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FEATURE |
MAS Investigation Report on the Sale and Marketing of Structured Notes Linked to Lehman Brothers: Where the Financial Institutions Went Wrong
The Lehman Brothers-linked Notes debacle rippled unpleasant consequences on economies the world over, including Singapore’s. This article examines the chain of events that led to this collapse.
The bankruptcy of Lehman Brothers triggered an investment nightmare for many investors in Singapore (as well as overseas). Complex Structured Notes1 linked to Lehman Brothers were sold to thousands of retail investors2 who might not have fully understood what they bought. Few, if any, would have appreciated that when they bought these Structured Notes, they were actually selling protection against the default of a basket of underlying Reference Entities (some 100-200 Reference Entities), the issuer, the swap counterparty or the swap guarantor on a “first-to-default” basis in a Credit Default Swap. To understand how it works, take the case of the Pinnacle Notes. These Notes were referenced to100 Reference Entities (or “Synthetic Collateralised Debt Obligation Reference Entities” or “Synthetic CDO Reference Entities”). Five of these Reference Entities (including Lehman Brothers) defaulted, thereby triggering a “Credit Event”. As a result of the Credit Event relating to the bankruptcy of Lehman Brothers, the early redemption value of the Pinnacle Notes dropped to zero (because there were no buyers in the market). In other words, whatever the principal amount invested, it was wiped out. The worst case scenario.
How many retail investors (including the elderly and less literate) understood that as purchasers of the Structured Notes, they had stepped into the shoes of “Protection Sellers”, taking on the credit risk of any of the Reference Entities and other defaulting parties (hence, it is called a “Credit Default Swap or “CDS”)? Many of the Relationship Managers who sold these CDS never understood them either. Many did not understand that the “first-to-default” concept means that if any one of the 100 Reference Entities were to default, it would trigger a Credit Event for the entire CDS. Some of them apparently told the clients that if one of the Reference Entities were to default, it was still safe because there were remaining Reference Entities left in the “basket”.
Many retail investors who lost their investments – not without justification – accused the 10 financial institutions3 (“Distributors”) which sold these Structured Notes of “mis-selling”. Because so many retail investors (including the vulnerable customers) suffered heavy losses, MAS stepped in. After seven months of investigations into the conduct of the 10 Distributors, MAS issued the “Investigation Report on the Sale and Marketing of Structured Notes linked to Lehman Brothers” on 7 July 2009 (“MAS Report”). The 99-page MAS Report is detailed and revealing. It points out clearly where each of the 10 Distributors has failed to comply with the standards required under the Financial Advisers Act (“FAA”).
Owing to the numerous operational lapses by the 10 Distributors, MAS took the unprecedented step of issuing a direction to prohibit them from distributing Structured Notes for periods ranging from six months to two years.4 Altogether 3,704 retail investors were compensated5 by the 10 Distributors with the total sum of $107 million (out of $373 million invested).
This article examines where the 10 Distributors have been found by MAS to have failed to satisfy the standard of conduct required under the FAA. The focus of this article is on the retail investors.
The regulatory framework governing the conduct of FAs in providing financial advisory services is found in the FAA, the MAS Notice and MAS Guidelines. The key provision in the FAA is s 27, which requires all FAs, when making a recommendation with respect to an investment product, to have a reasonable basis for their recommendation. The MAS Notice refers to “Notice on Information to Clients and Product Information Disclosure” (FAA-NO3”) and the MAS Guidelines refers to the “Guidelines on Standards of Conduct for Financial Advisers” (“FAA-NO4”).
