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6. Main Proposed Revisions to a draft for a composite Securities and Futures Bill

Main Proposed Revisions to a draft for a composite Securities and Futures Bill

Hong Kong - December 1996

F O R E W O R D

This paper contains the Commission's initial responses to the many valuable comments received on the contents of the consultation paper and the draft for a Composite Securities and Futures Bill published on 15 April 1996. It will be noted that the Commission has agreed with the thrust of many representations received and has modified its proposals accordingly. In certain other cases, the Commission whilst agreeing with the thrust of representations received has decided to put such representations in a 'wish list' of topics to be considered in the future.

The Commission welcomes any further comments on its proposed changes. These should reach The Chairman, Securities and Futures Commission, 12th Floor, Edinburgh Tower, The Landmark, 15 Queen's Road Central, Hong Kong by 6 January 1997.

EXECUTIVE SUMMARY

BACKGROUND

1. A consultation paper and a draft for a Composite Securities and Futures Bill were published on 15 April 1996 inviting comments from the public and the financial services industry on the proposed legislation. This document sets out the Commission's views in relation to comments received on major policy matters.
2. The consultation process after the publication of the draft bill included some 20 private briefings or public seminars, listed at Annex I, given by the Chairman and senior executives of the Commission. Altogether approximately 1,000 persons from the industry attended these briefings.
3. 50 written submissions, listed at Annex II, on the draft bill were received from the industry. The original period for receipt of comments was three months. This period was extended so that all comments received during the seven month period to 14 November 1996, including those of the Stock Exchange of Hong Kong Ltd. (SEHK) received on 22 October 1996, have been considered.

MAJOR POLICY MATTERS

4. The primary aim of the Draft Bill is to consolidate the various pieces of legislation covering securities and investments, futures and leveraged foreign exchange markets. In the process, some updating of the regulatory regime were inevitable to take account of changes in the markets since enactment of the main body of laws more than twenty years ago. These objectives have received widespread support. There is general agreement that the law on these subjects should be rationalized and enacted into a single ordinance. In addition to expressing support for individual proposals a number of commentators expressed reservations about, or opposition to, particular elements of the rationalization but only the SEHK indicated that "it would have tremendous difficulties in giving support to the passing of the draft bill in its published form".

Major changes stemming from the consultation process

5. In many cases, the Commission agrees with the thrust of representations received and has modified or introduced proposals accordingly; examples in the case of policy matters include -
   
   • not proceeding with the proposal to empower the SFC in particular circumstances to suspend or revoke licences with immediate effect;
   • following receipt of comments from the Hong Kong Association of Banks (HKAB), the Hong Kong Monetary Authority (HKMA), and bodies in the securities industry, making certain new proposals relating to exempt status within the licensing regime, which seek to address the concerns of all parties in the light of the serious policy concerns expressed by the Securities Review Committee in 1988;
   • introducing a new class of exempt persons, i.e. exempt futures dealers and exempt futures advisers;
   • clarifying the implications for fund managers and advisers of the definition of holding clients' assets;
   • redefining 'assets' for the purpose of Part VII to include derivatives;
   • repealing the 'sole business' requirement for leveraged foreign exchange trading companies;
   • agreeing that audited accounts should be lodged with the SFC within four months of the end of the financial year and not within three months as originally proposed;
   • abandoning the proposal in clause 8.6(2) to prohibit authorised financial institutions realizing securities except for repayment of loans/advances in relation to which securities were deposited as security;
   • removing specific directors' liability provisions for contract notes and statements of accounts other than for companies and directors involved in the leveraged foreign exchange trading industry;
   • restricting the scope of clause 8.6(4) in respect of intermediaries nominees in light of criticisms that the present provisions are too wide;
   • introducing public interest amendments to the insider dealing regime mainly suggested by the judiciary;
   • amending clause 12.5(1)(c) to limit its scope to untrue and misleading statements and to provide a reasonable belief defence similar to that in section 40A of the Companies Ordinance;
   • amending clauses 12.3 and 12.16 to clarify that stabilization activities are currently not permitted in Hong Kong or in Hong Kong listed securities;
   • proposing the inclusion of a 'good faith' defence to clauses 12.7 and 12.11 after considering concerns about the 'ought reasonably to know' test for culpability;
   • relaxing the unsolicited calls regime to limit prohibition to visits in person and telephone calls and to allow unsolicited calling of existing customers and professionals;
   • proposing that, with one exception (clause 9.2), only the Governor in Council should be enabled to make subsidiary legislation creating criminal offences and stipulating criminal sanctions and deleting the SFC's proposed powers to prescribe offences in rules (clause 14.13(3));
   • increasing pecuniary penalties in respect of misconduct to a maximum of $500,000;
   • redrafting clause 14.8, concerning the short selling regime, to reflect certain comments made. Proposed rules will be published prior to enactment of the Bill;
   • amending the definition of 'securities' in Schedule 1.

Major matters on which the Commission has maintained its view

6. Subjects on which the Commission has maintained its original views, or the thrust of the consultation paper and draft bill as published, include -

• its normal policy of consulting appropriately on the implementation of new or amended rules;
• the sufficiency of checks and balances in place to ensure that the independent and statutorily established SFC cannot successfully sustain abuses of its powers;
• the functions of the SFC to safeguard the interests of investors and to ensure that market transactions are conducted in fair, efficient, competitive and informed markets;
• the 'monopoly' status of the SEHK;
• the existence of the markets outside the SEHK and improving the Commission's ability to regulate them;
• the disposal of shares in the exchange companies when the owners are no longer licenced dealers;
• the levels of penalties;
• the powers to require a licensed person, or person to whom a licensed person is accountable, to transfer assets to a trustee;
• the making of Financial Resources Rules (being of a highly technical nature and which in any event are the subject of prior market consultation) without prior consultation with the Financial Secretary;
• the investor compensation proposals;
• the preservation of a limited number of strict liability offences which make directors liable for contraventions by the licenced entity. It will however be a defence for a director to show that he acted with reasonable diligence.

Matters to be considered further outside the context of the Bill

7. Whilst the Commission is sympathetic to certain other policy issues raised during the consultation, they will be dealt with separately from the rationalization process. They are -
   • whether there should be a professionals exemption for futures dealing and futures advising;
   • the making of rules permitting dealers to confer outside the Stock Exchange options on shares listed in the Stock Exchange where mischief will not ensue;
   • whether the professional exemption should be extended to include "institutional" or "accredited" or "sophisticated" investors or similar categorizations;
   • the lawfulness or otherwise of the grey market;
   • observations that the opportunity has not been taken to reform the area of the law relating to the offering of securities to the public;
   • further study of the insider dealing regime;
   • Part XIV secrecy provisions.

Minor policy matters and detailed technical points

8. In addition to comments on major policy issues, a large number of technical submissions were received regarding the detail of the draft bill. All points made have been considered; altogether some 200 amendments have been proposed to the draft bill. It is not feasible to include them in this document but they will, of course, be subject to scrutiny by the market and the legislature both when the bill is published and throughout the legislature process.

SCOPE OF CONSULTATION

9. The scope of the public consultation has been set out in paragraphs 1 - 3 above. However, the SEHK has expressed the view that it does not think the public consultation on the draft Composite Bill is or has been a complete one. The SEHK has also stated that "it is most unfortunate during the drafting stage of the Composite Bill over the last seven years, the Commission has not considered it appropriate to involve and to consult the Exchange on this piece of important legislation" and that had it been consulted some provisions on major issues which are, in its view, "either not practicable or disagreeable ..... would not have been included in the draft Composite Bill in its present form".
10. From the Commission's viewpoint there has been a large measure of consultation over the years, particularly from 1990 since when the SEHK has been kept informed of the proposals, invited to make representations, supplied with draft drafting instructions, supplied with a detailed policy paper, and invited to be involved in discussions on proposals for the draft Bill and its contents. Some details of this involvement are given at Annex III.

CONCLUSION

11. The Commission welcomes any further comments on its proposed changes following the receipt of comments given in relation to the consultation paper and the draft for a Composite Securities and Futures Bill published in April 1996. Further comments, if any, should reach the Commission's offices by 6 January 1997 to enable the Commission to finalize its proposals to the Administration.
12. Any further comments received thereafter will be forwarded to the Administration to enable these to be taken into account during the normal legislative process. In due course, the usual consultation will be undertaken in the case of any related rules to be made by the Commission.

