Discussion Documents: REPORT ON DISCLOSURE BY FINANCE COMPANIES


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REPORT ON DISCLOSURE BY FINANCE COMPANIES

SECTION 2 - RISK AND BUSINESS DISCLOSURE

The risks of the investment must be made clear to investors

28.: For investors to make informed investment decisions the risks associated with the investment must be sufficiently disclosed. The investment statement must provide investors with enough clear information about the risk of the investment for the investor to comprehensively understand the risks involved and determine whether the returns offered are suitable for them.
29.: Inadequate risk disclosure is likely to mislead investors. It is not the role of the finance company to assess the risk/return relationship of the investment for investors. However, investors should be able to make their own assessment of this relationship from clear risk disclosure by finance companies.
30.: It would be expected that investments with higher risks would offer higher returns to investors. As such, the return offered on an investment is usually a useful indication of the risk of the investment. Finance companies invest subscriptions from members of the public in a range of investments such as property development or consumer financing. The finance companies will themselves demand a return from those investments relative to the risk of those investments. Once the finance company's margin is taken into account, a comparative measure should be able to be made of the risk of the investment by the member of the public who invests with the finance company. However, if finance company margins differ markedly, there may be a distortion of the risk-return equation and the rates of return offered by finance companies may not accurately reflect the risks the investor assumes. The fact that returns offered may not, in itself, be a firm indicator of the risks of an investment highlights the need for finance companies to make clear disclosures that will assist investors to assess risk.

Principal risks for disclosure in the investment statement

31.

Disclosure about principal risks needs to be tailored to the activities and circumstances of each finance company. Disclosure of principal risks in the investment statement should not be limited to generic and standardised statements. Disclosure about principal risks in any investment statement will depend on factors such as a finance company's particular lending activities, risk management procedures and the types of debt securities offered. Finance companies should assess the circumstances of their business in relation to the disclosure of principal risks.

32.

While insolvency will always affect the likelihood of investors receiving their promised returns, simply stating that insolvency is a risk does not particularly assist investors and does not meet the requirements of Schedule 3D. Finance companies must include specific statements describing, in the context of the particular finance company's business, the principal risks that may lead to insolvency.

33.

Risk disclosure in the investment statement should be addressed by finance companies on two levels.

(a): Firstly, there should be a description of the principal risks that may apply to finance companies more generally. These risks may be reasonably generic, as among finance companies (and other issuers), and may include risks such as lending risk, liquidity risk and solvency risk. Some of these risks will be particularly applicable to finance companies due to the type of business they operate. Each finance company needs to assess what generic risks it considers to be principal risks for disclosure in the investment statement. It is likely that risks at this first level can be described in reasonably general terms. Some of these risks may be addressed more fully in the financial statements. Finance companies may wish to draw investors' attention to other important information on risk available in other documents.
(b): Secondly, there should be a description of the principal risks that are specific to the particular finance company. This will vary among finance companies depending on any finance company's principal activities and exposures.

34.

The requirement of clause 11 of Schedule 3D is to provide a brief description of the principal risks. This means that every principal risk must be set out, but the description of each should be brief. Non-disclosure of principal risks that are specific to the finance company is likely to deceive, mislead or confuse investors about the risks associated with subscribing for the debt security.

35.

The degree of detail that the finance company includes in the investment statement on its specific risks will need to be carefully assessed. A practical balance is required, so that adequate disclosure about specific risks is provided, but avoiding so much detail that the investment statement becomes misleading with any small change in the issuer's business, and so requires frequent updating.

36.

Finance companies may need to state in the investment statement that they are disclosing the principal risks specific to the company as they exist as at the date of the investment statement. Unlike a prospectus where a memorandum of amendments may be filed, there is no provision under the legislation enabling an investment statement to be amended. If a material change in the principal risks of the company occurs, then the investment statement will need to be updated and reprinted.

