CONTENTS

Paragraph
I. PURPOSE / 1 - 2
II. INTRODUCTION AND SUMMARY OF
RECOMMENDATIONS / 3 - 14
III THE NATURE OF THE PROBLEM / 15 - 34
IV OBJECTIVE AND SCOPE OF THE PROPOSED
REGIME / 35 - 36
V PROPOSED CHANGES IN SECURITIES
ORDINANCE / 37 - 49
VI PROPOSED CHANGES IN MONEY LENDERS
ORDINANCE / 50
VII FINANCIAL RESOURCES RULES / 51 - 80
VIII PROTECTION OF CLIENTS’ ASSETS / 81 - 88
IX CODE OF BUSINESS STANDARDS / 89 - 94
X COMPENSATION ARRANGEMENTS / 95 - 96
XI TRANSITIONAL ARRANGEMENTS / 97 - 98
XII INVESTOR EDUCATION / 99 - 100
XIII CONSULTATION / 101 - 102

i

I. PURPOSE

11This paper seeks public comments on proposals for the regulation of share margin financing activities.

22The proposals include changes to the Securities Ordinance (SO), the Money Lenders Ordinance (MLO) and the Financial Resources Rules (FRR) under the Securities and Futures Commission Ordinance (SFCO). Changes in applicable Codes of Conduct and Stock Exchange Rules are also contemplated. Interim measures pending the implementation of the long term proposals are also considered. Finally, recommendations about investor education are made.

II.INTRODUCTION AND SUMMARY OF RECOMMENDATIONS

33In the last few years, there was a marked increase in retail participation in the securities market and a substantial rise in margin trading through largely unregulated finance companies. Many of these companies failed to undertake prudent risk management measures, leading to over-lending to margin clients and other non-securities related borrowers and over-exposure to specific stock collateral and individual borrowers. This aroused the concern of the regulators and a series of inspections were carried out in late spring 1997 on these unregulated finance companies by the Securities and Futures Commission (SFC) and the Stock Exchange of Hong Kong (SEHK). This initiative was driven in part by the need to obtain detailed information about industry practices and in part by market volatility and concern regarding the absence of prudential regulation or supervision of finance companies. The inspections were necessarily limited to the provision of information that allowed for an assessment of whether the associated registered securities dealer was in compliance with licensing obligations.

44Whilst these inspections provided useful background information about the operation of the finance companies which are associated with securities dealers, a second round of inspections was conducted in October 1997 to ensure that these finance companies were not over-extending themselves in their credit provision. These inspections resulted in more prudent management of risks by these companies and no doubt contributed to their ability to withstand the sharp market fall in October 1997. In addition, an industry-wide survey was conducted in late 1997 to help identify any other potential problems and to assess any systemic risk which might have arisen from the concentration in margin clients and stock collateral.

55Following the recommendation of the SFC, an inter-agency working group (the Working Group) was established in December 1997 under Financial Services Bureau (FSB) to study the issue of regulating the share margin financing activities carried out by finance companies associated with securities dealers in particular. The C. A. Pacific incident added impetus and urgency to the deliberations of the Working Group.

66The Working Group comprised representatives of the FSB, the Hong Kong Monetary Authority (HKMA), the SFC, the SEHK, the Companies Registry and the Department of Justice.

77The finance companies under consideration tend to be associated with licensed securities dealers and are unregulated save for the requirements that they obtain a money lenders licence under the MLO and thereafter comply with the provisions under that Ordinance, except where exemptions are granted.

88Whilst the provision of share margin financing through unregulated finance companies has been available in Hong Kong for well over a decade, the less than satisfactory risk management and conduct practices of these companies have become apparent to the investing public in the recent months as illustrated by the large numbers of complaints received by the SFC, the SEHK, and the Police following the collapse of the C. A. Pacific Group.

99The Working Group, having considered the problems, the prevailing market and community sentiment on the issue, the need for market integrity and investor protection, market demand and the nature of the activity, recommends that these share margin financing activities be the subject of regulatory supervision by the SFC. Under the proposed regime, the finance companies must either seek separate licence from the SFC (hereinafter referred to as the stand-alone finance companies) or alternatively share margin financing activities will have to be provided through licensed securities dealers.

1010In either case, amendment to the existing securities regulatory regime will be necessary, and it will also be necessary to review the current rules and code of business standards and adapt these, where necessary, to the share margin financing business. The revamped requirements should be effective in addressing the various regulatory problems but at the same time take account of issues of capital efficiency and viability of the business.

