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Mnibonds: no small affair
Amid all the outwash from the financial tsunami, perhaps the most significant outpouring of regulatory interest in Hong Kong has been the fallout from the sale of Lehman Brothers-backed minibonds to Hong Kong investors. This story is a microcosm that represents the ultimate intersection between Wall Street and Main Street, and highlights how the convergence of social, political and business interests and needs can shape regulation.
First, the facts as they presently appear to be with regard to Lehman Brothers. The "minibond" product was a basket of collateralised debt obligations and credit default swap contracts, which Lehman Brothers guaranteed. A number of banks and financial institutions distributed the investment product to the Hong Kong public. Around 40,000 investors in Hong Kong who purchased these "minibonds" have suffered losses as Lehman Brothers has now filed a petition under Chapter 11, and is unlikely to be able to meet its obligations as guarantor in respect of the investment product. The present regulatory reviews are focusing on whether investors were properly apprised of the nature of the investment product and the corresponding risk.
There is one unarguable fact. Investors have made losses, many of whom are general members of the Hong Kong public, and not sophisticated investors. This has led to a public outcry and a political response. The Hong Kong government has intervened and agreed to buy back the minibonds. This will not fully compensate investors as market price is now significantly lower than original acquisition price. Nonetheless, the move has been broadly accepted as an appropriate political response to the social concern that losses were suffered by an unsuspecting public.
Let us assess issues from a legal, and then a regulatory, perspective. The primary contract was between the investors and Lehman Brothers. Lehman Brothers is in Chapter 11. Investors' losses are unsecured. Chances of recovery are slim or distant. The next port of call is the distributors of the minibonds. Any civil claim by investors against the distributors of the minibonds will be grounded in the laws that relate to misrepresentation and negligence.
A misrepresentation occurs when a person makes an untrue statement of fact or law which induces another to enter into a contract, and upon which he relies, and in consequence of which he suffers loss. A fraudulent misrepresentation requires proof that the misrepresentation was made knowingly without belief in its truth, or recklessly with indifference to its truth — this is difficult to prove.
A negligent misrepresentation, based on the Misrepresentation Ordinance, is more claimant-friendly. The claimant must prove that a misrepresentation of fact was made, that the misrepresentation continued to the point of the contract, and that the fact was incorrect at the time of the contract. Once the party who has suffered the loss proves, however, that the representation was, in fact, false, then the onus is upon the party who made the representation to prove that he reasonably believed in the accuracy of the statement up to the time the contract was entered into. #p#分页标题#e#
What, however, was the misrepresentation? This boils down to issues of mis- description. This may appear to involve statements of opinion, rather than fact, but the courts have moved to a view that a statement of opinion is actionable if it contains the implicit representation that there are reasonable grounds for holding that opinion. Specifically, recommendations of an investment product that a regulated person make are likely to be considered to contain implied representations that he has considered the nature of the investment product, that he has assessed the needs of the investor, and that the investment product meets those needs.
Also, the recent Field v Barber Asia Limited litigation highlights the impact of the law of negligence. In that case, a duty of care was held to arise regardless of the existence of contractual terms between the parties, and that the investor should have been provided with investment information that a reasonable investment adviser would consider necessary to provide and to warn of particular gearing risks.
It is too early to say whether the distributors of minibonds have incurred legal liability to investors. If there were client agreements, it is possible that those client agreements contained provisions that fashioned the scope of the liability of distributors in contract and negligence. This could be achieved by clearly setting out the role of the distributor and limiting any representations, implied or otherwise, to that role, and by imposing duties on investors to make disclosures to the distributors to assist the distributor to identify investment objectives and risk appetites. Additionally, the client agreement could contain disclaimers and warning statements. Further complexities may arise if the only agreements are between Lehman Brothers, not the distributing banks, and investors. Ultimately, however, much will depend on what the registered or licensed persons of the distributors said to investors, as the Barber case illustrates circumstances in which a person advising on investment products can assume responsibility, and create a duty of care, independently from the contract.
Civil claims may, at worst, lead to an award of damages against the distributors. This does not deal with the regulatory risk that the distributor faced.
The regulatory aspect Hong Kong regulation is based on a sectoral approach, under which separate regulators focus on different aspects of the financial services industry. For instance, the Hong Kong Monetary Authority regulates banking and deposit-taking activity, and the Securities and Futures Commission regulates a broad range of financial services that concern dealing or advising on securities or foreign exchange, and fund management. The benefit of a sectoral approach is that it facilitates a tailored and sophisticated regulatory approach to specific sections of the financial economy.