Disclosure about company activities in the investment statement

37.: Clear disclosure about company activities is required for investors to be able to understand what their investment money is being used for and to assess the risks involved with the investment.
38.: Finance companies need to clearly state their principal activities. Generalised statements about a finance company's activities or its structure and history do not provide sufficient information for investors about the principal types of financing activities that the company undertakes or the sector-specific risks to which it is exposed.
39.: Many finance companies make loans to individuals or businesses that may not have been able to obtain funding from other lending institutions due to insufficient security or because the lender is prescriptive in terms of the security that it requires. Other finance companies focus on property financing activities. Where these activities are principal activities they must be appropriately disclosed to investors.
40.: Disclosure is required in the investment statement about how long the issuer has been carrying on its described principal activities. 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.
41.: If certain activities of the finance company are not "principal activities" for inclusion in the investment statement, the activities may still be material matters for disclosure in the registered prospectus.

Use of rating information by finance companies

42.: Wherever a rating is used in a finance company's disclosure documents or any advertisement, then the Commission is of the view that the company is representing that the rating has relevance to investors and, as such, is material information. In such a case, the registered prospectus should contain sufficient information about the rating to allow investors to understand the rating and what it means. This applies to both solicited and unsolicited ratings. It may be helpful for the prospectus to refer also to the rating agency's website if appropriate information about the rating is located there.
43.: If a finance company has deliberately sought and obtained a rating, then, regardless of whether the rating is considered to be positive or negative, the rating is very likely to be material information that should be disclosed in the prospectus. Whether this is the case will depend on whether the rating is material to the offer of securities.
44.: Where a rating is disclosed as material, then any subsequent change in the rating must be disclosed and drawn to the attention of existing investors prior to the reinvestment or renewal of their investment.
45.: If a finance company chooses to compare the rating it has obtained to a rating system used by another rating agency, then the comparison of the ratings must not be misleading to investors.
46.: The Commission considers that a finance company that publishes a rating should provide investors with sufficient information about the rating to enable investors to assess what it means and the extent to which it can help them to work out whether the return on investment is appropriate relative to the risks of the investment.
47.: Where a report on the rating is provided by the rating agency and this report is published, the prospectus should draw investors' attention to the availability of this full rating report. It may be the case that a summary report, as agreed between the issuer and rating agency, is published.
48.: Finance companies should disclose whether the rating that they are referring to has been based solely on publicly available information or whether it is based on further information and analysis of the company.
49.: The Commission does not wish to express a view on the regulation of rating agencies at this point in time and considers that the issue is better addressed as a matter of law reform. The Commission notes that in December 2004 the International Organisation of Securities Commissions (IOSCO) published its Code of Conduct Fundamentals for Credit Rating Agencies. The Commission also notes that regulation of rating agencies is on the IOSCO agenda for 2005.

SECTION 3 - FINANCIAL REPORTING DISCLOSURE

Revenue recognition

50.: It is important that revenue from the different sources of a finance company's activities is clearly identified in the financial statements in or attached to a prospectus. Accounting policies adopted by finance companies to recognise each material revenue source should be clearly disclosed.
51.: The nature of the revenue earned may not be immediately apparent to readers of the financial statements. Where this is the case, the Commission encourages finance companies to provide more information about these revenue sources. The Statement of Concepts that underpins preparation of general purpose financial reports states that "information is understandable when users might reasonably be expected to comprehend its meaning". It also notes that the users' ability to understand financial information will depend in part on their capabilities and in part on the way the information is presented.
52.: The Commission also encourages finance companies to ensure that their accounting policy choices in this area of reporting comply with international best practice by reference to sources of authoritative support discussed in the Explanatory Foreword to Financial Reporting Standards.

Accounting treatment

53.: The Commission considers that an incorrect or inappropriate treatment of items in a financial report cannot be rectified by the disclosure of the accounting policies used, or by notes or explanations. One example is when property obtained through the enforcement of security is subsequently sold. SSAP 17 Accounting for Investment Properties and Properties Intended for Sale requires only the net gain or loss from the disposal to be recognised in the statement of financial performance. The Commission considers that it is incorrect and potentially misleading to recognise the proceeds from disposal of the asset as revenue and to include the cost of the property in operating expenses. While there is no impact on net income, the presentation may confuse readers of financial statements and cause a distortion in the rate of return.

