The Commerce Select Committee inquiry into finance company failures (the Inquiry) will mean yet more change in a sector which is already reeling under a tidal wave of legislative and regulatory reform.
The Terms of Reference (TOR) are very broad and the Committee is unlikely to go to the trouble of such a wide-ranging investigation without coming down with recommendations for action. But, while the Inquiry will mean more uncertainty, it also offers some opportunities.
This Brief Counsel looks at the TOR and offers some observations and analysis.
The closing date for submissions is 15 October 2009.
The Inquiry is a response to EUFA1 activist Suzanne Edmonds’ petition calling for a Royal Commission into the finance companies crisis, and to a report from the Registrar of Companies with his observations on the finance company failures2. The Registrar had expressed concerns about the use of moratoria which, although highly debatable and in some aspects plain wrong, were widely covered in the media.
The Committee Chair, Lianne Dalziel, has said that in drafting the TOR they tried to avoid duplicating other work streams. However the TOR appear to cut across the regulations review for finance company moratoria, announced today, the Cameron Taskforce’s work on simplified financial product disclosure, the Ministry of Economic Development’s (MED’s) review of the Securities Act and regulations and the Law Commission’s review of trust law - to name a few.
The Committee has identified four broad objectives from the Inquiry:
- ensuring investors are well-informed about investment proposals
- ensuring investors understand the implications of a moratorium proposal before voting
- ensuring advance actions can be taken to reduce the chances of failure, and
- ensuring adequate measures or redress exist when failures occur.
We will discuss the TOR in relation to each of these areas in order. But our high level view is that we are surprised at the Committee’s apparent preoccupation with populist and symbolic matters, such as tracing directors’ assets, when there are issues of real significance to be addressed, particularly in the enforcement area.
Despite a cascade of company collapses, there have been few prosecutions for misleading prospectuses and the like to date. Perhaps even more importantly, there does not seem to be any track record in New Zealand of a regulator proactively preventing misleading product disclosures going to market. Surely it is worth asking why the Australian Securities and Investment Commission (ASIC) stopped Bridgecorp from seeking deposits, when no New Zealand regulatory agency did the same.
Ensuring investors are well-informed
The TOR ask in relation to the quality of information available to investors:
- whether the marketing and advertising of investment proposals play a disproportionate role in investors’ decisions
- whether further rules are needed around the quality of advertisements for securities
- whether the disclosure of advisers’ commissions is adequate and whether commissions should be banned, and
- what steps can be taken to improve investor understanding of financial products and services.
We consider some of the thinking behind these questions is woolly. What does it mean to ask whether marketing and advertising plays a “disproportionate” role in investors’ decisions, and why would you ask? Will restricting advertising assist?
Existing technical rules restricting the content of advertisements are, in fact, awkward and of little value. It would be better to abandon them, in favour of a focus on prohibiting misleading disclosure. The key requirement is the availability of appropriate disclosure documents together with adequate financial advice in relation to the product (and alternatives), plus general law prohibiting misleading conduct generally.
Commission payments are a fact of life in many industries and the disclosure requirements relating to them are already detailed and extensive. Banning commissions threatens to reduce the advice available – scarcely the desired result. More extensive disclosure (i.e. compliance) would create an even greater threat to the smaller advisers, thereby threatening the range and heterogeneity of advice and creating barriers to entry which would favour the market incumbents.
Improving investors’ understanding has been a long-standing policy ambition, pursued over many years without (apparent) success. The Cameron Task Force is the latest to have a go, with its proposed development of a “simple” two page Key Information Document (KID) to give potential investors all the material information they need in a format which is concise, comprehensible and comparable across products.
That was the hope for investment statements too, but few people would argue today that the hope has been fulfilled. There is a fundamental incompatibility between requiring, on the one hand, all material information and risks to be disclosed and, on the other, wanting something to be short, sweet and simple.
The TOR are: to examine the quality of advice provided to investors in moratorium situations, including independent analysis of moratorium versus receivership and the independence of the management of the moratorium.
Chapman Tripp has extensive expertise in both moratoria and receiverships. Moratoria we have advised on include: Hanover Finance and its related companies, OPI Pacific Finance, Boston Finance, North South Finance, Beneficial Finance and Orange Finance. Receiverships we have worked on in the finance sector include: Bridgecorp, Belgrave Finance, Property Finance Securities, Provincial Finance, Western Bay Finance, Numeria Finance, Capital + Merchant Finance and Kiwi Finance.
In our experience, a finance company moratorium is a much more flexible instrument than a receivership and should generally result in investors getting more of their money back, although over a longer timeframe. Despite this, moratoria have tended to receive a bad press in New Zealand – often reflecting poor information or misinformation.
