Counterparty Risks of Lousy Broker

In May 2016, Guotai Junan Securities (Hong Kong) Limited was fined $1.3 million by SFC for the Client Identity Rule Policy. In Jun 2016, there was another enforcement case against Guotai Junan, which was much more severe.

As announced on 22 Jun 2020, Guotai Junan was fined $25.2 million by SFC for for multiple internal control failures and regulatory breaches in connection with AML, handling of third party fund transfers and placing activities, as well as detection of wash trades and late reporting.

Third party fund transfers

• Between Mar 2014 and Mar 2015, Guotai Junan failed to take reasonable measures to ensure that proper safeguards were put in place to mitigate the risks of money laundering and terrorist financing in processing 15,584 third party deposits or withdrawals for its clients, totalling approximately $37.5 billion.
• Despite red flags suggesting some of the third party fund transfers were unusual or suspicious, Guotai Junan failed to adequately monitor the activities of its clients, conduct appropriate scrutiny of the fund transfers, identify transactions that were suspicious and report them to the JFIU in a timely manner.
• Guotai Junan processed 5,406 third party deposits from Jul 2015 to Jun 2016 without always documenting the identity of the depositors, their relationship with the account holders, and the reasons for these third party deposits.

Placing activities

• While acting as the placing agent for the global offering of a Hong Kong-listed company’s shares between Dec 2015 and Jan 2016, Guotai Junan failed to take reasonable steps to ascertain whether the clients’ subscription applications were consistent with its knowledge of their background and source of funds, and make appropriate enquiries when there were grounds for suspicion.
• In particular, the funds used by five clients to subscribe for $28.8 million worth of the listed company’s shares were deposited by the same third party into the respective client accounts in amounts far exceeding their self-declared net worth.
• Despite such red flags, Guotai Junan did not take reasonable steps to verify the ultimate beneficial owners of the clients’ accounts and their source of funds, nor make appropriate enquiries to ascertain whether the clients were independent of the listed company. In the end, 3 of the 5 placees, who were allotted 11% of the listed company’s shares of the total placing under the international tranche, turned out to be the listed company’s employees.

Detection of wash trades and reporting obligation

• Guotai Junan failed to detect 590 potential wash trades in a timely manner between Jan 2014 and Jul 2016 due to a lack of adequate written trade monitoring procedures or guidelines and technical failures of its transaction pattern monitoring system.
• However, despite becoming aware in Jul 2016 of 210 potential wash trades which could not be detected in a timely manner as a result of the system failure, Guotai Junan did not report these 210 trades to SFC until 7 months later in Feb 2017.

More details of this case can be found from the Statement of Disciplinary Action.

If your firm is a financial institution conducting business with such a lousy broker, how would you evaluate the counterparty risks (regulatory risk, reputation risk, operational risk, etc.) in light of this enforcement case?

Reliance on Individual Consultants to Conduct Product Due Diligence

As announced on 19 Mar 2020, SFC reprimanded and fined Convoy Asset Management Limited (CAML) $6.4 million for control failures in solicitation and recommendation of bonds to clients.

CAML referred clients to a third party platform between Mar 2015 and Jan 2017 (Relevant Period) to execute 30 transactions of Chapter 37 Bonds, some of which involved solicitation or recommendation made to clients.

In recommending Chapter 37 Bonds to clients, CAML failed to:

• conduct proper and adequate product due diligence on these bonds before making recommendation or solicitation;
• have an effective system in place to ensure that the recommendation or solicitation in relation to bonds was suitable for and reasonable in all the circumstances;
• maintain proper documentary records of the investment advice or recommendation given to its clients and provide each of them with a copy of the written advice; and
• have adequate and effective internal controls and system in place to diligently supervise and monitor the sale of bonds through the third party platform and to ensure its compliance with applicable regulatory requirements.

The SDA revealed further details:

• During the Relevant Period, CAML introduced its clients to a third party platform to execute 30 Chapter 37 Bonds transactions in the secondary market for 28 retail clients. Clients who purchased bonds via the third party platform had to open accounts at both CAML and the third party platform. They were clients of both firms.
• CAML did not have product approval and due diligence procedures on Chapter 37 Bonds. It relied solely on individual consultants to conduct product due diligence (PDD) and to assess the risks of the bonds.
• CAML engaged the bond dealing services of the third party platform to assist its consultants to understand each bond product before recommending such product to clients. The platform offered the services of a designated bond expert to CAML, and provided briefings, presentations and articles to CAML’s consultants on bond products, as well as responded to enquiries from CAML’s consultants. However, the third party platform did not assign a risk rating to the bonds, and did not identify which of the bonds on its platform were Chapter 37 Bonds.
• CAML provided limited guidance to its consultants on how they should conduct PDD on the bonds, including for instance, what features they had to review and the criteria to be adopted, what other factors they should take into account, and the weight to be attributable to those factors. Its consultants were also not required to record in writing what documents they had reviewed, in what respects the bonds were considered suitable for different risk categories of investors, and justification for such findings.