Financial instruments

54.

The Commission's review of financial statements of finance companies also shows that information about certain compound financial instruments, such as convertible capital notes and subordinated shareholders' loans, has been omitted from some financial statements due to the compound financial instruments not being classified as debt instruments. Information that may be relevant to users of financial statements, and that is commonly omitted includes:

(a): Any redemption options held by either party to the instrument, including the period in which, or date at which the option may be exercised and the redemption price or range of prices; and
(b): Any options of either party to the instrument to convert the instrument into, or exchange it for, another financial instrument or some other liability, including the period in which, or the date at which, the options may be exercised and the conversion or exchange ratio(s).

55.

The Commission's review of financial statements has highlighted that improved disclosure is needed about the basis for recognising financial instruments in financial reports, or for treating them as unrecognised items. Some finance companies tend to overlook the following matters:

(a): The accounting for sale and repurchase agreements, reverse sale and repurchase agreements or their option derivatives;
(b): The accounting for financial instruments which are used for hedging purposes; and
(c): The accounting for loan transfers and securitisation of financial assets.

Loan transfer arrangements

56.: The Commission encourages finance companies that engage in loan transfer arrangements to state the basis for recognising loans acquired and for not recognising loans that are 'sold'.
57.: The Commission also encourages finance companies to provide a clearer description of transfer arrangements, for example, whether the transfer is through an assignment, novation or sub-participation, and whether or not there is a repurchase arrangement in place. Often finance companies describe the transfer as a 'sale of loans'. This description does not adequately allow an investor to understand the effects of the 'sale' including the transfer of risk and return associated with the loan.
58.: Understanding the nature of the transfer is important because it may affect the overall risk profile of the finance company, either through the disposal of certain risks (and returns) or through the company assuming certain risks of the loans acquired.
59.: Improved disclosure is also required in relation to the entity's accounting policies for 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.

Disclosure about related parties

60.

The adequacy and quality of disclosure by finance companies about related party lending generally needs to be improved. If related party lending occurs this should be clearly disclosed and explained to investors. The identification and disclosure of related party transactions and the risks of the activities of related parties are material matters for investors.

61.

The Commission is of the view that:

(a): Where significant levels of related party transactions exist, the related party's risk exposure may mean that the activities of the related party and the risks of its business become principal risks of the finance company and require disclosure in the investment statement, as well as being material information for disclosure in the registered prospectus.
(b): In such cases the investment statement and registered prospectus should explain what criteria or restrictions govern related party lending and whether related party lending is on an arm's length basis.
(c): Investors should be referred to the terms of the trust deed for further information on related party transactions as appropriate.
(d): If one entity significantly finances the activities of another related party the investor should be able to judge the performance of the other entity.
(e): The Discussion Paper sets out a range of issues for consideration in relation to related party lending. Disclosure in relation to these various issues is a matter for each finance company to determine in terms of its materiality, relevance, and the particular circumstances of the company. These issues may be of such a type or level to concern the principal activities of the finance company, be a key factor that determines returns, or be a principal risk for disclosure in the investment statement. If they are not of a type or level to require disclosure in the investment statement, then they may otherwise be material matters for disclosure in the registered prospectus (including in the financial statements).

62.

Statement of Standard Accounting Practice 22 (SSAP-22) establishes criteria for the disclosure of related party relationships between reporting entities and related parties. The Commission's review of financial disclosure by finance companies has highlighted that descriptions about related party transactions in the financial statements are often insufficient to constitute reasonable compliance with SSAP-22.

63.

