Finance companies - an option for investors who understand the risk


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22 August 2006

News release

Finance companies - an option for investors who understand the risk

Jane Diplock, Chairman, Securities Commission

Finance companies are a relatively small part of the New Zealand investment market. Households have $7.5 billion invested in finance companies. This compares with $60 billion invested in registered banks, according to the Reserve Bank of New Zealand Financial Stability Report of May 2006.

Finance companies take in money from investors and lend money out for various ventures. People who borrow from finance companies cannot borrow money at cheaper rates from a bank because they don't meet the bank's credit criteria.

Consequently there is a significantly higher risk of the repayments falling behind or stopping altogether, and there is a risk that the finance company won't have the money to repay investors.

Currently, investing $5,000 in a registered bank for a year gives a return of about 6%. Investing the same money in a finance company for the same term returns about 3% above the bank rate. That difference might seem small in percentage terms, but it may not be representative of the higher risk an investor takes with a finance company. People should realise that an extra 3% return is a 50% increase in interest and so must represent at least a 50% increase in risk.

Investments with finance companies are generally for a fixed term. Usually this means that investors can't withdraw their money until the end of the term even if the company's financial position deteriorates. If they can cash in the investment early they will probably have to pay a penalty.

The governance of a finance company is very important and the skills and track records of its directors and managers, particularly their skills and experience in pricing risk and financial management.

Before accepting money from an investor, the law requires a finance company to disclose certain information about itself in a prospectus and an investment statement. It is very important for a potential investor to read these.

These documents must be accurate when they are prepared. If things change for the worse while the investment is being advertised, and the change makes the documents inaccurate or misleading, the finance company must stop the offer until they have been corrected.

The prospectus must contain the most recent audited financial statements of the company. If it is 9 months since the date of those statements, interim financial statements must be provided together with a certificate from the directors stating that there have been no adverse changes and the prospectus is still accurate.

If you don't understand the information in the finance company's investment statement or prospectus, you should ask an investment adviser, financial planner, broker, lawyer or accountant to explain them.

You should be especially clear about who the finance company is lending money to, and how well the repayments are going. This is why it is so important for investors and their advisers to read a prospectus.

The Securities Commission does not have a prudential regulatory role over finance companies - it cannot step in to stop a finance company failing, or take action against a finance company that fails, or help investors recover their money.

The Commission's job is to intervene only if a finance company does not provide the required information for investors to make a decision on whether or not to invest.

If the investment statement, prospectus or advertising is not up to standard the Commission can require the finance company to correct the information. If necessary the Commission can take the offer off the market until any breaches are remedied. Once the offer is stopped, the Commission's role ceases.

A finance company must have a trustee to look after the interests of investors. The trustee must be approved by the Commission or be established by Act of Parliament. The trustee's duties and powers are set out in the trust deed.

The trustee oversees the situation if a finance company is in trouble, and appoints a receiver if necessary.

The receiver's job is to recover as much money as possible for investors and other creditors, including through legal action. The trustee must advise the Registrar of Companies who has information-gathering powers and can lay criminal charges if appropriate.

With their higher rate of return than a registered bank, well-managed finance companies are still an investment option for mum and dad investors to consider.

But they must always understand the risks they take with their money. This includes assessing whether the promised return is high enough for the risk they are taking.

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