The smart bets for SFC enforcement trends in the year of the Horse

Transcription

1 Ashurst Hong Kong February 2014 Dispute resolution briefing The smart bets for SFC enforcement trends in the year of the Horse As we head into a new lunar year, it is time to consider what the smart bets are for the SFC's enforcement trends and priorities in Hong Kong during the Year of the Horse. Just like any horse race, there are a number of possible favourites. However, based on form (and some might say with the whip firmly in the SFC's hand), there are a number of strong contenders for enforcement priorities in the Year of the Horse: Algorithmic trading is all about speed. With the SFC's new requirements in the Code of Conduct having taken effect from 1 January 2014, we can expect algorithmic trading to be a strong contender for enforcement action. With a requirement for at least one responsible officer to be designated as in charge of algorithmic and electronic trading, this one will be watched with interest. Enforcement action under section 213 appears to be a firm favourite of the SFC and it is by no means a one-trick pony whose use is limited to insider dealing and market misconduct. With the dust now settled on the Tiger Asia case, it is to be anticipated that the debate on the narrow jurisdictional point raised through those proceedings will fall away and that we will increasingly see the SFC rely on this provision to help it achieve financial recoveries for investors across a broader range of breaches of the Securities and Futures Ordinance (SFO). Corporate governance issues are an odds-on favourite for continued enforcement action. The SFC has recently signalled it will take an increasingly pro-active approach to this issue, with the formation of a new team that will review company reports, announcements and analyst commentary to identify and follow up on potential disclosure and governance failings. With the recent regulatory reforms on ongoing corporate disclosure and sponsor liability also now being in force, the smart money is on more scrutiny of listed companies, their directors and IPO sponsors. With the Hong Kong courts accepting submissions by Hong Kong banks and financial institutions to uphold contractual terms that no advice has been given and that the SFC's Code of Conduct cannot over-ride express contractual terms, the SFC's proposal to amend the Code so that a "Suitability Requirement" is required in all client agreements could become a late contender. While the SFC's consultation conclusions on this proposal will no doubt take heed of industry views, there is a chance of further departure from the traditional rule of law. ALGORITHMIC TRADING HOW FAST CAN IT GO? Algorithmic trading offers many advantages to market participants, including the ability to execute complex trading strategies at lightning fast speeds. However, the speed at which algorithms operate gives rise to the potential for things to go wrong very quickly. While the rapid development of algorithmic trading technologies may have initially made it difficult for regulators to keep up, events such as the "Flash Crash" in 2010 and Knight Capital trading incident in August 2012 put algorithmic and electronic trading firmly on the radar of many securities regulators around the globe, including the SFC, which commenced a consultation on electronic trading in July The consultation conclusions were released in March 2013, with the outcome being that stringent new provisions were introduced into the Code of AUSTRALIA BELGIUM CHINA FRANCE GERMANY HONG KONG SAR INDONESIA (ASSOCIATED OFFICE) ITALY JAPAN PAPUA NEW GUINEA SAUDI ARABIA SINGAPORE SPAIN SWEDEN UNITED ARAB EMIRATES UNITED KINGDOM UNITED STATES OF AMERICA

2 Conduct for Persons Licensed by or Registered with SFC (Code of Conduct) that took effect from 1 January With the new Code of Conduct requirements now in force, it is a safe bet that the SFC will be closely scrutinising compliance with them and will take enforcement action where serious breaches have occurred. The new rules, which are contained in a new paragraph 18 and Schedule 7 of the Code of Conduct, will impact on those offering algorithmic trading, direct market access and internet trading platforms in Hong Kong. For those offering internet trading and direct market access (DMA) platforms to clients, the new rules provide that they must ensure the integrity and adequacy of their systems, that they have appropriate pre-trade controls in place and that regular post-trade monitoring is carried out to identify potentially improper trading patterns. Where a DMA service is offered, providers must also ensure that they have minimum client requirements in place, including arrangements to ensure that all users are capable of using the system and understanding applicable regulatory requirements. The requirements relating to the adequacy of systems, pre-trade controls and post-trade monitoring also apply to those developing or offering algorithmic trading platforms. Additional requirements applying to algorithmic trading include obligations to ensure that: the design and development of an algorithmic trading system is supported by people adequately trained and qualified to understand the compliance and regulatory issues that might arise from the use of the system; those who will use the algorithmic trading system have a good understanding of how it will work. In particular, a licensed or registered person is required to ensure that all users of its algorithms are, if necessary, provided with training on each of the algorithms and whether they are appropriate to use in certain market conditions, that they are updated in a timely manner on any changes to the algorithms and provided with documentation on how to use them; algorithms and any subsequent modifications made to them are adequately tested before they are released to ensure that they will operate as intended (including in extreme market circumstances); and adequate records are kept for the design, development and testing of algorithms. At least one responsible or executive officer must also be appointed to take responsibility for the overall management and supervision of electronic trading systems. The policy objectives behind the new rules are understandable, particularly in light of the SFC's mandate of maintaining a fair and orderly market. On one view, the new rules merely set out in more detail what licensed corporations should have already been doing for their electronic and algorithmic trading platforms under the pre-existing General Principles contained in the Code of Conduct. However, the specific requirements in the Code