26 April 2008

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.

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