Although insider trading has been a crime in Hong Kong since 2003, the Securities and Futures Commission (SFC) was initially slow to prosecute offenders, commencing its first criminal insider dealing prosecution only in January 2008. However, as recent headlines have demonstrated, the SFC has rapidly made up for lost time by securing 10 criminal convictions in the 14 months since the first conviction in July 2008. Mark Steward, the SFC’s Executive Director of Enforcement, has indicated that the Commission will continue to fight insider dealing using all available remedies.

Dual civil and criminal regime for insider dealing

One of the changes brought about by the Securities and Futures Ordinance (Cap 571) (SFO) was the introduction of a dual civil and criminal regime, under Parts XIII and XIV, for dealing with market misconduct. Previously, insider dealing was not a criminal offence and was dealt with through civil proceedings before the Insider Dealing Tribunal.

The dual civil and criminal regime means that the SFC can either bring a civil case before the Market Misconduct Tribunal or commence criminal proceedings against an alleged insider dealer. In deciding whether to prosecute, the SFC will have regard to the guidelines in the prosecution policy of the Department of Justice, which require two basic factors to be considered:

1. The strength of the SFC’s case. The burden of proof is greater in criminal proceedings and the SFC will generally only recommend criminal proceedings where there is admissible, substantial and reliable evidence that an offence has been committed and there is a reasonable prospect of a conviction. Where there is a lack of sufficient evidence to meet the criminal burden of proof, the SFC is likely to initiate civil proceedings.

2. Whether, taking into account the circumstances of a particular case, it is in the public interest to bring a prosecution before the courts.

Under the civil regime, authorities are empowered to impose a financial penalty not exceeding the amount which is the greater of HK$10 million or three times the amount of the profit gained or loss avoided by the insider dealer: s 194(2) SFO. Under the criminal provisions, an insider dealer could be subject to a maximum fine of HK$10 million and 10 years’ imprisonment upon conviction: s 303(1) SFO.

Common examples of insider dealing

The definition of what constitutes insider dealing is the same under both the civil and criminal regimes. The SFO defines insider dealing by listing various situations in which insider dealing occurs: ss 270 and 291 SFO. The majority of the successful convictions for insider dealing that the SFC has secured fall under one of the following scenarios:

• Where a person connected with a listed corporation deals in (or counsels or procures another to deal in) the securities of the listed corporation (or a related corporation) when the person is in possession of what he or she knows to be inside information (that is, price-sensitive information not available to the public at large): s 245 SFO.

• Where a person receives inside information and then deals in (or counsels or procures another to deal in) the securities or derivatives to which the information relates.

• Where a person connected with a listed corporation receives inside information and then discloses the information to another person knowing that the other person will make use of the information to deal in (or counsel or procure another to deal in) the securities or derivatives to which the information relates.

It is unfortunate that, despite attempts by institutions to educate and encourage employees to act ethically and lawfully, we continue to see obvious and flagrant breaches of the insider dealing laws, such as insiders purchasing shares themselves on the basis of confidential information or insiders passing on information to family members.

For example, in April 2009, an accounting manager of a subsidiary of a listed company was fined and jailed for insider dealing in shares of another listed company after he learned price-sensitive information about a proposed asset swap transaction between the two listed companies. The accounting manager placed orders on his and his wife’s accounts before the asset swap proposal was announced publicly and sold the shares after the announcement was made, making a profit.

Another example of such a breach was in the case of HKSAR v Ma Hon-yeung (DCCC 229-240/2008) which involved a vice-president of a financial institution. The vice-president learned of a proposed privatisation of a listed company and tipped off his girlfriend and three other family members within days of becoming privy to the proposed deal. All of them bought shares in the listed company prior
to the proposed deal and made a profit as a result. Their trial in March 2009 marked the first such indictable trial in the District Court for insider dealing under the SFO and resulted in an immediate custodial sentence.

The vice-president and his girlfriend were given custodial sentences and the three family members were ordered to do community service. Fines were also imposed in amounts equal to profits made by the defendants.

