In these FAQs on SFC License Type 9, we provide guidance on SFC asset management regulation
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The Market Misconduct Tribunal (“MMT”) adjudicates cases of insider dealing, market manipulation as a result of improper disclosure of insider information and failure to disclose insider information. Though the Market Misconduct Tribunal has no power to order the imprisonment of anyone found liable, the reputational and financial consequences of a finding of liability for mishandling insider information are significant.
This article is the 3rd in a 3 part series relating to insider information. In this article, we provide guidance for persons under investigation for mishandling of insider information. This guidance will be relevant to listed companies and their directors, traders, research analysts and other market participants. It will extend to insider dealing, the failure to disclose insider information in a timely manner or the failure to disclose insider information accurately and it will outline the potential penalties and other consequences which may arise from a finding of liability.
In the 1st of these 3 articles, "New Requirements For Disclosure Of Material Non-Public Price Sensitive Information (MNPI): A Guide For Hong Kong Listed Companies", we provide guidance for listed companies and their directors on how to handle insider information with a view to complying with regulatory requirements in relation to insider information. In the 2nd of these 3 articles, Price Sensitive Information and the Market Misconduct Tribunal: A Guide to Defending SFC Enforcement Action, we provide guidance on responding to SFC enforcement action alleging mishandling of insider information.
Table of Contents
Under the Securities and Futures Ordinance (“SFO”), the Market Misconduct Tribunal Market Misconduct Tribunal is responsible for adjudicating allegations of misconduct (“market misconduct”), including (i) allegations of failures by listed companies and their directors to disclose insider information , (ii) allegations of the disclosure of false or misleading information, whether by listed companies and their directors or by others seeking to influence the market, (iii) allegations of trades undertaken to manipulate the market, and (iv) allegations of insider dealing insider dealing.
Though a finding of liability by the Market Misconduct Tribunal is not a finding of criminal liability and cannot result in imprisonment, it may nevertheless cause serious reputational damage, carrying with it the stigma of quasi-criminal liability. Such a finding is typically followed by orders of the Market Misconduct Tribunal which can include the following:
As may be evident from the foregoing, where listed companies and their directors fail to disclose insider information on a timely and proper basis, they can be liable to a fine. However, it is unclear whether the power to impose a fine is or is not constitutional. In Koon Wing Yee v. Insider Dealing Tribunal, the Court of Final Appeal struck down as unconstitutional the power of the Insider Dealing Tribunal under predecessor legislation to fine a person found to have engaged in insider dealing. That legislation, like the present legislation, classified the offence as a civil one but the court found that the offence was in substance criminal rather than civil in nature.
The court’s reasoning was based on the fact that insider dealing is misconduct of a very serious and dishonest nature and the fact that the fine was punitive. Arguably, the failure to properly disclose insider information is as serious and as dishonest as dealing whilst in possession of insider information. Indeed, such a failure constitutes a criminal offence in some jurisdictions.
An order for costs requires a person found liable to pay the costs of the Hong Kong government and the legal, investigative and expert costs of the SFC in the proceedings. Depending on the duration of the Market Misconduct Tribunal proceedings and the complexity and contentiousness of the matters heard, it is easy to see that costs can be significant. Indeed, financial liability under cost orders can (and often does) exceed that under a fine or an order for disgorgement.
Costs under an order for costs are separate from the costs which a person found liable by the Market Misconduct Tribunal will likely have also incurred in defending himself, including his own legal fees and fees for any experts retained to assist in his defence.
Although at first glance an order for disgorgement is straightforward, the Market Misconduct Tribunal and the courts have defined 3 different tests for disgorgement: (i) the actual profit realized test, (ii) the notional profit test, and (iii) the notional loss avoided test.
A key difficulty in practice is determining whether the actual profit realized test or the notional profit test should be applied. In insider dealing cases, the Court of Final Appeal has determined that the actual profit realized test applies where market prices have not yet reflected the insider information which had been exploited and the notional profit test applies where market prices have reflected such information.
In Re Dealings in the Shares of China Huiyan Juice Group Limited, shares were bought on insider information between August 7 to 29 and were sold on September 3 and 4. Though the insider information was released on September 3, the Market Misconduct Tribunal found that the market had not fully digested that information until September 5. As a result, the Market Misconduct Tribunal ordered disgorgement of the actual profit realized.
