SFC Reminds Intermediaries of Compliance with Requirement to Report Material Breaches, Infringements or Non-compliance

Key Points

• The SFC has reminded intermediaries of applicable ongoing reporting requirements.
• Efforts by the SFC to ensure that intermediaries report, amongst other things, material breaches, infringements of or non-compliance with laws, rules and regulations administered by the SFC (and suspected breaches, infringements or non-compliance).
• Reminder follows the SFC becoming aware of intermediaries not properly reporting breaches of, or non-compliance with, applicable legal or regulatory requirements.

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Introduction

Further to circulars issued by the Hong Kong Securities and Futures Commission (the SFC) in May 2015¹ and in June 2018² addressing general notification requirements applicable to intermediaries under the Securities and Futures (Licensing and Registration) (Information) Rules (the Information Rules), the SFC issued a further circular on 14 September 2018 specifically addressing the reporting by intermediaries, to the SFC, of material breaches, infringements of or non-compliance with laws, rules, regulations or codes administered by the SFC (the Circular)³ in accordance with the reporting requirement within Paragraph 12.5 of the SFC’s “Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission” (Code of Conduct)⁴.

The Circular provides illustrative examples of non-compliance observed by the SFC in connection with the failure to report material breaches, infringements of or non-compliance by intermediaries.  The examples highlighted by the SFC serve as a reminder to intermediaries of the types of material breaches, infringements or non-compliance that must be reported to the SFC. 

General Reporting Requirement

Paragraph 12.5 of the Code of Conduct requires all licensed or registered persons to report to the SFC in certain circumstances, including (but not limited to) the occurrence of any material breach, infringement of or non-compliance with any law, rules, regulations, and codes administered or issued by the SFC, the rules of any exchange or clearing house of which the licensed or registered person is a member or participant, and the requirements of any regulatory authority which apply to the licensed or registered person, or where the licensed or registered person suspects any such breach, infringement or non-compliance whether by: (1) the licensed or registered person; or (2) any person employed or appointed by the licensed or registered person in order to conduct business with clients or other licensed or registered persons.

Scope of the Circular

The Circular specifically highlights the following types of reporting failures in accordance with Paragraph 12.5(a) of the Code of Conduct:

• suspected unlicensed dealing activities – an intermediary conducting Type 1 (dealing in securities) regulated activity in Hong Kong without: (1) holding a SFC Type 1 license; (2) being able to rely on available exemption (such as the Type 9 incidental exemption, or the “principal” exemption (applicable only to dealing conducted solely with respect to Category “A” Professional Investors)); or (3) appointing a third party service provider (holding a Type 1 SFC license) for the purpose of conducting the relevant “dealing” activity
• suspected unauthorized trading activities – covering trades that occur when an accountholder disputes certain transactions on the grounds that it has: (1) not placed the order(s); and/or (2) not authorized the account executive or the intermediary to operate the account
• failure to comply with “suitability” requirements - non-compliance with the SFC’s suitability requirements under Paragraph 5.2 of the Code of Conduct⁵. This requirement includes ensuring that an intermediary conducts: (1) an investor suitability analysis on all Individual Category “B” Professional Investors and all unsophisticated Corporate Category “B” Professional Investors; and (2) an analysis of all Corporate Category “B” Professional Investors, to consider whether: (i) appropriate corporate structure and investment process and controls are in place; (ii) the person(s) responsible for making investment decisions on behalf of the corporate Category B Professional Investor has sufficient investment background; and (iii) the investor has an awareness of the risks involved (considered in terms of the person(s) responsible for making investment decisions)
• failure to maintain records - breaches of the Securities and Futures (Keeping of Records) Rules⁶, which require intermediaries (and their associated entities) to maintain certain minimum accounting, trading and other records (depending on the regulated activity(ies) carried out) and to maintain such records in a manner that permit an audit to be carried out
• failure to provide contract notes / statements of account / receipts - breaches of the Securities and Futures (Contract Notes, Statements of Account and Receipts) Rules⁷, applicable to intermediaries licensed or registered to conduct asset management activity (and their associated entities)
• failure to record orders - non-compliance with the order recording requirements under Paragraph 3.9 of the Code of Conduct, being: (1) the requirement to record and immediately time-stamp agency orders and internally generated orders; (2) the requirement to use a telephone recording system to record order instructions received by telephone from clients (and to maintain telephone recordings for at least six months); and (3) the requirement to prohibit staff members from receiving client order instructions through mobile telephones when on the trading floor, in the trading room, in the usual place of business where orders are received, or the usual place where business is conducted (and to have a written policy in place to explain and enforce such prohibitions).

