Financial institutions operating in Asia are facing a growing number of contentious issues. This publication summarises those issues with reference to the key regulatory and legislative developments which have arisen in China, Hong Kong and Japan. We then look forward to see what lies ahead in 2008.
Although issues such as fraud, corruption and inappropriate SOE lending remain significant problems within the Chinese financial services environment, significant progress has been made by the authorities in these areas and the problems are becoming well understood. Regulatory emphasis is now shifting to more sophisticated problems of the type which take up much regulatory attention in more developed jurisdictions.
Areas of relevance to non-Chinese financial institutions that have witnessed significant attention from the authorities in 2007, and are likely to continue to do so in 2008, include the following.
Market manipulation and insider dealing
2006 and 2007 saw significant rises in the Shanghai and Shenzhen stock markets, after several years of stagnation. Short term trading by ordinary citizens has also become much more popular over the same period. The authorities have been alive to the risk of market overheating and the potential political impact of a crash. Regulatory responses have included the imposition of additional stamp duty (specifically designed to cool the market) and also an increased focus on market misconduct. For example:
- The China Securities Regulatory Commission (CSRC) and the Shanghai and Shenzhen exchanges all issued warnings of "clampdowns" on insider dealing and market manipulation. From mid-2007, market manipulation and insider dealing replaced false reporting of profits as the most commonly prosecuted illegal market behaviour in China.
- New rules were issued by the CSRC in April 2007 emphasising, amongst other things, systems for monitoring of trading and for maintaining the security of inside information.
- New rules were issued by the CSRC and the Shanghai exchange in mid-2007, amending the regime for immediate suspension of trading in the event of large, unexplained price movements.
- In February 2008 the first ever prison sentences for insider trading were imposed (securities traders received sentences of 18 to 30 months and fines of over US$11 million).
- In September 2007 a proposal was announced to amend the securities legislation so as to expand the civil liability for market manipulation (including provision for disgorgement of unlawful profits). A notorious case highlighted by the authorities as a justification for such amendments involved the manipulation of a pharmaceutical company's share price for 42 days in a row by the propagation of false rumours.
In January 2007, the CSRC published measures (under powers granted by recent amendments to the companies and securities legislation) imposing more stringent requirements of prompt and accurate information disclosure on issuers, sponsors and shareholders. The measures also:
- Require companies to develop internal rules specifying disclosure responsibilities of various senior personnel, which would then be filed with the stock exchange and the company's local CSRC office.
- Provide for civil liability for companies and individuals responsible for false or misleading statements.
A number of cases brought during the year illustrate the emphasis on accurate disclosure of information. In one case in January 2008, the former chairman of a listed company was jailed for 12 years for false information disclosure (amongst other wrongdoing).
The Chinese Anti Money Laundering (AML) statute came into force on 1 January 2007.
The relevant authority, the People's Bank of China (PBOC), issued regulations on various dates in 2007 imposing various obligations on financial institutions in this context.
- Customer identity verification
- Record keeping
- AML compliance roles
In July 2007, China became a full member of the Financial Action Task Force on Money Laundering.
In November 2007 it was reported that the PBOC had penalised 662 banking institutions, including 10 non-Chinese banks, for violating AML rules. This followed spot checks on over 3,000 institutions. Fines in excess of US$5 million were imposed.
Unauthorised provision of financial services
The authorities increased their focus in 2007 on unauthorised activities connected with money laundering such as:
- Large scale syndicates for the laundering of cash into assets such as stocks and property (major state owned enterprises have reportedly been found to be among the clients of these syndicates).
- The authorities reported finding significant unauthorised equity funds (funds totalling over US$700 million were reported to have been uncovered in the first quarter of 2007 alone). Prosecutions have ensued.
- Offering stock tips for fees on the internet – another activity which has led to prosecution.
Improving co-ordination and reducing scope for overlap and contradiction between different authorities was a noticeable theme in 2007 and may well accelerate in 2008:
- Shortly after the end of 2007, the CSRC announced consolidation of various of its investigative and prosecution functions with a view to operating in a more co-ordinated way.
