Framework for the Implementation of Electronic Commerce in the Capital Market Consultation Paper Comments The Securities Commission invites your written comments on all aspects of this Consultation Paper. Comments are due by 21 April 2000 and should be sent to: Framework for the Implementation of Electronic Commerce in the Capital Market Project Law Reform and Regulatory Policy Department Market Policy & Development Division Securities Commission No.3 Persiaran Bukit Kiara Bukit Kiara 50490 Kuala Lumpur Facsimile: 651-5101 E-mail: firstname.lastname@example.org ISBN 983-9386-24-7 You may also contact the Corporate Affairs Department at tel: 654 8000 for additional information and assistance. CONTENTS 1. INTRODUCTION 1-4 • Objective • Background • Scope • State of Play • Methodology 2. PRINCIPLES OF REGULATION AND DEVELOPMENT OF EC IN THE CAPITAL MARKET 4-5 3. ISSUES 5-7 • Physical infrastructure 3.1 Trading infrastructure • Regulatory infrastructure 8 - 12 ISSUES OR OFFER OF SECURITIES 3.2 Cross-border issue or offer of securities 3.3 Electronic prospectus 3.4 Advertising and share-hawking 3.5 Information vs offer 3.6 Unit trust funds DEALING IN SECURITIES, FUND MANAGEMENT AND INVESMENT ADVISORY BUSINESS 12 - 26 3.7 Cross-border offer of services 3.8 Disintermediation and the licensing regime 3.9 Branching 3.10 Technology intermediaries 3.11 Know your client and signatures 3.12 Advertising 3.13 Investment information and investment advice 3.14 Electronic contract notes 3.15 Electronic record-keeping 3.16 Security/operational integrity 3.17 Stock market facilities 3.18 Documentation for submission and disclosure 3.19 Enforcement 3.20 Training and education 4. APPENDIX A i - ii 1 INTRODUCTION Objective 1.1 The Securities Commission (SC) wishes to develop a framework for the orderly and effective implementation of electronic commerce (EC) in the capital market. The framework will be developed to implement national-level initiatives on economic activities through EC, as well as to develop the domestic EC framework to keep abreast of international developments. The framework will be incorporated into the Capital Market Masterplan currently being developed by the SC. 1.2 The SC fully supports the development of EC in the capital market due to the enormous benefits that EC will bring to the market place in creating greater competition and efficiency. We wish to encourage the use of the Internet and other technology in the conduct of capital market activities, without compromising the SC’s regulatory objectives. 1.3 The SC views the development of this framework as a collaborative effort between the public and private sectors, to determine the proper equilibrium between enterprise and regulation. The SC sees its role as facilitating private sector use of technology solutions, by assisting in removing impediments to EC, whether physical or regulatory in nature. 1.4 This Consultation Paper raises issues and makes recommendations in relation to some of these impediments to EC. The SC therefore seeks comments and views on all aspects of this Consultation Paper. The SC also welcomes comments and views on any other issue which may impact on the facilitation of EC in the capital market, even if those issues are not discussed in this Consultation Paper. The SC will use comments received on the issues raised and/or recommendations made by this Consultation Paper, to identify critical areas for reform and to develop appropriate responses. 1.5 The SC targets the implementation of recommendations relating to regulatory clarification to be carried out within one year after the receipt of public comment on this Consultation Paper. The implementation of all other recommendations will be subject to the recommendations of the Capital Market Masterplan. Background 1.6 This Consultation Paper forms a follow-up to the SC’s last public comment on electronic commerce in the capital market, in our paper entitled “Discussion Paper on EC and the Malaysian Capital Market – Regulatory and Developmental Challenges” (1997 paper). The paper was presented at the SC’s Electronic Commerce in the Capital Market Conference held in September 1997. 1.7 Since the 1997 paper, the SC has also issued a policy statement entitled “Primary Offers of Securities via the Internet”, that clarified the SC’s position on offers of securities via the Internet in relation to section 32 of the Securities Commission Act, 4 1993 (SCA). In addition, the SC has applied its views to at least one primary market offering of securities via the Internet, stating that the fund, which was being offered to Malaysians, had not been approved by the SC. Scope 1.8 This Consultation Paper retains the definition of EC adopted in our 1997 paper: “ EC could be broadly defined as the use of Information Technology (IT) to effect linkages among functions provided by participants in commerce. The term describes technology platforms that allow - • the transfer and dissemination of information to a wider number of users within and between networks; • the execution of trade and other transactions without the need for parties to the transactions to be physically present at the same location; and • the distribution or delivery of services and products in electronic form, such as software products offered by software vendors on the Internet.” 1.9 In light of this broad definition of EC, this Consultation Paper will apply to different forms of technology used for the conduct of capital market activities. Since 1997, however, the world has seen the tremendous growth of Internet technology worldwide, as a medium for both communication and commerce. Although the SC approaches regulation of the capital market on a technology-neutral basis, the SC has recognised the need for clarification of the conduct of SC-regulated activities using technology platforms, particularly the Internet. 1.10 Specifically, the Consultation Paper seeks views on the conduct of the following activities using technology platforms:- • Securities dealing, fund management and investment advisory activities, which fall within the scope of the Securities Industry Act, 1983 (SIA); and • Issue or offer of securities, which falls within the scope of section 32 of the SCA. 1.11 This Consultation Paper has concentrated its discussions on the securities market in light of the pace of change seen in this sphere of the capital market. However, many of the recommendations contained in this consultation paper, where relevant, may be equally applicable to the futures market. In addition, some portions of the Consultation Paper have made specific references to the Kuala Lumpur Stock Exchange (KLSE) and its Member Companies. Similarly, where relevant, discussions of a general nature pertaining to that exchange may be applicable to the operation of other exchanges. State of Play 1.12 Since the release of the SC’s 1997 paper, the Malaysian capital market has seen eagerness by market participants to explore the benefits offered by technology, particularly that offered by the Internet. 5 1.13 Since 1997, the SC has identified the development of an Electronic Reporting System (ERS), as a pilot project. The ERS is intended to provide an electronic means by which market intermediaries can report to the SC, as opposed to the current reporting in hardcopy format. Last year, the Securities Industry Development Centre (SIDC) developed a computer-based simulation training game called WISE Investor accessible via the SC web-site. The game provides a tutorial to enable investors to link their investment strategies to economic fundamentals under a simulated trading environment. 1.14 At industry level, the stockbroking industry has been witness to new ways of communicating information and orders between investors and Member Companies. Since 1995, Kuala Lumpur Stock Exchange (KLSE) Member Companies who wish to provide electronic means of routing orders from its clients, whether through proprietary or open systems, must comply with the Code on Electronic Client- Ordering System (ECOS) for KLSE Member Companies (ECOS Code). 