Panel on Financial Affairs (Minutes) 27 Jan 98

Provisional Legislative Council

PLC Paper No. CB(1) 1320
(These minutes have been
seen by the Administration

Ref : CB1/PL/FA/1

Panel on Financial Affairs

Minutes of Special Meeting held on Tuesday, 27 January 1998, at 10:30 am in Conference Room B of the Legislative Council Building

Members present :

Hon Paul CHENG Ming-fun, JP (Chairman)
Hon NGAN Kam-chuen (Deputy Chairman)
Hon NG Leung-sing
Hon Eric LI Ka-cheung, JP
Hon Henry WU
Hon CHAN Choi-hi
Dr Hon LAW Cheung-kwok

Members attending :

Hon Allen LEE, JP
Hon LAU Kong-wah

Members absent :

Dr Hon David LI Kwok-po, JP
Hon Ronald ARCULLI, JP
Dr Hon Philip WONG Yu-hong
Hon CHIM Pui-chung

Public officers attending :

Mr Rafael HUI, JP: Secretary for Financial Services
Mr Anthony NEOH, SC, JP: Chairman, Securities and Futures Commission
Mr Alec TSUI: Chief Executive, Stock Exchange of Hong Kong

Clerk in attendance :

Ms Pauline NG: Assistant Secretary General 1

Staff in attendance :

Mr Andy LAU: Senior Assistant Secretary (1)6

I Briefing on the downfall of CA Pacific and the state of the securities brokerage industry

The Chairman said that the CA Pacific Securities liquidation incident had sparked wide public concern about the integrity and stability of the securities brokerage industry and raised doubts on the adequacy of measures to protect the interest of small investors. The special meeting was convened in order for the Administration to brief members on the latest development of the incident and the way forward in strengthening the integrity of the securities market and in enhancing investor protection.

2. At the invitation of the Chairman, the Secretary for Financial Services (SFS) briefed members that the Securities and Futures Commission (SFC) maintained a Unified Exchange Compensation Fund (the Fund) in respect of members of the Stock Exchange of Hong Kong Limited (SEHK). Under the present compensation rules, there was a maximum total payout of $8 million per broker which had to be shared by all clients with a valid claim on that broker. Presently, the Fund had a net asset of $480 million. In the light of the CA Pacific Securities liquidation incident, the Government and the regulatory bodies had agreed to relax the current compensation rules and the upper limit of compensation. In this connection, SEHK and SFC would each inject $150 million into the Fund immediately and if necessary, another $150 million would be further injected by each party. The Government would also seek the Finance Committee's approval of a loan to top up the Fund should it fall below a level that was considered to be prudent in overall risk-management terms. SFS replied in response to a member that since government lending was not necessary at this stage, the repayment terms of the loan had yet to be drawn up. However, references could be drawn from the precedent of the Life Boat Loan set up in 1987. As to the ceiling and exact amount of compensation, he said that these would be worked out upon receiving claims from investors.

Justifications for the relaxation

3. Members were generally in support of the Administration's initiative to provide assistance to small investors. A member opined that more assistance should be rendered to affected investors. Some members, however, queried the justifications and the legal basis for the proposed relaxation of the compensation rules and whether the interests of other contributors would be adversely affected as a result.

4. SFS responded that the Fund had long existed as a means to compensate investors who suffered losses as a result of default of responsibilities on the part of members of SEHK. As such, the present proposal did not involve any fundamental policy change. Under the existing compensation rules, cash clients of CA Pacific Securities were already entitled to claim against the Fund. However, since some clients of CA Pacific Securities claimed that they had been led to open margin accounts without their consent or under misrepresentation and had in fact not availed themselves of the margin trading facilities, the authorities considered that a more flexible approach should be adopted in assessing their eligibility for claims against the Fund. He further said that in view of the prevailing economic situation, the Government considered it desirable to provide more assistance to small investors, but had no intention of using public monies to assist mismanaged companies.

5. Regarding the eligibility of clients who had made use of the credit facilities of the finance company under CA Pacific Securities, SFS said that they would not be entitled to claim against the Fund. They would, however, have a claim against the finance company and might recover some of their investment from its liquidated assets. Should they consider that fraudulent or deceptive activities were involved, they might report the case to the police for investigation.

