SDI Breach

In an article SDI breaches go dark at SFC dated 6 October 2009, David Webb voiced out that SFC has quietly stopped disclosing details of successful prosecutions for breaches of the securities disclosure-of-interests (SDI) provisions of SFO, including the name of the offender and the company whose shares are involved. Probably "alerted" by this article, SFC has recently resumed the practice of disclosing prosecution for SDI breaches.

On 26 November 2009, SFC announced that the High Court has dismissed an appeal by Mr Liu Su Ke against his conviction in June 2009 for failing to disclose his interest in shares in Warderly International Holdings Ltd (607.hk). Liu had earlier appealed against his conviction on two counts of failing to notify both SEHK and Warderly within three business days of becoming aware that he had acquired an interest in 231.8 million Warderly shares. Liu was convicted on 2 June 2009 in Eastern Magistracy on two summonses and fined the sum of $5,000 in respect of each summons.

On 28 December 2006 Liu received, from Mr Yeung Kui Wong, the chairman and an executive director of Warderly at the time, a deposit of certificates for 231.8 million Warderly shares together with share transfer documents as security for a loan of $6 million to a subsidiary of Warderly. As part of the arrangement, Liu obtained an irrevocable right to sell the shares to the extent of any failure by the subsidiary to repay the loan. On that basis, SFC contended and the Court found that Liu acquired a notifiable interest in the shares which he failed to disclose within three business days after becoming aware of his interest as required under SFO. Accordingly, the judge has dismissed the appeal and upheld the convictions.

In delivering the judgement, the judge considers a number of important legal issues concerning the enforcement of the obligation to disclose notifiable interests in listed securities including whether the absence of a reasonable excuse for not disclosing is an element of the offence, whether the offence is one of strict liability and the presumption of innocence.

SFC has successfully prosecuted 70 charges of failing to disclose a notifiable interest or change of interest so far this financial year against 11 individuals.

Email Supervision Failures

Last month US FINRA fined MetLife Securities and three of its affiliates a total of US$1.2 million for failing to establish an adequate supervisory system for the review of brokers' email correspondence with the public. The fine also resolves charges of failing to establish adequate supervisory procedures relating to broker participation in outside business activities and private securities transactions.

From March 1999 to December 2006, MetLife Securities and its affiliate broker-dealers had in place written supervisory procedures mandating that all securities-related emails of brokers be reviewed by a supervisor. However, the firms did not have a system in place that enabled supervisors to directly monitor the email communications of brokers. Instead, the firms relied on the brokers themselves to forward their emails to supervisors for review. To monitor compliance with the email-forwarding requirement, the firms encouraged — but did not require — managers to inspect brokers' computers for any emails that had not been forwarded as required. But brokers were able to delete their emails from their assigned computers, thus rendering spot-checks unreliable.

The firms also conducted annual branch audits, which were likewise ineffective because they did not allow for timely detection of email-forwarding failures. Moreover, the method employed by the auditors to identify email-forwarding deficiencies (prior to July 2005) was itself flawed, consisting mainly of a review of hard-copy files for any correspondence (including emails) that had not been forwarded. Brokers were therefore able to withhold emails without detection by the firm and conceal evidence or "red flags" of misconduct contained in their emails.

During the period from March 1999 through December 2006, two MetLife Securities brokers engaged in undisclosed outside business activities and private securities transactions without detection by the firm, although the misconduct was reflected in more than 100 separate emails that the brokers sent or received using their MetLife Securities email addresses. MetLife Securities did not discover the misconduct of either broker through supervisory review of emails because the brokers did not forward their emails to their respective supervisors.

MetLife Securities ultimately discovered that one of those brokers, Mark Salyer, stole nearly US$6 million from his customers in connection with his participation in numerous private securities transactions to raise capital for real estate development companies with which he had a relationship. In January 2009 SEC barred Salyer from association with any broker, dealer or investment adviser. FINRA's investigation of the misconduct of the other MetLife broker is continuing.

FINRA also found that the firms' inability to ensure compliance with the email-forwarding requirement meant they could not adequately enforce their own supervisory procedures relating to outside business activities and private securities transactions.

