Opes investors fail at first hurdle

I know that some people have lost a lot of money through the collapse of Opes Prime, so it seems a bit ghoulish to be fascinated by it – but there you have it, I can’t help myself – I’m fascinated. There are so many interesting equitable and property law questions raised by it (tracing, equitable mortgages, mere equities, trusts in undifferentiated property), not to mention corporate governance issues. Some of my favourite topics!

Anyway, I saw yesterday that Finkelstein J of the Federal Court had handed down an important judgment from the point of view of investors seeking to reclaim their shares (Beconwood Securities Pty Ltd v Australia and New Zealand Banking Group Limited [2008] FCA 594).

I should explain briefly how the Opes Prime arrangement worked before getting into the judgment. Investors “loaned” their shares to Opes Prime in return for a cash advance. As a term of the Securities Lending Agreement (SLA), Opes promised that when the money advanced to the investor was repaid to it, Opes would redeliver shares to the investor which were equivalent in number and type to those originally provided. The value of the cash advance supplied was less than the value of the shares provided to Opes. The difference between the value of the cash advance and the value of the shares is referred to as the “margin”. Problems occur if the value of the shares fall below the value of the cash originally advanced to the investor, because then the value of the security is less than the value of the loan, and will not be sufficient to recompense Opes if the investor does not pay it back. In those circumstances, a “margin call” should be made to the investor, whereby the investor is required to “top up” the amount of shares provided so that the value of the shares is again greater than the value of the cash. One of the issues seems to have been that margin calls were not made when they should have been made to certain significant and substantial investors. And of course, the general stock market slump contributed to the drop in value of the shares beyond the margin.

As Finkelstein J notes at [9]:

In this case credit risk is all important. Boiled down to its essence, a party’s exposure to loss in the event of default is equal to the margin. That is to say, if the non-defaulting party is on the short side of the margin (ie the value of the assets delivered to him is less than the value of the assets provided) he will suffer a loss and, in the case of insolvency, be required to prove for the difference in the insolvency of the defaulting party.

In other words, the investors will have to pay the difference if their shares are not adequate security for the cash advances they received.

The investors are alleging that they were told by Opes that they would retain some form of ownership in their original shares. In fact, this was not true from a legal perspective (as will be discussed in greater detail below). Opes loaned the shares received from investors to its bankers, ANZ Bank (the defendant in this case) and Merrill Lynch. In return for this, Opes received cash advances, which were presumably used in part to fund the provision of cash collateral to investors. However, ANZ became aware that Opes was in financial difficulties, and appointed receivers to the firm. ANZ and Merrill Lynch commenced selling the shares that had been provided by Opes as security for its loans. Presumably this drove the value of shares even further below the margin. It was at this point that shocked investors started challenging the sales, as they had thought they retained some kind of ownership in the shares, and that it was not in ANZ’s power to sell them off.

In Beconwood, the plaintiffs claimed that they had retained a proprietary interest in the shares which they had loaned to Opes in two ways:

1. Through an equity of redemption pursuant to a mortgage of the legal title to the shares
2. Through an equitable charge over the shares

Both of these interests are proprietary security interests. Let me explain the equity of redemption first. In general law land, the actual title to the property is transferred to the lender, but the borrower retains the beneficial interest in the property (so he or she can live there and enjoy the property). What happens when the borrower has paid back all of her loan? It is then that the equity of redemption comes into play – it means that the lender has to transfer the legal title back to the borrower – the borrower is entitled to “redeem” her property.

An equitable charge is a little different. Legal ownership in the security property is never transferred to the lender at all – the lender merely has a right to sell off the borrower’s property if the borrower defaults.

The investor failed to make out either kind of security interest. In essence, this came down to Clause 3.4 of the SLA between Opes and the Investor, which stated as follows:

Notwithstanding the use of expressions such as “borrow”, “lend”, “Collateral”, “Margin”, “redeliver”, etc., which are used to reflect terminology used in the market for transactions of the kind provided for in this Agreement, all right title and interest in and to Securities “borrowed” or “lent” and “Collateral” which one Party transfers to the other in accordance with this Agreement will pass absolutely from one Party to the other free and clear of any liens, claims, charges or encumbrances or any other interest of the Transferring Party or of any third party (other than a lien routinely imposed on all securities in a relevant clearance system) without the transferor retaining any interest or right to the transferred property, the Party obtaining such title being obliged only to redeliver Equivalent Securities or Equivalent Collateral, as the case may be. Each Transfer under this Agreement must be made so as to constitute or result in a valid and legally effective transfer of the Transferring Party’s legal and beneficial title to the recipient.