SFC does not disclose the identity of the third party platform, probably due to the fact that another disciplinary action is being taken against this firm.

SFC's Statement on HSBC's Cancellation & Suspension of Dividends

As we know, HSBC Holdings plc made an announcement made on 31 March 2020 relating to the cancellation of its fourth interim dividend for 2019 (Cancellation) and the suspension of payment of any further dividend until the end of 2020 (Suspension).

SFC said it has received a large number of enquiries and complaints from the investing public and professional bodies in Hong Kong in relation to the Cancellation and the Suspension.

SFC does not usually comment on individual cases. However, in light of the significant public interest in this matter, SFC issued a statement on 15 May 2020 to inform the public about the actions that SFC has taken, including its communications with the Bank of England’s Prudential Regulation Authority (PRA) and HSBC.

Matters relating to the banking and prudential supervision of HSBC lie outside the SFC's regulatory ambit. SFC communicated with HSBC and PRA to establish the circumstances leading up to the Cancellation and the Suspension. SFC also conveyed to them the views of Hong Kong investing public, including:

• the overall impact on Hong Kong retail shareholders;
• reliance of many Hong Kong retail shareholders on dividend distributions by HSBC as a form of regular income; and
• that the Cancellation was made after the ex-dividend date in relation to the fourth interim dividend.

SFC understands that PRA's request for the Cancellation and the Suspension, and HSBC's agreement to such request, was made after carefully considering and balancing various factors, including the following:

• In line with regulators internationally, PRA has been monitoring the impact of COVID-19 on PRA-regulated firms and their groups and has put in place various measures to advance its general objective during this difficult time.
• As at 31 March 2020, there was a high level of uncertainty as to the duration and impact of the economic implications of COVID-19 on a global basis. PRA noted that there was a real risk of a very rapid reduction in economic activity globally in response to restrictions imposed by a number of governments and a particular need for additional lending to help real economies bridge the gap to the eventual removal of those restrictions.
• PRA considered the need for early action to preserve the capital position of firms in the face of continuing economic uncertainty. Further, PRA has the necessary statutory power to require HSBC to take capital preservation actions and it was clear that PRA stood ready to exercise such powers should HSBC not agree to take the requested action.
• The interests of HSBC's shareholders around the world balanced against the urgent need for capital preservation to finance the global economy during, and following, the COVID-19 pandemic. In particular, the PRA noted that a cessation of dividends to ensure adequate capital to support lending, in the case of HSBC, was likely to benefit the Hong Kong economy as well as the UK and the global economy.
• The announcement made by the European Central Bank on 27 March 2020 recommending banks not to pay dividends or engage in share buy-backs.

Further, according to the board of HSBC, HSBC's long-term interests were best served by acceding to PRA's requests, instead of requiring PRA to exercise its statutory power.

SFC also notes that HSBC received the PRA's direct request for the Cancellation at around 5:03p.m. (London time) on 31 March 2020 and HSBC published its announcement on the Cancellation prior to trading in Hong Kong on 1 April 2020.

SFC has conducted a careful examination of all information available to it to date (including, but not limited to, the matters mentioned above), and assessed it against the threshold criteria for investigating matters under the SFO such as insider dealing, failure to disclose inside information, disclosure of false or misleading information and unfair prejudice to shareholders, and has concluded that there is at present no ground on which regulatory action should be pursued under the SFO in respect of the Cancellation and the Suspension.

SFC's lengthy statement may reveal that it has been under a high political pressure to pursue this matter. Hong Kong, as of today, is still an international financial centre. SFC respects PRA's request and defends HSBC's action.

Checking of SFC licence records

When we check whether a firm or an individual is licensed by SFC, of course we visit SFC's public register. But today I accidentally find another website, which extracts data from SFC's public register but may be useful to a certain extent.

This homepage of SFC Licence Guru lists out licensed corporations with RO/rep most recently licensed. When inputting an individual's name into the search box, you can find out his licence history (no matter his licence is active or inactive) and the link to the official SFC record is also provided. However, you can't get any result by inputing a company name into the search box, which is a limitation.

Of course, David Webb's website can also provide similar licence checking function, where the data are more comprehensive.

Licensing Matters under COVID-19 Pandemic

On 31 Mar 2020, SFC issued the FAQs for "Licensing related matters in light of the COVID-19 pandemic". I would like to make comments on certain messages given by SFC to intermediaries.

All licensed individuals who are originally required, by way of licensing conditions or otherwise, to pass post-licensing regulatory examinations within a prescribed timeframe which falls due on or before 30 Sep 2020, will be allowed an extended period of 3 calendar months after the original due date to meet the requirement.

Comment: This is necessary as HKSI has suspended the regulatory exams (up to 11 Apr 2020, but may be extended due to the potential change of government policy). If the pandemic is not yet put under control, SFC would probably further extend the grace period.

