Hong Kong regulatory enforcement update: Q2 2016

Trends in SFC enforcement actions

The SFC’s 2015/16 annual report was published on 22 June 2016.  We note the following discernable trends from this report and elsewhere:

• Identified instances of AML non-compliance in 2015/2016 are 91% greater than for the equivalent period in 2014/2015 (see below).
• The SFC continues to plough through its backlog of investigations, closing 436, which appears likely to have adversely affected their ability to close investigations within seven months, as the figure for the latter has slipped by 19% in 2015/2016, reversing an emerging trend in recent years toward shorter investigation times.
• There was a notable increase in the level of investigations concerning intermediary misconduct.  We believe this has been driven by closer surveillance by the SFC of AML and licensing perimeter issues, and intermediary handling of client accounts and orders.
• The number of criminal prosecutions remains low relative to earlier years, perhaps as the SFC shifts it focus away from volume prosecutions in the lower courts to indictable offences (see our Newsflash).  For now, the trend towards greater use of the Market Misconduct Tribunal and other civil proceedings as a proportion of enforcement activity continues to grow.
• The number of on-site inspections conducted by the SFC remained unchanged, but has resulted in a 52% jump in the number of breaches identified by the SFC.  These breaches were mainly for controls weaknesses, non-compliance with the SFC’s Code of Conduct and failure to observe AML guidelines, and likely accounted for the 50% increase in compliance advice letters issued in 2015/2016.

* Reproduced from the SFC Annual Report 2015-16.

Cross-border or crossing the line? 

During an investigation into certain trades completed by AA (a licensed corporation), the SFC received a request from the Japanese regulators to provide them with information obtained from the applicants by the SFC under its information gathering powers, including the record of an interview conducted by the SFC with AA’s responsible officer, EA. 

AA and EA say that the SFC decided to provide compelled evidence to the Japanese regulators without any (or adequate) restriction on its use in any intended criminal proceedings and safeguards as to secrecy, and therefore commenced a judicial review of the SFC’s decision  - AA & EA v SFC (HCAL 41/2016).   Having received the evidence from the SFC, the Japanese regulators commenced proceedings against the applicants.  Although those proceedings are classified as “administrative” in Japan, the applicants say that they are in fact criminal in nature.

It is worth recalling that privilege against self-incrimination in criminal proceedings is preserved, even if one is compelled to respond to the SFC’s question, provided privilege is claimed before responding to the question (the SFC can however rely upon it in disciplinary or civil proceedings).  Under section 186(6) of the SFO, where privilege is claimed, the SFC should not share that privileged Q&A with a foreign regulator.

Another interesting ground raised in the judicial review is the constitutionality of section 181 of the SFO which does not afford the same protections against self-incriminations as questions asked by the SFC in a section 182/183 interview.  Section 181 enables the SFC to compel a licensed person or holder of securities to disclose particulars of a trade, including the person(s) involved, the instructions given and the nature of the product traded.

Leave to judicially review the SFC’s decision was granted by Zervos J (former DPP), and the substantive hearing (the date for which remains to be fixed) should be a point of interest for all regulated entities in Hong Kong engaged in cross-border activities.  If the SFC is found to have acted improperly in providing the information to the Japanese regulators, one potential outcome is that greater safeguards and protections could be imposed on the flow of information from the SFC to foreign regulators where that information has been obtained during the course of a regulatory investigation in Hong Kong. 

With requests from overseas regulators likely to increase in the wake of the Panama Papers, the consequences of these proceedings could be significant for both the SFC and regulators in other financial centres alike. 

Cross-border regulation:  cooperation with FINRA

Staying with the theme of cross-border regulatory co-operation, the SFC and the Financial Industry Regulatory Authority (FINRA) of the United States have entered into a Memorandum of Understanding (MoU) for mutual assistance in the supervision and oversight of cross-border regulated entities.  The MoU was concluded on 9 May 2016 and joins the extensive list of international regulatory agencies with which the SFC has executed similar MoUs. 

This new agreement between the SFC and FINRA is a further nod to the inter-connectivity of entities regulated in both the United States and Hong Kong.  The SFC and FINRA expect, as do we, that cooperation will mostly take place through informal oral conversations, but they have also agreed to share non-public information and engage in formal cooperation to discuss issues of common interest.  No doubt the team at the SFC which concluded the MoU will be watching developments in the judicial review proceedings in AA v SFC with interest.

