Issue of Advertisements of Unauthorized Fund

As announced by SFC on 21 Mar 2013, the Eastern Magistracy acquitted Pacific Sun Advisors Limited (Pacific Sun) and its director Mr Andrew Mantel for 4 counts of issuing advertisements to promote a collective investment scheme (CIS) without SFC's authorization, in contravention of S.103 of the SFO.

SFC alleged that between Nov and Dec 2011, the defendants issued an advertisement on the corporate website of Pacific Sun promoting a CIS called "Pacific Sun Greater China Equities Fund" (the Fund) without SFC's authorization. On or around 2 and 3 Nov 2011, the defendants issued an advertisement regarding the launch of the Fund to the public by email without SFC's authorization.

During 3 days of evidence, the defendants submitted that they intended to sell interests in the units of the Fund only to professional investors and so the advertisements did not require SFC's authorization under a statutory exemption. But SFC submitted that the exemption did not permit advertisements that had not been authorized by SFC to be issued to the public and that in this case there was no evidence that the interests in the Fund had only been sold to professional investors.

The Magistrate accepted the defendants' argument and ruled also that the advertisements did not constitute invitations to the public to invest in the Fund. SFC will consider an appeal of the decision.

This case is interesting. For my previous interpretation of S.103 of the SFO, advertising an unauthorized fund without SFC's authorization is no doubt illegal, even if the promoter has the "intention" of selling the fund to PI only. The court judgement has overturned this thought!


Subsequent update on 10 Jun 2014:

• Following SFC's appeal concerning the acquittal in which the Court of First Instance in Jan 2014 issued a ruling clarifying that the advertisements in question did not fall within the exemption and ordered the case to be returned to the Magistrates’ Court for reconsideration.
• The Court of First Instance made it clear that the exemption only applies where the advertisement states on its face that the terms of the offer are limited to professional investors. SFC considers this ruling protects retail investors from the risks of direct marketing of inappropriate or risky investment products.
• As a result, Pacific Sun and Andrew Mantel were convicted at the Tsuen Wan Magistrates' Court on 4 charges of issuing advertisements to promote a CIS without SFC's authorization. Pacific Sun was fined $20,000 and Andrew Mantel was sentenced to 4 weeks' imprisonment suspended for 12 months.

Subsequent update on 20 Mar 2015:

• The Court of Final Appeal (CFA) upheld an appeal by Pacific Sun and Andrew Mantel in relation to issuing advertisements to promote a CIS without SFC's authorization. The ruling of the CFA overturned a decision by the Court of First Instance on the interpretation of S.103 of the SFO.
• The CFA decided the Court of First Instance erred in its ruling in that the exclusion applies even if the intention to dispose of the securities or interests in a CIS only to professional investors is not expressed in the advertisement, invitation or document. The CFA made it clear that the burden of establishing the exclusion applies rests on the defendant and not on SFC.
• The CFA also stated that the professional investor exemption would not apply if a person published an unauthorized offer to the public and sold the advertised securities to a retail investor.
• This ruling means advertisements of unauthorized CIS can be issued to the general public if the issuer only intends to sell them to PI. It also means a contravention of S.103 of the SFO can only be established well after the offer to the public has been issued.
• SFC alleges that it will study the CFA's decision to determine whether there should be any proposal to amend S.103 of the SFO.

Inadequate Investor Profiling

As announced on 4 Mar 2013, SFC reprimanded Manulife Asset Management (Hong Kong) Limited (MAM) and fined it HK$24 million for inadequate internal controls in relation to the distribution of Manulife Global Fund (authorized by SFC) from 2007 to 2012.

SFC's findings focus on MAM's systems and processes for understanding its customer’s financial situation, investment experience, and investment objectives in soliciting or recommending the sale of the Fund to them.

Between 2007 and 2009, Manulife Asset Management obtained this information by performing an investor profile for each customer. However, 73% of the customers in 2009 were not profiled or their information was either incomplete or outdated for at least 12 months.

Needless to say, "not profiled" is more severe than "incomplete" which is in turn more severe than "outdated". However, SFC gave only the total percentage (73%) of all these deficiencies but did not provide the breakdown.

After 2010, MAM introduced a questionnaire to assess each customer's risk profile. By Feb 2012, the new process had not been fully implemented to all customers and MAM still had not secured a completed risk profile questionnaire from 70% of the Fund's customers.

Together with concerns about the quality and extent of its record-keeping, these failures have jeopardised MAM's capacity to ensure that recommended securities are suitable for each customer.

Despite these failures, SFC said there has been no default in any of the sub-funds of the Fund nor has any customer complained about the performance or suitability of the fund. Then how did SFC come up with such a huge amount of penalty? Of course, MAM is a big firm. If it was a small IFA incurred with the same deficiencies, I don't think SFC could impose a fine of $24 million.

