babcocks regulatory loophole

Babcock's regulatory loophole
Alan Kohler
The Spectators


The ghost in the room with Babcock & Brown’s staff, as they meet with their bankers this week to review whether to have a review, is the fact that the entire business structure and goodwill value is based on regulatory neglect.

Everyone is agreed that it is a long way back for Babcock & Brown, and that regaining the confidence of the market and the banks will take more than a few independent chairmen and some asset sales. They can do it, no doubt, but it’s going to be tough.

But the question remains: should the regulators allow the group to go on at all? Should they allow something like it ever to happen again? (Definitely not.)

An ASX listing rule passed in September 1999 was badly worded. Phil Green drove a truck through it. Both the ASX and ASIC jumped out of the way and have quietly ignored what is a clear regulatory mishap ever since.

Babcock cannot be sacked as manager of its funds. Even if the fund owners vote 100 per cent to end the management contracts, it can’t happen. The term is 25 years, and can only end upon insolvency of the manager, an unresolved breach, loss of licence, or a change of control…of the manager, but not the fund.

This is why banks are prepared to lend so much to Babcock itself, on top of what they lend to the funds and their assets – because the base cash-flow from fees is guaranteed.

It would be like choosing a super fund and having your money locked there for 25 years, or signing an unbreakable 25-year mobile phone contract.

It is also the key difference between Babcock and Macquarie, although Macquarie is the inventor of special voting shares (which allow it to control the funds’ boards) and 'contingent fees' (which must be paid even if Macquarie is sacked), which have the same effect.

The Babcock prospectuses were all scrutinised by the regulators; so why did they allow 25-year, unbreakable, management contracts? Here’s why.

ASX Listing rule 15.16, introduced on September 1st, 1999, says: “...a management agreement for an investment entity must provide for each of the following: (a) the manager may only end the management agreement if it has given three months' notice (b) if the term of the agreement is fixed, it must not be for more than five years (c) if the agreement is extended past five years, it will be ended on three months' notice after an ordinary resolution is passed to end it.”

That seems pretty clear: no more than 5-year terms and after that, a 50.1 per cent vote can end it. Babcock’s agreements are all in breach.

Except for the definition of investment entity, spelled out elsewhere in the listing rules: “...its objectives do not include exercising control over or managing any entity, or the business of any entity, in which it invests.

In other words, the definition of an investment entity does not contemplate infrastructure funds, which clearly do control the things they invest in, unlike listed investment companies and real estate investment trusts, which do not.

On the whole, infrastructure funds are designed to exploit, in various ways, a loophole in the listing rules that allows managers to put a clamp on what is actually an investment fund, and not be sacked. Babcock’s is just the most effective of a wide variety of clamps.

In many cases these were granted waivers. An April 2007 study of waivers by Riskmetrics for the Australian Council of Super Investors found that externally managed entities represented 4.3 per cent of the waiver seekers and 14.3 per cent of the actual waivers granted (in other words a few promoters got a lot of waivers).

Infrastructure fund management fees – base plus performance – are, in my view, mostly trailing commission for setting the funds up, since the underlying assets of the funds pay for their own management.

All infrastructure funds say the manager is paid to search for new assets for the fund – which is true, except that in most cases the fund also pays full tote transaction fees to the manager when assets are sold to it.

Between executives of Babcock & Brown, who get first call on the cash and were paid $110 million last year, and the banks, which get second call on the cash to service upwards of $50 billion in debt, the equity holders don’t stand much of a chance.

They are at the end of the line, and whereas the managers and banks have watertight contracts ensuring their own cash flows, the “owners” simply get to take risk and get paid distributions – often out of asset revaluation reserves, funded by capital.

No wonder the share prices have collapsed.