CHAPTER 17
CASE STUDY IN ACQUISITION MANAGEMENT: THE OCEANIC CAPITAL CORPORATION
TABLE OF CONTENTS
17.1 INTRODUCTION
17.1.1 BACKGROUND
17.1.2 MAJOR OPERATIONS
17.2 KEY PARTICIPANTS AND CHRONOLOGY IN SUMMARY FORM
17.2.1 PARTICIPANTS AND THEIR ROLE
17.2.2 CHRONOLOGY OF KEY EVENTS
17.3 BASIS FOR ACQUISITION
17.3.1 STRATEGIC RATIONALE
17.3.2 INVESTMENT CRITERIA
17.4 RELEVANT OBSERVATIONS
17.4.1 TIMING AND BASIS OF TRANSACTION - ADVICE TO THE BOARD
17.4.2 PREPARATION OF SALE AGREEMENT
17.4.3 LACK OF FOLLOW UP OF KPMG PEAT MARWICK HUNGERFORDS ADVICE
17.4.4 RELEVANT CONCLUSIONS
17.5 FINANCIAL PERFORMANCE OF INVESTMENT
17.5.1 NINE MONTHS ENDED 30 JUNE 1988 ($15.2M LOSS)
17.5.2 YEAR ENDED 30 JUNE 1989
17.5.3 YEAR ENDED 30 JUNE 1990
17.5.4 YEAR ENDED 30 JUNE 1991
17.6 EFFECTIVENESS ASSESSMENT: THE BANK'S DUE DILIGENCE PROCESS AS APPLIED TO OCEANIC CAPITAL CORPORATION
17.6.1 BUSINESS FUNDAMENTALS AND RISK ANALYSIS
17.6.2 VOLUME OF FUNDS UNDER MANAGEMENT
17.6.3 QUALITY AND RETENTION OF KEY STAFF
17.6.4 QUALITY OF REPORTING SYSTEMS
17.6.5 FINANCIAL POSITION OF INSURANCE COMPANY
17.6.6 FINANCIAL REVIEW
17.6.7 ASSESSMENT OF VENDOR REPUTATION
17.7 OTHER RELEVANT MATTERS
17.7.1 BOARD INFORMATION
17.7.2 CONFLICT OF INTEREST
17.7.3 UNDERLYING CLARITY OF BOARD INFORMATION AND QUALITY OF COMMUNICATION WITH BANK EXECUTIVE
17.7.4 BOARD FOLLOW UP
17.7.5 SUPPORTING WORKING PAPERS
17.8 FINDINGS AND CONCLUSIONS
17.9 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT
17.9.1 TERMS OF APPOINTMENT A
17.9.2 TERM OF APPOINTMENT C
17.9.3 TERM OF APPOINTMENT D
17.9.4 TERM OF APPOINTMENT E
17.10 APPENDIX: ORGANISATION CHART
17.1 INTRODUCTION
Oceanic Capital Corporation Limited ("Oceanic Capital Corporation"), the holding company of an insurance and funds management group of companies (the "Oceanic Group"), was purchased in March 1988 for $59.0M. The Bank's key strategic goal was to acquire an established funds management operation.
Oceanic Capital Corporation was forecast to achieve a net profit after tax of $6.6M and $8.2M in 1988 and 1989, respectively. Its actual post-acquisition performance has been well below these early expectations, as indicated hereunder:
|
Years ended 30 June |
|||
|
1989 |
1990 |
1991 |
|
| Oceanic Group Net Profit/(Loss) after tax and extraordinary items |
1.5 |
4.2 |
(83.3) |
The poor performance has in part been influenced by post-acquisition events, such as the collapse in the property market and consequent impact on the property unit trust industry. Nevertheless, analysis of results indicate that a substantial amount of losses could have reasonably been anticipated by due diligence prior to acquisition.
The events and circumstances surrounding the acquisition of Oceanic Capital Corporation have been the subject of detailed examination by the Investigation to determine the shortcomings in the Bank's acquisition management which resulted in these losses.
17.1.1 BACKGROUND
The Oceanic Group of companies was formed on 31 August 1987 by an amalgamation of existing insurance and funds management businesses. The core activities of the Oceanic Group consisted of life insurance in Australia and New Zealand, funds management (the group then had approximately $392.0M funds under management), a small general insurance operation, and a majority interest in Credit Card Sentinel Limited, a credit card services company which provided services related to the loss of credit cards by the cardholders.
All of the share capital of Oceanic Capital Corporation was beneficially owned by APA Holdings Limited ("APA Holdings"). The original intention of APA Holdings was to have Oceanic Capital Corporation publicly floated by December 1987, however, the stock market crash in October 1987 caused these plans to be cancelled. Oceanic Capital Corporation was then offered for sale by private treaty. The Investigation was advised by Mr O Reichert, Associate Director Finance and Operations, of Oceanic Capital Corporation, that there were some ten parties expressing interest in Oceanic Capital Corporation and that the main competing bidder against the Bank was a management buy-out team.
On 31 March 1988, the Bank acquired 100 per cent of the share capital of Oceanic Capital Corporation from APA Holdings. The purchase price was $60.0M, subject to an escrow amount of $2.0M designed to accommodate any adjustments to the purchase price following detailed examination of the records of Oceanic Capital Corporation. At final settlement $1.0M was refunded following the identification of adjustments accommodated by the contract of sale.
17.1.2 MAJOR OPERATIONS
The major operations of Oceanic Capital Corporation are set out in the Appendix at the conclusion of this Chapter of the Report.
17.2 KEY PARTICIPANTS AND CHRONOLOGY IN SUMMARY FORM
17.2.1 PARTICIPANTS AND THEIR ROLE
The following table sets out the key participants in the acquisition of Oceanic Capital Corporation.
| Organisation/Name/Title | Description of Role |
| THE STATE BANK OF SOUTH AUSTRALIA |
| Mr T M Clark, Managing Director | Introduced the acquisition to the Bank. Held discussions with senior Oceanic Capital Corporation executives in relation to salary packages to ensure confidentiality in executives' salaries. Became a Director of Oceanic Capital Corporation after the acquisition. |
| Mr J B Macky, General Manager, Information Systems and Subsidiaries | Initial project leader for the Oceanic Capital Corporation acquisition. His role ceased after the Board meeting on 24 March 1988. |
| Mr K L Copley, Chief Manager, Finance and Planning | Member of Oceanic Capital Corporation acquisition team who assumed project leadership later in the transaction. Became a Director of Oceanic Capital Corporation after the acquisition. |
| Mr Copley advised the Investigation that Mr Guille (a senior bank executive) conducted a "short assessment of the executives involved in Oceanic Capital Corporation". Mr Guille regarded his role as related to gaining knowledge of the staff and personnel practices in Oceanic Capital Corporation. |
| Mr G S Ottaway, General Manager, Subsidiaries (Mr Ottaway assumed responsibility for subsidiaries from Mr Macky during the transaction) | Became a Director of Oceanic Capital Corporation after the acquisition, in accordance with his responsibility for subsidiaries. |
| EQUITICORP TASMAN LIMITED |
| Mr M Boyte, Managing Director | Provided valuation reports of Oceanic Capital Corporation management rights and life assurance business dated 14 August 1987 and 29 September 1987, respectively. These valuation reports were prepared by Mr Michael Smith and Mr Mark Clay of CIBC Australia Limited. The sale agreement for Oceanic Capital Corporation also identified Equiticorp Australia Limited ("Equiticorp") as a secured creditor of APA Holdings. File notes of Mr Copley indicated that this loan to APA Holdings was paid out by the Bank on the sale of Oceanic Capital Corporation. |
| OCEANIC CAPITAL CORPORATION
Mr J Purvis, Managing Director Mr I Brown, Finance Director Mr O Reichert, Associate Director, Finance and Operations |
| WESTGARTH BALDWICK
Mr J Munton |
Legal advisers to the Bank in respect of the acquisition of Oceanic Capital Corporation. |
| KPMG PEAT MARWICK HUNGERFORDS
Mr R Pitcher, Partner (Melbourne) |
Adviser to the Bank in respect of finance and accounting issues. |
| WILLIAM M MERCER, CAMPBELL, COOK & KNIGHT ("MERCERS") |
| Mr M Hughes Mr P Luk Mr C Latham |
Actuarial advisers to the Bank and Oceanic Capital Corporation. Mr Copley advised the Investigation that he was aware of the potential conflict of interest arising from consulting the Bank and Oceanic Capital Corporation. Nevertheless, he was satisfied that the conflict had been resolved by Mercers allocating different partners to consult for the Bank. |
| FREEHILL, HOLLINGDALE & PAGE
Mr T M Mistele |
Legal advisor to APA Holdings. |
| DELOITTE HASKINS & SELLS
Mr W R Finney, Audit Partner |
Auditor of Oceanic Capital Corporation. |
| APA HOLDINGS LIMITED ("APA HOLDINGS")
Mr G Carter, Chief Executive Officer (and controlling shareholder) |
Executive officers of the vendor. |
17.2.2 CHRONOLOGY OF KEY EVENTS
The following table sets out the key events which are fundamental to understanding the circumstances of the transaction.
