
	Advanced Search

DISCLOSURE BY FINANCE COMPANIES

Risk and disclosure about related party lending

42.

The Commission is concerned about the adequacy of disclosure by finance companies in relation to related party transactions, including related party lending. Related party lending includes in-substance financing transactions that occur between related parties taking the form of the 'sale' of loans or loan portfolios.

43.

Identification and disclosure of related party transactions, and the risks of the activities of related parties, are important and material matters for investors. They are matters about which investors and commentators often raise concerns.

44.

If related party lending occurs or is likely to occur, then this should be clearly disclosed and explained.

45.

The Commission's view is that investors particularly need to be made aware of:

(a): Who the related parties are and the nature of their relationship with the issuer.
(b): The nature of transactions undertaken with related parties (and particularly any related party lending and/or borrowing) and the volume of transactions undertaken.
(c): Whether related party transactions occurred on any special or unusual terms or conditions not available to unrelated parties.
(d): Related party balances owing or receivable at the date of the prospectus or the date of the financial statements accompanying the prospectus.
(e): The nature of the activities related parties are involved in.
(f): An indication of the financial health of related parties and their ability to repay any loans.
(g): Whether any related party debts have been written off or forgiven during the reporting period.

46.

Without this information, investors may not be able to assess the risks of the investment and will not know what entities and activities their investment is ultimately funding.

47.

The Commission also notes Statement of Standard Accounting Practice No. 22 Related Party Disclosures. SSAP-22 establishes criteria for the disclosure of related party relationships between reporting entities and related parties. Finance companies must ensure that they properly disclose all of the information necessary to comply with accounting and financial reporting standards in relation to disclosure of related party transactions.

48.

Where a finance company engages in related party lending, the activities of the related parties may require disclosure in the investment statement and may be material information for disclosure in the registered prospectus.

49.

As is the case with the finance company itself, the exposure to risk of the related party is likely to be affected by factors such as the types of business activities that it is involved with and the environment in which it operates. This risk exposure may have an impact on the performance of the finance company, particularly where related party lending is material in the context of the finance company's business. If the related party's exposure to risk is significant, then the activities of the related party and the risks of its business may become principal risks of the finance company and require disclosure in the investment statement under clause 4 of Schedule 3D. The Commission considers that in such circumstances the activities of the related party and the corresponding risks to the finance company are also likely to be material matters that should be disclosed in the registered prospectus.

50.

The activities of the related party and the risks of its business may be a key factor that determines the return on investment and a principal risk of a subscriber not receiving the described returns. The Commission is of the view that such information may need to be described in the investment statement in relation to the question "What are my risks?" It is key information that a prudent but non-expert person is likely to want to know in order to decide whether to subscribe for the securities.

51.

The Commission considers that the investment statement and registered prospectus need to explain what criteria or restrictions govern related party lending and should refer investors to the terms of the trust deed for further information as appropriate so that investors can evaluate it. If a parent company or other related entity is financing the activities of subsidiaries (or a subsidiary is funding the activities of the parent company or other related party) there should be some way for the investor to judge the performance of the other entity. The performance of that other entity may be a risk factor relevant to an investor's decision to invest with the finance company. This would be of particular importance where the finance company has few assets and is dependent on the related entity's ability to honour its loan obligations.

52.

Related party transactions can have a material effect on the activities of a finance company and its financial position. The existence of a related party relationship may expose the finance company to risks that may otherwise not be present.

53.

The Commission considers that there are a range of matters in relation to related party transactions and lending that are likely to require consideration by directors of finance companies. These issues may be of such a type or level to concern the principal activities of the issuer under clause 4 of Schedule 3D. They may be key factors that determine the returns and require disclosure under clause 9 of Schedule 3D. They may be principal risks for disclosure under clause 11 of Schedule 3D. If so, the Commission is of the view that they need to be disclosed in the investment statement. If they are not of a type or level to trigger disclosure in the investment statement but are otherwise material matters, then we think that disclosure is required in the registered prospectus. These issues may include:

(a)

Identification of Relationships

Who are the related parties of the finance company?

What is the nature of the relationship between the company and its related parties? For example, the relationship may rest on holding equity interests in a group structure, or through investments held in or by related entities on the basis of ownership interests. Alternatively, the relationship may be established only on the basis of common governance, such as through common shareholders and/or directors.

(b)

Activities

What are the activities of the related parties?