Victims from Taiwan

Don't presume victims of Lehman Brothers related products sold in Hong Kong were limited to local residents. Some of them may be overseas investors.

As announced on 4 Dec 2012, SFC reprimanded President Securities (Hong Kong) Limited and fined it $2 million for failing to act in the best interests of its clients when accepting subscriptions for a number of Lehman Brothers related structured products by 21 Taiwanese clients in 2008.

SFC's investigation found that the selling process of the products gave rise to a number of regulatory concerns:

• The Taiwanese clients were referred to President Securities by its parent company in Taiwan, President Securities Corporation (PSC). They opened accounts with President Securities before they purchased the products, but the account opening process was handled by PSC.
• President Securities staff signed as witnesses on the Taiwanese clients’ account opening documents when, in fact, they had never met the clients.
• No one from President Securities contacted the Taiwanese clients to verify their identities, explain the account opening documents to them, establish their financial situation, investment experience, and investment objectives, and make risk disclosure to them.
• President Securities did not sufficiently ensure that the Taiwanese clients understood the products and accepted the risks associated with them before accepting their subscriptions for the products. It relied on standard risk disclaimers signed by the Taiwanese clients even though no explanation of the disclaimers had been given to the clients.
• A number of the products prescribed minimum subscription requirements to restrict the categories of investors eligible to invest in them. Since some of the Taiwanese clients' subscriptions amounts did not meet the minimum subscription requirements, President Securities pooled their orders together so as to meet the minimum subscription requirements. However, President Securities did not inform such clients that their orders would be pooled together.

It appears that President Securities was only a booking center for the product distribution, while all the (lousy) jobs were done by its parent company.

Product Due Diligence Totally Outsourced

As announced on 16 Aug 2012, SFC reprimanded and fined RBC Investment Management (Asia) Limited (RBC) HK$4 million in relation to its provision of investment advice to clients on a number of non-SFC authorized funds between Nov 2006 and Jul 2008. RBC also agreed to make repurchase offers to eligible customers and compensation to eligible former customers in a resolution made under S.201 of the SFO.

SFC's investigation found that:

• RBC did not provide adequate guidance to its staff on conducting due diligence on funds before making investment recommendations or solicitations to clients.
• RBC relied on its Singapore office to conduct due diligence on investment products but it saw no record of any due diligence conducted by its Singapore office, and therefore was not aware of the scope and the extent of any due diligence carried out by its Singapore office.
• RBC did not provide adequate practical guidance to relationship managers (RMs) in providing investment advice or recommendations. RBC also did not have any measure for the overall risk of investment products it sold.
• RBC's RMs did not record or document any product suitability assessment they had undertaken to demonstrate that RBC was reasonably satisfied that the investment products recommended by the RMs were suitable for their clients.
• RBC relied only on e-mails, meeting call reports, file notes and telephone recordings as records of investment advice and recommendation. However, such records are incomplete and do not provide a substantiated account of the advice and/or recommendation given and the underlying rationale.

While a licensed firm may outsource the product due diligence work to an external specialist, it can't turn a blind eye to the whole process.

More User-Friendly Law

Today SCMP reports that the Department of Justice (DoJ) is now planning to make Hong Kong legislation more accessible to the public by adopting a simpler and gender-sensitive writing style. Such initiative will be applied to all legislation starting from this year.

Eamonn Moran, a law draftsman of DoJ, cited Australia and New Zealand as examples of countries that effectively used plain language in legislation to make laws more accessible to the public.  Then people don't need to be a legal professional in order to understand what the law is saying.

Under the new style, "he" will no longer be used to denote "she", and we will see "police officer" instead of "policeman" or "lay person" instead of "layman".  My puzzle is whether in future legislation we must use "she/he" (lady first).

The word "shall" will be replaced by "must" to impose an obligation.  No kidding, in the past I really heard a guy arguing that "shall" is only a future tense expression!

In addition, law drafters will limit unbroken text to about 50 words.  Interestingly, SCMP's article mentions one sub-clause under Section 187 of the Securities and Futures Ordinance  (SFO), which uses 179 words to explain the use of incriminating evidence in proceedings.  Let me end this blog post by reproducing this sub-clause below:

QUOTE

(2) Notwithstanding any other provisions of this Ordinance, where-
(a) an authorized person within the meaning of section 179 requires a person to provide or make an explanation or statement under that section; or
(b) an investigator requires a person to give an explanation or further particulars or to give an answer to any question under section 183,
and the explanation or statement, the explanation or further particulars, or the answer (as the case may be) might tend to incriminate the person and the person so claims before providing or making the explanation or statement, giving the explanation or further particulars, or giving the answer (as the case may be), then the requirement as well as the explanation or statement, the explanation or further particulars, or the question and answer (as the case may be) shall not be admissible in evidence against the person in criminal proceedings in a court of law other than those in which the person is charged with an offence under section 179(13), (14) or (15) or 184, or under section 219(2)(a), 253(2)(a) or 254(6)(a) or (b), or under Part V of the Crimes Ordinance (Cap 200), or for perjury, in respect of the explanation or statement, the explanation or further particulars, or the answer (as the case may be).

