Criminal Procedures Not Applicable to SFC Disciplinary Process

This week SFC announced that the Court of Appeal has allowed SFC's appeal against a decision of the Securities and Futures Appeals Tribunal (SFAT) and decided that criminal procedures are not applicable to SFC disciplinary proceedings.


On 19 March 2010, the SFAT altered SFC's decision to revoke the licence of Asser Li Kwok Keung and ban him for 10 years to a suspension for 18 months for lying to SFC and breaching his undertaking to co-operate. In addition, in its determination, the SFAT equated the obligations of the SFC in disciplinary proceedings with that of a prosecutor in criminal proceedings.


SFC appealed to the Court of Appeal against both the penalty imposed by the SFAT and its analogy drawn between SFC's disciplinary process and criminal procedures.


The Court of Appeal, comprising Madam Justice Kwan JA, Mr Justice Stone and Mr Justice Bharwaney, unanimously allowed the SFC’s appeal and increased the penalty for Li from a suspension of licence for 18 months to a prohibition order for three years.


Jack's comment: Many market practitioners believe that SFC's disciplinary process is a kind of "private punishment" and should be subject to the rigidity of criminal procedures. Unfortunately, the Hong Kong court usually supports SFC, especially when SFC can use taxpayers' monies to extend its power.

Synthetic ETFs

Last week SFC and HKEx a new effort to raise investors' awareness of Exchange Traded Funds (ETFs) that primarily adopt synthetic replication strategy (synthetic ETFs). A traditional ETF (also known as physical ETF) invests in securities that replicate or represent the composition of the index it tracks, and a synthetic ETF uses financial derivative instruments to track index performance.


A manager of an ETF may adopt one or more of the following strategies to achieve the fund's index tracking objective:

1. full replication by investing in a portfolio of securities that replicates the composition of the underlying index;
2. representative sampling by investing in a portfolio of securities featuring a high correlation with the underlying index, but not exactly the same as those in the index; or
3. synthetic replication through the use of financial derivative instruments (such as swaps and performance-linked structured products issued by counterparties) to replicate the index performance. 

Synthetic ETFs' managers have agreed to adopt new measures aimed at helping investors to better differentiate between index tracking strategies of ETFs. The new measures, supported by the SFC, HKEx and the industry following extensive discussions, are in line with ongoing efforts to strengthen protection for investors.


Addition of marker to stock short names of synthetic ETFs


Effective from 22 November, 2010, a marker X will be placed at the beginning of the English and Chinese stock short names of all synthetic ETFs listed on SEHK.


The marker will make synthetic ETFs more visible on the stock pages of HKEx's securities trading system and on the HKEx website and the HKExnews website. The stock short names of traditional ETFs will remain the same.


Annotation of names of synthetic ETFs


Building on the preceding measure, by 16 January 2011, managers of synthetic ETFs will be required to put an asterisk (*) and an annotation in English "(*This is a synthetic ETF)" and in Chinese "(*此基金為一隻合成交易所買賣基金)", as the case may be, right after the name of a synthetic ETF whenever it appears in offering documents and marketing materials for a synthetic ETF issued by the manager or on the manager’s behalf to investors in Hong Kong.


This requirement will also be applicable to all notices and other communications with Hong Kong investors in respect of synthetic ETFs whenever the name of the synthetic ETF is mentioned, including information on the corporate websites for Hong Kong investors run by or on behalf of synthetic ETFs' managers.


Investor education initiatives


SFC will continue its investor education efforts to help investors better understand synthetic ETFs.


HKEx is updating its product education material to explain the purpose of the stock short name marker and the risks of ETFs using synthetic replication.


HKEx will also enhance the HKEx website to highlight disclosure of ETF product features. For example, it will indicate which ones use synthetic replication and which ones do not. This will help investors find ETFs by their product features more easily.


HKEx has enhanced the hyperlinks to ETF websites from the HKEx website to provide easier navigation to ETF websites.


Other measure to enhance transparency of ETFs


To assist managers of ETFs in complying with the ongoing disclosure obligations under the Code on Unit Trusts and Mutual Funds and/or Listing Agreement, SFC and HKEx today jointly issued a circular containing a list of potential events that may trigger such disclosure obligation.


Jack's comment: Retail investors should thank Next Magazine's article published several months ago for reporting the danger of synthetic ETFs. SFC is often working on hindsight when handling products.

False Portfolio Valuation Report to Conceal Stealing

This week SFC banned Ms Pauline Ellen Cousins, a former managing director and responsible officer of Crown Asset Management Limited, from re-entering the industry for life.

