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DISCLOSURE BY FINANCE COMPANIES

Risks and the use of rating information by finance companies

76.

There is no formal or mandatory ratings system for finance companies in New Zealand. Some ratings agencies have developed certain rating systems for application to New Zealand finance companies.

77.

It appears that most New Zealand finance companies either do not use this type of rating information, or obtain a rating but choose not to make it public.

78.

Some finance companies do refer to ratings in their advertisements. The Commission is aware that other finance companies have obtained ratings but have chosen not to use them, as the rating may not be viewed favourably by investors.

79.

Finance companies that use ratings generally compare the rating to a well-known standard such as Standard & Poor or Moody's, and advise prospective investors that a copy of the ratings report is available from the finance company. Others simply state that they have obtained a particular rating without providing further information.

80.

The Commission is aware that the use of ratings information by some finance companies is of concern to investors. The Commission has received complaints from members of the public who have expressed concerns or doubts about the use of ratings by finance companies, particularly in relation to the advertising of securities. This raises the issue of whether the use of ratings by finance companies may in some cases be misleading or confusing for investors.

81.

Ratings may be useful for providing a basis on which to assess the relative risks of investing with different finance companies. Ratings may assist investors to grade the level of risk in each debt investment relative to other debt issues and to work out whether each debt investment offers them appropriate returns relative to the risk the investor would have to assume.

82.

However, with only a few finance companies using ratings and the lack of a standard ratings system, the Commission considers that it can be difficult for investors to make any relative assessment about the companies and the various investments that is meaningful. It may be difficult for investors to use the ratings to work out whether appropriate returns are being offered relative to the level of risk involved with investing in a particular company.

83.

Some finance companies have been rated as offering investments appropriate only for sophisticated investors. Others are rated as being sub-investment grade. There does not appear to be corresponding risk analysis in these finance companies' disclosure documents to indicate that an investment may be more appropriate for sophisticated investors or that investors in these debt securities are assuming greater levels of risk. This strongly suggests that the quality of risk disclosure by these finance companies needs to be improved so that distinctions can be drawn by prospective investors between different debt products offered to the public, and assessments made of the financial standing and activities of the finance company.

84.

The Commission considers that any rating obtained by a company is likely to be a material matter for disclosure in the registered prospectus. The Commission's view is that the investment statement should at least briefly explain what the rating means and tell investors where they can obtain further information about the rating. Additional material information about the rating should then be disclosed in the registered prospectus. The Commission understands that ratings companies usually provide the issuer with a report on the rating. Where this is published, the Commission is of the view that the investment statement should also draw investors' attention to the availability of this information.

85.

The Commission is of the view that where a finance company has obtained a rating, and that rating is disclosed to investors, the finance company must also ensure that any subsequent change in the rating is disclosed to investors prior to the reinvestment or renewal of their investment.

86.

The situation may be different where ratings are unsolicited by finance companies. The Commission questions inclusion of ratings information in the disclosure documents where these are not actively sought out, or otherwise used by finance companies. The Commission considers that if an issuer chooses to refer to, or use, an unsolicited rating then again further information about the rating should be made available.

SECTION 3 - RANKING OF SECURITIES

Description of ranking of securities in advertisements

87.

Regulation 14(1) of the Regulations provides that no advertisement shall refer to any debt securities without also stating either that the securities are unsecured, or the nature and ranking in point of the security of the securities. The definition of "advertisement" in section 2A(2) of the Act includes an investment statement.

88.

There are several different types of debt securities offered by finance companies. These include securities described as "secured debenture stock", "unsecured deposits", "subordinated notes", "secured deposits" and "unsecured subordinated notes".

89.

Some investors are not aware of the different risks as between these types of securities. Where there is very little information in the investment statement about the nature and ranking of the securities, investors are likely to find it difficult to ascertain and weigh up the risks of investing in a particular type of debt security, relative to other types of debt securities.

90.

The Commission is of the view that there is room for confusion for investors due to the numerous terms and descriptions that are used by finance companies in relation to the debt securities that they offer.

91.

Regulation 14(1) requires finance companies to either clearly state that the securities are unsecured, or to clearly describe the nature of the securities, how they are secured, and their ranking. This is relevant to the requirement to provide a description of the securities being offered in clause 2 of Schedule 3D and is also likely to be relevant to the question of risk in the investment statement.

92.

