An overview of the Lehman Brothers minibonds saga
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b r i e fing su mma ry 16 D e c e m be r 2008
An overview of the Lehman
In the wake of the collapse of Lehman
Brothers, so-called ‘minibonds’ have caused
a great deal of controversy in Hong Kong.
Brothers minibonds saga Questions have been raised over the sales
and marketing practices of distributors and
whether complex structured products are
Fin an cial service s m a rket d evel o p m ents 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? Lehman Brothers Commercial Corporation Asia or
Lehman Brothers Asia, as arranger (the arranger),
Minibonds are structured derivative products linked to
arranged for the minibonds issued by the issuer to be
the credit of certain specified reference entities. The term
distributed by the distributors (typically retail banks) to
‘mini’ is thought to indicate that these bonds were sold in
retail investors in Hong Kong. Minibond holders were
smaller minimum denominations (which were as low as
entitled to receive a coupon payment on a periodic basis.
HK$40,000 in certain cases), making them affordable to
The proceeds of sale were used by the issuer to purchase
retail investors.
certain US-dollar-denominated underlying assets (the
Structured products having a similar structure to that of collateral) selected by the arranger on behalf of the issuer.
minibonds were commonly sold to institutional investors Those assets included collateralised debt obligations
as credit-linked notes in many jurisdictions. However, it (CDOs) and other asset-backed securities. The collateral
was not very common for such structured products to be was held by HSBC Hong Kong, as trustee.
sold to retail investors. In Hong Kong, minibonds were
The issuer entered into a swap agreement with Lehman
distributed as retail products from 2003.
Brothers Special Financing (Lehman Special Financing),
as swap counterparty, under which the issuer would pay
Lehman Brothers’ minibonds to Lehman Special Financing a sum equal to the interest
and other income it received for the collateral. Lehman
In Hong Kong, minibonds linked to the insolvent US
Special Financing in turn would pay the issuer fixed
investment bank Lehman Brothers Holdings (LBH) were
payments equal to the interest due on the minibonds.
issued by Pacific International Finance (the issuer), a
LBH guaranteed the obligations of Lehman Special
special purpose vehicle incorporated in the Cayman
Financing under the swap agreement.
Islands. According to the website of the Securities and
Futures Commission (the SFC, the independent statutory Payment of the principal amount on the minibonds was
body responsible for regulating Hong Kong’s securities linked to the performance of certain ‘reference entities’
market), a total of 36 series of minibonds were issued by identified in the relevant prospectus. The reference
the issuer in Hong Kong. It has been reported that about entities differed from series to series. Under the swap
43,700 investors in Hong Kong bought approximately agreement, if any of the reference entities suffered certain
HK$12.7bn-worth of the issuer’s minibonds. ‘credit events’ (bankruptcy, failure to make payment
on specified indebtedness or restructuring of specified
The simplified diagram on the next page shows a typical
indebtedness), the issuer would be obliged to deliver all
series of minibonds issued by the issuer, based on
of the collateral to Lehman Special Financing in return
prospectuses available on the SFC’s website.
for the payment by Lehman Special Financing to the
An overview of the Lehman Brothers minibonds saga
1 Freshfields Bruckhaus Deringer LLP, 16 December 2008A typical series of minibonds
Lehman Brothers
Holdings
Indirect ownership
Lehman Brothers Special Financing
(the swap counterparty)
Interest on Minibond
collateral coupon
Trustee Pacific Minibond
International coupon
Finance
(the issuer) Retail investors
Lehman Brothers Commercial Corporation Asia Sale
or Lehman Brothers Asia proceeds
(the arranger and calculation agent)
Interest on Sale
collateral proceeds
Collateral
issuer of the ‘credit event redemption amount’, which interest rates or otherwise) or if the market value of the
would be used to pay the principal of the minibonds. collateral were less than its stated principal amount. In
The credit event redemption amount was based on the addition, the minibonds would cease to accrue interest
market value of the reference entity’s obligations, but upon the occurrence of the credit event, but the amount
was adjusted based on the termination value of the other received by the issuer from Lehman Special Financing
components of the swap agreement and the market value would not be payable to the holders of the minibonds
of the collateral. until the minibonds’ stated maturity date.