- In August 2007, the CSRC, the Shanghai and Shenzhen Stock Exchanges, the China Financial Futures Exchange, the Chinese Securities Depository and Clearing Corporation and the China Futures Margin Monitoring Centre commenced discussion of a formal arrangement for improving the co-ordination of market supervision and investigation.
- Perhaps most significantly, there have been persistent rumours (including in state media stories which were subsequently withdrawn without being clearly denied) of a possible merger of the CSRC with the China Banking Regulatory Commission (CBRC) and China Insurance Regulatory Commission (CIRC) to create an FSA-type single regulator. Whether this will actually happen, and if so the timing, remains unclear.
2007 proved to be an important year for litigation in the financial services regulation arena in Hong Kong. A number of noteworthy judgments were handed down, including a rare example of a successful human rights challenge in the context of the regulation of insider dealing, which was subsequently overturned in 2008. We summarise the developments below.
Insider Dealing Tribunal proceedings: use of compelled evidence upheld and fining power struck down
In June 2007, the Court of Appeal handed down a landmark decision in Koon Wing Yee v Insider Dealing Tribunal which held that the SFC's power to compel those suspected of insider dealing, to give selfincriminating evidence for use in Insider Dealing Tribunal (IDT) proceedings, was unconstitutional. The court held that the power was contrary to the safeguards enshrined in the Hong Kong Bill of Rights and Basic Law (i.e. the right to: be presumed innocent until proven guilty, a fair hearing and not be compelled to testify against himself or confess guilt), as triggered by a "criminal charge". The court held that the safeguards were available because the IDT's inquiry was tantamount to criminal proceedings, given that its power to impose a financial penalty of up to three times the amount of any profit gained or loss, was akin to a power to impose a criminal fine.
The Financial Secretary appealed this decision and in March 2008 the Court of Final Appeal handed down judgment. The court unanimously upheld as valid the IDT's power to rely on compelled evidence, and in doing so, struck down the IDT's statutory fining power. The court held that, in light of the relief granted, the true character of IDT proceedings is civil and that the civil standard of proof should be applied.
The Court of Final Appeal's decision is unlikely to impact on the future regulation of civil insider dealing in Hong Kong because the IDT's successor, the Market Misconduct Tribunal (MMT), does not have the same fining powers. In fact, in separate litigation, the court held that the MMT's powers do not constitute a criminal penalty and any evidence compelled for use in MMT proceedings is not unconstitutional.
A question mark exists over whether those who were previously fined an amount greater than the profit or loss avoided as a result of insider dealing can appeal such fines. Whilst a declaration of invalidity of a statutory provision operates retrospectively to the date of enactment of the relevant provision, the scope for appeals has been reduced by the Court of Appeal's decision in Lau Luen Hung and Insider Dealing Tribunal, which clarified that those found responsible for insider dealing are unlikely to be allowed an extension of time to appeal on the back of a change in law alone.
ICAC's power to compel production of documents
In June 2007, the Court of Final Appeal confirmed in P v. Independent Commission Against Corruption that the Independent Commission Against Corruption's investigative powers extended to requiring those involved in investigations to obtain and produce relevant documents that are located outside Hong Kong.
Audio-recording of SFC interviews
In November 2007, the High Court in A v The Securities and Futures Commission confirmed that the SFC has an implied power to audio-record compulsory interviews and can insist on this approach. Whilst the court left open the question of whether the SFC has an implied power to video-record interviews, it expressed doubt that video-recorded interviews should be treated differently.
SFC freezing injunctions
At the end of the year, the High Court ruled that the SFC can apply to freeze assets up to the amount of a prospective financial penalty. In The Securities and Futures Commission v A , the SFC had obtained the first ever freezing injunction in a case of suspected insider dealing. The value of assets frozen was calculated on the basis of the likely amount in the event a financial penalty. The court held that legislation was wide enough to allow the SFC to do so.
In 2007 the SFC announced its long awaited proposals to give statutory backing to certain Listing Rules, so as to address the lack in both policing powers and available penalties for breaches under the current regime. The relevant Listing Rules focus on core continuing disclosures of most concern to minority shareholders. The proposed approach is three tiered: (1) broad general principles will state the standards expected by the market and the spirit behind the existing Listing Rules, (2) further explanations of the principles will be added as a new Schedule to the SFO and (3) a non-statutory Listing Code will contain detailed and technical provisions. The implementation of these proposals is still some way off, with another possible public consultation in the pipeline.
