Hong Kong regulatory compliance

1. INTRODUCTION

The Securities and Futures Ordinance (SFO) contains civil and criminal market misconduct offences under Parts XIII and XIV of the SFO, respectively. 6 types of market misconduct are covered: insider dealing, false trading, price rigging, disclosure of information about prohibited transactions, disclosure of false and misleading information inducing transactions and stock market manipulation. Civil cases of market misconduct are dealt with by the Market Misconduct Tribunal (MMT) while criminal cases go before the courts.

The following provides a summary of the laws on insider dealing only.

WHAT IS INSIDER DEALING?

In broad terms, insider dealing typically occurs when:

• a person connected with a Hong Kong listed company (e.g. a director or staff member) has privileged information which could impact the company’s share price when it becomes publicly known, and trades or procures someone else to trade the company’s securities or derivatives so as to make a profit or avoid a loss before the information becomes publicly available; or
• a person obtains information from another person they know to be connected with a listed company and trades or procures another person to trade in the company’s securities or derivatives so as to make a profit or avoid a loss before the information becomes publicly available

The SFO definition of insider dealing covers seven circumstances (sections 270 and 291):

1. Person with inside information deals in shares of a corporation with which he is connected – Sections 270(1)(a) and 291(1)(a)

   Insider dealing occurs when a person connected with a listed corporation has information which he knows is inside information in relation to that corporation and:

   • deals in the corporation’s listed securities or their derivatives or in those of a related corporation; or
   • counsels or procures another person to deal in such listed securities or derivatives, knowing or having reasonable cause to believe that the other person will deal in them.

2. Take-over offer – bidder deals in shares of target – Sections 270(1)(b) and 291(2)

   Insider dealing occurs when a person who is contemplating or has contemplated making a take-over offer for a listed corporation and knows that the information that the offer is contemplated, or is no longer contemplated, is inside information:

   1. deals in the corporation’s listed securities or their derivatives or in those of a related corporation otherwise than for the purpose of the take-over; or
   2. counsels or procures another person to deal in such listed securities or derivatives otherwise than for the purpose of the take-over.

   This provision is designed to stop, for instance, a director of a company which is about to launch a take-over bid from telling his friends to buy shares in the intended target in order to make a profit when the price of those shares inevitably rises. It does not stop the director of the bidder from buying shares in the target (or indeed counselling or procuring others to do so) in a “dawn raid” where the sole purpose of such purchases is to facilitate the take-over itself.

   The provision is also designed to catch, say, a director of the bidder who sells short in the target when he knows (but the public does not) that the bidder is not going to increase its offer price at the end of the initial offer period, but will instead let the offer lapse.

   “Take-over offer” is defined in Schedule 1 to the SFO.

3. Person connected with a corporation leaks inside information about that corporation – Sections 270(1)(c) and 291(3)

   Insider dealing will also occur when a person connected with a listed corporation has information which he knows is inside information in relation to the corporation and discloses the information, directly or indirectly, to another person, knowing or having reasonable cause to believe that the other person will use the information to deal, or counsel or procure another person to deal, in the corporation’s listed securities or their derivatives, or in those of a related corporation.

   This offence is designed to cover the person who deliberately leaks confidential information with a view to someone (whether it be the person to whom he has leaked the information or some other person) using that information to make a favourable deal trading the securities on the Hong Kong Stock Exchange.

4. Bidder leaks take-over information – Sections 270(1)(d) and 291(4)

   Insider dealing also occurs when a person who is contemplating or has contemplated making a take-over offer for a listed corporation and knows that the information that the offer is contemplated or no longer contemplated is inside information discloses the information, directly or indirectly, to another person, knowing or having reasonable cause to believe that the other person will use the information to deal or to counsel or procure another person to deal in the corporation’s listed securities or their derivatives, or in those of a related corporation.

   This section applies where a person who is contemplating or has contemplated making a take-over offer for another corporation leaks to another person information to the effect that he is contemplating such an offer, or is no longer contemplating such an offer, with a view to that other person using the information to deal in the target’s securities or to counsel or procure another to deal in them.

5. Recipient of inside information from a person connected with a corporation deals in shares of that corporation – Sections 271(1)(e) and 291(5)

   It will also be insider dealing when a person has information which he knows is inside information in relation to a listed corporation which he received, directly or indirectly, from a person whom he knows is connected with the corporation and whom he knows or has reasonable cause to believe held the information as a result of being so connected:

   1. deals in the corporation’s listed securities or their derivatives or in those of a related corporation; or
   2. counsels or procures another person to deal in such listed securities or derivatives.

   This catches the recipient of the leaked information who uses it either by dealing himself or by counselling or procuring someone else to deal. (The person who actually leaks the information would be caught by Sections 270(1)(c) and 291(3).)

   In the MMT case of China Huiyuan Juice Group Ltd,¹ the MMT ruled that the fact that the identity of the connected person is unknown is not fatal to an insider dealing charge under this subsection.

6. Recipient of inside information about a take-over deals in shares of the target – Sections 270(1)(f) and 291(6)

   Insider dealing also occurs when a person has received, directly or indirectly, from a person whom he knows or has reasonable cause to believe is contemplating or no longer contemplating making a take-over offer for the listed corporation, information to that effect which he knows is inside information in relation to the corporation and:

   1. deals in the corporation’s listed securities or their derivatives or in those of a related corporation; or
   2. counsels or procures another person to deal in such listed securities or derivatives.

   This provision catches the recipient of the leaked information who uses it either by dealing himself or by counselling or procuring someone else to deal. (The person who actually leaks the information would be caught by Sections 270(1)(d) and 291(4).)

7. Person with inside information seeks to facilitate a dealing on an overseas market – Sections 270(2) and 291(7)

   Insider dealing also occurs when a person who knowingly has inside information in relation to a listed corporation in any of the circumstances set out above (i.e. in sub-section 270(1) and sub-sections 291(1)-(6)) and:

   1. counsels or procures another person to deal in the corporation’s listed securities or their derivatives or in those of a related corporation, knowing or having reasonable cause to believe that the other person will deal in such listed securities or derivatives outside Hong Kong on an overseas stock market; or
   2. discloses the inside information to another person knowing or having reasonable cause to believe that he or some other person will use the inside information to deal or counsel or procure another person to deal in the corporation’s listed securities or their derivatives or in those of a related corporation outside Hong Kong on an overseas stock market.

Insider dealing in foreign-listed securities

Where insider dealing involves securities that are listed on foreign exchanges, the court will rely on the offence of using fraudulent or deceptive devices in transactions in securities, futures contracts or leveraged foreign exchange trading under section 300 of the SFO rather than section 270 or section 291. This was demonstrated by the landmark decision in the Court of Final Appeal (CFA) case of Securities and Futures Commission v Young Bik Fung and others.² Two solicitors (Betty and Eric) were found guilty of illegally profiting from inside information.

The case involved two solicitors who worked at separate law firms at the time and thus owed fiduciary duties to their principals (the law firms), including various duties of loyalty and confidentiality. They were also subject to restrictions on trading securities. The solicitors were in a relationship and cohabited between 2003 and 2006, and remained friends after the relationship ended in 2006. 2 other defendants in the case were sisters of one of the lawyers.

One of the solicitors, Betty, had been seconded by her employer to a Hong Kong bank (HK Bank) to assist on HK Bank’s takeover of Hsinchu International Bank Company Limited (Hsinchu) which was listed on the Taiwan Stock Exchange. She had been reminded and acknowledged that she was an insider and had access to highly confidential and sensitive information.

Discussions took place between the two banks between August and September 2006. Information about the tender offer and the offer price of NT$24.50 per share constituted confidential price sensitive information about Hsinchu’s shares before the public announcement of the tender offer on 29 September 2006. Betty was aware of the confidential price sensitive information on 14 September 2006.

9 days before the tender offer, on 20 September 2006, a new securities account was opened with Tai Fook Securities Co Ltd (Tai Fook Account) by the third defendant, which allowed her to trade in Taiwanese shares. Between 21 and 29 September 2006, the four defendants put together substantial sums of money and injected them into the Tai Fook Account. Between 22 and 29 September, the 3rd Defendant acquired 1,576,000 shares in Hsinchu for the defendants at an average price of NT$16.99.

The two solicitor defendants went to considerable lengths to raise funds, including drawing overdrafts and liquidating a considerable portion of their investment portfolios. One solicitor borrowed HK$300,000 from her sister, while the other borrowed HK$430,000 from his sister, the third defendant, who obtained the money by breaking a fixed deposit due to mature in 2 weeks, resulting in the forfeiture of interest of HK$1,228.

On 29 September 2006, when the Tender Offer was announced, the offer price was 44% above the average price of the defendants’ acquisitions. The third defendant accepted the tender offer for all the Hsinchu shares in the Tai Fook Account and distributed the profit of around HK$2.69 million in proportion to their contributions.

The court also considered a second transaction in which the roles of the two solicitor defendants were reversed: the 2nd defendant was the tipper and the 1st defendant was the tippee.

The Decision

The court relied on section 300 of the SFO, as opposed to the SFO’s insider dealing provisions because of the extra-territorial feature of the case. The insider dealing regime applies to securities listed on the Hong Kong Stock Exchange. Since the securities involved in the case were listed in Taiwan, the defendants’ conduct was outside the scope of the Hong Kong insider dealing regime.

Section 300 of the SFO

Section 300 of the SFO prohibits fraudulent or deceptive schemes in transactions involving securities. Section 300 prohibits a person from:

1. employing any device, scheme or artifice with intent to defraud or deceive; or
2. engaging in any act, practice or course of business which is fraudulent or deceptive, or would operate as a fraud or deception,

directly or indirectly, in a transaction involving securities, futures contracts or leveraged foreign exchange trading.

In order to establish the Section 300 offence, the conduct must be fraudulent or deceptive and relate to a transaction involving securities.

Fraud and Deception

The court had no difficulty applying section 300 based on the facts of the case. It held that Betty’s decision and conduct in misusing confidential material price sensitive information, and knowingly breaching dealing restrictions which applied to her as a person working on the deal, amounted to a scheme or act of deception.

Transaction involving securities

The definition of “transaction” in section 300(3) SFO includes “an offer and invitation (however expressed)”. There is no requirement for the transaction to have been completed. Since the offer to buy the securities was made in Hong Kong, Section 300 applied. The fact that the securities were traded outside Hong Kong was irrelevant. The court also accepted that the third defendant’s acceptance of the tender offer in Hong Kong would also have brought the case within the scope of Section 300. The court held that for the purposes of Section 300, the fraudulent and/or deceptive conduct is consummated when the information is deployed to sell or purchase securities – and not from the moment the fraudster obtains the confidential information.

The CFA held that section 300 of the SFO could be applied in respect of securities listed outside of Hong Kong, provided “substantial activities constituting the crime”³ occurred within Hong Kong. The court found that substantial activities of the case occurred in Hong Kong.

