Great debacles of our time: Brokers get broken

Oh this is a right pickle.

Once upon a time, stockbrokers were venerable institutions with names like JB Were & Sons, Potter Warburg, Ord Minnett and others. They screamed integrity, even if you knew that the way they profited was by buying and selling shares, hence putting them in situations where conflicts of interest can and did arise.

Over time, advising their clients on share trading became much of a side event, as they branched out into areas that could "add value" to their revenue flows.

Derivatives trading became more prevalent. Then full financial planning services. Institutional advice. And margin lending.

About the same time, fund managers, custodians and superannuation funds were finding that they could open up more income flows by lending out their shareholdings to other institutions or investors. The money that flowed from this was valuable.

Why would anyone borrow shares? There appears to be two main drivers for this:

1. Borrowed shares can be sold, thereby covering an activity known as "short selling", which is where you sell securities that you don't possess. You can then buy them back later, which you need to do before passing the securities back.

2. Holders of borrowed ordinary shares can vote on resolutions of listed companies.

The mechanics of stock lending is a weird one to me - and I don't really know the full legal reasons why. When shares are lent, legal title actually passes from the lender to the borrower.

So what actually happens here?

Normally, when title to a security changes hands, there is a Capital Gains Tax (CGT) event. Where stock lending is concerned, for no apparent reason, this rule appears to head straight out the window.

So if the lender is not being pinged for the transfer of securities, one would expect that they have retained some sort of beneficial ownership. In which case, normally, when the shares in question are sold by the borrower - this should give rise to a CGT event for the lender. This doesn't appear to be the case either.

Legal responsibility for the CGT on shares being sold and then bought back would appear, then, to lie in the hands of the borrower. And I'm not really sure how this works, given that what I know of our CGT rules, assets need to be bought before they can be sold.

(Although, it should be noted that most share borrowers fall into the category of "professional investors", in which case, profits retrieved from the selling and buying back of shares would appear, to this observer, to fall into the income category, which makes the whole thing a little bit simpler to work out.)

Which means that ordinary tax laws go out the window a little bit here, and there must be some loopholes or explicit exemptions that are currently in place to facilitate this sort of activity.

But back to brokers again.

Eventually, someone had to connect the dots and work out that margin lending and stock lending could be combined in a profitable way. This would have been a no-brainer for stockbrokers, given that margin lending (or pretty much most lending arrangements for that matter) and stock lending are largely unregulated.

Brokers, who by now had extensive margin lending operations, were changing their arrangements with regards to margin lending subtly. The scope of the change was minor, but a biggie nonetheless: Brokers would assume ownership of the securities outright, rather than merely taking a charge over them.

Then, the broker could on-lend the securities in question.

I don't expect that this is limited to a handful of firms, either. While I have no evidence to back this up, I suspect that the practice is rampant, and it's only some who have been caught doing this.

Consequently, it was only a matter of time before a broker found themselves in hot water over this.

Tricom's problems came to light at the start of this year, when there was a huge slide in the value of stock markets around the globe precipitated by the woes in the US housing and credit markets. Essentially, they had lent out so much of their clients' stock, that when the slide hit and their clients were selling, they couldn't get the stock back in time to enable settlement for the sales made by their clients.

Tricom is still in business. They've since been bailed out by a lot of their owners and clients. Which makes them incredibly lucky.

More worrying was the problems caused by the collapse of another stockbroker not long after. Opes Prime collapsed after similar problems, however Opes Prime's problems were far sillier.

Opes Prime already were exposed to completely ridiculous practices that they'd put in place where they were accepting small listed companies as security for margin loans. This is not normally done.

Normally, margin lenders won't accept shares for security if they lie outside the ASX100, or maybe the ASX200 at a pinch. Opes Prime appeared to accept shareholdings in micro-caps, which was phenomenally silly.

Malcolm Maiden, in The Age described Opes Prime as the "margin lender of last resort".

Indeed, Marcus Padley said somewhere that the value of shareholdings outside the All Ordinaries Index posted as security came to in excess of 65% (if my memory serves me correctly) of Opes Prime's total book. Unbelievable!

Anyway, compounding this was the insistence of Opes Prime to take advantage of lax stock lending laws to move shareholdings between accounts in order to avoid making margin calls on clients' accounts. This was dangerous stuff, and eventually, the losses were going to be big.

ANZ Bank got dragged into this, as they were Opes Prime's principal financier, and held title themselves to much of Opes Prime's stock. How they did this, I'm not really sure. Opes Prime would have been extraordinarily stupid to have allowed ANZ to have ownership of the shares in question, given their practices.

At the end of the day, both the ASX and ASIC have come under heavy fire for allowing situations like Tricom and Opes Prime to happen. I'm not sure why - they couldn't really have prevented this, anyway. I'll talk about this some more in a few moments.