6. The Chairman, SFC (C/SFC) added that like other developed markets, Hong Kong's securities market had put in place a compensation mechanism to protect the interests of investors. However, to avoid creating a moral hazard, a cap was required for any compensation scheme. The Fund, initially at an amount of $50 million from contributions from members of the SEHK, was supported by a special levy collected from investors. The levy was subsequently suspended when the Fund had accumulated to $480 million. Prior to the CA Pacific Securities incident, the SFC had commissioned an actuarial study to examine the possibility of lifting the cap per claimant and allowing all claims up to a certain amount to be paid in full. However, the circumstances at the time of the study did not justify the implementation of such a proposal.

7. C/SFC assured members that the SFC would try to assist claimants as far as possible within the bounds of the statutory provisions. He advised that for any claim to be enforceable, an investor must have a direct contractual relationship with the licensed broker. However, it had come to light that most of the clients of CA Pacific Securities had signed margin agreements or authorizations allowing other members of the group, particularly, an unregulated finance company, to pledge their shares to other parties. Under such circumstances, compensation for this group of clients would involve complicated legal issues. SFC would invite them to submit applications for claims and examine each application on its own merits.

8. In response to a member, C/SFC said that the liquidator had a legal responsibility to look into matters relating to mismanagement of the company. The police would take follow-up actions on any suspected criminal offences. As such, the directors concerned could not evade any statutory responsibility for misbehaviour even if the victims did not pursue the case after receiving compensation from the Fund.

9. A member remarked that whilst the trade had divergent views on the proposed relaxation of the compensation rules and the ceiling of compensation, it was generally in support of the Administration's move to restore the confidence of the market and investors, which would be conducive to the normal operation of the market. He commented that the trade had been particularly concerned about the upper ceiling of the compensation because of its implication on the amount of levy to be imposed, and in turn, the future of the industry. The trade was also concerned that margin lending might be unnecessarily restricted and called on the Administration to adopt a more balanced approach.

Further relaxation

10. A member pointed out that some investors might intend to conduct cash trading but had inadvertently signed the authorization documents or made use of the margin facility whilst awaiting the company's calculation on the exact amount required for settlement. He asked if the Administration would be prepared to amend the compensation rules to make these types of clients eligible for compensation.

11. SFS replied that the Administration had no intention of changing the policy concerned. In the case of the CA Pacific, however, since a large number of clients had claimed that they had been led to open margin accounts without their consent or under misrepresentation, a flexible arrangement was therefore proposed for assessing their claims. But any further relaxation to cover margin clients who had made use of the credit facility would create a moral hazard and was considered not appropriate.

Compensation and liquidation

12. On the eligibility criteria for compensation from the Fund, C/SFC advised that a valid claim should be for pecuniary loss incurred in the course of or in connection with CA Pacific Securities' stockbroking business; or in relation to any money, securities or other property entrusted to CA Pacific Securities or any of its employees.

Cash clients

13. C/SFC advised that CA Pacific Securities had more than $400 million worth of shares held in the central clearing house at the time of its demise. If cash clients had not signed any authorization documents for the company to pledge their shares, they would be able to get back their shares in full, irrespective of the amount of monies involved. The SFC would make an effort to ensure that investors would get back their shares as soon as possible upon establishing their contractual relationship with the securities company.

Clients who claimed to be misled into opening margin accounts

14. C/SFC advised that for clients who claimed to have been misled into opening margin accounts, SFC and SEHK, on the basis of information available to the liquidator, would need to assess each case on its own merits. Where claimants had lost their trading records and account statements, the liquidator would need to refer to the set of documents kept by the company. Regarding the exact amount of compensation payable and the repayment schedule, he said that these had yet to be determined pending further information to be gathered by which the liquidator would then be made available to SFC and SEHK. In this connection, SFC would discuss with the liquidators to speed up the work.

15. To notify overseas clients including those in China, the Chief Executive (CE)/SEHK advised that the Exchange had placed advertisements in some major newspapers advising on how and where to submit claims. SFC and SEHK had set up a special task force to assist CA Pacific Securities' clients to register their claims and to apply for claims against the Fund under the existing securities legislation. The task force would obtain a list of the company's clients from the provisional liquidator and offer assistance to the clients in completing and submitting claims, which in accordance with the statutory provision, had to be submitted not later than 1 May 1998. He assured members that the Compensation Committee comprising broker and lay Council Members of SEHK would be responsible for determining the claims in accordance with guidelines. There would be adequate checks and balances in the examination process.

Liquidation

16. Apart from seeking compensation from the Fund, C/SFC said that clients could also claim against the company through the liquidation process. However, for the purpose of liquidation, a statutory cut-off date would be imposed by the court by way of notices. In this respect, the task force would also contact the clients to assist them in filling out the relevant applications. The liquidation process would be monitored by the court and run parallel to processing of claims against the Fund.