COMMENTS ON DETAILS OF MAIN POLICY MATTERS RAISED IN RELATION TO THE CONSULTATION PAPER AND THE DRAFT FOR A COMPOSITE BILL

GENERAL

Rule Making Powers and Consultation

13. Observations were made to the effect that the Commission had reserved to itself wide and extensive rule making powers and that the rules to be made were not the subject matter of the consultation process. The power to make rules currently exists and is necessary and in the best interests of the market as it enables the SFC to address rapidly changing market conditions in a timely way. This cannot be achieved by primary legislation because of the lead time involved. All rules made by the Commission are, of course, subject to scrutiny (see: s.34(2) of the Interpretation and General Clauses Ordinance, Cap.1), by the Legislative Council, which has the power to amend or even repeal them. The Commission takes this opportunity to reiterate that, as in the past, it will consult the relevant sectors of the industry on the content of draft rules.

Checks and Balances

14. The SEHK made reference to what it described as the lack of checks and balances in the draft bill, suggested that the existing legislation is already deficient with regard to checks and balances mechanisms, and expressed general concern about mechanisms to guard against abuses of power. The Commission is pleased to note that, notwithstanding the foregoing, the SEHK expressed its full confidence in the Commission discharging its duties reasonably, fairly and honestly. Some other respondents appeared unaware of the arrangements currently in place for "watching the watchdog". That being so it is appropriate to emphasize that any subsidiary legislation made by the SFC may be amended or revoked by the Legislative Council and that disciplinary proceedings may be the subject of appeal to an independent tribunal. The actions of the Commission may also be the subject of judicial review by the courts and by the Commissioner for Administrative Complaints.
15. It is also worthwhile recalling that the Securities Review Committee (SRC), the Administration and the Legislature agreed that the SFC should be accountable to the Administration, that while it is not part of the civil service, it should be and be seen to be, part of the wider Government machinery. The SFC Ordinance empowers the Governor to appoint the Chairman and other directors of the SFC and to dismiss all or some of them. The Commission consists of five executive directors and five non-executive directors. The latter participate in policy formulation on the work of the Commission and keep an independent eye on the Commission's executive management and organizational matters. Under the Ordinance the Governor has the power to give the SFC directions and must approve the annual budget. The SFC is also obliged to present an annual report and statement of account to the Governor who lays them before the Legislative Council. In addition, regulatory actions undertaken by the Commission are subject to Judicial Review. A clear trend has emerged that persons who do not agree with the regulatory actions of the Commission are turning more and more to the courts for redress.
16. These are powerful checks and balances, particularly so against the background of the SRC recommending that matters concerned solely or primarily with securities markets and regulation should fall squarely to the SFC, that in particular, supervisory rules, such as capital ratios and conduct of business codes, and new market contracts should not need approval from Government, and that the Commission should ensure that the Exchanges properly regulate their markets and have extensive powers to intervene if they fall down on the job.
17. As indicated by the SRC, "while it is important that Government should continue to provide an overview, difficulties will arise if this becomes interference". The dividing line between pure security regulation issues and issues with wider implications is thin, perhaps increasingly so given the integrated nature of modern financial markets. In order to ensure the SFC's independence the SRC recommended that all statutory regulatory powers should lie with the SFC. This recommendation is in line with the perception, which continues to be current, in most advanced markets that regulatory agencies should be independent of political pressures. The Commission also draws particular attention to the SRC statement that "one of the failings of the (then) existing Hong Kong system has been the lack of distance" (between the market and the Financial Secretary). "In the early morning of 20 October 1987, the SEHK Chairman called the Financial Secretary who was subsequently, rightly or wrongly, presented as having been consulted on the market closure. In future, the Administration should be held in reserve. It will have an opportunity to hear the SFC and to take advice. If absolutely necessary it can overrule the SFC - if need be by direction but preferably by sheer political authority". This is the present position. The political authority rests with the Government whilst the regulatory and advising function rests with the Commission. The Commission sees no case for change.

Consultation

18. The SEHK's submission stated that its view that "it is most unfortunate that during the drafting stage of the Composite Bill over the last seven years, the Commission has not considered it appropriate to involve and consult the Exchange on this piece of important legislation". It had not been involved and consulted on this legislation. The SFC has difficulties understanding the concerns as during the evolution of the proposals, major issues, including the Review of the Licensing Regime, exempt status within that regime, were the subject of public consultation in which the SEHK participated actively. The current statutory monopoly of the SEHK, short selling, and investor compensation issues were raised and discussed over the years with the Chairman and/or senior executives of the Exchange and their comments/contributions were taken into account in developing these proposals. Annex III gives details of some of these contacts.
19. The SEHK stated in its comments that, if implemented, some of the major provisions of the bill "will seriously prejudice the interests of the Exchange, its members and the securities industry." The Commission would stress that it would like to see the Stock Exchange continue to grow as one of the great Stock Exchanges of Asia and the World, in keeping with the need, mandated in the Basic Law, to maintain Hong Kong's position as an international financial centre. The draft aim to do no more than this.

Extra-territoriality

20. Some respondents commented on the perceived haphazard inclusion or exclusion of the words "in Hong Kong" throughout the Bill. There is nothing repugnant in legislation which prohibits, and creates offences in respect of, conduct which occurs in Hong Kong or which affects Hong Kong. Legislation is assumed not to be extra-territorial unless the context requires. Accordingly the words 'in Hong Kong' will be removed except where they are necessary to distinguish acts in Hong Kong from acts outside Hong Kong affecting Hong Kong.

Securities (Disclosure of Interests) Ordinance

21. Work is continuing on preparing the legislative text to implement changes in the provisions of the Securities (Disclosure of Interests) Ordinance. This text will be published separately at some point with a view to enactment in due course but not as part of the current bill.

Companies Ordinance

22. Parts II and XII of the Companies Ordinance will be reviewed separately by the SFC following completion of the review of the remainder of the Companies Ordinance commissioned by Government.

INDIVIDUAL PARTS OF THE BILL

Part I - Preliminary

23. There was general support for most definitions being placed in a separate schedule. Indeed some commentators advocated all definitions being placed in one schedule. The latter proposals have not been adopted but those suggestions together with detailed comments on the wording of individual definitions have been considered and amendments proposed where necessary.

Part II - Securities and Futures Commission

24. Support was expressed for the explicit provisions in the Bill that a function of the SFC shall be to take all reasonable steps to safeguard the interests of investors and to ensure that market transactions are conducted in fair, efficient, competitive and informed markets.
25. The SEHK suggested that the meaning of the phrase "competitive and informed" markets should be clarified. The Commission has not proposed alterations to these particular terms but, as part of the wider machinery of Government, endorses fully the Financial Secretary's statement on Hong Kong as a financial centre set out in his 1996-97 Budget Addendum, i.e., "Government will continue to support the private sector in its drive to make Hong Kong the region's leading financial centre. This will mean encouraging the private sector in the development of new financial products and the provision of new services while, at the same time, maintaining the highest prudential and regulatory standards. The aim is to provide an open, fair and reliable operating environment in which Hong Kong's financial services and businesses can compete and flourish."
26. It is not proposed to adopt the suggestion that the legislation should include a right for the Exchanges to be consulted on any proposal to reduce the transaction levy although, doubtless, the SFC and the Administration would so consult before proposals are submitted to the Governor in Council.
27. The provisions of clause 2.14(5) are preserved. Their main purpose is to ensure that any property bought for use as offices (which would not be done without consulting the Administration) should not count as part of the reserves of the Commission when assessing twice annual operating expenses. This is the sum accepted as being a prudent level of reserves.
28. The SEHK suggested that since the arrangement has been working satisfactorily for the past five years, there should be some form of statutory recognition of the Memorandum of Understanding (MOU) Governing Listing Matters between the Commission and the Exchange in so far as it provides that certain functions in listing matters will be discharged by the Exchange and not the Commission. It is however difficult to see the need for this as the relevant legislation has already been amended in the manner set out in Appendix 4 of the MOU, to reduce the SFC's powers in relation to listed companies, to include a statutory immunity equivalent to that conferred on the SFC, and to transfer to the Exchange the Commission's statutory powers in relation to prospectuses of listed companies. It is integral to the relationship established by the MOU that the Exchange's front line role in relation to listing related matters is dependent on it continuing to observe its obligations under the MOU fully, in good faith and to the best of its ability and that the SFC can resume a role in the day-to-day regulation of listing related matters should the Exchange fail to do so. The MOU has to be operated flexibly in the light of market conditions and a spirit of co-operation between the Exchange and the SFC. To further entrench the Exchange's role in statute would be inconsistent with the spirit of MOU itself as an instrument intended to preserve a practical balance in the relationship between the Exchange and the SFC, which has contributed so far to the successful operation of the MOU in practice.

