Hong Kong Regulatory IN THIS ISSUE NEWSLETTER NEWS

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1 Hong Kong Regulatory MARCH 2018 IN THIS ISSUE NEWS SFAT Signals a (New) Sterner Approach for Disciplinary Misconduct, Warns Fines to be More Severe Than Cost of Doing Business...1 Short Sellers Face Hefty Fines for Undisclosed Short Positions...2 Strict Adherence to Client Assets Segregation Rules Required of Licensed Entities...3 SFC Cracks Down on Unlicensed Bitcoin Exchanges and ICOs...3 REGULATORY STANDARDS/UPDATES...4 INTERMEDIARIES/MARKET SUPERVISION...5 KEY PRODUCT DEVELOPMENTS...6 SIGNIFICANT ENFORCEMENT ACTIONS...6 NEWS SFAT SIGNALS A (NEW) STERNER APPROACH FOR DISCIPLINARY MISCONDUCT, WARNS FINES TO BE MORE SEVERE THAN COST OF DOING BUSINESS In November 2017, the Securities and Futures Appeals Tribunal (SFAT), the statutory watchdog that reviews regulatory as well as disciplinary decisions made by the Securities and Futures Commission (SFC), upheld the bulk of a record fine on a private bank for misconduct surrounding the sale of structured financial products. The SFAT reduced the fine imposed by the SFC from a staggering HK$605 million to HK$400 million over failures to put in place robust controls to ensure that certain Lehman Brothers-linked notes and forward accumulators sold between 2003 and 2008 had matched the investment strategies and risk profile of clients. The SFAT also substituted revocation of the bank s regulatory licenses with one-year suspensions. This landmark decision which represents the largest-ever fine imposed on any financial institution in Hong Kong highlights ongoing concerns from the regulators about attempts to contract out of the regulatory obligations under the Code of Conduct and dispels any wishful thinking that lower standards are to be tolerated for execution only services provided to professional investors. The decision also provides important guidance on the duty to ensure the suitability of financial products and that institutions can no longer afford to rely on non-reliance declarations clients sign to acknowledge they understand the nature and risks of financial products. The SFC argued that the bank sold financial products that were too risky and failed to warn clients about the heightened risks associated with Lehman despite the fact the bank had cut back its own exposure. The regulator sought to strip the bank of its regulatory licenses (even though there was no suggestion that the failings continued beyond Lehman s collapse) and use a multiplier (per breach per complaint) to maximize sanctions under the disciplinary regime. The bank denied culpability, disputing the SFC s findings. It argued it had discharged its obligations under the Code when read alongside the contractual documents and said the scale of the fines was penal in nature and thus untenable in the disciplinary context. Visit sidley.com for more information on Sidley s regulatory practice. The SFAT found that the Code imposed a positive duty on [institutions] to make adequate disclosure of relevant and material information to its clients for structured products. This duty, it added, cannot be avoided by seeking to pass the responsibility to individual clients, for example, to raise concerns about or exclude a particular issuer, or unwind a transaction (which was never guaranteed and often very expensive). This does not Hong Kong Regulatory MARCH

2 This landmark decision which represents the largest-ever fine imposed on any financial institution in Hong Kong highlights ongoing concerns from the regulators about attempts to contract out of the regulatory obligations under the Code of Conduct and dispels any wishful thinking that lower standards are to be tolerated for execution only services provided to professional investors. mean liability attaches when financial institutions fail to anticipate potential defaults in products sold to clients. Rather, institutions are under a regulatory burden to warn clients about credit risk if they intend to continue selling structured products in times of distress. In failing to do so, the SFAT had no hesitation in concluding that the bank had put many clients at unnecessary risk of loss and had not acted diligently in the best interest of its clients. The SFAT said the disclaimers contained in account documents and risk disclosure statements might provide commercial certainty for the bank under private law but noted this was not determinative in the public law regulatory context. The SFAT also found there had been a failure to ensure suitability of product for clients, compounded by inadequate paper trails (in itself a breach of regulatory obligations). The lack of proper audit trails coupled with apparent suitability mismatches were all