Submission on SFC's Consultation Paper on the Review of the Level and Funding of the Investor Compensation Fund

Introduction

1. The Consumer Council welcomes the opportunity to offer its comments in response to the consultation paper issued by the Securities and Futures Commission (SFC) on the review of the level and funding of the Investor Compensation Fund (ICF). The Council is more concerned with enhancing protection of investors and will focus on the following issues.

Level and funding of the ICF

Source of funding

2. The Council would like to comment concerning the funding arrangement of the ICF for consideration of the SFC. The Council has reservation with funding the investor compensation scheme through a product levy which comes solely from the investor compensation levies on exchange-traded product transactions ^[1] . Under the present levy arrangement, the cost of compensation is clearly paid directly by the investors (the consumers) of the financial services. The Council believes that firms conducting securities business should have responsibility for contributing to the ICF in case of failures of firms, instead of leaving compensation to be funded by investors. 
3. As far as the Council is aware, the source of compensation funding for similar investor compensation schemes in other jurisdictions is mainly industry-based. For example, the sources of funding in Canada, the UK and the US ^[2] are by contributions (collected through assessments paid by securities firms based on certain percentages of their gross revenues) from firms which are authorized to conduct investment services. In the local context, the source of funding of the Deposit Protection Scheme in Hong Kong is collected from banking institutions.
4. Notwithstanding the fact that the investor compensation levies in Hong Kong may not be significant when compared to the total transaction amount (i.e. for every $50,000 securities trading, the buyer and seller only need to pay investor compensation levy of $1 each), the Council is of the view that the cost of financing the ICF should, in principle, be borne by the firms involved instead of being primarily funded by investors. The need to change should be considered not only to bring Hong Kong in line with overseas practice, but also to counteract disparities in funding arrangements for compensation and unequal conditions of competition between different types of firms (providing banking and securities services) within the financial sector in Hong Kong. 
5. Funding source is an area which the Council feels there is the greatest need for immediate action, and the time is opportune for review since there is ample reserve built-up at the current moment. The Council strongly suggests that the SFC and the Investor Compensation Company (ICC) should take this funding issue as a matter of priority by commencing a review of the arrangement for financing the ICF, to truly reduce the burden on investors.
6. As to an industry-funded compensation scheme, some may argue that the costs of the levies although initially borne by firms are likely to be passed on to customers through higher charges. As a result, the benefits of not requiring direct payment from investors may be partly removed through the transfer of costs by firms. However, the Council still sees a benefit in that the change in the way the ICF is funded may affect the behavior of consumer, e.g. consumers may derive confidence from the commitment of the industry through contributions to an industry-funded compensation scheme and hence be more likely to invest in the securities market.

Coverage limit

7. With regard to the compensation coverage limit, it is mentioned in the consultation paper that the per investor limit would be maintained at a similar level $150,000 per investor as a result of the assessment of the consistency on the level of coverage to that provided in 1998 when the $150,000 per investor limit was first adopted.
8. In its previous submission, the Council pointed out that the above coverage limit was in fact behind those adopted in the major countries of the world. For example, the compensation limits are CAN$ 1,000,000 for an investor in Canada, ￡ 48,000 in the UK, and US$ 500,000 in the US respectively. Whilst recognizing that a higher limit may incur extra costs and funding, the Council feels that the existing level of compensation limit may be inadequate. It is because on average only 76% of claimants have losses paid in full from the ICF (Appendix 1 of the consultation paper refers); leaving one quarter of the claimants not fully satisfied. In light of this, the Council is in favor of increasing the per investor limit, so that the percentage of claimants receiving full compensation would be increased.

Policy for size of the ICF

9. Whilst the Council is in favour of increasing the per investor limit which will have bearing on the eventual fund size, the Council is of the view that at the current compensation limit of $150,000 per investor and paid by investor directly, the prevailing investor compensation levies should be suspended, once the targeted self-funding level is reached. Continuing to impose the levy only incurs cost burden to investors but will not provide more protection to investors.
10. On the size of the ICF, the Council agrees that IFC should not be accumulating assets beyond the amounts it needs. Taking into account that addition regulatory measures (e.g. the imposition of a re-pledging limit on client collateral) will be implemented to reduce broker default risks and that the estimated annual loss has fallen in recent years (paragraph 2.8 of the consultation paper refers), it appears to the Council that further accumulation of funding might not be necessary. The Council appreciates that allowance needs to be given to varying investment rate of return in determining the buffer between the minimum prudent level and the self-funding level. The Council does not venture to suggest the appropriate self-funding level, suffice to say that the fund size should not be set at an unnecessarily high level having regard to a prudent base amount of assets as determined by the risk model in order to lower the burden on investors. In any case if the need arises, the ICF may resort to back-up funding arrangements with the Government, for purposes of protecting investors and maintaining public confidence in the securities market.

Levy triggering mechanism

11. The Council agrees that there should be an automatic mechanism for triggering reinstatement or suspension of the levies when the ICF falls below the minimum prudent level or exceeds the self-funding level. A similar mechanism can be found with the Deposit Protection Scheme in which a target range with upper and lower limits are set up to provide an adequate buffer to the scheme.
12. From the perspective of investor protection, the Council considers that a re-instatement procedure is of particular importance in ensuring that there is no significant reduction in the funding level beyond what is required to provide sufficient protection to investors. The Council is however concerned that the automatic levy triggering mechanism may be confusing to investors especially those not engaged in regular trading. The Council therefore urges the SFC to take such measures as to ensure that any notice of changes to the prevailing levy arrangements will be properly and effectively brought to the attention of the public and the market.