2. Insider Dealing – Definitions

2.1 “Securities”

“Securities” are broadly defined in Part 1 of Schedule 1 to the SFO and include:

1. shares, stocks, debentures, loan stocks, funds, bonds or notes of, or issued by, or which it is reasonably foreseeable will be issued by, a body, whether incorporated or unincorporated, or a government or municipal government authority;
2. rights, options or interests (whether described as units or otherwise) in, or in respect of, any of the foregoing;
3. certificates of interest or participation in, temporary or interim certificates for, receipts for, or warrants to subscribe for or purchase, any of the foregoing;
4. certificates of interest or participation in, temporary or interim certificates for, receipts for, or warrants to subscribe for or purchase, any of the foregoing;
5. interests in a collective investment scheme;
6. any interests, rights or property commonly known as securities, whether in the form of an instrument or not; and
7. structured products not falling within paragraphs (a) to (e) where a structured product is:
   1. an instrument under which some or all of the return or amount due (or both the return and the amount due) or the method of settlement is determined by reference to one or more of:
      1. changes in the price, value or level (or a range within the price, value or level) of any type or combination of types of securities, commodity, index, property, interest rate, currency exchange rate or futures contract;
      2. changes in the price, value or level (or a range within the price, value or level) of any basket of more than one type, or any combination of types, of securities, commodity, index, property, interest rate, currency exchange rate or futures contract; or
      3. the occurrence or non-occurrence of any specified event or events (excluding an event or events relating only to the issuer or guarantor of the instrument or to both the issuer and the guarantor);
   2. a regulated investment agreement; or
   3. any interests, rights or property prescribed, or of a class or description prescribed, by notice under section 392 of SFO as being regarded as structured products.

2.2 “Listed securities”

The SFO’s insider dealing offences apply only to securities listed on the Hong Kong Stock Exchange at the time of the dealing in question. The definition of “listed securities” includes:

1. issued unlisted securities provided that, at the time of the insider dealing, it is reasonably foreseeable that they will be listed and they are subsequently in fact listed; and
2. unissued securities provided that, at the time of the insider dealing, it is reasonably foreseeable that they will be issued and listed and they are subsequently in fact issued and listed.

This is intended to catch “grey market” dealings prior to a secondary issue of securities. As insider dealing can only occur in relation to a “listed corporation”, insider dealing in an IPO grey market is not covered. The market manipulation provisions may however apply to such trading to the extent that it affects post listing prices and trading.

Securities are also treated as listed notwithstanding that dealings in them may have been suspended.

2.3 “Corporation”

The definition of “corporation” includes the large number of companies which are listed in Hong Kong but incorporated abroad.

2.4 “a person connected with a corporation”

A person connected with a corporation (an “insider”) is someone who is on the inside track who has access to information about a corporation by reason of his relationship with it. Sections 247 and 287 define an individual as connected with a corporation if:

1. he is a director or employee of that corporation or a related corporation. Directors include shadow directors, i.e., persons in accordance with whose instructions the corporation’s directors are accustomed or obliged to act;
2. he is a substantial shareholder (i.e. has an interest in 5% or more of the issued voting share capital) in the corporation or a related corporation;
3. his position may reasonably be expected to give him access to inside information concerning the corporation by reason of:
   1. a professional or business relationship existing between himself (or his employer or a corporation of which he is a director or a firm of which he is a partner) and that corporation, a related corporation or an officer or substantial shareholder in either corporation; or
   2. his being a director, employee or partner of a substantial shareholder of the corporation or a related corporation; or
4. he has access to inside information by virtue of being connected (within the meaning of a, b or c above) with another corporation where that information relates to a transaction (actual or contemplated) involving both corporations or involving one of them and the listed securities of the other or their derivatives, or to the fact that such transaction is no longer contemplated; or
5. he was connected with the corporation within the meaning of a, b, c or d above at any time within 6 months preceding any relevant dealing.

A corporation is connected with another corporation if any of its directors or employees are so connected.

Under sections 248 and 288, any public officer or member or employee of certain bodies who in his capacity as such obtains inside information about a corporation will be deemed to be connected with that corporation.

2.5 “Inside information”

Two or more corporations will be related corporations of each other if one of them is:

1. the holding company of the other;
2. a subsidiary of the other; or
3. a subsidiary of the holding company of the other;

Corporations are also related where the same individual:

1. controls the composition of the board of directors of one or more corporations;
2. controls more than half of the voting power at general meetings of one or more corporations; or
3. holds more than half of the issued share capital (excluding any part which carries no right to participate beyond a specified amount on a distribution of either profits or capital) of one or more corporations.

Each of the corporations referred to in paragraphs (a) to (c), and their respective subsidiaries, are regarded as related corporations of each other.

2.6 Inside Information Defined

Section 245(1) of the SFO defines “inside information” in relation to a corporation as specific information about:

1. the corporation;
2. a shareholder or officer of the corporation; or
3. the listed securities of the corporation or their derivatives,

which is not generally known to the persons who are accustomed or would be likely to deal in the listed securities of the corporation but which would, if it were generally known to them, be likely to materially affect the price of the listed securities.

Inside information may thus include information about changes in a corporation’s shareholders or officers and about rights attaching to listed securities and derivatives over those securities.

The definition of inside information which applies to the insider dealing offences is the same as the definition which applies to Hong Kong listed corporations’ obligation to publicly announce inside information under Part XIVA of the SFO. Guidance on what information constitutes inside information is set out in the SFC’s Guidelines on Disclosure of Inside Information.⁴

Inside information must be “specific”

Information will be specific if it is capable of being identified, defined and unequivocally expressed.

In Firstone International Holdings Ltd, Chinese Estates Holdings Ltd, Chinney Alliance Group Limited, Gilbert Holdings Ltd,⁵ it was determined that information will be sufficiently specific:

“if it carries with it such particulars as to a transaction, event or matter, or proposed transaction, event or matter, so as to allow that transaction, event or matter, to be identified and its nature to be coherently described and understood.”

Information does not need to be precise in order to be specific. According to the SFC Guidelines,⁶ it is not necessary that all particulars or details of the transaction, event or matter are precisely known. Information may still be specific even if it has a vague quality and may be broad which allows room, even substantial room, for further particulars. For instance, information that a company is having a financial crisis would be regarded as specific, as would contemplating a forthcoming share placing even if the details are not known.

However, specific information is to be contrasted with mere rumours, vague hopes and worries, and with unsubstantiated conjecture.

Inside information must be information that is not generally known

Inside information is information that is known only to corporate insiders and is not generally known to the market, defined as persons who are accustomed or would be likely to deal in the corporation’s listed securities.

The fact that there are rumours, media speculation or market expectation as to an event or set of circumstances relating to a corporation does not mean that the information is “generally known” to the market. The SFC has noted a clear distinction between the market having actual knowledge of a fact which has been properly disclosed by the corporation and speculation of what might have occurred with respect to a corporation which remains to be proved.⁷

Information in the media, analyst research reports or electronic subscription databases

Information relating to a corporation that appears in the media, analyst research reports or electronic subscription databases may consist of published historical financial information, market commentary, speculation, rumour or leaked information. This information cannot be assumed to be information that is generally known to the market, even where media reports are widely circulated.⁸

In determining whether information appearing in the media and research reports is generally known, corporations must consider not only how widely the information is disseminated, but also the accuracy and completeness of the information and whether the market can rely on that information. In particular, corporations should consider whether:

1. the sources contain all the information the corporation would need to disclose as inside information under Section 307B(3) of the SFO so that there are no material omissions which may make the disclosure false or misleading;
2. the market will realise that the information in these sources reflects the information known to the corporation; and
3. the information will be regarded as speculation or opinion of persons outside the corporation.

If the information known to the market is incomplete or there are material omissions, or doubts as to its bona fides, the information cannot be considered to be generally known and the corporation have to make full disclosure.

In the MMT case of CMBC Capital Holdings Limited (CMBC Capital)⁹, it was held that CMBC Capital and six of its former directors failed to disclose inside information relating to significant improvement in the company’s financials for the five months ended 31 August 2014 as soon as reasonably practicable under the SFO. It resulted in the former CEO and company secretary, Mr. Phillip Suen Yick Lun, and the former chairman, Mr. Paul Suen Cho Hung, being fined HK$1.2 million and HK$900,000, respectively and a 15- month disqualification order against the former.

Facts

CMBC is a Main Board listed company engaged in securities investment, short-term loan financing, supply and procurement of metal minerals, recyclable materials and timber logs.

On 28 November 2013, CMBC Capital (formerly known as Poly Capital Holdings Limited) announced its interim results for the six months ended 30 September 2013 (the 2013 Interim Results), with a segment loss of HK$14,347,000 in securities investment and a loss before tax of HK$12,030,000.

On 26 June 2014, CMBC Capital announced its annual results for the year ended 31 March 2014, with a segment profit of HK$417,282,000 in securities investment and profit before tax of HK$417,153,000 (the 2014 Annual Results).

On 23 September 2014, the company secretary of CMBC Capital sent the unaudited consolidated management accounts of the company for the four months ended 31 July 2014 to the board of directors via email. The management accounts recorded a significant increase in profit of the company and showed that:

1. CMBC Capital made a profit of HK$345,772,000 in July 2014;
2. the cumulative profits from 1 April 2014 to 31 July 2014 were HK$372,952,000; and
3. cumulative profits from securities investment were HK$379,600,000 from 1 April 2014 to 31 July 2014

On 13 October 2014, the company secretary sent the unaudited consolidated management accounts of CMBC Capital for the five months ended 31 August 2014 to the board of directors via email. The management accounts showed further improvements in the company’s financials from the previous month and the improvement was significant when compared with the 2013 Interim Results and the 2014 Annual Results.

The August management accounts showed that:

1. CMBC Capital made a profit of HK$464,909,000 in August 2014;
2. the cumulative profit from 1 April 2014 to 31 August 2014 was HK$837,861,000; and
3. cumulative profits from securities investment was HK$847,743,000 from 1 April 2014 to 31 August 2014cumulative profits from securities investment were HK$379,600,000 from 1 April 2014 to 31 July 2014

On 17 October 2014, upon the Stock Exchange’s enquiry on the recent decrease in price and increase in trading volume of shares of CMBC Capital, the board issued an announcement stating that it was not aware of any reason for those movements or any information that must be announced to avoid a false market in its shares or any inside information that needed to be disclosed under the SFO.

The unaudited consolidated management accounts for the period ended 30 September 2014 were circulated to the board sometime between 30 September 2014 and 7 November 2014.

The management accounts showed that:

1. CMBC Capital made a profit of HK$815,259,000 for the six months ended 30 September 2014; and
2. profits from securities investment were HK$945,938,000 for the six months ended 30 September 2014.

On 7 November 2014, CMBC Capital issued a profit alert after trading hours which, inter alia, provided that:

1. upon a preliminary review of the unaudited management accounts, a sharp improvement of results with profit for the six months ended 30 September 2014 is expected compared to a loss in the corresponding period in 2013; and
2. the improvement in results was mainly attributed to the estimated substantial net investment gains measured at fair value through profit or loss of over HK$900 million for the six months ended 30 September 2014 as compared to the net investment losses measured at fair value through profit or loss of HK$20,492,000 as provided in the 2013 Interim Results.

Upon the publication of the profit alert, the closing share price on the next trading day increased by 24.84% compared to the closing price on the previous day and the trading volume increased by 144,533,000.

