The same day the Shenzhen and Hong Kong Stock Connect was approved for official launch, the China Securities Regulatory Commission (“CSRC”) announced its decisions for administrative sanctions in the relevant cases against the Hangzhou Hundsun Network Technology Service Co., Ltd. (“Hundsun”) and other concerned parties for the illegal operation of a securities business. Three software service providers including Hundsun were held liable by the CSRC for “illegally operating a securities business”, and they each are subject to “Mo Yi Fa San”, i.e. (i) the confiscation of all illegal gains, and (ii) a fine of three times the value of such illegal gains; simultaneously, corresponding decisions for administrative sanctions were issued against four securities brokers and six clients engaged in stock margin financing.
Recalling the developments in this case, we may note the supervisory actions taken by the regulators in July 2015 (see JunHe Client Alert – Supervision Measures Concerning Illegal Stock Margin Financing by CSRC and NIIO dated July 15, 2015): targeting the stock margin financing activities that escaped the supervision and control of the banking and finance regulations, the CSRC required the China Securities Depository and Clearing Corporation Limited to stringently enforce the “Real Name Requirement” for opening securities accounts, to strengthen inspections regarding opening accounts and usage of “Special Institutional Accounts” (i.e., segregated accounts or private fund accounts), to prohibit any account holder from illegally conducting securities trading in violation of the relevant regulations by using “sub-accounts”, “segregated sub-accounts”, and/or “virtual accounts” opened under the same securities trading account; and furthermore required the rectification of securities activities directly or indirectly in violation of laws conducted by information technology servicing institutions. The CSRC believed that the illegal stock margin financing escaping regulatory control was one of the root causes for the abnormal volatility of the stock market in 2015 and therefore remedial actions were to be taken directly against the relevant parties of the illegal stock margin financing activities.
Below we have briefly summarized the unlawful matters which have been determined and their legal basis applied by the CSRC, so that the relevant market participants may take note of the latest trends in securities regulatory law enforcement, and thus identify and better understand the “bottom line” of securities compliance.
According to the decisions for administrative sanctions against Hundsun, the CSRC determined the unlawful matters in terms of three main aspects:
(1) The attributes of the system’s functions: the HOMS Financial Investment Cloud Platform (“HOMS System”) developed by Hundsun had the functions of opening sub-accounts for securities trading, accepting mandates for securities trading, offering query services for securities trading information, and clearing and settlement for securities and funds; these functions of the HOMS System are related to various regulated securities businesses, which enable the ultimate investors to participate in securities trading without opening an account at a securities broker.
(2) The purpose of marketing: Hundsun continuously marketed the HOMS System over a long period of time in newspapers and magazines, emails, network promotion and seminars, the purpose of which was more than recommending the system itself -- its goal was to attract more ultimate investors to use the system for securities trading.
(3) The method of fee collection: Hundsun entered into the Investment Management Platform Service Agreement with each of its clients engaged in stock margin financing, under which it would collect a percentage of fees based on the securities trading volume. In view of their subjective intentions, the CSRC decided that Hundsun sold the systems to clients who were not qualified to conduct securities business, provided them with the relevant services and obtained economic benefits, while being fully aware of the business patterns of stock margin financing of the clients.
The main legal basis applied in the decisions for administrative sanction made by the CSRC are Articles 122 and 197 of the Securities Law in relation to “illegal operation of a securities business”, i.e., “no entity or individual may engage in any securities business without the approval of the securities regulatory authority under the State Council”; otherwise, it “shall be banned by the securities regulatory body, any illegal gains shall be confiscated and a fine of between one and five times the value of the illegal gains shall be imposed;……”.
The defense of Hundsun in this case consists of two aspects, i.e. its subjective intention and the objective constitutive elements of a securities business: first of all, it was not subjectively at fault in assisting any of its clients to operate illegal securities business; secondly, its business was only providing software services, selling the HOMS System and offering software technology services to its clients, and not participating in trading securities on behalf of investors, nor collecting any commissions; therefore it should not constitute illegal operation of a securities business.
