Proposed Establishment of an Independent Insurance Authority

During August 2010, FSTB issued the Consultation Paper on Proposed Establishment of an Independent Insurance Authority. This Monday (11 October 2010) was the due day for submission. I provided the comments to FSTB on behalf of the International Academy of Financial Management - Hong Kong Chapter ("IAFMHK"), which are set out as follows:

Consultation Questions

1. Do you agree that an independent IA should be established along the principles set out in paragraph 2.6?

IAFMHK: We agree to the establishment of an independent IA for more effective regulation of the insurance industry. This is in line with the regulatory practices of banking and securities industries in Hong Kong.

2. Do you think that there are other important principles in addition to those set out in paragraph 2.6 that the Administration should adopt in working out the detailed legislative proposals for the establishment of the independent IA? If so, what are they?

IAFMHK: We think that the independent IA should also adopt two more principles: (a) protection of the interests of insurance agents working for insurance companies; and (b) education of the general public about insurance products and industry practices.

3. Do you agree that the independent IA should have an expanded role beyond the existing functions of the IA as set out in paragraph 3.1? If so, do you agree that the independent IA should assume the additional functions as proposed in paragraphs 3.3 and 3.4?

IAFMHK: Agree, especially the independent IA should be able to directly supervise insurance intermediaries.

4. Do you agree the independent IA should also have a duty to enhance the competitiveness of the insurance industry, which will help to reinforce Hong Kong’s status as an international financial centre?

IAFMHK: The fundamental responsibility of the independent IA remain the enforcement of insurance regulations. However, it should adopt a pragmatic regulatory approach to avoid hindering the industry from product innovation and business versatility.

5. Do you agree that the independent IA should be vested with additional powers as proposed in paragraph 4.7 to enable it to regulate insurers more effectively?

IAFMHK: Agree. The additional powers are necessary for the independent IA to enforce the relevant laws and regulations.

6. Do you consider that the existing self-regulatory arrangements for insurance intermediaries should be changed, and if so, do you support that Option 2 (i.e. direct supervision of insurance intermediaries by the independent IA) should be pursued? If not, why?

IAFMHK: We support Option 2.

7. Do you consider that in relation to the sale of insurance products in banks, the HKMA should be vested with powers similar to those for the independent IA to allow HKMA to regulate bank employees selling insurance products given the different client profile and sale environment in banks?

IAFMHK: Different client profile and sale environment is not a sufficient reason to justify that sale of insurance products in banks should be regulated by the HKMA. For avoidance of regulatory arbitrage, sale of insurance products by insurance companies, insurance brokers, independent financial advisors and banks should be regulated by a single and specialist regulatory body.

8. Do you agree that the recommendations as set out in paragraphs 6.5 to 6.8 should be pursued for the independent IA to operate as an independent entity? Any other views?

IAFMHK: We largely agree to the recommendations but suggest that the incentive pay should be linked to the meeting of certain objective performance pledges.

9. Do you agree with the proposed checks and balances and governance arrangements for the independent IA as set out in this Chapter?

IAFMHK: We agree to the proposed checks and balances and governance arrangements. In addition, we suggest the establishment of a mediation and arbitration mechanism to resolve the commercial disputes among insurance companies, insurance intermediaries and/or insurance policyholders.

10. Do you agree that the Government should provide a lump sum to support the independent IA in its initial years of operation and the independent IA should seek to reach full cost recovery in six years?

IAFMHK: We agree that the Government should provide financial assistance to the support the independent IA in its initial years of operation. However, we suggest a longer period (say, 10 years) for full cost recovery to reduce the burden of the insurance industry.

11. Do you agree with the proposed fee structure as set out in paragraphs 8.2 and 8.6?

IAFMHK: We agree to the proposed fee structures.

Regulatory Framework for Pre-Deal Research

Last week SFC started a two-month public consultation on proposals to expand the scope of the present requirements governing conflicts of interest for analysts so that not only research reports on listed securities but also those on IPOs are covered.

The proposed changes to existing regulatory requirements are summarized in SFC's consultation questions below. My initial comments are also provided.

1.   Do you agree that the requirements in paragraph 16 of the Code of Conduct should be extended to cover research analysts in relation to Pre-deal Research reports?

Jack: It makes sense for paragraph 16 to cover analysts issuing pre-deal research reports as well.

