HKSI LE Paper 2 Past Paper (1)

HKSI has recently released also the past paper (December 2006) of licensing examination Paper 2, which is usually taken by people who intend to become a responsible officer for Types 1/4/8 regulated activities. Again, I provide my explanations of the answers here.

HKSI LE Paper 2 (Dec 2006) - Q&A 1~20 (with explanations):

1(A) - Even a stock has been suspended for trading, those transactions completed before the suspension should be settled as usual. There is not such thing called Securities & Futures (Suspension of Trading) Rules. Nobody is entitled to any compension due to trading suspension.

2(C) - (I), (II) and (IV) are correct based on common senses of law. (III) is wrong because PDPO does not require the provision of access to personal data free of charge.

3(A) - (C) and (D) are too serious to pass the fit and proper standards. When comparing (A) and (B), obviously (A) is less adverse.

4(A) - Listing of companies is covered by Listing Rules. Issue of contract notes is covered by Securities & Futures (Contract Notes, Statements of Account and Receipts) Rules.

5(D) - Institutional investor is typically subject to less investor protection under SFO and thus not protected by Securities & Futures (Investor Compensation - Claims) Rules.

6(C) - (A) is wrong because annual audited accounts must be submitted to SFC within 4 months of the financial year end. (B) is wrong because appointment of an auditor must be notified to SFC within 7 business days. (D) is wrong because financial year end must be notified to SFC within 1 month.

7(B) - In (I), (II) and (III), the client can confirm that the intermediary has received his assets in an alternative way, thus issue of a receipt by the intermediary is exempted by the Rules.

8(B) - For records which are orders and instructions from clients, the record retention period required by the Rules is only 2 years, while 7 years is applicable to all other records.

9(A) - (I) is incorrect because the Fund would not cover certain professional investors and clients of certain intermediaries. (II) is incorrect because the Fund cover all securities traded on SEHK.

10(B) - (I) is wrong because contract notes must be issued within T+2. (IV) is wrong because the two intermediaries must agree in writing as to who will provide contract notes to the client.

11(C) - Segregation of client money within 1 business day is specified by the Rules.

12(D) - It is not practical for the licensed person to notify the client before dealing in options through another intermediary, thus (D) would not be included in the options client agreement.
13(B) - (B) is correct because such goods and services are of demonstrable benefits to the clients.

14(A) - "Prompt execution" and "best execution" are obviously related to the broker's level of diligence.

15(C) - The dealer has failed to fulfil the "prompt execution" requirement under the diligence principle under the Code.

16(C) - (III) is a requirement under Securities & Futures (Client Securities) Rules and thus can't be waived.

17(D) - (D) is wrong because tape records must be kept for at least 3 months.

18(D) - (I) is wrong because a guideline can never override the Code.

19(A) - Simply speaking, there are no such requirements as (III) and (IV) in the Listing Rules.

20(A) - Exchange traded options are traded on the Hong Kong Futures Automated Trading System (HKATS).

Market Misconduct by Overseas Entity

Last week SFC commenced proceedings under S.213 of SFO ("Injunctions and other orders") in the High Court against Tiger Asia Management LLC, a New York-based asset management company, and three of its senior officers, Mr Bill Sung Kook Hwang, Mr Raymond Park and Mr William Tomita. Founded in 2001, Tiger Asia specialises in equity investments in China, Japan and Korea. All of its employees are located in New York. Tiger Asia has no physical presence in Hong Kong.

According to an article of Finance Asia, the Tiger Asia fund is one of many Tiger-branded funds that have been seeded by the original Tiger Fund daddy, Julian Robertson. Hwang's Tiger Asia fund is among the first of the "Tiger baby" funds that Robertson began to nurture in 2000, after he had closed his own, massively successful hedge fund.

SFC has applied for an injunction order to freeze assets of Tiger Asia and the three senior officers, including those located overseas, up to $29.9 million. The amount is equivalent to the notional profit made by Tiger Asia in alleged insider dealing and market manipulation activities.

The proceedings followed an SFC investigation into suspected insider dealing and market manipulation by Tiger Asia and the three senior officers in relation to dealings in the shares of China Construction Bank Corporation (CCB) on 6 January 2009.

