Introduction

Recently, the Securities and Futures Commission (“SFC”) has reprimanded two licensed corporations, Celestial Commodities Limited (“CCL”) and Celestial Securities Limited (“CSL”) and fined them HK$4.9 million and HK$1.4 million respectively for mishandling of client money and related internal control failings. CCL and CSL were held to be in violation of the Securities and Futures (Client Money) Rules (“Client Money Rules”) and the Code of Conduct for Persons Licensed by or Registered with the SFC (“Code of Conduct”).

Background facts

CCL’s mishandling of client money

During January 2009 to December 2015 (the “Relevant Period”), CCL used money from its client trust accounts held with bank A and bank B to pay monthly commission rebates to its account executives on around 180 occasions (the “Payments Out”). The amount of Payments Out ranged from HK$249,000 to over HK$1 million each month and amounted to approximately HK$44 million over the Relevant Period.

To replenish the shortfall in client trust accounts after the Payments Out, CCL transferred amounts equal to the Payments Out (the “Payments In”) from CCL’s house account to its client trust account at bank C. Such Payments In usually took place within 1 to 4 days after the Payments Out. However, there were 2 occasions where CCL only replenished the shortfall in the client trust account after 14 days and 41 days respectively.

The evidence suggested that the above arrangement was made for operational convenience as it allowed CCL to pay commission rebate directly into its account executives’ accounts held at Bank A and Bank B via the electronic transfer system.

CSL’s mishandling of client money

CSL effected 3 payments totalling HK$40 million on 8 July 2015 (the “Material Time”) from its client trust accounts into CCL’s client trust accounts at Bank D in fund swap arrangements. Such arrangements were made to ensure that CCL’s client trust account with Bank D, which was the designated settlement bank account with the Hong Kong Exchanges and Clearing Limited (“HKEx”), would have sufficient funds to meet the margin calls made by HKEx to CCL on a timely basis.

In fact, at the Material Time, further evidence suggested that funds held by CCL in client trust accounts at various banks were sufficient to meet the margin calls from HKEx without the need of the fund swap arrangements. Therefore, such arrangements were purely made for operational convenience.

CCL’s & CSL’s internal control failures

SFC investigations further revealed that the accounting staff of CCL and CSL were given a free reign in handling client money. There was little supervision, instructions or guidance from the responsible officers and senior management during the Relevant Period or the Material Time.

Regulatory requirements in relation to
client money handling

The Client Money Rules prescribe the manner in which licensed corporations shall treat and deal with client money received or held in Hong Kong.

Client Money Rules: scope

Licensed corporations and its associated entities (“Licensed Corporations”) are obliged to keep client money in safe custody in the course of the conduct of any regulated activity for which the licensed corporation is licensed: Section 3(1) of the Client Money Rules. However, the Client Money Rules do not apply if the client money is transferred outside Hong Kong or remains outside Hong Kong: Section 3(2) of the Client Money Rules.

Client Money Rules: key requirements

Pursuant to section 4(1) of the Client Money Rules, Licensed Corporations are required to hold client money in a segregated account with an authorized financial institution, each of which shall be designated as a trust account or client account.

Within one business day of the receipt, Licensed Corporations shall pay client money into a segregated account, to the client from whom or on whose behalf client money is received or in accordance with a written direction or standing authority: Section 4(4) of the Client Money Rules.

Client money shall be retained in the segregated account until it is paid to the client, in accordance with a written direction or standing authority from the client, or used to meet the client’s obligations to meet settlement or margin requirements: Section 5(1) of the Client Money Rules.

Licensed Corporations are not permitted to pay client money to its officers or employees unless that officer or employee is the client on whose behalf such client money is being held: Section 5(3) of the Client Money Rules.

Code of Conduct

Apart from the Client Money Rules, the Code of Conduct also stipulates the following requirements in relation to client money handling and such requirements are relevant to the assessment of whether a registered/ licensed person is fit and proper to remain registered / licensed:

1.         to act with due skill, care and diligence, in the best interests of its clients: General principle 2 of the Code of Conduct;

2.         to ensure that client positions or assets are promptly and properly accounted for and adequately safeguarded: General principle 8 and paragraph 11.1(a) of the Code of Conduct;

3.         to have internal control procedures and financial and operational capabilities which can be reasonably expected to protect its operations, its clients and other licensed or registered persons from financial loss arising from theft, fraud, and other dishonest acts, professional misconduct or omissions: Paragraph 4.3 of the Code of Conduct; and

4.         to ensure that it has adequate resources to supervise diligently and does supervise diligently persons employed or appointed by it to conduct business on its behalf: Paragraph 4.2 of the Code of Conduct.

Breaches

CCL, by using money from client trust accounts to pay commission to its account executives, was in breach of sections 5(1) and 5(3) of the Client Money Rules. Subsequent replenishment of the shortfalls in the client trust accounts would not relieve CCL from its liabilities because client money had already been exposed to unnecessary risks during the time gap between the Payments Out and the Payments In.

On the other hand, CSL’s transfer of client money from its client trust accounts to CCL to enable the latter to meet its margin calls was a clear breach of section 5(1) of the Client Money Rules. The fund swap arrangement exposed client money to unnecessary risks.

Failure to safeguard client money constituted breach of General Principle 8 and paragraph 11.1(a) of the Code of Conduct. By utilising client money for operational convenience, both CCL and CSL violated the General Principle 2 of the Code of Conduct as they placed their own interests ahead of that of their clients.

Lastly, the internal control failures such as the lack of proper control and supervision to safeguard client assets indicate breaches of paragraphs 4.2 and 4.3 of the Code of Conduct.

Key takeaways

Handling client money is inevitable in the everyday operations of Licensed Corporations. Client Money Rules and the Code of Conduct stipulate the regulatory obligations with which Licensed Corporations should comply to ensure safe custody of client money. Failure to comply with such obligations may give rise to civil or criminal liabilities, even if the client money is subsequently made whole again. To minimise potential liabilities, it is of pivotal importance for Licensed Corporations to maintain proper accounting procedures, internal controls and regular staff trainings in relation to client money handling in accordance with the provisions of Client Money Rules and the Code of Conduct.