SEC Charged UBS for Unregistered Business

Apart from Allen Stanford, last week USB was in the spotlight. SEC filed an enforcement action against UBS, charging the firm with acting as an unregistered broker-dealer and investment adviser and assisting its cross-border US clients in tax avoidance.

SEC's complaint alleges that UBS's conduct facilitated the ability of certain US clients to maintain undisclosed accounts in Switzerland and other foreign countries, which enabled those clients to avoid paying taxes related to the assets in those accounts. UBS agreed to settle the SEC's charges by consenting to the issuance of a final judgment that permanently enjoins UBS and orders it to disgorge US$200 million. In connection with a related criminal investigation, UBS has entered into a deferred prosecution agreement with the Department of Justice pursuant to which UBS will pay an additional US$180 million in disgorgement, as well as US$400 million in tax-related payments.

From at least 1999 through 2008, UBS acted as an unregistered broker-dealer and investment adviser to thousands of US persons and offshore entities with US citizens as beneficial owners. UBS had at least 11,000 to 14,000 of such clients and held billions of dollars of assets for them. The US cross-border business provided UBS with revenues of US$120 to US$140 million per year.

UBS conducted that cross-border business largely through client advisers located primarily in Switzerland, who were not associated with a registered broker-dealer or investment adviser. These client advisers traveled to the US, on average, two to three times per year on trips that generally varied in duration from one to three weeks. In many instances, the client advisers attended exclusive events such as art shows, yachting events, and sporting events that were often sponsored by UBS, for the purpose of soliciting and communicating with US cross-border clients. UBS also used other US jurisdictional means such as telephones, fax, mail and e-mail to provide securities services to its US cross-border clients.

SEC further alleges that UBS was aware of the requirement for registration with SEC. UBS took action to conceal its use of US jurisdictional means to provide securities services. Among other things, client advisers typically traveled to the US with encrypted laptop computers that they used to provide account-related information, to show marketing materials for securities products, and occasionally to communicate orders for securities transactions to UBS in Switzerland. Client advisers also received training on how to avoid detection by US authorities of their activities in the US.

UBS has been ordered to terminate its US cross-border business and to retain an independent consultant to conduct an examination of its termination of the business. If UBS is further required to disclose the identities of all "secret accounts", this would probably be a disaster for the offshore private banking business in Switzerland.

Cross-Border Market Manipulation

US SEC recently charged George Georgiou of Toronto, Ontario, with manipulating the market in four separate microcap stocks — Avicena Group, Neutron Enterprises, Hydrogen Hybrid Technologies, and Northern Ethanol. SEC alleges that Georgiou, who controlled the publicly traded stock of each company, manipulated the market from 2004 through Sep 2008 to artificially inflate each company's stock price or create the false appearance of an active and liquid market. He made at least US$20.9 million in ill-gotten gains from his manipulation schemes.

SEC alleges that each of the manipulation schemes followed a similar pattern. Georgiou controlled all or a large percentage of the unrestricted, publicly-traded stock of each company. He had influence with management, access to confidential shareholder lists, and was able to coordinate the release of company news with his illegal trading. In conversations and through his own e-mails, Georgiou admitted his intent to manipulate each of the stocks, and gave directions to his nominees.

Georgiou used many nominee accounts at offshore broker-dealers in Canada, the Bahamas, Turks and Caicos, and other locations. He asserted direct control over some accounts by issuing trading and wiring instructions directly to broker-dealers, and indirect control over others by communicating trading instructions to nominees who, in turn, executed Georgiou's trading instructions.

Through these accounts, Georgiou used a variety of manipulative techniques in each scheme, including controlling the trading volume through promises of profits to nominees; executing or directing matched orders, wash sales, or other prearranged trades; marking-the-close; and paying illegal kickbacks in exchange for purchases.

Georgiou's manipulation of Hydrogen Hybrid Technologies was in the nature of a pump-and-dump scheme in which Georgiou arranged and paid for the publication of a promotional mailer sent to seven million US addresses. Georgiou coordinated manipulative trading with the publication of the mailer, and ultimately received more than US$3.8 million when he dumped his shares into the artificially inflated market. Part of Georgiou's manipulation of Northern Ethanol stock involved the payment of an illegal kickback to a person Georgiou believed was a corrupt registered representative, but who was in reality an undercover FBI agent.

