Webb-site.com proposes a solution to reduce the recurrent problem of brokerage failures, while at the same time improving communications with shareholders and retail investor participation in corporate governance, bringing HK up to international standards.

Trust, but Verify
21 July 2006

The recent failure of Tiffit Securities (see our other story today) is another in a long series of brokerage collapses. Sometimes they go quietly, returning stock and cash to clients without loss, but often, the failure involves theft or fraud, where the broker has succumbed to temptation and abused or stolen client cash and/or stock, often in a last ditch attempt to avoid bankruptcy.

Government officials and industry representatives tend to react to these failures with a mixture of apathy and denial, rather than seeking lasting solutions which will reduce the frequency and scale of client losses. They talk about "isolated incidents" and call for "greater self discipline". Secretary for Financial Services Fred Ma Si-hang said on 19-Jul-06 "I think it is time for the industry to be more self-disciplined". So don't expect any action from Government. He also said, referring to Tiffit and the collapse in May of Whole Win Securities "I do not think the two cases suggest the whole brokerage industry has a problem".

In fact, here is a list of failed stock brokerages on which the SFC has issued restriction notices since 1996:

18-07-2006 Tiffit Securities (Hong Kong) Limited
26-05-2006 Whole Win Securities Limited
03-04-2003 Tai Wah Securities Ltd
05-11-2002 Pacific Pearl Securities Limited
07-06-2002 Lawsons Securities Company
21-02-2002 Teil Stock Investment Company
23-01-2002 Ying Kit Stock Company
24-01-2000 Win Successful Securities Ltd
25-05-1998 Chark Fung Securities Company Ltd
07-05-1998 Foreluxe Securities Ltd
19-01-1998 C.A. Pacific Securities Ltd
15-10-1996 C.K. Securities Company
May-96 Cheong Woon Securities Company
Mar-96 Wei Xin Securities Ltd

A proposal

Webb-site.com and its editor David Webb, who is an elected independent non-executive director of HKEx and also a member of the SFC's Shareholders Group, hereby propose a solution which requires action by both of them. Our proposal, explained below, will:

The background

Most retail brokers act not just as agents for buying and selling stock, but also as custodians of the client's assets, including stock and often cash. The stock is normally held in a pooled account in the broker's name with the Central Clearing and Automated Settlement System (CCASS) operated by Hong Kong Securities Clearing Co Ltd (HKSCC), a wholly-owned subsidiary of Hong Kong Exchanges and Clearing Ltd (HKEx). HKSCC in turn holds the stock in the name of a subsidiary, HKSCC Nominees Ltd, on the register of shareholders of each listed company.

The problem with this, from the perspective of the retail investor, is that they have no way of knowing when the broker illegally removes the client's shares from its pooled account, or pledges them to a bank or money lender. Investors also, by default, do not receive annual reports or shareholder circulars, because the brokers have no obligation to pass them on, nor are brokers obliged to seek voting instructions. Retail investors are out of the loop, and this is shown by the very low voting figures (excluding insiders) in shareholder meetings, particularly in small companies which often lack institutional investment.

The SSA system

To reduce the theft risk, in the mid-90s HKSCC came up with the snappily-named Stock Segregated Account with Statement Service (SSA), whereby each client's shares are held by the broker in a separate, named account, and a printed statement is sent to the client each time stock is added or removed from the account, as well as a monthly statement. The account remains under the broker's control, but there is transparency over its operation. A monthly charge of HK$10 per account is charged by HKSCC to the broker, who can either absorb it, or pass it on to the client. The client also receives corporate communications such as annual reports and circulars directly from registrars.

Unfortunately, as is common with monopolies, HKEx has not innovated the SSA service any further since it was first introduced, when the internet was in its infancy. Statements are still sent by mail, which is slow and expensive to administer. They won't even let you use a P.O. Box, for no obvious reason, which means the client has to tell HKSCC where he sleeps at night if he wants the service. Although the stock is held in the name of the broker's client, HKSCC does not recognise any relationship with the client, and does not accept voting instructions from the client.

