Shortage in Compliance Profession

During this sluggish financial market environment, does the excess demand for compliance practitioners remain? Recently HKSI released a research report titled "Grooming of Talent in the Financial Industry", which is an industry research conducted on the manpower gap in the financial sector. I've got the following insights relevant to the compliance profession from this report:

• Competition for talent is keen in the financial industry, though the shortage has been relieved after the sub-prime crisis. So this year the turnover rate of compliance officers has been lower.
• There is an acute shortage in compliance because this area requires specialized knowledge that can't be easily nurtured through universities. Many firms, particularly smaller companies, prefer not to hire inexperienced people. They are willing to train existing staff but less willing to train new hands from scratch. It follows that fresh graduates or laymen may encounter barriers to entry for the compliance profession.
• Two rapid areas of growth are private banking and wealth management. These areas require people with good interpersonal skills and other soft skills as much as hard skills. This happens to be the area in which Hong Kong's new university graduates appear to be the weakest. Soft skills are not only important for relationship managers but also for compliance officers.
• There is a big gap between self-rated ability and employer-rated ability. While employers are generally satisfied with employees' technical skills, they are not so satisfied with their general lack of creativity, problem solving skills, management skills, and languages skills. Compliance officers spending time only on technical knowledge may lose competiveness in the future.
• Many employees have a strong desire to pursue a career in the financial industry and have the motivation to learn. But they will need to be more proactive, instead of being reactive. They should also develop a global perspective and have a good sense about the financial markets. Some compliance officers, especially those trained up by a regulatory body, have remain bureaucratic and narrow-minded in facing with the rapid changes of the world.

Mis-Pricing of Asset-Backed Securities

FSA recently fined the UK operations of Credit Suisse (the subsidiaries) £5.6 million for breaching FSA Principles 2 and 3 by failing to conduct their business with due skill, care and diligence and failing to organise and control their business effectively.

Credit Suisse announced its financial results for 2007 on 12 Feb 2008. On 19 Feb 2008, Credit Suisse announced that it had identified mismarking and pricing errors by a small number of traders and that it was repricing certain asset-backed securities. The re-pricing involved a write down of revenues by US$2.65 billion. In relation to the write down, Credit Suisse disclosed in its 2007 Annual report in Mar 2008 that a SOX 404 material weakness had existed in its internal controls over financial reporting as at 31 Dec 2007.

The breaches related to the pricing of certain asset-backed securities held by the Structured Credit Group (SCG) within Credit Suisse's Investment Banking Division. The principal activities of the SCG are structuring and issuing securities based on underlying pools of assets, including CDOs and credit correlation trades. These are often highly complex, high risk, leveraged products. The subsidiaries were responsible for ensuring the adequacy and effective operation of their systems and controls, including those provided in part by other companies within the group.

Credit Suisse's senior management commissioned a detailed review of the causes of the write down which identified serious failings in the design, implementation, operation and management of controls over the SCG. The principal failings identified in that review were set out as follows:

• The systems and controls of the subsidiaries for the supervision of traders in the SCG and for the pricing of highly complex products within the SCG were not effective and were not applied consistently. The systems and controls in place, such as a complex matrix structure for the supervision of traders in the SCG, were too complicated and fragmented. Some individuals within control functions lacked a clear understanding of the responsibilities that had been assigned to them.
• There were failures to respond adequately to a number of warning signals or "red flags" and to translate identified concerns about price testing variances in CDO positions within the SCG into tangible or timely actions.
• Certain personnel within control functions with responsibility for recording or checking prices were overly deferential in challenging certain SCG traders and do not appear to have had sufficient seniority or management support to challenge effectively.
• Undue reliance was placed on the technical ability and revenue contribution of certain front office staff, who were highly influential in down-playing price testing variances and in influencing the price testing methodology used, and did not take appropriate action to control and manage such staff effectively.
• Certain control functions failed to escalate in a timely manner price testing variances that were identified, owing to issues such as the complex booking structure used for the CDO trading business, a lack of effective supervision over price verification processes and an over-reliance on assertions made by certain front office staff.

One of the key lessons learnt from this case is the over-reliance on front office staff because they have more technical knowledge of complex deals than the control function staff. As a matter of risk management, firms may assign some front office staff to work at control functions for a period of time to bridge the knowledge gap. Of course front office staff may not always be willing to sacrifice their high pay to become a "coach", but how about such job rotation is arranged during a bear market (like the present)?

Exempt Principal Trader

Recently the Takerovers and Mergers Panel has reported a decision relating to Lehman Brothers Asia Ltd, which cast some light on the issues of Chinese Walls.

