Best Execution

In SFC's Code of Conduct, "best execution" means when acting for or with clients, the intermediary should execute client orders on the best available terms. In actual world, under what circumstances would this principle be violated?

Last week SEC settled fraud charges against Morgan Stanley & Co. Inc. for its failure to provide best execution to certain retail orders for OTC securities. In particular, Morgan Stanley embedded undisclosed mark-ups and mark-downs on certain retail OTC orders processed by its automated market-making system and delayed the execution of other retail OTC orders, for which Morgan Stanley had an obligation to execute without hesitation.

Morgan Stanley will pay around US$7.9m in disgorgement and penalties to settle SEC's charges. All of Morgan Stanley's revenue from its undisclosed mark-ups and mark-downs will be distributed back to the injured investors through a distribution plan.

From Oct 2001 through Dec 2004, Morgan Stanley failed to obtain best execution for certain orders for OTC securities placed by retail customers of Morgan Stanley, Morgan Stanley DW, Inc. and third party broker-dealers that routed orders to Morgan Stanley for execution. As a result of this conduct, Morgan Stanley breached its duty of best execution with respect to these retail customers' orders.

Morgan Stanley failed to provide best execution to more than 1.2 million executions valued at approximately US$8 billion. Morgan Stanley recognized revenue of $5,949,222 through its improper use of undisclosed mark-ups and mark-downs. As stated by SEC, Morgan Stanley was recklessly programming its order execution system to receive amounts that should have gone to retail customers.

Suitability Obligations

Last week SFC published the FAQ on suitability obligations. This may be regarded as a principles-based regulatory approach towards investment advisers (IA). That means, SFC has not intended to expand the existing Code of Conduct requirements but only supplement them with guidance on best practices.

Basically most of the tips given by SFC belong to "old wine in new bottle", but the following points are remarkable:

• SFC states clearly that suitability means "matching" the risk return profile of investment products with personal circumstances of clients.
• In terms of KYC information for suitability purpose, Code of Conduct has only mentioned clients' financial situation, investment experience and investment objectives. SFC has extended this information list to investment knowledge, investment horizon, risk tolerance and capacity to make regular contributions.
• SFC shows understanding that many clients are not willing to disclose their financial situation. In this case, IA is expected to explain to clients the limitations of his advice and the assumptions made by him.
• When conducting product diligence, IA should not rely only on offering documents and marketing materials, but make their own enquiries and obtain full explanations from product issuers.
• Where IA only recommend investment products which are issued by their related companies, they should disclose this limited availability of products to each client.
• IA should document and provide a copy to each client of the rationale underlying investment recommendations made to the client.
• Client files, esp. those with a higher mis-selling risk, should be sample reviewed by qualified and competent personnel (by compliance officer?).

The FAQ guidance has reflected SFC's dissatisfaction with its observations of selling practices over the past years. Needless to say, the enhanced sales compliance practices would make the life of IA less easier.

Analyst Conflicts of Interest

Since April 2005 SFC has implemented the new Paragraph 16 added to the Code of Conduct in order to address the analyst conflicts of interest problem. Before that, the compliance awareness of certain research analysts was perceived to be quite low.

This week SFC reprimanded and fined two guys from South China Research Ltd, namely Patrick Pong (research analyst) and Anthony Teoh (head of research). It is a rare case for a research head being disciplined.

Pong's Case

• In one case in 2003, Pong purchased securities days before he prepared a BUY report on the same securities, but failed to disclose his interest in the report. This research report was however not initiated by Pong (requested by his boss?).
• In another case in 2003, Pong purchased shares days before South China issued a SELL report on the same shares (i.e. his trading is contrary to the research recommendation).

Teoh's Case

• Teoh subscribed for IPO securities recommended by a South China research report, sponsored by South China Capital Ltd, and co-led by South China Securities Ltd in underwriting the allotment. He sold the securites on their debut trading day.
• Teoh allocated the preparation of a research report to his subordinate who had a pre-existing interest (I guess this subordinate was Patrick Pong).

