Hong Kong regulatory enforcement update: Q3 2016

Trends in SFC enforcement actions

The following broad trends can be seen in the The Securities and Futures Commissions (SFC’s) latest published quarterly report for April - June 2016:

• The SFC’s statistics show an improvement in the number of investigations closed, showing a 51.4% increase from the last quarter (66.7% year-on-year increase).
• Despite an increase in the actual number of investigations closed, the percentage of investigations completed “within seven months” continues to fall (from 56% in Q2 2015 to 45% in Q2 2016). This may be due to the SFC’s recent practice to group smaller regulatory breaches together and deal with them in one go (see enforcement action against Morgan Stanley Hong Kong Limited below).
• Despite the SFC’s Memorandum of Understanding with the DOJ (which we reported on earlier this year), continuing is the trend towards fewer criminal prosecutions and greater use of disciplinary proceedings, the Market Misconduct Tribunal and other civil proceedings. There were no criminal prosecution this quarter, while proposed disciplinary actions increase by 220% (or 128.6% year-on-year) and the number of civil proceedings remains high. The SFC perhaps is able to exert more control over the disciplinary process.
• The number of compliance advice letters issued by the SFC decreased by 46.6% from the last quarter, but represents a year-on-year increase of 155.9%.

Anti-money laundering: mixed messages from the two regulators?

There has been much debate about how one should interpret the HKMA’s recent Circular and SFC’s subsequent Announcement which send out somewhat contradictory messages on how banks should approach their anti-money laundering (AML) controls.

For dual-regulated financial institutions, the difference in attitude from the HKMA and SFC is no doubt confusing. On the one hand, the HKMA is encouraging banks not to be overly prescriptive in following AML guidelines (in its words disproportionately stringent), which might have the effect of excluding customers. The SFC, on the other hand, affirms its hard line against inadequate AML controls and urges licensees to enhance internal control systems immediately.

This apparent dichotomy may be explained by the different business areas that the HKMA and SFC each focus on: the HKMA looking at traditional banking services typically offered by retail and commercial banking and the SFC concerned with regulated activities including those carried out by wealth management, often dealing with high net-worth individuals. The HKMA’s message to banks about avoiding financial exclusion reflects their interest in protecting the interests of retail or commercial banking customers (both existing and prospective).

The key takeaway, however, is that despite HKMA’s comments on financial inclusion, banks should be reminded that both regulators are equally keen to take severe action against those who are in breach of the Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance (AMLO) or Guidelines adopted by the SFC and HKMA.

• The HKMA took disciplinary action against State Bank of India Hong Kong Branch last year and ordered it to pay HKD 7.5m for breaching provisions under the AMLO and HKMA Guideline. State Bank of India’s breaches included failure to identify the ultimate beneficial owner in multi-layered companies, failure to identify large and unusual transactions and failure to periodically screen their customers.
• Although the SFC has not taken any disciplinary action under the AMLO, it has consistently sanctioned licensees for breaches of the Client Identity Rule Policy (and early example of AML driven regulation) when banks failed to provide information within two days about the ultimate beneficial owner behind transactions. This is evident from the cases of Sassoon Securities Limited (pre-AMLO) and Guotai Junan Securities (Hong Kong) Limited (post-AMLO).

More importantly, the Guotai Junan case serves as a timely reminder to banks that they should review the terms and conditions of their client agreements, to see if they are aligned with the Client Identity Rule Policy and whether there is sufficient protection against breaches by way of a contractual agreement from the client.

For a full analysis of the content of the Circular and Announcement, see our article Anti-Money Laundering: reconciling the HKMA and SFC’s seemingly conflicting requirements

Internal controls: many a little makes a mickle

Recent enforcement actions suggest that the SFC is now grouping smaller control flaws under one investigation and trying to negotiate settlements with banks that involve guarantees that they will get their house in order. The regulator is ready to impose heavy fines for clusters of smaller breaches to ensure improvement in behaviour. The overall objective is to allow the SFC to redirect resources to discipline conduct that has significant market impact.