The family members avoided custodial sentences because they were merely opportunistic investors making use of the relevant information divulged by the vice-president. There was no evidence that they assisted him in carrying out his plot for personal gain by using insider information. The conduct of the girlfriend, on the other hand, warranted a custodial sentence as she was the person executing the plot on behalf of the vice-president. She was fully aware of his position of trust in the financial institution and had used her trading account to perpetrate the plot. As such, the court viewed her involvement in the misconduct as being much more serious than that of an opportunistic investor; community service could not adequately reflect her culpability.

Commenting on the sentences, Martin Wheatley, the SFC’s chief executive officer, clearly indicated that insider dealing is a serious crime that deserves severe punishment with no exceptions for first time offenders.

How can a client best avoid an insider dealing problem?

Apart from the obvious reputational risk posed by insider dealing activity, clients should also be aware that banks, securities and futures licensees and listed companies are required to establish and maintain appropriate internal control systems including measures to ensure compliance with all relevant laws and rules. Examples of the relevant laws and rules include:

• Section 279 of the SFO which imposes a duty on every officer of a corporation to put in place reasonable measures to prevent the firm from engaging in insider dealing; failure to do so may give rise to civil sanctions under s 258 of the SFO including disqualification as a director and prohibition from dealing in securities for a period not exceeding five years.

• The Rules Governing the Listing of Securities on the Hong Kong Stock Exchange (Listing Rules) that seek to protect investors against improper use of confidential information by insiders, by, inter alia, imposing a general obligation on the listed company to disclose to the market price-sensitive information: r 13.09; and imposing restrictions on dealings by a director in the securities
of his or her company: Appendix 10. The directors of a listed company are also under a duty to ensure that the employees of the company who are likely to be in possession of unpublished pricesensitive information are subject to the same dealing restriction: Appendix 10, para 13.

• The Code of Conduct module of the Supervisory Policy Manual issued by the Hong Kong Monetary Authority (HKMA) which sets out the minimum standards of codes of conduct that the HKMA expects an authorised institution to adopt. These include prohibition of staff members from dealing in the shares or securities of any listed company when in possession of privileged or price-sensitive information not generally known to the public.

• The Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission which imposes an obligation on the persons licensed by or registered with the SFC to implement and maintain measures appropriate to ensuring compliance with the relevant law, rules, regulations and codes administered or issued by the SFC, the Hong Kong Stock Exchange (if applicable) and the requirements of any other regulatory authority that apply to a licensed or registered person: para 12.1.

A properly prepared and communicated compliance system should be the best defence against insider dealing. Such a compliance system should include the following measures:

• Establishing a Code of Conduct which encompasses a set of ethical standards in which staff are expected to adhere to, and having a system in place to enforce it. In particular, a specific policy for handling price-sensitive information should be established.

• Ensuring that staff are alert to activities which infringe on the Code of Conduct and making a report of such matters mandatory.

• Establishing a reporting channel for matters which may give rise to a breach of the Code of Conduct or other applicable laws and regulations.

• Specifying an officer who is responsible for queries related to the Code of Conduct and for taking appropriate action to follow up on cases reported by staff.

• Conducting a regular review of the Code of Conduct so that necessary updates can be incorporated to keep abreast of changes in the business environment and regulatory requirements.

• Promptly seeking the assistance of relevant regulatory or law enforcement authorities.

• Establishing and maintaining a system of periodic and ad hoc spot-checking and auditing to ensure that the Code of Conduct and internal policies are being complied with and are suitable and effective.

For any such system to be effective, it is essential for institutions to communicate with and provide training for employees on:

• how to identify and handle inside information;

• what laws, regulations and policies apply to the handling of inside information;
• common insider dealing problems and how to avoid them; and

• what to do if an employee suspects insider dealing has taken place or is about to occur.