1.15 Initially, electronic broker-client linkages took the form of proprietary systems. Member Companies provided share trading, investment information and other services through dial-up or Intranet systems to their customers. In the late 1990’s, the growth of brokerage services via the Internet in more developed jurisdictions, saw interest kindled in local Member Companies to similarly take advantage of the benefits in terms of cost and distribution afforded by Internet-based systems. 1.16 To date, several Member Companies have already obtained approval from the KLSE to provide Internet order-routing facilities to their clients, on the basis of their compliance with the ECOS Code. These facilities have been developed by each Member Company on an individual basis, either in-house or in collaboration with third party technology service providers (technology vendors). Some of these facilities are already operational. 1.17 The KLSE Group of Companies has also taken more initiatives towards increasing public accessibility to corporate and depository information. Last year, the KLSE has established KLSE Link, which makes available all announcements made by public- listed companies on the KLSE website. The Malaysian Central Depository (MCD) also introduced MCD-Call Direct to enable investors to make inquiries regarding their CDS accounts through the telephone. 1.18 The Malaysian Exchange of Securities Dealing and Automated Quotation (MESDAQ) saw the listing of its first company accompanied by the posting of its electronic prospectus on the MESDAQ website in 1999. It is believed that this electronic prospectus constitutes a first in the region. 1.19 The presence of technology vendors and financial portals has seen the creation of a new breed of intermediaries. These technology vendors are keen to offer their expertise to provide technology, oftentimes Internet-based, solutions to local financial service providers who want to outsource their information technology requirements. Portals provide a ready platform for advertising and trading. 6 Methodology 1.20 The development of the framework will involve a two-tiered approach:- • determining the principles which the SC should adopt in regulating EC in the capital market; and • applying those principles to capital market EC issues. 2 PRINCIPLES OF REGULATION AND DEVELOPMENT OF EC IN THE CAPITAL MARKET 2.1 The SC’s functions, as articulated in section 15 of the SCA, are both regulatory as well as developmental in nature. Our mission statement encompasses both of these broad functions of regulating and developing the capital market:- “To promote and maintain fair, efficient, secure and transparent securities and futures markets and to facilitate the orderly development of an innovative and competitive capital market”. 2.2 The SC is of the view that the fundamental principles of regulating the Malaysian capital market apply regardless of the medium of its operation. For example, our mandate to protect investors must continue to be paramount, to ensure investors’ continued faith and confidence in the integrity of the market. The SC views the use of technology as merely a change in the medium of communication or delivery over traditional paper-based activities, and therefore should be subject to the same standard of regulation. 2.3 This Consultation Paper will also assist the SC in clarifying its regulatory approach in relation to the use of technology in capital market activities, with the objective of providing transparency and consistency in regulatory approach. 2.4 The SC therefore, will use the following pre-defined principles to develop EC in the capital market, in no particular order of priority. • The SC to apply the fundamental principles of regulation of the capital market regardless of medium of operation. • The SC to provide transparency and consistency regarding how the regulatory framework applies in an electronic environment. • The SC to regulate and facilitate capital formation, not impede it. • The SC to co-operate and share information with other capital market regulators, particularly in the areas of surveillance and training. • The SC to ensure that investors without access to electronic information are not disadvantaged. 7 • The SC to take the lead in promoting and facilitating the adoption of electronic transactions in the capital market. 2.5 The SC is also mindful that the development of an innovative and competitive capital market requires consideration of both physical and regulatory infrastructure. Physical infrastructure deals with the availability of enabling technology to support capital market activities whilst regulatory infrastructure deals with providing the proper policies and regulations, as well as clarity thereof, for such activities. 2.6 The SC sees its role as facilitating private sector use of technology solutions, by assisting in creating proper support, payments and security systems, as well as removing uncertainty about the regulatory framework and amending inappropriate laws and regulations, where necessary. The SC is also keen to assist in training and education programmes to assist market participants in developing their knowledge of technology-related matters. 2.7 As a general principle in relation to the use of technology to conduct capital market activities, the SC will not seek to regulate such activities conducted from outside Malaysia, provided that such activities are not detrimental to the investing public in Malaysia. 3 ISSUES Physical infrastructure 3.1 Trading infrastructure Order-routing 3.1.1 As discussed earlier, several Member Companies have already developed Internet order-routing systems. However, the SC has been given to understand that the cost of developing Internet order-routing in-house, can be substantial, relative to the size of the Member Company, in terms of software development and infrastructure set-up. In addition, there is also an apparent uncertainty on the part of some Member Companies as to the precise technical requirements for such an Internet system. 3.1.2 The SC therefore recommends that Member Companies be allowed to develop their own systems, either in-house or with technology vendors, provided they comply with certain systems and interface requirements set down by the exchange. Currently, such requirements are set out in the KLSE ECOS Code. The SC is of the view that any requirements set down by the exchange must address matters such as security, cost, equal access, reliability and availability, as well as ease of monitoring and surveillance. The SC recommends that the exchange reviews the provisions of the ECOS Code to ensure that such requirements are contained therein. 8 3.1.3 In addition, the SC recommends that the exchange conducts preliminary vetting of technology vendors to ensure that they comply with the said minimum requirements. Member Companies can therefore be secure in the knowledge that the systems offered by those vendors are compatible, and in compliance with, the requirements of the exchange and the SC. A system for periodic audit of the system should be in place to ensure continuous compliance with such requirements. 3.1.4 For the longer term, the SC recommends that the exchanges look into improving and upgrading their current trading engines to incorporate gateway solutions to allow for open access regardless of medium in which trades are routed to the trading engine. Other markets have seen tremendous interest in the development of wireless applications and services such as short messaging services (SMS) and wireless application protocols (WAP) for order-routing purposes. Clearing and settlement 3.1.5 Currently, online-routed trades are cleared and settled in the same way as traditionally-routed trades. The SC has been given to understand that the current payments system is a large hindrance to the development of Internet trading in Malaysia. Although buy and sell orders can be routed electronically, there is no corresponding ability for online transmission of money settlement via links to banks or other payment sources. 