Brian Gaynor: Stop sweeping failure under carpet

Feltex Carpets' performance is a disgrace and a terrible indictment of the New Zealand business and investment community.

Where is the Securities Commission? Why hasn't it initiated an inquiry into the company's initial public offering (IPO) and subsequent performance?

The commission launched inquiries into the Wakefield Hospital IPO after its share price fell 44 per cent and into the Vertex IPO after the company's market price declined 41 per cent.

For some unknown reason, the commission has remained silent on Feltex, even though the company's share price has plummeted more than 85 per cent below its $1.70 IPO price and net earnings for the June 2005 year were 51 per cent below the prospectus forecast.

When the commission finally stirs into action - and this should be a matter of when, not if - it needs to look at three main areas: the disclosure of the company's pre-IPO arrangements, the prospectus forecasts and disclosure since listing.

Credit Suisse First Boston Asian Merchant Partners (CSFB) purchased all 19.5 million Feltex ordinary shares for $21.8 million between 1996 and 2002. Shortly before the IPO prospectus was registered on May 5, 2004 the company had a share split with the 19.5 million shares converting into 120 million shares.

According to the prospectus, all 120 million shares were to be sold at an indicative price per share of between $1.70 and $1.95. Thus CSFB was selling its interest in Feltex for between $204 million and $234 million, compared with a purchase price of just $21.8 million.

In addition, Feltex would also be offering between 25.6 million and 29.4 million new shares to investors at the same price.

But CSFB wasn't the only one benefiting from the share sale.

According to Feltex's $50 million secured bond prospectus, issued in April 2003, CSFB intended to offer all Feltex directors and a number of the carpet company's executives a share option plan to acquire up to 20 per cent of the Feltex shares owned by CSFB. The prospectus also stated that CSFB "may offer certain former employees of Credit Suisse First Boston options to acquire an aggregate of up to 5 per cent of its [Feltex] shares".

There is a possibility that this latter group included individuals associated with First New Zealand Capital, the joint lead managers of the 2004 IPO, as First NZ was part of the Credit Suisse Group until 2002.

The IPO prospectus was more specific as far as the share option plan for directors and executives was concerned.

It stated that this long-term equity incentive plan was realisable in the event of a trade sale or IPO of Feltex. Essentially, the plan participants were able to receive a cash sum equal to the difference between what they had to pay CSFB for shares and what these shares were worth. According to the prospectus, the plan participants would then acquire shares in the IPO "with a value equal to approximately half of the benefit received by them, collectively, from the plan".

As 6,479,900 Feltex IPO shares were subject to the plan, the collective outcome would be as follows at the indicative high and low IPO share prices:

* At $1.70 per share, the plan participants would receive $22.02 million, of which $11.01 million would be received in cash and $11.01 million reinvested in Feltex at $1.70 a share.

* At $1.95 a share, the plan participants would revive receive $25.26 million, of which $12.63 million would be received in cash and the same amount reinvested in Feltex shares at $1.95 a share.

These were in addition to normal director fees and executive remuneration.

Unfortunately, Feltex's disclosure on this matter is extremely poor and it is difficult to know exactly what each director received. But based on the assumption that all the shares purchased by them in the IPO were through this plan and they realised 50 per cent of the plan proceeds in cash and reinvested the remainder in Feltex shares, the six long-term directors benefited from the IPO as follows:

- Tim Saunders (chairman) $1.7 million

- Sam Magill (CEO) $8.4 million

- Michael Feeney $0.75 million

- Craig Horrocks $0.88 million

- David Hunter $0.75 million

- Peter Thomas $1.78 million.

These gains have been reduced by Feltex's share price collapse, but the directors are still well in the money while other IPO participants have suffered horrendous losses. CSFB's profit has also been reduced by the amount paid out under the share option plan.

A Securities Commission inquiry needs to answer the following questions:

* Are these directors' realisation figures correct?

* Was the scheme for former Credit Suisse employees enacted and did any individuals associated with First NZ participate?

* Why weren't these benefits more fully disclosed in the prospectus and 2004 annual report?

* Should directors be incentivised to obtain the highest price in an IPO, particularly when they are remaining on the board?

The second issue the commission needs to address is the prospectus forecast.

Feltex reported a net loss of $18.3 million for the June 2002 year and a net profit of $6.8 million for the 2003 year. It forecast net earnings of $22.3 million for the 2004 year, which it achieved, but fell substantially short of the 2005 forecast of $25.9 million.

The commission's investigations into the Wakefield Hospital and Vertex IPOs showed a number of deficiencies regarding the disclosure of risks and profit forecasts.

The inquiry into Feltex should determine whether the company's business risks were adequately disclosed and whether the profit forecasts were realistically struck. The commission should also decide whether it is best practice for individuals who will obtain material benefits from a high-priced IPO to dominate the profit forecast process.

Finally, the commission should investigate whether Feltex's disclosure requirements are adequate for a public issuer and the role of directors and management under these regulations.

On April 20, Feltex reached agreement with the NZX to pay $150,000 plus costs, on a no-admission-of-guilt basis, for breaches of the NZX's continuous disclosure rules.

On June 7, the company released an "update" giving an overly optimistic trading review and its share price rose from 33 cents to 38 cents on unusually high turnover.

This announcement and all recent company releases have been made by a public relations consultant. Chairman Tim Saunders, who received director fees of $140,000 last year, and chief executive Peter Thomas, who is on a base remuneration of A$420,000 ($510,800) and a bonus scheme up to an additional 80 per cent of this, seem to have gone to ground as far as shareholder communications are concerned.

The Securities Commission should ask:

* Is Feltex's disclosure adequate and consistent with the requirements of a public issuer?

* Why should the company - effectively the shareholders - pay an NZX fine for inadequate disclosure when management and directors are to blame?

* Should public relations consultants be responsible for important announcements regarding trading performances?

* What are the specific responsibilities of directors and senior executives regarding disclosure?

At the very least, the Securities Commission should initiate an inquiry into Feltex to establish best-practice guidelines regarding the interests of directors in an IPO, the disclosure of these interests and the conflicts of interest that occur when directors benefit from a higher IPO price.

Disclosure of interest: Brian Gaynor is an investment strategist and analyst at Milford Asset Management.