SFC proposes guidelines for intermediaries conducting and receiving market soundings in securities and capital market transactions.

On 11 October 2023, the Securities and Futures Commission (SFC) issued a consultation paper (Consultation Paper) proposing new “Guidelines for Market Soundings” (Guidelines) for Hong Kong intermediaries conducting market soundings for securities and capital market transactions (such as private placements and block trades). Market participants will welcome this development, as the absence of specific guidance on market soundings has caused some inconsistencies in market practice, as the SFC noted following its thematic review of market soundings in 2022. 

SFC-licensed intermediaries should review the Guidelines and consider whether and to what extent their existing market sounding procedures should be adjusted to comply with the Guidelines.

Background

The background and context to the Consultation Paper originates from the offence of “insider dealing”, which is both a civil and criminal offence under the Hong Kong Securities and Futures Ordinance (SFO). Insider dealing occurs when a person trades in listed securities or their derivatives while in possession of “inside information” (e.g., information related to a listed company not generally known to the public, which, if known, would likely materially affect the price of the listed securities).

In addition to complying with the SFO to avoid committing an insider dealing offence, the SFC also requires its licensed intermediaries to comply with general principles found in the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct), including to act honestly, fairly, and in the best interests of its clients and the integrity of the market. However, the Code of Conduct does not contain specific guidance related to market soundings.

In 2022, the SFC conducted a thematic review of market sounding practices in Hong Kong. It found that there were varying methods adopted by intermediaries when receiving information related to proposed transactions, particularly when the information might not be regarded as price-sensitive or “inside information”. The SFC found that some intermediaries had policies to restrict trading when in receipt of inside information, while others had more expansive internal controls with prescribed standards of conduct and other compliance requirements relating to all non-public information received during market soundings.

In the thematic review, the SFC also referenced a decision by the Securities and Futures Appeals Tribunal in 2022. The decision found that the Code of Conduct was breached when a person dealt based on information received during the market sounding process, even though the conduct did not technically constitute an insider dealing offence under the SFO.

The SFC recognised that no specific regulatory requirements governing market soundings are currently available in Hong Kong, as compared to other jurisdictions like the European Union and the United Kingdom. The SFC believes it appropriate to formalise its expectations for market participants in the form of the new Guidelines.

Scope of the Guidelines

The Guidelines are proposed to apply in connection with market soundings, which is defined as the communication of non-public information (irrespective of whether this is price-sensitive inside information or not) to potential investors prior to the announcement of a securities transaction. This is designed to gauge investors’ interest in a potential transaction or to determine the specifications related to a potential transaction, such as its size, pricing, structure, and selling method.

The Guidelines will apply to SFC-licensed or registered persons acting in any of the following capacities (Market Sounding Intermediary):

• As a person disclosing information during the course of a market sounding (Disclosing Person). For example, a sell-side broker acting on behalf of a client, an issuer, or an existing shareholder selling in the secondary market (Market Sounding Beneficiary) in a possible securities transaction; or
• As a person receiving information during the course of a market sounding (Recipient Person). For example, a buy-side firm that is sounded out by a Disclosing Person as a potential investor in a securities transaction.

However, the Guidelines are not intended to apply to:

• speculative transactions or trade ideas put forward by a Disclosing Person without consulting with the potential Market Sounding Beneficiary or without any level of certainty of such transactions materialising;
• transactions of such size (e.g., in relation to average trading volume or market capitalisation), value, structure, or selling method that would be considered ordinary day-to-day trade execution (e.g., a broker sourcing potential buyers or sellers to execute a trade after receiving an actual order instruction from a client with a genuine intent for execution); or
• public offerings of securities (since there are already extensive rules governing public offerings).