factors the SFAT said counted against the bank. In light of all the evidence, including profits earned and losses suffered by many clients, the SFAT endorsed the use of a multiplier (albeit with some slight modification) as an appropriate penalty. In the future, it cautioned, penalties imposed for convenient avoidance of the requirements of the [Code] will constitute something more severe than the mere cost of doing business. This stricter approach, viewed in conjunction with the SFC s reluctance to tailor sanctions for suspected misconduct under its new leniency guidelines, may persuade parties to contest more cases of alleged misconduct. SHORT SELLERS FACE HEFTY FINES FOR UNDISCLOSED SHORT POSITIONS The turbulent start to the markets has encouraged short sellers to increase their positions. Based on publicly disclosed figures, the aggregate number of shares on loan in Hong Kong has increased 10 percent since the start of the year the highest level since the disclosure rules took effect in 2012 and is now worth more than HK$466 billion (approximately US$60.5 billion). Short selling occurs when an investor borrows shares in order to sell them at the current market price hoping to replace the borrowed shares at some future point when the price falls. It often attracts scrutiny from regulators who view such activity as a bet that a company s share price will fall. In Hong Kong, short sellers must disclose net short positions of HK$30 million or 0.02 percent of the class of shares (whichever is lower). These thresholds are far more stringent than those of many other international financial markets. For instance, European markets adopt 0.2 percent Hong Kong Regulatory MARCH

3 of the issued share capital of the listed company as the reporting threshold with no alternative reporting threshold set with reference to a fixed monetary amount. Derivatives do not count (but separate rules apply where substantial shareholders hold interests). Market participants should periodically review and test the adequacy of their systems and procedures to monitor, capture and report short positions in Hong Kong and remedy deficiencies (if any) in light of the new sterner philosophy for handling disciplinary misconduct. Investors who fail to comply with the reporting rules risk monetary fines and criminal sanctions. The SFC recently imposed fines of over HK$40 million (in aggregate) in a series of enforcement actions for undisclosed short positions, tagging errors and inadequate documentary assurance to confirm that the sales were covered and other related shortcomings. Market participants should periodically review and test the adequacy of their systems and procedures to monitor, capture and report short positions in Hong Kong and remedy deficiencies (if any) in light of the new sterner philosophy for handling disciplinary misconduct. STRICT ADHERENCE TO CLIENT ASSETS SEGREGATION RULES REQUIRED OF LICENSED ENTITIES The SFC fined a Swiss-headquartered international financial group HK$12 million last month for failing to segregate client securities. The regulator said both the Hong Kong and brokerage arms of the group had failed to comply with the Client Securities Rules, which require client securities received or held in Hong Kong to be deposited into segregated accounts for safe custody. The firms had failed to adequately segregate client securities from house securities in its settlement process, which resulted in clients securities being comingled and used to settle proprietary trades, the SFC said. Even though all client securities were accounted for and there were no instances of customer complaints due to late settlement, it noted the sanctions would have been substantially higher but for the fact that the failings had been self-reported. All regulated entities that hold client assets (money or securities) are required to ensure they have adequate systems, controls and records to deposit, segregate and protect client assets in safe custody. Other firms with responsibility for client assets should take this as a warning that there is no room for failure to properly segregate client assets and ensure their own processes adhere to safe custody rules. The SFC raised other failings, including failure to comply with requirements on reporting short positions, lack of governance to ensure that investment products sold to clients were suitable and lax controls in its electronic trading systems that, when aggregated, led to a total fine of HK$39.3 million. In total, 14 exchanges and ICOs operating in or with connections to Hong Kong received stark warning letters from the SFC requiring them to halt trading of cryptocurrencies without appropriate regulatory licenses. SFC CRACKS DOWN ON UNLICENSED BITCOIN EXCHANGES AND