The Financial Services Authority (FSA) has today published a decision notice indicating that it has decided to fine Alberto Micalizzi £3 million and ban him from performing any role in regulated financial services for not being fit and proper. This is the FSA’s largest fine for an individual in a non market abuse case.

At the relevant time, Micalizzi was the chief executive officer and a director of Dynamic Decisions Capital Management Ltd (DDCM), a hedge fund management company based in London.

The FSA has also decided to cancel the permission of DDCM to conduct regulated business.  The FSA believes DDCM is failing to satisfy the threshold conditions and is not fit and proper, because it failed to ensure that its business was conducted soundly and prudently and in compliance with proper standards.

Micalizzi and DDCM have referred this matter to the Upper Tribunal (the Tribunal) where they and the FSA will each present their case.  The Tribunal will then determine the appropriate action for the FSA to take. The Tribunal may uphold, vary or cancel the FSA’s decision.  The Tribunal’s decision will be made public on its website.

The decision notice for Micalizzi, dated 20 March 2012, states that between 1 October 2008 and 31 December 2008, the master fund (the Fund) managed by DDCM suffered catastrophic losses of over USD390 million, approximately 85% of its value. In the FSA’s opinion, in late 2008, to conceal the losses, Micalizzi lied to investors about the true position of the Fund and entered into a number of contracts, on behalf of the Fund, for the purchase and resale of a bond (the Bond contracts). The FSA believes that the bond was not a genuine financial instrument and that Micalizzi was aware of this when he entered into the Bond contracts.

In the FSA’s view, the Bond contracts were deliberately undertaken by Micalizzi to create artificial gains for the Fund. The mechanism for this deception was simple: units of the Bond were sold to the Fund at a deep discount to their face value, and then valued by the Fund at approximately their face value when reporting to investors. 

The FSA believes that Micalizzi used this mechanism to book purported profits from the Bond Contracts of over USD400 million in late 2008, which counterbalanced the Fund’s losses enabling it to report a modest profit each month.  In total, Micalizzi used at least USD 7.5 million of the Fund´s (and therefore investors´) money in relation to the Bond contracts, despite knowing that the Bond was not a legitimate financial instrument.

Despite the losses suffered by the Fund, Micalizzi continued to seek new investors.  It is the FSA’s view that by providing false and misleading information he deliberately concealed the true value of the Fund from one new investor who subsequently invested USD 41.8 million on 1 December 2008.

In May 2009 the Fund was placed into liquidation.  The Fund’s liquidator estimated that the Fund’s assets on liquidation were worth approximately USD 10 million.  To date, no payment has been made to any investor by the liquidator.

In August 2010, Micalizzi was informed that the FSA had opened an investigation into his conduct.  The FSA has found that during the course of that investigation Micalizzi repeatedly provided it with false and misleading information.

Tracey McDermott, the FSA’s acting director of enforcement and financial crime, said:

“Those managing investments are in positions of trust and significant responsibility.  Although investing in hedge funds can carry greater risk than many other asset classes, investors in funds controlled by regulated hedge fund managers are entitled to be treated with exactly the same honesty and integrity as other firms.  Alberto Micalizzi’s conduct fell woefully short of the standards that investors should expect and behaviour like his has no place in the financial services industry and we are committed to tackling it wherever we find it.”

Notes for editors

1. The Decision Notices for Alberto Micalizzi and Dynamic Decisions Capital Management Ltd.
2. Micalizzi was in breach of Principle 1 of the FSA’s Statement of Principles and Code of Conduct for Approved Persons (APER). 
3. The FSA concluded that DDCM is failing, or is likely to fail, to satisfy the threshold conditions set out in Schedule 6 to the Financial Services and Markets Act 2000 (FSMA) in that, in the opinion of the FSA, DDCM is not fit and proper as it has failed to ensure that its business is conducted soundly and prudently and in compliance with proper standards in breach of Threshold Condition 5 (Suitability).
4. The FSA banned and fined DDCM compliance officer Dr Sandradee Joseph in Nov 2011 in a related case.
5. The FSA regulates the financial services industry and has four objectives under the Financial Services and Markets Act 2000: maintaining market confidence; securing the appropriate degree of protection for consumers; fighting financial crime; and contributing to the protection and enhancement of the stability of the UK financial system.
6. The FSA will be replaced by the Financial Conduct Authority and Prudential Regulation Authority in 2013. The Financial Services Bill currently undergoing parliamentary scrutiny is expected to receive Royal Assent by the end of 2012.