The Commission has received complaints from members of the public who have questioned how advertisements can state that debt securities are "first ranking" when the prospectus and investment statement refer to prior charges or claims, for example, prior claims under the Companies Act 1993 or by the Inland Revenue Department. Complainants have been concerned that the description of debt securities as "first ranking" or "first ranking, subject to prior charges" may be misleading to investors when prior claims take priority in the event of insolvency.

93.

The Commission notes that prior claims under other legislation may not relate to the priority of the debt securities relative to other debt securities that are offered. In terms of the ranking of the security, a debt security may well be "first ranking" if there are no other debt securities offered by the finance company that are of equivalent or higher ranking. However, debt securities may not be first ranking relative to claims under other legislation.

94.

The Commission is of the view that the requirements of regulation 14(1) need to be balanced against the requirements of regulation 8 that an advertisement must not deceive, mislead or confuse with regard to any material particular. It needs to be made clearer in advertisements for first ranking debt securities that the reference to "first ranking" relates to the security being first ranking only in respect of the securities offered by the particular finance company and that prior charges or claims under other legislation may take priority.

95.

Some finance companies offer two types of debt securities within the same investment statement. Where this is done the Commission is of the view that the finance company must clearly state for each type of security offered either that the security is unsecured, or the nature and ranking of the security. The difference between the rankings of the securities also needs to be made clear in the investment statement so that the relative risks of the investments can be assessed.

Disclosure about prior claims and equal ranking claims in the investment statement

96.

Clause 12(2) of Schedule 3D requires a brief description in the investment statement of any claims on the assets of the issuer that will or may rank ahead of the claims of subscribers in the event of the issuer being put into liquidation or wound up. The same information is required in respect of any claims that will or may rank equally with those of subscribers under clause 12(3) of Schedule 3D.

97.

Some investment statements provide relatively full explanations that creditors may be required to be paid in priority in law and then go on to provide examples of who these preferential creditors may be and the legislation that may be relevant. Other finance companies include more general statements. The Commission considers that, as clause 12 requires a "brief description" of claims on the assets of the issuer, it is insufficient to simply note that the only claims that rank ahead are prior claims, without describing them.

98.

The Commission is of the view that a description of prior claims on the assets of the finance company must be such that investors are able to appreciate the effect of these claims in relation to the risks that the investor assumes.

99.

If the debt security is first ranking, subject to prior charges or claims, then the nature of the prior charges and claims must be clearly and prominently disclosed in the investment statement. Where there are material prior charges for fixed amounts that will have an effect on the substantive precedence of the debt security these need to be disclosed where possible. If there are precise claims on assets that may rank in priority, then each of these needs to be identified and quantified.

100.

Disclosure in the investment statement of any restrictions on the level of prior charges is also useful. This indicates whether charges may be restricted to a certain portion of the assets of the company.

101.

Where two types of debt security are offered in the investment statement a description of the claims on the assets that rank ahead of the claims of subscribers needs to be described for each type of security offered.

102.

Some finance companies' investment statements include information about claims that will rank ahead of subscribers' claims, but the investment statement does not also explain if there are any claims that will rank equally with those of subscribers. It may be the case that there are no claims that would rank equally and the provision is interpreted as not applicable. Under regulation 7A(3), if a matter specified in Schedule 3D is not applicable then the investment statement does not have to refer to that matter and does not have to state that the matter is not applicable. However, if this is not the case, finance companies need to be aware that they must comply with this requirement of disclosing and describing equal ranking claims as well as prior ranking claims. Again, where more than one type of debt security is offered in an investment statement, information on equal ranking claims must be provided in respect of each type of debt security offered.

SECTION 4 - OTHER DISCLOSURE ISSUES

103.

The Commission's review of finance companies' disclosure documents has also identified a need for improved disclosure by some companies in the following areas.

Consistency between the investment statement and the registered prospectus

104.

Under section 38F of the Act, the Commission has, subject to certain considerations, the power to suspend the investment statement and/or prohibit its distribution if the Commission is of the opinion that the investment statement is inconsistent with the registered prospectus. An investment statement must therefore be consistent with any registered prospectus referred to in it. This is a requirement under regulation 9 of the Regulations.

105.

The Commission has noted a number of discrepancies between information contained in the investment statement and the information contained in the registered prospectus in relation to offers of various types of debt securities by finance companies.

106.

