Open Letter to Legco Lehman Incidence Investigation Committee and SFC

Dear Legco Member, Dear SFC Officer,

We are writing to you to express our questions and disagreements with the “SFC Lehman Brothers Minibonds Incident Report” (“the SFC Report”). We respectfully request that Legco Lehman Incidence Investigation Committee investigates questions below regarding Banks’ wrong-doing in conjunction with the sale of minibonds to retail investors, and moves towards proper compensation for minibond victims. We respectfully request that SFC addresses each question below to the Legco Committee and to the public.

The key issue with Minibond is not about if it declared “principal protected” or not. The key issue is about misrepresentation and omission of the true nature and risk of the so-called “Minibond”. Lehman bankruptcy only triggered an awakening call. It made the public and minibond holders realize that the true nature and risk of minibond was not being disclosed in the past few years.

It is not uncommon for banks to find all the possible loophole even lame excuse to hide the truth of minibond sales, in the name of the best interest of Hong Kong as Financial Center or in the name of the best interest of shareholders. The Government must try its best to protect the public's interest, especially when public does not have much legal way to challenge banks. A thorough investigation on the minibond sales will help to restore the tarnished trust in banks, and will be for the best interest of Hong Kong as a financial center in the long term.

Minibond
1. Minibond is “Secured collateral and Swap” per SFC summary.
- Most minibond collateral was AAA-rated securities. The AAA-rated securities waere mostly AAA-rated CDO/Synthetic CDO.
- Swap agreements included Credit Default Swap (CDS) with 5-7 well-known companies as reference entities.
- Most CDO collateral included CDS with 100-155 reference entities whose credit rating in the category of AAA to CCC. It was rated as AAA after enhancement and its average portfolio credit quality was usually at BBB/BBB. A CDO portfolio with 125 reference entities (Series #19 collateral), would lose 100% principal upon the 10th credit event in respect of reference entities.
Product Description and Disclosure
2. Definition of full disclosure by SFC:

