Mis-selling of Accumulator

Before the incident of Lehman Minibond, many private banking clients had already complained on mis-selling of accumulator. Though these cliens were typically professional investors and thus accumulator was not authorized by SFC, it did not mean selling of such product to them was not subject to suitability obligations.

Last week (SFC) has prohibited Ms Ronnie Wong Wang, a former client adviser at Goldman Sachs (Asia) LLC, from re-entering the industry for two years.

An SFC investigation found that:

• in November 2007, Wong entered into an accumulator transaction with a total exposure of $13.8 million on behalf of a high net worth client without the client’s instructions, knowledge and proper authorisation;
• in December 2007, Wong prepared a spreadsheet for the client which contained inaccurate information in that it did not present a true picture of the client's portfolio. The spreadsheet included profits that had not yet accrued and overstated the client’s earnings by US$1.72 million.
  

Wong admitted to SFC that she had entered into the accumulator transaction without proper authorisation. However, she claimed it was a good investment and the client normally accepted her recommendations. Although the client signed a confirmation of the transaction in January 2008, she complained to SFC about the unauthorised transaction in March 2008.

Private banking is a business model where the clients place a high degree of trust on the advisers, especially when the advisers can make huge profits for them. When the clients has realized that the trust could be abused, it's the right time for private banks to change the culture.

Manipulated Settlement Process

SFC has recently banned Ms Agnes Li and Ms Chan Sheung Ling, both former employees of Hang Tung Securities Ltd, from re-entering the industry for life.

An SFC investigation revealed that between July 2000 and April 2007 Li used her sister's account with Hang Tung to carry out personal trades in securities. Li started incurring substantial trading losses in her sister's account in February 2006 and losses in that account continued to rise thereafter. Li manipulated the settlement process to avoid paying for the losses and she owed Hang Tung $3.8 million as at April 2007.

In order to conceal the losses, Li utilised the settlement process as a credit facility. She used proceeds of sales of securities (settled before T+2) to offset amounts due for subsequent purchases of securities (settled beyond T+2). Li then gave the relevant bought or sold notes to Hang Tung's settlement department which processed the trades according to information supplied by her. On many occasions, Li was able to match proceeds from the sales against the amounts due for her purchases, and she only ended up paying or receiving a small difference. As a result of such an arrangement, Li never settled her trades in full and her losses rolled over.

During these times, Chan oversaw the Accounts and Settlement Department at Hang Tung. By allowing Li to offset the cost of her purchases against the sales, Chan's conduct facilitated the concealment of Li's failure to settle the transactions in full since the actual outstanding amount in the account of Li's sister was not reflected in certain internal reports.

Chan also used inaccurate internal reports to compile Hang Tung's financial returns and used sale proceeds due to another client to settle the account of Li's sister, which is in breach of the Client Money Rules and Hang Tung's written policy.

This case again demonstrates an important fact: front-line staff can't perfectly commit fraud without the facilitation of a corrupted back office.

Retail Distribution Review

In June 2006, UK FSA launched the Retail Distribution Review (RDR), looking at how investments are distributed to retail consumers in the UK. Through the review, they identified various long-running problems that impact on the quality of advice and consumer outcomes, as well as confidence and trust, in the UK investment market. Following extensive discussion with industry and consumer representatives, they are now proposing amendments to regulatory requirements to deliver various changes.

FSA's proposals involve:

Improving clarity for consumers about advice services

• They are proposing changes to make it easier for consumers to distinguish between the different forms of advice on offer to them, with all investment firms clearly describing their services as either "independent advice" or "restricted advice". Their rules and guidance will ensure that firms that describe their advice as independent genuinely do make their recommendations based on comprehensive and fair analysis, and provide unbiased, unrestricted advice. Equally, where consumers choose to use a restricted service - such as a firm that can only give advice on its own range of products - this will be made clear.

Addressing the potential for remuneration bias ("Adviser Charging")

• All firms that give investment advice must set their own charges, in agreement with their clients, and will have to meet new standards regarding how they determine and operate these charges. The proposals bring to an end the current, commission-based system of adviser remuneration: they propose to ban product providers from offering amounts of commission to secure sales from adviser firms and, in turn, to ban adviser firms from recommending products that automatically pay commission. Consumers will still be able to have their adviser charges deducted from their investments if they wish, but these charges will no longer be determined by the product providers they are recommended.

Increasing professional standards of advisers

• We plan to raise the minimum level of qualification for investment advisers, and to institute an overarching Code of Ethics and enhanced standards for continuing professional development. They are also proposing visible maintenance and enforcement of these standards through the establishment of a Professional Standards Board.

FSA has recently issued the consultation paper "Distribution of retail investments: Delivering the RDR", which sets out detailed proposals to implement the wide-ranging reforms. The changes, which will take effect from the end of 2012, will improve outcomes for savers and investors by enhancing the quality of advice they receive, and prepare both consumers and the industry for the future.