Part III - Securities and Futures Appeals Panel

29. The right of registered persons to be heard in person by the independent Securities and Futures Appeal Panel will be preserved. The right to be a party to any such appeal will continue to be limited to registered persons who are the subject of the disciplinary action.
30. Views were invited on the proposed provision (clause 3.2(3)(c)) to enable the SFC to specify that its decision to suspend or revoke licences should have effect where the Commission determines that its decision should, in the interest of the investing public or the public interest, come into operation before the time for making an appeal expires or an appeal is determined.
31. Commentators generally recognized that the aim of the proposal was to protect the public interest and the investing public but were mainly disinclined to support the enactment of the proposed power in the absence of external checks and balances. For example, suggestions were made that the immediate implementation of the decision should be subject to endorsement by the High Court or consultation with the Financial Secretary. It is probable that those or similar requirements would not result in speedier resolution of problems than is the case under the present system.
32. In these circumstances, notwithstanding the fact that the two exchanges and their clearing houses currently have such powers, this proposal is withdrawn. It could, however, be reinstated by Government and the Legislative Council during the legislative process if those bodies decide that the public interest and the interests of the investing public are such that such immediate powers should be available.

Part IV - Exchanges

33. The Commission's views on checks and balances have been stated at paragraphs 14 to 17 above. They are not repeated here. However, the Commission is the independent statutory authority on subjects under its purview and no change to that position is proposed.
34. Although the financial press has editorially, and has carried reports which, questioned the need to retain the monopoly of the SEHK, there was nevertheless a substantial sector of opinion expressed in the written comments that the current monopoly of the SEHK should be retained in the new legislation. But it was apparent from some submissions that the nature of the monopoly is not widely understood. The present position is that the Exchange Company recognized by the Commission shall have the exclusive right to operate a stock market in Hong Kong. The Exchange Company currently so recognized is the SEHK.
35. A stock exchange as envisaged in the current and proposed legislation performs three functions: (a) the provision of a platform for the listing of shares in public companies, (b) the provision of a platform for the trading of such shares, and (c) the regulation of its members. The proposed Bill provides that only one recognized exchange company may be authorised to operate a stock market in Hong Kong as it is not apparent that the securities market in Hong Kong requires more than one stock exchange at present. Furthermore, the SEHK has shown that it by and large caters to present market needs in relation to the three functions of an exchange. The transitional provisions of the Bill specify that the SEHK shall be regarded as the Stock Exchange Company on commencement of the Ordinance. The scheme of the proposed legislation therefore does not allow the recognition of a second Stock Exchange Company.
36. With a few exceptions, which included the SEHK, respondents were content that the existence of markets outside the SEHK should be taken into account and that the Commission should have the ability to regulate them within the scope of the regulatory framework by way of clause 4.12. Examples of these are electronic extensions of overseas markets, proprietary trading systems, and markets on the internet. Overseas exchanges are already easily accessible from Hong Kong and proprietary trading systems are best characterized as sophisticated brokerage operations rather than as stock exchanges. The Commission has almost no regulatory powers over such systems. They may engender serious investor protection and reciprocal market access concerns, and these concerns can only be addressed if there is regulatory oversight. There was also agreement that there should be further market consultation when the conclusions of the Working Group on Automated Trading Systems comprising persons from the market, the HKFE, the SEHK, and the SFC are published. The SEHK's suggestion that it should be the regulator of these systems will be drawn to the attention of the Working Group.
37. Comments were received on the contents of clause 4.4 which deals with transactions that may be conducted on an exchange. It was apparent that there was some confusion over its intent. Under the clause, the Stock Exchange will trade securities and the Futures Exchange futures contracts. Insofar as it is humanly possible, an attempt has been made to devise mutually exclusive definitions of 'securities' and 'futures contract' (these definitions appear in Schedule 1). However, it is impossible to forecast whether an instrument will in future be devised which falls within the definition of neither.
38. Clause 4.4 is intended to allow either of the exchanges to apply to trade an instrument which falls within neither of the definition of 'securities' or 'futures contract. In considering approval, the Commission will apply usual regulatory principles, namely whether the instrument is one whose properties are susceptible to systemic risk controls or to market manipulation and whether the members of the applicant exchange have the necessary expertise to deal with the risk controls and investor protection issues arising from trading of the instrument proposed to be traded. In appropriate cases, the Commission may consult the other exchange or other market participants.
39. The SEHK and connected persons advanced reservations regarding clause 4.5, an effect of which would be to ensure the disposal of shares in an exchange company when the owner was no longer a licenced dealer. In practice, this does not constitute a change to the existing law insofar as the SEHK is concerned, because section 11 of the Stock Exchanges Unification Ordinance already has the effect of prohibiting a person, whose registration as a dealer has expired or been revoked, from remaining a shareholder of the SEHK. Clause 4.5 merely confirms and clarifies this position in relation to exchange companies generally. The SEHK believes "that there is no real justification" for allowing a non-shareholder of the Exchange to use the facilities of the Exchange. Clause 4(5) provides that non shareholders may use the facilities on such terms as the company permits and the SEHK currently allows non shareholders to use the SEHK's facilities in the stock option market. No changes are proposed.
40. There was express support for the duties of the Exchange Companies being as provided in the Bill although the SEHK felt that some aspects of clause 4.6 could give rise to practical difficulties. The Commission will discuss these details with the SEHK separately to allay its concerns.
41. The provisions of clause 4.6(5), which require the Commission to be informed of the expulsion or suspension of a member of a market, which are retained, apply to a recognized exchange company; they are not specific to the SEHK.
42. The SEHK has suggested that clause 4.6(6) should be removed "as it cuts down on the autonomy of the Exchange" and would give rise to interpretation difficulties. As already stated the duties set out in clause 4.6 would apply to all recognized exchange companies and under the existing legislation the stock exchange company is subject to the duty to ensure a fair and orderly market and to act in the interest of the public, particularly the investing public. The Draft Bill would extend this duty so as to apply to, for example, the futures exchange company, and also require every recognized exchange company to enforce its rules and to maintain adequate and properly equipped premises, competent personnel and adequate systems, security and contingency plans. The Commission remains of the view that these requirements are necessary, particularly in view of the fact that modern trading systems are highly automated. It should also be noted that provisions similar to those in clause 4.6 may be found in the regulatory regimes of most advanced markets, particularly those in the U.S. and the U.K.
43. The Commission supports the provisions of clause 4.8 which, among other things, provides that any new rules and amendments to rules submitted by a recognized exchange company should be accompanied by an explanation of their purpose and likely effect, including their effects on the investing public, in sufficient detail to enable the Commission to decide whether to approve them or refuse to approve them. The SEHK objects to having a statutory duty to give such explanations to the Commission. It believes that the Commission should be of sufficient competence to decide on its own whether rules should be approved or not and that the Commission should be able to make its own assessment on the impact of rules without having to rely on the Exchange's explanation. The Commission believes that the provision of explanations (i.e. reasons) for changes should be both routine and unexceptionable.
44. The SEHK has reported that the Commission should not have (see clause 4.9) the power to prescribe trading and position limits. The Commission has such powers under the existing law which there are no plans to change.
45. One association of market participants intimated that the conduct of grey market trading (i.e. in shares of a new listing candidate before official trading on the Exchange begins) is a practice which many investment houses have avoided in Hong Kong believing it to be in some way unlawful. The association requested that the SFC clarify the position, one way or the other, and reflect the result in the Bill. There is no specific criminal offence of grey market trading whether under statute or at common law. But grey market trading is governed to some extent by sections 76 and 80 of the Securities Ordinance and certain SEHK Rules and may be unlawful in circumstances involving option and forward trading and short selling. This issue will be followed up outside the context of the current Bill.

