Hannah Cassidy and team from Herbert Smith Freehills take a close look at the SFC’s recent proposals for amending the Securities and Futures Ordinance (SFO) to enhance investor protection and remediation against wrongdoing, as well as to upgrade insider dealing provisions.
The SFC has proposed a number of sweeping enforcement-related reforms that would significantly enhance the SFC’s ability to obtain investor compensation orders against regulated persons who have committed wrongdoing.
In addition, the ambit of the professional investor (PI) exemption for the purposes of the offers of investments regime would also be realigned with its original intended purposes, and would be limited to unauthorised investment advertisements issued only to PIs. Finally, the proposed changes would allow the SFC to tackle cross-border insider dealing offences more effectively.
As the SFC is the driving force behind these proposed reforms, there is little doubt that, once granted, they will be quick to use their new powers, significantly impacting the enforcement landscape in Hong Kong.
The SFC launched its two-month consultation on 10 June 2022, with a deadline for comments on 12 August 2022. The proposed amendments are divided into three main parts, as set out below.
Increasing focus on investor protection and remediation
Although the package of reforms relates to three separate parts of the SFO, they all highlight the SFC’s focus on investor protection.
- The proposed amendments to section 213 would mean the SFC can more readily act in a representative capacity on behalf of investors where there has been wrongdoing. This perhaps signals a move away from the SFC’s deterrent approach to one that is even more focused on investor remediation, complementing the SFC’s front-loaded approach to regulation. The prospect of section 213 proceedings will also no doubt shift the dynamic of future regulatory discussions in the context of disciplinary actions – the mere threat of a newly augmented section 213 application may be enough to ensure that firms compensate investors who are impacted by wrongdoing, without the SFC having to actually instigate proceedings.
- The proposed amendments to the offers of investments regime are designed to protect retail investors from risky and unsuitable products.
- The enhanced insider dealing provisions seek to put Hong Kong on a level footing with other international financial centres, and make it easier for the SFC to take action against wrongdoers who disrupt the market.
If the package of proposals is adopted as currently drafted, firms and individuals will need to prepare themselves for the prospect of more aggressive enforcement action and potentially greater financial consequences.
Part 1: Expansion of section 213 of the SFO
Background to section 213
Section 213 is an important tool used by the SFC to obtain compensation for investors who have sustained loss as a result of another person’s wrongdoing. It is a statutory regime allowing the SFC to apply to the Hong Kong Court of First Instance (CFI) as a claimant on behalf of a class of investors and obtain civil remedies. Orders made under section 213 are ‘by their nature designed’ to ensure that certain of the SFC’s objectives are advanced, including protecting investors.
Section 213(2) of the SFO currently enables the SFC to apply for the following remedial and other orders:
- an order restraining or prohibiting a breach of the ‘relevant provisions’
- an order requiring a person to take such steps as the CFI may direct, including steps to restore the parties to any transaction to the position in which they were before the transaction was entered into (Restoration Order)
- an order restraining or prohibiting a person from dealing in specified property
- an order appointing an administrator
- an order declaring that a contract is void or voidable, and
- an order directing a person to do or refrain from doing any act to ensure compliance with any other court order made.
Section 213(8) of the SFO further sets out that the CFI may, in addition to or in substitution for an order made against a person under the relevant provisions of section 213, make an order requiring the person to pay damages to any other person (Damages Order).
There have been a number of successful actions by the SFC to obtain remedies for investors who have suffered loss as a result of misconduct, such as insider dealing and the disclosure of false or misleading information by listed companies. This includes the landmark Court of Final Appeal case in 2013: Securities and Futures Commission v Tiger Asia Management LLC & Ors (Tiger Asia).
However, whilst the SFC has successfully obtained orders to provide remedies for investors, the SFC’s ability to apply for relief under sections 213(2) and 213(8), including Restoration and Damages Orders, is limited by section 213(1) of the SFO, which requires the contravention by a person of any of the ‘relevant provisions’ (which includes any provision of the SFO, the prospectus regime under the Companies (Winding Up and Miscellaneous Provisions) Ordinance and other legislative provisions), and terms and conditions of a licence or registration under the SFO, among others.
Crucially, a breach of the SFC’s codes and guidelines (for example, the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct)) by a regulated person, however serious, cannot currently give rise to a cause of action under section 213 if it does not constitute a breach of the ‘relevant provisions’ or other specified requirements or conditions. Furthermore, the SFC does not currently have any statutory powers under sections 194 and 196 of the SFO (which set out the SFC’s disciplinary powers) to directly require a regulated person to take any steps to restore, compensate or otherwise protect the interests of investors or clients who may have been adversely affected by the regulated person’s conduct.
To close this gap, the SFC proposes the following amendments:
- introduce an additional ground under section 213(1) for the SFC to apply for orders under section 213 where it has exercised any of its disciplinary powers under sections 194 or 196 of the SFO against a regulated person
- introduce an additional order that may be made by the CFI under section 213(2) to restore the parties to any transaction to the position in which they were before the transaction was entered into, where the SFC has exercised any of its disciplinary powers under sections 194 or 196 against a regulated person (ie, a Restoration Order), and
- in line with previous revisions to section 213 to ensure that the grounds for seeking additional orders in respect of open-ended fund companies (OFC) were consistent with those set out in section 213(1), make a consequential amendment to section 213(3A) to add an additional ground to enable the SFC to apply for orders under section 213, where it has exercised any of its disciplinary powers against a regulated person who is a director, investment manager, custodian or sub-custodian of an OFC.
