News & Insights

SFC concerned about ‘backdoor licensing’

On 4 May 2017, Julia Leung, Executive Director, Intermediaries, of the Securities and Futures Commission (SFC), gave a speech at the Hong Kong Securities and Investment Institute on “Supervision in a time of change” in which she discussed some of the challenges facing the SFC and how they are addressing them. One of the issues she mentioned was the sheer pace of growth of the industry in Hong Kong. The number of new corporate licence applications grew more than 50% last year.

The Mainland has overtaken the US as the source of the largest number of shareholder groups controlling Hong Kong’s licensed corporations: about 13% are now controlled by Mainland corporates.

The activities that market players engage in are evolving too. We now have more asset managers than brokerage firms. The number of firms carrying out Type 9 asset management activities is now more than the number carrying out Type 1 regulated activity (dealing in securities). Nearly two-thirds of new firm applications are now for a Type 9 licence.

An increasing number of individuals, many from the Mainland, with little or no experience in the Hong Kong securities industry, are looking to set up or acquire brokers and asset managers here. As a result, the SFC has to conduct a more detailed scrutiny of applications and work closer with other regulators such as the CSRC.

In her speech, Julia Leung noted a development which is causing concern: “Some firms whose businesses are small and dormant are being offered for sale in the market for several million dollars. The price tag comes with two individuals who are paid tens of thousands per month simply for being responsible officers (ROs) in name only without having to report for duty at the office.”

The inference is that the purchasers are willing to pay a premium for an existing licensed entity as a “backdoor licence”, either (i) to avoid some of the time and cost involved in applying for a new licence, or (ii) because they are concerned that they may not meet the qualifying criteria to obtain a licence themselves, or (iii) because they wish to avoid the responsibilities and potential liabilities attaching to licensed persons, particularly ROs. None of these motivations bears scrutiny. Time and cost savings in acquiring an existing entity instead of applying for a new licence are unlikely to outweigh the purchase price and the time and cost involved in due diligence and negotiating the purchase of the existing entity. SFC approval of a purchase of a licensed entity involves approval of all the new substantial shareholders as well as any new ROs and licence applications for any new staff. Other changes to the business are also likely to involve notifications to or approvals by the SFC, and as Julia Leung pointed out: “The unlicensed individuals who control the company might think that they can manage the firms without having to bear the consequences of their action. This is misguided, as anyone involved in the management of licensed corporations is liable for breaches, and the SFC may exercise its disciplinary powers to sanction them. SFC may revoke the licences of corporations and these ROs for hire who do not genuinely carry on a business of a regulated activity.”

The SFC has long had a policy to discourage “ROs for hire.” They will not approve a person to act as an RO for more than one company unless the companies form part of a group and they are satisfied that the RO can devote sufficient time to discharge their duties to each of the licensed entities, and that any conflicts of interest arising can be dealt with adequately.

Unless the individual new owners intend to be passive investors, they will need to apply to be licensed if they become involved in the regulated activities of the licensed corporation, and if they “call the shots” they will need to be approved as ROs, regardless of whether they are appointed as directors. As Julia Leung went on to say: “At the heart of any firm is a group of individuals at the top who call the shots. If we want to improve conduct and change behaviour, it should start from the top by clarifying who has responsibility for what, and holding them accountable for the conduct and behaviour of the firm. The Manager-in-Charge (MIC) regime we introduced last December aims at providing clarity around the question of who has responsibility for what in a firm, and putting some structure around reporting that information back to the SFC.”

Following the introduction of the MIC regime, all licensed entities should be considering which individuals within their organisations, whether in Hong Kong or overseas, need to be notified to the SFC as managers in charge of the eight “Core Functions’, the deadline for which is 17 July 2017.

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