Banks in Hong Kong carrying out traditional banking business as well as securities will have to reconsider their commercial and internal organizational structures, in light of the newly-enacted Securities and Futures Ordinance (SFO). The concept of a level playing field between banks and securities houses, which Hong Kong regulators have been implementing on an informal basis over the past few years, has now been firmly enshrined in the SFO. With a few exceptions, once the SFO takes effect, banks will be subject to effectively the same regulatory regime as other regulated entities carrying on securities business.
Hong Kong's regulatory regime
In Hong Kong, financial institutions may be regulated by more than one regulatory authority. Generally, they are regulated by either the Hong Kong Monetary Authority (HKMA) or the Securities and Futures Commission (SFC), depending on the types of activities that they carry out. Banks and deposit-taking companies (authorized institutions) offering traditional banking and deposit-taking services are supervised by the HKMA, whereas securities houses and other financial institutions (registered persons) offering services in relation to securities, futures contracts and related financial products are governed by the SFC. The HKMA derives its statutory power to supervise authorized institutions from one primary piece of legislation, the Banking Ordinance. However, until recently, the SFC has had to rely on more than 12 separate pieces of legislation for its statutory powers to supervise persons in the securities and futures industries. The SFO is an overhaul, and consolidation, of the previous fragmented supervisory framework.
It became clear during the SFO's public consultation period that many non-exempt market participants wanted authorized institutions carrying on a securities business that benefited from exempt status to be subject to the same rules and regulations as SFC-registered persons. The SFO creates this level playing field by introducing several key provisions applicable to authorized institutions, which are discussed in greater detail below.
Regulated activities
To appreciate the extent of the application of the SFO to authorized institutions, it is necessary to briefly set out the main types of activities that it will govern. These regulated activities are summarized below. The SFO prohibits any person from carrying on a business in any regulated activity unless an appropriate authorization or exemption is granted by the SFC, through its various powers under the SFO. The SFO also excludes certain activities from falling within each definition of a "regulated activity". A full analysis of the activities that are caught (or exempted) by the SFO is outside the scope of this article. The relevant provisions, and the SFO in its entirety, can be viewed on the SFC website (www.hksfc.org.hk) and on the Hong Kong Department of Justice website (www.justice.gov.hk).
Type 1: Dealing in securities
"Dealing in securities" means making or offering to make an agreement with another person to:
acquire, dispose of, subscribe for or underwrite securities; or
secure a profit from the yield of securities or by reference to fluctuations in the value of securities.
"Securities" is broadly defined in the SFO to include shares, stocks, debentures, loan stocks, funds, bonds or notes of any body or of a government or a government authority and includes any rights, options or interests in any of them. The definition catches a wide range of financial products including derivatives (if linked to securities), debt instruments, options and warrants. As a catch-all, the definition also includes any interests, rights or property commonly known as securities. Hong Kong's financial secretary may prescribe, by notice in the government gazette, any interest, right or property as being or not being regarded as a security for the purposes of the SFO.
The usual types of services or financial products offered by brokerage and securities houses and underwriters will be considered as "dealing in securities".
Type 2: Dealing in futures contracts
"Dealing in futures contracts" means making or offering to make an agreement with another person to enter into, or to acquire or dispose of, a futures contract.
Under the SFO, a "futures contract" is defined as any contract or an option on a contract made under the rules or conventions of a futures market. This would catch all agreements with a future delivery or settlement date, whether settled by cash or physical delivery, carried out on, or pursuant to the rules of, any futures exchange. As with securities, the financial secretary may prescribe, by notice in the government gazette, any interest, right or property as being or not being regarded as a futures contract for the purposes of the SFO.
Type 3: Trading in leveraged foreign exchange
The definition of this regulated activity covers any foreign exchange trading (not necessarily leveraged) or provision of financial accommodation to facilitate foreign exchange trading. Arrangements such as currency swaps, currency caps, currency collars, currency floors, currency options and spot foreign exchange contracts (spot only to the extent payments are made in the future) will generally fall within the definition of leveraged foreign exchange trading. The SFC may, by the making of rules, exempt any person or type of business from falling within the definition.
"Financial accommodation" is defined in the SFO to mean the provision of a loan or any other credit facility, including an overdraft, a discounted negotiable instrument, a guarantee or a forbearance from enforcing any debt that in substance is a loan.
