Report on the Lehman-related Securities (12)

IV. Banking Supervision defers to Bankers’ Arrogances

 

In order to understand a scam that deceived ten of thousands of victims over a period of six years in an industry that is subject to additional two-fold regulations, one has to be wary of the pitfall of mono-causality. The ‘piggybacked structure’ design with an appealing but deceptive façade is only the fuel. By itself, the destructive fire would not come into being. It takes the willful blindness of the SFC in approving the prospectuses and the indulgence of the HKMA towards the distributor banks to provide the heat and oxygen that cause and sustain the fire for as long as it did.

 

Like the SFC, the HKMA also produced its report about the scam and submitted it to the government (available at www.info.gov.hk/hkma/eng/new/lehman/lehman_report.htm). Again like the SFC Report, the ‘Report of the Hong Kong Monetary Authority on Issues Concerning the Distribution of Structured Products Connected to Lehman Group Companies’ is an undated piece of shoddy work without any person or department within the organization wishes to be responsible for it.

 

As the HKMA had been indulgent towards the banks while they put the scam into action, it is hardly surprising that its Report is nothing but a self-serving forward-looking statement. In order to gross over the most crucial issue of ‘suitability assessment’ that directly concerns the banks, the Report has to circumvent the core of the scam, namely the ‘piggybacked structure’ and its deceptive façade. This proves to be the achilles heel of the SFC and the HKMA. While the purported exposition of ‘minibond’ in the SFC Report is merely an exercise of plagiarism, the equivalent in the HKMA Report is an amalgam of irrelevance, superficiality and trickery. The HKMA devotes about 4 pages of its 85-page Report to answer the question ‘what are Lehman structured products?’ The answer is a total shambles and it is difficult to make any sense of it but we will try nonetheless.

 

First of all, the HKMA advises that the Lehman-related securities ‘can be broadly grouped into five categories as set out in Table 1’ (para. 2.2 emphasis original). Table 1 is divided into 5 columns under the headings of (i) Category, (ii) Issuer and Arranger, (iii) Issue dates, (iv) Amount involved, (v) Remarks. The ‘remarks’ consist of seeming summaries of how the products work which, as one would appreciate from the exposition about the products in chapter 2, is an evidently futile attempt that is bound to be neither informative nor conducive to any useful purposes.

 

So, what is the basis of categorization used by the HKMA? To illustrate the folly of this part of the Report, the categories used in the Report are shown below:

- Credit-linked notes where LBHI is not a reference entity (Minibonds)

- Equity-linked notes (Pyxis Notes)

- Fund-linked notes (ProFund Notes)

- Credit-linked notes where LBHI is a reference entity (Constellation Structured Retail Notes) (Retail-Aimed Callable Investment Notes) (Octave Notes)

- Private placements

Even a casual glance of this list of categorization will alert the reader that the HKMA focused only on the façade of the Lehman-related securities. Although the prospectuses only mention the ‘hidden component’ in a very sketchy manner, the HKMA staff is among the top of professionals in the industry and one needs look no further for proof of this claim than at the remuneration of Mr. Joseph Yam and his immediate lieutenants. Their packages of remuneration definitely stand head and shoulder above their counterparts elsewhere in the world. As such, they should feel some gratitude towards the Hong Kong public for their trust and generosity. But, like the SFC, the Hong Kong taxpayers are also short-changed by the HKMA as evidenced in its Report. 

to be continued......
Extract From: "Exposure - the Truth About Lehman-HSBC Fraud"

Report on the Lehman-related Securities (11)

III. Disclosure-based Regulation

 

In December 2008 the SFC submitted to the Financial Secretary a report (the ‘Report) purportedly to address the causes and consequences of the scam. What is emerged is a shame and the shoddiness of the report should convince any perceptive and fair-minded person how corrupt (at least morally and intellectually) the government is and how individuals of decency and integrity will not want to associate themselves with such an administration.

 

The Report is titled ‘Issues raised by the Lehmans Minibonds crisis’ (available at: www.sfc.hk/sfc/doc/EN/general/general/lehman/Review%20Report/Review%20Report.pdf). Could the ‘Lehmans’ be just a typo? Computer-users would have no difficulty in appreciating how hard for this error to happen without the person performing the task noticing it. Another piece of damning evidence of shoddiness is the decision to use the label ‘Minibonds’ to describe what the SFC has been saying all along, namely ‘Lehman Brothers-related retail structured products’. Could the use of label ‘Minibonds’ be merely a casual mistake? To answer this question properly, one needs to bear in mind the deflection tactic used by the SFC to preclude public discussion about the deceptive disclosure statements in the relevant prospectuses. By invoking the label ‘minibond’, the SFC may be trying to keep alive the emotional debate about the propriety of the label among the less educated victims. To the extent that the label is relevant, it is peripheral to the core issues surrounding the blatantly misleading disclosure in the marketing materials – the very documents that were approved by the SFC.

