Sue Newberry is a senior lecturer in financial accounting at the University of Canterbury. Ed.

The benefits of foreign investment in New Zealand and open financial markets have been urged on us all. The foreign investment regime deals with both land and corporate investment. Here, I want to cover the corporate investment aspects by commenting on the underlying financial market assumptions and what may happen when those assumptions don’t hold.

Few countries can hope to have the assumed perfect financial market where no single shareholder or group of shareholders can dominate investee companies. New Zealand certainly does not, and is known instead as having a "thin" market or "thin" share trading environment. Such an environment exists when a few major shareholders control a sufficient number of a company’s shares to be able to control or significantly influence board and management decisions. Particular dangers emerge in such circumstances and I want to explain one of those dangers – asset stripping, followed by share price hyping while major shareholders sell down their shares to more naïve investors. Crudely put, in Wall Street terminology, this latter part of the pattern is known as "pump and dump" because the share price is pumped while the more knowledgeable shareholders dump their shares.

We are already aware of the costs to New Zealanders of the nasty surprises inflicted by former State- Owned Enterprises (SOEs), Air New Zealand and TranzRail*. Their functions are important to New Zealand and they cost New Zealanders dearly because of the need to bail out the companies, which is why they were previously State-owned. Remaining Air New Zealand and TranzRail shareholders also lost considerable investment value in their shares. Some of the asset stripping that preceded these "surprises" was concealed through financial reporting practices of varying levels of sophistication, including off-balance sheet financing techniques.

*These two were such shining examples of privatisation that they have both ended up being renationalised, to a different degree in each case. The collapse of Air New Zealand in 2001 led to the Government becoming its reluctant owner once again, after having to bail it out. In 2004, the Government became, once more, the owner of the nation’s rail track network, having baulked at the chance of completely renationalising the railways. See Watchdogs 98, December 2001 and 106, August 2004, for details. The relevant articles can be read online at http://www.converge.org.nz/watchdog/98/01.htm and http://www.converge.org.nz/watchdog/06/06.htm TranzRail, of course, won the Roger Award three times in its first six years (before being declared permanently ineligible for nomination and shunted into the Hall of Shame). Considerable details about its misdeeds can be found in the various annual Roger Award Judges’ Reports. These can be found online at www.cafca.org.nz. Follow the Roger Award Links. Ed.

In this article, I want to begin by explaining and criticising the basic financial markets model underlying our foreign investment regime, and then to show how the thin market flaw in this model, in combination with sophisticated financial reporting techniques, can open up scope for asset stripping followed by "pump and dump" arrangements.

The efficiency with which financial markets allocate resources has long been exaggerated; its weaknesses underplayed ("Reclaiming the Public Sphere: Problems and Prospects for Corporate Social and Environmental Accounting", in Critical Perspectives on Accounting, Vol. 12, pp713-733; G Lehman, 2001). The underlying theoretical idea seems to be that open competitive global financial markets provide an all-important intermediating role in an economy and, thus, benefits us all. The latest changes to the foreign investment regime (see the lead two articles in this issue for details. Ed.) will help to open our financial markets even more..

Financial reporting is important in this competitive global financial market economy because investors require confidence in the companies operating in the financial markets. Why would they invest in them otherwise? Just some of the international agencies emphasising the importance of financial reporting include the International Monetary Fund, the US Agency for International Development, the European Bank for Reconstruction, the World Bank and the Asian Development Bank. Even Colin Powell, while US Secretary of State, suggested that global accounting standard-setters have some sort of civic responsibility to help develop and promote this global sharemarket investment economic model (www.state.gov/secretary/rm/200999.htm).

Accounting standard-setters standardise accounting practices and help to determine practices they deem appropriate where there is no accounting standard. This combination of standardised and blessed practices results in a flexible set of what is known as generally accepted accounting practices (GAAP). Supposedly, "true and fair" financial reports prepared in compliance with GAAP, and certified as such by auditors, will maintain investors’ confidence.

