SFC and Minibond Fiasco

(Reproduced from SCMP 2010.01.27)

The Lehman Brothers minibond mess could have been avoided had the Securities and Futures Commission imposed the measures needed to properly vet their sale and suitability to investors, a former senior manager with the regulator said.

Harold Ko Ping-chung, the commission's former head of insurance-related policies and products, told lawmakers that he believed different standards used by the commission's investment products and corporate finance departments, and lax supervision and staff inexperience contributed to the Lehman minibond fiasco.

Minibonds were handled by the corporate finance department, which only required that necessary product information be disclosed, and not the investment products department, which looked at whether the various parties involved in the product were suitably qualified.

Since leaving the commission about five months ago, Ko has been keen for lawmakers to hear his evidence. He testified publicly yesterday for the first time before the Legislative Council subcommittee investigating what went wrong. He also met the subcommittee last week behind closed doors.

The collapse of Lehman Brothers in September 2008 left holders of minibonds linked to it virtually worthless. Minibonds are not corporate bonds, but are high-risk, credit-linked derivatives. They are marketed as a proxy investment in well-known companies.

Ko spent much of his two decades with the commission vetting investment products. His deep understanding of the regulator's work in authorising Lehman minibonds is seen as invaluable as lawmakers prepare to summon banking representatives to testify.
Ko is no stranger to politics. In the 1990s he was a core member of United Ants, a grass-roots human rights group. He also ran unsuccessfully for a seat in Legco in 1995.

(Jack's comment: This is not a unified regulatory body. It consists of different operating units pursuing their private interests by all means. This is the misfortune of the Hong Kong securities industry. Salute to Mr Harold Ko.)

Futures Trader Acquitted of Price Rigging Charges

In recent years, SFC initiated a number of criminal prosecutions against stock market manipulators. Last week the Eastern Magistracy acquitted a futures trader, Mr Tsoi Bun, of five charges of manipulating the calculated opening prices (COP) of index futures contracts in the futures market. This was the first criminal prosecution for market manipulation in Hong Kong's futures market under SFO.

A COP is calculated during the Pre-Market Opening Period and serves as the market opening price for the corresponding product. It is calculated only if the highest bid price of the limit orders entered into the Automated Trading System of the Exchange (HKATS) is greater than or equal to the lowest ask price of the limit orders. If more than one price satisfies this criterion, the COP will be calculated according to the established formula set forth in Rule 4.84 of Trading Procedures for Stock Index Futures and Stock Index Options Traded on HKATS.

Tsoi was charged of manipulating the COP of HSCEI futures contracts and HSI futures contracts during the morning Pre-Market Opening Period on five trading days between February and September 2007.

The Deputy Magistrate ruled that there was insufficient evidence to prove beyond reasonable doubt that Tsoi had manipulated the calculated opening price on each of the trading days in question. SFC is reviewing the ruling to determine whether there should be an appeal and will continue to pursue civil proceedings against Tsoi.

In addition to the criminal charges, SFC has on 21 July 2009 sought orders in the High Court under section 213 of SFO stopping him from placing orders on the futures market during the Pre-Market Opening Period. In response to that application, Tsoi gave the court an undertaking that he would not place any order held in his name or in the name of another person on the futures markets during the Pre-Open Allocation Sessions. The undertaking remains in force.

The civil proceedings against Tsoi contains additional allegations that were not part of the criminal trial including allegations that Tsoi continued to manipulate the COP after the commencement of the SFC’s criminal proceedings.

I am quite interested to know how the evidence provided by SFC was insufficient to prove beyond reasonable doubt that Tsoi had manipulated the futures market.

Dual Filing Update (Jan 2010)

SFC has recently released another newsletter to update market participants on the dual filing arrangements. During the 6 months ended September 2009, SFC received 64 listing applications via SEHK and found causes to comment on 53 applications. Some of the cases reviewed by SFC are highlighted below.

Understanding potential risks on business viability

• In one case, the listing applicant breached certain regulatory provisions when entering into contracts with its customers which, in the worst case, might render the contracts illegal. The potential result could be the loss of its business licence, the very basis on which the listing was sought. The applicant did not appear to have followed the advice of its legal adviser to mitigate the effects of such breaches. The extent of the deficiencies raised substantial doubts as to whether the sponsors had critically assessed the applicant's business viability, of which disclosure alone might not necessarily be adequate to address the issues. The listing application was allowed to expire, leaving these issues unresolved.
• In another case, a large part of the applicant's business was substantially derived from its connected persons and employees, although the proportion decreased from over 90% to 40% of its profit during the track record period. The reliance on these connected clients was expected to continue after listing. The applicant's ability to obtain third party funding for its business also depended on its ability to generate a sufficient level of revenue, which in turn was substantially derived from the transactions with the connected clients. It was questionable whether the applicant could carry on its business independently. In addition, some of these connected clients were directors of the applicant. Concerns were raised at the risk that they might override the internal control procedures to facilitate their own transactions or make decisions in favour of themselves at the expense of the interests of the shareholders. Even internal controls and corporate governance measures may not be sufficient to reduce or eliminate these inherent risks. The listing application was formally withdrawn after the regulators raised these concerns with the sponsors.

