Failures to Monitor Suspicious Trading Activities

SFC announced that it reprimanded and fined China Industrial Securities International Brokerage Limited $3.5 million for internal control failures relating to monitoring of suspicious trading activities and recording of client order instructions. I am more interested in reviewing the following issues described in the SDA.

Failures to ensure all identified unusual transactions were properly examined and the relevant examination findings and outcomes were adequately documented

• Since June 2015, China Industrial has been using a third-party post-trade surveillance system to detect suspicious trading activities.
• China Industrial’s post-trade monitoring policy provided that Compliance Department would circulate daily reports on the alerts generated by the surveillance system to the ROs of the relevant departments that handled client accounts for review on a daily basis. Each department would receive and assess alerts that were relevant to the client accounts they handled and the ROs were required to make specific enquiries with the relevant AEs and/or clients for different types of alerts.
• However, the evidence shows that:
• prior to May 2018, the daily reports were not sent to 2 of the 4 Frontline Departments that handled client accounts;
• between 29 Mar and 7 Sep 2016, there were a total of 1,607 alerts. However, there is no review record for these alerts; and
• during the periods from 1 Aug 2017 to 31 Jul 2019 and from 1 Jun to 31 Oct 2020, there were a total of 18,008 alerts. However, there are review records for only around 5,000 alerts.
• According to China Industrial’s former ROs, the surveillance system generated many false alerts, which they would discuss, review and remark on the list of alerts. Nevertheless, China Industrial failed to properly maintain the ROs’ alert review records and/or to ensure that the ROs adequately record their examination remarks.

Failure to implement effective compliance procedures in relation to the alert reviews

• Compliance Department would select 5 to 8 sample alerts per month for review and the review findings and follow-up actions were recorded in writing.
• However, the monthly check records show Compliance Department focused on examining the actual sample alerts (e.g. comparing the specific trade and client profile covered in each sample alert), and never reviewed the adequacy of the records kept and whether the steps taken by the ROs to examine the unusual transactions flagged by the alerts were compliant with the post-trade monitoring policy.

Many firms may have the misconception that putting in place a surveillance system which generate a lot of daily alerts is adequate. But now the regulatory is getting more concerned about the quality of monitoring. Unless RegTech facilitated by AI has become mature and reliable, human efforts in screening out false alerts and following up true alerts remain critical.

Misleading Share Placement

On 18 May 2023, SFC announced that it reprimanded and fined China On Securities Limited $6 million over its failures as the placing agent in a share placement between 25 Nov and 6 Dec 2019.

Summary of facts in this case:

• On 25 November 2019, China On entered into a share placing agreement with the then majority shareholder (vendor) of Hon Corp (with GEM listing cancelled on 22 Jun 2022), under which it agreed to procure, as the vendor’s agent, not less than 6 placees to subscribe for shares representing up to 45% of Hon Corp’s total issued share capital. The agreed total placing price for the shares would amount to HK$57.24 million (i.e. HK$0.265 per share).
• When completion takes place, (i) China On should pay, or procure the placees to pay, to the Vendor the aggregate placing price; and (ii) the Vendor should allot the shares to the placees. The vendor deposited the shares into its account with China On thereafter.
• In the meantime, China On entered into a subscription agreement with each of the placees on 27 November 2019. Subsequently, on 28 November 2019, without the vendor’s specific authority, China On entered into a bought and sold note relating to the shares on behalf of the vendor with each of the placees, in which the transaction prices were inconsistent with the placing price agreed with the vendor.
• On 6 December 2019, in the absence of the vendor’s consent or any funds deposited by the placees to settle the placing price, China On arranged to transfer the shares from the vendor’s account to the placees’ accounts. Such arrangements were made by China On in the mere hope that the placees would sell the shares on the market and the sale proceeds from such disposal would be sufficient to settle the placing price with the vendor, without even considering that the sale proceeds might fall short of the agreed placing price, not to mention other settlement risks which had not been accepted by the vendor.
• China On’s then responsible officer (RO) handling the placement claimed that he carried out the above arrangement because he had received instructions from two individuals (including a consultant of China On and a person associated with the minority shareholder of China On, both were not licensed representatives or employees of China On), that the vendor had agreed to allot the shares to the placees and receive payment from the placees only after the placees successfully sold the shares on the market. Whilst the RO had no idea how these "associates" communicated with the vendor, he did not seek written or any other direct confirmation from the vendor before effecting the above arrangement.
• Almost all the shares were immediately sold by the placees on the market on 6 December 2019, and the account statements issued by China On show that HK$53 million was credited from the placees’ accounts to the Vendor’s account on the next business day (9 December 2019). This amount fell short of the total agreed placing price for the shares of HK$57.24 million because the RO was under the unverified and unsupported belief that the vendor had agreed with one of the placees for the placing price of HK$4.24 million to be settled “off market” (i.e. not through China On).
• On 9 and 10 December 2019, China On was informed by law enforcement agencies that the placees were suspected to be involved in market manipulation. On 21 January 2020, SFC issued a restriction notice on China On, prohibiting it from disposing of or dealing with any assets in the placees’ accounts up to the total value of HK$170 million. Since the placees did not have any additional funds in their accounts, China On refused to make payment of the agreed price for the shares to the vendor.