Date Event
16 December 1987
Equiticorp Tasman Limited forwarded valuation reports by CIBC Australia Limited on the Oceanic Capital Corporation Management Rights and APA Life Assurance Limited. The covering letter addressed to Mr Clark, was signed by Mr Boyte, and refers to earlier telephone discussions.
January 1988 (est)
Bank management review the Oceanic Capital Corporation Information Memorandum, which was prepared by Oceanic Capital Corporation management.
9 February 1988
Mr Macky, Mr Copley and Mr Guille, Chief Manager Personnel (in the limited respect mentioned earlier) investigate the acquisition of Oceanic Capital Corporation, and prepare a Board recommendation (16 February 1988) requesting that the Directors approve the Bank entering into negotiations to acquire Oceanic Capital Corporation.
17 February 1988
Submission of a recommendation dated 16 February 1988 to the Bank Board seeking approval in principle to enter into negotiations for the acquisition of Oceanic Capital Corporation.
The Board Paper contained references to investigations which would be made, including:
. stating that the purchase would be subject to independent valuation by actuaries and accountants (item 2(c), page 1);
. proposing detailed examination of records by accountants (third last paragraph, page 5); and
. stating that the price would be subject to due diligence and adjusted according to any discoveries made (item 5, page 7).
The Board approved, in principle, entering into negotiations after a discussion of forty five minutes (as recorded in the Board Minutes of 17 February 1988), subject to the following terms and conditions relevant to the investigatory process:
"A satisfactory independent valuation by Consulting Actuaries and Accountants."
The Board Minutes did not refer to examination of records by accountants or the due diligence which was also referred to in the Board Paper.
Furthermore, the Board Minute did not specify whether the due diligence should be undertaken before or after acquisition. This matter had been left unclear in the Board Paper.
23 February 1988
Conference between Mr Pitcher (KPMG Peat Marwick Hungerfords), Mr Copley, and Mr Macky. Meeting discussed various issues in respect of Oceanic Capital Corporation and deal strategies.
Mr Pitcher told the Investigation, that it appeared to him at the time that a decision had been made to offer $55.0M for Oceanic Capital Corporation.
He had also suggested at that time that 20 per cent of the purchase price be withheld as a contingency sum. According to Mr Pitcher he had, up to this point, only been involved in talking over accounting and acquisition strategy issues. Mr Pitcher had not provided valuation advice, nor was his opinion sought on the value of key intangible assets.
25 February 1988
Board meeting held which referred to the approval in principle given on 17 February 1988, and noted that the Bank was currently formalising arrangements to make an offer of $55.0M subject to the conditions set out at the Board meeting on 17 February 1988, and with a $10.0M escrow amount payment which was only to be made "after satisfactory completion of investigations of the company's affairs by consulting actuaries and accountants."
The Board noted the progress in negotiations in the purchase.
The offer of $55.0M was made on 25 February 1988; APA Holdings rejected the Bank offer on 5 March 1988.
15 March 1988
Facsimile received from Mr Vickery (APA Holdings), addressed to Mr Macky, advising of the terms and conditions of an offer from another bidder for Oceanic Capital Corporation which it was alleged was being formalised. The facsimile invited the Bank to reconsider its offer and proposed negotiations in Adelaide if this was in prospect.
22 March 1988
The negotiations were reopened, at a higher price of $60.0M. The Bank knew that APA Holdings had cash commitments due at 31 March 1988, and Mr Copley has advised the Investigation that the Bank endeavoured to use this to its advantage. A Heads of Agreement was entered into between the Bank and APA Holdings for the purchase of Oceanic Capital Corporation which agreement contained a condition that the sale was subject to final approval of the Board being given on or before 25 March 1988.
24 March 1988
Recommendation for the acquisition of Oceanic Capital Corporation is presented to the Bank Board and Board approval for the purchase given (Minute 88/83).
30 March 1988
Approval given by Premier of South Australia for the purchase of Oceanic Capital Corporation by the Bank as required by Section 19(7) of the State Bank of South Australia Act, 1983 ("the Act").
22 to 31 March 1988
Preparation, completion and settlement of Sale Agreement. It has been stated by Westgarth Baldwick subsequently (facsimile 10 April 1990) that they made comments in relation to the Sale Agreement, basically, seeking clarification from Mr Copley on certain details of the transaction and suggesting additional warranties for the agreement. The facsimile dated 10 April 1990 to Mr Copley from Mr Munton of Westgarth Baldwick (discussed below) indicates that the advice regarding the warranties was not acted upon by Mr Copley. Initial settlement took place on 31 March 1988 with the payment of $60.0M to APA Holdings and other interested parties (including the Equiticorp Group) $2.0M of which was held in escrow by Freehill, Hollingdale & Page. The draft sale agreement received by the Bank on 25 March 1988 contained reference to Equiticorp as a beneficiary of the proceeds of the sale (refer clause 4.2 (a) (viii) of draft sale agreement).
Early April 1988
KPMG Peat Marwick Hungerfords requested to conduct enquiries at Oceanic Capital Corporation to determine whether any adjustments should be made to the purchase price in accordance with the contract.
6 April 1988
Mercers, the consulting actuaries, provided a financial position assessment of APA Life Assurance Limited which was to be acquired as part of the Oceanic Capital Corporation acquisition.
18 April 1988
Mercers provided an assessment of Oceanic Unit Trust operation (being trusts managed by Oceanic Funds Management Limited).
21 April 1988
KPMG Peat Marwick Hungerfords provided draft report to Mr Copley on their investigation of Oceanic Capital Corporation which was discussed with Mr Copley on 22 April 1988. Furthermore, on 26 April 1988 KPMG Peat Marwick Hungerfords wrote to confirm the discussions held with Mr Copley in respect of the draft report on 22 April 1988. KPMG Peat Marwick Hungerfords warned that "the nature and quantum of matters being uncovered is such that it is clearly essential... that we carry out further in-depth examinations...". According to Mr Pitcher, KPMG Peat Marwick Hungerfords raised serious concerns over Oceanic Capital Corporation, and were preparing to develop strategies to pursue significant claims under warranties.
27 April 1988
Mr Copley reported to the Board of directors on the progress in the investigation of Oceanic Capital Corporation. The concerns raised by KPMG Peat Marwick Hungerfords and Mercers were not revealed. However, Mr Copley confirmed to the Board that most of the issues raised were identified at the time of the initial investigation, and that he was still satisfied that the purchase price was fair and reasonable.
29 April 1988
The final KPMG Peat Marwick Hungerfords report on the investigation is issued. Mr Pitcher has advised the Investigation that KPMG Peat Marwick Hungerfords were not requested to follow up on the concerns raised in their report or their letter of 26 April 1988, nor were they ever requested to conduct further work.
17 to 20 May 1988
Various replies received by Mr Copley from Oceanic Capital Corporation, its auditors and the vendors disputing issues raised by KPMG Peat Marwick Hungerfords.
27 May 1988
Deed of Settlement/Deed of Release entered into, parties agreed to split the $2.0M escrow sum. It is important to note that the Deed of Release released the vendor from any future warranty obligations except a taxation warranty which subsequently has proved ineffective in respect of a major taxation liability (discussed later in this report).
17.3 BASIS FOR ACQUISITION
17.3.1 STRATEGIC RATIONALE
The strategic rationale for the purchase of Oceanic Capital Corporation was set out in a recommendation ("Oceanic recommendation")(), dated 22 March 1988 discussed by the Bank Board of Directors at their meeting on 24 March 1988 and was also discussed in an earlier Board submission dated 16 February 1988. The Oceanic recommendation was prepared by Mr Macky, General Manager, Information Systems and Subsidiaries and Mr Copley, Chief Manager, Finance and Planning. The Oceanic recommendation was presented to the Board by Mr Macky on 24 March 1988. A Bank Board Minute (88/83) records the Board's approval for the purchase of Oceanic Capital Corporation.
