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There is a reason approval is required

Approval mechanisms form an important part of risk management. The Four Eyes Principle (also known as the two-person rule) is a widely used internal control mechanism which requires that activities or transactions which involve material risk must be subject to checking by someone who is competent and has appropriate authority.

Approval of a transaction implies that the approver has reviewed the nature and terms of the transaction (and any supporting documentation), and is satisfied that the transaction is appropriate, accurate and complies with applicable requirements. Approvers should review supporting documentation, question unusual items, and make sure that necessary information is obtained to justify the transaction before they give approval.

In a recent enforcement case by the Securities and Futures Commission (SFC), a responsible officer (RO), who was also the chief executive officer (CEO) of a licensed company (Company), placed 199 illegal short selling orders involving 21 listed securities through his personal account and the discretionary account of a client without informing the Company or the client. He concealed his uncovered positions by buying the relevant stock at the end of the trading day. Sometimes he would cover his position through a cross trade with his discretionary client at a price favourable to himself.

Another RO, who was responsible for monitoring employee dealings and supervising the operation of discretionary accounts at the Company at the material time (the Supervising RO), routinely approved the CEO’s transactions without making any inquiries nor checking whether there were any irregularities.

The Hong Kong Stock Exchange (the Exchange) made enquiries of the Supervising RO in March 2014 regarding some of the CEO’s short sales, but he failed to conduct any proper investigation.

Although the Supervising RO issued a warning letter to the CEO on behalf of the Company in early April 2014 following the Exchange’s enquiries, he continued to rubber-stamp the CEO’s personal dealings.  As a result, the CEO was able to continue his illicit activities for another two months.

The SFC found that the CEO had failed to:

  • obtain proper approval for his personal dealings, short sales and cross trades as required by the licensed company’s internal policies;
  • avoid conflict of interest and take steps to ensure fair treatment of the client in operating the client’s discretionary account; and
  • report cross trades to the Exchange on four occasions as required by its Rules.

The CEO was banned from the industry for 28 months following his criminal conviction for illegal short selling; the Supervising RO’s licence was suspended for 7 months; and the Company was publicly reprimanded and fined HK$6.3 million.

The Company was a relatively small enterprise, and it is likely that there was a high degree of trust between the ROs: such businesses often operate as quasi partnerships, which rely on the partners’ good faith and integrity. However, the case demonstrates the need for vigilance even in such a relationship.

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