 

It is understandable why the SFC wants to avoid such terms like ‘retail’ and ‘structured’. Typically a prospectus for structured product resembling the afore-mentioned Saphir notes would run to some 100 pages in length. The sheer number of entities in a typical portfolio and the complexity of contractual provisions governing the swap arrangement dictate that the prospectus has to be lengthy and peppered with tables, diagrams, charts, and other visual aids to help readers to understand the intricacies of the product.

 

Given the complicated structure of the product, the only way to ensure that every purchase is based on informed consent is by full and fair disclosure in the marketing materials. But the effectiveness of disclosure, however full and fair, is doubted by many respectable professional opinions for reason that such complicated products are inherently unsuitable for retail investors. Their lack of access to market information and lack of knowledge to assess the significance of it are some of the major handicaps disadvantaging the retail investors. 

 

The existence of proper disclosure in a prospectus is only an essential pre-condition of preventing fraud or other ‘mis-selling’ from taking place. Equally important are the willingness and ability of the distributor to understand the product, as well as the ability of its sales team to have such understanding that enables them to explain the details to the prospective investors. Thus, it is a two-stage suitability assessment. The first stage concerns the suitability of the distributor itself to sell the product. And only when the distributor who has reason to believe its staff is capable of explaining the product and assessing the suitability of any particular prospective investor that it should involve in the sales of the product.

 

The sales of these Lehman-related securities for six years unmistakably demonstrate the complete breakdown of these safeguards. The abdication by SFC of its duty to know the products and assess adequacy of disclosure is matched by the same culpability of HKMA to let the distributor banks to disregard the suitability assessment.

 

Does the SFC have anything to say about its jurisdiction over disclosure in the Report? In paragraphs 24.3 and 24.4 of the Report, the SFC argues that (i) verification of accuracy of what is disclosed; and (ii) assessment of suitability of the products, should not be the duties of SFC. The practices of its counterparts overseas are used by the SFC to justify this argument.

 

This is just another deflection tactic. About half of the total victim investors of this Lehman-related securities scam are elderly and individuals with little education or otherwise suffering from handicap of one form or the other. The profiles of these victims are known to the two regulators but they persistently refuse to release it for no good reason whatsoever. To the extent that the demand for verification and assessment is genuine in the sense that it was made by some of the victims, the SFC should know better that these are not the key issues. One of the real issues that the SFC should have addressed but again it has failed to do, in the Report as well as in the media; is whether the SFC is required to detect inadequacy, inconsistence, or discrepancy in the documents submitted for approval.

Misstatement in a document could be a result of negligence or fraud. The possibility of this should always be in the mind of those SFC staff responsible for vetting the prospectuses. Yet the Report clearly reveals a conscious effort to steer clear from this simple and evident aspect of the SFC work. The ‘piggybacked structure’ could be hard for the uninitiated to understand but the SFC is staffed by professionals well remunerated by any standards; and it has never been mentioned that these officials were constraint by any shortage of resources. In the circumstances, it is reasonable for the public to expect them to perform their duties to a high standard of excellence.

The shoddy Report proves how much the public is short-changed by the SFC. But that is not all. As the scam is about the Lehman-related securities, one would expect to find in the Report some detailed analysis of the products. Instead of any analysis, one can only find a 2-page (pages 33-34) shameless copying from the prospectuses masquerading as answer to the self-imposed question ‘what is a minibond?’ By relying almost exclusively on the prospectuses, the SFC is tantamount to vouchsafing the compliance of the prospectuses with statutorily required standard. The LBV has written to the SFC on 27^th February 2009 requiring an explanation of its conclusion that disclosure is adequate and requesting a constructive dialogue on our queries over its assertions. The letter to SFC is re-produced in full in appendix A of this report.

The SFC is a member of the International Organization of Securities Commissions (IOSCO), an international standard setting body created in 1983. So far, the SFC has not been able to summon up the courage to answer pertinent questions raised by some of the more knowledgeable victims. This is a fact of crucial public importance because, if the SFC is content to hide behind its own illusory reality, the foundation of our financial system will turn into quicksand sooner than we could expect. The fact that this city was selected for this scam, and the conduct of the regulators in the last six months, reveal what kind of future is in store for us.  

to be continued......

