Trading Ban Against Tiger Asia

SFC is beating the "tiger" again by seeking court orders to prohibit New York-based asset management company, Tiger Asia Management LLC, from dealing in all listed securities and derivatives in Hong Kong in the light of further insider trading allegations concerning the shares of another bank -- Bank of China Limited (BOC). This is the first time SFC has taken this kind of action.

SFC has also amended the current proceedings against Tiger Asia and three of its senior officers, Mr Bill Sung Kook Hwang, Mr Raymond Park and Mr William Tomita (collectively the "Tiger Asia parties") to include the new allegations and is seeking to freeze an additional amount of up to $8.6 million of Tiger Asia’s assets, equivalent to the notional profit Tiger Asia has allegedly made in one of the new claims.


This is on top of the $29.9 million that SFC has applied to freeze when it first commenced proceedings in August 2009 against the Tiger Asia parties in relation to dealings by Tiger Asia in the shares of China Construction Bank Corporation (CCB) on 6 January 2009.


The proceedings were commenced under section 213 of SFO. Tiger Asia was founded in 2001 and is a New York-based asset management company that specialises in equity investments in China, Japan and Korea. All of its employees are located in New York. Tiger Asia has no physical presence in Hong Kong. Park joined Tiger Asia in April 2006 and, at all times since, his job title has been Managing Director, Head of Trading, and his responsibilities include managing the trading desk, supervising orders and managing broker relationships. Tomita joined Tiger Asia in April 2008 and is charged with supporting the trading activities led by Park. Both Park and Tomita report to portfolio manager, Hwang, whom SFC alleges made the trading decisions for the CCB and BOC trades.


SFC alleges that in the case concerning BOC shares:

• Tiger Asia was given advance notice and was invited to participate in two placements of BOC shares by UBS AG and Royal Bank of Scotland (RBS) on 31 December 2008 and 13 January 2009 respectively;
• Tiger Asia was provided with details of both placements after being told and agreeing the information was confidential and price sensitive;
• Tiger Asia also agreed not to deal in BOC shares after receiving the information;
• Tiger Asia short sold 104 million BOC shares before the placement by UBS AG on 31 December 2008 making a notional profit of $8.6 million; and
• Tiger Asia sold 256 million BOC shares before the placement by Royal Bank of Scotland on 13 January 2009 (of which 251 million shares were short sales) making a notional loss of around $10 million.

SFC contends that these transactions constitute illegal insider trading in shares of BOC.

These allegations will be heard by the court in the same proceedings involving similar allegations against the Tiger Asia parties involving dealings in shares of CCB, at a date yet to be fixed.

SFC is also seeking orders to unwind the transactions if the court finds they contravened SFO and to restore affected counterparties to their pre-transaction positions. The amount of assets that SFC is seeking to freeze is to ensure there are sufficient funds to satisfy any restoration orders that may be made by the court.

(Jack's comment: Cross-border enforcement of SFO would be a challenge to SFC. Would UBS AG and RBS be implicated as well?)

Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages

Last week US SEC charged Goldman Sachs & Co. and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter.

SEC alleges that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.

"The product was new and complex but the deception and conflicts are old and simple," said Robert Khuzami, Director of the Division of Enforcement. "Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party."

SEC alleges that one of the world's largest hedge funds, Paulson & Co., paid Goldman Sachs to structure a transaction in which Paulson & Co. could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events.

The marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.

After participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.'s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.

Goldman Sachs Vice President Fabrice Tourre was principally responsible for ABACUS 2007-AC1. Tourre structured the transaction, prepared the marketing materials, and communicated directly with investors. Tourre allegedly knew of Paulson & Co.'s undisclosed short interest and role in the collateral selection process. In addition, he misled ACA into believing that Paulson & Co. invested approximately $200 million in the equity of ABACUS, indicating that Paulson & Co.'s interests in the collateral selection process were closely aligned with ACA's interests. In reality, however, their interests were sharply conflicting.