Another important development was the commencement of legislative changes to implement the long debated Civil Justice Reforms. The reforms aim to improve the cost-effectiveness of the civil procedure system and to reduce complexity and delays in litigation. It is anticipated that the relevant legislative and court rule changes will be implemented by 2 April 2009 and will result in significant piecemeal reform of the current litigation process. Amongst other things, greater case management by judges, wider pre-action discovery and enhanced settlement offers will be part of the new regime.
Legislative procedures were instigated in 2007 to implement the landmark agreement signed by Hong Kong and Mainland China under which they agreed to recognise and enforce certain judgments made in each other's courts. The legislation will give effect to the agreement by providing for the registration and enforcement by the Hong Kong courts of money judgments, given by designated Mainland courts, exercising their jurisdiction pursuant to a valid exclusive choice of court clause contained in a commercial agreement. Although it was anticipated that the legislation would come into force in Hong Kong by the end of 2007, the legislative process has been very slow, and implimentation may still be a way off.
Another significant development was the government's announcement of its intention to adopt a cross-sector competition law in Hong Kong, departing from the present approach of sector specific regulation. The following anti-competitive practices will be restricted: price-fixing, bid-rigging, market allocation, sales and production quotas, joint boycotts, unfair or discriminatory standards and abuse of dominant position. The draft legislation is due to come before the Legislative Council in the 2008-9 session.
Class actions could be heading Hong Kong's way under wider plans to improve the civil procedure system. In 2007 the Law Reform Commission has established a committee to consider whether a scheme for multi-party litigation should be adopted in Hong Kong and, if so, to devise a suitable model for the jurisdiction. As multi-party litigation requires special management, a specific procedural regime for this area would be a welcome part of civil justice reform in Hong Kong.
The change in enforcement approach
At the end of 2006, a new Executive Director of Enforcement was appointed at the SFC. As a result, 2007 marked a divergence in regulatory approach from previous years. We summarise the developments below.
In 2007, the number of investigations handled by the SFC reduced by 30-40%. This reflects the fact that the SFC is now handling more complex cases and is targeting serious malpractices, as opposed to technical breaches of the rules. It is unlikely that this reflects an increase in compliance. Criminal prosecutions increased by 50%. Out of 120 charges, 111 related to market manipulation. The SFC also sought to increase the number of civil actions, notably injunctions seeking freezing orders over the last year. The SFC has also worked to increase the speed in which it deals with investigations. Over 70% of investigations are now completed within 7 months.
In 2007, the SFC focused its enforcement efforts into corporate governance failures, insider dealing, market manipulation and intermediary misconduct. Market manipulation accounts for the greatest percentage of all cases currently being handled. The SFC is also getting tougher on failure to cooperate with the SFC and on internal controls failures.
In May 2007 the SFC obtained for the first time a disqualification order against a director (Yick Chong San) for misfeasance / misconduct under the Securities Futures Ordinance. The director was banned for four years from acting as director or in the management of any listed company. The SFC has recently revealed that it has two other such cases waiting in the wings.
Another hot area of enforcement focus has been in relation to the misappropriation of client assets. In 2007, the SFC imposed two notices against brokerages restricting further operations (Man Lung Hong Securities Limited, August 2007 and Great Honest Investment Company Limited, November 2007). Freezing injunctions and orders prohibiting two individuals from leaving Hong Kong were also obtained in the second case.
In August, the SFC declared that it was "cracking down" on the secret operation of client accounts by licensees for personal trading. There have been a number of enforcement cases clamping down on this activity over the last two years, and there was a concentration of such cases in 2007. Finally, in December, the SFC took an innovative approach to the settlement of a case and for the first time imposed a suspended disciplinary penalty. South China Capital Ltd and South China Research Ltd agreed to engage an independent audit firm to carry out an internal control review within three years, and if found to have committed similar failures thereafter, would be suspended for 18 and three months respectively. Even more recently in April 2008, the SFC has for the second time imposed a suspended penalty, on similar terms (Core Pacific-Yamaichi Capital).
