SFAT Casts Doubt on Legality of Introduction Arrangements between Hong Kong Brokers and their Offshore Affiliates
June 19, 2009
By Timothy Loh and Henri Arslanian
A recent determination by the Securities and Futures Appeal Tribunal suggests that the introduction of trades from introducing brokers in Hong Kong to executing brokers based in London, New York or other financial centers may constitute active marketing by these offshore executing brokers, thereby subjecting these offshore executing brokers to licensing requirements. Prior to this determination, the industry generally believed that licensing requirements would not apply. In this article, we review the determination and explore its potential consequences on the industry in Hong Kong.
TIMOTHY LOH | Financial Services & Law Review
Vol. 3 (2009) at p. 27
The
Securities and Futures Appeals Tribunal ("SFAT")
determination dated May 15, 2009 regarding Applications No. 7, 8 and
9 of 2007 is the first judicial interpretation of the active
marketing section of the Securities and Futures Ordinance ("SFO").
In the determination, the SFAT upheld disciplinary action against
representatives of a corporation licensed by the Securities and
Futures Commission ("SFC")
in Hong Kong for Type 3 (leveraged foreign exchange) regulated
activity in connection with the introduction by these representatives
of foreign exchange trades to an unregulated offshore affiliate.
Whilst
the SFAT is not a court of law and its determinations do not create
binding judicial precedents, the SFAT is chaired by a judge of the
Court of First Instance and its determinations are thus significant.
The
SFAT findings in this determination appear to disturb established
market understanding of the active marketing section and indeed,
appear to expand the scope of this section beyond the SFC's own
published interpretation. Consequently, the SFAT determination
raises concerns as to whether intra-group introduction arrangements
employed by global banks between their Hong Kong offices
("Introducing Broker")
and offshore offices ("Executing
Broker") breach licensing requirements under the SFO.
LEGAL FRAMEWORK
The
SFO provides that no person shall carry on a business in a regulated
activity or hold himself out as carrying on a business in a regulated
activity without being authorized or licensed to carry on a business in that regulated
activity.
In
this regard, the active marketing section provides that if (i) a
person actively markets, whether by himself or another person on his
behalf and whether in Hong Kong or from a place outside Hong Kong, to
the public any services that he provides, and (ii) such services, if
provided in Hong Kong, would constitute a regulated activity, then
the provision of such services so marketed shall be regarded as
carrying on a business in that regulated activity or the person's
marketing of such services shall be regarded as holding himself out
as carrying on a business in that regulated activity.
CURRENT INDUSTRY UNDERSTANDING
The
industry has generally understood the active marketing section to
require marketing that is (i) active, (ii) related to a service, and
(iii) directed to the Hong Kong public.
Marketing
Marketing
is generally understood to mean advertising or promoting or offering
for sale, activities preliminary to providing a service or a product.
Thus, the industry traditionally has taken the view that the
provision of a particular service falls outside the ambit of the
active marketing section. Consequently, where a broker outside of
Hong Kong executes a trade for a member of the Hong Kong public,
industry understanding is that the broker is not by reason only of
executing the trade considered to be actively marketing its brokerage
services in Hong Kong.
Active
In
the ordinary language, the word "actively" would presumably be
contrasted with "passively" and would thus suggest vigorous or
frequent efforts to achieve a pre-determined objective rather than
simply accepting or allowing what happens. In keeping with this, the
industry understanding, as well as the SFC's own published
interpretation, is that the marketing of services may be considered
to be "active" where there is a detailed marketing plan to
promote the services or where the services are extensively advertised
through, for example, mass media, internet activities or telephone
calls. However, where the services our sought out by investors of
their own initiative, the industry and indeed the SFC have generally
understood that marketing not to be active.
Service
The
SFO itself refers only to the provision of "services" and not
"products". Thus, the industry has generally understood the
active marketing section as not controlling the marketing of shares,
units and other financial products.
Public
The
SFO suggests that the active marketing must target the public in Hong
Kong to fall within the active marketing section. Indeed, the SFC's
own interpretation of the active marketing section is that a one-off
marketing exercise is not considered as being active marketing.
SFAT DETERMINATION
In
Applications No. 7, 8 and 9 of 2007, the SFAT was asked to review SFC
disciplinary actions against 3 representatives of Hantec
International Ltd. ("Hantec HK").
Hantec
HK and the representatives concerned were all licensed by the SFC for
Type 3 regulated activity (leveraged foreign exchange trading).