From April 2008, Lehman worked specifically on a proposal which would result in the privatization of CITIC International Financial Holdings Ltd ("CIFH") (183.hk) listed on SEHK. On 3 Jun 2008, CIFH announced that it had received a proposal from Gloryshare Investment Ltd, a wholly-owned subsidiary of the CITIC group, regarding the proposed privatization. It envisaged that Banco Bilbao Vizcaya Argentaria S.A. ("BBVA"), presently a substantial shareholder of CIFH, would increase its shareholding in CIFH from 15% to 30%, the balance being held by Gloryshare or members of its group.

By 10 Jun 2008 Lehman was formally retained by Gloryshare as its adviser and on that date Glorysky and CIFH jointly announced the terms of the privatization proposal. In summary, members of CIFH will receive, in consideration for the cancellation of their shares, one "H" share of China CITIC Bank Corporation Ltd ("CNCB") (998.hk) and HK$1.46 in cash for every share in CIFH. In anticipation of resumption of trading on the following day, the Lehman group instituted a restriction on all proprietary trading, but not agency trading, in the shares in CIFH and CNCB.

However, on 11 Jun 2008 the Lehman group:

• purchased 31,000 shares in CIFH for the purpose of rebalancing a hedge against existing swaps with a client on the MSCI HK Index;
• purchased 179,000 shares in CIFH for the purpose of unwinding a short position resulting from OTC sales to clients; and
• purchased 72,000 shares in CIFH for the purpose of executing a "Lehman Performance Swap" for a client through its direct market access (DMA) system.

On 13 Jun 2008 the Lehman group purchased a further 41,000 shares in CIFH for the purpose of covering a short position created as a result of a client facilitation trade. HK$6.27 was the highest price paid by the Lehman group for purchases of shares in CIFH during the offer period. When the Compliance and Control divisions of the Lehman group were aware of these purchases, they immediately informed SFC.

Under the Takeovers Code, the Lehman group is treated as a person "acting in concert". The Code places strict disciplines on a financial adviser to an offeror in respect of in shares of the offeree. In the case of a securities exchange offer, purchases made by the Lehman group above the offer price will result in that offer being accompanied by a full cash alternative at the highest price paid. This would increase the cash element of the offer from HK$2.6 bn to between HK$10.92 bn and HK$11.16 bn!

Nevertheless, the Code recognizes that for a multi-service financial group the disciplines it imposes on a financial adviser and its group may have an impact on other activities which are unrelated to the provision of advice to an offeror. Therefore the Code contains provisions for exemptions for principal traders. But the Lehman group failed to apply for the exempt principal trader status.

The Panel finally decided to exercise its discretion to waive the requirement for a cash alternative for the following reasons:

• the size of the purchases were very small relative to the size of the offer and the total volume of shares in CIFH traded;
• the purchases had a negligible impact on public shareholders;
• the imposition of the cash alternative requirement would have a substantial and adverse impact on Gloryshare who had no knowledge of the purchases; and
• the remedy would be disproportionate to the scale of the purchases if the primary obligation for the offer fall on the Lehman group.

If the Panel did not give a leeway to this case, then I think the Lehman group would get into great trouble!

Socially Responsible Investing

Socially responsible investing (SRI) describes an investment strategy which seeks to balance the pursuit of financial return and social merit. In general, socially responsible investors favor corporates that promote environmental protection, consumer protection, human rights, etc., while avoiding businesses involving in alcohol, tobacco, gambling, weapons, etc. Some investment funds (e.g. Islamic fund) are characterized by SRI, but we seldom hear about incidents of serious breaches of SRI rules.

SEC recently charged New Hampshire-based Pax World Management Corp. with violating investment restrictions in socially responsible mutual funds that investors were told would not contain securities issued by companies involved with producing weapons, alcohol, tobacco or gambling products.

Pax World, the SEC-registered investment adviser to several socially responsible mutual funds, including the Pax World Growth Fund and Pax World High Yield Fund, purchased at least 10 securities that the Funds' SRI restrictions prohibited them from buying — contrary to representations it made to investors and the boards of the Funds. Pax World agreed to settle SEC's charges and was ordered to pay a penalty of US$500,000.

Pax World violated the Funds' SRI restrictions by making purchases in the securities of companies that derived revenue from the manufacture of alcohol or gambling products, derived more than 5% of their revenue from contracts with the U.S. Department of Defense, or failed to satisfy the Funds' environmental or labor standards. Pax World Funds held at least one security that violated their SRI restrictions at all times from 2001 through early 2006. For example:

• In 2003, Pax World purchased for the Growth Fund securities issued by an oil and gas exploration company that had failed its three most recent screens.
• In 2004, Pax World purchased for the High Yield Fund securities issued by a conglomerate primarily engaged in the shipping industry but which derived revenue from gambling and the manufacture of liquor.

Pax World failed to consistently follow its own internal SRI-related policies and procedures that required that all new securities be screened by Pax World's Social Research Department prior to purchase to ensure compliance with the funds' SRI disclosures. Pax World failed to screen 8% of all new security purchases from 2001 to 2005.

SRI funds are surging in Asia and thus SRI compliance monitoring would become a new agenda to the compliance function.