As with market efficiency, the validity, credibility and legitimacy of GAAP and the associated audit certification has been exaggerated. The funding of the major accounting standard-setting bodies comes from transnational corporations, major stock exchanges and global accounting firms, thus raising questions whether the standards and practices they bless really are in the public interest as the standard-setters like to claim ("The Milieu of the IASB", The Journal of the American Academy of Business, Vol 4, No 1; AM Brown, 2004).

The current idea under this model is that a good company will maximise profits at all times, with those profits increasing over time; and maximise returns to shareholders in the form of dividends. That few, if any, companies can hope to maintain such a pattern honestly and survive seems to go unnoticed in the more simplistic analyst community. A company that does not produce such a pattern may expect to be punished with a reduced share price, while a company that does produce it is likely to be rewarded with a higher share price.

The reported profits figure is not cash. In any profit squeeze, management may be expected to conjure up all sorts of reasons for changing the accounting to improve reported profits regardless of what might be considered the underlying reality. Especially when profits are inflated to meet the increasing profit trend expectations, and dividends are linked to a specified percentage of reported profits, the company may not have the resources to meet its dividend commitments. This can set in train a process of self cannibalisation (asset stripping) as the company’s senior executives attempt to produce the expected reported results by various means, including outright sales or disposals of "surplus" assets; changing accounting policies; changing particular deals; and off-balance sheet financing techniques to shift or raise debt off-balance sheet and feed that money back in to look like sales and profits, and to cover the dividends. The last two techniques have become especially notorious internationally over the last five or six years. More crude Wall Street terminology describes as sluts* (simultaneous, legally unrelated transactions) the profit-enhancing and off-balance sheet financing techniques popularised in the US telecommunications industry in 2001/02. According to the US Securities and Exchange Commission, the engagement of one telco, Qwest, in such transactions bordered on fraud and it has been in the courts over them (Independent, 27/10/02, p7). *Pumping and dumping, and sluts - this ugly sexist language tells us a lot about the mindset of these self-proclaimed Masters of the Universe. Ed.

If the investors in a company’s shares were held constant, these fancy tricks and the self cannibalisation form of asset stripping would make no sense. However, especially in a thin trading environment, informed, active investors aware of the asset stripping might be expected to look for the best returns from a company while holding its shares, and to dump their shares on less knowledgeable investors when they realise the company is near the limit of what can be done using these processes.

Clearly, gaps exist between the global financial markets model being promoted as so good for us, and the reality. These gaps have the potential to produce the opposite effect from that supposedly intended. As I argued in my first article (Watchdog 106, August 2004; "Financial Reports: Weapons OfMass Deception. Review Of The Financial Reporting Act 1993", which can be read online at http://www.converge.org.nz/watchdog/06/03.htm), the realities of financial reporting may mean that maintaining investor confidence amounts to little more than maintaining a con. Because New Zealand is a small market particularly prone to thin trading conditions, the danger is that the theoretical appeal of open competitive markets could be damaging, and this would be true in any country where thin markets are more common.

Telecom was one of the early SOE privatisations. From 1991, its shareholdings were dominated by US investors, followed by investors from Europe and Asia. In 2002, just 13% of Telecom’s shareholding was held by Australians and New Zealanders. More recently, a significant pattern change in Telecom’s shareholding has emerged. Telecom’s shares suddenly seem attractive and are being touted openly, especially by ABN AMRO, as a good buy, with the result, it seems, that the share price is rising and demand for the shares has increased. Also, the company seems to be reporting improved profits and has announced larger dividend payouts as a percentage of profits, increasing them from 50% to 75% for 2003/04, with plans announced to raise them further to 85% for 2004/05. But it is not merely the reported profit figure Telecom is offering this big payout ratio on – it is an adjusted profit figure achieved after adding back to the reported profit amortisation and relevant non-cash items (Telecom Annual Report, 2004, p41). With these adjustments, it is feasible the company could pay out more than 100% of the profits actually reported.

By 31 July 2004, Australians and New Zealanders held 46.4% of Telecom’s shares (Australians, 20.2%; New Zealanders 26.2%), while North American investors held 25.7%; British investors held 19%; Asians 4.5% and Europeans 3.5%. In the quarter ended 31 July 2004 alone, this pattern change involved more than $900 million of shares transferred from foreign hands to Australian and/or New Zealand hands. At the time of writing (December 3) Telecom’s share price had risen to $6.09, and locals continue to snap up the shares.