Monitoring of staff emails is not a simple matter. Apart from corporate email accounts, dealing malpractices may also be detected from webmail accounts. How could such monitoring be done without infringing privacy?

Concealment of Unauthorised Trading Losses

UK FSA recently fined UBS AG £8million for systems and controls failures that enabled employees to carry out unauthorised transactions involving customer money on at least 39 accounts.

The unauthorised activity, which took place between January 2006 and December 2007 at UBS' London-based wealth management business, only came to light when a whistleblower raised concerns internally.

Upon further investigation, it was discovered that UBS employees had taken part in the trading of foreign exchange and precious metals using customer money without authorisation and allocated losses to customers' accounts. An internal UBS investigation estimated that as many as 50 unauthorised transactions a day were taking place at the operation's peak.

FSA investigation found that UBS had failed to:

• manage and control the key risks, and the level of risk, created by its international wealth management business model;
• implement effective remedial measures in response to several warning signs that suggested the business' systems and controls were inadequate; and
• provide an appropriate level of supervision over customer-facing employees.

Further details disclosed by FSA's Final Notice:

• The services UBS provides to its international wealth management customers in the UK include, amongst other things: bank account services, investment advisory, portfolio management, trade execution, and the safekeeping of documents and assets.
• International wealth management customers are typically non-UK resident individuals who have substantial assets to invest, and are sophisticated, active and performance-driven investors.
• The London Branch afforded the Desk Heads a high degree of autonomy and authority. Each Desk Head supervised the Client Advisers operating on that specific International Business Desk. Desk Heads’ responsibilities included preparing investment documentation, contributing to technical discussions and liaising with Legal, Compliance and ‘Back Office’ functions. Where appropriate, Desk Heads were also expected to meet clients with the Client Advisers.
• During the Relevant Period, UBS’ control framework was designed to operate on the basis of a ‘Three Lines of Defence’ model. The ‘First Line of Defence’ was the business itself (i.e. Client Advisers and Desk Heads). The ‘Second Line of Defence’ was UBS’ Risk and Compliance department, which, amongst other things, undertook monitoring and risk assessments. The ‘Third Line of Defence’ was the Group Internal Audit function and external auditors.
• On 31 December 2007, a UBS employee reported to UBS’ Money Laundering Reporting Officer a concern regarding a proposed transfer of funds from a customer’s account to a particular Desk Head’s (“Desk Head ‘A’”) personal account. As a result, the Risk & Compliance department announced it would undertake a review of the International Business Desk headed by Desk Head ‘A’ (“Desk X”). The announcement of this review prompted another employee on Desk X to escalate a concern regarding an unauthorised inter-customer transfer of a structured product at a non-market price.
• In response to these concerns, UBS suspended relevant employees on the Desk and conducted a comprehensive investigation. The investigation established that Desk Head ‘A’ and certain other employees on Desk X had engaged in and/or facilitated unauthorised FX and precious metals transactions by using certain customers’ money without their authorisation and allocating any resulting profit or loss to the affected customers’ accounts. There was a high volume of FX transactions during the Relevant Period; UBS’ investigation identified approximately 50 such trades per day during 2006, which continued (at a reduced rate) throughout 2007.
• UBS’ investigation established that losses arising from the Unauthorised Trades were allocated to the accounts of other affected customers on the same Desk by exploiting the following failings in the control environment: (a) FX transactions could be executed by providing UBS’ FX traders with only an identifier for the trade and the details of the amount and the currency to be traded. Full details of the transaction, including the account number, could be provided to UBS’ FX traders up to 24 hours later. This allowed the performance of the trade to be assessed before Desk Head ‘A’ decided how any losses (or profits) should be allocated; (b) FX trades that had already been executed and booked could be cancelled and then subsequently re-booked onto another customer’s account; and (c) FX trades made nominally on behalf of a number of customers could be consolidated into a single trade with an ‘averaged’ price, thereby hiding the number of deals and the patterns of price.
• UBS’ investigation identified that losses resulting from the Unauthorised Trades were concealed by Desk Head ‘A’ and certain other individuals on Desk X from UBS’ customers by adopting the following techniques: (a) unauthorised transactions were made on the accounts of customers on the Desk who utilised UBS’ ‘retained mail’ facility. Customers using the ‘retained mail’ facility did not receive timely statements and updates on their accounts; as such, it was less likely that such customers would discover in a timely way the unauthorised activities on their accounts in comparison to those customers receiving periodic statements; (b) customers with significant liquid funds in their accounts were persuaded by the Desk to “lend” funds to other customers on the Desk who had incurred losses as a result of the Unauthorised Trades. These “loans” were documented on UBS headed notepaper by way of purported ‘UBS Guarantee Letters’. This procedure was intended by the employees on Desk X to give the lending customers the impression that the loan had been approved by UBS; however, no such approval had been given; and (c)a number of internal transfers were routed inappropriately through one of UBS’ internal ‘suspense’ accounts. The use of the suspense account enabled the true origin of the funds to be concealed as the source would not be displayed on the customers’ statements.
• Desk Head ‘A’ and other individuals working on Desk X were able to deploy these techniques without effective challenge from UBS’ systems and controls.
• UBS reported the findings of its investigation to the FSA on 30 January 2008. In February 2008, UBS commissioned an independent third party to assist it in identifying those customers who had been affected by the Unauthorised Trades. This work identified that 39 clients of “Desk X” had been affected by the Unauthorised Trades.

