Hong Kong’s Market Misconduct Tribunal (MMT), the statutory tribunal established to adjudicate civil contraventions of the Securities and Futures Ordinance Cap. 571 (SFO), recently cleared two persons of insider dealing: a former company secretary and a potential investor interested in acquiring the proposed sell-down of the chairman’s (and majority shareholder’s) entire stake in a listed company. This case confirms that civil liability for shareholders or other persons who trade when in possession of “inside information” is not triggered when the information is made public or becomes stale. The Securities and Futures Commission (SFC) argued that the pair disposed of their entire shareholding interest in the stock after becoming aware of information regarding its poor financial situation unknown to the market, thereby avoiding a loss before trading was halted. It was not disputed that the pair dealt in the shares while in possession of inside information. The case hinged on the market context within which the pair acted, including the knowledge available to the market. The defense was that the information on which they acted was not precise, was generally available or was unlikely to have a significant effect on price. Background In 2006, the company released annual results that showed a drop in net profits from HK$58 million to just HK$398,000. This led to a 14 percent fall in the stock price. The company subsequently defaulted in the repayment of bank loans, which culminated in tightening of credit and a series of writs issued by banks and other creditors for nonpayment, each of which the SFC alleged was not generally known to the market. Six months later the company published its interim results. This showed further declines in net profits from HK$20.4 million to just HK$2.19 million. The SFC viewed this as positive news and a sign that things were “improving.” The MMT rejected this optimism because it failed to take into account any market analysis. The MMT noted that the stock price had plunged to its lowest value on record following release of its interim results. The investor was interested in buying the chairman’s stake and restructuring the company, but neither came to fruition. He only injected HK$10 million. This loan was another event that the SFC argued was not known to the market. In 2007, the company announced a potential acquisition of an oil platform in China. A week later, it announced the resignation of its chairman and the company secretary. Following these resignations, the company secretary disposed of his entire shareholding in the company. The potential investor also withdrew his interest but was allotted shares in the company in exchange for the nonsettled loan, which he also disposed of shortly thereafter. This was followed by a series of announcements at the NEWS No liability for insider dealing when information is made public or becomes stale .....................................1 Expanding the regulatory regime—the pitfalls of writing negative research ....................................3 REGULATORY STANDARDS/UPDATES ........................5 INTERMEDIARIES/MARKET SUPERVISION .........................................6 KEY PRODUCT DEVELOPMENTS .......6 SIGNIFICANT ENFORCEMENT ACTIONS ...................7 Hong Kong Regulatory | DECEMBER 2016 • 2 Hong Kong Regulatory NEWSLETTER request of the Hong Kong Stock Exchange claiming the company was unaware of any reasons for the subsequent unusual price and volume movements in the stock. These unexplained movements attracted SFC scrutiny. The SFC took a closer look at the reasons behind the trading and began gathering information about dealings involving major shareholders or connected parties. Eventually the SFC directed all trading to be suspended. Trading resumed some six years later after a major corporate restructuring. The stock price plunged 69 percent, although this figure is misleading because it ignores the option offered to existing investors to purchase four new shares at a discounted price for each existing share held. When does inside information become stale? Among the questions the MMT had to consider was whether some or all of the information in question continued to constitute inside information at the time the alleged wrongdoers disposed of their shares—a question it said it had considered carefully and in some depth with the benefit of expert evidence. The MMT was critical of the shortcomings in the SFC’s expert evidence, in particular the failure to undertake any analysis of market movements. It was persuaded that even if the inside information might have been of contemporaneous interest to the investing public, the stock price had already declined to such an extent that the market would have regarded the news as being priced-in at the time of the disposals such that it was unlikely to have a significant effect. In particular, it noted that this view was supported by the market activity