How to avoid a finance company collapse

This week was overshadowed by yet another finance company going into administration, the Queensland property financier Wickham Securities.

Investors – reported to be almost entirely superannuation funds, with the vast majority of them self-managed funds – stand to lose up to $27 million invested through unsecured deposit notes called debentures.

Investors were offered returns of close to 10% per annum, while the property developers that the firm lent to were apparently charged an average interest rate of more than 20%.

About 300 people have been caught up in the collapse as administrators investigate roughly $145 million of property developments said to be securing the loans. At the same time, the Australian Securities and Investments Commission (ASIC) has reportedly sought an injunction against Sherwin Financial Planners, managed by Wickham founder Brad Sherwin, to prevent money being moved between a range of related companies and people.

The latest drama once again highlights the regulatory ‘black hole’ that swallowed thousands of investors in rural Victoria’s Banksia Securities just three months ago, and the 2009 Trio Capital collapse is still fresh in many memories.

It may be too late for the SMSF investors caught up in the Wickham collapse, but others should pay careful attention so as not to fall into the same traps. With this in mind, Eureka Report has compiled a list of some of the things to remember so as not to be caught out the next time a finance company crumbles.

1. If you want APRA protection, make sure your money is with an institution under its regulatory oversight.

The Australian Prudential Regulation Authority (APRA) has a limited purview when it comes to protecting investors. It supervises banks, building societies, and credit unions – known as ‘authorised deposit-taking institutions’ – as well as insurers, reinsurers and non-SMSF super funds.

APRA looks at risks and risk models, and imposes requirements on institutions in an attempt to make sure they’re able and willing to hold up financially when under pressure.

When Banksia Securities collapsed last October, administrators said one of the problems was that its 50-year-plus history in a small town meant many people treated it like a local bank, even though the regulatory system didn’t. Investors should always check to see if their ‘local bank’, really is one.

2. Remember that ASIC’s power is limited.

Even where regulatory oversight does exist, its powers are (perhaps startlingly) limited. ASIC released a very revealing chart last year (which can be viewed in full here), in which it outlined its “surveillance coverage of regulated populations in 2011-12”.

In short, it explains how frequently ASIC’s staff get around to looking at the things it regulates. The answer? Not that often.

For investors, the key areas to note are the financial advisers, investment managers and deposit sectors.

When it comes to financial advice, ASIC had 29 staff covering more than 3,300 personal advice licences and 1,300 general advice licences. For all but 50 of the personal licences (covering 64% of advisers) ASIC conducts “primarily reactive surveillance”. For all general licences it conducts “reactive surveillances only”. That is, only when issues or complaints are raised.

The 43 staff covering investment managers look at 589 ‘responsible entities’ in charge of funds, and while they look into the top 25 ever year, as well as four of those most at risk and 20 in concerning sectors, it leaves 540 responsible entities covered by reactive surveillance only.

To put this in perspective, there are more people employed to monitor Telstra’s social media pages (60) than there are to monitor the entire managed investment sector.

To quote Queensland Senator Sue Boyce on the issue: “That’s scary!”

ASIC chairman Greg Medcraft is clear on this point: “It is about time we were realistic about what we do and what we cannot do,” he told a Senate committee hearing last year.

“ASIC is not a prudential regulator, not a conduct and surveillance regulator,” he said.

“The warning we have to Australians is frankly what we have is a system that is based on self-execution and relies on people to do the right thing. It is so important – I will not emphasise this more – that it is up to the gatekeepers to do the right thing.”

3. Read the prospectus carefully, and the warnings.

The Wickham Securities website (according to an archived version, since the site has since been taken offline) included some clear warnings on its home page for investors.

“Investors should be aware an investment in Wickham Securities is an investment in unsecured deposit notes issued by Wickham Securities,” it warned.

“An unsecured deposit note is not a bank deposit.

“Investors should also be aware of the risks associated with investing in Wickham Securities, including the risk of losing some or all of an investor’s principal investment.”

4. Higher returns mean higher risk.

This is a basic tenet of investing, applicable to almost any situation.

Here’s what ASIC had to say in 2004 about investment scams: “If it sounds too good to be true, it’s probably because it is, and you are not likely to see your money again.”

And again, as recently as last month: “Remember if it’s too good to be true, it probably isn’t true.”

Of course it’s less clear cut with legitimate investment schemes and funds, but outsize returns are almost always coupled with outsize risks. A finance company offering 10% returns in the current environment may bear a more careful risk analysis.

The same goes for the underlying assets of a scheme. Wickham Securities was reportedly charging more than 20% interest in the struggling property development sector.

“There’s nothing wrong with riskier returns… [but] you need to look at what is the underlying asset for that return,” administrator Grant Sparks said.

Government guaranteed term deposits with banks may only be paying 4% these days, but they are just that: government guaranteed.

5. Self-managed super investors must be particularly cautious, as there are fewer protections against fraud or theft.

The SMSF Professionals Association of Australia (SPAA) has frequently warned and informed investors about the different rights members have compared with APRA-regulated funds. After the collapse of Trio in 2009, Treasury granted financial assistance to affected superannuation fund members – but not to 285 SMSFs and more than 400 other direct investors.

This is because Part 23 of the Superannuation Industry Supervision (SIS) Act doesn’t provide for financial compensation to any investors other than APRA-regulated funds.

However, SPAA chief executive Andrea Slattery says while it’s correct SMSFs have fewer legal avenues for recourse against fraud, “it’s wrong to say they have no available options”.

The ATO lists recovery action under the Corporations Law, if advice or services were provided by an Australian Financial Services Licensee who was involved in the fraudulent conduct or theft, as one option, as well as approaching the Financial Ombudsman Service.

“However, access to these legal options gives no guarantee that the fund will be compensated for fraudulent conduct or theft. Depending on the circumstances the fund may receive no compensation or limited compensation,” the ATO warns.

“SMSF trustees need to take preventative steps to avoid this situation from occurring.”

With much of the financial system still recovering from the global financial crisis, compounded by the subsequent euro zone debt crisis, there are still many risks remaining for investors.

Investors should be cautious, then, not to compound these risks by stepping too far – or allocating too high a percentage of assets – into an area where protection and regulation is still unclear.