Dictum non meum pactum: Lehmans minibond transactions

Paul Lejot No holder of structured notes arranged by Lehman Brothers will be consoled by an awareness of history, especially of being victim to the most contagious single financial shock since 1974s collapse of Bankhaus Herstatt.1 Lehman was among the worlds foremost banks trading in credit and interest rate products and securities. Its transactional relationships were extensive and intricate, and its bankruptcy now the largest yet in the United States. The results of the failure are currently unquantifiable and may have second order effects on individuals in Hong Kong, Singapore and elsewhere in ways that would be controversial in other advanced jurisdictions. This article examines problems pertaining to complex financial instruments, highlighted by the 15 September 2008 bankruptcy filing of Lehman Brothers Holding Inc., the firms listed parent. It deals mainly with sales to Hong Kong retail buyers of structured notes branded minibonds.2 These were debt issues arranged by Lehman and sold with its help through 21 bank and securities dealer distributors.3 Structuring securities was important in Lehmans global activities and the firms sales to retail buyers in Asia were prolific. The analysis focuses on the even-handedness of the sale of complex instruments managed by Lehman in Hong Kong, and the supervisory regime under which such sales are made.4 It also asks whether certain common law jurisdictions might reconsider the formation of complex financial contracts and seek a more generally moral market for their use. Many types of investors use complex transactions, largely as a result of the growing utility of securitisation, other forms of credit risk transfer, and financial derivatives. They are legitimate instruments but present problems of completeness of disclosure that market regulators are usually expected to monitor, especially in contract formation. This is a problem not only for retail users but for many professional intermediaries, as recent English decisional law and the crisis of 200708 both seem to show.5 Such complex instruments must either carry warnings that make clear their speculative nature, or be supported by information sufficiently complete and well-presented to allow the decision of a reasonable buyer to be fairly informed.6

Visiting Fellow, Asian Institute of International Financial Law, Faculty of Law, the University of Hong Kong, and Visiting Research Fellow, ICMA Centre, University of Reading. The author thanks an anonymous reviewer for comments and Rick Glofcheski and Puja Kapai for helpful suggestions. 1 Herstatt failed and was hastily closed by German regulators with its substantial foreign exchange trades unsettled or in transit. This magnified the impact of the collapse and quickly led to international regulatory cooperation to deal with systemic Herstatt risk. 2 Retail means buyers of financial instruments who are not professional investors or intermediaries and whose participation in any single issue is modest. They may be intelligent, clear-sighted and accustomed to buying and selling any such instruments but could not reasonably be seen as sophisticated. 3 Lehman subsidiaries were licensed by the Securities & Futures Commission (SFC) in corporate finance and securities advisory, and securities and futures dealing. No Lehman arm has held a Hong Kong banking licence. 4 It does not deal with mis-selling claims against distributors nor the buyback proposal made on 17 October by the Hong Kong Monetary Authority (HKMA). That proposal exhorts distributors to repurchase minibonds on unspecified terms. It would neither alter the obligations of distributors nor create for them a new duty of care. 5 A leading banking misrepresentation case Peekay Intermark Limited & Another v Australia and New Zealand Banking Group Ltd [2005] EWHC 830 (Comm), [2006] EWCA Civ 386 showed confusion in both arranger and buyer as to the terms and design of structured notes. 6 This concern was raised in the context of other Hong Kong retail-targeted instruments; see P. Lejot, Cover up! Hong Kongs Regulation of Exchange-traded Warrants (2006) 36 HKLJ 2, 277. It would apply also to complex option-based contracts known as accumulators. 38 Hong Kong Law Journal 3, 585, 2008

