Lessons from Lehman Minibonds
20 October 2008
As most readers will know by now, tens of thousands of retail investors in Hong Kong and Singapore have been affected by the failure of Lehman Brothers Holdings Inc. (LBHI), which went into Chapter 11 bankruptcy protection on 15-Sep-08. The focus of this article is not on cleaning up the Minibond debris, but on how we can reform the regulatory system for structured financial products to reduce the impact of failures like Lehman in future. We propose three main measures in this article. Without such reforms, there is a risk that the authorities may just ban retail sales of such products altogether. So if you are a distributor or issuer, you have an interest in supporting these measures too.
Lehman created several special-purpose investment vehicles which issued unlisted structured financial products through retail distributors, i.e. banks and stockbrokers. The issuers were called Pacific International Finance Ltd (PIF), Atlantic International Finance Ltd (AIF) and Pyxis Finance Ltd (Pyxis). The products issued by PIF were marketed as "Minibonds", by AIF as "ProFund Notes" and by Pyxis as "Pyxis Notes". A list of these can be found on the SFC's web site. According to the SFC, the total outstanding principal of the products is HK$12.73bn, of which $12.57bn is PIF Minibonds. In addition, there were credit-linked notes which referenced LBHI, in the amount of $2.91bn. Altogether then, the exposure is about HK$15.6bn (US$2.0bn).
There are 36 different series of PIF Minibonds - the advertisement for the latest one, Series 36, is here, in which the coordinating distributor was Sun Hung Kai Investment Services Ltd (SHKIS, owned by Sun Hung Kai & Co Ltd, 0086.HK). The issue prospectus for Series 36 shows that the series was distributed by Chong Hing Bank, Dah Sing Bank, KGI Asia, Mevas Bank, Public Bank (HK), Wing Lung Bank and SHKIS. Other banks were involved in other series.
You will see that it does say on the front cover "The Notes are not principal protected". In this example, the investor was receiving a "coupon" of 5.5% in exchange for taking the risk that any one of 7 companies would default on their reference debts, in which case the holder would only get back whatever the defaulted debt was worth, if anything, minus expenses. The reference debts for 3 of them (HSBC Bank PLC, DBS Bank Ltd and Standard Chartered Bank) were subordinated notes. However, none of the 7 companies has defaulted - it was only the Lehman collapse which caused the problems.
Each SIV took the issue proceeds (minus commissions to the distributors and other expenses) and invested them in a bunch of collateral, including swaps with a Lehman entity guaranteed by LBHI. In our Series 36 example, the collateral was synthetic Collateralised Debt Obligations (CDOs). PIF entered into a swap with Lehman Brothers Special Financing Inc (LBSF) to swap the interest and principal from the CDOs for part of the amounts due on redemption of the notes. PIF also entered into a Credit Default Swap (CDS) with LBSF under which PIF received a payment in return for insuring the 7 reference credits against default. If any of them had defaulted, then LBSF would receive the collateral and PIF would receive the value of the defaulted debt. LBSF was guaranteed by LBHI. So in effect, Minibond investors were putting up cash to underwrite compound credit default swaps.
LBHI was also the guarantor of collateral for the ProFund Notes, the Pyxis Notes and for some series of Minibonds. On 17-Sep-08, as a result of the bankruptcy filing, Lehman Brothers Asia Ltd announced it had suspended the provision of quotes or liquidity in the products.
Three steps forward
If any good is to come from the Minibond saga, then there are 3 things that the Government and legislators should act on:
- A unified financial services regulator
- A statutory cooling-off period for cancellation of purchases of financial products
- Mandatory disclosure of commissions in all marketing and contractual documents.
Let's deal with these in turn.
1. A unified regulator
With the best will in the world, we cannot expect a comprehensive and consistent approach to regulation when so many regulators regulate in the same space. Currently, we have four main regulators and four sub-regulators. The four main financial services regulators are:
- the Hong Kong Monetary Authority (HKMA) which runs our currency board, manages our shrinking quasi-sovereign wealth fund (known as the Exchange Fund) and regulates banks;
- the Securities and Futures Commission (SFC), which regulates exchanges, securities and futures brokers and fund managers, authorises fund prospectuses and has statutory oversight of false or misleading disclosure by listed companies under the so-called "dual filing" scheme;
- the Mandatory Provident Fund Schemes Authority (MPFA), which regulates the retirement savings scheme; and
- the Office of the Commissioner of Insurance (OCI), which regulates insurers.
The four sub-regulators are:
- The Stock Exchange of Hong Kong Limited (owned by Hong Kong Exchanges and Clearing Ltd, 0388.HK) which regulates Listed Companies under the oversight of the SFC;
- the self-regulatory Hong Kong Federation of Insurers (HKFI), which operates the Insurance Agents Registration Board
- two self-regulatory bodies of insurance brokers approved by the Commissioner of Insurance, namely the Hong Kong Confederation of Insurance Brokers and the Professional Insurance Brokers Association.
