Under the Ordinances administered by the SFC, securities, futures and leveraged foreign exchange intermediaries are required to register with or be licensed by the SFC before they can carry on business in Hong Kong. These requirements enable market participants generally, and investors in particular, to have confidence that the people and organisations with which they deal are fair, efficient, honest and financially sound.

The Ordinances also impose ongoing requirements on registered/licensed intermediaries, including maintenance of adequate capital, proper books and records, segregation and safe custody of client assets, and submission of annual returns and accounts to the SFC.

The Intermediaries Division is responsible for ensuring that registered/licensed intermediaries meet the initial and ongoing requirements under the Ordinances. The Licensing Department administers the registration/licensing requirements, while the Intermediaries Supervision Department supervises compliance with the provisions of the relevant Ordinances.

In order to obtain or maintain a registration with the SFC, a person must satisfy the SFC that he is a "fit and proper" person.

In assessing whether a person is fit and proper, the SFC is required to take into account :

• his financial status;
• his educational or other qualifications and experience relevant to the nature of the functions he intends to perform;
• his ability to perform such functions efficiently, honestly and fairly; and
• his reputation, character, financial integrity and reliability.

In the case of a limited company seeking a registration or licence, the fit and proper test will be applied to all its directors, substantial shareholders and related persons.

A total of 4,940 applications for registration were received by the SFC during the year. Together with those carried forward from the preceding year, a total of 4,359 approvals were granted, 34 applications were refused and 321 applications were withdrawn. A detailed breakdown by category of these data is contained in Table 1 below.

Intermediaries registered under the Securities Ordinance (SO) and Commodities Trading Ordinance (CTO)

As at 31 March 1997, a total of 17,154 intermediaries were registered with the SFC. A detailed breakdown by category is in Table 2 below.

Table 3 below shows the number of institutions declared to be exempt dealers and exempt investment advisers by the SFC. During the year, 2 applications for declaration as exempt dealer and 2 applications for declaration as exempt investment adviser were received by the SFC. Three institutions were declared to be exempt dealers and 1 exempt investment adviser application was withdrawn. Five exempt dealer and 1 exempt investment adviser declarations were revoked.

During the year, the SFC received 1 trader and 286 representative applications. Three trader licences and 601 representative licences were granted, and 1 representative application was refused. One trader application and 476 representative applications were withdrawn. A detailed breakdown by category is in Table 5, shown below.

 

Figure 1 Total Registrants - Securities and Commodities 1989 - 1997 (as at March 31st)	Figure 2 Number of Dealing and Advising Business 1989 - 1997 (as at March 31st)

During the year, the SFC also completed the processing of the remaining 2 applications from the batch of 45 submitted by then existing traders, including Emperor International Exchange (Hong Kong) Company Limited, the largest trader in Hong Kong.

The licence to Emperor International Exchange was granted on 29 January 1997 on the basis of a range of measures adopted, and a number of undertakings provided by the company. These include a revamp of its organisational and management structure thereby ensuring operational independence, strengthening its internal control and compliance regime, and engaging an independent firm of auditors to conduct semi-annual focused compliance audits for a period of two years. These measures and undertakings are the most onerous in the history of the SFC.

As at 31 March 1997, the total number of licensed traders and representatives were 22 and 1,349 respectively. A detailed breakdown by category is shown below in Table 4.

During the year, the SFC received notifications from 3 corporations that they met the criteria for exemption from licensing as leveraged foreign exchange traders. As at 31 March 1997, there were 36 corporations falling within the qualifying class under the Exemption Rules.

As indicated in Tables 1 and 2, the number of applications for registration under the Securities Ordinance and Commodities Trading Ordinance received by the SFC during the year has increased by 256 to 4,940 and the size of the registrant population has grown by approximately 6.5% over the preceding year. While the number of applications received from business entities has declined by 18.5%, the number of applications for registration as representatives has increased by about 9.5%. This is a continuation of the trend, which began a few years ago, of business entities further consolidating their operations in Hong Kong. A comparison of the number of accredited individuals per registered business entity provides a clearer picture. The ratio of 9.3 : 1 as at 31 March 1996 has increased to 9.9 : 1 as at 31 March 1997.

The trend cited above is more obvious in the securities industry, where further consolidation and convergence were seen. Sole proprietorship businesses (whose population has dropped from 178 as at 31 March 1996 to 153 as at 31 March 1997) were increasingly being incorporated or acquired by larger firms. The number of registered persons per securities dealing firm increased from 13 per firm to 14 per firm on a year-end basis.

