Misleading Sales Literature

Without sufficient investment knowledge, many retail investors are easily cheated by misleading sales literature. The risk is even higher If they do not spend time to study the stuff and ask the right questions.

NASD recently fined two Fidelity broker-dealers $400,000 for preparing and distributing misleading sales literature promoting Fidelity's Destiny I and II Systematic Investment Plans, which were sold primarily to U.S. military personnel.

Issuance and sales of new systematic investment plans (also known as periodic payment plans), which typically require investors to make a fixed number of monthly payments over a 10- to 15-year period, were prohibited by Congress last fall. Previously sold plans remain in force.

NASD found that the two broker-dealers violated NASD advertising rules by preparing and distributing various pieces of misleading sales literature. For instance, from May 2003 through Jan 2006, the Fidelity broker-dealers prepared and distributed a brochure entitled "Time is Money" that included misleading performance claims about the Destiny Plans. According to "mountain charts" contained in the brochures, Destiny Plans significantly outperformed the S&P 500 Index over a 30-year period. But during the most recent 10- and 15-year periods - the time frame most relevant to current and prospective investors - Destiny Plans substantially underperformed the S&P 500 Index. The 30-year time period masked the underperformance of the Destiny Plans over the most recent 15 years.

The brochures also showed Destiny Plans' average annual total returns for 1, 5 and 10 years as well as the life of the Plan, without showing comparable returns for the S&P 500 Index. Again, this created the misleading impression that Destiny outperformed the S&P 500 Index throughout the periods shown. The comparable S&P 500 Index average annual total returns would have shown that the S&P 500 Index significantly outperformed Destiny during the more current time periods.

Finally, the broker-dealers used the performance of Destiny Plan Class O shares in these charts, when new Plan investors could only purchase Class N shares. Class N shares did not perform as well as Class O shares because of higher ongoing expenses. The broker-dealers prepared and sent over 10,000 copies of these brochures to Destiny retail brokers or their registered representatives to use them with both prospective investors as well as current Plan holders.

NASD also found that in May 2003, the Fidelity broker-dealers prepared and distributed a misleading Destiny newsletter to over 325,000 Destiny Plan holders. The newsletter included a mountain chart showing Destiny I Plan performance. While the chart showed Plan performance, Fidelity disclosed the average annual total returns for the underlying mutual fund portfolio, rather than for the Plan. Because Plan holders paid a 50 percent upfront sales charge on each of the first year's payments and a continuing sales charge on each additional payment until plan payments were completed, the average annual total returns for the Plans were significantly lower than that of the underlying funds.

Fidelity did not adequately supervise the review of this Destiny sales literature in light of the unusual features of the Destiny products.

As part of the settlement, for the next five years, the two broker-dealers are required to notify Destiny Plan holders who want to increase their investments in existing Destiny Plans that additional shares of the underlying fund can be purchased outside the Destiny Plans without paying the additional creation and sales charges of up to 50% on the first year's payments.

Unauthorized Portfolio Management

In HK, there have been enforcement cases against financial consultants who mis-advised clients of frequent fund switching. The situation would be even worse if such switching activities are not authorized by clients.

FSA fined Charterhouse Consulting Wealth Management Ltd £122,500 for carrying out discretionary portfolio management without permission and for various conduct of business failings.

Charterhouse regularly switched a number of clients between funds although the firm did not have permission to operate in this way. It would often send clients an email before 6.30am in the morning proposing the switching of funds and requiring a response by 8.00 am. Switches would then take place without any further instruction from the client.

Charterhouse also failed to:

• record sufficient client information to demonstrate the suitability of its advice;
• ensure transactions were appropriate for its customers' attitude to risk; and
• communicate with its clients in a clear, fair and not misleading manner.

Charterhousethe has taken mitigating steps to regularize its business activities which included the cessation of business activities falling outside its permitted activities. As a result of agreeing to settle at the earliest opportunity Charterhouse has received the maximum 30%, discount afforded under FSA's "Discount Scheme". The fine would otherwise have been £175,000.