The strategic rationale for the purchase appears from the Oceanic recommendation to be as follows:
(a) Oceanic Capital Corporation would generate income derived from management of third party assets and therefore would enhance profitability without a detrimental effect on the Bank balance sheet ratios. This was perceived to assist in achieving a targeted return on equity and assets for the Bank Group.
(b) Oceanic Capital Corporation would provide a funds management capability which was "deemed as being necessary in order to provide the expertise to manage the Bank's superannuation funds, and to enable the generation of products for sale through the branch network." ()
(c) The acquisition would allow for geographic expansion and provide access to new markets for the Bank because the activities and markets of Oceanic Capital Corporation were mostly located in the eastern states, Western Australia and New Zealand.
(d) The Bank's Personal Finance Services division had been undergoing growth, and there had been growth in the general market for investment advice and products; Oceanic Capital Corporation was perceived as being capable of meeting a demand for a diversification of investment products.
Interviews conducted by the Investigation with Mr Macky and Mr Copley confirmed that the above items were the strategic objectives of the Bank. The acquisition of a funds management capability was stressed as being extremely important and the acquisition of Oceanic Capital Corporation was considered preferable to:
(a) setting up a funds management company; or
(b) expanding the role of Executor Trustee & Agency Co, which had specialist skills in cash management.
17.3.2 INVESTMENT CRITERIA
The Oceanic recommendation also set out the financial criteria upon which the investment in Oceanic Capital Corporation was justified to the Bank Board. This is described below under the topics of (a) Profitability; and (b) Net Asset Value.
(a) Profitability
The Oceanic recommendation included an attachment which set out a profit summary of the actual combined results of the businesses and entities comprising the Oceanic Group for the period from 1982 to 1987 and also included projections for 1988 and 1989. The table below sets out the most relevant components of that summary being the actual result for 1987 and forecasts for 1988 and 1989.
|
Years ended 30 September |
|||||
|
Item |
Actual |
Forecast |
Forecast |
||
| Operating Profit Before Tax |
3.1 |
6.7 |
8.4 |
||
| Income tax expense |
(0.9) |
(0.7) |
(0.4) |
||
| Operating Profit After Tax before extraordinary items |
2.2 |
6.6 |
8.2 |
||
| Extraordinary items |
(7.8) |
- |
- |
||
| Net Profit/(Loss) After Tax |
(5.6) |
6.6 |
8.2 |
||
The extraordinary item in 1987 comprised write-offs related to the group formation in August 1987 and also included a $6.0M write-off relating to the diminution in value of fund management contract rights due to the decline of funds under management.
It should also be noted that the 1989 forecast provided above was originally $11.7M, but was revised downwards by 30 per cent by Mr Macky and Mr Copley because they believed the assumed increase in operating profit was unrealistic.
The relevant discussion on forecasts from the Oceanic recommendation is set out below:
"PROFITABILITY
Attachment 4 is a profit summary providing actual results for the period 1982 to 1987 and with projections for 1988 and 1989. The projections for 1989 demonstrate an increase in operating profit from the actuals of 1987 to the projected of 1989 of 283%. We are of the opinion that this is unrealistic and accordingly have adjusted the 1989 projection down by 30% in order to provide what we consider to be attainable projections.
The new management of the group are extremely confident in improving the profitability of the company. That confidence is shared by Messrs Macky and Copley.
We have been provided with profit figures for the four months to 31st January 1988 which show that the group has made a profit in that period of $3,473,000.
This includes two special profits; an unbudgeted incentive fee of $588,000 and a fee of $700,000 relating to 1987. Thus the ordinary operating profit for the period can be adjusted to $2,185,000. This indicates that the profit projection for 1988 of $6.6 million is attainable and would provide a level of profitability which although not at the 15% criteria sought from subsidiary companies of State Bank, is sufficient to cover the cost of the capital necessary to make the investment."
The Oceanic recommendation did not specify the cost of capital used in this assessment or how it had been calculated, nor has the Investigation team's search located, or had produced by the Bank, any working papers to support this calculation.
The forecast for 1988 was supported by the results for the four months to 31 January 1988 which indicated a profit of $3.5M. Mr Copley identified in that result an unbudgeted incentive fee of $0.588M and income of $0.7M which actually related to the prior year. He therefore concluded that the operating profit for the period was $2.2M which, on an annual basis, approximated the $6.6M forecast. He also indicated to the Investigation that it was anticipated at the time that the operations of Oceanic Capital Corporation would generate synergistic benefits, although there had been no attempt to specifically identify and quantify such benefits. The assessment of forecast earnings was critical to the evaluation of the investment.
As will be discussed in detail in this Chapter the assessment of the achievability of forecast results was seriously deficient, because it failed to:
(a) review and confirm the accuracy of the reported result for the four months ended 31 January 1988;
(b) critically analyse the underlying assumptions upon which the forecasts were based;
(c) heed the observations made by the consulting actuaries, William M Mercer, Campbell, Cook & Knight ("Mercers") who questioned the achievability of the fund management operations' projections; and
(d) assess and appraise the budget and forecast setting procedures of Oceanic Capital Corporation management, which would be relevant in determining the likely reliability of management forecasts.
Based on the evidence and for the reasons stated in this Chapter, I am of the opinion that Mr Copley and Mr Macky failed to exercise proper care and diligence in assessing the forecasts presented by Oceanic Capital Corporation management.
(b) Net Asset Value
The Investigation was advised in interviews with Mr Copley that the purchase price for Oceanic Capital Corporation was determined principally on an assessment of the "balance sheet assets" rather than a specific assessment of "ongoing earnings".
In the first Board recommendation dated 16 February 1988 (seeking approval in principle to proceed with negotiation for the acquisition of Oceanic Capital Corporation, which was granted by the Board on 17 February 1988, subject to important terms and conditions), a detailed analysis of the valuation of balance sheet assets was provided. The summary set out below is extracted from that Board recommendation, and gives the initial assessment of the value of assets made by the Bank's management on their initial review of Oceanic Capital Corporation.()
|
Item |
$M |
|
Net Assets at 30 September 1987 |
81.9 |
|
APA Holdings Subordinated Loan |
(4.1) |
|
77.8 |
|
|
Adjustments: |
|
|
(a) Write-down of investments |
(0.9) |
|
(b) Write-down of management rights |
(1.2) |
|
(c) Write-off Life Assurance Licence valuation |
(3.0) |
|
(d) Write-off Life Assurance Agency valuation |
(17.0) |
|
(e) Write-off goodwill on acquisition |
(1.3) |
|
Net Assets at the Bank Management valuation |
54.4 |
The Bank Board Paper of 16 February 1988 provided the following explanations of the adjustments above:
(a) Investments were revalued to "... reflect their current values".
(b) "... Management Fund Rights reduced by $1.235M to reflect 7.5% of the current value of the fund." () The value of management fund rights was determined by Mr Macky and Mr Copley to be 7.5 per cent of the value of funds under management. In interviews with the Investigation, Mr Copley stated that 7.5 per cent was, in his opinion, reasonable, and was supported by a valuation prepared by CIBC Australia Limited ("CIBC Australia") dated 14 August 1987 (before the stock market crash of 19 October 1987). The CIBC Australia report was prepared for APA Holdings in preparation for the intended public listing of Oceanic Capital Corporation. The adjustment of $1.235M was to reflect the decreased value of management rights due to the reduction of funds under management.
(c) to
(e) Reflected full writedowns of those intangible asset valuations because "... [Mr Macky and Mr Copley] believe they have no value".
It should be noted that of net assets of approximately $86.5M, some $80.5M related to "intangible assets" or, in the case of the retained earings of the Life Assurance Statutory Fund, assets not yet recognised in the balance sheet of Oceanic Capital Corporation. The position can be stated as follows():
|
$M |
|
|
Management contract rights (contracts to manage certain public unit trusts and which provide a right to future management free income) |
19.2 |
|
Life Assurance |
|
|
39.6 |
|
17.4 |
|
3.0 |
|
Goodwill on Consolidation (recognised on the purchase by Oceanic Capital Corporation of the group operating companies on 31 August 1987.) |
1.3 |
|
Total |
80.5 |
The resultant adjusted net assets of approximately $55.0M provided the basis for the first bid of $55.0M for Oceanic Capital Corporation, which bid offer was made by Mr Macky in a letter dated 25 February 1988. The offer required a $10.0M escrow sum, with adjustments to the purchase price being made on the basis of verification and valuations by consulting actuaries, accountants and property valuers. Mr Copley has stated in interviews with the Investigation that, in his view, the $55.0M assessment represented the real value of Oceanic Capital Corporation, and he attempted to achieve this outcome in the final purchase price.