Apart from arranging insurance for your home or car, the insurance agents and brokers do of course also sell long-term savings products such as endowment policies or unit-linked insurance.
This alphabet soup of regulators results in overlapping mandates as well as gaps between their mandates. There are duplications of resources, and inevitably inconsistent approaches to guidance and supervision of selling intermediaries. If a product is mis-sold by a stockbroker, you complain to the SFC. If it is mis-sold by a bank, you complain to the HKMA. And if a life assurance product is mis-sold by an insurance broker, then you are back in self-regulatory land.
Out of crisis comes reform. As we have said before, what Hong Kong needs is a single financial services regulator (let's call it the Financial Services Commission) which will regulate the issue, management and sale of all financial products, both assets (savings, investment and insurance products) and liabilities (personal loans, mortgages, credit cards and so on). This would combine the roles of the SFC, COI, MPFA and part of the HKMA. The HKMA could retain its role as a quasi-central bank, supervising capital adequacy of the banking system, running the currency board and managing the Exchange Fund, in which the money backing the peg and the public wealth are comingled.
2. A Statutory Cooling-off Period
After a failure like Lehman, arguments about mis-selling are bound to focus on whether the investor understood the product and whether the risks were properly explained to him, and whether the product was "suitable" for the investor. The only certain winners in such arguments are lawyers. Except in blatant cases, the argument will often come down to a dispute over what was said, while the bank will normally have covered itself with written documents which the client signed, acknowledging the risk and declaring that they had understood it. The document will often also contain a "no representations" clause which states that this is the whole agreement, and the client is not relying on any other representations made by the distributor and is relying only on the prospectus. So although we have laws against misrepresentation, it will be an uphill struggle for any client to bring a successful claim of mis-selling, unless they happened to have a recording of the over-the-counter conversation.
These sales often take place in a high pressure environment. The client might have walked into a bank to make a time deposit and walked out with a Minibond, never having had time to properly read or understand the product leaflet, let alone the prospectus. For this reason, many countries now have a statutory "cooling-off" or cancellation period, which allows the customer enough time to leave the "hot" sales environment and go home, talk to friends, family or advisers, read the documents and then change their mind and get their money back.
Hong Kong does have a cooling-off period, but only for Long Term Insurance Policies, under the Cooling-off initiative of the HKFI. This allows 21 days from the date of signing the application form, 14 days from the issue date of the policy and 5 days after the delivery date of the policy, whichever is later. During that period, the policyholder can cancel the policy for a full refund (less a market value adjustment where applicable).
A similar approach must be taken with unlisted structured products. Examples can be readily found in other markets. Australia has a 14-day cooling-off period for investment life insurance products, retirement savings accounts, various non-life insurance, many managed investment products and superannuation products. This is contained in Section 1019B of the Corporations Act 2001. In Singapore, in Jul-03, the Monetary Authority introduced a 7-day cancellation period for Unit Trusts.
Of course, some investors, even with a cooling-off period, will never inform themselves about what they have bought. In that case, they have nobody to blame but themselves. A golden rule of investing: if you don't understand what you are buying, then don't buy it.
For other consumer services and products too
This approach to consumer protection could and should be extended to other products and services where there is either a long period of payment obligations, a large purchase price, or a long period of service or product delivery. For example, a purchase of a timeshare in a holiday home, or the purchase of a new apartment, or an 18-month commitment to a pay-TV or mobile phone subscription. Cancellation periods should be long enough to allow the consumer to reach an informed decision (if they choose to inform themselves) but short enough to give the seller a binding contract within a reasonable period, to avoid abuse. We would suggest 14 calendar days excluding the day of the contract. Any deductible charges for use of the service during the cancellation period (e.g., phone calls or pay TV) or market value adjustment methods (e.g. a drop in unit trust NAV) should be disclosed at the point of purchase.
In the case of market value adjustments, they must be symmetric, allowing the buyer to keep any market gain as well as bear any loss up to the point of cancellation. Vendors should not be allowed to deduct selling commissions or expenses, otherwise the cancellation price could become a deterrent to cancellation in itself.
Initially, banks, phone and TV companies and other affected vendors might object to this proposal as an interference in private contract, but they would eventually realise that it also increases protection for them against allegations of mis-selling, because the consumer has had adequate time to fully understand what they have agreed to and seek advice if necessary. The vendor can then be more robust if a customer tries to wiggle out of a contract after the cancellation period has expired.
