FINRA recently fined Edward D. Jones & Co. US$900,000 for its failure to timely deliver official statements to customers who purchased new-issue municipal securities and related supervisory and recordkeeping failures. With limited exceptions, broker-dealers selling a new-issue municipal securities are required to deliver a copy of the official statement to the customer on or before settlement date. New-issue securities are those sold during the initial distribution of bonds to the public.
FINRA found that Edward Jones' late deliveries occurred when the firm was conducting retail transactions but was not a member of the underwriting syndicate for a new issue. The firm's failures from 2002 through 2006 were systemic. During that time period, Edward Jones engaged in approximately 100,000 new-issue municipal bond transactions in which it was not an underwriter. For a significant number of those transactions, the firm was late in delivering official statements to its customers. The firm's systemic late deliveries had multiple causes, including lack of training for employees, incorrect instructions to employees, limited photocopying capacity and errors by employees of the firm, including trading supervisors.
The late deliveries continued. In September 2008 alone, the firm was late in mailing official statements to customers in over 6,200 transactions, which represented 19% of the firm's municipal bond transactions. Edward Jones's own internal communications repeatedly referenced that it was not timely delivering official statements. Nevertheless, the firm failed to take reasonable and sufficient steps to comply with its delivery obligations. Edward Jones also failed to keep required records, did not have written supervisory procedures addressing the requirements for delivery of official statements until May 2006, and that those procedures contained incorrect guidance.
In Hong Kong, SFC licensed / registered intermediaries are required by the S&F (Contract Notes, Statements of Account and Receipts) Rules to provide official transaction and account statements to their customers within specified time frame. I did also witness the above systemic problems resulting in late delivery of statements, but (touch wood) so far SFC has not imposed a heavy penality for such problems.
Wednesday, April 15, 2009
Wednesday, April 08, 2009
Market Abuse by Market Maker
UK FSA has won its market abuse case at the Financial Services and Markets Tribunal (the Tribunal) against Winterflood and two of its traders, Mr Sotiriou and Mr Robins.
Winterflood is an FSA authorised firm and the largest market maker in AIM securities. In June 2008, FSA found that Winterflood and its traders had played a pivotal role in an illegal share ramping scheme relating to Fundamental-E Investments Plc (FEI), an AIM listed company. In particular, the market maker had misused rollovers and delayed rollovers thereby creating a distortion in the market for FEI shares and misleading the market for about six months in 2004.
In May 2003, Mr Eagle was seeking to secure control of an AIM shell company as an investment vehicle to acquire electronic technology companies, and he identified FEI as suitable for this purpose. He agreed with the two shareholders of 85% of the shares in FEI to arrange for their shares to be sold and then he arranged with Winterflood for executing the deal. Mr Eagle thereafter instituted a share ramping scheme in FEI shares, the effect of which was to inflate the share price of FEI shares.
The key elements of the share ramping scheme were as follows:
Winterflood is an FSA authorised firm and the largest market maker in AIM securities. In June 2008, FSA found that Winterflood and its traders had played a pivotal role in an illegal share ramping scheme relating to Fundamental-E Investments Plc (FEI), an AIM listed company. In particular, the market maker had misused rollovers and delayed rollovers thereby creating a distortion in the market for FEI shares and misleading the market for about six months in 2004.
In May 2003, Mr Eagle was seeking to secure control of an AIM shell company as an investment vehicle to acquire electronic technology companies, and he identified FEI as suitable for this purpose. He agreed with the two shareholders of 85% of the shares in FEI to arrange for their shares to be sold and then he arranged with Winterflood for executing the deal. Mr Eagle thereafter instituted a share ramping scheme in FEI shares, the effect of which was to inflate the share price of FEI shares.
The key elements of the share ramping scheme were as follows:
- Acquisition of SP Bell: Mr Eagle proposed to buy a 10% stake in FEI himself but had to find buyers for the remaining 75%. To do so, he needed to generate significant demand for its shares. On 27 May 2003, Mr Eagle acquired SP Bell Limited, an agency-only stockbroking firm, using an investment vehicle. He intended to find buyers for the remaining 75% of FEI shares and to maintain demand thereafter by, for the most part, selling to clients of SP Bell. By acting as middleman, Winterflood helped Mr Eagle to conceal the full extent of his role and in particular the significant commission he stood to gain from the original shareholders.
