WINNERS AND LOSERS IN HONG KONG'S LEHMAN MINIBONDS

C O N F I D E N T I A L HONG KONG 001683

SIPDIS

STATE FOR EAP/CM AND EEB/IFD/OMA

E.O. 12958: DECL: 09/02/2034
TAGS: EFIN ECON PGOV HK
SUBJECT: WINNERS AND LOSERS IN HONG KONG'S LEHMAN MINIBONDS
SETTLEMENT

REF: A. HONG KONG 167

B. HONG KONG 63

C. 08 HONG KONG 2183

D. 08 HONG KONG 2027

Classified By: Acting Consul General Chris Marut, Reason 1.4 b/d


1. (C) Summary: A July agreement between 16 Hong Kong banks
and the Hong Kong Securities and Futures Commission (SFC) to
offer compensation to most Lehman Bros, minibond investors
in Hong Kong has been criticized for allowing banks accused
of mis-selling to avoid criminal prosecution, but has been
overwhelmingly accepted by investors. Several weeks before
the October deadline for responding to the deal, close to 60
percent of eligible investors have agreed to the banks' offer
to buy back minibonds at 60-70 percent of their face value.
Hong Kong officials believe the settlement offer is generous
to investors and will resolve a contentious political
problem. The SFC compelled reluctant banks to come to the
negotiating table by threatening to revoke their licenses to
sell securities. But the key to the settlement may have been
agreement by Bank of China Hong Kong (BOC HK) to compensate
investors. Approval from Beijing broke the logjam and
pressured the other banks to join the agreement, say local
sources. The HKG is considering significant reforms to
increase oversight, tighten restrictions on financial product
sales and create additional channels to protect consumers.
End Summary


2. (C) Comment: This deal is good for minibond investors,
who faced a long and uncertain process to claim the value of
the minibonds' underlying assets. The Tsang administration's
public demand that banks compensate Lehman minibond buyers
meant their credibility hinged on efforts to get investors
money back, rather than on their support for the legal
process. This outcome resolves the HKG's immediate problem
as public criticism should diminish significantly. However,
its heavy-handed tactics in dealing with the banks undermine
due process and won't help Hong Kong's long-term
competitiveness. The HKMA's reputation as Hong Kong's
premier financial regulator has taken a blow, as LegCo
members and the public assign much of the blame for bank
misbehavior to lax HKMA oversight. The SFC's negotiations
with the banks were acrimonious, but the SFC victory will
strengthen their regulatory credibility and may lead to
additional transparency requirements in the equities market.
The 16 minibond-selling banks will have to increase
provisions to buy back these products, but profits at all
Hong Kong banks will be squeezed as the industry will be
subject to stricter oversight of investment product
marketing. End Comment.

=========================
The Minibond Deal is Done
=========================


3. (C) After months of negotiations, the Hong Kong SFC, the
HKMA and 16 Hong Kong banks announced a deal July 22 to allow
most purchasers of Lehman Bros, minibonds (high-risk credit
linked derivatives) to sell these products back to the banks
where they were purchased for 60 percent of their face value.
Purchasers over 65 years of age can receive 70 percent of
the face value. The offer is limited to non-professional
investors. If banks are able to recoup any of the underlying
collateral, an additional payment of 10 percent will be
disbursed to minibond investors. If more than 70 percent of
the underlying value of the minibonds is recovered by the
banks, they will pay the excess to eligible investors. In
addition, banks agreed to immediately implement special
procedures for complaints related to the sale of structured
products. Banks will submit to an independent review of
their processes related to the sale of structured products
and the handling of complaints and implement any
recommendations. In return, all investigations of bank
mis-selling (i.e., misleading investors, failing disclose
risk, or selling to inappropriate customers) connected to the
sale of these products will be dropped. Qualified investors
have 60 days from the date of receiving a repurchase order
from the banks to accept or decline. As of August 27, 14,935
of approximately 25,000 eligible investors have responded,
with virtually all (14,806) accepting the offer. While some
are expected to reject the settlement, government officials
expect almost all will eventually agree.


