Clipping the ticket

By Fiona Rotherham

Monday 1st April 2002

Doug Somers-Edgar - high-profile founder of Money Managers - is under fire for claiming his company is impartial when it isn't, for hiding risk and for repeatedly clipping the ticket on his main investment product, First Step. He claims jealous competitors are out to get him. FIONA ROTHERHAM finds there's more to it than that.

It's Sunday morning, early, and Doug Somers-Edgar's gruff voice is hitting the airwaves in "The Money Show", his weekly one-hour advertorial on Radio Pacific. He starts off lamenting the tall poppy syndrome he claims is alive and well in New Zealand, smoothly throws in a plug for a property development promoted by his associated property syndicator Dominion Property Funds, then launches into a defensive tirade about how he doesn't cut callers off when they ring into the show. Half an hour later, he's doing just that.

"Phil" is interrogating Somers-Edgar about First Step, a highly popular investment scheme promoted exclusively by Money Managers, New Zealand's most popular investment advisory company. New Zealanders have invested nearly $300 million into this scheme and Phil wants to know, among other things, if investors understand how much of the money invested in First Step has gone, not into a general investment pool, but into companies partly controlled by Somers-Edgar. Phil, who you might logically assume is a competitor because of his persistent questioning, is given the old heave-ho, ostensibly because other callers have been waiting too long for their turn. Listening in, you can't help but feel that Somers-Edgar's patience has worn a little thin.

Mind you, Somers-Edgar is a tad testy these days. He screens not only the callers he talks to, but also the journalists whose questions he'll answer. He's upset at a series of National Business Review articles saying First Step is proving "a nice little earner" for Somers-Edgar, thanks to a complex structure that enables him to rake in money every step of the way (the industry calls it "clipping the ticket").

He is a shareholder, a director, or in some way associated with companies and trusts promoting First Step, managing its funds, approving its loans and even receiving the money that's invested. The complicated structure is legal - and tax-efficient. It should be; Russell McVeagh and Ernst & Young helped devise it. But you have to ask how many of the mainly "mum and dad" investors really understand the risk implications.

Somers-Edgar says the structure is fully disclosed to investors in the scheme's weighty prospectus. "It is disclosed at so many levels, you can't miss it," he says. He also points out that despite the hefty fees, First Step's mainly elderly investors still get a return well above what they'd get from a bank.

So it's fully disclosed, it's legal, and investors get good returns. What's the fuss about? It's this. Are investors fully aware of how high their risk is? For a start, First Step money is invested in the riskier end of the market, including a bit in New Zealand property ventures that banks won't cover, and in small companies.

If you want an example of the risks in property financing, just look at the failed $21 million Metropolis junk bond Money Managers heavily promoted. Junk bonds are well towards the Nigerian tax scheme end of the investment risk scale, and therefore not necessarily ideal for the retirement savings of New Zealand's elderly. It's questionable whether enough investors understand the risk - many certainly complained they didn't, after Metropolis collapsed.

And considering the risk involved, shouldn't the First Step returns be higher? The Premium Performance Trust, First Step's most risky (and highest return) trust is projected to return just 8% for the year to June 30 this year. You wouldn't get that much less if you invested your money in the bank, with none of the risk of losing the lot. But then, First Step never tells its investors where their money is ultimately being lodged.

And then there's the fee structure. Investors are resigned to paying fees when they put their money in a trust. But before investment money is on-lent to the public, the First Step structure channels it through companies associated with Somers-Edgar and two much less high-profile but related players - Gerald Siddall and Russell Tills of NZ Funds Management. This means First Step investors pay at least four lots of fees and expenses in the various stages between handing their money over and it being loaned out for them. Most of the companies receiving the fees are associated with Somers-Edgar, Siddall and Tills (see "Clip, clip").

The maverick

It is easy to find people in the investment industry with an opinion on Somers-Edgar. They either love him or hate him, and most do the latter. Detractors accuse him of arrogance and greed. "I think we've ruffled too many feathers," he says.

