David Hargreaves says the CBL disaster appears to have revealed massive loopholes in our regulatory processes; shareholders and the investment community deserve better

By David Hargreaves

Here's a hypothetical situation for you.

Imagine you are buying a house. It's in Auckland, so, we are talking serious money. Let's say $1 million. You do all your due checks and processes, find the finance and sign up for the house.

Then you find out somehow or other about the existence of a confidential land assessment done for the council that reveals the property is on a landslip risk and therefore may be worth considerably less than what you've just paid - if in fact anything at all.

Would you be A/ "Oh, well, never mind, it's just money." Or would you be B/ "Why the @#X wasn't I told?".

Let's try another situation. In this case an investor decides to buy shares in a company, let's call it CBL. The investor does all the checks based on the publicly available information and announcements, satisfies themselves based on the available information that the company is sound, and then buys the shares, say for $3.17 each.

Subsequent to buying the shares our investor then finds out that the regulator of the industry our company has operated in, let's say insurance, and let's call the regulator the Reserve Bank of New Zealand, has been for months investigating the company and imposing increasingly stringent conditions on it and what it could spend.

Further, the regulator/RBNZ had formed the view, expressed to CBL as long ago as August - but kept confidential -  that CBL "has not been and is not carrying on its business in a prudent manner".

Would our investor have liked to have known this? Weren't they entitled to know this? And would they have paid $3.17 a share if they had known? Well, of course not.

So, the first situation is hypothetical and the second, unfortunately, all-too real. 

The point I'm trying to make is, yes, the buyer beware rule should always be heeded. But, after you've made all the checks you possibly can in buying something and sought all the information publicly available, you are probably entitled to believe you are getting fair value for your money. CBL shareholders were not. And information that would have told them this was not made available to them till too late. 

I think the CBL case has thrown up a very serious loophole or at least flaw in our regulatory processes. There should be a formal inquiry into what went wrong here. It must not be allowed to happen again.

The credibility of the market is in question. 

Information for all

Sharemarkets depend on having information available to all parties on which informed investment decisions can be made. With CBL the regulators had information I believe was material and they did not inform the market of that. Not a word.

To my mind there is no doubt at all that something needed to have been said the moment the RBNZ started getting closely involved with CBL in July last year, and specifically after the RBNZ wrote to the company issuing directions on July 25 and indicating it was to seek an independent report on the company. 

A look at the trading figures on the NZX and Australia's ASX (on which CBL was also listed) suggests that between the two markets from that date (July 25) till the trading halt last month something over 43.5 million CBL shares changed hands. With the price seldom going under NZ$3 during that time, these trades would have been worth comfortably in excess of NZ$130 million. That's a lot of money changing hands for a stock that was not (in view of what was going on) being properly priced by the market. Nor was the market a properly 'informed' one. 

The company was 'worth' a shade under NZ$750 million when trading in the shares was halted.

Harbour Asset Management, which had the misfortune to to accumulate - on behalf of clients - over 7% of the CBL shares, reckons they might now be worth 28c each. This would make its holding worth around $5 million, versus over $50 million before the trading in shares was halted.

The Harbour calculation would make the whole of CBL now worth $66 million - which is bad next to nearly $750 million a month ago.

Worth nothing

But actually, sorry to be a bundle of joy here, but I think when the final calculation is done those shares will be worth nothing. Zip, nada, not a nickel. Shareholders are pretty much last in the queue of what becomes a long line of hands-out when a company is liquidated.

Now we don't know for sure what will happen to CBL. But my guess is we won't see it operating as a company again.

Experience of company failures suggests that once the specialists start getting under the hood the financial problems are almost always bigger than earlier thought.  

In the case of CBL assets will be sold as they can be to meet secured creditors - something in the region of $180 million worth of them. I can't think of many if any instances in New Zealand where a company has gone under and then shareholders have actually got something back. I can think of very many instances where they did not. There may be litigation - that's highly likely, in fact probable. And that's probably the only way. But that would take time.

