When selling, advising or brokering certificates and derivatives, special information is required to avoid liability towards investors. Credit institutions sold “guarantee” certificates and similar constructs to bank customers, for example the Lehman Brothers Bank, as a safe investment: numerous liability traps await bank and savings bank advisors.
I. Consultant incompetence and conditions trap
Certificates are bearer bonds issued by banks that are not protected by a deposit protection fund or a state guarantee in the event of insolvency. Most consultants have not read the certificate terms and conditions or sales brochures of up to 200 pages. They could not point out any risks to bank customers or investors – even sales managers and business administrators are affected.
II. prospectus and market trap
Anyone who has read the terms and conditions of the Certificates or Derivatives will have noticed time and again that not all risks have been clearly explained. Above all, in the vast majority of cases, issuers are unable to ensure that the securities can be traded at all times – in such cases, the term “technical problems” is used succinctly.
III Rating Trap
As with subprime paper, credit institutions have always relied on positive “ratings” which have proven to be incorrect. It is therefore not surprising that savings banks and banks were still selling Lehman papers until a few days before the collapse. As a rule, such ratings and rankings were not examined at all by specialist departments in the credit institutions, to the extent that they were able to do so at all.
IV. Market disruption and liquidity trap
It happens again and again that a bank gives notice to investors but cannot or does not want to determine the NAV (net asset value) of the investments exactly. Investors then wait for months for their money, because not even the issuer can estimate the value itself in order to be able to announce the price data (quotas).
If, exceptionally, an investor realizes a profit on exit, then according to some stock exchange regulations the transaction can still be cancelled by the bank two days later – a system to protect credit institutions from customer profits?
V. Quota Trap
The price of the securities is regularly complicated to determine because a large amount of data is involved, e.g. share price, expected dividend or price fluctuation, interest rate level. Every year it seems to happen more than 1000 times that no quota can be “set”. No investor gets to see a comprehensible calculation of his quota.
VI. yield trap
Guarantee and partial protection products are predominantly sold to investors as security-oriented. Many investors and their advisors overlook the fact that guarantees also have their price – due to the compound interest effect, it often seems cheaper to buy safe bonds with a risk-free interest rate. Most certificates do not pay the dividends of the underlying baskets or indices, which reduces profitability for the client. Likewise, yield losses must be accepted if the customer needs his money prematurely, since the guarantees issued only take effect at the end of the term (usually after a few years), which is something buyers of such constructions are rarely aware of. I wonder why.
VII Risk and complexity trap
Long and short certificates are pure speculation, with built-in leverage – if the market price moves in the “wrong” direction, the result is like playing roulette or a total loss. Another variant are bonus certificates, where the price of a share or index must remain within a certain range – if this is not the case, a practical rule, the investor loses the claim to the previously firmly promised return and the investor is threatened with substantial losses.
With highly complex designs using clever product units, consultants and customers were led to believe that they had found the formula for generating above-average returns effortlessly (without risk). The fact is that issuer and seller earn well from it and the customer is lulled into a pseudo-security.
The effects of barriers, caps and “if-then formulas” are rarely comprehensible.
For example, there is a certificate from a basket of three indices (Euro STOXX 50, Nikkei 225 and the S&P 500), where the client receives his stake back after a certain term if none of the indices has lost more than 50% since the certificate was issued. If only one index loses more than 50% during the observation period, the performance of the worst fund is paid out at the end of the term. But it gets even better: If all indices are above their starting value on the observation days (which is what one should actually aim for), the capital investment is repaid early. Which serious bank advisor has to sell such a construct and which customer really needs such an investment? Probabilities are worked with, according to which certain situations (“Do you believe that big bank XY will go bankrupt?”) will allegedly not occur. However, practice (the market) shows that not everything on the stock exchanges and capital markets can be explained by highly complex series of figures. That would be too easy; occasionally common sense should be used!
IX. Insurance Trap
Investors also have the chance to lose their entire stake by buying a life insurance policy that invests the customers’ money in certificates. This seems similar to an investor who spends his money for his old-age provision on lottery tickets every week – because this lottery could also work out well. In such cases there can hardly be any question of needs-based mediation.
