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The Collapse Of Westpoint
May, 2006
Following the series of high-profile corporate collapses in 2001, including HIH, Harris Scarf and Ansett Australia, the Federal Government embarked on dramatic legislative reform to the Corporations Act 2001(Cth) to overcome some perceived regulatory deficiencies. The amendments in the CLERP 9 reforms introduced tougher standards for auditor independence, prospectus disclosure and CEO/CFO sign-off of company accounts. It was hoped that these reforms would make it harder for situations, like HIH, to arise.
Recently, we have seen another Australian group of companies, the Perth-based property developers, Westpoint, go into administration. This time, the CLERP 9 amendments won't help. This is not a case of directors being involved in market manipulation or creative accounting. A major contributor to Westpoint's downfall, its involvement in mezzanine financing, is legal. This raises the question of whether there exists a loophole in the Corporations Act, allowing property developers to offer this kind of high-risk investment to unsophisticated retail investors.
Mezzanine financing
Mezzanine financing is used by developers to cover the gap between what the bank will lend and the cost of the development. In cases like Westpoint, the mezzanine investors are used to attract the secured bank loans, because banks are often reluctant to provide significant loans to uncompleted construction projects without some other significant source of funding. If the project developers are unable or unwilling to provide substantial funding for the project then they must find unsecured lenders who are willing (i.e. mezzanine funding).
Mezzanine financing, while inherently risky, is not illegal. It is usually targeted at sophisticated investors (people who are of high net worth (over $2.5 million) or investing more than $500,000) who know what they are doing and realise they are taking on a higher risk. The money is usually raised through debentures, where the are risks well-disclosed.
Westpoint was different in that it did not target sophisticated investors. It targeted mum and dad investors through 'educational seminars' and a web of financial planners who took a cut of 10% per their troubles (unbeknown to the investor). An information memorandum, usually considered adequate for sophisticated investors, provided scant information about the risks involved.
Westpoint's promissory notes
Westpoint offered investors the change to lend money to it, in the form of promissory notes. In exchange for these mezzanine investors received the promise of a high rate or return, around 10-12%.
The promissory notes were supposed to work like fixed-interest investments, with terms of one and two years, and interest paid monthly or quarterly. The investors would get their capital back upon maturity of the note.
What sounded to be a good investment was fraught with undisclosed risks. It appears the promissory notes were mostly used to fund interest payments to earlier investors, pay commissions to financial planners and meet Westpoint's day-to-day running costs.
By 2001, the warning signs began to appear. Some investors had their maturity dates on their notes extended and could not access their capital. Then, after a while, the interest payments stopped.
Securities or managed investments?
Westpoint raises some interesting questions. Why were investors not properly informed of the risks? And how come the Australian Securities and Investments Commission (ASIC), who knew what Westpoint was doing, did nothing to stop it.
The answer may come down to a possible loophole in the Corporations Act which allows mezzanine financing with minimal disclosure.
In 2004, ASIC commenced proceedings against two of the Westpoint companies (Australian Investments & Securities Commission v Emu Brewery Mezzanine Ltd and Bayshore Mazzanine Pty Ltd v Australian Securities and Investments Commission [2004] WASC 241), arguing that the promissory notes were 'debentures' and therefore fell within the definition of 'secuties' and regulated by the Corporations Act, Chapter 6D. ASIC argued Westpoint was required properly disclosure these notes to ASIC and invtesors through a prospectus.
The court found that the promissory notes were not debentures because that definition in Corporations Act, s 9 expressly excludes promissory notes with a face value of more than $50,000. All of the promissory notes offered by Westpoint were for more than $50,000. Accordingly, Westpoint did not beach prospecus disclosure requirements of the Act.
However, the court did find that the issue of the promissory notes were an issue of interests in a managed investment scheme and therefore required a product disclosure statement under the Corporations Act, Chapter 5C.
An appeal has been heard, with the decision reserved.
Conclusion
Whether Westpoint has breached the prospectus disclosure requirments or the disclosure requirements for a managed investment scheme, the outcome may be largely academic for the 4,000 small-time investors who have lost somewhere around $300 million. However, a clear decision on the disclosure requirements for this type of investing may prevent investors being burnt in the future.
Taken from an email by Musgrave Peach Commercial Lawyers
