The hidden dangers of section 115 of the SFO

Section 114 of the Securities and Futures Ordinance (Cap.571) (the SFO), sits at the heart of a regulatory licensing regime that provides, essentially, that it is an offence (punishable by fines and imprisonment), without a licence, to:

• carry on a business in a regulated activity (or a regulated function, in the case of individuals); or
• hold oneself out as carrying on such a business.

The entity that gets licensed is primarily the corporation, which employs the individuals (Responsible Officers and/or Licensed Representatives) who carry out “regulated functions” in respect of those regulated activities (and are thus accredited to the licensed corporation).1

After section 114 comes a less well-known section entitled “Application of section 114 in relation to conduct or activities outside Hong Kong”. On its face, section 115 of the SFO appears to be little more than a complementary provision to section 114, and one designed to delineate the jurisdictional limits of section 114.  As noted by one commentator:

“Reading s114 together with s115, it seems clear that s114 prohibits any person from providing any services in Hong Kong which amount to regulated activities; if activities falling within the definition of regulated activities were not performed in Hong Kong, then unless that person has actively marketed such overseas services in Hong Kong within the meaning of s115, such a person would not have contravened s114, even if such overseas services were ultimately provided to customers in Hong Kong”.2

However, in practice, the section has proven to be problematic for many overseas managers either seeking to establish a marketing presence in Hong Kong only, or looking to use locally licensed brokers/agents to market their products.  In this article, we will examine the hidden danger posed by section 115 in the context of three3 specific types of regulated activities – Type 1 (dealing in securities), Type 2 (dealing in futures contracts), and Type 3 (leveraged foreign exchange trading).

Why these three types of licences in particular? While section 115 applies across all of the 10 types of regulated activities as set out in Schedule 5 of the SFO, these three are the only ones which permit a non-licensed party to carry out the relevant activities through a party that is licensed to do so – that is, a securities dealer (for Type 1 activity), a futures dealer (for Type 2 activity), or a trader (for Type 3 activities).  However, the extent to which one may rely on these licensed parties is curtailed by section 115 – and without a proper appreciation of the subtleties of that section, many (especially overseas) dealers/traders may find themselves being unwittingly in breach of the SFO.

Section 115

Conceptually, section 115 is a straightforward provision: 

• if you actively market your services (or you do it through someone else) in Hong Kong (whether you’re outside of Hong Kong or you’re in Hong Kong)
• and those services, if provided in Hong Kong, would be regulated activities, then
• providing those services would amount to carrying on a business in a regulated activity in Hong Kong under section 114(1)(a), and
• marketing such services in Hong Kong is considered holding yourself out as carrying on a business in that regulated activity in Hong Kong.4 

Marketing a product into Hong Kong

Type 1 (dealing in securities) and Type 2 (dealing in futures contracts) regulated activity both encompass “marketing” of securities (in the case of Type 1 activity) and futures contracts (in the case of Type 2 activity). 

For Type 1 activity, “dealing in securities” means making or offering to make an agreement with another person for or with a view to acquiring, disposing of, subscribing for or underwriting securities, or “inducing or attempting to induce another person to enter into or to offer to enter into an agreement” for the same. Similarly, for Type 2 activity, “dealing in futures contracts” encompasses both a “dealing” element, that is, “making or offering to make an agreement with another person to …acquire or dispose of a futures contract” and a “marketing” element : “inducing or attempting to induce another person to enter into…or acquire or dispose of a futures contract”.

Relevantly, the definition of both Type 1 and Type 2 regulated activities contemplate that they may be carried out by a party that is not licensed to do so, provided that it performs the relevant act through a third party that is so licensed, that is, either a securities dealer or a futures dealer.5

It follows, therefore, that an unlicensed entity may also market a security or a futures contract through a licensed securities dealer or futures dealer.  This is common practice in Hong Kong, where certain overseas funds, for example, engage licensed distributors or placement agents to attract investors.  In the case of group companies, it would also mean that a foreign securities dealer or futures dealer could establish a subsidiary in Hong Kong (as a Hong Kong private company), obtain the necessary licence for that subsidiary, and have it market particular securities or futures products on behalf of the foreign parent, to Hong Kong investors. 