ICOS The SFC is looking to crack down on unlicensed Bitcoin exchanges and issuers of initial coin offerings (ICOs). Last month, it took regulatory action against several cryptocurrency exchanges and ICOs. These measures follow the SFC s initial Statement on ICOs (Sept. 5, 2017) and subsequent Circular on Bitcoin futures contracts and cryptocurrency-related investment products (Dec. 11, 2017). In total, 14 exchanges and ICOs operating in or with connections to Hong Kong received stark warning letters from the SFC requiring them to halt trading of cryptocurrencies without appropriate regulatory licenses. Most have complied or taken immediate remedial actions, the SFC stated. The SFC also noted it would not hesitate in bringing further action against those that flout its warnings or persist in carrying on regulated activities without a license. Hong Kong Regulatory MARCH

4 Ashley Alder, Chief Executive of the SFC, also urged market professionals, including lawyers, accountants and consultants involved in structuring such products, to do proper gatekeeping to prevent frauds or dubious fundraising and to assist [the SFC] in ensuring compliance with the law. Both the SFC and the Hong Kong Monetary Authority (HKMA) have raised concerns in the past over the lack of transparency surrounding virtual commodities, which are transacted or held anonymously and pose significantly higher inherent money laundering/terrorist financing risks. In 2014, the SFC and HKMA published circulars reminding the industry that existing anti-money laundering rules catch virtual commodities, such as Bitcoin. Where relevant, heightened measures need to be taken in high-risk situations and suspicious activity involving potential or existing customers that are operators of schemes related to virtual commodities reported to the Joint Financial Intelligence Unit. REGULATORY STANDARDS/UPDATES SFC Warns MICs are Accountable (Whether Located in or Outside Hong Kong) November 2017: Following implementation of the new managers-in-charge (MIC) regime, the SFC announced its measures for augmenting senior management accountability in licensed corporations to heighten awareness of accountability, regulatory obligations and potential liabilities for senior management and MICs. Where a corporation (which may or may not be a licensed corporation) is found guilty of an offense under the Securities and Futures Ordinance, the SFC may seek to extend criminal liability to its officers (including MICs) where the offense is committed with their consent or connivance or is otherwise attributable to their recklessness. The SFC also warned that its disciplinary powers apply to all regulated persons (whether located in or outside Hong Kong). SFC Signals Shift in Regulatory and Supervisory Priorities Focusing on the Asset Management Sector December 2017: The SFC s inaugural Compliance Bulletin highlighted that Type 9 intermediaries surpassed intermediaries licensed for securities dealing and made up 54 percent of all intermediaries (as at the end of September 2017) and signaled it intends to reposition the way it supervises the industry with an increased focus of the asset management sector. The SFC also highlighted instances of compliance failures by fund managers (conflicts, commissions/rebates, soft dollars, safe custody of client assets and liquidity management) and cautioned intermediaries to take all necessary measures to avoid similar egregious conduct. SFC Revamps Leniency Guidelines December 2017: The SFC revamped its Guidance Note on Cooperation to provide greater transparency to the industry on credit for cooperation and global resolution of multiple compliance failings within corporate groups. Regulated entities can expect to avoid stiffer penalties by promptly reporting rule infractions (where clients or the investing public do not sustain losses). However, the revised guidelines make it clear that the need for public accountability and credible deterrence trumps offers to resolve a matter in private or on a no admission of liability basis. SFC Amends AML/CFT Guidelines March 2018: The SFC amended its guidelines on Anti-Money Laundering (AML) and Counter- Terrorist Financing (CFT) to track changes to the legal regime relating to customer due diligence (CDD) for ultimate beneficial owners, reliance on CDD performed by intermediaries, as well as Hong Kong Regulatory MARCH