As a postscript to this, broking firm Lift Capital have just gone under, after inappropriate margin lending arrangements with three of the company's directors sent this firm under.

So the question remains - why is only investment covered by the financial services provisions of the Corporations Act? Why isn't lending?

This is more a gripe than a question that I'm going to attempt to answer today.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Great debacles of our time: The failed Qantas takeover

This one was always one that had our full attention from day one. And it stands as an example of a pretty good lesson in how not to do a private equity deal.

The story goes like this - a company that is roundly considered an all-Australian icon, Qantas, is subject to a takeover, where the guys taking the company over is a small cabal of management in league with Macquarie Bank and a bunch of private equity financiers including Texas Pacific and Allco Finance Group and others.

Naturally, all the usual stuff comes out - the unions complain about possible off shoring of jobs, politicians complain in parliament about the possible loss of an all-Australian icon, staff complain about an uncertain work environment and the media lap it all up.

Anyway, institutions holding the shares refuse to sell and the whole deal falls down in a blaze of uncertainty in what was possibly the most anti-climactic end to a private equity deal yet.

Anyway, I found this whole thing amusing from start to finish. I would have found it even funnier if I didn't hold shares in Qantas and Macquarie Bank, but this was truly a debacle that ranks highly on our great debacles scale.

The first thing about this story was the degree to which management could not keep it quiet that they were going to attempt a management buy-out. Rumours abounded and bubbled around to the point where the ASX had to issue a please explain. Fortunately, by that point, the consortium funding this was ready to go public and so the deal financially came out. Not before, I'm sure, people read the newspapers and acted on the rumours which were, by that stage, smoking hot.

I'm sure that I'm not the only one who thinks that the ASX took far too long to act to get the rumours addressed. But this was funny stuff.

Anyway, the consortium's takeover attempt goes public and is embraced fully by the Qantas board after some weak attempts to show some form of neutrality. You do have to note at this point in time, and also throughout, very little disclosure has been made as to how many in management or on the board were in on this. It appears that disclosure only takes place these days when possession of the shares in the new entity takes place.

So the terms of the private equity deal are fairly attractive relative to the share price - $5.60 per share prior to a fully-franked dividend of $0.15 per share which means that the takeover offer price is $5.45 per share after the dividend is paid out.

Acceptances are slow coming. That's OK, the consortium is happy with this. They're expecting them bit by bit. But they're still confident that they'll get the required 90% acceptances to allow mandatory acquisition of the remaining shares by the cut-off date.

Meanwhile, some of the institutions are holding out. It's clear that quite a few of them do not want to sell.

One of them, Andrew Sisson from Balanced Equity Management breaks the silence that fund managers usually put up by publicly announcing that the offer by the consortium is simply not good enough.

It is clear at this stage that the bid is now in deep trouble.

It is at about this point, if memory serves me correctly, that the desperate consortium tries to pull a rabbit out of a hat. This was quite novel and really quite amazing for this type of takeover. The consortium extend their offer and says that they'll proceed with only 70% acceptances.

I found this bit hilarious - basically, they were saying that they were happy to allow 30% of the company to remain on the market.

This bit was always going to backfire for several reasons:

• Retreating to 70% acceptances looks desperate; and
• A new possibility for investors has emerged.

A new possibility for investors had emerged, and it was one which would have been particularly attractive to some, although admittedly not so attractive to others - investors had effectively been offered a once-in-a-lifetime entry in at the ground floor to a private equity deal involving a management buy-out.

Time was running out now.

To complicate matters, as they do, ever since the board of Qantas announced that they were approving the bid, hedge funds just could not help themselves.

Now what hedge funds do here is very simple. They go out there and, without breaching the mandatory takeover offer rules, they get their hands on as much of the company that they can, while taking advantage of the arbitrage difference between the buy price and the takeover offer price.

As a result of all the shares changing hands, Qantas, which is prevented by law from being owned by more than 49% foreign investors, is suspected to have breached this provision and it is thought that the amount of shares in the hands of overseas hedge funds may have cleared the 49% mark by a good portion.

What is also interesting to note, is that the hedge funds themselves signalled their intention for the fun and games to continue by issuing acceptances for part of their shareholdings in the hope that this activity could be stretched out. More on this later.

Anyway, hedge funds were in it up to their eyeballs and stood to make a killing should the takeover go through.

So the deadline approaches, and the consortium approaches every man and his dog on the share register attempting to get enough acceptances to enable the bid to be extended.

At the deadline, all they had to do was to get 50% acceptances, and an automatic extension of two weeks would have been added to the deadline.

It is at this point that the funniest part of this little arrangement happens.

Leading up to the deadline, it was clear that they had about 47-48% acceptances and they just needed one of the hedge funds to get on board - because it was clear that any of the Australian fund managers who were holding out would not be selling.

