The SFC’s Guidelines to Address Analyst Conflicts of Interest (the “Guidelines”) came into effect on April 1, 2005. These impose strict requirements on investment banks and broker/dealers in relation to reducing and disclosing analysts’ conflicts of interest. The full text of the Guidelines and a set of related “Frequently Asked Questions and Answers” are available on the SFC’s website at www.sfc.hk. The purpose of this note is to summarise the principal features of the Guidelines.
The Guidelines are set out at Paragraph 16 of the Code of Conduct for Persons Licensed or Registered with the Securities and Futures Commission and accordingly apply only to corporations licensed and authorized institutions registered under Part V of the Securities and Futures Ordinance (the “SFO”). They do not regulate the conduct of journalists or media organisations.
The Guidelines are based on the principles of the International Organisation of Securities Commissions (“IOSCO”) and cover the 9 key areas identified in IOSCO’s Statement of Principles for Addressing Sell-Side Securities Analyst Conflicts of Interest which are:
- Analyst trading and financial interests
- Firm financial interests and business relationships
- Analysts’ reporting lines and compensation
- Firm compliance systems and senior management responsibility
- Outside influence
- Clarity, specificity and prominence of disclosure
- Integrity and ethical behaviour
- Investor education.
2. REGULATORY BACKGROUND
In the same way as any other person carrying on business in a regulated activity in Hong Kong, analysts employed by securities firms are required to be licensed by the Securities and Futures Commission (the “SFC”) and are subject to the SFC’s relevant codes and guidelines.
The SFC’s Code of Conduct governs the business conduct of licensed or registered persons, including conflicts of interest. It requires licensed corporations and registered institutions and their representatives (including analysts) to act honestly, fairly and in the best interests of clients. They should try to avoid conflicts of interest, and exercise due care and diligence when providing advice. Where licensed corporations, registered institutions or their representatives have material interests in transactions which give rise to actual or potential conflicts of interest, they should refrain from advising or dealing in relation to the transaction unless the material interest or conflict has been disclosed to the client and they have taken all reasonable steps to ensure fair treatment of the client.
Licensed corporations and registered institutions are also required to establish corporate policies and procedures in accordance with the Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the SFC. These require the effective segregation of the sales and dealing functions from the research function where the possibility of potential conflicts of interest exist. Where practicable, the research and corporate finance functions should be segregated to ensure the objectivity of the research function. These guidelines further require that compliance procedures should be in place to govern the preparation, approval and dissemination of research reports. The guidelines further recommend that staff members should be required to disclose (at least semi-annually) details of their transactions in relation to products in which the firm deals or on which it advises.
Analysts and other licensed persons breaching these Codes are subject to disciplinary action by the SFC. The disciplinary sanctions which the SFC may impose include suspension or revocation of licence, public or private reprimand and a prohibition order against undertaking regulated activities. A monetary fine may also be imposed either alone or in addition to other sanctions.
Analysts are also subject to the SFO’s provisions relating to Hong Kong market misconduct. Dealings in insider information and market manipulation attract both criminal and civil sanctions under the SFO. In addition, Sections 298 and 300 of the SFO respectively provide for the criminal offences of disclosure of false or misleading information to induce transactions and employment of fraudulent or deceptive devices in securities or futures contract transactions. In terms of civil liability, Section 277 SFO provides for civil liability in respect of disclosure of false or misleading information to induce transactions and Section 391 provides for civil liability where a person makes a communication to the public (or a group comprising members of the public including shareholders of a listed corporataion) concerning securities or futures contracts which is false or misleading in a material particular.
Analysts who receive a bribe in return for issuing favourable reports also contravene the Prevention of Bribery Ordinance, administered by the Independent Commission Against Corruption of Hong Kong (“ICAC”).
3. SCOPE AND APPLICATION OF THE GUIDELINES
The Guidelines cover investment research on:
- securities that are shares listed on the Hong Kong Stock Exchange, or warrants or options on such shares which are listed or traded on the Hong Kong Stock Exchange (“securities”) and
- investment research that has an influence on securities.
They do not cover research on fixed income securities, foreign exchange or collective investment schemes.
Definition of “Analyst” (Paragraph 16.2(a)).
An analyst is defined for the purposes of the Guidelines as “any individual within a firm who prepares and/or publishes investment research or the substance of investment research”. The term covers independent, buy-side and sell-side analysts.
The following are however excluded from the scope of the Guidelines:
- a person giving advice or comments wholly incidental to his dealing or broking function;
- investment research conducted solely for the firm’s and its group companies’ internal consumption and not for distribution to clients;
- personal (one-to-one) investment advice; and
- research on macro-economic or strategic issues.
Definition of “Firm” (Paragraph 6.2(d))
“Firm” is defined as any corporation licensed or authorized institution registered under Part V SFO and any of its group companies that carries on business in Hong Kong in investment banking, proprietary trading or market making, or agency broking, in relation to securities.
4. FIRM COMPLIANCE SYSTEMS (Paragraph 16.7)
The Guidelines require firms to establish, maintain and enforce written policies and control procedures to eliminate, avoid or manage actual and potential analyst conflicts of interest. These policies and procedures should be drawn up having regard to a firm’s particular structure and business model and the experience and investment profile of its clients.
5. ANALYST TRADING
Analyst Integrity (Paragraph 16.11)
Analysts are required to have a reasonable basis for their analyses and recommendations. Terms used in making recommendations should be defined and such definitions should be used consistently.
Firms to Establish Dealing Policies for Analysts (Paragraph 16.4(a))
Firms are required to establish and maintain written policies and control procedures governing analysts’ personal trading activities.
Limitations on Analysts’ Dealings(Paragraph 16.4(b))
Analysts and their associates are prohibited from trading in the securities of a listed corporation reviewed by the analyst:
- in a manner contrary to the analyst’s outstanding recommendation; or
- within 30 days before and 3 business days after the issue of investment research on the listed corporation.
There are exceptions allowing:
- analysts and their associates to trade during the blackout period in special circumstances outlined in the firm’s policy and pre-approved by the relevant legal or compliance function; and
- analysts to issue research within 30 days after he or his associate has traded securities of a listed corporation on the occurrence of a major, publicly known event that would affect the price of the relevant securities.
The Guidelines adopt a much narrower definition of “associates” than the definition which applies generally for the purposes of the SFO. In the Guidelines, “associates” are defined as:
- the analyst’s spouse or natural or adopted child or step-child under 18;
- the trustee of a trust of which the analyst, his spouse, child or step-child under 18, is a beneficiary or discretionary object; and
- any other person accustomed or obliged to act in accordance with the analyst’s directions or instructions.
6. ANALYSTS’ FINANCIAL INTERESTS AND RELEVANT RELATIONSHIPS (Paragraphs 16.4 (c) and (d))
An analyst’s research report must disclose if the analyst or any of his associates is an officer of, or has any financial interest in, the listed corporation reviewed by the analyst.
The term “officers” has the same meaning as in the SFO, that is “a director, manager, or secretary of, or any other person involved in the management of a corporation” (Part 1 of Schedule 1 to the SFO).
“Financial interest” is defined in the Guidelines as any commonly known financial interest, such as investment in the securities of a listed corporation or a financial accommodation arrangement between the listed corporation and the firm or analyst. Excluded from the definition are commercial lending conducted at arm’s length and investments in collective investment schemes notwithstanding that the scheme has investments in a listed corporation’s securities.