In the above cases, obviously the analysts had no intention to produce objective research reports. It appeared that the research team had not put in place compliance measures to prohibit staff dealings in black-out period, in quiet period and to the contray of recommendations. I think the head of research should bear the most responsibility in putting his subordinate in conflicts of interest.

Cross-Market Insider Trading

The securities markets have been globalized to facilitate both legal and illegal trading activities. Last time we found a case of cross-market manipulation, this time cross-market insider trading.

Last week SEC charged Hafiz Naseem, an investment banker with Credit Suisse, with illegally divulging non-public information to a person believed to be a banker in Pakistan concerning the leveraged buyout of TXU Corp. by an investor group led by Kohlberg Kravis Roberts & Co. and Texas Pacific Group. Naseem misappropriated the information from his employer, Credit Suisse, which served as a financial advisor to TXU in connection with the buyout.

In Feb 2007 Naseem telephoned the Pakistani banker on several occasions and disclosed non-public, material information about the proposed but unannounced TXU buyout. After receiving the insider information, the Pakistani banker purchased 6,700 TXU call option contracts with Mar 2007 expiration dates through UBS AG London, and made profits of approximately US$5m following public announcement of the buyout.

In addition, Naseem divulged pending, but unannounced, business combinations and deals involving eight other issuers, where Credit Suisse served as an investment banker or financial advisor in all of these deals. Naseem's phone calls from his work phone to the Pakistani banker's home and cell phones were made immediately before announcements of the proposed deals. The Pakistani banker also purchased securities in those companies in advance of public merger announcements, obtaining additional profits of more than US$2.4m.

Naseem opened a brokerage account in Pakistan in May 2006 and granted the Pakistani banker trading authority over that account to conceal his personal financial benefit from his misappropriations. SEC is seeking injunctive relief, disgorgement, and money penalties against Naseem.

SEC also identified another previously unidentified trader who purchased in advance of the public announcement regarding TXU. Francisco Javier Garcia, believed to be a resident of Switzerland, purchased TXU securities through Fimat Frankfurt and is believed to have done so on inside information.

When investigating into the tipping by Naseem, SEC had obtained the assistance provided by Credit Suisse in the process of identifying Naseem as well as the cooperation afforded by NYSE, Chicago Board Options Exchange, Swiss Federal Banking Commission and UK FSA in helping to piece together evidence from across the globe, such as phone and brokerage records, to uncover Naseem's unlawful insider trading.

Cross-Market Manipulation

Following a joint investigation, this week NASD and the Chicago Stock Exchange (CHX) fined and suspended two traders for artificially inflating the price of the stock of Material Science Corporation (MSC), a NYSE-listed company, in connection with MSC's repurchase of its stock.

NASD imposed a $25,000 fine and a three-month suspension on Klaus Offenbacher, a trader with NASD-registered First Analysis Securities Corporation of Chicago. CHX imposed a $20,000 fine and a two-month suspension on Bruce Kaminski, a floor broker with Dougall & Associates of Chicago, a CHX Participant firm. Neither MSC, First Analysis Securities Corporation nor Dougall & Associates had knowledge that Offenbacher and Kaminski planned to artificially increase the price of MSC stock.

Offenbacher was responsible for repurchasing MSC stock on behalf of the issuer pursuant to the company's stock repurchase program. MSC wanted its repurchases to fall within the safe harbor provision of SEC's rule governing issuer buy-backs, which provides that issuer purchases cannot be the opening purchase of the day and cannot exceed the highest independent bid or last independent transaction price.

On 21 Aug 2006, Offenbacher received authorization from MSC to repurchase 100,000 shares of MSC stock pursuant to the repurchase program. The same day, Offenbacher located an institutional customer willing to sell a 174,300-share block of MSC stock with a limit price of US$9.90. Later that day, Offenbacher attempted to contact the principals of MSC to get approval to purchase the entire block. MSC stock closed that day at a price of $9.80 per share.