Between 2002 and 2006, Cousins produced four false portfolio valuation summaries to a client. The portfolio valuation summaries belonged to other clients and Cousins used them to mislead her client into believing that he had invested a lump sum of $1.75 million in an investment-linked assurance scheme. Instead Cousins had, without her client's authority, invested the lump sum in the shares of a hi-tech company, which was subsequently put into administration.

The disciplinary action follows Cousins' conviction in the District Court on four counts of furnishing false information. Cousins was sentenced to 21 months' imprisonment in December 2009 in proceedings commenced by the police’s Commercial Crime Bureau following referral by SFC.


Jack's comment: In the age of web 2.0, we shouldn't trust any paper produced by intermediaries.

Whistleblower Program

Last week the US SEC voted unanimously to propose a whistleblower program to reward individuals who provide the agency with high-quality tips that lead to successful enforcement actions.

Rules Requirements

Under the proposed rules, a whistleblower is a person who provides information to the SEC relating to a potential violation of the securities laws.

To be considered for an award, a whistleblower must …

Voluntarily provide the SEC …

In general, a whistleblower is deemed to have provided information voluntarily if the whistleblower has provided information before the government, a self-regulatory organization or the Public Company Accounting Oversight Board asks for it.

… with original information …

Original information must be based upon the whistleblower’s independent knowledge or independent analysis, not already known to the Commission and not derived exclusively from certain public sources.

… that leads to the successful enforcement by the SEC of a federal court or administrative action …

A whistleblower's information can be deemed to have led to successful enforcement in two circumstances: (1) if the information results in a new examination or investigation being opened and significantly contributes to the success of a resulting enforcement action, or (2) if the conduct was already under investigation when the information was submitted, but the information is essential to the success of the action and would not have otherwise been obtained. 

… in which the SEC obtains monetary sanctions totaling more than $1 million.

The proposed rules further define and explain these requirements.

Key concepts would include …

Avoiding unintended consequences:

Certain people would generally not be considered for whistleblower awards under the proposed rules. These include:

• People who have a pre-existing legal or contractual duty to report their information.
• Attorneys who attempt to use information obtained from client engagements to make whistleblower claims for themselves (unless disclosure of the information is permitted under SEC rules or state bar rules).
• Independent public accountants who obtain information through an engagement required under the securities laws.
• Foreign government officials.
• People who learn about violations through a company's internal compliance program or who are in positions of responsibility for an entity, and the information is reported to them in the expectation that they will take appropriate steps to respond to the violation.

This last exclusion — which is intended to prevent company personnel from "front running" legitimate internal investigations — ceases to be applicable if the company does not disclose the information to the Commission within a reasonable time or acts in bad faith. In these circumstances, such people can become whistleblowers.

Certain other people — such as employees of certain agencies and people who are criminally convicted in connection with the conduct — are excluded by Dodd-Frank.

The SEC also would not pay culpable whistleblowers awards that are based upon either the monetary sanctions that such people themselves pay in the resulting SEC action, or on sanctions paid by entities whose liability is based substantially on conduct that the whistleblower directed, planned, or initiated. The purpose of this provision is to prevent wrongdoers from benefitting by, in effect, blowing the whistle on themselves.

Providing Information to the SEC and Seeking a Reward:

The proposed rules also would describe procedures for submitting information to the SEC and for making an award claim after an action is brought. The claim procedures would provide opportunities for whistleblowers to fairly present their case before the Commission makes a final award determination.

The SEC also would pay an award based on amounts collected in related actions brought by certain agencies that are based upon the same original information that led to a successful SEC action.

Supporting Internal Compliance Programs:

The proposed rules include provisions to discourage employees from bypassing their own company’s internal compliance programs.

For instance, the proposed rules:

• Would treat an employee as a whistleblower under the SEC program as of the date that employee reports the information internally — as long as the employee provides the same information to the SEC within 90 days. Through this provision, employees will be able to report their information internally first while preserving their “place in line” for a possible award from the SEC.
• Permit the SEC to consider higher percentage awards for whistleblowers who first report their information through effective company compliance programs. 

What’s Next?

The proposal seeks public comment and data on a broad range of issues relating to the whistleblower program. After careful review of the comments, the Commission will consider what further action to take on the proposal.


Jack's comment: I can hardly imagine such a whistle-blowing program would be implemented in any Chinese society!

Medical Researcher Charged With Tipping Inside Information

We often see directors of listed companies or investment bankers being charged with insider dealing.  Recently there is a US case involving a doctor.


This week US SEC charged a French medical doctor and researcher with breaking securities laws by tipping a hedge fund manager with confidential information about a clinical trial that he was involved in.


SEC alleges that Yves M. Benhamou, M.D., breached his duty of confidentiality to Human Genome Science, Inc. (HGSI) when he illegally tipped non-public negative details about a clinical trial for the drug Albumin Interferon Alfa 2-a (Albuferon) ahead of a public announcement by the company.