After a slow start, the wheels in the clog of the Market Misconduct Tribunal (MMT) have started to turn. The MMT replaced the IDT in April 2003 to provide for a civil regime for insider dealing (alongside a criminal regime). Yet, the first case only came before the MMT in August 2007. Two more cases have since come before the MMT, although no final reports have been released. Despite this slow start, we can expect cases to come before the MMT much quicker, following the MMT's criticism of the SFC and Financial Secretary's delays in bringing cases before it.
Also of note is that the SFC has recently launched its first prosecutions for criminal insider dealing since insider dealing was made a criminal offence in 2003.
Enhanced cross-border co-operation between Chinese and Hong Kong financial services regulators?
With so many Chinese businesses now having a listing on the Hong Kong Stock Exchange, the absence of any formal mechanism for co-operation between the China Securities Regulatory Commission (CSRC) and SFC in investigations, has been a major gap in the effectiveness of the Hong Kong regulatory system. However, co-operation between the SFC and CSRC has recently taken a step forward.
On 2 April 2007 the two regulators announced the exchange of side letters designed to enhance cooperation in cross-border investigations. It is hoped that the SFC will in future be able to use this arrangement to benefit from the CSRC's powers under Chinese law to seek to obtain evidence that would previously have been out of reach. Likewise, the CSRC may seek the SFC's assistance in interviewing Hong Kong-based witnesses and obtaining documents located in Hong Kong.
Further, in 2007 the CSRC became a signatory member of the IOSCO Memorandum of Understanding. This is another avenue that the SFC could pursue when seek regulatory co-operation from its Mainland counterpart.
Financial Reporting Council opened for business
In July 2007, the Financial Reporting Council (FRC), an independent statutory body for investigating audit irregularities and accounting infractions by Hong Kong listed entities, came into operation. Consultation on the FRC began in the wake of the Enron saga and in Hong Kong, the collapse of Euro-Asia Agricultural Holdings. The Hong Kong government sees the FRC as a key initiative to enhance the quality of Hong Kong's financial markets and boost investor confidence. The FRC has not yet released any investigation reports, but it is understood that one investigation is underway
Looking forward to 2008, we expect the key themes for enforcement to continue to be corporate governance failures, insider dealing (particularly since the SFC has recently launched its first prosecutions for criminal insider dealing) and market manipulation. Focus on internal controls is likely to remain. The SFC has recently released a circular on the implementation of risk management policies and procedures, which indicates that risk management may be a future area of contentious activity. We also expect to see greater co-operation with foreign regulators, particularly between the SFC and the Mainland regulators. We also expect the SFC to audio record more interviews in the future. We anticipate a continued reduction in the number of investigations handled by the SFC, in keeping with the SFC's aspiration to focus on the more serious regulatory infractions. Finally, we expect the SFC to be open to suspended penalties when entering into future settlement negotiations.
2007 saw the full implementation of the "Financial Instruments and Exchange Law" ("FIEL"): the most significant revision of the regulation of Japan's financial services sector since 1948. Japan's Financial Services Agency ("FSA") describes FIEL as a "New Legislative Framework for Investor Protection" and the goals of improved regulation of "Financial instruments businesses" and categorisation of investors by level of experience are clearly laudable. However, there is a sense amongst financial services sector executives in Japan, both domestic and international, that Tokyo's attractiveness as a financial market is in precipitous decline and that regulatory rigour can be overdone: the FIEL corset may look good, but it probably will not allow for badly needed growth.
Whilst Japanese banks hope to avoid much of the pain of the subprime loan crisis in the US, rumours circulate that losses on collateralised debt obligations (CDOs) could hurt some Japanese financial institutions. Ominously, TSE1 has fallen further in 2008 than most leading equity market indices. It is against this background of desperation at missed opportunities that legislative proposals have already been made to reduce the burden of regulation, such as the alleviation of "firewalls" between business units. These plans form part of the FSA's recent "Plan for Strengthening the Competitiveness of Japan's Financial and Capital Markets" (the "Plan"), published on 21 December 2007.
This review will look at FIEL and the Plan, the new regulatory mood that the Plan hopes to instil and recent enforcement actions. It concludes with a discussion of recent trends in shareholder activism in Japan. 2008 could be a busy year for regulators and financial services sector managers if the clarification that FIEL introduced can be followed by some market friendly measures.