This paper may serve as a good reference for the Hong Kong regulatory regime.

Legal Professional Privilege

In response to numerous complaints on SFC's authorization of Lehman Brother Minibonds, SFC has alleged that the regulatory focus for authorizing product documentation is on disclosure rather than on the commercial merits of the investment. However, SFC would examine whether any facts, matters or circumstances that should have been disclosed to SFC were not disclosed by the Minibonds issuers and their advisers at the time the offer prospectuses and marketing materials were submitted for vetting.

Recently SFC has applied to the High Court for an order directing Lehman Brothers Asia Ltd (in liquidation) to comply with an SFC Notice to produce certain records in connection with its investigation of the offer and marketing of Minibonds. The Notice required Lehman Brothers to produce to SFC all documents relating to the assessment of Minibonds by an internal Lehman Brothers committee called the New Product Review Committee.

SFC believes the Committee oversaw or approved products including the Minibonds and that these documents are relevant to its investigation. In response to the Notice, lawyers for Lehman Brothers produced certain documents but objected to the production of 17 other documents on the grounds that these documents should not be produced because they were the subject of a claim of legal professional privilege. It appears the claim arises because a member of the Committee was an in-house lawyer at Lehman Brothers.

SFC disputes that the entire contents of these documents are necessarily the subject of a valid claim of legal professional privilege and asserts that they should be produced to SFC in compliance with the Notice. Discussions between SFC and the liquidators of Lehman Brothers and their lawyers, since December 2008, have not resolved this claim of privilege. In bringing this proceeding before the court, SFC wants to ensure there is an independent adjudication on the issue.

Legal professional privilege is an interesting subject of debate in this case. It protects communications between a lawyer in his professional capacity and his client, provided they are confidential and are for the purposes of seeking or giving legal advice. However, in general documents sent to or from an independent third party (even if created with the dominant purpose of obtaining legal advice) should not be covered by this privilege. I am interested to know what exactly the documents SFC is looking for.

Rampant Churning

US SEC and Alabama Securities Commission (ASC) recently charged a broker-dealer in connection with rampant churning of customer accounts, widespread supervisory failures, and other securities violations that resulted in significant harm to clients and substantial profit to the firm. Also charged by SEC and ASC were several of the firm's senior officers and registered representatives. Churning is a fraudulent practice that occurs when a broker engages in excessive trading without regard to the customer's investment objectives for the purpose of generating commissions and other revenue.

SEC alleges that Aura Financial Services and six registered representatives used fraudulent sales practices and high-pressure sales tactics to convince customers to open and invest money in Aura brokerage accounts, which the brokers subsequently churned. Aura and the brokers enriched themselves with approximately US$1 million in commissions and other fees paid by the customers while largely depleting the customers' account balances through trading losses and excessive transaction costs.

ASC issued an amended order to show cause against Aura and three of its senior officers, based upon the findings of several ASC audits. The order alleges that Aura and the three managers violated their supervisory and compliance responsibilities under the Alabama securities laws. Despite the fact that many of the firm's representatives had criminal or disciplinary backgrounds and multiple prior customer complaints, Aura and the three managers failed to adopt appropriate procedures, failed to enforce rules, failed to conduct branch office inspections, and failed to maintain files of and follow up on customer complaints.

In addition to alleging the supervisory failures, ASC also cited Aura with unauthorized trading by a former representative which included trading after the death of the trustee. The firm's representatives operated under the "honor system" and documentation evidencing active oversight was lacking. Aura failed to perform independent review of customer complaints and summarily dismissed certain complaints based solely on the representations of their agent or representative.

The amended order requires Aura, within 28 days, to show cause to ASC why its registration as a broker-dealer and agent in the State of Alabama should not be suspended or revoked. The named supervisors in ASC's order are Timothy M. Gautney, Aura's founder and Chief Operation Officer; Loyd Gilford King, Aura's Corporate Treasurer; and John Wesley Woodruff, Jr., Aura's Chief Compliance Officer.

SEC's complaint has charged six current and former Aura registered representatives located in branch offices in Florida and New York. SEC alleges that the scheme began in approximately 2005. Although some of the misconduct stopped when two of the registered representatives left Aura in August 2008, the scheme continued through at least April 2009.

What a house of thieves!

Unregulated Financial Markets and Products

In May 2009, IOSCO's Technical Committee published "Unregulated Financial Markets and Products - Consultation Report". The Report contains interim recommendations for regulatory action designed to improve confidence in the securitisation process and the market for credit default swaps (CDS). The interim recommendations contained in the Report address issues of immediate concern with respect to securitised products and CDS. Securitised products include asset-backed securities (ABS), asset-backed commercial paper (ABCP) and structured credit products such as collateralised debt obligations (CDOs), synthetic CDOs, and collateralised loan obligations (CLOs).