This is not controversial in the context of section 115 of the SFO. So long as the licensed entity/affiliate in Hong Kong (the Domestic Licensed Party or DP)  does not “actively market” (see below for what this means) the services that are being provided by the overseas unlicensed entity (the Foreign Unlicensed Party or FP), but only restricts its marketing to a specific product (that is, a specific security, or a specific futures contract) that is being offered by FP, this is permitted under section 114 SFO and would not trigger liability under section 115.6 

Marketing a service into Hong Kong

The corollary to the above, of course, is that in marketing the specific security or futures contract, the DP must be careful that it does not venture into territory that amounts to it marketing a “service” that is being, or that will be provided by, the FP.  This distinction is pretty clear in the context of Type 1 and Type 2 regulated activity, but even so, some instances where parties may find themselves at risk of crossing over into section 115 territory would include, for example:

• where the DP describes to potential customers proprietary systems or processes that have been developed, or are implemented by, the FP (in the context of making the actual product itself, or the trading or use of it, better in some way), or
• where the DP  provides information about the FP generally, that covers adjunct or support services which may, themselves, amount to regulated activities if carried out in Hong Kong, eg, in the context of a securities dealer, describing margin or wealth management services that the FP (or other entities within the group) may provide.

Type 3 regulated activity, however, is where the distinction between marketing a “service” as opposed to marketing a “product” can become challenging. 

While Type 1 and Type 2 regulated activities are expressed in terms of the “dealing” in a specific product (that is, securities, or futures contracts), and Type 3 regulated activity also covers “dealing” in leveraged foreign exchange contracts, the definition of “leveraged foreign exchange trading” as a whole goes beyond “dealing” in just a single product but also encompasses the provision of a range of services that  includes:

• providing any financial accommodation (ie, lending money) in relation to “foreign exchange trading”7 or in relation to any “dealing” in a leveraged foreign exchange contract, and

“dealing” that facilitates either of the above two acts.

Like Type 1 and Type 2 activities, the definition of Type 3 regulated activity also contemplates the use of a licensed third party (a trader)8.  However, the formulation of that exemption refers to the entire series of “acts” that comprises “leveraged foreign exchange trading”, specifically : “[leveraged foreign exchange trading]…does not include any act performed…(xiv) by a person through a trader…”

So, it should be possible to use a trader to:

• buy/sell a leveraged foreign exchange contract, or induce (ie market) a leveraged foreign exchange contract to a customer
• provide financial accommodation to facilitate foreign exchange trading or to facilitate buying, selling or marketing of a leveraged foreign exchange contract to a customer
• buy/sell or market, on a discretionary basis or otherwise, any other arrangement to enter into a contract to do any of the above acts.

Put another way, if a DP induces (on behalf of the FP) a Hong Kong person to enter a leveraged foreign exchange contract with the FP, that is clearly permitted under section 114 and would not trigger liability under section 115.  Similarly, if the DP induced a Hong Kong person to take out a loan in respect of a single foreign exchange trade, that would also not fall within the realm of section 115.

However, it is clear, from the way the drafters of the SFO defined Type 3 regulated activity, that they were also contemplating not only “dealing” in a discrete product (leveraged foreign exchange contracts),  but also “dealing” in (ie, buying/selling AND marketing) certain services such as the provision of financial accommodation and arrangements that facilitate leveraged foreign exchange trading.

That is why, for example Type 3 activity is called “leveraged foreign exchange trading”, as opposed to “dealing in leveraged foreign exchange contracts” (which would have been the formulation one would expect if the framers intended for this to be similar to Type 1 and 2 activities).  Similarly, in relation to the provision of financial accommodation, it is submitted that the drafters would have referred to the act as “providing financial accommodation in relation to a foreign exchange trade” (or similar), as opposed to “the act of providing financial accommodation to facilitate foreign exchange trading”. 