- Rollover trades and delayed rollover trades: In order to procure sufficient purchasers for the 85% interest of the original shareholders, and to continue to buy FEI shares in the market following the initial sale, Mr Eagle introduced 50 new clients to SP Bell in the period from 18 July 2003 to 13 May 2004. However, a number of the Eagle clients did not have sufficient funds to pay for the shares, so in order to avoid those clients being required to make payment, Mr Eagle instituted a scheme whereby their FEI positions were purportedly rolled from one SP Bell client to another. From 5 January 2004, Mr Eagle refined the rollover scheme by the use of delayed rollover trades, whereby the size and price of the buy and sell legs of the rollover trade were agreed at the outset, but the two legs of the transaction were then executed at different times of day. The effect of the rollover scheme was to defer settlement, potentially indefinitely. However, it required a rising share price in order to operate successfully.
- Consistent purchasing of FEI shares by SP Bell: In order to support and increase the FEI share price, SP Bell consistently purchased FEI shares (in particular, from Winterflood), regardless of market conditions. In many cases, this trading was not authorised by the underlying clients, and shares bought were not paid for but were simply added into the rollover scheme. The trading did not represent genuine market demand for the shares.
- Involvement of Winterflood: The involvement of Winterflood, Mr Sotiriou and Mr Robins was critical to the success of the share ramping scheme. In addition to executing the trades referred to above, there were many untaped conversations between Mr Eagle and Winterflood, particularly Mr Sotiriou. On a number of occasions there was obvious pre-arrangement of trades where details were agreed on untaped lines before they were executed on taped lines.
The FEI share ramping scheme had the effect of misleading the market as to the supply, price or value of and demand for FEI shares and of distorting the market in FEI shares. It caused the positioning of the FEI share price at an artificially high level, and resulted in an almost five-fold increase in the share price of FEI between May 2003 and July 2004.
On 15 July 2004, the share price of FEI fell sharply from 11.75p to 7.5p as a result of sustained selling. The London Stock Exchange also received information that substantial unsettled positions in FEI shares had accumulated within SP Bell. At 10:35am, the Exchange temporarily suspended trading in FEI shares because it was of the view that the market was disorderly. The suspension of trading caused the unsettled positions in FEI shares at SP Bell to crystallise. Neither the clients of SP Bell nor SP Bell itself had sufficient funds to settle the resulting debt of over £9 million. On 23 July 2004, SP Bell ceased trading and was placed into administration.
FEI was the single most profitable stock for each of Winterflood, Mr Sotiriou and Mr Robins. Winterflood received £204,403 from the sale of the interest of the original shareholders and approximately £941,133 from its trading in FEI shares between January and July 2004. The profitability of trading in FEI also had a direct impact on the level of bonus awarded to Mr Sotiriou and Mr Robins. As a result of their conduct, FSA decided to impose fines of £4 million, £200,000 and £50,000 on Winterflood, Mr Sotiriou and Mr Robins respectively.
Wednesday, April 01, 2009
Regulation of Short Selling
In more mature stock markets, short selling is usually permitted, but it could be prohibited during a financial crisis (like the one in 2008). Recently the Technical Committee of IOSCO released the Consultation Paper on Regulation of Short Selling.
The Technical Committee believes that short sellling have important functions such as providing more efficient price discovery, mitigating market bubbles, increasing market liquidity, facilitating hedging and other risk management activities. However, there is also a general concern that during extreme market conditions, certain types of short selling may contribute to disorderly markets.
Short selling is typically defined based on two factors: (i) a sale of stock that (ii) the seller does not own at the point of sale. Some jurisdictions (like Hong Kong) do not directly define short selling but prohibiting "naked" short selling.
The Consultation Paper has developed the following high level principles for effective regulation of short selling, briefly highlighted below:
Principle 1 - Short selling should be subject to appropriate controls to reduce or minimize the potential risks that could affect the orderly and efficient functioning and stability of financial markets.