3.1.6 The SC intends to facilitate any efforts by exchanges and their Member Companies to work with the relevant authorities to explore the possibility of integrating the current clearing and settlement systems for both securities and futures trading within a payment system. On the securities side, the SC recommends that the central depository, looks into providing depositors’ access to their securities balances via the Internet as well as other electronic media. Straight-through processing 3.1.7 In developing any trading infrastructure, all participants should also bear in mind that the infrastructure should incorporate elements of straight-through processing (STP). STP has been defined as an uninterrupted transmission from the point of trading, through a chain of intermediaries, down to the last entity ultimately involved in the settlement process and back, which aims to minimise manual interference in the clearing and settlement process, with the process possibly crossing borders at the same time. The benefit of STP is that data is captured at source, so as to avoid re-keying information. This would result in faster processing to minimise time-lag, as well as minimise exception processing, reduce the risk of failed trades, reduce costs, facilitate cross-border trading, improve management information, and ultimately meet the demands of a shorter settlement cycle. STP can be attained by providing systems’ inter-connectivity via electronic communications amongst all parties to a trade. 9 Recommendations Order-routing The SC recommends that Member Companies be allowed to develop their own systems in-house provided they comply with certain systems and interface requirements set down by the exchange. The SC recommends that the exchange reviews the provisions of the ECOS Code to ensure that it takes into account matters such as security, cost, equal access, reliability and availability, as well as ease of monitoring and surveillance. In addition, the SC suggests that the exchange conducts preliminary vetting of third party technology solutions to ensure that they comply with the said minimum requirements. For the longer term, the SC recommends that the exchanges look into improving and upgrading their current trading engines to incorporate gateway solutions to allow for open access regardless of medium. Clearing and settlement The SC intends to support and facilitate efforts by exchanges and their Member Companies, to work with the relevant authorities to explore the possibility of integrating the current clearing and settlement systems for both securities and futures trading within a payment system. On the securities side, the SC recommends that the central depository looks into providing depositors’ access to their securities balances via the Internet. Straight-through processing The SC recommends that the development or enhancement of any trading infrastructure should incorporate elements of straight-through processing. 10 Regulatory infrastructure ISSUE OR OFFER OF SECURITIES 3.2 Cross-border issue or offer of securities 3.2.1 The SC’s Policy Statement entitled, “Primary Offers of Securities via the Internet” provides practical measures that should be taken by potential offerors to ensure that such issues or offerings do not fall within the ambit of section 32 of the SCA. The Policy Statement may also serve as a guide to potential Malaysian issuers or offerors who wish to post their issues or offers over the Internet, to avoid falling foul of similar legislative prohibitions in other jurisdictions. 3.2.2 A copy of the policy statement is attached as Appendix A. Recommendations The SC’s policy statement entitled “Primary Offers of Securities via the Internet” provides a guide to the applicability of domestic laws to primary offers of securities over the Internet. The SC considers the issue or offer of securities that is accessible in Malaysia, as an offer of securities within the provisions of section 32 of the SCA, for which the approval of the SC must be sought. However, the policy statement states that the SC will take into account the following factors to determine whether to subject the offer to the provisions of section 32:- • the intention of the person making the offer – whether the offer is in fact targeted to a person in Malaysia; • the penetration of the offering of securities in Malaysia; and • the involvement of a person from Malaysia in making the offer. 3.3 Electronic prospectus 3.3.1 For the immediate future, the SC recommends that prospectuses only appear on the web-page of the relevant regulatory authority, such as the relevant exchange. This will alert prospective investors to the fact that the prospectuses have been duly approved and registered with the relevant authorities. In addition, there is assurance that the electronic prospectus received by the investor is complete and protected from alteration or tampering. 3.3.2 The SC also intends to review current paper-based requirements for prospectuses, such as the requirements of printing, type sizes as well as publication, to allow for prospectuses to be distributed in an electronic format. 11 3.3.3 Reasonable steps must be taken to ensure that the investor receives an application form attached to or accompanied by an electronic prospectus, or a printout of it. This will encourage investors to read the prospectus before share application. A mere hyper-link to the prospectus should not be sufficient unless it is accompanied by a clearly visible provision in the main body of the form that the law prohibits the passing on of the form unless it is accompanied by a prospectus. The electronic prospectus and any promotional material must be made available in a way that encourages investors to make decisions on the basis of the prospectus, and not on the basis of the promotional material, or pressure selling. 3.3.4 To ensure that investors without electronic access are not disadvantaged, the SC recommends that issuers should still provide paper copies of the prospectus lodged. The site should also prominently feature the appropriate disclaimers as to who is eligible for the offer, with such disclaimers to be couched in a way as to avoid any cross-border problems with regulatory authorities in other jurisdictions. 3.3.5 For the moment, the electronic prospectus should contain the same information in the same sequence as the paper prospectus duly registered and lodged, except for differences allowed by the relevant regulatory authorities. However, for the future, the SC is also considering the impact of the flexibility and variety offered by the electronic format. The sites may include hyper-links that change the presentation of material from the linear sequence of printed materials to free-ranging associational links between different parts of a document, or even to a range of different documents and multi-media applications. Information may be customised by users, producers and distributors of electronic documents. 3.3.6 The SC will also examine the extent to which non-text based information, such as graphical, pictorial or “talking heads”, may be used by issuers to provide the same information as that contained in a traditional prospectus. In addition, the SC is also open to views on enhancements over and above a paper prospectus, in an electronic prospectus, such as allowing for search functions for searching defined expressions, immaterial changes to sequence of information presentation, prompts to assist investors to use and find information, and zoom facilities. 12 Recommendations The SC recommends that electronic prospectuses should only appear on the web-site of relevant regulatory authorities, such as exchanges. The SC intends to review paper based requirements for prospectuses, such as margins, type-size and publication, to cater for electronic prospectuses. The SC recommends the preparation of guidelines on electronic prospectuses to include the following provisions:- • electronic applications forms to be accompanied by an electronic prospectus; • electronic prospectus to be secure, protected from unauthorised alteration; • presentation of the prospectus in a way to encourage investors to decide on the basis of the prospectus and not on the basis of promotional material or pressure selling; • paper copies to be available; and • disclaimers as to eligibility of the offer to avoid cross-border problems. The SC intends to study the impact of the flexibility and variety offered by the electronic format, in the context of the presentation of electronic prospectuses. 