Structured notes are one example. These are usually debt obligations,7 where a holders right to income or principal is tied to the performance of financial or other assets that are contractually and administratively unconnected to the notes. Any single issue will specify one or more reference variables whose uncertain outcomes dictate the return on the instrument. They first appeared in the late-1980s and are now bought by many professional and high net worth investors. Highly-rated frequent borrowers will issue structured notes at the instigation of leading investors; banks arrange new issues specifically to match the views of their larger private clients as to the behaviour of interest rates, financial indexes or asset prices. Structured notes can target retail users, typically by using well-known companies or popular share issues as reference entities. Some are transparently speculative but others like minibonds can be designed to seem conservative in their headline terms. Contractual intricacy and probability-based returns make structured notes exacting to value, as with all proprietary instruments based on subjective financial modelling. This makes product comparisons almost impossible for the non-specialist. Retail structured notes became noticeable in Hong Kong after the SFC relaxed certain prospectus rules for unlisted securities in February 2003.8 The market now exceeds US$4.6 billion in claims. Issues have been arranged by 19 intermediaries among which five or six banks are prominent, Lehman being by far the most successful with a 35 per cent market share and over 33,000 Hong Kong buyers.9 Its minibonds were targeted solely to retail with a low nominal purchase price of around US$5,000 and accompanying gifts of inexpensive consumer products or supermarket coupons. Lehmans marketing material for one 2005 issue showed an Egyptian landscape beneath a cobalt sky, and the slogan, Just as pyramids are a long-standing symbol of strength, the Minibond Series 16 combines the strength of Hutchison Whampoa and five well-known financial institutions to let you invest with peace of mind.10 When Lehman failed, 39 series of minibonds and similar issues were outstanding with Hong Kong claims exceeding US$1.6 billion.11 Most minibonds were referenced to credit risks, that is, the return on each issue was a function of the credit standing from time-to-time of specified borrowers, all well-known Chinese or international companies or banks.12 Recent issues had between six and eight reference names; earlier series were linked to one entity or as many as 150 separate companies. The last completed issue was series 36 in May 2008, which paid quarterly coupons of 5.05.5 per cent providing that during the three year term of the notes none of seven reference entities entered bankruptcy or an involuntary reorganisation, or defaulted on its borrowings. In each case, the notes would be redeemed immediately at a discount to their face value.13 Lehman could also exercise a free call option to redeem the notes early without compensating the holder for reinvestment losses. The notes were unlisted, intentionally illiquid, and at any time their value would be opaque. Taken together, these features mean that a non-retail intermediary would see minibonds as inherently costly and without utility as investments or for hedging purposes. Most non-retail actors seeking similar speculative exposure would negotiate with an arranger or issuer and never accept uncompensated credit
Known as debentures under the Companies Ordinance Cap 32 s 2. Mainly to permit repeated issuance under umbrella programmes, with dual prospectuses for the programme and each issue. 9 Distributors were paid substantial sales fees. Lehman also sold successfully to retail in Singapore, Taiwan and Germany. Structured products are widely sold but retail buyers are prominent in relatively few jurisdictions. 10 Notwithstanding images of places of interment, the SFC seems indifferent to lifestyle marketing being used to foster demand. Slogans for other series included: A variety of tenures [sic] producing tasty potential returns, sound investment opportunity and steady returns. 11 SFC estimate, see http://www.invested.hk/invested/en/html/section/products/structured/unlist_cls.html (accessed 2 December 2008). 12 Separate issues arranged by another bank used Lehman as a reference entity. 13 A discount linked to the settlement value of credit derivatives for the reference entities. These are widely traded but their price would not be readily available or intelligible to retail.
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risk or incomplete disclosure of core terms. The outcome might be a loss, but any purchase would result from balanced negotiation. Retail buyers lack all such leverage. Minibonds had four commercial elements: an advance by noteholders, the purchase of securities as collateral to support the resulting claim, an array of swap contracts between the collateral pool and Lehman, and the sale to Lehman of credit default protection by the pool. Noteholders acquired claims against an insubstantive Cayman Islands special purpose vehicle (SPV) formed for Lehmans use. Each issues net proceeds were applied to buying tranches of collateralised debt obligations (CDOs) from Lehman with credit risks matching the reference entities.14 These provide security for the noteholders claims, and at inception equalled the minibond issue amount. Lehman then entered interest rate or basis swaps with the SPV to manufacture a single revenue stream matching the minibond coupon dates. Finally the SPV leveraged its collateral by selling credit protection to Lehman, entering credit default swaps15 and receiving fees to enhance the revenue available to service the notes. Any CDSrelated payment due to Lehman would have priority as a claim on SPV collateral. There were two purposes here: Lehman created a tame buyer for its CDOs and obtained credit protection to hedge its massive securities inventory. Selling to retail was a lucrative by-product. In effect, minibond buyers sold credit protection in a similar way to insurer AIG, rescued shortly after Lehmans collapse largely because its CDS commitments were considered systemically threatening. The commercial bargain for noteholders is an enhanced return contingent upon there being no profound credit deterioration in a reference entity, whereupon their claims would be extinguished at a material discount, free of subrogation rights. Minibond prospectuses show that the SPV was subject to no restrictions on borrowing: issuance was theoretically limitless.16 These arrangements are not unfair in themselves and may be attractive to an informed reasonable buyer. Likewise, bounded rationality explains the wager at Happy Valley races, helping pleasure seeking rather than rational financial choices. Minibonds competed with conventional financial instruments but may be better regarded as purely speculative and economically similar to gaming instruments, notwithstanding their statutory treatment.17 Less noticeable was a supervening condition in all minibond issues requiring Lehmans parent to remain solvent. International Swap and Derivatives Association (ISDA) convention allows the termination of outstanding swap contracts upon the bankruptcy of a counterparty or its guarantor. Lehmans bankruptcy filing was such an event. If the SPV were to terminate its swaps, the minibonds would become subject to mandatory redemption even though no credit event had occurred among the many reference entities. This leaves a theoretical choice for the SPV, supervision of which devolves to the minibond trustees, to terminate the swap contracts or seek replacement counterparties. Termination forces a sale of collateral, leaving minimal proceeds for distribution to minibond holders net of SPV payments due to Lehman and noteholder trustees. Prolonging the swaps avoids a forced sale
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CDOs are debt securities collateralised by conventional securities issued by named reference entities. Synthetic CDOs are similar in intent but use credit default swaps (CDSs) to mimic the behaviour of such a collateral pool. 15 The most common form of credit derivative, used to acquire or protect against credit risks. 16 Minibond prospectuses and other source documents are posted at: http://www.sfc.hk/sfc/html/EN/general/general/lehman/lehman_structure_products.html (accessed 2 December 2008). 17 No financial instrument is subject to Hong Kong gaming legislation unless the SFC decides otherwise, but such action is unknown. While in Richardson Greenshields of Canada (Pacific) Ltd v Keung Chak-kiu & Hong Kong Futures Exchange Ltd [1989] 1 HKLR 476, predating the Gaming Ordinance Cap 148, Sears J found that dealing in certain futures contracts was a genuine commercial activity, [1989] 1 HKLR 482, and neither a game nor a bet for a risk-seeking user, the courts decision relied upon those contracts having uses other than the purely speculative.