In contrast, for example, in Re Dealings in the Shares of Mirabell International Holdings Limited, shares were bought on insider information on February 21 and 22, the insider information was disclosed to the market on February 28 and the shares were sold on March 10 and April 21. The Market Misconduct Tribunal found that the market had fully digested the insider information by March 3. As the sales took place after the market had fully digested the information, the Market Misconduct Tribunal applied the notional profit test.
Under the notional profit test, the profit to be disgorged is calculated based on the price at the time the market fully takes into account the insider information. So, in the Mirabell case, even though actual sales took place on March 10 and April 21 at $5.80 and $5.83 per share, the profit to be disgorged was calculated based on $5.83, the two-day weighted average price over February 29 and March 3, the date on which the Market Misconduct Tribunal found the insider information had been fully digested.
The application of the actual realized profit test and the notional profit test has not yet been conclusively determined by the courts outside of the insider dealing context. The SFC has sought in the past to seek disgorgement not of the actual profit but rather, the theoretical economic benefit that the person earned from his misconduct. The latter represents the maximum amount the person could have earned had he timed his trading perfectly.
Like the notional profit test, the loss avoided test is based on the notional loss that would have been avoided. In insider dealing cases, the notional loss is determined based upon the volume weighted average price at the time the market had fully absorbed the negative insider information.
So, for example, in Re Dealings into the Shares of Chaoda Modern Agriculture (Holdings) Limited, an insider dealing case, shares were sold at an average price of $5.304 on June 16 whilst in possession of negative insider information. The insider information was released on June 18 and the Market Misconduct Tribunal found that it had been fully digested by the end of June 19. The two-day weighted average price of June 18 and 19 was HK$4.551. Though disgorgement was not in fact ordered, the Market Misconduct Tribunal calculated the loss avoided per share as being the difference in $5.304 and $4.551.
Because the actual realized profit test and the notional profit test are applied depending upon a finding by the Market Misconduct Tribunal as to when insider information or the effect of market misconduct has been fully reflected into market prices and because the notional loss test requires a similar finding, Market Misconduct Tribunal proceedings will typically include expert evidence. Such expert evidence will go to the time at which insider information was fully digested or the time until which market misconduct distorted market prices. This is inherently a difficult exercise.
To illustrate the difficulty, assume that A owns a stock which he bought at $5 before coming into possession of insider information. Assume further that A came into possession of negative insider information and whilst in possession of such information, sold that stock at the then prevailing market of $10. Upon release of the insider information, the stock slid to as low as $7 over a period of 3 days. However, over that 3 day period, the market as a whole declined each day for a total decline of 15 per cent. By selling at $10, arguably, A avoided a loss of $3 but given the decline of the market as a whole, it might equally be argued that A only avoided a loss of $1.50, as the stock would have declined by 15 per cent. in any event to $8.50. Moreover, it might be argued that the insider information had been fully digested by the end of the 1st day after the release of the insider information and that, as a result, in calculating the loss avoided, no account should be taken of the decline in the price of the stock and the 2nd and 3rd day after the release of the insider information.
It can be readily seen that a person who is subject to an allegation of market misconduct faces some uncertainty in terms of liability under any order for disgorgement. It is possible that such a person may need to disgorge profit which exceeds his actual cash inflows from his misconduct. However, he will not know if he will be required to do so until the Market Misconduct Tribunal proceedings complete.
Quite apart from the orders which can be made by the Market Misconduct Tribunal, a person found to have mishandled insider information bmay face civil action through the Hong Kong courts. Such a civil action can take the form of proceedings by investors themselves under a statutory right of action. Alternatively or in addition, such a civil action can take the form of court proceedings brought by the SFC. Whilst investors have yet to take advantage of the statutory right of action, the SFC routinely takes civil action on behalf of investors.
It will be self-evident that any court proceedings by which a person found liable for market misconduct is required to pay compensation to investors who suffered a loss as a result of the market misconduct may impose a heavy financial burden on this person. Depending on market turnover, this burden could, in dollar terms, easily exceed the burden of the orders of the Market Misconduct Tribunal to pay a fine, to disgorge profit made or loss avoided or to pay costs.
The SFO includes a statutory cause of action for investors to seek compensation for losses resulting from market misconduct, including mishandling of insider information. Under this statutory right of action, a person who breaches regulatory requirements in respect of the handling of insider information may be liable to pay compensation by way of damages to any other person who sustains any pecuniary loss as a result of the breach. This right of action arises independently of regulatory enforcement through the MMT. Thus, for example, it seems that if a person relies upon publicly available information to make an investment and the information turns out to be wrong and as a result, the person suffers a loss on his investment, he may sue for that loss. However, liability for compensation will only arise where it is fair, just and reasonable.
