Unidentified Research Analysts

On 24 Jun 2019, Securities and Futures Appeals Tribunal (SFAT) affirmed the decision of SFC to reprimand FT Securities Limited (FTSL) and fine it $3.5 million for regulatory breaches and internal control failures in relation to preparation and publication of research reports.

FTSL published 3 equity research reports on its website between July 2012 and April 2013. SFC found that, during the relevant period:

• FTSL's research reports, which were published in the name of its research analyst, were in fact prepared and written by 2 unidentified individuals who were not its employees. FTSL did not know their identities, background or contact details, nor did it take any steps to ascertain whether they were related to or had any financial interests in the companies covered in the research reports;
• FTSL falsely disclosed in one of the research reports that it did not provide any investment banking services to the company covered in the research report in the 12 months preceding the publication of the report when in fact it had been appointed as the placing agent for the placing of the company’s convertible bonds;
• FTSL had no formal policies or procedures governing the preparation and publication of research reports;
• FTSL did not segregate its research and corporate finance functions to avoid any actual or apparent conflicts of interest. Staff members responsible for handling the placing activities of the company covered in the research report were concurrently involved in the preparation and publication of the report; and
• FTSL failed to demonstrate that there was a reasonable basis for the analyses and recommendations in the research reports.

SFAT accepted that FTSL was culpable of egregious failures to comply with the regulatory requirements addressing analyst conflicts of interest, and its failure to ensure independence and objectivity of research reports might damage investor confidence in the research sector and in the financial services industry more broadly.

Para. 16 of SFC Code of Conduct has taken effect for over 10 years, but many firms are yet to establish effective compliance monitoring on the research function. This case is remarkable that unidentified research analysts were used.

Serious Breaches of Client Money Rules

SFC reprimanded China Merchants Securities (HK) Co., Limited (CMSHK) and fined it $5 million for regulatory breaches and internal control failings related to mishandling of client money.

In Sep 2014, CMSHK self-reported to SFC regarding its failure to segregate client money in accordance with Client Money Rules.  Subsequently, CMSHK performed a look-back review to examine its operational processes and controls governing the segregation of client monies during the 3-year period from 1 Oct 2011 to 30 Sep 2014.

The review identified around 800 incidents of non-compliance with the Client Money Rules with individual transaction amounts ranging from HK$68,000 to HK$308 million.

These incidents were classified into 6 categories:

1. Transfer of funds from client trust accounts to house accounts during client money segregation process.
2. Transfer of funds from client trust accounts for repayment of CMSHK’s bank loans.
3. Transfer of funds from client trust accounts for granting term loans to CMSHK’s clients.
4. Transfer of funds from client trust accounts for purposes of funding proprietary investments of CMSHK’s fellow subsidiary company.
5. Transfer of funds from client trust accounts for purposes of paying CMSHK’s expenses.
6. Transfer of a rounded amount from a client trust account for purposes of facilitating potential client withdrawal requests, settlement of securities dealing in overseas markets and fee payments for stock lending/borrowing.

Even if clients’ funds improperly transferred out were subsequently returned to the client trust account on the same day, the above misconducts (obviously arising out of deliberate or reckless decisions) can't be tolerated.

SFC also said CMSHK failed to employ fit and proper staff to conduct its business and have proper internal controls and procedures in place to ensure compliance with the Client Money Rules and safeguard client assets.  Which senior management member(s) of CMSHK would be held liable?

I don't think $5 million fine is commensurate with the seriousness of this case.

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.