SFC alleges that:

• on 6 January 2009, before the market opened, a placing agent in Hong Kong invited Tiger Asia to participate in a proposed placement of CCB shares in Hong Kong by the Bank of America Corporation (BOA);
• the placing agent told Tiger Asia about the size and the discount range of the proposed placement;
• this information was confidential and price sensitive and Tiger Asia and the three senior officers knew this;
• Tiger Asia then short-sold a total of 93 million CCB shares on 6 January 2009 ahead of the public announcement of the CCB placement;
• Tiger Asia covered its short sales out of the placement shares that it bought on 7 January 2009 at a discount to the prevailing market price; and
• Tiger Asia made a substantial notional profit of $29.9 million.

SFC also:

• alleges downward manipulation of CCB share price by Tiger Asia on 6 January 2009 at the time of the short sales;
• is seeking final orders against Tiger Asia and the three senior officers, including orders to unwind the relevant transactions if the court finds the transactions have contravened SFO and to restore affected counterparties to their pre-transaction positions;
• considers it necessary to seek a freezing order to ensure there are sufficient assets to satisfy any restoration orders that may be made by the court; and
• is seeking orders to prevent Tiger Asia and the three senior officers from trading in listed securities and derivatives in Hong Kong in similar circumstances.

Overseas entities might think that SFC can never taken any legal / regulatory action against their insider dealing and market manipulation because they are not located at Hong Kong. Let's see if SFC can "beat the tiger" this time.

Licensing Requirements for Selling ILAS

Last week SFC issued a circular to clarify the licensing requirements arising out the promotion, offering or sale of investment-linked assurance schemes (ILSA) by insurance intermediaries (agents and brokers) to the public.

Regulated activities relating to the sale of ILAS are Type 1 (dealing in securities) and Type 4 (advising on securities). ILAS by itself is defined as a collective investment scheme (CIS) but excluded from the definition of "securities" under SFO. The question is whether advising clients acquiring ILAS on the selection of underlying funds would constitute dealing in securities or advising on securities.

In its circular, SFC highlights that premium payments made by ILAS policyholders are first applied in respect of fees and commissions, with the balance being paid to the insurer and notionally invested in the underlying funds specified by policyholders. Although it is the performance of these underlying funds that determines the value of the ILAS policy from time to time, the policyholder's premium payments are not invested in these underlying funds for them. Instead, these investments, if made, are for the account of the insurer itself.

SFC takes the view that advising or making recommendations to policyholders concerning the selection by them of the underlying funds of ILAS, does not constitute advising on securities, even if those underlying funds are securities. The reasons are as follows:

• Advising on securities, within the meaning of SFO, is concerned with advice relating to the acquisition or disposal of securities by the person being advised. In the case of ILAS, the underlying funds are not acquired or disposed of.
• Advice given to ILAS policyholders is only concerned with selection of underlying funds whose performance will notionally be used to calculate the value of the ILAS policy from time to time.

SFC also takes the view that promoting, offering or selling ILAS to the public (including giving advice to policyholders concerning selection of underlying funds) does not constitute dealing in securities, which is defined as making an agreement with another person or inducing another person to enter into an agreement (a) for acquiring, disposing of, subscribing for or underwriting securities; or (b) the the purpose of which is to secure a profit from the yield of securities or by reference to fluctuations in the value of securities. The reasons are as follows:

• Units in ILAS are not securities.
• Underlying funds of ILAS are not acquired or disposed of for the policyholders.
• It can't be said that the purpose (or even the dominant purpose) of acquiring an ILAS policy is to secure a profit from fluctuations in the value of underlying funds.
• SFO definition of dealing in securities excludes the issue of any advertisement, invitation document authorized by SFC.

Even if advising concerning ILAS underlying funds were regarded as advising on securities or dealing in securities, SFC considers that there would be no carrying on of a business in these regulated activities. This is because advising concerning ILAS underlying funds:

• does not stand alone as a discrete business carried on its own right
• by itself does not generate any financial gain
• appears to occur haphazardly
• does not indicate the existence of an established and ongoing business principally involving that particular activity

Two important implications could be derived from this circular. First, insurance intermediaries would no longer be regulated by SFC when they are selling (or mis-selling) ILAS and advising (or mis-advising) ILAS underlying funds. Second, in future the number of licensed corporations and representatives would be substantially reduced because:

• Selling of direct funds (no matter by banks, brokers or so-called IFA) constitutes only dealing in securities, not advising on securities.
• Corporations / representatives licensed for Type 1 could advise on securities without Type 4 based on the "wholly incidental" exemption.
• Advising concerning ILAS underlying funds is no longer regarded as Type 4.