3.4 Advertising and share-hawking 3.4.1 Advertising is the publishing of notices or announcements that are available to the world at large. Share-hawking on the other hand, deals with direct solicitations to subscribe for or purchase securities. The basis of the prohibition against share- hawking is that it is undesirable to permit shares to be sold by door to door salespeople to persons who are not experienced in business matters. 3.4.2 The accessibility of the Internet creates problems in distinguishing between advertising and share-hawking. For example, sending e-mail to different persons to offer securities for subscription or purchase, or invitations to subscribe for or buy securities, is of limited distribution and may be considered as “securities hawking”. However, at what point would multiple e-mails change from securities hawking to advertising? The Internet’s ability to allow such postings to be spammed has implications for disclosure requirements as advertising disclosure is less restrictive than that for securities hawking. In addition, another factor which may be taken into account is the number of times such an e-mail is sent. Frequent e-mails are indicative of high-pressure tactics. 3.4.3 The SC considers websites and electronic bulletin boards to be advertisements because they can be viewed by anyone with access to these services. 13 3.4.4 The SC is of the view that chat rooms should be considered a public forum using an electronic medium. Given its interactive nature, such “conversations” should not be considered correspondence. But as with other oral communications, makers of such statements should still be liable if the statements are misleading or fraudulent in nature. Recommendations The SC is of the view that the distinction between advertising and share- hawking over the Internet should depend on the extent to which the message is available to the public: • group e-mail (mass mailing), web-sites, electronic bulletin boards and chat rooms are to be considered advertising; and • individual e-mail is to be considered share-hawking. 3.5 Information vs offer 3.5.1 The SC takes the view that the provision of corporate information is an offer of securities, if it contains both detailed information and a means to subscribe. The regulator must take into account that these may be offered through hyper-links to another site rather than on the website itself. In such circumstances, the normal provisions relating to documents containing offers which are to be deemed prospectuses, would apply. Recommendations The SC recommends that the posting of corporate and securities information on an issuer’s website would constitute an offer of securities requiring SC approval, when it includes both detailed information and a means to subscribe, either on the web-page itself, or via hyper-links. 3.6 Unit trust funds 3.6.1 Currently, the SC Guidelines on Unit Trust Advertisements and Promotional Material allow advertisements issued by way of computer transmission, so long as they draw attention to the prospectus of the unit trust scheme. 3.6.2 However, the Guidelines state that the advertisements should not allow for transactions to be conducted via computer transmission. 3.6.3 Many unit trust schemes have expressed interest in allowing the purchasing of units online. Similar to the approach taken with shares, SC, being the relevant regulator 14 intends to work with technology vendors to develop guidelines and standards for the electronic sale of units. 3.6.4 In relation to the promotion of unit trust schemes, the Securities Commission (Unit Trust Scheme) Regulations 1996 (UT Regulations), allows persons to hawk unit trust schemes, where that invitation or offer to subscribe for or purchase any units is accompanied by a prospectus. The SC considers that an offer sent by mass e-mail with a hyperlink to a prospectus will satisfy this requirement, only if it clearly states in the body of the e-mail that this offer is prohibited by law unless accompanied by a prospectus. Recommendations The SC recommends that transactions on units in unit trust funds via computer transmission be permitted, with the SC working with relevant technology vendors to develop standards and guidelines for the electronic sale of units. The SC is of the view that an offer sent by mass e-mail with a hyperlink to a prospectus must clearly state in the body of the e-mail that this offer is prohibited by law unless accompanied by a prospectus. DEALING IN SECURITIES, FUND MANAGEMENT AND INVESTMENT ADVISORY BUSINESSES 3.7 Cross-border offer of services 3.7.1 The licensing requirements embodied in the SIA, apply to persons who conduct securities activities regardless of the medium of communication or delivery in which they conduct those activities. 3.7.2 However, the SC considers the determination of whether a person is in fact carrying on the business of dealing in securities, fund management or investment advice, to be a question of fact in each case. 3.7.3 In relation to cross-border provision of these services, the SC’s Policy Statement entitled, “Primary Offer of Securities via the Internet” provides practical measures that should be taken by market intermediaries to ensure that they do not fall foul of the domestic licensing regime. 15 Recommendations The SC is of the view that the licensing requirements embodied in the SIA, apply to dealers, fund managers and investment advisers and their representatives regardless of the communication or delivery media used in the conduct of their businesses. The SC considers the determination of whether a person is in fact carrying on the business of dealing in securities, fund management or investment advice, to be a question of fact in each case. The SC is of the view that the provision of services in relation to dealing in securities, fund management and investment advice that is accessible in Malaysia, is an activity for which licensing is required pursuant to the SIA. However, the SC will take into account the following factors to determine whether to subject the providers of such services to the licensing provisions: • the intention of the person making the offer of services – whether the offer is in fact targeted to a person in Malaysia; • the penetration of the offer of services in Malaysia; and • the involvement of a person from Malaysia in making the offer of services. 3.8 Disintermediation and the licensing regime 3.8.1 The role of market intermediaries, such as dealers, will continue to change as a result of EC. The SC as well as other market participants must be prepared to deal with the increased “disintermediation” that occurs when end-purchasers and end- sellers are able to deal with each other directly without the need for an intermediary. This is particularly so, in circumstances where that intermediary provides pure order- execution function only, a function that is easily automated. 3.8.2 One of the main concerns expressed in relation to electronic order-routing, is the necessity for a dealer’s representative to “push” the final button to execute the trade. Risk management considerations prompted requirements to ensure that the final execution of the trade is done by a dealer’s representative, who would be best placed to know whether the trade should be executed for the client or not. 3.8.3 The SC recommends that this requirement be reconsidered in light of the ability to put in place electronic risk management parameters in a straight-through system. Orders from investors may therefore be routed automatically albeit via the Member Company to the trading engine, but without the need for human intervention. 3.8.4 In the long term, this may pave the way for the bypassing of dealer’s representatives altogether, with all trades being handled by the Member Company. The SC is of the view that the decision on whether to attribute online trades to dealer’s representatives 16 or to the member company itself, is purely a commercial decision and should depend on factors such as the provision of value-added services by the dealer’s representative. The SC does not express a preference for either model of trade attribution. 