The Southlander retired in his 30s after successfully investing in property and the share market. Two years later, in 1986, he set up Money Managers, which has proved to be a real cash cow. The 56-year-old made NBR's Rich List for the first time last year, with an estimated wealth of $50 million.

He is a dominant industry force, and puts far more money into advertising than any of his competitors. It appears to pay off. Money Managers claims to be the country's largest investment advisory company, with 48 offices nationwide (most of them franchised) and more than $2 billion invested by clients. "Doug has been a trailblazer in the industry in many ways, and has built a very successful business," says industry commentator Philip Macalister. Others call him a maverick, walking very close to the regulatory line.

And the authorities have been watching.

Several years ago the Advertising Standards Complaint Board upheld a complaint about Money Managers claiming to be independent when the company was taking commission on the products they were selling. Despite it being blatantly untrue, the company's website still proclaims: "Money Managers are impartial. This is important to you, as you can be sure the investments we recommend to you are based on your needs, not ours. By dealing with an impartial investment adviser, you can be sure we will recommend you to withdraw from an investment when it is no longer appropriate for you." Somers-Edgar says Money Managers has decided not to say that any more and is in the process of changing its advertising message. Maybe, but the company's stationery is still emblazoned with the word "impartial".

The First Step prospectus was suspended by the Securities Commission last year for two reasons. First, because of its claim to have "no fees". (Somers-Edgar says "no fees" relates to the absence of exit and entry fees; the Securities Commission insisted investors be told about the annual fees.) Second, because financial forecasts were annualised even though the fund had only been running for nine months. The annualised returns were also the subject of an Advertising Complaints Board decision last June.

Somers-Edgar has the firm handshake and folksy charm of a practised salesman. Dressed in a polo shirt with company logo and sweating despite the office air conditioning, he doesn't look like someone who just spent millions of dollars building a swanky North Shore house.

Somers-Edgar says he's had to be innovative in devising investment structures for his clients because "no one else in the industry was meeting their needs". Money Managers was the second in the industry to set up a masterfund for investors (First Masterfund), and second to set up a scheme exploiting the tax effectiveness of Australian unit trusts for Kiwi investors (First Step). Competitors have followed both moves. Somers-Edgar blames his competitors for orchestrating a campaign against First Step, saying it is because he and the company have been so successful. "There's plenty of incentive for them to shoot at us," he claims. "Money Managers does as much retail managed funds business as Tower and AMP combined."

If competitors are behind the scrutiny of First Step, so what? That's just a smokescreen. The real issue is the amount of risk investors face, and just who is making the most money?

Revealing all

Michael Donovan, one of Money Managers' original franchisees, has since fallen out with Somers-Edgar. Even so, he's kept his money invested in First Step and defends the level of disclosure (hey, he did sell a lot of people into the scheme). He claims most investors don't want to know about the "engine-room stuff", as he calls it, but are only interested in their return. "The key phrase I used was: 'What I'm selling is trust. You have to trust me, trust Money Managers, trust Doug'. He does a jolly good job of selling trust."

Arguably, what he is less good at is disclosing risk.

The Metropolis junk bond is just one of three failed junk bond issues heavily promoted by Money Managers. But investors who complain they weren't aware of the risks have little recourse for their complaints. Money Managers' advisers are not members of the industry body, the Financial Planners and Insurance Advisers Association. The First Step scheme does not recognise the Insurance and Savings Ombudsman.

Somers-Edgar says disgruntled clients can come straight to him: "They don't have a problem." Complaining to him has brought no relief to Metropolis bond investors who are still awaiting a new prospectus from the developer, Andrew Krukziener, which will restructure the bonds Money Managers promoted nearly a year after he defaulted. Bond holders were told by the trustee recently that the prospectus is held up getting approval because of problems with disclosure by the developer.

Disclosure is a hot topic in the investment advisory business right now. The main thrust of the Securities Commission recommendations, currently before the government, is for mandatory disclosure by investment advisers. The commission wants to broaden what is disclosed and when, including any material benefits likely to influence the advice given and any possible conflicts of interest. Somers-Edgar says his advisors already meet the mandatory disclosure requirement.

