Repledge of Securities Collateral

Recently someone asked me if a Type 1 broker providing securities margin financing (SMF) can repledge clients' securities collateral to another Type 1 broker. I answered NO. Then he argued that Section 8 of Client Securities Rules (CSR) permits this. He had a misinterpretation of CSR.

In fact, Type 1 intermediaries are only allowed by Section 7 of CSR to repledge margin clients' securities collateral to authorized financial institutions ("AFI", i.e. banks in Hong Kong), but Type 8 intermediaries (licensed for SMF) are allowed by Section 8 to repledge securities collaterals to either AFI or Type 1 intermediaries.

Having said the above, I also want to highlight Section 3 of CSR:

"…these Rules apply to client securities and securities collateral of an intermediary that are—
(a) either—
(i) listed or traded on a recognized stock market [i.e. SEHK]; or
(ii) interests in a collective investment scheme authorized by the Commission under section 104 of the Ordinance; and
(b) received or held in Hong Kong by or on behalf of—
(i) the intermediary in the course of the conduct of any regulated activity for which the intermediary is licensed or registered; or
(ii) an associated entity of the intermediary in relation to the conduct of such regulated activity."

Therefore, if the securities collateral is not listed on SEHK (e.g. US stocks) or even unlisted (e.g. an OTC bond), Type 1 / 8 intermediaries are implicitly allowed by CSR to repledge such collateral to any third party.

Licensing Fraud

As announced on 4 Feb 2019, SFC revoked the licence of W. Falcon Asset Management (Asia) Limited (Falcon) for window-dressing its liquid capital, breaching the terms of a restriction notice and failing to provide timely notification of the resignation of its director who engineered the window-dressing scheme.

Falcon provided SFC with false or misleading information in its licence application and financial returns between Jun 2014 and Jun 2017.

Falcon window-dressed its month-end liquid capital by including in its liquid capital computation the amount of certain cheques, which were subsequently dishonoured.  This practice was adopted from the time of Falcon's SFC licence application. Had the amount of these cheques been excluded, Falcon would have been denied a licence to carry on regulated activities due to a liquid capital deficit at the time of its licence application and at each of the month-ends over a three-year period.

In May 2017, the director of Falcon guaranteed a loan taken out in the name of Falcon. Two months later, SFC issued a restriction notice against Falcon after a self-report by Falcon that its liquid capital had dropped below the required level. Subsequently, Falcon defaulted on repayment of the loan and proceeded to enter into a debenture with the lender, thereby subjecting its assets to a floating charge, contrary to the terms of the restriction notice.

The director resigned from Falcon on 23 Oct 2017, but both the director and Falcon failed to provide SFC with written notification of such resignation within 7 business days as required.

This was indeed a fraud case. SFC must chase those fraudsters.

Subsequent update on 19 Dec 2019:

• SFC banned Mr Ang Wing Fung, the former chairman of Falcon, and its former CFO and company secretary Mr Chan Kam Wah, from re-entering the industry for life and 3 years, respectively, in connection with their roles in window-dressing the liquid capital of Falcon.

• Ang was the mastermind of the window-dressing scheme and its operation was facilitated by Chan.

• Chan, who reported to Ang, had full access to various bank accounts of which Ang was a signatory. As the person in charge of accounting, he was fully aware of the true financial condition of Falcon. He was also aware that cheques signed by Ang would certainly be dishonored upon presentation due to insufficient funds in the bank accounts on which they were drawn and closure of some of these accounts. But he continued to take part in the window-dressing scheme to disguise Falcon's failure to maintain sufficient capital.

Key Personnel Requirements

As announced on 8 Jan 2019, SFC reprimanded and fined FWD Life Insurance Company (Bermuda) Limited (FWD Life) $2.4 million for failures in complying with the key personnel requirements under the SFC Code on MPF Products and the Fund Manager Code of Conduct.

FWD Life (licensed for RA9) failed to ensure there were at least 2 key personnel who met the minimum 5-year investment experience requirement in managing retirement funds or public funds under the MPF Code at all times.

Specifically, from Dec 2012 to Nov 2016, FWD Life had only one key personnel in place who met the minimum investment experience requirement. FWD Life only discovered it had insufficient key personnel when MPFA made enquiries in Jan 2017.

FWD Life also failed to implement policies and procedures for the designation and monitoring of key personnel and to communicate to relevant staff members of their designation as key personnel. FWD Life's failure in this respect contributed to the duration of its breach of the MPF Code.

Whenever a management member (no matter RO/MIC/director/key personnel) is going to leave a licensed corporation, a compliance officer should naturally check if the minimum threshold will be breached and then alert the senior management. This is a basic duty.

Wash Trade Arranged by Fund

As announced on 27 Dec 2018, SFC reprimanded and fined Ardon Maroon Fund Management (Hong Kong) Limited (now known as China Silver Asset Management (Hong Kong) Limited) $800,000 for cross-trade related failures in managing Ardon Maroon Asia Master Fund (AM Fund).

