FINRA recently fined HSBC Securities (USA) Inc. $375,000 for recommending unsuitable sales of inverse floating rate Collateralized Mortgage Obligations (CMOs) to retail customers. HSBC failed to adequately supervise the suitability of the CMO sales and fully explain the risks of an inverse floating rate or other risky CMO investment to its customers.
As a result of HSBC not implementing an adequate supervisory system and procedures relating to the sale of inverse floating rate CMOs to retail customers, six of its brokers made 43 unsuitable sales of inverse floaters to retail customers who were unsophisticated investors and not suited for high-risk investments.
In addition, HSBC's procedures required a supervisor's pre-approval of any sale in excess of $100,000; FINRA found that 25 of the 43 CMO sales were in amounts exceeding $100,000 and that in five of these instances, customers lost money in their inverse floating rate CMO investments. HSBC has paid these customers full restitution totaling $320,000.
A CMO is a fixed income security that pools mortgages and issues tranches with various characteristics and risks. CMOs make principal payments throughout the life of the security with the maturity date being the last date by which all of the principal must be returned. The timing of the return of principal payments can vary depending on interest rate changes.
One of the more risky CMO tranches is the inverse floater, a type of tranche that pays an adjustable rate of interest that moves in the opposite direction from movements of an interest rate index, such as LIBOR. Since 1993, FINRA has advised firms that inverse floating rate CMOs "are only suitable for sophisticated investors with a high-risk profile."
HSBC did not provide its brokers with sufficient guidance and training regarding the risks and suitability of CMOs. In particular, the firm did not inform its registered representatives that inverse floaters were only suitable for sophisticated investors with a high-risk profile. In addition, the firm did not provide its registered representatives with information regarding the risks associated with the specific inverse floaters that were available to be sold.
HSBC also failed to comply with a FINRA rule, adopted in November 2003, which requires firms to offer certain educational materials before the sale of a CMO to any person, other than an institutional investor. The educational materials must include, among other things, the characteristics and risks of CMOs, in general, and the specific characteristics and risks associated with the different tranches of a CMO.
During the relevant time period, HSBC did not advise its registered persons that they were required to offer written educational material to their customers before they sold them CMOs. Although HSBC provided its brokers with a CMO brochure, the brokers did not offer the brochure to every CMO investor, nor did they know that they were required to give the materials to all potential CMO investors before selling them a CMO. Moreover, the brochures did not comply with FINRA's content standards. In particular, the brochure failed to discuss inverse floaters and failed to include a section on risks associated with purchasing CMOs.
Jack's comment: Investor floater is a highly risky product, no matter it is associated with CMOs or not. Such kind of product should not be offered to retail investors unless they can demonstrate full understanding of its risk profile. Distribution of education materials to retail investors is certainly not enough.
Wednesday, September 01, 2010
Wednesday, August 25, 2010
Review of Insider Dealing Sentence
Last week The Eastern Magistracy today sentenced Mr Pablo Chan Pak Hoe, who was earlier convicted of insider dealing in a proposed takeover, to serve 240 hours of community service. Chan was also ordered to pay the SFC investigation costs totalling $44,478.
Magistrate Anthony Yuen Wai Ming (who recently put Amina Mariam Bokhary on one year's probation with respect to her third conviction for assaulting a police officer) had earlier found Chan guilty of one count of insider dealing in the shares of Universe International Holdings Ltd between 2 May 2008 and 19 June 2008 when he acted as a representative of the controlling shareholder in a proposed acquisition.
SFC had informed the Magistrate that Chan made a profit in the order of $120,000 when he sold the shares following the announcement of the acquisition. Under the community service order, Chan does not have to repay or disgorge any profit from his insider dealing and is able to retain it.
SFC is seeking a review of this sentencing decision.
Jack's comment: Compared with previous cases of insider dealing, the sentence in this case was really "exceptional"...no imprisonment, and even no disgorgement of profit. I am not informed that the defendant in this case has also suffered from bipolar disorder!
Magistrate Anthony Yuen Wai Ming (who recently put Amina Mariam Bokhary on one year's probation with respect to her third conviction for assaulting a police officer) had earlier found Chan guilty of one count of insider dealing in the shares of Universe International Holdings Ltd between 2 May 2008 and 19 June 2008 when he acted as a representative of the controlling shareholder in a proposed acquisition.
SFC had informed the Magistrate that Chan made a profit in the order of $120,000 when he sold the shares following the announcement of the acquisition. Under the community service order, Chan does not have to repay or disgorge any profit from his insider dealing and is able to retain it.