- The Technical Committee recommends the imposition of a strict settlement (e.g. compulsory buy-in) of failed trades. Having a short settlement cycle (no later than T+3) can help to reinforce settlement discipline. Other measures such as price restriction rules (e.g. uptick rule), "locate" requirement (e.g. stock borrowing) and "flagging" of short sales are also useful for preventing abusive short selling.
Principe 2 - Short selling should be subject to a reporting regime that provides timely information to the market or to market authorities.
Principle 3 - Short selling should be subject to an effective compliance and enforcement system.
- The Technical Committee encourages market authorities to consider extending their power to require information parties suspected of breach, beyond the scope of licensed or registered persons if they lack such power. Market authorities should also review whether their cross-border information sharing arrangements are sufficient to facilitate cross-border investigation.
Principle 4 - Short selling regulation should allow appropriate exceptions for certain types of transactions for efficient market functioning and development.
- Legitimate short selling should not be prohibited. Activities falling under category may include bona fide hedging, market making and arbitrage activities. Short selling regulation should consider building in flexibility. For example, failed trades arising from market making activities are not subject to strict settlement requirements but rather allow more time to close out the positions.
Based on my observations, Hong Kong is to a large extent fulfilling the above four principles for regulation of short selling.
Wednesday, March 25, 2009
Commission Rebate Scheme for Warrant Trading
Once a time the Hong Kong Government was proud of Hong Kong being a key hub for warrant trading. What do they feel when your territory's stock exchange has become a big gambling house? In fact, the active trading of warrants was partly induced by the "commission rebate schemes" offered by warrant houses.
Last week SFC reprimanded Macquarie Equities (Asia) Ltd and fined it $4 million following an investigation into Macquarie's operation of a commission rebate scheme in relation to derivative warrants issued by Macquarie Bank Ltd (MB warrants). SFC found that Macquarie operated the commission rebate scheme in breach of its obligation to act with due skill, care and diligence in the best interests of the integrity of the Hong Kong market. In fact SFC banned commission rebate schemes in March 2006.
Macquarie used the commission rebate scheme to reduce transactions costs for investors and stimulate trading in selected MB warrants. Under the rebate arrangement, Macquarie agreed to reimburse investors, through their participating brokers, either in full or in part, the brokerage costs they were charged by their brokers for trading specified warrants.
In January 2002, SFC warned Macquarie that they should ensure their commission rebate scheme did not facilitate trading of MB warrants that was not for any genuine economic or commercial purpose. SFC was concerned that such scheme could encourage improper trading and lead to a false market for the MB warrants. SFC identified heavy trading activities in MB warrants between two clients from two participating brokerages during the period from January 2004 to January 2005. The two clients repeatedly traded the MB warrants at or near the same prices within short time intervals and created substantial amounts of turnover.
For example, in one particular warrant, on one day, two clients of two participating brokers engaged in about 400 trades between themselves in just over 60 minutes of trading with a transaction around every 10 seconds (being 90% of turnover on that day). The trades were conducted at or near the same prices within short time intervals and with effective brokerage commission costs below the amount of commission rebate paid by Macquarie. It appears the trading turnover of the relevant MB warrants was inflated and may have misled investors into believing that certain MB warrants were more actively traded than was actually the case.
While generating a significant amount of commission rebate from Macquarie, the two brokerages gave the clients discounts on brokerage costs for large volume trading. The two clients were then able to generate risk-free profit from the difference between the commission rebate and the discounted brokerage costs. Macquarie had put in place some controls to deal with the risk to market integrity and monitored the payment of commission rebate, but it failed to check whether the commission rebate scheme was providing clients with more money than was required to rebate actual brokerage costs. The volume and nature of the trading should have alerted Macquarie to make additional inquiries about the operation of the scheme and to check whether it was distorting the market for these MB warrants.
The SFC considers that if Macquarie had realised the true nature of this trading activity, Macquarie would have been obliged to ban those brokers from further participation in the commission rebate scheme. Macquarie eventually did ban some commission rebate scheme participants, but this was too late.