in the stock, which indicated investors had viewed the company as a shell that was undervalued and a target for acquisition. Furthermore, the issue of the writs—which it noted had been published in the press—did not have any adverse effect on the stock at all based on historical trading data. Taking into consideration all relevant external factors, the MMT unanimously held that none of the information (whether viewed individually or collectively) if generally known would be likely to materially affect the price of the stock at the time of the trading in question. What is the appropriate test to calculate the “notional loss avoided” when dealing with allegations of insider dealing? Even if it was wrong, the MMT went on to expressly reject the SFC’s calculations of the “notional loss avoided,” which is typically tested by reference to the actual shares sold and what would have happened had the shares been retained. It felt compelled to consider this aspect of the case to “establish guidance should something similar occur in the future.” It noted that the SFC based its calculations on two scenarios as follows. The SFC proposed that the MMT adopt the weighted average trading price in the week after trading resumed but ignore the 4-to-1 share option that had been taken up only by investors holding 55 percent of the share capital of the company (which if taken into account would in fact have resulted in a gain). In the alternative, the SFC argued that the extended period of suspension indicated that the pair had notionally suffered a total loss. The MMT dismissed the latter scenario as being premised on something “that simply did not happen.” As regards the former, the MMT held that it “flew in the face of common sense to ignore an event that did take place.” The MMT concluded it was “totally inappropriate and impossible” to assert that a notional loss had been avoided with any “credibility” based on the unique circumstances of the case. Conclusion There is no time limit under the SFO whereby inside information is deemed to be stale. Circumstances in which inside information may become stale include, for example, where previously confidential discussions on a major transaction are confirmed to have broken down or the information in question has been superseded by other events or developments that make it immaterial to an assessment of the company. In each case, a careful analysis is required of what, if any, information has been disclosed publicly since the receipt of the inside information and an evaluation of the continued materiality of the inside information at the particular time the recipient is considering whether to trade in the shares of the company in question. There is no time limit under the SFO whereby inside information is deemed to be stale. …a careful analysis is required of what, if any, information has been disclosed publicly since the receipt of the inside information and an evaluation of the continued materiality of the inside information at the particular time the recipient is considering whether to trade in the shares of the company in question. Hong Kong Regulatory | DECEMBER 2016 • 3 Hong Kong Regulatory NEWSLETTER Two recent Securities and Futures Appeals Tribunal (SFAT) and MMT decisions mark the first occasion the regulatory framework and specific regulatory obligations for statements of opinion have been examined in Hong Kong. EXPANDING THE REGULATORY REGIME—THE PITFALLS OF WRITING NEGATIVE RESEARCH Can statements of opinion, rather than statements of fact, lead to liability under Hong Kong securities laws? Two recent Securities and Futures Appeals Tribunal (SFAT) and MMT decisions gave a qualified answer to that question. The decisions mark the first occasion the regulatory framework and specific regulatory obligations for statements of opinion have been examined in Hong Kong. Liability for negative research under the licensing regime Rating agencies and analysts have come under increasing scrutiny from regulators in the wake of the subprime crisis when collateralized debt obligations (CDOs) and other complex financial instruments started to implode despite being assigned AAA credit ratings. Many investors argued that they had invested in exotic financial products at least in part because of the ratings they had been assigned, which prompted the need for urgent formal regulation. Under the Hong Kong regime, credit rating agencies (CRAs) and their rating analysts who provide credit rating services are required to be licensed for Type 10 regulated activity under the SFO and are subject to SFC supervision. All licensed CRAs and rating analysts are required to comply with the applicable rules, codes and guidelines of the SFC, including the Code of Conduct for Persons Providing Credit Rating Services (the CRA Code). When considering whether the CRAs and the rating analysts are fit and proper to become licensees, the SFC would in general consider the