Failure to Disclose Inside Information

The SFC alleged that the 2014 April to August financials constituted inside information as it was specific information about the company. It was also not generally known to persons who were accustomed to or would be likely to deal in the listed securities of CMBC Capital but would be likely to materially affect the price of the securities if it were generally known to them.

The inside information did or ought reasonably to have, come to the knowledge of the board on or around 13 October 2014 by the email sent that day. Once the information came to the knowledge of the board on or around 13 October 2014, CMBC Capital was obliged to disclose the information to the public as soon as reasonably practicable under section 307B(1) of the SFO. The information, however, was not disclosed until the profit alert was published on 7 November 2014. Under section 307A(2) of the SFO, the disclosure requirements are breached when a listed company contravenes section 307B(1).

The SFC also alleged that the former directors breached section 307G(2)(a) of the SFO for their intentional, reckless or negligent conduct that had resulted in the breach of disclosure requirements by CMBC Capital and/or section 307G(2)(b) of the SFO for failing to taken all reasonable measures from time to time to ensure that proper safeguards exist to prevent breach of the disclosure requirements. The former CEO and former chairman admitted that their negligent conduct led to CMBC Capital’s breach of the disclosure requirements.

Information that is likely to have a material effect on the price of the listed securities

Section 245(1) requires that inside information must be information “which would if it were generally known to [the wider investing public to] be likely to materially affect the price of the listed securities”.

That is to say the information must be price sensitive. It is not sufficient that the information should simply affect the price of the securities. The effect must be material:

“… information that would be likely to cause a mere fluctuation or a slight change in price would not be sufficient; there must be the likelihood of change of significant degree in any given circumstances that amount to a material change.”¹⁰

Information that is likely materially to affect the price of a corporation’s securities is information which may well materially affect the price, i.e., it is more likely than less likely that the price will be affected materially.

The standard by which materiality is judged is whether the information on the particular share would influence persons who would be likely to deal in the share, in deciding whether or not to buy or sell it. The test of whether the information is likely to materially affect the price is necessarily a hypothetical one since it has to be applied at the time the information becomes available. Obviously, there are no fixed thresholds of price movements or quantitative criteria that can determine the materiality of a price movement. Volatility of “blue-chip” shares is typically less than that of small, less liquid stocks and “blue-chip” securities usually move within ranges narrower than those of small stocks. Hence smaller percentage movements may be material for large company stocks.

While the actual magnitude of the share price movement once the information becomes publicly known indicates the extent of probable change the information might have caused, this is by no means conclusive. It is possible that the actual price change once the information is released is moderate due to the mixed impact of the information released and other extraneous factors. Further, a material price movement may have been pre-empted by the fact that the share price has already declined substantially in the period leading up to the release of the information.

The ruling of the MMT case of Warderly International Holdings Limited¹¹ (discussed below) shows that the fact that a connected person dealt in shares of a listed company while in possession of inside information does not always constitute insider dealing as it is fact specific.

2.7 Dealing in securities

Under section 249 of the SFO a person deals, whether he acts as principal or agent. Agreeing to deal and buying or selling the right to deal will also be dealings under the SFO.

WHAT IS NOT INSIDER DEALING?

3. Defences

Sections 271 and 292 of the SFO set out defences to insider dealing where a person can establish that they fall within one of the following categories:

3.1 The dealing, counselling or procuring was made:

1. for the sole purpose of acquiring qualifying shares as a director or intending director of a corporation;
2. in good faith in performance of an underwriting agreement for the listed securities or derivatives in question; or
3. in good faith as a liquidator, receiver or trustee in bankruptcy.

3.2 Chinese Wall Defence

A corporation (e.g. an investment bank or sponsor firm) will have a defence if it can demonstrate that:

1. there were effective arrangements in place (i.e. a “Chinese wall”) to ring-fence any inside information in the possession of any of its directors and employees; and
2. each person who took the decision for the corporation to deal, counsel or procure a dealing in the listed securities or derivatives in question did not have the inside information at that time and had not received advice from those in possession of such information.

3.3 Innocent Purpose Defence

It is a defence if the purpose for which a person dealt in or counselled or procured another to deal in the listed securities or their derivatives or disclosed information did not include the purpose of securing or increasing a profit or avoiding or reducing a loss, whether for himself or another, by using the inside information. The use of the “innocent purpose defence” was clarified on 12 October 2018, when the CFA delivered its decision in the case of Securities and Futures Commission v Yiu Hoi Ying Charles and Others.¹²

3.4 It is a defence if a person dealt or counselled or procured another to deal in a corporation’s listed securities or their derivatives:

1. as agent;
2. he did not select or advise on the selection of such listed securities or derivatives; and
3. he did not know that the person for whom he acted was connected with that corporation or had the inside information.

3.5 Off-market dealings

It will be a defence if the dealing occurred off-market in Hong Kong and:

1. the person dealing in listed securities or their derivatives and the other party:
   1. entered into the dealing directly with each other; and
   2. at the time of the dealing, the other party knew, or ought reasonably to have known, of the inside information; or
2. where a person counselled or procured another person to deal in listed securities or their derivatives, he counselled or procured the other party to enter into the dealing directly with him and at that time the other party knew, or ought reasonably to have known, of the inside information.

3.6 It is a defence where a person dealt in listed securities or their derivatives but did not counsel or procure the other party to deal and at the time of the dealing the other party knew, or ought reasonably to have known, that he was a person connected with the corporation.

This defence operates on the assumption that people who transact with someone they know or should know is a company insider, should be on notice that the other party may be insider dealing and so make adequate inquiries with the insider before dealing with them and maybe negotiate terms as to the disclosure of inside information.

3.7 A person will have a defence if they counselled or procured another to deal in listed securities or their derivatives and establishes that:

1. the other person did not counsel or procure the other party to the dealing to deal in the listed securities or derivatives; and
2. at the time he counselled or procured the other person to deal, the other party to the dealing knew, or ought reasonably to have known, that the other person was a person connected with the corporation.

This gives a defence to a person who counsels or procures a person to deal in the same circumstances as a defence is available to a person who deals under 3.6 above. It is really a logical extension of that defence and would, for example, protect a merchant bank who introduced a prospective purchaser to a substantial shareholder of a listed corporation who the bank thought might want to tender to divest their shareholding and advised the shareholder on the sale.

3.8 A defence is available to a person who dealt or counselled or procured another to deal in a corporation’s listed securities or their derivatives where:

1. the person acted in connection with any dealing which was under consideration or was the subject of negotiation, or in the course of series of such dealings and with a view to facilitating the accomplishment of the dealing or the series of dealing; and
2. the inside information was market information arising directly out of his involvement in the dealing or the series of dealings.

“Market Information” is defined to include facts such as:

• that there has or is to be (or that there has not been or is not to be) a dealing in listed securities or their derivatives or that any such dealing is under consideration or negotiation;
• the quantity and price (or price range) of the listed securities or their derivatives; and
• the identity of the persons involved.

This gives a defence to a person who trades with knowledge of his own trading intentions or activities and also to those who simply execute or facilitate a trade on his behalf. This defence caters for the situation in which a person, whose trading activities might be price-sensitive information (e.g. a substantial shareholder and therefore a connected person, increases his stake in a listed company). Without such an explicit defence a person dealing with ‘insider’ information about their own trading activities is technically insider dealing.

3.9 Dealing subject to the rules of a recognised clearing house will have a defence where the deal was entered into by the clearing house with a clearing participant for the purposes of the clearing and settlement of a market transaction.

Sections 272 and 293 provide a further defence where a trustee or personal representative dealt in or counselled or procured a dealing in listed securities or their derivatives on advice obtained in good faith from an appropriate person who did not appear to him to be a person who would have been involved in insider dealing if he himself had dealt in the listed securities or their derivatives.

Sections 273 and 294 provide a defence where a person dealt in listed securities or their derivatives in the exercise of a right to subscribe for or otherwise acquire such securities or their derivatives which was granted to him or was derived from securities held by him at a time when he was not aware of any inside information.

Innocent purpose defence

The innocent purpose defence provided by section 271(3) of the SFO was clarified on 12 October 2018, when the CFA ruled in a four-to-one decision for the Securities and Futures Commission (SFC) in Securities and Futures Commission v Yiu Hoi Ying Charles and Others. The respondents, Mr. Yiu Hoi Ying Charles (Mr. Yiu) and Ms. Wong Nam Marian (Ms. Wong) held 6 million shares and 10 million shares in Asia Telemedia Limited (ATML), respectively. ATML owed a debt of HK$58.08 million to Goodpine Limited.

In April 2007, Goodpine Limited served a statutory demand on ATML and stated that it would issue a winding-up petition against ATML if the debt was not repaid within 21 days. While this was known to Mr. Yiu and Ms. Wong, it had not been announced to the public. At the same time, shares in ATML experienced a price surge. Mr. Yiu took advantage of the surge by selling all of his 6 million ATML shares in May 2007 and obtained a net profit of HK$5.305 million. Ms. Wong sold her 10 million ATML shares between February and June 2007 and made a net profit of HK$5.1 million. The SFC alleged in proceedings before the Market Misconduct Tribunal that the respondents’ knowledge of Goodpine Limited’s statutory demand to ATML constituted inside information and that they engaged in insider dealing when they relied on that information to dispose of their ATML shares at a profit.

Mr. Yiu and Ms. Wong relied on the innocent purpose defence by claiming that the reason for their disposals was the speculative surge in ATML’s share price at the time and not their knowledge of the inside information (i.e. Goodpine Limited’s issue of a statutory demand and threat to wind-up ATML). They argued that ATML’s financial situation would be “dealt with behind closed doors” eventually and would not influence the market. The MMT (and later the Court of Appeal) accepted that defence. However, that defence was rejected in the CFA’s four-to-one decision for the SFC.

Whether Mr. Yiu and Ms. Wong could rely on the defence turned on what constitutes use of the inside information. The CFA reasoned that using inside information means turning the possession of inside information into action. Mere withholding or non-disclosure of inside information is insufficient to show use of the inside information. The inside information had to be exploited for financial advantage. The respondents knew that the price of the ATML shares was artificially high because of the inside information they possessed and they disposed of the shares to profit from that knowledge.

The CFA’s ruling seems to suggest that officers of a listed corporation are considered to be using inside information and cannot rely on the innocent purpose defence if they possess inside information which is not publicly known when they deal in the corporation’s securities. The respondents’ belief as to what might happen in the future (i.e. that ATML’s financial situation would be dealt with behind closed doors) was considered irrelevant. The defence does not apply as long as the inside information played a role in the decision making, regardless of how big or small a role the inside information had in the decision making process. What mattered was whether the elements of insider dealing were satisfied and whether the defence was applicable when the transaction took place.

The implications of the judgement are that officers of listed companies who possess inside information should avoid dealing in the companies’ shares until the inside information has been publicly announced.

4. Consequences of Insider Dealing

The SFO creates dual civil and criminal insider dealing regimes.

4.1 Civil Proceedings

The Market Misconduct Tribunal conducts civil proceedings and, where appropriate, imposes civil sanctions against those it determines to be wrongdoers.

