Let's fix investor OH&S
By Scott Francis September 30, 2011
PORTFOLIO POINT: There are four ways markets are stacked against retail investors. Here’s what should be done.
The extreme volatility of the past two months will remind many of the darks days of the GFC and the many misdeeds that took place then.
As we monitor negotiations in Europe over sovereign debt problems and speculate about their impact on global growth, it is worth revisiting the previous crisis and exploring those events that put smaller investors at a disadvantage. That might help us avoid them in the future or at least be aware of the traps that may lie ahead.
There are four areas I believe are worth paying particular attention to when thinking about ways investment markets in Australia are stacked against the aims of the humble retail investor, and what could become hot topics once more if things deteriorate even further.
Unfair “capital raisings” by companies that disadvantaged small investors. Ownership of shares by directors through margin loans. Companies and investments that pay “pretend dividends”. The role of credit rating agencies misjudging the risk of investments
Let’s consider these one at a time.
Unfair capital raisings
During the course of the GFC many companies chose to issue more shares to give them more cash to work with. This was particularly important during the “credit crunch” that followed the rout, making it more expensive and difficult to borrow money. Usually the shares issued were at a significant discount to the sharemarket price.
The problem in all of this was that not all shareholders were treated equally. With some share issues institutional shareholders had access to larger numbers of shares than retail investors, and for others all retail investors were limited to the same amount of stock.
In the case where a reasonably large number of shares are issued, especially at a discount to the share price, it is important that all investors have equal access to buy new shares. There is a simple and fair mechanism (adopted by many companies): the use of “pro rata” share offers, where all shareholders are able to buy a number of discounted new shares based on how many existing shares they own. For example, a company might have a 1 for 10 rights issue, which would allow every investor to buy one new share for every 10 existing shares they own. This is a simple mechanism that is fair to all and should be the minimum standard for raising money through the issue of new shares.
Retail investors have a right to feel annoyed any time they are treated differently to institutional investors. Essentially, when you own shares in a company you are a part-owner of that company and you deserve to be treated the same as any other part-owner.
Directors owning shares through margin loans
Any time directors are forced to sell shares, other investors look with some interest – and possible concern. During the last crisis there were a number of cases where directors were forced to sell shares owned through a margin facility, and falling prices forced their sales.
Perhaps the most famous example of this is ABC Learning, where Eddie Groves was forced to sell large numbers of shares from a margin facility as the company’s share price collapsed. The potential impact of this on investors is significant: directors selling shares always erodes confidence, particularly when share prices are volatile; company directors often own relatively large shareholdings which will further push share prices down as they are sold; and, as directors sell large numbers of shares, the ownership and management of the company may become particularly fluid.
In February 2008 the ASX provided Update 0208, which dealt with the financing arrangements of directors owning shares. The statement said that:
“Where a director has entered into margin loan or similar funding arrangements for a material number of securities, ASX advises that listing rule 3.1, in appropriate circumstances, may operate to require the entity to disclose the key terms of the arrangements, including the number of securities involved, the trigger points, the right of the lender to sell unilaterally and any other material details. Whether a margin loan arrangement is material under listing rule 3.1 is a matter which the company must decide, having regard to the nature of its operations and the particular circumstances of the company.”
In a fair world complete and transparent disclosure of all director interests held through margin loans should be a starting point. With the damage that can be done when a company director is forced to sell in a margin call situation, active corporate governance around prudent gearing ratios and exposures would seem appropriate.
Many investors see the payment of dividends or distributions from their investment as a sign that there are strong underlying cash earnings. During the GFC we saw this assumption violated as dividends and distributions were paid from sources other than earnings. For example, investors in Westpoint (and other finance operations) assumed the regular distributions received were from the earnings from the loans made.
They were not: they were from new investors’ money, and these “pretend” interest payments may have misled many investors into thinking their investment was safer than they were. Similarly, the BrisConnections units that were floated on the sharemarket came with the promise of an attractive distribution. This distribution was made to investors prior to any “real” earnings from the company – making it look more attractive to investors looking for regular income, even though the underlying toll road was not producing any earnings. BrisConnections ended up paying only a shadow of the forecast dividends as it spectacularly failed for small investors.
If investments were forced to clearly state the situations where dividends and distributions were not paid from true earnings, this information could be used by investors so as not to overstate the presence of dividends or distributions in evaluating the risk of an investment.
Poor analysis from credit rating agencies
CDOs, or collateralised debt obligations, are often cited as one of the root causes of the GFC. In essence, CDOs were financial instruments the contained large numbers of US residential mortgages ranked by order of risk. The profligate lending habits of US financiers were revealed when mortgage holders began to default en masse, leading to a collapse in value of US residential property and the CSOs they were built from. Some of these had even been rated AAA by credit rating agencies.
These CDOs found their way into the hands of individuals, superannuation funds, banks and even city councils – all of whom were likely influenced by the security of a AAA credit rating. The need for effective and reliable credit ratings has been discussed at the highest government levels since these failings; and investors are entitled to know what has changed, and how reliable credit ratings will be in the future. Many have speculated that the recent string of sovereign debt downgrades have been part of an attempt to reposition themselves. How genuine this is remains to be seen.
The GFC was a time when investors were so busy trying to cope with what was happening that the time to reflect on issues that needed to be addressed was in short supply. However, there were failings that can be improved that will make the investment world at least a little safer for investors in the future – whether that be through companies raising money in a fairer way, clearer disclosure and management of risks around margin loans, greater understanding of dividends and distributions paid from sources other than earnings, and a better credit rating system.