Legal update: SFC reprimands and fines SFM HK Management Limited HK$1.5 million over illegal short selling

12Dec2018

Case Background

The Securities and Futures Commission announced on 6 December 2018 that it has reprimanded and fined SFM HK Management Limited (“SFM”) for HK$1.5 million for its naked short selling, contrary to section 170 of the Securities and Futures Ordinance (“SFO”).

SFM is licensed under the SFO to conduct Type 1 (dealing in securities), Type 2 (dealing in futures contracts) and Type 9 (asset management) regulated activities.

According to the relevant SFC announcement, Great Wall Motor Company Limited (2333.HK) (“Great Wall”) announced its proposed bonus share issuance on 28 August 2015 (“Bonus Issue”), pursuant to which bonus shares equivalent to 200% of the existing shares would be issued. The Bonus Issue was subject to certain conditions and expected to be settled on 13 October 2015.

As at 30 September 2015 (ex-entitlement date of the Bonus Issue), a fund (“Fund”) which was managed by SFM held 808,000 shares in Great Wall. As a result, the Fund’s custodian notified SFM that the Fund would be entitled to 1,616,000 bonus shares pursuant to the Bonus Issue.

However, the SFM’s trade support team mistakenly booked the said 1,616,000 bonus shares into the trading system without segregating them into a restricted account, which was required under SFM’s internal policy. As such, the trading system displayed that a total of 2,424,000 Great Wall shares were available for trading as at 30 September 2015 while 1,616,000 of them were actually not available. Based on the wrong information, a portfolio manager of the Fund placed an order to sell all 2,424,000 Great Wall shares on 2 October 2015, resulting in a net short position of 1,616,000 shares.

The Fund’s custodian discovered the said net short position on 6 October 2015 and automatically lent 1,616,000 Great Wall shares to the Fund, therefore the entire trade could be settled in the normal settlement cycle. SFM subsequently discovered the incident on 9 October 2015. On 12 October 2015, a report was made by SFM to the SFC.

SFC’s Findings:

The SFC found that SFM had failed to (a) act with due skill, care and diligence in handling and dealing in the shares under the Bonus Issue; and (b) diligently supervise its staff members and implement adequate and effective systems and controls to ensure compliance with the short selling requirements under s.170 of the SFO. SFM was also found in breach of general principles 2 (diligence), 3 (capability), 7 (compliance) and paragraphs 4.2 (staff supervision), 4.3 (internal control, financial and operational resources) and 12.1 (compliance: in general) of the Code of Conduct.

Illegal short selling / Naked Short Selling

S.170(1) of the SFO creates a criminal offence for a person selling securities at or through a recognized stock market unless at the time of the sale (a) he (or his client, if he is an agent) has a presently exercisable and unconditional right to vest the securities in the purchaser of them, or (b) believes and has reasonable grounds to believe that he (or his client, if he is an agent) has such a right.

S.170(3) provides a few exceptions to the general restriction set out in s.170(1) i.e., a person will not be considered as conducting the illegal short selling of securities if (a) he acts in good faith, believing and having reasonable grounds to believe that he (or if he is a representative of a Type 1 intermediary, his client) has a right, title, or interest to or in the securities short sold, (b) it is a short sale by an exchange participant who is acting as a principal and in the course of his business of dealing in odd lots of securities in accordance with the applicable rules, and the short sale is effect solely for the purpose of accepting or disposing the odd lots, (c) it is a short sale effect pursuant to an option contract traded on a recognized stock market; and (d) it is a short sale prescribed in rules of the SFC.

Pursuant to s.170(4) of the SFO, the maximum penalties for contravention of s.170(1) are a fine of HK$100,000 and imprisonment for 2 years.

The SFC has published a guidance note in 2003 listing out a few circumstances where a seller will be regarded as having “a presently exercisable and unconditional right to vest the securities in the purchaser of them” even if he does not have such securities in hand at the time of placing the selling order. Please refer to “The Guidance Note on Short Selling Reporting and Stock Lending Record Keeping Requirements” for further information.

Russell Bennett / Peter Tang

The above is not intended to be relied on as legal advice and specific legal advice should be sought at all times in relation to the above.

If you would like to discuss any of the matters raised in this article, please contact:

Russell Bennett
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Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.