Inconsistent explanations on impact of the global financial crisis

• In one case, the listing applicant, a Mainland property developer, claimed that the global financial crisis, uncertain economic prospects, and the tightened credit markets reduced the demand for its properties. However, it actually sold more properties in terms of square meters after the turmoil. In a similar case, the applicant claimed that the downturn in 2008 reduced property prices on the Mainland but the average selling price of its properties continued to increase by more than 20% in the same year.
• In another case, the listing applicant attributed the decline in its net profit to the global financial crisis since the second half of 2008. However, its net profit for the second half of 2008 was actually more than double the net profit for the first half.

Disclosure of instances of regulatory non-compliance

• The media have widely reported that the Chinese central government has introduced stringent measures against leaving land idle where property developers miss specified development deadlines. In one case, the listing applicant delayed construction and was in breach of land grant contracts signed with the local regulatory bodies. No analysis of the potential adverse financial and operational impact on its business was provided. Nor was there any basic information relating to the idle land, the amounts invested, any regulatory notices received or any measures taken to address the breach.
• In another case, the listing applicant did not obtain the construction permit before commencing construction of a property project and in the worst case could be liable to penalty or forfeiture of the land. However, no disclosure was made relating to the length of the delay, when and whether the construction permit could be obtained, the estimated penalty and the total costs of investment or other information that was important for potential investors to assess the financial and operational impact on the listing applicant.
• In another case, the draft prospectus omitted the applicant's past record of production without valid permits, which had led to the temporary suspension of operations during the track record period. In a similar case, the applicant’s various major litigation and regulatory breaches, which had exposed it to penalties and potential disruption of operations, were omitted from the draft prospectus.

Conduct of sponsors

• In one case, the listing applicant consistently represented to the regulators that the reason why the ownership of a key asset had not been transferred from the parent, but had rather been entrusted to the company, was a prolonged regulatory approval process. However, it was later revealed that the parent's interest in the key asset was, in fact, subject to a lock-up, which prevented the parent from transferring ownership to the applicant in the near future. This rendered the previous reasons submitted by the sponsor for the entrustment arrangement potentially false and misleading. It also raised substantial concerns as to the adequacy of the due diligence performed by the sponsor to understand and verify the rationale behind the arrangement. The disclosure was rectified only after the regulators had persistently challenged the sponsor’s representation.
• In another case, the listing applicant initially disclosed in the draft prospectus that all three of its executive directors remained as directors of a major subsidiary after its disposal. In fact, only one executive director remained as a director of this company, which was actually managed by the purchaser after the disposal. Had the regulators not enquired into the matter, the statement made could be false or misleading since the prospectus representation would mean that all three executive directors remained involved in the day-to-day management of the major subsidiary after its disposal to a third party.
• In a similar case, the listing applicant sold its products to distributors which contributed more than 40% of its total revenue during the track record period. The sponsor failed to perform sufficient due diligence on the number of distributors provided by the listing applicant and the initial disclosure of the number of distributors was revised down by 20% upon enquiry by the regulators.
• In another case, the initial draft prospectus failed to disclose the applicant's trading business. When we queried this point, it was revealed that this business segment actually contributed more than 30% of the applicant's total revenue throughout the track record period. As a result, the draft prospectus was substantially revised to rectify the misleading disclosure on the businesses of the applicant.

Enhanced Monitoring of Compliance with the Code of Banking Practice

As a result of a recent review, last week HKMA announced that it will be introducing the following new measures for enhanced monitoring:

1. Annual self-assessments with revised reporting template

• The current biennial self-assessment exercise will revert to a yearly basis. As a transitional arrangement, the forthcoming exercise will cover a reporting period from 1 June 2008 to 31 December 2009. This will enable HKMA to assess banks' full compliance with the current version of the Code which took effect on 2 January 2009.
• In addition, the reporting template for the self-assessment has been revised so that banks set out their rationale for any deviation from the norm in certain areas. For instance, section 12.3 requires banks not to charge customers "extortionate interest rates". A bank might be charging over 48% (the level presumed under the Money Lenders Ordinance to be extortionate) in some cases but decide that it is in compliance with that section because it sees itself as having strong justification for doing so. Instead of reporting a simple "yes" as in the existing template, the revised template would require the bank to provide further information on its justification for cases where it charges in excess of 48%.
• As in the past, all banks are required to commission their internal audit department, compliance department or other equivalent unit to conduct the self-assessment. The chief executive of the bank should co-sign the self-assessment report. Where an instance of non-compliance is identified, the bank concerned should provide details of the case including its plan to rectify the situation. A full account should be given if the instance of non-compliance is a recurrence of similar instances identified in previous exercises.