Extract From: "Exposure - the Truth About Lehman-HSBC Fraud"

Report on the Lehman-related Securities (10)

( II. Dissecting the ‘Piggybacked Structure’....... continued)

Is it believable that HSBC is unaware of the totally inadequate disclosure in the Pacific
prospectuses?

By comparing the two products, the following table reveals how implausible HSBC Bank is
ignorant of the deceptive aspects of the Pacific prospectuses.

to be continued......

Extract From: "Exposure - the Truth About Lehman-HSBC Fraud"

Report on the Lehman-related Securities (9)

( II. Dissecting the ‘Piggybacked Structure’....... continued)

It should be noted that while most of the Lehman-related securities are fixed rate product, the
security (because of the inherent volatility) is designed to generated variable rate return. In
order to enable Lehman to benefit from the potential higher return without having to assume
the risks embedded in the synthetic CDO, Saphir would enter into swap agreement with
another Lehman-controlled entity (the ‘swap counterparty’) whereby return generated from
the portfolio would be paid by the former to the latter in exchange for a sum equivalent to the
interest payable to the victim investors. In other words, the victim investors of each series of
Lehman-related securities were asked to underwrite an extremely complicated portfolio of
derivatives for a meager return because they were not informed of the risk at the time of the
investment. The bulk of benefit flowing from the portfolio went to Lehman, secretively
through the hidden component in the ‘piggybacked structure’.

Although the swap between Saphir and the ‘swap counterparty’ is all within the control of
Lehman, Saphir had to use the money received from Pacific to purchase collateral in order to
give the arrangement the respectability in the eye of the more regulated world. After all, the
Saphir notes are subject to the relevant European regulations governing disclosure. With
more transparency, there are few anomalies. The exact opposite happens in Hong Kong. Such
latent sense of lawlessness, fostered by the frequent disregard of the law by the government,
encourages or even causes the fraudsters to conceive and implement the scam here.

The very contrived nature of this ‘piggybacked structured’ is also manifested in the
misstatement that the investors’ money was used to purchase the security as if it is something
of value. The security, as explained above, is also a credit-linked note embedded with a swap
arrangement between Saphir and another Lehman entity similar to a SPE. The swap
agreement is a private bilateral contract the value of which depends to a large measure on the
collateral selected by the parties to back up their mutual promises. In other words, to describe
the ‘security’ (i.e. Saphir notes) as ‘collateral’, which is what Pacific does in its prospectuses,
is a misstatement for the simple reason that there is ‘real collateral’ underlying the Saphir
notes. With regard to the Saphir notes series 2008-8, the ‘real collateral’ is USD61,000,000
Principal amount floating rate note issued by Landesbank Baden-Wurttemberg. It is to the
purchase of this ‘real collateral’ that the fund of investors of minibond series 12 has gone.
The existence of this ‘real collateral’ is kept hidden from the investors because the term
‘collateral’, together with its conceptual significance, has been misappropriated to apply to
the ‘hidden component’ (the Saphir note).

to be continued......
Extract From: "Exposure - the Truth About Lehman-HSBC Fraud"

Report on the Lehman-related Securities (8)

( II. Dissecting the ‘Piggybacked Structure’....... continued)


To sum up, the ‘piggybacked structure’ consists of two layers:

(a) The first layer could be a CLN featuring well-known corporations for the purpose of
deceiving the investors into believing that their investment would be safe so long as those
corporations are solvent.

(b) The second layer of synthetic CDO masquerading as ‘collateral’ so as to justify only
very sketchy information is given about it in the prospectuses.


For those readers who are interested in getting a quick grasp of the gist of the scam, they are
recommended to turn to Appendix C where they would find a comparison of the table of
contents of the following two prospectuses:

(a) The above-mentioned HSBC CLN prospectus dated 8th April 2005; and

(b) The issue prospectus of minibond series 19 dated 25th April 2005.


These two prospectuses are meant to describe two very different products – a simple CLN in
one case and an unprecedented contrivance of ‘piggybacked structure’ in the other. Despite
the vast differences, the two prospectuses look astonishingly alike in contents and length. At
this point, the reader should bear in mind that:

(a) Pacific Finance is controlled by HSBC in the sense that HSBC holds all the issued
shared capital of Pacific Finance and provides its employees as directors of the SPE.

(b) The same law firm, the Linklaters, provided legal advice in respect of these two
prospectuses.