Type 4: Advising on securities
"Advising on securities" means giving advice, or issuing analyses or reports, on the timing or the terms on which any particular securities should be acquired or disposed.
Investment advisers, analysts and researchers who advise or make recommendations in relation to the acquisition or disposal of securities will fall into this category.
Type 5: Advising on futures contracts
This definition mirrors the Type 4 definition, that is, "advising on futures contracts" means giving advice, or issuing analyses or reports, on the timing or the terms on which any particular futures contracts should be entered into.
Investment advisers, analysts and researchers who advise or make recommendations in relation to the acquisition or disposal of futures contracts will fall into this category.
Type 6: Advising on corporate finance
This is a new regulated activity and is primarily intended to catch advisory services provided in connection with public offerings, mergers, acquisitions and corporate restructurings of public or listed companies.
Type 7: Providing automated trading services
This is a new regulated activity and was introduced to address the growing number of internet trading systems. "Automated trading services" are services provided by means of electronic facilities, whereby:
offers to sell or purchase securities or futures contracts are regularly made or accepted;
persons are regularly introduced, or identified, to other persons in order that they may negotiate or conclude sales or purchases of securities or futures contracts; or
where these transactions may be novated, cleared, settled or guaranteed.
Providers of electronic trading platforms such as trade matching or settlement systems will be caught. However, bulletin boards and information vendors will generally fall outside the definition.
Type 8: Providing securities margin financing
"Securities margin financing" means the provision of financial accommodation to acquire, or maintain holdings in, securities listed on any stock market (whether inside or outside Hong Kong), whether or not those or other securities are pledged as security for the accommodation.
Type 9: Providing asset management services
"Asset management" means providing a service of managing a portfolio of securities or futures contracts for another person, and is a new category of regulated activity intended primarily to regulate fund managers and fund management houses.
Exemptions
There are numerous exemptions to each definition of regulated activity. Generally, intra-group dealings, dealings with professional investors, principal dealings and advice by certain professionals such as lawyers and accountants are exempted. The exemptions most relevant to authorized institutions appear later in this article.
Key features of the SFO for authorized institutions
Registration
Before the enactment of the SFO an authorized institution that dealt in securities was entitled to be declared as an exempt dealer. The declaration would be made automatically on application to the SFC. An authorized institution could therefore carry out the same activities as a registered dealer without submission to the usual SFC vetting process.
An authorized institution could also carry out investment advisory services in relation to securities, leveraged foreign exchange trading and securities margin financing without registration with, or a declaration of exemption from, the SFC.
The rationale for this approach was that the authorized institution, in the process of obtaining its authorization from the HKMA, would have already been scrutinized by the HKMA and would have been found to be "fit and proper". In addition, authorized institutions are subject to the comprehensive statutory provisions of the Banking Ordinance and to the supervision and regulation of the HKMA in respect of the whole of their business, including their securities business. The level playing field concept was enforced by the HKMA declaring that it expected exempt authorized institutions to have the same standards and practices, in relation to their securities business, as SFC-regulated entities. This included, for example, adherence to the SFC's Code of Conduct for Registered Persons and ensuring that employees who carried out securities activities were fit and proper to undertake those activities. Failure to do so could call into question the institution's fitness and propriety under the Banking Ordinance.
The initial proposal by the SFC in its public consultation paper in April 2000 was to keep the status quo by allowing authorized institutions to keep their exempt status to minimize regulatory overlap as was declared by both regulators. If the HKMA was satisfied that an authorized institution was fit and proper to carry on a regulated activity, the SFC would automatically make a declaration of exemption.
This approach was abandoned in the SFO provisions that were enacted in March 2002 when it became clear that participants in the securities and futures industries (other than authorized institutions) were firmly against the proposal. Authorized institutions are now required to apply for registration with the SFC as "registered institutions" if they wish to engage in regulated activities. The SFO sets out the procedure for this. In the first instance, any application for registration received by the SFC will be referred to the HKMA. The HKMA will consider the application and consult with the SFC about the merits of the application and advise the SFC on whether the HKMA considers the applicant to be fit and proper. The SFC will decide whether or not to register the applicant, having regard to any advice given by the HKMA and may rely wholly or partly on that advice.
When considering the application, the SFC may impose such reasonable conditions as it considers necessary, or amend or revoke the conditions or impose any new conditions as may be reasonable in the circumstances, in all cases only after consultation with the HKMA. An applicant aggrieved by any SFC decision may appeal to the Securities and Futures Appeals Tribunal.