Anti-Fraud Controls of Private Bank

Private banking has long been perceived as a high risk area. Inherent risk (client profile, transaction nature, etc.) is one thing, control risk (lack of management oversight, inadequate procedures, etc.) is another thing.

FSA recently fined BNP Paribas Private Bank (BNPP Private Bank) £350,000 for weaknesses in its systems and controls which allowed a senior employee to fraudulently transfer £1.4 million out of clients' accounts without permission.

This is the first time a private bank has been fined for weaknesses in its anti-fraud systems. The 13 fraudulent transactions were carried out between Feb 2002 and Mar 2005 using forged clients' signatures and instructions and by falsifying change of address documents.

During its investigation, FSA found that BNPP Private Bank did not have an effective review process for large transactions, over £10,000, from clients' accounts. The bank's procedures were not clear about the role of senior management in checking significant transfers prior to payment. As a result, a number of fraudulent transactions were not independently checked.

In addition, a flaw in the bank's IT system allowed the senior employee to evade the normal Middle Office processes. This meant that basic authorisation and signatory checks were not carried out on internal cash transfers between different customer accounts.

The bank's failings were serious because they enabled significant fraud to take place and failed to detect subsequent transfers to cover it up for a long period of time. It also failed to improve its procedures for monitoring large transactions or carry out remedial action on a timely basis. This was despite the bank being aware that certain of its procedures required improvement as a result of an FSA visit in relation to money laundering systems and controls in Aug 2002 and subsequent internal reviews.

Best Execution

In SFC's Code of Conduct, "best execution" means when acting for or with clients, the intermediary should execute client orders on the best available terms. In actual world, under what circumstances would this principle be violated?

Last week SEC settled fraud charges against Morgan Stanley & Co. Inc. for its failure to provide best execution to certain retail orders for OTC securities. In particular, Morgan Stanley embedded undisclosed mark-ups and mark-downs on certain retail OTC orders processed by its automated market-making system and delayed the execution of other retail OTC orders, for which Morgan Stanley had an obligation to execute without hesitation.

Morgan Stanley will pay around US$7.9m in disgorgement and penalties to settle SEC's charges. All of Morgan Stanley's revenue from its undisclosed mark-ups and mark-downs will be distributed back to the injured investors through a distribution plan.

From Oct 2001 through Dec 2004, Morgan Stanley failed to obtain best execution for certain orders for OTC securities placed by retail customers of Morgan Stanley, Morgan Stanley DW, Inc. and third party broker-dealers that routed orders to Morgan Stanley for execution. As a result of this conduct, Morgan Stanley breached its duty of best execution with respect to these retail customers' orders.

Morgan Stanley failed to provide best execution to more than 1.2 million executions valued at approximately US$8 billion. Morgan Stanley recognized revenue of $5,949,222 through its improper use of undisclosed mark-ups and mark-downs. As stated by SEC, Morgan Stanley was recklessly programming its order execution system to receive amounts that should have gone to retail customers.

Suitability Obligations

Last week SFC published the FAQ on suitability obligations. This may be regarded as a principles-based regulatory approach towards investment advisers (IA). That means, SFC has not intended to expand the existing Code of Conduct requirements but only supplement them with guidance on best practices.

Basically most of the tips given by SFC belong to "old wine in new bottle", but the following points are remarkable:

• SFC states clearly that suitability means "matching" the risk return profile of investment products with personal circumstances of clients.
• In terms of KYC information for suitability purpose, Code of Conduct has only mentioned clients' financial situation, investment experience and investment objectives. SFC has extended this information list to investment knowledge, investment horizon, risk tolerance and capacity to make regular contributions.
• SFC shows understanding that many clients are not willing to disclose their financial situation. In this case, IA is expected to explain to clients the limitations of his advice and the assumptions made by him.
• When conducting product diligence, IA should not rely only on offering documents and marketing materials, but make their own enquiries and obtain full explanations from product issuers.
• Where IA only recommend investment products which are issued by their related companies, they should disclose this limited availability of products to each client.
• IA should document and provide a copy to each client of the rationale underlying investment recommendations made to the client.
• Client files, esp. those with a higher mis-selling risk, should be sample reviewed by qualified and competent personnel (by compliance officer?).

