Securities Investor Protection in the context of the Recent Financial Crisis – Hong Kong’s Experience 2-3 November 2009 Irene Tang Associate Director, Supervision of Markets Division International Forum for Securities Investor Protection in the Context of Financial Crisis

2 Coverage of Investor Compensation Fund (ICF)  Licensed persons authorized to deal in securities and futures contracts irrespective of whether they are exchange participants of Hong Kong Exchanges and Clearing Limited (HKEx) provided that the trades relate to HKEx products  Authorized institutions trading in HKEx products  Licensed persons authorized to provide securities margin financing in relation to HKEx products

3 Definition of “Default” “default” in relation to a specified person or an associated person of the specified person, means  The insolvency, bankruptcy or winding up of the specified person; or  Any breach of trust, defalcation, fraud or misfeasance committed by the specified person or associated person of the specified person

4 Per Investor Compensation Limit Limit of compensation :  HK$150,000 per investor for securities trading and HK$150,000 per investor for futures trading

5 Collapse of Lehman Brothers Holdings Inc. On 15 September 2008, Lehman Brothers Holdings Inc. filed a petition under Chapter 11 of the U.S. Bankruptcy Code.

6 SFC issued restriction notices on Lehman entities in Hong Kong  On 16 September 2008, the SFC issued restriction notices on four SFC licensed entities of Lehman Brothers in Hong Kong. – Lehman Brothers Asia Limited – Lehman Brothers Securities Asia Limited – Participant of the Stock Exchange of Hong Kong Limited – Lehman Brothers Futures Asia Limited – Participant of the Hong Kong Futures Exchange Limited – Lehman Brothers Asset Management Asia Limited  Lehman Brothers Asia Limited, Lehman Brothers Securities Asia Limited and Lehman Brothers Futures Asia Limited were wound up and KPMG was appointed as liquidators.

7 Most Lehman clients not likely covered by ICF  Clients are mainly Lehman group companies or licensed corporations of SFC  “Qualifying client” does not include a licensed corporation, a person licensed or authorised in a jurisdiction for carrying on an activity similar to that of the defaulting intermediary or an associated person of the defaulting intermediary.  not “qualifying clients”  not qualified to claim against the ICF  So far no claims for compensation against the ICF from clients of the Lehman entities  No broker defaults other than the Lehman-related entities during the financial crisis.

8 Minibond holders not covered by ICF  Investors suffer from the failure of Lehman because of their investment in Lehman issued Minibonds  Minibonds are unlisted structured products arranged by Lehman  Not covered by ICF, ICF only cover defaults of SFC licensed and registered persons in relation to trading in HKEx traded products

9 Investors’ losses in Minibonds  Funds raised from investors were mainly used to purchase collateral such as CDO.  The bankruptcy filing of Lehman Holdings resulted in the early termination of the Minibonds. Under the terms and conditions of Minibonds, in the event of early termination, investors would only get back their share of the proceeds of sale of the collateral less any amount which the issuer may owe to Lehman.  Value of the collateral dropped significantly in most series of the Minibonds.  Investors suffered heavy losses.

10 Complaints from investors of Minibonds  HKMA and the SFC received many complaints  Complainants alleged that the distributors (mainly banks and a few brokers) had not properly informed them of the potential risks involved  Lots of demonstrations and protests  Legislative Council Subcommittee to investigate the Minibonds incident  HK Government, HKMA and SFC worked to resolve the issue

11 Investigations into Minibond-related complaints  HKMA and the SFC investigated complaints relating to banks and brokers.  The SFC adopted a top-down approach in investigation.  The SFC investigated into the brokers’ and banks’ internal systems and controls relating to their sale of Lehman Minibonds to clients.

12 Settlement agreement between the SFC and two licensed brokers  The SFC reprimanded two brokers. Two brokers agreed to – make voluntary offers to purchase all outstanding Lehman Minibonds bought by clients at a price equal to the principal amount invested by those clients, – to engage an independent audit firm to review their internal controls, systems and procedures, etc.  329 clients fully recovered initial investments  Settlement amount about HK$90 million

13 Settlement agreement between SFC, HKMA and 16 banks Key features of the banks’ repurchase agreement are:  Each bank will offer to repurchase from each eligible customer all outstanding Minibonds at a price equal to 60% of the nominal value of the original investment for customers below the age of 65 or at 70% of the nominal value for customers aged 65 or above as at 1 July  Once the underlying collateral is recovered and paid to the banks, each of them will make a further payment of initially up to 10% of the nominal value of the Minibonds to eligible customers below the age of 65 and, if recoveries exceed 70%, the banks will pay the entire excess amount to eligible customers who have accepted the repurchase offer.

14 Settlement agreement between SFC, HKMA and 16 banks (cont’d)  The repurchase agreement covers about 29,000 Minibonds investors, estimated amount about HK$6.3 billion.  Up to 7 October 2009, 23,829 customers responded to the repurchase offers (23,606 customers or 99.1% accepted the offers).

15 Lessons we learned from the Minibond incident Most complaints alleged mis-selling by distributing brokers and banks.  Misrepresentation – the products wrongly presented as a low risk alternative to deposits and that the risks and complexity were not properly explained;  Complexity – the products were too complex and risk disclosures were ineffective in alerting investors;  Suitability – failure of brokers and banks to do proper customer due diligence, inexperienced retail investors were left holding products not suitable to their investment profile.

16 Measures to strengthen investor protection  On 25 September 2009, the SFC has issued a “Consultation Paper on Proposals to Enhance Protection for the Investing Public”.  To solicit comments on proposals to fine-tune existing regulations governing the sale of unlisted securities and futures products to the public.

17 Some key proposals of consultation paper  Pre-sale documentation – Criteria for authorising offer documents, including advertisements, should be consolidated into a single SFC Handbook, which will include a new Code on Unlisted Structured Products. – A “Key Facts Statement” should accompany each offer document for retail investment products.  Disclosure at the point of sale and after – Intermediaries selling to the public should disclose their own commercial interest (e.g. commissions, fees and other benefits) to prospective investors.  Selling practices – Intermediaries will be required to find out their clients’ knowledge of derivative products if they are selling unlisted structured products with such elements embedded.  Post-sale cooling-off period – For longer-term products with a limited secondary market, a cooling-off period should be given within which an investor can change their mind. This should allow a refund of capital and related commission, but be subject to a reasonable administrative charge and any legitimate market value adjustment.

18 Hong Kong Government is studying measures  Hong Kong Government is studying the feasibility of establishing an Investor Education Council and a financial dispute resolution body.

19 Questions & Answers