If any of the reference entities suffered a credit event, The stated maturity date was typically three to six years
the holders of the minibonds would lose a portion of after the issue date. If no reference entity suffered a
their principal amount; this loss would be greater if credit event before the stated maturity date, and no
Lehman Special Financing were owed any amount upon other redemption event occurred, the holders of the
termination of the swap agreement (due to changes in minibonds were entitled to receive a payment on the
An overview of the Lehman Brothers minibonds saga
2 Freshfields Bruckhaus Deringer LLP, 16 December 2008maturity date equal to the liquidation value of the to the decline in the market value of the collateral at
collateral. An event of default of an asset included in the maturity or upon an earlier redemption event.
collateral, or a reduction of the principal amount of an
asset in accordance with its terms (a feature common to
Misselling investigations
many asset-backed securities), could result in a partial
redemption of the minibonds (at a loss to the holder of According to the SFC’s Enforcement Reporter
the minibonds). (issue 60), published in October 2008, misselling can be
broadly categorised into two classes. First, an investor
A purchaser of the minibonds was exposed to multiple
may be given materially wrong information about a
risks: the credit quality of the reference entities; the
financial product, leading him to make an investment
credit quality of Lehman Special Financing, as swap
decision that he would not have made if the correct
counterparty; interest rate risk; currency risk; and the
information had been provided. The second type occurs
market value of the underlying collateral.
when an investor ends up investing in a product that
is not suitable given his financial position, investment
Lehman’s collapse objectives, expectations and risk tolerance level. In
Hong Kong, thousands of Lehman Brothers minibond
LBH and Lehman Special Financing filed for bankruptcy
holders claimed that they bought the minibonds after
under chapter 11 of the US Bankruptcy Code on
being assured by banks that they were low-risk products,
15 September 2008 and 3 October 2008 respectively.
only to see the value plunge after LBH and its subsidiaries
This event constituted an event of default under the swap
declared bankruptcy in September.
agreement, entitling the issuer to terminate the swap
agreement. A termination of the swap agreement would The Hong Kong Monetary Authority (the HKMA), Hong
result in early redemption of the minibonds. The amount Kong’s de facto central bank, and the SFC have been
payable to holders of the minibonds on early redemption working closely in investigating complaints about the
would be an amount equal to the liquidation proceeds alleged misselling of Lehman Brothers minibonds. By
of the collateral, adjusted by the amount payable by 4 December 2008, the HKMA had received 19,196
Lehman Special Financing or the issuer in respect of the complaints about Lehman Brothers-related products and
termination of the swap agreement. had referred 207 cases involving complaints of alleged
misselling to the SFC.
Many of the minibonds referenced reference entities
that have not experienced credit events. However, even The Hong Kong government has also put forward a buy-
if no reference entity has suffered a credit event, upon a back proposal that has been agreed upon and accepted
termination of the swap agreement due to the insolvency by the Hong Kong Association of Banks (the HKAB)
of Lehman Special Financing, a holder of minibonds on behalf of the distributors of the Lehman Brothers
would be exposed to the credit risk of Lehman Special minibonds. According to the proposal, the banks will buy
Financing, as swap counterparty, to the extent that any back the Lehman Brothers minibonds at their mark-to-
amount was payable by Lehman Special Financing, market value.