The deal closed on 26 April 2007, and Paulson & Co. paid Goldman Sachs approximately $15 million for structuring and marketing ABACUS. By 24 October 2007, 83% of the RMBS in the ABACUS portfolio had been downgraded and 17% were on negative watch. By 29 January 2008, 99% of the portfolio had been downgraded.

Investors in the liabilities of ABACUS are alleged to have lost more than $1 billion.

(Jack's comment: I agree that Goldman Sachs was wrong for failing to disclose Paulson & Co.'s short interest and involvement in the collateral selection process; but in order to charge Goldman Sachs and Tourre for fraud, SEC must justify that investors' losses were caused by such misrepresentation. Those CDO investors are all institutional rather than retail. They were capable of performing an independent valuation of the CDO, which would not be affected by knowing that they were betting with Paulson & Co.)

Fraud Related to Subprime Mortgages

US SEC recently announced administrative proceedings against Morgan Keegan & Company and Morgan Asset Management and two employees accused of fraudulently overstating the value of securities backed by subprime mortgages.

SEC alleges that Morgan Keegan failed to employ reasonable procedures to internally price the portfolio securities in five funds managed by Morgan Asset, and consequently did not calculate accurate "net asset values" (NAVs) for the funds. Morgan Keegan recklessly published these inaccurate daily NAVs, and sold shares to investors based on the inflated prices.

James Kelsoe, the portfolio manager of the funds and an employee of Morgan Asset and Morgan Keegan, arbitrarily instructed the firm's Fund Accounting department to make "price adjustments" that increased the fair values of certain portfolio securities. The price adjustments ignored lower values for those same securities quoted by various dealers as part of the pricing validation process. Kelsoe actively screened and manipulated the pricing quotes obtained from at least one broker-dealer. With many of the funds' securities backed by subprime mortgages, Kelsoe's actions fraudulently prevented a reduction in the NAVs of the funds that otherwise should have occurred as a result of the deterioration in the subprime securities market.

Morgan Keegan priced each portfolio's securities and calculated its daily NAV through its Fund Accounting Department. Each fund held various amounts of securities backed by subprime mortgages and lacked readily available market quotations. Therefore, the securities were internally priced using fair value methods to determine the amount that the funds would reasonably expect to receive on a current sale of the security. The funds stated that the fair value of securities would be determined by a valuation committee using procedures adopted by the funds. In fact, the responsibility was essentially delegated to Morgan Keegan, which along with the valuation committee failed to comply with the funds' procedures in several ways.

From at least January to July 2007, Kelsoe had his assistant send approximately 262 "price adjustments" to Fund Accounting. In many instances, these adjustments were arbitrary and did not reflect fair value. Despite the lack of any supporting documentation, Kelsoe's price adjustments were routinely entered into a spreadsheet used to calculate the NAVs of the funds. Kelsoe also routinely instructed Fund Accounting to ignore month-end quotes from broker-dealers that were supposed to be used to validate the prices the firm had assigned to the funds' securities.

Joseph Weller, a CPA who was head of the Fund Accounting Department and a member of the Valuation Committee, did nothing to remedy the deficiencies in Morgan Keegan's valuation procedures, nor did he otherwise make sure that fair-valued securities were being accurately priced and NAVs were being accurately calculated.

(Jack's comment: Can we still trust the accountants? "Fair value" is kidding.)

Insider Dealer subject to "Life Sentence"

Last week SFC announced that it has banned Mr Steve Luk Ka Cheung (once a famous fund manager) from re-entering the industry for life following a Market Misconduct Tribunal (MMT) determination that Luk had engaged in market misconduct. Steve Luk's licence was revoked in November 2006.

MMT determined that Luk, a former vice-president and fund manager of JF Asset Management Ltd, and two other parties had engaged in insider dealing in respect of the shares of China Overseas Land and Investment Ltd (COLI). MMT made certain orders against Luk, including orders that he should not, without the leave of the court, take part in the management of any company and acquire, dispose of or otherwise deal in any securities for nine months.