The MMT is an independent body chaired by a judge or former judge who sits with two members and a presenting officer appointed by the Secretary for Justice when conducting proceedings. It is inquisitorial and is entitled to direct that the SFC carry out further investigations and report its findings to the MMT.

Under the SFO the presenting officer is a lawyer whose role is to present evidence to the MMT. He should be more like a prosecuting counsel rather than a counsel assisting the tribunal and he should be independent.

There are detailed provisions in the SFO governing the composition of, and procedures to be followed by, the MMT.

MMT Proceedings

If it appears to the SFC that market misconduct has, or may have, taken place, it can institute proceedings before the MMT under Section 252 of the SFO. Proceedings are instituted by the SFC giving the MMT notice specifying the matters prescribed by Schedule 9 to the SFO.

The purpose of MMT proceedings is to determine:

1. whether any market misconduct has taken place;
2. the identity of persons who have engaged in market misconduct; and
3. the amount of any profit gained or loss avoided as a result of the market misconduct.

The MMT may identify a person as having engaged in market misconduct if:

1. he has perpetrated any market misconduct;
2. the market misconduct was perpetrated by a corporation of which he is an officer with his consent or connivance; or
3. another person engaged in market misconduct and he assisted or connived with that person in the perpetration of the market misconduct, knowing that such conduct constituted or might constitute market misconduct.

The MMT makes its findings on the civil standard of proof. It therefore needs to be satisfied that a person has engaged in market misconduct on the balance of probabilities (rather than beyond reasonable doubt which is the criminal standard of proof).¹³

The MMT has powers to receive any evidence, whether or not the evidence would be admissible in civil or criminal proceedings. It also has wide powers to compel the giving of evidence and to prevent the publication of information about the evidence it receives. Significantly, a person is not excused from complying with a requirement of the MMT to give evidence on the ground that to do so might incriminate him (section 253(4)) and such compelled self-incriminatory evidence may be considered by the MMT.

In Securities and Futures Commission v Cheng Chak Ngok and Another (September 2018), the SFC had appealed against the MMT’s decision that Mr. Cheng had not engaged in insider dealing in shares of China Gas Holdings Limited (China Gas). The Court of Appeal allowed the appeal and examined certain principles.

Facts

Mr. Cheng was the executive director, chief financial officer and company secretary of ENN Energy Holdings Limited (ENN), which in 2011 considered acquiring China Gas. China Petroleum & Chemical Corporation (Sinopec) agreed to form a consortium with ENN to finance the acquisition. Mr. Cheng had responsibility for negotiating the financial proposal for ENN. He obtained information regarding: (a) the consortium formed to finance the acquisition; (ii) the timing of the announcement of the general offer (the Announcement); and (iii) the offer price. The SFC considered that insider dealing had been committed by Mr. Cheng when he used a third party’s securities account to purchase China Gas shares immediately prior to its suspension of share trading before the Announcement. He obtained a profit of approximately HK$3 million when he later sold the shares. However, on the available evidence, the MMT decided that it was not satisfied on a balance of probabilities that Mr. Cheng had dealt in China Gas shares at the material times. Consequently, insider dealing could not be proved. The SFC appealed against that decision.

Principles set out by the Court of Appeal

Nature of MMT Inquiry

The Court of Appeal noted that the nature of the MMT’s inquiry on market misconduct is civil and inquisitorial. This means that the judge has an examining or inquiring role in investigating the facts, rather than the impartial role of the judge in an accusatorial system. The function of the MMT is to inquire into the question of insider dealing, not to decide between competing positions or claims. MMT proceedings are inquisitorial.

Standard of Proof

As the nature of inquiry by the MMT is civil, the standard of proof is on a balance of probabilities. Case law establishes that the standard of proof will be proportional to the seriousness of the allegations (i.e. the more serious the allegation, the more compelling the evidence required).

Burden of Proof

The concept of burden of proof is only relevant in adversarial proceedings. In inquisitorial proceedings, no party has the burden of proof.

SFC’s Grounds for Appeal

The SFC specified 4 grounds of appeal:

1. the MMT had erred in law in (a) misdirecting itself that the inquiry was adversarial in nature, (ii) misdirecting itself that burden of proof applied and rested with the SFC, and (iii) failing to exercise its investigative powers under the SFO;
2. the MMT had applied a criminal standard of proof which required the SFC to prove the case beyond reasonable doubt and evidential principles applicable to criminal proceedings in evaluating the evidence;
3. the MMT erred in concluding that it could not be satisfied that Mr. Cheng had engaged in insider dealing on a balance of probabilities; and
4. the MMT failed to exercise its investigative powers under the SFO before concluding the inquiry.

Decision of the Court of Appeal

Standard of proof

The Court of Appeal found that MMT had not properly evaluated the available evidence and was wrong in applying the criminal standard. The MMT accepted that Mr Cheng’s evidence was confusing and suspicious, but insisted on the SFC providing more compelling evidence to prove the case. The MMT thus erred in requiring the SFC to prove the case on the basis of the criminal standard of proof.

Burden of proof

The Court of Appeal also found that the MMT had incorrectly imposed the burden of proof on the SFC. The Court of Appeal’s view was that no burden of proof need be imposed in an inquisitional inquiry. The SFO requires the SFC to present evidence to the MMT to enable the MMT to come to a decision.

The Court of Appeal thus provided clarification that in market misconduct proceedings before the MMT, the SFC is only required to present evidence and information to the MMT, which should investigate the facts to reach a decision on a balance of probabilities.

MMT Orders

At the end of any proceedings the MMT may under subsection 257(1) SFO impose the following sanctions on any person found to have committed market misconduct:

1. a disqualification order – that a person shall not, without the leave of the Court of First Instance, be or continue to be a director, liquidator, or receiver or manager of the property or business, of a listed corporation or any other specified corporation or in any way, whether directly or indirectly, be concerned or take part in the management of a listed corporation or other specified corporation for up to 5 years;
2. a cold shoulder order – that a person shall not, without the leave of the Court of First Instance, in Hong Kong, directly or indirectly, deal in any securities, futures contract or leveraged foreign exchange contract, or an interest in any of them or a collective investment scheme for up to 5 years;
3. a cease and desist order – that the person must not again engage in any specified form of market misconduct;
4. a disgorgement order – that the person pay to the Government an amount up to the amount of any profit gained or loss avoided as a result of the market misconduct;
5. Government costs order – that the person pay to the Government its costs and expenses in relation to the proceedings and any investigation;
6. SFC costs order – that the person pay the SFC’s costs and expenses in relation to any investigation; and
7. disciplinary referral order – that any body which may take disciplinary action against the person as one of its members be recommended to take such action against him.

A disgorgement order may, at the discretion of the MMT, be made subject to compound interest from the date of the occurrence of the market misconduct in question (section 259). The SFC also has the ability to fine regulated persons.

When making an order, the MMT may take account of any previous convictions in Hong Kong, any previous findings of market misconduct by the MMT and any previous findings of insider dealing under the predecessor ordinance (the Securities (Insider Dealing) Ordinance (s257(2) SFO).

Failure to comply with a disqualification, cold shoulder or cease and desist order is a criminal offence under sub-sections 257(10) and 258(10) punishable by a maximum fine of HK$1 million and/or up to 2 years’ imprisonment.

In addition, sections 253(2) and 254(6) prescribe a penalty of a maximum fine of $1 million and a maximum of 2 years’ imprisonment for failure to comply with various requirements of the MMT or disrupting its proceedings. The conduct referred to in those sections and in sections 257(10) and 258(10) is also liable to be punished as contempt under section 261.

Appeals

Any person who is dissatisfied with a finding or determination of the MMT may appeal to the Court of Appeal but only in respect of a point of law or, with the leave of the Court of Appeal, on a question of fact (section 266).

Under the SFO, a party who is not satisfied with certain decisions by the SFC (i.e. disciplinary action) may appeal to the Securities & Futures Appeal Tribunal (SFAT). Recent MMT and SFAT decisions have reiterated that:

• SFC disciplinary proceedings are civil in nature for the purposes of the Hong Kong Bill of Rights; and
• the civil standard of proof in section 218(7) of the SFO, allowing for flexibility in respect of the seriousness of the issue (a sliding standard of proof)¹⁴, should be used in any SFC disciplinary proceedings and SFAT proceedings,¹⁵ except for charges of contempt. It is possible for the civil threshold to approach or even be identical to the criminal standard if the potential penalty can lead to loss of liberty¹⁶. However, generally, the standard of proof in disciplinary proceedings of offences that are not generally applicable to the public, but only to a limited group of individuals, such as licensed persons, would not be criminal.

Re China Huiyuan Juice Group Ltd

In China Huiyuan Juice Group Ltd, Ms. Sun Min was prosecuted for buying around 8.6 million shares of China Huiyuan Juice Group Ltd, a PRC fruit drinks producer listed on the Main Board of the Hong Kong Stock Exchange, on 6 different occasions thorough 4 different companies ahead of its announcement that it would be acquired by Coca-Cola. Ms. Sun, owner of a shipping business, made a profit in excess of HK$55.1million when she sold all her shares in the company within 48 hours after the public announcement of the Coca-Cola takeover.

Ms. Sun had close connections with the management of the company, but there was no direct evidence proving that she received insider information on the Coca-Cola takeover. She denied having any inside information or knowledge of the takeover. The SFC’s case against her centred around the circumstantial evidence and inferences from handwritten notes on the Coca-Cola takeover found in Ms. Sun’s secretary’s diary, which were taken in a meeting between Ms. Sun, her husband, her secretary and the COO of Ms. Sun’s shipping company. The SFC was unable to identify from which connected person the inside information came. The secretary was unable to recall how the information was collected nor whether it was passed to her employer.

The MMT held that if the identity of the connected person who passed on the insider information could not be ascertained, the MMT would decide, based on all available evidence, whether a compelling inference could be drawn that the insider information must have been from an unidentified connected person and that Ms. Sun must have known of that fact.

The information did not constitute a mere rumour and was fact specific. Some of the handwritten notes in the diary concerned PRC antitrust law. The MMT considered that an ordinary investor would not have considered PRC antitrust law issues unless they knew of the potential Coca-Cola takeover. On that basis, the MMT inferred that the information came from an insider even though the insider’s identity could not be ascertained.

The MMT also considered that the inside information in the diary must have come from Ms. Sun or she must have known of the information. Absent any reasonable reason, that would have been passed on in the normal course of events. The MMT therefore rejected the secretary’s evidence that she was unsure whether she had passed on the information to Ms. Sun.

Re Warderly International Holdings Limited

Facts

Warderly International Holdings Limited (Warderly) was a company formerly listed on the Main Board of the Hong Kong Stock Exchange and engaged in the production of electronic goods in the PRC.

In mid 2006, Warderly encountered cash flow problems due to a surge in raw materials prices and the settlement of a large profit tax claim from the Hong Kong Inland Revenue Department. From July 2006, it defaulted in repaying bank loans and banks tightened their credit lines to Warderly and suppliers stopped providing raw materials. There were also several labour strikes in the PRC factories between September 2006 and April 2007 due to unpaid or delayed wages.

