Originally Published 10th October 2008
Issuers of structured products in Hong Kong must consider whether their offering and advertising materials adequately disclose the risks affecting investors' returns as a result of current market conditions.
Amid growing claims of mis-sales by distributors of Lehman's "Minibonds", the SFC has released a circular (also see SFC press release) requesting issuers to review the adequacy of their product disclosure.
The approach taken by the SFC is to place responsibility on issuers to determine what constitutes adequate disclosure.
Both retail and "sophisticated" individual investors holding underperforming (and, in some cases, failed) investments make a variety of claims, the most consistent being mis-sales by their distributors. They claim not to have understood what they were buying.
Investors have many different types of exposure to entities in the Lehman group. The most prominent example is what has generally become known as "Lehman Minibonds". The Minibonds gave investors exposure to (and the return depended upon) the creditworthiness of one or more entities (in some cases, including a Lehman entity). Lehman entities played other roles such as guarantor and swap counterparty. The Minibonds were secured by a portfolio of instruments linked to the creditworthiness of highly rated entities.
The Lehman entities are now unable to perform their various roles. The value of the Lehman Minibonds will depend upon the value of the security, the value of which is stressed because of current market turmoil.
The Lehman Minibonds were an innovative product for Hong Kong. The product offering materials were written in plain language with the aim of explaining a complex financial structure in a way capable of being understood by retail investors. The product has been very successful with HK$12.6 billion issued over four years.
The SFC has issued a statement that it "will examine whether any facts that should have been disclosed to the SFC were not disclosed by the Minibond issuers and their advisers at the time the offer prospectuses and marketing materials for each series of Minibonds were submitted for vetting".
Investors appear to have claimed that their distributors did not comply with their obligation to explain the product and its risks or that the product was simply not suitable for some investors (no amount of explanation would have been adequate).
The circular contains three propositions that:
- offering documents must contain sufficient information necessary for investors to make an informed investment decision - this is a restatement of the existing law
- marketing materials must be clear, fair and present a balanced picture with adequate and prominent risk disclaimers - again, a restatement of the existing law, and
- marketing materials must contain "upfront, prominent and adequate warnings" of all relevant risks having regard to the prevailing market circumstances.
The key theme of the circular and the press release is the adequacy of the disclosure about two current risks - extreme market conditions and bankruptcy failure by any entity involved in an offering.
Distributors are also reminded of their obligation to properly explain structured products to their clients so that they understand what they are buying.
What does this mean for issuers?
Each issuer must decide whether its offering material remains accurate in the light of current extreme market conditions. What does that mean in practice?
The SFC leaves open the possibility of issuers that currently issue structured products under annually approved programmes, continuing to do so with little or no amendment to the programme documents.
In the absence of any further guidance from the SFC, we suggest the SFC's announcement has the following implications:
- issuers that currently issue structured products under programmes approved by the SFC (bonds, equity linked investments ("ELIs"), structured deposits, etc.) or the HKSE (warrants, CBBCs) within the last 12 months may continue to issue but should undertake an immediate review of all offering material to ensure the key risks identified by the SFC are highlighted. Any supplementary disclosure should be made as soon as possible, and
- given the similar approach to documentation taken by issuers, there needs to be a collective view taken on the nature of the amendments to be made (if any).
A few areas to consider include:
- the possible bankruptcy of the issuer or its related entities, the link between the credit of the issuer and the payment of any return on the product
- the possibility of the investor losing the entire value of his investment
- the effect of extreme market volatility on the performance of the product, in particular early termination
- the need for investors to obtain advice and understand what they are buying
- ratings are not a guarantee of an issuer's ability to pay. Ratings may change
- future financial information may be materially adverse to that disclosed in any programme document
- the market price of a product (and the ability to provide any liquidity support) will fluctuate according to changed market circumstances
- the possibility of changes to regulation in Hong Kong or other countries that may affect the issuer's ongoing ability to offer a particular type of product, and
- factors that may affect the value of any security given to secure an issuer's obligations.
Most offering materials already contemplate these risks in one form or another. We do not suggest there is any defect in those materials. The issue appears to be one of emphasis; that is, whether the offering materials prominently highlight the risks in light of current market volatility.
Issuers might determine that no changes are necessary. The SFC has left that decision to issuers.
The SFC's circular is a timely reminder to issuers of the need to consider their compliance obligations in light of current market turmoil. Existing disclosure has been crafted having regard to market standards, the SFC's requirements and the needs of investors. We expect further prominence to be given to a number of key risks.
Please let us know if you have any questions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.