Category: Financial Markets

Companies may be misleading investors by not openly assessing the true value of assets

From The Conversation.

Some companies are taking years to recognise asset impairments, and may be misleading investors who are not privy to the valuation decisions. Research shows this is because managers of many firms think or hope that assets are not overvalued.

This occurs when companies either don’t recognise, or delay the recognition of asset impairments. These asset impairments represent a downward adjustment in the value of assets, to what is called “recoverable amount”. This is determined by either the value the asset could be sold for, or its value to the business right now.

One example of this process of recognising asset impairments can be easily seen in Nine Entertainment Corporation Ltd in 2015. Through the first half of 2015 the share market value declined significantly, and by year end its book value (the value of net assets on the balance sheet) would have exceeded the firm’s market value.

This was probably occurring as investors revised their estimates of future returns in response to changes in the television industry and increasing competition from pay television, internet-based television and other online media. These factors are indicators of declining asset values, which are explicitly identified in the regulation, and this requires a test for asset impairment by the firm.

Next, Nine would have determined the recoverable amount of the assets. The company would have had to estimate future returns and, while there are extensive guidelines on how this should be done, considerable judgement is still required. The end result in this case was an asset impairment of A$792 million that resulted in Nine reporting a loss for the year.

The Australian Securities and Investment Commission (ASIC) regularly reviews the financial reports of listed firms. Where necessary, it seeks their explanations for particular accounting treatments. Risk-based criteria are used to select which firms are reviewed and in some instances this leads to material changes in their reports.

The most recent review by the corporate regulator into end-of-year financial reports for 2015 found the biggest number of the queries (11 out of 24) into accounting related to the valuation of assets.

It is unlikely this is a consequence of poor regulation. The regulation sets out clear criteria, identifying the circumstances when asset impairment should be formally considered (i.e., where indicators of impairment exist) and the basis for calculating the amount of asset impairment.

In some cases determination of asset impairments should be straight forward. For example, where firms are unprofitable and the book value exceeds the market value of equity, the indicators of impairment are readily observable to all because it can be identified using “firm level” information.

However, in other cases it is not so straightforward and determining whether impairments are necessary and calculating the recoverable amount is then much more difficult.

Asset impairments are required to be evaluated at the level of business units, or what the regulation refers to as “cash-generating units”, rather than at the firm level. Accordingly, while asset impairments may be necessary in some business units, the need for or amount of asset impairments may be obscured in firm-level information.

For example, Arrium is clearly experiencing financial problems and has made a number of asset impairments. But it is not all bad; some of its business units are profitable. When the firm level information is considered it may start to mask the very poor performance in other business units. Hence, whether the need for asset impairment is obviously necessary will depend on relative size and number of poorly performing business units.

Significant judgement will be required in these cases. This includes defining business units and attributing assets to them. Only then can future returns be estimated, and this can never be done with certainty. If there are problems with the exercising of this judgement, then maybe the assumptions on which asset impairment decisions are based should be made clear and disclosed.

Unfortunately, the people who use these financial statements, such as investors, are often kept in the dark because firms are only required to disclose the assumptions behind their judgements if an impairment is actually made. However if these disclosures were always made, it would either support the asset values reported, or alternatively confirm that asset impairments are really necessary.

In the absence of these disclosures, investors and other users of financial statements do not get important up-to-date information about future returns that would underpin share prices.

It’s time to amend the regulation and reveal the explanations for not recognising asset impairments. Whenever there are indicators that impairment is necessary, companies should be required to disclose their assumptions even if the decision is not to impair.

Doing this will highlight how asset impairments are being (or, more critically, not being) determined and assets valuation will always be more transparent.

Authors: Peter Well, Professor, Accounting Discipline Group, University of Technology Sydney; Brett Govendir, Lecturer, University of Technology Sydney;  Roman Lani, Associate Professor, Accounting, University of Technology Sydney.

 

An uncertain election result may lead to stagnant financial markets

From The Conversation.

For the second time in the space of ten days, it appears that betting markets and pollsters have got it wrong. First, despite odds showing a 90% likelihood of “Remain” winning, the UK voted to “Leave” the European Union in its June 23 referendum.

Now, a mammoth federal election campaign has resulted in political stalemate in Australia, and the result will not be known until Tuesday at the earliest.