requirements set out in the CRA Code as one factor. If a licensed CRA or rating analyst is found guilty of misconduct, the SFC may take a range of disciplinary actions, including revocation or suspension of license, fines or public reprimand. Six weeks after inception of the new statutory regime in Hong Kong, Moody’s published a “red flags” report about accounting and governance warning signs indicative (albeit not conclusive) of impending credit risk for various Chinese issuers. The SFC was critical of what it said were errors in Moody’s report and alleged it had inadequate internal controls and procedures to ensure that its opinions were presented in a fair, accurate and nonmisleading manner. Following a three-year investigation, the SFC publicly reprimanded Moody’s and imposed a fine under its (newish) disciplinary jurisdiction over CRAs. Moody’s disputed the SFC’s power to sanction it and argued that the report was merely a useful “screen” for analyzing companies and did not fall within its regulated credit-rating activities. It also contested the fine on appeal to the SFAT, which reviews disciplinary decisions made by the SFC. The SFAT ruled that the report did form part of Moody’s regulated activity as a rating agency and fell within the SFC’s jurisdiction. However, the SFAT did not agree with the SFC’s claim that Moody’s failed to put in place adequate internal controls and procedures and reduced the fine imposed by the SFC from HK$23 million to HK$11 million.1 1 See Moody’s Investor Service Hong Kong Ltd v SFC (SFAT No. 4/2014) dated March 31, 2016 (pending appeal). Hong Kong Regulatory | DECEMBER 2016 • 4 Hong Kong Regulatory NEWSLETTER In its ruling (which is now itself pending appeal to the Court of Appeal), the SFAT held that an opinion cannot be a false statement unless the speaker does not actually believe it (and unless it is also objectively factually incorrect). However, a honestly held statement of opinion can still trigger disciplinary liability when it falsely implies that the speaker had a reasonable factual basis for the opinion or when the statement implies the existence of some fact that is untrue or misleading (notwithstanding the inclusions of appropriate qualifications or disclaimers by Moody’s that the SFAT felt “added confusion, building into the report a fundamental contradiction”). In this context, the SFAT held that the fact that there was no significant correlation between the number of red flags and the credit risk of the issuer fell short of the SFC’s required due diligence requirements. The SFAT noted that “despite internal concerns as to the accuracy of the red flag framework, Moody’s persisted in the publication.” Liability for negative research under the market misconduct regime A few months later, the MMT, being the statutory body responsible for deciding whether any person (whether or not licensed or registered with the SFC or resident in Hong Kong) has engaged in market misconduct, ruled that a U.S.-based short-seller’s stock commentaries can give rise to civil liability for market misconduct under section 277 of SFO2 when the speaker had no reasonable factual basis for the opinion (or part of it) or when the statement implies the existence of some fact that is not true if it is likely to induce others to deal in the market.3 The case involved the publication of a highly critical report on a major P.R.C. property developer, which made serious allegations of insolvency and various forms of accounting fraud. The short-seller denied liability. He explained that he had received an anonymous package by mail containing in draft the same analysis that he later chose to use in his publication. As part of his defense, he contended that he did not accept the contents of the package at face value but went through a fact-checking exercise, relying only on information in the public domain before “eliminating all information that could not be verified.” While the MMT did not find that the short-seller “knew” that his factual allegations were false or misleading, it was critical that no attempt had been made to approach the company in question for comment or seek advice from relevant experts. It held that factual assertions of this nature could not “in all integrity” be made “without an understanding of applicable accountancy standards and yet, on the evidence, it was apparent that [he] had taken no steps to ensure that his assertions of fact were made in the knowledge of those standards.” The MMT concluded that “for a professional [market commentator and/or analyst] in the field, bearing in mind the very serious nature of those assertions, this was recklessness of a gross nature.” Accounting for the fact that the attack on a prominent listed company in Hong Kong was not “one off” but part of a wellestablished track record likely to be repeated, the MMT imposed the maximum five-year “cold shoulder” order and forced the short-seller to disgorge his gains from shorting the shares of the company totaling HK$1.5 million. In coming to this determination, the MMT noted that whatever cynicism short-sellers might hold about Chinese companies, the end does not justify the means “no matter what the collateral damage to general investors.” Conclusion After a recent spate of concerns in the market about accounting misconduct and governance scandals involving distressed mainland corporations, as well as a new statutory licensing regime to regulate credit rating agencies, these decisions arguably provide important guidance on the professional standards expected of SFC licensees and others to act with due skill, care and diligence and on the integrity of the market when writing negative research. 