What are the root problems in my opinion? First, too many investors believe that actively traded warrants are "good" warrants. Second, SFC was wrong in releasing the warrant market in 2001. May I ask those frontline staff working for warrant houses a question: don't you feel guilty of teaching the general public to gamble?
Last week SFC reprimanded Macquarie Equities (Asia) Ltd and fined it $4 million following an investigation into Macquarie's operation of a commission rebate scheme in relation to derivative warrants issued by Macquarie Bank Ltd (MB warrants). SFC found that Macquarie operated the commission rebate scheme in breach of its obligation to act with due skill, care and diligence in the best interests of the integrity of the Hong Kong market. In fact SFC banned commission rebate schemes in March 2006.
Macquarie used the commission rebate scheme to reduce transactions costs for investors and stimulate trading in selected MB warrants. Under the rebate arrangement, Macquarie agreed to reimburse investors, through their participating brokers, either in full or in part, the brokerage costs they were charged by their brokers for trading specified warrants.
In January 2002, SFC warned Macquarie that they should ensure their commission rebate scheme did not facilitate trading of MB warrants that was not for any genuine economic or commercial purpose. SFC was concerned that such scheme could encourage improper trading and lead to a false market for the MB warrants. SFC identified heavy trading activities in MB warrants between two clients from two participating brokerages during the period from January 2004 to January 2005. The two clients repeatedly traded the MB warrants at or near the same prices within short time intervals and created substantial amounts of turnover.
For example, in one particular warrant, on one day, two clients of two participating brokers engaged in about 400 trades between themselves in just over 60 minutes of trading with a transaction around every 10 seconds (being 90% of turnover on that day). The trades were conducted at or near the same prices within short time intervals and with effective brokerage commission costs below the amount of commission rebate paid by Macquarie. It appears the trading turnover of the relevant MB warrants was inflated and may have misled investors into believing that certain MB warrants were more actively traded than was actually the case.
While generating a significant amount of commission rebate from Macquarie, the two brokerages gave the clients discounts on brokerage costs for large volume trading. The two clients were then able to generate risk-free profit from the difference between the commission rebate and the discounted brokerage costs. Macquarie had put in place some controls to deal with the risk to market integrity and monitored the payment of commission rebate, but it failed to check whether the commission rebate scheme was providing clients with more money than was required to rebate actual brokerage costs. The volume and nature of the trading should have alerted Macquarie to make additional inquiries about the operation of the scheme and to check whether it was distorting the market for these MB warrants.
The SFC considers that if Macquarie had realised the true nature of this trading activity, Macquarie would have been obliged to ban those brokers from further participation in the commission rebate scheme. Macquarie eventually did ban some commission rebate scheme participants, but this was too late.
What are the root problems in my opinion? First, too many investors believe that actively traded warrants are "good" warrants. Second, SFC was wrong in releasing the warrant market in 2001. May I ask those frontline staff working for warrant houses a question: don't you feel guilty of teaching the general public to gamble?
Wednesday, March 18, 2009
Squawk Boxes
Have you heard about this term "squawk box"?
According to Investopedia:
SEC recently charged Merrill Lynch, Pierce, Fenner & Smith Inc. with securities laws violations for having inadequate policies and procedures to control access to institutional customer order flow information. Merrill Lynch agreed to settle the SEC charges and pay a US$7 million penalty, among other remedies. In a series of related cases, SEC previously sued brokers from Merrill Lynch and other broker-dealers and employees at the day-trading firms who used the information to illegally trade ahead.
According to the SEC proceedings, Merrill Lynch utilizes institutional equities "squawk boxes", which are internal intercom systems used by broker-dealers to broadcast institutional customer order information to traders and sales traders at the broker-dealer. From 2002 to 2004, several Merrill Lynch retail brokers at three branch offices permitted day traders at other firms to listen to confidential information on large unexecuted block orders of Merrill Lynch institutional customers. The Merrill Lynch brokers put their telephones next to the squawk boxes and let the day traders listen to the squawk box, often for the entire trading day. The day traders used the broadcasts to trade ahead of the orders placed by Merrill Lynch customers.
