Hong Kong Regulatory IN THIS ISSUE NEWSLETTER NEWS

Transcription

1 Hong Kong Regulatory DECEMBER 2015 IN THIS ISSUE NEWS Rogue traders SFC imposes stiff penalties for delayed reports of misconduct...1 Responsible officers SFAT declines to shift blame up to senior management or down toward employees...2 Disgruntled investors SFAT upholds investors rights to mediate claims against investment advisers...4 REGULATORY STANDARDS/UPDATES...6 INTERMEDIARIES/MARKET SUPERVISION...7 KEY PRODUCT DEVELOPMENTS...7 SIGNIFICANT ENFORCEMENT ACTIONS...8 NEWS ROGUE TRADERS SFC IMPOSES STIFF PENALTIES FOR DELAYED REPORTS OF MISCONDUCT In July 2015, Hong Kong s securities regulator, the Securities and Futures Commission (SFC), reprimanded and fined a Japan-headquartered financial institution HK$4.5 million for failing to report admitted misconduct of a rogue trader immediately. Background The trader had been on secondment to the Hong Kong office and licensed with the SFC. The trader reported to his employer that he had made certain trading losses totaling US$3.3 million, which he explained had been the result of an error. His employer initiated an inquiry to ascertain the true cause of the losses. A week later, it discovered that the trader s trading activities were inconsistent with his explanation. The employer then arranged to interview the trader to clarify the inconsistencies. The trader admitted to making manual adjustments to conceal his losses. The next day, the employer reported the losses to the SFC and undertook to provide a further report if it identified other issues. At the time of its initial report, the employer failed to inform the SFC about the trader s admission that he had attempted to hide his activities. Not until a month later, after the employer completed a formal preliminary report of its internal investigation, was the SFC notified that the trader had admitted to dishonestly making manual adjustments, entering fictitious trades and providing false information to mislead his employer and conceal his activities. In taking disciplinary action against the employer, the SFC stressed that where employers have reason to believe or suspect that licensed staff have engaged in conduct that affects their ability to carry on regulated activity competently, honestly and fairly, this information should be disclosed to the SFC promptly (especially where admissions are obtained from staff). In this case, the SFC stated that the information should have been reported no later than the day after the trader admitted to making manual adjustments. In its subsequent press release, the SFC stated, There can be no excuses for such delays in reporting matters requiring our immediate attention. Delays, like these, contribute to misconduct and prejudice investigations. In October, the SFC banned the trader from re-entering the industry for 30 months. Visit sidley.com for more information on Sidley s regulatory practice. Hong Kong Regulatory DECEMBER

2 This marks the third occasion in the past five years that the SFC has levied fines on financial institutions for internal control failings when making self-reports. The SFAT ruling confirms that ROs will be held personally accountable for compliance failures under their watch and that there is little or no room for blame shifting to the employer. Conclusion The SFC s disciplinary actions reinforce the need for employers to strictly comply with their obligation to self-report immediately upon any material breach, infringement or noncompliance with any law, rules, regulations, and codes administered or issued by the [SFC] or where it suspects any such breach, infringement or non-compliance by persons it employs or appoints to conduct business with its clients or other licensed or registered persons (emphasis added) as set out under paragraph 12.5 of the Code of Conduct for Persons Licensed by and Registered with the SFC. The SFC expects intermediaries to report problems immediately not after internal investigation, not after legal advice has been obtained, but right away, without leaving out any important information or admissions of dishonesty. This marks the third occasion in the past five years that the SFC has levied fines on financial institutions for internal control failings when making self-reports. Last year, the SFC publicly reprimanded and fined a Europe-headquartered financial institution HK$6 million for failing to detect unauthorized trading activities by a rogue trader. In that case, the SFC noted that the financial institution avoided a stiffer penalty by self-reporting the misconduct promptly on a Saturday. In 2011, the SFC imposed a HK$6 million fine and suspended the former Responsible Officer (RO) for eight months at a U.S.