In the last six months, we have seen fund managers being subject to Securities and Futures Commission (SFC) enforcement actions in various areas, including internal controls, insider dealing and false trading.
Whilst internal control deficiencies are operational risks faced by all financial services intermediaries (and their clients), fund investors are particularly susceptible to deficiencies that fail to detect or prevent the mismanagement of investments. In this case, both the fund management company and the investment manager were penalised, which reflects the SFC’s focus on individual accountability.
SFC fines asset management company and suspends its manager for fund mismanagement1
In February 2024, the SFC publicly reprimanded and fined an asset management company HK$2.8 million for fund mismanagement which occurred between May 2018 and May 2020. The SFC also suspended the investment manager, “S”, from advising on securities and managing assets for seven months.
The company, through S, failed to ensure that the fund’s investments were in line with its stated investment objectives and investment restrictions. Specifically:
- The fund only held one to three stocks at any given point in time during a 21-month period from its inception.
- The fund also had highly concentrated positions in two Hong Kong stocks, one of which (Stock X) was not a permitted investment according to the company’s internal policy.
The company had an internal policy governing permitted investments. S bought Stock X, which was not on the company’s list of permitted investments. Secondly, he obtained the agreement of the company’s Legal & Compliance Department to temporarily assign Stock X a permitted trading status with the explanation that it was urgently needed to participate in a share placement. The Legal & Compliance Department agreed to this, provided that S obtained approval from the company’s Investment Committee by a specified deadline. S did not obtain approval by the deadline, and the purchase of Stock X was made in the secondary market and not during a placement of the shares.
The Investment Committee repeatedly rejected S’s requests to add Stock X to the list of permitted investments, and finally only added it to allow the stock to be sold. However, there were no procedures in place as to how such disposal should be carried out. which meant that, the fund’s investors were exposed to the risk of the fund holding an unsuitable stock.
The SFC concluded that the fund’s dealing with Stock X, at the time of purchase and subsequently, showed that it did not have adequate internal controls.
It is interesting that the SFC said that not only did S fail as a first line of defence, but the Legal & Compliance Department also failed as a second line of defence.
In addition, various other deficiencies were found, relating to:
- Liquidity risks: at various times, between 60% and 90% of the fund’s portfolio was invested in illiquid assets.
- Concentration risks: at various times, two stocks amounted to more than 20% of the fund’s NAV.
- Delay in executing the stop-loss procedure: Stock X should have triggered a forced sale within three working days, but this was delayed for two weeks.
SFC sues prominent hedge fund, its director and a former trader for insider dealing
In May 2024, the SFC commenced criminal proceedings against a prominent global hedge fund, its director and a former trader for the offence of insider dealing in the shares of a Hong Kong listed company.2 The parties were criminally charged for allegedly trading in the shares upon receiving insider information from a connected person and prior to entering into a block trade in June 2017. In July, the case was transferred from a lower-level magistrates’ court to the district court. The Hong Kong district court can impose sentences of up to seven years in prison for insider dealing offences.
A block trade, as the description implies, is a trade of a large block of shares off-market at a discount to the market price. It is usual for market soundings (communications between sell-side and buy-side market participants) to take place before a block trade. However, what information is exchanged needs to be carefully handled. Market soundings are under the regulatory spotlight in Hong Kong. The SFC issued a consultation paper in October 2023, in which it stated that “in the past years, the SFC has observed an increasing number of cases regarding trading activities ahead of placings and block trades, amongst others. These cases appear to indicate that some intermediaries might have taken advantage of or unfairly exploited information received during market soundings to make unjustified profits whilst the same information was not generally available to the rest of the market.”3
The issues will take some time to play out over the course of the court proceedings. However, the reputational risks that come with a high-profile prosecution can be substantial and should not be underestimated.
Hong Kong Market Misconduct Tribunal (MMT) penalises former hedge fund manager for matching orders
In July 2024, an ex-director of a Hong Kong based hedge fund, “L”, was, among other things, (1) ordered to disgorge an illicit profit of over HK$5.6 million, and (2) disqualified for four years from being a director, liquidator, receiver or manager of Hong Kong corporations by the MMT for carrying out matched trades.
For a period of 22 trading days between August and September 2014, L placed a series of buy and sell orders on two Hong Kong-listed shares through the hedge fund’s account. These transactions were frequently matched and executed against opposite offers made by L’s mother. The matched trades had the effect of creating a false or misleading appearance of active trading, or with respect to the price of dealings, in the two listed shares, resulting in gains of HK$5.6 million in L’s mother’s brokerage account at the expense of the hedge fund. L, to his credit, did not contest the matter and subsequently agreed (a) a statement of agreed and admitted facts, and (b) a document entitled “orders jointly proposed by the SFC and L”.
The orders that were jointly proposed did not include a disgorgement order of the profits gained from the misconduct. Hence, an intriguing legal point arose: as the gains were made by L’s mother (there is no evidence she was involved in her son’s market misconduct), did the law – specifically section 257(1)(d) of the Securities and Futures Ordinance – allow the MMT to make a disgorgement order against L?
Section 257(1)(d) states:
“(1)…the Tribunal may make one or more of the following orders in respect of a person identified as having engaged in market misconduct –
…
(d) an order that the person pay to the Government an amount not exceeding the amount of any profit gained or loss avoided by the person as a result of the market misconduct in question”.
Somewhat interestingly, the SFC initially took the view that a disgorgement order under section 257(1)(d) is confined to any profits made by L, who was the person who had engaged in the market misconduct. Here, as the profits were deposited into L’s mother’s account, the inference was that they were for her benefit and not profits gained by L. To order L to pay an amount other than his own gains would therefore constitute a penalty, but the SFO does not allow the imposition of a penalty.
The MMT ruled that it did not need to be satisfied that L received or enjoyed a benefit or was in a position to exercise control over it. It only needed to be shown that L committed market misconduct resulting in a profit. The MMT has the power to make an order under section 257(1)(d) and the discretion to decide if it should make the order and the terms on which the order is made. It is heartening to note the practical approach of the MMT in drawing inferences from the evidence that “reflect the reality of our world…using common sense, knowledge of everyday life and experience of human nature”.
In the end, the MMT made an order that L pay the profit gained from his market misconduct to the government.
- See SFC enforcement news
- See SFC enforcement news
- See SFC website
Client Alert 2024-153
