Brian Gaynor: Investment ethics a million miles away

DNZ shareholders have seen the value of their investment fall despite managers being in line for a big payout. Photo / Sarah Ivey

There has been much discussion in recent years over the need for investment industry organisations and their employees to have a "duty of care", to "owe specific duties" and to have a "fiduciary duty" to investors.

This column totally endorses these concepts because they create an ethical overlay over all activity in the investment sector. The behaviour of market participants should be judged against these requirements, not just the letter of the law.

Unfortunately, a number of developments indicate that we seem to be a million miles away from having this ethical overlay. There is little incentive for New Zealand capital market participants to adopt a principled approach because our laws are poorly enforced and unethical behaviour is often well rewarded.

The December 2009 household asset statistics, released by the Reserve Bank this week, clearly indicate that poor law enforcement and immoral behaviour have contributed to the low participation in our capital markets.

New Zealanders have 74 per cent of their total assets in residential property and only 13.6 per cent in capital markets, which includes fixed interest, super/life/managed funds and direct equities (see graphs).

By comparison, Australians have 59.7 per cent of their assets in housing and 30.8 per cent in capital markets.

Several developments in firms such as DNZ Property Fund Ltd, Rural Portfolio Investments Ltd and NZ Farming Systems Uruguay Ltd, illustrate this missing ethical overlay and why people are reluctant to invest in our capital markets.

DNZ's special shareholders' meeting on Wednesday was dominated by the poor performance of the company compared with the proposed payment of up to $43 million for the management company, jointly owned by DNZ's Chief Executive Paul Duffy and Alastair Hasell.

Shareholders argued that the value of their shareholding had fallen by between two-thirds and three-quarters yet Duffy and Hasell would see their investment appreciate two or three times under the proposal.

DNZ's management company should have a "duty of care" to the 8000 DNZ investors yet it appears that the interests of Duffy and Hasell will be satisfied first and then, and only then, the interests of the retail investors.

The arguments in support of Duffy and Hasell are always couched in terms of their legal rights and that these should come first. But what is the point of our legislators promoting an ethical overlay to protect investors when the management company of a large property company disregards this and gives a clear priority to its own self-interest?

A number of attendees praised Duffy for his management skill. This was hard to agree with as there has been considerable shareholder wealth destruction under his stewardship, he has conflicts of interest, and he seems to put his own interests ahead of the 8000 DNZ shareholders because the higher the price he gets for the sale of the management company, the greater the impact on DNZ's net asset value.

Rural Portfolio Investments, the brain child of Craig Norgate and Baird McConnon, is also riddled with conflicts of interest and it is hard to believe that a "duty of care" obligation to retail investors has been its dominant philosophy.

There are so many things wrong with the company it's difficult to know where to start. It should never have been promoted to retail investors; it had no independent directors; its prospectuses were incredibly complex; outside investors are unsecured creditors under the Companies Act 1993; and Norgate's financial involvement appears to have been less than indicated.

The original prospectus stated that Norgate had invested $20 million of equity in Rural Portfolio but it now appears he has none.

Was he bought out by the McConnon family? If so, why did McConnon buy out Norgate instead of the retail investors in the public issue? Should directors of public issuers adopt a "duty of care" approach to each other while taking a different attitude to outside investors?

Rural Portfolio, which was placed in receivership on May 3, sold 46.8 million PGG Wrightson shares this week at 52c each. There are two important issues regarding this transaction:

* The sale process should have been announced to the market before it occurred as it was obvious PGG Wrightson's share price would rise after this overhang of shares had been sold. Institutional investors were fully aware of the sale process but uninformed sellers at 52c on that day have every right to be aggrieved

* Investors in Rural Portfolio should have been offered an in specie distribution of the PGG Wrightson and NZ Farming Systems Uruguay instead of the shares being sold at depressed prices to institutions. After the share sales it appears that Rural Portfolio investors will receive approximately 42c in the dollar back ($25 million of their $60 million investment) but they had the potential to realise more if the shares had been distributed to them.

The PGG Wrightson share sale seems to have been executed by the receiver from an expedient point of view rather than from a "duty of care" obligation to investors.

The sad story of NZ Farming Systems Uruguay (NZFSU) also raises the issue of the need for a capital markets ethical overlay.

NZFSU issued its first prospectus in November 2006 and sold 115.6 million new shares at $1 each.

The company listed on the NZX in December 2007 following a successful second capital raising. This was a one-for-two rights issue at $1.50 a share.

The fees payable to the management company, PGG Wrightson Funds Management Ltd, were as follows;

* An annual management fee of 1.5 per cent of the gross asset value of the company up to June 2008 and 1.0 per cent per annum after that.

* A performance fee calculated as 20 per cent of the amount by which the share price growth plus distributions exceeded 10 per cent per annum.

The company grew far more quickly than planned, which boosted the annual fee, and the board and management company talked up the company's prospects and share price which finished the June 2008 financial year at $1.74. This enabled the management company to earn a performance fee of US$13.6 million ($19 million) for that year.

This performance fee, which remains unpaid, is a massive impost on NZFSU as it still operates at a loss and is struggling to raise badly needed additional funds. If financial advisers, conventional investment managers and other investment sector participants are required to have a primary "duty of care" to outside investors then why doesn't the same principle apply to PGG Wrightson Fund Management?

This management company had huge conflicts of interest which were totally inconsistent with its "duty of care" obligations to outside investors.

The problem is that we are a long, long way from adopting a strong ethical overview in relation to our capital markets. Most professional advisers, directors and associates of the DNZ, Rural Portfolio and NZ Farming Systems Uruguay debacles argue that it's time for us to move on, to forget these disasters.

The problem is that we keep on moving on from debacle after debacle while making no attempt to improve ethical standards. As a result, New Zealanders have deserted our capital markets for residential property.

Our capital markets will remain depressed until the majority of market participants adopt a "duty of care" or ethical overview philosophy. They must also act as strong gatekeepers to ensure that those who are unwilling to adhere to these principles should not be put in charge of investors' money.

Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.