(NOTE: This is one of my many investigative exposés on commercial crimes during my newsroom days. It bagged the Society of Publishers in Asia (SOPA) award for Excellence in Business Reporting in 2005. Somehow the link to the story is not working so I am pasting the entire script below. I also penned a follow-up piece under a different byline following the Lehman Brothers mini-bonds scandal – you can find it here.)
By Vanson Soo 2004-11-01
Fund losses spark fury
There is never a shortage of bad investments _ or people eager to sell them to you. From Internet come-ons to “boiler rooms” in Bangkok, investors are bombarded with a steady stream of supposedly low-risk, high-return deals.
What is not so common is an investment scheme making similar claims marketed by one of the United Kingdom’s biggest financial institutions carrying what many investors took to be the implicit approval of reputable banks on three continents.
More than 7,000 Hong Kong investors, many of them affluent professionals and small businessmen, invested in one such product, the Offshore With Profits (OWP) funds sold by Clerical Medical Insurance (CMI), a subsidiary of Halifax-Bank of Scotland, one of the UK’s biggest mortgage lenders. Hong Kong was the place where a significant amount of sales for a fund that totalled about US$3.5 billion at its peak _ it is now about half that size _ took place with investors here typically investing more than US$100,000 each.
Although CMI says it does not have complete data, available information suggests that Hong Kong investors alone put more than US$700 million in the funds. Most now wish they had not. That is especially true of those who borrowed up to three times their initial investment to buy extra shares in the fund, only to see its asset value dive. At stake is whether or not they were misled by the sales pitch _ and whether Hong Kong regulators will conduct a thorough investigation into what is shaping up as one of the biggest losses in Hong Kong fund history.
Investors in the funds who sought to cut their losses after markets fell paid stiff fees. On top of an exit fee of up to 9 per cent they also paid an early redemption fee that ranged as high as 25 per cent _ a fee that CMI had said in its promotional materials would be imposed “only occasionally” without setting out how it would be calculated or how high the fee might go.
At the same time, many banks began calling their loans, forcing investors in effect to pour even more of their own capital into an investment that had already gone badly awry.
Meanwhile, Hong Kong regulators refuse to say whether or not they are investigating CMI. For its part, CMI in September said that it would stop marketing funds in Hong Kong. Not surprisingly, many of the investors in the fund are seething, and have already organised into at least two groups to seek redress, either from Clerical Medical, the advisers who sold them the funds, or both. (They can be reached at firstname.lastname@example.org.)
No one has accused the firm of doing anything illegal; indeed, the fund was duly registered with the Securities and Futures Commission. What they do claim is that the tenor of the sales pitch, which emphasised safety and low risk, was fundamentally misleading.
And the encouragement they say they were given to leverage their investment stressed how they could substantially boost their gains, with warnings about heightened risk given little emphasis to an investor base that was unfamiliar with gearing.
“What has happened was completely different from what I was told,” said Nilesh Shah, an Indian entrepreneur who came to Hong Kong to set up his trading company in 1988.
“We have invested in funds without SFC approval that are safer,” said Jignesh Raj, an Indian businessman and a Hong Kong resident since the 1970s.
In its marketing materials, CMI said OWP and similar funds it sold were suitable for investors “looking for an investment that reflects long-term trends in equity and bond markets, combined with valuable guarantees that protect the value of the investment”.
It was such an apparent good deal that many investors succumbed to the temptation to quadruple their bet by borrowing from a roster of blue-chip banks that cater to high-net-worth individuals. One reason investors may have turned a blind eye to the risks inherent in OWP and similar funds was their track record. Marketing materials distributed by one Hong Kong adviser, Richmond Asset Management, in 2001 cited an average return from 1995-2000 for CMI’s US dollar fund of 15.83 per cent. That period, of course, spanned one of the greatest bull markets in US history.
But when stocks turned south, it was a very different story. CMI’s funds, which were 70 to 80 per cent invested in equities, were hard hit. To compound matters, CMI stuck with equities, only pulling out abruptly after the September 11, 2001 attacks on the World Trade Center, when the fund switched to bonds and cash and imposed an exit penalty in order to keep assets from draining out of the fund at such a rapid clip that they could have crippled its ability to repay remaining investors.