Finance companies must ensure the disclosure documents are carefully checked for content and for consistency to meet the requirements of the legislation. If further information about a particular matter is fully explained in the prospectus but is briefly explained in the investment statement, the finance company should state in the investment statement that other important information is available in the registered prospectus and ensure that the information provided in both documents is consistent. However, the investment statement must still include sufficient information to answer the requirements of Schedule 3D.

Maturity of investments

107.

Clause 9(2) of Schedule 3D requires information about the dates on which, or frequency with which, the returns from the securities will be due and paid.

108.

Some finance companies' investment statements do not clearly disclose what the finance company will do to advise investors when the investment is about to mature.

Neither is information provided about the options available to investors on maturity of the investment. The Commission's view is that clause 9(2) requires clear information to be provided to investors about whether they will be contacted prior to maturity, allowing sufficient time for investors to decide what they wish to do with the investment.

109.

This type of information also appears relevant to the question in clause 14 of the investment statement about "How do I cash in my investment?" For example, if the investment will be cashed in on maturity, unless an investor contacts the company to reinvest for a further term, this should be clearly explained. Similarly if the investment will be rolled over unless the investor indicates that they want to cash it in, then this needs to be explained.

"How do I cash in my investment?" - disclosure about the effects of early termination

110.

Clause 14 of Schedule 3D of the Regulations requires the investment statement to contain a brief description of any rights of the issuer, subscriber or any other person to terminate the investment early. If any charges are payable by a subscriber, the investment statement must refer to the information given under clause 7(1)(e) - early termination charges or clause 7(1)(f) - switching or sale charges.

111.

As these disclosure provisions are linked by reference, the Commission considers that information about early termination charges should be disclosed in relation to both sections of the investment statement (i.e. both the question "What are the charges?" and the question "How do I cash in my investment?").

112.

The Commission has found that some finance companies are not including such information under both sections of the investment statement. Regulation 7A(4) requires all information specified under an italicised question in the investment statement provisions to be set out in the investment statement under that question. A failure to include the required information on early termination charges under both clause 14 and clause 7 would appear to breach this requirement.

113.

The level of detail about the effects of early termination appears to vary considerably among finance companies' investment statements. The Commission is of the view that some investment statements need to provide clearer and fuller information in the investment statement about the effects of early termination and the situations in which it will be permitted.

114.

Clause 14 requires a brief description of any rights of the subscriber to obtain payment of the returns from the securities. It needs to be made clear to investors that their money is being locked in for a particular term and can only be terminated before that term in what may be very limited circumstances, such as the death of an investor or financial hardship caused by unforeseen circumstances. The Commission considers that some finance companies should give more prominence to the provisions explaining that early withdrawal will be permitted only in exceptional circumstances and that early termination will affect the investor's right to obtain payment of the returns.

115.

The Commission notes that if early termination is approved, then the finance company may charge an early withdrawal fee, determined by reference to the interest rate that would have applied to the full term of the investment, or may adjust the interest rate applicable to the deposit. The Commission considers that finance companies need to explain these fees clearly in the investment statement, as this affects the rights of subscribers to obtain payment of the returns.

Date of investment statement

116.

Section 38E(1)(b) of the Act requires an investment statement to prominently state the date at which it is prepared. Finance companies must ensure that this requirement is met.

117.

Several investment statements for debt securities offered by various finance companies do not state this date prominently. In some cases the information is in very small print and is contained within the text in the body of the investment statement, rather than displayed upfront. This can be contrasted to the approach taken by other finance companies that prominently state the date of the investment statement on the cover of the document.

How much do I pay?

118.

Clause 5 of Schedule 3D of the Regulations requires certain details to be included in the investment statement in relation to payment of money by subscribers in respect of the securities. These provisions cover aspects such as the amounts payable, the person to whom and the place where payments are to be made, and the frequency of payments (if applicable).

119.

The Commission has noted a case where the investment statement does not provide details about the person to whom payments should be made. While it may be presumed that payment is to be made to the finance company, there is no express information that tells an investor that the finance company will be the entity that receives the subscriptions. This information is important, not just in a practical sense, but also so that there is transparency about which entity collects the subscription money. Finance companies must ensure that these requirements are met.

Ordering of information within the investment statement

120.

Under regulation 7A(4) all information and statements specified under an italicised question in Schedule 3D to the Regulations that are required to be contained in an investment statement must be set out together in the investment statement under that question.

121.

