TWO BASIC CANONS

New Zealand Herald, Volume LXXI, Issue 21874, 9 August 1934, Page 13

TWO BASIC CANONS

VIOLATION OF BOTH " ILLUSORY SECURITY " SPECULATIVE INVESTMENTS [BX TELEGRAPH SPECIAL REPORTER] WELLINGTON, Wednesday "A comparison of the constitution and policy of the Investment Executive Trust of New Zealand, Limited, which exemplifies the contractual type of trust, with the British type," continues the report, "will serve to reveal structural weaknesses which have made possible (or at least have facilitated and encouraged) the dangerous and objectionable practices referred to in greater detail later in the report. The capital resources of investment trusts are procured by means of ordinary shares, preference shares and debentures.

"The ordinary rule in trusts of the British type is that at no time should debenture capital exceed share capital. The total capital of 63 such trusts is distributed as follows:—Ordinary shares, £34,550,000; preference shares, £36,334,000; total share capital, £70,884,000; total debenture capital, £45,192,000. From this it will be seen that in practice the debenture liability is substantially less than the total share capital. Capital Composition "The capital composition of the Investment Executive Trust of New Zealand, Limited, is in marked contrast with the British practice. The nominal capital is £IOO,OOO, but the prospectuses so far issued provide for debentures totalling £4,000.000.. The total nominal capital is one-fortieth of the total nominal value of the debentures which may be issued. Paid-up share capital as at October 17, 1933, totalled approximately £30,000 (ordinary £24,000, preference £5675), but the debenture issue totalled £493,290, or over 16 times the share capital. "Of the ordinary capital of £24,400, two individuals, Messrs. J. W. S. McAi'thur and C. G. Alcorn, hold £22,575. Control of the debenture funds, totalling nearly £500,000 is in their hands.

"In the same way, other contractual trusts operating in New Zealand show a small ratio of share capital to debenture liability.

"In the case of trusts of the British type, security to the debenture-holders consists of the total assets of the undertaking. The debenture capital is backed by the whole of the paid-up share capital of the company, and this is normally in excess of the debenture capital. A debenture carries a fixed rat« of interest and is a mortgage secured against the whole of the assets of the trust. Nature of Debenture "A debenture of the Investment Executive Trust of New Zealand, Limited, is a contract to pay over a certain proportion of the net revenue proceeds derived from investments made with the debenture funds. These appear to be reduced before investment by capital charges in respect of brokerage and administration costs, which have totalled up to 10 per cent of the nominal value of the debentures.

"Debenture-holders may require the repayment of their debentures if the average interest over any two successive years falls below 3 per cent per annum, or on the winding-up of the company, but the assets of the company are not charged by the debentures of any series. The share capital of the company is free from liability in respect of debentures, hence the security behind the debentures in any series consists simply in securities and funds held to the credit of the series and arising from transactions with the funds provided by the debenture-holders themselves. Duties of Trustees

"A further essential difference, having relation to the question of security, is the appointment of trustees. Many, if not all, British trusts appoint trustees with power to inspect security portfolios and power of audit. While the power of the trustees will be circumscribed by .the conditions of tho trust, deed, their appointment does provide an additional safeguard against abuse. The Investment Executive Trust of New Zealand, Limited, appoints 110 trustee, and debenture-holders have no powers of audit.

"The essential bearing of the above on the facts which are disclosed later in our report is this. By provision of a small share capital, a small group of individuals has obtained control over a large volume of funds and used these, unhampered by trustees, or by incurring any risk of loss of their own capital. There is nothing to prevent them from manipulating the funds to their own advantage, but even apart from such possible manipulation, they stand to gain a very high rate of return on their own capital, while avoiding any loss which may result from using debenture funds in speculative investments. Integrity Imperative "In such circumstances, it becomes all the more imperative that those who direct the policy should be men of undoubted integrity. "Two basic canons of investment policy should be the diversification of investments and the avoidance of speculative investments. One authority states that a trust with a capital of £2,000,000 should not invest more than £3OOO in any one enterprise. As a general principle, securities should not ho purchased save in established undertakings with ample assets and assets which have been proved by experience to be a sound investment. "The Executive Trust of New Zealand, Limited, violates both these canons. Its debenture certificates provide that on completion of an issue of debentures, not more than 10 per cent of the funds contributed shall be in any one security, but this provision does not apply until the issue is completed. Hence, it can be deliberately evaded by refraining from completing an issue, and the appearance of security through diversification is illusorv.

"The existence of a large number of subsidiary or related companies facilitates such evasion, for it is possible to place investments in several such concerns and then divert them to a particular object, which may be selected primarily because it furthers the interests of the directors themselves. The interests of the debenture-holders are subsidiary. Subsidiary Companies

"Investment trusts which are mindful of the interests of those who invest with them and are anxious for their own reputation should refrain from the establishment of subsidiary or interlocked companies, except for such ancillary purposes as marketing of their debentures. The Investment Executive Trust group, hereinafter described in detail, comprises at least 15 companies which are connected by common shareholders or directors, shareholdings in each

other,' or other forms of financial interdependence. No elaborate argument is required .to demonstrate the openings which this gives to use the funds of the debenture-holders to serve the personal ends of those in control, or to obtain profits by way of commission, or the danger that the security of the deben-ture-holders may be steadily whittled away. "The second basic canon, the avoidance of speculative securities, has also been flagrantly violated, for it will be shown that a considerable proportion of the funds of tne debenture-holders has been used in the purchase and renovation of a building. This is certainly neither an established concern nor a proven enterprise, but is definitely a speculative investment. It will be shown that the device of the subsidiary or related companies has been used to facilitate this investment. At the same time, it has enabled a transaction to be undertaken in such a way as to throw the burden of risk on the debenture-holders, while leaving it open to the directors to enjoy any exceptional profits which might conceivably be realised. "The debenture-holders have no means of obtaining knowledge of the transactions directed to the purchase of this building, because they have no powers in regard to the inspection of the portfolios of the securities."