Connected Brokers

There is a potential conflict of interests when a securities firm has the discretion to direct client orders to its affiliated brokers. This issue is also compounded by the best execution problem.

NASD recently fined New York's HSBC Brokerage (HBI) $250,000 for failure to have adequate systems in place to supervise government securities transactions to ensure best execution.

In addition, the firm routed orders to HSBC Securities (HSI), an affiliated firm, without taking adequate steps to ensure that customers would not be harmed in the pricing of these securities. HBI's inability to provide documentary evidence of its supervisory review for best execution of trades inhibited NASD's ability to review transactions for best execution.

HBI's retail brokerage business was largely located in HSBC bank branches. To support the retail business, HBI operated a trading desk to handle orders that were placed by brokers who had direct contact with HBI's clients. One desk was devoted to filling orders for fixed income products. When a client order was placed, HBI required traders on the fixed income desk to call several broker-dealers on the "street" in an effort to get the best price for a client's transaction.

Toward the end of 2003, there were discussions between HBI and HSI about increasing business between the two affiliated firms and efforts were undertaken by HBI to increase its order flow to its institutional affiliate. In late 2003, HBI began to increase its order flow to HSI, and in May 2004, HBI directed its fixed income traders to route all government securities orders to HSI for execution. As a result, the dollar volume of U.S. Treasury transactions that HBI sent to HSI rose from approximately 24% in Oct 2003 to approximately 79% in Apr 2004, and to close to 100% from Jun through Dec 2004. While its traders were required to "shop" an order for a government securities transaction before placing it with the affiliate, HBI had inadequate systems to monitor this process by its traders.

NASD also found that while several HBI officers recognized the increased risk associated with directing all government securities orders to a single, affiliated broker-dealer, the firm failed to put reasonable policies and procedures in place to ensure that clients received best execution for these orders. The firm had minimal systems in place to supervise for best execution prior to May 2004, and no further steps were taken to monitor for best execution after the directive to send all customer orders to the affiliated firm.

HBI was unable to provide documentary evidence of supervisory review for best execution for any of the trades requested by NASD as part of its review. This, combined with the fact that the firm did not have a system for recording competitive bids, severely limited NASD's ability to review transactions for best execution. NASD identified several transactions in which the firm violated its best execution obligations, but the firm lacked the records needed for a thorough best execution review.

Disqualification of Director

Though the process of codifying certain provisions in Listing Rules is yet to be finished, SFC is not a teethless tiger. Under S.214 of SFO, SFC may make an application to the Court where it appears that the business or affairs of a listed company have been conducted in a manner that:

1. is oppressive to the shareholders;
2. involves defalcation, fraud, misfeasance or misconduct towards the listed company or its shareholders;
3. results in shareholders not receiving all the information with respect to its affairs or business that they might reasonably expect; or
4. is unfairly prejudicial to the shareholders.

Last week SFC obtained orders in the High Court against Mr Yick Chong San, a former director and CFO of Riverhill Holdings Ltd, a company previously listed on GEM. The orders disqualify Yick from being a director or involved in the management of any listed company, subsidiary or affiliate, without the leave of the Court, for 4 years.

This is the first time SFC has applied to the High Court seeking a disqualification order based on misfeasance or misconduct.

SFC’s allegations concerned a decision by Yick to pledge $10m of Riverhill’s money (raised by Riverhill in the IPO) to secure a loan for a third party. This was a misuse of the funds because it was contrary to representations made in Riverhill’s prospectus and no information was given to shareholders about any changes in the use of the IPO funds.Yick failed to take proper skill and care in entering into the deal and did not ensure the company’s funds were recoverable or properly secured on commercial terms. The third party defaulted on the loan and Riverhill lost the entire $10m reducing its net asset value by more than 20%.

There were also similar breaches in relation to unsecured loans totalling about $25 million authorised by Yick to employees of Riverhill and other third parties, again not disclosed to shareholders. The moneys loaned to the employees were used to open accounts with brokers through which Yick then directed trading in securities for Riverhill.

Given the seriousness of the above misconduct, I don't think the disqualification order is sufficient to create a deterrent effect.