Recommended Action

In order to ensure compliance with the notification requirement of Paragraph 12.5 of the Code of Conduct, the SFC recommends that all intermediaries should review their incident escalation and reporting mechanisms and implement appropriate controls.

As these mechanisms and controls are ordinarily found within an intermediary’s regulatory compliance manual, intermediaries should consider whether any changes, by the intermediary, are required to existing internal policies and procedures.

Intermediaries should also consider necessary amendments to standard transaction documents, client agreements and other service provider agreements in order to ensure that the reporting requirement in Paragraph 12.5 of the Code of Conduct (and other reporting requirements applicable to intermediaries) can, at all times, be fully discharged.

Reminder – Timeline for Reporting to the SFC

Paragraph 12.5 of the Code of Conduct requires reporting to be made to the SFC immediately upon the happening of any of the stated events.

In the Circular, the SFC reiterated that all material breaches and non-compliance (whether actual or suspected, and irrespective of whether these were identified by the intermediary itself, stemmed from customer complaints or were identified through other sources) should be reported to the SFC as soon as practicable upon identification.

The SFC highlighted that intermediaries should prioritize the reporting of the material breach(es) / non-compliance(s) to the SFC, and that reporting should not be delayed by the intermediary awaiting the completion of internal investigations, obtaining legal advice and/or taking remedial action.

Reminder – Scope of Paragraph 12.5 Reporting Requirement

The reporting requirement in Paragraph 12.5 of the Code of Conduct applies to all licensed corporations and registered institutions.  The Circular noted that although the Hong Kong Monetary Authority (HKMA) is the frontline regulator with respect to registered institutions (such as licensed banks), in order to discharge the reporting obligation under the Code of Conduct, such entities must report directly to both the SFC and the HKMA.

The reporting requirement in Paragraph 12.5 of the Code of Conduct applies to the licensed or registered person “as a firm,” rather than to particular licensed individuals (such as a responsible officer of a licensed corporation).

Conclusion

The Circular highlights an area of particular concern to the SFC (failure to report) and is in line with the Intermediaries Supervision Division’s general policy of signaling to intermediaries those regulatory issues with which it is dissatisfied.

In light of the Circular, all intermediaries (both SFC licensed corporations and registered institutions) would be well advised to revisit their compliance manuals and operational policies and procedures relating to the reporting of material breaches, infringements or non-compliances to the SFC, in order to ensure that appropriate reporting mechanisms and controls are properly integrated into such policies and procedures.

Intermediaries would also be well advised to consider ways in which to cultivate an open compliance culture, within which the importance of SFC reporting is properly understood by all employees.

The Circular serves as a further reminder that the SFC is a vigilant regulator and carefully monitors intermediaries, in order to ensure compliance with standards imposed by the Securities and Futures Ordinance (Cap. 571) (SFO), the subsidiary legislation to the SFO, the Code, and the various circulars, guidelines and Frequently Asked Questions issued by the SFC from time to time.

Contact Information

If you have any questions regarding this alert, please contact:

¹ “Circular to Intermediaries Regarding Compliance with Notification Requirements” (May 2015) -

² “Circular to Intermediaries on Compliance with Notification Requirements” (May 2018) -

³ “Circular to Intermediaries: Compliance with Notification Requirement” (September 2018) -

⁴ “Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission” (20^thEdition, August 2018)

⁵ The requirement to ensure the suitability of the recommendation or solicitation for that client is reasonable in all the circumstances (as supplemented by the SFC’s Frequently Asked Questions on Triggering of Suitability Obligations” (23 December 2016) and “Frequently Asked Questions on Compliance with Suitability Obligations by Licensed or Registered Persons” (23 December 2016)).

⁶ Securities and Futures (Keeping of Records) Rules (Cap 571O)

⁷ Securities and Futures (Contract Notes, Statements of Account and Receipts) Rules (Cap 571Q)