A common criticism is that the moratorium returns control to the directors and executives which led the company into trouble in the first place. First, it should be noted that a moratorium is not an option where there has been fraud or incompetence. Second, the criticism ignores a number of salient facts:
- companies can, and often do, get into difficulty for other reasons than management malfeasance or negligence. Many of the finance sector collapses, for example, reflected the macro-economic environment or were precipitated by an industry-wide domino effect
- typically the terms of the moratorium will include a mixture of new blood and new rules; changes on the board and in the senior executive, and new governance covenants, and
- the engagement of experienced professional advisors - insolvency practitioners and lawyers – brings a new dynamic into the decision-making.
The other major criticism is that moratoria let the directors off the hook. Again, not so:
- moratoria have not involved a formal waiver of claim against the company or the board, and
- the moratorium monitor, usually appointed by the trustee, has similar powers of investigation as a receiver and – like a receiver – has limited power to set aside transactions (only a liquidator appointed primarily for unsecured creditors can do that).
The TOR pick up the concerns expressed by the Registrar of Companies in the 2007/08 financial review of the MED but, as stated above, many of the Registrar’s comments are incorrect.
He states that: “There is no regulatory oversight of these moratoria, matters being left with the companies, their trustees and the affected investors.”
He is correct that the moratorium is a creature of contract rather than statute and is heavily negotiated between the parties. That is one of its great strengths. It allows flexibility, and for the terms of the agreement to fit the circumstances of the individual case, unlike the straight jacket of receivership.
But he is wrong to suggest there is no regulatory oversight. The Reserve Bank3, the Securities Commission and the Registrar himself4 all have oversight roles. And – within the terms of the moratorium – oversight is also provided by the trustee, the moratorium manager, the independent directors, the professional advisers, and through enhanced governance and reporting covenants.
The Registrar goes on to state: “The various proposals have been the subject of some criticism, however investors have agreed to delayed repayment plans approved by the company’s trustee so there is no reason or room for a regulatory agency to intervene.”
Again, wrong. Moratorium documents are a form of offer document and, like offer documents, are subject to review by the Securities Commission which will ban them if it considers they contain misleading information – as happened recently with the a Property Finance Group moratorium proposal. Also, as investors have not been asked to waive any claims, they can still sue for any negligence, and the regulatory agencies can still bring prosecutions and class actions.
Chapman Tripp has been responsible for providing the legal advice on most of the larger finance company moratoria and has sought to make them as robust as possible by incorporating some of the best features of receivership without its rigidities – such as the need to re-document existing contracts and to fire and then re-employ staff personally within a short timeframe.
On 3 December last year, the Securities Commission released a publication suggesting 13 questions investors should ask themselves when weighing up whether to go for a moratorium or a receivership. These questions, reproduced below in the box, reflected Chapman Tripp’s existing practice and have now become common industry practice.
Moratorium or receivership?
Questions for investors
- How would my rights be different under receivership?
- How much am I likely to get under receivership, and when?
- How much do the directors think I will get under a moratorium, and when?
- Which is more in my interests, given my investment needs (including payout timeframes)?
- What assumptions have the directors made if they say a moratorium will result in better returns? What are the risks compared with the risks of receivership?
- Who would supervise a moratorium and report to the trustee or investors?
- What is the plan to change the moratorium proposal if there are changes in the company’s situation or economic conditions?
- Do I get another chance to vote if things aren’t going as expected?
- Is there an independent expert’s report and if so, what does it say?
- Have there been any independent valuations of assets?
- If parties related to the company are contributing assets, are there independent valuations?
- What does the trustee have to say about the moratorium?
- What are the financial and legal implications for the directors and other related parties under receivership compared with a moratorium?
It may be that the Committee, in its wisdom, decides to make these criteria for evaluation mandatory requirements in the law. Certainly the Government has confirmed today that it is looking to further regulation. That will do no harm and may increase public confidence in the moratorium as a mechanism.
In our view, however, legislation is unnecessary. We consider that the existing oversight provisions, the Securities Commission guidelines, the need to negotiate mutually agreed terms between the trustees and the directors and the engagement of external professional advisors already provide sufficient assurance that all relevant interests will be represented and treated fairly.
As Heath J commented in his oral judgment in Paris v Hanover Finance Ltd, 8 December 2008:
“[T]he decision (before the investors) is whether acceptance of what is on the table now is preferable to what might be available through other means. That is quintessentially a commercial judgment for individual investors to make. It is appropriate that it be left to their democratic decision. It is inappropriate for the Court to intervene pre-emptively.”