On 21 May, the SFC in Hong Kong announced the results of a consultation to form the Financial Dispute Resolution Centre that will provide a forum for resolving issues between buyers and sellers of financial products.  This is very important for banks and those in the retail industry, but it was the 'one more thing' at the back that interested us the most.

In this case 'the one more thing' is actually a few more things and they have nothing at all to do with the FDRC.

In the consultation relating to the FDRC the SFC slipped in a section where it asked the industry to continue an extension of the time that tapes are held for (not a big issue really), the banning of the use of mobile phones to take client orders (a bit more important), a requirement that firms provide expert witnesses to the SFC on request or have their fitness to hold a license called into question (now that is a doozy), and a requirement to report any suspicion of a breach of legislation, code or guideline by a client of a licensed firm to the SFC (that got our attention).

The last two items are important because of two separate points.  In relation to provision of witnesses, surely the SFC's relationship with the industry is now not so bad as to require compelling witnesses to help it in clear conflict with the common law duty that an employee has to devote his working time to his employer and not some third party.  The SFC has watered down a little bit its original proposal, but new amendments to the code of conduct will require firms to co-operate in this area.  The visual image of Hogan's Heroes and 'vee haff vays of making you talk' comes to mind.  The SFC was wrong to proceed in this direction.

The requirement for a firm to report on another firm has likewise been reduced.  That is very good news.  Previously there were significant concerns about how a firm could demonstrate compliance in this area.  It was certainly one of the weirdest SFC proposals that this writer has seen.

The revised proposal (and thus the new rule) only applies now to market misconduct issues and reduction to those issues is sensible and was really something worth waiting for from the SFC. 

The new rules (which come into effect in December) will require firms to report a suspicion of insider dealing, false trading, price rigging, market manipulation or rumour mongering.  Previously the consultation paper was too wide in calling for reporting of any breach of legislation, a code or a guideline. 

The SFC described the requirement to report as follows:

In response to feedback concerning the threshold for reporting clients and difficulties in determining whether clients have complied with applicable laws and regulations, we wish to clarify that we do not require firms to conduct any investigation or make any decision on whether or not a client has been guilty of misconduct. We simply require firms to report the facts or matters indicating that a client may be guilty of misconduct. This would include credible information received by a firm from a third party suggesting a breach or suspected breach has occurred. We would add that there is no duty on firms to report clients to the SFC based merely on unsupported speculation or vexatious comment.

Notwithstanding that guidance, firms will still need to engage in training about how to detect and report these issues and this will be costly.  It adds to the current range of actions that the SFC can take against an intermediary caught up in the actions of their client and has the effect of shifting more of the burden of proof to the intermediary to establish that they could not have known what the client was up to.

While the reduction in scope is welcome, the SFC has also not really gone far enough, in our view, of assuaging the serious concerns the industry had about a lack of legislative backing for these provisions.  The new provisions may still give rise to claims against firms making a disclosure either under the AML related laws of Hong Kong or in relation to breach of client confidentiality.  The SFC set out some cases and defences that firms may wish to raise if pursued for doing what the SFC wants them to do, but that is not an ideal way to do business when compared to the statutory protection that AML legislation provides in similar reporting circumstances.

Which brings me back to the 'one more thing' theme of this blog.  These new provisions are very serious.  Why they were lumped in with an important, but less controversial, topic like the FDRC is unclear and seems strange.  More thought is what is needed on these issues rather than the current amendments.  Financial intermediaries want to be sure that when they do (in good faith) what a regulator wants them explicity to do, that they are protected from action by their clients.  We are concerned that these new provisions do not appear to go far enough in that respect given that a decision has been made to proceed with the changes to the Code of Conduct.

Today the HK SFC announced a consultation paper on the sponsor regime.  Hong Kong remains one of the most active IPO markets in the world and thus any proposed changes to a sponsor regime can have significant effects to the local economy and the broader international capital raising market place.

The announcement read:

The Securities and Futures Commission (SFC) has launched today a two-month consultation on proposals to enhance the regulatory regime of sponsors.

