Calculating returns to debenture holders
Over the past four years Axiom Forensics has been engaged by lawyers acting for both plaintiffs and defendants in relation to a number of failed debenture schemes. These have included Banksia, Provident Capital, GR Finance and LKM, amongst others.
In three recent matters (Provident Capital, LKM and GR Finance), the New South Wales Supreme Court / Federal Court of Australia (as applicable) approved the settlement of claims brought in three separate class actions that arose following the failure of the debenture issuer.
In each of the matters Axiom has been involved in, the claims have centered on a claim that the trustee should have appointed receivers at an earlier point in time. In this article Axiom outlines a five step framework that we have applied in determining the loss suffered by debenture holders arising from the delay in the appointment of a receiver.
Debentures are medium-term investments issued by a company where investors lend money in exchange for a regular and fixed interest amount for the term of the investment. The invested funds (principal) are repaid at the end of the term (maturity) and are (usually, but not always) secured by real property.
Broadly speaking, the business model employed by debenture issuers is as follows:
- Raise capital via the issuance of debentures to retail investors (typically “mum and dad” investors and self-managed superannuation funds seeking “above average” investment returns);
- Take the raised capital and loan it to property developers (typically being those developers whom, for a variety of reasons, have been unable to secure capital via the more traditional means of obtaining finance (such as a bank)) for the purposes of developing commercial and/or residential property;
- Charge the property developer a relatively high rate of interest on the loaned monies (recognising the higher degree of risk);
- Pay the debenture holders a rate of interest that is higher than offered by banks in respect of term deposits; and
- Profit the margin (being the difference between the interest rate paid by the property developer(s) to the scheme and the interest rate paid from the scheme to the debenture holders).
Chapter 2L of the Corporations Act 2001 imposes a number of obligations on issuers of debentures, including the requirement to have a trust deed and appoint a trustee before making an offer of debentures under a prospectus.
Approach to quantifying cents in the dollar returns
The matters Axiom has been involved in required the calculation of the cents in the dollar return of principal that debenture holders would have experienced had the trustee of the scheme(s) appointed receivers to wind up the scheme(s) at an earlier point in time.
For example, where the scheme actually collapsed at, say, 30 June 2013 (resulting in a significant loss of debenture holder capital), Axiom was instructed to calculate the cents in the dollar returns that would have eventuated, had receivers been appointed at an earlier point in time (for example, at 30 June 2007).
In undertaking these engagements Axiom has developed and applied a five step framework for quantifying the hypothetical cents in the dollar returns to debenture holders.
Step 1: Starting point is the financial reports
It should be no surprise that the most useful starting point to quantifying the hypothetical position of a company as at a particular point in time is that company’s audited financial statements.
However, audited financial statements are a starting point only because they have (usually) been prepared on the assumption that the company is a going concern. A going concern premise assumes that, as at the date of the financial report, the company is trading (and intending to continue to trade) on a ‘business as-usual’ basis.
In the matters Axiom has been engaged, given the instruction that a receiver should have been appointed earlier, a going concern premise has not been appropriate. Accordingly, whilst the financial statements represent a starting point to the analysis, care must be taken to ensure a liquidation premise is adopted when considering the recoverable values of net assets reported in the company’s audited financial statements.
Step 2: Assessment of the realisable value of loans
It has been the case in the matters Axiom have been involved in that by far the largest asset of these schemes has been ‘Loans receivable’, being the monies that have been lent to property developers (for the purposes of property development) which are to be repaid to the scheme at a later point in time (for example, once the development project is complete).
In our view, it is necessary to have regard to the value of the schemes’ loans receivable asset in two parts:
(i) Non-performing loans:
Being loans to borrowers where the available evidence establishes that they are past due and/or in default (for example, interest repayments have ceased being made and are more than 90 days overdue).
Whilst the circumstances surrounding each separate non-performing loan typically differs, it is generally the case that hypothetical amounts recoverable from these loans (if any) would arise from a receiver exercising their right to obtain possession of any underlying secured property and selling such property at market value.
Accordingly, the hypothetical cents in the dollar return arising from non-performing loans can be derived from establishing the market value of each underlying secured property, after making an allowance for costs arising from realising each subject property. This amount is then compared to the reported book value of each loan to determine if the book value of each loan is understated. By way of example, if the book value of a loan was $1 million, but an estimate of the market value of the underlying secured property (after deducting selling costs) was only $400,000, then the recorded book value of the loan would need to be adjusted (written down) by $600,000.