Part V - Clearing Houses

46. No major issues were raised in respect of this part.

Part VI - Licensing of Intermediaries

47. A number of comments were received on the implications of the proposed definition of 'hold'. It is proposed that the definition be refined and, rather than being included in clause 6.1, that it be included amongst the general definitions which are contained in Part 1 of Schedule 1. The amendment which is proposed to the definition of "hold" is designed to clarify and narrow the scope of the definition contained in clause 6.1 of the Bill, most notably so that it will provide that where a person carries on business, he will not be regarded as holding property unless, inter alia, there is a connection between the property and the business. This is designed to ensure that a licensed person will not be regarded as "holding" another person's property where he does so in circumstances which are unrelated to the business for which he is licensed. Notwithstanding these changes, the provisions of the Bill will replicate the situation which currently prevails in practice that fund managers and advisers in the securities industry who hold or in effect have control over clients' property will be required to be licenced as securities dealers and comply with the requirements of that licensing regime, including the Financial Resources Rules. The Commission is strongly of the view that any lower level of investor protection is inappropriate and cannot be contemplated. Traditional fund management activities where the custodial function is separated from the asset management function will continue to fall within the investment advisor regime. This means that where clients' assets are held by an independent custodian or trustee, a fund manager or adviser will not be regarded as holding the assets, even if the custodian or trustee is within the fund manager's corporate group. However, if at any stage the fund manager or adviser "holds" clients' property then a dealing licence will be required.
48. Comments were made that an effect of clause 6.2(4)(c) was that exemption would not be accorded to entities which dealt on an agency, as opposed to proprietary basis, with professionals. This effect is intended and is consistent with the current policy that persons dealing as agents should come under regulatory oversight.
49. Suggestions were made that the 'professionals exemption' should be extended to include persons not necessarily falling within the current professionals definition such as "institutional" or "accredited" or "sophisticated" investors. These suggested refinements require detailed examination which will be addressed outside the Bill.
50. Representations were received that the 'professionals exemption' should be extended to futures. This proposal is not agreed in the context of the current bill but it is recognized that this subject merits further consideration. However, c.6.10 will be amended to include futures; new definitions of 'exempt futures dealer' and 'exempt futures adviser' resembling those of 'exempt securities dealer' and 'exempt securities adviser' will be included in Part I of Schedule 1. The bill's class exemption provision powers will also be amended to include futures.
51. Comments were received that the 'sole business requirement' for a leveraged foreign exchange trading company was outdated and should be abolished. The 'sole business' requirement was originally introduced for financial prudential reasons, namely, that a firm's capital base is not exposed to other business risks. In the light of the operation of the Financial Resources Rules and supervisional experience of leveraged forex firms, it is now considered that relinquishment of the 'sole business requirement' will not reduce the level of effective regulation of these firms. The SFC therefore recommends repeal of this existing legal requirement.
52. The LFETO in present form provides through the definition of leveraged foreign exchange trading that, as intended, spot foreign exchange transactions are governed by the LFETO, i.e. persons conducting spot transactions are required to be licenced unless exempt.
53. The Securities Review Committee recommended the total abolition of the exemption system. Subsequently, the SFC concluded, after a review of the system, that there was a need for aspects of the exempt regime to continue but that main-stream securities dealing of currently exempt persons and particularly the retail activities of banks, should no longer be exempt from regulation by the SFC.
54. There was general agreement on these middle-ground compromise proposals when the industry, the Hong Kong Association of Banks (HKAB) and Government, were consulted in detail in 1990. Implementation was deferred to allow the relevant legislation to be put in place including a right of appeal to the SFC Appeals Panel against a decision by the SFC to revoke exempt status.
55. Notwithstanding its previous position taken in the 1990 consultation exercise, the HKAB has now expressed its grave concern, and that of its member banks. It is now of the view that the proposals are neither in the best interests of the securities and banking industries, nor of their respective customers. HKAB is of this opinion mainly because of its view that all areas of banks' activities are closely supervised by the Hong Kong Monetary Authority (HKMA) and that they conform to high standards and comply with strict rules such as capital and liquidity requirements and observe capital adequacy requirements which are much more stringent than those which apply to stockbrokers. HKAB is concerned about possible duplication or conflict of responsibilities between the SFC and the HKMA, the cost of licensing bank staff as dealers, training costs for bank staff and concomitant administrative costs. It believes that the retail securities activities of banks are different from those of stockbrokers taking the view that, in essence, banks only provide a convenient point for their customers to gain access to the services of brokers.
56. The stock broking element of the industry takes the contrary view. It believes that an inherent and essential element of a level playing field for all industry participants is exposure to the same standards of regulatory oversight. This view is consistent with the actual regulatory approach adopted in most major financial markets in which the banks' securities and banking businesses are regulated by separate specialist regulators. Some securities professionals have, in line with the SRC proposal, advocated total abolition of the exemption system.
57. As a result of comments made by HKAB and the HKMA, SFC staff made a series of visits to five banks with the agreement of those concerned. A report is at Annex IV but briefly banks' securities clients do not normally have a relationship with the executing broker and the interposing of the banks can give rise to allocation and compensation problems, some client agreements were unsatisfactory and at one major group ample scope for abuse by dishonest staff was detected. Breaches of s.75 of the Securities Ordinance were noted as were contraventions of the Code of Conduct. But overall the securities operations of the banks visited were well run. They are certainly capable of generating increasing competition for traditional brokers, particularly small brokers.
58. In the light of the representations of the HKAB and the broking industry, the Commission has come to the following views -
    1. that in keeping with the prevailing trend in all developed markets and the views of the HKAB, the prudential supervision of banks should remain with the banking regulator, namely, the HKMA, notwithstanding that a bank engages in securities dealing and investment advice. This means that all capital adequacy and risk management matters shall remain with the HKMA;
    2. that although in all developed markets, all securities dealing and investment advisory activities are subject to conduct oversight by securities regulators and in light of this, and despite the fact that the SRC had recommended the total elimination of exempt status for banks, it is now proposed that only the following securities dealing activities come under conduct oversight by the SFC -
       1. market conduct associated with public offers and mergers and acquisitions of shares in listed companies;
       2. securities dealing involving retail clients (namely clients who are not 'private banking clients' i.e. they have assets under management of under US$1 million or those who are not private banking clients but who seek to buy and sell securities with a bank in an amount of less than US$1 million);
    3. that in order to assist banks to bridge to this system of conduct oversight every effort will be made to minimise the administrative burden on banks. In particular, the following facilities will be available to each bank -
       1. banks which act for clients to sponsor public offers of shares in listed companies or represent clients in dealing with the Commission in relation to mergers and acquisition of companies listed will be deemed to have complied with the proposed legislation if staff involved in such activities are accredited to a subsidiary licenced as an 'investment adviser'. Alternatively, the bank will be licensed as investment advisers but the SFC will defer to the HKMA in all 'capital' and risk management matters;
       2. banks engaged in non-exempt securities dealing activities will be deemed to have complied with the legislation if staff involved in non-exempt securities dealing activities are accredited to a subsidiary licenced under the new legislation for securities dealing. Alternatively, the banks will be licenced as securities dealers (in the same manner as four large Japanese banks which are already so licenced) but all prudential matters will remain with the HKMA.
    4. Unless banks wished to be licenced as 'investment advisers' or 'securities dealers', there will be no overlap of regulatory oversight between the Commission and the HKMA since banking staff involved in such activities will be accredited to SFC licenced non-banking subsidiaries. Where banks are so licenced, regulatory oversight by the SFC will be restricted to conduct questions arising from such activities while all other aspects of regulation remain with the HKMA. Any resulting matters of regulatory consideration will be conducted within the umbrella of the SFC-HKMA Memorandum of Understanding signed in 1995.
59. Representations were received that trust companies should continue to enjoy exempt dealer status on an "automatic basis". In fact trust companies currently do not have exempt status on an automatic basis. The SFC may declare trust companies exempt dealers under s.60(4) of the Securities Ordinance. In future most trust companies should be qualified to apply under clause 6.10(1) of the Bill.
60. Clause 6.15(7) is concerned with the misconduct of licenced persons. Since exempt dealers/advisers are not licenced, section 6.10(4)(a) is ineffective and redundant and will be deleted from the Bill. The existing clause 6.10(4)(d) is an adequate 'catch-all' provision where the conduct of an exempt securities dealer has been such as to warrant the revocation of his exempt status.
61. In disciplinary cases, the present system of issuing letters of mindedness to registered persons and allowing them the opportunity to be heard is retained. The Commission has been advised that under the existing legislation it is acceptable for it to stipulate that a response to a letter of mindedness is to be made in writing and that the courts would regard the opportunity to respond in this manner as being an opportunity to be heard within the meaning of the legislation. Notwithstanding the legal position, it has recently been contended that the opportunity to be heard means that the Commission is obliged to convene an oral hearing. Since the language of the existing legislation appears to have given rise to this misunderstanding, the opportunity is being taken to state expressly that where a person has the opportunity to be heard, the Commission shall in its discretion determine whether he will be heard orally or in writing. It is essential for the Commission to have such discretion because should it be obliged to convene oral hearings in all cases, the burden on its resources would be intolerable.
62. Registered commodity trading advisers presently effect market transactions through a licenced dealer. In future, commodities advisers holding client's property will be required to be licenced as commodities dealers. This would normally mean that the dealer must be a member of the Hong Kong Futures Exchange (HKFE). In these circumstances the Commission would, where appropriate, exercise its power under clause 6.11(2)(d) to exempt the applicant for a dealers licence from the requirement for HKFE membership.
63. Clause 6.11 will be amended to streamline dual licence application/exemption procedures.
64. The clause 6.11(4) provision regarding the grant of short term licenses to persons undertaking securities dealing or advising business in Hong Kong reflects a published statement of licencing practice.
65. As a result of the weight of comments received from the industry, it has been decided on balance, notwithstanding potential public interest and interests of investors concerns, to abandon generally (except in the limited circumstances of clause 9.2) the proposals that breaches of rules made by the SFC should give rise to criminal offences and sanctions. It is now proposed that breaches of rules made by the SFC should normally only give rise to criminal offences and sanctions when the offences and sanctions are specified in regulations made by the Governor in Council.
66. However, in keeping with overseas trends and to reflect the increasingly serious view being taken by the public and the SFC of misconduct by licensed persons (including failures to comply with statutory requirements and licence conditions and acts which are prejudicial to the public interest), it is proposed to increase the pecuniary penalty specified in clause 6.15(3)(c) to a level not exceeding $500,000. It is to be noted that where a person's conduct has been such as to make him liable to criminal prosecution and to the imposition of a pecuniary penalty under clause 6.15(3)(c), it is proposed that he may only be penalized once in respect of that conduct. The provisions of clause 6.15(7)(c) have also been widened to expand the scope of the misconduct which can result in the imposition of a pecuniary penalty. In view of both this and the proposed increase in the maximum level of a pecuniary penalty which may be imposed under clause 6.15(3)(c), it is also proposed to confer rights of appeal to the Securities and Futures Appeals Panel upon those against whom a pecuniary penalty is imposed.
67. It was suggested that non statutory codes generally including the Fit and Proper Criteria and Codes of Conduct should be incorporated into the Bill by reference. The Commission considers it inappropriate to incorporate these matters into the Bill and thinks it preferable for market participants to be able to have access to codes which are written in language which is less formal than that adopted in legislation.
68. The SEHK expressed disappointment that the draft Bill does not seek "to deal with 'dual registration' and 'dual supervision' of members and registered persons of the Exchange with an ultimate objective of putting them under the sole jurisdiction of the Exchange".
69. The concept of devolving the SFC's licensing powers to the SEHK was examined in detail but rejected by the Securities Review Committee, despite its coming down in favour of continuing the self-regulatory approach in the course of its comprehensive review of the regulatory framework governing the Hong Kong markets in 1987/88. The reasons can be found in chapter 10 of its Report. Briefly, these are the difficulties in maintaining uniform licensing standards across the market and the SEHK's ability and willingness to discharge the function in an efficient, effective and impartial manner.
70. Under the existing licensing system, "dual registration" and "dual supervision" in respect of SEHK members does not arise. The licensing system is required by the Securities Ordinance whilst supervision of members by the Stock Exchange arises from the status of membership. To argue that members should be exempt from licensing is akin to arguing that persons should be exempted from the laws of Hong Kong simply because they are members of a professional body, or a private membership association/club, which "regulates" their conduct.
71. The SEHK is, and remains, a private limited company, albeit with the current right to operate a stock market in Hong Kong having regard to the general interest of the market. It is not accountable to the public and many of its members have consistently declined such responsibility, the recent stance by many of its members and the Hong Kong Stockbrokers' Association against being included in the ICAC Ordinance as a public body being in example.
72. Moreover, the understandable but nevertheless inherent conflicts of interests of a private membership organization run largely by its members militate against consideration being given to the Exchange having sole responsibility for licensing, monitoring and disciplining its members and their staff. In any event, its "registration" system is based on membership criteria as opposed to an objective but rigorous "fit and proper" test and it has only limited powers effectively to regulate its members and their staff, as recent cases, including those of Wei Xin, Cheung Woon and CK Securities have shown.