-headquartered financial institution and condemned delays in reporting misconduct until after a follow-up investigation by its external auditor was completed. In the current regulatory climate and market turmoil, financial institutions and licensed corporations may wish to conduct stress tests of all detection, escalation, notification, red flag practices and policies to mitigate similar weaknesses. RESPONSIBLE OFFICERS SFAT DECLINES TO SHIFT BLAME UP TO SENIOR MANAGEMENT OR DOWN TOWARD EMPLOYEES In August 2015, the Securities and Futures Appeals Tribunal (SFAT), the statutory watchdog that reviews SFC disciplinary decisions, upheld the SFC s decision to revoke the approval of a RO for serious internal control or compliance failures. The SFAT ruling confirms that ROs will be held personally accountable for compliance failures under their watch and that there is little or no room for blame shifting to the employer. Background At the time, the RO was one of two and the only one based in Hong Kong. The RO held a high position of responsibility within the organization and had taken charge of oversight of the compliance functions pending replacement of the previous compliance officer, who had resigned, even though the RO did not possess experience in this area. The SFC s investigation found that the RO did little to discharge her responsibilities in her compliance role, and her awareness of the importance of compliance appeared to be low. For instance, she was oblivious to the red flags that trigger a duty to report suspicious transactions to the SFC and Joint Financial Intelligence Unit and not merely to the compliance department or to senior management of the head office. In summary, the SFAT identified three principal failings: Failure to identify and report suspicious transactions involving certain deposits of shares into accounts that were not commensurate with the client s reported financial background and net worth in a timely manner. Failure to establish anti-money laundering (AML) internal control policies and procedures and ensure that AML training was provided to staff members. Failure to establish effective procedures to protect client assets in effecting payments and enforce internal policies on employee dealings and account opening procedures. Some of the more significant aspects of the decision are summarized on page 3. Hong Kong Regulatory DECEMBER

3 The tribunal held that the RO of a licensed corporation is the person who bears primary responsibility for compliance with all applicable regulatory standards and that where there is a failure in respect of compliance there is little or no room for blame-shifting. Extent of RO s responsibility for compliance with regulatory standards The tribunal held that it had no hesitation in accepting the SFC s submissions that the RO of a licensed corporation is the person who bears primary responsibility for compliance with all applicable regulatory standards and that where there is a failure in respect of compliance there is little or no room for blame-shifting. When disciplinary action is directed at the RO for compliance failures, the tribunal held that for the regulatory framework to be applied effectively and efficiently, it is not possible for the RO to shift responsibility either upwards towards more senior management or downwards towards employees who do not stand in the same position or level of the RO. Extent of RO s culpability for compliance weaknesses where no loss suffered The tribunal was unimpressed with the RO s plea for leniency with regard to her previous unblemished career in the financial industry for over 13 years and to the deficiencies in the internal control systems being unintentional, not causing loss to any clients and not constituting any breach of her fiduciary duty. The tribunal held that little weight could be attached to these mitigating factors. This was because in the disciplinary context much more consideration has to be given by the regulatory body to maintaining the reputation of the financial markets in Hong Kong. The tribunal noted that her failings as RO were serious and systemic, not an isolated incident, and it voiced a major concern with the lack of AML policies, which, in the current climate, was an enormous area of concern to national governments, banks and financial institutions all over the world. Her responses during the SFC investigation also showed an inability to appreciate the true nature and extent of her responsibilities as RO, despite having been one for a considerably long period (nearly eight years). The tribunal stated that any losses to clients or others would be aggravating factors, but the absence of such losses counts very little by way of mitigation and can only be said to be fortuitous. Hong Kong Regulatory DECEMBER