It is clear from these provisions that the final decision is made by the SFC alone, although checks and balances are built into the process. An interesting question, though probably an academic one, arises if the HKMA makes a recommendation that the SFC does not accept. In such a case, provided that the SFC has undertaken the requisite consultation with the HKMA, and has acted reasonably and in good faith, it would be difficult for an applicant to challenge the SFC's decision on that basis alone.
Exemptions available to authorized institutions
Authorized institutions may, of course, elect not to register with the SFC. Under the SFO, they would still be able to carry on Type 3 (trading in leveraged foreign exchange) or Type 8 (securities margin financing) regulated activities. The exemption available in relation to Type 8 is available only where the financial accommodation is provided for the purpose of facilitating acquisitions or holdings of securities by the authorized institution's clients.
In addition, an authorized institution that seeks, and receives, registration in respect of the following regulated activities does not need to seek a separate registration for certain other regulated activities:
Registered for |
No separate registration for |
Type 1 (dealing in securities) |
Type 4 (advising on securities) or Type 6 (advising on corporate finance) with respect to certain offers to acquire or dispose of securities or where the provision of advice is wholly incidental to the dealing in securities |
Type 2 (dealing in futures contracts) |
Type 5 (advising on futures contracts) where the provision of advice is wholly incidental to the dealing in futures contracts |
Type 9 (providing asset management services) |
Type 1 (dealing in securities) and Type 2 (dealing in futures contracts) if such dealing is solely for the purpose of providing asset management services |
Executive officers
Under the SFO, SFC-regulated entities must have two "responsible officers" who must supervise the entity's business of regulated activities. Registered institutions will have to appoint two executive officers who will have a similar duty in respect of the regulated activities of the registered institution. The HKMA must consent to each appointment of an executive officer and must be satisfied that each executive officer is a fit and proper person and has sufficient authority within the institution to be an executive officer. There must be at least one executive officer who is available at all times to supervise the business of the regulated activities. This concept of "executive officer" is incorporated into the Banking Ordinance by the Banking (Amendment) Ordinance 2002 (BAO), which was enacted at the same time as the SFO.
The requirement that each executive officer must be fit and proper is also incorporated into the seventh Schedule of the Banking Ordinance. The seventh Schedule sets out the minimum criteria for authorization that authorized institutions (including registered institutions) must meet, on a continuing basis, to continue to be authorized by the HKMA. Breach of any of the minimum criteria is a ground on which the HKMA may suspend or revoke the authorization of, or take other disciplinary action against, the registered institution concerned.
Another change made by the BAO is to the eighth Schedule to the Banking Ordinance, which specifies the grounds on which the HKMA may suspend or revoke the authorization of, or take other disciplinary action against, an authorized institution. One of the grounds is where a person becomes or continues to act as an executive officer without the consent of the HKMA.
The combined effect of these new provisions is to ensure that registered institutions appoint properly-qualified and otherwise "fit and proper" persons as executive officers.
HKMA Register of Relevant Individuals
The HKMA has always kept a register for public inspection with the name and principal place of business and other details of authorized institutions. As a result of the BAO, the register will now include the name and details of employees (relevant individuals) of registered institutions who carry out "regulated functions". A regulated function is defined by the BAO as: "...any function performed for or on behalf of or by arrangement with the registered institution other than work ordinarily performed by an accountant, clerk or cashier".
This is a wide definition and would include directors, executive officers, front line dealers and possibly persons responsible for operational and risk management functions in relation to regulated activities. Relevant individuals cannot carry on a regulated activity for a registered institution unless their details have been entered into the HKMA register. As with executive officers, relevant individuals must also satisfy the fit and proper criteria.
Fit and proper criteria
The SFO provides for the following matters to be taken into account (along with any other matter that may be considered relevant) in the consideration of whether an applicant is fit and proper:
the applicant's financial status or solvency;
the educational or other qualifications or experience of the applicant having regard to the nature of the functions which, if the application is allowed, the applicant will perform;
the ability to carry on the regulated activity competently, honestly and fairly; and
the reputation, character, reliability and financial integrity of the applicant.
It is likely that the SFC and the HKMA will work together to determine a set of criteria that will apply to authorized institutions seeking registration under the SFO.