Few investors foresaw the advent of the downturn, and fewer still its severity. In such a market, liquidity _ the ability to freely buy and sell _ is everything. In the OWP and similar funds, however, the penalties made investors hesitate. They often did not realise how deep a hole their investment was in until it was too late.
And it is those investors who doubled or tripled their bets _ no one seems to know how many, but their numbers clearly are substantial _ who have been most badly hurt.
It is over the question of just exactly who encouraged investors to borrow money to buy more shares in OWP and similar funds that is most at issue. CMI apparently never mentioned the idea in the materials distributed directly to investors _ and which were approved by the SFC. And when interviewed by telephone from CMI’s Bristol, England headquarters in September, Gordon McAra, CMI’s chief spokesman, insisted that arrangements for bank loans “were made by brokers rather than ourselves”. In a subsequent e-mail, he said that he could “find no trace of any documentation or any other means that would in any way suggest that we were involved in encouraging policyholders to consider gearing/leverage of their policies, or that we recommended Bank of Scotland, Rothschild, Rabo or any other lenders”, he wrote, adding that “any such arrangements were between the policyholder and their advising IFA [independent financial adviser]”.
That’s not how many financial advisers remember it. Many say it was CMI that promoted the idea of gearing, and that it was CMI’s presentations to advisers that got many excited. Some proceeded to promote gearing to their clients and approached banks to provide the loans. Many brokers singled out Colin Reid, sales manager at CMI in Hong Kong until about three years ago, as one of those who pushed the idea .
One local financial adviser, who used to sell CMI funds and refused to be named, said Reid “categorically mentioned that gearing was available” from banks during training sessions for prospective intermediaries at CMI Hong Kong’s office in 1999. “If CMI denied it was they who introduced it, how can they explain how hundreds of individual intermediaries in Hong Kong embraced the concept all at once?”
Another broker said CMI promoted the idea of gearing but was careful not to mention it at all in its marketing materials. “They were very smart to do that,” this adviser said.
He recalled witnessing Reid write and distribute to local financial advisers in 1999 an illustration of the benefits that could be gained from gearing. According to him, some banks even paid a 0.25 per cent commission to the financial advisory firms, on top of the commission they received from CMI, on every dollar geared.
Mark Rawson, then regional director for CMI Financial Management Services in Hong Kong and whose current role in the company is unclear, said in an interview that Reid left the company some time between 2000 and 2001 and is currently back in the UK. (Efforts to contact Reid were unsuccessful.)
Rawson, who only agreed to an interview after The Standard unearthed documents relating to the gearing practices, said he was not aware whether banks, including the Bank of Scotland, paid any commission to financial advisers. He refused to discuss CMI’s commission payments to advisers, which ranged from 2 per cent to at least 5 per cent of the investment, saying only that the company paid “market norms”.
Whether CMI actively promoted gearing or not, there is evidence that the company was more than willing to discuss the subject with financial advisers. In a letter from Rawson faxed to one adviser on Septmber 22, 2000, and later distributed to many others in ways that remain in dispute, Rawson provided a sample of the kind of boost that leverage could give to an investment in CMI’s Guaranteed Growth Fund, another product marketed by the firm. It shows that a US$100,000 investment, when coupled with a US$250,000 loan from the Bank of Scotland (which was not then affiliated with CMI) would produce a return of US$331,488 after deducting the loan and accrued interest based on the performance of a similar CMI fund.
In an e-mail on Friday, Rawson said that the letter was prepared in response to a question from the adviser, and that it was for the purpose of “updating their own internal material”. He could not explain how other brokers obtained the document. A spokesperson for the firm in Hong Kong suggested that the original broker may have sent the material to competing financial advisers.
Rawson also gave a presentation to advisers in January 2001 that explicitly illustrated the difference in returns between a “standard” and a “geared” investment. The presentation indicated that the OWP “offers access to real asset returns with very low risk. Ideal as core holding and protected part of a portfolio”. The presentation went on to say that “gearing is a higher risk strategy for more sophisticated investors and needs to be balanced within a total portfolio”.