and would also be exposed to the market value of the
The buy-back proposal, though, has hit a stumbling
collateral, which would need to be sold to redeem the
block after the issue of a cease-and-desist order from
minibonds. Much of the collateral reportedly consists of
Lehman’s US counsel to HSBC Hong Kong, as a result
CDOs, other asset-backed securities or other obligations
of the ‘automatic stay’ imposed by Lehman’s US
that are worth far less than their original principal
bankruptcy filings. It is not yet clear to what extent
amounts. Therefore, due to the insolvency of LBH and
chapter 11 bankruptcy proceedings in the US may
Lehman Special Financing, and the resulting exposure
preclude buy-back efforts in Hong Kong and HSBC
to the current market value of the collateral, holders of
Hong Kong is seeking US legal advice on this matter.
the minibonds may have lost all or a significant portion
of their initial investment. It is worth noting that, even Separately, the Hong Kong Legislative Council (the
if LBH and its subsidiaries had remained solvent, holders LegCo) has set up a subcommittee to examine how
of the minibonds would eventually have been exposed the HKMA and the SFC regulate the sale of structured
An overview of the Lehman Brothers minibonds saga
3 Freshfields Bruckhaus Deringer LLP, 16 December 2008products and to investigate the issues relating to the strengthened and the corresponding liability under the
Lehman Brothers minibonds and retail structured yen loan (relative to the pounds sterling-denominated
products. On 12 November 2008, it voted to invoke investment) increased, causing Ms Field to suffer a loss.
its powers under the Legislative Council (Powers and
The court, having considered that Barber Asia was
Privileges) Ordinance to conduct a public probe of
never paid by Ms Field for services rendered but merely
Hong Kong banks that have been accused of misselling.
received commission from companies whose products
The probe will analyse internal procedures and bank
Ms Field had acquired through Barber Asia, found that
regulations and will require the banks to produce all
there was no contract, express or implied, between
internal documentation and communication, with the
Ms Field and Barber Asia. Nevertheless, the court found
intention of revealing any systemic issues. During the
that Barber Asia had been negligent in advising
investigation, lawmakers will be able to summon bankers
Ms Field because it failed to heed her stated desire to
and finance staff to answer questions. The LegCo
adopt a conservative investment strategy and to warn
sub-committee handling the inquiry is expected to meet
her of the existence and nature of the risks involved
twice before Christmas to discuss information-gathering
and, as such, breached its duty of care to Ms Field. The
and will start its inquiry after the Chinese Lunar New
court confirmed that if an investment advisor ‘assumes
Year (late January 2009) at the earliest.
the responsibility of providing advice to a plaintiff, and
On 10 December 2008, it was reported that a number knows or ought to know that the plaintiff is likely to rely
of banks had reached settlement agreements with on that advice, a duty of care is likely to arise. Pertinent
minibond holders and that the investors had received factors to take into account will also include the relative
approximately HK$30m in compensation. We skill and knowledge of the parties, the context in which
understand that the settlements make up only a small the advice is given, whether the giver of the advice is
percentage of the total losses suffered by minibond doing so completely gratuitously or is getting a reward
holders in Hong Kong. (whether in some direct or indirect form) and whether or
not there are any express disclaimers of responsibility’.
Common law tortious liability and Following the decision in Susan Field v Barber Asia,
Susan Field v Barber Asia financial advisors should always ensure that their
advice is consistent with the investment objectives of
An important issue for Lehman Brothers minibond
the investor and all of the risks have been adequately
holders is whether they can recover damages for alleged
explained to, and understood by, the investor. A mere
misselling of minibonds. Retail investors in Hong Kong
general introduction of the products is not considered
have in the past been awarded damages for their financial
sufficient to discharge this duty of care. The extent of the
advisors’ negligence.
applicability of this case remains to be seen. One major
The leading case is the Court of Appeal case of Susan difference between the Susan Field v Barber Asia case and
Field v Barber Asia. the current minibond saga is that the initial investment
product purchased by Ms Field, as found by the court,
Ms Field was an inexperienced investor who, at the
was one that could be regarded as conservative – it was
outset, made it clear to her financial advisor, Barber Asia,
the subsequent investment strategy to gear up the low-
that she wanted to invest her savings in a conservative
risk investment and to take on exposure to fluctuation
way. Barber Asia advised her to invest in conservative
in currency exchange rate that gave rise to a high risk.
