Diploma in Investment Compliance

Last week the Chartered Institute for Securities & Investment (CISI), the ICMA Centre at the Henley Business School and the FINRA of the US announce that they have joined forces to support and enhance education, training and certification in financial compliance.

The CISI is the largest and most widely respected professional body for those who work in the securities and investment industry in the UK and abroad and has developed a suite of well recognized and supported programs centered around product knowledge and regulation to support practitioners in the financial services industry. Since 2006, the ICMA Centre and FINRA have developed and offered a highly regarded Diploma in Capital Markets Regulation and Compliance aimed at mid-level securities professionals. With the development of the CISI 's Diploma in Investment Compliance, the industry was faced with two separately recognized routes to certification,and it was agreed that, by joining forces, the parties can work together to better enhance the professional credentials of capital markets practitioners in the UK.

The agreement will mean that those who have already achieved the Diploma in Capital Markets Regulation and Compliance will become members of the CISI and those with a partially completed qualification will receive appropriate exemptions from the jointly supported Diploma in Investment Compliance. In addition, the ICMA Centre will work with the CISI to deliver advanced certification for those who have completed the Diploma in Investment Compliance and whose needs are for expanded coverage of topics required by senior compliance staff in financial institutions.

(Jack's comment: Hong Kong financial industry doesn't have such kind of compliance qualification for the practitioners. Why don't SFC and HKSI work with CISI to promote the Diploma in Investment Compliance?)

Mystery Shopping Programme

Following the Minibond incident, both HKMA and SFC have proposed the use of mystery shopping to detect sales malpractices. Last week they jointly issued an invitation to tender for the Mystery Shopping Programme (MSP) for the sale of unlisted securities and futures investment products in Hong Kong.

Scope:

• The MSP is a market wide exercise focusing on the retail market and capturing experiences from different types of Intermediaries in the banking sector and the securities sector selling investment products.
• The regulators want to ascertain if the sales consultants follow their rules and regulations during the sales process, including but not limited to making of recommendations and/or solicitation on investment products. The MSP will focus on a number of areas, including "know your client" procedures, risk disclosure and suitability of investment recommendation.In addition to the audio recordings, all completed questionnaires and materials received by the shoppers must be handed over to the service provider, which will in turn, be provided by the service provider to the regulators at the conclusion of the MSP. No copies may be retained by the shoppers or the service provider. The regulators may require the service provider to certify that all the audio recordings, completed questionnaires and materials received by the shoppers have been returned to the Regulators. During the MSP, the regulators may request for documents and audio-records of particular samples for testing or review purpose.
• The MSP will cover shoppers of various age groups and with specific investment objective, investment experience, financial position and attitude to risks.

Sample size:

• The target Intermediaries will be determined by the regulators and the sample size will cover (i) the banking sector which includes large, medium and small banks; and (ii) the securities sector which includes securities brokers and investment advisers.
• The exact number of target Intermediaries and sample size are to be determined but tenderers should give separate quotations in multiples of 50 samples starting from 400 up to 700 samples (total for both banking and securities sectors).

Methodology and main duties of the MSP service provider:

• All shoppers are to be sourced, recruited and trained by the MSP service provider. It is expected that the shoppers will use their real personal identity and act as potential clients. In relation to the method of initial approaches to the sales consultants within targeted Intermediaries, it is expected that there will be a mix of approaches from "walk in", telephone and/or responding to advertising or marketing.
• The regulators may request all mystery shopping interviews to be audio-recorded and the recordings to be handed over to the regulators. No copies may be retained by the shoppers or the service provider.
• The service provider will undertake to comply with the Personal Data (Privacy) Ordinance in performing the MSP.
• A shopper questionnaire will be designed by the regulators and mandatory for shoppers to complete and to submit the same to the regulators upon request. This questionnaire will document the shoppers' experiences and consist mainly of closed-end questions requiring yes/no answers with some open-end questions requiring opinions from the shoppers.
• Training provided by the service provider should cover posing as potential clients. The service provider should also provide training and simulations on how to audio-record mystery shopping interviews, carry out assessment process, complete questionnaire, etc.
• All the mystery shopping meetings must be face-to-face. It is expected that a number of meetings may be conducted before reaching a point where investment recommendation on investment products will be provided, and the shoppers would not be required to make any investment. In the event that a shopper makes an investment out of his own volition, the shopper has to bear his own costs and risks. The regulators will under no circumstances be liable for any investment and related expenses and for any loss or damage incurred by the shopper.
• During the mystery shopping exercise, the service provider will perform on a regular basis quality control on the completed questionnaires, which will include reviewing samples of completed questionnaires by checking the answers of the completed questionnaires against the relevant audio-recordings and provide the regulators with statistics of the answers in the completed questionnaires.
• The service provider will administer the mystery shopping interviews (e.g. follow up with the shoppers on completion of the questionnaire, debrief the shoppers after the first few mystery shopping interviews to resolve any unanticipated problems and perform quality control on data gathered, which includes but is not limited to an independent review on the completeness and accuracy of all the completed questionnaires).
• After the first two weeks of commencement of interviews conducted by the mystery shoppers, the regulators will select samples conducted during that period, review the documents received by, and questionnaires (if any) completed by, the shoppers and listen to the audio recordings to test the adopted working approach carried out by shoppers and other elements of the MSP and provide feedback to the service provider.
• The service provider should establish and maintain such measures and procedures to provide for the safe custody and proper handling of information (including audio recordings and materials received by the shoppers) obtained in the MSP and to prevent unauthorised access to, or use of, such information. The service provider shall also comply with all instructions of the regulators relating to the handling and storage of the information obtained in the MSP.
• The service provider will provide bi-weekly status report to the regulators summarising issues identified, and task progress, etc.
• The service provider will analyse the results of the completed questionnaires and summarise the findings for the purpose of preparing reports to the regulators.

(Jack's comment: Thanks HKMA and SFC for creating employment opportunities. I am interested in assisting the service providers for training the mystery shoppers.)

Misleading Investors About Subprime Mortgage Investments

SEC recently charged Boston-based State Street Bank and Trust Company with misleading its investors about their exposure to subprime investments while selectively disclosing more complete information to specific investors. State Street has agreed to settle SEC's charges by paying more than $300 million that will be distributed to investors who lost money during the subprime market meltdown in 2007. This payment is in addition to nearly $350 million that State Street previously agreed to pay to investors in State Street funds to settle private claims.

According to SEC's complaint, State Street established its Limited Duration Bond Fund in 2002 and marketed it as an "enhanced cash" investment strategy that was an alternative to a money market fund for certain types of investors.

By 2007, however, the fund was almost entirely invested in subprime residential mortgage-backed securities and derivatives that magnified its exposure to subprime securities. But State Street continued to describe the fund to prospective and current investors as having better sector diversification than a typical money market fund, and failed to disclose the extent of the fund's concentration in subprime investments.

State Street sent investors a series of misleading communications beginning in July 2007 concerning the effect of the turmoil in the subprime market on the Limited Duration Bond Fund and other State Street funds that invested in it. At the same time, however, State Street provided particular investors with more complete information about the fund's subprime concentration and other problems with the fund. These other investors included clients of State Street's internal advisory groups, which provided advisory services to some investors in this fund and related funds.

Based on this more complete information, State Street's internal advisory groups subsequently decided to recommend that all of their clients including the pension plan of State Street's publicly-traded parent company (State Street Corporation) redeem their investments from the fund and the related funds. State Street sold the fund's most liquid holdings and used the cash it received from these sales to meet the redemption demands of better informed investors, leaving the fund and its remaining investors with largely illiquid holdings.

(Jack's comment: Packaging subprime investments as a money market fund is no different from telling investors that Minibond is equivalent to time deposit.)

