Printed from: http://www.seccom.govt.nz/publications/documents/disclosure/01.shtml?print=true on Wed 25 November 2009

DISCLOSURE BY FINANCE COMPANIES

INTRODUCTION

Background to the discussion paper

1.

The Commission has been reviewing the debt security disclosure documents of some finance companies. Disclosure documents of 30 finance companies were reviewed.

2.

Over the past few years finance companies have been taking a higher profile in New Zealand, and competing more aggressively for investors' money. There has been an increase in the marketing and advertising of the various debt securities on offer. The higher interest rates offered by finance companies have been attractive to investors in the low interest rate environment.

3.

The Commission regularly receives and deals with complaints and inquiries from members of the public who are concerned about the practices of some finance companies and the information that is disclosed. Often these people have invested in debt securities offered by finance companies. The increase in the number and profile of finance companies has seen a corresponding increase in the number of complaints that the Commission receives and deals with. These trends have prompted the Commission to undertake this review.

4.

Finance companies' offer documents, like those of other issuers, need to comply with the Securities Act 1978 (Act) and the Securities Regulations 1983 (Regulations). The documents must not mislead investors. In its review the Commission has seen some investment statements and prospectuses that provide a good level of useful information for investors. It has seen some that do not. The Commission is of the view that some finance companies are not meeting the minimum requirements of the legislation. The Commission considers that these finance companies need to consider the disclosures that they are making, and make changes where necessary to their disclosure documents to ensure future compliance with the legal requirements of the Act and Regulations.

5.

The Commission has decided to publish this discussion paper, outlining the Commission's preliminary views on the information that should be disclosed by finance companies to assist investors to make informed investment decisions. The Commission seeks comments from finance companies and other interested parties on these preliminary views. Once it has received and considered comments, the Commission will publish a report to provide guidance on its expectations for disclosure by finance companies.

6.

Many of the matters raised will be relevant also to other issuers of debt securities, and to issuers more generally. We welcome comments from these people also. The Commission intends to undertake a further review of finance companies' offer documents at a later date, and will take enforcement action where appropriate following that review.

7.

This discussion paper does not include detailed issues concerning disclosure of financial information by finance companies. The Commission is undertaking a separate project on financial disclosure by finance companies.

Issue areas

8.

The Commission has identified the following broad issue areas relating to disclosure and compliance by finance companies for inclusion in this discussion paper. Many of these issues are interrelated:

the risk/return relationship - including risk disclosure, principal risks, company activities, related party lending, and the use of rating information;

ranking of securities - including prior ranking claims;

other disclosure issues - including early termination rights, termination charges, and inconsistent information;

advertising - including the prominence of required information and areas of common non-compliance with the advertising requirements of the Act and Regulations.

9.

The issues that the Commission has identified relate, in most cases, to concerns that members of the public have raised, or issues that the Commission's enforcement activities have highlighted.

SECTION 1 - KEY PROVISIONS OF THE ACT AND REGULATIONS

10.

Generally, an offer of securities to the public must be made with a registered prospectus and an investment statement.

Investment statement

11.

An investment statement is the principal point of sale disclosure document. Its purpose, as stated in the Act, is to:

(a): Provide certain key information that is likely to assist a prudent but non-expert person to decide whether or not to subscribe for securities; and
(b): Bring to the attention of such a person the fact that other important information about the securities is available to that person in other documents.

12.

Regulation 7A of the Regulations sets out the requirements for the investment statement:

(a): The investment statement must contain the information required by Schedule 3D of the Regulations. This requires every investment statement to be set out in a question and answer format, addressing the eleven questions found in Schedule 3D;
(b): All the information, statements, and other matters required to answer each question must be set out in the investment statement under that question;
(c): The information required to answer each question must be set out "in a succinct manner"; and
(d): An investment statement may state that "additional information" about a matter specified in Schedule 3D is set out in a registered prospectus.

Registered Prospectus

13.

This is often a larger document, which must set out all material matters relating to an offer of securities. In the case of debt securities, it must contain all the information, statements, certificates, and other matters set out in the Second Schedule of the Regulations that are applicable.

14.

Regulation 5 of the Regulations contains further requirements for registered prospectuses. Regulation 5(1) provides that if a statement required in the registered prospectus would be misleading without the addition of further information, that further information must be included also.