However, when one takes into account section 115 SFO, that very clearly prohibits the marketing of any service that would amount to regulated activity if performed by that person in Hong Kong.  This, therefore, cleaves away a large part of what is provided for in the definition of Type 3 activity.  This is where the disconnect lies when trying to fit Type 3 activity within the “mould” of Types 1 and 2 activities. Importantly, this may also potentially mislead parties who are not aware of the intricacies of section 115 into thinking that by using a DP, they can perform everything that is defined under Type 3 activity (in the same way they can in relation to Type 1 and Type 2 activity).

Indeed, even if one considered the definition of a “leveraged foreign exchange contract” alone, it can be seen that the framers contemplated the carrying out of a series of acts that taken together result in the execution of such a contract.9

There is every risk that if an FP were to induce a Hong Kong customer to enter into a single leveraged foreign exchange contract through a DP, the authorities could still construe that as the marketing of a bundle of services (which together comprise the actual product - being the specific leveraged exchange contract), which would trigger liability under section 115 SFO.

The Hantec Decision

The hidden dangers of liability under section 115 was certainly brought to the fore in the  recent case of  Ng Chiu Mui  & Anor v Securities and Futures Commission case10  (the Hantec Case).

The facts of the Hantec Decision are not controversial. 

The Hantec group of companies (the Hantec Group) is listed, through Hantec Holdings Ltd., (the Listco) on the main board of the HKEx.   Within the Hantec Group,  Cosmos Hantec International (CHI), a private company incorporated in New Zealand, carried on the business of offshore leveraged foreign exchange trading.   CHI was not registered or in any way licensed by the SFC.   Another company, Hantec International Limited (HIL), was established in Hong Kong, and also carried on a business in Hong Kong as a foreign exchange broker.  HIL was licensed to carry out Type 3 regulated activity in Hong Kong by the SFC. 

HIL and CHI were associated by virtue of being subsidiaries of the Listco - in the case of HIL, a 100% subsidiary of the Listco and for CHI, an indirect 30% subsidiary of the Listco. 

CHI had, at one point, a presence in Hong Kong by virtue of having established a “liaison office”. But that office was raided by the SFC, and as a result, CHI left to establish an office in Macau instead. HIL moved into the premises formerly occupied by its sister company.  HIL and CHI shared common staff and officers, and this case arose from the prosecution by the SFC of the responsible officers (ROs) and licensed representatives (LRs) of HIL following complaints made against a number of LRs of HIL, in respect of their activities on behalf of CHI. 

On review of a decision made by the SFC (under section 194 and 198 of the SFO), Stone J, sitting as Chairman of the Securities and Futures Tribunal (the SFAT), found (among other things) that CHI had been “actively marketing” its services into Hong Kong through the actions of the ROs and LRs of HIL under section 115 SFO.   The carrying out of those services by CHI amounted to Type 3 regulated activity, and as CHI was not licensed to do so, it was in breach of section 114 SFO.  The ROs and LRs were also found guilty of misconduct (among other things, by having aided and abetted in the breach of the SFO by CHI). 

What did the Tribunal look at in coming to its decision that CHI had been “actively marketing” under section 115 SFO?  It appears from the decision the following:

• first, that LRs of HIL had induced individuals to open accounts with CHI in order to trade leveraged foreign exchange contracts;
• secondly, that the LRs of HIL were named in account opening documents (for leveraged foreign exchange trading by CHI) as the responsible “Account Executives”;
• thirdly, that there were internal documents of CHI showing Hong Kong as one of its target markets; and
• finally, that there were documents and other correspondence purporting to show the involvement of another company within the Hantec Group in the affairs of CHI.11 

There are two aspects of the Tribunal’s decision on this particular aspect that are surprising.  The first is the dismissal of the SFC’s views/guidance, as set out in its 2003 FAQ, about what “actively markets” means.12 

As argued by the defence, the SFC’s own views, when taken in conjunction with parliamentary materials created around the time of introduction of the Securities and Futures Bill (which would later become section 115 of the SFO in its present form)13 in totality indicate that “actively market” means no more than marketing in the primary sense of pro-actively advertising the service to the Hong Kong public, but did not encompass, for example the actual sale of products to individual customers.