SFC and Minibond Fiasco

(Reproduced from SCMP 2010.01.27)

The Lehman Brothers minibond mess could have been avoided had the Securities and Futures Commission imposed the measures needed to properly vet their sale and suitability to investors, a former senior manager with the regulator said.

Harold Ko Ping-chung, the commission's former head of insurance-related policies and products, told lawmakers that he believed different standards used by the commission's investment products and corporate finance departments, and lax supervision and staff inexperience contributed to the Lehman minibond fiasco.

Minibonds were handled by the corporate finance department, which only required that necessary product information be disclosed, and not the investment products department, which looked at whether the various parties involved in the product were suitably qualified.

Since leaving the commission about five months ago, Ko has been keen for lawmakers to hear his evidence. He testified publicly yesterday for the first time before the Legislative Council subcommittee investigating what went wrong. He also met the subcommittee last week behind closed doors.

The collapse of Lehman Brothers in September 2008 left holders of minibonds linked to it virtually worthless. Minibonds are not corporate bonds, but are high-risk, credit-linked derivatives. They are marketed as a proxy investment in well-known companies.

Ko spent much of his two decades with the commission vetting investment products. His deep understanding of the regulator's work in authorising Lehman minibonds is seen as invaluable as lawmakers prepare to summon banking representatives to testify.
Ko is no stranger to politics. In the 1990s he was a core member of United Ants, a grass-roots human rights group. He also ran unsuccessfully for a seat in Legco in 1995.

(Jack's comment: This is not a unified regulatory body. It consists of different operating units pursuing their private interests by all means. This is the misfortune of the Hong Kong securities industry. Salute to Mr Harold Ko.)

Futures Trader Acquitted of Price Rigging Charges

In recent years, SFC initiated a number of criminal prosecutions against stock market manipulators. Last week the Eastern Magistracy acquitted a futures trader, Mr Tsoi Bun, of five charges of manipulating the calculated opening prices (COP) of index futures contracts in the futures market. This was the first criminal prosecution for market manipulation in Hong Kong's futures market under SFO.

A COP is calculated during the Pre-Market Opening Period and serves as the market opening price for the corresponding product. It is calculated only if the highest bid price of the limit orders entered into the Automated Trading System of the Exchange (HKATS) is greater than or equal to the lowest ask price of the limit orders. If more than one price satisfies this criterion, the COP will be calculated according to the established formula set forth in Rule 4.84 of Trading Procedures for Stock Index Futures and Stock Index Options Traded on HKATS.

Tsoi was charged of manipulating the COP of HSCEI futures contracts and HSI futures contracts during the morning Pre-Market Opening Period on five trading days between February and September 2007.

The Deputy Magistrate ruled that there was insufficient evidence to prove beyond reasonable doubt that Tsoi had manipulated the calculated opening price on each of the trading days in question. SFC is reviewing the ruling to determine whether there should be an appeal and will continue to pursue civil proceedings against Tsoi.

In addition to the criminal charges, SFC has on 21 July 2009 sought orders in the High Court under section 213 of SFO stopping him from placing orders on the futures market during the Pre-Market Opening Period. In response to that application, Tsoi gave the court an undertaking that he would not place any order held in his name or in the name of another person on the futures markets during the Pre-Open Allocation Sessions. The undertaking remains in force.

The civil proceedings against Tsoi contains additional allegations that were not part of the criminal trial including allegations that Tsoi continued to manipulate the COP after the commencement of the SFC’s criminal proceedings.

I am quite interested to know how the evidence provided by SFC was insufficient to prove beyond reasonable doubt that Tsoi had manipulated the futures market.

Dual Filing Update (Jan 2010)

SFC has recently released another newsletter to update market participants on the dual filing arrangements. During the 6 months ended September 2009, SFC received 64 listing applications via SEHK and found causes to comment on 53 applications. Some of the cases reviewed by SFC are highlighted below.