2.   Do you agree that the requirements of paragraph 16 of the Code of Conduct should be extended to cover research analysts covering proposed listings of and listed SFC-authorised REITs in Hong Kong?

Jack: It makes sense for paragraph 16 to cover research reports on REITs as well.

3.   Do you agree that the firm employing research analysts preparing pre-deal research reports on a Applicant should be required to establish, maintain and enforce a set of written policies and control procedures to ensure that these analysts are not provided by the firm with any material information or forward looking information (whether qualitative or quantitative), concerning the Applicant that are not: (a) reasonably expected to be included in the prospectus; or (b) publicly available?

Jack: Agree, but SFC should issue some guidelines on (i) the benchmark for such policies and control procedures (e.g. additional Chinese Wall procedure); and (ii) what constitutes material information or forward looking information that will not be included in the prospectus or publicly available. Also, SFC should specify which party can make the final judgement on such unprovided information.

4.   Do you agree that a research analyst preparing a research report on an Applicant should not seek to obtain from the Applicant or its advisers, any material information or forward looking information (whether qualitative or quantitative), that are: (a) not reasonably expected to be included in the prospectus; or (b) publicly available?

Jack: Ditto

5.   Do you agree that the proposed amendments to Paragraph 16 of the Code of Conduct set out in Appendix 1 implement the above proposals?

Jack: The proposed amendments are not adequate. See above comments.

6.   Do you agree that sponsors should take steps to ensure that all material information or forward looking information (whether qualitative or quantitative), disclosed or provided to analysts is contained in the relevant prospectus or where the proposed listing does not involve a prospectus the relevant listing document, offering circular or similar document?

Jack: Agree in principle, but what steps should be taken by sponsors? Shall a sponsor review the pre-deal research reports to ensure that all material or forward looking information provided to analysts is contained in the prospectus. If the reports contain information gathered by the analysts through their own due diligence, how can the sponsor confirm that such information is not obtained from the Applicant? If the sponsor reviews the research reports, would the independence of analysts be compromised?

7.   Do you agree that the proposed amendments to the CFA Code of Conduct set out in Appendix 2 implement the above proposal?

Jack: The proposed amendments are not adequate. See above comments.

Scripless Securities Market

Last week SFC announced the plan to introduce a scripless securities market in Hong Kong after the consultation. The key features of the proposed scripless model are summarized below:

• Dual system : The existing paper-based system will be retained for the time being so that it runs in parallel with the proposed scripless system. Investors will be allowed to dematerialise securities held in paper form into uncertificated form and also to rematerialise them back into physical form, as long as the dual system exists. The duration of maintaining the dual system will be kept open for now.
• Full dematerialisation ultimately : Dematerialisation will be made compulsory eventually i.e. the paper-based option will be removed altogether.
• Phased approach : Existing securities will be dematerialised in batches starting with shares of companies incorporated in Hong Kong.
• Register to comprise two parts : The register of holders will consist of a certificated sub-register which is maintained by the share registrar and an uncertificated sub-register which is maintained by HKSCC. To facilitate inspection, corporate action processing and corporate entitlements calculation, HKSCC will provide the respective share registrars with a day-end record of the uncertificated sub-register. The day-end record will also allow share registrars to reconcile the two sub-registers.
• Removal of the immediate credit arrangement : One of the consequences of the register of holders comprising two sub-registers is the removal of the immediate credit arrangement by HKSCC.
• Account types to hold uncertificated securities : Investors will be able to hold their uncertificated securities through four different account types. Only one of these, namely the Issuer Sponsored Account (ISA), is a new account type under the proposed model. The other three are essentially modified versions of the existing CCASS Participant Account (CPA), Stock Segregated Account and Investor Participant Account (IPA).
• Name on register : Investors will be able to hold securities in CCASS in their own names i.e. they will have the option of becoming the legal owner of the securities and of enjoying the full benefits of legal ownership.
• Unique identification numbers : Currently, investors who hold securities within CCASS are required to provide an identity proof (such as their HKID) during the account opening process with a broker/bank/custodian or HKSCC, as the case may be. Building on this practice, we propose that investors' identification numbers be made available to both HKSCC and the relevant share registrar.
• Attending and voting at shareholders' meetings : The Working Group is keen to preserve the status quo of allowing beneficial owners to attend and vote at shareholders' meeting and considers that the better way to achieve this may be to simply allow the appointment of multiple proxies. This way, brokers / banks / custodians who hold shares on behalf of clients will be able to appoint their clients as proxies to attend and vote at meetings. For clients who merely wish to vote but not to attend the meeting, their interest can be represented by brokers / banks / custodians through appointing the chairman of the meeting as a proxy to vote on their behalf.
• Disseminating corporate communications and providing corporate action services to securities holders : As HKSCC Nominees will no longer be the registered holder of uncertificated securities in CCASS, there will be changes in the dissemination of corporate communications and provision of corporate action services to holders of uncertificated securities. Accordingly, we propose that share registrars will disseminate corporate communications to all registered holders (both certificated and uncertificated) and HKSCC will continue to provide additional services like providing receivable notices to uncertificated holders who hold their securities through a CPA, Participant Sponsored Account (PSA) or IPA.
• Regulation of share registrars : Share registrars will be able to become a new category of participants in CCASS (if they meet the admission criteria). This will allow them to use the existing CCASS infrastructure to communicate electronically with other CCASS Participants and to handle instructions relating to uncertificated securities. Additionally, in view of their more active and involved roles and functions in the scripless environment, share registrars will be more directly and robustly regulated.
• IPOs : In the scripless environment, the existing four ways to apply for an IPO (applications via a white form, a white form eIPO, a yellow form and CCASS eIPO) will remain largely unchanged. The main difference will be that applicants under the white form and white form eIPO options will be able to choose if their securities should be issued in uncertificated or physical form.
• Scope : Pending resolution of certain practical issues, the scripless proposals will be implemented in relation to shares of listed companies - starting first with those incorporated in Hong Kong and then those incorporated overseas.
• Shares and debentures of companies incorporated overseas and listed in Hong Kong : We will focus first on companies incorporated in Bermuda, Cayman Islands, Mainland China and UK mainly because companies incorporated in these four jurisdictions make up the vast majority of overseas companies listed on the SEHK and will therefore have a greater impact on the scripless initiative.
• Roll-out plan for implementing a scripless securities market : There will be two distinct implementation timelines which are independent of one another - one for existing securities and the other for IPOs. In both cases however, there will first be a pilot run.

Jack's comment: There are so many advantages of the scripless model. It should have been implemented since ten years ago!

RMB Products

RMB products are getting hot in our city. Therefore HKMA recently issued a circular to remind all banks to ensure that the material features and risks of such products are adequately taken into account in the product due diligence process and the suitability assessment of customers. Key points are summarized below:

Proper disclosure of the nature of RMB products

Banks should ensure that customers understand the nature of the RMB product including any underlying investments and whether any deposit protection is available.

Proper disclosure of the risks of RMB products

The following paragraphs highlight some of the key risks relevant to RMB products.

RMB currency risk

When a customer opens a RMB deposit account, the bank should disclose to the customer the RMB exchange rate risk and the fact that RMB is currently not freely convertible and conversion of RMB through banks in Hong Kong is subject to certain restrictions. Such risks should also be disclosed to its customers during the marketing and selling process of RMB investment and insurance products. In particular, for personal customers, the bank should explain that as the conversion of RMB is subject to a daily limit, the customer may have to allow time for conversion of RMB from/to another currency of an amount exceeding the daily limit.

For RMB products which are not denominated in RMB or with underlying investments which are not RMB-denominated, banks should disclose to their customers that such products will be subject to multiple currency conversion costs involved in making investments and liquidating investments, as well as the RMB exchange rate fluctuations and bid/offer spreads when assets are sold to meet redemption requests and other capital requirements (e.g. settling operating expenses).