But just what are investors getting told?

First Step's investment statement and prospectus outline the risks. Some 80% of Money Managers' clients are aged 55 and over. How many of them bothered to read the dense prospectus is a moot point. Most rely solely on what their investment adviser tells them. Somers-Edgar refuses to divulge the total "cost on funds" - how much money First Step generates compared to how much investors get back. He says that information is "not relevant".

Managed funds analyst Graham Rich has an opinion, however. He admits to a few run-ins with Somers-Edgar over the years. "They're paying more than they ought to pay and are invested in higher risk than they ought to be for that return," Rich says. Take the high-risk, high-return Premium Performance Trust. It lends to businesses wanting mezzanine financing - the sort of financing that attracts a market rate of between 17% and 25%. Why, then, are First Step investors only getting a projected return of 8%?

Three weeks after first phoning Money Managers' "Money Show" on Radio Pacific, the caller named Phil rings again. He questions why no binding ruling has been sought on First Step's tax effectiveness from the Inland Revenue Department. Somers-Edgar says there is no need because the scheme exploits Australian law. He then badgers the caller to reveal who he really is. Phil refuses to do so, just before he's cut off again.

Clip, clip

Understanding the structure of the First Step trusts and its related companies isn't for the faint-hearted. But it's essential to understanding the fees investors are paying and the risk they face. Start with Somers-Edgar on the one hand, and Gerald Siddall and Russell Tills of NZ Funds Management on the other. First Step is part of the global investment pool of Australian unit trusts set up in early 2000, ultimately controlled by NZ Funds Management and its owners. Money from the global trusts - as well as money given to Money Managers to invest - is channelled through First Step to companies associated with Somers-Edgar, Tills and Siddall, then on-lent to the public.

To begin at the beginning, First Step investors choose which of the four First Step trusts to put their money into, based on the level of risk they want. This is the first clip of the ticket. Money Managers gets a commission of 0.8125% of the total funds it attracts for each client placed into the scheme. The money goes to Macquarie's Gilt Edge Access Account (the only bit not controlled by Somers-Edgar, Siddall and Tills) while investors queue to get into the scheme. This is the second clip of the ticket. The account charges management fees of 0.95% to 1.3% of the daily average balance.

Funds go through Security Registry (SRL), the trustee of the four trusts and loans administration manager. It is owned by Cadmont Holdings, a company controlled by NZ Funds Management and Money Managers. Here's the next clipping of the ticket: SRL's profit as trustee is derived from the difference between the interest paid to the First Step trusts and the interest rate at which it lends out funds.

The investment manager is NZ Funds Management. Neither it nor the administration manager receives fees, although the First Step trustee can alter that at any time. Both, however, get their expenses paid. Clip, clip.

The First Step trustee also gets a clip of the ticket, an annual fee of 0.12% per trust (and remember, there are four trusts) based on the gross value of the assets. The trustee is ultimately owned by Siddall, Tills, NZ Funds Management and Jersey-registered Vernco Holdings.

SRL can lend to anyone it likes, including parties it is associated with. And it does. Related-party lending in the latest accounts is 26% of loans made. It lent $55.8 million in the year ending December 2001 to Structured Finance (NZ), which is 50% owned by SRL. In the same period it lent $11.2 million to CTT Financial Services, a company half-owned by SRL.

Both these companies on-lend to the public, therefore, Somers-Edgar reckons, you can't call it related-party lending other than for financial accounting purposes. He claims the real related-party lending is only 2.6% of the total portfolio.

As a rule, trustees don't like related-party lending because historically it has caused problems. It is, however, fairly common. How much trustees allow depends on the scheme's trust deed - in First Step's case it is more or less open slather. Trustee Corporations Association chairman Stephen Eaton says his company, Perpetual Trust, usually limits related-party lending to 10% of total loans, with strict conditions on the lending criteria and a sign-off from an independent director.

