Insider Dealer Arrested

A recent big news in the HK compliance field is that a former managing director at Morgan Stanley Asia Ltd has been arrested and charged for insider dealing and counselling or procuring another person to deal in a listed company's shares prior to the announcement of an acquisition deal.

Mr Du Jun was detained at the Hong Kong International Airport last Thursday after arriving from Beijing and appeared at the Eastern Magistracy last Friday. He is no longer employed by Morgan Stanley and has been residing mainly in Beijing since last year. No plea was taken and the case was adjourned to 5 Sep 2008 for transfer to the District Court. He was granted bail but was ordered to surrender all travel documents and report to the Police twice a month.

The arrest was made following an SFC investigation with Morgan Stanley's cooperation (by reporting Du's trading to SFC in May 2007). The charges allege that on nine occasions between 15 Feb 2007 and 30 Apr 2007, Du dealt in the shares of CITIC Resources Holdings Ltd (CITIC Resources), a company listed on SEHK, whilst in possession of material and price sensitive information not known to the market. The information related to a proposed deal by CITIC Resources to acquire oil field assets, which was announced on 9 May 2007.

It is alleged that Du obtained the information while he was part of a Morgan Stanley team involved in advising CITIC Resources. The charges relate to a total of 26.7 million shares in CITIC Resources allegedly acquired by Du at a cost of about $86 million. On 30 Apr 2007, the last day Du was alleged to have bought CITIC Resources shares, the share price of CITIC Resources closed at $3.68. The price rose by 13.86% to $4.19 on the day of the announcement. Du is also alleged to have counselled or procured his wife Ms Li Xin, who is not facing any charges, to deal in CITIC Resources shares on 27 Feb 2007.

This is a high profile case for SFC to demonstrate its teeth to hunt a tiger. Morgan Stanley's surveillance system and whistle blowing also take the credit.

Beware of IT Guys

A listed company should have the policy of prohibiting certain employees from dealing in the company shares during the "blackout period" prior to results announcement because they are likely in possession of unpublished price sensitive information. Such employees usually comprise all directors and senior management as well as staff carrying out sensitive functions like finance, company seretary, etc. However, IT people may be missed out.

FSA recently fined John Shevlin £85,000 for market abuse. He was employed as an IT technician at the Body Shop International plc ("Body Shop"). On 10 Jan 2006 he established a short position equivalent to 80,000 Body Shop shares through a Contract for Difference ("CFD"), in effect betting that the share price would fall. This trade was made on the basis of inside information. He obtained the inside information by improperly accessing confidential emails which had been sent or received by senior Body Shop executives in connection with the company's Christmas trading announcement. The emails contained details of Body Shop's Christmas trading results and a draft announcement that the Body Shop had underperformed expectations.

Shevlin closed out his CFD position on 11 January 2006 after Body Shop announced its Christmas trading results to the market and made a profit of £38,472. He even borrowed £29,000 (more than his annual salary) to effect the trade.

FSA finds there is cogent and compelling circumstantial evidence against Shevlin, including that:

• He was able to log into the email accounts of certain senior executives from their computers, given that it would have been in the name of the account holder, such access is unlikely to be traceable as being by Mr Shevlin;
• He arranged substantial finance on an urgent basis to enable him to effect the CFD trade before the surprise announcement;
• He placed the CFD trade on the day before the announcement and was keen that his trade took place on that day;
• His CFD trade was of a considerable size, one which accounted for approximately 26.7% of the trading volume in that stock on that day;
• His CFD trade was significantly larger than any CFD he had previously traded. The underlying value of the trade was £213,536 which represented more than double Mr Shevlin's net assets;
• The level of financial risk undertaken by Shevlin was much higher than he had undertaken on previous trades and was such that it could have resulted in serious financial hardship if the trade had gone against him.

As a result, FSA does not accept Shevlin's assertions that he based his trading strategy on information obtained by research or analysis using public information; instead, his CFD trade was based on inside information obtained from the computers of Body Shop's senior executives.

QFII-Related Lawsuit in China

Today I've read a news article from Finance Asia about the first QFII-related lawsuit in China. Nanning Sugar, a company based in Guangxi province, has filed a lawsuit against Martin Currie Investment Management (MCIM) and Martin Currie Incorporated (MCI) with the Nanning Intermediate People's Court for alleged breaches of Article 47 under the PRC Securities Law. Nanning Sugar has successfully obtained court orders to freeze Martin Currie's assets in China, with a total of RMB 39.6 million under MCIM's QFII account, until the case is heard in court.

Article 47 stipulates that if a shareholder purchases and sells a stake of over 5% in a listed company within six months, the listed company is entitled to the proceeds of the trade. This rule was originally designed to deter short-term and insider trading. Nanning Sugar claims that Martin Currie should pay back the profit it made from trading the company's stock between Aug 2007 and Jan 2008, as well as accrued interested and incurred legal costs.