Part VII - Supervision and Investigations

73. It has been said that the powers of investigation appear too broad and the penalty provisions unduly harsh, e.g. up to two years imprisonment for failure to produce records or documents or provide an explanation or make a statement. The powers of investigation remain essentially the same as they are under the current legislation. The Bill provides for higher penalties as a result of consistent calls by the Legislative Council for review. The penalties are over 20 years old and have now been set to a level advised as appropriate by Government's Legal Department, having regard to penalties in Hong Kong legislation.
74. Support was received for the proposition (clause 7.18) that the SFC should have power to order a licenced person or a person to whom a licensed person is accountable to transfer assets to a trustee to safeguard client assets if the risk of the assets being dissipated exists. The SEHK sees no reason why this should be the case. The Commission proposes to retain these provisions which are solely designed to safeguard client assets when necessary.
75. It has been suggested that it is not clear whether assets encompass derivatives. Accordingly, for the purposes of Part VII 'assets' will be defined as including securities, options, futures contracts and other similar contractual arrangements. Clauses 7.16, 7.17 and 7.18 are relevant.

Part VIII - Books, Records, Capital Requirements, Accounts and Audit

76. It has been observed, correctly, that the current s.28 SFC Ordinance requirement to consult the Financial Secretary prior to making Financial Resources Rules, has been omitted. We do not believe it necessary to retain the s.28 requirement as Financial Resources Rules are highly technical in nature and would in any event be fully exposed to the market for consultation before being made. The Commission, however, draws the point to attention for consideration by Government and the Legislature.
77. Clause 8.6 has been redrafted so that it does not apply to exempt persons. This means that exempt persons will not be required to hold and account for clients' securities or otherwise deal with them in accordance with rules made by the Commission.
78. The proposals in clause 8.6 regarding a minimum monitoring role for the SFC over nominee companies received support.
79. The proposals requiring audited accounts to be lodged with the SFC and published in a newspaper not later than three months after the end of the financial year have been represented as imposing practical difficulties for those involved. The Bill will be amended to revert to the currently obtaining four months.
80. There was adverse comment on the provisions of c.8.6(2), which is more restrictive than the current law. The clause prohibits authorised financial institutions realizing securities except for repayment of loans/advances in relation to which the securities were deposited as security. This was a well meaning proposal but we now agree that it could be counter productive. The proposal is abandoned and will be deleted from the Bill.
81. It is agreed that the provisions of clause 8.6(4) in respect of "intermediary's nominees" are too wide. It is proposed to amend the bill so that the sole business restriction is restricted to a nominee associated with a licensed person.
82. Complaints were made that the provisions of clause 8.8(4) with regard to liabilities of directors for contract notes and statements of accounts applied to all directors of securities, futures, and leveraged foreign exchange trading corporations. This was perceived as impracticable and unduly harsh. The clause will be amended so that it applies to a licenced person who is in contravention of the clause and, where the licenced person is a licenced foreign exchange trader, to every director or shadow director of the trader, as is already the case under to the LFETO.

Part IX - Business Conduct

83. The Commission believes it essential that it retains powers in respect of conduct of business codes.
84. Representations were received that exempt persons which are Licensed Banks and Trust Companies registered under the Trustee Ordinance should not be subject to clauses 9.1 and 9.2 as they are already sufficiently regulated in their conduct of business by Ordinance or at common law. The provisions have been retained. Some exempt dealers act as fund managers and should be subject to conduct standards. Compliance with such conduct standards could well prove less onerous than the alternative of loss of exempt status.
85. Clause 9.2 provides for criminal offences and penalties (not exceeding a fine at level 5, currently $50,000, and imprisonment for 6 months) for breach of business conduct rules made by the Commission in this specific and specialist area. The provision, which is similar to that in s.73 of the Leveraged Foreign Exchange Trading Ordinance, has been retained. (The Commission also notes that section 88 of the Sex Discrimination Ordinance (Cap 480) empowers the Equal Opportunities Commission to create offences by rules, breach of which may result in a fine not exceeding level 4 (currently $25,000) and imprisonment for 2 years). Clause 6.15(7)(c) will be amended to provide that contravention of rules made under clause 9.2 may also be dealt with by the imposition of a pecuniary penalty.
86. There was a considerable weight of feeling that clause 9.3, which mirrors section 76 of the Securities Ordinance, should not be enacted, a continuing prohibition on option trading by a licenced or exempt securities dealer being perceived to be outmoded. It was suggested that if the prohibition were not removed then, at least, rules could be made permitting dealers to confer options in cases where mischief would not ensue. The SFC proposes to adopt this suggestion. Clause 9.3 will be retained and rules, which will also apply when the Bill is enacted, will be made in the near future by the Commission under s.76 of the Securities Ordinance.