15.

The Commission is of the view that:

(a): Disclosure by many finance companies in their investment statements is insufficient to properly answer the questions set out in Schedule 3D of the Regulations.
(b): Disclosure and registered prospectuses by many finance companies fall short of the required standard of "all material matters" in clause 34 of the Second Schedule to the Regulations.
(c): The requirements of Regulation 7A need to be more clearly understood.

16.

The amount of information needed in any investment statement will be dependent on the context of the issuer's particular business, the issuer's lending activities, the types of debt securities that are being offered, and the risks of the investment.

17.

Directors of finance companies and their advisers should rigorously check that all applicable disclosure requirements are met. Directors are required to certify that the investment statement complies with the securities legislation and does not contain any matter that is likely to deceive, mislead or confuse with regard to any particular that is material to the offer of securities. Directors are also required to certify that the investment statement is not inconsistent with the registered prospectus relating to the security.

SECTION 2 - RISK DISCLOSURE AND RETURNS

The risk/return relationship of the investment must be made clear to investors

18.

The Act and Regulations aim to ensure that investors are provided with adequate disclosure about investments, and the persons that issue, offer, and promote them to enable investors to make informed investment decisions. In order to make an informed investment decision, the risks of the investment must be sufficiently disclosed.

19.

Many investors are aware that the risks associated with an investment should be a fundamental determinant of the expected return on the investment. The general rule of investment is "the higher the return, the higher the risk".

20.

The Commission is of the view that:

(a): Few finance companies adequately discuss the risks of the investments that they offer in terms of the returns.
(b): The prudent but non-expert person is unlikely to be able to gain an adequate understanding or appreciation of the risks of a particular debt security investment from the information contained in the investment statements of most finance companies.
(c): As a result, investors are likely to find it difficult to make any relative assessment and distinguish among the types of debt securities offered by different finance companies.
(d): The risk/return relationship is fundamental to investment decision-making. Inadequate disclosure about the risk/return relationship of the investment is likely to have the potential to mislead investors.

21.

The Commission considers that the investment statement must provide sufficient information to enable an investor to ascertain, assess, and weigh up the risks of investing in the finance company's debt securities in relation to the return offered by the finance company.

Principal risks for disclosure in the investment statement

22.

Clause 11(1) of Schedule 3D to the Regulations requires an investment statement to contain a brief description of the principal risks of the following matters:

(a): The money paid by a subscriber not being recovered in full by the subscriber;
(b): A subscriber not receiving the described returns;
(c): A subscriber being required to pay more money than that disclosed elsewhere in the investment statement.

23.

The investment statements for many finance companies contain disclosure information on risk that is highly standardised. Some we have seen simply state that the principal risk to investors is the company becoming insolvent. While this is of course true, it does little to assist investors.

24.

The Commission does not consider that merely stating that insolvency is a risk meets the requirement of briefly describing the principal risks. The Commission's view is that where clause 11(1) requires "a brief description of the principal risks", a finance company is required to include more specific statements describing, in the context of the particular finance company's business, the principal risks that may lead to insolvency.

25.

The Commission considers that risk disclosure should be addressed by finance companies on two levels. Firstly, a description of the principal risks that may apply to finance companies generally. These may be reasonably generic, and applicable to a wide range of issuers. However, the Commission considers that there are likely to be certain risks that are particularly applicable to finance companies. These types of risks (as disclosed by some finance companies) may include:

(a): Lending risks - risks associated with lending funds and not being fully repaid the principal, interest and other fees.
(b): Liquidity risk - whether the finance company has enough cash liquidity to meet its obligations.
(c): Economic downturn risk - risks concerning the stability of the economy and a downturn in the sectors to which the finance company is exposed.
(d): Interest margin risk - risks to profitability associated with the margin between the cost of funds invested with the finance company and the interest rate that the finance company charges borrowers for those funds.
(e): Pricing risk - the risk that the value of a security (financial asset or financial liability) will fluctuate due to changes in interest rates, currency fluctuations, or market prices.
(f): Solvency risk - risks of not being able to pay debts as they fall due.
(g): Regulatory risk - changing legal requirements and the effect of legislation on industry sectors.

26.

