[This post has been sent to Hong Kong regulators and to victims of unauthorized funds which were distributed via ILAS portfolio bonds. Victims may refer to the information in this post when filing complaints.]
Section 114 of the Securities and Futures Ordinance (SFO) forbids anyone from carrying on a business in an SFC-regulated activity (or holding themselves out as doing so) unless they hold an SFC license to engage in that activity. Anyone who breaks the law commits a criminal offense. The maximum punishment is a fine of $5 million HKD and 7 years imprisonment.
Selling Funds Is a Type 1 Activity
Anyone who wants to sell funds for a living must hold a Type 1 SFC license to deal in securities:
Selling Funds through an ILAS Is Not Necessarily a Type 1 Activity
Under certain conditions, a person can legally sell funds indirectly through an investment-linked assurance scheme (ILAS) without needing an SFC license to deal in securities. The person only needs a license to sell this type of insurance policy.
The SFC issued a circular on 13 August 2009 stating its views on whether insurers, corporate insurance brokers, and insurance intermediaries needed to hold an SFC license when selling ILAS. The SFC concluded that, “as a general rule”, they do not. However, it stated that there could be exceptions in some circumstances. The SFC advised those selling ILAS to seek their own legal advice if they were engaged in activity that departed from what was described in the circular:
Much of the ILAS business conducted in Hong Kong falls outside the scope of SFC’s 2009 circular, which means that the SFC’s circular was pretty useless, if not deliberately misleading. Below, I describe three common scenarios in which a person selling ILAS likely needs a Type 1 SFC license.
Outside the Scope of SFC’s Circular (#1):
Selling ILAS Policies that Contain Minimal Life Cover
Schedule 5 of the SFO defines dealing in securities as “inducing or attempting to induce another person to enter into or to offer to enter into an agreement…the purpose or pretended purpose of which is to secure a profit to any of the parties from the yield of securities or by reference to fluctuations in the value of securities.”
Note that the value of an ILAS policy is determined by reference to fluctuations in the value of funds, which are classified as securities.
The SFC disagrees that selling ILAS falls under the definition of dealing in securities. The SFC claims that ILAS policies are purchased primarily to obtain life cover, not to profit from an increase in the value of the underlying funds. Here is a screenshot from SFC’s 13 August 2009 circular:
While it is true that some ILAS policies do provide a material amount of life coverage, most do not.
A portfolio bond, for example, usually only provides coverage equal to 1% of the value of the underlying funds. The annual fees applied towards the policy are much greater than 1%. Mathematically, the life coverage is completely canceled out.
The only justification for owning this type of ILAS policy is to profit from an increase in value of the underlying funds. Corporations and individuals who sell this type of ILAS policy are therefore dealing in securities, as described in paragraph (b) of the SFO definition.
This could be why the Hong Kong Confederation of Insurance Brokers (CIB), a self-regulatory organization, warns its members that they may need an SFC license when selling such policies. Here is an excerpt from CIB’s regulations for insurance brokers selling ILAS:
Outside the Scope of SFC’s Circular (#2):
Issuing Any Advertisement, Invitation, or Document Which Is Not Authorized by SFC
Although sales of many types of ILAS polices fit the SFO description of dealing in securities, a person is excluded from the SFO definition of dealing in securities if the person “issues any advertisement, invitation, or document” which has been authorized by the SFC. This is stated in sub-paragraph (xi) of the definition:
In its 2009 circular, the SFC referenced the above exclusion when arguing that selling ILAS, in general, does not constitute dealing in securities:
According to Section 102 of the SFO, the definition of “invitation” and “advertisement” includes invitations or advertisements which are made verbally (such as in person at a cafe) or in writing (such as in an email or Whatsapp conversation). If, when selling ILAS, an insurance intermediary issues any advertisement, invitation, or document which has NOT been authorized by the SFC, then the exclusion mentioned in sub-paragraph (xi) of the SFO definition of dealing in securities would no longer apply. The intermediary would need to hold a Type 1 SFC license.
The Office of the Commissioner of Insurance (OCI) pointed this out in a 4 June 2007 circular:
OCI advised insurance intermediaries to do the following:
Invariably, most insurance intermediaries issue some kind of verbal or written advertisement that is not authorized by the SFC. For example, intermediaries frequently promote ILAS as a “fund platform” or “tax wrapper”. Many insurance brokers, especially expat brokers, openly advertise ILAS portfolio bonds as vehicles for accessing a wider range of funds, including unauthorized funds. I know one retail investor who was cold-called by an insurance broker who promoted a certain unauthorized fund without even mentioning the portfolio bond (until later).
Insurance brokers who sell portfolio bonds which are linked to unauthorized funds necessarily must issue unauthorized advertisements, invitations, or documents related to the unauthorized funds. It is impossible to introduce an unauthorized fund without at least making a verbal unauthorized advertisement. Consequently, this activity will automatically classify as dealing in securities, which requires a Type 1 SFC license.
The Professional Insurance Brokers Association (PIBA), a self-regulatory organization, seems to hold a similar view. In its Code of Conduct for brokers selling ILAS, it advises its members to obtain an SFC license before selling portfolio bonds:
Brokers who have promoted unauthorized funds via portfolio bonds without a Type 1 SFC license likely committed a criminal offense.
If they promoted unauthorized funds to retail investors (non-professionals), they likely committed a second criminal offense. Section 103 of the SFO forbids issuing “an advertisement, invitation or document which…contains an invitation to the public…to acquire an interest in or participate in…a collective investment scheme…unless the issue is authorized by the [SFC]“. Both OCI and SFC have warned the industry to take care not to break this law. An offense is punishable by up to 3 years imprisonment and a fine of $500,000 HKD.