Self-report, delay not

Last year, we reported on Mark Steward’s comment that self-reports should be made before internal investigations and legal advice.  Continuing on this theme, we see SynerWealth Financial Limited’s (SynerWealth) failure to share information with the SFC resulting, in part at least, in it being fined and publicly reprimanded by the SFC.

The SFC’s investigation found that from November 2012 to January 2014 there were at least 65 instances of uncovered (or ‘naked’) short sales executed by SynerWealth which resulted from its failure to put in place effective systems and controls to detect and prevent such activity.  Of the $2.7 million fine, $1 million was attributed to SynerWealth’s failure to self-report the deficiencies of its trading systems to the SFC in a timely manner as required by clause 12.5 of the SFC’s Code of Conduct, making this a further reminder from the SFC of the need for regulated entities to ensure that they are vigilant in ensuring that they are asking themselves the right questions and escalating identified issues to the SFC in a timely way.

It is also interesting to note that although the SFC’s Statement of Disciplinary Action states that SynerWealth was “not a fit a proper person to remain licensed”, at the time of writing it remains precisely that according to the SFC’s website.

Conflict of interest on interest

State Street Global Advisors Asia Limited (State Street) was fined $4milion for regulatory failings related to its systems and controls for setting the rate of interest earned on cash balances of a tracker fund. 

The cash balances were deposited with an affiliate of State Street: State Street Bank and Trust Company.  The SFC concluded that State Street was obliged to ensure that the cash deposited with its affiliate yielded a rate of interest not lower than the prevailing commercial rate in Hong Kong for deposits of the same size and term, and that it did not do so.  The SFC also found that State Street’s internal procedures on the management of the fund’s cash balances were inadequate, and that State Street had failed to manage and minimise the conflict of interest between the fund’s investors and the interests of State Street and its affiliate. 

Although the conflict of interest between State Street and the investors was addressed only in passing, it is likely that the fact State Street benefited (intentionally or otherwise) was one of the primary drivers behind the SFC’s enforcement action in this instance. 

The hefty sanction serves as a useful reminder of the strict approach that the SFC will take where it believes that investor interests are inadequately protected by systems and controls established by regulated entities.

SFC CEO Mr Ashley Alder appointed as Chairman of IOSCO Board

On 12 May 2016 Mr Alder was appointed Chairman of the Board of International Organisation of Securities Commissions (IOSCO).  He succeeds Mr Greg Medcraft, Chairman of the Australian Securities and Investments Commission.  Mr Alder previously served as the Vice Chairman of the IOSCO Board from December 2015 to May 2016, and the Chairman of the IOSCO Asia-Pacific regional Committee from 2013 to May 2016.  The IOSCO Board is constituted of 34 member countries with a broad geographical representation.

IOSCO is the leading international policy forum for securities regulators, and is recognised as the global standard setter for securities regulation.  The organisation’s membership regulates more than 95% of the world’s securities markets in more than 115 jurisdictions. Through its regulatory structures, it aims to cooperate in developing and promoting adherence to internationally recognised and consistent standards of regulation, oversight and enforcement, with the primary aim of investor protection.  It also encourages the exchange of information at both global and regional levels to assist in the development of markets and the strengthening of market infrastructure and regulation.

Mr Alder’s continuing position on the IOSCO Board, and the opportunities for information sharing and comparison which it provides, will no doubt reinforce the existing trend for enhanced coordination and cooperation between regulatory agencies in the major financial centres.  Readers may have detected this trend simply from the content of this update

Increase in non-compliance with anti-money laundering regime

There was a stark year-on-year 91% increase in identified instances of non-compliance with the SFC’s anti-money laundering guidelines.  The number increased from 117 in 2014-15 to 223 in 2015-16.  This is likely a result of the SFC (and the HKMA, following its enforcement action against the State Bank of India in July 2015) focussing on ensuring that regulated entities are properly applying the AML regime in Hong Kong. 

Given the very public efforts to tackle trade-based money laundering in Hong Kong, and the ongoing issues surrounding Hong Kong’s connections with the Panama Papers (see the government’s press release on the Panama papers here), it is perhaps unsurprising that AML remains at the forefront of the SFC’s enforcement agenda in 2016.

* Obtained from the HKMA press releases