The following events and loans occurred between November 2006 and May 2007:

1. On 23 August 2006, Warderly’s annual report for the year ended 30 April 2006 showed a dramatic fall in net profits from HK$58million the previous year to a mere HK$398,000.
2. On 17 November 2006, Warderly’s subsidiary, Sharp Venture Holdings Limited (Sharp Venture) borrowed from Mr. Liu Su Ke a loan of HK$2million at an interest rate of 5% per month, repayable after 1 month and interest rate at 1.5% per month thereafter if the loan remains outstanding (Loan Terms);
3. On 11 December 2006, Mr Liu lent a further HK$1.2million to Sharp Venture with the Loan Terms to enable it to pay its workers over Chinese New Year;
4. On 28 December 2006, Mr Liu, via his company Vision Eagle Limited, lent another HK$6million to another Warderly’s subsidiary, Housely Industries Limited (Housely) with the Loan Terms. A letter of authorisation was also executed by Mr. Yeung Kui Wong, the Chairman and majority shareholder of Warderly, pledging all his 231.8 million Warderly shares to Mr. Liu as security; and
5. On 23 January 2007, Warderly announced its interim results for the 6 months ended 31 October 2006. This showed net profit had dropped to HK$2,194,000 from HK$20,443,00 for the same period in 2005 and bank balance had reduced from HK$116,168,000 to HK$27,775,000.
6. On 28 January 2007, Warderly failed to repay the loan plus interests that were due to Mr. Liu.
7. Between 15 February 2007 and 4 April 2007, Mr. Luu Hung Viet, Derek, a potential investor who was initially interested in acquiring Mr. Yeung’s shareholding in Warderly and to restructure the Warderly Group, lent a total sum of HK$10million to Housely at a monthly interest rate of 3% per month. Mr. Yeung pledged 50million Warderly shares at HK$0.20 per share to Mr. Luu. Mr. Luu further committed himself, subject to due diligence, to take up the additional HK$12.8million debt owned by Warderly to Mr. Liu;
8. On 12 March 2007, Warderly announced a potential acquisition of an oil project in China; and
9. On 14 May 2007, trading in Warderly shares was suspended with a closing price of HK$0.48.

Warderly Share Trading

Mr. Lo Hang Feng was a partner of a Hong Kong law firm and was the legal adviser and company secretary of Warderly at the material time. He bought 1,597,500 Warderly shares in late 2003 and early 2004 at prices between HK$1.14 and HK$1.20 per share. It was alleged that before the public was made aware of Warderly’s financial position, he sold all his Warderly shares on 3 occasions on 28, 29 and 30 March 2007 for prices between HK$0.51 to HK$0.53 per share.

It was also alleged that the 50 million Warderly shares pledged by Mr. Yeung and held by Mr. Luu via his 3 nominees were sold on his instructions on 3 April, 4 April, 30 April 2007 and on 2 May 2007 for a prices between HK$0.39 to HK$0.48.

The Relevant Information

The SFC argued that the following specific events were “relevant information” (now renamed inside information):

1. Tightening of banking facilities since July 2006, and the subsequent events such as overdue loans, rescheduled payments, demand letters and writs issued by banks and lenders;
2. The HK$2million loan from Mr. Liu on 17 November 2006 at an interest rate of 5% per month;
3. Further loans from Mr. Liu totalling HK$7.2 million at an interest rate of 5% on 11 and 28 December 2006;
4. Warderly’s failure to repay the loan and interest due to Mr Luu when they became due on 28 January 2007; and/or
5. The HK$10 million loan from Mr. Liu in February 2007 that carried an interest rate of 3% per month and was secured by 50 million Warderly shares.

The SFC alleged that Mr. Lo and Mr. Luu engaged in insider dealing as they were in possession with the relevant information concerning Warderly’s poor financials, which was not publicly known, and avoided losses by selling their Warderly shares.

Do the 5 Specified Events Constitute Relevant Information?

The MMT heard expert evidence as to whether the 5 specified events were relevant information. The MMT held that information regarding Warderly’s poor financials were already known to the public as its dire financial state was already disclosed in its Annual Report of August 2006 and the interim report for the 6 months ended 31 October 2006 (the Financial Reports). The MMT considered that the Financial Reports showed that Warderly was in serious financial trouble that even the most unsophisticated investor would understand. Further, the news of the issuance of writs for unrepaid loans was already in the public domain.

Therefore, by the time the price per share hits its lowest level of HK$0.214 after the publication of the poor finances and news of ongoing litigation for unrepaid loans, the increasing difficulty with securing funding, the various loans taken out and the loan defaults were trivial in nature. The public already knew of the poor financial position of Warderly. This was supported by the fact that from examining historical stock prices of Warderly, the publication of the news of the issue of writs for unrepaid loans had no adverse impact on the stock prices.

By early February 2007, Warderly shares were trading as if it were a shell company for backdoor listing. Warderly was already being evaluated for its potential to be reinvested with a different core business than electronic goods manufacturing which were of little or no consequence by then.

The MMT heard from experts that in cases of potential backdoor listing, the share price often rise dramatically along with market increase in the trading volume and increased volatility due to rumour and press comments. The MMT noted that from 9 February 2007, the price of Warderly stocks spiked and increase trading volume compared to the month prior thereto. Such activity maintained until trade suspension on 14 May 2007. There was also the announcement of the possible injection of an oil processing company into the Warderly group and increased press comments in March and April 2007. All these supported the view that Warderly was trading as a shell company ripe for backdoor listing.

As such, by the end of March 2007, the 5 specified events could not be shown to be relevant information which if publicly known, would materially affect the share prices. Thus, Mr. Lo and Mr. Luu were not held to have engaged in insider dealing.

Trading in Warderly shares was suspended on 14 May 2007. On 16 December 2013, after a backdoor listing, Warderly resumed trading under a different name and engaged in property, building, investment and healthcare businesses.

The Warderly case shows that a connected person dealing in listed stocks while in possession of price sensitive inside information does not always constitute insider dealing. Whether insider dealing has taken place or not is fact specific.

4.2 Criminal Liability

All forms of market misconduct (including insider dealing) are liable to prosecution as a criminal offence under Part XIV of the SFO.

Penalties

The maximum criminal sanctions under the SFO are a maximum of 10 years’ imprisonment and fines of up to HK$10 million. In addition, the court may make disqualification, cold shoulder and disciplinary referral orders. Failure to comply with a disqualification or cold shoulder order is an offence liable to a maximum fine of HK$1 million and up to 2 years’ imprisonment.

No double jeopardy

A person will not be subject to the “double jeopardy” of both civil proceedings under Part XIII and criminal proceedings under Part XIV for the same conduct. The SFO provides that a person who has been subject to criminal proceedings under Part XIV may not be subject to MMT proceedings if those proceedings are still pending or if no further criminal prosecution could be brought against that person again under Part XIV in respect of the same conduct and vice versa (sections 283 and 307).

The decision as to whether to take civil or criminal proceedings in relation to suspected market misconduct is made by the Secretary for Justice. The SFC may also institute summary criminal proceedings before a magistrate for less serious market misconduct offences, although the Secretary for Justice is able to intervene in the SFC’s conduct of any such proceedings. The decision whether to take criminal or civil proceedings is made in accordance with the Department of Justice’s Prosecution Policy which provides two criteria for the institution of criminal proceedings: that there is sufficient evidence for a criminal prosecution and that a criminal prosecution is in the public interest. If these tests are not met, suspected market misconduct will be dealt with through civil proceedings before the MMT.

4.3 Civil Liability – Private right of action

The SFO provides a private right of civil action against any person who has committed market misconduct or any offence under Part XIV in favour of anyone who has suffered a pecuniary loss as a result, unless it is fair, just and reasonable that the perpetrator should not be liable (sections 281 and 305).

A person will be taken to have committed market misconduct if:

1. he has perpetrated any market misconduct;
2. corporation of which he is an officer perpetrated the market misconduct with his consent or connivance; or
3. any other person committed market misconduct and he assisted or connived with that person in the perpetration of the market misconduct, knowing that such conduct constitutes or might constitute market misconduct.

It is not necessary for there to have been a finding of market misconduct by the MMT or a criminal conviction under Part XIV before bringing civil proceedings. Findings of the MMT are however admissible in the civil proceedings as prima facie evidence that the market misconduct took place or that a person engaged in market misconduct. Further, a criminal conviction constitutes conclusive evidence that the person committed the offence. The courts are able to impose injunctions in addition to or in substitution for damages.

Transactions not Void or Voidable

Sections 280 and 304 SFO provide that a transaction is not void or voidable by reason only that it constitutes market misconduct.

5. Liability of Officers of a Corporation

5.1 Duty of Officers

Section 279 of the SFO imposes a duty on all officers of a corporation to take reasonable measures to ensure that proper safeguards exist to prevent the corporation from acting in a way which would result in the corporation perpetrating any market misconduct.

The definition of an “officer of a corporation” includes a director (including a shadow director and any person occupying the position of a director), manager or secretary of, or any other person involved in the management of, the corporation. The last category (i.e. any other person involved in management) could, in principle, catch supervisors and anyone else with management responsibilities.

Under Section 258, where a corporation has been identified as having been engaged in market misconduct and the market misconduct is directly or indirectly attributable to a breach by any person as an officer of the corporation of the duty imposed on him under section 279, the MMT may make one or more of the orders detailed above in respect of that person even if that person has not been identified as having engaged in market misconduct himself.

Civil Liability

The SFO clearly provides that anyone who suffers pecuniary loss as a result of market misconduct has a right of civil action to seek compensation. As noted, an officer of a corporation which perpetrated market misconduct is taken to have committed market misconduct himself, if the corporation perpetrated the misconduct with his consent or connivance.

Criminal Liability

Under section 390 of the SFO, where it is proved that an offence committed under Part XIV was aided, abetted, counselled, procured or induced by, or committed with the consent or connivance of, or attributable to the recklessness of, any officer of the corporation, or any person purporting to act in any such capacity, that person, as well as the corporation, is guilty of the offence and liable to be punished accordingly.

Disciplinary Proceedings

Under Part IX of the SFO, any regulated person who is guilty of misconduct or who, in the opinion of the SFC, is not a fit and proper person to be or to remain the same type of regulated person, is subject to a widened range of disciplinary procedures. “Misconduct” is defined to include any contravention of the SFO or of the terms of any licence issued or registration made under it.

The SFC may revoke or suspend a person’s licence in respect of all or any part of the regulated activities for which he is licensed. In addition, or alternatively, the SFC may impose a fine not exceeding the greater of HK$10 million or 3 times the amount of the profit gained or loss avoided by the regulated person as a result of his misconduct, or such other conduct which led to the SFC’s opinion that he is not fit and proper. The SFC may also impose prohibition orders preventing an offending person from, among other things, applying to be registered or licensed under the SFO. Approvals granted to responsible officers may also be suspended or revoked. Persons covered by these provisions include corporations licensed under the SFO, their responsible officers and persons involved in their management. Significantly, authorised financial institutions (which must be registered with the SFC to conduct regulated activities (e.g. securities dealing, asset management etc.,), their executive officers, persons involved in the management of their regulated business and individuals named in their register as carrying out a regulated activity, are also subject to the SFC’s disciplinary regime.