2. Exception reporting

• Based on results from previous self-assessment exercises, most of the non-compliance cases concern subjects covered in Chapter 1 (Relationship between Banks and Customers) and Chapter 2 (Accounts and Loans) of the Code. These also tend to be areas that attract customer complaints and therefore call for priority attention. Henceforth, banks should notify HKMA as soon as practicable of any breach of any provision within Chapters 1 and 2 of the Code, adopting the standard format below. Such exception reporting will facilitate HKMA's timely monitoring of rectification action, and should also help focus banks' attention on measures needed to strengthen their compliance with the Code.

3. Mystery shopping

• Both self-assessment and exception reporting inevitably reflect banks' own perspectives of their compliance with the Code. Drawing on the monitoring frameworks in other jurisdictions, including the UK and Australia, HKMA is proposing to introduce a trial mystery shopping scheme as a proactive approach to seek to assess compliance from the consumer's perspective. By testing customer experience against expectations set by the Code, this research technique may reveal useful information regarding levels of compliance with the Code and identify potential areas for improvement.
• Starting from 2010, HKMA will engage the services of one or more organisations engaged in market research activities to undertake mystery shopping exercises. In determining the scope and frequency of such exercises, HKMA will be guided by any concerns or trends emerging from the self-assessment results or other sources regarding banks' compliance with the Code. A key area, by way of example, which lends itself to the mystery shopping technique is the use of mystery shoppers to assess the extent to which bank staff are able to provide clear and accurate information in accordance with requirements under the Code.
• HKMA does not intend to take the findings of a particular mystery shopping exercise to be fully representative of a bank's general level of compliance with the Code. Nevertheless, where mystery shopping indicates possible compliance problems within a bank, it will prompt HKMA to consider follow-up work to establish why any failings occurred. The findings will also provide HKMA with insights to share with the AI concerned. In addition, examples of good and bad practice identified by any mystery shopping campaign can be shared with banks generally with a view to improving industry practice.

I particularly support extending mystery shopping to banking practices. Bank staff should understand that misleading customers is unacceptable in both banking and investment services.

新監管 新財管

(This article was published in Hong Kong Economic Journal on 30 December 2009. I also submitted to SFC the following responses to their proposals to enhance investor protection on behalf of IAFM Hong Kong Chapter.)

近日見到證監會在電視及報章大賣廣告，積極宣傳其建議加強投資者保障措施的公眾諮詢文件。該諮詢為期三個月（直至本年底），提出了多項建議，以優化現時適用於向公眾銷售非上市投資產品的規例。

去年雷曼兄弟的倒閉，引發金融海嘯，令香港不少投資者因購入「迷你債券」（Minibond）或雷曼相關產品而蒙受損失。事件引致大量公眾投訴及社會議論，而事後的檢討工作令人關注到過去若干非上市投資產品售予公眾的手法。後遺症是大眾因個別不良的銷售行為而對財富管理這個方興未艾的行業產生反感。筆者作為國際金融管理學會（IAFM）香港分會的會長，有責任大聲疾呼：「以往過分由銷售主導的財管行業是誤入歧途，而優質的財管服務應以客戶真正及全面的需要為本。」

證監會諮詢文件載有的建議，範圍涵蓋投資過程的每個階段【圖】，包括售前文件及廣告、銷售手法及利益披露，售後持續披露及冷靜期等課題。對於專業的財管人員來說，新的監管要求不應被視為工作上的負擔，反而是改善行業形象的契機。當然，某些建議在具體執行上有技術上的考慮。最近筆者跟部分IAFM的本地會員交換過意見後，想籍本文回應諮詢文件第三部分「中介人操守」中的建議。以下就以答問形式（根據諮詢文件列出的問題），扼要地向證監會提出對加強監管投資產品銷售的觀點。




