The New Paper: Latest structured product scandal

Tue, Nov 04, 2008
By Larry Haverkamp

SAY you have a persuasive friend named George. He promises a high return if you leave your money with him for five years.

Five years later, you get two shocks. First, your return is much less than promised. Then you learn George has been siphoning off your money, which explains the low returns.

You confront him. He is indignant. He won't even discuss the matter. Instead, he wants to talk about you. If you can prove you are old and uneducated, George will take pity and refund part of your money.

Hey! What does that have to do with anything?

You recall a similar story from America. Banks mis-sold auction-rate notes and were later required to repurchase a whopping $80 billion of them AND pay $750 million in fines.

Even the world's largest fund - Fidelity - agreed to buy back ALL the notes it sold to investors, regardless of their age or education.

Errors in auction-rate note sales were verbal. George's mis-selling can be backed up in black and white, or rather the lack of it.

Nowhere were his charges mentioned in the prospectus or any other documents. He simply took your money without telling you.

You guessed it. The story of George is about the latest banking scandal - a structured product, called credit and equity-linked notes or 'linked-notes' for short.

Over the past 10 years, sales of linked-notes have been in the billions. They have been in the news lately due to the 15 Sep bankruptcy of US investment banker Lehman Brothers.

Hardest hit have been High Notes 5 ($103m, a total loss), Jubilee 3 ($28m, a total loss) and Minibonds ($508m, a partial loss).

A feature common to ALL linked notes is that investors never see the charges. They include:
> costs embedded in the initial pricing;
> counter-party returns in the product's risk/return structure;
> commissions from buying and selling the options, swaps and underlying bonds;
> market-making and surrender fees; and
> annual management fees, including trailer fees kicked back to distributors.

They are deducted directly from the yield. Investors are likely to attribute the low return to market conditions rather than unseen costs.
Most importantly, unit trusts and investment-linked products (ILPs) routinely publish their charges. Linked notes never do.

THREE REMEDIES
The question of the day is: 'Should non-disclosure of embedded charges invalidate linked-note sales contracts and require a refund from issuers and distributors?'

Three remedies are possible.
1. THE BEST: Banks reimburse customers for the cost of the linked-notes plus accrued interest. It is similar to the remedy used in the case of auction-rate notes.
2. THE SECOND BEST: Banks limit reimbursement to money taken without customers' knowledge. It would amount to a refund of the undisclosed charges.
3. THE THIRD BEST: Banks simply reveal the undisclosed charges. It is a non-cash settlement, but at least investors would finally learn how much money was taken from their accounts.