Ensuring advance actions can be taken to reduce the chances of failure
The TOR ask:
- Should regulators have the power to “call in” particular products that may raise investor protection issues in order to scrutinise whether those products should be allowed to go to market?
- Should the law provide for extended whistle blowing protections?
- Does the law deal adequately with directors and managers who have been implicated in inappropriate activity in respect of finance companies and who go to start up new firms? If so, what steps could be taken to improve how the law addresses these issues?
With an investor protection hat on, it is difficult to answer “no” to these questions. Submitters who are opposed to the changes indicated will therefore need to put up a compelling argument.
The Securities Act already gives the Securities Commission the power to suspend or cancel prospectuses and advertisements. The same power will be available for individual adviser disclosures when the Financial Advisers Act 2008 commences in late 2010.
While a companion “call in” power may enhance the regulator’s gatekeeper role (from being the ambulance at the bottom of the cliff), used inappropriately it could stifle the development of innovative new products. An outright product ban should be rare and only available in extreme circumstances.
It is generally acknowledged that riskier products with potentially higher returns have their place in the investment market, so the focus should be on targeted and relevant risk disclosure with the regulator having the power to require enhanced disclosure for higher risk products, rather than simply banning them.
Amendments to corporate and personal insolvency law in 2006, and to director banning orders in 2008, following more than 10 years of consultation, already make it harder for failed directors to start up new firms. And, to the extent the question raises a concern with non-disclosure of past wrongdoing (rather than the simple ability of a wrongdoer to start up again), the gap can easily be filled by simply requiring disclosure. A specific disclosure requirement here would mean issuers cannot take the view that past misdeeds by directors need not be disclosed because they are no longer sufficiently material to investors.
We also query whether the TOR are asking the right questions here. Should not the Committee also look at the ability of the regulatory agencies to enforce existing laws?
Ensuring adequate measures or redress exist when failures occur
The TOR ask:
- Do directors and managers of finance companies hold the appropriate professional indemnity insurance (PI)? What is the state of the market for professional indemnity insurance for directors?
- To what extent could the law make it easier to trace funds following the recent finance company collapses? How can this be facilitated to make it easier for investors to get financial redress for their losses?
- Should the law make it easier to penetrate trusts that may protect the assets of culpable directors?
Although confined to PI insurance, we assume that the Inquiry will also consider other types of cover, including Directors and Officers Insurance. The question of the availability of insurance has to be considered in relation to disclosure and regulation generally. Insurance will never be a complete answer as the cover will seldom be as great as the potential losses, and the payment of claims will depend on whether the directors have properly disclosed the risks to the insurer as well as compliance with other conditions.
Availability of product in the market is therefore not the issue so much as whether sufficient cover has been purchased and whether the policy has been complied with. Accordingly, a more useful focus for the Inquiry would be whether these matters are being sufficiently disclosed or whether they ought to be the subject of monitoring by regulatory agencies.Bullet points two and three are the Inquiry at its most overtly political. Although there will be some exceptions, access to the assets held by directors do not generally make a material difference to recoveries by investors.
We also question whether this is the right place to analyse and make recommendations on the laws relating to trusts and to the tracing of assets. These are big issues and, if they are to be explored, should be explored through dedicated inquiries rather than as an appendage to this inquiry. The Law Commission recently commenced a comprehensive review of the law of trusts, and the courts have recently been actively considering litigation over efforts to penetrate trusts and pursue director’s personal assets.
Although not covered by the TOR, we hope that the Committee will reconsider some earlier policy decisions in the course of the Inquiry. Chapman Tripp highlighted some of these issues in a press statement last month on flaws in the Financial Advisers Act (FAA).
Further, the requirement that finance companies get credit ratings will be costly to comply with and could provide false assurance, given the number of high profile, rated banks and other financial institutions which have had to be bailed out over the last 18 months.
Similarly with the extension of the FAA to advice to sophisticated persons about wholesale investment products. This will impose new costs in order to provide a protection to investors who - literally – do not need it.
We are also concerned at the repeal of the provisions in the Securities Markets Act that allowed for compensation, class actions and other civil redress against deficient investment advisers, in favour of the bureaucratic regime in the FAA and the Financial Service Providers (Registration and Dispute Resolution) Act (FSPA). While the FAA and FSPA do require registration, authorisation, and minimum standards of advisers, they also dilute the remedies currently available to investors to recover their losses.
The FAA provides no effective means of financial remedy for breach of conduct obligations by multiple investors against individual advisers or allow for actions against their employers, because existing law provisions for class actions or actions against an adviser’s employers have been omitted.
For further information or assistance with preparing a submission, please contact the authors on the right.