Insurer Treated Customers Unfairly

There have been complaints to media from time to time against HK insurance companies for not treating their customers fairly, but seldom we've seen disciplinary actions taken by the Insurance Authority and made known to the public.

FSA recently fined Hastings Insurance Services Ltd £735,000 for failing to treat its customers fairly in relation to cancelling around 4,550 incorrectly priced car insurance policies.
During two separate periods between Jul and Sep 2007, Hastings discovered that due to an internal system error, inaccurate insurance quotations were given to customers, which resulted in some of them paying significantly lower premiums than they should have. Hastings cancelled the policies but in doing so failed to give sufficient consideration to paying the premium shortfall to the insurance provider or investigating other possible remedies.

FSA found that the firm had invoked a cancellation clause to cancel the policies which FSA considers was not generally intended to be used in circumstances such as these. The way in which the policies were cancelled and the service that the firm gave to its customers following the cancellation showed the firm focussed on the financial cost to itself and did not properly consider the alternatives or the detrimental effect on customers.

Following these incidents the firm has now strengthened the controls surrounding customer treatment and agreed with FSA to write to all affected customers and review the compensation it offered to ensure that its customers are treated fairly.

It is indeed quite ridiculous that customers have to suffer from an internal system error in this way.

Good Practices on Transaction Monitoring

HKMA has recently developed a guidance paper "Good Practices on Transaction Monitoring" in consultation with the Industry Working Group on Prevention of Money Laundering and Terrorist Financing (IWG). The purpose of transaction monitoring is to alert banks to unusual or suspicious activities for further examination and investigation. Banks should put in place effective monitoring systems to identify and report suspicious transactions for AML/CFT.

During 2007, HKMA completed a round of thematic examinations of selected banks focused on transaction monitoring. While banks have generally established appropriate MIS reports for transaction monitoring, the systems and procedures of certain banks are not considered to be sufficiently effective, having regard to the types of business activities they engage.

The guidance paper seeks to highlight the essential features of an effective transaction monitoring system. Some of those major detailed guidances are set out below:

• Good understanding of customers and updating of their risk profiles on a risk-sensitive b basis are important elements of an effective transaction monitoring system.
• The monitoring system should comprise two components: (a) monitoring by front-line staff; and (b) monitoring of past transactions.
• Front-line staff are in the best position to identify unusual activities because they know most about the customers. They should be well trained to perform this function.
• Periodic MIS reports should at a minimum cover the following transactions: cash transactions, wire transfers, cheque transactions, loan payments and prepayment, and reactivation of dormant accounts followed by unusually large or frequent transactions.
• The current transaction should be compared with the past transaction patterns and risk profile of the customer.
• Suspicious transactions identified by the system should be carefully investigated and followed up.
• An automated transaction monitoring system should be used but it can't replace human awareness in detecting unusual or suspicious activities.
• Parameters or criteria used to generate monitoring reports require regular review and updating.

This guidance paper may not be very practical but at least it alerts us to a more serious attitude towards transaction monitoring.

Insider Dealer Arrested

A recent big news in the HK compliance field is that a former managing director at Morgan Stanley Asia Ltd has been arrested and charged for insider dealing and counselling or procuring another person to deal in a listed company's shares prior to the announcement of an acquisition deal.

Mr Du Jun was detained at the Hong Kong International Airport last Thursday after arriving from Beijing and appeared at the Eastern Magistracy last Friday. He is no longer employed by Morgan Stanley and has been residing mainly in Beijing since last year. No plea was taken and the case was adjourned to 5 Sep 2008 for transfer to the District Court. He was granted bail but was ordered to surrender all travel documents and report to the Police twice a month.

The arrest was made following an SFC investigation with Morgan Stanley's cooperation (by reporting Du's trading to SFC in May 2007). The charges allege that on nine occasions between 15 Feb 2007 and 30 Apr 2007, Du dealt in the shares of CITIC Resources Holdings Ltd (CITIC Resources), a company listed on SEHK, whilst in possession of material and price sensitive information not known to the market. The information related to a proposed deal by CITIC Resources to acquire oil field assets, which was announced on 9 May 2007.

It is alleged that Du obtained the information while he was part of a Morgan Stanley team involved in advising CITIC Resources. The charges relate to a total of 26.7 million shares in CITIC Resources allegedly acquired by Du at a cost of about $86 million. On 30 Apr 2007, the last day Du was alleged to have bought CITIC Resources shares, the share price of CITIC Resources closed at $3.68. The price rose by 13.86% to $4.19 on the day of the announcement. Du is also alleged to have counselled or procured his wife Ms Li Xin, who is not facing any charges, to deal in CITIC Resources shares on 27 Feb 2007.

This is a high profile case for SFC to demonstrate its teeth to hunt a tiger. Morgan Stanley's surveillance system and whistle blowing also take the credit.