Core Principles

Under the proposed Guidelines, a Market Sounding Intermediary will be required to adhere to the following requirements:

• Market integrity: maintain the strictures of confidentiality and not trade on or use any non-public information passed or received during market soundings for its own or others’ benefit or financial advantage until the information ceases to be non-public.
• Governance: establish and maintain robust governance and oversight arrangements in place to ensure effective management supervision over its market sounding activities (e.g., establishing appropriate governance arrangements for market soundings and designating persons to supervise and monitor internal controls).
• Policies and procedures: establish and maintain effective policies and procedures specifying the manner and expectations in which its market soundings should be conducted (e.g., implementing policies and allocating roles to personnel).
• Information barrier controls: implement adequate and effective physical and electronic information barrier controls to prevent the inappropriate disclosure, misuse, and leakage of non-public information during the course of market soundings (e.g., physical segregation, system user access controls, restricted lists).
• Review and monitoring controls: establish and maintain effective procedures and controls to monitor and detect suspicious behaviour, misconduct, or non-compliance with internal guidelines related to market soundings (e.g., trade surveillance controls).
• Authorised communication channels: only use recorded and authorised communication channels (audio, video, or text) to conduct market soundings.

Specific Requirements for Disclosing Persons

Before initiating contact with Recipient Persons or other potential investors, a Disclosing Person should:

1. conduct assessments on information to be disclosed during the different stages of market soundings and determine whether the information would constitute non-public information;
2. obtain consent from the corresponding Market Sounding Beneficiary to engage in market soundings regarding their possible transaction; and
3. determine in advance the standard information to be disclosed to recipients, the timing of such market soundings, and the suitable number of recipients.

The Disclosing Person should use a standardised and pre-approved script during initial and subsequent market sounding communications. At minimum, the script should contain:

1. a statement that the communication is for the purpose of a market sounding and that the Recipient Person or other potential investor is obliged to keep confidential any non-public information disclosed and not to trade on or use the information received for its own or others’ benefit or financial advantage until the information ceases to be non-public;
2. a statement that the conversation is being recorded and a request for the consent for recording;
3. confirmation that the individual is the person designated to receive market soundings;
4. a statement that the Recipient Person or potential investor will receive information which the Disclosing Person considers to be non-public and a request for their consent to receive the non-public information; and
5. if possible, an estimation of when the information will cease to be non-public.

If the relevant consent is not received at any stage, then the Disclosing Person should cease market sounding.

When non-public information has been disclosed during market soundings, a Disclosing Person should conduct assessments using best endeavours to determine if that information has ceased to be non-public and should inform the Recipient Person(s) or other potential investor(s) in writing as soon as possible.

The Disclosing Person should also keep records in relation to its market soundings for a period of not less than seven years with respect to the consents, disclosures, market soundings, assessments, and notifications made in connection with the above requirements.

Specific Requirements for Recipient Persons

The SFC expects that a Recipient Person will:

1. designate a specified person(s) who is properly trained to receive market soundings, and inform Disclosing Persons of such arrangement upon being contacted by Disclosing Persons for the purpose of market soundings; and
2. inform Disclosing Persons whether it wishes to (or not to) receive market soundings in relation to either all potential transactions or particular types of potential transactions from the Disclosing Persons.

A Recipient Person should also keep records for a period of not less than seven years on notifications given to Disclosing Persons, recordings of market soundings received, and a list of the personnel involved.

Next Steps

The deadline for responding to the Consultation Paper is 11 December 2023. A six-month transition period to ensure compliance within the industry is expected after the gazettal of the final rules.

Market participants should review their internal controls, policies, and procedures and workflows to map out their existing market sounding practices and make any specific enhancements that are required to comply with the Guidelines.

The Consultation Paper clearly shows that the proposed core principles in the Guidelines codify the SFC’s existing expectation that intermediaries should not use any non-public information received for their personal benefit (irrespective of whether this constitutes an insider dealing offence). With such broadly drafted Guidelines, firms should consider whether any secondary activities they are conducting (such as hedging, proprietary trading, or similar transactions) may be impacted when the Guidelines come into effect.

We will continue to follow the consultation process and will provide another update when the SFC issues its conclusions to the Consultation Paper.