The key provisions of FAA-NO3 are summarised below:
1. Para 10: FA not to make false or misleading statements;
2. Para 11 (b)(ii): FA to prominently present the warnings and to explain the risks; and
3. Para 11(c)(iii): opinion to have reasonable basis and to state that it is an opinion.
The key provisions of FAA-NO4 are summarised below:
1. Para 4.1: FA to act with competence;
2. Paras 4.3 & 4.4: FA to ensure employment of suitably qualified representatives and to provide relevant training;
3. Para 5.1: FA to act with due care and diligence;
4. Para 5.4: FA to have adequate systems and procedures in place to supervise its representatives;
5. Paras 6.3 & 6.4: FA to disclose material risks and draw clients’ attention to warnings, exclusions and disclaimers;
6. Para 6.5: FA to give clear, adequate, not false or misleading information;
7. Para 6.6: FA to distinguish between facts and opinion; and
8. Para 10.2: FA to ensure its representatives comply with applicable laws, rules and regulations.
Let us examine where the 10 financial institutions went wrong in their sale of the Structured Notes to the retail investors.
FAs are required under para 5.1 of FAA-G04 to act with due care and diligence and s 27 of the FAA requires FAs to recommend with reasonable basis. Hence, MAS expects FAs to conduct “product due diligence” before they sell their financial products to the investors. This is a due diligence process on the product to determine:
1. the risk rating of the product eg, “conservative”, or “balanced” or “growth” or “aggressive”; and
2. the target client segment or profile for whom the product is suitable.
This is to ensure that the product an FA recommends is suitable to the client’s needs. This is the “suitability” rule in s 27.
With the exception of DBS Bank, the Distributors either completely failed to conduct any product due diligence (in the case of the six securities firms) or where they did, they got it wrong. For instance, Maybank initially wrongly classified the Minibonds series as “conservative” (when the prospectus clearly stated that they “can involve a high degree of risk”). As a result, 64 sales were made to “conservative” and “moderate” investors. Hong Leong too wrongly classified the Minibonds and the Pinnacle Notes as “low to medium” investors (where the Pinnacles prospectus clearly stated that they “are only suitable for investors willing to take considerable risks”). Due to the wrong classification, 882 sales were made to “conservative” investors and a further 428 sales were made to investors with no experience. Perhaps this explains why Hong Leong compensated (in full) the largest number of investors (893).
As a result, MAS found that the Distributors failed to meet the standards in para 5.1 and para 10.0 (failing to ensure compliance with s 27) of FAA-G04.
Paras 4.3 and 4.4, FAA-G04 require all FAs to ensure that they employ suitably qualified representatives to sell the investment products and to provide relevant training to equip these representatives. Hence, MAS expects all FAs to conduct product briefing for the representatives before they are allowed to sell the product. If a representative missed the product briefing, he is expected to attend a replacement class or a personal coaching. MAS expects all attendance to be compulsory and all attendances are to be recorded. However, the MAS Report found that almost all the Distributors failed to comply with paras 4.3 and 4.4 of FAA-NO4.
All the six securities firms did not make product briefing compulsory. The other Distributors either did not monitor attendance or they had no attendance record for the replacement briefings or coaching. As a result of these lapses, many representatives were allowed to sell Structured Notes without attending the product briefings.
Besides performing the product due diligence, FAs are expected to perform due diligence on the customer to determine the “risk profile” of the customer. They may be classified as “conservative”, “moderate” or “aggressive”. This is to ensure that the risk rating of the product matches the risk profile of the customer. This is required under para 5.1 and para 10.2 of FAA-GO4 (to comply with the law eg, s 27). The prospectus of the Structured Notes also contained various “risk warnings” to alert investors that the Notes are only suitable for certain investors who are prepared to accept considerable risk.6 FAs are required, under para 11(b)(ii) of FAA-NO3 and para 6.3 of FAA-GO4, to draw the client’s attention to these warnings. However, MAS found that several of the Distributors failed to comply with these provisions.
The risk profiling questionnaire in ABN AMRO’s fact-find-analysis contained an error which resulted in 44 clients given a higher risk profile than they should have been given. This may result in selling Structured Notes to the wrong investors. The High Notes (“HN5”), issued and arranged by DBS, clearly stated in its pricing statement that they “are not suitable for inexperienced investors”. Yet DBS sold HN5 Notes to 54 clients with no investment experience. These investors who suffered loss and who are not compensated, may allege that these banks have failed to comply with the “suitability” rule in s 27, FAA.
