Govt ambivalence on key investment issues destroying confidence in industry
The demise of Strategic Finance demonstrates once again that investors have been badly let down by our securities laws, regulators, directors, management, the accounting profession and investment advisory industry.
The failure of successive Governments to take decisive action on a number of important investment issues is the main reason why there is little confidence in our capital markets and they continue to shrink, particularly when compared with Australia.
Strategic Finance was incorporated in Wellington on April 20, 1999. Its original directors were Allen Mazengarb from New Plymouth, Paul Butlitz from Wellington and Aucklander Fraser Heaven.
The company had 6 million shares, paid to 70 cents each, owned by interests associated with Butlitz and Heaven.
Its first prospectus, which was issued on August 1999, declared that the company would offer financial services to the commercial property sector.
This included term, bridging and development loans which would be on a shorter-term basis with a "defined exit strategy or firm repayment ability".
One of the features of the company was that Strategic Investment Group, then called Trident Property, was appointed as Strategic's investment manager for a fee to be agreed from time to time. Butlitz and Heaven were shareholders in the investment management company.
Strategic Finance, under chief executive Jock Hobbs, got off to a great start and in the June 2000 year raised $41.6 million from the public.
A year later it purchased Strategic Mezzanine Partners from parties associated with Brian Fitzgerald, a former Equiticorp executive. Most of the assets seemed to comprise the $6.2 million of goodwill that appeared on Strategic's balance sheet. This was a strange purchase for a highly geared finance company.
Strategic's 2002 and 2003 prospectuses were informative with graphs showing the percentage of first mortgage, second mortgage and other loans. There were also graphs on the loan maturities, property type and location.
However the 2004 prospectus was a step backwards as these graphs disappeared and it was much harder to ascertain the composition and quality of the loan book.
Nevertheless the company's total assets, net profit and dividends continued to rise as illustrated in the accompanying table.
Total assets went from $188.6 million to $696.1 million in the five years ended June 2007 and net profit surged from $6.6 million to $30.0 million over the same period.
Most property-related finance companies had a similar experience as investors flooded them with money and these funds were used to finance riskier and riskier property developments.
The problem with most property-related finance company prospectuses was that they contained little substantive information and endeavoured to create the impression that the directors and executives were experts at assessing property development projects.
In November 2005 Kerry Finnigan, a former chief executive of Hanover Finance, replaced Jock Hobbs but the latter remained on the board.
It appears that Hobbs was the largest shareholder at the time with a 15 per cent stake but ownership disclosure was poor, with a number of shareholdings held through unidentified trusts.
In 2006 the Australian-listed company Allco purchased just over 50 per cent of Strategic from six large shareholders. A year later Allco acquired full 100 per cent ownership.
The purchase price was mainly in the form of Allco shares which could only be sold on a one-third basis after each of September 2007, September 2008 and September 2009.
Allco was placed in receivership in November 2008. Meanwhile Strategic switched its promotional focus from disclosure to a credit rating from the relatively unknown Rapid Ratings. Brisbane-based Rapid Ratings granted Strategic a B1.
This was fifth from the top of a 20-level scale and, according to the September 2005 prospectus, indicated that the probability of the company defaulting on its obligations on a one-year time horizon was only 0.19 per cent.
The company's last fundraising prospectus, which was dated November 2007, was also incredibly positive.
Finnigan was particularly optimistic and had the following headings over his introduction: "Stability, Strength and Size", "Expertise and Experience", "Planning for Future Growth" and "Realising our Potential".
However on page 22 the following note appeared: "The majority of Strategic Finance's property loans involved the capitalisation of interest, with payments of interest not due until the end of the loan term".
In other words Strategic Finance was reporting interest and fee income that was not received. This is consistent with the country's accrual accounting standards and with other property-orientated finance companies.
Strategic made bad debt and impairment provisions of only $89,000 for the June 2007 year, representing just 0.013 per cent of total assets, and paid large dividends in 2007 and 2008.
On August 7, 2008 Strategic withdrew its prospectus and suspended all repayments to investors. Three weeks later Allco agreed to sell the company back to a consortium of Strategic executives but the transaction was never completed.
Strategic's loan portfolio is highly concentrated, with its top 10 loans accounting for 67 per cent of its portfolio, and by the end of October 2008 around 60 per cent of the loan book was in default as the loans had not been repaid by their due date.
Investors voted in support of a moratorium in December 2008 following a strong recommendation from chairman Denis Thom and his fellow directors.
PricewaterhouseCoopers' John Fisk, who wrote the independent report, took a neutral stance and wrote "the real decision facing security holders is whether they have confidence that Strategic Finance's directors and management will be able to use the time that the moratorium will provide to prudently manage Strategic Finance's assets to enhance the amount of cash that will ultimately be available to Security holders".
Directors and management didn't achieve these objectives and Perpetual Trust appointed Fisk as receiver last week. The collapse of Strategic Finance, and a raft of other finance companies, clearly demonstrates that the country's investment sector has serious structural problems. These include:
* Financial advisers, many of whom have no investment experience, recommend products on the basis of the brokerage, much of it trailing, paid to them.
* Finance companies use the terms "secured deposits" and "secured debentures" to give the impression that money obtained from investors is much safer than it is.
* Prospectus and investment statement disclosure is woefully inadequate and the Securities Commission and Companies Office are asleep at the wheel as far as their stewardship of these were concerned.
* There were far too many related party transactions.
* There was also far too much capitalisation of interest and fee revenue, which is disguised by accrual accounting methods. For example in the June 2009 year Strategic Finance recorded $100.8 million of interest and fee revenue in its Income Statement yet $71.7 million of this was capitalised and not received.
* Finance companies paid high dividends, even in 2007 and 2008, and many of these were paid out of new investor deposits because finance companies had large operating cash deficits due to the capitalisation of interest and fees.
* Finance company debt and impairment provisioning were far too low.
* Loan portfolios were far riskier than the impression given to investors and directors and management had far less expertise than their promotional information indicated.
Unfortunately most of these deficiencies have been evident for a long, long time - and have resulted in large investor losses in the past - but successive regulators and governments have done nothing to address these problems.
The unwillingness of these organisations to set some basic principles regarding investment products, and then police these principles, is a national disgrace.
* Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.
