VOLUME EIGHT THE MANAGEMENT OF ACQUISITIONS

CHAPTER 16
THE MANAGEMENT OF ACQUISITIONS: GENERAL OBSERVATIONS

TABLE OF CONTENTS

16.1 INTRODUCTION

16.2 RELEVANCE OF DUE DILIGENCE TO THE BANK GROUP
16.2.1 OCEANIC CAPITAL CORPORATION
16.2.2 UNITED BUILDING SOCIETY

16.3 METHODOLOGY OF EVALUATING THE STATE BANK GROUP DUE DILIGENCE
16.3.1 DETERMINE TRANSACTION FUNDAMENTALS
16.3.2 IDENTIFY KEY DUE DILIGENCE STEPS
16.3.3 EXAMINATION OF EVIDENCE OF DUE DILIGENCE
16.3.4 RELATE DUE DILIGENCE SHORTCOMINGS TO FINANCIAL CONSEQUENCES
16.3.5 IDENTIFY OTHER ISSUES

16.4 PLAN OF EACH CHAPTER
16.4.1 INTRODUCTION
16.4.2 KEY PARTICIPANTS AND CHRONOLOGY
16.4.3 BASIS FOR ACQUISITION
16.4.4 FINANCIAL PERFORMANCE OF INVESTMENT
16.4.5 EFFECTIVE ASSESSMENT: THE DUE DILIGENCE PROCESS AS APPLIED TO THE ACQUISITION
16.4.6 OTHER RELEVANT MATTERS
16.4.7 FINDINGS AND CONCLUSIONS

16.5 INFORMATION SOURCES

16.6 SUMMARY OF DUE DILIGENCE REVIEW INVESTIGATIONS

16.1 INTRODUCTION

This Volume of the Report ("The Management of Acquisitions: General Observations") outlines the processes undertaken by the Bank leading to the acquisition of two significant non-performing assets, namely Oceanic Capital Corporation Limited ("Oceanic Capital Corporation") and the United Building Society (later renamed United Banking Group Ltd, "United Banking Group").

In June 1991, following a decision by the Bank to sell Oceanic Capital Corporation, provisions and write-offs were made totalling $83.3M. The United Building Society, acquired in May 1990, incurred a loss of $123.3M in 1991.

Management of Bank assets in accordance with accepted principles of financial management would require the undertaking of due diligence assessments prior to any substantial investment of Bank resources. The Investigation has reviewed the due diligence investigations undertaken by the Bank Group in relation to the acquisitions of Oceanic Capital Corporation and United Building Society. This review was undertaken to determine whether:

(a) management performed adequate and appropriate due diligence in respect of each acquisition; and

(b) any subsequent losses or poor investment performances are attributable to factors which should have been detected in the due diligence investigations.

Furthermore, Section 19(7) of the State Bank of South Australia Act, 1983 ("the Act") provides that:

"The Bank shall not acquire more than ten per centum of the issued shares of a body corporate without the approval of the Treasurer".

Accordingly, the Treasurer, and, by necessity, the officers of the Treasury responsible for advising the Treasurer, participated in, and provided an additional layer of review in, the Bank's process of acquiring certain equity investments. The Investigation has not, however, considered the adequacy of any Treasury review or approval process in discharging the obligations of the Treasurer, as these are matters which are covered by, and form part of the Terms of Reference of the Royal Commission's inquiry into and report upon the Bank. Senior Counsel assisting me in the review of the two acquisitions referred to above was advised by the Senior Counsel assisting the Royal Commission that the Commission would address issues associated with the Treasurer's approval under Section 19(7) of the Act.

This Volume of the Report is relevant in addressing Terms of Appointment A(b) and A(c) which call upon the Auditor-General to investigate, inquire into and report on:

"...

(b) what were the processes which led the Bank or a member of the Bank Group to engage in operations which have resulted in material losses or in the Bank or a member of the Bank Group holding significant assets which are non performing;

(c) whether those processes were appropriate."

