An overview of the Lehman Brothers minibonds saga

Transcription

1 briefing summary 16 December 2008 An overview of the Lehman Brothers minibonds saga Financial services market developments In the wake of the collapse of Lehman Brothers, so-called minibonds have caused a great deal of controversy in Hong Kong. Questions have been raised over the sales and marketing practices of distributors and whether complex structured products are appropriate for the retail market. In this briefing we summarise the principal characteristics of the minibond products, describe the recent regulatory investigations into whether misselling occurred and identify issues that financial institutions should take into account when reviewing their selling practices. We also discuss potential tortious liability arising from misselling practices and likely future developments in this area. What are minibonds? Minibonds are structured derivative products linked to the credit of certain specified reference entities. The term mini is thought to indicate that these bonds were sold in smaller minimum denominations (which were as low as HK$40,000 in certain cases), making them affordable to retail investors. Structured products having a similar structure to that of minibonds were commonly sold to institutional investors as credit-linked notes in many jurisdictions. However, it was not very common for such structured products to be sold to retail investors. In Hong Kong, minibonds were distributed as retail products from Lehman Brothers minibonds In Hong Kong, minibonds linked to the insolvent US investment bank Lehman Brothers Holdings (LBH) were issued by Pacific International Finance (the issuer), a special purpose vehicle incorporated in the Cayman Islands. According to the website of the Securities and Futures Commission (the SFC, the independent statutory body responsible for regulating Hong Kong s securities market), a total of 36 series of minibonds were issued by the issuer in Hong Kong. It has been reported that about 43,700 investors in Hong Kong bought approximately HK$12.7bn-worth of the issuer s minibonds. The simplified diagram on the next page shows a typical series of minibonds issued by the issuer, based on prospectuses available on the SFC s website. Lehman Brothers Commercial Corporation Asia or Lehman Brothers Asia, as arranger (the arranger), arranged for the minibonds issued by the issuer to be distributed by the distributors (typically retail banks) to retail investors in Hong Kong. Minibond holders were entitled to receive a coupon payment on a periodic basis. The proceeds of sale were used by the issuer to purchase certain US-dollar-denominated underlying assets (the collateral) selected by the arranger on behalf of the issuer. Those assets included collateralised debt obligations (CDOs) and other asset-backed securities. The collateral was held by HSBC Hong Kong, as trustee. The issuer entered into a swap agreement with Lehman Brothers Special Financing (Lehman Special Financing), as swap counterparty, under which the issuer would pay to Lehman Special Financing a sum equal to the interest and other income it received for the collateral. Lehman Special Financing in turn would pay the issuer fixed payments equal to the interest due on the minibonds. LBH guaranteed the obligations of Lehman Special Financing under the swap agreement. Payment of the principal amount on the minibonds was linked to the performance of certain reference entities identified in the relevant prospectus. The reference entities differed from series to series. Under the swap agreement, if any of the reference entities suffered certain credit events (bankruptcy, failure to make payment on specified indebtedness or restructuring of specified indebtedness), the issuer would be obliged to deliver all of the collateral to Lehman Special Financing in return for the payment by Lehman Special Financing to the 1 Freshfields Bruckhaus Deringer LLP, 16 December 2008

2 A typical series of minibonds Lehman Brothers Holdings Indirect ownership Lehman Brothers Special Financing (the swap counterparty) Interest on collateral Minibond coupon Trustee Pacific International Finance (the issuer) Minibond coupon Retail investors Lehman Brothers Commercial Corporation Asia or Lehman Brothers Asia (the arranger and calculation agent) Sale proceeds Interest on collateral Sale proceeds Collateral issuer of the credit event redemption amount, which would be used to pay the principal of the minibonds. The credit event redemption amount was based on the market value of the reference entity s obligations, but was adjusted based on the termination value of the other components of the swap agreement and the market value of the collateral. If any of the reference entities suffered a credit event, the holders of the minibonds would lose a portion of their principal amount; this loss would be greater if Lehman Special Financing were owed any amount upon termination of the swap agreement (due to changes in interest rates or otherwise) or if the market value of the collateral were less than its stated principal amount. In addition, the minibonds would cease to accrue interest upon the occurrence of the credit event, but the amount received by the issuer from Lehman Special Financing would not be payable to the holders of the minibonds until the minibonds stated maturity date. The stated maturity date was typically three to six years after the issue date. If no reference entity suffered a credit event before the stated maturity date, and no other redemption event occurred, the holders of the minibonds were entitled to receive a payment on the 2 Freshfields Bruckhaus Deringer LLP, 16 December 2008