Clearly, the repercussions of a hung parliament are not as wide-ranging as “Brexit” and we are unlikely to see Canberra’s streets flooded with protesters. However, when Australian markets open on Monday they will still be faced with a high degree of political uncertainty. Investors do not tend to react favourably to such ambiguity.

Investors reduce risk under political uncertainty

Investors tend to respond in one of two ways. The most-common situation is for the political uncertainty to manifest in higher levels of market volatility and a flight to quality as investors try to reduce their exposure to risk.

This was what we witnessed post-Brexit: Australian stockmarkets and the dollar fell by more than 3%, while “safe” government bond yields hit an all-time low.

An alternative is for markets to become locked in stasis – where investors sit on their hands, unsure as to whether they should buy or sell. Market liquidity falls and asset prices become resistant to change.

This is effectively what happened following the hung parliament of August 2010. In the aftermath of that election, stock prices remained within a tight trading range and the dollar hardly budged over the course of the following week.

When the result of the 2016 election is finally known, it appears that the outcome will be either a minority Coalition government or a hung parliament. The Senate is likely to be more fractious than prior to the election.

Talk has already started about potential unrest among the conservative faction of the Liberal Party who supported former prime minister Tony Abbott. There is even discussion of an election re-run if the parliament proves ungovernable. Clearly, this uncertainty could linger for months.

Concerns for jobs and growth

The likelihood of a lengthy period of uncertainty is important. It means it will be difficult to pass any economic or budgetary reforms. Without such reforms, it is unlikely the budget will return to surplus in the near future (if ever) and it becomes more likely that the AAA credit rating will be lost.

This creates multiple concerns for Australian financial markets, and the broader economy. A credit rating downgrade will likely increase the cost of funding for Australia’s banks.

The Big Four banks will be particularly impacted given the significant role that offshore funding plays in their balance sheet management. This will mean higher interest rates for borrowers – which would not be beneficial for the housing market.

A prolonged period of uncertainty will make it difficult for firms to finalise investment decisions. At a time when the economy is still attempting to transition away from the boom in mining investment this will dent economic growth and employment. So much for “jobs and growth”.

Essentially, this is a recipe for a “risk-off” environment of declining stockmarkets and a depreciating Australian dollar. It is also likely that the market will price a higher likelihood of a reduction in the RBA target rate at the July or August meeting. This will further aid a continued rally in relatively safe government bonds (bond prices rise as yields fall).

If you consider the ongoing political uncertainty resulting from Brexit and the forthcoming US presidential elections in addition to the federal election, then months of nervous markets may lay ahead.

Author: Lee Smales, Senior Lecturer, Finance, Curtin University

UK Loses AAA Rating – S&P

Rating agency Standard & Poor’s (S&P), the only agency which had previously given the UK a AAA rating, just revised it down. S&P said the the referendum result could lead to “a deterioration of the UK’s economic performance, including its large financial services sector”. They say Brexit will “weaken the predictability, stability, and effectiveness of policy making in the UK”. This follows downgrades from Fitch – from AA+ to AA – forecasting an “abrupt slowdown” in growth in the short-term and Moody’s last Friday cut the UK’s credit rating outlook to negative.

A ratings drop is likely to raise the cost of Government debt on the international markets. Here is the pound US$ chart, which fell further on Monday to a 31 year low.

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Brexit rocks Australian sharemarket, worse to come

From The Conversation.

The UK has voted to leave the European Union but even before all the votes were counted volatility made its way across Asian markets and to Australia.

The S&P ASX200 has finished 3.3% down at the close, wiping off approximately $50 billion in value, while the Australian dollar has dropped 3.4% to 73.4 US cents.

Richard Holden, Professor of Economics at UNSW says the volatility is likely to continue at least for another 24 hours.

“We could see volatility, perhaps not as extreme as the current levels, for a really extended period of time,” Professor Holden says.

One of the major factors in this will be how affected UK banks and therefore Australian banks will be by this decision, as they rely on short term funding for their operations.

“If those markets start to dry up and there’s uncertainty about their funding getting rolled over, one day to the next, then that’s when things can go pear shaped within an incredibly short period of time,” he adds.

The position of hedge funds, banks and other financial institutions in betting on currencies in over-the-counter markets (not regular currency markets) in times like this, also adds to the uncertainty.

“Basically we don’t know, what we don’t know and suddenly there’s a liquidity crunch and someone gets into trouble and that has flow-on effects like we saw in 2008,” Professor Holden says.