SFC allows all licensed individuals who are unable to fulfil the annual CPT hours by 31 Dec 2020 to carry forward any unfulfilled CPT hours for the calendar year of 2020 to 2021.

Comment: Different from taking exams, fulfilling CPT hours at home (i.e. taking online courses) is perfectly acceptable under SFC's CPT Guidelines, given that it requires the submission of course assignment (e.g. quiz) upon completion.

An LC is required to notify SFC of significant changes in its business plan covering internal controls, organisational structure, contingency plans and related matters, including but not limited to:

• Confirmation of staff infection which may have an impact on the LC’s operations 

• Closing of office premises as a result of staff infection or government lockdown, including overseas office premises, if the closure has implications for the LC’s operations or the carrying on of its regulated activities (e.g. temporary closing of overseas office premises which handles back and middle office functions)

• Changes to its organisational resources (e.g. split team arrangements, staff relocation to overseas offices) 

• The triggering of the LC’s business continuity plan

Comment: It is desirable for SFC to design a questionnaire to facilitate LCs in making such kind of reporting.

While an LC has arranged for its staff to work from home or from its overseas offices which are not premises approved under s130 of the SFO, it should ensure that the staff will be able to remotely access the LC’s trading or other systems, and that the activities conducted by the staff will be captured in the records and documents generated by these systems. If certain records and documents need to be kept in unapproved premises on a temporary basis, the LC should send them back to the approved premises of the LC as soon as practicable.

Comment: During the current extraordinary circumstances, indeed SFC should adopt a lenient approach towards an LC's technical breach of operational rules.

If an LC or AE anticipates delays in preparing its audited accounts or other documents, it may apply for an extension of the submission period asap. SFC will consider these applications pragmatically.

Comment: This year LCs and AEs are required to submit the new version of Business and Risk Management Questionnaire (BRMQ), which is much more lengthy than the old one. Request for delayed submission of BRMQ may be necessary.

Nothing is certain but death and regulations.

Over-charging of Commission in Bond Transactions

As announced on 19 Mar 2020, SFC banned Ms Chan Tan Lo, a former relationship manager of BOCI Securities Limited (BOCIS), for 14 months.

Chan executed nine bond transactions for two clients in Mar 2016, she failed to disclose and/or provided them with inaccurate information about the final execution prices and/or the actual commission rates she charged them. She also overcharged them in these transactions.

Further details are disclosed in the SDA:

• During the regular sample checking of the telephone recordings of the trades executed by its RMs, BOCIS found that in 9 bond transactions Chan executed for the clients from 1 Mar 2016 to 23 Mar 2016, Chan charged them higher commission rates than had been previously agreed with them.
• According to the clients, they agreed with Chan that BOCIS could charge them a commission of 0.2% of the execution price in bond transactions executed on their behalf. The clients were not willing to pay any commission rate higher than 0.2% as had been agreed with BOCIS.
• Audio-recordings of the telephone conversations between Chan and the clients' representative show that during the price quotation stage:

• Chan quoted the best available prices to the clients' representative for the 9 bond transactions.

• Chan either expressly told the clients' representative that there would be a mark-up of 0.2%, or did not correct the clients' representative when he expressed his understanding that there would be a mark-up of 0.2%, or indicate to him that the mark-up might change.

• When the 9 bond transactions were executed at a better price, Chan unilaterally increased the mark-up without informing the clients' representative of the increase and seeking his consent to charge a higher mark-up for the transaction. Chan failed to disclose, and/or provided inaccurate, information to the clients about the actual execution prices and the actual commission rates charged by her, and overcharged the clients commission by 0.2% to 0.8% in the 9 bond transactions.

This is no doubt cheating. This case was revealed by sample checking of telephone recordings. For a better control, the trading system should record the agreed commission rate for the clients and automatically ban any over-charing of commission.

2020-21 Budget - Financial Services

The following points about financial services in the 2020-21 Budget Speech announced on 26 Feb 2019 are relating to the securities industry:

• In order to strengthen the competitiveness of Hong Kong as an ETF listing platform, the Government proposes to waive the stamp duty on stock transfers paid by ETF market makers in the course of creating and redeeming ETF units listed in Hong Kong.
• To attract more private equity funds to Hong Kong, the Government has been making full efforts to introduce new fund structures, including the preparation of new legislation on the establishment of a limited partnership regime that meets the operational needs of funds, so as to encourage the setting up of private equity funds in Hong Kong. The Government also plans to provide tax concession for carried interest issued by private equity funds operating in Hong Kong subject to the fulfilment of certain conditions.
• The Government will further enhance Hong Kong's AML/CTF regime having regard to the recommendations of FATF's evaluation report, and consider incorporating virtual asset service providers and dealers in precious metals, stones and jewellery into the AML/CTF regulatory framework.

Compliance professionals should pay more attention to the last point - further enhancement of the AML/CTF regime.