Introduction

In late January 2022, the Securities and Futures Commission’s (“SFC”) took disciplinary action against Citigroup Global Markets Asia Limited (“CGMAL”) for misconduct in conducting its cash equities business as a licensed corporation from 2008 to 2018. In the disciplinary action, the SFC publicly reprimanded and fined CGMAL HK$348.25 million for regulatory breaches and internal control failures in relation to issuance of Indications of Interest (“IOI”) and client facilitation activities by its cash equities business pursuant to section 194 of the Securities and Futures Ordinance.

This case highlights a few conduct issues that are not uncommon in client facilitation which have been SFC’s recurring concern: there had been conflict of interest issues and certain traders had misrepresented, or were at least not 100% accurate and transparent to, their clients in the course of executing facilitation trades.

CGMAL’s regulatory breaches and internal control failures

Mislabelled IOIs

Firstly, it was revealed that, since at least 2008, the high touch equities sales trading desk had sent IOIs tagged as “Natural”, “In Touch With” and/or “P:1” to clients whilst there was indeed no genuine client interest nor any specific client that CGMAL was in touch with. The mislabelled IOIs were generated to provoke client enquiries with a purported belief that traders would be able to find natural opposite flows to cross with the client order in view of the stock’s active trading and CGMAL’s trading platform scale. This is a direct contravention of the SFC circular issued to licensed corporations on client facilitation dated 14 February 2018 (“2018 Circular”), in which paragraph 4 explicitly states that “IOIs should only be disseminated when they are based on a genuine client or proprietary intent to trade.”

To make matters worse, on the evidence, the SFC found that the dissemination of mislabelled IOIs was intentional, in that the head of the trading desk expressly referred labels of “In Touch With” and “P:1” as “fake flow” or “the fake” in contemporaneous correspondence, suggesting that CGMAL’s senior management knew or must have known that the IOIs were not backed by any reasonable expectation of interest from a client. Further, CGMAL’s senior management remained ignorant when some of the clients complaint of inaccurate IOIs.

Misrepresentation and non-disclosure
on principal nature of facilitation trades

Secondly, upon review of sample facilitation trades, the SFC found that, during January 2014 to December 2018, certain traders or even heads of the trading desks (1) gave factually incorrect information to the client or took positive steps to conceal the trade’s principal nature; (2) made misleading statements that the trade would be executed on an agency basis or remained silent on clients’ misunderstanding of the same; and (3) remained silent on the involvement of facilitation desk and failed to obtain client’s consent prior to routing client’s order.

The SFC identified the main root cause of the above misconduct was the commercial pressure faced by traders to solicit more business from clients and increase CGMAL’s market share in view of clients’ preference of agency based transactions rather than transactions on facilitation. Such misrepresentation and non-disclosure had extended for a long time and the senior management had allowed the establishment of a culture within CGMAL to encourage chasing revenue at the expense of basic standards of honesty and clients’ interest. Such CGMAL’s refrain from disclosing the true nature of trade to its client, allowing its clients to go through a trade without aware of the potential conflict of interest issues, does not only put CGMAL itself at risk, but is a clear contravention of paragraph 3 of the 2018 Circular. Paragraph 3 of the 2018 Circular had made clear that disclosure on the nature and basis of traders to clients and prior and clear consent from clients before the execution of facilitation trades cannot be compromised (see further below).

Internal control failures

Against the above backdrop, it can be preliminarily observed that the misconduct was prevalent for over 10 years. With no surprise, GCMAL’s controls, monitoring and management supervision were rather vulnerable and deficient. The SFC framed it as “serious and systemic lapses across CGMAL’s governance and controls framework”.^[1] As examples:

1.        Lack of internal controls relating to “In Touch With” IOIs: Following on the issue of “Mislabelled IOIs” stated above, prior to 2018, although CGMAL represented to clients that the AFME/IA Framework for Indications of Interest (“AFME Framework”) was adopted (in particular for the requirements for the issuance of “P:1” or “In Touch With” IOIs), CGMAL did not have any policies in place to guide and monitor its issuance of IOIs, nor any controls to ensure that the traders properly understood and followed the AFME Framework. After 2018, some procedures were implemented by CGMAL but did not cover all types of IOIs.