Part X - Investor Compensation

87. The fidelity insurance proposal in respect of dealers who are not exchange members was generally welcomed. There will be consultation with the industry before appropriate levels are set.
88. The SEHK has expressed strong reservations in respect of proposals for the future of the Unified Exchange Compensation Fund. The policy and concepts behind the Compensation Fund aspects of Part X of the draft bill were presented to the statutory 5-member Compensation Fund Committee in February 1993. The Committee included, and still includes, two nominees of the SEHK - the CEO and one other, usually a Council Member. The proposals presented flowed in part from SEHK's expressed desire to take on the administration of the Fund. The Committee supported a concept of modifying the per broker limit in the current legislation to a per client limit in revised legislation. It also supported the concept of "bare bones" legislation regarding the Compensation Fund with detailed provisions to be contained in subsidiary legislation. The concepts endorsed by the Compensation Fund Committee are now reflected in Part X of the draft bill. It should, be noted that the provisions in Part X of the draft bill are subject to the transitional provisions set out in paragraphs 27 to 29 in Schedule 8 (p.370 - 371 of the draft bill), which in effect means that Part X will not come into effect until future discussions between the Exchanges and the Commission result in agreement as to the administration of compensation funds. Until then, the transitional provisions retain the existing arrangements.
89. Subsequently in July 1995 the Compensation Fund Committee approved an actuarial study of the Fund to analyze the size of Fund that would be appropriate for various alternative compensation schemes. The final report of the actuary was received by the Committee in October 1996. This report will assist in the formulation of proposed revised compensation arrangements by the Committee with the participation of the two SEHK nominees. Any subsidiary legislation necessary will, as usual, be the subject of consultation.

Part XI - Insider Dealing

90. Observations were made that the Bill provides that investigation fees, tribunal costs and other penalties under clause 11.19(1) have to be paid before an appeal has been finalized or the time for appeal has expired and that this is unfair as is the fact that similar provisions currently apply, Securities (Insider Dealing) Ordinance s.23 and s.31. The Legislature enacted the provisions which are currently in force and it is not proposed that they should be repealed. Nor are amendments proposed to clause 11.19.
91. Some securities professionals expressed regret that the opportunity had not been taken to provide that insider dealing be a criminal offence in respect of which criminal penalties should apply at the same time as providing civil remedies for injured parties. The possibility of incorporating 'settlement' provisions was also mentioned. A comment was also made that, unlike clause 12.15, Part XI does not provide for statutory compensation and the saving of common law remedies. Nevertheless, a person who suffers loss through insider dealing will retain his legal remedies. However, we do believe that these are all important issues which merit further study when more experience has been gained from cases brought under the present insider dealing related laws.
92. As a result of comments from the Judiciary made during the consultation process amendments to the draft Bill are proposed in the public interest including -
    • to empower the Tribunal to require the SFC to conduct interviews, whether or not documents are also sought,
    • to give the Tribunal explicit power to order parties or witnesses to provide evidence by affidavit,
    • to give the Tribunal explicit power to order costs to the exonerated whose attendance at sittings has been necessary whether as witnesses or not,
    • to specify that a placement for shares to be issued should, in law, amount to insider dealing in appropriate circumstances, and

• to include appropriate 'contempt of Tribunal' provisions.

The proposed amendments do not give additional powers to the SFC.

Part XII - Market Manipulation

93. The proposal that bucketing should be a specific offence found favour although a number of commentators thought that it should be made clear that the bucketing provisions were not intended to prohibit OTC activities. It is proposed to amend the draft bill accordingly.
94. Interest was expressed by some respondents as to how the SFC would enforce laws relating to trans-border manipulation of the Hong Kong market. Enforcement in these circumstances, as in the case of manipulation of overseas markets from Hong Kong, will be facilitated by the existence of agreements with overseas regulatory bodies.
95. Clause 12.5(1)(c) has been said to extend liability for misstatements and omissions radically without allowing for any due diligence defence. It is now proposed to revise this clause so that it refers only to making an untrue or misleading statement of material fact and to a statement which is untrue misleading through the omission from it of a material fact. It is also proposed that a defendant will have a defence if he establishes that up to the time of making the statement he had reasonable grounds to believe, and did believe, that the statement was not untrue or misleading; this test is adopted from that in section 40A(1) of the Companies Ordinance.
96. It has been represented that c.12.7 and c.12.11 are so widely drafted that they could apply to such things as research reports and market commentaries, and information disseminated by newspapers. It was suggested that one test for culpability, 'ought reasonably to know', is too severe. Following consideration of these concerns the Commission now proposes that in a prosecution of a person for an offence under those clauses that the defendant has a defence if he establishes that up to the time of the dissemination of the information he acted in good faith and could not in the circumstances of the case reasonably have known, and did not know, that the information was false in a material particular or materially misleading.
97. Comments were made that the Bill will, in essence, make illegal all stabilization activities conducted anywhere in the world with respect to securities listed in Hong Kong and all stabilization activities in Hong Kong with respect to securities traded on a stock market outside Hong Kong. It was also suggested that provisions prohibiting stabilization should not come into effect until appropriate rules are made under clause 12.16 to permit stabilization activities. In fact stabilization activities are currently not permitted in Hong Kong or in Hong Kong listed securities. Clauses 12.3 and 12.16 will be amended to clarify this point.
98. It was also suggested that 'safe harbour', such as stabilization, rules made under c.12.16, albeit of a permissive nature, should be the subject of consultation. It is therefore suggested to Government that in the Secretary for Financial Services' speech on the Bill to the Legislative Council an undertaking be given on behalf of the SFC that there would be consultation with the market prior to promulgation of any rules made under c.12.16.

Part XIII - Offers of Investments

99. The current law and the proposals in the draft Bill were designed to preclude undesirable unsolicited calling. Cold calling can be both inappropriate and a nuisance. We believe that it should continue to be limited by law. But we have been convinced by the weight and cogency of representations from the market that cold calling prohibitions should be limited to a visit in person and telephone calls. Accordingly it is proposed that passive cold calling, e.g., by letter or facsimile, should be permitted. It is also proposed that existing customers and professionals not be subject to any prohibition. Part XIII will be amended accordingly. Also, in order to give the Commission the flexibility to respond to future market and technology changes, a rule making power will be added to clause 13.10 to permit the SFC to prescribe that particular activities are not unsolicited calls.
100. Some disappointment was expressed that the opportunity has not been taken to reform areas of law relating to the offering of securities to the public where there is said to be much uncertainty, particularly with regard to distinguishing offers to the public and offers of a private nature. The Commission believes that these issues will be best addressed at the time that the provisions of the Companies Ordinance are amended following the outcome of the separate review of that Ordinance commissioned by Government.
101. From comments received, it seems that some members of the industry believe that it is the Commission's view that an offer to 50 or less investors is not an offer to the public. This is not the case now, nor will it be the case on enactment of the Bill. Whether a particular offer is an offer to the public will continue to be determined under the law and on the facts of each case.
102. A representation made was that the most disappointing aspect of this Part is the failure to rationalize the statutory provisions regarding misrepresentation, with attention being drawn to the -
     
     • Misrepresentation Ordinance

       Money damages, rescission and damages in lieu of rescission for fraudulent, negligent and innocent misrepresentation (ss1-3).

     • Protection of Investors Ordinance

       Civil and criminal remedies for misrepresentations made fraudulently, recklessly, negligently, and in statements, promises or forecasts (ss3,8)

     • Securities Ordinance

       Criminal penalties for making false or misleading statements for the purpose of inducing the sale of securities (s138).