Related-party lending is risky for investors. Money Manager clients putting their dollars in First Step also face another risk. There are potential loans of $100 million to each First Step trust made available by the scheme's trustee and its parent. These are secured by a joint debenture, giving the trustees (rather than First Step investors) first rights to the trusts' assets if the money they're owed isn't paid back on time.

It is not known who these loans are ultimately being lent to, on what terms or what risk profile. Yet it would appear if enough of these loans default, the shortfall would have to come from the money put in by First Step's mainly "mum and dad" investors.

The picture gets really tangled when investors try to work out who holds debentures over what. There's a complex roundabout of debentures and revolving credit facilities (like a blank cheque for a loan) between the related parties, from the trustees to SRL, then on to Structured Finance, CTT Financial Services and its subsidiary, CTT One. The impact of all these debentures is that the risk of default is suffered by the small investor before the related-party lenders.

The only mitigation, if you can call it that, is that the debenture holders' recourse is limited to the assets of the relevant Securities Registry Trust. In other words, it won't tumble like a house of cards if one falls over.

For the latest scheme amendment, existing First Step investors and those waiting to get in were sent letters giving them the chance to get their money back or withdraw their application. The letter states the change from one Security Registry Trust to four and invites investors to look for more detail in the amended prospectus. Somers-Edgar reckons the total withdrawals in December were double the average $2 million a month, but three of the withdrawals were from investors who wanted to get their money out to buy houses.

You have to ask why you would set up such a complex structure. Because you're entrepreneurial? To reduce accountability? To keep as much money as possible in-house? First Step has no independent trustee. But then again, investors know that.

Auditing the auditor

The role of accounting and consultancy giant Arthur Andersen in Enron, the world's largest corporate collapse, has refuelled debate on the dual role of the big accountancy firm. Is it possible to expect them to provide an independent audit of a company's financial results, while at the same time raking in huge fees for providing corporate consultancy and other services?

Well before Enron's woes came to light, the New Zealand Arthur Andersen had its own conflict to deal with. It stepped down between February and June last year as auditor of the First Step investment scheme, because that role conflicted with its statutory supervisor role. Organisations applying for Securities Commission approval to become a statutory supervisor have to give a written undertaking that no one from, or associated with, the company will also be an auditor of the scheme they're involved with.

Company Office documents show Arthur Andersen was also the auditor and statutory supervisor of some Australian unit trusts set up under the same global umbrella group as First Step.

It would appear Arthur Andersen resigned as auditor of both sets of trusts at the same time. Neither Arthur Andersen nor NZ Funds Management's principals Gerald Siddall and Russell Tills would return Unlimited 's calls. Via his personal assistant, Arthur Andersen's managing partner Gavin Leake said the firm had a policy of not commenting on clients' business.

There was a clear period of overlap between the time Arthur Andersen was appointed statutory supervisor of both schemes in early 2000 and when it stopped being auditor in early 2001.

Securities Commission chief executive John Farrell says the commission has the powers to remove its approval of statutory supervisors when they don't comply with the requirement under section 48 of the 1978 Securities Act. He says discussions are still continuing with Arthur Andersen about the undertakings made.

Financial statements for the First Step trusts show Arthur Andersen received audit fees totalling $11,000 in the year ending June 30, 2001. Brown Woolley Graham (now Grant Thornton) also recieved audit fees in the same period totalling $12,000. The statutory supervisor is paid by the trustee; how much is undisclosed.

Financial accounts for Global Investment Services, the trustee of the other Australian unit trusts, show Arthur Andersen received a total of $19,000 in audit fees for the year ending June 2001, while Brown Woolley Graham was paid $22,000.

A Global Investment Services prospectus amendment in April last year names Arthur Andersen Statutory Supervisor as the scheme's statutory supervisor, Arthur Andersen Legal as the solicitors to the statutory supervisor and Arthur Andersen as auditor.

Clip, clip,clip.

Fiona Rotherham
fiona@unlimited.net.nz

Comments from our readers

No comments yet