STORM INVESTORS MAY NOT BE ALONE
By Tony Martin SC
Mr Martin is an experienced commercial barrister practising at the Sydney Bar
The hapless plight of the Storm clients is distressing. They are facing significant losses and, in many cases, financial ruin as a consequence of an aggressive gearing strategy recommended to them by their financial adviser, Storm.
If the reported settlement with the margin lender, CommBank, proceeds, hopefully that will restore some sense of financial stability and dignity in their otherwise shattered lives.
But is this disaster confined only to the Storm investors? Probably not.
The core problem is to be found in the aggressive gearing strategy promoted by Storm that involved margin lending. A margin loan enables you to borrow money to invest in shares, using existing investments as security. Borrowing money to invest in shares in this way, also known as “gearing”, can result in higher returns relative to your equity in the share portfolio, but it can also magnify the your potential losses if the value of the share portfolio falls.
When an investor enters into a margin loan to buy shares, the margin lender takes security (i.e. a mortgage) over the share portfolio so that in the event of default the shares can be sold to repay the loan. The investor is exposed to the risk the shares might fall in value because the share market can rise and fall frequently and rapidly.
If this happens, as it has occurred in the current financial crisis, the shares would be worth less than the loan creating a shortfall in the security for the margin lender.
To protect themselves against the possibility of a shortfall, margin lenders limit the borrower’s level of gearing to a set percentage (known as the loan-to-value ratio or LVR) of the value of the share portfolio. Usually, the LVRs are set at a maximum of 70%. This means that the borrower has to contribute the difference (i.e. 30%) from their own money. This difference is called the “margin”.
The aggressive gearing strategy employed by Storm amounted to “double gearing”. It involved the investor borrowing to buy shares using the equity in their homes as the security for that loan. They would then use those shares as security for entering into a margin loan to buy additional shares; that is, to effectively “double up” the gearing. This had the effect of further increasing the gains and further magnifying the losses that would otherwise have been obtained under a normal margin loan.
The strategy worked like this: an investor would borrow $50,000 to buy shares using the equity in their home. They would then use those shares as security to take out a margin loan for another $50,000 to buy further shares. As a result, they would have shares at a value of $100,000 but funded by a corresponding debt of $100,000, which required servicing.
To say the least, this “double gearing” strategy was inherently risky. It was riskier than just entering into a normal margin loan. By increasing the “gearing” level, the “risk” of the investment was also correspondingly increased. These increased risks were at least threefold.
Firstly, there would usually be no equity in the investment from the outset. The investor would have usually borrowed 100% of the value of the share portfolio. This meant that the investor was exposed to the risk that any fall in the initial value of the shares would put the investor immediately in a “negative equity” position.
Secondly, the “double gearing” strategy increased the risk for the investor of their losses being magnified in a market downturn beyond that which they would have suffered if they had just entered into a normal margin loan.
Thirdly, the “double gearing” strategy increased the impact on the investor of a margin call received in the event of a market downturn. The investor would need to meet the call from their own additional financial resources or otherwise sell part of their underlying share portfolio. The selling of any part of their portfolio in a falling market would immediately crystallise their losses.
ASIC has recently stated that it believes that the “double gearing” strategy used by Storm has “not been widely used”, but nonetheless is “directing resources to assessing other planners and advisers” to confirm this. Perhaps it will be found that there are relatively few investors in the position of the Storm clients who had margin loans using the “double gearing” strategy. However, in the light of past experience in circumstances where opportunities for financial gain existed in an unregulated market, it would be surprising if these gearing practices were not more widespread than is currently apprehended.
The fundamental problem in Australia is that margin lending is unregulated as a financial product. However, what is clear is that any investor embarking upon a margin loan needs to be fully aware of the risks involved before entering into that transaction. When the risks of the margin loan are further compounded by the use of the “double gearing” strategy, the need for the investor to be aware of the additional risks associated with that strategy is exacerbated.
In Australia, a large number of investors who entered into margin loans did so on the advice of their financial advisers. As part of their obligations to their clients, the financial advisers must warn the investor of the risks involved before entering into such a transaction. This is particularly so when the investor employed the “double gearing” strategy. The investor must warn of all of the additional risks associated with such a strategy. The investor must also be advised that they should have available other financial resources to meet any margin call in the event of a market downturn. If those other financial resources were not readily available, this type of investment would probably not have been suitable for that particular investor.
If the financial adviser did not give these warnings, that would probably constitute a breach of their duty of care to the investor. In those circumstances, the financial adviser would be liable to compensate the investor for any losses that result from that breach. The question now is how long it will take before these actions begin to surface for determination in the courts.