5 changes to the retention period for CDD records. The SFC has urged licensed corporations and associated entities to review existing internal AML/CFT policies and procedures and take any necessary steps to ensure continued compliance with the new requirements. Failures to comply may otherwise adversely affect the fitness and properness of licensed persons. INTERMEDIARIES/MARKET SUPERVISION HKMA/SFC Announce Conflicts of Interest in Financial Groups Major Regulatory Focus November 2017: Following joint thematic reviews, the SFC and the HKMA published a circular with guidance on best practices to manage potential conflicts of interest arising from the sale of in-house products by banks and licensed corporations (LCs) within a single financial group. The circular confirmed that conflicts of interest are a major regulatory focus for both industry regulators, noting that compliance policies put in place by intermediaries in respect of conflicts were inadequate in key areas. FMCC SFC Adopts Major Rewrite Following conclusion of the SFC s consultation to enhance regulation of the asset management industry, the SFC amended the Fund Manager Code of Conduct (FMCC) and Code of Conduct (with certain modifications or clarification of the regulatory intent) and published further guidance. November 2017: Following conclusion of the SFC s consultation to enhance regulation of the asset management industry, revisions to the Fund Manager Code of Conduct (FMCC) (with certain modifications or clarification of the regulatory intent) came into effect in November. The SFC also announced that it is conducting a further consultation on the disclosure requirements of monetary and non-monetary benefits applicable to discretionary accounts under the Code of Conduct for reasons licensed by or registered with the SFC (the Code). The amendments to the Code will become effective nine months after conclusion of the further consultation. The changes (see our December 2016 newsletter) apply to Hong Kong-licensed fund managers responsible for the overall operation of a fund (even if the fund s board of directors makes final decisions) and potentially extends to Hong Kong fund managers who act only as submanager or subadviser of an offshore fund. SFC Proposes Major Revision to Retail Funds Code December 2017: The SFC announced a three-month consultation to revise the Code on Unit Trust and Mutual Funds to ensure that the regulatory regime for SFC-authorized retail funds aligns with regulations of other jurisdictions and international standards. The proposals (i) clarify the regulatory obligations for management companies, trustees and custodians, (ii) set limits on derivatives investments, (iii) impose mandatory diversification and disclosure requirements and (iv) standardize valuation of fund assets and liquidity risk management, including reporting obligations to the SFC for pricing errors. If implemented, existing funds will have a 12-month transition period to comply with the new rules. OTC Derivatives SFC Proposes Refinements to the New Licensing Regime with Carve-Outs for Fund Managers December 2017: Following commencement of the new mandatory clearing and reporting of over-the-counter (OTC) derivative transactions that came into effect in September 2016 and July 2017, respectively, the SFC published a three-month consultation paper proposing to make (among others) certain refinements to the new OTC derivatives licensing regime. Importantly, as regards fund managers, the proposals confirm that the SFC intends to extend the existing exemption for Type 9 licensed persons who manage portfolios for wholly owned group companies to cover all OTC derivative products. However, fund managers who centralize their group s dealing and advising activities into a single entity are not exempt from the OTC Hong Kong Regulatory MARCH

6 licensing regime if such dealing or advising services in OTC derivatives products are provided to funds managed by its affiliates (without the manager performing any fund management role itself). The refinements come into effect when the new OTC licensing regime commences. SFC Warns LCs About Product Suitability Concerns and Offers Guidance on Best Execution Practices January 2018: Following a series of on-site inspections and thematic reviews, the SFC released two circulars to LCs highlighting (i) compliance failures to ensure the suitability of financial products and (ii) best practices for executing client orders on the best available terms. The SFC also noted that some LCs had categorized bonds as low risk based on credit ratings only. Others had inadequate controls to detect and monitor suitability mismatches and did not retain adequate compliance records. The SFC urged LCs to take immediate action to rectify any deficiencies and warned that it will take enforcement action against delinquent LCs. SFC Highlights Listing Reform at Regulatory Forum March 2018: The SFC held its third annual regulatory forum focusing on the need for changes in listing regulation to deal with shell activities, backdoor listings, dilutive rights issues and other corporate governance problems