4 The landmark ruling confirms that IAs licensed by the SFC who sell investment products and fail to resolve eligible disputes under the Financial Dispute Resolution Scheme will face disciplinary action and/or hefty monetary penalties. DISGRUNTLED INVESTORS SFAT UPHOLDS INVESTORS RIGHTS TO MEDIATE CLAIMS AGAINST INVESTMENT ADVISERS In July 2015, the SFAT upheld the SFC s decision to reprimand and fine an investment adviser (IA) for unilaterally opting out of the mechanism for resolving eligible monetary disputes with a disgruntled investor under the Financial Dispute Resolution Scheme (the scheme). The tribunal reduced the fine imposed by the SFC from HK$700,000 to HK$400,000. The landmark ruling confirms that IAs licensed by the SFC who sell investment products and fail to resolve eligible disputes under the scheme will face disciplinary action and/or hefty monetary penalties. Duty to mediate disputes under scheme The scheme came into effect in June 2012 with the aim of providing a low-cost venue to resolve monetary disputes against financial institutions licensed by the SFC and/or authorized by the Hong Kong Monetary Authority (HKMA) (except those providing only credit-rating services). To be eligible, a claim must not exceed HK$500,000 and cannot be related to a contractual dispute about policies, fees or investment performance, except concerning an alleged nondisclosure, inadequate disclosure, misrepresentation, negligence, incorrect application, breach of fiduciary duty, breach of any legal obligation or maladministration. Affected clients must also agree to forgo court proceedings and bring eligible claims within 12 months from the date of purchase of the relevant product (or knowledge of loss). To prevent financial institutions from sidestepping the scheme, amendments were made to the Code of Conduct obliging them to comply with and be bound by the dispute resolution process under the scheme. Background In this case, a retail investor agreed to subscribe US$100,000 to a closed-end private equity fund, which she paid to an IA licensed by the SFC. The fund was not a financial product authorized by the SFC. Neither the fund nor the fund manager had any presence in Hong Kong. However, the IA had entered into an administration services agreement with the fund manager that obliged him (among others) to answer client enquiries. Once invested, the capital was not protected and could not be redeemed at will (contrary to the investor s Hong Kong Regulatory DECEMBER

5 understanding). Also unknown to the investor was the fact that 15 percent of the subscription proceeds was paid as commission to a third party rather than invested into the fund. The investment turned out to be very poor, and the investor suffered significant losses. When the investor was eventually able to redeem her interest in the fund, she was able to recover only approximately US$31,000, netting a total loss of US$69,000. She lodged a claim against the IA to recover her losses under the scheme (and agreed to cap her claim to the statutory ceiling). The IA refused to participate in a mediation, arguing that he should not be made subject to the scheme on the basis that the investor was not his client, he did not provide any financial services and he did not receive any fee/remuneration. Rather, the contractual relationship was between the investor and the fund. Against this background, the Financial Dispute Resolution Centre (FDRC), which administers the scheme, was left with no alternative but to serve a formal noncompliance letter, which it sent to the IA and the SFC. This led to SFC disciplinary action. At this point, the IA shifted his position and agreed to participate in a mediation. Some of the more significant aspects of the decision are summarized below. The SFAT held that the Financial Dispute Resolution Scheme provided two bases upon which eligible disputes may be referred to mediation. The SFAT stressed that there should be no further excuse on the part of members of the financial industry for a lack of understanding, at least, of the [scheme s] basic architecture and concluded that sterner penalties can be expected in the future. Are investors entitled to bring claims against IAs with whom they have no contractual relationship under the scheme? The tribunal held that the scheme provided two bases upon which eligible disputes may be referred to mediation. The first arose from contracts between eligible investors and the financial institution. The second arose from any act or omission of the financial institution, when it has acted as agent, in connection with the provision of financial services to affected investors. It was therefore clear that jurisdiction under the scheme is not restricted to disputes arising out of a formal contractual arrangement. The terms of the administration services agreement between the IA and the fund manager provided that the IA was exercising his discretion acting as the fund manager s agent in providing information to clients and potential clients and in receiving applications for investment. The fact that the IA received no fee/remuneration from the investor was irrelevant. This is because the provision of financial services was not defined under the terms of the scheme by reference to a financial reward. A financial service therefore did not cease to be such because the provider received no fee/ payment. The tribunal therefore concluded that there was no merit in the IA s challenge against jurisdiction but recognized that this is ultimately a determination to be made by authorized FDRC