While encouraging industry responses in the securitisation process and CDS market, IOSCO recognises that industry initiatives alone will not be sufficient to restore transparency, market quality and integrity and has therefore formulated a number of interim recommendations to address the following concerns associated with both these areas.

Securitisation

Interim Recommendation 1 – Wrong Incentives

1. Consider requiring originators and/or sponsors to retain a long-term economic exposure to the securitisation;
2. Enhance transparency through disclosure by issuers of all checks, assessments and duties that have been performed or risk practices that have been undertaken by the underwriter, sponsor and/or originator;
3. Require independence of experts used by issuers; and
4. Require experts to revisit and maintain reports over the life of the product.

Interim Recommendation 2 – Inadequate risk management practices

1. Mandate improvements in disclosure by issuers including initial and ongoing information about underlying asset pool performance and the review practices of underwriters, sponsors and/or originators including all checks, assessments and duties that have been performed or risk practices that have been undertaken. Disclosure should also include details of the creditworthiness of the person(s) with direct or indirect liability to the issuer;
2. Strengthen investor suitability requirements as well as the definition of sophisticated investor in this market; and
3. Encourage the development of alternative means to evaluate risk with the support of the "buy-side".

Interim Recommendation 3 – Regulatory structure and oversight issues

IOSCO recommends that jurisdictions should assess the scope of their regulatory reach and consider which enhancements to regulatory powers are needed to support the interim recommendation #1 and #2 in a manner promoting international coordination of regulation.

Credit Default Swaps

Interim Recommendation 4 – Counterparty Risk and Lack of Transparency

In forming the interim recommendations below, IOSCO considered the establishment of central counterparties (CCPs) for the clearing of standardised CDS as an important factor in addressing the issues of counterparty risk and transparency.

Interim Recommendation 5 – Regulatory structure and oversight issues

IOSCO recommends that jurisdictions should assess the scope of their regulatory reach and consider which enhancements to regulatory powers are needed to support the interim recommendation #4 in a manner promoting international coordination of regulation.

Program Trading & Pre-Hedging

FSA recently banned and fined trader Nilesh Shroff for deliberately disadvantaging his customers by "pre-hedging" trades without their consent. Shroff has been prohibited from performing any regulated function on the grounds that he is not fit and proper and has been fined £140,000.

While Shroff was a senior trader at Morgan Stanley, FSA found that he disadvantaged his clients on seven occasions between June and October 2007 by partially "pre-hedging" program trades without the clients' consent.

At the material time, Mr Shroff's position at Morgan Stanley was executive director, risk-trading program and his role included the management of the programme trading risk book and the facilitation of program trades on behalf of clients. This involved the preparation of pricing and the execution of trades and the ongoing management of the risk portfolio. The overall objective of the risk book was to manage risk from customer trades.

"Program trading" is the term used to describe a transaction or series of transactions by an institution when acquiring or disposing of an entire portfolio or a material part of a portfolio. Program trades can be all "one way" or a combination of buys and sells.

All the program trades made by Mr Shroff on behalf of clients were made on a principal (rather than agency) basis. For a principal trade, typically a number of brokers will be asked to tender to acquire the portfolio from or for the institution, quoting a premium or discount to the mid-price for each security at a designated strike time, which is known as the "snap". The premium or discount (the "risk fee") is expressed in a number of basis points. Transactions with brokers are often conducted via an institution's centralised dealing desk.

Principal trades are attractive to customers who want to undertake a large number of trades at the same time but do not want to assume the risk of the share prices moving against them in the period between the commencement and completion of trading. The broker assumes that risk in return for the risk premium.

The execution of a principal programme trade usually involves the following steps:

1. The customer provides limited information about its portfolio, e.g. sectors and percentages of average daily volume ("ADV"), to a number of brokers to enable them to assess the risk and quote for the trade, but without disclosing the component securities and, usually, whether the customer is a buyer or a seller in respect of each;
2. The customer receives the quotes from the brokers;
3. The customer reviews the quotes and awards the trade to one of the brokers;
4. The customer communicates the award to the winning broker and a snap time is agreed;
5. The customer provides the broker with the full details of the component securities and indicates whether they are buying or selling; sometimes this information is provided before the snap but more usually afterwards. In the case of the trades referred to in this notice, details of the portfolios were provided to Morgan Stanley before the snap;
6. Each stock is supplied to or purchased from the customer by the broker at the snap time at the quoted premium or discount to the mid-market price.

"Pre-hedging" refers to trading by a broker for his firm's benefit in advance of carrying out a trade for his customer, using information provided by that customer. Where customers instructed Shroff to buy particular stocks, he bought those stocks for the firm first, causing the price to increase before he executed the customers' trades. Where the customer order was to sell he first sold on behalf of the firm, decreasing the price. Shroff knew such unauthorised pre-hedging was expressly prohibited by FSA and Morgan Stanley's policies and not in his clients' interests.

It appears that pre-hedging is a kind of front-running in the context of program trading.