Certain related party transactions were not disclosed because it was provided in the finance company's Trust Deed that these transactions do not constitute related party transactions. The Commission is of the view that, for financial reporting purposes, all transactions with related parties must be disclosed if they meet the definition of related party transactions and the criteria for disclosure set out in SSAP 22.

64.

In addition, certain related party arrangements are not disclosed because the relationship is with a third party via a related party. The Commission encourages disclosure of transactions where a related party has significant influence on a transaction between a finance company and a third party.

Conduit issuers and funding vehicles

65.

Where a special purpose company raises money from the public solely to pass it on for use by another entity, or a finance company is used as a mechanism for gathering subscriptions from the public to fund the activities of another entity, detailed information is required about that other entity.

66.

The Commission is of the view that:

(a): The finance company's obligations to the other entity need to be fully disclosed.
(b): The financial health of the other entity and the purposes for which the money is to be used are material to the risk of investing with the finance company and are likely to be principal risks of the investment that requires disclosure in the investment statement.
(c): If a finance company acts as a conduit or funding vehicle, then this is likely to be a principal activity of the finance company for disclosure in the investment statement.
(d): If the other entity is an "issuer", then full disclosure under the Act and Regulations is required in relation to that entity as an "issuer". If the other entity is not an "issuer", then the transactions between the conduit and the other entity are likely to be material to the business of the finance company and disclosure should be made in the registered prospectus about the entities involved, the amounts involved, the activities of those entities, whether there are any guarantees, the purposes for which the recipient will use the funds, and the ability of the entity to repay the loan.
(e): Where there is a formal guarantor relationship, disclosures are required to be made to investors on request 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 entity for which the conduit issuer is raising funds, then this is material information for disclosure in the registered prospectus.
(f): Any relevant guarantee arrangement, even if not from members of the borrowing group, is likely to be material information for disclosure in the registered prospectus.

Policies on lending, outstanding debts and risk management

67.: Finance company policies in relation to the categorisation of debts are important in assessing the risks associated with securities and the impact of such risks on investor returns.
68.: Financial Reporting Standard 33 (FRS-33) requires disclosure in a financial institution's accounting policies about the company's categorisation of bad debts. The Commission noted in its Discussion Paper that information included in a prospectus under FRS-33 may not be sufficient to prevent a prospectus from being misleading and, if so, additional information may be required to be included in the prospectus.
69.: The Commission's review of financial disclosures by finance companies in relation to loans and credit risk has highlighted that some finance companies define and classify impaired and non-accrual loans in a way that is not consistent with FRS-33. If each finance company interprets which loans are categorised as impaired and non-accrual differently to what is defined in FRS-33, then there is a risk that the comparability of the disclosure required, especially on the quality of loans and the provisioning policies for bad and doubtful debts, becomes difficult to understand and potentially meaningless. For this reason, finance companies should ensure that the definitions or descriptions used are aligned with FRS-33.
70.: Information about a finance company's general lending policies is likely to be material to an investor's assessment of the risks of the investment offered. These policies may include the general processes that borrowers must go through to obtain loan approval (including whether or not borrowers are required to take on payment protection insurance), the extent to which the credit protection insurance covers the entity's loss should a loan go into default, the company's main debt collection policies, and whether borrowers are required to have guarantors. These matters may be relevant to the question of risk in the investment statement and are likely to be material information for disclosure in the registered prospectus. Some finance companies are currently making such disclosure in their investment statements, and the Commission encourages this.
71.: FRS-33 requires a financial institution to disclose its credit risk management policies. Paragraph 13.1 of FRS-33 provides guidance about how information about a financial institution's credit risk management policies could be usefully disclosed. The Commission's review shows that most finance companies fall short of providing meaningful disclosure on the company's credit risk management policies despite the guidance provided in FRS-33. While most finance companies state that they have a credit risk management policy in place, they do not disclose what those policies are. Few finance companies provide information about company policies to mitigate credit risks assumed in the different lending sectors. The Commission considers that this information is important if investors are to understand the risks involved in the business of the finance company and considers this to be an area where disclosure needs to improve.

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