(2.1) In the SFC Report Section “2.2. Regulatory Structure”, Section 2.2.1 stated “ …disclosure and suitability. The first of these is the responsibility of SFC - to ensure that, based on the information provided by the product issuer, sufficient information is disclosed in the product documentation by the issuer to enable a reasonable person to make an informed decision. “.
We assume that ‘a reasonable person’ here refers to persons who are not credit derivative product experts such as 黃元山，迷宗.
- As reported in news:“證監會行政總裁韋奕禮表示、證監會角色並非要監察投資產品價格是否穩定, 而是要確保所批核之投資產品, 有全面市場披露”.
(2.2) William Pearson of SFC said in 2005: “(…). We are seeing more complicated products come on to the scene, but I think as long as the disclosure is clear, accurate and not misleading, we will be happy to see that carry on”, in the Asian Structured Products Review 2005, (http://www.pacificprospect.com/downloads/asian_structured_products_review.pdf )
3. The SFC Report failed to point out that the prospectuses misled retail clients with the prominent “credit-linked to 7 reference entities”.
By choosing Synthetic CDO as minibond collateral, the prospectuses should have been fully aware that minibond’s value would be greatly decided by credit risk of its collateral’s portfolio holding. However, the prospectuses never clearly stated that minibond was in fact credit linked with “7 AND MANY Other” reference entities. The prospectuses failed to disclose where the risks truly lie.
Why did the SFC Report fail to find the prospectuses not meeting SFC’s “Clear, Accurate, No misleading” requirement?
4. The SFC Report Section 16.3.1 made biased observation on the prospectuses.
The SFC Report quoted the declaration of “not principal protected”. But the SFC Report failed to notice the following statements in the page 9 (of Series #27) of the Issue Prospectus:
"Are our Notes principal protected?
Our Notes are not principal protected: if a credit event happens to any one of the 7 reference entities before the maturity date, you will lose part, and possibly all, of your investment”.
Above statements effectively suggested that the “not principal protected” was conditioning on the credit event of 7 reference entities. Banks staff did not offer any other advise on such understanding.
What was the reason that the SFC Report did not identify above inaccurate and misleading statement?
Why were most (or all) banks staff having the similar misunderstanding on the condition of “not principal protected”?
5. The SFC Report Section 16.3.2 made biased observation on the prospectuses.
The SFC Report quoted “Our Notes are not suitable for everyone. (…). Before applying for any of our Notes, you should consider whether our Notes are suitable for you in light of your own financial circumstances and investment objectives. If you are in any doubt, get independent professional advice.” from the Prospectuses.
However, the SFC Report failed to notice the following statements in the page 10 of Issue Prospectus (Series #27):
“Who should buy our Notes? Are they suitable for everyone?
Our Notes are not suitable for everyone. (…).
Our Notes are only suitable for investors who are:
looking for fixed rate quarterly interest income (…),
confident that none of the 7 named reference entities will be affected by a credit event. (….)”.
Above statements in plain English clearly suggested (to retail clients) that, if you were confident on the 7 reference entities, the Notes was for you.
What was the reason that the SFC Report did not identify above misleading and inaccurate statements in the prospectuses?
6. A prospectus must disclose where the money would be invested into and where the interest and repayment of principal would be coming from. The SFC Report failed to identify that the Prospectuses never clearly disclosed such information. Why did the SFC Report consider the prospectuses disclosure as sufficient and acceptable?
The prospectuses only stated that “We use the money which you invest in our Notes to buy a package of assets.” (page 19, “What happens to my money? How can Pacific International Finance Limited pay me back?”).
The brand name of minibond and the term “credit linked to 7 reference entities” gave retail clients false illusion that the minibond money would be invested into debt/loans of 7 reference entities. The truth was that, the Minibond money was not invested into the 7 reference entities or any of the undisclosed 100+ reference entities that comprised of the minibond CDO collateral.
7. The SFC Report failed to identify that the prospectuses omitted CDO collateral related material information.
(7.1) Plenty of credit rating information on the 7 reference entities was disclosed. The prospectuses mentioned the AAA-rating on the CDO. But there was no mentioning on the credit rating information/or guideline on the reference entities that comprised of CDO collateral. The Prospectuses at least should be able to state clearly about credit linked to many other reference entities, and to disclose some guideline on the criteria for selection of the reference entities such as the expected number of reference entities and the expected percentage of reference entities below BBB/or BB /or B-/etc.
(7.2) The prospectuses at least should be able to disclose that a Synthetic CDO usually would experience 100% principal loss when 8% (or less) of the reference entities has default event. It does not need 10% or more of the reference entities to have default event for the 80%-100% principal loss.
The prospectuses did not provide “sufficient information” on minibond, and obviously were way off the “Clear, Accurate and non misleading, Disclosure (全面市場披露 )” requirements. We contend that the prospectuses consistently omitted material fact and gave misleading statement, so that a reasonable person would not be properly informed of the true nature and risk of minibond.
Why did the SFC Report consider the prospectuses disclosure as sufficient and meeting SFC requirements?
Code of Conduct at Point of Sale
The SFC Report Section 2.5 listed requirements on regulated body (banks) or HKMA/SFC registered staffs.
8. The SFC Report failed to identify that banks provided clients with incomplete material information.
The CDO collateral information held the most important material information on the Minibond. The diminished collateral value also proved the criticalness of such collateral information. The prospectuses were only part of minibond information. Detailed Information about the collateral, including evidence of the rating and the terms and conditions of the collateral, would have provided Minibond buyers with a 2nd chance to know what the Minibond was really comprised of.
Such collateral information was not available to minibond purchaser when they signed the purchase agreement. However, such collateral information usually would be made available prior to the issue date. Banks should have requested such information after offer closed. Banks should have sent such CDO collateral information documents /or notice of such documents’ availability to minibond purchasers. Banks are required to provide clients with relevant material information for derivative products, according to SFC’s Code of Conduct. But Banks failed to do so. Why was this not mentioned in the SFC Report?
9. The SFC Report failed to identify that Banks’ due diligence was insufficiently thorough over the past few years’ minibond sale. Evidence is as follows:
- Banks should have cautioned us that minibond was not invested into any debt / bonds issued by any of the 7 reference entities.
- Banks should have cautioned us that AAA-rated securities (or AAA-rated CDO), may not be the same as AAA-rated conventional bond, and should have cautioned us about the nature and risk related to CDO collateral. $10 million cash or cash equivalent is very different from $10 million worth of combined asset value of cash / stock /commercial real estate / residential real estate / machinery
- It was never mentioned to us what CDO was comprised of and what kind of risk CDO may have.
- It was never pointed out to us that the key asset of CDO collateral was CDS with many entities, and its value was decided by the credit risk or default event of its portfolio holding.
- It was never mentioned to us that a AAA-rated Synthetic CDO may have average portfolio credit quality at BBB/BBB-.
- We were never told to be aware that minibond was, in fact, not only credit linked with 7 reference entities, but also credit-linked with many other entities at various rating categories from AAA to CCC. A 8% (or less) default rate in the CDO collateral would result 100% principal loss.
- And, we were never explained about the First-To-Default with the 7 reference entities, nor the credit event redemption amount. Constellation is an example about how crucial to understand such terms prior to purchase.
We contend that, instead of exercising due diligence, Banks in fact collaborated, we would suggest fraudulently, with the minibond issuer, hiding the risk of the Synthetic CDO from the bank's retail clients, with the objective of increasing the sale of the minibonds. Banks such as Shanghai Commercial bank / Wing Hang Bank /etc, rated the minibond as “Medium Risk”, considerably downplaying the product’s risk level, is another proof of banks’ faulty due diligence.
Why did the SFC Report fail to identify this?
10. What was the SFC Report’s conclusion on the banks minibond sales related training and procedures?
- (10.1) What was the understanding of banks staffs regarding all the risks listed in the SFC Report Section “16.4”? Did banks staff explain all these risks to their clients at the point of sale, other than credit-linked to 7 reference entities and no liquidity / long lockup period?
- (10.2) The SFC Report Section 2.3.1 stated “2.3.1 ..... Intermediaries were still under an obligation pursuant to the Code of Conduct to explain the nature and risks of the product they were selling and ensure it was suitable". Does SFC consider that the mentioning of “credit-linked to 7 reference entities and no liquidity / long lockup period” was sufficient for fulfilling such requirements?
- (10.3) The SFC Report Section 2.5.2 stated “2.5.2. The Code of Conduct also imposes obligation on intermediaries to ensure their staff are properly trained and supervised”. To what extent, was this demonstrated by SFC’s investigation?
- (10.4) How would SFC define banks / banks staff’s Honesty and Fairess, Care to their Clients? Should it be defined as:
"For a complex credit derivative product like minibond, the responsibility of Bank's staff is limited to: passing the Issuer Prospectus to the client when being requested, and telling clients with minimum information, even if the minimum information could be misrepresenting and misleading on true nature and risk of the product”?

Respectfully yours,