Georgiou also defrauded two offshore broker-dealers by obtaining margin loans using the manipulated stocks as collateral, further funding his manipulations and allowing him to withdraw cash that he wired to offshore bank accounts.

This guy is really a manipulator at an "international level".

Segregation of Wealth Management Business

The HKMA's Lehman Report has made a number of recommended actions for banks to take in order to avoid mis-selling of investment products. One of the most controversial recommendations is that steps should be taken to ensure clear differentiation between traditional deposit-taking activities and retail securities business, including:

• physical segregation of banks' retail securities business from their ordinary banking business
• a requirement that staff involving in selling investment products to retail customers should not be involved in ordinary banking business
• a requirement that banks make clear, through physical signs and warnings, the distinction between deposits and investments and particularly the risks attached to the latter
• a requirement that there be complete information separation between a retail customer's deposit accounts and his investment accounts and a prohibition on a bank's making use of deposit-related information to target and channel retail customers into investment activities

HKMA also recommends that the above forms of segregation should apply to banks' insurance activities and other investment activities.

Recently I read an Finance Asia article about China's recent measures to tighten the distribution of investment-linked policies which are also prevailing in Hong Kong and vulnerable to mis-selling complaints. It is said that investment-linked policies have been a key revenue generator for China's insurance companies in the past few years. As a result of the bursting of product bubble in 2008 and widespread revelations of mis-selling, China Insurance Regulatory Commission (CIRC) is taking the following measures to revamp the way these products are sold, in order to restore consumer confidence:

• Banks are banned from selling investment-linked policies from their regular counters. They should instead put up counters dedicated to wealth management or set up wealth management centres for this purpose to prevent banking customers from confusing policies as saving products.
• The minimum premium size of these policies is raised to Rmb30,000, which might differentiate the middle-class customer who can afford to invest from the everyday customer who may not understand the risks associated with the product.
• Insurers are required to develop an internal risk rating system for their distribution channels. Staff involved in distribution should know their customers' financial status, experience in investment and risk tolerance level, and recommend a suitable product accordingly. Both customer and the sales staff are now required to acknowledge the recommendation with signatures on a legally binding document. If the staff believe a customer to be unsuitable for a product, the customer will be required to counter-sign on an endorsement of the risk assessment report.
• Distribution of investment products in rural regions is clamped down and selling of investment-linked policies by agents with less than one-year of experience is banned. All agents involved in investment-related products will be required to sit through at least 40 hours of training, while third-party distributors such as banks will have their suitability to sell reassessed every six months.

The key rationale for requiring banks to segregate their wealth management business is to make it more professional. As far as I know, some giant banks in China have already arranged their sales staff to take professional certification trainings (like CWM) to enhance their service quality.

(Extended reading: Survey identifies weaknesses in selling process)

AML Program for e-Brokers

Given the popularity of financial crime committed via electronic means, the regulatory bodies have requested e-brokers to put in place more automated surveillance tools for detecting suspicious transactions.

Recently US FINRA imposed a US$1 million fine against E*Trade Securities, LLC and E*Trade Clearing, LLC, collectively, for failing to establish and implement anti-money laundering (AML) policies and procedures that could reasonably be expected to detect and cause the reporting of suspicious securities transactions.

FINRA requires brokerage firms to establish and implement AML procedures that address a number of areas, including monitoring the trading in customer accounts as well as the flow of money into and out of these accounts. Firms are required to monitor trading in customers' accounts for certain types of suspicious trading activity and file with Department of Treasury's Financial Crimes Enforcement Network (FinCEN) a report of any suspicious transaction relevant to a possible violation of law or regulation.

FINRA has further instructed each broker/dealer that its AML program must be tailored to its business. A firm needs to consider factors such as its size, location, business activities, the types of accounts it maintains and the types of transactions in which its customers engage. One of the factors that brokerage firms are instructed to consider generally is the technological environment in which the firm operates. On-line firms such as E*Trade specifically have been instructed to consider conducting computerized surveillance of account activity to detect suspicious transactions and activity.