Based on the facts summarised above, SFC found that China On was grossly negligent, if not reckless, in its disregard of its fundamental duties to safeguard its client’s assets and ensure that it was acting under its client’s instructions and authorities.

My comments/queries:

• It appears that the share placing arrangement was misleading, given that the actual transaction prices were lower than the agreed placing price.
• Whether or not the placees were really procured by China On is questionable.
• I suppose SFC had investigated the two "associates", the vendor and even Hon Corp; if yes, the investigation results had better been disclosed.
• Who were the "law enforcement agencies" informing China On? Were they including the PRC authorities (e.g. CSRC)?
• If the placees were suspected to be involved in market manipulation, does it mean this share placing was part of it?

Victims of a Stock Manipulation Scheme

SFC banned Peter Law Chi Kin from re-entering the industry for 10 years for taking part in a stock manipulation scheme.

In mid-2016, Wong Kwun Shing, Law’s colleague at Convoy Asset Management Limited (CAML), introduced to Law a scheme operated by certain unknown manipulators to offload the shares of a GEM listed company to retail investors who were willing to hold onto the same for one to three months in return for a cash rebate of 12% to 15% of the transaction value.

Between June and July 2016, Law solicited and arranged for the clients to buy the shares from the manipulators. Law represented that he had met the manipulators to discuss the plan to push up the share price, but in fact he neither knew nor had direct contact with the manipulators. The clients agreed to buy and hold the shares until Law gave them permission to sell.

Wong would agree the date, time, quantity and price of each transaction with the manipulators in advance and inform Law of the same. At the agreed date and time, the manipulators would place an ask order within one to two spreads of the prevailing nominal price. Upon receiving Wong’s confirmation, Law would instruct the client to place a corresponding bid order. After the transaction was completed, Wong would pay the cash rebate collected from the manipulators to Law for onward distribution to the client.

Before the clients were allowed to dispose of the shares, the share price of the company collapsed and they suffered substantial losses.

Law admitted that he received a "referral fee" from Wong / the manipulators for soliciting the clients to participate in the scheme, which was calculated on the basis of the value of the shares the clients purchased. He did not disclose to the clients his financial interest in the transactions.

Law repeatedly gave reckless advice to some of the clients in connection with their investment in the shares, e.g.

• He represented that the scheme was "100% safe" and riskless, or had a guaranteed return of 12%, without explaining that the clients might suffer losses if the share price were to drop.
• He suggested one of the clients sell all her existing holdings and use the proceeds to invest in the company, without analysing and warning her of the concentration risk.
• He suggested two of the clients make use of the overdraft facilities offered by a brokerage firm to acquire a larger quantity of the shares, without explaining to them the risk of "margin call". Instead, he assured one of them that the brokerage firm would not force sell the shares in his account, and advised the other to ignore the brokerage firm's demand for deposit of additional funds. In the end, both their shares were force sold by the brokerage firm when the share price plummeted.
• When the share price started to fall, he dissuaded the clients from offloading their shares and reassured them that they would recoup their losses or even make a profit by holding onto the shares. As a result, the clients missed the opportunities to mitigate their losses.

Though the clients were victims, they had in fact participated in this stock manipulation scheme in return for a remuneration. Would SFC prosecute them?