Misappropriation of clients' assets at brokerage firms does happen. But luckily such cases are few and far between.

These offenses are in fact mainly committed by employees of the brokerage companies who may have served the company for many years and have gained management's trust to perform their duties with limited supervision.

While brokerage houses are obliged to report any suspected case of misappropriation to the Securities and Futures Commission, an independent and formal investigation into the case in tandem with a full review of the brokerage firm's internal control systems normally ensues.

In most cases, the misappropriated funds will need to be traced to all relevant parties. This will help identify losses suffered by the clients and the brokerage firm, and pinpoint the reasons that may have contributed to the fraud.

A typical misappropriation case may begin with a genuine client placing an order with an employee - usually an Account Executive - to purchase shares. The Account Executive uses the client's money to buy shares on his or her behalf, then allocates these shares to a dormant or fictitious client account instead of the genuine client's account.

To facilitate the misappropriation, the Account Executive may forge the "signature" of the dormant or fictitious client on the relevant documents to sell the shares at a higher price, and withdraw the proceeds from the dormant or fictitious account.

When the genuine client wants to sell the shares, the Account Executive will sell the same amount of shares from another client's account to cover up for the shortfall. Sometimes, the Account Executive will account for the shortfall by buying back the relevant shares in the market at a lower price, before the genuine client gives instructions to sell them.

The Account Executive also creates fictitious statements of account and sends them to the relevant client to cover up the illegal activities. At the same time, the Account Executive withholds statements of account that should be sent to the dormant or fictitious client.

Most misappropriation cases take advantage of weaknesses in the brokerage firm's internal control systems. Some common deficiencies include insufficient supervision, ineffective segregation of duties, an inadequate transaction-reporting system, as well as low IT security controls.

To prevent such incidents from occurring, management at brokerage houses can take the following precautionary measures:

* Ensure monthly statements are sent out to all clients regularly, and that nobody is able to withhold a statement without proper authorization;

* Restrict and control the use of all stationery that bears the company's name;

* Properly segregate the duties of staff members;

* Instruct back-office staff to call clients directly to confirm their instructions;

* Regularly review inactive or dormant accounts to prevent them from being misused and to avoid unauthorized transactions;

* Pay attention to any requests for third-party cheques or fund transfers to third-party accounts;

* Set up proper access rights for computer systems;

* Encrypt all data to protect sensitive information that is transmitted outside the company or stored on portable storage devices (such as USB storage devices).

Meanwhile, clients are advised to take the following precautionary measures:

* Check monthly statements carefully to make sure that all transactions have been entered into according to their instructions;

* Follow up promptly if they fail to receive monthly statements;

* Never trust or rely on Account Executives excessively; and

* Contact the brokerage company's management directly if there is any complaint or questions concerning their Account Executives.

The regulatory bodies have implemented various rules and regulations to prevent fraudulent activities. However, both clients and management of brokerage firms should do their part too and take precautionary measures.

Anita Hou is a director and Matthew Chu is a senior manager at Grant Thornton, a member firm of Grant Thornton International Ltd, which is one of the world's leading accounting and consulting firms.

(HK Edition 09/16/2010 page2)