You may doubt whether this SFC circular is also relevant to promotion, selling or offering of MPF schemes (which are also regarded as CIS but not securities under SFO). My interpretation is that even selling of MPF schemes does not constitute Type 1, advising concerning constituent funds of MPF schemes may still fall within Type 4 because, unlike ILAS, constituent funds are acquired or disposed of for employee participants.

SFC had better issue a separate circular to clarify the licensing requirements for selling of MPF schemes. If MPF intermediaries were also exempt from licensing, then we may envisage that in future only equity research analysts need to be licensed for Type 4.

Flash Orders

Flash orders have been used for years but have become increasingly popular in recent months as more traders and exchanges adopted the approach. Last week WSJ reported that US SEC is considering a ban of flash orders. The Chairman Mary Schapiro said she has asked SEC's staff to develop a proposal to eliminate the inequity that results from flash orders.

Flash order technology means high-frequency trading, a lightning-fast, computer-based trading technique. It allows some traders to have a sneak peek at market activity, giving high-frequency traders an advantage over retail investors.

Flash orders were pioneered by the Chicago Board Options Exchange's stock exchange earlier this decade as that exchange looked for a way to improve execution speeds. Flash remained a niche part of the industry until around June 2006, when a small stock-trading platform, Direct Edge, owned by Knight Capital Group Inc., adopted the practice. Now, Direct Edge is the third-largest stock trading platform by matched volume in the country. Its success has helped prompt competitors to adopt their own versions of flash.

In a flash order, a firm wishing to buy or sell stock can elect to freeze the order on an exchange for as long as half a second. This move can have several effects, one of which concerns a system of rebates and fees on trading orders. Typically on trades, exchanges pay rebates to traders who post shares to buy or sell and charge fees to traders who respond to those offers. This setup creates an incentive to earn rebates. A flash order puts a trader in the position of poster, rather than responder. The hope is that another trader who needs to buy or sell quickly steps in on the other side of the trade. This dynamic boosts the chance the flash-order trader will complete the trade on the exchange and get the rebate.

The following diagram found from the internet explains how flash orders work:

Critics say that flash orders give the high-speed traders a window into the direction of the market, giving them the ability to trade at lightning speeds ahead of less fleet-footed investors. On the other hand, flash-order advocates say the orders help traders get better prices. They say a ban could cause trading volume to drop on the exchanges that permit flash as traders look for better execution in alternative, less-transparent venues.

Meanwhile, in a sign of regulators' growing concern about evolving electronic trading, SEC staff is also studying rules for so-called dark pools, private electronic-trading networks that match buyers and sellers anonymously. The pools have been gaining market share in recent years as more trading firms use them.

SEC staff is looking at requiring disclosure of post-trade information to show which dark-pool operator is executing which trades, according to people familiar with the matter. That would give investors a better idea of the liquidity and depth of a particular operator. SEC is also considering whether to have the information disclosed on a real-time basis or collected and disclosed in an aggregate form.

Another area under review is the "indications of interest," which are similar to flash orders. If an exchange can't execute an order, it will look at indications of interest from a number of dark pools. Rather than flash the order for a potential mate, the exchange can route it through the dark pools that expressed indications of interest.

Are you dazzled by the flash?

Inter-dealer Brokers

SFC recently issued a circular to clarify the licensing obligations of inter-dealer brokers. Typically, inter-dealer brokers carry on the business of facilitating transactions between institutional clients and financial institutions in relation to a wide range of financial instruments, including listed securities and futures contracts, listed structured products, unlisted fixed income products and OTC derivatives. Transactions in listed instruments may be effected by inter-dealer brokers OTC or through an exchange.

SFC's concern is that some inter-dealer brokers might be carrying on a business in a regulated activity in Hong Kong, without having been appropriately licensed under SFO. The licensing obligation is largely dictated by the nature of the financial instruments that they trade, their clients and the booking structures which they employ. However, it is likely in most cases that inter-dealer brokers are carrying on a business in Type 1 / 2 / 3 regulated activity. Accordingly, it must be appropriately licensed unless it can rely upon any of the exemptions stipulated in SFO.

Some inter-dealer brokers might take the view that they are not required to be licensed because they are able to rely upon the "as principal" exemptions provided for in the definitions of "dealing in securities" and "dealing in futures contracts". However, SFC points out that these "as principal" exemptions are quite narrow in their scope and that some of their business activities might well fall within the above definitions.