However, Martin Currie argues that:

• the action taken by Nanning Sugar is wholly unwarranted because Nanning Sugar has misunderstood how the current system works for foreign investors;
• the fact that Martin Currie companies owned more than 5% of the issued shares is clearly incorrect;
• MCIM has only held a maximum of 1.6% of Nanning Sugar's shares in the period of the alleged breach; and
• the rest of the stake that totals over 5% as Nanning Sugar has claimed belonged to four different clients and was invested across three different QFII accounts, some of which are advised by MCI (a separate legal entity from MCIM).

There is a widespread concern about its impact of this case on the further reforms amid expectation for a coming QFII scheme expansion. The PRC Securities Law in China was first adopted in 1999 and later revised in 2005. Given the short history of the asset management industry in China, most of the rules remain untested and are subject to regulators' interpretation and revision as the market expands. Market partitiorners have been concerned about the legal loopholes and overlapping regulations.

QFII investors are currently subject to regulation by the CSRC and rules on foreign exchange by SAFE. Given China's legal system is based on a civil law system, instead of case law, rulings follow the word of the law without reference to precedence. The inconsistencies between the securities law and the regulation on disclosure of equity interest could lead to potential conflicts when applied to foreign investors under the QFII scheme.

Let's see how this case is finally adjudicated by the PRC court.

Bear Stearns Hedge Fund Fraud

Bear Stearns is again under the spotlight. This time the subject is hedge fund fraud related to subprime crisis.

SEC recently charged two former Bear Stearns Asset Management (BSAM) portfolio managers for fraudulently misleading investors about the financial state of the firm's two largest hedge funds and their exposure to subprime mortgage-backed securities before the collapse of the funds in June 2007.

SEC alleges that when the hedge funds took increasing hits to the value of their portfolios during the first five months of 2007 and faced escalating redemptions and margin calls, then-BSAM senior managing directors Ralph Cioffi and Matthew Tannin deceived their own investors and certain institutional counterparties about the funds' growing troubles until they collapsed and caused investor losses of US$1.8 billion.

The Bear Stearns High-Grade Structured Credit Strategies Fund and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund collapsed after taking highly leveraged positions in structured securities based largely on subprime mortgage-backed securities. Cioffi acted as senior portfolio manager and Tannin acted as portfolio manager and chief operating officer for the funds, and they misrepresented the funds' deteriorating condition and the level of investor redemption requests in order to bring in new money and keep existing investors and institutional counterparties from withdrawing money.

For example, Cioffi misrepresented the funds' Apr 2007 monthly performance by releasing insufficiently qualified estimates — based only on a subset of the funds' portfolios — that projected essentially flat returns. Final returns released several weeks later revealed actual losses of 5.09% for the High-Grade Structured Credit Strategies Fund and 18.97% for the High-Grade Structured Credit Strategies Enhanced Leverage Fund.

Cioffi and Tannin also misrepresented their funds' investment in subprime mortgage-backed securities. Monthly written performance summaries highlighted direct subprime exposure as typically about 6% to 8% of each fund's portfolio. However, after the funds had collapsed, the BSAM sales force was ultimately told that total subprime exposure — direct and indirect — was approximately 60%.

Cioffi and Tannin continually exaggerated their own investments in the funds while using their personal stake as a selling point to investors. Tannin repeatedly told investors, directly and through the Bear Stearns sales force, that he was adding to his own stake in the funds in order to take advantage of the buying "opportunity" presented by the funds' losses. Tannin never actually added to his investment. He mocked as "silly" at least one investor who sought to redeem instead of following Tannin's supposed example. Meanwhile, Cioffi redeemed US$2 million, which was more than one-third of his personal investment in the funds at the end of March 2007. Cioffi transferred it to another BSAM fund that he described as "short subprime," which he knew was profitable at the time.

The real hazard of hedge funds is often operational risk rather than market risk. Subprime fund managers are more terrible than subprime securities.

Investment Adviser Fined

In the two reports on thematic inspections of investment advisers, SFC stated that it had identified certain malpractices of Hong Kong's investment advisers. So far not too many cases have been concluded and announced, thus the following one is remarkable.

This week SFC issued a reprimand to Mr Choy Kwong Wa Christopher, a former responsible officer of Pacific World Asset Management Ltd (then licensed for RA4 & RA9), and fined him $570,000.

SFC found that Choy:

• mis-stated in a fund's marketing materials the credit rating of the notes in which Pacific World invested through the fund;
• accepted commission from the notes issuer without disclosing this to his clients, which may create a potential conflict of interests in that Pacific World's advice as to the suitability of this fund may have been influenced by that commission;
• failed to ensure that Pacific World's clients received updated information about a reduction in the fund's net asset value and surrender price from the fund launchers;
• failed to ensure that Pacific World's investment advisers kept a record of advice they gave their clients; and
• did not supervise the suitability of investment advice given to clients.