In connection with the asset assessment mentioned above, I regard it as illogical and unwise to acquire an investment as a going concern where that investment comprised such a high proportion of intangible assets, on a valuation basis other than one related to future earnings potential. Furthermore, not only did the Bank management fail to adopt a valuation approach based on future earnings potential, they also failed to adequately assess the earnings potential of Oceanic Capital Corporation in their investigations.
In order to record the acquisition of Oceanic Capital Corporation in the Bank's accounts, an assessment of the consolidated balance sheet of Oceanic Capital Corporation, at 31 March 1988 (the acquisition date) was required. This assessment was actually made on 13 July 1988 some three and a half months after the acquisition date, although there is nothing particularly unusual about the lapse of time actually taken to perform the assessment. In accordance with generally accepted accounting practice (and consistent with Approved Accounting Standard ASRB 1013: Accounting for Goodwill) the Bank was obliged to determine the fair market value of all assets and liabilities of Oceanic Capital Corporation, at 31 March 1988, in order to determine the opening balances for consolidation in the State Bank Group accounts.
This process and the adjustments made are generally referred to as "purchase accounting". Any valuation adjustments to either assets or liabilities made in purchase accounting are reflected as "pre-acquisition" adjustments to the book value of assets and liabilities acquired (Oceanic Capital Corporation) and are not included in the post-acquisition profit and loss statement. The State Bank Group profit and loss statement should therefore only reflect the results of "post-acquisition" activities of the Bank's subsidiaries.
The Investigation reviewed the purchase accounting entries made at acquisition date, effectively recording the opening balances at valuation. It was noted that the net assets of Oceanic Capital Corporation were written down to precisely the purchase price (approximately $59.0M) resulting in no goodwill or premium arising on consolidation. The Investigation also found that the asset write-downs finally made in the accounts of Oceanic Capital Corporation did not correspond with either the initial valuation assessments disclosed to the Bank directors (shown above) or the recommendations of KPMG Peat Marwick Hungerfords or Mercers.
The significant differences in the sequence of revaluation adjustments are set out below:
|
Decreased to |
|||
|
Item |
Initial |
KPMG |
Actual |
| Elimination of policy holder’s share of unrealised gains on property |
- |
7.4 |
7.8 |
| Overstatement of Deferred Acquisition Costs |
- |
0.8 |
2.4 |
| Write-down of Life Licence |
3.0 |
2.5 |
0.5 |
| Write-down of Life Agency |
17.0 |
17.4 |
3.9 |
| Increase in GAAP liabilities of Life Assurance Statutory Fund |
- |
- |
3.0 |
A review of the Board Minutes and supporting papers indicated that these material valuation adjustments were not brought to the attention of the Bank directors. Given the original premise (as advised by Mr Copley) that the purchase price was justified on the basis of net asset values, I would have expected the final asset configuration to have been advised to the Board as a matter of course and certainly when the final accounts of the Bank for the year ended 30 June 1988 were considered and approved.
Furthermore, there is some question concerning the reliability of the valuation of the intangible assets, in particular, of Management Contract Rights ($19.2M) earlier discussed but which were not adjusted above. Concerns were expressed by Mercers in the report dated 6 April 1988, which also questioned the achievability of the fund managers' profit plan and the value of the funds management company. Interviews with Mr Copley and reviews of relevant document files of Mr Copley indicate that these issues were not followed up by Mr Copley during the course of the due diligence review, or reported to the Bank Board. Mr Copley told my Investigation that he had been instructed by Mr Clark to `back off' and leave the integration and management of Oceanic to Mr Ottaway and the Oceanic management. He also said that as the obtaining of the report from Mercers and Mr Pitcher after acquisition was for the purpose of negotiating the return of the amount in escrow, he believed the passing of the reports to Oceanic management completed his management responsibilities in the matter.
Mr Clark agreed that although he may have indicated to Mr Copley that the integration and management of Oceanic was to be left to others, at no time did he even suggest to Mr Copley that he was to curtail his due diligence responsibilities. The full text of Mercers conclusion is quoted from their report below:
"CONCLUSIONS
(a) James Purvis' business plan can no longer be justified in the post-crash environment. It is not even known whether sales will be able to offset redemptions in the foreseeable future. The fund size has returned to September 1986 level and is likely to stay at that level (if not decline further) for quite some time to come.
(b) Management indicated that the 1987 expenses of $8.5M included some extraordinary items. It further indicated that this could be cut down to about $3.7M if no further marketing thrust was undertaken.
(c) A possible pro forma statement for the next few years will therefore look like:
|
Net service fee |
100,000 |
|
Management fee (@ say 1.2%) |
2,400,000 |
|
Total |
2,500,000 |
|
Expenses |
(3,700,000) |
|
Pre-tax surplus |
(1,200,000) |
(d) Based on the above we find it difficult to assign a substantial value to the fund management company except to the extent that the expertise developed over the years and the tax loss carried forward must be worth something.
This opinion will have to be revised if it can be demonstrated, or if one has good reason to expect, that the management is able to reduce the expenses to a level well below that suggested above.
(e) As of today the probability that the contingent liabilities mentioned in Notes 17(a) (in relation to Oceanic Property Trust) and Notes 17(c) (in relation to Oceanic Mortgage Trust) to the accounts will materialise is small."
In my opinion, the valuation of the management rights included in the acquisition accounts at $19.2M appears excessive, given that:
(a) the fund management company was not profitable; and
(b) the collapse of the stock market in October 1987 resulted in loss of funds under management and created a general level of uncertainty for funds managers at the time.
In my opinion, it was wrong for Mr Copley and Mr Macky to rely, as they said they did, on the CIBC Australia Report to confirm the value of the Management Rights and to support their valuation methodology, for the following reasons:
(a) The CIBC Australia Report was prepared for the vendors ("APA Holdings") and not the Bank.
(b) The CIBC Australia Report was prepared for specific purposes which were not related to the transaction which the Bank was contemplating.
(c) The CIBC Australia Report applied three valuation methodologies, one of which was "Percentage of Funds under Management", the method used by Mr Macky and Mr Copley. The other two methodologies provided in the CIBC Australia Report were "Capitalised Operating Revenue Approach" and "Discounted Cashflow Approach". These are earnings based methodologies which used profitability forecasts included in a business plan prepared by Mr Purvis. As the CIBC Australia Report used two earnings based methodologies, it was not reasonable to have assumed that the only appropriate valuation approach was the "Percentage of Funds under Management" approach. Indeed, in my opinion, the valuation of Management Rights should be primarily based on an earnings methodology with reference being made to the "Percentage of Funds under Management" as a subsequent cross-check of any valuation made, any material differences in which would warrant reconciliation.
(d) The CIBC Australia valuation was prepared in August 1987, which was prior to the stock market crash in October 1987. On all of the evidence, the stock market crash would have had a significant impact on the immediate prospects of the fund management operation and therefore its value. The forecast profits used for the purposes of the CIBC Australia valuation were obtained from the business plans prepared by Mr Purvis which has been questioned by Mercers in their report of 6 April 1988.
(e) The CIBC Australia Report was based on capitalisation rates determined by comparisons made with publicly listed companies prior to the stock market crash. In my opinion, it would have been obvious to any reasonably competent businessman that these statistics would have required revision for the consequences of the stock market crash.
On the basis of the above mentioned matters, I am of the opinion that Mr Copley and Mr Macky failed to exercise proper care and diligence in discharging their responsibilities for the proper assessment of the value of Oceanic Capital Corporation and ensuring the Board was adequately informed on asset values.
17.4 RELEVANT OBSERVATIONS
17.4.1 TIMING AND BASIS OF TRANSACTION - ADVICE TO THE BOARD
A key feature of the Oceanic Capital Corporation acquisition was that the investment was made prior to completion of a detailed due diligence investigation. Whilst the investigation by KPMG Peat Marwick Hungerfords did locate issues which would normally be found in a due diligence examination, their investigation was not requested until after settlement on 31 March 1988.