問題：你是否同意，本部分的若干建議應只適用於非上市投資產品？請解釋你的意見。

回應：不完全同意。不少散戶投資者對上市的高風險投資產品（如窩輪、牛熊證等）其實認識不深。諮詢文件的部分建議亦應適用於上市投資產品，例如中介人在推介窩輪時，亦須評估投資者對衍生工具的認識，及披露有否收取發行商的利益等。另一方面，某些非上市投資產品(例如一般基金或傳統債券)較少產生系統性的銷售風險。建議證監會把監管力度集中在衍生工具及結構式產品上。

問題：你認為中介人在執行「認識你的客戶」程序時，應否向客戶查詢其對衍生工具的認識，並將具備相關知識的客戶（專業投資者除外）歸類為「對衍生工具有認識的客戶」，以協助中介人確保就非上市衍生產品所提供的投資意見及投資產品均適合客戶？請就中介人如何評估投資者是否對衍生工具有認識的建議措施發表意見。

回應：同意中介人應該在肯定客戶對衍生工具有足夠認識後，才向其提供有關產品的投資意見。至於如何評估投資者是否對衍生工具有認識，建議證監會設計並要求投資者完成一份測試問卷，在其獲得及格分數後才可被歸類為「對衍生工具有認識的客戶」。

問題：應否將符合以下條件的高資產淨值投資者，視為有具體的認識和專業知識：(a) 目前或曾經在相關的金融行業擔任專業職位至少一年，而該職位的工作涉及相關產品；或 (b) 曾就相關產品接受培訓或修讀相關課程？ 你有其他提議嗎？

回應：符合(a)的投資者恐怕人數不多，(b) 則相對地較為可行。建議由證監會或香港證券專業學會設定相關培訓或課程的內容及程度。

問題：投資組合最低總值規定應設定在甚麼水平？請說明理由。

回應：金融海嘯後，香港高資產淨值投資者的人數已大減。現時的投資組合最低總值規定（港幣八百萬）應足以區別高資產淨值投資者。況且再高的總值規定亦不能保證投資者具有足夠的投資知識。

問題：如分銷商及╱或其任何有聯繫者明確地從或將會從產品發行人（直接或間接）收取金錢利益，以下三個披露資料的方案中哪個較為合適？請解釋你的意見。
方案1.1 － 披露金額或百分率
方案1.2 － 披露百分率範圍或上限（即“x%至y%”或“不多於y%”）
方案1.3 － 披露概括資料

回應：方案1.2比方案1.1較有彈性，同時亦已給予投資者足夠的利益披露。

問題：假設分銷商並非明確地就分銷投資產品收取任何利益，你認為以下哪種披露方案較為合適？ 請解釋你的意見。
方案2.1 － 披露分銷報酬的具體資料
方案2.2 － 披露概括資料

回應：方案2.1在計算上恐怕過於複雜，亦難以確立標準的計算方法。方案2.2似乎較為可行。

問題：假設分銷商通過背對背交易賺取銷售利潤，以下哪種披露方案較為合適？請解釋你的意見。
方案3.1 － 披露銷售利潤的具體資料
方案3.2 － 披露概括資料

回應：建議採用方案3.1，但只要求披露銷售利潤的百分率範圍或上限。這樣既能保障分銷商的商業秘密，亦能令投資者對交易費用有所預算。

問題：你認為應否限制分銷商不可為推銷個別投資產品而向投資者送贈超市禮券、影音器材等具現金價值的贈品（費用及收費折扣除外）？

回應：不同意證監會過分干預營商手法，但建議在風險披露聲明中加入警告，提醒投資者不應以贈品作為投資決定的主要考慮。

問題：證監會建議在銷售披露文件載述多項資料，包括 (a) 以主事人還是代理人身分行事；(b) 與產品發行人的聯繫；(c) 金錢利益及非金錢利益；及 (d) 投資者享有的費用及收費折扣。你對以上內容有何意見？

回應：同意以上的披露有助投資者了解分銷商在銷售過程中的利益衝突。

問題：你認為應否強制規定將客戶風險狀況評估及投資產品的建議或銷售過程錄音，或是現行的備存紀錄規定已經足夠？如將錄音定為強制規定，你認為錄音紀錄應保存多久？請解釋你的意見。

回應：將錄音定為強制規定在執行上有很多技術上困難。首先，證監會通常要求使用中央控制的錄音系統，這對於經常要在辦公室外跟客戶面談的非銀行投資顧問來說並不切實可行。另外，非銀行的客戶一般較為熟練，亦可能對言談之間錄音較為敏感。建議證監會中間落墨，要求銷售人員用書面形式記錄客戶的風險狀況及投資產品建議後，再由獨立之職員在辦公室以錄音系統致電客戶確認重點資訊，把錄音過程縮短在十分鐘之內。這樣安排應可平衡投資者保障及商業效率。

Private Placement Offering Failures

US FINRA recently fined Pacific Cornerstone Capital and its former CEO, Terry Roussel, a total of $750,000 for failing to include full and complete information in private placement offering documents and marketing material. FINRA also charged Pacific Cornerstone and Roussel with advertising violations and supervisory failures.