FINRA found that between Jan 2003 and May 2007, E*Trade did not have an adequate AML program based upon its business model. Because E*Trade did not have separate and distinct monitoring procedures for suspicious trading activity in the absence of money movement, its AML policies and procedures could not reasonably be expected to detect and cause the reporting of suspicious securities transactions. The firm relied on its analysts and other employees to manually monitor for and detect suspicious trading activity without providing them with sufficient automated tools. FINRA determined that this approach to suspicious activity detection was unreasonable given E*Trade's business model.

Apart from money laundering activities, I think e-brokers should also enhance their automated surveillance systems to monitor trading activities for market abuse.

Repurchase of Minibonds

The most shocking compliance news immediately before the Chinese New Year should be the "agreement" entered into by Sun Hung Kai Investment Services Ltd (SHK) with SFC under s201 of SFO to resolve disciplinary cases without completing the formal hearing process. Simply speaking, Sun Hung Kai agrees with SFC to repurchase Lehman Brothers Minibonds from its clients. This case is comparable to the ex-gratia payments made by Towry Law in 2004.

SFC also issued a reprimand to Sun Hung Kai in respect of internal systems and controls relating to its sales since 2002 of Lehman Brothers Minibonds to its clients, following SFC's investigation. Sun Hung Kai has agreed to make a voluntary offer to purchase all outstanding Minibonds bought by eligible Sun Hung Kai clients at original value, with the following exceptions:

• those clients who purchased Minibonds only from the secondary market on an execution only basis and had not previously purchased Minibonds through Sun Hung Kai in primary offerings
• professional investors (PIs), including financial institutions, insurers and other corporations falling under paragraphs (a) to (i) of the definition of "professional investor" in Part 1 of Schedule 1 to SFO [Then how about those PIs defined under S&F (Professional Investors) Rules?]
• those clients who had already commenced legal action against Sun Hung Kai unless the clients are willing to stay or end the legal action
• those clients who had concluded a settlement with Sun Hung Kai and already received payments that exceeded the principal they invested

SFC estimates the total amount of the repurchase offer will be up to $85 million.

The decision follows an investigation by SFC which raised a number of concerns with Sun Hung Kai, specifically with respect to:

• the adequacy of product due diligence on Minibonds before they were distributed to eligible clients;
• the adequacy of training given to Sun Hung Kai retail sales staff on Minibonds to enable them to understand the product and all its material risks;
• the assessment of the level of risk for each particular series of Minibonds, the communication of those risk ratings to its retail sales staff and the measures that ought to have been taken to ensure that its sales staff gave reasonably suitable advice by matching the risk-return profile of each series of Minibonds with the personal circumstances of each eligible client; and
• the record-keeping of investment advice given to eligible clients and any queries raised by them.

Sun Hung Kai does not admit any liability or wrongdoing arising from these matters but acknowledges the seriousness of these concerns. Given the high public interest in resolving these issues quickly, to avoid unnecessary costs and expenses and to affirm its commitment to the highest standards of conduct, Sun Hung Kai has also agreed with SFC to the following:

• to offer to its eligible clients to purchase all outstanding Minibonds bought through Sun Hung Kai at a price equal to the principal amount invested by those clients (the eligible clients will retain all coupon payments received to date) with payments to be made within 30 days of the date of acceptance, and each eligible client who accepts this offer will be required to transfer their Minibonds (or entitlement thereto) to Sun Hung Kai and sign a release and waiver of claims they may have against Sun Hung Kai;
• to engage an independent audit firm to conduct a review of Sun Hung Kai's internal control and compliance systems;
• if, within 18 months from the completion of Sun Hung Kai's current enhancement exercise (which shall be completed within 6 months from the date of this agreement), SFC finds the same concerns of a materially serious nature as those identified by it in this investigation, Sun Hung Kai's licence will be partially suspended for a period of three years to the extent that Sun Hung Kai will not be allowed to sell or distribute unlisted or structured products to clients and provide advice to clients in relation to these products; and
• continue to support and cooperate fully with SFC.

Let's wait and see what actions HKMA and SFC will take against those retail banks which had distributed Minibonds.