The Investigation not only has examined the procedural steps of due diligence undertaken by the Bank, but also has reviewed the participation, interaction, and decision making, of the Bank Board and executive management. This Volume is therefore relevant in addressing Term of Appointment C which requires the Auditor-General:

"... to investigate and inquire into and report, with reference to the above matters, whether the operations, affairs and transactions of the Bank and the Bank Group were adequately or properly supervised, directed and controlled by:

(a) the Board of Directors of the Bank;

(b) the Chief Executive Officer of the Bank;

(c) other officers and employees of the Bank;

(d) the Directors, officers and employees of the members of the Bank Group."

The Investigation, of necessity, has examined the representations and reports given by executive management to the Bank Board, and evaluated the adequacy of these advices. As such this Volume is also relevant in addressing Term of Appointment D which requires the Auditor-General, in relation to Terms of Appointment A and B, to investigate and inquire into and report:

"... whether the information and reports given by the Chief Executive Officer and other Bank officers to the Board of the Bank:

(a) were under all the circumstances, timely, reliable and adequate;

(b) sufficient to enable the Board to discharge adequately its functions under the Act."

The evaluation of the Bank's acquisition management has been based on the detailed examination and analysis set out in Chapter 17 - "Case Study in Acquisition Management: The Oceanic Capital Corporation" and Chapter 18 - "Case Study in Acquisition Management: The United Building Society" both Chapters being contained in this Volume of the Report . With the exception of Beneficial Finance Corporation Ltd, these acquisitions represented the most important investments (by value) of the Bank outside of its core banking activity. They were selected for the further reason that they were among the most notable acquisitions made by the Bank in the six years to 1991, and both subsequently were the cause of substantial losses for the Bank.

16.2 RELEVANCE OF DUE DILIGENCE TO THE BANK GROUP

A large part of the Bank's growth in assets, the expansion of business activities, and the commencement of interstate and overseas activities, was achieved by the acquisition of established businesses and the purchase of receivables.

Prudent management of Bank resources should have required a reasonable level of enquiry and investigation of prospective investments to ensure:

(a) vendor representations were reasonably based and supported by independent evidence;

(b) material risks associated with the proposed investments were identified;

(d) the Bank had the management capability of understanding and managing the business acquired.

In my opinion, management of the State Bank Group should have taken advantage of any reasonable opportunity to address controllable risks associated with proposed acquisitions. By undertaking adequate due diligence reviews State Bank Group management would have minimised obvious risks of loss to the Bank.

Enquiries made by the Investigation of Mr T M Clark, Group Managing Director, and other Bank executives, confirmed that the Bank did not have any formal policy that set out the processes and procedures which should govern the acquisition of new companies and businesses. The checks and precautionary investigations undertaken by the Bank management in assessing prospective acquisitions were made on an "ad hoc" basis, and largely at the discretion of the executive officer who was primarily responsible for the transaction. Each transaction, therefore, may be regarded as unique; the Bank's acquisition process cannot be judged by an evaluation of an established set of procedures, because such formalised procedures simply did not exist.

The Bank Board had a statutory duty to administer the affairs of the Bank in accordance with accepted principles of financial management and with a view to achieving a profit.⁽⁾ Any acquisition would, as a matter of law, have to be assessed in accordance with these criteria. Even in the absence of a formalised policy it was still possible for Bank Management to evaluate a prospective acquisition and exercise proper care and diligence by:

(a) remaining objective and dispassionate in its assessment of the acquisition entity;

(b) subjecting the proposed acquisition to adequate due diligence examination in respect of key risk areas, and, if necessary, by reference to expert independent advice in situations where the Bank did not possess the appropriate technical resources;

(d) ensuring all Board conditions and requirements were satisfied;

(e) applying prudent judgement in setting the terms and conditions of the sale so that the Bank would not become exposed to unfair or onerous conditions; and

(f) ensuring that properly planned post acquisition strategies were agreed upon, were capable of implementation and that the acquisition would be an integrated component of the Bank's business.

16.2.1 OCEANIC CAPITAL CORPORATION

Oceanic Capital Corporation, an insurance and funds management group, was acquired by the Bank in March 1988 for $59.0M. In my opinion, due diligence procedures on the acquisition of Oceanic Capital Corporation were necessary for the following reasons:

(a) its activities were outside the traditional retail banking operations of the Bank;

(b) its operations were principally located outside South Australia;

(d) the Bank was outlaying $59.0M;

(e) Oceanic Capital Corporation had a relatively low net tangible asset backing ($6.0M)⁽⁾; and

(f) the vendor was a debtor of the Equiticorp Group, of which the Group Managing Director of the Bank was both a Director and Shareholder, and therefore a potential conflict of interest existed.