In other words, it was clearly stated in the SLA that full ownership of the shares was transferred to Opes. All that the investor was entitled to upon repayment of the cash advance was equivalent shares – not necessarily the same shares as those which were originally provided to Opes. The point to be made about shares is that they are fungible – one share is very much like another, and it doesn’t particularly matter which one you get as long as you get an equivalent back. Finkelstein J makes the point that economically speaking, the arrangement was very much like a mortgage, but legally speaking, the analysis just could not be sustained.

The plaintiff then tried to argue that there was a necessary implied term in the SLA that the investor had a charge over any shares of the equivalent type held by Opes until it received its shares back, but it also failed in this respect too.

Finkelstein J’s judgment seems correct to me. Regardless of the representations Opes may or may not have made to its clients, it is the terms of the SLA which are fundamental, and the terms are explicit that the investors do not retain an interest in the shares. Clearly the investors did not read the terms of the SLA closely enough.

Finkelstein J makes an interesting analysis of US law. It is clear that the US has been using these kind of “securities lending arrangements” for longer than Australia, and that the market in the US is highly regulated in respect of these arrangements (unlike the Australian market). Perhaps the Australian regulators need to consider instituting US-style regulation if these kind of securities lending arrangements continue in popularity.

Listing a law firm on the stock exchange

I saw in The Australian today that law firm and personal injury specialist Slater & Gordon had incorporated and listed on the Australian Stock Exchange.

Most law firms are partnerships. The partners fall into two groups. Equity partners own part of the firm itself. They have a say in the way in which the firm is run, and who receives promotions and who gets a salary rise. They are entitled to a hefty share of the firm’s profits. This is in contrast to salaried partners, who receive the rank of “partner”, and a salary reflecting that achievement, but they do not gain a share of the profits of the firm. Salaried partners want to become equity partners, because, as this US article indicates, it is much more profitable.

I presume that upon incorporation, the partners of a firm become majority shareholders instead. As majority shareholders, they will still have a say in the way in which the firm is run, but they will be paid dividends as shareholders.

The advantage of floating a law firm on the stock exchange is that it will allow a firm to raise funds by issuing more shares. Apparently, in the case of Slater & Gordon, the money raised from the float will be used to purchase other small personal injury firms, and expand business into other states. Former equity partners and some employee solicitors will also do very well from the deal.

Is it a good idea? Well, I certainly don’t claim to be a stock market expert. But as far as I can see, there are two interesting and controversial points raised by the listing of Slater & Gordon.

1. Slater & Gordon is a firm which has a reputation for bringing class actions on behalf of “little guys” against large corporations. Now it will be listed alongside many of those corporations. Somehow that just seems ironic to me.
2. In law firms, there is a tension between (a) making a profit from one’s client and (b) doing the most efficient job possible for the client. As I have explained in one of my very first posts, because solicitors bill by six minute units, one doesn’t want to be too quick and efficient, otherwise you won’t be able to charge the client much. It seems to me that by adding shareholders to the mix, the firm will be pulled in three ways instead of two – (a) profiting from one’s client, (b) doing the most efficient job possible for one’s client and (c) keeping one’s shareholders happy. And I haven’t even mentioned the lawyer’s duty to the court (which is supposed to be our primary duty)! Apparently Slater & Gordon’s company constitution explicitly confirms that its primary duty is to the court, then to clients, and then to its shareholders, so it is trying to manage this aspect.

I wonder whether this will catch on elsewhere? I suppose we’ll just have to watch and see whether it is a success and whether other firms follow suit.

Update

I recommend a couple of other commentaries on this issue:

• John Flood has offered a comprehensive and thoughtful post (as usual)
• Professor Mitt Regan is intending to publish an interesting discussion in the Georgetown Journal with Bruce McEwen and Professor Larry Ribstein – it takes a while to read, but it is worth it.
• Blawgs.com has also posted a small piece – I wonder whether there will be any responses?

Update 2

On further conversations with colleagues, more questions occur.

What happens if Slater & Gordon are running an action against a particular individual who is very well-resourced, and that individual buys a substantial number of shares in Slater & Gordon and then demands that the action against him cease?

I note that the prospectus is very clear that one of the risks of investing in the company is that it may be required to act against the interests of the shareholders, and that the corporate governance policy reiterates this (documents available here).

Secondly, what is the standing of the firm in a legal action? Is a public company a valid form for a law firm? Thirdly, does the fact the firm is a corporation limit the Law Institute’s ability to regulate the firm? I note that the prospectus says that investors must be aware that the Law Institute will have disciplinary powers over lawyers who do not meet practicing standards.

I don’t know the answers to these questions – I’m just putting them out there for consideration.