3.8.5 The SC recommends therefore, that any existing requirements for manual intervention by dealer’s representatives at the point of execution be removed. However, the SC recommends that the exchange should be responsible for setting the appropriate interface standards between the broker-client linkage and the broker- front-end. 3.8.6 In the long-term, the SC must consider the artificiality of the licensing regime that makes a distinction between the dealing entity and the dealer’s representative in an electronic environment. This requires more in-depth examination and extensive consultation with affected parties. 3.8.7 Nevertheless, the SC encourages the re-training of dealer’s representatives to provide more value-added services in relation to the trade execution process. Recommendations The SC recommends that orders be allowed to be routed directly from investors to the trading engine of the exchange via a Member Company, without the need for manual intervention of a dealer’s representative. The SC recommends that the exchange develop appropriate interface standards that automate order-routing from the broker-client linkage and the broker front-end. In the long-term, the SC intends to study the artificiality of the two-tiered licensing regime in an electronic environment. 3.9 Branching Broker-client linkages 3.9.1 Currently, dealing licences are issued on condition that the dealers carry out business at the geographic location specified in the licence. The SC takes the view that an electronic broker-client linkage, be it through a closed or open system, would merely constitute a new medium through which clients communicate with their brokers, no different from a telephone or the facsimile. 3.9.2 This approach should also extend to Internet kiosks or trading centres which house systems and facilities providing market information and order-routing for independent investors to do trading, provided that the kiosks are established within the geographical area of the licensed premises of the Member Company. For example, 17 a member company licensed to operate in the Klang Valley should only be allowed to set up kiosks within the Klang Valley. Such kiosks should also not be manned by any personnel. Off-site servers 3.9.3 Member Companies have expressed interest in siting their servers outside the requisite designated office. The cost of bandwidth between the Internet service provider and the server located at the licensed premises is prohibitive. It is more cost-effective to site the server at the Internet service provider. The SC recommends that situating servers off-site should not be considered branching. Recommendations Broker-client linkages The SC is of the view that electronic broker-client linkages, should not be considered a branch of the Member Company. The SC is also of the view that Internet kiosks are also not to be considered a branch of the Member Company provided they are established within the geographical area of the licensed premises of the member company, and are not manned by any personnel. Off-site servers The SC recommends that Member Companies be allowed to site their servers outside their licensed premises, without it being considered a branch. 3.10 Technology intermediaries Technology vendors 3.10.1 In light of the high costs of developing software applications in-house, both for Internet trading and other forms of electronic brokerage systems, many Member Companies may be keen to outsource or purchase off-the-shelf/ready-made applications from third party technology vendors. Companies resort to these solutions because they are seen to be easy and proven solutions, as well as being much more cost-effective. This is particularly so with smaller Member Companies which cannot afford to develop the system in-house. 3.10.2 A problem may arise because of the very broad definitions of “dealing in securities” or “stock market” in the SIA. For example, there is the possibility that a vendor offering Internet broking systems to Member Companies may be considered to be dealing in securities or even to be operating a stock market. 18 3.10.3 The SC wishes to clarify that such vendors are not considered a dealer or operator of a stock market. Such clarification will hopefully ensure that regulatory requirements do not unduly restrict the development of software applications. The SC also hopes that this move would level the playing field between large Member Companies who can afford to develop applications in-house and the smaller ones who cannot do so. 3.10.4 The SC also suggests that the exchanges establish standards and issue minimum guidelines for such vendors to create their products. The SC is of the opinion that it may be more helpful for the exchanges to work with technology vendors, as opposed to the Member Companies themselves, to ensure that such vendors adhere to the standards set down by the regulators. This would also provide Member Companies with certainty in using the products provided by these vendors. Financial portals 3.10.5 Portals act as gateways to the Internet, and have been described as the key to providing financial services on-line. Portals aggregate content and provide links to financial sites of service providers and information providers, in the hopes of attracting “eyeballs” (viewers) and creating “stickiness” (customer loyalty). 3.10.6 The key concern with regards to financial portals is whether the portal itself should be licensed for providing brokerage or investment advisory services. Traditionally, this has largely been determined by the compensation arrangements between these portals and the dealers or investment advisers who link to the site. A compensation scheme that provides a stake in each securities transaction is generally considered to be acting as a dealer. Such compensation could be in the form of a referral fee, a fee based on the volume, or a fee based on the value of the shares bought or sold. 3.10.7 However, just as traditional vendors would not be allowed to participate in a transaction-based compensation arrangement for fear of contravening licensing requirements, portals and technology vendors should only be allowed to charge a flat up-front fee for their services. For the avoidance of doubt, no economic benefit should be tied to the value or volume of the trades involved in the transaction. In this way, the SC will continue to view these technology intermediaries as mere conduits, similar to the phone or newspaper, which carry the transaction or the information between the Member Company and the investor. 19 3.10.8 However, the SC may look into requiring the registration of these portals. Recommendations The SC is of the view that the activities of technology intermediaries should not be considered dealing in securities or operating a stock market. The SC recommends that the relevant exchanges develop standards and work with technology vendors to ensure compliance with those standards. The SC recommends that compensation arrangements between these technology intermediaries and capital market intermediaries be on an up-front, flat-fee basis. The SC recommends that financial portals be subject to registration. 3.11 Know your client & signatures 3.11.1 Persons who provide brokerage, fund management and advisory services are required to have a reasonable basis when making a recommendation to their client, having regard to the client’s investment objectives, financial situation and particular needs. 3.11.2 Rules of the exchange and central depository have been formulated to ensure that customer accounts are opened before a dealer’s representative or an authorised depository agent respectively. A dealer’s representative would be held liable for any losses arising from discrepancies in his client’s personal particulars or signature of the account he causes to open, arising from his default. Mere electronic instructions therefore would not suffice. 