Legal Professional Privilege

In response to numerous complaints on SFC's authorization of Lehman Brother Minibonds, SFC has alleged that the regulatory focus for authorizing product documentation is on disclosure rather than on the commercial merits of the investment. However, SFC would examine whether any facts, matters or circumstances that should have been disclosed to SFC were not disclosed by the Minibonds issuers and their advisers at the time the offer prospectuses and marketing materials were submitted for vetting.

Recently SFC has applied to the High Court for an order directing Lehman Brothers Asia Ltd (in liquidation) to comply with an SFC Notice to produce certain records in connection with its investigation of the offer and marketing of Minibonds. The Notice required Lehman Brothers to produce to SFC all documents relating to the assessment of Minibonds by an internal Lehman Brothers committee called the New Product Review Committee.

SFC believes the Committee oversaw or approved products including the Minibonds and that these documents are relevant to its investigation. In response to the Notice, lawyers for Lehman Brothers produced certain documents but objected to the production of 17 other documents on the grounds that these documents should not be produced because they were the subject of a claim of legal professional privilege. It appears the claim arises because a member of the Committee was an in-house lawyer at Lehman Brothers.

SFC disputes that the entire contents of these documents are necessarily the subject of a valid claim of legal professional privilege and asserts that they should be produced to SFC in compliance with the Notice. Discussions between SFC and the liquidators of Lehman Brothers and their lawyers, since December 2008, have not resolved this claim of privilege. In bringing this proceeding before the court, SFC wants to ensure there is an independent adjudication on the issue.

Legal professional privilege is an interesting subject of debate in this case. It protects communications between a lawyer in his professional capacity and his client, provided they are confidential and are for the purposes of seeking or giving legal advice. However, in general documents sent to or from an independent third party (even if created with the dominant purpose of obtaining legal advice) should not be covered by this privilege. I am interested to know what exactly the documents SFC is looking for.

Rampant Churning

US SEC and Alabama Securities Commission (ASC) recently charged a broker-dealer in connection with rampant churning of customer accounts, widespread supervisory failures, and other securities violations that resulted in significant harm to clients and substantial profit to the firm. Also charged by SEC and ASC were several of the firm's senior officers and registered representatives. Churning is a fraudulent practice that occurs when a broker engages in excessive trading without regard to the customer's investment objectives for the purpose of generating commissions and other revenue.

SEC alleges that Aura Financial Services and six registered representatives used fraudulent sales practices and high-pressure sales tactics to convince customers to open and invest money in Aura brokerage accounts, which the brokers subsequently churned. Aura and the brokers enriched themselves with approximately US$1 million in commissions and other fees paid by the customers while largely depleting the customers' account balances through trading losses and excessive transaction costs.

ASC issued an amended order to show cause against Aura and three of its senior officers, based upon the findings of several ASC audits. The order alleges that Aura and the three managers violated their supervisory and compliance responsibilities under the Alabama securities laws. Despite the fact that many of the firm's representatives had criminal or disciplinary backgrounds and multiple prior customer complaints, Aura and the three managers failed to adopt appropriate procedures, failed to enforce rules, failed to conduct branch office inspections, and failed to maintain files of and follow up on customer complaints.

In addition to alleging the supervisory failures, ASC also cited Aura with unauthorized trading by a former representative which included trading after the death of the trustee. The firm's representatives operated under the "honor system" and documentation evidencing active oversight was lacking. Aura failed to perform independent review of customer complaints and summarily dismissed certain complaints based solely on the representations of their agent or representative.

The amended order requires Aura, within 28 days, to show cause to ASC why its registration as a broker-dealer and agent in the State of Alabama should not be suspended or revoked. The named supervisors in ASC's order are Timothy M. Gautney, Aura's founder and Chief Operation Officer; Loyd Gilford King, Aura's Corporate Treasurer; and John Wesley Woodruff, Jr., Aura's Chief Compliance Officer.

SEC's complaint has charged six current and former Aura registered representatives located in branch offices in Florida and New York. SEC alleges that the scheme began in approximately 2005. Although some of the misconduct stopped when two of the registered representatives left Aura in August 2008, the scheme continued through at least April 2009.

What a house of thieves!

Unregulated Financial Markets and Products

In May 2009, IOSCO's Technical Committee published "Unregulated Financial Markets and Products - Consultation Report". The Report contains interim recommendations for regulatory action designed to improve confidence in the securitisation process and the market for credit default swaps (CDS). The interim recommendations contained in the Report address issues of immediate concern with respect to securitised products and CDS. Securitised products include asset-backed securities (ABS), asset-backed commercial paper (ABCP) and structured credit products such as collateralised debt obligations (CDOs), synthetic CDOs, and collateralised loan obligations (CLOs).