2.        Inadequate / failure to enforce internal guidelines in relation to pre-trade disclosure of and client consent for facilitation activities: Prior to 2018, CGMAL’s internal policies required its traders to make pre-trade disclosure and/or obtain client consent before executing a facilitation trade, but the SFC found that such requirement was not implemented in practice. To illustrate, there were pre-set messages to be sent to clients but all these messages were equivocal and vague and hence not sufficient to  inform clients that CGMAL was acting on a principal basis nor obtaining their prior consent for facilitation trades. These same messages were sent to clients even if the trades were not facilitated and when the orders were executed by CGMAL in both agency and principal capacity.

3.        Deliberate exclusion of the requirement for prior client consent for facilitation trades from internal guidelines: Despite the 2018 Circular which states in its paragraph 3 that in client facilitation, “the nature of trades should be disclosed to clients and their prior consent be obtained”, CGMAL failed to include such consent requirement in its internal guidelines as CGMAL’s Independent Compliance Risk Management (“ICRM”) had wrongly advised that a client could be deemed to have given implied consent in some circumstances. The SFC made it clear that such view was misconceived and directly in contradiction with the 2018 Circular.

4.        Ineffective compliance monitoring: The SFC found that, prior to 2014, CGMAL had no compliance monitoring at all regarding the accuracy of IOIs and the disclosure of CGMAL’s capacity in and obtainment of client consent for facilitation trades. Since around mid-2014, ICRM started with some checking but such was found to be ineffective.

5.        Lack of training: CGMAL did not provide any training or guidance to its traders on the categorization of IOIs or how traders should communicate with clients when they responded to CGMAL’s IOIs. The need to obtain clients’ consent was left out in the compliance training. The SFC was of the view such lack of training contributed to the traders’ incompetence and deficiencies.

6.        Communications between agency and facilitation traders not recorded or monitored: Contrary to paragraph 2 of the 2018 Circular, CGMAL failed to include in its internal guidelines the requirement of recording and monitoring communications between agency and client facilitation traders. Within CGMAL, the traders communicated by “shouting across the trade floor” and hence such was not recorded at all.

7.        Insufficient segregation between agency and facilitation desks: Paragraph 2 of the 2018 Circular requires the segregation of agency and facilitation activities in which it specifically requires client facilitation traders be prohibited from accessing agency order flows in trading system. Although such was included in CGMAL’s internal guidelines, it was again not enforced. The SFC found that there were instances where the traders shared agency flow information with the facilitation desk without the client’s knowledge.

Conclusion

This disciplinary action serves as a wake-up call for licensed corporations, particularly those who engage in the cash equities business and client facilitation activities, to adhere to the most important and clear regulatory principles and requirements in the Code of Conduct for Persons Licensed by or Registered with the SFC. Honesty, fairness, transparency to and the duty to avoid conflict of interest with clients are of paramount importance. The 2018 Circular, together with another SFC circular issued to licensed corporations regarding inspection findings related to client facilitation dated 14 May 2019 (“2019 Circular”), stress that traders as individuals must obtain unequivocal and explicit clients’ consent prior to each facilitation trade and make clear to their clients the basis of each trade such that their clients possess a genuine and clear intent to trade. Licensed corporations also shoulder responsibilities in making clear policies and procedures to: (1) make sure that their traders are properly trained and be able to comply with the expected standard; (2) detect and address areas of non-compliance for management’s attention and review in order to respond and remedy the same promptly; and (3) review and update the guidelines and procedures on a regular basis. As observed above, these are clearly-worded in the handy circulars but it is still not uncommon for licensed corporations and their traders to fall short of the required standard.

In the 2019 Circular, the SFC made clear that “[it] will not hesitate to investigate any apparent improper conduct and non-compliance, and shall take regulatory action against the individuals (including relevant Managers-in-Charge) as well as the brokerage firms as appropriate).”  In this disciplinary action, the SFC demonstrates no hesitation in imposing heavy penalties on CGMAL as (1) the misconduct was found to be dishonest and intentional; (2) GCMAL had allowed the misconduct to subsist for over 10 years; (3) its senior management had turned a blind eye to the misconduct; and (4) ICRM had failed to properly discharge its compliance function. It clearly serves to warn all licensed corporations against dishonest and intentional misconduct. Even in seemingly routine tasks in day-to-day business operation, ranging from issuing IOIs to seeking client consent for facilitation trades, licensed corporations should always serve its clients diligently and honestly to avoid reprimands and penalties from authorities. Further, it is important to note not only licensed corporations would bear the responsibilities, so do the senior management personnel: the SFC has made a remark in this case that it is of the view that all the above misconduct was attributable to the failures by certain former members of CGMAL’s senior management to discharge their supervisory duties and the SFC has made clear that it would commence disciplinary proceedings against them in due course.