Introduction

In FT Securities Limited v Securities and Futures Commission (Application No. 6 of 2018), the Securities and Futures Appeals Tribunal (“SFAT”) affirmed the decision (“Decision”) of the Securities and Futures Commission (“SFC”) to issue a disciplinary penalty against FT Securities Limited (“FTSL”) on the basis of misconduct in preparation and publication of three research reports and failure to comply with the Code of Conduct for Persons Licenced by or Registered with the SFC (“Code of Conduct”) and the Internal Control Guidelines for Persons licensed by or Registered with the SFC (“Internal Control Guidelines”).

Background

FTSL was licensed to carry on business in Type 1 (dealing in securities) and Type 4 (advising on securities) activities. FTSL issued three research reports on its website between July 2012 and April 2013 concerning Neptune Group Limited and Chinese Food and Beverage Group Limited (“Chinese F&B”) (collectively, “Research Reports”).

SFC’s decision

In respect of the Research Reports, the SFC issued a Notice of Proposed Disciplinary Action on 23 May 2017, which found that FTSL had:

• made a false and misleading disclosure regarding its investment banking relationship with the issuer in one of the research reports;
• failed to identify and eliminate, avoid, manage or disclose actual or potential analyst conflicts of interest;
• failed to ensure that its analysts had a reasonable basis for the analyses and recommendations stated in the reports;
• failed to define the terms used in making recommendations and utilize such definitions consistently; and
• failed to provide adequate supervision and put in place effective systems and controls over the preparation and publication of the research reports.

In light of the above, the SFC issued a Decision Notice on 16 November 2018 to publicly reprimand FTSL and fine it at HK$3.5 million (reduced from the proposed pecuniary penalty of HK$5 million since FTSL did not dispute the SFC’s findings) under section 194 of the Securities and Futures Ordinance (Cap 571) (“SFO”) for regulatory breaches and internal control failures in relation to preparation and publication of the Research Reports.

FTSL’s appeal to SFAT

FTSL applied to the SFAT pursuant to section 217 of the SFO for a review of the Decision on the ground that the pecuniary penalty was manifestly excessive and disproportionate in the circumstances of the case.

FTSL argued, among others, that no quantitative basis had been advanced by the SFC for stipulating a pecuniary penalty and there was no evidence of loss by clients or investors having occurred as a result of the impugned conduct. On the other hand, the SFC submitted that the circumstances of the breaches committed by FTSL and the internal system of FTSL on publishing research reports called for “the imposition of a substantial fine”.

SFAT’s findings

The SFAT’s role is to conduct a full merits review as if it were the original decision maker. In relation to SFC’s findings and considering the SFC Disciplinary Fining Guidelines, the SFAT commented on the following issues:

Systems and controls to address analyst conflicts of interest

The SFAT took into account of the unchallenged findings of the SFC that FTSL was culpable of egregious failures to comply with the regulatory requirements addressing analyst conflicts of interest. First, there were no written policies and control procedures to address potential analyst conflicts of interest, as required by paragraphs 16.3(d) and 16.7(a) of the Code of Conduct. Secondly, no related training had been provided to members of staff of FTSL. Thirdly, while the Research Reports was published by an “Elisa Chan”, the Research Reports were in fact prepared by two unknown researchers. Neither Elisa Chan nor other staff members of FTSL knew the identities, background or contact details of the two researchers. Fourthly, FTSL failed to establish internal information barriers to avoid any apparent and actual conflicts of interest.

Based on the above, the SFAT was satisfied that FTSL conducted itself with a contemptuous lack of regard to important regulatory requirements. Such failures were not born of inadvertent disregard of written policies and controls stipulated by FTSL. Rather, there were no stipulated policies and controls.  This state of affairs subsisted throughout the nine months from July 2012 to April 2013, during which the Research Reports were prepared and published. The duration and frequency of the conduct was one of the factors which the SFC took into account in respect of the nature and seriousness of the conduct.

False and misleading statement in the Chinese F&B Research Report

The Chinese F&B Research Report contained the statement “[FTSL] has not been party to any agreement in the past 12 months for the provision of investment banking services to the company covered in this research report”, which was found to be false and misleading. In fact, FTSL had conducted placement activities for Chinese F&B and received placing commission. The employees responsible for preparing the relevant Research Report were aware of the placement but no reference in the Research Report identified FTSL as the placing agent. FTSL had admitted the disclaimer was published due to an oversight.

By publishing a false disclaimer in the report, FTSL had breached paragraph 16.5(d) of the Code of Conduct. The SFAT concluded that FTSL exhibited a high degree of incompetence and was culpable of considerable negligence.

No reasonable basis for the analyses and recommendations in the Research Reports

The SFAT was satisfied that FTSL was unable to demonstrate that there was a reasonable basis for the analyses and recommendations in the Research Reports, in breach of paragraph 16.11(a) of the Code of Conduct. In particular, there was a lack of supporting documents and certain documents being relied upon were dated after the publication of the Research Reports.

FTSL’s objection to the Decision

In its submissions, FTSL made reference to three previous disciplinary actions taken by the SFC in respect of Merrill Lynch Far East Ltd and Merrill Lynch (Asia Pacific) Limited, JP Morgan Securities (Asia Pacific) Limited (“JP Morgan”) and Moody’s Investors Service Hong Kong Limited. In relation to the action against JP Morgan, in which a pecuniary penalty of HK$3 million had been imposed, FTSL argued that the conduct of the present case was of a less serious nature. Comparatively, FTSL was less structured in terms of size and experience, and had only ever issued three Research Reports, which were in respect of only two companies of relatively low market capitalisation.

SFAT’s decision

Considering FTSL’s multiple breaches of the Code of Conduct over a period of more than nine months, the SFAT was satisfied that the SFC was correct in concluding that the circumstances of the regulatory breaches committed by FTSL was more serious that those committed by JP Morgan. The SFAT agreed with the SFC’s consideration that “the failure to ensure independence and objectivity of research reports might damage investor confidence in the research sector and in the financial services industry more broadly”.

The SFAT concluded that since the imposition of a pecuniary penalty was intended to be both punitive and to act as a deterrent both to FTSL and to other market participants, the level of penalty was appropriate. It should be noted that the SFAT considered the original proposed pecuniary penalty of HK$5 million appropriate and accepted the discount of 30% (to HK$3.5 million) as an acknowledgement of a clear acceptance of culpability by FTSL, which was similar to the approach by courts when facing a guilty plea in criminal proceedings.

Takeaway points

The decision of the SFAT affirmed the approach adopted by the SFC in regulating the preparation and publication of research reports by licensed corporations. It is of stark importance for licensed corporations to impose adequate internal systems and controls in compliance with the Code of Conduct and Internal Control Guidelines to avoid analyst conflicts of interest. Further, in preparing research reports, licensed corporations should avoid adopting disclaimer templates and take active steps to ensure research reports are free from misleading or false information.

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.