Who is to Blame for BrisConnections?

by Stubborn Mule on 17 April 2009 · 10 comments

Bolton as The DudeIn the latest instalment of the ongoing debacle that is BrisConnections, Nicholas Bolton shrugged off the mantle of hero to mum and dad shareholders in exchange for a secretly arranged $4.5 million dollars. I have to admit I would have enjoyed the Schadenfreude of seeing Bolton continue to stick it to Macquarie Bank, but whatever his shortcomings (which include a striking resemblance to the One.Tel dude—thanks to the friend who pointed this out to me and to Crikey!), and however tempting it is to blame him for not finishing the job, it was never his job to protect shareholders.

When it comes to assigning blame, it should fall fair and square on the ASX. If they were doing their job properly, they should never have allowed BrisConnections to be listed in the first place.

To explain why requires a (relatively) brief explanation of instalment receipts. Also known as partly paid shares, they are a means a of issuing shares in a company in stages. If a company was estimated to be worth around $200 million, rather than issuing 100 million shares at $2 each, this approach involves selling 100 million “instalment receipts” (rather than fully paid shares) at $1 each. At some point in the future, holders of these receipts would pay a further $1 and their receipts convert into ordinary shares. This means of raising capital is very well suited to construction projects where the company does not require all of the capital upfront and was, for example, used to finance the construction of the Sydney Olypmic Stadium prior to the 2000 Olympics.

So, using instalment receipts was a natural approach to raising capital for the construction of Brisbane’s Airport Link. However, there is a crucial difference between the approach Macquarie Bank used with BrisConnections and most previous projects such as the Olympic Stadium and the Telstra privatisation. In the earlier examples, payment of later instalments was optional. Holders of instalment receipts had the choice of paying the next instalment and converting their holdings to fully paid shares or simply walking away with nothing. However, in the case of BrisConnections, paying the instalment is not optional and this makes a big difference.

To see why, I’ll go back to the hypothetical example of the $200 million company. Imagine that, for some reason (project problems, global financial crisis, or whatever), the value of the company fell to $150 million and then to $100 million and finally to $60 million. If they had originally raised capital by issuing 100 million $2 shares, then the share price would fall to $1.50, then to $1 and finally to $0.60. Obviously investors would be disappointed to see their investment fall in value, but these things happen on the share market.

Now imagine that they had issued 100 million $1 instalment receipts with a compulsory instalment payment of $1 in the future. So, even though the original investors had only invested $1, they had effectively committed $2. Initially worth $1, these instalment receipts would fall in value to around $0.50 when the company fell to $150 million. This is because the overall value of a fully paid share is $1.50 and instalment receipt holders have committed to paying the final $1, so the balance is $0.50. It gets messier as the value of the company continues to fall. When the company is worth $100 million, the instalment receipts are essentially worth $0 and with the company worth $60 million they should be worth negative $0.40! What this means is that a holder of one of these receipts should be prepared to pay someone $0.40 per receipt to take them off their hands. Since a “buyer” of the receipts considers the company to be worth $0.60 per share but knows there is a commitment to pay $1, they would want to be compensated $0.40 per share to take on the commitment of paying the instalment.

This is where is gets problematic for the ASX. The way the stock exchange system is set up, it is impossible to trade on the exchange with negative prices. So, even though these hypothetical receipts have a negative value, they would have to trade at a positive price. And they are not worth that! This is exactly what happened with BrisConnections. It got to the point where it was trading at price of a fraction of a cent when the value of the instalments were in fact negative. As a result, investors unaware of the future instalment obligation thought they were snapping up large numbers of shares at a bargain price and instead are now faced with enormous liabilities that many will simply be unable to pay.

The ASX has responded by announcing new rules requiring better disclosure from brokers. This misses the point. No amount of disclosure will change the fact that BrisConnections instalments could not be traded at real, negative prices. Even if everyone had full disclosure and (assuming no-one was trying anything tricky like Bolton) so no-one bought any units at near zero prices, this would leave the problem that existing investors would be unable to sell their holdings at all.

When the BrisConnections receipts were first listed, everyone might have expected the value of the company to go up not down, but the possibility that it could have gone down was always there and this should have raised alarm bells with the ASX right from the start.

Put simply, if the ASX cannot cope with negative prices, they should never allow anything to be listed on the exchange that has the slightest chance of having a negative value.

Since instalment receipts are hardly new, why has this only come up now? The secret lies in the fact that the instalments for Telstra, the Olympic Stadium and so many others were optional. Since there would never be a committed liability for instalment holders, the prices of the receipts could certainly go down to very close to zero, but they could never be negative. Of course, if no-one paid the instalment this would create some difficulties for the company and they would have to raise fresh capital, but a debacle like BrisConnections could never happen. Why was BrisConnections structured with a committed instalment? I can only guess the certainty of future cashflows for BrisConnections made it much easier for Macquarie Bank to pull out fatter fees for structuring the deal in the first place, which is why I would not have been sorry to see it all collapse for them (and it still might). Even if I am right in my suspicions, this would hardly be surprising news about Macquarie. So, I don’t really blame them, I blame the ASX.

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{ 9 comments… read them below or add one }

1 Steven Reynolds April 19, 2009 at 11:54 am

A great analysis, Sean. I’d love to see you writing for the AFR.

Something else that would help here, I think, is compulsory education for non-professional, mum-and-dad shareholders trading via online brokers. This is required for some things, e.g. if you want to place conditional orders via Westpac Broking, you actually need to pass an online test to demonstrate your understanding of such orders and various scenarios before activating that feature of your account. Anyone trading online should have a base level of understanding of what it is they’re actually doing, especially considering many people are risking their own superannuation savings with self-managed funds.