Morgan Stanley Hong Kong Limited was publicly reprimanded and fined a hefty HKD 18.5m for an array of internal control failures that spanned across six years from December 2010 to March 2016. The SFC found that the bank, in breach of the Code of Conduct, had failed to (i) adequately avoid conflicts of interest between principal trading and agency execution, (ii) comprehensively document the design and operation of its electronic trading systems, (iii) comply with the disclosure requirement for 29,000 of its short selling orders, (iv) comply with contract limits, (v) comply with the reporting obligations regarding large open positions, and (vi) follow client instructions. As a result, the bank agreed to engage an independent reviewer to conduct a forward-looking review of its internal controls.

Although on a smaller scale, the same trend can be seen in the SFC’s disciplinary action against HSBC. The bank was publicly reprimanded and fined HKD 2.5m for breaching the position limit (section 4(1) of the Securities and Futures (Contracts Limits and Reportable Positions) Rules) and breaching the Code of Conduct by failing to implement adequate internal controls to monitor its positions in futures and options to ensure compliance with the prescribed position limit on 18 occasions over a period of just over two months. Specifically, the SFC found that the bank was not prompt in identifying and reporting its breach, the internal teams within the bank lacked adequate knowledge about its state of compliance (which led to the late identification and reporting) and there was no centralised intra-day monitoring of positions at the time of the incident. In determining its sanction against HSBC, the SFC took into account HSBC’s admissions, cooperation with the Commission and efforts in taking steps to strengthen its internal controls. HSBC informed the media that no clients were impacted by its breaches.

These enforcement actions serve as a useful reminder for financial institutions to:

• Review and strengthen the implementation and monitoring of their systems and controls.
• Track systems weaknesses that have been reported or have become known over the course of previous investigations.
• Proactively manage and reduce its exposure to regulatory risk by initiating conversations with the regulator about any control failures identified and the proposed remedial measures.
• Obtain legal advice on remediation before the SFC calls to talk about remediation and fines.

Heavier fines where conflicts of interest involved

BNP Paribas Wealth Management (BNPPWM) received a HKD 4m fine for overcharging its clients around HKD 9.5m in 2,322 transactions between 01 January 2011 and 31 December 2013. BNPPWM was found to have breached the Code of Conduct by failing to exercise due skill, care and diligence to ensure the monetary benefits it received from client transactions were fair and reasonable, and in accordance with its representations to the clients.

We contrast this decision with the disciplinary action against State Street Global Advisors Asia Limited (State Street) (which we previously reported on) which was similarly fined HKD 4m, for mismanaging the interest on certain cash deposits of the fund’s investors but which only called for State Street to pay HKD 318,315 back into the fund, a relatively modest amount. The SFC specifically found that State Street had failed to manage and minimise the conflict of interest between the fund’s investors and the interests of State Street. The sanction received by BNPPWM appears lenient in comparison, given the large amount that it had overcharged its clients. This is perhaps because of the absence of any conflict of interest. The fact that BNPPWM self-reported the matter to the HKMA and the SFC also played a part in the level of sanction.

Responsible authorship: where does the Left case leave us?

Andrew Left, head of Citron research and an activist short seller based in the US, was found culpable of market misconduct under the SFO for publishing a false and misleading research report on the Chinese property developer Evergrande Real Estate Group Limited. See our full analysis of the decision.

This case marks the first time the Market Misconduct Tribunal has made a ruling against a short seller engaged in the publication of otherwise unregulated market commentary. The key takeaway is that the Tribunal, when deciding whether the disseminated information was false or misleading, considered only information that was publicly available at the time. This serves as a reminder to analysts to minimise the risk of breaching the SFO by, amongst other things, being sure that conclusions in research reports are supported by publicly available information and not based on erroneous grounds.

It is also clear that the SFC will not shy away from prosecuting offshore parties in the name of protecting the Hong Kong market from false and misleading publications.

Deferred Prosecution Agreements: the future for Hong Kong’s enforcement approach?

Deferred Prosecution Agreements (DPAs) are a common tool in the US for prosecutors and regulatory bodies for reaching an agreement with financial institutions when breaches are identified. DPAs commonly include a provision for the regulator to appoint an independent compliance monitor to ensure that actions promised by banks are undertaken, in exchange for the regulator foregoing further investigation and criminal indictment. Banks in Asia that have a presence in the US are not immune to these arrangements and may be subject to these types of monitoring. The question is, will the Hong Kong regulators adopt DPAs as part of their enforcement action in the future?