During the period from 7 to 26 January 2004, Mr David Tsien Pak Cheong, then an equity salesman of JP Morgan Securities (Asia Pacific) Ltd, disclosed to Mr Edmond Leung Chi Keung and Luk relevant information in respect of negotiations between JP Morgan and COLI in relation to a top-up placement of the latter's shares. Leung and Luk then separately sold COLI shares held by funds they managed to avoid the loss to those funds in the value of those shares, flowing from what they believed would be a fall in the market price of COLI shares following disclosure of the relevant information to the market.

Let's have a look at the following remarks on Steve Luk extracted from MMT's report:

• In common with the other Specified Persons, Mr Steve Luk was a man of considerable experience in the financial services industry at the time of the commission of his acts of insider dealing. In 1990, he obtained an MBA degree from Columbia University. In 2004, he was a Vice-President of JFAM and manager of two of its funds, having been employed by that organisation for 14 years. At the time of the insider dealing one of the funds, JPM China Fund, held shares to a value of US$600 million whilst the other fund, JF Greater China Open Fund, held shares to the value of US$250 million. He was permitted to trade in the funds without requiring the permission of others. Clearly, Mr Steve Luk was a man in whom JFAM reposed considerable trust and who bore considerable responsibility. His insider dealing was a breach of that trust.
• Although Mr Steve Luk's acts of insider dealing were committed in a period of not much more than an hour on the afternoon of 26 January 2004, it is to be noted that, having placed the original order to sell COLI shares in the two funds that he managed, a little later he intervened to reduce the price limit at which they could be sold and placed a third sell order for the fund of a colleague. In all, he sold 9.1 million COLI shares in the three funds.
• The Tribunal accepts that Mr Steve Luk received no direct benefit of having succeeded in avoiding loss in the three funds by his sale of COLI shares. However, in so far as the two funds that he managed benefited from his market misconduct in avoiding loss, that was to be reflected in the assessment of his performance as a fund manager, measured by the funds outperforming the MSCI China Index, and ultimately in monetary terms in the bonus he received.

It is your judgement on whether the penalty for Steve Luk is too harsh or not, but definitely this case tells you again how a momentary slip (一念之差) can ruin one's life.

Guidelines on Disclosure of Inside Information

This week SFC issued a draft set of guidelines to explain "inside information" and its application, in parallel with FSTB's publication of proposals to make it statutory for listed corporations to make timely disclosure of "price-sensitive information" (PSI).

FSTB's Consultation Paper proposes to include in SFO a statutory requirement for a listed corporation to disclose to the public as soon as practicable PSI that has come to its knowledge.

As part of the proposals, SFC has drafted guidance on what constitutes "inside information", a new term used in the proposed legislation to mean PSI. "Safe harbours" and how they would apply are also described in the "Draft Guidelines on Disclosure of Inside Information".

Key contents of the Draft Guidelines include:

• What may constitute inside information?
• Examples of possible inside information concerning the corporation
• When and how should inside information be disclosed?
• Responsibility for compliance and management controls
• Safe Harbours that allow non-disclosure of inside information
• Guidance on particular situations and issues

Listed companies should carefully read through the Consultation Paper and Draft Guidelines to understand the new "minefield" set by SFC!

Director Qisqualification Over Timely Disclosure

SFC has recently obtained orders in the High Court to disqualify two former executive directors of Warderly International Holdings Ltd for failing to ensure timely disclosure of material information to the company's shareholders. This is the first time directors have been disqualified for this type of misconduct.

The orders disqualify Ms Ellen Yeung Ying Fong and Mr John Lai Wing Chuen, from being directors or being involved in the management of any corporation, without leave of the court, for five years, effective 7 April 2010.

Both Yeung and Lai accepted they had breached their duties to Warderly by failing to manage the company with appropriate care. In particular, they agreed they failed on a number of occasions to ensure Warderly complied with the disclosure requirements under the Listing Rules and to give shareholders all the information they might reasonably expect. SFC is also taking similar action against four other former directors of the company.