3 maturity date equal to the liquidation value of the collateral. An event of default of an asset included in the collateral, or a reduction of the principal amount of an asset in accordance with its terms (a feature common to many asset-backed securities), could result in a partial redemption of the minibonds (at a loss to the holder of the minibonds). A purchaser of the minibonds was exposed to multiple risks: the credit quality of the reference entities; the credit quality of Lehman Special Financing, as swap counterparty; interest rate risk; currency risk; and the market value of the underlying collateral. Lehman s collapse LBH and Lehman Special Financing filed for bankruptcy under chapter 11 of the US Bankruptcy Code on 15 September 2008 and 3 October 2008 respectively. This event constituted an event of default under the swap agreement, entitling the issuer to terminate the swap agreement. A termination of the swap agreement would result in early redemption of the minibonds. The amount payable to holders of the minibonds on early redemption would be an amount equal to the liquidation proceeds of the collateral, adjusted by the amount payable by Lehman Special Financing or the issuer in respect of the termination of the swap agreement. Many of the minibonds referenced reference entities that have not experienced credit events. However, even if no reference entity has suffered a credit event, upon a termination of the swap agreement due to the insolvency of Lehman Special Financing, a holder of minibonds would be exposed to the credit risk of Lehman Special Financing, as swap counterparty, to the extent that any amount was payable by Lehman Special Financing, and would also be exposed to the market value of the collateral, which would need to be sold to redeem the minibonds. Much of the collateral reportedly consists of CDOs, other asset-backed securities or other obligations that are worth far less than their original principal amounts. Therefore, due to the insolvency of LBH and Lehman Special Financing, and the resulting exposure to the current market value of the collateral, holders of the minibonds may have lost all or a significant portion of their initial investment. It is worth noting that, even if LBH and its subsidiaries had remained solvent, holders of the minibonds would eventually have been exposed to the decline in the market value of the collateral at maturity or upon an earlier redemption event. Misselling investigations According to the SFC s Enforcement Reporter (issue 60), published in October 2008, misselling can be broadly categorised into two classes. First, an investor may be given materially wrong information about a financial product, leading him to make an investment decision that he would not have made if the correct information had been provided. The second type occurs when an investor ends up investing in a product that is not suitable given his financial position, investment objectives, expectations and risk tolerance level. In Hong Kong, thousands of Lehman Brothers minibond holders claimed that they bought the minibonds after being assured by banks that they were low-risk products, only to see the value plunge after LBH and its subsidiaries declared bankruptcy in September. The Hong Kong Monetary Authority (the HKMA), Hong Kong s de facto central bank, and the SFC have been working closely in investigating complaints about the alleged misselling of Lehman Brothers minibonds. By 4 December 2008, the HKMA had received 19,196 complaints about Lehman Brothers-related products and had referred 207 cases involving complaints of alleged misselling to the SFC. The Hong Kong government has also put forward a buyback proposal that has been agreed upon and accepted by the Hong Kong Association of Banks (the HKAB) on behalf of the distributors of the Lehman Brothers minibonds. According to the proposal, the banks will buy back the Lehman Brothers minibonds at their mark-tomarket value. The buy-back proposal, though, has hit a stumbling block after the issue of a cease-and-desist order from Lehman s US counsel to HSBC Hong Kong, as a result of the automatic stay imposed by Lehman s US bankruptcy filings. It is not yet clear to what extent chapter 11 bankruptcy proceedings in the US may preclude buy-back efforts in Hong Kong and HSBC Hong Kong is seeking US legal advice on this matter. Separately, the Hong Kong Legislative Council (the LegCo) has set up a subcommittee to examine how the HKMA and the SFC regulate the sale of structured 3 Freshfields Bruckhaus Deringer LLP, 16 December 2008