The proposals combining new and existing sponsor requirements will become part of the Code of Conduct (Note 1). The key elements of the proposed regime include:

• When submitting a listing application:
  -　a sponsor should have completed the vast majority of due diligence;
  -　the first draft of the prospectus should be published on the website of Hong Kong Exchanges and Clearing Ltd; and
  - 　a sponsor should have resolved key issues concerning the operation, governance and structure of the company, and issues affecting the suitability for listing.
• Due diligence – a sponsor should:
  -　gain thorough knowledge and understanding of a company;
  -　adopt an open and questioning approach and should not accept statements at face value; and
  - 　collaborate and discuss with auditors, lawyers, directors and other experts to assess all information available to it about the company.
• Responsibility for disclosure – a sponsor should:
  - 　be reasonably satisfied through due diligence on the company that information in the prospectus is true, accurate and complete;
  - 　be able to demonstrate that it is reasonable for it to rely on accountants’, valuers’ and other experts’ reports in the prospectus – this does not involve repeating the work done by experts but involves testing the information provided in the reports to ensure that the totality of disclosure in the prospectus is credible and coherent; and
  - 　be closely involved in the preparation of the Management Discussion and Analysis section of a prospectus to ensure that sufficient qualitative information explaining the company’s track record is communicated clearly to potential investors.
• Resources and management – a sponsor’s Management should:
  -　ensure sufficient resources are allocated to an initial public offering (IPO);
  -　oversee the progress and the standard of due diligence; and
  -　be closely involved in resolving difficult issues.
• Restrict the number of independent sponsors for each listing to one only or a limited number.
• Make clear in sections 40 and 40A of the Companies Ordinance that sponsors have civil and criminal liability for untrue statements (including material omissions) in a prospectus.

"Sponsors play a lead role in coordinating an IPO. They advise and guide directors and are centrally involved in ensuring that prospectuses contain reliable and relevant information for potential investors,” said Mr Ashley Alder, the SFC's Chief Executive Officer. “Our proposals are aimed at encouraging best practice across all sponsor firms whom investors rely on as key gatekeepers of market quality.”

The public is invited to submit their comments to the SFC on or before 6 July 2012. Written comments may be submitted on line via the SFC website (www.sfc.hk), by email to sponsors@sfc.hk, by post or by fax to 2810 5385.

Both we – and you – need to act differently to address why this happens.  And we have to move on from the past approach of many regulators, which reflected a belief that the most important thing needed to make financial services markets work well was transparency — fair disclosure of terms and fair sales processes. 

We cannot just rely on firms and consumers to do the right thing all the time, when past experience has told us that this does not always happen, especially given the pressures both consumers and firms face.

Regulation — and especially product regulation — is therefore necessary to protect consumers and help them avoid mistakes.  

And to create regulation that builds trust and confidence in financial firms, we need to not only understand how consumers make decisions and how problems arise, but also understand firms better, and make a judgement on whether they can deliver fair outcomes. 

In the old days the question to firms would only be “Do you have a strategy?” Now it is about examining firms’ whole approach and following the money to understand what lies behind profitability and the implications of firms’ strategies. 

This will be displayed in how we actually deal with your firm on a day-to-day basis in the FCA.  We will replace our current way of assessing your firm’s risks with an approach focused on your business model and whether it can deliver good outcomes for consumers.  Alongside this, we will have more of our staff specialising in wider, cross-industry issues or emerging risks rather than tied to specific firms.

We are looking at whether firms have product development and approval processes that are well-designed and can weed out harmful or inappropriately marketed products.

This is about us getting more closely involved at an earlier stage, to identify products with the potential for problems for consumers and to intervene to prevent their inappropriate sale — often this will be where the risks are likely to outweigh the benefits the products will bring.  The FSA has already proposed a new and intrusive approach to the way firms bring financial services products to the retail market – the FCA will look to build on this.

The FCA will also intervene where the product may be well known and of use to consumers but the sales and distribution process of a firm does not meet regulatory standards and problems for consumers are occurring.

Product intervention does not necessarily mean a heavy-handed approach such as a ban, though sometimes it will be necessary when other options do not work or are not feasible.  There are many other things we can do behind the scenes with firms.

 In all of this, we accept that firms need to be able to generate acceptable returns for shareholders, and have to be financially robust.  But this is about ‘good profits’ rather than profit at any cost — either to firms’ own stability or their customers’ best interests. 

The key point is that in the FCA, we will be looking to firms to construct business models where fair treatment of customers is central.  And we will expect those in executive management and on the boards of firms to step up their engagement with this side of the business and take this seriously.

It is interesting that Martin seems to be suggesting that this new regulator will spend a lot more time looking at the business models of firms rather than the specifics of product disclosure or transparency.  Sounds fine in principal, but do regulators have this ability?