16.2.2 UNITED BUILDING SOCIETY

United Building Society, a New Zealand building society, was acquired by the Bank in June 1990 for $NZ 150.0M. In my opinion, due diligence investigations on the acquisition of United Building Society were necessary for the following reasons:

(a) the Bank was outlaying and placing at risk $NZ 150.0M;

(b) United Building Society was known to be trading unprofitably at the time of sale;

(d) United Building Society was at the time of sale, a building society, and therefore operated in a different regulatory and commercial environment to the existing retail banking operations of the Bank.

16.3 METHODOLOGY OF EVALUATING THE STATE BANK GROUP DUE DILIGENCE

The Investigation evaluated the due diligence undertaken in each transaction by applying the methodology described below.

16.3.1 DETERMINE TRANSACTION FUNDAMENTALS

The relevant members of the Bank management were interviewed and documentary evidence associated with these transactions was reviewed by the Investigation with the objective of identifying:

(a) the strategic rationale of the Bank, which it is claimed, justified the investment;

(b) the investment performance standards required, or specified in the proposals given to the Board, for comparison with Bank investment criteria;

(d) a chronology of events in relation to the transaction, and identifying all the key participants involved in the transaction, including the Bank management, outside consultants and executives, and some staff of the entities being acquired.

The Investigation identified the key individuals involved in each transaction. A chronology of events surrounding the transaction was prepared on the basis of interviews with the key participants and documentary material retained by the State Bank Group.

16.3.2 IDENTIFY KEY DUE DILIGENCE STEPS

Having regard to the background of the transaction, the strategic rationale of the Bank, and a review of the information memoranda, financial statements, and other information made available to the Bank for the acquisition negotiations, the key areas of investigation, based upon the principal risk areas, were determined by the Investigation. This analysis was made in order to identify the steps which would have been required, at a minimum, to complete a competent due diligence investigation of the investment.

16.3.3 EXAMINATION OF EVIDENCE OF DUE DILIGENCE

Schedules were prepared by the Investigation, which identified each major due diligence step required for the pre-acquisition review of the investment. These schedules also identified the objective of each step, and the reasons the objectives were considered important in the circumstances of the investment. They also contained the specific enquiries and investigations considered by the Investigation to be necessary to fulfil the objectives of each major due diligence step. The schedules were provided to the Bank management responsible for the due diligence investigations, who were requested to:

(a) identify whether the specific enquiry/investigation, noted in the schedule, was performed in the due diligence review;

(b) provide evidence of that investigation or enquiry (if the due diligence step had been performed); and

(c) indicate, if the due diligence step was not performed, reasons for the omission or an explanation of why the Bank due diligence team did not consider it a necessary step.

The above analysis and enquiry determined:

(a) areas of fundamental importance to the due diligence investigation which had not been undertaken by the Bank; and

(b) shortcomings in the due diligence investigation undertaken by the Bank. Such shortcomings included inadequate enquiry or analysis, or inaction by management on key issues actually identified in the due diligence process.

16.3.4 RELATE DUE DILIGENCE SHORTCOMINGS TO FINANCIAL CONSEQUENCES

Each investment was reviewed in order to determine its genuine post-acquisition performance. This financial analysis was directed at clarifying the following aspects of the investment:

(a) The pre-acquisition financial position of the investment, as ascertained or confirmed by the due diligence process.

(b) The actual balance sheet immediately prior to acquisition, used for the purchase accounting entries. (Note that this is distinct from (a) because evidence exists that the Bank created additional pre-acquisition provisions which, in certain cases were released as post-acquisition profits).

(c) The post-acquisition results were analysed and adjusted so as to be comparable with initial forecasts and profit histories of the investments, as disclosed in the investment recommendation proposals given to the Board of Directors of the Bank.