Rather than providing a comprehensive list of Telecom’s changing accounting policies, deals, and off- balance sheet financing techniques, I want to update earlier comments about just two examples of Telecom’s financial reporting practices that should give cause for concern. Both were mentioned in my previous article (Watchdog 106, August 2004; "Financial Reports: Weapons Of Mass Deception. Review Of The Financial Reporting Act 1993", which can be read online at http://www.converge.org.nz/watchdog/06/03.htm), but that article was written before the 2004 annual reports were published.

In the August 2004 Watchdog, I explained arrangements between Telecom and Southern Cross Cables Holdings (an associate company of Telecom’s, based in Bermuda’s tax haven). Briefly, just a few years after an initial investment of less than $45 million in Southern Cross, Telecom reaped a dividend of $263 million, increasing the Telecom Group’s reported profits by 52% or $221 million. This dividend was taken even though Telecom reported that Southern Cross was making such losses Telecom had written down its share investment in Southern Cross to zero. The result of this write-down was that Southern Cross (and a few other companies) became the New Zealand equivalent of Enron*-style off- balance sheet entities. According to Rod Deane, Telecom’s chairman, Telecom’s investment in Southern Cross was "splendid" (Telecom Annual Report, 2001).

* The collapse of the gigantic US corporation, Enron, in 2001, and subsequent court cases against its leading executives, has become synonymous with the sheer, breathtaking criminality of much of US Big Business. Its transnational auditor, Arthur Andersen, was also caught out covering up Enron’s crooked schemes, and it too collapsed. The ramifications of all this are still being worked through. Until September 11, this was the really big story of 2001. George Bush, who, apart from anything else, was personally connected to Enron, must say a prayer of thanks every night to Osama bin Laden. Ed.

As I reported in August, when Enron subsequently collapsed, and off-balance sheet entities such as these became notorious, claims were made in New Zealand that, unlike the United States, our financial reporting standards make sense and such deals couldn’t be concealed here. Of course, mentioning Southern Cross in relation to those claims didn’t go down too well, but such claims were made, including by Telecom’s Chief Executive, Theresa Gattung (Press, 3/3/02).

This compilation significantly changes the key ratios that Telecom reports. Two of those ratios are return on assets and gearing. Return on assets represents the percentage return earned from the use of the company’s assets over the year. As noted above, analysts look for a constantly rising trend and Telecom has shown such a trend with its calculations since 2001, but Telecom routinely adjusts its calculations. The calculation should express net reported profit as a percentage of average total assets for the year (Table 2).

I reported in the August Watchdog that Telecom’s 2003 Financial Report revealed a $2.1 billion transaction between the Telecom parent company and Telecom IP Ltd, a subsidiary company. Briefly, the Telecom parent "sold" its previously unrecorded and unreported intellectual property (IP) to Telecom IP Ltd for $2.141 billion, recognising the full amount as a gain on sale. The sale amount was reported as being at fair value, the profits arising because the value had not been recognised previously.

There was no effect on the consolidated Financial Report because transactions between a parent and its subsidiaries are eliminated for consolidation purposes, and the transaction seemed to go largely unnoticed in the analyst community. As reported in the August Watchdog, this IP transaction set up a perfect arrangement for raising debt off-balance sheet, feeding the money raised into on-balance sheet debt reduction and reported profits, and then boasting about strong operating cash flows and debt reduction.

Sure enough, in its 2004 results announcement, Telecom reported cash flows so strong that debt had been reduced significantly and increased its dividend payouts. My question in August was whether Telecom’s improvements were genuine, or whether the improved financial results arise from off balance sheet debt, circular transactions and deceptive financial reporting. It is worth noting that if the latter is the case, such practices are regarded as bordering on fraudulent in the United States. But then, of course, as we noted with Telecom’s treatment of Southern Cross, Telecom’s Chief Executive believes that New Zealand’s financial reporting requirements make far more sense than do the US requirements.