What are the risks associated with the activities of the related party?

Are investor funds used to fund the activities of related parties, or their related parties?

(c)

Lending

What is the total volume of related party lending?

Is the level of related party loans capped or limited?

What proportion of the loan portfolio does related party lending account for?

What proportions of any outstanding amounts on loans are from loans made to related parties?

(d)

Funding

What is the total volume of related party funding?

What is the entity's purpose for entering into transactions resulting in financial obligations to related parties?

(e)

Requirements under the trust deed

How does the trust deed define a related party?

What are the main terms or restrictions of the trust deed in relation to related party transactions?

What criteria are used to determine what a material transaction for disclosure with a related party is?

(f)

Financial standing

Does the related party have the ability to repay loans?

Have any related party loans been written off or forgiven?

Has a related party defaulted in any repayments of the loans or delayed any repayment instalments?

Does related party lending obscure the true extent of a finance company's indebtedness?

(g)

Special rates or concessions

Are related party loans made on an arm's length basis or at less than the market interest rates available to non-related entities for similar loans?

Are related party borrowings obtained on terms and conditions that are more or less favourable than those available to parties not related to the lender?

Is there any security for related party loans?

(h)

Other

Is the related party lending "signed off" by an independent director?

Is investment in the finance company being promoted by a related party?

Conduit issuers and funding vehicles

54.

Where special purpose companies are raising money from the public solely to pass it on for use by another company, the Commission is of the view that detailed information is required about that other company and that this is a material matter to be disclosed in the registered prospectus. Information about the other company may also be required to be disclosed in the investment statement in relation to the factors concerning the risks of the investment.

55.

In some cases finance companies may be structured specifically to borrow funds which are then passed to another entity, usually within the same group of companies or in circumstances of common governance involving one or more related entities. The finance company is simply used as a mechanism for gathering subscriptions from the public in order to fund the activities of other parties.

56.

Persons who subscribe for securities in such a situation are essentially making an investment decision on the creditworthiness and standing of the parent company (or other entity that is receiving the money). The risks and rewards of investing with a finance company that is a conduit depend on the ability of other entities to repay the loans.

57.

The Commission considers that in circumstances where finance companies are used as conduits or funding vehicles, providing information in the disclosure documents about the finance company only is insufficient. The nature of the obligations to the parent company (or other entity that is using the subscription monies to fund its activities) needs full explanation and disclosure. The financial health of the parent company (or other entity) and the purposes for which it uses the money are likely to be material to the risks of investing with the finance company.

58.

The Commission is of the view that in such circumstances the principal activities of the parent company, or other entity, and the risks associated with such activities should also be disclosed in the registered prospectus.

59.

The use of conduit companies raises questions about the application of the definition of "issuer" in section 2 of the Act:

"Issuer" means -
(a): In relation to an equity security or a debt security, or to an advertisement, investment statement, prospectus or registered prospectus that relates to an equity security or a debt security, or to a trust deed that relates to a debt security, the person on whose behalf any money paid in consideration of the allotment of the security is received:"

60.

Where entities are simply being used as conduits, it may be argued that the entity receiving the money is the "issuer" in terms of the definition. This is because the finance company is essentially receiving money on behalf of that other entity. The other entity may therefore be the "person on whose behalf any money paid in consideration of the allotment of the security is received". If so, the Commission is of the view that full disclosure under the Act and Regulations would be required in relation to that entity as an issuer.

61.

The contra argument is that the conduit company is the legal beneficiary of the money and has the debt relationship with the investor. The fact that the conduit company enters into transactions with the other entity does not affect this relationship, and the conduit company legally remains the issuer.

62.

Even if the other entity is not an "issuer" under the Act, it may be the case that the transactions between the conduit finance company and other entity or entities are material in terms of the business of the finance company. If this is a material matter then the Commission is of the view that particulars such as the transactions, the entities that are involved, the amounts that are involved, whether there are any guarantees in place, and the ability of those entities to repay the loans must be disclosed to investors in the registered prospectus so that the disclosed information is not misleading.

63.

Disclosure about these matters would appear to be particularly important where the finance company has few assets, other than the loan receivables, and is dependent on the related entity honouring its loan obligations. The Commission considers this information to be highly material to investors if the conduit issuer is set up as a special purpose subsidiary. In such a case the conduit company's only asset is likely to be the debt of the parent entity. The risks to the investor depend on the ability of the parent company to repay the subsidiary.