Secondly, the Commission is of the view that a description of the principal risks specific to the particular finance company should also be disclosed. This is likely to include disclosure about how more general risks, such as those outlined above, may impact on the particular finance company as a result of the company's principal activities and exposures. Directors will need to assess what the finance company's main exposures and risks are, and describe them in the investment statement where they are principal risks that relate to the matters set out in clause 11 of Schedule 3D of the Regulations.

27.

The Commission acknowledges that an investment statement must set out the information required by Schedule 3D "in a succinct manner". However the requirement to be succinct must be balanced against the need for informative disclosure that meets all of the requirements of the legislation. It must also be balanced against the requirement not to deceive, mislead or confuse investors. Non-disclosure of risks that are specific to the finance company may deceive, mislead or confuse an investor about the full extent of the risks associated with subscribing for the debt security.

28.

The Commission's view is that disclosure of principal risks in the investment statement needs to be tailored more to the activities and circumstances of each particular finance company.

Disclosure about risk and company activities in the investment statement

29.

Clause 4 of Schedule 3D to the Regulations requires an investment statement to include a brief description of the principal activities carried on by the issuer and an indication of how long the issuer has been carrying on those activities.

30.

The level of risk to the investor is likely to be influenced by the activities of the company and the industries or sectors that it invests in. If company activities are poorly disclosed then it is very difficult for investors to assess the level of risk involved in the investment. Clear statements and appropriately detailed descriptions about the types of lending a finance company undertakes allow investors to determine whether they are comfortable with their subscriptions being used for investment in particular sectors or industries.

31.

The Commission has found that some finance companies are not meeting the requirements of clause 4 of Schedule 3D in their investment statements.

32.

Some finance companies only provide a generalised statement about the finance company's activities. Other finance companies do not describe their principal activities in this part of the investment statement, but rather discuss aspects of the company such as its structure and history.

33.

The Commission's view is that a generalised statement about a finance company's activities, without the inclusion of specific details, does not provide sufficient information to prospective investors to enable them to make an informed investment decision and does not comply with the requirements of clause 4 of Schedule 3D.

34.

Disclosure of the principal activities of the finance company should be such that it provides prospective investors with useful information and sufficient detail about what types of financing activities the company undertakes. In many cases finance companies may be exposed to sector-specific risks. For example, a finance company may be exposed to risks associated with property development financing if this is the finance company's principal activity.

35.

Some finance companies lend money in relation to secondary financing activities. Many finance companies make loans to individuals or businesses that may not have been able to obtain finance from other lending institutions. These persons may have difficulties raising traditional bank funding due to insufficient security. This is a factor that the Commission considers material to the risk/return relationship of the investment. The Commission considers that such information should be disclosed to investors where it is a principal activity of the finance company.

36.

Similarly, where disclosure is made in relation to property financing activities as a principal activity, the finance company should make it clear whether the lending activities involve lending in relation to property under development or to developed property, and whether the property lending is to the commercial or residential sectors.

37.

The Commission's view is that the requirement to briefly describe the principal activities carried on by the issuer goes beyond the general statements that many finance companies currently provide in their investment statements. Finance companies need to consider whether sector-specific risks are an issue and whether such risks need to be disclosed in relation to clause 4 of Schedule 3D.

38.

An understanding of the nature of the financing activities is important to enable investors to better assess the level of risk exposure that their investment may have. If the activities of a finance company are not "principal activities" for inclusion in the investment statement, the activities may still be a material matter for disclosure in the registered prospectus.

39.

Clause 4 of Schedule 3D of the Regulations also requires an indication of how long the issuer has been carrying on the described principal activities. Some finance companies only provide details about when the finance company was established.

40.

Disclosure about the length of time that a company has undertaken the described principal activities enables investors to ascertain the history of the company and its experience in providing finance to particular sectors. The Commission considers that the length of time a company has been involved with a particular principal activity can be an important factor for an investor making a decision whether to invest with the company.

41.

The Commission's view is that merely stating details about when the finance company was established is not what is required by the wording of clause 4 of Schedule 3D. The Commission considers that the wording of the provision requires disclosure about how long the finance company has carried on the described principal activities. For example, the company may have been incorporated 10 years ago, but only operated as a finance company for 3 months. Alternatively, it may have been a finance company since incorporation, but recently has switched its principal activities from lower to higher risk investments. This type of information enables prospective investors to understand what the company is currently doing and how that may differ from what it has done in the past.

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