Here is OCI’s warning:
Here is SFC’s warning:
Outside the Scope of SFC’s Circular (#3):
Carrying on a Business of Distributing Dodgy, Unauthorized, High-Commission-Paying, Offshore Funds through ILAS Portfolio Bonds
In its 2009 circular, the SFC claimed that, even if selling ILAS were to be regarded as an SFC-regulated activity (e.g., dealing in securities), it could not be regarded as carrying on a business in an SFC-regulated activity, because (according to SFC), there is no financial gain derived from promoting the funds which underlie an ILAS policy:
In the case of dodgy, unauthorized, offshore funds which are relentlessly flogged by expat insurance brokers, SFC’s observation is clearly incorrect. The South China Morning Post has reported that the LM Managed Performance Fund, which wiped out the savings of thousands of people across the world (including in Hong Kong), paid commissions which were as high as 15%. This is approximately twice as much as the 6-8% commissions paid by the insurance companies who supplied the portfolio bonds.
Promoting these dodgy, unauthorized funds via portfolio bonds is a huge business. According to another article in the South China Morning Post, more than 80 unauthorized funds, which were marketed in Hong Kong via portfolio bonds, have been “suspended” since 2008. Many of the funds turned out to be frauds. The news article does not mention the number of unauthorized funds which have not been suspended (yet), but presumably the number is quite large.
Insurance brokers who make a living promoting these dodgy, unauthorized funds are clearly carrying on a business in an SFC-regulated activity (dealing in securities), since they are issuing unauthorized advertisements, invitations, and/or documents (relating to the unauthorized funds) when they sell ILAS portfolio bonds (which contain minimal life cover). The brokers are not protected by the exclusion in sub-paragraph (xi) of the SFO definition of dealing in securities.
Therefore, these insurance brokers must hold a Type 1 SFC license to avoid breaching Section 114 of the SFO—even if they are dealing with professional investors.
Multiple sources say that many insurance brokers deny receiving commissions for promoting unauthorized funds via portfolio bonds. One source says that these brokers have fund commissions paid to a related SFC-licensed corporation (whose address is in the same building). Another source says the brokers have the commissions paid to an offshore company in order to evade corporate taxes. This practice of hiding fund commissions (from clients, regulators, and the government) likely involves criminal acts of fraud, bribery, and money laundering.
If brokers are hiding fund commissions in order to avoid being accused of breaching Section 114 of the SFO, I do not think they succeeded.
They would still be regarded as carrying on a business in an SFC-regulated activity, as they still earn money (the ILAS commission) by doing an act which exactly fits the SFO definition of dealing in securities:
“inducing or attempting to induce another person to enter into or to offer to enter into an agreement…the purpose or pretended purpose of which is to secure a profit to any of the parties from the yield of securities or by reference to fluctuations in the value of securities.”
Since the brokers issued advertisements, invitations, or documents which were not authorized by the SFC, they are not protected by the sup-paragraph (xi) exclusion.
The fact that ILAS, or notional units in an ILAS, are not by themselves classified as securities is irrelevant.
Financial Partners Limited
According to an article in the South China Morning Post, “When an Investment Fund Goes Bad“, a company named Financial Partners was one of the most aggressive distributors of the LM Managed Performance Fund in Hong Kong.
A search for Financial Partners on the Confederation of Insurance Brokers (CIB) website gives a single result for a company named “Financial Partners Limited” whose CEO is Peter Kende. This is presumably the same Financial Partners and Peter Kende mentioned in the South China Morning Post article.
According to SFC records, Financial Partners Limited only held a Type 4 SFC license (advising on securities) during the period when it was presumably selling LM funds. It did not obtain a Type 1 license (dealing in securities) until June 2014, more than 1 year after LM collapsed. Peter Kende also did not hold a Type 1 license until June 2014.
Assuming that my above analysis of the law is correct, then Financial Partners Limited would have needed a Type 1 license to legally distribute unauthorized funds via portfolio bonds. The company did not hold this license.
It seems that insurance companies selling ILAS with minimal life cover would also be dealing in securities if they issued any advertisements, invitations, or documents which are not authorized by the SFC.
In the case of an insurer who sold an ILAS portfolio bond that was linked to an unauthorized fund, it is hard to see how the insurer could have processed the application without issuing some kind of unauthorized advertisement, invitation, or document related to the unauthorized fund.
As I pointed out in another blog post last week, insurance companies that sold portfolio bonds linked to the LM Managed Performance Fund had a duty to distribute the fund’s unauthorized documents to policyholders or potential policyholders. I believe this may have required the insurers to hold a Type 1 SFC license.
Royal Skandia and Friends Provident are two insurance companies that sold portfolio bonds linked to the LM Managed Performance Fund. A search on the SFC’s website indicates that these companies did not have an SFC license.
SFC Should Issue a New Circular Addressing the Issues Raised in this Blog Post
The SFC’s 2009 circular was inadequate, inaccurate, and misleading because it failed to address the following facts, which the SFC should have known: (1) Most ILAS policies sold in Hong Kong contain minimal life cover; (2) intermediaries frequently issue unauthorized advertisements; and (3) in the case of portfolio bonds, intermediaries profit obscenely by promoting underlying funds.
If it turns out that large segments of the insurance industry have breached the SFO—and I believe they have breached it—then the SFC’s seemingly deliberate ignorance of the facts will have been one of the causes.