6. Proceedings under Section 213 SFO

Section 213 SFO enables the Court of First Instance (CFI), on the application of the SFC, to grant orders to prevent or remedy breaches of the SFO and other relevant ordinances. Section 213 of the SFO also covers:

1. aiding, abetting or assisted, counselled or procured another person to commit a breach of the SFO;
2. inducing, by threats, promises or otherwise, another person to commit a breach of the SFO;
3. directly or indirectly being knowingly involved in or a party to a breach of the SFO; or
4. attempting or conspiring with others to commit a breach of the SFO.

The available remedies include but not limited to injunctions and orders requiring the person to take steps to restore the parties to a transaction to the position they were in before the transaction or restraining or prohibiting a person from acquiring, disposing of or deal in any property. The CFI has to satisfy itself that it is desirable to make one or more of the order(s) and that the order(s) will not unfairly prejudice any person.

The decision of the CFA in Securities and Futures Commission v Tiger Asia Management LLC¹⁷ (Tiger Asia) and others confirmed the power of the CFI to make final orders sought by the SFC under section 213 of the SFO on the basis of insider dealing or other market misconduct without there having been a prior finding of such market misconduct by either the MMT or a criminal court.

Tiger Asia was a New York-based asset management company with no physical presence in Hong Kong. Tiger Asia and two of its senior officers were found to have breached the insider dealing and market manipulation provisions of the SFO in dealing in shares of Bank of China Limited (BOC) and China Construction Bank Corporation (CCB) in December 2008 and January 2009 and manipulated the price of CCB shares in January 2009.

With respect to the BOC shares, Tiger Asia was invited to take part in two placements of BOC shares in December 2008 and in January 2009, respectively. It was provided with confidential and price sensitive details of both placements. Upon receiving the inside information, Tiger Asia agreed not to deal in the BOC shares. It then short sold 104 million and 256 million BOC shares before both placements and made profits of around HK$9 million and loss of around HK$10 million respectively.

With respect to the CCB shares, Tiger Asia was invited to take part in the proposed placement by a placing agent, who informed Tiger Asia about confidential and price sensitive information on the size and the discount range of the proposed placement. Tiger Asia made a profit of around HK$32 million by short selling 93 million CCB shares before news of the placement became public. Tiger Asia then covered its short sales with the placement shares bought at a discount to the prevailing market rate. Tiger Asia also manipulated the CCB share price during the closing auction session.

The court ordered Tiger Asia and the two senior officers to pay around HK$45.3 million to investors affected by their insider dealing.

Section 213 of the SFO is remedial in nature and is concerned with handling the adverse consequences of actual or potential market misconduct. Proceedings commenced under section 213 of the SFO are stand-alone proceedings and are intended to provide remedies to protect interests of those involved in the impugned transaction(s). Section 213 of the SFO serves as another avenue through which the SFC protects investors’ interests.

It is also clear from the case of HKSAR v Du Jun¹⁸that the SFC can pursue both criminal proceedings for insider dealing or other market misconduct offences and an order under section 213 SFO. Mr. Du Jun, a former Morgan Stanley managing director of the fixed income department, was involved in the ongoing projects with CITIC Resources Holdings Limited (CRH) and learnt that that CRH intended to acquire an oilfield in the PRC. On the basis of that insider information, he purchased a total of 26.7 million shares of CRH between February and April 2007. The total purchase cost amounted to around HK$87 million. The share price spiked after the public announcement of the proposed acquisition of the oilfield in the PRC. He made a profit of around HK$33.4 million and a loss of around HK$31.3 million when he sold all his CRH shares on two occasions.

Mr. Du Jun was convicted of insider dealing for which he was sentenced to six years’ imprisonment and fined HK$1.7 million.

In separate section 213 proceedings in December 2013, the court granted a restoration order against Mr. Du Jun ordering him to pay HK$23.9 million to 237 investors affected by the insider dealing.¹⁹ The amount ordered to be paid was intended to restore counterparties to the insider dealing transactions to their pre-transaction positions through payment of the difference between the shares on the date of the transaction (taking into account the inside information possessed by Mr. Du Jun) and the actual transaction price.

7. Other Insider Dealing Cases

7.1 Securities and Futures Commission v Chan Pak Hoe Pablo

The case of Securities and Futures v Mr. Chan Pak Hoe Pablo provided guidance for sentencing in insider dealing cases. Mr. Chan was a representative of the controlling shareholder of Universe International Holdings Limited (Universe) and was convicted of insider dealing in Universe shares by the Eastern Magistrates’ Court.²⁰

He was involved in Goldwyn Management Limited’s proposed acquisition of Universe from the controlling shareholder between March and June 2008. He gained price sensitive information between May and June 2008 from his involvement in the negotiation and he subsequently purchased 3,880,000 Universe shares. On 19 June 2008, it was announced that Universe’s controlling shareholder was in negotiation with a third party for the disposal of its entire shareholding in Universe and trading in Universe shares was suspended. The share price increased by around 40% when trading resumed and Mr. Chan made a profit of HK$120,000 when he disposed all of his Universe shares.

Mr. Chan was initially sentenced to 240 hours of community service (the Community Service Order) and was ordered to pay the SFC’s investigation costs of HK$44,478 (the Cost Order) by the Eastern Magistrate Court. This meant that he could retain the profits he made from insider dealing. Upon the SFC’s application to the Eastern Magistrate Court for a sentence review, the Magistrate sentenced Mr. Chan to 4 months imprisonment and ordered him to pay a fine of HK$120,000, representing the profits he made from insider dealing.

The Court of First Instance, on hearing Mr. Chan’s appeal, indicated that the starting point of a custodian sentence for insider dealing should be 6 months’ imprisonment.²¹ The Court upheld the Community Service Order and the Cost Order due to the Court’s interpretation of section 104(9) of the Magistrates Ordinance, which states that the Magistrates lacked jurisdiction to grant the application for review of a sentence once Mr. Chan had lodged a notice of appeal against his conviction.²²

However, the Court of Final Appeal reversed such interpretation and held that a pending appeal against one part of a magistrate’s decision does not preclude a review by that magistrate of another part of their decision in the same case.²³ Consequently, the High Court’s sentencing was set aside and the Magistrate’s sentencing upon review, being 4 months imprisonment and a HK$120,000 fine was restored. Taking into account the fact that Mr. Chan had already completed the Community Service Order by that time, 3 months’ imprisonment, a fine of HK$120,000 and the Cost Order were imposed instead.

The Honorable Mr. Justice Ribeiro stated that the appropriate sentencing for insider dealing cases is a custodial sentence and a fine to disgorge all the profits made from insider dealing.²⁴

In HKSAR v Du Jun²⁵, the Court of Appeal acknowledged that the differing circumstances of each insider dealing case means that sentencing will vary between cases. Nevertheless, the Court of Appeal endorsed the following 8 sentencing considerations from the case of R v McQuoid:²⁶

1. the nature of the defendant’s employment or retainer, or involvement in the arrangements which enabled him to participate in the insider dealing of which he was guilty;
2. the circumstances in which he came into possession of confidential information and the use he made of it;
3. whether he behaved recklessly or acted deliberately, and almost inevitably therefore, dishonestly;
4. the level of planning and sophistication involved in his activity, as well as the period of trading and the number of individual trades;
5. whether he acted alone or with others and, if so, his relative culpability;
6. the amount of anticipated or intended financial benefit or (as sometimes happens) loss avoided, as well as the actual benefit (or loss avoided);
7. although the absence of any identified victim is not normally a matter giving rise to mitigation, the impact (if any), where proved, on any individual victim; and
8. the impact of the offence on overall public confidence in the integrity of the market; because of its impact on public confidence, it is likely that an offence committed jointly by more than one person trusted with confidential information will be more damaging to public confidence than an offence committed in isolation by one person acting on his own.

7.2 Re Hong Kong Aircraft Engineering Company

Mr. Albert Lam Kwong-Yu, former Civil Aviation Department Director and former non-executive director of the then Main Board-listed²⁷ Hong Kong Aircraft Engineering Company (HAECO), was convicted of insider dealing of HAECO shares by the Eastern Magistrates Court and was sentenced to 5 months’ imprisonment, suspended for 2 years. He was also fined HK$50,000 and ordered to pay half of the SFC’s investigation cost, totalling HK$107,131.²⁸

Mr. Lam obtained price-sensitive information as the non-executive director of HAECO regarding Swire Pacific’s acquisition of 15% of HKAECO’s stocks from Cathay Pacific. He purchased 4,000 HAECO shares on 4 June 2010 minutes after he was informed of the price sensitive information and that an urgent board meeting would be held on the same day about the acquisition. Mr. Lam made a profit of HK$79,000 from the trade.

The Court rejected Mr. Lam’s case that he was intoxicated by alcohol when he made the online trade. To complete the trade, he was required to access his email and online banking accounts, move between webpages, insert details of the trade and transfer money to the security account which he had insufficient funds to complete the trade. These tasks required him to be conscious and alert.

7.3 Re China CBM Group Company Limited

Mr. Au-Yeung Siu Pang, former group finance manager of GEM-listed China CBM Group Company Limited (China CBM), was sentenced to 4 months imprisonment and was fined HK$120,000 by the Eastern Magistrates’ Court for insider dealing in China CMB shares.²⁹

Around 27 March 2012, he learnt of two pieces of insider information relating to China CBM while he was involved in auditing the company’s financials for the year ended 31 December 2011. He became aware that China CMB suffered an unaudited loss of around RMB 52million in 2011 and was at risk of trading in its shares being suspended because the outstanding audit issues could not be resolved in time for the 2011 annual results to be published on time. On 28 March 2012, on the basis of such insider information, Mr. Au-Yeung counselled or procured his father to sell 500,000 China CBM shares beneficially owned by Mr. Au-Yeung and on the following day he sold 600,000 China CMB shares himself.

On 30 March 2012, trading in China CMB’s shares was suspended. When trading resumed on 4 October 2012 the share price dropped 20% compared to the last traded closing price before the trading suspension. Mr. Au-Yeung’s insider dealing resulted in him avoiding a notional loss of HK$174,000.

Regulatory Developments

Role of Big Data

Recently, the SFC has focussed on adopting new technology to detect possible cases of insider dealing. Sometimes referred to as “big data”, “regtech” or “suptech”, these tools allow regulators to monitor trading patterns in large amounts of data and identify suspicious trading activity that suggest insider dealing has occurred. The US Securities and Exchange Commission’s (SEC) Analysis and Detection Center of the Market Abuse Unit has been in operation since 2010 and is responsible for analysing trade patterns and data to detect insider dealing in the US. In early 2017, the SEC entered into a supervisory cooperation arrangement with the SFC to facilitate information sharing between the regulators on regulated entities such as investment advisers, broker-dealers and securities exchanges operating in the US and in Hong Kong. The increased use of new technology combined with information sharing between regulators could lead to a more collaborative global effort to tackle insider dealing.

8. Chinese Walls and Requirements for SFC Licensed Entities

What is a “Chinese Wall”?