SFC is seeking a review of this sentencing decision.
Jack's comment: Compared with previous cases of insider dealing, the sentence in this case was really "exceptional"...no imprisonment, and even no disgorgement of profit. I am not informed that the defendant in this case has also suffered from bipolar disorder!
Wednesday, August 18, 2010
Morgan Stanley Breached the Research Rules Again
Recently FINRA censured and fined Morgan Stanley & Co., Inc. $800,000 for failing to make public disclosures required by FINRA's rules governing research analyst conflicts of interest. The firm also failed to comply with a key provision of the 2003 Research Analyst Settlement by failing to disclose the availability of independent research in customer account statements.
In addition to the censure and fine, Morgan Stanley must review a sample of its research reports and certify to FINRA that they comply with FINRA's research analyst conflict-of-interest rules. These reviews and certifications must take place every six months for two years.
FINRA found that from April 2006 to June 2010, Morgan Stanley issued equity research reports that failed to disclose accurate information about the relationships Morgan Stanley, or its analysts, had with companies covered in its research reports. Overall, these inaccuracies resulted in approximately 6,836 deficient disclosures in about 6,632 equity research reports and 84 public appearances by research analysts. Among the deficient disclosures were:
In determining the appropriate sanctions in this matter, FINRA considered Morgan Stanley's self-review and self-reporting of some of its disclosure violations and remedial steps taken by the firm, as well as a prior FINRA settlement in 2005 that found the firm violated FINRA's research analyst disclosure rules.In settling this matter, Morgan Stanley neither admitted nor denied the charges, but consented to the entry of FINRA's findings.
Jack's comment: The credibility problem of research analysts has not fundamentally changed since the burst of the IT bubble. The financial penality is just a piece of cake to a giant investment bank.
In addition to the censure and fine, Morgan Stanley must review a sample of its research reports and certify to FINRA that they comply with FINRA's research analyst conflict-of-interest rules. These reviews and certifications must take place every six months for two years.
FINRA found that from April 2006 to June 2010, Morgan Stanley issued equity research reports that failed to disclose accurate information about the relationships Morgan Stanley, or its analysts, had with companies covered in its research reports. Overall, these inaccuracies resulted in approximately 6,836 deficient disclosures in about 6,632 equity research reports and 84 public appearances by research analysts. Among the deficient disclosures were:
- Securities holdings of an analyst, or a member of the analyst's household, in a subject company;
- Morgan Stanley's receipt of investment banking and non-investment banking revenue from subject companies;
- Morgan Stanley's role as a manager, or co-manager, of a public offering of securities for subject companies;
- Morgan Stanley's role as a market maker for certain subject companies' securities; and
- Price charts for securities covered in equity research reports and the valuation method used to support published price targets.
In determining the appropriate sanctions in this matter, FINRA considered Morgan Stanley's self-review and self-reporting of some of its disclosure violations and remedial steps taken by the firm, as well as a prior FINRA settlement in 2005 that found the firm violated FINRA's research analyst disclosure rules.In settling this matter, Morgan Stanley neither admitted nor denied the charges, but consented to the entry of FINRA's findings.
Jack's comment: The credibility problem of research analysts has not fundamentally changed since the burst of the IT bubble. The financial penality is just a piece of cake to a giant investment bank.
Wednesday, August 11, 2010
Introducing Non-SFC Authorised Fund to Clients
SFC has just suspended the licence of Ms Kou Sao Peng for three months from 4 August 2010 to 3 November 2010. SFC's investigation found that Kou, while acting as a consultant of TTG (HK) Ltd, an investment adviser, introduced a non-SFC authorised fund to several clients in 2008.
The introduction of the fund preceded the completion of due diligence process by TTG. As such, the fund was not yet approved by TTG for recommendation to clients. In order to sell the fund to her clients, Kou asked her clients to sign a form acknowledging themselves as "execution only" clients who specifically requested to purchase the fund. Kou should not have done so given the fund was actually introduced by her to the clients.
An "execution only" transaction usually means a transaction executed by a firm upon the specific instructions of a client without solicitation or recommendation by the firm, where the firm does not, and is not expected to give investment advice relating to the merits and suitability of the transaction.
Moreover, Kou did not consider TTG’s due diligence on the fund before introducing it to the clients and ignored an instruction from her supervisor to monitor the fund for a longer period before introducing it to any clients.