In particular, SFC does not interpret the "as principal" exemptions as being applicable to transactions such as back-to-back arrangements which involve the temporary interposition of a third party (such as an inter-dealer broker) between the parties who are, in the real sense, the buyer and the seller. Where a broker routinely facilitates or effects such transactions by entering into back-to-back contracts with the buyer and with the seller, it is not able to rely on the "as principal" exemptions. There is no "as principal" exemption provided for in the definition of "leveraged foreign exchange trading".

Some inter-dealer brokers which are approved money brokers under Banking Ordinance might take the view that they are not required to be licensed under SFO because they are able to rely upon the "money broker" exemptions provided for in the definitions of "dealing in securities" and "leveraged foreign exchange trading". Again, SFC states that these "money broker" exemptions are quite narrow in their scope. There is no "money broker" exemption provided for in the definition of "dealing in futures contracts".

In determining whether an inter-dealer broker is able to rely upon the licensing exemptions stipulated in SFO, SFC takes into account all of the relevant facts and circumstances and, in particular, whether the business model of the broker primarily involves agency brokerage.

SFC's clarification in this circular may be coming late because I've heard many inter-dealer brokers in Hong Kong are not aware of their licensing obligations.

Enhancement of AML Regulatory Regime for Financial Sectors

At mid-July 2009, FSTB has launched a 3-month public consultation on its legislative proposals to enhance the anti-money laundering (AML) regulatory regime for the financial sectors. The proposals include codifying the customer due diligence and record-keeping requirements for financial institutions in law and putting in place an AML regulatory regime for remittance agents and money changers. The aim of the proposals is to address the deficiencies indentified by the FATF its evaluation of Hong Kong.

Summary of the key proposals are set out below:

Proposed Scope of the Future Legislation

• The proposed legislation will apply to the following financial institutions:

1. Authorized institutions (banks/deposit-taking institutions)
2. Licensed corporations regulated by SFC
3. Insurance companies and intermediaries carrying on or advising on long term business (i.e. life insurance)
4. Remittance agents and money changers (RAMCs)

• SFC, HKMA, OCI and C&ED will be designated as regulatory authorities to supervise compliance in respect of the securities, banking, insurance and RAMC sectors respectively.

Obligations of financial Institutions, Powers of the Regulatory Authorities and Offences and Sanctions

• The financial institutions will be required to implement CDD and record-keeping requirements in accordance with international standards, which are not substantially different from the existing requirements set out in the guidelines issued by the financial regulators.
• The regulatory authorities will issue guidelines on the statutory obligations to facilitate compliance.
• The regulatory authorities will be empowered to supervise compliance. These powers will be modeled on relevant powers in SFO, including powers to:

1. access to financial institutions' business premises for routine inspections
2. access to, extract or make copies of books and records of the financial institutions
3. require information and answers from financial institutions, staff and counterparties in investigation into suspected breaches
4. enter into and search a premises and seize documents/records and other items upon warrants
5. impose supervisory sanctions, including fines, public reprimand, suspension or revocation of licence having regard to the fitness and properness of the regulatees, and issue directions on remedial actions to be taken
6. prosecute offences summarily
7. share and exchange information with local and foreign authorities

• There will be appropriate checks and balance in the system, including the establishment of an independent appeals tribunal to hear appeals lodged by financial institutions against regulatory authorities' decisions made under the proposed new legislation.
• A financial institution commits an offence under the proposed new legislation only if it breaches the statutory customer due diligence and/or record-keeping requirements without reasonable excuses.
• No one will commit an offence under the proposed new legislation solely due to inadvertence on his/her part. A member of the management of a financial institution will be personally liable in case of a breach by the financial institution only if the breach was committed with his/her consent, connivance of, or is attributable to any recklessness on his/her part. Other staff members of the financial institution commit an offence only if they willfully breach the statutory obligations.
• The maximum level of penalty of the criminal sanctions will be specified in the new legislation, which will be determined by drawing reference from sanctions for offences of similar nature.

Licensing of the Remittance Agents and Money Changers

• A licensing system for RAMCs to be administered by the C&ED will be put in place. It will provide "fit and proper" test and other licensing criteria. Granting of new or renewed licences will be subject to a specified fee, to be determined on the cost recovery principle. C&ED will make regulations to prescribe the application and processing matters.
• To tackle unlicensed activities, carrying on a remittance and money changing business without a licence would be a criminal offence with penalty of fine and/or imprisonment.
• C&ED would be conferred with appropriate powers to take enforcement action against unlicensed RAMCs, such as the power to arrest/seizure as the Police currently have in administering the registration system for RAMCs under the Organized and Serious Crimes Ordinance.