Handling of broker defaults

13. The Council is glad to see set out in the consultation paper a range of suggestions to help improve the existing procedures in handling of broker defaults. However, it is disappointing that the SFC has recommended not to pursue further on these suggestions.
14. In general, the Council is of the view that compensation should be paid to claimants as soon as reasonably possible and that delays in paying compensation to claimants should be kept to a minimum. The Council's comments with respect to the suggestions are as follows.

Power for the ICF to advance funds to redeem pledged shares

15. The Council considers that the suggestion of empowering the ICF to advance funds for redemption of pledged shares by a defaulting broker is worthy of further exploration by the SFC. As noted in the consultation paper, the suggestion provides some benefits to investors, for example, avoiding increase of the amount in default through accrual of interest on the outstanding loan balance. The C.A. Pacific Securities Limited (CAPS) is a case in point that illustrates some claimants could have to wait for as long as 4 years after the default for return of their shares.
16. In order to balance the investor benefits against any cost implication to the ICF and deal with the alteration of the existing proprietary rights of investors as noted in the consultation paper, the Council suggests that rules could be made to specify circumstances under which the ICF may, in appropriate cases, advance funds for facilitating the return of client's shares pledged by a broker as a security for a loan. And there should be clear guideline setting out the conditions to be met for the power to be involved. For instance, possibility of substantial delay in the liquidation process could be one of the conditions required.
17. In fact, the Council notes that the Securities Investor Protection Act in the US allows the Securities Investor Protection Corporation (SIPC) to advance to the trustee such moneys as may be required to pay indebtedness of the debtor to a bank or lender if the trustee determines that the aggregate market value of securities to be made available to the trustee upon the payment of such indebtedness does not appear to be less than the total amount of such payment.
18. The Council therefore suggests that the SFC should further explore the SIPC's model, with a view of finding a way to reduce the losses of investors arising from interest accrued on the outstanding loan balance.

Power for liquidators to sell securities and distribute money

19. To save administrative costs in administering clients' securities, the Council considers that options other than empowering liquidators to sell clients' securities and distribute money are worthy of further deliberation by the SFC. The Council notes that Canada adopts various ways in lieu of satisfying a claim by the delivery of physical securities to claimants. For the purpose of expediting the compensation process, the Council considers this can provide some useful reference for consideration of the SFC.
20. In Canada, the Canadian Investor Protection Fund (CIPF), a trust established by the sponsoring self-regulatory organizations (e.g. the investment dealers association and the stock exchange) will work with a trustee to arrange to have some or all customer accounts transferred, or for sale of an insolvent firm's business to another securities firm where the customer can access the account directly. The purpose of such a transfer is to permit customers to continue dealing with their accounts in an orderly way and to reduce losses. If that is not possible, CIPF can deliver the contents or value of the account to a customer. If the securities are not available to be returned, CIPF can compensate the customer for the market value of those securities as at the bankruptcy date.
21. If the power is given for the ICF to deal with securities in an expeditious manner, there should be clear guideline setting out the circumstances under which the ICF may exercise such power. Having said that, the overriding concern should be that if ownership of clients' shares is identifiable, they should be returned to their respective owners.

Use of ICF funds to pay for the costs of an administrator

22. The Council supports the SFC's recommendation that the SFC should where practical strive to appoint an administrator at an early stage to protect client assets and return shares to clients. In addition, the Council suggests that the ICF may consider, for benefits of claimants, to specify itself or the SFC as administrator in circumstances that the liabilities of a debtor to unsecured creditors appear to aggregate small amount and that there appear to be a small number of customers of such debtor. A close reference can be found in the US investor protection scheme that if a court issues a protective decree upon receipt of an application by the SIPC in relation to insolvency of a firm, such court may appoint the SIPC as trustee for the liquidation of business of the debtor.
23. Nevertheless, it would be necessary to explore further whether there would be any conflict of interest on the roles of the SFC and the ICF as administrator and creditor of the defaulted firm.
24. To serve the consumer protection objective, the Council suggests that no allowances, other than reimbursement for reasonable costs and expenses incurred, should be granted to the ICF or the SFC for serving as administrator, for the sake of maximizing recoveries to claimants. This ensures that a claimant will not be placed in a more costly position than the claimant would have been had other parties taken on the role of the administrator.

Notes:

1.      The current investor compensation levy on securities transactions is 0.002% payable by buyers and sellers; for futures contracts, it is $0.5 per side of a contract or $0.1 per side of a mini contract or stock futures contract.

2.      It is worthwhile to note in case of the US that it is only when the US Securities and Futures Commission determines industry assessments would not satisfactorily cover the costs, that it may impose a transaction fee on purchasers of equity securities at a rate not exceeding 1/50 of 1% of the purchasing price (US$ 0.20 per US$ 1,000), and this fee would not apply to transactions of less than US$ 5,000.