1111The review has concentrated on the following areas:

a11proposed changes to the SO (Cap. 333) to bring share margin financing clearly within the regulatory ambit;

b11proposed changes to the FRR (subsidiary legislation of the SFCO, Cap. 24) as applicable to licensed securities dealers to ensure adequate capital backing for share margin financing activities;

c11proposed introduction of measures to better protect clients’ assets;

d11proposed introduction of Code of Business Standards to regulate share margin financing;

e11proposed transitional arrangements; and

f11proposed investor education programme.

1212The Working Group also noted that the SFC and SEHK have been working together to review the existing Brokers’ Fidelity Insurance Scheme and the Unified Exchange Compensation Fund with input from external consultants with a view to providing greater flexibility than present arrangements. In addition, under the proposed Composite Securities and Futures Bill, all registered dealers will be required to maintain a fidelity insurance policy.

1313The Working Group’s overall strategic objective is that share margin financing should be permitted only where adequate safeguards are in place for the protection of investors as well as market integrity. Similarly, capital requirements imposed should be set at levels consistent with the risks undertaken and not as a barrier to deter bona-fide and properly managed companies. In drafting its proposals, the Working Group has borne in mind the strong local retail element in the share margin financing market and the fact that the provision of share margin financing facilities is clearly responsive to a demand in the market place.

1414Summary of Recommendations:

Securities Ordinance

  • to amend definition of “dealer” and “dealing in securities”;
  • to adopt the definition of “loan” in the MLO for the purpose of interpreting the amended definition of “dealer”;
  • to empower the SFC to grant exemption to stand-alone finance companies from certain provisions of the SO; and
  • to amend sections 81 and 84 of the SO to provide for better protection of clients’ interests (see paragraphs 81 to 88).

Money Lenders Ordinance

  • to exempt a loan made by a dealer (as proposed to be re-defined under the SO) for the purpose of share margin financing from the MLO.

Financial Resources Rules

  • to impose a sole business requirement;
  • to impose a minimum paid-up capital requirement;
  • to retain the 5% total liabilities test as proposed in the 1997 consultation;
  • to apply a 25% haircut deduction to less liquid stocks listed on the SEHK;
  • to levy a new concentrated risk adjustment on exposures to individual accounts or specific stock;
  • to allow collection of collateral from margin clients on settlement day; and
  • to introduce reporting and notification requirements focusing on share margin financing as well as liquidity issues.

Protection of Clients’ Assets

  • to limit the use of clients’ securities by securities dealers;
  • to ensure proper disclosure of information; and
  • to segregate margin and cash client accounts.

Code of Business Standards

  • to prescribe additional minimum standards in margin lending and margin call policies in addition to existing SFC Codes and SEHK Rules;
  • to require the adoption of prudent risk management and cashflow management measures; and
  • to disclose the status of client’s account in contract notes and statement of accounts.

Transitional arrangements

  • to allow existing finance companies and securities dealers 30 days to decide whether to apply for registration under the proposed licensing regime; and
  • to waive certain FRR requirements for 6 months.

III.THE NATURE OF THE PROBLEM

11Share margin financing has been a popular market activity in Hong Kong. In a small minority of cases, share margin financing is conducted within a licensed securities dealer and subject to applicable rules governing capital and the treatment of client assets. Such operations are generally sound and do not pose an undue risk to investors or the market. However, not all share margin financing is conducted in the same way. In many cases, it is conducted through the largely unregulated finance companies which usually are not prudently managed and these are the centre of the present concern.

22These companies, though usually associated with stockbrokers, are independent finance companies (or called money lender companies) licensed under the MLO. The practice of using a money lender company to operate share margin financing business is believed to have been in existence in Hong Kong for over a decade. But with the introduction of higher financial resources requirements and tighter regulatory standards for securities dealers in the late 1980’s and early 1990’s, such practice has become more widely used, apparently to circumvent the stringent regulation that the regulated entities are subject to.

33In considering the issues raised by share margin financing in Hong Kong it should be clearly understood that the practices here differ from those in most other jurisdictions.

44In most jurisdictions, share margin financing is used to refer to the provision of a loan funded out of the capital available to a securities firm, the loan being for the purpose of share trading and secured by the shares of the individual to whom the loan has been advanced. In Hong Kong, while some securities dealers do provide share margin financing for their clients without relying on external funding from unrelated institutions, the majority finance their margin loans out of a combination of facilities made available by third party banks, inter-group loans and credit balances maintained by margin clients. The facilities from those banks are themselves secured by the pooled stock of many clients. The money provided by the banks is not necessarily applied for the benefit of those clients whose stock has been used to secure the advance. Indeed in many cases the stock which secures the bank loan is owned by clients who do not themselves borrow money for share trading.