officers on a case-by-case basis. Are IAs entitled to opt out of the scheme? The tribunal was unimpressed with the IA s failure to acquaint himself with the true nature and extent of the [scheme], either by studying it or by taking advice in respect of it. The tribunal expressly rejected any excuse that this was due to simple oversight, inadvertence or a technical breach. This was because licensed persons have a positive obligation to be acquainted with [and submit to the scheme] under the Code of Conduct. However, the tribunal acknowledged that willingness to participate in mediation after the SFC s disciplinary action did constitute a material factor in mitigation. Conclusion This approach arguably gives teeth to the recent reforms. The tribunal acknowledged the fact that this was the first disciplinary matter since the scheme came into operation. It stated that some recognition must be given to the fact that, the [scheme] being relatively new and untested, the scope of its jurisdictional reach and, in particular, the process for determining eligibility of claimants and their claims, may not generally have been understood. However, it stressed that there should be no further excuse on the part of members of the financial industry for a lack of understanding, at least, of the [scheme s] basic architecture and concluded that sterner penalties can be expected in the future. Hong Kong Regulatory DECEMBER

6 Since commencement of its operation to the end of 2014, the scheme received on average 500 to 1,000 inquiries relating to financial products or services each year and handled 82 applications for mediation services and seven arbitration cases, with a success rate of over 80 percent for mediation cases. However, the majority of inquiries were ineligible because they were made after the 12-month limitation period, exceeded the monetary threshold or were against organizations that fall outside the scheme. REGULATORY STANDARDS/UPDATES OTC derivatives SFC proposes changes to financial resources rules July 2015: The SFC issued proposals to extend the financial resources regime to licensed corporations (LCs) engaged in over-the-counter (OTC) derivative activities. The proposals aim to mitigate and manage systemic risk in the OTC derivative market by adopting a single net capital requirement under both liquidity and capital adequacy rules. The proposals would require LCs (among others) to maintain a minimum fixed-dollar baseline net capital requirement of US$20 million. SFC issues circular for Hong Kong futures or options brokers to apply for exemptions to deal directly with U.S. customers August 2015: The SFC issued a circular for LCs interested in obtaining exemptions to solicit and accept orders and funds directly from U.S. customers in relation to the trading of futures or options products on exchanges under the SFC s oversight without having to register as futures brokers with the Commodity Futures Trading Commission (CFTC) in the U.S. Applications for exemptions are required to be made via the SFC. No fee is required for applying for the CFTC exemption. OTC derivatives HKMA and SFC issue further consultation on mandatory clearing and expanded mandatory reporting regime September 2015: Following commencement of the new mandatory reporting and recordkeeping rules for OTC derivative transactions which came into effect on July 10, 2015, the HKMA and SFC jointly issued a consultation paper with proposals to introduce the first phase of mandatory clearing and the second phase of expanded mandatory reporting obligations under the new OTC derivatives regime. The new centralized clearing regime focuses on certain standardized interest rate swaps (but excludes other less frequently used derivative product types, such as forward rate agreements, for the time being) between major dealers. The expanded mandatory phase aims to catch all OTC derivative products and widen the scope of transaction information to be reported. While the consultation focuses on putting in place adequate internal policies, systems and control procedures and staff training, the goal is to produce clear guidance on the types of transactions/products to be reported to aid the consistent gathering of OTC derivative transaction data and monitor risks to the financial system. SFC publishes revised guidelines for the regulation of ATS November 2015: The SFC issued a consultation paper with plans to revise the Automated Trading Services (ATS) guidelines. The consultation is open for comment for 40 days. The proposals aim to expand the guidelines to cover not only services for the trading and clearing of securities or futures contracts, but also services for the trading or clearing of OTC derivatives. Importantly, central counterparties (including those based overseas) who currently provide, or market, clearing services for OTC derivative transactions to persons in Hong Kong Hong Kong Regulatory DECEMBER