The statutory right of action includes a fast-track mechanism wherein findings of the Market Misconduct Tribunal are admissible in Hong Kong court proceedings by which investors seek compensation to establish liability. Though a finding of the Market Misconduct Tribunal does not bind a court, the admission of the finding relieves individual investors of the burden of undertaking the time and cost intensive forensic exercise to discharge their burden of proof.
Whether it is because of a lack of awareness, the absence of a desire to incur costs or otherwise, in the years since the statutory right of action was introduced for investors, no investors have taken advantage of it. This is not to say however, that persons found liable need not fear potential liability to compensate investors.
Section 213 of the SFO provides that where a person has engaged in market misconduct, a Hong Kong court may make an order:
“requiring the person to take such steps as it may direct, including steps to restore the parties to any transaction to the position in which they were before the transaction was entered into”.
Such an order is known as a “compensation order” or a “restoration order”.
The SFC has frequently relied upon the SFO, s. 213 to seek compensation for investors. Thus, for example, in SFC v Tiger Asia Management LLC, a case concerning insider dealing, the SFC obtained a court order against Tiger Asia under s. 213, which required Tiger Asia to pay HK$45.2 million to around 1,800 investors affected by its insider dealing. Similarly, in SFC v Tsoi Bun, the SFC used s. 213 to obtain an order against a futures trader, Mr Tsoi Bun, requiring him to pay HK$13.7 million to around 500 investors affected by his market manipulation.
An unresolved issue is how the quantum of compensation is to be calculated under s. 213 in the absence of agreement between the SFC and the person found liable of a market misconduct.
In SFC v Sun Min, Mr. Sun had been found by the Market Misconduct Tribunal to have engaged in insider dealing. The SFC sought a compensation order under the SFO, s. 213. Mr. Sun and the SFC agreed that Mr. Sun would pay as compensation to each counterparty who sold shares to him a sum equal to the difference between the sale price and the value of the shares once the insider information had been digested. Though the court granted an order in terms by consent, it queried whether this methodology of calculating the quantum of compensation was correct, noting that the compensation was neither in the nature of a disgorgement of Mr. Sun’s profit nor a restoration of any loss suffered by any given counterparty.
Strictly speaking, a Hong Kong court applies the SFO, s. 213 independently of the Market Misconduct Tribunal. Thus, a finding of liability by the Market Misconduct Tribunal is not a precondition to the court making an order under s. 213. It is open to a court to make an order under s. 213 if it is satisfied that there has been insider dealing, a failure by a listed company to disclose insider information, market manipulation or other market misconduct may have occurred. Conversely, a finding of liability by the Market Misconduct Tribunal is not itself sufficient to enable a court to exercise its powers under s. 213. The court will need to be satisfied that a market misconduct has in fact taken place.
A consequence of this independence is that a person who is the subject of allegations of market misconduct may be subjected to proceedings under the SFO, s. 213 prior to or in parallel with the institution of Market Misconduct Tribunal proceedings.
Having said that, compensation orders have often been ordered following findings of liability by the Market Misconduct Tribunal.
It is possible that a finding of liability by the Market Misconduct Tribunal (or indeed, the mere institution of Market Misconduct Tribunal proceedings) may result in regulatory action by the SFC beyond a mere compensation order. The SFO, s. 213 is not limited to ordering persons liable for market misconduct to restore parties to their original position. The section empowers courts to make a number of orders including:
The courts have in fact used the SFO, s. 213 to support compensatory orders by, for example, freezing assets of a person who is alleged to have engaged in market misconduct. The effect of a freezing order would be to ensure that assets are available for a compensation order which might be made in the event the person were found liable for market misconduct.
Where the market misconduct prejudices shareholders of a listed company, section 214 of the SFO empowers the courts, on an application by the SFC, to make a number of orders including:
There is no specific precedent as yet of the use of the SFO, s. 214 in conjunction with Market Misconduct Tribunal proceedings. However, there have been proceedings under s. 214 involving listed companies and their directors who have failed to ensure that shareholders have been given all the information with respect to the affairs of these companies that such shareholders might reasonably expect. Allegations of this type are not substantively different in nature than allegations of a failure to disclose insider information.
In these FAQs on SFC License Type 9, we provide guidance on SFC asset management regulation
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