In our experience, this can be a complex and time intensive exercise, often requiring the attainment of retrospective property valuations from an independent property valuation expert.
(ii) Performing loans:
Being loans to borrowers where the available evidence establishes that the borrowers are still servicing the loan and that there are no impending signs of default. Whilst each loan should be assessed on its own individual merits, typically a receiver would either:
- Allow the borrower to continue the development and ensure principal and interest repayments are made as and when they fall due; or
- Sell the performing loan book to one or more investors at market value.
Typically, the most reliable means of quantifying the value of a performing loan book at a hypothetical point in time is to have regard to the market value achieved by market participants arising from the sale of comparable performing loan books.
Step 3: Assessment of the realisable value of other assets and liabilities
It is always necessary to consider the remaining categories of assets reported in the subject company’s financial statements. In summary, some of the more common assets / liabilities Axiom has seen held by these debenture schemes, including our suggested approach for estimating each item’s recoverable amount, is as follows:
- Cash: Fully recoverable based on 100% of the amount reported in the financial statements. However, in our experience, the available cash is typically eroded by receivers and other professional costs, which we address at step 4 below.
- Tax assets: Should always be considered on a ‘case-by-case’ basis, however usually ascribed $Nil recoverable value based on the assumption that there would be no future profits upon which to utilise these tax assets under a hypothetical windup scenario.
- Property, plant and equipment: Should always be considered on a ‘case-by-case’ basis depending upon the nature of the assets. The expertise of a plant and equipment valuation expert may be required, depending on the nature and amount of plant and equipment involved.
- Trade creditors, liabilities and contingent liabilities: Should always be considered on a ‘case-by-case’ basis. Care must be taken to investigate and establish whether any ‘off-balance sheet’ liabilities exist and whether or not such liabilities (if any) would rank in priority to debenture holders.
Step 4: Deduct the costs of the hypothetical receivership
Given the instruction to quantify the hypothetical cents in the dollar return to debenture holders under circumstances where a receiver would have been appointed at an earlier point in time, it is necessary to consider the costs of an earlier hypothetical receivership.
In this regard, consideration should be given to:
- The state of the loan book at the actual receivership appointment date, as compared to the state that the loan book would have been in had a receiver been appointed at an earlier point in time (for example, would there have been fewer ‘non-performing’ loans and therefore potentially less work required by a receiver);
- The extent of legal issues that would have existed had a receiver been appointed at an earlier point in time; and
- The hourly rates of professionals and how those rates have differed throughout the passage of time.
Step 5: Calculation (illustrative example)
Having followed steps 1 through 4 above, the table below demonstrates how the ‘cents in the dollar’ return to debenture holders can be calculated:
|Description ($’000)||Actual return||Hypothetical return|
|Step 2: Value of ‘Loans and Advances’||Nil||100,000|
|Step 2: Value of ‘Interest Receivable’||Nil||10,000|
|Subtotal – Step 2||Nil||110,000|
|Step 3: Add value of other assets||Nil||10,000|
|Step 3: Subtract value of liabilities||(50,000)||(50,000)|
|Subtotal (Step 3)||(50,000)||(40,000)|
|Sum of Step 2 and Step 3||(50,000)||70,000|
|Step 4: Subtract hypothetical Receivers’ fees||(500)||(300)|
|Amounts available to debenture holders (after fees)||(50,500)||69,700|
|Step 5: Divided by amounts payable to debenture holders||100,000||100,000|
|Equals: Cents available to debenture holders||$Nil||$0.70|
|Loss suffered||$0.70 per $1 invested|
As illustrated, the hypothetical return to debenture holders (had receivers been appointed at an earlier point in time) would have been 70 cents for every dollar owing to debenture holders. This can be compared to the actual case, where, as a result of a failure to appoint a receiver at an earlier point in time, the amounts available to be repaid to debenture holders is $Nil, meaning that the loss suffered by the debenture holders arising from the failure to appoint receivers at the earlier point in time is 70 cents for every dollar owing to debenture holders.
Calculating the cents in the dollar return to debenture holders in circumstances of an alternative hypothetical receivership date requires careful study and analysis of the subject scheme’s:
- Financial statements; and
- Loan book (with a particular focus on “problem” loans).
The five step process described in this article can be adopted as a framework to assessing the cents in the dollar return to debenture holders assuming the appointment of receivers as at an earlier point in time.