There are developments that hint at a possibility. First, DPAs have spread beyond the USA already. In the UK, the Crown Prosecution Service and the Serious Fraud Office started adopting the use of DPAs in 2014. The first DPA was entered into between the Serious Fraud Office and the then Standard Bank Plc (now ICBC Standard Bank Plc) for an independent reviewer (PwC LLP) to review the bank’s anti-bribery and corruption controls and to ensure compliance with the Bribery Act, in exchange for an indictment under the Bribery Act to be suspended. Secondly, in Hong Kong, it has been observed that the SFC and HKMA have already been increasingly requiring banks under investigation to appoint independent third party auditors to review their internal systems and controls as part of the remedial process. This can be seen as a step towards the possibility of formally adopting DPAs.

Mr Thomas Atkinson, Executive Director of SFC Enforcement, will also no doubt be familiar with DPAs given his previous post as Director of Enforcement at the Ontario Securities Commission in Canada.

In light of recent (and likely ongoing) focus by the Hong Kong regulators on AML controls, we believe it is just a matter of time until the SFC or HKMA adopts a similar approach as the US and UK.

Listing reforms consultation extended to 18 November 2016

Despite the recent sizable listing of Postal Savings Bank of China (USD 7.3bn), the Hong Kong bourse is still struggling to recover lost ground after losing Alibaba’s record USD 25bn IPO in 2014.

The HKEX and the SFC published a joint consultation paper in June 2016 proposing the establishment of two equally represented committees - a listing regulatory committee to approve complicated applications and a listing policy committee to set new policies - giving the SFC control early on in the listing process, in addition to its veto power at the final stage under the current structure.

The consultation paper sparked heated debates in the city with opponents arguing that the new structure will result in over-regulation and kill off the IPO market. It is notable, however, that the proposed listing reform was inspired by the handing over of power by exchanges to financial authorities in the UK and Singapore, and both the UK and Singapore experienced a decrease in new listing volumes subsequent to such handover.

The SFC seems to have adopted a softer tone recently, saying that it will be open-minded to changes suggested by stakeholders and would listen to market views. The consultation period is now extended by two months to 18 November 2016.

Better late than never

Hong Kong has finally caught up on the FinTech scene following the HKMA’s launch of a “sandbox” model on 06 September 2016. The Fintech Supervisory Sandbox (FSS) allows banks to experiment with financial technologies involving actual banking services and a limited number of participating customers without full compliance with the HKMA’s usual supervisory requirements. This is in line with developments that have already taken place in the UK, Australia and Singapore, and shows a willingness to provide FinTech startups a more flexible environment to develop products and services in collaboration large banks.

However, unlike the sandbox offered by regulators in other jurisdictions, the FSS applies only to AIs. For non-AIs, the HKMA will set up the HKMA-ASTRI FinTech Innovation Hub, which is intended to be a place for various stakeholders including banks, payment services providers, FinTech start-ups, the HKMA, etc to collaborate and innovate.

Further consultation conclusions on introducing mandatory clearing and expanding mandatory reporting for OTC derivatives market

In July this quarter, the HKMA and SFC published a further consultation conclusion relating to mandatory clearing and reporting for the second stage of OTC derivatives regulatory regime. This publication sets out revised proposals on the technical aspects of the next stage of the clearing and reporting regime, providing further clarification on the reporting requirements.

Market participants who are subjected to mandatory clearing are reminded that their mandatory clearing obligations in Hong Kong started on 01 September 2016. The SFC had designated four central counterparties for OTC derivatives, namely:

1. Chicago Mercantile Exchange Inc
2. Japan Securities Clearing Corporation
3. LCH.Clearnet Limited
4. OTC Clearing Hong Kong Limited

The full announcement for the designation of CCPs can be found here.

Enforcement activities (Reproduced from the SFC quarterly report April - June 2016)


Enforcement dashboard

(i) Enforcement activities

(ii) HKMA complaints volume tracker (July to August 2016)*

* Obtained from the HKMA press releases