2 stubbornmule April 19, 2009 at 5:23 pm

@Steven: You are absolutely right. You also need to pass a quiz before you are allowed to sell options on the ASX’s Options Exchange on the basis that people need to understand the risk they are running. The experience of BrisConnections shows that options are the only instruments that can catch investors out.

3 CV April 20, 2009 at 10:19 am

Another great post Mule. You might also wish to focus on the role Trevor Rowe (AM) in this saga. He is on the Board of the ASX. He is Chairman of Queensland Investment Corp (largest Bris Connect shareholder) and is of course Chairman of Bris Connect Management Company. What a strange coincidence?

4 evo April 20, 2009 at 5:24 pm

Another great post, Mule. Note however that (to the best of my knowledge) this was not the first security to trade on the ASX which had a possibility of having negative value. When Macquarie Airports listed, it was partly paid and unitholders were legally obliged to stump up with the remaining instalment regardless of the value of the underlying company (or trust).

The ASX should have noted at the time the perils of allowing such an instrument to exist on their exchange. From memory the units went as low as 40c in the dollar, and the question as to whether these units could possibly have negative value was doing the rounds.

It is astounding how little attention in the press has been given to the ASX in their negligence in permitting such a security to be listed in the first place.

5 stubbornmule April 20, 2009 at 5:27 pm

@evo: thanks for the point on Macquarie Airports. Interesting to see the connection between the two deals: Macquarie Bank! I’m sure they structured it that way to maximise the fees they could pull out of the deals up-front.

6 dan April 21, 2009 at 8:09 am

the reason the asx can’t cope with “negative” prices, is that ever since the gang of dutch fellows got together in the amsterdam coffee shop and chipped in to buy a boat and hire a captain to sail to the new world to share in plunder, stock exchanges have been places where people sell Stock (ie something), or as we call it today – Equity.

The invention of the limited liability company (shareholders had a floor and could not be asked for a cent more – even if they owned a company which sold asbestos or thalidomide) allowed shares to be traded in the knowledge that if it all went tits up (the boat sank on the way to the new world) there could be no further call on the shareholder.

The partly paid share – with no walk away option – no longer really looks like the kind of equity our exchanges evolved to trade. It starts to look a lot more like debt.

Debt on the other hand is a much older human commercial beast (there being injunctions against in the bible and whatnot).

We have been talking about this Briscon saga for many months now, and I doubt this topic of endless fascination has been exhausted.

Dan

PS. Thanks for picking up my Bolton/One.Tel Dude piccy

7 Tim April 23, 2009 at 7:18 pm

ASM,

Honest and intelligent insights as ever. The comments from CV about the potential conflict by Trevor Rowe are spot on too. I feel that self directed on-line investors need to be stick the phrase “Caveat emptor” at the top of their PC screen!! Any who has ever bought a few shares should know 1. that the da. suffix to the stock code has has a particular meaning (or at least should prompt additional fact finding), and 2. that considering buying a share worth 1c or less which has dropped from $1 (should prompt additional fact finding).

tim
“video bonaque sed sequor male”

8 Equity Guy April 26, 2009 at 9:06 pm

Mule,

Good post. Agree that the Brisconnect saga has seen a wealth transfer from uninformed to informed investors all of which, while legal, is not good for the reputation of the market. I certainly feel sorry for (some of) the affected retail investors, however in defence of the ASX, partly paid shares have been around in Australia since the 1860s so are not exactly a “new” innovation. So perhaps the fault should lie with the discount brokers in failing to protect their newb clients, rather than the exchange.

A quick (and rough) history lesson
Pre 1850s: Limited liability companies did not exist. Shareholders were responsible in full for any debts of the company even if they owned a small percentage of the firm (sounds scary).

1860: Partly paid shares were introduced in Australia, investors were liable for the full amount of unpaid call payments.

1871: No liability shares were introduced in 1871 in Victoria, under which shareholders were not obliged to pay outstanding calls on shares.

Today: CORPORATIONS ACT 2001 – SECT 254M recognises both contributing and no-liability companies. Under the former “If shares in a company are partly paid , the shareholder is liable to pay calls on the shares in accordance with the terms on which the shares are on issue. This subsection does not apply to a no liability company. Note: The shareholder may also be liable as a contributory under sections 514-529 if the company is wound up”

So BCS does not seem a particularly unusual or innovative corporate structure. It probably made sense at the time given capital was required as the road was gradually built (although paying dividends from year 1 in no way seems natural).

According to Commsec (see http://www.comsec.com.au/public/news.aspx?id=1023), in fact Telstra 3 installment receipts *did* in fact impose a legal requirement on shareholders to make the second payment, as did MGX and BCS.

Imagine if the GFC had arrived a few years earlier, and T3 did a Brisconnect. The fallout from that would have been huge.

Equity Guy

9 stubbornmule April 27, 2009 at 9:37 am

@Equity Guy: thanks for the historical context. While I participated in T1 and T2, I did not participate in T3. It is very interesting to see that T3 had a compulsory instalment, and you are right that the fallout in that case would have been much bigger if it had collapsed in value than would have been the case with BrisConnections.

I should point out that I have no doubt that compulsory instalments are completely legal (as, indeed, are other forms of liability, debt included). The reason I nevertheless think that instruments like this should not be listed on the ASX is not because they are legal, but because the exchange cannot facilitate fair trading when value becomes negative. No amount of disclosure by brokers would change that. So while improving broker disclosure is a good thing, there is still a fundemental problem with these instruments. It’s just that the problem is hidden in a rising market.

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