In fact, Merrill Lynch lacked written policies or procedures to limit which employees within the firm had access to the equity squawk box, to track which employees had access, or to monitor employees for possible misuse of the order information. This created conditions that rogue brokers could exploit, as happened in this case.
According to Investopedia:
- Squawk box is an intercom speaker often used on brokers' trading desks in investment banks and stock brokerages.
- It allows a firm's analysts and traders to communicate with the firm's brokers.
- Firms usually use squawk boxes to inform their brokers about current analyst recommendations, market events and information about block trades. This line of communication helps to keep brokers updated on important market factors and allows the firm to guide the trading of its brokers.
SEC recently charged Merrill Lynch, Pierce, Fenner & Smith Inc. with securities laws violations for having inadequate policies and procedures to control access to institutional customer order flow information. Merrill Lynch agreed to settle the SEC charges and pay a US$7 million penalty, among other remedies. In a series of related cases, SEC previously sued brokers from Merrill Lynch and other broker-dealers and employees at the day-trading firms who used the information to illegally trade ahead.
According to the SEC proceedings, Merrill Lynch utilizes institutional equities "squawk boxes", which are internal intercom systems used by broker-dealers to broadcast institutional customer order information to traders and sales traders at the broker-dealer. From 2002 to 2004, several Merrill Lynch retail brokers at three branch offices permitted day traders at other firms to listen to confidential information on large unexecuted block orders of Merrill Lynch institutional customers. The Merrill Lynch brokers put their telephones next to the squawk boxes and let the day traders listen to the squawk box, often for the entire trading day. The day traders used the broadcasts to trade ahead of the orders placed by Merrill Lynch customers.
In fact, Merrill Lynch lacked written policies or procedures to limit which employees within the firm had access to the equity squawk box, to track which employees had access, or to monitor employees for possible misuse of the order information. This created conditions that rogue brokers could exploit, as happened in this case.
Wednesday, March 11, 2009
Remote Participation of Hong Kong-Based Markets
Some people asked me such a question before: If financial firms located overseas place agency orders to trade securities / futures through SEHK / HKFE, are they required to be licensed by SFC? I would say if the firms place such orders to a local broker (of course licensed by SFC) for execution, then they are exempt from licensing. However, if they want to become direct exchange participants of SEHK / HKFE, they must be licensed.
Recent SFC published a consultation paper to address the issue of remote participation of Hong Kong-based markets (mainly SEHK and HKFE). SFC understands that globalization and advances in technology has made it possible for market players to access a market from a remote location without local presence. The current definitions of "dealing in securities" and "dealing in futures contracts" under SFO are wide enough to catch the dealing activities of all participants (including remote participants) of a Hong Kong-based market. However, SFC is unable to grant licences to participants unless they have a place of business in Hong Kong, which is not feasible.
To facilitate remote access to the local futures market and enlarge its investor base, SFC is proposing to amend the definition of "dealing in futures contracts" such that participants of a Hong Kong-based futures market do not need to be licensed by SFC if the following requirements are met:
Recent SFC published a consultation paper to address the issue of remote participation of Hong Kong-based markets (mainly SEHK and HKFE). SFC understands that globalization and advances in technology has made it possible for market players to access a market from a remote location without local presence. The current definitions of "dealing in securities" and "dealing in futures contracts" under SFO are wide enough to catch the dealing activities of all participants (including remote participants) of a Hong Kong-based market. However, SFC is unable to grant licences to participants unless they have a place of business in Hong Kong, which is not feasible.
To facilitate remote access to the local futures market and enlarge its investor base, SFC is proposing to amend the definition of "dealing in futures contracts" such that participants of a Hong Kong-based futures market do not need to be licensed by SFC if the following requirements are met:
- the market is operated by either an exchange company recognized by SFC or an automated trading services provider authorized by SFC;
- the participant must be a remote participant;
- the participant must not establish a place of business in Hong Kong, conduct any dealing activities in Hong Kong, serve Hong Kong clients, nor market their services to Hong Kong public; and
- the remote participant must be regulated, or be a participant of an overseas futures market which is regulated, in their home jurisdiction by a recognized regulator.
