In the SFC Enforcement News issued on 19 December 2007, the SFC referred to an agreement it had entered into with an entity pursuant to section 201 of the Securities and Futures Ordinance. This provision enables the SFC to enter into agreements with a person who is subject to the SFC's disciplinary action, and to take additional action as the SFC
considers appropriate in the circumstances of the case. The entity in question, which holds Type 4 (advising on securities) and Type 6 (advising on corporate finance) licences, has agreed to engage an independent firm to carry out an internal control review within three years of the agreement, with the time of the review and its terms to be determined by the SFC. The entity also agreed that if it should be found during the three year period to have committed failures of the kind for which it is currently
being sanctioned, then it would be suspended from sponsorship activities for a minimum period of 18 months. The final penalty will reflect the gravity of any subsequent breach.

The SFC investigation identified the following issues:

• failure to ensure that representations made and information provided by the licensee or its clients to regulators were true, accurate, complete and not misleading in a material respect;
• failure to conduct due and careful enquiries on the listing applicant's business;
• failure to supervise staff properly and diligently; and
• failure to keep a proper audit trail of work done.

Full details can be found in the SFC press release dated 19 December 2007, which is available at http://sfc.hk.

The SFC Enforcement Reporter for January 2008 refers to this case and highlights the new approach taken by the SFC, whereby the SFC may agree to delay the imposition of its formal disciplinary sanctions and penalties if the entity agrees to an independent review of its activities without prior notice.

Previously the SFC has used independent reviews to assist management to
identify and address internal control weaknesses and failures. However, until now, most of these reviews were conducted with prior notice. The element of surprise is viewed by the SFC to be a more accurate test of the efficiency of an entity's internal control environment. This type of arrangement is expected to be used by the SFC in future cases where it considers there is a strong commitment to ensure serious control failures are not repeated.

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Hong Kong Stamp Duty Relief for Stock Borrowing and Lending Transactions

The sales and purchases of Hong Kong stocks are usually subject to stamp
duty at an ad valorem rate of 0.1%. Whilst the Hong Kong Stamp Duty Ordinance provides for an exemption from payment of stamp duty in respect of stock borrowing and lending transactions, the qualifying conditions for the relief are often neglected.

In general, stock borrowing and lending transactions can be exempt from the payment of stamp duty if the stocks borrowed are for specified purposes, such as, the settlement of the sale of Hong Kong stock. In order to qualify for the exemption, one of the conditions is to register the stock borrowing and lending agreement (Agreement) with the Stamp Office. The Agreement must be registered with the Collector of Stamp Duty (Collector) after it is executed not later than 30 days after the stock borrowing is effected.

Under the Stamp Duty Ordinance and in accordance with the practice notes issued by the Inland Revenue Department, the obligation to register an Agreement falls on the borrower and not the lender. However, the lender can still take advantage of the stamp duty relief by registering the Agreement on its own initiative and also file a notification with the Stamp Office. The Stamp Office used to issue reminders to stock borrowers upon receipt of a lender's notification but they stopped issuing such reminders after April 2003. As a continuing obligation, the stock borrower is also required to keep proper records of the stock borrowed and returned and produce such records for the inspection of the Collector upon request.

If the Agreement is not registered with the Collector, then stamp duty will be levied. Contract notes for the relevant sales and purchases of Hong Kong stocks must be stamped 2 days after the sale and purchase if effected in Hong Kong, and within 30 days if effected elsewhere. If the contract notes are not stamped within the specified time, penalties of up to 10 times the stamp duty due are payable.

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SFC Guidance on Suitability of Investment Advice

Our newsletter of June 2007 referred to the SFC's FAQs on suitability
obligations of licensed and registered persons who are engaged in financial
planning and wealth management business activities (IAs) relating to the
provision of investment advice, the making of recommendations and/or
solicitation . The full text of the FAQs can be found on the SFC website
(http://sfc.hk).

The FAQs provide practical guidance to the relevant provisions of the SFC's Code of Conduct and the SFC's Management, Supervision and Internal Control Guidelines.

Although not intended to be exhaustive or prescriptive, the FAQs explain the suitability obligations for IAs as follows:

a) Know your client. The IA should understand the client's financial situation, investment experience and knowledge, investment objective and time horizon, and also risk tolerance. Each client's information should be documented and where appropriate, updated on a continuous basis.

b) Understand the investment products you recommend. Conducting a thorough product due diligence on both the product and the product provider is considered essential. Questions to ask should include: how does the product work; how are the underlying investments made up; what is the level of risk; what are the fees and charges; what is the experience and relative performance of the product provider. Other important questions would cover details of any lock-ins or penalties for early withdrawals; valuation and pricing arrangements; and custody arrangements. IAs need to make their own inquiries and it is not generally sufficient to rely solely on a prospectus or marketing documents to obtain all the required information.

c) Provide reasonably suitable recommendations by matching the risk return profile of each investment product with the personal circumstances of each client. IAs need to use their professional judgement to match the characteristics and risk exposure of the product with the investment needs and other relevant circumstances of each client. Where an IA is only recommending investment products issued by a related company, they should disclose this fact to their client.