The commercial judgement of the Bank management in proceeding with the transaction on this basis must be seriously questioned because the escrow amount (contingency sum) of $2.0M was unlikely to be sufficient to recover any significant adjustment in the purchase price. It was also substantially less than the escrow of 20 per cent of purchase price (which would have been $12.0M) or the $10.0M escrow included in the initial offer by the Bank for Oceanic Capital Corporation, dated 25 February 1988. Any larger claims would therefore only be recoverable under the warranties in the sale agreement, which immediately placed the Bank at a disadvantage, because any recovery under warranty would be subject to:
(a) the ability of the Bank to legally enforce the relevant warranty (which has not proven possible in respect of subsequent taxation warranties);
(b) the financial capability of the vendor to honour any warranty obligations which might prove to be legally enforceable (this is of particular importance because, at the time of the transaction, it was publicly believed that the vendor and its related companies were under financial pressure and the Bank had endeavoured to exploit this circumstance in negotiation);
(c) being able to identify the claim within the defined warranty period; and
(d) the costs and time delays involved in enforcing the warranties.
In my opinion, the basis of the transaction was not adequately presented in the Oceanic recommendation for the following reasons:
(a) It was not stated explicitly that the due diligence examination would be undertaken after initial settlement.
(b) The nature, extent, and results of due diligence enquires, to date, (and related limitations pending the advice of consultants, accountants and actuaries) were not explicitly stated.
(c) The extent to which the terms and conditions of the previous "approval in principle" (Board meeting 17 February 1988) had, or had not been, fulfilled were not clearly stated.
(d) The fundamental risks in the transaction and the steps taken to investigate them were not summarised.
(e) The methods adopted to carefully assess the new management team were not explained.
(f) The limited review which had been conducted on future profitability was not explained.
(g) The limited extent of detailed investigation of the respective book values of intangible assets was not discussed, nor were changes in the earlier (16 February 1988) opinion of Mr Copley and Mr Macky on the value of certain key intangibles (Life Agency) reconciled within the Oceanic recommendation of 22 March 1988.
(h) The recommended escrow sum of $2.0M was not justified; nor was it reconciled with:
(i) The $10.0M escrow sum included in the 25 February 1988 Bank offer for Oceanic Capital Corporation.
(ii) The recommendation by Mr Pitcher (KPMG Peat Marwick Hungerfords) on 23 February 1988, that a contingency sum equivalent to 20 per cent of the purchase price (or $12.0M based on $60.0M purchase price) be withheld.
Moreover, the taxation exposures of Oceanic Capital Corporation were not disclosed and explained.
I have received a submission from Piper Alderman, Barristers and Solicitors, on behalf of certain past directors and two present directors (the "Piper Alderman Submission" dated 19 November 1991) which also states that the recommendation to acquire Oceanic Capital Corporation dated 22 March 1988 was received late, and the further recollection of some of the directors for whom they act that it may actually have been received by the Board at its meeting on 24 March 1988. Clearly if this did occur, it is most unsatisfactory communication of such a material transaction, although I am unable to make a firm finding regarding this matter.
Management's perception of the Board was relevant in their consideration of the nature and depth of information to be provided to the directors. It has been stated to the Investigation, by Mr Copley, that information had been provided to the Board on earlier occasions and that the directors had typically shown "no reaction". In his view the Board, at the time of the Oceanic recommendation was "not a terribly ... active Board". Mr Copley's assessment is to be contrasted with that of Mr Clark in respect of another unrelated transaction dealt with in Chapter 18 - "Case Study in Acquisition Management: The United Building Society" ("United Bank"). Mr Clark's comments in respect of the acquisition of United Bank described his assumption of the degree of knowledge of directors. In this context he identified the Board members as including a leading accountant, a leading lawyer and leading businessmen, who would be assumed to identify key commercial considerations and raise relevant questions if any such matters were unclear in Board Papers. Mr Copley asked the Investigation to note that in the intervening period between the time of his comment and that of Mr Clark, the Board had gained a new Chairman and had changed its attitude.
In my opinion, it is the right of a Board - especially the State Bank Board - to expect the submission of papers, in support of recommendations, which are complete, comprehensive, accurate, explicit, relevant, unambiguous and submitted in a timely fashion. It is the role of the executives to ensure, honestly, diligently and objectively that the Board has all the relevant facts in such a form as to enable it to make an informed decision on matters before it. In my opinion, the Board with respect to this particular transaction was not afforded information that met these standards. Accordingly, on the basis of the evidence, I am of the opinion that the executives primarily responsible for the preparation of the Oceanic Capital Corporation related Board Papers, ie Mr Copley and Mr Macky, failed to exercise proper care and diligence in relation to this aspect of the matter.
The information upon which the Board based their decisions was materially deficient in the areas discussed in detail above. The provision of this information was the responsibility of Mr Copley and Mr Macky.
17.4.2 PREPARATION OF SALE AGREEMENT
The following extracts of a facsimile, dated 10 April 1990, from Mr Munton of Westgarth Baldwick's to Mr Copley, recount the circumstances surrounding the preparation and finalisation of the Sale Agreement. The facsimile was prepared in response to an inquiry from Mr Copley when the Bank subsequently discovered that it was not able to recover taxation liabilities (to be discussed below) from the vendor. The facsimile states (in part):
"As you will recall the Agreement for Sale and the Deed of Release were drafted by Freehill Hollingdale and Page acting for APA. Although during the negotiations we requested substantial amendments to the documents (in particular to the warranty provisions) these were rejected by the vendor." [paragraph 3]
"You will also no doubt recall that at a meeting which took place prior to signing of the Agreement for Sale and which included yourself, Andrew Lumsden from this firm and myself [sic]. Our file note indicates that Ian Rischbieth was present for at least part of the meeting. At that meeting we explained to you that we were most unhappy about the form of the document and considered that it potentially left the Bank exposed on a number of issues. Your decision at that time was however that the consideration being paid for the company was below market and therefore you were prepared to accept these risks." [paragraph 4]
Mr Copley advised the Investigation that the short time available to prepare the Sale Agreement (22 to 31 March 1988) did not leave sufficient time to negotiate and incorporate the suggested amendments of Westgarth Baldwick. He was also of the view that a lot of what Westgarth Baldwick was suggesting at that late stage was "point scoring" against their opponents. Mr Copley recalled, however, that a senior Bank solicitor, Mr Rischbeith, was present with him at that meeting for the purpose of ensuring that the settlement documents were satisfactory.
Mr Copley told the Investigation that he could not recall specifically whether he consulted Mr Rischbeith as to whether the documents without the Westgarth Baldwick suggested amendments were satisfactory, but he said that having regard to his practice he would have done so. He said he could recall Mr Rischbeith having an opportunity to look at the suggested amendments, but was unable to recall whether Mr Rischbeith made any comments about them.
Mr Rischbeith has told the Investigation that his involvement in the Oceanic Capital Corporation acquisition as the Bank's legal advisor was minimal, and this was confirmed by Westgarth Baldwick in an interview with the Investigation.
Mr Copley acknowledged, however, that his decision to proceed with settlement of the purchase, notwithstanding Westgarth Baldwick's unhappiness about the form of the document, was based upon the critical factor of timing, namely, that the deal had to be completed and consummated by close of business on 31 March 1988, and because he considered the suggested amendments to be minor.
Mr Copley told the Investigation that he regarded both Westgarth Baldwick and Mr Rischbeith to be the "legal advisors" for the purposes of the Oceanic recommendation which stated that the Sale Agreement be subject to:
"...
4. The preparation of a legal agreement in a form acceptable to our respective advisers incorporating the above conditions and such other terms as are normal in this type of transaction."
This recommendation provided the terms and basis of Bank Board approval for the purchase of Oceanic Capital Corporation.
Neither Mr Rischbeith nor Mr Munton, of Westgarth Baldwick, regarded Mr Rischbeith as falling into the category of "legal advisor" for the purposes of the Oceanic recommendation and having regard to Mr Rischbeith's minimal involvement in the acquisition Mr Copley was not justified in so regarding him.
Mr Copley's decision to reject Westgarth Baldwick's advice and to proceed in the circumstances outlined above was contrary to the Oceanic recommendation.
As a result, the already disadvantaged position of the Bank was worsened because it was left exposed to potentially inadequate warranties in the Sale Agreement.
The comments of Mr Munton, quoted above, indicate that Mr Copley was on notice that the proposed Sale Agreement without the warranties which they regarded as necessary was not in the best interests of the Bank, and the decision to reject their advice was outside the authority given by the Bank Board.