Understanding potential risks on business viability

• In one case, the listing applicant breached certain regulatory provisions when entering into contracts with its customers which, in the worst case, might render the contracts illegal. The potential result could be the loss of its business licence, the very basis on which the listing was sought. The applicant did not appear to have followed the advice of its legal adviser to mitigate the effects of such breaches. The extent of the deficiencies raised substantial doubts as to whether the sponsors had critically assessed the applicant's business viability, of which disclosure alone might not necessarily be adequate to address the issues. The listing application was allowed to expire, leaving these issues unresolved.
• In another case, a large part of the applicant's business was substantially derived from its connected persons and employees, although the proportion decreased from over 90% to 40% of its profit during the track record period. The reliance on these connected clients was expected to continue after listing. The applicant's ability to obtain third party funding for its business also depended on its ability to generate a sufficient level of revenue, which in turn was substantially derived from the transactions with the connected clients. It was questionable whether the applicant could carry on its business independently. In addition, some of these connected clients were directors of the applicant. Concerns were raised at the risk that they might override the internal control procedures to facilitate their own transactions or make decisions in favour of themselves at the expense of the interests of the shareholders. Even internal controls and corporate governance measures may not be sufficient to reduce or eliminate these inherent risks. The listing application was formally withdrawn after the regulators raised these concerns with the sponsors.

Inconsistent explanations on impact of the global financial crisis

• In one case, the listing applicant, a Mainland property developer, claimed that the global financial crisis, uncertain economic prospects, and the tightened credit markets reduced the demand for its properties. However, it actually sold more properties in terms of square meters after the turmoil. In a similar case, the applicant claimed that the downturn in 2008 reduced property prices on the Mainland but the average selling price of its properties continued to increase by more than 20% in the same year.
• In another case, the listing applicant attributed the decline in its net profit to the global financial crisis since the second half of 2008. However, its net profit for the second half of 2008 was actually more than double the net profit for the first half.

Disclosure of instances of regulatory non-compliance

• The media have widely reported that the Chinese central government has introduced stringent measures against leaving land idle where property developers miss specified development deadlines. In one case, the listing applicant delayed construction and was in breach of land grant contracts signed with the local regulatory bodies. No analysis of the potential adverse financial and operational impact on its business was provided. Nor was there any basic information relating to the idle land, the amounts invested, any regulatory notices received or any measures taken to address the breach.
• In another case, the listing applicant did not obtain the construction permit before commencing construction of a property project and in the worst case could be liable to penalty or forfeiture of the land. However, no disclosure was made relating to the length of the delay, when and whether the construction permit could be obtained, the estimated penalty and the total costs of investment or other information that was important for potential investors to assess the financial and operational impact on the listing applicant.
• In another case, the draft prospectus omitted the applicant's past record of production without valid permits, which had led to the temporary suspension of operations during the track record period. In a similar case, the applicant’s various major litigation and regulatory breaches, which had exposed it to penalties and potential disruption of operations, were omitted from the draft prospectus.

Conduct of sponsors

• In one case, the listing applicant consistently represented to the regulators that the reason why the ownership of a key asset had not been transferred from the parent, but had rather been entrusted to the company, was a prolonged regulatory approval process. However, it was later revealed that the parent's interest in the key asset was, in fact, subject to a lock-up, which prevented the parent from transferring ownership to the applicant in the near future. This rendered the previous reasons submitted by the sponsor for the entrustment arrangement potentially false and misleading. It also raised substantial concerns as to the adequacy of the due diligence performed by the sponsor to understand and verify the rationale behind the arrangement. The disclosure was rectified only after the regulators had persistently challenged the sponsor’s representation.
• In another case, the listing applicant initially disclosed in the draft prospectus that all three of its executive directors remained as directors of a major subsidiary after its disposal. In fact, only one executive director remained as a director of this company, which was actually managed by the purchaser after the disposal. Had the regulators not enquired into the matter, the statement made could be false or misleading since the prospectus representation would mean that all three executive directors remained involved in the day-to-day management of the major subsidiary after its disposal to a third party.
• In a similar case, the listing applicant sold its products to distributors which contributed more than 40% of its total revenue during the track record period. The sponsor failed to perform sufficient due diligence on the number of distributors provided by the listing applicant and the initial disclosure of the number of distributors was revised down by 20% upon enquiry by the regulators.
• In another case, the initial draft prospectus failed to disclose the applicant's trading business. When we queried this point, it was revealed that this business segment actually contributed more than 30% of the applicant's total revenue throughout the track record period. As a result, the draft prospectus was substantially revised to rectify the misleading disclosure on the businesses of the applicant.