The S&P ASX200 index closed -3.3% following the Brexit vote. S&P ASX 200

He also warns that a drop in the Australian dollar shows that money could flow out of Australia and back to the UK as financial institutions there change their positions.

In the longer term, Brexit could affect the way Australian companies trade with the European Union through the UK.

“All of a sudden that’s going to be more complicated, it’s going to have to go through under some new trade agreement and we know that a series of bilateral trade agreements are always more complicated and have more nuance than large multilateral trade agreements,” Professor Holden says.

All this comes as Australia goes into the last week of an election campaign and this volatility will keep economic management top of mind for Australian voters.

“I don’t think either side of politics in Australia has an exclusive right to say they are going to be the best economic managers, I guess we’ll have to wait and see about that as well.”

Jenni Henderson, Assistant Editor, Business and Economy, The Conversation Interviewed Richard Holden,Professor of Economics, UNSW Australia

Ex-Deutsche Bank trader pleaded guilty in U.S. to Libor scheme

According to Reuters, U.S. and European authorities investigations relating to LIBOR rate rigging have resulted in roughly US$9 billion in sanctions worldwide against financial institutions, and 16 people being charged by the Justice Department. We discussed the problem of these financial benchmarks yesterday. Now, U.S. prosecutors have secured a guilty plea from a second former Deutsche Bank AG trader for conspiring to manipulate Libor, the benchmark interest rate at the center of global investigations of various banks, court records show.

Timothy Parietti, a 50-year-old former managing director of Deutsche Bank’s New York money market derivatives trading desk, pleaded guilty on May 26 in Manhattan federal court to conspiring to commit wire fraud and bank fraud, records unsealed on Wednesday showed. According to a transcript, Parietti admitted that from 2006 to 2008, he participated in a scheme with other bank employees to manipulate Libor so that trades he made on financial instruments linked to the benchmark might be more profitable.

“At the time, I knew that this practice was dishonest. I participated in this dishonest practice and I accept responsibility for my role,” Parietti said. “I’m sorry for my conduct.”

The plea, pursuant to a cooperation agreement, was followed on June 2 by the U.S. Justice Department unveiling an indictment against two other former Deutsche Bank traders, Matthew Connolly of New Jersey and Gavin Campbell Black of London.

Both cases followed the earlier guilty plea in October of a former senior trader at Deutsche Bank, Michael Curtler of London. The bank agreed in April 2015 to pay $2.5 billion to resolve related U.S. and U.K. probes. According to charging papers, from 2005 to 2011 Parietti and others engaged in a scheme to manipulate Libor, which was tied to the profitability of derivative trades in which they had a financial interest. In charging Connolly and Black, prosecutors said that at least eight other people, including Curtler, were involved in the scheme to submit false estimates for some Libor rates in order to manipulate it. Connolly has pleaded not guilty. Black’s attorney has previously declined comment.

 

ASIC commences proceedings against Macquarie Investment Management

ASIC has announced it has commenced proceedings in the Supreme Court of New South Wales against Macquarie Investment Management Ltd (MIML) as the responsible entity of the van Eyk Blueprint International Shares Fund (VBI Fund). The proceedings involve investments of $30 million made by the VBI Fund in 2012 into a Cayman Islands based fund, known as Artefact Partners Global Opportunities Fund (Artefact). The VBI Fund was one of the Blueprint series of funds of which van Eyk Research Pty Limited (now in liquidation) was investment manager, and MIML was responsible entity.

MIML has admitted to five contraventions of the Corporations Act and the parties have filed an Agreed Statement of Facts.

ASIC and MIML have agreed that MIML failed to comply with its duties as a responsible entity by:

  • failing to adequately address risks associated with the decision for the VBI Fund to make 3 investments into Artefact between 6 July to 30 October 2012;
  • allowing members to redeem or withdraw units from the VBI Fund when it was illiquid in contravention of the Corporations Act and the scheme’s constitution between 15 June 2013 to 9 September 2013; and
  • failing to make adequate and timely enquiries in relation to van Eyk’s monitoring of the VBI Fund’s investment in Artefact between 18 February 2013 and 21 July 2014 (including not making adequate and timely enquiries as to why a full redemption from Artefact had not been paid between 1 January 2014 to 21 July 2014).