The alternative approach, where there is a "super-regulator" for the entire financial services industry — such as the Financial Services Authority in the United Kingdom — avoids duplication of regulation, but also carries a risk of increased or cumbersome bureaucracy. The handling of the regulatory issues in respect of the minibonds highlights the Hong Kong approach to regulatory overlap inherent in a sectoral approach to financial regulation. #p#分页标题#e#
Already, the Hong Kong Monetary Authority has reviewed information received from aggrieved investors and has referred a number of matters to the SFC. This is a concrete example of the cooperative arrangements between HKMA and the SFC in respect of the regulation of persons working with banks who are involved in regulated activities such as promoting and advising on investment products. The HKMA, as the front-line regulator, will take the lead, but the SFC will take enforcement and regulatory action. Under the SFC's Code of Conduct that applies to registered and licensed persons, the areas of enquiry of the SFC will include breaches of the general principles concerning:
• Honesty and fairness, which includes the duty to ensure that representations made and information given to clients are accurate and not misleading.
• Diligence, which includes the duty to act diligently and carefully in providing advice and ensuring that advice and recommendations are based on thorough analysis and taking into account available alternatives.
• Information about clients, which includes the general obligation to ensure that a recommendation is suitable for the client in all the circumstances, and specifically that the client understands the risks of any derivative or leveraged product and that the client has sufficient net worth to assume the potential losses.
The SFC has identified two types of mis-selling, which are addressed in the Code of Conduct. First, when an investor is given materially wrong information about a financial product which induces him into making an investment decision. Second, when an investor is sold an investment product that is not suitable to his particular risk profile. The degree of public outrage suggests that the minibonds may not have been sold to suitable members of the public; however, it remains to be seen which type of mis-selling (if any) has occurred.
The SFC has already commented that investors need to be presented with a clearer picture of product risks, bearing in mind how the products will operate in market conditions, including extreme market circumstances and bankruptcy. One suspects that the SFC will take particular interest in reviewing the internal controls and procedures in respect of the sale and distribution of the minibonds.
The consequences of a breach of the Code of Conduct, apart from disciplinary sanctions such as public reprimands, fines, suspension and revocation, are inextricably linked with issues of investor confidence and reputation. The repercussions can already be seen in the active approach that some distributing banks have taken to offer to compensate investors where proof of mis-selling is established. It remains to be seen whether this will effectively deal with all the issues that specific investors may have, but the move also has the effect of allaying investor confidence and helps to limit any loss of goodwill or reputation. #p#分页标题#e#
The social and political environment has created the regulatory need to be seen to respond promptly. This, in turn, adds another element to the mix. Canny investors may wish to allow the regulators to progress with its enquiries, as the outcome of those enquiries may yield information or outcomes that may influence whether an investor will take the costly and potentially risky step of issuing legal proceedings. The regulatory investigations and the risk of civil proceedings are indirectly, but inextricably, linked.
Regulatory reports
In January 2009, the financial secretary published the SFC's and HKMA's incident reports on the minibonds crisis. The stated aim of the reports was to recommend ways in which the regulatory structure could be strengthened and investors could be better protected. Their impact is significant. The reports are framed as forward- looking documents, although they could be utilised by complainants as a "best practice" manual. The reports outline the types of allegations made against minibonds distributors. They include:
• Front-line staff failed to consider the risk profile and personal circumstances of their customers, particularly in the case of less-sophisticated, risk-averse investors.
• Front-line staff failed to provide customers with product information or explain product features and inherent risks.
• Front-line staff misrepresented that minibonds were a risk-free alternative to fixed deposits.
These complaints have led to an exploration by the SFC and HKMA as to whether the current regulatory system should be revised.
Let us look at some of the areas of focus in the HKMA and SFC reports and discuss the recommendations proposed.
Product documentation
One of the ways in which minibonds investors were provided information was by way of prospectus. Generally, before shares and debentures are issued, a prospectus is prepared. The SFC authorises and registers the prospectus. This does not mean, however, that the SFC "endorses" the prospectus. Ultimately, the SFC relies on the financial institution (and its professional advisers) to ensure that the prospectus complies with disclosure standards. The increasing complexity in financial products, however, has placed considerable strain on product documentation. The complexity of the product, coupled with issuer's need to protect against liability, has meant that documentation has become inordinately lengthy.
Minibonds investors have complained that product documentation was so lengthy and complex that they did not understand it (despite signing statements to that effect). The HKMA and SFC state in their reports that there is a need for clearer product descriptions with prominent risk disclosures. Regulators have recommended that issuers should provide a "product summary", which sets out in concise, clear language, the main features of the product and its risks. Does providing a product summary resolve the problem? Invariably, distributors will seek to protect themselves by qualifying the summary, and requiring that investors read the underlying documentation in any event. #p#分页标题#e#
Nevertheless, there is obvious merit to the argument that documentation written in clear, concise English would be better understood. Product summaries would serve a useful function in outlining investment products in a way that is manageable. The HKMA has sought to further this approach by recommending the introduction of a "health warning system", which delivers simple, clearly discernible warnings as to the risks in relation to retail structured products with embedded derivatives. This recommendation is limited to structured products with embedded derivatives, however, it does highlight that issuers should clearly outline the nature of the product, and its risks to investors. This obligation is nothing new.