This case again reveals the highly risky control environment of private banking.

Dark Pools

Recently Martin Wheatly, CEO of SFC, delivered a speech about regulating alternative trading venues, in particular dark pools and direct market access (DMA). Some major points are summarized below:

• Whatever term is used to describe them, be it dark pools or alternative trading venues, they are really just facilities that allow dealing activities outside traditional exchanges without prices being disclosed publicly.
• The proliferation of dark pools has been phenomenal during the last few years but the pace of development varies across the regions. According to US SEC, the number of active dark pools transacting in stocks that are tradedon major U.S. stock markets has increased from approximately 10 in 2002 to approximately 29 in 2009.
• In Asia, dark pools are still at an infancy stage. Some of the more prominent American and European firms have explored the prospects of setting up similar operations in the major markets in Asia, including Hong Kong. In Hong Kong, we have seen the number of dark pools, mainly brokers' internalisation pools, increased from just a handful several years ago to more than 10 currently.
• There have been discussions about the implication of dark pools for the integrity of the market. The main issue being debated is that a lack of transparency in dark pool operations deprives the public of fair access to information about the best available prices to some market participants and thus results in a two-tiered market. The dark pool is an institutional market. Regulators should carefully study the pros and cons of integrating this institutional trading venue and the trading venue offered by stock exchanges before making any policy changes. The primary focus here should be whether the two-tiered market has created difficulties for regulators to conduct market surveillance.
• Another unintended consequence of dark pools is the fragmentation of pricing data, thus making it difficult for investors to know where they are likely to get the best price for their orders. In some markets, there are rules requiring an exchange to route an order to another exchange or liquidity pool if there is a better price. But such order routing usually incurs costs to investors. The growth of dark pools calls for a review of the best execution policy.
• Price discovery is a major function of an exchange market and the efficiency with which it is carried out depends on whether orders from a diverse set of participants are properly integrated so as to achieve reasonably accurate price discovery and reasonably complete quantity discovery. Most of the dark pools determine execution prices with reference to exchange produced prices. If dark pools continue to grow and account for a significant portion of market share, it will affect the price discovery function currently performed by the exchange market.
• To bring about greater market transparency and fairness, US SEC has recently mooted three changes to enhance the transparency of dark pools: (a) dark pools in the U.S. are currently required to publicly display stock quotes if their trading volume exceeds 5% of the volume of a particular stock, but the new plan would reduce the threshold to 0.25%;(b) the second change would require actionable indications of interests to be displayed in the public quotation system; and (c) the third proposal requires real time reporting from dark pools for their executed trades, making the dark pools' identity visible to the public.
• Dark pools can offer something exchanges cannot, e.g. a wide range of order types including algorithmic trading tools. Thus, it is arguable that dark pools are not competing with the exchanges, they are in fact offering a different type of service or servicing a different segment of the market.
• Along with the emergence of dark pools or alternative trading pools, we have also seen a rapid development of advanced trading tools, in particular algorithmic trading or DMA in general. DMA allows institutional investors to trade faster and to have direct control of their order execution. The increase in trading speed can amplify any unintentional errors in the execution process. DMA also enables institutional investors to send a large amount of order flow to the market within a very short period of time, which may have a systemic impact on the market. For example, the use of DMA facilitates the automatic generation of time-sensitive orders based on the changing market conditions. In the past, we have seen a number of occasions when DMA users sent large orders to the exchanges merely based on the pre-set algorithmic formula without giving sufficient consideration to the prevailing liquidity level in the market. As a result, the stock prices fluctuated wildly triggered by the arrival of these large orders. It is therefore important that brokers who provide DMA services ensure that there is sufficient pre-trade monitoring and control of orders using DMA.
• Broker-sponsored access has raised more challenges for us to monitor DMA orders. Some brokers have offered their institutional clients direct access to the market without going through the brokers' trading systems. This kind of DMA provides market participants unfiltered access to the market and makes it difficult for brokers to conduct any meaningful pre-trade monitoring. The term "naked access" can better describe this type of trading activity. Some regulators have been looking into this issue.