2 Section 277 of the SFO prohibits the dissemination of false and/or misleading information inducing transactions. 3 See MMT Report in Evergrande Real Estate Group Ltd dated August 26, 2016 (pending appeal). …a honestly held statement of opinion can still trigger disciplinary liability when it falsely implies that the speaker had a reasonable factual basis for the opinion or when the statement implies the existence of some fact that is untrue or misleading (notwithstanding the inclusions of appropriate qualifications or disclaimers… …U.S.-based short-seller’s stock commentaries can give rise to civil liability for market misconduct under section 277 of SFO when the speaker had no reasonable factual basis for the opinion (or part of it) or when the statement implies the existence of some fact that is not true if it is likely to induce others to deal in the market. Hong Kong Regulatory | DECEMBER 2016 • 5 Hong Kong Regulatory NEWSLETTER REGULATORY STANDARDS/UPDATES SFC proposes major rewrite of Fund Manager’s Code of Conduct (FMCC) November 2016: The SFC announced a three-month consultation to rewrite the FMCC to address potential conflicts of interest, liquidity management, leverage, custody of fund assets, valuation, reinvestment or re-hypothecation of cash or other forms of collateral received in exchange for securities lending, repo or similar OTC transactions, as well as fund reporting and enhanced disclosure requirements for funds or managed accounts. If implemented, the proposals will also (i) restrict a fund manager from representing itself as “independent” if it receives commission or other monetary or non-monetary benefits which is likely to impair its independence and (ii) require a fund manager to disclose the range and maximum dollar amount of any monetary benefits received or receivable that are not quantifiable prior to or upon entering into any transaction. Reforms to derivative position limits regime September 2016: The SFC launched a one-month consultation to enhance the Securities & Futures (Contract Limits and Reportable Positions) Rules, Cap. 571Y. The position limit regime establishes different levels of position limits and large open position reporting requirements for different exchange-traded futures and options contracts. If implemented, the reforms will (among other things) triple the statutory limit for stock options contracts, and asset managers that meet certain specified criteria may seek the SFC’s authorization to hold or control exchange-traded futures and options contracts in excess of the statutory limit for fund management activities. SFC updates FAQs on collective investment schemes involving real property June 2016: The SFC released updated FAQs on offers of investments under the SFO outlining its views on arrangements involving the growing practice of schemes to sell interests in real estate projects to Hong Kong investors. The updated FAQs remind those who wish to operate, manage, promote or raise capital for any real estate project that such schemes may be deemed to be regulated collective investment schemes. The FAQs also clearly spell out the serious criminal consequences facing persons who issue marketing materials that contain offers to the public to invest in such projects unless appropriately licensed and/or subject to regulatory approval from the SFC. SFC updates FAQs on expanded short position reporting regime May 2016: Following the conclusion of the SFC’s consultation to expand the short position reporting regime to all designated securities that can be short sold, the SFC published revised FAQs to reflect the amendments to the Securities and Futures (Short Position Reporting) Rules (Rules). Starting March 15, 2017, market participants are required to report short positions in all designated securities, including collective investment schemes such as exchange-traded funds, real estate investment trust and other listed unit trusts/mutual funds. Under the existing regime, the reporting obligation applies to the list of specified shares published on the SFC’s website. Going forward, the SFC will stop sending email alerts regarding changes to the list of specified shares, and market participants are