In suspending Kou, SFC did not consider that Kou had acted dishonestly. Had there been a finding of dishonesty, the SFC would have imposed a more severe sanction.
Jack's comment: In the past, there were many investment consultants who attempted to deny solicitation of clients for purchasing non-authorized products by asking the clients to sign the "execution only" acknowledgement. This case reveals that such arrangement may not work.
The introduction of the fund preceded the completion of due diligence process by TTG. As such, the fund was not yet approved by TTG for recommendation to clients. In order to sell the fund to her clients, Kou asked her clients to sign a form acknowledging themselves as "execution only" clients who specifically requested to purchase the fund. Kou should not have done so given the fund was actually introduced by her to the clients.
An "execution only" transaction usually means a transaction executed by a firm upon the specific instructions of a client without solicitation or recommendation by the firm, where the firm does not, and is not expected to give investment advice relating to the merits and suitability of the transaction.
Moreover, Kou did not consider TTG’s due diligence on the fund before introducing it to the clients and ignored an instruction from her supervisor to monitor the fund for a longer period before introducing it to any clients.
In suspending Kou, SFC did not consider that Kou had acted dishonestly. Had there been a finding of dishonesty, the SFC would have imposed a more severe sanction.
Jack's comment: In the past, there were many investment consultants who attempted to deny solicitation of clients for purchasing non-authorized products by asking the clients to sign the "execution only" acknowledgement. This case reveals that such arrangement may not work.
Wednesday, August 04, 2010
Breach of Money Laundering Checks
This week FSA fined members of the Royal Bank of Scotland Group (RBSG) £5.6m for failing to have adequate systems and controls in place to prevent breaches of UK financial sanctions. FSA's Decision Notice
UK firms are prohibited from providing financial services to persons on the HM Treasury sanctions list. The Money Laundering Regulations 2007 (the Regulations) require that firms maintain appropriate policies and procedures in order to prevent funds or financial services being made available to those on the sanctions list.
During 2007, RBSG processed the largest volume of foreign payments of any UK financial institution. However, between 15 December 2007 and 31 December 2008, RBS Plc, NatWest, Ulster Bank and Coutts and Co, which are all members of RBSG, failed to adequately screen both their customers, and the payments they made and received, against the sanctions list. This resulted in an unacceptable risk that RBSG could have facilitated transactions involving sanctions targets, including terrorist financing.
FSA considers that RBSG’s failings in relation to its screening procedures were particularly serious because of the risk they posed to the integrity of the UK financial services sector. This is the biggest fine imposed by the FSA to date in pursuit of its financial crime objective. It is also the first fine imposed by the FSA under the Regulations.
As RBSG agreed to settle at an early stage of the FSA investigation, it qualified for a 30% reduction in penalty. The FSA would have otherwise imposed a financial penalty of £8m.
Jack's comment: It appears that many financial institutions in the world (especially private banks) have not yet changed their lax attitude towards the compliance with money laundering rules.
UK firms are prohibited from providing financial services to persons on the HM Treasury sanctions list. The Money Laundering Regulations 2007 (the Regulations) require that firms maintain appropriate policies and procedures in order to prevent funds or financial services being made available to those on the sanctions list.
During 2007, RBSG processed the largest volume of foreign payments of any UK financial institution. However, between 15 December 2007 and 31 December 2008, RBS Plc, NatWest, Ulster Bank and Coutts and Co, which are all members of RBSG, failed to adequately screen both their customers, and the payments they made and received, against the sanctions list. This resulted in an unacceptable risk that RBSG could have facilitated transactions involving sanctions targets, including terrorist financing.
FSA considers that RBSG’s failings in relation to its screening procedures were particularly serious because of the risk they posed to the integrity of the UK financial services sector. This is the biggest fine imposed by the FSA to date in pursuit of its financial crime objective. It is also the first fine imposed by the FSA under the Regulations.
As RBSG agreed to settle at an early stage of the FSA investigation, it qualified for a 30% reduction in penalty. The FSA would have otherwise imposed a financial penalty of £8m.
Jack's comment: It appears that many financial institutions in the world (especially private banks) have not yet changed their lax attitude towards the compliance with money laundering rules.
Wednesday, July 28, 2010
Regulation of Life Settlements
Last week US SEC released a staff report recommending that life settlements be clearly defined as securities so that the investors in these transactions are protected under the federal securities laws.