The regulator had concerns

What makes CBL different to other instances in which companies have failed, however, is the specific circumstances. The fact that the regulator in the shape of the RBNZ had very specific concerns about CBL going back some considerable time. The fact that it was privy to information that showed things were not well within the company.

What rights were the shareholders given?

The RBNZ does have a memorandum of understanding with the Financial Markets Authority, which oversees the NZX. And under the terms of this MOU the RBNZ did inform the FMA is was engaging with CBL.

This from the FMA: 

“The FMA was informed of the RBNZ investigation into CBL in August 2017. The FMA was informed that this investigation was subject to confidentiality orders.  The information which led to an investigation by RBNZ was in dispute by CBL.  This information was provided to the FMA under the FMA/RBNZ Memorandum of Understanding.”

I asked the FMA why it did not require at least some disclosure of the RBNZ's involvement with a company (CBL) that was then valued at something in the region of $750m, and was having its shares changing hands in what (in my view) was an uninformed market?

This was the response:

“Prior to 2 February 2018, although the FMA was aware of the RBNZ’s concerns, the information was in dispute between CBL and RBNZ.  During this period there was insufficient information to be able to contradict CBL’s assessment of its financial position.  The purpose of the RBNZ engagement was to substantiate the information being provided by CBL.  The FMA engaged with NZX Regulation, who engaged with CBL during this period and CBL confirmed to NZX Regulation that it was in compliance with its continuous disclosure obligations.

"The fact that a listed issuer is engaging with a regulator is not necessarily material information in itself.  The materiality of the information depends upon the nature and likely outcomes of that engagement. 

"On 2 February 2018 we received further information from RBNZ that led us to believe there was a significant risk of a false market in the CBL shares.  We passed this information on to NZX Regulation, and following dialogue between NZX Regulation and the company, CBL was put into trading halt.”

Well, I'm sorry, but I can't agree with the assertion that "the fact that a listed issuer is engaging with a regulator is not necessarily material information in itself". I think the fact that a regulator is engaging with a listed company - particularly when that regulator as in this instance believes the company "has not been and is not carrying on its business in a prudent manner" is highly material. 

A real worry

The fact that the FMA could make such a statement is, I think, a real worry. Because it does open up the possibility that this regrettable situation could be repeated. At the very least I do think we do need a rule that makes public the fact that a regulator is interacting with a publicly listed company.

I'm not saying that it would be easy to decide just what should be conveyed to the market at such times - but something should. Otherwise the whole thing begins to look like a tiered society structure, with the shareholders at the bottom, second-class citizens, being kept in the dark. But, you know, they are the people who are putting up money and taking risk. And they have an absolute right to know that a dispute is going on with the regulator - and then be able to make their own decision.

The reality is that all episodes such as this do is confirm on the part of the property believers that there is no other way. It's invest in property or nothing. And frankly, when you look at something like this, who can argue?   

There is a much broader issue here in the context of share investment as an asset class struggling in this country to hold its own.

A struggling market

The NZX has just recently lost one of its great success stories Xero - off to Australia in search of a bigger pool of investment funds. One of the largest companies Fletcher Building is now in the midst of a painful restructuring. One of the former darlings Sky Television is now a fast fading star. CBL was one of the top 50 stock by capitalisation and because of that the index-linked managed funds were obligated to hold shares.

The NZX is facing I think an uphill struggle to retain some relevance in New Zealand. The whole future of the managed funds industry here is now looking questionable.

This country needs a bigger pool of investment money to help companies survive and grow.

With the regulators shooting the sharemarket investment industry in the foot like I believe they have in this instance, the task is just that much harder.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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17 Comments

Unsure if this has been covered, but Deposit Power has gone belly up in Australia.