55Where share margin financing is conducted outside the licensed entity, there are differences in practice. In some cases, credit control policies are in place to limit the exposure of the finance company to particular investors or stocks. Many companies do ensure that they have ample security for their loans and they are assiduous in making calls for further security or in pursuing bad debtors. There may also be some correlation between the size of the loan portfolio and the capital base of the company.

66Unfortunately, however, many of these companies that offer share margin financing are not prudently managed and moreover, the client is not adequately informed of the risk of allowing shares to be pooled and repledged to banks as security for funding for the finance company.

77Amongst the problems seen in practice are the matters described below.

88A common complaint by clients is that share margin financing agreements are not properly explained or are in English only. Although it could be said that the client should take more care before signing an agreement, it is well recognised that in circumstances such as these, a combination of self-interest, unequal bargaining power and the coaxing of salesman can lead a person to enter into arrangements that, in hindsight, appear ill-advised. Many clients have professed ignorance of the implications of signing an agreement with the finance company and have failed to understand that a clear distinction in law exists between the finance company and the licensed securities dealer.

99The Working Group also noted that there were views that certain securities dealers had purposely persuaded would-be cash clients to enter into agreement with their associated finance companies using unjustifiable reasons. It is however unfortunate that a large number of investors fail to understand the full effect of the agreements before signing them especially the risk arising from the pooling of client stock and the repledging of that stock to secure bank facilities.

1010Furthermore, clients do not always fully understand their relationship with the securities dealers and finance companies. Under the existing regime, there are commonly three different contractual relationships as follow:-

a10a client-broker relationship between the client and the securities dealer who executes trades upon client’s instructions (maintained by a client’s agreement between them);

b10a borrower-lender relationship between the client and the finance company which provides loan(s) to the client whereby the client pledges the securities purchased to the finance company as collateral for such loans (maintained by a margin loan agreement between them); and

c10a settlement agency relationship between the client and the finance company which settles trades with the securities dealer on behalf of the client.

1111Appropriate agreements should be entered between the client, the securities dealer and the finance company to reflect the commercial substance of their relationships arising from the share margin financing and settlement arrangements. However, in some instances, the agreements signed between the client and the finance company do not adequately reflect the settlement agency relationship between them as well as their respective rights and obligations in such a relationship.

1212Margin client agreements often contain clauses requiring, for example, that:

  • the client shall declare that the securities dealer and the associated finance company are not answerable or responsible for the loss of or damage to any stock collateral; and
  • any moneys received from the margin clients may be placed and kept to the credit of a suspense account for so long as the securities dealer and the associated finance company think fit without any obligation in the meantime to apply the same towards the discharge of any money or liabilities due or incurred by the client to the securities dealer or the associated finance company.

11In addition, many finance companies are thinly capitalised. Some of them are heavily reliant on short term bank borrowings whilst others rely on credit balances maintained by margin clients to fund their margin receivables. This makes them vulnerable to liquidity pressure, particularly in an adverse market situation and in the face of concurrent demands for withdrawal of assets or closure of accounts by their clients.

22Some finance companies are not prudently managed. Despite the setting of reasonably prudent lending policies, management override may result in many cases of long outstanding margin calls and concentration of risks to particular individuals and specific stocks in circumstances contrary to stated company practice.

33Pooling of assets is a common practice amongst finance companies. This is done irrespective of whether the clients who have an interest in those assets have borrowed money from the finance companies and the amount involved. Finance companies are generally entitled by the agreements to make use of assets deposited by margin clients in any way they see fit. Take a margin client who has deposited stock collateral worth $1 million with the finance company but who borrowed only $1000. He may have assumed that he can always get his stock collateral back when he pays off his debt but this is by no means guaranteed. It will typically be the case that the $1 million worth of stock has been mixed with the stock of other clients and repledged to a third party bank or finance company. Return of the stock to a client depends upon the finance companies capacity to either repay outstanding amounts due to the third party bank or finance company or offer substitute security that is acceptable to that bank. In practice, in early 1998, neither option were available to many finance companies who had used all or close to all of their available bank lines. Client demands for the return of stock took several weeks to be met.

44Moreover, where clients have incurred a loss in their dealings with the finance companies they may not be eligible for claims against the Unified Exchange Compensation Fund or the Brokers’ Fidelity Insurance Scheme. The finance companies are not covered and the success of claims will depend upon a demonstration that the loss in fact arose because of a breach on the part of the SEHK member associated with that finance company.