Point-of-sale
Another area of complaint from minibonds investors is the way in which minibonds were sold. Currently, in Hong Kong, front-line bank staff can offer the whole spectrum of banking services, from fixed-term deposits to complex investments. Arguably, this allows customers to be steered away from simple, secure products towards riskier, more complex options. The HKMA and SFC have recommended a review of the banking structure which allows banks to use their ordinary business channels to help sell investment products.
There are several problems with the current system. First, customer perception; if the same member of staff is dealing with fixed deposits as well as investment products, it could imply, by circumstances alone, that investments are a safe, risk-free alternative to fixed-term deposits. Second, convenience; complex, risky products, may be too readily available to the general public.
The HKMA has, therefore, recommended that banks should take steps to ensure that there is a clear differentiation between traditional deposit-taking activities and retail securities, by taking measures such as physical segregation, using different staff to sell investment products, and to make clear through "physical signs and warnings" the distinction between deposits and investments. The HKMA has also recommended that risk assessment of investment products be carried out independently from the sales function. This measure is designed to ensure that a risk review is conducted independently from sales pressures. The current system of risk assessment is carried out by way of "profiling", which the staff that are attached to the sales function of the bank conduct. There is obvious potential for conflict of interest. By segregating the risk and sales function, the HKMA hopes to introduce a greater degree of impartiality into both processes.
These measures suggest that banks have failed to ensure that recommendations have been based on thorough analysis of investors' circumstances. The SFC and HKMA can point towards weaknesses in the regulatory system, however, market participants are still under an obligation to act honestly and fairly, and to exercise due diligence. The reports are, therefore, a cause for concern. Certain aspects of the reports appear quite critical of certain sales tactics; for example, the use of marketing gifts. Gifts, such as shopping vouchers, were offered to minibonds investors in return for their subscription. Regulators have recommended a review of these practices, which suggests that they might already fall foul of principles outlined in the code. #p#分页标题#e#
Other measures in the reports also suggest that banks did not exercise the necessary care when recommending minibonds to retail customers. Regulators have recommended introducing a "cooling-off" period in which an investor must take some time out before finalising a purchase. Regulators have also recommended introducing audio recording in risk assessment and sales processes to create more accountability. More regulation, however, is not necessarily better regulation. Ultimately, bank staff are responsible for ensuring proper suitability and disclosure requirements are carried out. Regulators can put in place the checks and balances, such as cooling-off periods, but at the point of sale, it is bank staff who must deliver services in accordance with the code. The HKMA and SFC recommendations, which increase the level of regulation, strongly suggest that banks have, on their own, failed to carry out care and diligence when dealing with customers.
Dispute resolution
The minibonds crisis has placed a considerable strain on the current regulatory system. Disgruntled investors have lodged thousands of complaints. The HKMA and SFC can look into these complaints as part of their investigative powers. They cannot compel any financial institution to pay compensation. Investors in Hong Kong are, therefore, forced to seek reparation via the courts. Trial is a costly and time- consuming process. Accordingly, the HKMA and SFC have recommended that a grievance procedure be introduced where complaints could be handled by dispute resolution outside of the courts. Regulators have not provided significant details of the scheme, as yet; however, this kind of process will undoubtedly shift the way in which parties resolve their disputes.
The SFC has stated that it will be conducting a "top-down" investigation into whether the sale of the minibonds was the result of any systemic weakness. This type of review suggests that significant changes may be on the horizon. Certainly, the admission by leading financial figures, such as Alan Greenspan, that banks and financial institutions cannot be left to regulate themselves, represents a significant shift in attitude towards the free-market model. The minibond issue is fascinating. It highlights many elements of regulation, both theory and practice, and how regulation is woven into the fabric of a functioning society. It is premature to make any conclusions about the minibond story, or to predict what, if any, changes may result for the regulatory landscape in Hong Kong as a result. A safe prediction is that the regulators will deliberate and reach conclusions, and that litigators will have some busy days ahead. If our wish is to live in interesting times, then presently our cup runneth over.
Pádraig Walsh is a partner and heads the firm's Hong Kong Financial Services Practice. He has extensive experience in advising clients in the financial services market on regulatory and compliance matters, and also assists funds and investment managers in their Hong Kong operations. #p#分页标题#e#
This article was first published in Complinet .
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