3.11.3 The “know-your-client” rule has several functions. The rule operates to ascertain credit risk of the client. Further, it is also necessary when the dealer provides investment advice. The advice must be tailored to the particular circumstance and investment needs of the individual client. Also, there is necessity to ascertain ownership of shares, for monitoring of substantial shareholding reporting requirements as well as determination of beneficial ownership of deposited securities. 3.11.4 It has been argued that without face-to-face or voice interaction, it is difficult for the licensed persons to obtain sufficient information about a client to meet suitability or other eligibility obligations. 3.11.5 There is therefore a conflict between the “know-your-client” rule and the removal of the prohibition against electronic communications in the opening of dealing and depository accounts. This has often been cited as a barrier to electronic trading on the Internet or proprietary systems, as it would still require manual opening of accounts before trading can be done electronically. 20 3.11.6 It has been argued that it defeats the benefit of the breaking of geographical barriers brought about by electronic networks. This is of concern to potential local clients in remote areas who would find it inconvenient to travel to the Member Company’s office or even to find Notaries Public to witness the signing of account opening forms. Needless to say, this is a problem for foreign investors as well, which many of the Member Companies with online aspirations hope to capture. 3.11.7 As at present, pure online opening of accounts do not provide for the level of certainty required for ascertaining beneficial ownership of shares, as required by the Securities Industry (Central Depositories) Act, 1991. As the rules already provide for Notaries Public to witness client account openings, it is recommended that the rules expand the categories of persons who can witness account openings. 3.11.8 Eventually, a pure order execution system, where money is to be paid up-front to the Member Company, may be the first candidate for the online opening of accounts, provided there is a safe, secure way of authenticating the identity of the investor. 3.11.9 In the long term, the SC intends to undertake a study into the possibility of replacing all legislative requirements for manual signatures with the technologically-neutral term “authentication”. The term “authentication” would cover both manual and electronic identification of an investor or service user, so long as the SC can be assured of its reliability. In keeping with its stance on technological-neutrality, the SC will not prescribe specific methods, such as digital signatures. It may, however, issue policy statements to provide guidance as to what constitutes suitable authentication. Recommendations The SC recommends that the category of persons authorised to witness the account opening signatures should be expanded to include persons acceptable to both the central depository and member companies. In the long term, the SC intends to undertake a study to consider replacement of all legislative requirements for written signatures with the technologically neutral term “authentication”. 3.12 Advertising 3.12.1 Advertising in any form in relation to fund managers, unit trust schemes and dealers are required to be approved either by the SC or the exchange. For fund managers, all advertising is required to be approved by the SC, pursuant to a licensing condition. Advertising for unit trust schemes, is governed by the Guidelines on Unit Trust Advertisement and Promotional Materials, wherein such materials require written consent of the SC. Member Companies on the other hand, require the approval of the KLSE before advertising its services or stockbroking business or any other matters relating to or in connection with its business. 21 3.12.2 In keeping with our stance on technology neutrality, approvals which are required in the traditional print or broadcast environment, should also apply to promotional or advertising materials over the Internet or any other electronic communication network. However, there is legitimacy in reducing the time required for such approvals, particularly in the age of instantaneous electronic communications. 3.12.3 Therefore, the SC recommends that we strike a balance between the need to ensure that such materials are not misleading or fraudulent, and ensuring speedy approvals. This may be achieved by the relevant regulatory bodies articulating the bases for their vetting of advertising materials, through the establishment of guidelines on advertising and promotional materials. Thereafter, the company, through its internal compliance officers, is to certify that such advertising and promotional materials are in accordance with such guidelines. A copy of such materials must thereafter be submitted to the relevant regulatory body. Recommendations The SC recommends that the relevant authorities issue guidelines in relation to the content of advertising and promotional material regardless of the medium in which it is communicated or delivered. The SC recommends that such authorities allow market intermediaries to certify through its compliance officers, that such advertising or promotional material conforms with the relevant guidelines. 3.13 Investment information and investment advice Newspapers vs online news vendors 3.13.1 A newspaper proprietor or a holder of a permit issued under the Printing Presses and Publications Act, 1984, is not required to be licensed as an investment adviser, provided that where the analyses or reports are given through that newspaper, the person receives no commission for the reports or the advice is incidental to the conduct of the business as a newspaper proprietor. A newspaper may arguably be defined as a “printed” publication and it is therefore arguable that the exemption would not extend to non-paper based versions of such publications. 3.13.2 The SC intends to clarify the requirement of “giving through the newspaper”, to enable online news vendors to take advantage of the exemption, particularly if the web site is run by entities appropriately permitted under law. 22 Factual information 3.13.3 Information vendors, electronic or otherwise, disseminating straightforward factual information would not be considered an investment adviser. However, if the information service provider issues or promulgates analyses or reports concerning securities as part of its business of disseminating information to the public, or if it holds itself out to be an investment adviser, it would therefore be considered as an investment adviser, and would be required to be licensed accordingly. Investment advice over the Internet 3.13.4 The safeguards provided by SIA in relation to disclosure of interests in securities, and suitability requirements, still apply regardless of whether the recommendations provided by the dealer, fund manager or investment adviser are in written, electronic or oral form. 3.13.5 The posting of any recommendation over a webpage or through the e-mail must therefore be accompanied by a disclosure of that adviser’s interest in those securities in the communication. 3.13.6 What then constitutes a “recommendation” in the context of the Internet? With the wealth of information on the Internet, the SC will determine the making of a “recommendation” by considering the degree of customisation of the information or intervention by the adviser to suit the particular client. 