Pacific Cornerstone agreed to make corrective disclosures to investors and to submit advertising and sales literature to FINRA for pre-use review for one year. Roussel was suspended in all capacities for 20 business days and in a principal capacity for an additional three months.

From January 2004 to May 2009, Pacific Cornerstone sold private placements in two affiliated companies using offering documents and accompanying sales literature that contained targets as to when investors would receive the return of their principal investment and the yield on their investment. The offering documents included statements that the affiliated entities targeted returns of principal in two to four years and targeted a yield on a $100,000 investment in excess of 18%. FINRA found no reasonable basis for those statements.

Further, Pacific Cornerstone and Roussel continued to use a similar targeted time period for return of capital and rate of return in successive offering documents, although those targets were not supported by prior performance. The offering documents failed to disclose the complete financial condition of one or both of the companies.

Pacific Cornerstone also offered private placement units of the two affiliated entities, Cornerstone Industrial Properties, LLC and CIP Leveraged Fund Advisors, LLC, to other broker-dealers and investment advisors, which in turn sold the units to the investing public. A total of approximately $50 million worth of units were sold to approximately 950 accredited investors over a period of almost six years. Pacific Cornerstone continued to use the same targeted two-to-four year return of principal and 18% rate of return in successive offering documents, despite not having met those targets.

During the same period, Roussel periodically sent letters to the private placement investors to update them on the progress of their investment that painted a positive — but unrealistic — future, without providing required risk disclosures. Roussel's letters also failed to disclose the complete financial picture of the two companies.

In Hong Kong, we rarely witness that offering to private placement investors and professional investors are so adequately supervised by SFC.

Displaying Fictitious Trades and Misleading Customers

US SEC recently charged a US subsidiary of the world's largest inter-dealer broker, U.K.-based ICAP plc, with fraud for engaging in deceptive broking activity and making material misrepresentations to customers concerning its trading activities.

As an inter-dealer broker, ICAP Securities USA LLC (ICAP) matches buyers and sellers in OTC markets for various securities, such as US Treasuries and mortgage-backed securities, by posting trade information on computer screens accessed by its customers who make trading decisions based in part on such information. Inter-dealer brokers with greater trade activity on their screens often are better positioned to attract customer orders and earn more commissions than those whose screens reflect little or no trading activity.

SEC's enforcement action finds that ICAP, through its brokers on its U.S. Treasuries (UST) desks, displayed fictitious flash trades also known as "bird" trades on ICAP's screens and disseminated false trade information into the marketplace in order to attract customer attention to its screens and encourage actual trading by these customers. ICAP's customers believed the displayed fake trades to be real and relied on the phony information to make trading decisions.

ICAP agreed to settle SEC's charges by, among other things, paying $25 million in disgorgement and penalties. SEC additionally charged five ICAP brokers for aiding and abetting the firm's fraudulent conduct and two senior executives for failing reasonably to supervise the brokers. The individuals have each agreed to pay penalties to settle SEC's charges.

According to SEC's order, ICAP's UST brokers displayed thousands of fictitious flash trades to ICAP's customers between December 2004 and December 2005. ICAP represented to its off-the-run UST customers that its electronic trading system would follow certain workup protocols in handling customer orders. Such ICAP customers therefore expected that their orders, once entered onto ICAP's screens, would be filled according to the workup protocols. However, ICAP's brokers on the UST desks used manual tickets to bypass such protocols and close out of thousands of positions in their ICAP house accounts, thereby rendering ICAP's representations concerning the workup protocols false and misleading. In some instances, ICAP's customers' orders received different treatment than the customers expected pursuant to the workup protocols.

ICAP held itself out as a firm that did not engage in trading that subjected its own capital to risk. ICAP's regulatory filings routinely made this point, noting specifically in one instance that the firm "does not engage in proprietary trading." During the relevant period, however, two former ICAP brokers on the voice-brokered collateral pass-through mortgage-backed securities (MBS) desk routinely engaged in profit-seeking proprietary trading that rendered ICAP's representations regarding proprietary trading false and misleading. ICAP failed to make and keep certain required books and records on the UST desks and the MBS desk.

Many individual and institutional investors in HK incurred losses from buying the shares of Asian Citrus (73.hk) based on the misleading information in the listing document and SEHK's trading system. Could SFC do something for them?