However, per Stone J: 

“For my own part, I fail to see why the term ‘actively markets’ should not, on its face, also be taken to include the actual sale of a particular product to a member of the Hong Kong public, although clearly much will depend upon the evidence surrounding the circumstances of any such sale.  However, it seems tolerably clear that an actual sale consequent upon the advertising of the service to the Hong Kong public must be regarded as falling within this rubric.”

The SFC’s guidance, together with historical material surrounding the creation of Section 115 were not, according to His Honour, to be relied on, for they were merely “_straws in the intepretative wind_”.  This has been affirmed on appeal by the Court of Appeal14 , but disappointingly, neither the Court of Appeal nor the SFAT offered any definitive guidance on what ‘actively market’ means, other than to resort to the generic formulation that one “must look at the particular facts and circumstances as they have been proved to exist in any given case”.

The more disconcerting aspect of the Tribunal’s decision, however, lies in the reliance Stone J placed on the fact of actual sale of a product, as being evidence for active marketing under section 115 SFO.  While in the decision itself, His Honour did say the fact of an actual sale would only form part of the “rubric”, and should be taken into account as part of the overall facts and circumstances surrounding any such sale - it appears clear from the decision that, in fact, that was the main thing on which His Honour hinged his determination that there had been active marketing. 

If we considered the factors that were highlighted by the SFAT, there is certainly no clear evidence of pro-active advertising as described in the SFC’s own FAQ (for example, a marketing plan, mass media publications, a schedule for related marketing etc) other than there having been internal documents which indicated that CHI had considered Hong Kong as one of its target markets.  But this is neither here nor there in terms of whether any active marketing was taking place, and is certainly short of the SFC’s own standards.  What was left for Stone J., was the evidence that LRs of HIL had induced individuals to open accounts to trade with CHI, and that these LRs had entered into agreements for leveraged foreign exchange trading  on behalf of CHI, thereby being named Account Executives on the account opening forms.

With respect, it would have been sufficient for Stone J to have relied solely on the evidence that LRs of HIL had induced others to open accounts with CHI in order to trade leveraged foreign exchange contracts, to establish liability under section 115.  This is clearly the marketing of a service in Hong Kong.   

By going further to consider the actual sale of the product (in this case, presumably, the signing of the account opening forms by HIL’s LRs on behalf of CHI), it is submitted that this creates problems on various fronts:

• First, it cuts across the delineation that is in place between the marketing of a service, and the marketing of a product (whether for Type 1, 2 or 3 activities15) - the latter being very clearly permissible under the terms of the specific definitions of those regulated activities.   Indeed, the actual sale of a product (whether a security, a futures contract,  a specific leveraged foreign exchange contract, or even the signing of an agreement for leveraged foreign exchange trading generally) should always be permissible under the specific definition of those three types of regulated activities, so long as that sale is done through a licensed “dealer” or “trader”.  If the actual sale of a product, which may be the result of the marketing of that product, can now lead to an inference that there had been active marketing of a service as well (thereby giving rise to liability under section 115), this would appear to expand the jurisdictional reach of section 115, and create liability where none may have existed previously.
• Secondly, this appears to re-draw the boundaries that the legislators had demarcated in framing section 114 and section 115 - which was probably an outcome that was never intended. 
• Finally, in practical terms, it also, creates real difficulties for DPs - licensed “dealers” and “traders” who have been engaged by foreign parties either to sell a particular product, or to market a particular product on their behalf; and for FPs looking to sell products into Hong Kong through properly licensed channels -  as the spectre of prosecution under section 115 now looms large.

The wide-reaching implications of the approach adopted by Stone J may be the reason why, on appeal to the Court of Appeal, the COA was careful to emphasise that:

“the Tribunal was not saying that an actual sale is sufficient [for] the purposes of “actively marketing”.  Rather, it is clear from the second limb that much would depend upon the evidence surrounding the circumstances of such sale”.

While this does go some way to providing some reassurance to the market that the sale of a product is, of itself, not sufficient to establish active marketing - it leaves open the “Pandora’s box” of potential liability under section 115 in circumstances where none may have been intended. 