FIEL only just implemented, but the "Plan" already needed
FIEL was approved by the Japanese Diet in June 2006 with full implementation of its provisions spread over the following 2 years. The most significant element of FIEL, which related to the legal framework for investment services (namely business registration and categorisation of investor groups), was formally implemented on 30 September 2007 (before the prescribed deadline of 13 December 2007). This element amended or abolished many laws that related to the regulation of, for example, foreign securities firms, investment advisory firms or the mortgage business. The resultant consolidation of many types of business under the category of "Financial instruments firms" which operate a "Financial instruments business" requiring registration was consciously based on similar regulatory schemes such as that operated by the UK's Financial Services Authority. FIEL also requires compliance with "rules of conduct" and seeks to categorise investors as, broadly, either "general" or "professional" investors. This rationalisation will be almost certainly beneficial over the long term but it has, in the short term, added to the burdens on senior managers, ensuring correct registration, and on sales staff, who need to be retrained to avoid the risk of inadvertent regulatory violations. The remaining phase of FIEL implementation requires enhanced disclosure by listed companies, particularly statutory quarterly reporting. It was hoped that these measures would bring Japan up to global standards in investor protection and corporate reporting.
The assumption is that such high quality financial markets will make Japanese capital markets more attractive to both domestic and overseas investors. Adopting an extra-legal viewpoint, such a view amounts to putting the cart before the horse: investors will put up with quite poor quality capital markets if they can share in economic growth and attractive corporate returns – as they did in the Japanese equity market during the 1960s, 1970s and 1980s or do in certain Asian stock markets currently.
The Plan is an attempt to reverse out of the dead-end in which Japanese financial markets and firms now find themselves. Details of the Plan can be accessed via the FSA's website but there are four highlighted policy areas:
- Creation of vibrant markets investors can have confidence in – particularly diversification of ETF funds and alliances between financial and commodity exchanges.
- Business environment that vitalises the financial services industry and promotes competition – see detail below.
- Improving the regulatory environment ("better regulation") – see detail below.
- Improving the broader environment surrounding the markets – these include developing internationally competitive human resources specializing in finance, law, accounting etc. and improving the urban infrastructure suitable for an international financial sector.
Legislative activity in 2008 is to be focused on improving the "business environment", although the content of the legislation is still unknown. Bills are expected to be introduced in the following areas:
- Revamp of the firewall regulation among banking, securities and insurance businesses – principally this is to involve lifting the ban on "interlocking officers and employees" and a relaxation of the restrictions on the sharing of undisclosed corporate customer information between banking and securities businesses.
- Broadening the scope of businesses permitted to banking and insurance groups – permitting commodities dealing, Islamic finance, emission trading, equity holdings for the purpose of corporate restructuring etc.
- Encouraging financial firms to manage conflicts of interest effectively – unfortunately, at this stage no meaningful detail is available about what this Bill might contain.
Amongst the Tokyo financial community, the alleviation of firewall restrictions is causing the most excitement. Managers report that recent discussions of such issues with the FSA now often conclude with the comment from the regulators that "there will be no need to worry about that firewall issue after September (2008)": so a major change in this area is widely expected.
These are all promising signs but until there is a true market in corporate control in Japan, that releases the considerable hidden value in the quoted sector, the attractiveness of Japan's capital markets can only continue to slide. Legislative or regulatory action can only achieve so much – and, however hard it is for a lawyer to admit it, that may be a rather limited amount in Japan's current circumstances (see below on the issue of shareholder activism).
Regulatory principles: "better regulation"
The other policy of note in the Plan concerns an improved regulatory environment by means of "better regulation" (which is also the term used phonetically in the Japanese language version). The modish profusion of borrowed English language phrases such as "rule-based", "principles-based", and "forward-looking approach" in the Plan's text, all transcribed phonetically into Japanese katakana, cannot disguise the fact that this "new" policy had already been announced by the FSA over the previous few months in press releases and speeches.