Early the following day, Offenbacher received approval from MSC's principals to purchase the block at $9.90 per share. Before the market opened, Offenbacher directed Kaminski to purchase 1,000 shares of MSC stock at $9.90 per share, in the event MSC opened below $9.90 per share. When MSC opened at $9.75 per share, Kaminski executed the 1,000 share transaction at $9.90 per share which artificially drove the stock's price up 15 cents to the level Offenbacher needed to execute the cross trade.

Kaminski's execution of the 1,000-share transaction on NYSE established an artificial reference price at which the larger block transaction was then executed on the CHX. As a result, the regulators found that Offenbacher and Kaminski knowingly and intentionally artificially increased the market price of MSC stock in an attempt to make it appear that the purchase fell within the SEC's safe harbor provision for issuer buy-backs.

If MSC, First Analysis Securities Corporation and Dougall & Associates did not direct Offenbacher and Kaminski to conduct the cross-market manipulation, what had motivated these two guys to play this illegal trick?

Failures in Complaint Handling

In UK, there is a special category of investment products called Structured Capital at Risk Product (SCARP), which is a "precipice bond" which provides a fixed level of income (which can be drawn down or accumulated) over a fixed investment period. It offers limited protection against the loss of the capital invested in the first place and whether or not customers get their original capital back depends on the performance of an index, or more than one index, or a selection of stocks.

From time to time FSA has reminded retail investors about the risk of investing in SCARP which has no capital guarantee and carries a long investment horizon. Some financial institutions were also fined by FSA for mis-selling of SCARP. For instance, recently FSA fined Sesame Ltd £330,000 for failing to treat its customers fairly by not handling complaints concerning SCARP adequately.

The problems with Sesame's complaints handling were identified as part of FSA's thematic review of SCARP during Mar and Aug 2004. FSA found that between Mar 2003 and Oct 2004 Sesame incorrectly rejected complaints from approximately 350 customers. These customers had lost nearly £5.9m. The complaints related to sales made by Sesame's legacy networks, which at least reflected the following problems:

• Sales of SCARP were made to retired customers who were unable to absorb the downside risk.
• Customers' risk attitude was wrongly recorded on customer files.
• Salespersons misled customers by describing SCARP as a low risk investment.
• Legacy networks and complanint handlers had applied inconsistent risk ratings to SCARP.
• Sesame did not take adequate action when it became aware of the increasing number of SCARP complaints.

After FSA identified the problems, Sesame took prompt action to ensure all affected customers were compensated and engaged external advisers to review its SCARP complaint handling procedures and train its staff.

Complaint handling function is more important for financial firms serving the retail market. If the management turns a blind eye to complaints, they will eventually suffer.

Compliance Consultants

While small financial firms may not afford employing a full-time compliance officer, appointment of a compliance consultant sounds like a feasible solution. However, in HK usually the senior management of small firms prefer performing compliance by themselves or asking the ops / admin staff to double up this function rather than looking for an external consultant. Given that compliance is a professional job, reliance on part-time or inadequately trained staff to take it up is quite risky.

FSA recently issued a factsheet about using a compliance consultant for small personal investment, mortgage and general insurance firms. The following key messages are conveyed:

• The firm's compliance responsibility would not be "contracted out" by using the consultant.
• The compliance needs should be established in order to identify the right services (e.g. risk assessment, setting up procedures, training, etc.) from the consultant.
• Qualifications, experience and service standards of potential consultants should be assessed to ensure that they can meet the firm's needs.
• The firm should act on the recommendations made by the consultant.

FSA carried out work in late 2006 and early 2007 to see if, and how, compliance consultants were used in small mortgage, general insurance and financial advice firms. The project also looked into whether the firms that did use consultants used them effectively.

In particular FSA visited 22 small firms employing compliance consultants in early 2007 and found nearly half of them still had significant weaknesses in respect of their regulatory requirements. The work also showed over a third of these firms were not acting on recommendations from their consultants that would have improved their regulatory position.

Does this survey indicate that small firms have only employed compliance consultants for "window dressing" instead of protecting them against regulatory risk?