Greenmail

Every time after experiencing a financial crisis, many people would dream for recovering their capital losses by making some innovative investments. In 1999 they put their stakes at IT stocks, in 2009 they have faith on "green" investments.

SEC recently charged four individuals and two companies involved in perpetrating a US$30 million Ponzi scheme in which they persuaded more than 300 investors nationwide to participate in purported environmentally-friendly investment opportunities.

Wayde and Donna McKelvy, who were previously married and living in the Denver area, particularly targeted elderly investors or those approaching retirement age to finance such "green" initiatives of Pennsylvania-based Mantria Corporation as a supposed "carbon negative" housing community in rural Tennessee and a "biochar" charcoal substitute made from organic waste. The McKelvys promoted Mantria investment opportunities through their Denver-based company Speed of Wealth LLC. With the help of two other promoters who are Mantria executives — Troy Wragg and Amanda Knorr of Philadelphia — they convinced investors attending seminars or participating in Internet "webinars" to liquidate their traditional investments such as retirement plans and home equity to instead invest in Mantria.

The "green" representations were laced with bogus claims, and investors were falsely promised enormous returns on their investments ranging from 17% to "hundreds of percent" annually. In fact, Mantria's environmental initiatives have not generated any significant cash, and any returns paid to investors have been funded almost exclusively from other investors' contributions. They overstated the scope and success of Mantria's operations in several ways to solicit investors. For instance, they claimed that Mantria was the world's leading manufacturer and distributor of biochar and had multiple facilities producing it at a rate of 25 tons per day. In fact, Mantria has never sold any biochar and has just one facility engaged in testing biochar for possible future commercial production. Furthermore, Mantria's only source of revenue has been from its resale of vacant lots for its purported residential communities in rural Tennessee, but those did not generate cash with which to pay investor returns because Mantria provided 100% financing for almost all of its vacant lot sales to buyers using other investors' funds.

Speed of Wealth has frequently advertised its events through television, radio and print advertising as well as Internet marketing. At seminars and webinars sponsored by Speed of Wealth, Wayde McKelvy along with Wragg or Knorr generally conduct a two-part presentation in which they urge investors to liquidate all of their traditional investments, including individual retirement accounts, employer-sponsored 401(k) plans, mutual funds, stocks, bonds, and savings accounts. McKelvy also encourages investors to borrow as much as possible against home equity, parents' home equity, and business lines of credit. He then recommends that investors use all of their funds to invest in what he describes as the "consistent and safe" high-yield securities offered by Speed of Wealth and Mantria.

