Brian Gaynor writes that Capital + Merchant's directors are not the only ones who need to face questioning.
The Securities Commission's decision to lay criminal charges against Capital + Merchant Finance directors once again puts the spotlight on the behaviour of finance companies.
Individuals lost most or all of their money in these companies because many acted as private banks for their owners, they lent money on high-risk property developments and they received almost no income because interest on loans was capitalised.
Each failed finance company seems to throw up a new scandal and Capital + Merchant is no exception.
In this instance the directors raised additional money from other financial institutions and placed these borrowings ahead of retail debenture holders. These prior charges were in two forms: Financial institutions were given prior charges over individual Capital + Merchant loans. Fortress Credit Corporation was given priority over all debenture holders and it would have to be fully repaid before retail investors received a cent back in a receivership.
Where was Perpetual Trust, the trustee that was supposed to be looking after debenture holders' interest, during this debacle?
Richard Simpson and Tim Downes of Grant Thornton were appointed receivers of Capital + Merchant by Fortress on November 23, 2007. Fortress, an aggressive New York-based lender, had a $20.55 million loan to Capital + Merchant which had priority over all other company borrowings.
Receivership occurred just four days after Capital + Merchant chief executive Owen Tallentire wrote to investors telling them the company was in a sound position and investors should consider reinvesting in the company as it lent to "astute borrowers". He also wrote that the secured debentures were "100 per cent insured" and "there will be no loss to investors".
Grant Thornton was refused entry to the company's premises and Capital + Merchant's directors sought an injunction to restrain the receiver from taking any further steps until an order of the court was obtained.
After the High Court hearing on November 28, Justice Harrison noted in his judgment that the troubled finance company "appears to be operating more in hope than expectation that borrowers will retire outstanding debt from sales or refinancing". He said the company appeared to have "a traumatised loan portfolio characterised by security over large amounts of bare land or uncompleted developments. Capital + Merchant appears to be sinking under the weight of non-performing loans, with its security margin being progressively eroded by the compounding effect of capitalised interest on principal in a flat or regressing market".
Justice Harrison found in favour of Fortress and Grant Thornton and the receivership proceeded.
Perpetual Trust appointed KordaMentha as second receivers on November 29 to protect the interest of debenture holders.
On December 5 Perpetual Trust wrote to the 7000 debenture holders but gave no indication of the dire situation they were facing. Trust chief executive Louise Edwards wrote: "We and KordaMentha will be working to ensure that the role of Fortress' receiver is completed efficiently, cost- effectively and quickly, with the least possible negative impact on your investment. Once Fortress has been repaid their $20 million, their receiver will retire and KordaMentha will continue on."
Grant Thornton discovered that only one of Capital + Merchant's 55 loans, a tiny $20,000 facility, was paying interest. All other loans had capitalised interest provisions.
The total value of Capital + Merchant's 55 loans was $182.6 million, including $37.6 million classified as related party loans (see table). Grant Thornton believes additional loans of $41.1 million, making a total $78.7 million or 43 per cent of the company's loan book, were to related parties. Only $1.75 million of the extra $41.1 million of related loans have been recovered.
But the biggest issue with Capital + Merchant was it was running out of cash, mainly because its investor reinvestment rates had fallen to between 10 per cent and 20 per cent coupled with the company's capitalised interest policies.
It began to borrow from other financial institutions, including Fortress, to fill its funding gap. This was in the form of prior charges over existing loans and prior charges over all the assets of the company.
As far as existing loans were concerned Capital + Merchant might have issued a $10 million loan against a property development valued at $15 million. To raise new money it would approach a financial institution with a proposal to borrow an additional $5 million with this lender having first charge over this property development.
If the development went bust, and only $8 million was recovered, the financial institution would get all of its $5 million back but only $3 million of the original $10 million loan would be recovered, with debenture holders taking a big hit.
As the accompanying table shows, the receivers have recovered $65.8 million of the $182.6 million loan portfolio but $41.6 million has been paid to financial institutions with prior charge over these loans.
The second and third mortgage line is a good example of this. The receivers recovered $36.9 million of this $48.3 million loan book but $27.2 million of the recoveries have been paid to prior ranking security holders.
Thus Capital + Merchant Finance debenture holders are entitled to only $9.7 million of these recoveries because financial institutions had a first claim over $27.2 million.
In addition Capital + Merchant Finance sold a portfolio of loans to Capital + Merchant Investments, a fully owned subsidiary. But Fortress has first charge over these assets and Capital + Merchant Finance won't get any money until Fortress is repaid its $50 million. As only $43.8 million of this loan portfolio has been recovered it is highly unlikely Capital + Merchant Finance will receive any of the $65.7 million due to it from Capital + Merchant Investments.
The end result as far as Capital + Merchant Finance's debenture holders are concerned is that only $24.2 million has been recovered from individual loans, after prior charges over individual loans of $41.6 million, and $23.4 million of this has been paid to Fortress, which has first priority over the assets of the company.
Grant Thornton believes "after accrued interest [on the Fortress security] and receivership costs we expect recoveries to be $nil for debenture holders from the assets of the company. In our view, the only recoveries for debenture holders will be from insurance claims and any legal claims against various parties".
Capital + Merchant Finance is another disgrace and questions need to be asked not just of the directors.
For example, why did Perpetual Trust allow the directors of Capital + Merchant to give prior charges over many of its loans to financial institutions?
Grant Thornton believes "if Fortress was included on the same priority ranking as the public debenture holders, the recoveries paid to investors of Capital + Merchant as a percentage of total debt is 26c in the dollar".
Several other parties, in addition to the directors, have questions to answer as far as the collapse of Capital + Merchant Finance is concerned.
Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.
bgaynor@milfordasset.com