3.13.7 A frequently-asked question in relation to advice concerning securities over the Internet (particularly when it appears in a chat room or webpage), is whether that adviser is providing investment advice, as defined within the SIA, and is therefore required to be licensed by the SC. 3.13.8 This hinges on whether the provision of information about securities on the Internet is by a person who is carrying on a business of advising others concerning securities, or issues analyses or reports, as part of a business. “Carrying on a business” is subject to the common law requirements of “system, continuity and repetition”, and will be a question of fact in each case. 23 Recommendations Newspapers vs online news vendors The SC intends to grant exemption to provide investment advice to media advisers, regardless of the medium i.e. via the newspaper, journal or other information service made available to the public. Factual information The SC is of the view that the dissemination of purely factual information through information service providers will not be considered as investment advice. Investment advice over the Internet The SC is of the view that investment advice will still be subject to the “disclosure of interest” as well as “suitability for the customer” requirements. The SC will determine that a “recommendation” has been made by considering the degree of intervention by the adviser in relation to the provision of investment information. The SC is of the view that internet advisers would require a license if it can be proved that they carry on the business of providing securities recommendations. 3.14 Electronic contract notes 3.14.1 The issuance of contract notes is governed by the provisions of the Securities Industry (Dealer’s Contract Note) Regulations 1997 (Contract Note Regulations). 3.14.2 Currently, there is no regulatory impediment to the issuance of contract notes by dealers in an electronic format, so long as it complies with all the provisions of the Regulations. The electronic contract note merely has to comply with the requirements of the Contract Note Regulations and transmitted to the client no later than the end of the next market day after the transaction was entered into. 3.14.3 However, in the interests of the client, the SC recommends that before such electronic contract notes are issued to a client, the Member Company must first obtain the authorisation of the client to deliver such contract notes electronically. 24 Recommendations The SC intends to amend the existing Contract Note Regulations to allow for electronic contract notes, by incorporating the following matters:- • requirement for consent of the client to be obtained; and • reporting requirements to the authorities. 3.15 Electronic record-keeping 3.15.1 The SC intends to ensure that the purpose for which any record keeping is required must be maintained even in an electronic environment. The SC’s role should not be to prescribe the required method of archiving material or ensuring its security, but instead ensuring that whatever method used must comply with specified criteria for storage and establishment of an audit trail. 3.15.2 Such criteria may include the requirement for the establishment of written procedures for intermediaries dealing with electronic communications relating to their businesses, to ensure that such communications are adequately supervised. This is particularly so for e-mail communications. 3.15.3 Tampering with electronic file information is of greater concern as electronic data may be altered without a trace, much less a paper trail. Data storage systems are also more vulnerable because of widespread personal computer ownership and inter-connection of computer systems. The SC considers the security and integrity of data storage to be important, whether in the manual or electronic environment. 3.15.4 The SC recommends that key standards of record-keeping must be met regardless of the technology used. These standards require that certain records must be created and maintained, that the records are durable, cannot be altered and are available and accessible to the regulator/enforcer. Recommendations The SC recommends that market intermediaries should have written procedures for dealing with electronic communications. The SC recommends that market intermediaries ensure security and integrity of their data storage systems, whether manual or electronic, by ensuring that records, where required by law, are created and maintained, that such records are durable and cannot be altered, and are available and accessible to the regulator or enforcer. 25 3.16 Security/operational integrity 3.16.1 Currently, the SC does not impose the requirement that market intermediaries regulatees utilise specific encryption technology or other means in order to secure the confidentiality of communication with customers. The SC will undertake study of this issue. Recommendations The SC intends to study the need to impose encryption or other security requirements on intermediaries’ electronic communications with their clients. 3.17 Stock market facilities 3.17.1 Electronic markets can now take the form of Internet open systems, electronic exchange proprietary systems, broker proprietary systems, media communications proprietary systems or even information technology systems and services-provider proprietary systems. Alternative trading systems (ATS) have developed around the world. “Alternative”, because they are operated by issuers, brokers and independent third parties, instead of the traditional member-operated exchange format. 3.17.2 However, the wide definition of “stock market” in the SIA, has raised concerns about the categorisation of these electronic markets as well as electronic broker- client linkages. The difficulty has been deciding where those linkages overstep the boundaries of traditional dealing activities and encroach upon the realm of being a “stock market”. 3.17.3 A stock market is a place at which, or means by which, buyers and sellers are systematically and recurrently afforded the opportunity to sell, purchase or exchange securities (trade execution) or provided with information on the basis of which they can offer, or invite offers, to sell, purchase or exchange securities (information providers). 3.17.4 In interpreting the statutory provisions, one has to keep in mind the function of the stock market to bring buyers and sellers together. The SC must also keep in mind the necessary elements for fair, efficient, transparent stock markets, inter alia, credible and transparent price formation, proper trading rules to prevent market manipulation and systemic risk, as well as proper trade confirmation and clearing and settlement support. 3.17.5 The SC views the following factors to be a guide as to the existence of a stock market:- • the extent of the market’s trade execution facilities; • the range of securities dealt with by the market; 26 • the range of market users; • the extent to which the market and its operators are subject to appropriate business rules; • whether the activity occurs within the scope of a broader market and is subject to supervision by a securities exchange; and • the volume and value of transactions in the market. Recommendations The SC intends to issue guidelines on factors it will take into account when deciding whether a dealing activity becomes operating a stock market:- • the extent of the trade execution facilities; • the range of securities dealt with; • the range of market users; • the extent to which the market and operators are subject to appropriate business rules; • whether the activity occurs within the scope of a broader market and is subject to the supervision of a securities exchange; and • the volume and value of the transactions. 3.18 Documentation for submission and disclosure 3.18.1 Legislative provisions in securities laws have references to paper and geographic- based documents. In addition, securities and futures laws also contain references to the persons notifying the SC in writing. Applications for licensing are also constrained by the requirement that it be paper-based. 3.18.2 These are merely examples of provisions that require amendment in order to make securities laws electronic-friendly. The SC recommends that references in those laws to words like attachment, signature, copy, keeping in place, paper etc, should be changed to recognise electronic communication methods. Recommendations The SC intends to amend provisions in the securities and futures laws to ensure they cater to both the traditional paper-based environment and an electronic one. 27 3.19 Enforcement 3.19.1 The SC will continue to enforce the provisions of securities and futures laws within its jurisdiction, regardless of the medium in which such contraventions are committed. Where necessary, the SC will also seek co-operation from regulatory and law enforcement organisations overseas. Recommendations The SC intends to continue to enforce laws under its purview, regardless of the medium in which contraventions of such laws are committed, and will seek overseas co-operation where necessary. 