The importance of educating employees on how to handle inside information is clearly illustrated in the case of HKSAR v Lam Kar Fai, Allen (DCCC 919, 921 and 922/2008) where convictions were obtained against an investment banker and a fund manager. The investment banker was convicted for feeding information on takeover rumours about a listed company to a fund manger through coded emails. The conviction was secured even though the investment
banker only knew about the deal by overhearing his colleagues’ conversations and was not directly involved in the transaction. The fund manager, in turn, purchased the shares of the listed company on behalf of a fund managed by his company and for himself, and he sold the shares for profit after the acquisition was announced. The investment banker did not personally profit from the information, but his wife made an indirect profit as a result of her interest in the fund.

Both the investment banker and the fund manager were sentenced to terms of imprisonment and were imposed with fines equivalent to the profits attributable to the insider dealing. Further, the SFC revoked the licence of the fund manager to carry on certain regulated activity and subsequently banned him from re-entering the industry for life.

Although both the investment banker and the fund manager pleaded guilty, the court felt that the facts in this case were serious enough to warrant imprisonment. This was especially so for the fund manager as the offence was committed in his professional capacity. As for the investment banker, even though he did not commit the offence in his professional capacity he was found to have abused his position as an employee. The court has also rejected the notion that the infrequency of criminal prosecution in respect of insider dealing
could give rise to any reasonable expectation of no prosecution or no imprisonment for the offence.

However, having a system in place is not enough – the system must be maintained and complied with – in a real and substantive way. Some common situations in which problems may occur include:

• The lack of good and effective communication between compliance departments and business units so that compliance officers do not have up-to-date information about deals being done across the company and which employees might have access to inside information.

• Those required to provide approval for trades do not have sufficient experience and seniority to identify ‘red flags’.

• Management does not encourage a compliance culture, and allows ‘minor transgressions’ which can lead to larger problems in the longer term, as well as posing an immediate risk to the company.

• The compliance system is not audited and spot-checked to ensure that compliance officers and others are properly performing their role and the systems themselves are effective and reliable.

In fact, a recent case has shown that permission from a relevant compliance unit to deal in shares would not absolve a person’s liability for insider dealing if such compliance has been obtained dishonestly and fraudulently. In HKSAR v Du Jun (DCCC 787/2008) there was evidence that the defendant had not told the truth of his holding of the relevant inside information to the compliance department when
applying for permission to deal in the relevant shares. As such, he was not permitted to shield his dishonesty behind the ‘approval’ he managed to obtain from the compliance department, which he would not have received had he told the truth.

Looking forward

It has only been in the last two years that the SFC has sought to crack down on insider dealing by applying its powers to bring criminal proceedings contained in the SFO. In response to suggestions that the commencement of criminal proceedings in insider dealing cases instead of civil proceedings represented a new strategy for the SFC to stamp out insider dealing, the SFC said this was not the case and stated that it would only commence criminal proceedings when there is sufficient evidence to establish a case beyond reasonable doubt, and
where it is in the public interest to do so.

Regardless of whether there has been any conscious decision by the SFC to use criminal sanctions as a new strategy to deter insider dealers, it is clear from the line of successful convictions for insider dealing that the use of criminal proceedings is certainly an important facet of the approach taken by SFC to curb this type of misconduct. This pattern of enforcement is expected to continue in the coming years, following the renewal of Mark Steward’s contract as the SFC’s Executive Director of Enforcement for a further three years.

Coupled with increased regulation generally of securities and futures licensees, banks and listed companies, the time is ripe for clients to review all internal control systems, including those that deal with insider dealing.

To date, no company officer or director has been penalised for failing to implement an effective compliance system following a successful criminal conviction for insider dealing. However, fines have been imposed on corporations in relation to a general failure to maintain good compliance practices (such as a failure to maintain a sufficiently robust ‘Chinese wall’), as well as internal control failures that contributed to market misconduct (such as a failure to segregate proprietary trading and client trading, and failure to detect misconduct committed by employees). All corporations should ensure that their internal procedures, controls and surveillance systems are operated properly and effectively before the SFC turns its attention to the management of a corporation.

Richard Chalk
Partner
Freshfields Bruckhaus Deringer

Kate Madgwick
Registered Foreign Lawyer
Freshfields Bruckhaus Deringer

Mary Lau
Associate
Freshfields Bruckhaus Deringer