Once the SFC’s proposed amendments have been implemented, section 213(8) would, without any further amendments, also enable the CFI to make an order against a regulated person to pay damages where the SFC has exercised any of its disciplinary powers against the regulated person (ie, a Damages Order).
Impact on regulated firms and individuals
Such expansion, if implemented, would significantly enhance the SFC’s ability to act as ‘the protector of the collective interests’ of investors who may have been adversely affected by misconduct, where such investors might otherwise be deterred by cost and other considerations from instituting proceedings to obtain redress for their losses. As Hong Kong’s legislation currently only provides for a very limited class action regime (via representative proceedings under the Rules of the High Court), and there are restrictions on litigation funding, this has limited the ability for individuals to seek class redress for violations, in particular for breaches of securities legislation.
Regulated firms and individuals should take note of the proposed broader threshold requirement for the SFC to apply for remedial orders under section 213, given the wide spectrum and breadth of requirements under its codes and guidelines. For example, a breach of General Principle 2 (due skill, care and diligence) or General Principle 7 (compliance with all regulatory requirements) under the Code of Conduct would suffice. It is also important to note that a ‘regulated person’ includes individuals involved in the management of the business constituting the regulated activity of a licensed corporation or registered institution, which can include individuals who are not licensed nor registered.
Given the SFC Code of Conduct does not currently have the force of law, the SFC’s proposals also call into question the legal status of the SFC Code of Conduct. If the proposals are accepted, firms and individuals should prepare by being fully aware of the new broader circumstances in which the SFC may institute section 213 proceedings, in order to manage and mitigate their enforcement risk.
The SFC is also able to impose disciplinary fines of up to a maximum of HK$10 million, or three times the profit gained or loss avoided (if greater). Although the SFC will determine the appropriate approach to levying fines based on the facts of each case, when these are imposed in conjunction with the remedial orders made by the CFI, the potential financial impact to the regulated person may be substantial.
It is unclear how the courts would calculate the size of the Restoration and Damages Orders under these proposals, although, in theory, it is open for the SFC and the regulated person to agree the quantum of compensation (section 213(2) is a restitutionary and compensatory rather than punitive provision). We would expect any financial penalty levied in disciplinary proceedings to take into account proposed Restoration or Damages Orders, although this is not certain.
Finally, the current legislation allows the SFC to seek interim relief when it appears that a breach had occurred or might occur, as well as final orders, such as Restoration Orders. Case law has also established that there is no need for the SFC to secure a judgment for breach of a relevant provision before applying for orders under section 213. Under the current proposals, the SFC will only be empowered to seek remedies for investors where it has exercised any of its powers under section 194 or 196 in respect of the regulated person, that is, only where it has already taken disciplinary action.
This may be in light of the arguments run in the Tiger Asia case (albeit unsuccessfully) that civil remedies could only be obtained in relation to breaches after there had been a successful conviction in a criminal court or a finding in the Market Misconduct Tribunal. This gives rise to an interesting question as to whether the CFI can look into the merits of the SFC’s disciplinary decision in determining a section 213 application. Under section 213(4), the CFI needs to satisfy itself, ‘as far as it can reasonably do so’, that it is desirable for the requested order to be made, and the making of the order will not unfairly prejudice any person. In the context of a section 213 application made on the back of a disciplinary decision, it is not clear how the CFI could do so without looking into the grounds of the disciplinary decision. Indeed, the conclusion of a disciplinary action brought by the SFC in respect of misconduct would not automatically mean that the CFI would make an order under section 213, given the inherent general discretion afforded it under section 213(1). One other observation is that the Securities and Futures Appeals Tribunal is the first port of call to review a disciplinary decision, and not the CFI, which decides on section 213 applications.
Going forward, we expect the SFC to use its new, enhanced powers under section 213 in a range of circumstances, for example where there has been wide-scale investment product mis-selling, fraud or misappropriation of client assets, market misconduct, corporate misfeasance and IPO-related misconduct.
Part 2: Amendment to the PI exemption to the offers of investments regime under section 103 of the SFO
Background to section 103
The offers of investments regime under section 103(1) of the SFO provides that it is a criminal offence to issue (or have in possession for the purposes of issue), whether in Hong Kong or elsewhere, an advertisement, invitation or document which to the defendant’s knowledge is or contains an invitation to the public to make certain investments, unless such issue is authorised by the SFC.
This includes an invitation to the public to:
- enter into or offer to enter into (i) an agreement to acquire, dispose of, subscribe for or underwrite securities, or (ii) a regulated investment agreement or an agreement to acquire, dispose of, subscribe for or underwrite any other structured product, or
- acquire an interest in or participate in, or offer to acquire an interest in or participate in, a collective investment scheme.