Section 4.3 of the Corporate Finance Adviser Code of Conduct provides that where a corporate finance adviser which is licensed or registered under the SFO (“CFA”) is part of a professional firm or group of companies undertaking other activities, e.g. auditing, banking, research, stock-broking and fund management, the CFA should ensure that there is an effective system of functional barriers (Chinese walls) to prevent the flow of information that may be confidential or price sensitive between the corporate finance activities and the other business activities. It specifies that the system should include physical separation between, and different staff employed for, the various business activities. It is for each CFA firm to decide what procedures and controls it should have to maintain an effective system of functional barriers in accordance with section 4.3 of the Corporate Finance Adviser Code of Conduct.

To prevent market abuse, many financial markets participants use Chinese walls. According to the UK Financial Conduct Authority (FCA), a Chinese wall is an arrangement that requires information held by a person in the course of carrying on one part of its business to be withheld from, or not to be used for, persons with or for whom it acts in the course of carrying on another part of its business. In a bank, a Chinese wall separates the M&A advisory division, which will often learn of inside information from its work for corporate clients on acquisitions, and its trading division which is restricted from trading if it knows such information.

Note that Chinese walls not only prohibit market participants from acting, but also protect them. If the information is held behind a Chinese wall, this provides evidence that the organisation did not deal on the basis of inside information. For example, a broker-dealer can continue to engage in trading activities without any fear of being guilty of insider trading.

Purpose of Chinese Wall

Chinese walls are used to prevent insider dealing and conflicts of interests by preventing the flow of non-public information. Chinese walls usually include:

• Physical separation of departments in different wings or floors of a building;
• Maintenance of separate accounting systems, records, support staff; and
• Restrictions on sensitive documents.

How to maintain Chinese Walls?

The SFC published an FAQ to clarify the meaning of and assist compliance with the Chinese walls requirement in 2013, which covers the following:

i. The importance of “Chinese Walls”

• In addition to the duty not to disclose confidential and/or price sensitive information to clients, CFA firms and their staff also have a broader duty to act fairly and in the best interests of their clients, avoid conflicts of interest situations and ensure the fair treatment of their clients.³⁰ The rationale behind Chinese Walls therefore is that any price sensitive and/or confidential information which a CFA has through advising on corporate finance/mergers and acquisitions should not be disclosed inappropriately or otherwise used by the firm or its staff, whether for its own benefit or for the benefit of other clients.
• Any disclosure of such information should be restricted to people who “need to know” it, e.g. in order to enable the firm to provide its services to the relevant corporate finance client. The existence of Chinese Walls is essential to reduce the risk of confidential/price sensitive information being misused or wrongly disclosed, which also risks contravention of the laws on insider dealing by preventing the spread of information between different departments of CFA firms.

ii. Person responsible for compliance

• The managing director, the board of directors, the chief executive officer or other senior operating management personnel (collectively, Senior Management) of a CFA are responsible for ensuring compliance with the Chinese Walls requirement. Senior operating management personnel refers to those in a position of authority over a CFA’s business decisions. The Senior Management should ensure that effective Chinese Walls are in place and that careful consideration is given to where Chinese Walls are placed within the organisation and which staff are grouped together.

iii. “Confidential information or price sensitive information”

• It is for each CFA to determine when it has confidential/price sensitive information which has to be protected. Generally, the SFC would expect non-public corporate finance information about a client to be confidential to that client.

iv. The importance of physical separation

• Section 4.3 requires that the effective system of functional barriers should include physical separation between, and different staff employed for, the various business activities. Where a CFA carries on different businesses, physical separation helps reduce the risk of accidental leakage and disclosure by confining information to a limited number of persons within a limited physical area.
• Although physical separation is a necessary element in an effective system, it is not of itself enough to constitute effective Chinese Walls. The SFC also accepts that it is not necessary for corporate finance staff to be permanently physically separated from all other staff on the private side which normally refers to groups of staff who deal directly with clients and have access to inside company information which is not available to the public. However, corporate finance staff must always be physically separated from non-private side staff (e.g. stock-broking staff and proprietary traders).

v. Other measures to maintain “Chinese Walls”

• In addition to physical separation, the senior management of CFA firms should look at the totality of their information-handling procedures and controls to assess whether they have an effective system.
• In determining the nature and extent of measures a CFA firm should adopt, it should consider:
  • The functions and rules of the staff on the private side that the firm plans to group together;
  • Whether the features of specific transactions require the information to be held confidential within a specific team (whether facilities for temporary separation are necessary for particular deals or teams within the Chinese Walls); and
  • Whether physical separation should be a permanent arrangement between particular business units (permanent physical separation between a firm’s corporate finance business and its proprietary traders is always necessary).
• In addition to physical separation, the senior management should also consider the following areas that can form part of the Chinese Walls:
  • Implementing a compliance culture and attitude
    • i.e. how to promote a compliance culture that values protection of client information e.g. through training, disciplinary action against staff in breach of policies, management example, etc;
  • Conflicts management controls and procedures
    • Conflicts management arrangements can help mitigate risks of information mis-use or disclosure. Conflict checks should be undertaken as soon as possible for new transactions or clients and in any event, before any pitch for a specific mandate, substantive discussions, or presentation to an appropriate business approval committee. It may also be necessary to obtain informed consent from relevant clients when conducting a conflict check.
  • Ways of handling/storing information
    • For example firms should consider implementing “clear desk” policies for paper documents and meetings where corporate finance information is to be discussed should be held in private. The use of code names for projects and deals should also be considered.
  • Physical controls in office setting
    • Examples include ensuring that visitors are accompanied at all times, holding client meetings only in client meeting rooms, and where necessary, holding internal discussions on matters that should not be discussed in shared office space in “Chinese box” rooms to which access is limited to specific deal team members.
  • IT infrastructure
    • Examples of IT controls that may be implemented include a printing system which only allows employees to print materials sent from their computers by swiping a personal access card on the printer’s control device and setting up segregated computer drives for individual deal teams for each transaction with restricted access and password-protected filing systems. Emails containing confidential information should be required to be encrypted.
  • Support functions
    • All staff, including those in support functions, should be subject to firms’ information-handling procedures and controls. Firms which rely on physical separation of their corporate finance business from their other activities should also consider whether and how that separation is reflected in the relevant support functions.
  • Insider lists and “above the wall” staff;³¹
    • Firms should maintain and regularly review lists of their employees with access to inside information relating, directly or indirectly, to corporate finance information, whether on a regular or occasional basis. The SFC recognises that some senior management staff and staff responsible for compliance will have access to corporate finance information, but without themselves being part of a firm’s corporate finance business. Appropriate controls should be implemented to ensure that these staff comply with the firm’s and their own information-handling obligations.
  • Training
    • Firms are required to train staff on the relevant legal and regulatory requirements and the firm’s procedures and controls to meet those requirements. Refresher training should be implemented from time to time.
  • “Wall crossings”
    • Corporate finance information may sometimes be legitimately disclosed by persons within a firm’s corporate finance business unit to staff on the non-private side of a Chinese Wall and sometimes even to other clients, for example, to conduct “market soundings” in a placing (“Wall-crossing” or bringing someone “Over-the-wall”). However, such disclosures must be subject to proper controls, and must not be made if such staff or client has expressly or impliedly refused to be “brought across the wall”. In particular, this must be done on a “need to know” basis (e.g. because the recipients’ views on a transaction are needed) and the recipients must be subject to a duty of confidentiality such that they cannot use or disclose the information for their own or others benefit until the information becomes public or otherwise ceases to be price-sensitive. Firms should keep proper records of such wall crossings.

The FAQ acts as a reminder that the above guidance is not directed at what firms must do to comply with the terms of the “Chinese Wall defence” to insider dealing. Also, corporate finance is not the only business in which client confidential information or price sensitive information arises. Therefore, all firms and staff should protect client confidentiality and prevent mis-use of confidential information in all circumstances.

Disadvantages of Chinese Walls

1. A Chinese Wall does not entirely stop the flow of inside information and prevent insider trading, nor does it always reduce conflicts of interest. Chinese Walls are more successful in preventing the accidental flow of inside information than they are in preventing purposeful misconduct and conspiracies to share inside information. Since a Chinese Wall is not successful in preventing an investment banker from intentionally disclosing inside information to retail traders, these deliberate disclosures of inside information will continue to occur.
2. A client’s right to be fully informed about all the facts may be jeopardised because of the lack of flow of information within an organisation. For example, a Chinese Wall may prevent a large multi-service firm from fulfilling its duty of undivided loyalty to customers. According to this fiduciary duty, a broker-dealer must disclose to its customers all material facts within its knowledge that in any way affect the transaction. The existence of a Chinese Wall may prevent retail traders from using information obtained from investment bankers to satisfy this duty of the firm’s retail traders.
3. Chinese walls may exert additional financial burdens on companies to set up effective management of price sensitive information.
4. Chinese walls may prevent companies from opportunities for collective thinking and other synergies of combining and integrating various departments.

How to reinforce Chinese Wall?

Given that Chinese Walls are not perfect and have disadvantages, a company may consider the use of watch list and restricted list to reinforce the Chinese wall. Restricted lists and watch lists are commonly used in Hong Kong.

Use of “Restricted List”

The SEC has proposed that a firm use a “restricted list” in addition to a Chinese Wall. A restricted list is a list of securities, maintained by a firm, in which proprietary, employee, and certain solicited customer transactions are restricted or prohibited.

An issuer or security may be placed on the restricted list in order to reinforce a firm’s information barrier, to comply with trading practices and other rules, to avoid the potential appearance of impropriety, or to meet other compliance or regulatory objectives. When an issuer appears on the restricted list, certain sales, trading and research activities involving that issuer’s securities or other financial instruments may be restricted. Restricted activities may include: proprietary trading, including market-making; solicitation of client orders; the recommendation of the issuer’s securities; and transactions for any employee, associated person, or related account with respect to the related securities or financial instruments. The restricted list is usually maintained by a firm’s compliance department, or by an institutional control room.³²

However, an obvious problem with the use of a restricted list is that the firm’s placing of a security on the restricted list may be equivalent to revealing the adverse information itself, particularly if the firm previously recommended the security. If the firm has an outstanding buy recommendation on a security, it will place the security on a restricted list if it obtains adverse information. This will rescind the recommendation but also keep the information from customers. However, the placement of the security on the restricted list signals that the firm has obtained negative information because otherwise it could continue to recommend the security. The SEC has attempted to address this problem by stating that the firm should place a security on the restricted list as soon as it enters into any relationship “likely to result in the receipt of inside information”. Obviously, this is not a very precise rule and may result in inconsistent application and uncertainty by broker-dealers regarding their potential liability. A restricted list is merely an addition to a Chinese Wall, so all the disadvantages of Chinese Walls still exist.³³

Use of “Watch Lists”

Broker-dealers typically employ watch lists in addition to Chinese Walls and restricted lists. Implicit in the use of watch lists and restricted lists is the assumption that Chinese Walls are insufficient to prevent the flow of inside information. A watch list is a list of securities whose trading is monitored by the firm’s compliance department, but there are no formal trading restrictions placed on them. The watch list is the most important element of Chinese Wall review procedures. This list enables the firm to determine if the Chinese Wall is effectively preventing the flow and misuse of material, non-public information. A watch list is only successful in detecting insider trading after it has already occurred, so it does not serve to improve the effectiveness of a Chinese Wall. Restricted lists, in contrast, attempt to prevent insider trading in the beginning. It has been argued that these attempts at improving Chinese Walls ultimately have proved ineffective and simply perpetuate their disadvantages.³⁴

Firms that conduct both investment banking and research or arbitrage activities must maintain some combination of restricted and watch lists, and should conduct regular reviews of trading in securities appearing on the lists. The self-regulatory organizations (SROs) set out specific minimum documentation standards concerning these lists, including records of the firm’s methods for conducting reviews of employee and proprietary trading, the firm’s procedures for determining whether trading restrictions will be implemented and the firm’s explanations of why, when and how a security is placed on or deleted from a restricted or watch list. Further, the firm must adequately document how it monitors employee trading outside the firm of securities on the restricted or watch lists.