7 will need to be authorized by the SFC as ATS providers. The new guidelines will come into effect on commencement of the new regime to regulate the OTC derivatives market, which is expected to be in mid Short position reporting regime to be expanded November 2015: The SFC issued a consultation paper with plans to extend the short position reporting regime to all designated securities that can be short sold. The consultation is open for comment for 30 days from November 27. Under the existing rules, the reporting regime only applies to certain designated stocks. If implemented, the expanded regime will trigger a short position reporting obligation for all designated securities, including collective investment schemes, such as exchange-traded funds, real estate investment trusts and other listed unit trusts/mutual funds. INTERMEDIARIES/MARKET SUPERVISION SFC issues circular providing guidance on fair valuation of fund assets July 2015: The SFC issued a circular to remind fund managers, trustees and custodians of their duty to ensure that net asset values for funds are correctly calculated, particularly where the current market value of a fund asset is unavailable or unreliable or becomes illiquid or difficult to value as a result of significant market events. The guidelines apply to valuation of all types of assets of a fund including equities (especially where trading is suspended), fixed income and other investments. The SFC stressed that it does not consider nil or limited subscription or redemption orders received by a fund to be valid reasons for fund managers to avoid undertaking a fair valuation adjustments. The SFC also urged fund managers to note their obligations to suspend dealings in the units of a fund where the market value or fair value of a material portion of the fund s assets cannot be determined. SFC head of enforcement resigns September 2015: Mark Steward, former head of the Enforcement Division, has left the SFC to take up a similar role with the Financial Conduct Authority in the UK. The SFC announced the appointment of Maureen Garrett, SFC deputy chief counsel, as acting head until a permanent replacement is found. SFC obtains broader powers to assist overseas regulators November 2015: The Government gazetted subsidiary legislation which widens the SFC s powers to provide supervisory assistance to overseas regulators. Historically, the SFC could share information in its possession for the purposes of assisting overseas regulators in enforcement matters involving a licensed corporation or a related corporation of a licensed corporation. However, the SFC was unable to share information for nonenforcement matters where a licensed corporation or related corporation was regulated by the overseas regulator. The new legislation, which is now in effect, bridges this gap. KEY PRODUCT DEVELOPMENTS Passporting/mainland China-Hong Kong MRF scheme July 2015: The mutual recognition of funds (MRF) scheme came into effect on July 1 and allows qualified funds in Hong Kong and mainland China with minimum net asset values of Hong Kong Regulatory DECEMBER

8 RMB200 million (US$32 million) to be registered and sold directly to the investing public in the other market through a streamlined vetting process. The scheme will not only liberalize crossborder investment channels but, in the long run, will promote more integrated financial markets in Asia and free capital flows across borders. At present, an aggregate quota for both northbound and southbound trading (each RMB300 billion) has been issued rather than individual quotas at the fund level. This simplified quota mechanism keeps things simple for the industry, investors and regulators. SFC launches pilot initiative to expedite product authorization November 2015: Effective November 9, the SFC launched a six-month pilot initiative to revamp the approval process for new fund applications. The initiative aims to streamline the time the SFC takes to vet and authorize offering documents within one to two months under a new fast-track procedure. Generally, applications for new subfunds under existing SFC-authorized umbrella funds managed by existing SFC-approved investment managers will be processed under a standard application stream. Nonstandard applications are expected to take two to three months. The higher levels of SFC enforcement actions likely indicate the aggressive regulatory environment and growing number of regulations as well as the increased resources and staff deployed/available to the regulator. SIGNIFICANT ENFORCEMENT ACTIONS SFC publishes figures of enforcement actions taken in 2015 The number of breaches noted during on-site inspections has continued to increase. Notably, breaches of the Fund Manager Code of Conduct have increased, with 48 breaches in 2015 (up from 22 in 2014). Noncompliance with AML rules has also climbed more than 30 percent, with a rising number of breaches of the requirements of contract notes and statements of accounts/receipts. Failure to maintain proper books and records continues to present challenges for intermediaries with the increasing number of regulatory requirements. However, internal