Benhamou was a member of the Steering Committee overseeing HGSI's clinical trial of Albuferon, a potential drug to treat Hepatitis C. Benhamou learned about two serious adverse events, including one death, occurring during the third phase of the trial. HGSI consequently decided to reduce the dosage for the patients in that arm of the trial and publicly announce the changes.


Benhamou tipped material, non-public information about the trial to the hedge fund portfolio manager upon learning of each new negative development. While serving on the Steering Committee, Benhamou provided consulting services to the portfolio manager with whom he had developed a friendship over the years.


The portfolio manager, based on the confidential information provided by Benhamou, ordered the sale of the entire position of HGSI stock held by six health care-related hedge funds that he co-managed (approximately 6 million shares). These sales occurred during the six-week period prior to HGSI's public announcement on Jan. 23, 2008, that it was reducing the dosage in one arm of the trial. Two million shares were sold in a block trade just before the markets closed on January 22. HGSI's share price dropped 44 percent by the end of the day on January 23. As a result of the sales, the hedge funds avoided losses of at least $30 million.

Fraud in Valuing Side Pocket

Last week SEC charged two hedge fund portfolio managers and their investment advisory businesses with defrauding investors in the Palisades Master Fund, L.P. by overvaluing illiquid fund assets they placed in a "side pocket."


SEC alleges that the hedge fund managers Paul Mannion and Andrews Reckles placed the Palisades hedge fund's investments in World Health Alternatives Inc. in a side pocket and valued those investments in a manner that was inconsistent with fund policy and contrary to an undisclosed internal assessment. They also stole investor money to pay for their own personal investments and made material misrepresentations in connection with a private securities transaction.



A side pocket is a type of account that hedge funds use to separate particular investments that are typically illiquid from the remainder of the investments in the fund. SEC's Asset Management Unit has been probing whether funds have overvalued assets in side pockets while charging investors higher fees based on those inflated values.


According to SEC's allegations:

• Mannion and Reckles stole more than approximately $1.6 million worth of warrants belonging to the fund. They also improperly used investors' cash on at least two occasions to make personal investments, and they deceived a securities issuer by making false representations about their trading positions in order to participate in a private offering by the issuer.
• Mannion and Reckles defrauded investors for at least a three-month period in 2005 through PEF Advisors LLC and PEF Advisors Ltd., two investment adviser entities they controlled. The fraudulent valuations of a convertible debenture, restricted stock, and bridge loans enabled Mannion and Reckles to report to investors misleadingly inflated net asset values, allowing them to take excessive management fees from the fund.

Jack's comment: That is one of the reasons why hedge fund managers are richer than their clients!

SEC's Largest-Ever Financial Penalty Against a Public Company's Senior Executive

Last week SEC announced that former Countrywide Financial CEO Angelo Mozilo will pay a record $22.5 million penalty to settle SEC charges that he and two other former Countrywide executives misled investors as the subprime mortgage crisis emerged. The settlement also permanently bars Mozilo from ever again serving as an officer or director of a publicly traded company.


Mozilo's financial penalty is the largest ever paid by a public company's senior executive in an SEC settlement. Mozilo also agreed to $45 million in disgorgement of ill-gotten gains to settle SEC's disclosure violation and insider trading charges against him, for a total financial settlement of $67.5 million that will be returned to harmed investors.


Former Countrywide chief operating officer David Sambol agreed to a settlement in which he is liable for $5 million in disgorgement and a $520,000 penalty, and a three-year officer and director bar. Former chief financial officer Eric Sieracki agreed to pay a $130,000 penalty and a one-year bar from practicing before the Commission. In settling SEC's charges, the former executives neither admit nor deny the allegations against them.
The penalties and disgorgement paid by Sambol and Sieracki will also be returned to harmed investors.


SEC filed charges against Mozilo, Sambol and Sieracki on June 4, 2009, alleging that they failed to disclose to investors the significant credit risk that Countrywide was taking on as a result of its efforts to build and maintain market share. Investors were misled by representations assuring them that Countrywide was primarily a prime quality mortgage lender that had avoided the excesses of its competitors. In reality, Countrywide was writing increasingly risky loans and its senior executives knew that defaults and delinquencies in its servicing portfolio as well as the loans it packaged and sold as mortgage-backed securities would rise as a result.


SEC's complaint further alleged that Mozilo engaged in insider trading in the securities of Countrywide by establishing four 10b5-1 sales plans in October, November, and December 2006 while he was aware of material, non-public information concerning Countrywide's increasing credit risk and the risk regarding the poor expected performance of Countrywide-originated loans.


Jack's comment: Don't invest in financial stocks until their risks taken are sufficiently transparent to you.