The Court will hear joint submissions from ASIC and MIML as to the appropriate penalty amounts. The final penalty amount is a matter that will be determined by the Court.

On 1 August 2014, MIML suspended redemptions from the VBI Fund and three other funds due to their exposure to the VBI Fund.  Between them these funds managed over $450 million.

On 15 August 2014, MIML terminated the VBI Fund, with unitholders owed around $30.9m relating to the Artefact investments. Since then, Artefact has repaid $20m to the VBI Fund. MIML recently paid the remaining approximately $10.9 million plus interest to unit holders (less fees and winding up costs) and expects to recover the majority of that amount from Artefact’s liquidator. ASIC acknowledges the efforts made by MIML to have the investors’ funds repaid.

ASIC has an ongoing investigation into van Eyk Research Pty Ltd, the entity MIML appointed as the investment manager of the VBI Fund. Van Eyk Research Pty Ltd went into liquidation in 2014.

Commissioner Greg Tanzer said, ‘The Corporations Act places important obligations on responsible entities which protect the interests of investors.  Those obligations require responsible entities to have a supervisory and monitoring role in relation to funds, even where external investment managers have been appointed. ASIC will take action against responsible entities when they fail to meet their obligations.’

The proceedings will be listed for directions on Monday 27 June 2016 and the parties will request an early hearing date from the Court.

ASIC highlights significant failures in the retail OTC derivatives industry

ASIC has released a report detailing the findings of a recent surveillance program and identifying some serious and widespread compliance failures in the retail over-the-counter (OTC) derivatives industry. Over 70% of AFS licensees reviewed demonstrated issues with three or more of the seven compliance risks.

OTC-ASICIn recent years, ASIC has made a number of public statements about the concerning degree of non-compliance in the retail OTC derivatives sector. ASIC considers retail OTC derivatives to be complex, high-risk products which are often difficult to understand, even for experienced investors.

ASIC has observed a material increase in the number of Australian financial services (AFS) licence applications from entities seeking to operate retail OTC derivatives financial services businesses in Australia. In conjunction with this trend, we also identified increasing non-compliance by existing AFS licensees with a number of their Australian regulatory requirements.

We recently undertook a review to assess a large proportion of the AFS-licensed retail OTC derivatives industry against the following seven compliance risks:

  • failure to comply with the net tangible assets (NTA) requirement
  • failure to comply with notification requirements for change of control events and issues around new ownership compliance
  • failure to comply with client money provisions
  • poor, misleading or deceptive Product Disclosure Statements (PDS) and website disclosure
  • failure to comply with financial reporting obligations
  • failure to supervise authorised representatives and non-compliance by authorised representatives, and
  • claims that no financial services are being provided under the AFS licence.

This report summarises the key findings of that review and identifies areas where compliance standards can be raised in the retail OTC derivatives sector.

Our findings

Our review identified a high degree of non-compliance. Over 70% of AFS licensees reviewed demonstrated issues with three or more of the seven compliance risks. In particular, our compliance review identified that:

  • over 80% demonstrated issues with the disclosure in their PDS or website
  • over 60% had undergone a change of control (with some issuers exhibiting multiple changes of control in a 12-month period) and 85% of those entities had failed to notify ASIC as required
  • over 50% had not adequately complied with their financial reporting obligations
  • around 50% required additional detailed assessment to determine whether they adequately complied with their NTA requirements, and
  • nearly 30% did not appear to be providing any financial service under their AFS licence, despite some being licensed for a number of years.

Many of the compliance concerns we detected were contraventions of well-established regulatory requirements or non-compliance with fundamental AFS licensing obligations. We also observed a significantly high number of smaller, foreign-owned or foreign-controlled AFS licensees demonstrating either a lack of awareness or understanding of their Australian regulatory obligations, or reluctance to invest resources in meeting compliance obligations for their Australian businesses.

In total, we obtained more than 150 regulatory outcomes as a result of our review, including:

  • recapitalisation to comply with financial requirements
  • improvements to defective disclosure
  • submission of overdue financial reports
  • corrections to registry and AFS licence information
  • improved supervision of authorised representatives
  • rectification of compliance failings
  • cessation of unlicensed conduct, and
  • AFS licence suspensions and cancellations.