The PI exemption under section 103(3)(k) provides that the offers of investments regime does not apply to the issue (or the possession for the purposes of issue) of any advertisement, invitation or document made in respect of securities or structured products, or interests in any collective investment scheme, that are or are intended to be disposed of only to professional investors.
In the 2014 case of SFC v Pacific Sun Advisors Ltd and Mantel, Andrew Pieter (Pacific Sun), the Court of Final Appeal gave a wider construction and held that the PI exemption applies to any advertisement having some connection or relation to investment products that are or are intended to be disposed of only to PIs. The Court of Final Appeal considered that the words ‘that are or are intended to be disposed of’ in section 103(3)(k) provide the substance of the exemption.
The SFC is concerned that unauthorised advertisements of investment products which may not be suitable for retail investors may be issued to the general public even though the products are intended for sale only to PIs. As a result, retail investors may be exposed to unauthorised offers or solicitations to invest in unsuitable risky or complex products.
Proposed amendments and impact
To address this issue, the SFC proposes to amend section 103(3)(k) to restore the narrower construction of the PI exemption, by exempting from the authorisation requirement those advertisements which are issued only to PIs. This would realign the PI exemption with the underlying policy and alleviate the difficulty of enforcing the regime, such that the SFC would not need to wait until the sale of a product has taken place in order to determine to whom it has been sold and whether the PI exemption applies.
Following such amendments, if implemented, unauthorised advertisements of investment products which are, or are intended to be, sold only to PIs may only be issued to PIs who have been identified as such in advance by an intermediary through its know-your-client and related procedures, regardless of whether or not such an intention has been stated in the advertisements.
As section 103(3)(j) – which provides for an exemption in relation to investment products sold, or intended to be sold, only to persons outside Hong Kong – is phrased in terms which are identical to the PI exemption, the SFC considers that for good order, this provision should be amended in identical terms for consistency and to avoid confusion.
It has been almost seven years since the Pacific Sun case, but the SFC is clearly intent on resolving the position through these amendments. A narrower PI exemption may also offer better protection for retail investors against unauthorised advertisements of virtual asset–related products, assuming that such products fall within the scope of section 103, that is, they constitute securities, structured products or collective investment schemes.
Part 3: Broadening the territorial scope of the insider dealing provisions under the SFO
Background to insider dealing regime
The SFO has established parallel and mirroring civil (section 270) and criminal (section 291) regimes in respect of insider dealing. Both regimes apply to insider dealing with respect to Hong Kong–listed securities or their derivatives, and securities dual-listed in Hong Kong and another jurisdiction, or their derivatives.
However, these regimes currently do not apply to the offence of insider dealing perpetrated in Hong Kong with respect to overseas-listed securities or their derivatives, nor do they expressly apply to any acts constituting insider dealing perpetrated outside Hong Kong in respect of Hong Kong–listed securities or their derivatives.
As a result of this statutory gap, the SFC has not been able to effectively deal with suspected insider dealing of overseas-listed securities or their derivatives. The SFC referred to the case of Securities and Futures Commission v Young Bik Fung & Ors, which involved insider dealing in overseas securities, as an example where it had to resort to seeking civil remedies under section 213 by establishing a breach of section 300 of the SFO as the insider dealing provisions were not applicable. However, the SFC has highlighted that there is an important conceptual difference between the nature of the conduct prohibited in section 300 and that prohibited in sections 270 and 291. Section 300 is designed to cover acts of fraud or deception involving transactions between specific persons, rather than fraud that deceives, and conduct that misleads the market as a whole, threatening the integrity of financial markets. Section 300 was not included in the market misconduct regime when the SFO was drafted.
Further, in the absence of express provisions specifying the territorial scope of the existing insider dealing regimes, the SFC has to apply the common law test to determine the territorial jurisdiction in each case.
Proposed amendments and impact
The SFC therefore proposes the following amendments:
- the definition of ‘listed’ as defined in sections 245(2) (civil regime) and 285(2) (criminal regime) of the SFO be amended to include overseas-listed securities or their derivatives, and
- a new section be added to Part XIII and Part XIV of the SFO to expand the territorial scope of the insider dealing regimes to include: (i) any acts of insider dealing involving Hong Kong–listed securities or their derivatives, regardless of where they occur, and (ii) any acts of insider dealing involving overseas-listed securities or their derivatives, if any one or more of such acts occur in Hong Kong.
These amendments, if implemented, would allow the SFC to tackle cross-border insider dealing given the increasing interconnectivity of global financial markets. It would also make Hong Kong’s insider dealing laws more in line with other major common law jurisdictions, such as Australia and Singapore. Furthermore, following the launch of Stock Connect, the proposed amendments would also strengthen the SFC’s regulatory powers in tackling insider dealing conducted in Hong Kong involving A shares listed in the Mainland.
Hannah Cassidy, Partner, Head of Financial Services Regulatory, Asia; Natalie Curtis, Partner; Calvin To, Associate; Gareth Thomas, Partner, Head of Commercial Litigation; Jojo Fan, Partner, Hong Kong; and Valerie Tao, Professional Support Lawyer
Herbert Smith Freehills
© Copyright June 2022 Herbert Smith Freehills