General rule

17. C/SFC added that as a general rule, the amount of compensation payable from the Fund should not exceed that receivable from liquidation. For example, if for every dollar of investment, proceeds of 70 cents were allocated upon liquidation, then the compensation ceiling from the Fund would be at 70 cents. The remaining 30 cents would not be compensated. The activation of the Fund would enable an earlier recovery of parts of the investment to investors. However if the proceeds from liquidation were only 10 cents per dollar of investment, investors might be able to obtain a higher amount of compensation through claims against the Fund. The exact amount of compensation payable would be subject to detailed assessment. He further advised that the Fund would be operated on a rolling basis and proceeds obtained from the liquidation would be ploughed back to the Fund.

Regulation of margin trading and the industry

18. The Chairman expressed concern about the existence of loophole in the prevailing legislation under which an unregulated finance company was permitted to pledge clients' shares to other parties in conducting their lending business and requested the Administration to review the matter for better protection of the investing public.

19. In response, C/SFC advised that following the review after the 1987 stock market crash, margin lending had already been covered by the Rules of the SEHK and the Financial Resources Rules of the SFC. However, some form of margin lending activities undertaken by related but unregulated bodies of securities companies had since emerged. During the period between 1993 and 1996, the demand for margin lending was not great as the volume of trading was not particularly high, and less than half of the market players were retail investors. Since March 1997, the market was moving away from a position where it was dominated by institutional trading of blue chips to a market increasingly dominated by very active retail trading of a broad range of stocks. The market boom and high volume of turnover, coupled with some of the unusual share movements, had prompted the SFC to pay special attention to the matter. In the light of the market change, suitable provisions had been incorporated in the draft Securities and Futures Bill to empower the regulatory body to request a subsidiary of a company to produce records and documents for examination purposes. However, due to the tight legislative timetable prior to the transfer of sovereignty, the Bill could not be introduced into the former Legislative Council.

20. Apart from adopting a more stringent suspension policy on stocks with questionable price movements, C/SFC said that the SFC also made various efforts to improve the capital structure of securities firms so as to cover unexpected market and credit risks. A survey was conducted in March 1997 to examine the financial position of the securities industry. Having noted that the lending to stock value ratio was 1:4, the SFC had requested the industry to further lower the amount of lending. As a result, the magnitude of margin lending had been reduced before the slump of the market in October 1997. Since then, the SFC had been keeping track of the most current financial position of securities firms.

21. Noting that the regulatory bodies had long been aware of the problem of margin lending by unregulated bodies, some members queried the reasons for the lack of timely action on the part of the Administration to tackle the problem. They also queried the Administration's decision to withhold the introduction of the Securities and Futures Bill as recommended by the SFC on the ground of opposition from members of SEHK. They opined that the regulatory bodies should be held accountable for the incident.

22. SFS replied that in the overall interest of Hong Kong, the integrity and stability of the financial sector on the one hand and an active and lively stock market on the other had to be maintained. Margin financing was common in other financial markets because it could facilitate the operation of the securities industry and vitalize a market. In line with the Government's traditional non-intervention policy, it was considered not appropriate to impose too much restriction on the securities industry. In formulating a policy decision, the Administration needed to strike a balance between providing a proper risk management system for the protection of investors and developing the market. He also said that in a bull market environment as was the case last year, margin trading had been regarded by investors as an opportunity rather than a threat. With the benefit of hindsight, there should have been more regulation of such kind of activities. However, the fact was that many market players were relying on margin trading to achieve what they wanted to achieve. In the wake of the CA Pacific incident, the Administration, after consultation with the trade, would introduce legislation to bring in a suitable regulatory framework to strengthen the integrity of the securities market and enhance investor protection.

23. Referring to the objection of the trade to the draft Securities and Futures Bill, SFS advised that members of the SEHK had expressed concern about the intent of the Bill as it simply required a subsidiary of a corporation to produce the records and documents as directed by the SFC. The Bill, as originally proposed by the SFC, would not impose any further regulatory requirements on the subsidiaries as was the case in respect of other authorized institutions. In view of the wide coverage of the Bill which would give rise to very significant ramifications on the securities and futures markets, the Administration considered it necessary to take a longer time to examine the details of the provisions and to extensively consult all the parties concerned. Whilst the Government was committed to protecting the interest of the investing public, there had been concerns about the growing authority of the SFC and the excessive regulation by the Government.