Enhanced Monitoring of Compliance with the Code of Banking Practice

As a result of a recent review, last week HKMA announced that it will be introducing the following new measures for enhanced monitoring:

1. Annual self-assessments with revised reporting template

• The current biennial self-assessment exercise will revert to a yearly basis. As a transitional arrangement, the forthcoming exercise will cover a reporting period from 1 June 2008 to 31 December 2009. This will enable HKMA to assess banks' full compliance with the current version of the Code which took effect on 2 January 2009.
• In addition, the reporting template for the self-assessment has been revised so that banks set out their rationale for any deviation from the norm in certain areas. For instance, section 12.3 requires banks not to charge customers "extortionate interest rates". A bank might be charging over 48% (the level presumed under the Money Lenders Ordinance to be extortionate) in some cases but decide that it is in compliance with that section because it sees itself as having strong justification for doing so. Instead of reporting a simple "yes" as in the existing template, the revised template would require the bank to provide further information on its justification for cases where it charges in excess of 48%.
• As in the past, all banks are required to commission their internal audit department, compliance department or other equivalent unit to conduct the self-assessment. The chief executive of the bank should co-sign the self-assessment report. Where an instance of non-compliance is identified, the bank concerned should provide details of the case including its plan to rectify the situation. A full account should be given if the instance of non-compliance is a recurrence of similar instances identified in previous exercises.

2. Exception reporting

• Based on results from previous self-assessment exercises, most of the non-compliance cases concern subjects covered in Chapter 1 (Relationship between Banks and Customers) and Chapter 2 (Accounts and Loans) of the Code. These also tend to be areas that attract customer complaints and therefore call for priority attention. Henceforth, banks should notify HKMA as soon as practicable of any breach of any provision within Chapters 1 and 2 of the Code, adopting the standard format below. Such exception reporting will facilitate HKMA's timely monitoring of rectification action, and should also help focus banks' attention on measures needed to strengthen their compliance with the Code.

3. Mystery shopping

• Both self-assessment and exception reporting inevitably reflect banks' own perspectives of their compliance with the Code. Drawing on the monitoring frameworks in other jurisdictions, including the UK and Australia, HKMA is proposing to introduce a trial mystery shopping scheme as a proactive approach to seek to assess compliance from the consumer's perspective. By testing customer experience against expectations set by the Code, this research technique may reveal useful information regarding levels of compliance with the Code and identify potential areas for improvement.
• Starting from 2010, HKMA will engage the services of one or more organisations engaged in market research activities to undertake mystery shopping exercises. In determining the scope and frequency of such exercises, HKMA will be guided by any concerns or trends emerging from the self-assessment results or other sources regarding banks' compliance with the Code. A key area, by way of example, which lends itself to the mystery shopping technique is the use of mystery shoppers to assess the extent to which bank staff are able to provide clear and accurate information in accordance with requirements under the Code.
• HKMA does not intend to take the findings of a particular mystery shopping exercise to be fully representative of a bank's general level of compliance with the Code. Nevertheless, where mystery shopping indicates possible compliance problems within a bank, it will prompt HKMA to consider follow-up work to establish why any failings occurred. The findings will also provide HKMA with insights to share with the AI concerned. In addition, examples of good and bad practice identified by any mystery shopping campaign can be shared with banks generally with a view to improving industry practice.

I particularly support extending mystery shopping to banking practices. Bank staff should understand that misleading customers is unacceptable in both banking and investment services.