In its latest regulatory sanction for misconduct by a licensed intermediary, the SFC heavily admonished the “pervasive dishonest behaviour” of CGMAL’s senior management and traders and described it as having “a culture that encouraged chasing revenue at the expense of basic standards of honesty”.4 The SFC pointed to serious lapses and deficiencies in CGMAL’s internal controls and compliance function, which fell far short of expectations. Consistent with the SFC’s focus on senior management’s accountability, the SFC noted that the breakdown in CGMAL’s internal controls exposed serious supervision failures on the part of CGMAL’s senior management.5
The SFC found that CGMAL failed to comply with the circular dated 14 February 2018 on client facilitation (2018 Circular).6 The 2018 Circular was issued to remind intermediaries that when they assume a risk-taking principal position in client facilitation activities, the nature of the trades should be disclosed to clients and clients’ prior consent should be obtained so that they are fully aware of the inherent conflicts of interest. The 2018 Circular also states that IOIs should contain sufficient details and should only be disseminated when they are based on a genuine client or proprietary intent to trade, and controls and monitoring with sufficient management oversight should be implemented to ensure they are accurate and updated in a timely manner.
In particular, in the course of the SFC’s investigation and CGMAL’s own internal investigation, which was triggered by a routine SFC on-site inspection, the following was uncovered:
The use of mislabelled IOIs
The SFC found that from 2008 (or before) to 2018, CGMAL’s Equities Sales Trading Desk adopted a practice of issuing IOIs labelled as ‘Natural’, ‘In Touch With’ and/or ‘P:1’ to clients, notwithstanding there was no actual client interest underlying such IOIs.7 The purpose of doing so was to provoke client enquiries under a purported belief that there were available opposite trades of active stocks on CGMAL’s trading platform. While the clients were under a misapprehension that it would be an agency trade, their orders were in fact routed to CGMAL’s Facilitation Desk when no counter-trade could be found on an agency basis.8 The resulting trades were therefore not of a riskless nature as expected for agency trades. It also exposed clients to possible conflicts of interest since CGMAL was assuming a risk-taking principal position rather than an agency position.
The SFC particularly noted:
- The contemporaneous correspondence showed that the heads and members of the trading desks, and CGMAL’s senior management were aware of the IOIs being mislabelled, and they were internally referred to as “fake flows” and “the fakes”.
- Various clients had raised complaints about the quality and accuracy of the IOIs. While such complaints were recorded and brought to the attention of senior management and the trading desks, no steps were taken to investigate or cease the practice. This suggests that the dissemination of the mislabelled IOIs was intentional.
- The mislabelling of IOIs was contrary to the relevant industry guidelines (which CGMAL asserted compliance with) and inconsistent with the general principles of being honest with clients, acting in the best interests of clients, disclosing conflicts of interest and taking all reasonable steps to ensure fair treatment of clients if conflicts of interest cannot be avoided, as required under the SFC’s Code of Conduct.9
Misrepresentations and non-disclosure to conceal the principal nature of facilitation trades
Among 174 sample facilitation trades executed by CGMAL’s various trading desks between January 2014 and December 2018, the SFC found that in 127 of them (i.e., 73 per cent), 23 traders and heads of desks:
- provided factually incorrect information to clients or took positive steps to conceal the principal nature of the trade;
- made misleading statements to suggest that the relevant trade would be executed on an agency basis; failed to explicitly indicate to the client about the involvement of the Facilitation Desk; or otherwise remained silent as to the client’s mistaken belief; and/or
- failed to seek client consent before routing the order to the Facilitation Desk for execution.
The SFC concluded that this demonstrated a practice of misrepresenting a facilitation trade as an agency trade, which was driven by commercial pressures placed on traders by CGMAL’s senior management to solicit more business and increase CGMAL’s market share. By adopting such practice, CGMAL could avoid losing trades to competitors.
Internal control failures
The SFC pointed to the prevalence of serious misconduct over a decade-long period as reflecting CGMAL’s serious and systemic lapses across its governance, and its internal systems and controls framework. The SFC found that CGMAL’s senior management turned a blind eye to the misconduct with a view to achieving business growth. In particular, the SFC noted that CGMAL had failed to:
- adequately implement and enforce policies and internal controls to:
- monitor issued IOIs and ensure they were backed by specific client interest; and
- ensure proper pre-trade disclosure of CGMAL’s principal capacity and obtain client consent for facilitation trades – the SFC found that (i) the language prescribed by CGMAL’s internal guidelines for making disclosure was vague; and (ii) CGMAL deliberately excluded the requirement for prior client consent for facilitation trades from its internal guidelines and such practice was endorsed by CGMAL’s compliance department;
- provide adequate training to traders on IOIs and pre-trade consent for facilitation activities;
- record and monitor communications and ensure there was sufficient segregation between the agency and facilitation desks; and
- identify and rectify system errors that had led to erroneous post-trade messages being sent to clients incorrectly indicating CGMAL had acted in an agency capacity when it acted as principal.
Observations in light of the SFC’s findings and conclusions
In reviewing the SFC’s findings and conclusions in the CGMAL case, financial institutions should give close consideration to the following matters:
- Where IOIs are issued, financial institutions should ensure that effective policies and internal controls are implemented and enforced to guide and monitor the issuance such that accuracy is assured and the descriptions applied are supported by facts (e.g., ‘In Touch With’ or ‘P:1’ labelling is only applied where it is backed by specific client interest).