SFC directed trading to be suspended in the company's shares in May 2007 and consequently, focused its investigation on events between July 2006 and April 2007. SFC alleged that the company should have disclosed its substantially depleted financial position to the market:

• there were legal proceedings underway in Hong Kong and the Mainland against Warderly and its subsidiaries by banks and creditors to recover overdue loans;
• Warderly’s operations were substantially disrupted by labour strikes in its Mainland factory;
• the company had appointed a financial adviser in respect of a proposed debt restructuring and re-organisation;
• a management committee had been appointed to solve Warderly’s financial problems;
• an external firm of accountants had been appointed at the request of a bank loan syndicate and had reported on the company’s deteriorating financial position; and
• the company was forced to raise money by way of loans at penalty interest rates to stay afloat.

(Jack's comment: In the future, when certain disclosure requirements of the Listing Rules have been codified under the SFO regime, those directors who fail to make timely disclosure of material information may even bear criminal liability.)

Lehman Brothers Examiner Report

Last week the Examiner appointed by the bankruptcy court released a 2,200-page report on a year-long investigation into the failure of Lehman Brothers, which has addressed the following three topics:

1. Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure?
2. Are There Administrative Claims or Colorable Claims for Preferences or Voidable Transfers?
3. Are There Colorable Claims Arising Out of the Barclays Sale Transaction?

I am of course most interested in the first topic, for which the Executive Summary is partially reproduced below:


Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure?


Lehman failed because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity to meet its current obligations. Lehman was unable to maintain confidence because a series of business decisions had left it with heavy concentrations of illiquid assets with deteriorating values such as residential and commercial real estate. Confidence was further eroded when it became public that attempts to form strategic partnerships to bolster its stability had failed. And confidence plummeted on two consecutive quarters with huge reported losses, $2.8 billion in second quarter 2008 and $3.9 billion in third quarter 2008, without news of any definitive survival plan.


The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule. But the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements – Lehman's CEO Richard S. Fuld, Jr., and its CFOs Christopher O'Meara, Erin M. Callan and Ian T. Lowitt. There are colorable claims against Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements.


Although Repo 105 transactions may not have been inherently improper, there is a colorable claim that their sole function as employed by Lehman was balance sheet manipulation. Lehman's own accounting personnel described Repo 105 transactions as an "accounting gimmick" and a "lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end." Lehman used Repo 105 "to reduce balance sheet at the quarter‐end."


In 2007‐08, Lehman knew that net leverage numbers were critical to the rating agencies and to counterparty confidence. Its ability to deleverage by selling assets was severely limited by the illiquidity and depressed prices of the assets it had accumulated. Against this backdrop, Lehman turned to Repo 105 transactions to temporarily remove $50 billion of assets from its balance sheet at first and second quarter ends in 2008 so that it could report significantly lower net leverage numbers than reality. Lehman did so despite its understanding that none of its peers used similar accounting at that time to arrive at their leverage numbers, to which Lehman would be compared.

Lehman defined materiality, for purposes of reopening a closed balance sheet, as "any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion)." Lehman's use of Repo 105 moved net leverage not by tenths but by whole points.


Lehman's failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those "low" leverage numbers to investors as positive news, created a misleading portrayal of Lehman’s true financial health. Colorable claims exist against the senior officers who were responsible for balance sheet management and financial disclosure, who signed and certified Lehman’s financial statements and who failed to disclose Lehman's use and extent of Repo 105 transactions to manage its balance sheet.
 
In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties; in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet and quarter end. The next day ‐ on June 13, 2008 ‐ Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee's assertions, despite an express direction from the Committee to advise on all allegations raised by Lee. Ernst & Young took virtually no action to investigate the Repo 105 allegations. Ernst & Young took no steps to question or challenge the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions. Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee's allegations and in connection with its audit and review of Lehman's financial statements.
 
 
(Jack's comment: Arthur Anderson died with Enron. Would Ernst & Young go with Lehman?)