The year has also seen increasing participation in Hong Kong by intermediaries from within Asia, especially the People's Republic of China and South East Asia (see Table 6). Apart from reflecting the importance of Hong Kong as a premier regional financial centre, this trend is also indicative of the continuing development of the region as an economic powerhouse and the importance of financial services as a component of this development.

Following world-wide trends, the leveraged foreign exchange industry continued to undergo a contraction. As indicated in Table 4, the population of both traders and trader's representatives declined significantly over the preceding year, with the number of licensed traders declined from 32 to 22 and that of representatives from 1,487 to 1,349.

Several factors have contributed to the decline in this industry, including:

• the impact of regulation, particularly the minimum margin requirements, the prohibition of credit for margin deposits, and the ban against cold calling/hawking etc., which has prevented the product from being marketed to persons who could not afford the risks involved, e.g. housewives, the young and the elderly;
• migration of the lower end of the business to Macau;
• the ban imposed by the People's Republic of China authorities on financial futures, including leveraged forex, which has deprived the industry of a significant number of big-ticket clients; and
• increased competition from Authorised Institutions, particularly the large retail banks which have entered the retail end of the market in a big way since the introduction of the LFETO.

In addition to the initial vetting of intermediaries at the entrance level, the Licensing Department also monitors the continuing fitness and properness of its registered and licensed persons. This function includes the maintenance and updating of a database on its registrant/licencee population. To this end, the Department commenced a survey in January 1997 on the business activities of registered firms. Although the responses from the survey are being collated and analysed, it is anticipated that the information obtained from the survey will give the SFC a more thorough understanding of the range of business activities undertaken by market intermediaries and facilitate the formulation of appropriate regulatory policies.

In order to safeguard the interests of investors and to promote and maintain the integrity of registered persons and the market, the SFC devoted substantial effort during the past year to the monitoring of the continuing fitness and properness of registered intermediaries. This effort carried out by both the Enforcement Division and Licensing Department led to formal inquiries being conducted into 173 cases, of which 124 resulted in some form of disciplinary action.

This year's inquiries centered mainly on issues such as short-selling, rat trading, misappropriation of clients' assets, unregistered activities, failure to implement adequate internal controls and failure to act in the best interest of the integrity of the market.

As a result, 2 registrants surrendered their registrations for a certain period of time and the SFC revoked 13 registrations, suspended 62 registrations, reprimanded 49 registrants and issued 27 warnings to registrants for various forms of misconduct during the past year. As at 31 March 1997, 6 revocations and 6 suspensions were the subject of appeal to the Securities and Futures Appeals Panel, the decisions of which are still pending.

Apart from the above inquiries and disciplinary action taken directly by the Department, a total of 52 cases concerning misconduct by members of the two Exchanges were referred to the respective Exchanges for action.

Some particular cases of interests are detailed below. Other cases are set out in the section of the annual report relating to the Enforcement Division.

Mr Lai Kim Leong

On 24 April 1996, the SFC suspended the registration of Mr Lai Kim Leong, dealing director of JCG Securities Limited, for five years. Lai was found to have misled the SFC during its investigation into insider dealing activities involving the shares of Public International Investments Limited (PIIL) and to have misled the Insider

Dealing Tribunal appointed by the Financial Secretary to investigate the matter when he testified before it. In addition, Lai was found to have withheld material information regarding his holdings in PIIL and JCG Holdings Limited.

Mr Yuen Moon Chung

On 7 June 1996, the SFC suspended the registration of Mr Yuen Moon Chung for 18 months. Yuen, whilst acting as a securities dealer's representative of G K Goh Securities (HK) Limited, misled the SFC during its investigation into insider dealing activities involving shares of PIIL. Yuen was also found to have assisted others in providing misleading information to the SFC.

Crosby Capital Markets (Asia) Limited

Crosby Capital Markets (Asia) Limited, a registered securities dealer, was publicly reprimanded by the SFC on 27 September 1996 following an inquiry into the placement of approximately 191 million shares in Giordano International Limited arranged by Crosby on behalf of Mr Jimmy Lai Chee Ying on 27 February 1996. The inquiry revealed that Crosby had accepted and executed a mandate to place Lai's shares on the same day as an announcement by Giordano stating, among other things, that "there was currently no definite proposal for such placing" and that Lai had not sought nor obtained Crosby's consent for a disposal of his shares.