Finance companies need to check whether information is required to be repeated or referred to in more than one part of the investment statement to meet the requirements of regulation 7A(4). This may raise issues about the practicality of repeating or re-emphasising information.

122.

The Commission's view is that finance companies must take into account the context in which the information is to be provided. The Commission considers that Schedule 3D requires enough information to be provided under each section of the investment statement to adequately answer the head question ( for example "What are my risks?") and the specific disclosures required under each clause.

Information on request

123.

Clause 18(c) of Schedule 3D requires a statement to the effect that the prospectus, financial statements and other documents of, or relating to the issuer, are filed at the Companies Office and available for public inspection. Clause 18(b) requires a statement describing where a copy of the prospectus and most recent financial statements of the issuer can be obtained free of charge.

124.

The investment statements for some finance companies state in relation to this provision that "further information is available from the Companies Office". The Commission does not consider this to be sufficient in terms of the requirements of the legislation. In particular, finance companies must make it clear that, while documents are available for public inspection at the Companies Office certain information can also be obtained by the investor free of charge from the issuer.

SECTION 5 - ADVERTISING

Key provisions of the Act and Regulations relating to advertising

125.

The meaning of "advertisement" is defined in section 2A of the Act. Under section 2A(1) an "advertisement" means a form of communication that -

(a): contains or refers to an offer of securities to the public for subscription; or
(b): is reasonably likely to induce persons to subscribe for securities of an issuer, being securities to which the communication relates and that have been, or are to be, offered to the public for subscription.

To be subject to the requirements of the Act, an "advertisement" must be authorised or instigated by, or on behalf of, the issuer or prepared in co-operation or by arrangement with the issuer and is to be, or has been, distributed to a person.

126.

The type of communication that may constitute an "advertisement" for the purposes of the Act is broad. The definition of "distribute" in the Act includes -

(a): make available, publish and circulate; and
(b): communicate by letter, newspaper, broadcasting, sound recording, television, cinematographic film, video or any form of electronic or other means of communication.

127.

An advertisement may be distributed by any of these methods of communication.

128.

An investment statement is expressly included in the definition of "advertisement" by section 2A(2)(b) of the Act.

129.

Under section 38 of the Act the meaning of an "authorised advertisement" includes an advertisement -

(a): that is an investment statement that relates to the securities and that complies with the Act and regulations; or
(b): refers to an investment statement that relates to the securities referred to in the advertisement and that complies with this Act and regulations.

130.

Regulation 8 requires that no advertisement shall contain any information, sound, image or other matter that is likely to deceive, mislead or confuse with regard to any particular that is material to the offer of securities contained or referred to in the advertisement.

131.

Under regulation 17 a certificate must be signed by a director or other authorised person in respect of an advertisement before it is distributed to the public. The form of this certificate is set out in the Fourth Schedule to the Regulations. The director or authorised signatory must certify that they have:

(a): Read, seen or listened to the advertisement; and
(b): That it complies with the Act and Regulations; and
(c): The advertisement 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; or
(d): The advertisement does not contain any matter that is inconsistent with the registered prospectus referred to in the advertisement.

132.

Under section 38B of the Act, the Commission may make an order prohibiting the distribution of a particular advertisement or any other advertisement relating to an offer of securities if it is of the opinion that the advertisement:

(a): Is likely to deceive, mislead or confuse with regard to any particular that is material to the offer of securities to which it relates;
(b): Is inconsistent with any registered prospectus referred to in it; or
(c): Does not comply with the Act and Regulations.

133.

Under the Act there are also obligations on the media to ensure that there is a certificate as required by regulation 17 for an advertisement before distributing an advertisement to the public.

134.

Finance companies need to carefully check the compliance of all advertising before advertisements are distributed for publication. All applicable requirements of the Act and Regulations in relation to the advertising of debt securities to the public must be complied with.

135.

The Commission's view is that finance companies should consider whether they need to develop compliance plans in relation to the advertising of securities to help ensure that all legislative requirements are met.

136.

Finance companies should check every part of an advertisement carefully so that it does not deceive, mislead or confuse prospective investors and also meets all of the content requirements of the Act and Regulations.

137.

Information may become misleading if it is not kept up-to-date. It is important that advertisements are accurate at the time they are distributed. If circumstances change between the time of distribution and publication, then the advertisement may need to be withdrawn and revised if it would otherwise be misleading.

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