SFC fines Merrill over sale of index-linked notes in 2007

The regulator says Merrill failed to assess the objectives of investors. It also fines Core Pacific-Yamaichi International (HK) over the sale of Lehman-related structured products.

Hong Kong’s Securities and Futures Commission (SFC) has reprimanded Merrill Lynch Asia-Pacific and fined it HK$3 million ($386,000) over the sale of index-linked notes in 2007.

In its investigation the SFC raised concerns that the bank had failed to properly assess the financial situation and investment objectives of more than 40 of the 72 customers in question, who had all invested in the index-linked notes.

The SFC also expressed concern that key product information was provided to clients after they had agreed to invest in the notes and that Merrill kept inadequate documentation to explain the rationale behind the advice they had given to customers.

But the SFC acknowledged that Merrill had agreed to repay customers 100% of the principal amount invested to repurchase outstanding notes within 30 days of receiving valid acceptance forms. The value of the repurchase offers is expected to be $3.7 million.

In addition, Merrill agreed to offer top-up payments to customers who bought the notes through it and redeemed them for less than their principal invested.

The SFC ruling concerns two structured investment products issued by Merrill Lynch. The products were five-year quarterly callable US dollar quanto accrual notes with a knock-in feature, one set of which was linked to the Nikkei 225 Index and the other to the Tokyo Stock Exchange Mothers Index.

Quanto is short for quantising adjusting option, a cross-currency derivative. The underlying and strike price currency is usually the foreign one and the currency in which the derivative pays out is domestic. This type of investment is paid at a fixed exchange rate.

The SFC code of conduct states that intermediaries have to know and assess the investment experience of clients in terms of the investment products they have traded, the frequency and size of their trades, their experience and awareness of the risks involved.

The SFC is empowered to revoke or partially revoke and suspend or partially suspend a licence or registration. It can also issue fines of up to HK$10 million, or three times the profit gained/loss avoided, whichever is higher. Plus it can also issue public or private reprimands.

The SFC acknowledges Merrill Lynch’s full cooperation to resolve its concerns and notes that the firm – which in September 2008 was acquired by Bank of America – has already commenced a review of its internal systems and controls.

It notes that Merrill will implement enhanced complaint-handling procedures regarding its distribution, sale and provision of investment advice in relation to unlisted structured products.

Separately, the SFC also reprimanded Core Pacific-Yamaichi International (HK) over the sale of Lehman Brothers-related structured products including minibonds, octave notes and constellation notes.

The regulator raised concerns over the firm’s internal systems and controls, specifically the adequacy of product due diligence, training and guidance given to its sales staff, and the establishment and implementation of proper guidelines and monitoring procedures on the sale and marketing of Lehman-related structured products.

CPYI sold about a total of HK$1.25 million worth of Lehman minibonds, about HK$12 million worth of octave notes, and about HK$700,000 worth of constellation notes.

Although the firm did not admit any liability, it agreed to repurchase all outstanding Lehman-related structured products from eligible customers at a price equal to the principal amount invested, less coupon payments received.

It has also offered to pay compensation in respect of previous holdings in Lehman-related products. The total amount for repurchase and compensation offers is about HK$9.6 million.

CPYI agreed to improve its complaints handling and have its procedures reviewed and to engage an independent reviewer to examine its systems and processes relating to the sale of structured products.

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