Nevertheless, the willingness of the FSA to justify its regulatory actions and pursue greater dialogue with industry participants is encouraging for the regulated in Japan. Clearly, the FSA wishes to signal a new beginning in which it relies less on "hard" raids, rigid enforcement and inspections and more on "soft" informal guidance, mutual understanding and discussions with market participants and overseas regulators. The Plan (and recent associated announcements) promises to translate more FSA manuals and materials into English, hold symposia to explain the FSA's approach, improve access and cooperate with overseas regulators amongst other worthy ideas.
Enforcement, prosecution of insider trading
Although the FSA now wants to show a softer side in its regulatory dealings, the prosecution of insider trading offences is currently being pursued more vigorously than in the past. Recent penalties have been high and intended to be exemplary. In January 2008 the former president of Homac Corporation was fined a total of ¥ 36.6m for insider trading (¥ 0.7m in fines and ¥ 35.9m in surcharges) – reportedly 10 times his profit from the suspect trade made in 2005.
FIEL has doubled the maximum imprisonment for criminal "unfair trading" from 5 to 10 years and increased maximum fines from ¥ 5m to ¥ 10m in the case of individuals (fines on corporates went from ¥ 500m to ¥ 700m). Similar increases were made in criminal penalties for "insider trading" (maximum imprisonment rose from 3 to 5 years and the fine on individuals rose from ¥ 3m to ¥ 5m). Recent news reports suggest that the FSA is proposing to double the insider trading penalties for individuals, following criticism that penalties were still too low. These might form part of the revisions to FIEL in 2008. There have also been calls for the maximum fines to be increased in the case of "civil money penalties" so that they act as a greater disincentive and increase the range of responses available to regulators.
The last twelve months have also witnessed a surge of shareholder activism in Japan. Last year corporate Japan faced a record number of shareholder proposals at AGMs, including those from foreign investors, stepping-up pressure on management to increase returns and manage their capital base better. At first sight, the outcome of these AGMs would appear to have dealt a blow to such activism: higher dividends proposals were roundly defeated, while about 300 Japanese companies approved pre-emptive advance warning systems ("AWS") or poison pills against takeover bids.
The most high profile example in 2007 was Steel Partners Japan's ("SPJ") launch of a US$ 260 million hostile takeover of Bull-Dog Sauce which resulted in the first deployment of a poison pill defence in Japan: the issuance of share acquisition rights ("SARs") to all shareholders and the re-purchase of those allocated to the "abusive" bidder. SPJ unsuccessfully took the question of discriminatory issuance all the way to Japan's Supreme Court setting a landmark legal precedent. The SARs repurchase cost Bull-Dog Sauce four-times its net profit for 2006-7 and diluted SPJ's shareholding to below 3%.
However, rather than retreat, it seems that the activists, with the firm belief that many Japanese companies' share prices are still significantly undervalued, appear set to continue their activities in Japan. On average, shareholder proposals at AGMs won a considerably larger percentage of votes last year than in previous years. Further, foreign investors are adapting their activism for the Japanese market: proposals are being framed more in the Japanese model of stakeholder rather than just shareholder value; bidders are complying fully with companies' AWSs (for example, SPJ in its latest tender offer bid for Sapporo); activists are also looking to assert board influence as much as building stakes by proposing value enhancement plans or board seats (for example, Children's Investment Fund proposals to J-Power).
Although corporate Japan is so far rejecting such advances, it is evidence of the increasingly adaptive approach of shareholder activists and it is safe to assume that this pattern is both likely to continue and, in the longer term, more likely to bring about successful shareholder intervention.
2007 was distinguished by the significant efforts required by financial services firms operating in Japan to achieve compliance with FIEL. This was not only the formal process of registration but also the retraining of many staff who sell financial products of all sorts domestically. Assuming favourable conditions in Japan's split Diet, this should now be followed in 2008 by further legislative change aimed at revitalising Japan's financial markets as envisaged by the Plan.
The wide range of financial products that can now be sold by, say, a bank branch in Japan should continue to expand and the firewalls that have hampered senior managerial efforts should be reduced. But this regulatory flexibility cannot address the poor returns on the domestic savings products that are being hawked to customers: namely the abysmal interest rates on domestic fixed interest instruments, the low level of domestic stock dividends and generally substandard returns on corporate equity. Until these are addressed, by internal corporate change or as a result of the efforts of shareholder activists, expectations of a financial market revitalisation should continue to be modest.