During 2004, one of my academic colleagues scoured the official company files in an attempt to understand what was going on with this IP transaction. He discovered an interesting trail that seemed to lead to a dead end. Briefly, after setting up Telecom IP Ltd in February 2003, Telecom set up another two subsidiary companies, in April 2003: Telecom IP Investments (No 1); and Telecom IP Investments (No 2). Each company’s constitution restricted it to fulfilling a series of agreements connected with a "brand financing transaction". This involved the assignment of certain registered and unregistered New Zealand trademarks and domain names to JP Morgan New Zealand Financing LLC and then licencing them back to Telecom IP Ltd. After these transactions, if indeed they proceeded, Telecom IP Ltd would no longer own the IP itself; it would merely own the licences to the IP owned by JP Morgan. At the time, a deal such as this would have given Telecom considerable tax benefits in New Zealand and its counter-parties further tax benefits in the United States (National Business Review, 30/5/03, Shoeshine). Telecom’s auditor, KPMG, opposed the efforts by the Minister of Finance, Michael Cullen, to change the tax laws to reduce the tax benefits of such transactions. KPMG is known internationally for its aggressiveness in selling such arrangements (NBR, ibid. and "Tax Me If You Can", SBSTV documentary, Australia, November 2003).

On September 1, 2003, Telecom IP Investments (No 1) and Telecom IP Investments (No 2) each adopted a new constitution, neither of which referred to the "brand financing transaction". At the same time, Telecom IP Investments (No 1) became a limited liability company and changed its name to Telecom IP Investments Ltd, exactly the same name as the original company registered in February 2003.

On September 4, 2003, this new Telecom IP Investments Ltd issued 75,000,100 shares and on the same day the directors of Telecom IP Investments Ltd, Telecom IP Investments (No 1) and Telecom IP Investments (No 2) resolved that the three companies should be amalgamated with Telecom IP Investments Ltd, with Telecom IP Investments Ltd continuing as the amalgamated company. Telecom IP Ltd, which had just issued 75 million shares, was struck off by the Registrar of Companies on September 5, 2003, as was Telecom IP Investments (No 2).

Less than a week later, on September 11, 2003, Telecom IP Investments Ltd again changed its name. It became Telecom IP Ltd. In other words, it took over the name of the company Telecom had set up in February 2003. We were intrigued to see what might be reported about this series of events in Telecom’s annual Financial Report. Nothing!

It is possible that there was no brand financing transaction and that this was all just a muddle. But closer scrutiny of the Financial Report reveals a couple of hints that some financing transactions were happening simultaneously, and the "benefits" for Telecom from such transactions could do more than just save tax dollars. The information about these transactions suggests they are legally unrelated to the planned brand financing transaction. In September 2003, TCNZ Finance Ltd, a 100% owned subsidiary of Telecom repurchased Euro 27 million of notes. From the figures reported, this seems to have been approximately $51 million (Telecom Annual Report, 2004, p 66). Also in August and September 2003, Telecom New Zealand Finance Ltd repurchased US$44 million of 6.5% Restricted Capital Securities. Again, from the figures reported, this seems to have been roughly NZ$75 million (pp 66-67). This reduces Telecom’s reported on-balance sheet debt but it is just $126 million whereas the value of the property sold was reported as $2.141 billion. Whatever has happened to the rest?

Because 100% owned subsidiaries are so closely held, there are no requirements to provide financial reports of these companies, so there is no way of seeing exactly what is going on. We don’t know how much of these subsidiaries’ debt is reported on their balance sheets and how much off it. This was one of the points I made in my comments on the Review of the Financial Reporting Act. What we do know is that Telecom guarantees the indebtedness of both of them. As is well known internationally, with sophisticated holding company structures such as this, cross guarantees tend to result in the whole pack of cards collapsing if one becomes too indebted.

New Zealand’s move to an integrated global financial market economy is deemed to be good for us. Agreement that this is the case requires a level of faith in the underlying financial market assumptions. As a close observer of financial reporting standard-setting and corporate reporting, I have little to no faith in those assumptions. Further, as a New Zealander becoming increasingly concerned about the general lack of investment community interrogation of major companies’ practices, the woeful lack of analyst scrutiny, and the hitherto toothless Securities Commission, I think this move exposes New Zealanders to subjection to increased financial predation, especially by the transnational companies.