Relevant Individual Suspended by HKMA

A couple of years ago the Banking Ordinance was amended to empowered HKMA to disclose details of disciplinary action taken against securities staff of banks. But in many cases disciplinary action was not taken because the concerned individuals had left the banking industry. This week HKMA issued the first press release (in a similar style to SFC's) about its enforcement action against a relevant individual.

HKMA has suspended all the particulars of Ms Chu Lai Kwan, a relevant individual employed by Hang Seng Bank, from the register maintained by the HKMA under S.20 of Banking Ordinance for one month from 5 Jun 2007 to 4 Jul 2007 for her concealment of her securities trading from her employer.

It was found that Chu conducted joint securities trading with her colleague through the accounts of a client and another colleague with her employer during the period from 2 April 2003 to 30 April 2004. She failed to declare her beneficial interests in these two accounts in accordance with the requirements of the staff dealing policy of her employer. She therefore breached SFC's Code of Conduct and was guilty of dishonesty and misconduct.

HKMA also disclosed that Ms Chu took the initiative to report her concealed securities trading activities to the Internal Audit (not Compliance?) of her employer during its investigation of a complaint (about what?).

I expect HKMA will announce more enforcement actions against relevant individuals in future. Although over the past years some securities staff of banks attempted to avoid HKMA's disciplinary action by jumping from banking industry to securities industry, HKMA could share their "bad records" with SFC.

2nd SFC Report on Investment Advisers

In 2004 SFC conducted the first round of thematic inspection on the selling practices of investment advisers (IAs) and issued a report of findings. Last week SFC issued a further report for its second round of such inspection.

Overall speaking, the deficiencies identified from those IAs in both rounds of inspections are similar, e.g. KYC, product due diligence, suitability, management supervision, documentation and management supervision. Investigation has commenced on some cases with more serious breaches of SFC regulations.

I just want to highlight the following more interesting issues / findings from the report:

• Clients were allowed to select all the available investment objectives, from "capital preservation" to "aggressive growth". They even selected "others" without giving further description. Sales staff failed to follow up on such inconsistency.
• When distributing an unauthorized CIS, the IA failed to spot the inconsistencies between OM and marketing materials. For example, marketing materials specified that the CIS is principal-protected although there was no such statement in OM.
• A retiree indicated in the client profile form that his investment objective as security of capital but subsequently switched his portfolio to higher risk funds (e.g. energy funds) without justification on the file.
• A client disclosed in the profile form a monthly income of $12k and personal net worth of $80m but was advised to invest a lump sum of $120k. No rationale for such advice was given.
• Investors signed off on confirmation forms that their advisers did not offer them advice but only carried out their orders. Of course this was not the fact.
• Most of the IAs do not disclose to clients the remuneration they receive from product providers. SFC is currently reviewing this issue and may consult the market on disclosure.
• A salesperson simply put down the words "good product" as the reason for recommending a fund to a client who did not indicate his risk attitude in the profile form.
• When reviewing the recommendations made by their sales staff, the management might not always detect and follow up on glaring exceptions and mismatches even though the had signed off for approving the recommendations.
• One firm had ignored the licensing condition that restricted it to only advise on funds and advised its clients on investing in equity linked financial instruments.

Misleading Sales Literature

Without sufficient investment knowledge, many retail investors are easily cheated by misleading sales literature. The risk is even higher If they do not spend time to study the stuff and ask the right questions.

NASD recently fined two Fidelity broker-dealers $400,000 for preparing and distributing misleading sales literature promoting Fidelity's Destiny I and II Systematic Investment Plans, which were sold primarily to U.S. military personnel.

Issuance and sales of new systematic investment plans (also known as periodic payment plans), which typically require investors to make a fixed number of monthly payments over a 10- to 15-year period, were prohibited by Congress last fall. Previously sold plans remain in force.

NASD found that the two broker-dealers violated NASD advertising rules by preparing and distributing various pieces of misleading sales literature. For instance, from May 2003 through Jan 2006, the Fidelity broker-dealers prepared and distributed a brochure entitled "Time is Money" that included misleading performance claims about the Destiny Plans. According to "mountain charts" contained in the brochures, Destiny Plans significantly outperformed the S&P 500 Index over a 30-year period. But during the most recent 10- and 15-year periods - the time frame most relevant to current and prospective investors - Destiny Plans substantially underperformed the S&P 500 Index. The 30-year time period masked the underperformance of the Destiny Plans over the most recent 15 years.

