FSA sets guidelines for investors in Lehman structured products; U.S. impact seen as limited

By Emma Trincal

New York, Oct. 27 - U.K regulator the Financial Services Authority announced Tuesday the result of a one-year investigation on how investors "received unsuitable advice or misleading information" when buying structured products issued by now bankrupt Lehman Brothers. But U.S.-based market participants said that the implications of the newly announced measures would not be significant on this side of the Atlantic.

Dan Waters, the FSA's director of conduct risk, said: "Given the failings we have come across in the marketing and selling of these products, today we are setting out a package of robust measures to help those who have lost money. We are also taking decisive action to address issues in the wider structured products market to ensure that all future investors will be treated fairly - and we will not hesitate in taking action if firms do not take steps to respond to our concerns."

Three bankruptcies

The FSA took direct action against three distributors that "packaged and marketed" Lehman-backed structured products. The U.K. regulator announced that "following the review" NDF Administration (NDFA), Defined Returns Limited (DRL) and Arc Capital and Income plc (ACI) "have gone into administration" - the equivalent of going into bankruptcy in the United States.

In its report published on its website, the FSA found "serious deficiencies in the marketing literature provided by a number of the plan managers selling these products."

U.S. versus U.K. distribution

"You are basically talking about small distributing entities in the U.K.", said the partner of a large law firm in New York involved with the Lehman bankruptcy proceedings and commenting on the three companies.

"This issue of distribution is becoming more prevalent, including in the U.S., as investors are more and more sensitive to the credit risk of the issuer. But in the U.S., for the most part, you'll see relationships between banks themselves where one will be issuing the paper while the other will use its own platform to distribute it," he said.

"An investor with exposure to notes issued by Merrill Lynch may want to buy notes issued by JP Morgan, with JP Morgan selling the notes off Merrill's platform," he said as an example.

Distributors' liability

Another important step taken Tuesday by the FSA was to notify noteholders who own structured products issued by Lehman that they would be entitled to file a separate claim.

"Investors who purchased Lehman-backed structured products through these firms may be entitled to compensation from the Financial Services Compensation Scheme," said the FSA through its press release.

Commenting on these announcements, the New York lawyer said that, "They're setting up a complaint protocol and they're telling investors that not only can they file a claim against Lehman; but that they can also go after the marketing firms who misled them or gave them unsuitable advice. Obviously there has been a lot of discussion about disclosure of structured products. But the U.S. tends to be better than the rest of the world, more fulsome than what you see in Europe."

U.S. rules clearer

This lawyer said that in the United States the Securities and Exchange Commission has clear rules establishing that "structured products holders who have a claim to Lehman may also have a claim against the people distributing those notes."

Explaining what the rules are in the United States, this lawyer said that "the issuer is liable for what it promises to pay on the notes while the issuer and the distributor share to a certain degree responsibility for disclosure."

"In the U.S., the issuer tends to have a pretty full responsibility and a lot is covered in the prospectus," he added.

Speaking about U.S. investors holding structured notes backed by Lehman, this lawyer said: "You may not be able to get outside the Lehman universe because in many cases, Lehman had its own distribution network through its subsidiaries." He concluded: "It's not clear whether the FSA actions will have any impact in the U.S."

Whether or not the FSA crackdown influences U.S. regulators, it does not mean that the structured products industry is not paying attention to what is happening across the Atlantic.

"We're monitoring it very closely to see if it's applicable to the U.S.," said Keith Styrcula, chairman and founder of the Structured Products Association in New York.

But Styrcula also pointed to the regulatory gap between the United States and the United Kingdom, which may limit the chances that the United States would follow suit, saying: "It's likely that there is a difference in the form of disclosure in the U.K. which led to the FSA actions. U.S. Federal securities law is clear that liability only attaches to underwriters that failed to conduct due diligence on the issuer. That's not the case here."

Suitability guidelines

In its effort to set new rules, the FSA published several reports all listed on its website relating to its review of structured products. One of them is a 10-page template designed for the selling parties to ensure that the investment is suitable for the client.

Another report provides guidance to all firms advising on structured products (both those backed by Lehman Brothers and other firms) on the standards it expects them to meet, including examples of "good and poor practice" the FSA identified during its review.

Some examples of "unsuitable" structured notes investments, as defined by the FSA, include recommending a product that did not match an investor's timescale. The FSA gave the example of a kick-out product meeting the customer's investment timescale if held to maturity, but no longer suitable if the product was to 'kick-out' ahead of maturity.

Other examples of unsuitable advice include exposing the investor to an "inappropriate level of risk" or recommending a product that does not meet the client's diversification needs or tax objectives, for instance when an investment is likely to give rise to a capital gains tax liability.

The U.K. regulatory arm said that it will "undertake follow-up assessments to ensure that firms are meeting its advice standards," next year.

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