of Conduct have affected the way many in the industry operate, particularly with regard to record retention and compliance policies for the design and pre-release testing of algorithms. Some in the industry have voiced concerns about the lack of detail in the new rules as to how to ensure: developers of algorithms are "suitably qualified", with development/programming work often being carried out by staff who are computer specialists who are not licensed with the SFC; what steps can or should be taken to ensure that those allowed to use algorithms have a good understanding of how they operate and the regulatory issues arising from them. Particular issues are likely to arise where licensed corporations permit clients direct access to algorithms (e.g. how does one monitor precisely who at the client has the ability to place, and is in fact placing, orders?); and an adequate level of post-trade monitoring for suspicious activity has taken place. While the SFC will expect a common-sense approach to be taken, clear precedents are currently lacking. It is therefore promising to be an interesting (and perhaps challenging) time for the responsible and executive officers who oversee electronic and algorithmic trading. SECTION 213 BY NO MEANS A ONE- TRICK PONY The SFC v Tiger Asia case garnered significant attention over the past three years. However, the focus on the narrow jurisdictional issue of when the SFC can deploy section 213 of the SFO for allegations

3 of insider dealing and other market misconduct has over-shadowed the broader implications of the case. In future, we can expect section 213 to feature significantly in the SFC's enforcement strategy and, far from being a one-trick pony, its use will not be limited to insider dealing or market misconduct cases. The SFC will likely seek to deploy it for a wide range of alleged contraventions of the SFO and, in particular, to secure compensation for investors aggrieved by breaches of the SFO. Background to the case On its face, section 213 of the SFO enables the SFC to seek remedial orders from the courts where there has been a breach of a "relevant provision" (i.e. any provision of the SFO and certain provisions of the Companies Ordinance and anti-money laundering legislation), a notice or requirement under a relevant provision, or the terms or conditions of a license under the SFO. The scope of the orders available under the section is broad, and includes injunctions, declarations that contracts are void, the establishment of investor compensation funds and other relief the court considers necessary. In Tiger Asia the SFC sought remedial orders and injunctions under section 213 for the defendants' alleged insider dealing. While on its face section 213 permitted the SFC to do this, it had only been used sparingly by the SFC in the past and the scope of its application had not been confirmed by the Courts. The Tiger Asia defendants mounted a jurisdictional challenge to the SFC's ability to seek orders under section 213. Through this challenge the defendants asserted that a "dual" regime applied for insider dealing and other market misconduct in Hong Kong, with the SFC having the ability to bring civil proceedings before the Market Misconduct Tribunal (MMT) or criminal proceedings before the courts under Parts XIII and XIV of the SFO. The SFC could not, argued the defendants, seek orders under section 213 independently of proceedings under these two routes. In May 2013, the Court of Final Appeal conclusively ruled in favour of the SFC's ability to resort to section 213 without the need to also institute proceedings under Parts XIII or XIV. It held that there was no limitation on the use of section 213, and that its primary purpose was to enable the SFC to seek remedies for the benefit of parties who had suffered as a result of breaches of the SFO, including for insider dealing and other market misconduct. Proceedings under section 213 were therefore analogous to actions for damages by private individuals, and served a distinct purpose from that of findings of civil or criminal contraventions of the market misconduct provisions. That the SFC defended its interpretation of section 213 all the way to the Court of Final Appeal is not surprising as the defendants had admitted insider dealing contraventions in the USA but remained outside the reach of a criminal prosecution in Hong Kong. Following the Court of Final Appeal's decision the SFC commenced proceedings in the MMT (thereby removing the ability to bring a criminal prosecution for the same conduct). In December 2013, three of the defendants admitted contraventions of the insider dealing provisions of the SFO in both the section 213 and MMT proceedings (the SFC accepted that the fourth defendant, a junior trader at Tiger Asia, was not knowingly involved in any insider dealing). The three defendants also agreed to pay HK$45 million to investors affected by their insider dealing, and it appears the proceedings will finally be resolved after the MMT has a hearing in May 2014 as to what other orders (e.g. prohibitions against trading in Hong Kong) ought to be made against them. The implications why section 213 has relevance beyond insider dealing and market misconduct The ability to use the section 213 process to commence civil proceedings against those who engage in market misconduct but are located outside Hong Kong (and outside the reach of its criminal courts) is undoubtedly a useful tool for the SFC to possess. However, the jurisdictional issues raised by the Tiger Asia case have over-shadowed a key message for the SFC's enforcement strategy namely that it will seek to use section 213 as a remedy for a wide variety of contraventions of the SFO. The SFC's Head of Enforcement, Mark Steward, foreshadowed in 2012 that section 213, while not used frequently in the past, has now been made "a significant part" of the SFC's enforcement strategy. Given the wide range of orders possible under section 213 which include injunctions, the voiding of contracts, appointment of administrators and (as in Tiger Asia) establishing investor compensation funds the SFC's intention to increasingly use section 213 is understandable. Investor protection and compensation is at the forefront of the SFC's regulatory objectives. At present there is no class action regime in Hong Kong and the cost barriers to individual investors in bringing private proceedings are substantial. The SFC's ability to impose fines is also limited. As the Court of Final Appeal recognised, section 213 will enable the SFC to protect the collective interests of those who have been harmed by breaches of the SFO.