One of the hedge funds gives enough acceptances to get the offer over the line - but a full five hours after the offer lapses.

The bid is declared dead, but the consortium is not giving up.

Soon, after the Takeovers Panel rules that they will not be accepting this, and Qantas, and the consortium both publicly declare the bid is dead.

What emerges not long after that is a comedy of errors, as it is discovered that, if they wanted to, the consortium could have chosen to exercise a bit of fine print in the takeover offer that they appeared to be completely unaware of. This point was cut and pasted into the takeover offer at some point, and seemed pretty clear in that if a shareholder had issued a partial acceptance, the bidder could have deemed that a full acceptance had been issued.

If the bidding consortium had chosen to enforce this, this bid would be easily over the line. Of course, it should be noted that a long and costly court battle would have ensued.

Instead they chose not to.

The bid was finally dead.

The big losers from this were the hedge funds - as a result of this failed takeover, they're all having to sell their shares well into the red.

Will this takeover be resurrected? Maybe. They'd want to do it better than this, though. This was a foul-up of monumental proportions.

Disclosure: This blogger owns shares in Qantas Airways Limited and Macquarie Bank Limited.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Carnage!

Yessireebob, there has been some carnage on the markets over the past week.

And on the whole, I have to applaud the sensible handling of this issue by the media. It was about six years ago that the infamous Tech Wreck happened, and some markets (for example, NASDAQ) around the world still haven't clawed back the ground that they lost during this time.

You may recall that the media fanned the flames caused by the fallout of the Tech Wreck by suggesting in no uncertain terms that investors were 'cutting their losses' by selling up.

Well, there has been none of this irresponsible talk in the media this time around, at least, in the Australian media, anyway. Most of the media commentators I've read are taking a pretty philosophical approach.

So what caused this?

Ostensibly, it appears to have been caused directly by a large slide on, of all places, the Shanghai Stock Exchange. This was a fall of about 9% on the back of fears that the People's Bank of China was about to introduce capital controls to limit speculation by hedge funds.

The fact that markets around the world were spooked by this is a pretty sad indictment on investor confidence generally.

For starters, the SSE has a total market capitalisation of only about CNY 7.2 trillion, which equates to AUD 1.2 trillion or USD 915 billion.

Compare this with these stock exchanges to see how piddly and little this is (all USD):

NYSE = 15.4 trillion
NASDAQ = 3.9 trillion
Tokyo = 4.6 trillion
LSE = 3.8 trillion

(Source - Wikipedia)

In fact, all the world's big stock markets are massively bigger than Shanghai.

Even the Australian Stock Exchange (ASX), which is not all that big, holds a healthy USD 1.1 trillion, which makes it larger than this tiddler.

Of course, the Shanghai Stock Exchange (SSE) is growing at a furious rate. Much faster than it's little brother the Shenzhen one, and faster still than Hong Kong, which was tipped to be THE stock exchange of China.

Here in Australia, though, the media has been relatively muted on the subject of the markets.

This could be partially due to the fact that the ASX has been one of the world's best performing bourses for three years running. Perhaps that has contributed to the general mood of the media which appears to have taken the attitude that this was a slide that was inevitable.

The ASX has been going gangbusters for some time, and was probably overdue a correction.

But should the concern over the slide in Shanghai have crossed over to the rest of the world's markets in the way that it has? This blogger thinks that the attention that Shanghai is getting is just a little idiotic.

More importantly, though, would restrictions on hedge fund movements in and out of China be a bad thing?

During the South East Asian currency crisis of the late 1990s, the then Malaysian government of Mahathir Mohamad imposed currency controls in order to stem the flow of money out of the country. Commentators everywhere decried this move against a 'free market', but in the end, things worked out well for Malaysia, which came out of the crisis largely intact, as opposed to some of the other member of the SE Asia bloc.

I remember very well at the time Mahathir accusing George Soros of ruining Malaysia with currency speculation.

Fast forward to today, and it appears that there is still paranoia in Asia over hedge fund activity.

The Chinese are being incredibly hypocritical if they are considering capital controls - the People's Bank of China (PBOC) now currently possesses roughly USD 1 trillion of foreign currency reserves. This makes it a powerful player in it's own right.

And it's not immune to its own brand of currency speculation. About this time last year, it engaged in a massive forward contract on the AUD in USD. The AUD was about to sink below USD 0.70 and it became in PBOC's interest to enter the market and short the AUD in order for their deal to pay off.

Meanwhile, the PBOC has kept the renminbi (CNY) at unfeasibly low levels against the rest of the world. It's really no wonder that all this foreign cash if flooding into China.

But as yet, China is not an economic powerhouse. Market reactions around the world to this are patently immature. Maybe in a few years time when the Chinese economy really has some clout, then this scenario would make more sense.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.