Last month we began this series on failed investment schemes by reviewing the failure of the South Sea Company (SSC), commonly known as the South Sea Bubble.
We made the observation that history repeats itself and that there are some common factors in these types of failures. This month we look at some current examples – including the Westpoint Property Investment Scheme.
The Westpoint failure involved a number of companies, but having the operations spread over numerous entities does not alter the factors involved in the failure. Westpoint started with almost no working capital, and mainstream financiers would not providing funding. Instead of shares being sold to the public – as with SSC – finance was obtained from loans through what is being called Mezzanine Funding.
Each separate investment was arranged through three companies:
- a management company
- a funding company
- a development company
The development company did the development, the management company took a fee for managing the development – but it was the funding company that borrowed the money.
Funds borrowed from the public were supported by Promissory Notes. The word ‘secured’ is deliberately not used, as issuing promissory notes avoided the granting of a recognized security, although the scheme could still be classified as a Managed Investment Scheme. This meant that money lent to Westpoint was unsecured, and the provisions of the Corporations Act dealing with prospectuses etc. could be avoided.
The people involved in Westpoint had no particular skills in raising money from the public, so they engaged the services of financial planners who had large numbers of clients looking for places to invest their money.
But many of these financial planners simply accepted the facts and figures provided by Westpoint without too much examination. They did not critically assess the investment’s potential. The fact that they were receiving a 12% commission on money lent meant that some were more prone to recommend this investment to their clients.
The commission, the management fee and the initial interest charged on the money meant that less than 80 cents in every dollar lent went towards the development. Margins were simply never going to be sufficient on the 80 cents to support the return on the $1 borrowed and make a profit. There would have to a 25% return on the development simply to make back the capital lent.
Westpoint relied on a hole in the legislation governing the raising of funds from the public. The Corporations Act prohibits offering securities to the public without a prospectus. Westpoint used promissory notes instead of securities and targeted so called ‘sophisticated’ investors lending over $50,000 to avoid that obligation. Unfortunately many of these investors were not sophisticated when it came to investing – they just had $50,000 available.
The ASIC sought a declaration that the promissory notes were securities. The Court disagreed. ASIC had to take a different tac and this took some time. The gap in the legislation lead to a lack of government control, which in turn lead to increased losses suffered by investors – just as it had in 1720.
The underlying investments (the developments) were not profitable enough and Westpoint eventually failed, having borrowed some $600 million.
A very similar pattern appeared with the previous Unlicensed Solicitor Mortgage Schemes. There was a distinct lack of legislative guidelines as solicitors were considered trustworthy business people. They may have been trustworthy, but some proved bad investment managers. They borrowed money primarily from their clients (unsecured) to lend to borrowers that could not obtain funding from mainstream financiers. The information provided – valuations and development information – were generally not examined carefully or with any great skill and some of the underlying investments proved to be very unprofitable. The solicitors involved took a fee relevant to the amount of money lent, not what return was achieved.
Our latest case is Queensland Paulawnia Forests Ltd. This was an investment scheme based on growing and harvesting Paulawnia trees. General public investors put in about $80 million based on predictions that the trees would grow, be harvested and profits would be made. The trees did not grow as planned.
Next month we look at the common factors in all of these investment schemes.