As explained above, this outline of the synthetic CDO will be brief as the primary tactic of
the scam is to conceal the importance of it. By playing down its importance, there is hardly
any disclosure about it in the relevant prospectuses – not even the existence of another swap
arrangement between the issuer of ‘security’ and another Lehman-controlled entity. Take the
example of the synthetic portfolio floating rate notes (series 2008-8) issued by Saphir as
example. The notes were purchased by Pacific as ‘security’ of minibond series 12. The value
of the notes is credit-linked to a portfolio of over 100 swap agreements (known as Credit
Default Swap) whose value, individually or collectively, is dependent to a large extent on the
sentiment of the international credit market. Whether, and if so the extent to which, the
investors are able to monitor this financial derivative market is not mentioned in the relevant
prospectuses. What is disclosed is the ‘publicly available information’ about the well-known
corporations at the façade level as if this is all that the investors need to know or to keep
abreast of. Where there is only partial disclosure when full disclosure is mandated, and where
what is not said would render what is said false and misleading; as it happens in the relevant
prospectuses, a case of criminal fraud is capable of being established, at least on a prima facie
basis.

to be continued......
Extract From: "Exposure - the Truth About Lehman-HSBC Fraud"

Report on the Lehman-related Securities (7)

( II. Dissecting the ‘Piggybacked Structure’....... continued)


The Mahogany Notes are relevant to this scam not only because they were sold under the
supervision of Lehman, but also because they are based on notes issued by another
Lehman-controlled SPE known as Saphir Finance plc (the ‘Saphir’). For those victims who
have received notices from the trustee (HSBC USA NA), they may recall Saphir is one of the
companies that supplied security to Pacific Finance for the minibond. In other words, Pacific
used money received from the victim investors to purchase ‘security’ (that is, the hidden
component) from Lehman-controlled SPE and Saphir is one of the security suppliers.

At this stage, more perceptive readers would notice some anomalies. The façade, which is a
CLN, requires collateral to back up the swap agreement. But why should the parties agree to
use the very risky and very complicated synthetic CDO as collaterals. This is entirely
contrary to the logic inherent in the role of collateral because when compared with the façade,
the ‘security’ is inherently more volatile. The only way to make this ‘piggybacked structure’
less absurd is to reverse the roles played by the CLN and the synthetic CDO. That is to say,
the synthetic CDO should be shown to the world as façade of the product, because it is a lot
more risky and is capable of generating higher return. By the same token, the CLN whose
basket of reference entities are among the most powerful corporations in the world with
known political connection with the most powerful governments, it is more logical to be the
collateral if only because of the little likelihood that any one of them would default.

.....to be continued.
Extract From: "Exposure - the Truth About Lehman-HSBC Fraud"

Report on the Lehman-related Securities (6)

( II. Dissecting the ‘Piggybacked Structure’....... continued)

The CLN issued by HSBC Structured Notes (Cayman) Limited is particularly relevant to this
scam because the directors of this special purpose entity (‘SPE’) are almost the same as the
Pacific International Finance Limited (the ‘Pacific Finance’) – the issuer of the minibond. In
addition to common directorship, there are more sinister signs suggestive of fraud perpetrated
by the HSBC Bank to be detailed below. Suffices it to note at this stage that the CLN sold by
the HSBC-controlled SPE, known as USD Callable Basket Credit Linked Notes (the ‘HSBC
CLN’), does not require the backing of ‘collateral’ because it is guaranteed by the HSBC
Bank. Therefore, the money received by HSBC Bank from investors of the HSBC CLN is
declared in the prospectus as applied by the Bank to its general banking business. As will be
elaborated below, despite the vast differences between the HSBC CLN and the
Lehman-related securities, the prospectuses of the two are almost identical in terms of
organization, contents, and layout. Given the common directorship, Pacific Finance has to be
taken to know its prospectuses are seriously defective as they are definitely inadequate for the
purposes of explaining the intricacies of the products and gravity of the risks involved.

The second component is hidden behind the façade because it is a very risky and complicated
product known as ‘synthetic collateralised debt obligation’ (Synthetic CDO). Any attempt to
provide a simplified explanation of this product runs the risk of misleading instead of
enlightening. However, a brief outline of it will appear after an exposition of the heart of the
scam. One can have a firm grasp of the scam and the complicity of the HKMA and SFC in it
by considering the sales of ‘Mahogany Notes series I and II’ by Mahogany Capital Limited in
Australia. The Mahogany Notes are essentially synthetic CDO-based products and the sales
of them in 2004 and 2006 were controlled by Lehman. To meet the statutory disclosure
requirements then in force in Australia, the Mahogany prospectuses contain detailed diagrams,
tables, charts, analyses, and the like to explain the nature and the risks of the notes.

.....to be continued.
Extract From: "Exposure - the Truth About Lehman-HSBC Fraud"