The FAQ guidance has reflected SFC's dissatisfaction with its observations of selling practices over the past years. Needless to say, the enhanced sales compliance practices would make the life of IA less easier.

Analyst Conflicts of Interest

Since April 2005 SFC has implemented the new Paragraph 16 added to the Code of Conduct in order to address the analyst conflicts of interest problem. Before that, the compliance awareness of certain research analysts was perceived to be quite low.

This week SFC reprimanded and fined two guys from South China Research Ltd, namely Patrick Pong (research analyst) and Anthony Teoh (head of research). It is a rare case for a research head being disciplined.

Pong's Case

• In one case in 2003, Pong purchased securities days before he prepared a BUY report on the same securities, but failed to disclose his interest in the report. This research report was however not initiated by Pong (requested by his boss?).
• In another case in 2003, Pong purchased shares days before South China issued a SELL report on the same shares (i.e. his trading is contrary to the research recommendation).

Teoh's Case

• Teoh subscribed for IPO securities recommended by a South China research report, sponsored by South China Capital Ltd, and co-led by South China Securities Ltd in underwriting the allotment. He sold the securites on their debut trading day.
• Teoh allocated the preparation of a research report to his subordinate who had a pre-existing interest (I guess this subordinate was Patrick Pong).

In the above cases, obviously the analysts had no intention to produce objective research reports. It appeared that the research team had not put in place compliance measures to prohibit staff dealings in black-out period, in quiet period and to the contray of recommendations. I think the head of research should bear the most responsibility in putting his subordinate in conflicts of interest.

Cross-Market Insider Trading

The securities markets have been globalized to facilitate both legal and illegal trading activities. Last time we found a case of cross-market manipulation, this time cross-market insider trading.

Last week SEC charged Hafiz Naseem, an investment banker with Credit Suisse, with illegally divulging non-public information to a person believed to be a banker in Pakistan concerning the leveraged buyout of TXU Corp. by an investor group led by Kohlberg Kravis Roberts & Co. and Texas Pacific Group. Naseem misappropriated the information from his employer, Credit Suisse, which served as a financial advisor to TXU in connection with the buyout.

In Feb 2007 Naseem telephoned the Pakistani banker on several occasions and disclosed non-public, material information about the proposed but unannounced TXU buyout. After receiving the insider information, the Pakistani banker purchased 6,700 TXU call option contracts with Mar 2007 expiration dates through UBS AG London, and made profits of approximately US$5m following public announcement of the buyout.

In addition, Naseem divulged pending, but unannounced, business combinations and deals involving eight other issuers, where Credit Suisse served as an investment banker or financial advisor in all of these deals. Naseem's phone calls from his work phone to the Pakistani banker's home and cell phones were made immediately before announcements of the proposed deals. The Pakistani banker also purchased securities in those companies in advance of public merger announcements, obtaining additional profits of more than US$2.4m.

Naseem opened a brokerage account in Pakistan in May 2006 and granted the Pakistani banker trading authority over that account to conceal his personal financial benefit from his misappropriations. SEC is seeking injunctive relief, disgorgement, and money penalties against Naseem.

SEC also identified another previously unidentified trader who purchased in advance of the public announcement regarding TXU. Francisco Javier Garcia, believed to be a resident of Switzerland, purchased TXU securities through Fimat Frankfurt and is believed to have done so on inside information.

When investigating into the tipping by Naseem, SEC had obtained the assistance provided by Credit Suisse in the process of identifying Naseem as well as the cooperation afforded by NYSE, Chicago Board Options Exchange, Swiss Federal Banking Commission and UK FSA in helping to piece together evidence from across the globe, such as phone and brokerage records, to uncover Naseem's unlawful insider trading.

Cross-Market Manipulation

Following a joint investigation, this week NASD and the Chicago Stock Exchange (CHX) fined and suspended two traders for artificially inflating the price of the stock of Material Science Corporation (MSC), a NYSE-listed company, in connection with MSC's repurchase of its stock.