3.20 Training and education 3.20.1 In relation to investors, the SC is of the opinion that the self-policing by educated investors is the best defence against contraventions of securities laws. 3.20.2 Training or education programmes can be in the form of formal seminars or through the posting of information on the web-sites of the relevant regulatory authorities. The SC intends to use its web-site to educate investors about the risks of investments in securities and derivatives. The SC intends to provide warnings about securities fraud on the Internet by providing information about possible fraudulent activities and securities risks associated with the transmission of financial information online. The SC also intends to post a list of licensed entities as well as issue/offer of securities to the public which have been approved by the SC. These postings will indicate to the public that these entities or offers have received the relevant regulatory approval. Investors can therefore assume that if the scheme or service provider does not appear on the SC homepage, that the scheme is not properly approved or that the service provider is not properly licensed. 3.20.3 The SC would like to encourage market institutions and market intermediaries to provide educational information on their web-sites as well, as we are of the view that it is more beneficial to educate investors at the decision-making points of action. These could take the form of splash screens, pop-up messages or side bar messages to provide alerts to the investor at crucial decision-making junctures. 3.20.4 In relation to market intermediaries, the issue of disintermediation by technology has brought home the necessity for re-training of affected representatives. The SC intends to work with market intermediaries to provide appropriate programmes to assist affected intermediaries to equip themselves to provide value-added services and face the challenges brought on by technology. 28 Recommendations The SC intends to assist in creating training and education programmes for intermediaries as well as investors, particularly in relation to the use of technology in the capital market. The SC recommends that market institutions and market intermediaries provide educational information on their own web-sites. The SC intends to work with market intermediaries to provide re-training programmes to face the challenges brought on by technology. 29 APPENDIX A POLICY STATEMENT (Issued as a press release on 18 August 1999) PRIMARY OFFERS OF SECURITIES VIA THE INTERNET The Securities Commission (SC) has received numerous queries from offerors or potential offerors who are based overseas about the possibility of their offer of securities via the Internet falling within the ambit of Malaysian securities laws. This statement is issued to address the concerns raised by the application of existing Malaysian securities laws, in particular section 32 of the Securities Commission Act 1993, to the primary offers of securities via the Internet. While the SC fully supports the development of electronic commerce in the Malaysian capital market, the SC is also entrusted with the duty to protect investors in Malaysia from illegal activities. Section 32 of the Securities Commission Act 1993 is specifically enacted to regulate the offer of securities in the primary market. Under section 32 of the Securities Commission Act 1993, a person (“offeror”) who: • makes available offers for subscription or purchase of securities in Malaysia; or • issues an invitation for subscription or purchase of securities in Malaysia, is required to submit a proposal to the SC. A person who fails to submit such a proposal commits an offence, who on conviction is liable to a fine not exceeding RM1,000,000 or to imprisonment for a term not exceeding 10 years or both. It is the SC’s view that an offering of securities on the Internet that is accessible within Malaysia is an offer that falls within the provisions of section 32. The approval of the SC must first be sought if the offer is accessible within Malaysia or if acceptances from within Malaysia have not been expressly excluded. However, the SC will take into account the following factors in order to determine whether an offer of securities on the Internet would be subject to the rigours of section 32 of the Securities Commission Act 1993: • The intention of the person making the offer i.e. whether the offer is in fact targeted to a person in Malaysia. In discerning the intention of the offeror, the SC will consider the offeror’s use of disclaimers, the establishment of local distribution networks, concurrent advertising or publicity in other forms of media in Malaysia, or denomination of prices in Malaysian currency; • The penetration of the offering of securities in Malaysia i.e. whether any person in Malaysia accepts the offer. This includes consideration of the issuer’s precautions to screen address and residency information and the amount of unauthorised sales; and • The involvement of a person from Malaysia in making the offer. i The SC recommends offerors or potential offerors to take certain measures to ensure that such offerings do not fall within section 32 of the Securities Commission Act 1993. These recommendations serve as a guideline for offerors and is neither legal advice nor does it purport to be an exhaustive list that will guarantee an offeror exclusion from the ambit of section 32 of the Securities Commission Act 1993. Such measures include: • Not publishing the offer or invitation in websites that are frequently visited by or draws the attention of a person in Malaysia. For example offering in websites that have “.my” in its address or that is offering content relevant to a person in Malaysia. • Ensuring that the offering does not contain information specifically relevant to a person in Malaysia. For example, tax rates or prices which are presented in Malaysian currency. • Designing or taking steps to automatically exclude and/or reject any subscriptions made by a person from Malaysia and to have a monitoring system on applications made by such person. For example, an offeror may programme their subscription system in such a manner to automatically reject any applications for subscription from a person in Malaysia where the telephone, address and postal addresses indicate that they are from Malaysia. • Restricting the access of information of the offering so that a person in Malaysia is unable to view documents that are related to the offering. • Incorporating a clear jurisdictional disclaimer into the on-line prospectus / offer document stating that the offer is not intended to be available in Malaysia or to any person in Malaysia or which clearly states at which jurisdictions that the offer is targeted in a list that excludes Malaysia. The SC would also take this opportunity to remind all persons in Malaysia to be wary of fraud that can be committed via the Internet. Traditional violations have been made easier through the misuse of technology. A person who invests in securities that have not been approved by the SC should also understand and be aware of the increased possibility of being defrauded. Whilst the SC conducts surveillance of offers that are made through the Internet, it is of the view that the best protection against fraud, particularly those committed over the Internet, is for investors to be aware of the risks associated with such offers. Investors should make the effort to ascertain the authenticity of the offer, as well as determine if such offers have been approved by the relevant regulatory authorities. An investor may check with the SC, by contacting the Corporate Affairs Department at telephone number 03-6548000 or e-mail: email@example.com, to find out whether securities offered via the Internet have been approved by the SC prior to investing in those securities.