The IP account system

There is also a more advanced service, the Investor Participant account, which gives investors direct custody in CCASS and does allow voting. The IP account is controlled solely by the investor, and the broker settles sales and purchases with the investor through the IP account, which is linked electronically to the investor's bank account. The broker inputs the details of the transaction, and the client must then "affirm" each transaction (by phone or internet) by 3.45pm on the second business day after the transaction, in order to authorise the settlement with the broker. That prevents the broker from stealing client shares or cash, but if an investor forgets to affirm a transaction, then it fails to settle.

We recommend the IP service to all serious investors, and use it ourselves, but the reality is that most brokers don't promote it, because of the increased risk of settlement failure and because they lose custody, so they can't charge you fees on dividends, custody fees and scrip fees, and they can't be sure of getting the "sell" order - you can use any broker you like when you have custody in your IP account. So you are not a captive customer.

The solution

We propose the following:

  1. HKEx should revamp the SSA system to allow all communications, including transaction statements and links to on-line issuer documents, to be sent to account holders by e-mail. This will give them instant notice when stock is moved in or out of their accounts by their broker, or when a shareholder meeting is being called.
  2. HKEx should also allow SSA holders to log in and view their stock balances on the web and by phone.
  3. HKEx should allow SSA holders to give voting instructions through the same web and phone system. To avoid conflicting instructions, brokers should not be permitted to vote shares in SSA accounts. By connecting CCASS directly with investors, this will greatly increase retail investor voting, improving the real effect of corporate governance rules designed to protect investors, which are ineffective if they don't vote, for example, on connected transactions.
  4. Due to lower costs, the electronic SSA system should be made available by HKEx for free, but the existing charge of HK$10 per month (or perhaps more) should be levied for those who want the printed, mailed service. This will incentivise use of low-cost electronic communications. HKEx will recover the cost through increased retail participation in the market, which generates fees itself.
  5. Brokers would continue to control the SSA accounts and handle anything involving cash, including transaction settlement and rights issue and warrant subscriptions. The SSA system should allow authorised re-pledging, by indicating a "P" on the statements. This will make it clear to investors whether or not their stock has been pledged by a broker to finance its business. If no such flag is attached, then in the event of a brokerage failure, no re-pledging of that stock will be recognised by HKSCC.
  6. Finally, and most importantly, the SFC should require that all client assets of retail banks and brokerages be held in SSA accounts. That is, every retail investor who wishes to leave stock in the custody of a bank or broker shall be required to have an SSA account and give either an e-mail address or, if they want printed statements, a postal address. Investors may instead take direct custody through the existing IP account service which will remain available.

We believe that the requirement for SSAs should also apply to retail banks, because although they have a much lower failure rate, it is just as important that we should start getting communications from listed companies through to bank clients and to receive voting instructions in the opposite direction. It would actually reduce the banks' workload by taking them out of the voting loop.

We realise that our reform proposal would cause the creation of about one million SSA accounts, but it would greatly increase transparency and restore confidence in small brokers. They should be in favour of it for this reason alone. Hong Kong is not going to reduce the brokerage failure rate simply by calling for self-discipline - there will always be temptations to steal or re-pledge stock without authorisation, but if all clients receive real-time statements, then the alarm bells will ring sooner, and that will be a deterrent in itself.

Much of the infrastructure is already available - the IP system, which currently has over 10,000 users, has both web and phone access and already processes voting information from issuers and collates voting instructions from investors. The electronic SSA system would be similar, but with a reduced and simpler set of services which leave formal custody and settlement with the broker and avoid the need for client affirmations of transactions. It is a "trust but verify" system.

Next step

The proposal, if implemented, will bring HK up to international standards of investor communication, while having regard to the specific structure of HK's retail investor industry.

Your editor will take this proposal to the HKEx Board as a director, and to the SFC as a member of its Shareholders Group. We also welcome comments from industry participants.

© Webb-site.com, 2006

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