The SFC was of the view that a person reading the announcement would reasonably infer that Lai would not, at least not on the very same day of the announcement, dispose of his shares in Giordano. The SFC, therefore, concluded that Crosby, in proceeding with the placement without taking steps to inform the market and/or to correct the perception created by that announcement, had failed in its duty to act in the best interest of the integrity of the market, and in so doing, had prejudiced the interests of members of the investing public.

As part of its effort to enhance efficiency and cater for an increasing workload caused by the growth in the intermediaries population, the Department began rebuilding its computer system during the year. The project, expected to be completed by the last quarter of 1997, has been designed to support electronic submission and imaging, and most importantly, full Chinese character input and display capabilities.

The SFC's pilot Common Anniversary Date scheme for registrants' annual submissions, initiated in mid-1995, has completed one annual operating cycle smoothly. The scheme, which enabled registered firms to adopt a uniform anniversary date for all their registrants to aggregate all annual fees payable into one payment, and to submit annual returns in bulk, has been well received by the 21 participating firms. In view of the positive response, the SFC has decided to extend this programme, on an optional basis, to all registered/licensed firms, including licensed leveraged foreign exchange traders.

In preparation for this across-the-board extension, the necessary technical arrangements, including amendments to the Leveraged Foreign Exchange Trading (Annual Returns) Rules and the Securities and Futures Commission (Annual Returns) Rules, have been completed. Furthermore, 5 seminar sessions were organised in March 1997 to brief interested firms on the mechanics of the programme. More than 250 compliance staff from 200 firms attended the seminars. By 31 March 1997, a total of 437 business entities, in addition to the pilot scheme participants, had joined the programme.

The Intermediaries Supervision Department is responsible for the financial regulation of registered intermediaries and the supervision of their business conduct. Registered intermediaries are supervised mainly through on-site inspections and off-site reviews of a wide range of financial and other returns.

In recognition of the role of the Exchanges as front-line regulators of their members, the SFC limits routine inspections of Exchange members to about 5% of the Exchange membership each year. Dealers who are not Exchange members, and other registered intermediaries, are normally covered by a three-year cycle of visits.

In view of the growth in the number of registered intermediaries and the increasing complexity and diversity of their activities, the Department has introduced a programme to enable it to prioritise its visit cycle. Moreover, it has re-focused its monitoring programme and supervisory strategy, placing more reliance on risk-based inspection techniques. New analytical tools, such as on-site analysis using laptop computers, were also introduced.

The Department has also streamlined the inspection programme, including revised inspection planning checklists and information questionnaires, to help focus on key issues to enhance the effectiveness and quality of site visits. In addition, inspection staff undertake a thorough analysis of target firms prior to an inspection to prepare themselves for the visit. These efforts have improved the effectiveness of the inspection programme, shortened the average length of visits and consequently increased the inspection coverage of registered intermediaries. They have also enabled the SFC to take more speedy regulatory action when required.

Alongside this change of strategy was the introduction of a computerised inspection results tracking system. The system allows instant access to the latest inspection progress and findings to enable prompt and proactive regulatory actions to be taken if circumstances dictate.

In addition, the Department has made greater use of outside resources to assist in compliance monitoring of registered intermediaries. Where significant inadequacies in the internal control systems are identified in the course of an inspection visit, the Department will require the intermediary to commission an independent compliance review by an external firm of professionals to detail the failures and to recommend improvements to processes and procedures. During the year, seven securities dealers and one investment adviser complied with such independent compliance review requests.

A breakdown of inspections undertaken for the year is as follows:

As a result of the above actions, routine inspection visits increased by 105% compared to 1995/96 as figure 4 illustrates.

The major types of rule breaches and non-compliance noticed during the course of inspections are as outlined in tables 7 and 8.

Although these tables suggest that the number of breaches noted during routine inspections have increased during the year, the Department does not regard this as a cause for concern or a reflection of a decline in the ethics and professional standards of the registered intermediaries visited. The Department believes this to be a result of the more focused inspection programme and the increase in inspection activity during the year. The experience of the Department is that the majority of registered intermediaries visited conduct their operations with a high level of professionalism and integrity, ensuring that clients are treated fairly.

A sample of the cases which the Department dealt with during the year is described in the following sections.

Frankwell Commodities Limited

The Department, together with the Hong Kong Futures Exchange, jointly conducted an on-site inspection visit on Frankwell. The inspection noted, among other things, that the company failed to meet the Financial Resources Rules and that the two major shareholders, whilst unregistered, were closely involved in the management of Frankwell's business, making all major decisions.

