Saturday, March 18, 2006

Brian Gaynor: Calan saga a classic conflict of interest

Recent developments concerning Calan Healthcare Properties Trust give New Zealanders yet another reason to shun the sharemarket.

The sale of the trust's management company to ING illustrates that there are two distinct investors as far as listed trusts are concerned: The shareholders of the management company and trust unitholders.

The management company usually skims off most of the cream while unitholders, who effectively own the assets, have limited rights and are often treated as second-class citizens.

The fundamental problem with trusts is that they are controlled by a separate management group. Unitholders have no interest in or control over these management companies. This can lead to conflicts of interest and lack of transparency.

Unitholders are represented and protected by a trustee rather than a board of directors. The individuals listed in a trust's annual report are directors of the management company, not the trust.

Directors' fees are often paid by the trust even though these individuals represent a separate entity.

The biggest problem with trusts is the potential conflict of interest between management companies and unitholders.

When Calan Healthcare Properties Trust listed on the NZX in 1999 the management company's remuneration structure was:

* An annual fee equal to 0.75 per cent of the gross value of the trust.

* An incentive fee equal to 10 per cent of the average annual increase in the gross value of the trust up to, but not exceeding, 1 per cent of the value of the trust. Thus, the annual fee could not exceed 1.75 per cent of total assets.

In addition, the management company is reimbursed costs incurred leasing tenancies and the acquisition, development, custody, ownership and disposal of assets. These costs have been substantial and have sparked heated debate at annual meetings.

The trouble with this fee structure is that it encourages the management company to put more emphasis on asset growth than earnings.

Calan cannot be accused of this because its growth has been relatively anaemic since listing. Between the June 1999 and June 2005 years, total assets rose 16.6 per cent to $217.9 million and net earnings 8 per cent to $10.5 million. Although overall asset growth has been minimal, a number of purchases, sales and developments have generated extra revenues for the management group.

A takeover offer can create a major conflict of interest between a management group and the unitholders of a trust.

Under section 18 of the Unit Trusts Act 1960, a management company can be removed when 75 per cent vote in favour of this motion at a meeting of unitholders. This means that a management group faces dismissal when a bidder reaches 75 per cent ownership, particularly if the offeror also operates a management company.

Under Calan's trust deed, the manager's compensation for loss of office is an amount equal to the base fee it received in the previous financial year. As far as Calan is concerned, this was $1.6 million in the June 2005 year.

Thus if a takeover offer for Calan was successful, the management group would receive $1.6 million on termination of office but, if the bid failed, the management entity could be sold for a much higher price.

On January 26, the day after ING Property Trust launched a stand in the market to acquire up to 9.7 per cent of Calan Trust at $1.25 a unit, Bruce Davidson, the chairman of the management company, said the management company had been in discussions with another ING entity about a "possible transaction".

Davidson did not disclose whether this transaction involved the trust, the management group or both.

He said that the other ING entity had withdrawn from these discussions and a committee of independent directors of the management company had been appointed to look into ING's stand in the market.

The management company did the right thing by appointing a committee of independent directors, but who had been negotiating with ING in the first place? Any negotiations undertaken by major shareholders of the management group could have created a conflict of interest because the best interests of their company and the trust do not necessarily coincide.

After ING Property Trust launched a full bid, the independent committee of the management committee appointed Ferrier Hodgson to prepare an independent appraisal. This concluded that Calan Trust units were worth between $1.41 and $1.55 compared with the assessed value of ING's takeover offer of $1.21 a unit.

The report outlined the governance structure of the trust but it failed to mention that ING could gain control by withdrawing the takeover offer and buying the management company instead.

The independent directors recommended that unitholders reject the offer. One reason given was: "Calan's specialist skills and experience in management of healthcare properties may not be available to Calan unitholders if they accept the offer."

No one seemed to anticipate that the management company could be sold to a third party and the healthcare expertise lost to unitholders even if the takeover was unsuccessful.

On March 9, ING Property Trust said it was withdrawing the takeover offer for Calan Trust but, at the same time, ING Property Trust's manager was buying Calan Healthcare Properties Ltd (Calan's management company). The sale price was not disclosed and there was no indication whether Calan's "healthcare expertise" would be moving to ING.

On the same day, Martin Lyttelton, one of the major shareholders in Calan's management company, said discussions had been held over the past 12 months to sell the management entity. He later disclosed that pricing and terms had been agreed in December 2005 but this had been withdrawn when ING Property Trust stood in the market.

Why didn't Lyttelton reveal this sale agreement to his fellow directors or Ferrier Hodgson? If he did tell these parties, why didn't they pass the information on to unitholders?

The sale of the management company unleashed a wave of anger and frustration among investors that has not been seen for a long, long time. Unitholders could not believe that the directors of the management company would advise them not to sell (units were trading on the market at $1.28 to $1.29 at the time) while shareholders of the management group were negotiating the sale of their company at the same time.

Market speculation is that the management entity was sold for $7 million to $8 million (some estimates are as high as $20 million), well above the estimated $1.6 million it would have fetched if the takeover offer had been successful.

Four shareholders invested $136,000 in the major management entity and should realise at least $7 million to $8 million.

By comparison, more than 5000 investors have contributed $146 million of equity to Calan Trust since 1994 and this is now worth only $165 million.

The Calan Trust saga illustrates once again the massive deficiencies and inadequacies of the Unit Trusts Act 1960 and the second-class status of investors under this statute.

One of the primary objectives of securities law reform should be to repeal this act. It seems pointless for the Government to try to encourage savings and investment through tax changes and the KiwiSaver scheme when it does not remove statutes that create huge conflicts of interest and enable promoters to make massive profits at the expense of public market investors.

Disclosure of interest: Brian Gaynor is a strategist and analyst at Milford Asset Management.


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