In the Matter of Staff’s Recommendations
to Suspend the Registrations of Morgan
Dragon Development Corp, John Cheong, and Herman Tse
Opportunities to be Heard by the Director
under Section 31 of the Securities Act
1. My decision is that the registrations of Morgan Dragon Development Corp. (Morgan Dragon), John Cheong, and Herman Tse (collectively, the Applicants) are suspended effective January 27, 2012. My decision is based on the:
- verbal arguments of Mark Skuce, Legal Counsel, Compliance and Registrant Regulation Branch (CRR) for Staff of the Ontario Securities Commission (OSC), and John Cheong on behalf of the Applicants,
- testimony of Teresa D’Amata, Kelly Everest (both Staff of CRR), and Cheong, and
- evidence provided at the opportunity to be heard (OTBH).
Registration history of the Applicants
2. Morgan Dragon was initially registered as a limited market dealer in early 2009. By operation of law, Morgan Dragon became registered as an exempt market dealer (EMD) in September 2009.
3. Cheong is the Chief Compliance Officer (CCO) and the only dealing representative of Morgan Dragon. Tse is the Ultimate Designated Person (UDP) of Morgan Dragon. Cheong and Tse each own 50% of Morgan Dragon.
Suspension letter to the Applicants
4. By letter dated November 22, 2011 (as amended by letter dated December 1, 2011), Staff advised the Applicants that it had recommended to the Director that:
- Morgan Dragon’s registration as an EMD
- Cheong’s registration as CCO and the only dealing representative of Morgan Dragon, and
- Tse’s registration as UDP of Morgan Dragon be suspended. Pursuant to section 31 of the Securities Act (Ontario) (Act), Morgan Dragon, Cheong, and Tse are entitled to an OTBH before a decision is made by me, as Director. The OTBH occurred on January 27, 2012. Cheong appeared at the OTBH on behalf of the Applicants. Mr. Tse, the UDP of Morgan Dragon, did not appear.
5. Staff’s suspension recommendations were based on the following allegations:
- failure to collect know your client (KYC) information and ensure trade suitability,
- reliance on an inappropriate prospectus exemption,
- failure to deal fairly, honestly, and in good faith with clients,
- late delivery of 2010 audited annual financial statements and significant working capital deficiency, and
- inappropriate use of investor proceeds.
Failure to collect KYC information and ensure trade suitability
6. Staff argued that the Applicants breached section 1.5 of OSC Rule 31-505 Conditions of Registration (OSC Rule 31-505) (as in force at the relevant time) and sections 13.2 and 13.3 of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103). The Applicants obtained signed accredited investor forms from investors at the time they invested in units of Morgan Dragon’s related issuer limited partnerships (LPs). No information on the accredited investor forms was verified by the Applicants and therefore Staff alleges that the Applicants were not able to ensure that the trades were suitable for clients. As well, some of the trades (and the related accredited investor forms) were completed prior to Morgan Dragon becoming registered in Ontario.
7. The client KYC forms were not completed until some time after the trades were made. In many cases, the client KYC information obtained by the Applicants conflicted with the information on the accredited investor forms, and no follow up was done by the Applicants. As well, many of the KYC forms indicated a low to medium risk tolerance by the investor or a one to three year investment horizon, both of which indicated that the client investments in the LPs (all of which were speculative, high risk and medium to long term real estate investments) were not suitable.
Reliance on an inappropriate prospectus exemption
8. Staff argued that the Applicants breached the requirements of paragraph 1.1(j) of National Instrument 45-106 Prospectus and Registration Exemptions. In at least four cases cited by Staff, the investor in an LP was a corporation. In these cases, the investor purportedly relied on an exemption that is only available to individual investors. The Applicants accepted these incorrect accredited investor forms. In responding to questions at the OTBH, Cheong (as CCO and the only dealing representative of Morgan Dragon) did not appear to be aware that corporations cannot rely on exemptions for individuals (such as the net financial assets exemption). He also didn’t know the correct income tests for individuals as accredited investors.
Failure to deal fairly, honestly, and in good faith with clients
9. By not collecting KYC information or ensuring trade suitability, Staff argued that the Applicants failed to deal fairly, honestly, and in good faith with their clients, contrary to section 2.1 of OSC Rule 31-505.
Late delivery of 2010 audited annual financial statements and significant working capital deficiency
10. The December 31, 2010 audited financial statements of Morgan Dragon were delivered on December 1, 2011, approximately eight months after they were due. The notes to the financial statements stated that Morgan Dragon was capital deficient as at December 31, 2010 by $5,846 and that the “company has made plan and arrangement to satisfy the working capital requirement by injecting additional funds to the company”. As at January 27, 2012, neither Cheong or Tse had injected any further funds into Morgan Dragon.