4 Section 213 is also applicable to a large number of contraventions of the SFO beyond insider dealing and market misconduct. The SFC is likely to seek to use it in cases of fraud and misappropriation of assets, for breaches of the ongoing disclosure of price sensitive information requirements that now apply to listed companies and their officers, and for breaches of the requirements for IPOs by issuers, directors and sponsors. The flexibility and potential breadth of application of section 213 is likely to make it an increasingly used enforcement tool, without the need to commence other proceedings under the SFO. The SFC may also be inclined to use the threat of section 213 proceedings to secure compensation deals, such as intermediaries entering into settlements with classes of aggrieved investors, particularly in situations where the Hong Kong courts might otherwise uphold contractual exclusions of liability that would act as a bar to investor claims. CORPORATE GOVERNANCE AN ODDS- ON FAVOURITE With the SFC recently signalling that it will take a more proactive approach to identifying and following up on potential breaches of corporate governance requirements, and with the new regimes for ongoing disclosure of price sensitive information and sponsor liability now being in place, enforcement action in the corporate governance sphere is an odds-on favourite for the Year of the Horse. The SFC has had some significant enforcement wins on corporate governance issues in recent years through using its pre-existing powers in the SFO. In the Hontex International Holdings Ltd case, the SFC obtained orders under section 213 requiring Hontex to make a repurchase offer to investors worth over HK$1 billion after it had included materially false and misleading information in its IPO prospectus. Section 214, which enables the SFC to seek a wide variety of remedial orders where the affairs of a listed company have been conducted in a manner that involves defalcation, fraud or other misconduct, or where inadequate information has been provided to shareholders or there is oppression or unfairly prejudicial conduct towards them, has also been used effectively. In 2012 the SFC obtained orders against the former chairman and an executive director of Styland Holdings Ltd requiring them repay HK$85 million after the company had entered into transactions that were for the benefit of those two individuals. Those two directors and several others also received lengthy disqualification periods. Section 194 has also been used against IPO sponsors, with Mega Capital (Asia) Ltd having its corporate finance license revoked and being fined HK$42 million for due diligence failures during the Hontex IPO. On 27 January 2014 the Securities and Futures Appeal Tribunal (SFAT) largely upheld the SFC's disciplinary action under section 194 against Sun Hung Kai International Ltd for its due diligence failures as sponsor in the Sino-Life IPO. In that case, the SFAT considered that a fine of HK$12 million and the suspension of its corporate finance license for 1 year was an appropriate penalty. The SFC's proactive approach With the SFC having a good track record for enforcement actions on corporate governance issues, it can be expected that it will continue to devote significant attention to this area. A more proactive approach was also foreshadowed by the SFC's chairman, Mr Carlson Tong, in a speech that he gave on 12 December In discussing corporate governance, Mr Tong identified several key areas for improvement. These include: directors, and in particular non-executive directors, taking responsibility and acting as effective internal gatekeepers of a company. Mr Tong expressed some concern that directors often excessively delegate internal control and risk management functions to staff; and companies needing to have a "moral commitment" to good corporate governance practices. Instead of taking a check-box or boilerplate approach to compliance and asking whether something is legal, companies should ask whether it "is the right thing to do." Mr Tong noted in his speech that early detection of corporate governance failings can greatly reduce market impact. Understandably from an investor protection and market integrity perspective, the SFC would clearly prefer to avoid Hontex and Styland-type situations altogether by acting before disaster strikes. To that end, Mr Tong announced that the SFC has established a new Corporate Regulation team, which has been tasked with reviewing company announcements and reports and monitoring analyst and press coverage to identify potential red-flags and follow up on them. Companies and practitioners have already noted an increase of SFC activity in this area, and it can be expected that enforcement action will be taken if the SFC considers it to be an appropriate response. Ongoing disclosure of price sensitive information Another key area for corporate governance noted by Mr Tong in his speech is the transparency of listed corporations. In this regard, the new ongoing disclosure regime for price sensitive information

