Late Reporting of Broker Information & Customer Complaints

Last week FINRA censured and fined UBS Financial Services, Inc. US$370,000, for making hundreds of late disclosures to FINRA's Central Registration Depository (CRD) of information about its brokers, including customer complaints, regulatory actions and criminal disclosures. Those reporting violations occurred over a three-year period, from Jan 2002 to Dec 2004. The firm also failed to disclose a significant number of customer complaints and filed late and inaccurate notices concerning the termination of certain brokers' relationships with the firm.

The violations may have hampered investors' ability to assess the background of certain brokers via Broker Check, FINRA's public disclosure program. They also may have compromised firms' ability to conduct background checks when making hiring decisions, reduced the ability of state securities regulators to review brokers' transfer applications and hindered FINRA from promptly investigating certain disclosure items.

Under FINRA rules, when a securities firm hires a broker it must ensure that information on the broker's registration application (Form U4) is updated and kept current in the CRD system. The firm must update that information whenever significant events occur, including regulatory actions against the broker, certain customer complaints, settlements involving the broker and certain criminal charges and convictions. Normally, those updates must be filed within 30 days of the event. A reportable event involving statutory disqualification (often the result of a criminal conviction) must be disclosed to CRD within 10 days. Firms also are required to notify FINRA within 30 days of the termination of a registered person's association with a member firm by filing a notice known as Form U5. Firms also must notify FINRA within 30 days of learning that information disclosed on a Form U5 filed for a broker has become inaccurate or is incomplete.

Regarding complaints, certain types of written, consumer-initiated, investment-related complaints made within the past 24 months must be disclosed on Forms U4 and/or U5. If a complaint alleges that a broker was involved in one or more sales practice violations and contains a claim for compensatory damages of US$5,000 or more, it must be disclosed. Additionally, complaints alleging broker involvement in forgery, theft, misappropriation or conversion of funds or securities must also be disclosed.

In HK, SFC has implemented a similar reporting system but enforced it more leniently. The chance of imposing severe penalties on securities firms for late reporting of broker information and customer complaints is relatively low.

Loophole of DoI System

Under the disclosure of interests (DoI) regime laid down in SFO, substantial shareholders (5% stake or above) of a listed company should make a disclosure for certain prescribed changes of interest (e.g. crossing a whole percentage number) within 3 business days, which is tighter than 5 days required by the Pre-SFO regime. The law permits such disclosure to be made by hand, post, fax or email. However, there is an underlying loophole.

In recent months Warren Buffet has gradually reduced his shareholdings in PetroChina (857.hk), triggering the disclosure obligations. However, he sent in the disclosure by regular mail, each time leaving Hong Kong investors in the dark for two weeks.

According to newspaper reports, even Martin Wheatley (SFC's CE) had to admit that:

• There is clearly a gap in our legal system.
• It was never intended that somebody could send their disclosure in by a very slow means of communication.
• It is allowed for in the SFO, but it's a deficiency we need to address.
• It will take time to amend the law because it requires primary legislation changes.

I wonder how many other substantial shareholders (esp. overseas investors not regulated by SFC) are taking advantage of this loophole.

Email Spam

Email spam is big issue globally. It is particularly harmful if it is relating to stock market "pump and dump" scheme.

US SEC recently announced that it had continued its assault on stock market email spam by suspending trading in the securities of three companies that haven't provided adequate and accurate information about themselves to the investing public.

The companies, all of which trade on the Pink Sheets, are susceptible to spam stock promotions because they have inadequately disclosed their assets, business operations and/or management, their current financial condition, and/or financing arrangements involving the issuance of the companies' shares.

The trading suspensions are part of SEC's Anti-Spam Initiative announced earlier this year that cuts the profit potential for stock-touting spam and is credited for a significant worldwide reduction of financial spam. A recent private-sector Internet security report stated that a 30% decrease in stock market spam was triggered by actions taken by the SEC, which limited the profitability of this type of spam. In addition, spam-related complaints to the SEC's Online Complaint Center have been cut in half.

Since the launch of its Anti-Spam Initiative in Mar 2007 to combat spam-driven stock market manipulations, SEC has suspended trading in the securities of 39 companies and has brought several spam-related enforcement actions.

SFC has also actively combating "boiler room" activities that are usually associated with email spam. But I think there would not be too many people in HK cheated by email spam.

Cross-Border Unlicensed Activities

Last week SFC suspended Ms Ng Suet Hing for one month for unlicensed activities. She is licensed to carry on Type 3 regulated activity, accredited to Hantec International Ltd.

SFC found that Ng assisted a HK resident to open an account at Cosmos Hantec Investment (NZ) Ltd, a New Zealand company not licensed by SFC, to trade leveraged foreign exchange contracts. Cosmos Hantec (NZ) is a related company of Hantec International Ltd. It carries on a business in financial services including leveraged foreign exchange trading which is currently not regulated in New Zealand. Ng subsequently attempted to notify Cosmos Hantec (NZ) that she was the client's account executive for the purpose of receiving commissions.

Some market practitioners have a false hope that if client transactions arising a regulated activity are booked in an overseas entity, there is no licensing requirement. They don't realize that if the clients are HK residents and the account opening process takes place in HK, SFC has to offer them investor protection.