11. Staff argued that Morgan Dragon was capital deficient for more than two days and that it did not report the capital deficiency to Staff as required by section 12.1 of NI 31-103. Morgan Dragon’s disclosed capital deficiency of $5,846 was based on an assumption that three related party loans ($74,401 from Tse, $74,401 from Cheong, and $32,898 from Morgan Dragon Capital Fund Inc. (a related company owned by Tse and Cheong that is the general partner of one of the LPs)) were all appropriately included as assets in the capital calculation because subordinated loan agreements had been entered into. However, no subordinated loan agreements have ever been filed with the OSC. At the OTBH, Cheong produced the signed subordinated loan agreements, each dated as of December 31, 2010. On questioning by me, he advised that the agreements had been signed sometime after October 27, 2011.
12. Based on Staff’s calculations (which excludes the three related party loans described above), Morgan Dragon’s capital deficiency was approximately $188,000. Because the subordination agreements were not filed with the OSC prior to the OTBH, the correct capital deficiency for Morgan Dragon as at December 31, 2010 was approximately $188,000.
Inappropriate use of investor proceeds
13. The audited balance sheet of Morgan Dragon shows a related party receivable and a related party payable to the same related party – Morgan Dragon Capital Fund Inc. During the OTBH, a number of questions were raised regarding these related party transactions (particularly the related party receivable). I was advised by Cheong that the funds for these related party transactions are from the investors in one of the LPs and that neither he or Tse (who collectively own Morgan Dragon Capital Fund Inc.) had provided sufficient funding to that entity to fund the related party transactions with Morgan Dragon. Staff argued, and I concur, that this is an inappropriate use of investor proceeds from the LP.
Summary of Staff’s arguments
14. Staff argued that in light of the allegations outlined above, the Applicants’ lack the requisite integrity, proficiency, and solvency and their registrations should be suspended. Staff also argued that section 28 of the Act permits me, as Director, to suspend the registrations of the Applicants on the basis that the Applicants are not suitable for registration, have failed to comply with Ontario securities law, or that their registrations are otherwise objectionable.
Cheong asks that the Applicants be permitted to surrender their registrations
15. Late in the OTBH, Cheong asked that the Applicants be permitted to surrender their registrations, rather than face suspensions of their registrations. He argued that he would like to someday return to the securities industry after he had completed some further courses and developed into a proficient securities professional. He acknowledged that he had made some mistakes, but advised that he would like to continue to work in the securities industry.
Decision on the suspension of the Applicants
16. My decision is to suspend the registration of Morgan Dragon, Cheong and Tse as of January 27, 2012. My decision was communicated verbally to Cheong, on behalf of the Applicants, at the OTBH on January 27, 2012.
17. My decision was made as a result of the allegations outlined above – all of which were proven by Staff. In my view, the Applicants’ conduct clearly demonstrates a fundamental lack of understanding regarding Ontario securities law and a pattern of non-compliance with Ontario securities law. As I said in Carter Securities Inc., Re (2010), 33 OSCB 8691: “In conclusion, in my view the evidence in this case supports my decision that Carter’s registration should be suspended. In concur with staff’s assessment that Carter has engaged in a pattern of conduct – through its individual registrants – that demonstrates that it lacks the integrity required of registered firms under the Act.”
18. Morgan Dragon has had a very significant (and ongoing) capital deficiency for some time. During the OTBH, I was advised that, despite disclosing in their annual audited financial statements filed with the OSC that they had a plan to rectify the capital deficiency, no injections of capital by either Cheong or Tse have been made.
19. I was also very concerned about the improper use of investor proceeds as outlined above under “Inappropriate use of investor proceeds” and the apparent registerable activity carried on by the Applicants prior the registration of the Applicants in Ontario as described under “Failure to collect KYC information and ensure trade suitability”. In my view, this conduct clearly demonstrates that the Applicants are unsuitable for registration and that their ongoing registrations would be objectionable.
20. My view is that Cheong has, as described by Staff during the OTBH, exhibited a “dangerous lack of proficiency” by his conduct to date. As well, I did not find his evidence at the OTBH to be credible. He was not responsive generally to Staff’s or my questions and appeared to lack even a basic understanding of Ontario securities laws. As a result, I decided that suspension of the Applicants was more appropriate than the request for them to surrender their registrations.
21. Lastly, as I advised verbally at the OTBH, in my view the suspensions of Cheong, Tse and Morgan Dragon should be permanent. Very serious – and proven – allegations were made by Staff during the OTBH. In my view, the nature and seriousness of these proven allegations leads me to conclude that none of Cheong, Tse or Morgan Dragon should again be permitted to be registered under Ontario securities law.
“Marrianne Bridge”, FCA
Deputy Director, Compliance and Registrant Regulation Branch
Ontario Securities Commission
February 10, 2012