After Wragg or Knorr describe Mantria's purported operations and corresponding securities being offered, they market Speed of Wealth and Mantria securities with high-pressure tactics. They frequently offer short-term incentives and bonuses in various programs to induce investors to "pledge" their investments, or to induce those who have pledged to send in their money immediately. In seminars, webinars, and conference calls, Wayde McKelvy often calls upon past investors to provide "testimonials" about their receipt of high returns from past programs. McKelvy and Wragg also tout the safety and security of Mantria's securities based on collateral consisting of deeds of trust given to investors on Mantria's Tennessee rural land holdings. Wragg even tells potential investors that because of the valuable collateral, investors may make more money on their investments if Mantria defaults than if Mantria makes the promised payments. The promoters frequently allude to Mantria's imminent closing of sales worth hundreds of millions of dollars, initial public offerings of securities that are "sure to come" and "sure to be a very huge Wall Street hit", or upcoming investments by "Wall Street."

Mantria and Speed of Wealth used investor funds to pay returns to other investors in typical Ponzi scheme fashion. Mantria and Speed of Wealth also did not tell investors that they kept a significant amount of their funds to generously pay commissions of 12.5% to the McKelvys.

The word "greenmail" could be redefined now.

Insider Trading by Lawyers and Traders

Last week SEC charged a pair of lawyers for tipping inside information in exchange for kickbacks as well as six Wall Street traders and a proprietary trading firm involved in a US$20 million insider trading scheme.

SEC alleges that Arthur J. Cutillo, an attorney in the New York office of international law firm Ropes & Gray LLP, had access to confidential information about at least four major proposed corporate transactions in which his firm's clients participated. Through his friend and fellow attorney Jason Goldfarb, Cutillo tipped this inside information to Zvi Goffer, a proprietary trader at New York-based firm Schottenfeld Group. Goffer promptly tipped four traders at three different broker-dealer firms and another professional trader Craig Drimal, who each then traded either for their own account or their firm's proprietary accounts.

Goffer was known as "the Octopussy" within the insider trading ring due to his reputation for having his arms in so many sources of inside information. Cutillo, Goldfarb, and Goffer at times used disposable cell phones in an attempt to conceal the scheme. For example, prior to the announcement of one acquisition, Goffer gave one of his tippees a disposable cell phone that had two programmed phone numbers labeled "you" and "me." After the announcement, Goffer destroyed the disposable cell phone by removing the SIM card, biting it, and breaking the phone in half, throwing away half of the phone and instructing his tippee to dispose of the other half.

This is a real case, not a TV drama.

HKMA Guideline on Sound Remuneration System

HKMA has recently developed this Guideline on the basis of the recommendations issued by the Financial Stability Board (FSB), which have been endorsed by the G20 as an international standard on sound remuneration practices. This Guideline serves to provide broad guidance on the governance and control arrangements for, and operations of, banks' remuneration systems. It is intended to apply to both locally incorporated banks and local branches of foreign banks.

The Guideline covers the following areas:

1. Governance – formulation of remuneration policy; board oversight (including the establishment of a remuneration committee); and the role of risk control functions (including, but not limited to, risk management, financial control, compliance, and internal audit) in respect of an bank's remuneration system.
2. Structure of remuneration – proportionate balance of fixed and variable remuneration; use of instruments for variable remuneration; and exceptional use of guaranteed minimum bonuses.
3. Measurement of performance for variable remuneration – pre-determined criteria for performance measurement; adjustments to performance assessment in respect of current and potential risks and the overall performance of a bank and relevant business units; and the exercise of judgement in the process of determining variable remuneration.
4. Alignment of remuneration payouts to the time horizon of risks – deferment of variable remuneration (including minimum vesting period and pre-defined performance conditions); claw-back provision and restriction on hedging exposures in respect of the unvested portion of deferred remuneration.
5. Adequate disclosure on remuneration – disclosure in respect of the design and implementation of remuneration systems; and aggregate quantitative information on remuneration broken down by senior management and by other employees whose activities could have a material impact on the risk exposure of a bank.

HKMA intends to finalize the Guideline by the end of 2009 and expects all banks to fully implement it within 2010.

It appears that even last year's financial tsunami has not caused a disaster affecting the stability of Hong Kong's banking industry, HKMA is more proactively intervening in the banking industry by following the international recommendations. If banks' remuneration system has to be regulated, how about insurance companies and the securities industry?

As a compliance practitioner, I am also interested to know how the remuneration policy would be formulated for the compliance function.