control weakness and breaches of the code of conduct continue to make up more than 50 percent of total infractions in We also see continued use of the SFC s coercive powers in the form of warrants/dawn raids. While investigations have increased to 553 (from 346 in 2014), the number of cases resulting in formal SFC disciplinary action has declined to 36 (from 55 in 2014). The higher levels of activity likely indicate the aggressive regulatory environment and growing number of regulations as well as the increased resources and staff deployed/available to the regulator. Internal control failures/mis-selling July 2015: A licensed person was suspended for eight months for operating secret accounts. The SFC stressed that traders attempts to conceal their personal share dealings will encourage the inference that such conduct is intended to hide or prevent detection of potential market misconduct over personal trading activities. August 2015: The securities trading arm of an investment bank was reprimanded and fined HK$15 million for internal control failures involving the provision of dark liquidity pool trading services. The SFC noted that the use of dark liquidity pools for trading is on the rise and stressed the imperative for intermediaries who operate dark pools to ensure that users are provided with sufficient information to enable them to understand how their orders are handled and executed. October 2015: A six-month ban was imposed on a licensed representative for operating a discretionary account without written authorization from the client. The SFC stressed that reliance on oral authorization (unless documented in writing) to operate client accounts on a discretionary basis is insufficient. November 2015: A licensed corporation was reprimanded and fined HK$4 million for misselling unlisted investment products to retail clients. The SFC reminded licensed Hong Kong Regulatory DECEMBER

9 corporations that offer investment advice of the need to implement special procedures to document (and provide a copy to the client) of the reasons and rationale underlying investment advice or recommendations for investment products, in particular the need to disclose profits made from back-to-back transactions. Life bans and disqualification orders The Hong Kong court expressly rejected a plea to allow a director to continue to work as a manager in a mainland company that held shares in a Hong Kong company. Life bans and disqualification orders were imposed on licensed representatives and directors of listed companies: The SFC imposed a life ban for misappropriation of client assets worth HK$3.5 million by a licensed representative (with disciplinary action taken before criminal trial based on voluntary admissions to the SFC). The SFC obtained a series of disqualification orders against the former chairman, CEO and executive directors of a Hong Kong-listed company (ranging from four years to seven years) who devised a scheme to falsify dealings by the company to clear outstanding receivables and publish false or misleading announcements to the investing public. The Hong Kong court expressly rejected a plea to allow a director to continue to work as a manager in a mainland Chinese company that held shares in a Hong Kong company. The court held that such an exception would defeat the purpose of the order by permitting delinquent directors to do indirectly what disqualification orders are designed to prohibit directors from doing. Licensing-related issues June 2015: The SFC updated its FAQs, setting out its views on some common licensing issues, including the statutory secrecy provisions. The SFC confirmed that disclosure by licensed representatives to employers of the fact that they have received warning letters from the SFC (including the content of warning letters) does not breach any statutory secrecy provisions. October 2015: A banker licensed to carry on regulated activities with the securities-trading arm of a retail bank since 2012 was banned for six years after admitting to forging her academic qualifications/certificates to secure employment. In July 2015, the SFC banned another individual for three years in a related incident with a different financial institution. Bribery November 2015: A former head of research at a local securities brokerage was banned for 15 years following conviction for accepting a HK$100,000 bribe to write a favorable valuation report on a listed company. CONTACTS Alan Linning Partner alinning@sidley.com Effie Vasilopoulos Partner evasilopoulos@sidley.com Dominic James Counsel dominic.james@sidley.com sidley.com AMERICA ASIA PACIFIC EUROPE Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Prior results do not guarantee a similar outcome. Attorney Advertising For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, ; One South Dearborn, Chicago, IL 60603, ; and 1501 K Street, N.W., Washington, D.C , Sidley Austin refers to Sidley Austin LLP and affiliated partnerships as explained at sidley.com/disclaimer. Hong Kong Regulatory DECEMBER