What is the reason behind the failure of so many mortgaged focused managed investment schemes (MIS)? Many Australian investors who have lost money are asking this very question. Can it be put down to the GFC swindling directors or just bad law that allows conflicts of interests and fails to protect investor interests? My view is that at the moment the whole corporate model is flawed, because a director who is on the board of the reporting entity is also permitted to be on the Board of the Management Schemes and make investments decisions. So if the wolf is bad who is the trustee?
Last financial year witnessed a number of managed investments schemes where redemptions of millions of investor dollars have been frozen or folded losing the majority of investor funds. No one has really tallied up the losses, but an educated guess would put the damage at many billions of dollars. Investors most affected have been retirees that may not have been informed or fully appraised about the extent of the risk involved or the risky investment models used by the directors of these schemes. Many of these investors have been let down by, directors and auditors and flawed investment models. The model should not be flawed with a board of directors, Credit Committee, Auditors and Valuers. However, the failure of some large mortgage investment schemes indicate this whole area needs a rethink?
A managed investment scheme is simply an investment fund, has at least three directors with oversight by a responsible entity. The Responsible Entity (an unlisted Public Company) must hold an Australian Financial Services License issued by ASIC . The Responsible Entity (RE) effectively is a trustee of the Investment funds. The law sets out directors duties for operating an RE and provides criminal and civil sanctions if the directors and/or the RE breach fiduciary duties. Directors are required to be independent and implement compliance requirements. It is fair to say that the legal operations of an RE’s is a complex area of the law and clouded in rules and requirements that even ASIC finds difficult to work out if they are working and implemented. ASIC has introduced guidelines and policies aiming at protecting investors. However, Managed investment schemes do not have the same disclosure requirements as companies listed on the ASX.
However, at the end of the day much depends on how these schemes are run and the capabilities and investment skills of the directors. The framework to a great extent relies on auditors, disclosure and independent directors to raise red flags were appropriate. Additionally, MIS where mortgage lending is involved boasts that the mortgage investment involves a single loan to a specific borrower secured over real property with disclosure to investors about risk in the PDS (Information statement). What potentially was not disclosed was that investing in these financial products, investors were taking on the development risk and lending to former bankrupts and companies in external administration.
Why have these managed investment schemes involving mortgages lost so much for investors? Is it the GFC? Property has only gone down in Australia last year by an average of 6 to 15% depending on the expert research articles such as RPdata and BIS Sharpnel reports. However, some of these funds have defied the market by in three years shaving off more than 20 to 80% of investors funds.
So why are investors losing money and where are the independent directors and auditors in all these operations raising red flags for investors before these investments go south? Well the answer to this question seems to raise a number of interwoven issues. In the first place, some of these funds have invested in over inflated property developments with questionable or elastic valuations prior to the GFC. Another factor is that often the RE is lead by one dominant director majority shareholder who can dominate the investment direction of the board. In some instances a controlling director can appoint accommodating friends as fellow board members. In some of these schemes and contrary to the compliance requirements, there is often little or no independence about directorships and no real way to prove otherwise.
Other weaknesses in the Managed Investment Scheme frame work is the way an RE is operated by an unlisted Public company with a majority shareholder, who is often the founder or dominant director. This director/shareholder receives management fees whether the investment funds perform or not. The model allows for conflict of interests, as the dominant director can be on the Board of the RE and also control the investments of the funds. RE operators with an inept board and questionable lending practices have the capability to operate schemes to the detriment of investors. In this scenario, unless there is a whistle blower inside the fund, negligent or dishonest conduct is difficult to detect until after the fact. This means it is too late to save investor funds. There has been little regulatory action taken against the directors of these funds who have lost money in suspicious circumstances. There have been no criminal convictions for directors under the regime. To take negligent or dishonest directors to task one need’s a magic legal wand required to test legislation that has never been before a court.
What needs to change is a process whereby more independent directors with appropriate industry expertise are appointed in the spirit of compliance plans under the MIS requirements. The other issues are that auditors need to be more accountable, on guard and proactive in the review of the valuations of property and not be wise after the fact. Audit rules do not give the clarity of what steps to follow in reviewing these funds. There is a lot of subjectivity involved and auditors can be blindsided. The whole process depends upon fiduciary and audit gate keepers doing their role properly. If they fail, then the investors loose out!
One thing is for sure, no matter how many rules the law puts in place , what is needed on these MIS boards are “pure” independent directors and appropriate disclosures to investors and auditors that do their job. There are of course criminal sanctions available but these remain untested in this area. At the end of the day investors want their money back and do not want to fight for what has already been earnt!