Other risks associated with RMB products

• Limited availability of underlying investments denominated in RMB – For RMB products that do not have access to invest directly in Mainland China, their available choice of underlying investments denominated in RMB outside Mainland China may be limited. Banks should explain to the customers that such llimitation may adversely affect the return and performance of the RMB products.
• Projected returns which are not guaranteed – If the RMB investment product (e.g. RMB ILAS) is attached with a statement of illustrative return which is (partly) not guaranteed, banks should clearly disclose to their customers that the return which is not guaranteed and the assumptions on which the illustrations are based, including, e.g. any future bonus or dividend declaration.
• Long term commitment to investment products – For RMB products which involve a long period of investment (e.g. RMB ILAS), banks should remind customers that if they redeem their investment before the maturity date or during the lock-up period, they may incur a significant loss of principal where the proceeds may be substantially lower than their invested amount. Customers should be reminded of the early surrender/withdrawal fees and charges as well as the loss of bonuses as a result of redemption before the maturity date or during the lock-up period.
• Credit risk of counterparties – Banks should disclose to their customers the credit risk of counterparties involved in the RMB products. To the extent that the RMB products may invest in RMB debt instruments not supported by any collateral, AIs should ensure customers' understanding that such products are fully exposed to the credit risk of the relevant counterparties. Where a RMB product may invest in derivative instruments, counterparty risk may also arise as the default by the derivative issuers may adversely affect the performance of the RMB product and result in substantial loss.
• Interest rate risk – For RMB products which are, or may invest in, RMB debt instruments, banks should disclose to their customers that such instruments are susceptible to interest rate fluctuations, which may adversely affect the return and performance of the RMB products.
• Liquidity risk – Banks should remind customers of the liquidity risk associated with the RMB products, and where applicable, the possibility that the RMB products may suffer significant losses in liquidating the underlying investments, especially if such investments do not have an active secondary market and their prices have large bid/offer spreads.
• Possibility of not receiving RMB upon redemption – For RMB products with a significant portion of non-RMB denominated underlying investments, banks should disclose to their customers that there is a possibility of not receiving the full amount in RMB upon redemption. This may be the case if the issuer is not able to obtain sufficient amount of RMB in a timely manner due to the exchange controls and restrictions applicable to the currency.
• Additional risks associated with leveraged trading – Banks should note that leveraged trading facilities should not be offered to personal customers and Designated Business Customers (DBCs) in respect of RMB products. While banks may extend RMB loans to corporate customers, prior to conducting leveraged trading of RMB products for corporate customers, banks should ensure that the customers understand and are willing to accept the risks and the terms and conditions of the borrowing arrangement. Banks should explain to customers that leveraging heightens the investment risk by magnifying prospective losses. Customers should be properly informed of the circumstances under which they will be required to place additional margin deposits at short notice and that their collateral may be liquidated without their consent. Banks should also ensure their customers' understanding of the risk that market conditions may make it impossible to execute contingent orders, such as "stop-loss" orders. In addition, customers should be reminded of their exposure to interest rate risk, and in particular, their cost of borrowing may increase due to interest rate movements.

Jack's comment: HKMA almost treats RMB products like Lehman minibonds. My concern is that people buying RMB products are too distracted by the expectation of RMB appreciation, ignoring the scene behind these products.

Basel III

(Extracted from BIS Basel Committee's Press Release 2010.09.12)

At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010. These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the Seoul G20 Leaders summit in November.

The Committee’s package of reforms will increase the minimum common equity requirement from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%. This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative and securitisation activities to be introduced at the end of 2011.

Increased capital requirements

Under the agreements reached today, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments. This will be phased in by 1 January 2015. The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period.

The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions. This framework will reinforce the objective of sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and high dividends, even in the face of deteriorating capital positions.

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above. In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt. In addition, work is continuing to strengthen resolution regimes. The Basel Committee also recently issued a consultative document Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability. Governors and Heads of Supervision endorse the aim to strengthen the loss absorbency of non-common Tier 1 and Tier 2 capital instruments.

Transition arrangements

Since the onset of the crisis, banks have already undertaken substantial efforts to raise their capital levels. However, preliminary results of the Committee’s comprehensive quantitative impact study show that as of the end of 2009, large banks will need, in the aggregate, a significant amount of additional capital to meet these new requirements. Smaller banks, which are particularly important for lending to the SME sector, for the most part already meet these higher standards.