5 contained in the SFO came into effect on 1 January While the approach taken in the new regime largely follows the provisions previously contained in the Listing Rules, it now has the force of law and can result in significant penalties, including fines of up to HK$8 million, disqualification of directors and officers for up to 5 years and cold-shoulder orders. The new regime has clearly had an impact, with announcements about price sensitive information increasing 52% over the previous year, and profit alerts and warnings up 16 % over the same period. With the new regime now having been in place for over a year, the SFC can be expected to test the extent of its scope in enforcement actions. Sponsor liability The new sponsor liability regime, which is primarily contained in the SFC's Code of Conduct, also came into effect on 1 October The Code of Conduct now contains a number of specific requirements for IPO sponsors, including duties to conduct reasonable due diligence, maintain proper records and to inform the stock exchange when it becomes aware of information in respect of a listing application that suggests it is not in compliance with the Listing Rules or other regulatory requirements. To encourage the submission of quality first drafts of prospectuses to the stock exchange, sponsors must also ensure that all material information is included in the initial draft prospectus (called an application proof) and that they have satisfied themselves that the information in the application proof is substantially complete. The way in which sponsors carry out their duties has been an area of concern to the SFC over recent years, as can be demonstrated through the actions it has taken under the old regime against Mega-Capital (Asia) Ltd and Sun Hung Kai International Ltd. The very recently released decision of the SFAT in the Sun Hung Kai case endorses the SFC's expectations as to the minimum standards for sponsors. In its decision the SFAT made very clear that a sponsor is "more than the mere servant" of a listing applicant and that they have a duty to act with independent professionalism to ensure relevant information is provided to the stock exchange and investors. Sponsors must therefore be willing to challenge their clients over deficiencies in the information provided and cannot place undue reliance on the opinions of experts such as lawyers and accountants. Failures to meet the standards contained in the new regime will continue to attract enforcement action. CLIENT AGREEMENTS IS THE "SUITABILITY REQUIREMENT" A SURE THING? In May 2013 the SFC issued its Consultation Paper on the Proposed Amendments to the Professional Investor Regime and Client Agreement Requirements. Through this document the SFC proposed that the Code of Conduct be amended so that: the "Suitability Requirement", a requirement contained in the Code of Conduct that licensed or registered persons should ensure the suitability of recommendations or solicitations made to clients, should be included in all client agreements as a contractual term; and it would be a breach of the Code of Conduct to include in client agreements terms that (i) are inconsistent with a licensed or registered person's obligations under the Code of Conduct or (ii) misdescribe the actual services to be provided to the client. While the period for comments on the consultation paper closed in August 2013, the SFC has not yet issued its consultation conclusions. However, if the SFC's proposals are adopted it is likely to have a significant impact on client agreements and the way the industry operates within Hong Kong. Background to the proposals The "Suitability Requirement" contained in paragraph 5.2 of the Code of Conduct is viewed by the SFC as one of the pillars of investor protection in Hong Kong. It forms part of the Know Your Client obligations in the Code of Conduct, and the SFC expects that, when making recommendations or solicitations to clients, the investment product being sold is suitable for them. However, the Code of Conduct does not have the force of law. It is used by the SFC to assess whether someone is fit or proper to become (or remain) a registered or licensed person. While breaching the Code of Conduct might give rise to suspension or revocation of a person's licence or provide grounds for a fine under section 194 of the SFO, the Suitability Requirement does not provide the SFC with the power to require compensation to be paid to aggrieved investors and breach of a regulatory obligation does not, of itself, create a private cause of action in Hong Kong. On the other hand, it has become increasingly common practice for financial institutions in Hong Kong to include as clauses in client agreements terms to the effect that no advice has been given or recommendation made to the client, that no

6 representations have been made about the suitability of an investment and that the investor has chosen to proceed solely on the basis of their own decision. Following the financial crisis, a number of investors have sought to rely on the requirements in the Code of Conduct in support of their claims against financial institutions. This has been done on the basis that the Code of Conduct shapes a duty of care alleged to be owed to the investor or, alternatively, that the requirements contained in the Code of Conduct are an implied term of contract. These attempts have not been successful before the Hong Kong courts. In Kwok v HSBC Private Bank (Suisse) SA it was held that the Code of Conduct could not over-ride express contractual provisions to the contrary. Shortly afterwards in DBS Bank (Hong Kong) Ltd v San Hot HK Industrial Company Ltd it was held that the Code of Conduct was not relevant to determining the contractual duties owed