Don't judge a hybrid by its cover, or notes

22:35, Jun 19 2013

In a choice of two admirable candidates for chief executive, one a rugby player and one a golfer, Chalkie would choose the golfer.

Rugby is a game of grey areas and dark arts, whose rules are regarded only as general guidance and not necessarily to be taken literally. A hand in the ruck will get a pat on the back if it helps win the game.

The golfing code, by contrast, is a rigorous thing. Players will penalise themselves rather than risk the shame of even a minor transgression.

Thus, if it came to deciding how to account for a loan, say, Chalkie reckons the golfing executive would call it a debt, while the rugby player would think about whether it could pass for equity.

You can get a feel for footie flexibility in the Hybrid section of the NZX's debt market. The securities listed there are a hotch- potch of semi-bonds, many of them perpetuals - that is, they have no maturity date. This means although they are like debt because they pay interest, they are also like equity because they don't repay money at a given time.

Think of them as the ladyboys of the investment world. Neither one thing nor the other, but willing to go with the flow.


Of course Chalkie is not suggesting rugby players like ladyboys - it's just a simile.

However, the Financial Markets Authority is a bit uptight about them - hybrids, that is - and has been looking up their skirts to ascertain their fundamental character.

In a report published last month, the FMA said it had examined hybrids from 21 issuers and found concerns about five of them. After further investigation, it found one of those five had been classified in accounts as partly equity, when it should have been wholly debt.

This immediately brought to Chalkie's mind the unsavoury matter of a loan from Cayman Islands company Agria to NZX- listed PGG Wrightson.

In January 2010 Agria lent $33.8m to PGW and received a bunch of convertible redeemable notes in return. These notes were classified as equity by PGW, which had the dual effect of making its net assets and its profits look bigger - the former because the debt didn't count as a liability and the latter because interest payments were classed as dividends, not expenses.

The company said the notes could be classed as equity because it had discretion to stop paying the interest. Arguably this may be so, but the dividend stopper had the rider that PGW couldn't pay dividends until all outstanding interest was paid. Chalkie therefore reckons the notes had only a passing resemblance to permanent equity and were actually debt dressed up with tights and make-up.

In fact, the things were so hairy-legged PGW itself described them as "costly subordinated debt" when it decided to repay them in December 2011.

As this disgraceful episode shows, hybrids can easily deceive investors who judge books by their covers, so it was heartening to see the FMA draw attention to them.

Bizarrely though, the FMA is refusing to name the company it thinks has misclassified its debt as equity. Investors have thus been told one of the 21 hybrid issuers was misleading them, but not which one.

This is about as helpful as knowing one of your jelly beans is vomit-flavoured - every bite is blighted until the moment your jaws clamp on the bilious pill, by which time it is too late to avoid the consequences.

In Chalkie's view, the FMA's stance is plain dumb and positions the regulator as a shield for corporate embarrassment rather than a protector of market integrity.

Asked why it was being so obtuse, the FMA said it had obtained its information using its legislative powers and was therefore obliged to keep it confidential. "We consider that disclosing the name of the issuer would prejudice the future supply of similar information or information from the same source, as issuers would be less willing to comply with voluntary requests if they believe that in doing so these details would be published," it said.

This is odd though, because the FMA says its review used public information in prospectuses and financial statements. So issuers would be less willing to supply information that is already public? Chalkie's credulity is twanging dangerously.

Furthermore, the FMA said "the release of the information requested would unreasonably prejudice the commercial position of the issuer concerned".

So if people actually knew the debt had been misclassified, they would think differently about the issuer. Well, gee, doesn't that mean they should be told? And isn't the FMA supposed to be "supporting investors in making informed decisions"?

Chalkie hopes the FMA is not suffering a relapse of securitiescommission-itis, recognisable by a tendency to secrecy, inaction and excessive legal influence.

Of course, anyone can trawl through truckloads of financial documents and try to figure out which company is pulling a fast one. However, it's no simple task.

Take a $251 million perpetual note issue from trans-Tasman crop protection and seeds company Nufarm, for example. These notes are known as Step Up Securities and were issued in November 2006 with a face value of $100 each. They currently carry a coupon rate of 6.95 per cent and have a market value of $90. But are they debt or equity?

Nufarm says they are equity because it doesn't have to pay back the money.

On the other hand, it does appear to have an obligation to pay the interest, because if it doesn't it can't pay dividends or return capital to shareholders until all the arrears have been paid up. This matches a standard definition of a liability.

Accountants can argue about this stuff until the cows come home, but Chalkie reckons Nufarm is pushing the boundaries.

One way to deal with the situation is simply to avoid investing in companies with hybrid securities, although rugby players may be more relaxed about giving them a try.

Chalkie is written by Fairfax Business Bureau deputy editor Tim Hunter.