required to monitor changes to the list of designated securities published on the Hong Kong Exchanges and Clearing Limited (HKEx) website. Hong Kong Regulatory | DECEMBER 2016 • 6 Hong Kong Regulatory NEWSLETTER INTERMEDIARIES/MARKET SUPERVISION OTC derivatives—HKMA/SFC issue further consultation conclusions on clearing and reporting rules September 2016: In July, the Hong Kong Monetary Authority (HKMA) and SFC jointly published further consultation conclusions on technical aspects of the over-the-counter (OTC) regime, including detailed guidance on reportable transaction information/data fields as well as a mechanism to mask counterparty information in appropriate cases. With the subsidiary legislation now enacted, the first phase of mandatory clearing (which applies to certain standardized interest rate swaps) came into effect on September 1, and the second phase of the expanded reporting rules (which cover all OTC derivative products) will come into effect on July 1, 2017. SFC signs MoU with FINRA to increase supervision of cross-border entities May 2016: The SFC entered into a memorandum of understanding (MoU) with the U.S. Financial Industry Regulatory Authority (FINRA) to share upon request information (or arrange for such information to be provided on a voluntary basis even though no request has been made by the other regulator) on supervisory issues that enhance oversight of crossborder entities regulated by one or both agencies. The MoU, which came into effect on May 9, entitles both regulators to conduct on-site inspections of entities physically located in the other’s jurisdiction (even where regulatory inspections would not be available to the overseas regulator) in line with an MoU entered into with the Commodity Futures Trading Commission in December 2015. SFC recruits new head of enforcement May 2016: The SFC appointed Tom Atkinson as its new head of the enforcement division for a three-year term following Mark Steward’s departure in September 2015. Atkinson had been head of the Ontario Securities Commission enforcement branch, a role he held for seven years. In his inaugural speech at the seventh Pan Asian Regulatory Summit (hosted by Thomson Reuters), Mr. Atkinson stressed the need for the SFC to reassess its enforcement priorities, organizational structure and enforcement tools. He emphasized the need for “quality over quantity” and the desire to “[look] for ways to maximize speed and effectiveness” in key risk areas. KEY PRODUCT DEVELOPMENTS Hong Kong-Shenzhen Stock Connect scheme approved August 2016: Following launch of the Hong Kong-Shanghai Stock Connect scheme, the SFC announced the approval of the long-awaited cross-border link to trade shares listed on the Shenzhen Stock Exchange through Hong Kong (and vice versa). Trading commenced on December 5, 2016. It is worth noting that Section 295 of the SFO prohibits conduct in Hong Kong or elsewhere that creates a false or misleading appearance of trading on any automated trading service (ATS). The Shenzhen Stock Exchange is deemed to be an ATS. Therefore, manipulative trading on or via the new link will be caught regardless of the source of trading or where the relevant conduct occurs. Hong Kong Regulatory | DECEMBER 2016 • 7 Hong Kong Regulatory NEWSLETTER SFC concludes pilot initiative to expedite product authorization May 2016: Following the six-month pilot initiative to revamp the approval process for new fund applications, the SFC formally adopted the new fast-track procedure to streamline the time taken to vet and authorize offering documents within one to two months for new fund applications, including mainland funds seeking recognition under the Mainland-Hong Kong Mutual Recognition of Funds arrangements. Generally, applications for new subfunds under existing SFC-authorized umbrella funds managed by existing SFC-approved investment managers will be processed under a “standard application” stream. Nonstandard applications are expected to take two to three months. SIGNIFICANT ENFORCEMENT ACTIONS Internal control failures ■ November 2016: The SFC revoked an asset manager’s licenses and banned its responsible officer for 10 years following serious breaches of fiduciary duties as an investment adviser and related failures to disclose conflicts of interests to investors. ■ October 2016: A licensed foreign exchange dealer was fined HK$4 million for order execution malpractices. ■ September 2016: A major financial institution was reprimanded and fined HK$2.5 million for failing to monitor and comply with the prescribed position limits in breach of the Securities and Futures (Contract Limits and Reportable Positions) Rules, Cap. 571Y. ■ August 2016: The securities arm of a well-known U.S.-based investment bank was reprimanded and fined a record HK$18.5 million for (among other things) failing to maintain adequate written documentation concerning the design/operation/testing of its electronic trading systems. ■ July 2016: Two regulated entities at a large U.S.