17.4.3 LACK OF FOLLOW UP OF KPMG PEAT MARWICK HUNGERFORDS ADVICE
KPMG Peat Marwick Hungerfords informed Mr Copley of significant issues arising from their investigations and recommended in their letter dated 26 April 1988 that further detailed work was required. The text of that letter (which is reproduced in full below) also implies that future claims under warranties were envisaged at the time, and is consistent with the account of events given by Mr Pitcher to the Investigation.
"26 April 1988
PERSONAL PRIVATE AND CONFIDENTIAL
Mr K Copley
Chief Manager
Finance and Planning
State Bank of South Australia
97 King William Street
ADELAIDE SA 5000
Dear Kevin
I confirm our discussions in Sydney last Friday during the review of our preliminary report and our subsequent telephone conversation on the weekend concerning still further notifiable matters against the Vendor.
Because of the time constraints for next Friday we are finalizing our report in its present state of completion to enable you to impact upon the escrow withheld sum. The nature and quantum of matters being uncovered is such that it is clearly essential, as agreed in our discussions last Friday, that we carry out further in depth examinations of the Oceanic Group and the Managed Funds to be as reasonably satisfied as one could expect to be that all material downsides are identified and brought to account.
As part of the examinations and verifications we carry out following Friday 29 April, we will thoroughly review the management financial statements and reports to 31 March 1988 so as to give you and your Company the appropriate comfort as to the reliability and accuracy of what becomes the starting point for the new owner. This will also substantially assist you in establishing the pre-acquisition starting point. It will provide the measuring base for the performance of the Management Team now responsible to your Company and in doing so the figures we resolve upon for you will have washed away any further opportunity for management to draw on problems or events impacting now but resulting from the past because we will ensure that they are booked as of 31 March 1988.
Sentinel will receive even further attention from us. You are obviously and properly very concerned at what we have uncovered in the structuring, restructuring and disposal of Sentinel to the Life Company. Although we have only had a very brief time to look into the activities of Sentinel from what we have been able to piece together we believe the losses for the full year will be very considerable as set out in our report. Further, that losses will continue into the future. In accordance with your request we will thoroughly appraise the activities of Sentinel and provide you with our view of what the projections should realistically be for the periods ahead. My present view is that immediate consideration should be given to disposing of the business to another party or perhaps to the USA Partner. If a disposal alternative is not available then closure may be appropriate, both to cut losses and to have management concentrate on core business. Even if the losses are finally wound down to a profit in say three years time, there is no evidence at this early stage that ultimate profitability will be of a level sufficient to support the size of the investment having in mind that in two to three years time the investment (losses including the writing off of deferred expenditures) could well be of the order of $10.0M plus.
Turning to the Managed Funds, you will gather from our report that the management companies have not been conducting the affairs of the funds as they should. Our review of the funds and the management thereof will be directed to the fundamental issues of asset existence, fund records and identification and reconciliation of unit holders, distribution procedures and activities, fund reporting, management conduct.
In this short period of three weeks we have now gathered more than enough evidence to indicate that what you are being advised by Oceanic as being in order or under control or provided for - is not in fact the case. I do not wish to imply any intention on Oceanic's part to mislead (I should hope not) but perhaps out of a lack of attention to detail and fully informing themselves on the facts and/or the broader implications of certain actions they have taken before responding to your questions or making authoritative statements.
Finally, following our discussions with your Company's Solicitors in Sydney for clarification of the warranties and escrow clauses of the Contract, I confirm my recommendation that any of the matters we have uncovered which are lacking in specifics due to the need for more time and documentation to get the specifics, such items should not be notified on Friday. All of the definitive issues where you believe a litigation course is not the more appropriate one to take, should be notified because the escrow section of the Contract then ensures that everyone of these items must be dealt with by the expert and a decision made in June. You therefore avoid the pain of long drawn out litigation proceedings. Those items which are not notified on Friday are, according to the advice of your Solicitors, fully claimable under the warranty sections of the Contract provided they are identified within twelve months of March 1988. With regard to the major controversial item of the allocation of the surplus arising from the revaluation of property between the policy holders and the shareholders in the life company ($7,350,000), we are making every endeavour to obtain authoritative third party support of our views so as this item can hopefully become a notified item to be tabled no later than noon on Friday 29 April 1988.
Yours sincerely
Ron [Emphasis Added]"
Mr Pitcher and Mr Copley confirmed with the Investigation that no further work by KPMG Peat Marwick Hungerfords was requested after 29 April 1988, and no further work was performed. Mr Copley, however, stated that he had discussed the issues raised in the KPMG Peat Marwick Hungerfords and Mercers report with Oceanic Capital Corporation management and the external auditors of Oceanic Capital Corporation, Deloitte Haskins & Sells. He advised the Investigation that at the time he had felt that the issues of concern were resolved in these discussions, although with the benefit of hindsight he conceded that adequate follow up had not been performed. He advised the Investigation that the Board was not advised of the contents of either the KPMG Peat Marwick Hungerfords or the Mercers reports.
The Investigation reviewed the correspondence between Mr Copley, APA Holdings, Oceanic Capital Corporation and Deloitte Haskins & Sells in respect of the issues raised by KPMG Peat Marwick Hungerfords in their report of 29 April 1988. This correspondence only revealed a debate over the specific items raised by KPMG Peat Marwick Hungerfords in that report, in the context of disputing the settlement of the escrow sum. In my opinion, that debate did not constitute an investigation, and further examination of the nature and scope recommended by KPMG Peat Marwick Hungerfords in their letter of 26 April 1988, was clearly called for. Mr Copley was unable to recall, in interviews with the Investigation, whether any further work was conducted, and was not able to produce any documentary evidence of further follow-up work.
Mr Clark has stated to the Investigation that if he had become aware of the findings and recommendations of KPMG Peat Marwick Hungerfords in their letter of 26 April 1988 he would have stopped the transaction from proceeding. He stated that he was under the impression that due diligence had been conducted after the original presentation to the Board on 17 February 1988. The basis for this assumption was that there was an understanding that the Board's approval at this meeting was conditional on due diligence having been performed. The submission from Piper Alderman, Barristers & Solicitors, on behalf of certain of the Bank Directors, also asserts this understanding. Mr Macky, in his evidence to the Investigation, was of a similar impression and acknowledged that, with the benefit of hindsight, it was reasonable for the Board when it approved the purchase on 29 March 1988 to have assumed that due diligence had been conducted after its approval in principle on 19 February 1988. Mr Copley was of the view, in his evidence, that there was no basis for the Bank to make that assumption. Mr Macky has, since his earlier evidence, asserted in a submission on his behalf by Finlaysons, that on reflection and with the benefit of hindsight, he believes that the Board should have felt that some due diligence investigations had been completed, but not the entire exercise, otherwise there would have been no need for inclusion of an escrow amount nor to appoint an investigating accountant and actuary.
On the basis of the enquiries and reviews of the Investigation, I have concluded that, in all probability the follow-up of the advice and recommendations of KPMG Peat Marwick Hungerfords was not conducted. In the circumstances of the transaction such work was, in my opinion, clearly called for. In my opinion, this omission is one of the most significant deficiencies of the due diligence process; and, on the basis of the evidence and material available to me, it was Mr Copley's primary responsibility to ensure that it had been completed, and that the Board was informed both of the contents of the consultants reports, and the satisfactory disposal and clearance of all material issues that were raised.
Mr Copley both failed to pursue the further enquiries, and subsequently executed the Deed of Release which released the vendor from the warranty obligations (except for a single taxation warranty) of the Sale Agreement. The Bank management, therefore, not only failed to pursue potential warranty claims, but also placed the Bank in a position where it was no longer able to pursue these matters in the future. It should be emphasised that the Deed of Release was executed within a month of Mr Copley's having been advised by KPMG Peat Marwick Hungerfords to conduct more detailed investigations.
Mr Copley acknowledged, in interviews with the Investigation, that he decided to enter into the Deed of Release without further follow-up action on the issues raised by KPMG Peat Marwick Hungerfords. He further acknowledged that Mr Clark would not have been aware of any recommendations for follow up action at the time the Deed of Release was executed. Mr Clark also denied even being made aware of the findings and recommendations of KPMG Peat Marwick Hungerfords and Mercers.