Hong Leong and Maybank committed the same error in failing to provide scoring for their client profiling. By failing to provide scoring for their “client investment experience”, “investment time horizon, experience and diversification needs”, both Distributors would not be able to determine the client’s risk profile. Without an accurate client risk profile, the Distributors would be in danger of mis-selling ie, recommending without reasonable basis. Hong Leong also erroneously classified the Minibonds under “bond fund” category. Minibonds (being Structured Notes) were higher risk products than bonds (corporate/sovereign) in the capital market.
Kim Eng Securities committed several errors in re-writing the prospectus with its own write-ups. MAS found that the write-ups contained a number of inaccuracies and misleading statements that were inconsistent with the prospectuses and pricing statements.
First, it stated that the Minibond series and the Jubilee Notes were very low risk when these Notes clearly stated that these were “sophisticated instruments and can involve a high degree of risk”. Secondly, it stated that the investors would be able to receive their principal sums together with the coupons ie, interest, as long as none of the Reference Entities experienced a Credit Even. This was inaccurate because the investor would still not receive their principal and coupon should the issuer or Swap Counterparty (which pays the investors from their investments) or the Swap Guarantor default. Thirdly, it further stated that the Minibond Series 2 and 3 were backed by a portfolio of corporate debt. MAS found this to be materially false because the pricing statement clearly stated that the Notes would be backed by a portfolio of credit-linked notes or Synthetic CDOs. Lastly, MAS also found that the statement in the write-up that the proceeds from the subscription of the Notes would be invested in a portfolio of credit issues linked to the basket of Reference Entities to be materially false. The pricing statement of the Notes clearly stated that the proceeds would be invested into a portfolio of credit-linked notes or Synthetic CDOs. MAS found that Kim Eng Securities had breached the various provisions mentioned above, including para 6.5 of FAA-GO4 (making false and misleading statements).
As a matter of general observation, MAS found the common failing in the Distributors product briefing materials was that it did not highlight the fact that the performance of the underlying securities themselves was a source of risk to the performance of certain of the Minibonds Notes and the risk of the significant loss of principals on early redemption of the Minibonds Notes.
Under s 27, all FAs must have a reasonable basis when they recommend an investment product. To achieve this, FAs are expected to perform product due diligence and to determine the risk profile of the client so that the recommendation is suitable to the client’s needs and risk profile. So a “needs-analysis” is typically performed in accordance with MAS “Notice on Recommendation on Investment Products” (F“AA-NO1”). This is also to determine whether a client wishes to receive advice or recommendation.7 If the client elects “product advice”, “no advice” or “execution only”; the FA is freed from having to advise the client. In such cases, s 27 does not apply. Another method used by some Distributors to avoid s 27 was to use “introducers” in such a way that the Distributors do not have to advise the purchasers of the Structured Notes they sold to.
Most of the securities firms Distributors opted for “execution-only” when they sold the Structured Notes to their clients. They took the view that they need not have to perform product due diligence nor had did they need to conduct any due diligence on their clients because they were not advising their clients. They understood their role was merely to process their clients’ orders and to execute them. However, MAS found that these Distributors permitted their representatives to express opinions on the Notes despite adopting the “execution-only” approach. This, according to MAS, amounted to “advising others concerning any investment product” (one of the four FAA regulated activities). Hence, for such cases, MAS took the view that they still must comply with para 11(c)(iii) of FAA-NO3. That is to say, if they express an opinion, it must have a reasonable basis. In other words, they are still “caught” under s 27. It is submitted that MAS is right to adopt this interpretation, for those cases where opinion were given by the Representatives. The law looks at the substance, but never the form, of the transaction.