     • Companies Ordinance

       Civil and criminal penalties for misleading and false statements in prospectuses (ss40,40A) and in statements in lieu of prospectuses (ss30(2A),43(5)); and criminal penalties for false statements under (s349).

103. There may be some justification for adopting a new and consistent approach in respect of the provisions specified. However, the existing law is satisfactory and, it is thought, understood. Any reform is outside the scope of the current exercise. It may be examined further in due course.

Part XIV - Miscellaneous

104. The clause 14.1 secrecy provisions mirror those in the current law. It has been suggested that amendments should be made. This will be considered at a future date, not as part of the current exercise.
105. Commentators have recognized that in a dynamic industry there is a need for the SFC to have the ability to make rules in response to developments in the market place. Nevertheless, concerns have been expressed that the SFC's powers extend to making rules, without external scrutiny, which have statutory effect. The Commission has invariably consulted the market before making such rules. And all subsidiary legislation made by the SFC may be amended or revoked by the Legislative Council the specific attention of which must be drawn to such legislation at the sitting immediately subsequent to publication in the Gazette.
106. Respondents also felt that the SFC should not have rule making powers of a nature that, essentially, permit the SFC to decide what is, or is not, a criminal act or criminal omission to act and in respect of which the Courts may award fines or imprisonment. As a result of these representations it is now intended to delete the SFC's proposed powers to prescribe offences in rules (clause 14.13(3)), replacing it with a power for the Governor in Council to make regulations creating offences. With regard to disciplinary procedures concerning the misconduct of licensed persons, as distinct from prosecutions for criminal conduct, a pecuniary penalty of up to $500,000 is proposed.
107. The Leveraged Foreign Exchange Trading Ordinance, enacted by the Legislature in 1994 introduced, for companies which contravene the Ordinance, a stricter test of responsibility for directors of corporate traders than had customarily been the case under the Securities Ordinance and similar Ordinances. Directors may be prosecuted under the LFETO for offences committed by their company, but under section 66 of the Ordinance, a defence of 'reasonable' diligence is provided for. Essentially, the draft bill, as published for consultation, extended the liability of directors for the breach of certain regulatory provisions by LFETO licenced persons to their counterparts in the securities and futures industry.
108. Submissions from several market participants expressed clear opposition to these aspects of clause 14.9. Some other submissions expressed reservations. Reasons given for unacceptability included the view that strict liability offences are inappropriate and that the defences provided reversed the onus of proof and were very difficult to make out. This, in the view of many, would place directors, particularly non-executive directors, in an untenable position. The Commission has given careful consideration to these views and has reviewed the provisions of these strict liability offences which make directors (and shadow directors) liable for contraventions by the licenced entity but (for the reasons set out in the next paragraph) remains of the view that they are appropriate save that it is now proposed that the provisions of clause 8.8.(4) should not accord vicarious liability to directors (and shadow directors) of other than licenced foreign exchange trading entities for which a similar provision exists in the LFETO.
109. The SFC's view is that the proposed law addresses an issue of public and social concern. Strict liability offences should as a matter of principle be rare and should therefore only be promoted if they are necessary to effectively achieve the objects of the statutory framework by encouraging appropriate vigilance by directors to prevent the commission of prohibited acts or failure to act in accordance with regulatory requirements. All the offences in question are breaches of regulatory provisions which are fundamental in the operation of a licenced intermediary in the interest of investors protection. They deal with such fundamental questions as whether the firm is licenced, whether when it ceases business the fact is reported to the SFC, compliance with financial resources rules, keeping of proper accounts, segregation of client assets, appointing and dismissing auditors and reporting the same to the SFC, lodging of accounts with the SFC and the publication of financial statements. It will be a defence for a director to show that he acted with reasonable diligence and in practice, a different standard will be expected of executive and non-executive directors. Whereas the directors as a whole would be expected to ensure that the licenced firm has systems to ensure the compliance of the provisions in question including seeking appropriate reports to the board, executive directors will normally be expected to ensure that there is actual compliance as reported to the board. The Commission believes it entirely reasonable that such standards should apply to directors in the securities, futures, and leveraged foreign exchange industries. Persons who are unwilling to exercise reasonable supervision and reasonable diligence (the standards, depending on the particular facts of each case might well be different for individual executive and individual non-executive directors) should not accept directorships. If this view is wrong both the public and the Legislature may be expected to say so during the legislative process.
110. In the Commission's view, contrary to that of some members of the industry, maximum sentences have not been increased to such an extent that they are disproportionate to the crimes. The sentences are proposed on the advice of Government's Legal Department. They have been updated to reflect the gravity of the offences and to deter behaviour which is contrary to the interests of investors and the public interest. Trials are conducted and sentences are imposed by the Courts, not by the SFC, taking account of the circumstances of individual cases.
111. Some respondents thought that failure to supervise or to ensure compliance with administrative requirements should not constitute a criminal offence. The Commission's view remains that such conduct may be of such a serious nature as to justify criminal proceedings.
112. Some also felt that a breach of legislation (including subsidiary legislation), which constitutes a criminal offence should not also constitute an administrative offence of misconduct for which disciplinary or administrative action can be taken (and vice versa). Nor, they believe, should the decision as to whether to pursue the criminal or administrative route be left to the discretion of the SFC. The Commission is of the view that it is appropriate in many cases for both criminal and disciplinary or administrative action to be taken and that it is appropriate for the Commission to determine the action to be taken. In each case, the consequences of such actions are subject to review by independent bodies.
113. Clause 14.8 has been redrafted to reflect comments made on the short selling regime. Proposed rules in respect of short selling will be published prior to enactment of the Bill.
114. Observations were made that clause 14.10 extends the Commodities Trading Ordinance liability of principal for agent/employee to all areas covered by the Bill. It is intended to maintain this extension which confirms the common law position and clarifies some of the SFC's administrative powers.

Schedule 1

115. Amendments are proposed to the definition of "associate" and by way of the introduction of new definitions of "controls the composition of the board of directors of the corporation" and "substantial shareholder". These will be based upon the definitions introduced into the Securities and Futures Commission Ordinance in 1996 (after the publication of the Bill) to coincide with the enactment of section 26A of the Securities and Futures Commission Ordinance, and those introduced into the Leveraged Foreign Exchange Trading Ordinance at the same time, to coincide with the enactment of section 14A of the Leveraged Foreign Exchange Trading Ordinance. Sections 26A and 14A will be incorporated into Part VI.
116. The expression "associate" is already defined in Part 1 of Schedule 1. It is proposed that the definition be amended for the purposes of Part VI to coincide with the definitions referred to in the preceding paragraph, and that the existing definition be retained for the purposes of Parts XI and XII. These are the three Parts of the Bill in which the expression "associate" appears.
117. Whilst it is not proposed to amend the definition of "futures contract", an amendment to the definition of "securities" is proposed. This change involves the deletion of paragraph (c) which specifically includes within the definition of "securities", "options on stock indices, other than options which are futures contracts", returning the definition to a form which is much closer to the original version in the Securities Ordinance. It is thought that since the original definition has stood the test of time, important changes should only be made after further experience is gained in the operation of the new legislation.
118. It is to be noted that clause 4.4 (discussed in paragraph 38) will confer upon the Commission the ability, in response to market conditions and developments, to indicate whether, and in which circumstances, particular dealings are to be regarded as dealings in futures contracts, or in securities, or in both. The effect of this would be to introduce a necessary degree of flexibility to advance market development.
119. It is proposed that the Commission's rule making powers provided for in clause 14.13 of the Bill be expanded to permit the Commission to make rules prescribing whether or not transactions which are not conducted on the exchanges are to be treated as dealings in securities or futures contracts. This power is considered essential to enable the Commission to respond quickly to market changes and to regulate the market in a fair and efficient manner.

Schedule 2

120. Amendments are proposed to Part I clauses 15, 16, and 19 to facilitate the conduct of the business of the SFC by its directors.

List of Briefing Sessions and Seminars

Comments Received

Consultation with SEHK

The Exchange has been consulted at every practicable stage of the development of the draft bill. In the course of a public consultation exercise, the Commission wrote to the Exchange on 2 January 1990 soliciting its views on the review of exemption policy under the Securities Ordinance. The Exchange, in its response dated 5 March 1990 which contained the views of the Membership Committee, endorsed by the Council, supported the Securities Review Committee's recommendation to abolish exempt status, essentially for "equity" reasons. It argued that since the exempt policy was introduced in 1974, exempt institutions have engaged in securities business to a significant extent and were in direct competition with registered dealers, that, due to their exempt status, they had a competitive advantage over registered dealers and the regulatory framework necessary for the protection of investors did not apply to their activities. However, the Exchange added that it supported the Commission's reviewing the activities of existing exempt dealers as a first step in strengthening regulation.

