs of members of a single family, which is not being run as a business (i.e. not receiving any income, other than reimbursement of operating expenses from the family) or have the pursuit of profit as its business objective, should not in the ordinary course be considered as carrying on a business from a licensing perspective. It is also not the SFC’s intent to extend its regulatory oversight to this type of single family office setup.
C3:
A single FO is typically low key, not being run like a business. I think not many single FOs would be licensed by SFC in foreseeable future.

Q4:
If two or more single family offices co-operate together for the purposes of sharing a common administrative infrastructure in order to reduce operating overheads, would such arrangements trigger a licensing obligation?
A4:
The discussion in the response to Q3 above on the types of factors required to be present in order to give rise to a licensing obligation under the Ordinance would apply equally in these circumstances.
The sharing of office premises and administrative infrastructure by two or more family offices would not of itself automatically trigger a licensing obligation for such single family offices. However, where two or more single family offices make arrangements for the sharing of human resources involved in investment related matters, research or the investment process, this may be regarded as a multi-family office structure (see also the response to Q5 below) and, where the provision of services is carried on as a business, increases the likelihood of a licensing obligation arising.
C4:
If the different single FOs share not only administrative team but also investment team and they are required to be licensed, there is a potential conflict of interest problem - a licensed person (investment staff) is generally disallowed by SFC to carry out a regulated activity for 2 or more licensed corporations if they are not within the same group.

Q5:
What constitutes a multi-family office for the purposes of the Circular and is a multi-family office required to be licensed?
A5:
As mentioned in the Circular, “a multi-family office by definition serves more than one high net worth family” and such arrangements are likely to be evident.
Multi-family offices are typically established and run as commercial ventures. The issue of whether a multi-family office is required to be licensed under the Ordinance will be primarily determined by the three key factors set out in the response to Q3.
C5:
I envisage multi-FOs are more likely to be licensed by SFC. When the number of family clients increases, a multi-FO is akin to a private bank.

Buy High Sell Low

As we all know, “buy low sell high” is the invincible law of investing. If someone is deliberately breaching this principle, he would be in trouble.

From time to time I observe some clients trading with the following red flags:

• They focus on stocks with thin turnover;
• Their trading volume corners the market turnover;
• They conduct day trading, where the time interval between the buy order and the sell order is quite short; and
• The buy order price is often the same as, or even lower than, the sell order price.

Securities regulators would probably regard the above trading pattern as potential market misconduct (namely false trading) because it appears to have no economic substance. If the market is normal (all demands and supplies are genuine), nobody can always buy low sell high (otherwise he is the God). Market manipulators just intend to create artificial turnover. If they persistently buy low sell high, arbitragers would be attracted. So they would only persistently buy and sell at the same price, or buy high sell low.

Compliance professionals should endeavor to detect such suspicious transactions, block these fraudsters and file suspicious transaction reports to regulatory authorities. Of course, occasional “buy high sell low” may not be suspicious (it may be caused by a wrong judgement), but persistent behavior is another matter. That’s why detection of suspicious transactions requires holistic consideration of various red flags.