Introduction

On 15 December 2015, the Securities and Futures Commission (“SFC”) reprimanded three securities and brokerage companies in the JP Morgan group (together “JP Morgan” or the “JP Morgan Group Companies”) for various regulatory breaches and internal control failings. The breaches are noteworthy as they may also be committed by group companies which conduct securities-related business.

Intra-group aggregation of
trading units for short selling

One of the breaches committed by the JP Morgan Group Companies is “naked” or “uncovered” short-selling. Section 170(1) of the Securities and Futures Ordinance (“SFO”) provides that a person shall not sell securities at a recognized stock market (including the Hong Kong Stock Exchange (“HKEx”)) unless he has (or with reasonable grounds believes himself to have) a presently exercisable and unconditional right to vest the securities in the purchaser. Violation of section 170(1) is a criminal offence. In other words, it is a crime for a person selling securities at or through HKEx without a pre-existing right to sell those securities.

The implication of section 170(1) of the SFO on short selling is that a short seller must at the time of selling have acquired the rights to sell over the subject securities, either by having securities borrowing arrangement or holding a right to acquire those securities (option, convertible security, etc). In this way, short selling is required by law to be “covered” by a pre-existing right to sell.

For an entity which holds multiple trading books (which is the case for most entities conducting securities trading business), there may be a long position in one book but a short position in another. Section 8.3 of the Guidance Note on Short Selling Reporting and Stock Lending Record Keeping Requirements clarifies the SFC’s view that it is only the aggregated position of the entity which is the concern of section 170 of the SFO. In other words, an entity may still short securities even when there is a net short position in one of its trading books, so long as the entity’s position for the relevant securities is net long when all its positions in the different trading books are combined.

However, such aggregation is allowed only within the same legal entity. Where there are multiple legal entities in a group conducing securities trading business, for the purpose of section 170 of the SFO the trading books of one entity cannot be taken into account for aggregating the net position of another entity. Each entity must have a net long position before it can carry out short selling.

JP Morgan breached section 170 of the SFO as a result of allowing cross-entity aggregation in its internal control system, and as a result some entities in JP Morgan carried out short selling when their individual aggregated position is net short. In other words, because of the cross-entity aggregation, an entity in the JP Morgan Group Companies sold securities at  HKEx when it did not actually have the pre-existing right to sell those securities but mistakenly believed that it had such right, as those securities were not held by it but by another legal entity in the group.

Conflicts of interest between
trading as principal and as agent

Most other breaches of JP Morgan are related to conflicts of interest. As JP Morgan operated a dark liquidity pool trading service (“the JPMX”), i.e. an over the counter order matching service which matches the orders from different clients of JP Morgan without involving a stock exchange. JP Morgan presented to the SFC that JPMX would only perform agency to agency trades (i.e. trades between JP Morgan’s clients but not between JP Morgan and its clients). In actual fact, however, JP Morgan also conducted facilitation trading where JP Morgan trade with its clients as a principal.  Therefore, upon an onsite inspection the SFC discovered that some client orders had been improperly routed to another pool in the JPMX  and crossed with the orders where JP Morgan was the principal. On some occasions, the orders where JP Morgan was the principal, were improperly entered into the JPMX.

The SFC also found that JP Morgan had set incorrect access rights for its facilitation traders (who traded for JP Morgan as principal with its own clients), which allowed them to view the client orders of JP Morgan’s clients. The SFC also found that the JP Morgan trading desks that handled client orders had reporting lines to senior managers who also handled facilitation trading activities, which creates a potential conflict of interests.

General Principle 6 and Paragraph 10.1 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission require that in a case of conflicts of interest, clients must be fairly treated and be disclosed with material interest or conflict that the licensed person has. In practice, measures like Chinese Wall are adopted to satisfy the compliance requirement as regards conflicts of interest.

The SFC found that the JP Morgan Group Companies failed to adopt appropriate and sufficient measures to ensure fair treatment of clients against conflicts of interest in the following aspects:

1.        absence of systems or procedures and regular compliance review programs to prevent facilitation trade with JP Morgan as principal from being executed without clients’ consent;

2.        wrongfully granting excessive system access right to facilitation traders to view client order flow information beyond those traders’ defined access right – those who trade for JP Morgan as principal with its own clients could view what orders the clients had made;

3.        having reporting structure under which agency orders were directed to managers who were also facilitation traders, which allowed the traders (trading for JP Morgan as principal with its own clients) to potentially abuse the information obtained by JP Morgan through acting as an agent of its clients;

4.        absence of effective systems or control to guard against potential misuse or abuse of client agency order flow information by facilitation traders; and

5.        incorrectly routing principal orders (trading between JP Morgan and its own clients) and agency orders (trading by JP Morgan on behalf of its clients) for matching as a result of human and systems errors.

Lessons to learn

As a result of the above findings, the SFC has imposed a fine $30 million in total on the JP Morgan Group Companies.  A brief breakdown is as follows: $18 million for short selling activities; $9 million for client facilitation and principal trading activities and $3 million for dark liquidity pool trading services.

The case of JP Morgan reveals certain challenges in regulatory compliance faced by securities trading group companies which engage themselves in facilitation trading activities. It is noteworthy that there would be more stringent capital and liquidity requirements if the measures under the Dodd-Frank Act and Basel III are adopted in Hong Kong. In assessing whether to carry out or continue facilitation trading business, financial institutions should take into account the compliance costs in maintaining the separation between its facilitation trading business and client business, apart from the increased capital requirements and increased risk of regulatory oversight.

Also, to avoid unintentional uncovered short selling, trading books of each legal entity under the group must be clearly separated. Intra-group procedures and programs must also be adequate to address potential and actual conflicts of interest.