While the COA identified a clearer basis on which to say that there was marketing of financial services by CHI in Hong Kong16, it was also a shame that the COA did not seize the opportunity to explain the distinction between the marketing of a product as opposed to a service in Hong Kong, and how that distinction is supposed to work in the context of using licensed dealers/brokers for Types 1, 2, and 3 regulated activities.

Conclusion

For foreign entities looking to access the Hong Kong market (in relation to Type 1, Type 2 or Type 3 products), it is clear that the existing framework contemplates the use of licensed domestic “dealers” or “traders” to sell or market specific products on their behalf to local clients.

However, section 115 creates the hidden danger of the local intermediaries marketing more than just the product, but overstepping their bounds into also selling the services of the foreign entity - thereby pulling that party into the jurisdiction of section 114 for carrying out regulated activity without a licence.  In respect of Type 1 and Type 2 activities, therefore, and as we have set out above, it is very important to clearly delineate between the marketing of a product (which is allowed), and the marketing of a service (which is not permitted).

In the context of Type 3 regulated activity, however, section 115 poses even more difficulties because of the manner in which the framers formulated that regulated activity - namely, that the core activity being regulated is a bundle of services, as opposed to the dealing in a specific product. Unfortunately, Type 3 activity also follows the formulation of Type 1 and Type 2 activity in terms of the ability to use locally licensed “traders” to carry out Type 3 functions.  As we have seen, when properly interpreted, however, section 115 serves to severely cut down the scope of activities that those locally licensed traders can, in fact, perform.  The danger for foreign parties that are not familiar with these subtle differences, and who assume that the “dealer” exemption under Type 3 would apply in the same way as for Type 1 and Type 2 activities, is the risk of unwittingly breaching section 115.

The development of the jurisprudence around this particular issue has added to the potential for triggering liability under section 115, with the Hantec Decision (confirmed on appeal) opening up a whole new “minefield” of potential liability under section 115 whenever an actual product is sold by a locally licensed “dealer” or “trader” on behalf of an unlicensed foreign party.  This has “muddied” the waters not only for Type 3 regulated activity, but also for Types 1 and Types 2 activity, where liability clearly was not intended to exist.   

For foreign parties contemplating providing financial services in Hong Kong through domestic licensed brokers, it is more important than ever now to get professional legal guidance around the potential traps and pitfalls.  Especially in the case of foreign exchange brokers, the scope of what can be undertaken by a domestic broker is extremely restricted - so much so that the only safe way of conducting activity in Hong Kong would be to get licensed under the SFO. To this end, it should be noted that that although not specifically required under the SFO, the SFC does not, as a matter of practice, license branch or representative offices in Hong Kong. Foreign brokers must, therefore, come to Hong Kong and incorporate a local subsidiary before that entity can obtain a licence from the SFC. 

This situation clearly impacts on Hong Kong’s competitiveness as a financial centre, and warrants re-examination. 

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1 See generally sections 114(2)(a), 114(3), 114(4), 116 and 117 of the SFO.

2 Butterworths Hong Kong Securities Handbook, 2013 Reissue, para[114.16].

3 The Securities and Futures (Amendment) Ordinance 2014 will introduce a framework for regulation of over-the-counter derivative products and transactions, in particular, by adding, among other things, a new Type 11 (dealing in OTC derivative products) regulated activity that, like Types 1, 2 and 3 regulated activities, will permit the use of an OTC derivative products dealer – see section 2(n), Part 2A, Schedule 5 – but we will not be considering this new section for the purposes of this article.

4 See generally section 115(1) SFO.  The same goes for an individual who is actively marketing a “regulated function” into Hong Kong – section 115(2) SFO.