Abuse and Fraud Prevention in Private Banking and Wealth Management

The recent case of misappropriation of private banking client assets by a former relationship manager of Hang Seng Bank should have stimulated the nerve of HKMA. Last week HKMA issued a circular to share with banks on some of the lessons learnt recently on staff abuses and frauds in private banking and the higher end of retail wealth management business.

HKMA considers that a unique characteristic of PB is the close relationship between customer and relationship manager (RM) and the "all-inclusive" money management services provided by the RMs to their customers. Unless strong management control and oversight are maintained, the close customer-RM relationship, as well as the large amount involved in transactions, may make it susceptible to staff abuses or even frauds, such as unauthorized transactions and misappropriation of client funds.

This circular sets out some of the lessons learned recently on the prevention of staff abuses and frauds in PB, particularly in the areas of hold-mail service, address changes, and escalation and prompt reporting of non-compliance and suspicious transactions. In addition, the attachment to this circular puts forth some good practices in general on management control and oversight to minimise chances of staff abuses and frauds in PB operations.

• Control on hold mail service and address change - Customers should receive bank statements on their cash and investment transactions. Some banks provide hold mail service to their customers (because for instance the customers demand a confidential relationship). This may be open to abuse such as concealment of unauthorized transactions as customers may not be able to verify the accuracy of their cash and investment transactions in a timely manner. In general, banks should not allow hold mail service. If the customer insists on this service, banks must have control measures in place to mitigate the risks. These controls should include having such applications (which should be submitted in writing by the customer) reviewed and approved by the supervisory staff of the responsible RM and the compliance department, separating custody of the customer's mail and independent reconfirming with customers requesting this service by an independent person in the back office. Also, there must be a limit on the period (no more than 3 months) within which the customer must collect their mails held by the bank from a person independent of the RM, such as the back office. There should also be an independent process to verify and approve change of customer address and request for cheque books handled by the RM.
• Staff compliance - Banks should adopt zero tolerance for exceptions in processing cash withdrawals or fund transfers. If exceptions are provided, they should be subject to independent and close monitoring. Non-compliant staff should be given formal warning and/or disciplined.
• Whistle blowing and reporting of suspicious cases - As shown in a number of abuse and fraud cases, the junior staff may feel compelled or be intimidated to cooperate with the culprit despite observing irregularities. Senior management of banks must be made aware of any suspicious cases involving possible criminal elements in a timely manner. To this end, banks should have policies and procedures in place on when and how to escalate suspicious cases (which may arise from customer complaints, MIS reports, or whistle blowing by another staff) to the senior management for attention. A hotline or compatible reporting channels should be set up for staff to report in confidence irregular activities encountered at work to an independent unit such as Compliance or Internal Audit. In addition, whenever there is a suspected case involving possible criminal elements, banks are expected to report the incident to both the Police and HKMA in a timely manner.
• Transaction control and monitoring - If left unchecked, a close customer-RM relationship may make unauthorized fund transfers/withdrawals and investment transactions more susceptible because of the customer's trust and reliance on the RM. Activities of RMs should be subject to frequent (preferably daily) reporting to and review by their supervisors. Banks should develop an independent and robust process to review and confirm client orders, and cash transfers/withdrawals over certain value and investment instructions handled by the RM. For high risk transactions, such as transfers to unregistered third parties, banks should have procedures to confirm these transactions with the customers, such as phone call-back by an independent person of the back office or by SMS messages to the customers. Also, banks should have in place a system to sample check and monitor irregular transactions. Where irregular, unusual, high-risk, or suspicious transactions are identified, back-end checkers should call back customers to seek confirmation. More checks on transactions should be carried out on customers who are old-aged, reside outside Hong Kong, or have opted for hold mail service. There should also be management monitoring and review of staff's transactions through the bank to ensure that any irregularities (such as any unusual increases in securities trading) can be explained or investigated.

Banks should review their PB operations to ensure that their controls are effective, having regard to the points mentioned above and the good practices set out in the attachment. Banks which have grown rapidly in this area and which have not carried out any review in the past year should conduct the review as a matter of priority. Going forward, HKMA will examine selected Banks' PB operations and retail wealth management to assess the sufficiency of their management control and oversight.

Overall speaking, I would say a private bank is bearing the same level of operational risk as a securities house.