Pacific World has already ceased businesses of regulated activities and therefore Choy alone bears the overall responsibility. The magnitude of the fine reflects the seriousness of this case. What other IA firms would follow?

Why SG Failed to Detect the Fraud?

Societe Generale made headlines during Jan 2008 when it revealed that one of its traders made a series of unauthorized transactions over the past few years, which eventually caused a total loss of US$7.2 billion to the bank. Why did SG fail to detect the fraud?

It was reported that the 31-year-old trader Jereme Kerviel took massive "directional positions" in transactions that depend on the ability to correctly predict how the price of a security will move over time.

Kerviel had been an IT employee at SG before being moved to the bank's front office. He made over 1,000 fraudulent transactions dating back to Sep 2004 and concealed the fraud using various techniques that exploited his in-depth knowledge of the bank's computer systems and procedures. His techniques allowed him to bypass easily all the IT and process controls the bank had put in place to detect fraudulent transactions.

Last week The bank's general inspection department released a 71-page report on the incident, following a 27-page preliminary report released in Feb 2008. The report, called "Mission Green", highlighted 5 reasons the bank failed to detect Kerviel's activities despite several signs that, in retrospect, should have been obvious.

1. Supervision was lacking. Despite several internal alerts that should have triggered a closer look at his activities, Kerviel remained largely unsupervised, especially in the early part of 2007, when the bulk of his illegal activity took place. Between Sep 2004 and Jan 2007, his direct managers completely failed to detect any fraudulent activity, though there were several internal alerts. Kerviel's direct manager resigned in Jan 2007, and Kerviel did not have another manager until Apr. During this period, Kerviel was largely unsupervised and validated the earnings of his operational center himself.
2. A new desk manager assigned to Kerviel in Apr 2007 was ineffective and weak, and did not have enough support from his superiors.Kerviel's direct manager had no specific knowledge of trading practices (wow!), and no attempts were made to verify his supervisory abilities. During the second half of 2007, the desk manager and his immediate superior were caught up with other projects and in dealing with high employee turnover rates; thus distracted, they missed Kerviel's activities. The manager did not carry out an analysis of the earnings generated by his traders - a task that was supposed to be one of his primary responsibilities.
3. Several alerts by the front office got little attention and less response. Long before Kerviel's activities were unearthed in Jan 2008, there were several signals that were either simply ignored or not properly responded to. For instance, despite the suspiciously high value amount (59% of his group's earnings) and growth in Kerviel's declared earnings during 2007, no investigation or analysis was ever done. Similarly, between 28 Dec 2007 and 1 Jan 2008, there was an unusually high level of cash flow for Kerviel's primary operations center where he traded from. But no one noticed. Even two queries related to Kerviel by Europe's Eurex securities exchange did not receive much attention from Kerviel's direct manager. Neither did two alerts from SG's middle office informing Kerviel's manager of anomalies concerning Kerviel that were detected during routine reviews.
4. Kerviel's manager had an overly tolerant attitude toward intraday trading activities. Such trading by Kerviel was "unjustified" given his assignment and lack of seniority as a trader, the report noted. It was this intraday trading that gave Kerviel a context for carrying out his illegal trading activities.
5. The operations environment was critically chaotic. A "chronically" understaffed middle-office operations group, combined with fast growth and a rapid multiplication in the number of products, contributed to a chaotic operations environment, which made it easier for Kerviel to conceal his activities.

In addition, the report indicated that Kerviel may well have had an accomplice in-house an assistant who helped enter the hinky transactions. Kerviel has said repeatedly that other traders at SG followed the same practices, and that he has been made a scapegoat for others' failings in addition to his own.

Then how many "hidden" rouge traders were still staying at the bank?

Tipping

I have some friends working in the Big 4 accounting firms and investment banks. They often complain that they have been prohibited to buy many good companies listed on SEHK because such companies are their auditing or due diligence clients. However, there are always people willing to take the legal risk.

Last week SEC alleged that from summer 2006 through fall 2007, James E. Gansman, a former partner in Ernst & Young's Transaction Advisory Services department, tipped his friend Donna Murdoch about the identities of at least seven different acquisition targets of clients who sought valuation services from his firm. Murdoch was a registered securities professional and managing director of a Philadelphia-based broker-dealer and investment banking firm.

Gansman misappropriated the information about pending acquisitions on numerous occasions in breach of a duty of confidentiality owed to E&Y and its clients. Murdoch used the non-public information to trade in the securities of the target companies; to tip her father, who also traded; and to make recommendations to two others, who traded as well.

This insider trading case involves "tipping" - just like the case of the HK famous banker David Li. I always wonder whether the tipper has obtained any real benefit by tipping his friend to "get rich quickly".