The SFC issued the consultative document on Review of Licensing Regime to the public, including the Exchange, for consultation in November 1990. The Exchange, which responded in January 1991 stated that its Membership Committee had considered and in general agreed with the recommended changes contained in the consultative document. Amongst other things, the Committee considered that banks should not be granted exempt status, that overseas visitors could be granted licences provided they are licensed by their home regulators whose requirements are similar to those of Hong Kong, educational or experience requirements should be imposed on investment advisers and education as a qualification for a licence as a dealer should be retained. The Committee had reservations on allowing dealer representatives to work for more than one business entity and on the level of fines under the penalty system.

In March 1993, the SEHK was provided with a detailed policy paper concerning the proposals for regulation of the stock and futures exchanges. Shortly thereafter, a briefing was given to exchange and clearing house executive staff. SEHK executives expressed reservations concerning, among other things, the elimination of SEHK's "monopoly", disposition of SEHK shares by non-dealers, and the proposal that rule changes provide reasons therefor. Drafting instructions were not provided to the SEHK at that time as they had not yet been prepared.

In July 1993, following a request for an update by the SEHK, an additional summary of the legislative concepts was provided and the SEHK informed that the Commission had endorsed the proposals at its June 1993 meeting and had determined to proceed with the preparation of drafting instructions. It was also explained to the SEHK that in relation to SEHK's "monopoly" the existing legislation did not provide an effective monopoly and that it was otherwise inadequate in relation to electronic trading systems. SEHK's executives indicated that they would brief the SEHK Council and the SFC undertook to consult SEHK in refining the legislative proposals.

The SEHK's Executive Committee considered the proposals in July 1993. The SFC was informed that the SEHK would not be expressing any firm views on the proposals until the Council and SEHK members generally had been consulted. The SEHK asked that consultation take place on the draft legislation before the detailed legislation was submitted to the Governor in Council and published in the Gazette.

In March 1995, SEHK's Council formed an ad hoc Committee to study the legislative proposals and asked for copies of the drafting instructions for the draft bill. After obtaining the approval of the Financial Services Branch, the SFC provided SEHK with the draft drafting instructions in relation to Part IV of the draft bill concerning exchanges, Part VIII on financial regulation of intermediaries and Part IX on business conduct. The SEHK was also told that no completed draft legislation had yet been received as a result of these instructions. The point was also made that the drafting instructions were at that time subject to further analysis by SFC staff - this being an effort to respond to SEHK's concerns about its "monopoly" whilst maintaining an effective policy in relation to electronic trading systems.

On 22 September 1995, the Chairman SFC and staff met the Secretary for Financial Services and the Chairman SEHK and staff to discuss the proposed legislation. In direct response to SEHK's concerns, detailed revised drafting instructions were prepared by the SFC and provided on 2 October 1995 to the Law Draftsman and to the Financial Services Branch to preserve SEHK's "monopoly" and to retain certain terminology as advocated by SEHK.

The revised draft legislation was designed to address the comments of SEHK as reflected in a letter of 25 October 1995 from the SEHK's CEO to the Chairman SFC. The SEHK asked that the "monopoly" be retained whilst introducing legislation to regulate electronic trading systems. This is the effect of clause 4.3 (and the transitional provisions in Schedule 8 of the draft bill) and clause 4.12. SEHK has stated that the proposals should be drafted differently, but has not to date suggested any specific drafting amendments.

In February 1996, the SFC provided the SEHK with the draft bill and accompanying consultation document, subject to embargo pending public release on 16 April 1996. On 16 March 1996 the Chairman SFC and executive directors and staff provided a briefing on the draft bill to the Chairman SEHK, the head of the SEHK ad hoc committee, and senior SEHK executive staff. Advance copies of the draft bill and consultation document were also provided to members of SEHK's ad hoc committee.

Since the March 1996 briefing for SEHK and the April 1996 public consultation on the draft bill, the SFC has conducted more than 20 additional briefing sessions, including briefings for the Hong Kong Stockbrokers Association, the Hong Kong Securities Professionals Alumni Association and two open briefings for SEHK members.

Details of the evolution of proposals in respect of the Compensation Fund are at page 21 of this document.

Comments on Visits to Retail Securities Operations of Certain Banks

1. In August 1996 SFC staff made a series of visits to five banks, covering the spectrum of the sector, which deal in securities under their exempt dealer status.
2. Apart from securities dealing wholly incidental to "normal" banking operations, i.e. activities such as custodianship, collateral for loans etc., the banks generally "deal" in securities by buying/selling of securities on behalf of clients, as distributing agents for unit trusts, and in the course of private banking activities.
3. Banks with a retail involvement indicated that their securities dealing "services" are essentially ancillary/complementary to their core banking business. Staff refrain from giving investment recommendations. However, fact sheets on funds, with an "analysis" of risk ratings of the funds and clients, are available from at least one bank.
4. In terms of the buying/selling of securities, clients are normally required to have an account with the bank and to open a securities account to access the service. This is available at selected banking halls and through telebanking. Clients do not normally have a relationship with the executing broker, which is usually selected at the discretion of the bank.
5. Due to the interposing of banks between clients and executing brokers -
   1. client orders to the brokers are not necessarily made in the name of the client but in the name of a bank nominee;
   2. client orders are sometimes pooled, with the banks having discretion to allocate fills if the pooled order is only partially executed. No internal guidelines as regards methods of allocation to ensure fair treatment between clients were seen; and
   3. trade confirmations/contract notes are issued by the executing broker to banks, which then issue these to their clients, usually two days after trade date. This is in breach of section 75 of the Securities Ordinance, which requires contract notes to be issued to clients before end of the day after trade date.
6. The interposing of the banks between client and broker could cause some problems in the event of a "default" as only direct clients can claim against both the Compensation Fund and the Broker Fidelity Insurance Scheme in the event of a default.
7. All banks visited require clients to sign a client agreement prior to provision of the service. The client agreements of two major banking groups decline all responsibilities for the accuracy or authenticity of instructions passed, do not accept liability for any loss arising as a result thereof or for losses resulting from the actions or omissions of the executing brokers. This is contrary to SFC standard Client Agreement requirements and erodes investor protection safeguards, even though banks might not hide behind disclaimers in the event of problems arising. Some client agreements also contained a number of clauses which potentially disadvantaged clients. For example, clauses in the agreement of one major bank exempted it from disclosing commission rebates to clients. This contravenes code 13.2 of the Code of Conduct. None of the banks visited adopted the standard risk disclosure statement recommended by the Commission. In the case of one bank, in addition to not conforming to the standard recommended, the statement appears in print smaller than the rest of the client agreement.
8. The internal order processing and settlement/custodial control systems of all the five banks appeared robust generally although the arrangements at one major group left ample scope for abuse by dishonest staff and should be tightened. Nearly all the banks expressly prohibit their staff from offering advice. Some but not all banks ban all staff dealing while one major group has rules which ensure the anonymity of clients.
9. Most of the banks ensure that staff servicing their securities operations are properly trained with some banks visited offering the most vigorous training programme, which includes sending staff to the SEHK brokers' course.
10. Banks generally do not make any effort re "knowing their clients" or establishing their investment objectives. This means that they will have little or no ability to implement the suitability and best interest of client rules in the Code of Conduct. But this is an extremely difficult area and there is a respectable argument that these are less relevant to pure agency broking services where no advice is offered.
11. The scale of operations of the retail securities operations of the five banking groups visited is relatively small. Their combined volume was about 2% of daily SEHK turnover in dollar terms on average. They had 25,000 active clients. They offer convenient and reliable service to small retail investors through their branch networks and offer a very competitive service. There is a good deal of truth in statements by small local brokers concerning severe competition from the banks.
12. As banks operate under exempt status, they are not required to licence their staff separately. This, in addition to the current one-branch-per-seat rule of the Stock Exchange, means that their operating overheads can be lower than those of an SEHK member. The fact that they are not subject to SFC financial resources rules and code of conduct further skews the playing field in their favour. There is, therefore, policy justification for leveling the playing field somewhat by bringing their operations under the same level of regulation as that applicable to the general broking community.

Last update: 7 Aug 2012