In an interview, Rawson said that “this presentation . . . was designed to talk solely to intermediaries, not to clients. And designed to illustrate that there were risks attached, so that advisers need to be aware, or at least make clients aware of that position”.
Many intermediaries said they were concerned about the use of leverage.
“The problem with gearing is that clients don’t understand or are not properly informed about how the gearing changes their risk profile,” said Kevin Slattery, chief executive of the Henley Group, one of the advisers that sold CMI products in Hong Kong _ but only ungeared.
CMI’s Rawson said the intermediaries are supposed to use only those promotional materials provided by CMI, which were SFC-approved, when they made their sales pitch to prospective clients. Those materials were not shy about the supposed advantages of the OWP fund. “High growth without high risk,” one marketing presentation reads. “Capital guaranteed. Growth guaranteed. Dividends guaranteed.”
Touted as a consistent top-10 performer, the marketing materials showed the CMI funds managed an average return of 15 per cent annually between 1978 and 1995, and 11.7 per cent during the worst five years.
“If you look back retrospectively, over almost any five-year timeframe since the World War II, historic returns from this type of product have exceeded the cost of borrowing,” said Chris Beale, director of financial advisers Clearwater International.
Unfortunately, gearing became popular just as the market was peaking. So it was losses, not gains, that were magnified.
CMI retail clients said they were told a list of well-known banks would lend up to three times the value of their investment to take up additional OWP shares. One client recalls being told by an adviser in mid-2001 that “there are several banks willing to lend against this investment, and naturally they have done a thorough due diligence on Clerical Medical”.
Another prospective client also says he was told by his adviser that financing was available for three times the value of his investment with “absolutely no asset-proof or income-proof” required. Furthermore, the investor was told “the entire capital invested in this fund is protected, hence the single-biggest capital risk of gearing is eliminated. The investment is guaranteed to repay borrowed capital”.
Rawson said in an interview that the banks which were willing to lend for OWP purchases included N M Rothschild, the Bank of Scotland, Northern Bank (from the Isle of Man), SG Hambros, Ned Bank (of South Africa) and the Royal Bank of Scotland.
Rawson said the Bank of Scotland were involved “in the very early days” but that there was “no formal arrangement between CMI and the Bank of Scotland”.
“If the question is did CMI discuss with the banks how our products work, and how they can be used, then the answer is yes,” he said.
When asked if gearing was discussed in these exchanges, Rawson said “there has to be, because essentially that is the purpose we would be looking at our plans. We provide the Bank of Scotland with information of our clients so that they can actually assess them from their credit point of view”.
In an e-mail response in September, CMI spokesman McAra said “we are not party to the loan arrangements and don’t have information on what was borrowed or on what terms or what the current outstanding value may be. This information can only come from the bank, client or broker. We have a declaration signed by the client and the adviser that they fully understand the risks associated with gearing”.
A source from Rothschild in the UK said it was the intermediaries who approached them individually to provide the loans. The bank in turn approached CMI to pledge the funds as a collateral.
However, the banker said the bank did not ask borrowers to provide any income or asset proof, since they could easily make up any shortfalls by making margin calls on the borrowers.
Though investors who borrowed to boost their exposure to OWP are obviously the worst hit, even those who merely put their own capital into the funds are aggrieved, arguing that CMI never properly warned them about the risks of the exit penalty being applied.
CMI defends the exit penalty, or market value adjuster, as essential to the funds’ operations. “Market value adjuster is a mechanism to ensure that the payoffs from the funds, in times of significant market fluctuations, are fair to those investors who remained in the funds,” Rawson said.
“CMI has never imposed this penalty in the history of running such a fund since 1824 and it is unlikely that it will do so in the near future,” a marketing document says.
So why did investors buy into all this? Some say the CMI funds did not appear too good to be true because they were actually less speculative than others on the markets. Investors said they also took comfort that the funds were SFC-approved and established banks were willing to provide the loans.
“One person can be fooled, but can all 7,000 be totally misled?” Shah said.
An SFC spokesman said it is concerned, in general, if licensed intermediaries gave inappropriate advice to investors. Investors can file complaints if they think their brokers acted inappropriately.