In this region we already see example of regulators trying to make decisions on the basis of how they think a business should be run and I must say that it rarely seems to be commerically wise.  I admire the thinking behind Martin's comments, I don't necessarily share his optimism for execution.

New regulatory measures take effect under Securities and Futures (Amendment) Ordinance

The Securities and Futures Commission (SFC) welcomes the enactment of the Securities and Futures (Amendment) Ordinance 2012 (Amendment Ordinance).

Under the Amendment Ordinance, which will be gazetted tomorrow, the SFC is empowered to implement the following new regulatory initiatives:

• The establishment of a statutory disclosure regime whereby listed corporations will be required to disclose price sensitive information (PSI) in a timely manner, backed by civil sanctions for non-disclosure of PSI;
• The SFC can directly institute proceedings before the Market Misconduct Tribunal (MMT), without having to first refer the case to the Financial Secretary for his decision, to enforce PSI disclosure requirement, and to deal with the existing six types of market misconduct under the Securities and Futures Ordinance (SFO) (Note 1); and
• The SFC will establish the Investor Education Centre (IEC) to take up broader investor education responsibilities covering the entire financial services sector (Note 2).

Provisions relating to the SFC directly instituting proceedings before the MMT and the establishment of the IEC will come into operation on 4 May 2012.

The PSI disclosure regime will take effect on 1 January 2013 to give listed companies sufficient time to prepare themselves to comply with the new requirements and to set up the necessary internal control systems.

End

Notes:

1. The six types of market misconduct under the SFO are insider dealing, false trading, price rigging, disclosure of information about prohibited transactions, disclosure of false or misleading information inducing transaction, and stock market manipulation.
2. The Investor Education Centre, a wholly-owned subsidiary of the SFC, is targeted to be launched in the fourth quarter of 2012.

This is a really important piece of legislation and will have an impact on financial firms who use or process company information as well as those that release it.  When coupled with the serious approach that the SFC already takes in relation to prosecutions and investigations on this topic, we are expecting to see material and relatively public changes to operations, as well as challenges to the legislation or its meaning when it becomes contentious.

Roll out date for the new legislation regarding disclosure by Hong Kong public companies is 1 January 2013.

We expect that public companies will want to roll out similar processes and monitoring controls for release of non public information that financial firms already have for the receipt of same.

SFC secures short selling convictions

The Eastern Magistrates Court today fined seven investors a total of $71,000, ranging from $2,000 to $30,000 each, after they had pleaded guilty to 11 charges of illegal short selling shares of Imagi International Holdings Limited (Imagi) in May 2010.

Acting Principal Magistrate Mr. David Dufton also ordered the defendants - Kung Ping Cheung, Chan Ki, Siu Kam Fung, Siu Kam Mei, Siu Hung Keung, Ma Siu Fan and Yau Ka Yiu - to pay the Securities and Futures Commission’s (SFC) investigation costs of $21,820.

The SFC told the court that, on 7 May 2010 and/or 11 May 2010, the defendants placed various orders to sell 31,000 to 16,855,600 shares of Imagi when they did not and could not have reasonable grounds to believe that they had a presently exercisable and unconditional right to sell the shares, thus constituting illegal short selling.

In May 2010, Imagi conducted a rights issue in which all shareholders received four rights for each old share. Each of the rights entitled shareholders to subscribe for one new share. However, not all shareholders exercised their rights to subscribe for the new shares. These non-subscribed new shares became excess rights which other shareholders could apply to subscribe for on top of their own entitlements.

The seven investors subscribed for Imagi excess rights shares and placed orders to sell the amount of shares that they thought they would be allocated or would be able to receive in time for settlement. At the time of short selling Imagi shares, they did not receive the excess rights shares or receive any confirmation as to the time and the quantity of excess rights shares they would receive.

“Taking advantage of a rights issue to sell shares in expectation of an allotment constitutes illegal short selling if the investor has no presently exercisable and unconditional right to sell the shares. It is also an abuse of the rights issue and the excess rights process,” Mr Mark Steward, the SFC’s Executive Director of Enforcement said.

“This kind of arbitrage carries all the risks of naked short selling. This case should send a clear message that this practice is illegal,” he added.

Speaking during a panel at the AsiaHedge Conference today, Ashley Alder, CEO of the SFC in Hong Kong made several interesting comments on his take on the regulatory issues facing hedge funds post financial crisis.