A rule requiring the FMA to disclose whenever it is investigating a company, would surely be just as damaging to the appeal of equity investing? One assumes a high percentage of its investigations reveal there is nothing of concern but meantime the share price of these companies will have tanked on the rumour. Damned either way.

Its a little like someone being accused of abuse. Before the proper investigation takes place, their name is made public. Way too soon in my view.
So which is better. Early publication before the facts are known or wait until its more certain?

NZX investigated Fletchers and found nothing wrong. Somehow I'm not sure they really had a look at all. Can we have confidence in our regulators given recent events? What else is on the cusp of floating upside down in the pond?

NO

I don't know whether this applied to Fletchers but my (admittedly limited) experience of the independence and muscularity of governance processes in corporates I've been involved with, has been less than impressive. I haven't experienced many truly independent spirited individuals who fearlessly grill divisional managers and are willing to assertively go head to head with boards and CEO's.

CBL confirmed to NZX Regulation that it was in compliance with its continuous disclosure obligations

Not just the regulators that need looking at. It would now be worth asking whether that confirmation was fair given the facts at that time.

I don’t know the business well but a little light reading suggests the problems started in 2016 with the Elite business that was closed down due to increased claims because of a change in EU legislation.

This story will run and run.

This illustrates the sensitivity of interdependent networks to cascading failure.....

"Deposit Power, which provided interim finance to property buyers, has closed its doors after the collapse of New Zealand's CBL's insurance, which was an issuer and guarantor of deposit bonds".

http://www.afr.com/personal-finance/10000-property-buyers-caught-in-depo...

Not just the regulators, the role of the external auditors needs to be examined too. Not just for CBL, but Fletchers etc.

Looking deeper than the transactional compliance level, would require an auditor to have extensive expertise in measuring risk underwriting quality. The lead time for adverse claims experience resulting from underpricing and poor risk selection to manifest, is often lengthy in the technically challenging performance guarantee/bond insurance segment. Poorer quality risk assessment by staff that nonetheless complies with underwriting rules and process, can still take an insurer down. The belief that auditors have enough expertise or time available to differentiate between compliance with laid down process, and sub optimal selection at individual case level where multiple risk factors combine with the need for subjective judgements, is misplaced.

Incredible situation, with the MD progressing in the Ernst & Young entrepreneurship competition from May/June of last year, all the media on that. Thanks interest.co.nz for covering this where other media has moved it off the business pages.

Still adorning the front here: http://www.ey.com/nz/en/about-us/entrepreneurship/entrepreneur-of-the-ye...

Is this like Juries not being told of previous convictions of the defendant ?

The Investment Banks, the Rating Agencies and the Regulators colluded to bring on the GFC in 2008.
No lessons have been learnt, it seems. Cheating the public has become more organised now.
Corporate power = Political power.
Lobbying is not Corruption.

The point missed by common taters is that disclosure of regulatory investigation of CBL to the market, would have immediately induced major shareholders to demand a series of come-to-Jesus meetings with the company. This would have placed additional pressure on CBL to front-foot the reasons behind the regulatory moves, and would almost certainly have enabled some disinvestment decisions by shareholders. After all, 60 or 70% of original purchase price , while not - shall we say - Optimal, would have been better than today's situation, where, to recycle an old Great Crash meme, the share certificates are worth less per square metre, than wallpaper....

CBL were allowed to sell insurance when they are insolvent. AMI were allowed to sell insurance and shares in themselves as a mutual while they were insolvent. The public servants are at fault here. The policy buyers and the investors were relying on the public service reports that the company was allowed to carry on as an insurance company and was solvent. Criminal charges should be laid. Public servants should be fired

The solution to the underwriting quality comment is easy. If and insurance company says you are covered for full cover then it should be law that your bank MUST accept this as full cover. In the event if an event your bank must guarantee the cost of repairs and recover it from the insurance company. That way dodgy insurance companies will be exposed by the banks early. The banks have knowledge that the public do not have.