Commissioner Cathie Armour said, ‘This report highlights some serious compliance failures in this industry. We expect industry to take note of our findings and proactively remediate any areas requiring improvement to ensure they have adequate and enduring compliance measures to fulfil their regulatory obligations.

‘The report also provides a prudent warning to investors. We hope the report will encourage them to be more aware of the risks of these types of products as well as improve their understanding of the standards of practice they should expect from retail OTC derivative providers.

‘As can be seen from our surveillance findings and announcements, many of these investment products may not be appropriate for average investors, who are often caught out by the complexity and may not understand the heightened risk profile,’ she said.

 

Insider trading is greedy, not glamorous, and it hurts us all

From The Conversation.

Much of the focus on the insider trading case of Oliver Curtis has been on the titillating details of the man’s social life, his wife and past relationship with his partner in crime John Hartman. However all this misses the point, it’s not about what the pair gained and stand to lose from the insider trading, it’s what we all lost.

Last week Curtis was found guilty of insider trading. His unethical behaviour hurts your retirement wealth and damages the integrity of our investment systems. It’s true that he wasn’t an “insider” to the companies he was trading. He had no knowledge of CEO and Board decisions or other company-specific material price-sensitive non-public information.

Rather, Curtis was receiving non-public information about buying and selling taking place at a friend, John Hartman’s, funds management firm. The firm Hartman worked for, Orion Asset Management, managed around $6 billion of funds at the time and the trades Hartman was privy to were often sufficiently large to affect prices.

The illegal trading took place through 45 buys and sells of “contracts for difference’ (CFDs) between May 2007 and June 2008. In simple terms, CFDs are securities which allow the holder to bet on stock gains and losses.

Most trades don’t affect prices, in a way that most fish don’t create waves. Large value ‘block’ trades though can impact prices like a humpback whale breaching.

Curtis was “front-running” these large trades using CFDs. Front running is a practice of placing orders ahead of upcoming block trades in order to benefit from the anticipated up or down movement it will have on the stock price. ASIC estimated the net profits Curtis made through this strategy amounted to over $1 million.

What’s the problem?

While there are legal forms of front running and insider trading, the kind of trading undertaken by Curtis is illegal for good reason. It is widely considered unethical, adds to the costs of investing, and destabilises core financial systems.

It is hard to believe Curtis and Hartman did not know they were breaking the law, particularly given Hartman’s testimony and the unambiguous wording. The ethics of insider trading, however, can be more complex.

In 1990, Jennifer Moore argued that the key ethical considerations are: fairness, ownership of property rights, and harm. Curtis was unethical in each of these ways.

Curtis and Hartman took advantage of an unfair access to information that the rest of the market didn’t have about large pending trades. Hartman’s employer owned the rights to that information and did not grant permission for that information to be shared.

While there appeared to be no victims, front running reduces the potential profits for those outside the illegal trade. In other words, other market participants were disadvantaged.

That disadvantage translates to added costs of investing and lower returns for everyone else. That includes the $350 billion of ordinary Australians’ superannuation wealth tied up in ASX traded securities.

This is the first major point that has been lost with the misdirected focus on the socialite’s Instagram pages.

Destabilising the system

The second and even more critical risk, however, is the potential erosion of the integrity of our financial systems. Lawful investors may shift their portfolios to other markets if they consider that there may be other illegal insider traders like Curtis still out there. Why play in system rigged against you?

One argument thrown up as a defence for insider trading is that if the insiders bring information to the market sooner, then prices will be more efficiently priced. There is little empirical evidence to indicate this works in reality.

Stock price efficiency is based on what is known about a company. Prices are most efficient when they reflect all known information, and “discovering” this efficient price is when new information (such as earnings announcement, CEO retirement, etc) becomes known.

Recent research on this topic in the U.S. found that insiders benefit for themselves with little of their inside information spilling over to benefit the public through more efficient prices. Strict regulation deters illegal insider trading with minimal adverse impact on this price discovery process.

The unscrupulous will continue to pursue ways to counter regulations. Recent studies detecting shifts in informed trading away from more heavily monitored equities markets to derivative and bond markets (which currently have less public data monitoring) point to this.

The public should expect more from those managing their wealth. Glamourising the lifestyles of those who have broken the law and acted unethically damages the good work being done by many others in our financial institutions. Illegal insider trading is not a victimless crime and we should not let tabloid distraction make us forget that.

Author: Danika Wright, Lecturer in Finance, University of Sydney