64.

The issue of conduits or funding vehicles is relevant to the sufficiency of the risk disclosure about exposure to related parties. The structuring of certain company groups and the extent of related party lending may raise the question of whether certain finance companies are being used as funding vehicles for the activities of other group members.

65.

Where this is the case, the Commission is of the view that the registered prospectus for the finance company should clearly inform prospective investors not only that the finance company is a conduit issuer or funding vehicle but should also include details about the recipient(s) of the funds and the purposes for which the recipient intends to use investors' money, including details of its activities, the risks associated with such activities and its ability to repay the loan. The Commission considers such information to be material information for disclosure.

66.

The Commission notes that often there will be a payment guarantee from the parent entity to the subsidiary company. Where there is a formal guarantor relationship, certain disclosures are required to be made on request to investors under section 54B of the Act or under the Second Schedule to the Regulations, in relation to guaranteeing subsidiaries. If there is no formal guarantor relationship but the ability to repay the investor depends on the creditworthiness of the parent company, the Commission considers this to be material to investors and it would need to be disclosed in the registered prospectus.

67.

Similarly, where the definition of "borrowing group" in the Second Schedule may not capture certain company structures, and therefore disclosure under these provisions is not required, the information about relevant guarantee arrangements may still be material information for disclosure in the registered prospectus.

Possible distortion of the risk/return relationship

68.

The Commission notes in relation to issues of financial reporting that concerns have been expressed by some commentators about the Return on Equity : Return on Assets ratio of some finance companies. There is some concern about whether this may be distorting the risk/return relationship where the interest rates offered by the finance companies are not accurately reflecting the risks that the investor assumes.

69.

The Commission considers that the question of such possible distortions reinforces the need for clear disclosure about the risks of the investment and the activities of the issuer so that investors can assess whether the debenture rate offered is a sufficient return for them, relative to the risks of the investment.

Risk and finance company policies on lending and outstanding debts

70.

Under Financial Reporting Standard 33 - Disclosure of Information by Financial Institutions, a financial institution's statement of accounting policies must disclose the accounting policies for the following matters:

(a): Impaired assets, including the criteria used to classify those assets and policies for recognising and determining their carrying amounts in the statement of financial position;
(b): Specific and general provisions for both recognised and unrecognised assets, and the basis on which these provisions are recognised in the financial statements; and
(c): Policies for recognition of revenue and/or principal payments received, and accounting policies for revenue due but not received, in respect of impaired assets.

71.

The Commission considers that finance companies' policies in relation to lending and debt collection and categorisation are important in assessing the risks associated with the debt security and the impact of such risks on investor returns.

72.

Some commentators have noted that there seems to be varying treatment of bad debts in the financial statements of finance companies, such that it makes a comparison between debts of the various finance companies difficult. The Commission notes that FRS-33 requires certain disclosure in a financial institution's accounting policies about the finance company's categorisation of bad debts. The Commission also notes that if information provided in the financial statements under FRS-33 about bad debts is not sufficient to give an accurate picture of a company's debt situation, the prospectus may be misleading unless additional information is included. In this case, regulation 5 of the Regulations requires the prospectus to contain this additional information. The "true and fair view" requirement of section 11(2) of the Financial Reporting Ac 1993 may also be relevant where compliance with FRS-33 does not fully disclose the situation.

73.

Generally there is little disclosure in the investment statement in relation to a finance company's lending policies and the processes that borrowers must go through to obtain loan approval. Only a few finance companies appear to state whether borrowers are required to have guarantors from which debts can be collected if the borrower defaults. Where the finance company provides finance to higher-risk borrowers or to borrowers with poor financial track records, then this information is likely to be material to assessing the risk/return relationship of investing with the finance company.

74.

Finance companies need to consider the impact of risks associated with credit control procedures, such as effective debt collection. In many cases, finance companies' lending activities involve small scale consumer finance. If finance companies do not have good processes for collecting outstanding debts then this could impact on the viability of the finance company and the risks to investors. This information is important in assessing the risks faced by the finance company in relation to investor returns. It may be relevant to the question of risk in the investment statement, or may otherwise be material information for disclosure in the registered prospectus.

75.

Some finance companies do provide explanations in the investment statement and registered prospectus about the processes that they have in place for debt collection and the percentage and amount of any loans that are overdue.

...PREV | INDEX | NEXT...