Presence of disclaimers in prospectus

Presence of disclaimers on Lehman-linked structured products prospectuses are a poor excuse at absolving financial institutions from blame
Written by Ng E-Jay
03 November 2008

Some discussion has been going around that the disclaimers on the prospectuses of the Lehman-linked structured products legally protect the financial institutions from blame, since those disclaimers clearly state that there is a chance that investors might lose some or all of their money in the event that certain unfortunate circumstances materialize.

For example, a statement on first page of the DBS High Notes 5 pricing statement reads: "If a Credit Event or a Constellation Event occurs before the Maturity Date, investors may lose their entire investment and may not receive any principal amount on the Notes." This statement was printed in bold.

A similar warning was printed on the cover of the pricing statement of Lehman Minibond Series 3: "There will be no guarantee from any entity to you that you will recover any amount payable under the Notes and you could lose all or a substantial part of your investment in the Notes."

And on page three of the same document, it said: "… the Notes are not principal protected nor capital guaranteed".

Is it true that such statements legally protect the financial institutions from blame? Perhaps so. If a collective lawsuit by investors materialize, this point may be challenged in court, and who knows, the ruling might be made in favour of investors.

My contention is that those statements and disclaimers do not morally protect them from blame, even if they do so legally. In other words, the financial institutions have committed a breach of ethics even if they have not committed a breach of law. The presence of disclaimers on Lehman-linked structured products prospectuses are a poor excuse at absolving financial institutions from blame, especially moral blame.

First and foremost, how many investors took these disclaimers seriously, even if they had read them on the first few pages of the prospectuses and they were printed in bold? Most would assume that the financial institutions were merely stating worst case scenarios for the mere sake of legally protecting themselves should the unthinkable happen. It is likely that most investors thought that such extreme scenarios had negligible probability. Did the sales representatives take special effort to mention that such extreme scenarios were not in fact impossible, but could actually occur, and in fact did occur many times throughout financial markets history?

How many sales representatives took the effort to emphasize the potential risks and pitfalls of these products to investors? How many of them made sure that investors knew there was a chance that all their money could be lost, that in financial markets history many banks had indeed failed when a crisis hit? I suspect not many. Most of them were probably too caught up in trying to make the sale that they downplayed the potential risks. Some investors say that the risk of the worst case scenario happening was played down by relationship managers who genuinely believed at the point of sale that the possibility of a credit event was close to zero.
Many retirees were offered the Lehman products even although the products were clearly not suitable for their investment horizon and risk profile. Even if a disclaimer was present in the prospectus that the investor could lose all his/her money, that fact that the product was even offered in the first place to an inappropriate investor itself constitutes mis-selling. This is a violation of the Financial Adviser's Act. This mis-selling is further compounded by the fact that some investors put all their life savings into a single product, in stark contravention of the principle of diversification, which the sales representative should have clearly advised.

However, even if we were to ignore the Financial Adviser's Act, the fact remains that bank sales personnel and financial advisers' representatives are to a large extent held in esteem by retirees and people who are not very well educated, because they are often assumed to be conversant in and knowledgeable about financial products. Some investors have said that they trusted their relationships managers so much that they simply went with whatever was recommended and did not bother to read the documentation.

To offer such a high risk product to these groups of investors and at the same time pay inadequate attention to the potential risks therein constitutes a breach of faith and trust on the part of sales representatives. Worse still, it has been shown that many of the sales representatives themselves do not know the mechanics about how these products actually work, when people actually assume them to posses adequate knowledge and training.

Finally, the strongest reason I submit why the sales of these Lehman products constitute a breach of ethics and morality is because these products are manifestly not suitable for retail investors to begin with, regardless of the risk tolerance of the individual investor. Only institutions and hedge funds should dabble in such volatile instruments like Credit Default Swaps, or invest in such potentially toxic products like Collateralized Debt Obligations with investors' money using large amounts of leverage.

The Financial Adviser's Act does not really address the issue of when an investment product is unsuitable for a particular investor, or for all individual investors. It only covers aspects like proper documentation of a client's financial status and what constitutes due diligence. I call on MAS to expand the scope of the Financial Adviser's Act to address such issues concerning complex financial instruments and structured products, and to enforce much more stringent audits and checks on financial institutions to ensure that due diligence and fair selling occurs at all times.