The brochures also showed Destiny Plans' average annual total returns for 1, 5 and 10 years as well as the life of the Plan, without showing comparable returns for the S&P 500 Index. Again, this created the misleading impression that Destiny outperformed the S&P 500 Index throughout the periods shown. The comparable S&P 500 Index average annual total returns would have shown that the S&P 500 Index significantly outperformed Destiny during the more current time periods.

Finally, the broker-dealers used the performance of Destiny Plan Class O shares in these charts, when new Plan investors could only purchase Class N shares. Class N shares did not perform as well as Class O shares because of higher ongoing expenses. The broker-dealers prepared and sent over 10,000 copies of these brochures to Destiny retail brokers or their registered representatives to use them with both prospective investors as well as current Plan holders.

NASD also found that in May 2003, the Fidelity broker-dealers prepared and distributed a misleading Destiny newsletter to over 325,000 Destiny Plan holders. The newsletter included a mountain chart showing Destiny I Plan performance. While the chart showed Plan performance, Fidelity disclosed the average annual total returns for the underlying mutual fund portfolio, rather than for the Plan. Because Plan holders paid a 50 percent upfront sales charge on each of the first year's payments and a continuing sales charge on each additional payment until plan payments were completed, the average annual total returns for the Plans were significantly lower than that of the underlying funds.

Fidelity did not adequately supervise the review of this Destiny sales literature in light of the unusual features of the Destiny products.

As part of the settlement, for the next five years, the two broker-dealers are required to notify Destiny Plan holders who want to increase their investments in existing Destiny Plans that additional shares of the underlying fund can be purchased outside the Destiny Plans without paying the additional creation and sales charges of up to 50% on the first year's payments.

Unauthorized Portfolio Management

In HK, there have been enforcement cases against financial consultants who mis-advised clients of frequent fund switching. The situation would be even worse if such switching activities are not authorized by clients.

FSA fined Charterhouse Consulting Wealth Management Ltd £122,500 for carrying out discretionary portfolio management without permission and for various conduct of business failings.

Charterhouse regularly switched a number of clients between funds although the firm did not have permission to operate in this way. It would often send clients an email before 6.30am in the morning proposing the switching of funds and requiring a response by 8.00 am. Switches would then take place without any further instruction from the client.

Charterhouse also failed to:

• record sufficient client information to demonstrate the suitability of its advice;
• ensure transactions were appropriate for its customers' attitude to risk; and
• communicate with its clients in a clear, fair and not misleading manner.

Charterhousethe has taken mitigating steps to regularize its business activities which included the cessation of business activities falling outside its permitted activities. As a result of agreeing to settle at the earliest opportunity Charterhouse has received the maximum 30%, discount afforded under FSA's "Discount Scheme". The fine would otherwise have been £175,000.

Anti-Fraud Controls of Private Bank

Private banking has long been perceived as a high risk area. Inherent risk (client profile, transaction nature, etc.) is one thing, control risk (lack of management oversight, inadequate procedures, etc.) is another thing.

FSA recently fined BNP Paribas Private Bank (BNPP Private Bank) £350,000 for weaknesses in its systems and controls which allowed a senior employee to fraudulently transfer £1.4 million out of clients' accounts without permission.

This is the first time a private bank has been fined for weaknesses in its anti-fraud systems. The 13 fraudulent transactions were carried out between Feb 2002 and Mar 2005 using forged clients' signatures and instructions and by falsifying change of address documents.

During its investigation, FSA found that BNPP Private Bank did not have an effective review process for large transactions, over £10,000, from clients' accounts. The bank's procedures were not clear about the role of senior management in checking significant transfers prior to payment. As a result, a number of fraudulent transactions were not independently checked.

In addition, a flaw in the bank's IT system allowed the senior employee to evade the normal Middle Office processes. This meant that basic authorisation and signatory checks were not carried out on internal cash transfers between different customer accounts.

The bank's failings were serious because they enabled significant fraud to take place and failed to detect subsequent transfers to cover it up for a long period of time. It also failed to improve its procedures for monitoring large transactions or carry out remedial action on a timely basis. This was despite the bank being aware that certain of its procedures required improvement as a result of an FSA visit in relation to money laundering systems and controls in Aug 2002 and subsequent internal reviews.