On 8 Aug 2014, Ardon Maroon gave instructions to one of its brokerages to execute

a cross trade for 15 million shares of a listed company on SEHK, which resulted in AM Fund conducting a wash trade and incurring transaction costs totalling $133,056. In respect of the cross trade ordered by Ardon Maroon, AM Fund was both the buyer and seller of the relevant shares.

Ardon Maroon then instructed another brokerage, which received 48 million shares of the same company, to deliver 15 million of such shares to settle the wash trade. 

Ardon Maroon claimed that the cross trade was conducted for the purposes of moving

shares between the two brokerages so as to reduce margin requirement at the

brokerage receiving the 48 million shares and achieve better financing at the

brokerage conducting the cross trade.

Use of wash trade for share transfer purpose is ridiculous!

Failure to Timely Disclose Inside Information

Recent SFC has commenced proceedings in the Market Misconduct Tribunal against CMBC Capital Holdings Limited (1141.hk, formerly known as Mission Capital Holdings Limited) and its former directors for failing to disclose inside information as soon as reasonably practicable.

On 13 Oct 2014, CMBC Capital's Company Secretary sent an email to inform the board of directors that the company had recorded a significant improvement in financial performance in the sense that:

• Interim result up to 30 Sep 2013 – Loss HK$12m
• Annual result up to 31 Mar 2014 – Profit HK$417m
• 5-month unaudited result up to 31 Aug 2014 – Profit HK$838m (mainly contributed by securities investment)

SFC has considered the 5-month profit as inside information.  However, CMBC Capital did not issue any profit alert announcement as such until 7 Nov 2014 (i.e. late for less than one month since the email issued on 13 Oct 2014). As a result, SFC has commenced the MMT proceedings.

This case is alarming to Hong Kong listed companies because many of them may not think unaudited result of less than 6 months could still be deemed as inside information and slightly late disclosure would be a big problem. I also wonder how CMBC Capital's Company Secretary advised the board during Oct 2014.

Email Monitoring System

As announced on 20 Sep 2018, SFC banned Mr Ngo Wing Chun, a former relationship manager of HSBC, from re-entering the industry for 12 months for unauthorized transfer of customer data.

Ngo sent an email containing personal data of approximately 995 customers from his HSBC email account to his two personal email accounts on 19 Nov 2015, his last working day at HSBC.

The customer data leakage was immediately detected by HSBC's email monitoring system before Ngo joined another bank in a similar capacity the following day. Ngo agreed to delete the email upon HSBC's request from his personal email accounts. There is no evidence that the customer data had been disclosed to any third parties.

Ngo's conduct was in breach of HSBC's internal policies, the PDPO and SFC's Code of Conduct.

Implementation of email monitoring system for detecting deliberate leakage of customer data and inside information has deserved a higher priority.

Ineffective AML Procedures

As announced on 17 Aug 2018, HKMA reprimanded Shanghai Commercial Bank Limited (SCOM) for contravening S.19(3) of Schedule 2 to the AMLO by failing to establish and maintain effective procedures for the purpose of carrying out its duty to continuously monitor business relationships. It also SCOM to pay a pecuniary penalty of HKD5,000,000 and submit to HKMA a report prepared by an independent external advisor assessing whether the remedial measures implemented by SCOM are sufficient to address the contraventions and the effectiveness of the implementation.

In summary, SCOM did not:

• continuously monitor its business relationship with 33 customers by examining the background and purposes of their transactions that were identified as (i) complex, unusually large in amount or of an unusual pattern and (ii) having no apparent economic or lawful purpose, and setting out its findings in writing;
• establish and maintain effective procedures for the purpose of carrying out its duty under S.5 of Schedule 2 to the AMLO to continuously monitor business relationships; and
• carry out customer due diligence (CDD) measures in respect of certain pre-existing customers when a transaction took place with regard to each of the customers that (i) was, by virtue of the amount or nature of the transaction, unusual or suspicious, or (ii) was not consistent with SCOM's knowledge of the customer or the customer's business or risk profile, or with its knowledge of the source of the customer's funds.

As regards the deficiencies in monitoring business relationships, although the relevant transactions were identified through SCOM's Management Information System (MIS) reports, which took into account different customer risk levels and transaction types, and were selected by SCOM's Compliance Department at the material time for further enquiry or investigation, SCOM had not adequately examined the background and purposes of those transactions and set out the findings in writing.

SCOM also lacked effective policies and procedures for monitoring the handling of MIS alerts including properly recording the follow-up actions taken and monitoring the review time, resulting in significant delay in alert clearance. As for carrying out CDD measures in respect of pre-existing customers, while one of the customers conducted the relevant transactions as early as in May 2012, SCOM failed to identify those transactions at the material time as unusual or suspicious or not consistent with its knowledge of the customer and had not conducted CDD measures accordingly.

It is the first time HKMA took a high profile action against a bank for contravention of the AMLO. This case reveals that putting in place surveillance systems and recruiting a team of compliance officers is no guarantee of compliance standards, effective implementation is critical.