X. Cost Trap
For virtually no investor or advisor, the costs are transparent, such as management and trading commissions, hidden costs. This also includes the “spread”, i.e. the difference between the buying and selling price. Added to this are management costs, custody account fees, issue surcharges or sales commissions, and the hope of price gains – usually with a simultaneous waiver of dividends. With a view to the MiFiD financial markets directive, investors could demand a reversal due to a conflict of interest later.
XI. Administration Trap
Apart from this, some banks and asset managers have also placed such securities in the custody accounts of their investors without a suitable client order or suitable investment guidelines.
XII Security Trap
Such papers are also sold as “absolute return” products, which were offered to investors as a real alternative to money market investments – only with more interest. The catch later was significant and difficult to understand losses in value – conservative investors were often not aware of these capital loss risks of 25% and more. After the bursting of the Internet bubble, certificates were sold to conservative customers in particular, who had already been hit hard with stocks from the Neuer Markt and who were now trying to make up some of the losses they had suffered with their foam curbed. The consultants also sold it quite aggressively: “Participate in the positive developments on the capital markets and be protected at the downside”. Why did the Germans become world champions in certification? Certainly not because the customers in the other countries were dumber…
XIII Credit rating trap
And finally, the expert speaks of issuer risk, because certificates and derivatives are threatened with total loss – as happened with Lehman Brothers securities, for example. But also with numerous other renowned issuers/issuers of certificates, a precise analysis leads to the result of high risks due to deficient creditworthiness. The advertising slogan about “guarantees and 100% capital protection” from the brochures often falls short.
XIV Tax fraud trap
In wealth management, combinations of derivatives with loans are used. These credit-financed derivatives are then, backed up by tax opinions from supposedly reputable law firms, advertised as a tax-saving model even by reputable credit institutions. No matter what the outcome of the sideways strategy bet, the investor should always remain in the plus. Unfortunately, however, the tax offices often see this quite differently and, for example, because of the lack of loss offsetting possibilities, juicy tax payments threaten. In the case of new types of capital investments advertised as tax-saving models, case law affirmed that the intermediary was liable for the lack of existing tax practice even despite the existence of information from the competent tax office – this information was not binding, however, and the tax authorities later changed their view.
The current crisis on the capital markets is not the cause of the imbalance in derivatives and certificates, but the result of the excessive use of derivative constructions (as with certificates) and leverage transactions as a commission machine.
Only the volume of CDSs (credit default swaps) in circulation, which lenders use to protect themselves in the event that a company is no longer able to repay its debts, had reached a volume of around EUR 55 trillion in September. That was roughly equivalent to the annual gross national product of the whole world!
The well-known investor Warren Buffett already warned of these developments in March 2003: “Mr Buffett argues that such highly complex financial instruments are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.
One could also compare these excrescences with a modern snowball system, which was very well camouflaged by the nesting.
Some of the authors have also been active as lecturers at top-class educational institutions for over a decade and have repeatedly found that the participants (mostly securities advisors) were not at all aware of the above.
“Because they didn’t know what they were doing” seems like a good summary of the situation.
PRAXISTIPPS for the future
In addition to the sales brochures, the intermediary or advisor must be fully aware of the terms of certificates and derivatives.
Basics, such as “issuer risk”, price fixing, subordinated hedging, etc. must be clear to the advisor with all the consequences and must not be underestimated.
The design of the certificate, the prospects for the underlying and the creditworthiness of the issuer are the minimum criteria for assessing the product.
Whether bonus, discount or other certificates are recommended depends additionally on the expected developments on the capital markets (sideways, strongly upward, slightly downward, etc.). So here again, the market opinion is required, with which not only the customer is overwhelmed.
Under no circumstances should the adviser or intermediary adopt ratings that he himself has not understood.
The documentation of the risk capacity and suitability of such securities for the customer requires particular accuracy.
With regard to the tax advantages promised to investors, attention should always be paid to the existence of binding information from the tax authorities.
by Dr. Johannes Fiala, Martin Dilg and RA Thomas Keppel
published in Experten-Report 01/2009, page 50-52
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About the author
PhD, MBA, MM
Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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