However, this time SFC is not introducing corresponding amendments to the definition of "dealing in securities" because SFC proposes to take a gradual approach to introducing remote participation in Hong Kong-based markets.
I think even such remote participants are not licensed by SFC, they would be indirectly regulated by SFC through the exchange rules and SFO provisions, especially for market integrity issues.
Wednesday, March 04, 2009
Remuneration Policies
One of the factors leading to the financial tsunami was "moral hazard" - investment bankers were motivated to take excessive risks in order to bet for a huge amount of bonuses without bearing the consequential losses. While the banks have been "nationalized", the remuneration policies would be expected to undergo a significant reform.
UK FSA recently published a draft code of practice on remuneration policies relevant to all FSA regulated firms. The aim of the code is to ensure that firms have remuneration policies which are consistent with sound risk management, and which do not expose them to excessive risk. However, It is not concerned with setting levels of remuneration, which are a matter for the boards of companies and their shareholders.
The specific principles of this code are highlighted as follows:
A. Governance
1. Boards and relevant remuneration committees should exercise independent judgement and demonstrate that their decisions are consistent with the firm's financial situation and future prospects. Their members should have the skills and experience to reach an independent judgement on the suitability of the remuneration policies, including the implications for risk and risk management.
2. The procedures for setting compensation within the firm should be clear and documented, and they should include measures to avoid conflicts of interest. Risk and compliance functions (in consultation with the firm's HR function as may be deemed appropriate) should have significant input into setting compensation for business areas.
C. Measurement of performance for long-term incentive plans
7. The measurement of performance for long term incentive plans, including those based on the performance of shares, should also be risk-adjusted.
D. Composition of remuneration
8. The fixed component of remuneration should be a sufficiently high proportion of total remuneration to allow the company to operate a fully flexible bonus policy.
9. The major part of any bonus which is a significant proportion of the fixed component should be deferred, with a minimum vesting period.
10. It is highly desirable that the deferred element of variable compensation should be linked to the future performance of the division or business unit as a whole.
UK FSA recently published a draft code of practice on remuneration policies relevant to all FSA regulated firms. The aim of the code is to ensure that firms have remuneration policies which are consistent with sound risk management, and which do not expose them to excessive risk. However, It is not concerned with setting levels of remuneration, which are a matter for the boards of companies and their shareholders.
The specific principles of this code are highlighted as follows:
A. Governance
1. Boards and relevant remuneration committees should exercise independent judgement and demonstrate that their decisions are consistent with the firm's financial situation and future prospects. Their members should have the skills and experience to reach an independent judgement on the suitability of the remuneration policies, including the implications for risk and risk management.
2. The procedures for setting compensation within the firm should be clear and documented, and they should include measures to avoid conflicts of interest. Risk and compliance functions (in consultation with the firm's HR function as may be deemed appropriate) should have significant input into setting compensation for business areas.
3. Compensation for staff in the risk and compliance functions should be determined independently of the business areas. They should have different performance metrics, with greater emphasis on the achievement of their own objectives.
B. Measurement of performance for the calculation of bonuses
4. Assessments of financial performance to calculate bonus pools should be principally based on profits. The bonus pool calculation should include an adjustment for current and future risk, and take into account the cost of capital employed and liquidity required.
5. Firms should not assess performance solely on the results of the current financial year.
6. Non-financial performance metrics, including adherence to effective risk management and compliance with regulations, should form a significant part of the performance assessment processC. Measurement of performance for long-term incentive plans
7. The measurement of performance for long term incentive plans, including those based on the performance of shares, should also be risk-adjusted.
D. Composition of remuneration
8. The fixed component of remuneration should be a sufficiently high proportion of total remuneration to allow the company to operate a fully flexible bonus policy.
9. The major part of any bonus which is a significant proportion of the fixed component should be deferred, with a minimum vesting period.
10. It is highly desirable that the deferred element of variable compensation should be linked to the future performance of the division or business unit as a whole.
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