Case involving Chinese Walls

Case 1: SFC v Young Bik Fung case

Facts

Two solicitors (Eric and Betty) and others had contravened SFO by insider dealing in the shares of Asia Satellite Telecommunications Holdings Ltd (AsiaSat) and had engaged in fraud and deception in transactions involving Hsinchu International Bank Company Ltd (Hsinchu Bank) shares.

Defendants’ arguments

• The defendant argued that the existence of a Chinese Wall in Linklaters should militate against the possibility of accidental leaks of confidential information to people outside the team.

SFC’s arguments

• The SFC argued that the court should have regard to the “realities of a legal office” and highlighted the fragilities ofLinklaters’ Chinese Wall.
• There was also evidence from Amy (Eric’s secretary) which revealed the fragilities in Linklaters’ system, e.g., she did not lock her filing cabinets as no keys were provided.

Court’s rulings in relation to Chinese Wall

• For section 291(3) (i.e. person connected with a corporation leaks inside information about that corporation) to apply, it must be proved that Eric was a “person connected with” AsiaSat. In the factual circumstances of the case, the SFC must prove, pursuant to section 287(1)(c)(i) of the SFO, that Eric occupied “a position which may reasonably be expected to give him access to relevant information in relation to [AsiaSat] by reason of … a professional or business relationship existing between” Linklaters and CITIC Group (AsiaSat’s major shareholder).

• Section 287(1)(c)(i) of the SFO provides as follows:

  “(1) For the purposes of Division 2, a person shall be regarded as connected with a corporation if, being an individual – …

  (c) he occupies a position which may reasonably be expected to give him access to relevant information in relation to the corporation by reason of –

  (i) a professional or business relationship existing between –

  1. himself, or his employer, or a corporation of which he is a director, or a firm of which he is a partner; and

  2. the corporation, a related corporation of the corporation, or an officer or substantial shareholder of either corporation; …”

• The test of “connected person” is an objective one, namely, what other people may reasonably expect of that person by virtue of his position. The limit that the definition places on the range of individuals who are connected persons is succinctly summarised in the following passage:
  • “… this objective test narrows the range of individuals within the definition of insider. It excludes individuals such as employees or other individuals in specified professional or business relationship, who occupy positions that quite unexpectedly give them access to unpublished price sensitive inside information. Hence, an individual’s formal position prevails over the qualitative nature of the information.”
• The defendant argued that although Eric was in the position of an employee within Linklaters, he was not part of the transaction team. As would reasonably be expected in any major law firm involved in corporate mergers and acquisitions work, Linklaters had a system in place to ensure that confidential information about any proposed deal that the firm was working on would be restricted only to those employees working on the deal. An employed solicitor who was not a member of the team working on the deal would not be in a position “which may reasonably be expected to give him access to relevant information” about that deal. It is clear from the evidence that Eric was not expected to have access to confidential information about the transaction in question.
• The Court held that the Chinese Wall in Linklaters did not prevent Eric from gaining confidential material price sensitive information in relation to AsiaSat. However, it would not be a correct application of the objective test to hold that Eric was a connected person. The court cited the following passage from a textbook:
  • “It may not always be a straightforward matter to determine whether an individual does occupy a position which may reasonably be expected to give him access to inside information about a company’s securities. Take the example of a market maker or investment manager in a securities house, in which there is also a corporate finance department. That securities house should ensure that a ‘Chinese Wall’ prevents inside information about corporate finance clients from leaving that department. If the corporate finance department is advising A Ltd about a prospective bid for its shares will this render X, an employee in the market making department, connected with A Ltd? The answer to that is probably ‘no’, since X, as a market maker in the securities house, does not occupy a position which may reasonably be expected to give him access to inside information about the securities of A Ltd if Chinese Wall arrangements have been adhered to. If the Chinese Wall arrangements are breached so that X receives that information, this may be insufficient of itself to make him connected with A Ltd as that breach should not have occurred. …“
• In other words, the Court held that Eric was not a connected person pursuant to section 291(3) of the SFO, notwithstanding that the court upheld the SFC’s case based on section 291(5) of the SFO (i.e. Eric was a recipient of inside information from a person connected with a corporation deals in shares of that corporation).
• The implication of this ruling is that, by simply working in a professional firm, like Linklaters, where Eric was a solicitor, but not in the team actually working on the confidential transaction in question, did not make Eric a “connected person”. This is because being in a different team of a firm that has Chinese Wall arrangements in place, would not bring Eric within s.287(1)(c)(i) as someone who occupied “a position which may reasonably be expected to give him access to relevant information … by reason of a professional or business relationship existing” between Linklaters and the client.

Case 2: ASIC v Citigroup Global Markets Australia Pty Ltd (No 4) [2007] FCA 963

In this case, the Federal Court of Australia gave its views on the adequacy of “Chinese Walls” and took into account a company’s compliance function in deciding whether there is a breach in the insider dealing provision under the Australian law.

Facts

• Citigroup Global Markets Australia Pty Ltd conducted business through various business divisions, including Investment Banking (“Private Side employees”) (“IB”) and Equities Trading (“Public Side employees”) (“ET”).
• Private Side employees were exposed to confidential, market sensitive information, whereas Public Side employees were not to be exposed to such information. Citigroup had in a place a Chinese Wall to segregate the IB and the ET such that the flow of information between them was restricted.
• ET bought shares in Patrick Corporation Limited (“Patrick”) at a time when IB was representing Toll Holdings on a takeover bid for Patrick. ET bought the shares on the last trading day before Toll Holdings announced its bid for Patrick.
• IB took steps to mitigate its action after it became aware of ET’s purchase. IB told ET to not to buy any more Patrick’s shares. ET listened to this advice but nevertheless sold 200,000 of Patrick’s shares at a profit.
• Toll Holdings subsequently announced its takeover bid for Patrick the following date.
• When IB became aware of the purchase, steps were taken that resulted in ET being told to stop buying any more of Patrick’s shares. ET did not purchase any more shares, but half an hour before the close of trading, ET sold 200,000 of shares that it had purchased that day at profit.
• Toll subsequently announced its takeover bid for Patrick the following day.

Major issues

• Whether Citigroup contravened insider trading provisions contained in section 1043A of the Corporations Act 2001 (the “Act”). Australian Securities and Investments Commission’s (“ASIC”) argued that:
  • After IB informed ET about the potential conflict, ET made a supposition that Citigroup was acting for Toll in the proposed takeover of Patrick. ASIC argued that this supposition constituted “information” within the meaning of that term in section 1042A of the Act. Thus, the disposal of the 200,000 shares should have constituted insider trading by Citigroup (“First Insider Trading Claim”); and
  • ASIA argued that Citigroup’s Chinese wall was not in place because: (a) it was likely that the senior IB personnel had knowledge of the takeover bid; (b) that knowledge was attributable to Citigroup as a whole, and (c) ET actually purchased Patrick’s shares (“Second Insider Trading Claim”).

Court’s rulings: Citigroup won

• First Insider Trading Claim
  • This claim failed because the employee was not an officer.
  • Under section 1042G(1)(a), the employee’s knowledge was not attributable to Citigroup unless he was an “officer” of Citigroup as defined by section 9 of the Act. For this claim to succeed, the employee who executed the trade should not only possess the insider information, but also have knowledge which is attributable to Citigroup.
  • The Court held that an “officer” for the purposes of the Act was someone with a senior management role, which this particular employee did not have. Also, Citigroup was acting for Toll in relation to the takeover of Patrick and the employee had not made the supposition as alleged by ASIC (i.e. he did not have the inside information).
• Second Insider Trading claim
  • This claim failed too.
  • Citigroup successfully raised the Chinese Wall defence found in section 1043F of the Act. i.e. Citigroup convinced the Court that it had compliance arrangements in place that could reasonably be expected to ensure that price sensitive information held by IB was not communicated to ET (or other Public Side employees). As required by the section, the decision to purchase the shares was made by a person other the persons who held the information and no information was communicated or advice given by IB with respect to the purchase.
• No appeal action was intended or lodged by ASIC.

Compliance implications – Chinese Walls

• The Australian court noted that a Chinese wall does not have to be absolutely perfect, rather a company should ensure there are reasonable steps to be taken in order to ensure the adequacy of a Chinese wall. The test as laid down in section 1043F of the Act is an objective one.
• The Court outlined the following relevant procedures that were required for effective Chinese walls:
  • physical separation by departments
  • educational programs
  • procedures for dealing with crossing the wall
  • monitoring by compliance officers; and
  • disciplinary sanctions.

Citigroup’s policies and training procedures with regards to Chinese walls

• The Court found that adequate procedures were in fact in place, referring to Citigroup’s written policies and compliance procedures. The written policy (among others) required Private Side employees (IB) not to communicate “material non-public information” to persons on the public side (ET) without involving legal or compliance personnel to assess the materiality of the information, and when appropriate, to implement “wall crossing” procedures.
• Citigroup’s written policies were available to all staff, regular training was provided and the policies were clear that employees were to be alert to the possibility of conflicts, and escalate any issues in relation to actual, apparent or potential conflicts of interest.
• Written policies and procedures of Citigroup were in place which set out the considerations that were to apply as to whether a public side employee should be brought over the Chinese Wall.
• However, the Court noted that “adequate arrangements require more than a raft of written policies and procedures. They require a thorough understanding of the procedures by all employees and a willingness and ability to apply them to a host of possible conflicts”.

Escalation procedures

• There was also a clear escalation policy, in which IB was able to advise the appropriate persons of the potential conflict, including the Compliance Department, Citigroup’s General Counsel and Chief Executive Officer. Accordingly, Citigroup’s in-house compliance division was able to properly advise IB and ET on what could or could not be disclosed to each other, and accordingly maintained the protection that the Chinese Wall provided.
• The Court found that such an escalation procedure supported the view that Citigroup had adequate Chinese Walls in place.

Lessons learnt from this case

• This case demonstrated the importance of an effective Chinese wall system which could help a company and its employees from breaching the insider dealing provisions.

April 2021

This note is provided for information purposes only and does not constitute, and should not be treated as a substitute for, legal advice. Charltons is only qualified to advise on Hong Kong law and the position set out in relation to the laws and regulations of any other jurisdiction represents only our understanding of the position in that jurisdiction. This note describes the position as at April 2021 only. Specific legal advice should be sought in relation to any particular situation.

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