4. (C) The government believes the settlement is a good one
for investors and for Hong Kong. Hong Kong Monetary
Authority (HKMA) Executive Director for Banking Supervision
Nelson Man praised the agreement for resolving a contentious

political issue for the government and for being extremely
generous to investors, who would be unlikely to recover as
much through individual lawsuits. SFC Executive Director
Mark Steward noted that banks are much better placed to
recover the value of underlying assets and predicted high
recovery rates. Financial Service and Treasury (FSTB)
Undersecretary Julia Leung noted that SFC, in its role as the
securities industry regulator, led the negotiations with the
banks. Initially, the SFC was too demanding, pursuing 100
percent compensation for minibond purchasers, in addition to
fines, said Leung. FSTB wanted a broad solution that could
be accepted by all sides, and instructed the SFC that
statutory remedies, including fines, would not resolve the
government's political problem. Dropping the investigations
of banks accused of mis-selling minibonds was necessary to
get banks to agree to the deal, said Leung. HKMA
investigation of the more than 21,000 complaints had found
few merited additional legal action.

====================================
SFC Squeezes Bank of China Hong Kong
====================================


5. (C) The negotiations between the SFC and the banks were
acrimonious. "The banks were in denial," said Steward. But
they had to come to an agreement, or face the prospect of the
SFC revoking their licenses to sell securities. Banks
understand now that they have to deal with the SFC, said
Steward. "This is a watershed for the banking industry in
Hong Kong," he said. Leung confirmed that the government had
threatened the banks with securities license revocation and
fines if there were no settlement. But the key to reaching
an acceptable compromise was BOC HK's offer of 60-70 percent
compensation, said Leung. Over half of the minibond sales
were through BOC HK branches, but the bank was reluctant to
settle without approval from Bank of China headquarters in
Beijing, she said. FSTB raised the issue with Mainland
counterparts on several occasions. Once the Mainland bank
agreed, the others quickly fell into line, said Leung.
Despite the contentious discussions, banks have publicly
supported the repurchase scheme. However, the banks were
not happy with the settlement or the process, according to
HKMA's Man. The banks distrust the SFC and prefer that the
HKMA retain its role as their primary regulator.


6. (C) The settlement not only resolves a political problem
for the HKG, it changes the relationship between the banks
and Hong Kong regulators. Previously, banks met regularly
with HKMA regulators, but their primary interaction with the
SFC was their request for SFC approval of investment
marketing literature. However, beginning in February 2009
the SFC has required banks to record conversations and
separate banking and investing service centers in branches to
avoid confusing customers. Under terms of the settlement,
the SFC and the HKMA are jointly requiring banks to
streamline their investment sales and complaint procedures
and banks are now improving audits and keeping better
records. Banks are requiring lengthy risk counseling and
assessments before selling new or risky investment products
like renminbi bonds, in anticipation of future HKMA and SFC
requirements which remain unclear.

=======================================
Moral Hazard Risks and Upcoming Reforms
=======================================


7. (C) The settlement scheme does increase investor moral
hazard in Hong Kong, said Man. The scheme applies only to
Lehman Bros, minibonds and not to similar products sold by
other institutions. Dissatisfied investors in other
structured products (of which there are many in Hong Kong)
may be more inclined to take their complaints to the streets,
rather than the courts, he said. Improved sales and
complaint procedures should address some of those concerns.
The scheme, however, is an imperfect compromise.


8. (C) The deal further widens the gap between Hong Kong's
principles-based market supervision and rules-based
enforcement frameworks, said Man. Hong Kong is now
considering limiting investor access to some products without
safeguards. The SFC has proposed requiring investment banks
to provide on-going risk assessments, i.e., informing
investors when a product in their portfolio has been
downgraded. According to Leung, the FSTB is considering
creating a financial ombudsman, based on the UK model, who
will address consumer complaints. The FSTB is also
considering creating a formalized Investor Education Council
to promote financial literacy. Finally, as part of its

response to the global financial crisis, Hong Kong is
reviewing its dual regulatory structure (with HKMA overseeing
banking and SFC supervising investments),with some
advocating a single regulator (the HKMA) overseeing both
banking and investments. These proposals are currently under
discussion within the government, said Leung, but there are
no plans to formally consult with the private sector.
MARUT