3. Mandatory disclosure of commissions
In the law of agency, it is illegal for an agent of a principal to receive a secret commission from a third party, unless the principal has consented. It is what is colloquially known as a "kickback". In financial services, we need to go further than that. It should not be possible to contract out of the disclosure. Too may banks and brokers put their staff forward as your "personal financial adviser" when in reality the bank is paid for sales by the issuer of the financial products, not by the purchaser. Deep in the small print of every contract, that fact is acknowledged but the amount is not disclosed.
In our example of Series 36 PIF Minibonds, the issue prospectus states on page 14:
"We will pay each distributor a commission based on the amount of Notes they sell. These commissions come out of the proceeds of issue of our Notes."
There is no disclosure of the amount. The advertisement (the only thing most investors read) didn't even disclose that a commission would be paid. The statement is also contradicted by a statement on page 19, which says:
"We always use all of the proceeds of issue of our Notes to buy the assets on which those Notes are secured." (emphasis added)
In our view, that's false and misleading. They didn't use all of the proceeds to buy assets - some of the proceeds are used to pay commissions to distributors.
A light bulb would go on in even the dimmest customer head if they were told, in every marketing document of a financial product, in clearly readable typeface, that the bank would be receiving 5% commission on each sale of the product - or whatever the rate and basis is. It would cause the customer to realise that at most, what they were buying was only worth 95 cents on the dollar at the outset - and probably much less, as it also has to include an expected profit for the issuer, otherwise they wouldn't issue it in the first place.
Similarly, how many people would commit to a 10-year life insurance policy, cancelling the previous one sold by the same agent before he moved to a new insurer, if they knew that the agent gets a commission equivalent to the first 9 months of premiums? This "twisting" is one of the reasons why insurance agency teams change hands so often - it gives them a chance to sell to the same customer again, or more accurately, to sell the customer to the insurer.
The SFC is well aware of the hidden commissions problem but has made no visible progress in addressing it, perhaps due to lack of political support, in which case the Minibond fiasco now creates a window of opportunity. In a press release on the Selling Practices of Licensed Investment Advisers on 23-Feb-05, the SFC said:
"In addition, the SFC plans to consider and engage the investment advisory industry to explore information disclosure issues such as the feasibility and benefits of requiring investment advisers to disclose to investors the commission and rebates received from product providers."
Plan...consider...engage..explore...feasibility...how tentative can you get? On 13-Apr-08, some 5 months before Lehman imploded, Webb-site.com wrote to the SFC asking them what progress they had made in the last 3 years on this issue. Alexa Lam, the Deputy CEO and Executive Director of the Investment Products Division, responded on 16-Apr-08:
"Following the issue of the press release in February 2005 mentioned in your email, the SFC discussed with relevant stakeholders the question of disclosure of commission rebates by distributors to clients. Not surprisingly, distributors generally did not favour disclosure of commission rebates as they considered that they would be disadvantaged competitively. Of course in formulating our regulatory policy, we have to take tough action where doing so would be the right thing even though it is unpopular with certain sectors of the industry. But looking around it is true that there is no consistent approach to dealing with this issue among major markets."
Regulatory deficiencies in other markets should be no excuse for not putting our own house in order. Why must HK always be a follower and never a leader when it comes to better regulation? Hong Kong must act now to require full disclosure of what intermediaries are paid for distributing financial products, including but not limited to life insurance, unit trusts and structured products.
In the wake of the Minibond fiasco, there should certainly be political support for the three measures outlined above. We should note that there is an alternative school of thought circulating among policy makers that the retail sale of structured financial products should simply be banned, as it creates too much trouble when things go wrong. Webb-site.com is not in favour of prohibition - it goes against the principle of free markets. Besides, there are plenty of financial products out there with high risk, such as derivative warrants listed on SEHK, some of which are quite exotic, not to mention complicated combination bets on horse races at the Jockey Club. But given that the prohibition school of thought may gain traction, the issuers and distributors should strongly consider supporting the above three steps as a desirable compromise.
Footnote: derivative warrants
Somewhat forgotten by the media in all this is that LBIH also had outstanding 134 series of derivative warrants which were listed on the Stock Exchange. These were all suspended from trading on the bankruptcy. There has been less noise about that as most of them were call warrants which would have crashed in value with the market and may expire worthless anyway, although there were some put warrants on the HSI which would now be worth a lot more. 35 of the warrants expired worthless (not because of the bankruptcy) on 30-Sep-08. A similar thing happened when another derivative warrant issuer, Peregrine Investments Holdings Ltd, went bust in Jan-98.
© Webb-site.com, 2008
Organisations in this story
- Hong Kong Monetary Authority
- LEHMAN BROTHERS ASIA LIMITED
- Lehman Brothers Holdings Inc.
- Mandatory Provident Fund Schemes Authority
- SECURITIES AND FUTURES COMMISSION