Mr Copley has told the Investigation that the decision to release the vendors from their warranties was consistent with a "handshake" deal made between Mr Clark and the vendor. He alleged that the understanding was that Oceanic Capital Corporation would be acquired by the Bank on a "walk in - walk out" basis. As he put it, "we bought the company warts and all." The Investigation questioned Mr Clark who denied being involved in negotiations with the vendor, or having made any agreements of the nature referred to by Mr Copley. Mr Clark advised the Investigation that Mr Macky and Mr Copley were responsible for the transaction, and any such decisions would have been made by either one. Mr Macky told the Investigation that although he was not aware of any "handshake deal" made between Mr Clark and the vendor, during the later stages of negotiations Mr Clark had a discussion with Mr Carter, and as a consequence of that meeting there was an increase in the pressure to complete the transaction speedily. Mr Clark acknowledged that he had discussions with Mr Carter, but only in relation to salary packages for senior executives.
17.4.4 RELEVANT CONCLUSIONS
The actions of senior Bank executives responsible for the above decisions were imprudent and lacked competence, in that they unnecessarily exposed the Bank to significant financial risk by the cumulative effect of the following:
(a) The Bank making the investment in Oceanic Capital Corporation prior to conducting any detailed due diligence investigation.
(b) Placing the Bank in a position where subsequent price adjustments could only be readily made against an escrow amount of $2.0M which was not sufficient to cover any material claims relative to an original purchase price of $60.0M.
(c) Placing the Bank in a position where it would have to rely on warranties in the Sale Agreement to recover any claim in excess of $2.0M from the vendor which is necessarily more complicated and difficult to achieve.
(d) Exacerbating the risks of (c) by failing to heed the advice of its lawyers to include adequate warranty protection for the Bank in the Sale Agreement and in doing so, not following the conditions incorporated in the Bank Board approval for acquisition of Oceanic Capital Corporation.
(e) Failing to act on the advice of KPMG Peat Marwick Hungerfords to conduct adequate investigations to identify potential warranty claims.
(f) Agreeing to release the vendor from its warranties under the Sale Agreement in circumstances where they were on notice from KPMG Peat Marwick Hungerfords that significant problems existed in Oceanic Capital Corporation that required further investigation which might reasonably have been expected to identify potential warranty claims against the vendor.
The Board's role is discussed in more detail in 17.7 hereunder.
On the basis of the above mentioned matters, I am of the opinion that Mr Copley and Mr Macky failed to exercise proper care and diligence in carrying out those aspects of their duties referred to above.
17.5 FINANCIAL PERFORMANCE OF INVESTMENT
The Investigation has reviewed and analysed the performance of Oceanic Capital Corporation in order to:
(a) compare the actual performance with the original forecasts included in the Oceanic recommendation, used to justify the acquisition of Oceanic Capital Corporation; and
(b) identify losses incurred by Oceanic Capital Corporation which should have been detected in the Bank's due diligence.
Set out below is a summary of the audited results of the Oceanic Group for the nine months ended 30 June 1988, and the three years ended 30 June 1989, 1990 and 1991.()
|
9 Months |
Years Ended 30 June |
|||||||
Entity/Item |
1988 |
1989 |
1990 |
1991 |
||||
| Oceanic Life Limited Australia New Zealand General Fund |
) ) ) |
|
|
|
|
|||
| Pendock Pty Limited |
(769) |
(320) |
856 |
(93) |
||||
| Oceanic Funds Management Limited |
|
|
|
|
||||
| Oceanic General Limited |
(1,421) |
(556) |
16 |
6 |
||||
| Non-operating subsidiaries |
82 |
7 |
(49) |
(94) |
||||
| Oceanic Capital Corporation Limited |
|
|
|
|
||||
| Group Net Profit/(Loss) After Tax and extraordinary items |
|
|
|
|
||||
|
[sic] |
||||||||
* Oceanic Capital Corporation was formed in August 1987.
The investment in Oceanic Capital Corporation has never achieved the forecast profits presented in the Oceanic recommendation, nor has it ever achieved the 15 per cent per annum return on investment required by the Bank.
I have set out under the following sub-headings, issues arising from the Investigation's review of results for each of the relevant accounting periods described above.
17.5.1 NINE MONTHS ENDED 30 JUNE 1988 ($15.2M LOSS)
This is an important period because it straddles the acquisition date (31 March 1988) of Oceanic Capital Corporation. The loss of $15.2M includes both pre- and post-acquisition profits/(losses) and also includes the write-downs and revaluations made on acquisition of Oceanic Capital Corporation. My review of this period has therefore attempted to identify each such component, and its impact on the reported result.
(a) Pre-Acquisition Results
The Investigation has reviewed the monthly Oceanic Capital Corporation finance reports prepared as Oceanic Board Papers from January to May 1988 and set out below are relevant comments:
|
Month |
Year |
Comments |
|
January 1988 |
3.5 |
This result provided the basis of acceptance of forecast achievement by the Bank management |
|
February 1988 |
2.5 |
This was briefly reviewed by KPMG Peat Marwick Hungerfords during their investigations on behalf of the Bank but not confirmed. KPMG Peat Marwick Hungerfords has recommended in a letter dated 26 April 1988 to Mr Copley that they be engaged to verify the management reports at 31 March 1988 to "give you [Mr Copley] and your Company the appropriate comfort as the reliability and accuracy of what becomes the staring point". The investigation was advised by Mr Pitcher that KPMG Peat Marwick Hungerfords did not receive further instructions from Mr Copley to conduct this work. |
|
March 1988 |
2.4 |
This trading profit subsequently become a trading loss of $1.2M after $3.6M of additional expense accruals were booked. |
|
April 1988 |
N/A |
Mr Reichert advised that a finance report probably was not prepared because Oceanic Capital Corporation management would have been distracted by the acquisitions process. |
|
May 1988 |
2.6 |
The $3.6M adjustments for additional expenses had not been recorded at this stage, therefore the management accounts imply that $0.2M in additional net profit had been recorded since March 1988. |
(b) Post-Acquisition Results
The finance report for June 1988 prepared for the Oceanic Capital Corporation Board of Directors did not provide the usual year to date trading result analysis for group operations. It did, however, note "Indications are that the Group will make a profit of approximately $3.1 million for the 3 months ended 30 June 1988." [emphasis added]
It should be noted that the three months ended 30 June 1988 is an important period because any profit or loss for Oceanic Capital Corporation from 31 March 1988 onwards (ie post-acquisition results) would be consolidated in the State Bank Group results in accordance with generally accepted accounting principles. Indeed, the Bank's 1988 Annual Report disclosed a $3.1M profit contribution from the Oceanic Group, which would only include Oceanic Capital Corporation results for the three months ended 30 June 1988 (the post-acquisition period). I question the accuracy of the reported result, and believe there is a likelihood that the $3.1M profit for the three months ended 30 June 1988 included some portion of pre-acquisition profit for the following reasons:
(i) The May 1988 finance report indicated only $0.2M of profit had been earned in the two months from 31 March 1988 which therefore implies that the majority of the $3.1M profit was generated in June 1988.
(ii) It is unlikely that a $3.1M profit for Oceanic Capital Corporation could have been generated in a single month given the historical and forecast levels of profitability.
(iii) A handwritten file note of Mr Copley was attached to a version of the March 1988 balance sheet included in a memorandum from Mr Reichert dated 24 June 1988. This note referred to adjustments of $3.0M to the March 1988 accounts which indicated that some provisions had been made with the effect of transferring pre-acquisition operating profit into post-acquisition operating profit to be recognised prior to June 1988. This notation is made in the following terms:
"Timing Differences
1. Approx $3M to be brought back June 88."
(iv) In meetings with the Investigation, Mr Copley confirmed his practice of establishing pre-acquisition provisions for reversal into post-acquisition profit and confirmed that this occurred in relation to Oceanic Capital Corporation. Whilst he could not confirm that the accounting entries had been made, he did agree that, based on the file note referred to above, the profits of the Bank earned from trading had been overstated by $3.0M in the year ended 30 June 1988. The auditors have submitted that, given the lack of precision involved in apportioning profit, the post-acquisition profit was acceptable for audit purposes.() I accept that any mis-statement in post-acquisition profit of Oceanic would not have been material in itself in relation to the Bank Group's profit for the year.
Mr Reichert has reviewed the additional amounts booked as expenses at 31 March 1988, and provided an analysis of each item included in the $3.6M amount. Although this analysis has given some background on the underlying nature of the accruals, it is not sufficient to confirm the extent to which the results for the three months ended 30 June 1988 included pre-acquisition profit. This matter requires review in order to determine whether there were reasonable grounds upon which to confirm the accuracy of the reported post-acquisition profit. This review has been conducted in the context of the external audit review pursuant to Term of Appointment B.
