Hedge Funds Push Back On HK Draft Rules For ‘Market Soundings’

(Bloomberg) -- One of the world’s largest hedge-fund associations said Hong Kong’s proposed rules for “market soundings” risk imposing an undue compliance burden on companies and people licensed in the city.

The draft guidelines cast greater oversight on non-public information sharing practices between brokers and potential investors ahead of deals. 

While the regulator has good intentions, the rules “would put Hong Kong out of step with all other major jurisdictions” and place licensees in the city at a significant disadvantage, especially in cross-border deals, according to Kher Sheng Lee, Asia-Pacific co-head of Alternative Investment Management Association, whose hedge and private credit fund members collectively oversee more than $3 trillion.

In an October consultation paper, the Securities and Futures Commission proposed that during market soundings, both brokers and potential investors licensed in Hong Kong need to safeguard the confidentiality of non-public information, a broader category than “price-sensitive inside information” currently adopted by markets including European Union and the UK. 

“Overall, this creates a material risk that some international capital markets activity can no longer be conducted from Hong Kong by licensed persons,” he said. “Many international market participants are likely to conduct market soundings and price discovery outside of Hong Kong to avoid substantial additional burdens and regulatory uncertainty.”

The SFC said its consultation ended on Dec. 11 and it was considering the responses received.

The feedback highlights the challenging path for regulators trying to supervise the gray area of information sharing in financial markets. The proposed rules follow the collapse of Bill Hwang’s Archegos Capital Management, an event that prompted scrutiny over private transactions of large blocks of shares, known as block trades. 

US regulators probed Morgan Stanley on how its employees shared and used information ahead of block trades, while the Hong Kong securities watchdog conducted a review on the so-called “market soundings” practices that gauge potential investor interest for such sales. 

Brokers and investors are divided over the matter, SFC itself said in the paper. Those opposed to expanded regulatory restrictions argue that trading on non-public information beyond inside insights should be a matter of ethics and morality. The concept is also undefined in existing or proposed guidelines, Lee said. 

European Union, UK and Australian restrictions summarized in the SFC consultation paper are limited to inside information. Defending its approach, SFC cited the difficulty in defining inside information.

Sharing information before a deal becomes public has long been a regulatory gray area. Most brokers resort initially to a “leaf in a forest approach” — giving broad descriptions without naming the stocks — before sharing more with investors who take a formal pledge not to act on inside information received in a process known as “wall crossing.” Still, there have been cases where the recipients have been able to guess the stocks, SFC wrote. 

The Hong Kong regulator in September 2022 suspended the license of Christopher Aarons as a representative and “responsible officer” of Trafalgar Capital Management (HK) Ltd. for two years. Chief executive officer of the hedge fund firm, he was found by a South Korean regulator to have traded on material non-public information of an unidentified securities company listed on the country’s exchange.

The broker did not identify the stock during market sounding exercises in January 2016. Nor was Aarons wall-crossed. Yet he was able to surmise the stock, cut short the call and shorted it through swaps, the SFC said in a statement on its website then. 

Hong Kong’s Securities and Futures Appeals Tribunal upheld the SFC sanction of Aarons, ruling that it was not necessary to determine the information received was inside information in the case.

SFC’s draft also fails to consider the many unlicensed participants of Hong Kong’s capital markets: family offices, proprietary trading firms, wealthy individuals and offshore investors, Lee said.

“The proposed guidelines will have the unintended consequence of creating an unequal playing field, since unlicensed and overseas market participants engaging in market soundings are not subject to the proposed guidelines,” he added. When market soundings are done by overseas brokers, it would be practically impossible for Hong Kong-licensed investment firms to comply with the draft rules. 

The rules would even apply to communications before a broker has been mandated by a client for the potential deal. Exempted are speculative trade ideas of brokers, who have yet to pitch them to potential issuers and sellers of shares, or public share sales and deals no larger than normal day-to-day trades. 

Other suggestions include the designation of a committee or person to oversee market soundings, an arrangement that is already commonplace among brokers. Investors on the receiving side of such information have less formal setup, the SFC said. 

Market soundings should only take place on authorized recorded communication channels, according to the draft. Both sides should keep audio, video or text records for no less than seven years. 

These rules could weigh down licensed participants. “Imagine Hong Kong in a relay race, but with extra weights in its shoes, struggling to keep pace,” Lee said. “These guidelines could curb Hong Kong’s competitive edge.”

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