In light of the findings, Frankwell's dealing directors and major shareholders were publicly reprimanded. Frankwell subsequently ceased business and requested the SFC to revoke its registration (see paragraphs 3.17 - 3.19).

Canwell Forex International Limited

An inspection by the Department in late 1995 into Canwell's operations uncovered strong evidence to suggest that Canwell did not possess the necessary regulatory capital. The company appeared to have arranged a series of short-term loans to cover the requisite capital whenever it had to produce evidence of the possession of such capital to the SFC. It also appeared to have falsified its monthly financial returns to the SFC to disguise the fact. An analysis of the actual accounts of the company indicated that it did not have sufficient assets to repay all client deposits.

In view of the findings, the SFC issued a restriction notice to freeze the assets of the company and successfully applied to the High Court under section 13 of the LFETO for the appointment of an administrator to Canwell to protect the interests of its clients. The administrator was further appointed as Receiver ad litem by the Court, on 17 January 1996, to represent Canwell against a legal claim made by a third party for the return from the administrator of $32 million, its primary assets at the time.

On 3 October 1996, a settlement agreement, approved by the Court, was reached between the administrator, the SFC and the third party which provided, among other things, for a sum of $6.6 million to repay all of Canwell's clients who traded with it after the commencement of the LFETO. The amount also covered the costs of the SFC and the administrator/receiver ad litem.

The licences of Canwell and its supervisory director were subsequently revoked. Further pursuit of the case rests with the Commercial Crime Bureau of the Hong Kong Police.

A review of the licensing and monitoring process was undertaken following discovery of the case to identify ways and means to uncover similar irregularities at an early stage. All the recommendations from the review have since been implemented.

Wei Xin Securities Limited

Wei Xin, a member of the Stock Exchange of Hong Kong Limited (SEHK), voluntarily ceased trading on 26 March 1996 in the face of serious financial problems. Thereafter, the SEHK suspended the membership of Wei Xin while the Hong Kong Securities Clearing Corporation Limited declared it a defaulter.

In order to protect the interests of investors while the liabilities of Wei Xin and an accurate evaluation of its clients positions were established, the SFC issued a restriction notice to Wei Xin on 16 April 1996 prohibiting it from carrying on business and dealing with its assets without the prior approval of the SFC. The action was taken under sections 39 and 40 of the Securities and Futures Commission Ordinance (SFCO). The restriction notice was withdrawn on 27 May 1996 when external administrators were appointed by the Supreme Court upon the application by a client of Wei Xin. The client also presented a winding up petition against Wei Xin.

At the winding up hearing, on 3 July 1996, the Supreme Court ordered that Wei Xin be wound up and the Official Receiver be appointed as provisional liquidator to handle the affairs of Wei Xin. The external administrators were later appointed by the Official Receiver to act as Special Managers to deal with claims against securities held by Wei Xin.

It is understood that substantially all clients' securities, including the proceeds from the sale of expiring warrants, have since been returned to clients.

Cheung Cheong Woon trading as Cheong Woon Securities Company (CWS)

Mr Cheung Cheong Woon, a sole proprietor trading as CWS, reported to the SEHK and the Commercial Crime Bureau, on 10 May 1996, that he had disposed of clients' securities without their consent since 1991 and that his liabilities exceeded his assets by at least $10 million. CWS's membership was suspended by the SEHK on the same day.

Based on information provided by the SEHK, the SFC issued a restriction notice, on 20 May 1996, prohibiting Cheung from dealing with his personal assets and the assets of CWS without the prior approval of the SFC. In order to ensure all investors' claims could be dealt with in an orderly manner, the SFC presented a petition to appoint the Official Receiver as the trustee in bankruptcy to deal with Cheung's financial affairs. The order was duly granted by the Supreme Court of Hong Kong.

On 26 July 1996, Cheung pleaded guilty to ten charges of theft and was sentenced to two years imprisonment.

Lai Kwok Kuen, Daniel trading as C.K. Securities Company

An inspection by the SEHK on C.K. Securities Company indicated that the company was unable to settle its indebtedness to clients and that stocks it held in the Hong Kong Securities Clearing Corporation Ltd were insufficient to meet its obligations to its clients. At the request of the SEHK, the SFC issued a restriction notice on 15 October 1996, pursuant to section 40 of the SFCO, to prohibit Lai from disposing of his assets without the SFC's prior written consent.