Pursuant to reg 31 of the Financial Advisers Regulations and MAS “Notice On Appointment and Use of Introducers as Financial Advisers (“FAA-NO2”), OCBC Securities and Phillip Securities engaged certain licensed FAs as “Introducers”8 to introduce clients to them to purchase the Structured Notes. However, they both adopted the “execution-only” approach in their sales process. Hence, they both did not offer advice to the purchasers of the Notes they sold to. Also, none of the Introducers advised the purchasers either because, according to reg 31 and the FAA-NO2, Introducers were not allowed to advise the clients they introduced. So, if an introduced investor wanted investment advice on the Notes he bought, he would not be able to receive any advice from the two Distributors and the Introducers. For such an investor, he was deprived of any opportunity to seek advice. MAS considered this to be an abuse of the “Introducer” regime under the FAA. MAS expected both OCBC Securities and Phillip Securities, as exempt FAs, when providing FA services, to be prepared to advise their clients who bought their financial product under this arrangement (since the Introducers were not allowed to advise).
It is submitted that MAS is right in adopting the above stand. For this abuse, OCBC Securities is banned indefinitely from using Introducers for all its FAA activities (not just selling Structured Notes). Phillip Securities got away with a lighter “sentence” of an overall one year ban (for Structured Notes).
Besides these 10 financial institutions, MAS is now looking into specific cases where individual representatives have mis-sold the Structured Notes.9 Investors who lost money and are contemplating suing the 10 financial institutions and the representatives would be waiting eagerly for this second report by MAS.
Following the debacle of the Lehman Brothers-linked Notes, MAS came up with two important initiatives. First, the issuance of “Guidelines on Fair Dealing-Board and Senior Management Responsibilities for Delivering Fair Dealing Outcomes to Customers” (“FAA-G11” or “Fair Dealing Guidelines”). Second, the much awaited Consultation Paper on the “Review of the Regulatory Regime Governing the Sale and Marketing of Unlisted Investment Product” (“Consultation Paper”).
The Fair Dealing Guidelines is a powerful set of MAS guidelines directed at the Board and Senior Management itself to ensure its institutions deal fairly with its customers (particularly retail customers). It is a “top-down” directive which is aimed to yield better compliance from the senior management down to the representatives. Briefly, MAS expects all FAs to deliver the following five fair dealing outcomes to its customers:10
1. Outcome 1: “Customers have confidence that they deal with financial institutions where fair dealing is central to the corporate culture.”
2. Outcome 2: “Financial institutions offer products and services that are suitable for their target customer segments.”
3. Outcome 3: “Financial institutions have competent representatives who provide customers with quality advice and appropriate recommendations.”
4. Outcome 4: “Customers receive clear, relevant and timely information to make informed financial decisions.”
5. Outcome 5: “Financial institutions handle customer complaints in an independent, effective and prompt manner.”
Whilst the Fair Dealing Guidelines focus on the fair dealing aspects in dealing with customers, the Consultation Paper seeks to strengthen the FAA regulatory regime governing the marketing of investment products. It is aimed at:
1. the promotion of more effective disclosure by improving the quality of information given to investors;
2. the strengthening of fair dealing in the sale and advisory process; and
3. enhancing MAS’ powers for breaches of the FAA.11 The key proposals include:
a. inclusion of a Product Highlights Sheet in addition to a prospectus;
b. restrictions on marketing materials: comparing the product with traditional bank deposits and the use of the term “capital/principal protected” (as opposed to “capital/principal guaranteed”);
c. restricting sales without advice to only customers who contact the bank unsolicited;
d. prohibiting bank tellers from referring retail customers to their representatives to purchase investment products;
e. remuneration structure of representatives (not to reward them according to sales targets alone);
f. complex investment products (not to be sold without advice and to carry “health warning”);
g. more vigorous product training for representatives;
h. seven days “cooling-off” period for unlisted debentures; and
i. the inclusion of civil penalty similar to those under the Securities and Futures Act (which includes “coat-tail” actions by investors).12
Will these two MAS initiatives prevent any Lehman Brothers type of investment fiasco in future? Only time will tell.
Tan Sin Liang*
S L Tan & Co
E-mail: sltannco@singnet.com.sg
*The author’s areas of practice are in regulatory compliance and derivatives.