In this case, even though Cosmos Hantec (NZ) is a related company of Hantec International Ltd, SFC fails to exercise further investigation power against this overseas company. As a result, HK investors who have opened an account with Cosmos Hantec (NZ) are now requested to contact SFC.

Hedge Fund Fraud

Hedge funds have the features of lower transparency and less regulation. Accordingly, it is no surprise that fraud cases could happen from time to time.

Last week SEC charged a San Francisco hedge fund manager with defrauding investors by dramatically overstating the fund's profitability and misusing fund assets. It alleged that Alexander James Trabulse sent account statements to investors in his Fahey Fund that inflated the fund's returns by as much as 200%, while using investor money to purchase cars and finance shopping sprees for his family members.

According to SEC, Trabulse founded the Fahey Fund in 1997 and raised about US$10m from approximately 100 investors. He told investors the fund invested in financial instruments like stocks, derivatives, and foreign currency. Trabulse lured investors by touting the fund's spectacular performance, when in reality the statements he provided to investors bore no relation to the fund's actual performance.

Trabulse also misused fund assets to pay for a wide variety of personal expenses, using the fund's bank account to pay for cars, a home theater system, and his ex-wife's overseas shopping allowance. He even gave one relative free reign to use the fund's bank accounts for personal use.

In the past participation in hedge funds was limited to high net worth individuals, where the regulators could find an excuse for not directly supervising them. While such kind of products has been prevailing in the retail market, this incident makes an alarm.

Misuse of Name & Logo

SEC recently settled enforcement proceedings against HSBC Bank USA, N.A., which will pay a US$10m civil penalty and US$500,000 in disgorgement for allowing its name and logo to be used in connection with a Florida-based offering fraud by Pension Fund of America, L.C. (Pension Fund).

SEC issued a settled cease-and-desist Order finding that from Aug 2003 to Mar 2005, HSBC served as trustee for the investment component of Pension Fund and its affiliated entities' trust plans. Since at least 1999, Pension Fund sold retirement and college "trust plans" that purportedly provided term life insurance and the opportunity to invest in one or more pre-selected mutual funds. However, Pension Fund failed to disclose, among other things, that it was taking up to 95% of the investors' funds to pay commissions and fees. Pension Fund raised at least $127 million from more than 3,400 investors, primarily from Central and South America.

In Mar 2005, SEC filed an emergency action in the U.S. District Court for the Southern District of Florida against Pension Fund and its principals to halt the offering fraud. The Court appointed a receiver over Pension Fund, who shut down its operations, marshaled its assets, and developed a claims process to distribute recovered funds to its investor victims.

It was found that HSBC allowed the use of its name and logo in Pension Fund's offering materials. HSBC also allowed Pension Fund to use marketing materials that falsely suggested that the trust plans were co-developed by HSBC and Pension Fund, and that investors' funds would be "totally safe" because the money would be deposited in a trust account at HSBC. In reality, Pension Fund deposited investors' funds in an ordinary checking account in its name at HSBC, and used up to 95% of such funds to pay its own undisclosed sales commissions, expenses and fees. Pension Funds' marketing brochures provided a list of mutual funds offered as part of the trust plans, but did not disclose any information about the sales commissions, administrative expenses, or the front-load mutual fund fees charged to investors. However, HSBC failed to follow its own internal procedures in reviewing and approving certain Pension Fund offering materials.

Additionally, HSBC actively participated in the selection of offshore, high front-load mutual funds to be offered to prospective investors under a negotiated fee arrangement between HSBC and Pension Fund. However, neither the amount of the funds' sales loads, nor HSBC's role in the funds' selection, were disclosed to investors. In Oct 2003, shortly after HSBC became trustee for Pension Fund's plans, HSBC drafted a letter on its own letterhead announcing the new relationship and inviting certain of Pension Fund's existing investors to transfer their funds to HSBC. Pension Fund sent the letter to approximately half of its existing investors, and enclosed a form bearing HSBC's logo that listed new mutual fund selections available upon transfer to HSBC. Neither the letter nor the enclosure disclosed that investors would incur new front-load fees in connection with such transfers, or the amounts of those prospective costs.

A globally known institution should be very cautious when associating its name & logo with a third party. Who in HSBC should ultimately bear the responsibility for this incident?

Records Kept at Overseas Premises

According to S.130 of SFO, a licensed corporation must obtain SFC's pre-approval before keeping records at a particular premise. In recent years, some firms have outsourced their back office functions to third parties located at overseas countries. However, SFC recently released a FAQ to clarify that it would not approve overseas premises for the keeping of records or documents under S.130.

The reason why the SFC will only approve premises located in Hong Kong is that while SFC is empowered by SFO to enter an intermediary's premises to inspect the records, it may be precluded from exercising this power in the event of the premises being located outside HK.

Accordingly, if an intermediary enters into an overseas outsourcing arrangement, it must ensure that all relevant records or documents, which are kept by an overseas third party, are also contemporaneously kept by the intermediary at the HK premises approved by SFC under S.130.

If records at overseas premises are maintained in electronic format, then it would not be a big problem making a copy to the intermediary's local office. But it could be a hardship for the overseas third party to remit hard copy records back to HK.