The FAQ highlights the fact that extra care should be taken in advising elderly or unsophisticated clients who may rely heavily on the IA to provide independent advice. As recent SFC enforcement actions have demonstrated, IAs should not assume that someone who has significant personal wealth or someone who works in a senior management capacity is necessarily a 'sophisticated investor'. Caution should also be exercised in
recommending overly complex investment products, products with long maturity dates and those which will attract penalty charges upon early redemption or withdrawal.

d) Provide all relevant material information to clients and help them to make informed investment decisions. This includes providing a copy of the rationale of the underlying investment recommendations made to the client. The client should also receive a copy of the prospectus and other offering documents for the products they are investing in. It is not sufficient to simply hand over marketing documents. IAs have to provide information on why they are recommending each product, explaining the advantages along with the disadvantages and downside risks. Plain language is required in making these explanations which must also be fair and not misleading.

e) Employ competent staff and provide appropriate training. All employees who are involved in providing investment advice and making recommendations should be competent and should fully comprehend all aspects of the investment products they recommend, including the risk profile of each product; and

f) Document and retain the reasons for each product recommendation made to each client. Additional internal controls for the IA would include keeping records of material queries raised by the client, the responses provided by the IA and details of all transactions undertaken for the client. It is the responsibility of the licensed corporation or registered institution to ensure their IAs comply with all legal and regulatory obligations. It is necessary to develop and implement policies and procedures embodying the general principles set out in the above and to ensure, as a final outcome, that licensees have recommended suitable products and that clients have been able to obtain the best possible advice.

A formal complaints policy and regular reviews of documents and procedures assist senior management to oversee these obligations and enable them to act quickly to address deficiencies and problems as they are identified.

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Notifying Changes to the SFC

Section 135 of the Securities and Futures Ordinance sets out various events to be reported by licensed persons to the SFC and by registered institutions to the HKMA and gives timelines for making these filings. In addition, Schedule 3 to the Securities and Futures (Licensing and Registration) (Information) Rules specifies additional changes that are required to be notified by licensed corporations, registered institutions, licensed individuals and substantial shareholders of a licensed corporation or registered institution.

Notifiable changes include changes in passport number or residential address of directors and substantial shareholders; changes in the status of any directorships, partnerships or proprietorships of licensed persons; and changes in any information supplied at the time of application for a licence.

Where details of a new directorship or other appointment are notified the SFC may require the licensed person to provide details of the business nature of the new appointment and to address whether the new appointment will give rise to any potential conflicts of interest. If the notification is made by a responsible officer, the SFC needs to be satisfied that the new appointment wil not affect his responsibility for supervising the business of the regulated activity of the licensed corporation.

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Malaysia and Dubai allow cross-border flow of Islamic funds

Early in 2007, the Securities Commission of Malaysia (SC) and theDubai Financial Services Authority (DFSA) entered into a mutual recognition agreement whereby crossborder marketing and distribution of Islamic funds would be permitted with minimal regulatory intervention. Under this agreement, Islamic funds that have been registered or notified with the DFSA will have access to Malaysian investors. Conversely, Malaysia will be entered onto the DFSA's Recognised Jurisdiction Notice. With this, Malaysian Islamic products will benefit from a gateway to a fastgrowing market in Dubai, while Malaysian investors will have access to a range of Islamic products from the Dubai International Financial Centre (DIFC).

As a result of this initiative, DIFC domestic funds will be the first foreign funds permitted to be sold into Malaysia. Foreign funds are generally not permitted to be sold into Malaysia under the current regulatory regime unless express approval on a case-bycase basis is obtained from the SC.

In order to facilitate the above agreement between the SC and the DFSA, the SC issued on 1 July 2007, the Guidelines for the Offering, Marketing and Distribution of Foreign Funds (Guidelines) which provide that the SC approves the offering, marketing and distribution of foreign funds in Malaysia provided they qualify as Recognised Funds (as defined in the Guidelines) constituted in Recognised Jurisdictions (as defined in the Guidelines). The Recognised Fund must be approved, registered or authorised by the relevant regulator in the Recognised Jurisdiction and if the fund is listed, it must be listed and traded on an exchange that is regulated by the relevant regulator in the Recognised Jurisdiction. In addition to that, parties responsible for the fund must be licensed, registered, authorised or approved by the relevant regulator in the Recognised Jurisdiction to operate and manage the fund. To date, the Guidelines have limited the definition of "Recognised Jurisdiction" to the DIFC only; and "Recognised Fund" to an Islamic fund which is notified or registered with the DFSA and includes public funds, private funds, umbrella funds, property funds (including REITs), feeder funds, fund-of-funds, private equity funds and commodityrelated funds.

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Deacons Financial Services Seminar Series

The first seminar in our 2008 Financial Services Series will be held on Wednesday, 5 March 2008 in our Hong Kong Office.

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Whilst every effort has been made to ensure the accuracy of this publication, it is for general guidance only and should not be treated as a substitute for specific advice.