The financial analysis quantified and identified underlying causes for post-acquisition performance as follows:

(a) subsequent specific write-downs, or provisions, or other losses, due to mis-statement of pre-acquisition assets and liabilities of the proposed investment;

(b) subsequent losses or trading performance below initial expectations, due to mis-stated projections (that is, unrealistic projection assumptions or compilation errors); and

(c) subsequent losses or trading performance below initial expectations, due to events occurring after the acquisition, which were not reasonably foreseeable at the time of acquisition.

The items arising in (a) and (b) were considered and, where possible, related to the identified shortcomings of the due diligence processes.

16.3.5 IDENTIFY OTHER ISSUES

Any other relevant issues or shortcomings were identified, including the quality of the administration of the investments, the appropriateness of the qualifications of due diligence team members, and conflicts of interest. The accounting practices of the Bank and its subsidiaries were analysed to assess whether, in this application, they may have had any effect in obscuring the genuine post-acquisition results of the investment.

16.4 PLAN OF EACH CHAPTER

The next two Chapters deal in turn with each of the acquisitions identified for detailed review as follows:

. Chapter 17: "Case Study in Acquisition Management: The Oceanic Capital Corporation"; and

. Chapter 18: "Case Study in Acquisition Management: The United Building Society".

Each Chapter has been segmented into the following sub-sections:

16.4.1 INTRODUCTION

This sub-section contains a discussion of the background to the transaction, and the major operations of each of the investments.

16.4.2 KEY PARTICIPANTS AND CHRONOLOGY

This sub-section details the key persons involved, and the events which are fundamental to a proper understanding of the circumstances of the transaction.

16.4.3 BASIS FOR ACQUISITION

This sub-section examines the strategic rationale for the acquisitions, and the investment criteria relevant thereto.

16.4.4 FINANCIAL PERFORMANCE OF INVESTMENT

This sub-section contains an analysis of the pre-acquisition and post-acquisition performance of the investment. Where the post-acquisition performance (ie subsequent losses or performance below original expectations) has relevance to the execution of the due diligence examination, the reasons and ramifications are explained.

16.4.5 EFFECTIVE ASSESSMENT: THE DUE DILIGENCE PROCESS AS APPLIED TO THE ACQUISITION

This sub-section contains the results of the detailed assessment of the due diligence steps required in each transaction. The reasons why such steps were necessary, and the steps actually taken and the resultant shortcomings, are both reviewed. Losses which can be attributed to due diligence shortcomings are also noted in this sub-section.

16.4.6 OTHER RELEVANT MATTERS

This sub-section contains discussion of matters also relevant to the broad enquiries being made by me, and which came to the attention of the Investigation during the due diligence enquiries. By way of example the information includes evidence of potential conflicts of interest of Mr Clark, and the quality of Board Papers.

16.4.7 FINDINGS AND CONCLUSIONS

This sub-section contains a summary of the major issues arising in each investigation, and the associated findings and conclusions.

16.5 INFORMATION SOURCES

The investigation of the acquisitions has been based on the following information sources:

(a) Interviews with management and directors involved in the transaction, or who subsequently became involved in the management and supervision of the investment.

(b) Relevant Board minutes and reports prepared in respect of the acquisitions.

(c) Document and correspondence files in respect of the acquisitions which have been retained by the State Bank Group or the individuals responsible for the transactions.

(d) Financial information (annual accounts, management accounts and operational data) provided to the Investigation by management in the State Bank Group.

Listed below are the line management, executives and key participants interviewed in relation to the due diligence investigations, all of whom were members of the management team of the Bank, unless otherwise specifically noted. The titles indicated below relate to their position at the time of the relevant transaction.

Oceanic Capital Corporation Limited

. Mr T M Clark, Group Managing Director, State Bank Group;

. Mr K L Copley, Chief Manager, Finance and Planning, State Bank Group;

. Mr J B Macky, General Manager, Information Systems and Subsidiaries, State Bank Group;

. Mr O Reichert, Associate Director, Finance and Operations, Oceanic Capital Corporation; and

. Mr R Pitcher, Partner, KPMG Peat Marwick Hungerfords.

