Chalkie : What did investors know about finance... | Stuff.co.nz

There is a street in Wellington called Waring Taylor St, crossing Featherston St between Customhouse and Lambton Quays.

Like most street names it has local significance, although Chalkie reckons it's also a sign we are slow learners of history's lessons.

William Waring Taylor was a Wellingtonian of prominence in the 19th century, an MP and well-to-do merchant, until he ran into a spot of bother late in life. No doubt he was quite a character, as was his sister Mary, a firebrand feminist way ahead of her time.

Some locals may know a bit about those two already, but Chalkie reckons their father's story could ring a few bells post financial crisis. Taylor pater, Joshua, was a Yorkshireman who lived in an elegant brick mansion and ran a wool trading business. He also had a private bank which collapsed in 1826, as private banks did a lot at the time.

A newspaper report early that February said: "We are sorry to announce that the Gomersal Bank in the West Riding of Yorkshire trading under the firm of Joshua Taylor and Co stopped payment on Saturday morning last owing to the failure of the house of Abraham Dixon and Son of London on which they drew ... much local inconvenience will be sustained."

Back then, there were lots of private banks, no regulation, and lots of failures. Taylor appears to have suffered a classic liquidity squeeze when his funding from Dixons dried up, as well as the misfortune to be a banker when bankers were still personally liable for the debts of their banks. He was bankrupted on January 31, 1826, and although he did his best to make good his creditors he still had debts when he died in 1840.

Getting on for two centuries since Gomersal Bank closed its doors, a string of finance companies has suffered the same fate. Just like the private banks of 19th century Britain, they experienced a credit crunch, a run on funds, bad debts, and were caught out by borrowing short and lending long.

Unlike Taylor, today's financiers have limited liability - a benefit circumscribed by legal obligations to be up front about their financial position.

Naturally, with much local inconvenience arising from the collapse of finance companies there has been suspicion investors were not told the full story when invited to buy debenture stock. This is the essence of the case filed by the Financial Markets Authority against directors and promoters of Hanover Finance and its subsidiary United.

Having read the statement of claim from the FMA and the statement of defence from Hanover director Mark Hotchin, Chalkie has a view on some of the claims and denials. But first, here is the basis of the tit for tat.

Hanover collapsed in July 2008 owing debenture investors about $465 million. United, which failed at the same time, owed $65m. A sister company, Hanover Capital, also failed owing $24m. In total, about 16,500 investors owed more than $550m were affected. Since then, it has become clear they have all suffered huge losses, although the overall amount is incalculable.

The FMA's allegations are focused on Hanover's prospectus issued in December 2007, subsequent advertising and a prospectus extension certificate dated March 2008.

Between December 2007 and July 2008, it says, investors put $35m into the Hanover companies, but were misled by false information in the prospectuses, investment statements and advertisements distributed during the period.

It is seeking compensation for investors, penalties of up to $500,000 from each of the defendants and court declarations that they have civil liability.

Hotchin denies there were untrue statements in those publications and argues the FMA's claim is time-barred anyway because it should have been able to bring a case within the required two years but did not do so.

Leaving aside the time-bar issue because it says nothing about what happened at Hanover, it's clear that much attention is focused on cash flow forecasts.

The prospectus opened with a statement from Hanover chairman Greg Muir that appeared designed to reassure readers about the company's liquidity. It talked about "the importance of prudent cash management" and said: "It is also important to maintain a balance between maturities of loans to borrowers on one hand, and funding from investors on the other, in order to ensure that investors are paid in full when their Secured Deposits mature.

"Our investors can take comfort that we are well placed in these areas," it said. There was $102m in cash as of September 2007 and the company was "managing its loan book to ensure an on-going correlation between the maturities of loans and deposits."

This was false, says the FMA, because it omitted relevant pieces of information giving a different view. In particular, maturing loans and deposits did not match - in the six months to December 2007 receipts from the loan book were $79m while payments required to secured depositors were just over $170m.

Furthermore, forecasts in July, September and December 2007, looking forward to March and June 2008, all showed shortfalls in loan maturities compared to debenture maturities of more than $50m.

However, Hotchin's defence argues the lack of correlation was not material and there was no requirement for loan and deposit maturities to exactly match because there were other ways Hanover could get cash, such as by getting deposits from investors.

In support of his argument, Hotchin cites positive cashflow forecasts from December 2007 based on contractual loan maturities.

Chalkie notes that similar positive contractual forecasts were included in the prospectuses, accompanied, in the extension certificate, with the words: "The forecasted cash flows exceed maturing liabilities throughout the full five-year maturity cycle and as a result the charging group will be able to meet its liabilities as they fall due."

There are two reasons Chalkie thinks Hotchin's arguments about loan/deposit maturity correlations are weak.

One, the above prospectus quote supports the FMA's view on the importance of maturity correlations.

Two, these days everyone born before yesterday knows contractual maturities are bunkum when it comes to property development lending like Hanover's.

This is because the loans were kept to short-term contracts, often of just six months, with interest capitalised - ie, added to the loan balance.

When property development projects take years to go from turning a sod to final sales, it should be clear that a six month loan is not generally a cash generating prospect. Instead, the idea was to provide a chance to review lending terms during a project, with the natural progression being to rollover the loan.

The difference between contractual loan terms and what was really happening was so great that a new accounting standard came into force from January 2007 requiring finance companies to disclose their expected loan maturities as well as the contractual.

As a good mate of Chalkie's noted four years ago, Hanover did not comply with the standard.

Hanover's auditor at the time was KPMG and Chalkie is intrigued by the subsequent professional disciplining of a KPMG auditor in 2010 for approving an unnamed finance company's non-compliance with the new standard.

It is also intriguing that the auditor also did not provide documentation to support the conclusion that X Limited's provision for credit impairment was adequate "when the audit work papers indicated that a substantially higher provision was, or might have been, warranted."

Chalkie suspects "X Limited" was Hanover. Whoever it was, Chalkie reckons the accounting profession's desire to keep X's identity secret shows how little it can be trusted to put high standards above craven self-interest.

But that's another story. The point here is that Hotchin's reference to contractual maturity profiles, repeated several times in his defence, is in Chalkie's view irrelevant in countering the FMA's claims.

While the claim and defence involve numerous detailed citations and rebuttals, another detail is worth a mention.

Hanover was so stressed, says the FMA, that in September 2007 it had largely stopped lending altogether - not a good look for a finance company.

Hotchin's defence statement admits "that by September 2007 [Hanover] had temporarily ceased lending," but says it was a prudent measure to help liquidity.

Furthermore it was properly disclosed because the prospectus said "as a natural consequence of the company's liquidity policy these circumstances have resulted in a decrease in the company's lending activities."

Chalkie reckons calling "ceased lending" a "decrease" is like calling whaling scientific.

It remains to be seen whether the other Hanover directors and promoters being pursued by the FMA adopt similar defences.

Ultimately, all of this detail is for the court to judge - did Hanover's documents give a realistic view of what investors were getting into?

It's an important point, because unless such disclosures can be relied upon, Chalkie reckons we might as well go back to unlimited liability.

Joshua Taylor and his descendants, it is said, eventually paid back every penny.

* Chalkie is written by Fairfax Business Bureau deputy editor Tim Hunter.

- ? Fairfax NZ News

Source: http://www.stuff.co.nz/business/opinion-analysis/7473146/Finance-companies-what-did-investors-know

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