The Governors and Heads of Supervision also agreed on transitional arrangements for implementing the new standards. These will help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy. The transitional arrangements include:

• National implementation by member countries will begin on 1 January 2013. Member countries must translate the rules into national laws and regulations before this date. As of 1 January 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs): 3.5% common equity/RWAs; 4.5% Tier 1 capital/RWAs, and 8.0% total capital/RWAs. The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015. On 1 January 2013, the minimum common equity requirement will rise from the current 2% level to 3.5%. The Tier 1 capital requirement will rise from 4% to 4.5%. On 1 January 2014, banks will have to meet a 4% minimum common equity requirement and a Tier 1 requirement of 5.5%. On 1 January 2015, banks will have to meet the 4.5% common equity and the 6% Tier 1 requirements. The total capital requirement remains at the existing level of 8.0% and so does not need to be phased in. The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 and higher forms of capital.
• The regulatory adjustments (ie deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, would be fully deducted from common equity by 1 January 2018.
• In particular, the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014, 40% on 1 January 2015, 60% on 1 January 2016, 80% on 1 January 2017, and reach 100% on 1 January 2018. During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.
• The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.
• Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.
• Existing public sector capital injections will be grandfathered until 1 January 2018. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10 year horizon beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.
• Capital instruments that do not meet the criteria for inclusion in common equity Tier 1 will be excluded from common equity Tier 1 as of 1 January 2013. However, instruments meeting the following three conditions will be phased out over the same horizon described in the previous bullet point: (1) they are issued by a non-joint stock company1; (2) they are treated as equity under the prevailing accounting standards; and (3) they receive unlimited recognition as part of Tier 1 capital under current national banking law.
• Only those instruments issued before the date of this press release should qualify for the above transition arrangements.

Phase-in arrangements for the leverage ratio were announced in the 26 July 2010 press release of the Group of Governors and Heads of Supervision. That is, the supervisory monitoring period will commence 1 January 2011; the parallel run period will commence 1 January 2013 and run until 1 January 2017; and disclosure of the leverage ratio and its components will start 1 January 2015. Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

After an observation period beginning in 2011, the liquidity coverage ratio (LCR) will be introduced on 1 January 2015. The revised net stable funding ratio (NSFR) will move to a minimum standard by 1 January 2018. The Committee will put in place rigorous reporting processes to monitor the ratios during the transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary.

Deficient AML Controls Over Omnibus Accounts

US SEC charged Pinnacle Capital Markets LLC with failing to comply with an anti-money laundering (AML) rule that requires broker-dealers to identify and verify the identities of its customers and document its procedures for doing so. SEC also charged Pinnacle's managing director Michael A. Paciorek with causing Pinnacle's violations.

Pinnacle is a broker-dealer based in Raleigh, N.C., with more than 99% of its customers residing outside the United States. Pinnacle's business primarily involves order processing with direct market access (DMA) software for foreign institutions comprised mostly of banks and brokerage firms and foreign individuals.

SEC found that Pinnacle established, documented and maintained a customer identification program (CIP) that specified it would identify and verify the identities of all of its customers. However, during a six-year period, Pinnacle failed to follow the identification and verification procedures set forth in its CIP.

Many of the firm's foreign entity customers hold omnibus accounts at Pinnacle through which the entities carry sub-accounts for their own corporate or retail customers. Pinnacle treats the sub-account holders of the foreign entity omnibus accounts in the same manner as it does its regular account holders. The vast majority of Pinnacle's regular account holders, as well as the omnibus sub-account holders, use DMA software to enter securities trades directly and instantly through their own computers. As a result, these account holders have direct, unfiltered control over how securities transactions are effected in the accounts. The foreign entity holding the omnibus account does not intermediate these trades. The DMA software allows the omnibus sub-account holders to route their securities transactions directly to the relevant market centers without intermediation.

From October 2003 to August 2006, Pinnacle did not verify the identities of 34 out of a sample of 55 corporate account holders. The Commission also finds that from October 2003 through November 2009, Pinnacle did not collect or verify identifying information for the vast majority of the beneficial owners of sub-accounts maintained by Pinnacle's omnibus brokerage accounts. Consequently, the order finds that Pinnacle's documented procedures differed materially from its actual procedures.

Pinnacle and Paciorek agreed to settle SEC's enforcement action without admitting or denying the allegations, and Pinnacle will pay $25,000 in financial penalties. As part of an action taken by FINRA in February 2010, Pinnacle also has agreed to certain undertakings, including extensive AML training for its employees, as well as the hiring of an independent consultant to review its AML compliance program.

Jack's comment: DMA plus omnibus account is really a perfect mix for not only keeping privacy, but also money laundering. KYC is always the No.1 fundamental compliance issue.

Sales of Inverse Floater CMOs

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.