United Building Society

. Mr T M Clark, Group Managing Director, State Bank Group;

. Mr T L Mallett, Chief General Manager, International Banking, State Bank Group;

. Mr K L Copley, General Manager, Group Finance, State Bank Group;

. Mr B Morrison, Manager Banking, State Bank Auckland, State Bank Group;

. Ms M Chin, Senior Manager, Internal Audit, State Bank Group;

. Mr T Morgan, Financial Controller, International Banking, State Bank Group;

. Mr G Clifford, Financial Controller, State Bank Auckland branch, State Bank Group;

. Mr T Janes, Executive Director, Ayers Finniss (Auckland);

. Mr P Johnstone, appointed Managing Director of Ayers Finniss in July 1990 who reviewed the transaction for the Board; and

. Mr N Cooper, General Manager, Finance, United Building Society.

16.6 SUMMARY OF DUE DILIGENCE REVIEW INVESTIGATIONS

In summary, on the basis of all the evidence and material available to me I have found that:

(a) So far as concerns Oceanic Capital Corporation:

(i) Oceanic Capital Corporation, acquired in March 1988 for $59.0M failed to achieved its forecast profitability and contributed a loss for the State Bank Group of $83.3M in 1991. Its performance was, in part, influenced by post acquisition events such as the collapse in the property market. My examination of the acquisition, however, has led me to conclude that a substantial amount of the post acquisition losses that were incurred could reasonably have been anticipated by adequate due diligence prior to the acquisition.

(ii) Key deficiencies⁽⁾ in the due diligence review of Oceanic Capital Corporation related to:

. inadequate assessment and analysis of historical and forecast profitability and related assumptions;

. inadequate assessment of Oceanic Capital Corporation asset values and the value of Oceanic Capital Corporation overall;

. lack of follow-up by Bank executives of key independent expert advice provided in the due diligence examination;

. inadequate review and analysis of the quality of management systems;

. inadequate evaluation of senior management on whom the achievement of profit forecasts depended;

. inadequate investigation and clearance of a significant taxation exposure known at the date of acquisition;

. poor commercial judgement by Bank executives in setting the terms and conditions of the transaction, in particular, in agreeing to purchase Oceanic Capital Corporation before full due diligence investigations had been completed, and subsequently and prematurely releasing the vendors from warranty clauses;

. inadequate information provided to the Board, including a failure to disclose a conflict of interest due to Mr T M Clark's directorship of Equiticorp, a secured creditor of the vendor of Oceanic Capital Corporation;

. inadequate documentation created or retained in respect of the due diligence investigation by Bank executives; and

. a lack of insistence, on the part of the Board, that key conditions set by the Board be met by management so as to ensure due diligence tasks were carried out.

(b) So far as concerns United Building Society:

(i) The net asset value of United Building Society at the date of acquisition was estimated by Bank management to be $NZ 40.2M; in my opinion, however, it was, in reality, a deficiency of approximately $NZ 17.9M. The forecasts presented to the Bank Board to support the investment were overstated, which became evident within three months of the acquisition, when the original 1991 forecast pre-tax profit of $NZ 36.0M was revised to $NZ 4.4M, which did not include any extraordinary items.

The actual result for the year ended 30 June 1991, for the original United Building Society Group, was a loss of $NZ 123.3M. Furthermore, the Board had been advised by Bank management that the $NZ 150.0M capital injection would be "passed straight back" to the Bank such that the Bank would have "no funding cost". Subsequent events have shown that the $NZ 150.0M was not "passed back" to the Bank. The Investigation found no evidence of assessment of the United Building Society capital requirements to support the funding cost statement to the Board.

(ii) A substantial portion of these losses, in my opinion, could have been anticipated by adequate due diligence prior to the acquisition. The due diligence conducted by the Bank was deficient in the following respects:

. inadequate financial review and assessment of historical and forecast earnings and related assumptions, cashflows, receivables, property values, and contingent liabilities;

. the investigations were poorly co-ordinated and controlled, and several crucial parts of the review - in particular, the review of internal controls - had not been completed;

. Ayers Finniss, who were responsible for completing major parts of the due diligence, and who were entitled to a "success fee", had a vested interest in ensuring that the acquisition was completed successfully (and were therefore affected by a conflict of interest); and

. the Board was not provided with an adequate standard of information upon which to base an investment judgement.

CHAPTER 16 THE MANAGEMENT OF ACQUISITIONS: GENERAL OBSERVATIONS