insurance funds. Later, Barber Asia persuaded her to
This is contrasted with the inherently risky nature of the
adopt a high-risk investment strategy to gear up her
minibonds. In addition, Ms Field was not provided with
existing investment by borrowing a loan denominated in
any introductory brochure for the high-risk investment
Japanese yen, using the existing investment as collateral,
strategy, whereas all the minibonds were sold with
for a new investment scheme denominated in pounds
prospectuses. Hence, arguably, the Lehman Brothers
sterling, intending to take advantage of the low interest
minibond holders made their investments ‘with their
rate for yen-denominated loans. Unfortunately, the yen
eyes open’.
An overview of the Lehman Brothers minibonds saga
4 Freshfields Bruckhaus Deringer LLP, 16 December 2008This material is for general information only and is not intended to provide
legal advice.
© Freshfields Bruckhaus Deringer LLP 2008
www.freshfields.com
Selling practices review Outlook
In recent weeks, distributors in Hong Kong have been One important question that still remains is whether
busy reviewing their past and existing selling practices to any investors will be able to get back any portion of their
determine whether there were any systemic weaknesses money. The banks have agreed to the government’s
or failures of management controls in connection with buy-back proposal and the HKAB expects to finish
the sale of Lehman minibonds and other high-risk calculating the value of some minibonds in December.
structured products. It has not been agreed whether the compensation will
be based on the market value of the collateral, the initial
The objective is to make sure that the population of
principal amount of the minibond or an amount falling
affected customers is clearly defined and to determine
somewhere in between. So far, we are aware only of a
whether any of those affected customers have legitimate
valuation being conducted for structured notes (not
complaints. Only then will distributors be able to make
minibonds) by DBS Group Holdings, the Singapore-based
an accurate assessment of their potential liability, if any.
bank, and the result was that all but a few such notes
Subject to appropriate claims for legal professional were found to be worthless. However, such products
privilege, a distributor will also need to be prepared to were directly linked to the credit of Lehman Brothers,
deal with requests for information from the HKMA and which is not the case with many of the minibonds.
the SFC on their review of prospectuses and marketing
Whatever happens, the regulatory framework covering
materials. The disclosures must be factually correct and
the sale of high-risk structured products is likely to
not misleading.
undergo significant changes and selling processes for
Issuers and arrangers of retail investment products, such products are likely to be significantly tightened.
particularly structured products such as the minibonds, Inevitably, painful lessons will need to be learned as part
should: of this process.
review whether risk disclosure and product
descriptions were adequate;
For further information please contact Richard Chalk
determine whether the marketing materials issued Partner, dispute resolution and
were clear and fair and presented a balanced picture, contentious regulatory
T +852 2846 3466
with adequate and prominent risk disclosure in E richard.chalk@freshfields.com
compliance with all applicable regulations; and
Perry Sayles
determine whether their marketing materials included Partner, structured finance and
up-front, prominent and adequate warnings of all risks. derivatives
T +852 2846 3412
The distributors, in reviewing past sales, will need to E perry.sayles@freshfields.com
assess whether the products were suitable for their Lea-Anne Lee
customers, consider whether their selling procedures Senior associate, financial services and
non-contentious regulatory
were sound and determine whether their staff explained T +852 2846 3323
the nature and characteristics of the investments that E leaanne.lee@freshfields.com
they sold and gave clear and competent advice to their Freshfields Bruckhaus Deringer LLP is a limited liability partnership registered in England and
customers about the options available to them. Wales with registered number OC334789. It is regulated by the Solicitors Regulation Authority. For
regulatory information please refer to www.freshfields.com/support/legalnotice. 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.
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.
An overview of the Lehman Brothers minibonds saga
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