to the investor. The Court also held in that case that the principle of "contractual estoppel", that parties can agree a certain state of affairs as underlying the contract even if it is not factually correct (e.g. that no advice or recommendation has been made), was well established under English law and there was no reason why it should not also apply in Hong Kong. Potential impacts If the SFC's proposed amendments to the Code of Conduct are adopted, it will become mandatory for the Suitability Requirement to be incorporated into a licensed or registered person's client agreements. Clients will therefore, for the first time in Hong Kong, have the ability to bring a contractual claim for any breaches of the Suitability Requirement. For licensed or registered persons who fail or refuse to incorporate the Suitability Requirement into client agreements, they will be in breach of the Code of Conduct and open themselves to potential sanctions under section 194 of the SFO. These sanctions can include the suspension or revocation of licenses and fines imposed by the SFC. The proposals therefore have potentially significant impacts for financial institutions operating in Hong Kong. While the SFC has not published its consultation conclusions, it is likely that the industry comments submitted on the proposals will raise a number of concerns: the clear trend of recent cases in England and Hong Kong is that the Courts will uphold appropriately drafted clauses that set out the basis upon which the parties contract and will not infer duties to be owed solely on the basis of the Code of Conduct. The SFC's proposal is inconsistent with this established approach; under Hong Kong law clauses seeking to exclude liability are already subject to statutory control through the Control of Exclusion Clauses Ordinance and Misrepresentation Ordinance. Exclusion clauses will only be upheld where they are, in all of the circumstances reasonable. However, the SFC's proposals do not recognise the availability of this pre-existing protection for investors; other investor protections have also been overlooked in the SFC's proposal. While it is generally accepted in the common law world that a clause that defines the basis on which the parties are doing business does not seek to limit liability (and is therefore not subject to statutory control as an exclusion clause), the Courts will not uphold such clauses where they seek to retrospectively alter what has gone before. In cases where a contractual term seeks to re-write history in a manner that excludes liability, the likely outcome is that will be viewed as an exclusion clause and can be set aside as unreasonable; incorporating the Suitability Requirement into client agreements where execution-only services are being provided is not appropriate. While the SFC's consultation paper recognises that the Suitability Requirement will not be applicable to non-advisory services, it nonetheless would like it to be contained in all client agreements without qualification; and the SFC's proposal appears to operate on a brightline test, that either advisory services are being provided or that they are not. Commercial reality is significantly more nuanced, and even where execution only services are being offered it is still common for a financial institution to offer investment ideas for consideration by potential investors or to highlight the full suite of products that they have on offer. With the Suitability Requirement as a contractual term, this may create the risk that a client will seek to rely on the term as giving rise to a contractual obligation to advise on suitability even where it was accepted at the time that no advice was being given or received. The SFC's proposals reflect a tension between what the law permits licensed or registered persons to do in

7 client agreements and what the SFC expects them to do. While the SFC's aim of increasing investor protection through the proposal is laudable (and one cannot doubt as a general principle that intermediaries should not mislead investors or mis-describe investments to them), it is less certain that the Code of Conduct is the appropriate means through which to effect such a fundamental change. Given the preexisting case law and industry practice, many would argue that legislative amendment is the more appropriate route to take. While the SFC's consultation conclusions may soften the proposed requirement or adapt to industry comments, it is unlikely to be "scratched" from the field in its entirety. Potential change on this front, and the need to incorporate some form of suitability criteria into client agreements is therefore likely to be a starter in the Year of the Horse. Further information For further information on our expertise or on any of the issues raised in this briefing, please contact: Gareth Hughes Partner, Hong Kong Angus Ross Partner, Hong Kong T: E: gareth.hughes@ashurst.com T: E: angus.ross@ashurst.com James Comber Counsel, Hong Kong T: E: james.comber@ashurst.com This publication is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying the information contained in this publication to specific issues or transactions. For more information please contact us at 11/F, Jardine House, 1 Connaught Place, Central T: F: Ashurst Hong Kong is a law firm and is part of the Ashurst Group. Further details about Ashurst can be found at Ashurst LLP 2014 Ref: February 2014