- There is an expectation that pre-trade notifications issued by a financial institution are unequivocal in informing clients of its agent vs principal capacity for the intended trades, and financial institutions should avoid adopting vague language (e.g., The bank may transact this order with you either partially or fully on a principal basis).
- For execution of facilitation trades, financial institutions should not rely on implied consent and the passive acquiescence of clients based on non-responses to pre-trade disclosure messages. Positive consent from clients is required and further compliance monitoring in respect of obtaining such consent is expected.
- Training and guidance should be provided to traders to ensure that they understand the categorisation of IOIs and can properly inform clients of the same. Also, traders should be aware of the need to obtain prior client consent for facilitation trading activities.
- Communication between agency and client facilitation traders should be recorded and monitored on a timely basis and it is insufficient to rely on the traders’ recorded phone lines for this purpose, particularly where such communication takes place by shouting across the trade floor.
- There should be proper segregation between the agency desk and the facilitation desk, which should be reflected both in the internal written guidelines and in practice.
- Tagging as to the financial institution’s trading capacity (i.e., as agent or principal) in its various internal systems should be regularly reviewed to ensure the actual capacity is reflected.
- Senior management should exercise proper supervision and oversight in managing the risks associated with the business and ensure that traders maintain appropriate standards of conduct and adhere to correct procedures. The failure to do so will attract regulatory scrutiny and disciplinary proceedings against the specific individuals involved.
Conclusion
As provided for under the SFC’s Disciplinary Fining Guidelines,10 the sanction against CGMAL demonstrates that the SFC continues to adopt a robust approach to deterring misconduct by licensed intermediaries through imposing substantive fines that reflect the nature and seriousness of the identified misconduct. As regards the size of the fine against CGMAL (i.e., HK$348.25 million), we note that it is similar to the HK$400 million fine imposed by the SFC against UBS AG on 11 November 2019, which was also a case involving deceptive practices against clients’ interests over a decade-long period and internal control failures.11 It can be surmised that the duration of the misconduct and the fact that there was an element of dishonesty factored significantly in determining the size of the fine.
The SFC also heavily criticised the lack of supervision on the part of CGMAL’s senior management and the participation of traders and heads of desks in the identified misconduct. The SFC has indicated that it will commence disciplinary proceedings against certain former members of CGMAL’s senior management in due course so it is expected that there will be further sanctions to follow in the wake of CGMAL’s reprimand.
Financial institutions and responsible officers are reminded to implement and enforce effective policies and systems to ensure their compliance with applicable regulatory obligations and avoid adopting business practices that fail to align with the SFC’s guidelines and circulars, in particular the SFC’s Code of Conduct. CGMAL’s case is also a timely reminder that the SFC’s routine on-site inspections (including inspections conducted remotely in light of the COVID-19 pandemic) can also lead to substantive investigations and sanctions, so financial institutions should be mindful to properly handle all regulatory inspections and seek professional assistance where appropriate.
- An IOI is a form of advertisement or representation commonly used by licensed corporations to source potential clients with an interest in trading.
- See SFC’s press release for sanction against CGMAL, available at https://apps.sfc.hk/.
- See SFC’s press release for sanction against Goldman Sachs (Asia) LLC, available at https://apps.sfc.hk/.
- Mr Ashley Alder, the SFC’s Chief Executive Officer, said: : “The severity of CGMAL’s failures exposed a culture that encouraged chasing revenue at the expense of basic standards of honesty… in the face of unrelenting commercial pressure to solicit more business and increase CGMAL’s market share, deceptive practices were deployed at the expense of clients’ best interest and to the detriment of market integrity”
- Mr Thomas Atkinson, the SFC’s Executive Director of Enforcement, said: “A key concern of the SFC is the failure of CGMAL’s senior management to ensure the maintenance of appropriate standards of conduct and adherence to relevant regulatory requirements, and to understand, manage and monitor its business and risks. The prevalence of the misconduct for a prolonged period reflects a failure … to properly discharge their management and supervisory responsibilities.”
- See SFC’s 2018 Circular, available at https://apps.sfc.hk/.
- According to the AFME/IA Framework for Indications of Interest issued by the Association for Financial Markets in Europe and the Investment Association in March 2017, ‘P:1’ or ‘In Touch With’ IOIs can be issued where there is a reasonable expectation of interest from a specific client and resulting trades are expected to be of a riskless nature.
- In an agency trade, the licensed corporation acts as agent to find a counterparty to cross with the client’s order. In a facilitation trade, the licensed corporation acts as principal and fulfils the client’s order by buying or selling the securities from/to the client using the firm’s capital.
- The SFC is of the view that CGMAL failed to comply with General Principles 1, 2, 5 and 6, and paragraphs 2.1, 2.3, 3.10, and 10.1. See the Code of Conduct for Persons Licensed By or Registered with the Securities and Futures Commission, available at https://www.sfc.hk/ (PDF download).
- See SFC’s Disciplinary Fining Guidelines, available at https://www.sfc.hk/ (PDF download).
- See SFC’s press release for sanction against UBS AG, available at https://apps.sfc.hk/.
Client Alert 2022-032
