Recent developments in the regulation of debentures

The last few years have seen a string of high profile collapses involving debentures where there appears to have been a loophole in the legislation regarding their regulation.

Background

Debentures are debt instruments used by an issuer to raise funds from investors in return for the payment of interest and are principally regulated under Chapter 2L of the Corporations Act 2001 (Corporations Act). Chapter 2L 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. Debenture trustees have a duty to exercise reasonable diligence to determine whether the property of the borrower and any guarantors will be sufficient to repay the amount deposited under the debentures and whether there have been breaches of the terms of the debentures or the trust deed.  Trustees are also subject to fiduciary duties to debenture holders and are responsible for undertaking a range of functions on behalf of debenture holders.

As debentures fall within the definition of a ‘security’ under the Corporations Act, a person offering debentures is also subject to the fundraising provisions of Chapter 6D of the Corporations Act, including the requirement to prepare a prospectus for the offer and certain rules relating to advertising and publicity for the offer of debentures.

Westpoint

One of the more prominent high profile collapses involving debentures is the Westpoint case where thousands of investors lost a total of almost $350 million. Westpoint targeted ‘mum and dad’ investors to raise mezzanine finance to fund property development. The mezzanine finance was raised through the issue of what the issuer described as promissory notes. The promissory notes were to provide fixed-interest returns over terms of one and two years. The investors were to get their capital back upon maturity of the note. Westpoint did not issue a prospectus before issuing the promissory notes because it believed the notes were not ‘debentures’ and therefore not ‘securities’. Westpoint provided disclosure in the form of an information memorandum which provided limited detail of the risks involved with the promissory notes.

ASIC took action against various Westpoint companies on the basis that the promissory notes were debentures and therefore fell within the definition of ‘securities’ and that Westpoint had breached its disclosure obligations by failing to issuing a prospectus.

The Supreme Court of Western Australia held that that the promissory notes were not debentures on the basis that definition of ‘debentures’ in the Corporations Act expressly excludes promissory notes with a face value of more than $50,000. All of the promissory notes offered by Westpoint were for more than $50,000. Accordingly, Westpoint was held not to have breached the prospectus disclosure requirements in the Corporations Act. This decision was affirmed by the Full Court of the Supreme Court of Western Australia on appeal.

Financial Services Modernisation Bill

Following the Westpoint decision it became apparent that there was a loophole in the legislation in that promissory notes issued with a face value of less than $50,000 were regulated as debentures, while promissory notes with a face value of more than $50,000 were treated as financial products, but were not subject to debenture regulation including the consumer protection requirement of having to appoint a trustee.

The Corporations Legislation Amendment (Financial Services Modernisation) Act 2009 received Royal Asset on 6 November 2009 which includes a number of amendments to the Corporations Act. Amongst other things (including new margin lending requirements) the new Act modifies the regulation of debentures to include all promissory notes within the definition of debentures and make them subject to the full range of consumer disclosure and protection measures which currently only apply to debentures under Chapter 2L.

The changes also include the creation of a publicly available register of trustees for debenture holders which is to include the following details:

• the name and address of the debenture issuer
• name and address of the trustee
• name of the trust to which it has been appointed
• the trustee’s ACN or ABN as applicable and
• date of the trust deed.

The new requirements will only apply to new debenture issues.

Debenture disclosure

There has also recently been developments in relation to the disclosure requirements applicable in respect of debentures. As many would be aware, ASIC issued regulatory guidance in 2007 in the form of Regulatory Guide 69 (RG 69) imposing additional disclosure requirements for debenture prospectuses.  RG 69 introduced eight disclosure benchmarks applicable to debentures requiring disclosure in respect of the following matters:

• equity capital
• liquidity
• rollover
• credit ratings
• loan portfolio
• related party transactions
• valuations and
• lending principles.

Issuers of unlisted debentures are required to address the benchmarks in their disclosures on an ‘if not, why not’ basis.

Following on from RG 69, ASIC issued a consultation paper in October 2009 outlining proposals to improve the benchmarks in RG 69.  The consultation sets out ASIC’s proposals to:

• adjust the disclosure benchmarks in RG 69, including those relating to minimum amounts of equity capital, adequate liquidity, and disclosure about loan portfolios and valuations
• improve the presentation and explanation of benchmark disclosures and
• change how it administers the law regarding the naming of debentures.

Comment

In order for any regulatory initiative that has the objective of minimising the risk of loss to investors to be effective is to promote better consumer understanding of complex investments such as debentures. While increased regulation, such as in the form of additional disclosure requirements, may assist some people in making better informed decisions before investing in debentures, it does not necessarily mean that ‘mum and dad’ investors will fully understand how debentures work and the risks involved.  This surely must be an important step in preventing further corporate collapses and investor losses.