4 products and to investigate the issues relating to the Lehman Brothers minibonds and retail structured products. On 12 November 2008, it voted to invoke its powers under the Legislative Council (Powers and Privileges) Ordinance to conduct a public probe of Hong Kong banks that have been accused of misselling. The probe will analyse internal procedures and bank regulations and will require the banks to produce all internal documentation and communication, with the intention of revealing any systemic issues. During the investigation, lawmakers will be able to summon bankers and finance staff to answer questions. The LegCo sub-committee handling the inquiry is expected to meet twice before Christmas to discuss information-gathering and will start its inquiry after the Chinese Lunar New Year (late January 2009) at the earliest. On 10 December 2008, it was reported that a number of banks had reached settlement agreements with minibond holders and that the investors had received approximately HK$30m in compensation. We understand that the settlements make up only a small percentage of the total losses suffered by minibond holders in Hong Kong. Common law tortious liability and Susan Field v Barber Asia An important issue for Lehman Brothers minibond holders is whether they can recover damages for alleged misselling of minibonds. Retail investors in Hong Kong have in the past been awarded damages for their financial advisors negligence. The leading case is the Court of Appeal case of Susan Field v Barber Asia. Ms Field was an inexperienced investor who, at the outset, made it clear to her financial advisor, Barber Asia, that she wanted to invest her savings in a conservative way. Barber Asia advised her to invest in conservative insurance funds. Later, Barber Asia persuaded her to adopt a high-risk investment strategy to gear up her existing investment by borrowing a loan denominated in Japanese yen, using the existing investment as collateral, for a new investment scheme denominated in pounds sterling, intending to take advantage of the low interest rate for yen-denominated loans. Unfortunately, the yen strengthened and the corresponding liability under the yen loan (relative to the pounds sterling-denominated investment) increased, causing Ms Field to suffer a loss. The court, having considered that Barber Asia was never paid by Ms Field for services rendered but merely received commission from companies whose products Ms Field had acquired through Barber Asia, found that there was no contract, express or implied, between Ms Field and Barber Asia. Nevertheless, the court found that Barber Asia had been negligent in advising Ms Field because it failed to heed her stated desire to adopt a conservative investment strategy and to warn her of the existence and nature of the risks involved and, as such, breached its duty of care to Ms Field. The court confirmed that if an investment advisor assumes the responsibility of providing advice to a plaintiff, and knows or ought to know that the plaintiff is likely to rely on that advice, a duty of care is likely to arise. Pertinent factors to take into account will also include the relative skill and knowledge of the parties, the context in which the advice is given, whether the giver of the advice is doing so completely gratuitously or is getting a reward (whether in some direct or indirect form) and whether or not there are any express disclaimers of responsibility. Following the decision in Susan Field v Barber Asia, financial advisors should always ensure that their advice is consistent with the investment objectives of the investor and all of the risks have been adequately explained to, and understood by, the investor. A mere general introduction of the products is not considered sufficient to discharge this duty of care. The extent of the applicability of this case remains to be seen. One major difference between the Susan Field v Barber Asia case and the current minibond saga is that the initial investment product purchased by Ms Field, as found by the court, was one that could be regarded as conservative it was the subsequent investment strategy to gear up the lowrisk investment and to take on exposure to fluctuation in currency exchange rate that gave rise to a high risk. This is contrasted with the inherently risky nature of the minibonds. In addition, Ms Field was not provided with any introductory brochure for the high-risk investment strategy, whereas all the minibonds were sold with prospectuses. Hence, arguably, the Lehman Brothers minibond holders made their investments with their eyes open. 4 Freshfields Bruckhaus Deringer LLP, 16 December 2008

5 This material is for general information only and is not intended to provide legal advice. Freshfields Bruckhaus Deringer LLP Selling practices review In recent weeks, distributors in Hong Kong have been busy reviewing their past and existing selling practices to determine whether there were any systemic weaknesses or failures of management controls in connection with the sale of Lehman minibonds and other high-risk structured products. The objective is to make sure that the population of affected customers is clearly defined and to determine whether any of those affected customers have legitimate complaints. Only then will distributors be able to make an accurate assessment of their potential liability, if any. Subject to appropriate claims for legal professional privilege, a distributor will also need to be prepared to deal with requests for information from the HKMA and the SFC on their review of prospectuses and marketing materials. The disclosures must be factually correct and not misleading. Issuers and arrangers of retail investment products, particularly structured products such as the minibonds, should: review whether risk disclosure and product descriptions were adequate; determine whether the marketing materials issued were clear and fair and presented a balanced picture, with adequate and prominent risk disclosure in compliance with all applicable regulations; and determine whether their marketing materials included up-front, prominent and adequate warnings of all risks. The distributors, in reviewing past sales, will need to assess whether the products were suitable for their customers, consider whether their selling procedures were sound and determine whether their staff explained the nature and characteristics of the investments that they sold and gave clear and competent advice to their customers about the options available to them. It is important that the distributors formulate a strategy at an early stage for dealing with the different aspects of the problem. This includes dealing with the customers, the regulators and others, such as the press. Outlook One important question that still remains is whether any investors will be able to get back any portion of their money. The banks have agreed to the government s buy-back proposal and the HKAB expects to finish calculating the value of some minibonds in December. It has not been agreed whether the compensation will be based on the market value of the collateral, the initial principal amount of the minibond or an amount falling somewhere in between. So far, we are aware only of a valuation being conducted for structured notes (not minibonds) by DBS Group Holdings, the Singapore-based bank, and the result was that all but a few such notes were found to be worthless. However, such products were directly linked to the credit of Lehman Brothers, which is not the case with many of the minibonds. Whatever happens, the regulatory framework covering the sale of high-risk structured products is likely to undergo significant changes and selling processes for such products are likely to be significantly tightened. Inevitably, painful lessons will need to be learned as part of this process. For further information please contact Richard Chalk Partner, dispute resolution and contentious regulatory T E richard.chalk@freshfields.com Perry Sayles Partner, structured finance and derivatives T E perry.sayles@freshfields.com Lea-Anne Lee Senior associate, financial services and non-contentious regulatory T E leaanne.lee@freshfields.com Freshfields Bruckhaus Deringer LLP is a limited liability partnership registered in England and Wales with registered number OC It is regulated by the Solicitors Regulation Authority. For regulatory information please refer to Any reference to a partner means a member, or a consultant or employee with equivalent standing and qualifications, of Freshfields Bruckhaus Deringer LLP or any of its affiliated firms or entities. 5 Freshfields Bruckhaus Deringer LLP, 16 December