While encouraging industry responses in the securitisation process and CDS market, IOSCO recognises that industry initiatives alone will not be sufficient to restore transparency, market quality and integrity and has therefore formulated a number of interim recommendations to address the following concerns associated with both these areas.

Securitisation

Interim Recommendation 1 – Wrong Incentives

1. Consider requiring originators and/or sponsors to retain a long-term economic exposure to the securitisation;
2. Enhance transparency through disclosure by issuers of all checks, assessments and duties that have been performed or risk practices that have been undertaken by the underwriter, sponsor and/or originator;
3. Require independence of experts used by issuers; and
4. Require experts to revisit and maintain reports over the life of the product.

Interim Recommendation 2 – Inadequate risk management practices

1. Mandate improvements in disclosure by issuers including initial and ongoing information about underlying asset pool performance and the review practices of underwriters, sponsors and/or originators including all checks, assessments and duties that have been performed or risk practices that have been undertaken. Disclosure should also include details of the creditworthiness of the person(s) with direct or indirect liability to the issuer;
2. Strengthen investor suitability requirements as well as the definition of sophisticated investor in this market; and
3. Encourage the development of alternative means to evaluate risk with the support of the "buy-side".

Interim Recommendation 3 – Regulatory structure and oversight issues

IOSCO recommends that jurisdictions should assess the scope of their regulatory reach and consider which enhancements to regulatory powers are needed to support the interim recommendation #1 and #2 in a manner promoting international coordination of regulation.

Credit Default Swaps

Interim Recommendation 4 – Counterparty Risk and Lack of Transparency

In forming the interim recommendations below, IOSCO considered the establishment of central counterparties (CCPs) for the clearing of standardised CDS as an important factor in addressing the issues of counterparty risk and transparency.

Interim Recommendation 5 – Regulatory structure and oversight issues

IOSCO recommends that jurisdictions should assess the scope of their regulatory reach and consider which enhancements to regulatory powers are needed to support the interim recommendation #4 in a manner promoting international coordination of regulation.

Program Trading & Pre-Hedging

FSA recently banned and fined trader Nilesh Shroff for deliberately disadvantaging his customers by "pre-hedging" trades without their consent. Shroff has been prohibited from performing any regulated function on the grounds that he is not fit and proper and has been fined £140,000.

While Shroff was a senior trader at Morgan Stanley, FSA found that he disadvantaged his clients on seven occasions between June and October 2007 by partially "pre-hedging" program trades without the clients' consent.

At the material time, Mr Shroff's position at Morgan Stanley was executive director, risk-trading program and his role included the management of the programme trading risk book and the facilitation of program trades on behalf of clients. This involved the preparation of pricing and the execution of trades and the ongoing management of the risk portfolio. The overall objective of the risk book was to manage risk from customer trades.

"Program trading" is the term used to describe a transaction or series of transactions by an institution when acquiring or disposing of an entire portfolio or a material part of a portfolio. Program trades can be all "one way" or a combination of buys and sells.

All the program trades made by Mr Shroff on behalf of clients were made on a principal (rather than agency) basis. For a principal trade, typically a number of brokers will be asked to tender to acquire the portfolio from or for the institution, quoting a premium or discount to the mid-price for each security at a designated strike time, which is known as the "snap". The premium or discount (the "risk fee") is expressed in a number of basis points. Transactions with brokers are often conducted via an institution's centralised dealing desk.

Principal trades are attractive to customers who want to undertake a large number of trades at the same time but do not want to assume the risk of the share prices moving against them in the period between the commencement and completion of trading. The broker assumes that risk in return for the risk premium.

The execution of a principal programme trade usually involves the following steps:

1. The customer provides limited information about its portfolio, e.g. sectors and percentages of average daily volume ("ADV"), to a number of brokers to enable them to assess the risk and quote for the trade, but without disclosing the component securities and, usually, whether the customer is a buyer or a seller in respect of each;
2. The customer receives the quotes from the brokers;
3. The customer reviews the quotes and awards the trade to one of the brokers;
4. The customer communicates the award to the winning broker and a snap time is agreed;
5. The customer provides the broker with the full details of the component securities and indicates whether they are buying or selling; sometimes this information is provided before the snap but more usually afterwards. In the case of the trades referred to in this notice, details of the portfolios were provided to Morgan Stanley before the snap;
6. Each stock is supplied to or purchased from the customer by the broker at the snap time at the quoted premium or discount to the mid-market price.

"Pre-hedging" refers to trading by a broker for his firm's benefit in advance of carrying out a trade for his customer, using information provided by that customer. Where customers instructed Shroff to buy particular stocks, he bought those stocks for the firm first, causing the price to increase before he executed the customers' trades. Where the customer order was to sell he first sold on behalf of the firm, decreasing the price. Shroff knew such unauthorised pre-hedging was expressly prohibited by FSA and Morgan Stanley's policies and not in his clients' interests.

It appears that pre-hedging is a kind of front-running in the context of program trading.