A life settlement is a transaction in which an individual with a life insurance policy sells that policy to another person, who then assumes responsibility for paying the premiums. Typically, the seller no longer wants the policy or can no longer afford to pay the premiums. In exchange, the insured party typically receives a lump sum payment that exceeds the policy's cash surrender value, but is less than the expected payout in the event of death.
The staff report by SEC's Life Settlements Task Force, which SEC Chairman Mary Schapiro established in August 2009, notes that the market for life settlements has grown over the past decade, raising questions about its regulation and oversight.
In particular, the report notes that there is inconsistent regulation of participants in the life settlements market, including those who arrange for the buying and selling of policies and those who provide estimates of an insured's life expectancy. In addition, the report notes that investors in individual life settlement transactions, or pools of life settlements, would benefit from the application of baseline standards of conduct to market participants.
In the report, the staff outlines the Task Force's findings about the life settlements market and recommends ways to improve market practices and regulatory oversight. It recommends that the Commission should:
Amending the federal securities laws to define life settlements as securities could have several benefits:
A life settlement is a transaction in which an individual with a life insurance policy sells that policy to another person, who then assumes responsibility for paying the premiums. Typically, the seller no longer wants the policy or can no longer afford to pay the premiums. In exchange, the insured party typically receives a lump sum payment that exceeds the policy's cash surrender value, but is less than the expected payout in the event of death.
The staff report by SEC's Life Settlements Task Force, which SEC Chairman Mary Schapiro established in August 2009, notes that the market for life settlements has grown over the past decade, raising questions about its regulation and oversight.
In particular, the report notes that there is inconsistent regulation of participants in the life settlements market, including those who arrange for the buying and selling of policies and those who provide estimates of an insured's life expectancy. In addition, the report notes that investors in individual life settlement transactions, or pools of life settlements, would benefit from the application of baseline standards of conduct to market participants.
In the report, the staff outlines the Task Force's findings about the life settlements market and recommends ways to improve market practices and regulatory oversight. It recommends that the Commission should:
- Consider recommending to Congress that it amend the definition of security under the federal securities laws to include life settlements as securities.
- Instruct the staff to continue to monitor that legal standards of conduct are being met by brokers and providers.
- Instruct the staff to monitor for the development of a life settlement securitization market.
- Encourage Congress and state legislators to consider more significant and consistent regulation of life expectancy underwriters.
Amending the federal securities laws to define life settlements as securities could have several benefits:
- The amendment would clarify the status of life settlements under the federal securities laws and provide for a more consistent treatment of life settlements under both federal and state securities laws.
- The amendment would bring intermediaries in the life settlement market within the regulatory framework of SEC and FINRA. This would subject them to regulatory requirements designed to protect investors from abusive practices and to promote business conduct that facilitates fair, orderly and efficient markets.
- The amendment would give SEC and FINRA clear authority to police the life settlements market, which could lead to early detection of abuses and help deter fraud.
Wednesday, July 21, 2010
Responsible Lending
Last week UK FSA has today outlined proposals to ensure all mortgages are carefully assessed to make sure borrowers can afford them.
Reflecting FSA's enhanced consumer protection strategy and intensive day-to-day supervision, the proposed changes aim to ensure all lenders get back to the basics of responsible lending and that problems are prevented before they can develop or get out of control.
Some of the key proposals include:
FSA found that:
Jack's comment: While FSA is enforceing responsible lending, it may have failed to ensure responsible borrowing.
Reflecting FSA's enhanced consumer protection strategy and intensive day-to-day supervision, the proposed changes aim to ensure all lenders get back to the basics of responsible lending and that problems are prevented before they can develop or get out of control.
Some of the key proposals include:
- Imposing affordability tests for all mortgages and making lenders ultimately responsible for assessing a consumer's ability to pay;
- Requiring verification of borrowers' income in every case to prevent over inflation of income and to prevent mortgage fraud;
- Extra protection for vulnerable customers with a credit-impaired history.
FSA found that:
- 46% of households either had no money left, or had a shortfall after mortgage payments and living costs were deducted from their income;
- Almost half of new mortgages between 2007 and the first quarter of 2010 were provided without a customer having to verify their income;
- The share of interest-only mortgages has been increasing. At the peak of the market, over 30% of all mortgages were interest-only;
- Many consumers with no repayment vehicle count on future house price rises or uncertain life events to repay their mortgage and some have no plan at all;
- Borrowers with a credit-impaired history are particularly vulnerable.
Jack's comment: While FSA is enforceing responsible lending, it may have failed to ensure responsible borrowing.
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