In times of cyclical downturn and adverse operating conditions, companies are vulnerable if they have a high exposure to debt. Directors who have used personal borrowings to acquire large amounts of shares in their companies add to that vulnerability and risk. Where adverse conditions continue and repayments are not made, lenders quickly lose faith in the management and the business of the corporation.

Recently, the Australian Stock Exchange (ASX) and the Australian Securities and Investments Commission (ASIC) issued warnings to the market about disclosure of directors' margin loans, material events under financing arrangements, short selling and market manipulation.

The warnings come in the wake of directors of several high profile companies being forced to meet margin calls relating to shares held in their own companies and large scale short selling of targeted shares. These warnings are a response to growing concerns expressed by market participants and commentators that a number of hedge funds and market participants are manipulating the market.

The general view is that hedge funds look to take advantage of highly leveraged companies, which may fall in value. In reality hedge funds also look at companies whose directors have undertaken substantial margin loans to purchase shares in their companies. Hedge funds exploit perceived market inefficiencies and rely on unconventional trading strategies to generate returns that do not follow the normal up and down investment cycles.

Debt or Equity?

Debt financing is money that a business borrows with the understanding that the full amount will be repaid in the future, usually with interest. There are a number of basic reasons why borrowing should be considered:

  • returns can be increased by using "other people's money" to buy an appreciating asset

  • using borrowed money to obtain assets allows the business' profits to be retained in the company

  • interest paid on the loan is generally tax deductible

  • there is no transfer of ownership or future profits of the business.

Equity financing is the act of raising money for business activities by selling share capital to individual or institutional investors. In return for the money paid, shareholders receive ownership interests in the corporation. The major advantage of equity financing is that the cash flow that would have been used to repay a loan can be used to grow the business.

For any business, the relative combination of debt and equity is critical. The value of a business is impacted by:

  • the relationship between debt and equity levels;
  • the tax benefit of interest can lower the cost of capital and therefore increases the overall value;
  • higher debt levels resulting in the direction of cash flow towards debt repayment rather than towards investment to assist growth;
  • too much debt may impact on the business' credit and its ability to raise money in the future; and
  • business with sufficient equity may be perceived more favourably by lenders and investors.

Higher levels of debt are more desirable where there is a relative degree of certainty as to increasing revenues or profits, but are more risky when uncertainty exists as to the operational performance.

Margin Loans

Borrowing money to invest in shares and managed funds using a margin loan has recently proved to be one of the riskiest ways of financing an investment. If the risks are understood, debt financing can be a very successful tool to financing an investment. However, it is essential to understand how margin lending products function and the associated risks involved.

A margin lending product is a form of borrowing money to invest in securities and financial products, such as listed shares and units in managed funds. The money borrowed is secured by the underlying investment. Interest is payable on the amount borrowed and the borrower may also be required to meet a "margin call" if the market value of the underlying investment falls below a certain level. If the borrower cannot repay the loan then he will be forced to sell the underlying investment to cover the margin call.

The Brisbane based childcare operator ABC Learning Centres Ltd recently felt the pain of margin calls. As a result of a general fall in the market together with an admission that directors had borrowed to acquire shares, the share price fell dramatically and margin calls resulted in three ABC directors, including co-founder Eddy Groves having to sell almost $95 million in stock as the share price of ABC plunged. As the directors offloaded ABC shares the share price plummeted even further.

The ASX warned that an entity may be required to disclose key terms of its directors margin lending arrangements, in particular the number of securities involved and the trigger points (such as share prices or selling rights of lenders). ASIC has said that it expects directors to disclose all relevant information relating to their margin loans.

Short Selling

ASIC has indicated that it is investigating whether hedge funds may have acted together to force down share prices by short selling stocks in companies in which directors have borrowed heavily to buy shares.

Short selling occurs when private investment funds speculate that the share price in a company will fall by selling shares they do not own, intending to buy them back at a lower price with the intention to make a quick profit. When this is done on a large scale it can have a powerful downward effect on a company's share price. Shares, which have been targeted in recent months, include Primary Health Care Ltd, City Pacific Ltd and most dramatically, Allco Finance Group Ltd, Centro Properties Group and MFS Limited (now known as Octaviar Limited).

The ASX and ASIC take the view that market efficiency requires transparency of short selling activity, irrespective of whether short selling is 'naked' (where the seller does not have in place arrangements for delivery of the securities) or 'covered' (where the seller does have such arrangements in place). The ASX and ASIC issued a further joint media release in March this year designed to alert market participants to existing obligations relating to both 'naked' and 'covered' short selling:

  • clients must inform their brokers when a sale is a short sale (and brokers must advise their clients of this obligation);
  • brokers must advise their clearers that the sale is a short sale, and must ensure that the clearer has secured a minimum 20% initial margin over the short position:
  • brokers must advise the ASX as soon as practicable that they are executing a short sale;
  • brokers must report to the ASX their unsettled net short sale position as at 7pm by no later than 9am on the next trading day.

The concerns raised by the ASX and ASIC in relation to disclosure of margin loans and short selling are linked. Margin lending and short selling by hedge funds can help increase market liquidity but can also lead to short term manipulation of share prices. Therefore there needs to be greater transparency around these transactions, as the personal financial position of a company's executives could put the company at risk, especially if the company is already highly leveraged.

Swaab was recently named winner 'Best Law Firm in Australia (Revenue < $20m)' and 'Attribute Award for Exceptional Service (Australia Wide)' and at the 2008 BRW- Client Choice Awards.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.