Fu Kor Kuen Patrick(“Fu”) and Lee Shu Yuen Francis (“Lee”), were convicted by the District Court of 20 counts of creating a false and misleading appearance of active trading in 20 different derivative warrants issued by Macquarie Bank Ltd, contrary to sections 295(1) and 295(6) of the Securities and Futures Ordinance (“SFO”). In May 2010, Fu and Lee were sentenced to 33 months and 36 months imprisonment respectively and each ordered to pay HK$694,498 to the Securities and Futures Commission for investigation costs.
On 23 December 2010, the Court of Appeal dismissed Fu and Lee's appeals against conviction, holding that the purpose of the market manipulation provisions is to keep markets free of manipulation and that breach of those provisions is serious, even in the absence of proof of loss to investors. However, the Court of Appeal held that the prison sentences were manifestly excessive and reduced them to 20 months and 21 months, respectively.
The alleged wrongdoing
It was alleged that Fu and Lee, traded between themselves various derivative warrants issued by Macquarie Bank Ltd, in a pre-determined manner, in approximately the same quantities and prices, in a repetitive fashion. The “ping pong” trading resulted in the inflation of the turnover for Macquarie-issued warrants by 80% (or over HK$450 million in value), with the result that potential investors were misled into thinking that the warrants were heavily traded by genuine buyers and sellers, when in fact the opposite was true.
The reason for the trading was because of commission rebates on trading offered by Macquarie Equities (Asia) Ltd (“MEAL”). The commission rebates had the effect of reducing transaction costs for investors and the high volume of trading by Fu and Lee meant that the commission rebates they earned exceeded their transaction costs, enabling them to earn a net profit of approximately HK$1 million. This was the first indictable prosecution under the SFO for manipulating derivative warrants.
Court of Final Appeal's Decision
On 24 May 2012, the Court of Final Appeal allowed Fu and Lee's appeals against conviction. Their convictions were quashed and sentences set aside (although by that time, they had already served their sentences).
It was not in dispute that Fu and Lee had engaged in their circular trading, with the objective of earning the commission rebates on offer or that by doing so they created a false and misleading appearance of active trading. However, the Court of Final Appeal held that the trial judge and Court of Appeal had been in error in finding that Fu and Lee's purpose (or one of their purposes) in trading was to create a false and misleading appearance of active trading.
Defence under Section 295(7) of the Securities and Futures Ordinance
The crux of the appeal before the Court of Final Appeal was the construction of section 295(7) of the Securities and Futures Ordinance, which provides a defence to a person who can prove that the purpose for which he committed the act was not (or where there was more than one purpose, the purposes did not include) creating a false or misleading appearance of active trading in securities. In this case, the Court of Final Appeal found that Fu and Lee's purpose had been to earn commission rebates and, although the result of their operation was the appearance of active trading, it was not their purpose.
Burden of Proof
The Court of Final Appeal held that Fu and Lee bore a persuasive burden of proof (to be discharged on a balance of probabilities) under section 295(7) to establish that they had an innocent purpose when their trading created a false appearance of active trading. The trial judge, they held, had been in error in holding that the prosecution carried the persuasive burden of proof. It was also held that the Court of Appeal was wrong in holding that the section 295(7) defence was irrelevant.
Apart from the matter of burden of proof, the Court of Final Appeal held that the trial judge's factual reasoning was open to criticism. It made a distinction between “the purpose” in section 295(7), which is the objective which the Defendants sought to achieve by engaging in the conduct in question, as opposed to “motive”, which was the reason for which the Defendants were acting in pursuit of the objective. It said that the existence of at least a primary purpose that was not a proscribed purpose was obvious once the primary facts relating to the trading appeared. The question, then, was whether that was their sole purpose, or whether they had the secondary purpose, contended for by the prosecution.
The Court of Final Appeal found that the purpose of pursuing commission rebates (a purpose which was consistent with a defence under section 295(7)) was obvious once the primary facts were established. There was no secondary purpose to the trades, since the price of the warrants remained fairly stable on those days they were traded. At the end of the day, they exited by selling the warrants to MEAL at about the price at which they were brought. Fu and Lee, it held, had made out the defence. In this case, Fu and Lee had not given evidence and the Court of Final Appeal remarked that in most cases a defendant will need to give evidence in order to discharge the persuasive burden of proof, as arguments advanced by counsel, or developed on the basis of expert witnesses, will not suffice where the existence of an innocent purpose remains speculative. However, the Court of Final Appeal said that the reason for Fu and Lee's behaviour was plain in this case, namely, to make a profit from the rebate scheme, and their convictions should be quashed and sentences set aside.
The proper form and function of expert evidence
In its judgment, the Court of Final Appeal also made observations about the proper function of expert witnesses. It said that the function of experts in cases of this nature was to put forward facts and matters concerning the derivative-warrant market, from which the Court might draw an inference concerning the Defendants' intention and purpose. Here, the parties' experts strayed well beyond their field of expertise because they had made statements of personal belief about Fu and Lee's intentions (i.e. state of mind) and the purpose of their trading activities, which was inadmissible. The expert reports in this case were also not in the proper form, as they failed to state (so that they could be tested against facts admitted or established by the evidence) the assumptions upon which opinions were based.
Commission rebates were not prohibited by the SFC at the time when the trades in question were executed. They have since been banned by the SFC and thus it would no longer be possible for traders to rely on a defence of commission rebates to justify their ping pong trades. However, the judgment is important, as it gives guidance on the interpretation and burden of proof of section 295(7). This case is also one of the recent cases where the courts rejected a case brought by the SFC.
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