1 “Structured Note” is defined in the Securities and Futures (Offers of Investments) (Shares and Debentures) Regulations 2005 to mean any type of debentures or units of debentures:- (a) which are issued:- (i) pursuant to a synthetic securitisation transaction; or (ii) by a specified financial institution; and (b) in respect of which:- (i) either or both of the principal sum and any interest are payable; (ii) one or more of the underlying securities, equity securities, equity interests are payable, and one or more of the underlying securities, equity interests, commodities and currencies are to be physically delivered, in accordance with a formula based on one or more of the following: (A) the performance of any type of securities, equity interests, commodity or index, or of a basket of more than one type of securities, equity interest, commodities or indices; (B) the credit risk or performance of any entity or a basket of entities; (C) the movement of interest rates or currency exchange rates.
2 $373 million of Minibonds were sold to 7,800 retail clients, $104 million of High Notes 5 were sold to 1,000 retail customers; and $18 million of Jubilee Notes were sold to 350 retail clients.
3 The 10 financial institutions are: ABN AMRO Bank, Malayan Banking, DBS Bank, Hong Leong Finance, CIMB-GK Securities, DMG & Partners Securities, Kim Eng Securities, OCBC Securities, Phillip Securities and UOB Kay Hian.
4 DBS Bank, ABN AMRO, Maybank and UOB Kay Hian were banned for six months. Hong Leong Finance was banned for two years and CIMB-GK, DMG Partners Securities, Kim Eng Securities, OCBC Securities and Phillip Securities were banned for one year.
5 Full or partial compensation: ABN AMRO (262), DBS (197), Maybank (1,100), Hong Leong Finance (2,048), remaining Distributors (297). Full compensation: ABN AMRO (91), DBS (64), Maybank (325), Hong Leong Finance (893), remaining Distributors (11).
6 The prospectuses to the Minibond Series and the Jubilee Series contained the following statements:
… the Notes are sophisticated instruments and can involve a high degree of risk.
The Pinnacle Series prospectus clearly stated:
… the Notes are sophisticated instruments and involve a high degree of risk ... give the highly specialised nature of these Notes, the Issuer and the Arranger consider that they are only suitable for investors willing to take considerable risks, who are able to determine for themselves the risk of an investment linked to derivatives and who can absorb a partial or complete loss of principal.
The pricing statement of HN5 also clearly stated:
an investment in structured products such as the Notes involve substantial risks ... structured products such as the Notes issued under the Programme are not suitable for inexperienced investors.
7 An investor can opt for any of the following four types of fact-find/needs analysis under FAA-NO1:
a. Full fact-find: This means the investor is prepared to disclose all information required by the FA and he wishes to receive recommendations on investment products that are suitable for him. Based on the information given, the FA then conducts a needs analysis of the investor and then recommends investment products suitable for him;
b. Partial fact-find: Same as (a), except the information given are not full but sufficient for FA to perform a needs analysis on the investor;
c. Product advice: This means the investor does not want to go through (a) and (b) above; he just wants to receive advice from the FA on a particular type of investment product based on his specific information; and
d. No advice (“Execution-only”): This means the investor does not want to go through (a), (b) or (c); he does not want any advice, he merely wants the FA to assist him to complete the relevant forms. Based on industry practice, option (a) is rare. Option (d) appears to be the more prevalent practice in the sale of the Structured Notes.
8 OCBC Securities and Phillip Securities engaged nine and two licensed FAs, respectively, as Introducers.
9 Para. 6, page (ii).
10 Para. 4, page 2.
11 Para 2.3.1, page 10.
12 Under the SFA regime, where a contravener has been convicted or ordered to pay a civil penalty by the court, the court may fix a date for all affected investors to file and prove their claims for compensation. Thus an affected investor can ride on the “coat-tail” of a criminal conviction or a civil penalty action brought by MAS. The advantage is that each investor need not have to file individual civil suits against the contravener for compensation.