of collateral and might improve recovery in the long-term yet is probably infeasible. Replacement has been discussed in relation to Singapore minibonds, but in all cases would be extraordinarily demanding without state support while Lehman is being liquidated, given that the SPV lacks organisational substance. Since the trustees cannot reasonably become active managers, the SPV is unable to withstand a collapse of the arranger. The minibond model represents flawed structured finance resulting from Lehmans core transaction purpose. Sales material and Lehman prospectuses warned that minibonds were not principal protected. This is required by the SFC and intended to suggest caution but the language is unreliable because it is by definition true of any debt obligation that is not cash collateralised. The words are a chimera for regulatory compliance. In spite of the warning, Lehman was central to the transactions as arranger, swap counterparty and guarantor, seller and valuer of collateral, SPV sponsor and credit protection buyer. Yet it was mentioned sparsely in the sales material and without clear explanation in formal information documents. Each issue was supported by documents conventional in style and length for complex securities. Series 36 involved an issue prospectus (54 pages in English), an issuer programme prospectus (51 pages) with substantially identical content, and a pricing supplement carrying final terms. Each series received SFC exemptions from Companies Ordinance prospectus requirements providing buyers were made by a distributor to confirm having read and understood the issue and programme prospectuses in either Chinese or English. The concession was granted to many issues made under similar umbrella programmes, and would have resulted from negotiations between arrangers and the SFC. Lehman would have argued that financial and other information as to its own standing was readily available elsewhere, and needed no repetition in documents for each single issue. However, the effect was to draw attention from Lehman as the main credit risk, create obstacles for a prospective buyer from enquiring into the mechanics of the notes, and lessen emphasis on Lehmans centrality in the transaction, not only as arranger but as commercial beneficiary and legal owner of prior claims on collateral. Prospectuses for most debt and equity new issues include information as to the use of transaction proceeds, even in the broadest terms and with no covenant as to compliance.18 The extent or purpose of Lehmans core interest in its issues were not disclosed in minibond issue or programme prospectuses, which stated only that the SPV would receive a small fee for its part in the transaction.19 Information on Lehman was contained in a separate base disclosure document (82 pages) which merely assembled current US statutory filings. Other transaction documents were listed in the prospectuses as being available for inspection while the notes were on offer or outstanding.20 It is unclear that it would be reasonable to expect an unsophisticated buyer to visit Lehmans Two IFC offices in Central Hong Kong on a working day to read and digest ISDA master agreements, swap confirmations, details of SPV collateral, or credit protection sold by the SPV. Investors may not read trustee agreements or exchange listing rules before feeling equipped to buy bonds or shares, but this case is different in that the transactions risk and purpose were neither simple nor plainly presented. No professional intermediary could have valued the notes using only the information provided to buyers in prospectuses and marketing material. SFC prospectus exemptions related in all cases to information on Lehman. Securities law and regulation are not intended to prevent or require compensation for losses but to set standards for contractual behaviour. The minibond debacle raises several concerns, ignoring instances of mis-selling or distorted distributor incentives. The SFC
For example, in Hong Kong to meet the requirements of the Companies Ordinance, Sch 3. For example, Minibond Series 36 issue prospectus dated 14 April 2008, p 19, see n 16 above. 20 And for photocopying at a reasonable fee, see Pacific International Finance Ltd (the main Lehman minibond SPV) Programme Prospectus dated 14 April 2008, p 25, and n 16 above.
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cannot have conducted its supervisory functions effectively if the minibond marketing that it allowed was neither clear nor fair. It may also have been unduly facilitating in allowing information exemptions for Lehman as the beneficiary of the transactions and their primary credit risk. This suggests a number of questions. Given the complexity of the notes, could any reasonable investor understand their terms and compare them with those available elsewhere? Was reasonable access to information given to buyers? What level of insight is needed to make a fairly-informed decision?21 The regulators presumption is that with fair information available, the buyer will make a reasonable decision, and the law assumes a duty of care for the buyer to look beyond simple marketing material. What then is a reasonable expectation of the buyer? Does an awareness of the speculative nature of a financial contract change over time? For example, are buyers of minibonds issued in 2008 less excused than those who bought notes before the global financial crisis became fully apparent? None of these questions is answered clearly by current Hong Kong regulation. Retail users may also be disadvantaged by the general reluctance of the courts (as in the UK) to interfere in commercial bargains, especially those subject to financial regulation. Scholars elsewhere have suggested that a doctrine of contractual unconscionability might be expanded to allow the court to make void bargains made between parties that are highly unequal and that are subject to information asymmetries that cannot be readily eliminated by the provision of additional data or supporting material.22 The Securities & Futures Ordinance categorises certain professional investor classes, leaving retail as the residual.23 Retail tends to be associated with an investor protection ethic exemplified by post-1930s US securities law, and strict disclosure requirements make structured note sales to US retail all but impossible. Legislation outside Hong Kong commonly further defines sophisticated investors by scale of wealth or experience, for example, in the US.24 The EU Directive on the Markets in Financial Instruments (MiFID) does likewise,25 and imposes an obligation on the regulated firm to know its client, but also allows investors to elect their status with results for the scope of instruments that they may freely buy. The UKs Financial Services and Markets Act 2000 is aligned with MiFID but states at s 5(1) that investor protection will be tempered by a concern for contractual freedom. This may also represent an overt expression of Hong Kongs current approach, restated by the SFC chief executive at the Legislative Council on 13 October, that: The requirement [for structured note buyers] is to understand the features of the product and [prospective buyers] should ask why does it pay me more than the normal deposit of the bank?26 At the same time he noted: These products were backed by triple A collaterals and the likely cumulative historical rate of failure for triple A collaterals over the past 25 years between 1981 and 2006 is 0.09 percent for the first three years.27 The suggestion was either that the risk of the notes was slight until Lehmans collapse, or that the SFC had earlier been justified in believing the