SFC Lehman Report

At the end of 2008 SFC has made a report to the Financial Secretary on issues raised by Lehman Minibonds crisis. Then it released the report but has removed certain contents to avoid prejudicing the investigation and enforcement work that is under way. This report is in fact quite a good summary of the existing regulatory framework and requirements governing the selling of investment products to retail investors. Compliance officers working in this area should read through it in detail.

This report has made a number of recommendations to further strengthen the regulatory system. Let me summarize my initial thoughts as follows:

• I tend to agree with SFC in adopting the Twin Peaks Approach. That means, HKMA continues to oversee safety and soundness of banks, while SFC will cover the business conduct of both banks and non-banks in respect of regulated activities. This will attain a more consistent enforcement of securities regulations.
• It may not be practical and useful to requre securities activities of banks to be conducted by separate entities. Instead, the professional standards of bank staff providing wealth management services should be substantially uplifted.
• Mystery shopping sounds like a useful technique to identify problems, but SFC needs to clarify how it would use the findings.
• SFC sticks to disclosure-based approach rather than merit-based approach in authorizing products sold to retail investors. This regulatory philosophy can of course increase Hong Kong's competitiveness in attracting product issuers. However, when SFC is adopting merit-based approach in licensing of intermediaries, why can't it do the same for product authorization? I won't fully this philosophy until the average investor education level was sufficiently high.
• I strongly suggest SFC streamline the existing product authorization regime to make it less complex and fragmented.
• Developing summaries for different products in plain language is definitely a good idea, but SFC should act as the central coordinator in this project to avoid duplicate efforts made by intermediaries.
• Ongoing disclosure obligations should be introduced for all types of investment products (securities, CISs and RIAs).
• SFC's recent efforts of consolidating the advertising guidelines for all different CISs in one document is a reasonable first step. It should further enhance the advertising guidelines to cover all types of investment products.
• The term "professional investor" should be renamed by not using the "professional" label to avoid unnecessary confusion.
• If other countries like Australia, the UK and Singapore have no problem of mandating disclosure of commission rebates at the pre-sale stage, what is Hong Kong waiting for?
• Cooling off clause provides a kind of investor protection, but would it be implemented with practical difficulties for unlisted and illiquid investment products?
• Setting up the dispute resolution procedure and a financial ombudsman seems necessary for Hong Kong, but where comes the funding?
• I support the establishment of an Investor Education Council operated by SFC. We can't really the intermediaries to do a good IE job given their conflicts of interest problem.
• Giving SFC the power to impose a compensation order as a disciplinary sanction is desirable as this can directly benefit the investors but forming a proper basis for computing the compensation amount in each case is not simple.

Customer Responsibility

Last year one of the main themes in HK's compliance field was "mis-selling". While the general public has attributed all the problems to the sales side, the voice of "buyer beware" is too little to hear. I won't say prevention of mis-selling is not critical, but prevention of "mis-buying" is also very important.

In Dec 2008 UK FSA released a discussion paper on customer responsibity in order to explore what steps the regulator or others could take to help financial consumers understand their own best interests more effectively. While FSA has no power to impose responsibilities on consumers, it is required by law to consider the general principle that consumers should take responsibility for their decisions when setting its consumer protection agenda.

The key findings of FSA's Financial Capability Baseline Survey indicate that:

• many people fail to plan adequately for retirement or for unexpected expenses or drops in income;
• while a relatively small proportion of the population experiences difficulties with debt, those problems are often severe;
• people do not take adequate steps to choose products that meet their needs - many do not shop around to find a good deal and people take risks without realising they are doing so; and
• under 40's are, on average, less financially capable than their elders (the greatest demands are placed on this younger group).

In a "better world" consumers should be empowered to engage and take on responsiblity. However, their relative lack of knowledge in potentially complex markets, behavioral constraints and firms' performance make this difficult and means that the balance of responsibilities currently operates in favor of consumers. FSA's current position on customer responsibility is summarized as follows:

If a firm fulfils its obligations and treats the customer fairly, then, even if the transaction turns out to be a disappointment to the consumer, this should not be blamed upon the firm.

SFC recently submited a report to Financial Secretary, suggesting how HK can improve its regulatory framework and enhance investor protection and education, following the events brought about by the collapse of Lehman Brothers during last Sep. I wish the issue of enhancing customer responsibility is adequately addressed in this report.