UNQUOTE

Grey Market Misconduct

As announced on 13 Feb 2012, SFC revoked the licence of Mr Paco Ng Kar Lun, and prohibited Ng and Mr Adrian Fong Wai Lap from re-entering the industry for 10 and 3 years respectively.

These decisions follow an SFC investigation into transactions conducted by Ng and Fong in relation to allegations they were involved in trading overpriced shares of Metallurgical Corporation of China Limited in the grey market prior to its listing on SEHK on 24 Sep 2009.

Although the scheme ultimately fell through, SFC said the conduct of Ng and Fong was inconsistent with the standards of integrity and honesty expected of licensees under the Code of Conduct.

ICAC has charged both Ng and Fong jointly for conspiracy to defraud.

SFC disclosed too little information about this case. How did trading overpriced shares in the grey market harm other investors? Were Ng's and Fong's trading misbehaviors so severe to deserve their respective heavy penalties?

Ponzi Scheme at Citi Asia

Today SFC announced in a press release that it has reprimanded Citigroup Global Markets Asia Limited, fined it $6 million, and suspended the approval granted to Ms Lisa Chan Sin Man, to act as a responsible officer. Her licence has also been suspended for 8 months. 


Citi Asia has also agreed to offer to pay compensation to customers affected by a fraudulent scheme operated by a former licensed representative in the amount of any principal lost by such customers.


The disciplinary action follows an investigation into suspected misconduct of a former licensed representative of Citi Asia, Mr X, who was responsible for operating what appears to have been a fraudulent scheme involving 13 Citi Asia wealth management clients who invested through Mr X on the basis their money would be pooled and used to purchase US Treasuries and other products.


It appears Mr X promised the affected customers that their principal was protected and returns were guaranteed. Instead, returns were funded wholly or partly from other affected clients induced by Mr X's representations. In effect, Mr X appears to have been operating a Ponzi or Madoff-style scheme in which high returns are paid to investors out of the contribution by new investors. Ponzi Scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk.


Mr X's scheme operated from 2004 until February 2009 when Citi Asia suspended Mr X while investigating the suspected misconduct. Shortly thereafter, Citi Asia dismissed Mr X for gross misconduct. However, Citi Asia failed to report Mr X's activities to SFC in a timely manner as required by the Code of Conduct.


After initially reporting to the SFC that Mr X had been dismissed for gross misconduct, Citi informed the SFC that an internal investigation was in progress, when in fact a preliminary report was already available which revealed important information in relation to Mr X's apparent fraudulent scheme. Citi Asia did not provide the report to SFC until after a follow-up investigation by Citi Asia's external auditor was completed.


By the time these reports were provided to the SFC, Mr X had left Hong Kong. He has not returned since then. While this was not Citi Asia's intention, the consequence of the delay in reporting details of the fraudulent scheme to SFC meant SFC and other law enforcement agencies had no opportunity to interview Mr X or to secure his whereabouts pending the completion of the investigation.


SFC also found that Mr X was insufficiently supervised by Citi Asia and Chan (as Mr X's supervisor) with the result that his fraudulent scheme was undetected despite a number of "red flags" which should have caused those supervising Mr X to instigate inquiries. For example, Mr X issued correspondence under Citi Asia's name referring to guaranteed returns contrary to Citi Asia's internal guidelines. Some of this correspondence was brought to Chan's attention but Chan accepted Mr X’s explanations and did not conduct any probative inquiry into the true nature of Mr X's dealings on behalf of Citi Asia’s clients. The reference to guaranteed returns in Mr X's correspondence was a very clear red flag. A quick check to verify the existence of the US Treasuries and other products supporting Citi Asia's clients' investments should have been conducted.


Citi Asia has agreed that it will pay for an external auditor, to be appointed by SFC, to audit the accounts of affected customers and assess the amount of compensation required to make them whole. Citi Asia will also pay for an external expert to conduct a review of the internal and external detection, escalation and notification practices and policies in Citi Asia's private banking division in relation to compliance with all applicable regulatory and legal requirements in its securities business, including:

• the identification and handling of red flags by all staff involved in regulated activities; and
• performance management of all staff engaged in supervision of staff conducting regulated activities, including calculation of compensation in respect to supervisory functions.

Citi Asia will implement all recommendations by the external expert and submit to a surprise audit of all detection, escalation, notification, red flag practices and policies at a time to be selected by SFC within two years of today’s date.


My questions:

• Why can't the identity of Mr X be disclosed?
• Did the compliance head of Citi Asia survive from this case?