To safeguard the interests of investors, the SFC made an application to the High Court under section 144 of the Securities Ordinance (SO) for the appointment of administrators to C.K. Securities Company. The administrators were duly appointed on 13 November 1996. The administrators received over $1 million from the closure of various bank accounts under the name of C. K. Securities Company and Lai Kwok Kuen. In addition, warrants with a short life span were sold for over $94,000 and substantially all securities, with the exception of those of clients whom the administrators were unable to contact, were returned to identifiable owners.

The case remains unresolved as the SFC has no power to close down a sole proprietor in the absence of an act of bankruptcy falling within the definition of the Bankruptcy Ordinance.

To provide relief for dealers and leveraged foreign exchange traders in unduly burdensome situations, the SFC has powers, under sections 29 and 55A of the SFCO and section 69 of the LFETO, to waive or modify certain requirements of the SO and the LFETO in respect of the safe custody of clients securities, segregation of clients' money and in particular the requirements of Financial Resources Rules.

Waivers or modification applications handled by the Department during the year were as follows:

During the year, the Department was involved in the following policy initiatives and review of subsidiary legislation.

Review of the Leveraged Foreign Exchange Trading Regulatory System

At the time the LFETO was introduced in September 1994, the SFC undertook to review the regulatory framework in light of experience gained during its initial phase of implementation. The SFC commenced a review of the regulatory framework in March 1996 and issued a consultation paper in August 1996 proposing a number of changes to the regulatory framework. Eighteen written submissions were received.

The comments were carefully considered by the SFC and a report concerning the consultation on the review was issued in April 1997. The report concluded that it remains appropriate to proceed with the proposed changes but that amendments are required to some recommendations to take account of points raised during the consultation exercise.

Review of the Financial Resources Rules

In order to ensure that the rules keep pace with changes in the market place and that no undue regulatory burden is imposed on registrants, a review of the Financial Resources Rules (FRRs) was conducted by the SFC during the year.

Although the review focused on the FRRs as applicable to securities and futures intermediaries, the FRRs for leveraged foreign exchange traders were also considered and consequential changes proposed. As a result of the review, a consultation paper was issued in March 1997 inviting comments on the review findings and the proposed changes.

Survey on the Over-the-counter (OTC) Derivatives Activities by Registered Firms

In 1995, the SFC conducted a survey on the OTC derivatives activities of registered persons. The survey was directed mainly at identifying firms which carried derivatives activities on their books and at establishing the nature and effectiveness of their risk management systems. The results indicated that only about 30 mainly large, internationally active securities firms, out of a total population of about 1,500 registered firms in Hong Kong, were engaged in OTC derivatives activities. The majority were engaged primarily in an agency role, and in the management of the derivatives positions of overseas affiliated companies.

As the first survey was of a qualitative and general nature, the SFC conducted a second survey, of the OTC derivatives activities of a selected group of registered persons, to collect quantitative information on the extent and nature of their involvement in this market, including proprietary derivative trading activities of affiliated companies managed by them. Twenty-four registered firms indicated their involvement in OTC derivatives activities as of 31 December 1995.

The results of the surveys indicate that for many large, internationally active firms, management of affiliates' derivatives positions constituted the major, if not the only, part of their derivatives activities. In addition, these firms had generally put in place the necessary risk management systems to assist them in conducting their derivatives activities prudently.

A report on the two surveys was published in April 1997. The report recommends a reporting requirement on the fact of involvement in OTC derivatives activities by a registered firm or its affiliates. Specific reporting requirements on the level of activities would be agreed with the firm on receipt of such a report. This new requirement will be introduced in the context of the review of the FRRs (see above).

During the year, joint inspections were conducted with overseas regulators on intermediaries who are registered with both the SFC and the overseas regulatory bodies.

The Department believes joint inspections are an effective way for regulators to learn from each other, share experience, identify any overlaps of regulatory coverage and develop relationships for more effective supervision.

In June 1996 and March 1997, the Department conducted joint inspections with staff of the Securities and Exchange Commission of the United States of America on several investment advisers/fund managers for which both regulatory bodies have responsibility.

The Department also conducted joint inspection visits on fund managers with staff of the Investment Management Regulatory Organisation Ltd of the United Kingdom.

In October 1996, the Department visited several securities dealers jointly with staff from the Risk Assessment Group of the Securities and Futures Authority of the United Kingdom. The objective of the joint visits was to understand and assess the risk management systems of those globally active entities which conduct extensive derivatives activities in Hong Kong, the United Kingdom and other major financial centres.