However, the aforementioned defense of Hundsun was rejected by the CSRC. Instead, the CSRC held that: first, in viewing the actor’s subjective intention, Hundsun had proactively entered into dialogues with the relevant securities brokers independently or in collusion with its clients for making a “channel” through negotiation, assisted its clients in allocation of securities trading accounts, formulated its internal annual performance review indicators based on the number of end-user investors using the HOMS System and the trading volume of the securities traded by the end-users, the final goal of marketing its HOMS System was to attract more end-users to join in using the system for securities trading, apart from that, it kept consistently upgrading the HOMS System, and even set up an independent HOMS trading system for illegal stock margin financing, all of this objective conduct prove the subjective fault of Hundsun to assist its clients in the illegal operation of securities businesses. Second, in view of the objective effect of the conduct itself, the HOMS System offered by Hundsun may accept a mandate from an unspecific investor to trade securities and offer securities trading query services, and even Hundsun without any due authorization had actively participated in the clearing business of sub-accounts, the so-called software technology service fees were collected in proportion to the securities trading volume essentially constituting a commission for the securities trading, the characteristics of this objective conduct basically match with the fundamental characteristics of a securities business.
Compared to Hundsun, in the cases of the Hithink RoyalFlush Information Network Co., Ltd. and the Shanghai Mecrt Software Technology Co., Ltd., which were also subject to administrative sanctions for “illegally operating a securities business”, the commonalities with respect to the determination of the unlawful matters are that the relevant systems all had the function to open sub-accounts for securities trading, accept mandates for securities buy and sell, offer securities trading query services, and provide clearing and settlement for securities and funds, so as to enable the investors’ securities trading with the system and avoid opening an account at a securities broker; the commonalities with respect to determination of the subjective intention are that both companies also sold systems to clients who were not qualified to operate securities businesses, provided them with the relevant services and obtained economic benefits, while being fully aware of the business patterns of the illegal stock margin financing of the clients.
Therefore, the decisive factors for determining a software service provider is “illegally operating a securities business” are (i) the securities brokerage functions provided through the relevant software system objectively; and (ii) the subjective intention of the software service provider to sell the system to a client while knowing that the client is not qualified to operate a securities business.
The main unlawful conduct of the four securities brokers, who were sanctioned simultaneously, is their failure to adopt effective measures to examine the identities of the relevant clients, i.e. failing to perform the duty of identity recognition. The relevant legal basis is Article 24 of the Administrative Measures on the Registration and Settlement of Securities, which is related to the duty of a securities broker to fully collect the information and credit status of its clients, and is obligated to supervise the use of the securities accounts of its clients; Articles 6, 8 and 13 of the Regulations on Strengthening the Management of Such Customer Information as Customer Transaction Terminal Information of Securities and Futures Operation Institutions, which is related to the duty to collect the information from the trading terminal of any client and ensure the authenticity and accuracy of such information; Article 28 of the Regulations on the Supervision and Administration of Securities Companies, which is related to the duty to examine the authenticity of the identity of any client.
As for the six clients engaged in stock margin financing business, their main unlawful conduct was providing their respective clients with the securities services related to account opening, taking trading mandates, clearing and query, and collecting a percentage of fees based on the securities trading volume, which therefore constitutes illegal operation of a securities business by applying Article 122 of the Securities Law.
It can be seen from the above, as far as a third party service provider is concerned, determination of unlawful conduct by the regulators relies on the substance instead of the form, i.e. the determination of subjective intention is more focused on the actual subjective intention as reflected by objective conduct. In addition, for any third party service provider and any institution or individual engaged in stock margin financing, the unlawful conduct cannot be exempt due to the “endorsement” and/or joint participation of the respective securities broker; as far as a securities broker is concerned, whether it has effectively performed its duty to examine the authenticity of the identity of its clients will be more determinant to the existence of illegal behavior. Considering that the regulatory environment for unlawful conduct occurring for the first time had been relatively lax, this decision for administrative sanctions of “Mo Yi Fa San” on this case is indeed severe.
In conclusion, unlike administrative sanctions against securities brokers and clients engaged in stock margin financing, the administrative sanctions against the software service providers in the relevant cases demonstrate new indications of the regulatory enforcement, which should put the relevant market participants on alert that: the purpose and means of financial innovations should not be designed to circumvent regulation, the financial regulators will, under the principle of “substance over form”, make a judgment on the related unlawful conduct and take the corresponding regulatory actions. Though no specific definition can be found for the “illegal operation of a securities business” in the relevant laws and regulations, the regulators may, according to their interpretation of the relevant provisions of the Securities Law, determine the unlawful conduct based on the principle of “substance over form”, the targets for penalization not only include any institution or individual engaging in illegal stock margin financing by using software provided by a third party, but also the third party software providers, which to a greater extent revives the traditional concept of “illegal operation of securities business” from the past. The above relevant cases represent a milestone in terms of the securities regulatory enforcement, and will profoundly influence regulation of the securities market and compliance of the securities operation institutions.