NASD imposed a $25,000 fine and a three-month suspension on Klaus Offenbacher, a trader with NASD-registered First Analysis Securities Corporation of Chicago. CHX imposed a $20,000 fine and a two-month suspension on Bruce Kaminski, a floor broker with Dougall & Associates of Chicago, a CHX Participant firm. Neither MSC, First Analysis Securities Corporation nor Dougall & Associates had knowledge that Offenbacher and Kaminski planned to artificially increase the price of MSC stock.

Offenbacher was responsible for repurchasing MSC stock on behalf of the issuer pursuant to the company's stock repurchase program. MSC wanted its repurchases to fall within the safe harbor provision of SEC's rule governing issuer buy-backs, which provides that issuer purchases cannot be the opening purchase of the day and cannot exceed the highest independent bid or last independent transaction price.

On 21 Aug 2006, Offenbacher received authorization from MSC to repurchase 100,000 shares of MSC stock pursuant to the repurchase program. The same day, Offenbacher located an institutional customer willing to sell a 174,300-share block of MSC stock with a limit price of US$9.90. Later that day, Offenbacher attempted to contact the principals of MSC to get approval to purchase the entire block. MSC stock closed that day at a price of $9.80 per share.

Early the following day, Offenbacher received approval from MSC's principals to purchase the block at $9.90 per share. Before the market opened, Offenbacher directed Kaminski to purchase 1,000 shares of MSC stock at $9.90 per share, in the event MSC opened below $9.90 per share. When MSC opened at $9.75 per share, Kaminski executed the 1,000 share transaction at $9.90 per share which artificially drove the stock's price up 15 cents to the level Offenbacher needed to execute the cross trade.

Kaminski's execution of the 1,000-share transaction on NYSE established an artificial reference price at which the larger block transaction was then executed on the CHX. As a result, the regulators found that Offenbacher and Kaminski knowingly and intentionally artificially increased the market price of MSC stock in an attempt to make it appear that the purchase fell within the SEC's safe harbor provision for issuer buy-backs.

If MSC, First Analysis Securities Corporation and Dougall & Associates did not direct Offenbacher and Kaminski to conduct the cross-market manipulation, what had motivated these two guys to play this illegal trick?

Failures in Complaint Handling

In UK, there is a special category of investment products called Structured Capital at Risk Product (SCARP), which is a "precipice bond" which provides a fixed level of income (which can be drawn down or accumulated) over a fixed investment period. It offers limited protection against the loss of the capital invested in the first place and whether or not customers get their original capital back depends on the performance of an index, or more than one index, or a selection of stocks.

From time to time FSA has reminded retail investors about the risk of investing in SCARP which has no capital guarantee and carries a long investment horizon. Some financial institutions were also fined by FSA for mis-selling of SCARP. For instance, recently FSA fined Sesame Ltd £330,000 for failing to treat its customers fairly by not handling complaints concerning SCARP adequately.

The problems with Sesame's complaints handling were identified as part of FSA's thematic review of SCARP during Mar and Aug 2004. FSA found that between Mar 2003 and Oct 2004 Sesame incorrectly rejected complaints from approximately 350 customers. These customers had lost nearly £5.9m. The complaints related to sales made by Sesame's legacy networks, which at least reflected the following problems:

• Sales of SCARP were made to retired customers who were unable to absorb the downside risk.
• Customers' risk attitude was wrongly recorded on customer files.
• Salespersons misled customers by describing SCARP as a low risk investment.
• Legacy networks and complanint handlers had applied inconsistent risk ratings to SCARP.
• Sesame did not take adequate action when it became aware of the increasing number of SCARP complaints.

After FSA identified the problems, Sesame took prompt action to ensure all affected customers were compensated and engaged external advisers to review its SCARP complaint handling procedures and train its staff.

Complaint handling function is more important for financial firms serving the retail market. If the management turns a blind eye to complaints, they will eventually suffer.