-based global investment banking group were publicly censured for failing to disclose trading activity in two companies after being hired to act as a corporate finance adviser. This was the second occasion this year the SFC has reprimanded foreign banking institutions for breaches of disclosure obligations under the Takeovers Code. ■ June 2016: An investment manager of an exchange-traded fund was reprimanded and fined HK$4 million for breaches of the Code on Unit Trusts and Mutual Funds involving (among other things) the failure to ensure that interest accrued on cash balances was deposited with a connected person. ■ June 2016: A major asset manager was reprimanded and fined a record HK$1.8 million for failing to disclose notifiable interests in Hong Kong-listed shares in client portfolios. ■ May 2016: A broker-dealer was reprimanded and fined HK$1.3 million for operational failures in its automated telephone recording facilities caused by faulty wiring that went undetected for several months. ■ May 2016: A licensed corporation was reprimanded and fined HK$2.7 million for failing to detect and report uncovered short sales and failing to self-report deficiencies in its internal control systems. Life bans and disqualification orders Life bans and disqualification orders were imposed on more licensed representatives and directors of listed companies: ■ Four life bans were imposed on relevant individuals (with disciplinary action being taken after criminal conviction) for various counts of fraud and theft relating to misselling investment products to retail customers in a sales commission scam and bribery. sidley.com AMERICA • ASIA PACIFIC • EUROPE Hong Kong Regulatory | DECEMBER 2016 • 8 Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Attorney Advertising - Sidley Austin LLP, One South Dearborn, Chicago, IL 60603. 312 853 7000. Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships as explained at sidley.com/disclaimer. Hong Kong Regulatory NEWSLETTER CONTACTS Alan Linning Partner, Head of Regulatory Practice Asia +852 2509 7650 firstname.lastname@example.org Effie Vasilopoulos Partner, Co-head of Investment Funds Practice Asia +852 2509 7860 email@example.com Dominic James Counsel, Securities & Derivatives Enforcement and Regulatory, Hong Kong +852 2509 7834 firstname.lastname@example.org ■ A 10-year disqualification order was imposed on a former officer of a listed company for diverting a potential transaction to acquire a coal mine without disclosing his interest in the target. Licensing-related issues ■ November 2016: An SFC-licensed trader was banned for 10 years following findings of fact made in abstentia by a foreign criminal court of conspiracy to manipulate an overseas futures market arising from orders that originated in Hong Kong. ■ October 2016: A major financial institution was fined HK$6.5 million after it self-reported it had carried on unlicensed regulated activities over a prolonged period of time for profit. ■ June 2016: An unlicensed corporation was convicted and fined HK$1.5 million for three counts of holding itself out as carrying on regulated activities, and its sole owner and director was sentenced to six months imprisonment (suspended for 18 months) for aiding and abetting. The corporation had entered into service agreements with three entities to advise on listing applications. Data privacy/Know Your Customer breaches/bribery ■ October 2016: A broker was suspended for one year following an Independent Commission Against Corruption investigation that revealed he had overstated his claims for reimbursement of client entertainment/meal expenses. ■ May 2016: A broker-dealer was reprimanded and fined HK$1.3 million for failing to answer a request to identify the ultimate client beneficiary of certain transactions within two business days (despite reminders from the SFC of its obligation to refuse transactions of those who are not prepared to provide information to regulators) in contravention of the Client Identify Rule Policy. ■ May 2016: A former relevant individual employed by a leading bank was banned for 12 months for unlawfully transferring client data/contacts to his new employer in breach of the Data Privacy Ordinance. Civil liability for late disclosure of inside information ■ November 2016: The MMT fined a Hong Kong-listed company and two senior executives HK$2 million after admitting to not disclosing inside information to the public regarding the commencement of insolvency-related proceedings abroad as soon as reasonably practicable. The disclosure was made a week late. This enforcement action was the first-of-its-kind taken by the SFC for breach of the statutory obligation to disclose inside information in a timely fashion under Part XIVA of the SFO, which came into force on January 1, 2013. A second action against another listed company and 10 senior executives is currently pending.