5 For Type 1, see para (iv) of the definition, and for Type 2, see para (ii) of the definition in Schedule 5, SFO.

6 See also section 58(4) of the Securities and Futures (Financial Resources) Rules (Cap 571N), which provides for approval (and a lower requirement in terms of regulatory capital) as an “introducing agent” in respect of Type 1, 2 and 3 regulated activity.  For Type 1 and 2 activities, the applicant must show that it conducts no business other than (A) communicating offers to effect dealings in securities to an exchange participant of a recongised exchange company or a specified exchange; and (B) introducing persons to an exchange participant of a recognised exchange company or a specified exchange, in order that they may (i) effect dealings in securities/futures contracts or options contracts; or (ii) make offers to deal in securities or futures contracts/options contracts. For Type 3 activity, the applicant must show that it conducts no business other than (A) communicating offers to effect leveraged foreign exchange trading to a recognised counterparty; and (B) introducing persons to a recognised counterparty in order that they may (i) effect trading in leveraged foreign exchange contracts; or (ii) make offers to trade in leveraged foreign exchange contracts. 

7 “foreign exchange trading” means entering into or offering to enter into, or inducing or attempting to induce  a person to enter into or offer to enter into, a contract or arrangement whereby any person undertakes to-

(a)   exchange currency with another person

(b)   deliver an amount of foreign currency to another person, or

(c)    credit the account of another person with an amount of foreign currency,

but does not include any act performed for or in connection with any contract or arrangement or a proposed contract or arrangement as described in paragraphs (i) to (xv) of the definition of “leveraged foreign exchange trading”

8 See sub-paragraph (xiv), Schedule 5, in the definition of “leveraged foreign exchange trading”.

9 “leveraged foreign exchange contract” means a contract or arrangement the effect of which is that one party agrees or undertakes to-

(a) make an adjustment between himself and the other party or another person according to whether a currency is worth more or less (as the case may be) in relation to another currency

(b) pay an amount of money or to deliver a quantity of any commodity determined or to be determined by reference to the change in value of a currency in relation to another currency to the other party or another person, or

(c) deliver to the other party or another person at an agreed future time an agreed amount of currency at an agreed consideration

10 At first instance, in the Securities and Futures Appeals Tribunal (SFAT) – Unreported, Application nos. 7, 8 and 9 of 2007, 15 May 2009.

11 See at para 17 of the decision.

12 The SFC, in its answers to “Frequently Asked Questions” (Topic 9), noted that in determining whether a person was actively marketing its services to the public, it would consider the nature of business activities as a whole and have regard to a number of the following factors:

• whether there is a detailed marketing plan to promote the services
• whether the services are extensively advertised via marketing means such as direct mailing, advertisements in local newspapers, broadcasting or other ‘push’ technology over the internet (as opposed to whether the services are passively available eg on a ‘take it or leave it’ basis)
• whether the related marketing is conducted in a concerted manner and executed in accordance with a plan or a schedule which indicates a continuing service rather than an one-off exercise
• whether the services are packaged to target the public of Hong Kong, eg written in Chinese and denominated in Hong Kong dollars and
• whether the services are sought out by the customers on their own initiative.

13 Annex 1 to Paper No CSA04/01 by the Financial Services Bureau and the SFC to the Bills Committee on Securities and Futures Bill and Banking (Amendment) Bill 2000, 17 November 2001. 

14 Ng Chiu Mui & Anor v SFC Unreported, CACV 141/2009, 26 May 2010

15 Query, however, how often, in practice any party would market a specific leveraged exchange contract as opposed to the service of leveraged foreign exchange trading generally.  That is, whether for Type 1, 2 or 3 activity, we would expect customers to sign customer agreements that would cover the provision of brokerage or trading services generally, as opposed to the specific buying and selling of a single security, or futures contract, or leveraged foreign exchange contract.

16 See at para 11, where the court noted:

• CHI had paid commissions to 4 HIL executives in respect of trades conducted by their clients
• Employees of OIM (a sister company to HIL and CHI) were instructed to assist CHI, including receiving completed account opening documentation and other correspondence in Hong Kong, forwarding the same to NZ
• Employees of OIM were asked to keep bank account opening documents and introductory brochures in Hong Kong for collection by customers
• HIL executives were involved in approving and checking fund transfers, and paying commissions to account executives on behalf of CHI on a daily basis.