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Certain Singapore distributors have offered to unwind sales to those thought most disadvantaged, especially the poorly educated or elderly. This approach involves an arbitrary categorisation that would be a controversial test in law. 22 Notably where intrinsic bargaining imbalances lead to information processing disabilities for one party, see M. Trebilcock, The Limits of Freedom of Contract (Cambridge, MA: Harvard University Press, 1993). See also H. Collins, Regulating Contracts (New York: Oxford University Press, 1999). 23 Cap 571 Sch 1. 24 At 15 UCC 2A (1) 77b. 25 Directive 2004/39/EC. 26 LC Paper No CB (2) 216/08-09, p 37. 27 LC Paper No CB (2) 216/08-09, p 37. The reference to historical default probability resembles an assertion in Lehmans issue prospectus for minibond series 36, p 54, see also n 16 above. The statement is misleading in conflating the default performance of all conventional AAA-rated debt issues with those of structured AAA CDOs. Furthermore the use of backed by collaterals wrongly suggests that at any time during their life, the amount of the notes outstanding was matched by the value of SPV collateral. 5

risks to be so. The SFC was arguably prepared to grant prospectus exemptions in the belief that the result would be immaterial. Far less information was provided on Lehman than the reference entities in minibond sales material or prospectuses, and both Lehmans core purpose in the transactions and the compensation paid to distributors were never disclosed to buyers. Unequal bargaining power between banks and their retail clients may be unavoidable, but the imbalance between what may be expected of the reasonable investor retail or professional in order to be given a sufficient picture of complex transactions suggests reforms that could include new and meaningful regulatory warnings, the standardisation of marketing material to assist comparisons of competing financial products, deliberate classification of investors, and the introduction of pre-execution cooling off periods to allow retail buyers time to consider their actions. A more open approach by the courts to contractual unconscionability would act as an incentive for these reforms to be made effective. Freedom of contract is upheld only when bargaining clarity prevents an instrument from becoming unconscionable, where the weight of knowledge needed to make a proper evaluation of the contract as a financial instrument makes a purchase unfair.28 Caveat emptor is a flawed principle if the law fails to ensure contractual completeness, or if supervisors fail to understand complex instruments or ensure that their purpose and speculative nature is made explicit. Structured notes can be made to suit all expected conditions, so the need for solutions to these problems will survive Lehmans collapse and todays stressed markets.

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The Unconscionable Contracts Ordinance (Cap 458) applies only to goods and services. 6