as well as its ongoing efforts to calibrate its regulatory responses. Earlier in March, the HKEx and SFC signed an addendum to the MOU for Listing Matters, which confers a more prominent and direct role for the SFC in supervising, monitoring and regulating serious listing matters. KEY PRODUCT DEVELOPMENTS the SFC has published guidance to provide A-shares issuers with basic information on the registration and distribution requirements in relation to the issue of rights shares offering documents to Hong Kong investors. China-Hong Kong Stock Connect SFC Clarifies Regulatory Requirements for Marketing of A-Shares to Hong Kong Investors December 2017: Following launch of the China-Hong Kong Stock Connect, the SFC has published guidance to provide A-shares issuers with basic information on the registration and distribution requirements in relation to the issue of rights shares offering documents to Hong Kong investors. The guidance confirms that A-share issuers may distribute to Hong Kong investors People s Republic of China rights offering documents once authorized by the SFC and registered with the Companies Registry. China-Hong Kong MRF Scheme SFC Clarify Regulatory Requirements for Marketing Mainland Qualified Funds Directly to Hong Kong Investors January 2018: Following launch of the mutual recognition of funds (MRF) scheme (see our December 2015 newsletter), the SFC has published guidance on the eligibility, disclosure and licensing requirements for mainland funds seeking authorization, as well as those wishing to market, sell or distribute qualified funds directly to the investing public in Hong Kong. SIGNIFICANT ENFORCEMENT ACTIONS We highlight below several noteworthy enforcement actions that may be of interest to responsible officers, licensed representatives, intermediaries and others operating in the Hong Kong financial markets. The SFC recently announced that corporate fraud and misfeasance are at the top of the list of enforcement priorities for 2018 (foreshadowed in our October 2017 newsletter). Other key priorities remain insider dealing and market manipulation, intermediary misconduct and money laundering internal control failures. Hong Kong Regulatory MARCH

7 Internal Control Failures December 2017: Two licensed corporations agreed to pay fines of HK$2 million and HK$2.6 million, respectively, to resolve failures to properly segregate client monies and tag short sales. February 2018: Two licensed corporations agreed to pay fines of HK$39.3 million and HK$4.5 million, respectively, to resolve multiple compliance failings within their corporate groups relating to deficiencies in electronic trading systems as well as other internal control weaknesses. March 2018: Two licensed corporations agreed to pay fines of HK$8.3 million and HK$9 million, respectively, to resolve multiple internal control failures relating to the segregation of client monies, underreporting of short positions, conflicts of interest (stemming from failures to separate traders handling discretionary orders from those handling proprietary accounts) and delays in promptly notifying the SFC about investigations relating to suspected violations of overseas regulatory requirements by Hong Kong-licensed staff. Life Bans and Disqualification Orders The SFC banned for life an account executive employed by a brokerage firm for unauthorized transactions causing a loss of HK$2.6 million. The High Court imposed a six-year disqualification order against the former chair of a listed company for obtaining retrospective board approval for a connected transaction (later aborted at a loss of RMB64.5 million) and failing to disclose his interest or disclose accurate information to the board about the valuation of the transaction. The High Court ordered a (now delisted) company and its former directors to repay the entire listing proceeds to compensate investors over false and misleading disclosures about its true financial positon contained in its IPO prospectus. Licensing-Related Issues January 2018: A bank agreed to pay a fine totaling HK$2 million after self-reporting trades in offshore listed index options without a Type 2 (dealing in futures contracts) license. CONTACTS Constance Choy Partner, Head of China Corporate and Finance cchoy@sidley.com Effie Vasilopoulos Partner, Co-head of Investment Funds Practice in Asia evasilopoulos@sidley.com Dominic James Counsel, Securities & Derivatives Enforcement and Regulatory dominic.james@sidley.com AMERICA ASIA PACIFIC EUROPE sidley.com 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. Attorney Advertising - Sidley Austin LLP, One South Dearborn, Chicago, IL Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships as explained at sidley.com/disclaimer. Hong Kong Regulatory MARCH