He said it is clear that internationally regulators are concerned about hedge funds becoming a shadow banking system that had potential to be systemically risky to the international marketplace particularly in credit transformation and collateral flows.  At this stage regulators are still grappling to identify this risk and remain interested in information gathering from the industry.

IOSCO is planning another hedge fund survey in September 2012 similar to its previous exercise, but this time including the US. The previous exclusion of US based funds and managers from the last survey meant that only 30% of global hedge fund assets were considered.

IOSCO is running a project to report to the Financial Stability Board by the autumn to more specifically quantify the systemic risks, if any, posed by hedge funds to the financial system.

These initiatives are covering a different regulatory concern (i.e. that of risk) than industry standard setting bodies like the Hedge Fund Standards Board as the role of such groups is to set best practice for the conduct of hedge funds towards their investors.

In relation to Hong Kong specifically, Alder was at pains to point out that criticism from governments internationally that Asia was creating potential for regulatory arbitrage was not accurate or fair.  The criticisms are being given voice when Asian financial centers like Hong Kong push back on changing local legislation to match legislation proposed in the US or Europe.  Given the different political situation in Asia and the different impact the financial crisis had on its banks, it is not appropriate in all cases for Asia to follow suit.  This reflects the views of the earlier speaker Julia Leung from Financial Services and Treasury who made the point that while the Hong Kong Government is willing to work towards convergence with the US and the EU, it is not looking for absolute equality.

The SFC is working on its bilateral relationships with other regulators.  With the SEC it is preparing for joint inspections of dual registered Hong Kong firms; in Europe the SFC has this month commenced work on having Hong Kong passported by ESMA as an acceptable jurisdiction for AIMD purposes.

The industry will no doubt be delighted to hear that the SFC is keen to move the local licensing department towards a substance over form approach albeit Adler himself noted this was a work in progress.  He also acknowledged the resourcing issue that the SFC and licensing in particular are facing.

Finally he was keen to put paid to rest the speculation that the Hong Kong based RQFII managers were given preferential treatment and received their Type 9 licenses faster than normal.   In fact these licence applications had been submitted to the SFC up to 12 months before the final PRC rules were released in December 2011 by SAFE and the SFC was simply waiting for that green light before moving from approvals in principal to granting their licenses.

The paper is a well known government mouthpiece and its reports often signify major turns in policy directions. In the speech Wen together assured the public about the safety and comfort of current government debts and pledged to contain government debts and to avoid spread of financial risks. This assurance is nothing new but the next part of his speech is more intriguing where he said there should be greater attention and controls placed on systemically important financial institutions. He even said China would “break monopolies” to encourage more private capital to flow into the financial sector.

Moreover Wen expressed an intention to explore a more multi-layer investment channel for China’s USD 3.18 trillion foreign reserves. This may foretell a switch its investment strategy, possibly away from traditional instruments such as US treasuries and Japanese bonds.

These promises sound fascinating; if realized, they could reshape the landscape of the present Chinese economy – one which some have criticized as heavily biased towards state owned enterprises. Though there is nothing likely to happen in the short term the picture Wen presents here is certainly a nice one to look at.  

The Reuters article on this piece of news can be accessed here.

The Economist has published an interesting article on the history of the Reserve Bank of India and summarized the challenges it has faced as a regulator.

The RBI grappled with its sense of purpose and became an almost subservient accomplice of political corruption. In 1997 and 2006 agreements were enacted to stop it being used as an ATM for the state. The magazine touted the RBI thereafter for its transformation into a normal central bank which readily addressed macroeconomic issues and even help India weathered relatively unscathed the 2008 financial crisis. Even though RBI’s independence is not enshrined in law, regulating officers expressed little concern about its independence in the latter part of the last decade.

However, the magazine pointed to emerging fears that the RBI has again fallen into the trap of becoming a lever of the state, this time for protecting India’s conservative political agenda. Banks today are still forced to invest 24% of their core assets into government bonds thereby pushing down the yield rate. As the Eurozone worries spread, the RBI has initiated a R14 billion bond-purchase program to guarantee low yields for state agencies.

India shares similar traits to pre crisis Greece. Both countries have pushed down public borrowing cost. Public credit in pre-crisis Greece was too cheap and government agencies were not carefully screened and assessed before they received a loan from the state; a state of affairs that exists in India today.

The Economist article on Reserve Bank of India can be accessed here.