Under
introduction arrangements, the representatives of Hantec HK would
solicit leveraged foreign exchange business from clients in Hong Kong
and introduce such clients to open an account and to trade leveraged
foreign exchange with Cosmos Hantec Investments (NZ) Ltd. ("Hantec
NZ"). At the material time, Hantec NZ was a New Zealand
company, which does not regulate leveraged foreign exchange trading,
and was not licensed by the SFC.
The
SFC disciplined the representatives of Hantec HK on the basis that
they had exceeded the ambit of their regulated activities and
illegitimately assisted Hantec NZ in carrying out its unregulated
business in Hong Kong.
On
appeal, the SFAT upheld the SFC's disciplinary action, dismissing
arguments from the representatives of Hantec HK that the active
marketing section means no more than marketing in the primary sense
of pro-actively advertising a service to the Hong Kong public and
does not encompass, for example, instances of the actual sale of
products to individual customers.
Marketing
vs. Provision of Service
In
dismissing these arguments, the SFAT stated that it seems "tolerably
clear that an actual sale consequent upon the advertising of the
service to the Hong Kong public must be regarded as falling within
this rubric (active marketing)''. Taken at face value, this
statement suggests that the industry understanding that the active
marketing section is limited to the marketing of services rather than
provision of services may not survive judicial scrutiny.
Active vs. Passive Marketing
At
the same time, whilst the SFAT cautioned that clearly much would
depend upon the evidence surrounding the circumstances of any sale,
it rejected commentary in the consultative paper presented to the
Bills Committee during the adoption process of the SFO and the SFC's
own published interpretation of the active market section as being
nothing more than "straws in the interpretative wind." As the
SFC's own published interpretation broadly reflects industry
understanding, the SFAT determination throws in doubt the industry's
understanding.
Service vs. Product
Whilst
not of apparent significance in this case as the subject matter was
in fact a service, the SFAT determination does not distinguish
between the terms "services", which is used in the SFO, and
"products", which is not used in the SFO. Indeed, the
SFAT uses these 2 terms interchangeably.
DISTINGUISHING FACTORS
Whilst
the arrangements between Hantec HK and Hantec NZ are very similar to
those used by many global banks operating in Hong Kong, it is unclear
to what extent this determination may be of more general application
and in particular how this determination may apply, if at all, to
these global banks.
Onshore Liaison Office
First,
it appears that at the initial stages, Hantec NZ operated a liaison
office in Hong Kong. The existence of this liaison office in Hong
Kong would, presumably, have required Hantec NZ to be licensed by the
SFC, not because it would be regarded as carrying on a business in a
regulated activity in Hong Kong as a result of the deeming effect of
the active marketing section but because in fact it did so.
Consequently, it may be suggested that the SFAT's discussion of the
active marketing section was unnecessary to the finding of liability
and that the arrangements used by Hantec HK and Hantec NZ are
distinguishable from those used by global banks in that the offshore
Executing Brokers of such global banks do not have liaison offices in
Hong Kong.
However,
there is some discussion in the SFAT determination of the relocation
of Hantec NZ's liaison office from Hong Kong to Macau and it is
possible that the introductions by representatives of Hantec HK to
Hantec NZ following the relocation may also have been the basis for
the disciplinary actions. If that were the case, the SFAT's
discussion of the active marketing section could remain relevant.
Executing Broker Unregulated
Secondly,
even if the SFAT determination does contemplate introduction
arrangements similar to those used by global banks, it is significant
to note that Hantec NZ was not regulated. In contrast, the
introduction arrangements of global banks typically involve an
offshore Executing Broker which is regulated in New York, London or
another credible financial center. Whilst the SFO does not
distinguish between offshore Executing Brokers who are regulated and
offshore Executing Brokers who are not regulated, the regulatory
status of an offshore Executing Broker is likely to be a factor that
would weigh in the SFC's whether decision to pursue enforcement
action and a court's application of the SFO.
POTENTIAL IMPLICATIONS
Whilst
not a binding judicial determination, the comments of the SFAT appear
to disturb established industry understanding of the active marketing
section. Taken at face value and assuming that the SFAT
determination cannot be distinguished, the determination opens new
concerns as to when offshore Executing Brokers may be required to
obtain an SFC license in Hong Kong to serve Hong Kong clients. The
consequences of such a requirement are drastic, requiring global
banks to choose whether to license the offshore Executing Broker or
restructure their onshore Introducing Broker to execute trades. The
latter option would eliminate economies of scale achievable through
the centralization of capital and operational resources in a single
location with the offshore Executing Broker.
|