24. Members expressed concern about recurrence of similar incidents in the brokerage industry and the way to monitor the situation to safeguard investors' interest. C/SFC reiterated that the Government was examining the Securities and Futures Bill for introduction into the first Legislative Council. A working group had also been set up with a view to bringing margin financing activities under regulation.

25. On the possibility of recurrence of similar incidents in the industry, C/SFC said that he had not received similar complaints against securities companies where clients had claimed to be misled into opening margin accounts. SEHK would remind their members to explain clearly to clients on the degree of risks and financial liability involved. They would also review the margin agreement currently in use for better protection of investors. The SFC would continue to work with SEHK to improve monitoring of the financial position of securities companies. Even though the SFC had no direct statutory authority to vet the books and accounts of finance companies, the industry had been adopting a co-operative approach to assist its work. This explained why the CA Pacific case in fact was uncovered by the SFC.

26. CE/SEHK added that in 1997, SEHK had launched a series of educational campaigns, offering some 15,000 training places, to educate investors on the degree of risks involved and their rights, in particular, when signing documents. Seminars had been conducted for SEHK members on the need to advise their clients properly. SEHK would continue to organize educational programmes for investors.

27. Noting a coverage in the press that a list of 18 companies were under surveillance by the SFC due to financial difficulties, a member enquired about the justifications for not disclosing their names and whether so doing would affect the interests of the investing public and other players in the industry. C/SFC said that even under any ordinary situation, companies would be subject to routine and regular surveillance for different purposes. The number of companies under surveillance would vary from time to time depending on the market situation. Securities companies were subject to the capital requirement as stipulated in the Financial Resources Rules and they would not be allowed to operate if the required standard was not met. The question of confidence was also at stake. Once the name of a company was disclosed, it would inevitably lead to a short term cash flow problem irrespective of how sound the financial position of the company might be. Given that the securities companies were financially healthy and that there was no legal basis to disclose their names, it was considered not appropriate to do so. The SFC would continue to closely monitor the financial position of securities companies to safeguard investors' interests.

28. Given the close examination by banks and lawyers of mortgage applications, a member enquired whether there was any malpractice on the part of the banks in approving loans to the finance company concerned with collateral security which might be obtained in an improper manner. He enquired whether the banking sector was acting in accordance with the guidelines issued by the Hong Kong Monetary Authority (HKMA) in vetting loan applications from subsidiary finance companies of securities companies.

29. C/SFC advised that the banking sector was subject to close supervision by the HKMA. He was not aware of any reported malpractice so far. With the financial turmoil, there was a drop in asset prices, and the collateral security required by banks had been further tightened. Banks would exercise prudent risk management procedures in approving loans. The bankruptcy of CA Pacific was not due to the improper operation of banks but the failure of its finance company in retrieving a property loan. In order to freeze the asset of the company for better protection of investors, the SFC had no other better choice but to apply for a winding-up order.

30. A member requested early implementation of the enhanced Central Clearing and Settlement System (CCASS) to allow individual investors to maintain their own accounts with the depository of the central system. C/SFC responded that presently an investor could open up a Stock Segregated Account with Statement Service in the CCASS through a broker. The investors would receive Daily Movement Statements and Monthly Balance Statements showing all stock movement activities. In May 1998, individual investors would be allowed to open stock accounts directly in CCASS.

31. A member suggested that in order to better protect investors, consideration might be given to confining margin lending activities to those subsidiaries which had a licence of a deposit-taking company or a restricted licence bank under the regulation of the HKMA. SFS replied that whilst the suggestion was in principle feasible, it would have very serious implications on the trade.

32. As regards whether all lending activities should be subject to the same degree of risk management and supervision as was the case for other authorized institutions, SFS said that in determining the extent of regulation, there was a need to strike a balance. Over regulation would inhibit normal commercial business and hence the Administration did not intend to bring all types of money lending activities (other than those by Authorised Institutions regulated by HKMA) under the same regulation as that now introduced for finance companies associated with stock trading.

33. To enhance the confidence of investors, C/SFC said that an insurance scheme might be considered to replace the Fund. He advised that in the United States, the Securities Investors Protection Corporation, formed in 1934, offered an insurance cover of US$ 500,000 per investor, and brokers taking out insurance from the Corporation might top up this cover. In fact, brokers in the United States offered typically US$1 million in insurance cover and some even up to US$5 million. The regulatory bodies would examine whether it was appropriate and feasible to introduce such an insurance scheme in Hong Kong in the long term.

II Any other business

34. There being no other business, the meeting ended at 12:10 pm.

Provisional Legislative Council Secretariat
26 May 1998