On 11 October 2023 the Hong Kong securities regulator SFC published a proposed set of market sounding guidelines for consultation (see consultation paper here). The SFC is now ready to introduce its first formal regulatory framework which is designed specifically to provide the market with guidance for this established practice.
The consultation paper sets out the SFC’s observations and findings from its phased thematic review commenced in 2022, which covered areas including governance and supervision, controls over disclosure and receipt of inside information and other non-public information, wall-crossings, prohibitions on trading, and record keeping requirements in connection with market soundings.
The proposed guidelines can be found in the Appendix to the consultation paper.
What are market soundings?
Under the SFC’s proposed guidelines, market sounding will cover communication of non-public information (which is not limited to inside information) with potential investors prior to the announcement of a securities transaction, to gauge their interest in a potential transaction or assist in determining the specifications related to a potential transaction (e.g. size, pricing, structure and selling method).
Certain types of communications are currently carved out from the scope of the proposed guidelines. However, for (i) and (ii) below there is likely to be a burden of proof on the intermediary to demonstrate that such carve-outs apply and can be maintained in hindsight. Broadly speaking, the carve-outs are communications:
- on speculative transactions or trade ideas (e.g. those without any level of certainty of such transactions or trades materialising);
- on day-to-day trade execution (e.g. a broker sourcing potential buyers or sellers to execute a trade after receiving an actual order instruction by a client with a genuine intent for execution);
- regarding public offerings of securities; and
- not associated with market soundings.
What’s the rationale of introducing this new regulatory framework now?
- Plugging the gap – the SFC has observed an increasing number of cases relating to trading activities ahead of placings and block trades, and the SFC recognises that there is currently no specific regulatory framework covering market soundings in Hong Kong.
- Clarifying regulatory expectations – The SFC also recognises that it is difficult for market participants to measure their market sounding conduct against the general principles of the SFC Code of Conduct (which are drafted in very broad terms and contain overarching obligations) without any specific set of conduct rules.
- Introducing a uniform set of conduct standards – The SFC observed that market participants’ current controls and practices on market sounding vary quite significantly. It is therefore necessary to introduce a common set of specific requirements as clear regulatory guidance on how market soundings should be carried out and how market sounding requests should be handled.
Who are caught by the proposed guidelines?
Any intermediaries (i.e. SFC licensed or registered person) acting in the following capacities:
- Disclosing Person – refers to a person disclosing information during the course of market soundings (e.g. sell-side broker acting on behalf of the issuer/shareholder); and
- Recipient Person – refers to a person receiving information during the course of a market sounding (e.g. buy-side firm sounded by a Disclosing Person as a potential investor).
Failure to comply with the proposed guidelines may not necessarily constitute a breach of law or attract any criminal penalty. However, it may cause the SFC to consider whether such failure adversely reflects on the Disclosing Person or Recipient Person’s fitness and properness to remain licensed or registered.
What are the key discrepancies – what fall short of the SFC’s expectations from the thematic review?
Inside information, non-public information, or both?
One key message from the SFC’s consultation paper is that market sounding policies are not just about limiting disclosure of inside information. It is broader than that. Market sounding frameworks should apply to any communication of any non-public information during market soundings, irrespective of whether the information constitutes inside information or not.
The SFC stated that firms which only apply their policies to inside information may run the risk of potential misconduct from an inaccurate determination. They also commented that it is not necessary to determine whether information given during market soundings constitutes inside information in considering the conduct of an intermediary. Essentially, the test is whether the intermediaries can be trusted to discharge their regulatory responsibilities (i.e. as a fit and proper person), not whether any insider dealing has in fact taken place.
Restrictions on dealing in non-public information – is this necessary?
The SFC also clarified that they think the information which is either inside information or non-public information should be subject to trading restrictions under market sounding policies. The rationale for this position is that – “the Proposed Guidelines aim to deter substandard conduct and uphold market integrity as part of intermediaries’ obligations under the Code of Conduct. Irrespective of the potential market impact arising from trading on any non-public information, undesirable conduct by intermediaries can affect the fairness and orderliness of our markets and undermine investor confidence in them”.
Meanwhile, the SFC emphasised that the proposal to restrict trading on non-public information passed or received during market soundings is not intended to restrict intermediaries’ legitimate hedging or proprietary trading activities. The key would be to establish effective and robust information barriers to prevent any leakage of information passed or received during market soundings.
Is it okay to only comply with market sounding policies after being formally mandated by issuer/shareholder?
The short answer is no. Even though the SFC recognises that it is not uncommon for intermediaries to conduct market soundings before receiving a formal mandate from issuer/shareholder, it takes the view that the proposed guidelines will apply to communication of any non-public information made during market soundings irrespective of whether a formal mandate is received. This will present challenges where an intermediary is positioning for a trade idea without any understanding as to timing for when a formal mandate might arise.
Can market sounding be carried out through unrecorded channels?
No, the SFC proposes that all market soundings should be conducted and received on authorised and recorded communication channels. This is an area where the SFC technically takes a slightly more restrictive approach than some of the other markets such as the EU where the EU regulator allows market soundings to be conducted through unrecorded channels (but followed by signed written minutes within 5 business days). In practice, this requirement on recorded channels should not be particularly burdensome for market participants taking into account current communications technology. However, that does restrict discussions to business hours when a recorded line/turret is available unless recording has been activated on mobile devices.
Key next steps for intermediaries
- Review the SFC’s proposed guidelines and let the SFC hear your views by 11 December 2023.
- Review existing policies and procedures on market sounding against the SFC’s proposed guidelines. This would also include reviewing relevant information barriers arrangements and assess their effectiveness and robustness.
- If not already done so, consider internal governance arrangements and be prepared to designate or appoint specific market sounding committee or persons who should be sufficiently independent from the “front-office” with an overall responsibility to monitor market soundings.
- For Disclosing Persons (e.g. sell-side brokers), assess readiness to comply with the specific requirements that the SFC set out under Part 3 of the proposed guidelines on pre-sounding procedures, standardised script, cleansing of non-public information, record keeping.
- For Recipient Persons (e.g. buy-side firms), assess readiness to comply with the specific requirements that the SFC set out under Part 4 of the proposed guidelines on handling of market sounding requests, record keeping.
Following the two-month public consultation, the SFC will publish its consultation conclusions together with the final guidelines.
Market participants will be given a six-month transition period to update their internal procedures and controls after the final guidelines come into effect.