Business conduct
The SFC is empowered under the SFO to make rules, codes and guidelines relating to practices and standards that registered institutions must comply with, in the conduct of regulated activities. The breach of a rule is generally an offence that may carry with it significant penalties. The breach of a code or guideline is not an offence but would obviously have implications not only in terms of reputation, but also in terms of the regulators' perception of the institution's ability (and the ability of its relevant employees) to comply with the "fit and proper" criteria applicable to it. At the time of writing, the majority of these rules, codes and guidelines are being prepared by the SFC and have generally not been finalized or issued.
Rules are likely to be made covering both front-office (client agreements, information provided to clients, disclosure of interests, know-your-client requirements and so on) and back-office functions (record-keeping, confirmations of trades, and so on), as well as general business conduct issues such as cold calling, short selling, stock borrowing and lending. Registered or authorized institutions may be exempt from certain rules that are already the subject of HKMA regulations.
Notification and filing obligations
The SFO also imposes certain notification obligations on registered institutions, for example, in relation to any cessation of business in the regulated activity for which an institution is registered (as soon as reasonably practicable and in any event not later than seven days before the intended cessation), change of address (seven days' advance notice), change in information previously provided (within seven days of the change) and change in financial year end. In general, the notification is made to both the SFC and the HKMA.
Rules are also likely to be made in relation to a registered institution's dealing with client securities and collateral (and possibly client monies). In general, only a registered institution or an "associated entity" of the registered institution can receive or hold client assets. The concept of associated entities is new and its introduction is motivated by the common practice of using nominee companies to hold client securities by securities dealers and concerns that these nominees are not adequately regulated. An associated entity is essentially any Hong Kong company, or foreign company registered in Hong Kong, that is in the same group of companies as the registered institution or under common control with the registered institution (by having the same parent company, for example). Associated entities will have to comply with SFC rules in relation to client securities and collateral even though they are not SFC-regulated entities.
It is likely that certain rules will not apply to an associated entity that is an authorized institution, on the basis that they are adequately supervised by the HKMA.
Use of titles
Under the SFO, the use of certain titles is prohibited unless the relevant registration is held.
Registered institutions and their employees can use the following titles if they are registered for the relevant type of regulated activity.
Registration |
May use the following titles |
Type 1 |
bond broker, bond dealer, securities dealer, stockdealer, stockbroker |
Type 2 |
futures broker, futures dealer |
Type 4 |
securities adviser, securities consultant, stock adviser |
Type 5 |
futures adviser, futures consultant |
Type 6 |
corporate finance adviser, corporate consultant |
Type 7 |
automated trading service provider |
There is no prohibited title in relation to Type 9 activities, presumably on the basis that the titles "asset manager" or "asset management" are too generic.
Further, authorized institutions may use the titles "leveraged foreign exchange dealer" in relation to Type 3 activities and "margin lender" or "securities margin financier" in relation to Type 8 activities, without being registered with the SFC.
Disciplinary action
Under the SFO, disciplinary action may be taken by the SFC if a registered institution has been guilty of misconduct or the SFC is of the opinion that the institution is not fit and proper. The SFC may suspend or revoke the registration of the institution (wholly or in part) in relation to regulated activities, publicly or privately reprimand the institution or prohibit the institution from applying to be registered. In addition, the SFC may impose a fine not exceeding the greater of either HK$10 million ($1.28 million) or three times the profit made or the loss avoided by the conduct triggering the disciplinary action.
Similar disciplinary action may be taken by the SFC against executive officers and relevant individuals.
"Misconduct" for these purposes means any contravention of applicable SFO provisions, contravention of any conditions attached to an HKMA consent or any act or omission relating to a registered institution's carrying on of a regulated activity that is likely to be prejudicial to the interests of the investing public or the public in general.
Market misconduct
Registered institutions should also be aware that certain activities in the securities and futures markets are prohibited and significant civil and criminal penalties may be imposed on any person (and not only regulated entities) who are found to have engaged in them. These include false trading, price rigging, disclosure of certain types of information, stock market manipulation and other forms of market misconduct.
In conclusion, the leveling of the playing field by the regulators has resulted in fewer exemptions for authorized institutions in the carrying on of securities and futures activities and in enhanced disciplinary powers for the SFC in relation to these activities. Authorized institutions have some time to consider their options, as the SFO gives them two years before they need to register; thereafter regulated activities (other than Types 3 and 8) can only be carried on by authorized institutions that have applied for, and have been granted, registration. The SFO is expected to come into effect at the end of 2002 or in early 2003.