The deliberate inclusion of pre-acquisition profits in the post-acquisition results would raise the following significant issues:
(i) The prospective overstatement of the reported net profit after tax of the State Bank Group for the year ending 30 June 1988 by the inclusion of Oceanic Capital Corporation pre-acquisition profit in the post-acquisition results for 1988.
(ii) Doubts as to the underlying authenticity of the Bank accounts generally.
(iii) On the basis of what was done, whether the actual lack of profitability of Oceanic Capital Corporation for the three months to 30 June 1988 should have alerted Bank management to the possibility that the forecast profitability for Oceanic Capital Corporation was not achievable.
On the other hand, if a significant portion of the $3.6M of expenses actually were incurred in the six months to 31 March 1988, then it follows that the pre-acquisition results reviewed in the due diligence process were, in fact, substantially overstated. If this were so, then the premise for Bank management's accepting the achievability of the 1988 forecast (ie the reported year to date profits of $3.5M at 31 January 1989) was also incorrect. In my opinion, such an overstatement of profit is likely to have been detected in due diligence if the review had included an analysis of year to date results. In this context, I note that KPMG Peat Marwick Hungerfords were not requested to pursue such further investigations, despite the recommendations to that effect in paragraph 3 of their letter of 26 April 1988. In my opinion, had such due diligence reviews been adequately and competently performed then doubts over the achievability of forecasts would have arisen.
On the basis of the matters referred to above, I am of the opinion that a significant portion of the post-acquisition result for the three months ended 30 June 1988 was, in reality, attributable to pre-acquisition earnings. This approach is contrary to generally accepted accounting practice.
(c) Impact of "One-Off Items" on Reported Result for Nine Months Ended 30 June 1988.
The Oceanic Capital Corporation reported loss of $15.2M for the nine months ended 30 June 1988 was influenced by the following "one-off" items, which should be excluded from the results to identify "normal" operating profit for the period:
| Item | $M |
| (i) Adjustments to asset values as identified by the Bank in order to establish an opening balance sheet for Oceanic Capital Corporation (referred to as "acquisition adjustments") |
| . Adjustments to GAAP reserves
- elimination of policyholders share of unrealised property gains |
(7.8) |
| - overstatement of deferred acquisition costs | (2.4) |
| - increase in liabilities | (3.0) |
| . Write-down of Life Licence | (0.5) |
| . Write-down of value of Agency network | (3.9) |
| . Write-off of goodwill | (1.3) |
| . Write-down of investments | (0.8) |
| (ii) Other items not attributable to normal operating profit |
| . Profit on sale of subsidiary (Credit Card Sentinel Pty Limited) | 3.2 |
| . Over provision of prior year income tax
Total |
1.1
(15.4) |
By excluding the "one-off" items identified in the analysis above from the reported loss of $15.2M, it may be interpreted that the Oceanic Group actually only recorded a marginal profit for the nine month period. If this was, indeed, the case, it is impossible to accept the $3.1M profit reported for the three months ended 30 June 1988 further supporting the suspicion that there has been a shifting of pre to post-acquisition profit in this period.
17.5.2 YEAR ENDED 30 JUNE 1989
In the year ended 30 June 1989 Oceanic Capital Corporation achieved a net profit (after tax) of $1.5M. This compared with a budgeted net profit for the same period of $8.2M. The budget for the year ending 30 June 1989 was not significantly different from the forecast for the year ending 30 September 1989 contained in the Oceanic recommendation. An Oceanic Capital Corporation Board Paper prepared by Mr Purvis, Managing Director, dated 15 August 1989 provided an analysis of the causes for the unfavourable result against budget, and identified the following significant one-off items. The items are quoted from the Board Paper in the table below:
".....
|
Effect |
||||
|
1. |
a. | Write-off of agent loans accumulated over the last ten years or so. |
(900) |
|
| b. | Stamp Duty assessed for the period 1984-87 and not covered by warranties given to State Bank by APA Holdings |
(949) |
||
| c. | Change in basis of valuation of policy reserves for Australia. |
(1,271) |
||
| 2. |
a. |
Effect of weaker NZ dollar on translated value of surplus. |
(1,340) |
|
|
b. |
Release of Section 50 reserves. |
3,900 |
||
|
c. |
Change in basis of valuation of policy reserves for NZ. |
(1,324) |
||
|
4. |
Pendock realised losses, funding costs and unrealised losses. |
(3,265) |
||
|
6. |
Effect of the unbudgeted investment advisory success fee. |
1,200 |
||
|
$(3,949) |
||||
..."
The Managing Director's report noted that Oceanic Capital Corporation had reduced the number of agencies "from over 750 to less than 50".
The rationalisation of the agent network raises a separate issue, namely, that some doubt would have to be cast over the carrying value of the agency network at 30 June 1989, which had been carried forward as an intangible asset at $13.5M. Mr Copley advised the Investigation that he raised this issue at an Oceanic Capital Corporation board meeting, and was told that there was significant worth in the Returned Servicemens League connection and no adjustment was warranted. The value attributed to the Agency network was reviewed prior to the acquisition, and was originally assessed by Mr Copley and Mr Macky to have no value. As previously discussed, the final purchase accounting entries did not reflect this write-down. The life agency network has subsequently been written off in the year ended 30 June 1991.
The Investigation requested Mr Reichert to provide details of the change in the basis for the valuation of policy reserves in Australia and New Zealand (items 1(c) and 2(c)). Mr Reichert advised that the valuation revision related to subsequent reviews of anticipated expense levels, bonus rates, and interest rates, which were not envisaged at the time of preparing the budget.
The release of Section 50 (Life Insurance Act 1945) reserves noted at item 2(b) relates to the release of an accumulated surplus in the New Zealand statutory fund. This represented a change in Company policy, whereas previously Oceanic Capital Corporation recognised its share of the New Zealand insurance reserve in accordance with Australian statutory limitations. This change in policy was not anticipated in the budget.
The losses referred to in item 4 relate to a subsidiary of Oceanic Capital Corporation, Pendock Pty Limited ("Pendock"). I understand from interviews with Mr Copley and Mr Reichert that Pendock was acquired as a "shelf company" in May 1988 to acquire, at book value, certain non-performing investments (known as "dog stocks") from equity unit trusts managed by Oceanic Capital Corporation. Mr Copley advised me that this arrangement was entered into in order to improve the performance of the Oceanic Capital Corporation unit trusts and hence attract new investor interest.
Oceanic Capital Corporation Board Papers and Bank Lending Credit Committee papers indicate that a $40.0M facility was established with the Bank to fund Pendock's acquisitions, of which approximately $20.0M was drawn down. Mr Copley told the Investigation that this was provided by the Bank as an indication of good faith and to demonstrate the Bank's support to Oceanic Capital Corporation. It was his understanding that the $20.0M was to be used to remove some of the "dog stocks" out of the company and to better the performance of those funds.
The Investigation questioned Mr Reichert on the intended purpose and function of Pendock in the Oceanic Group. In particular, Mr Reichert was requested to:
(a) explain why Pendock acquired units in trusts managed by Oceanic Capital Corporation;
(b) provide details on the losses incurred by Pendock; and
(c) state whether the Bank Lending Credit Committee was aware of these activities.
Mr Reichert advised the Investigation as follows:
(a) Pendock was also established to enable Oceanic Capital Corporation to invest in various unit trusts managed by Oceanic Capital Corporation. These investments were "to act as a defence against a potential attack on the management contract rights by ex executives and to provide the trusts with critical mass". Mr Reichert provided an analysis showing that Pendock (Oceanic Capital Corporation ultimately) realised approximately $0.39M of losses on these investments (excluding funding costs, ie costs in borrowing the money to acquire the funds).
(b) Pendock purchased non-performing investments from equity trusts managed by Oceanic Capital Corporation and ultimately realised approximately $1.6M in losses attributable to these investments (excluding funding costs).
(c) He was not able to state when the Bank's credit management became aware of the investment in the Oceanic Unit Trust, but noted that he would have expected Mr Ottaway to have informed the Bank of the situation as Mr Ottaway was both a member of the Bank Credit Lending Committee and a director of Oceanic Capital Corporation at the time.
It would be reasonable to expect that losses attributable to equity investments transferred from the unit trusts should have been identified in the due diligence process. Furthermore, it would have been reasonable to expect the due diligence investigation to have identified the relative under-performance of the Oceanic Capital Corporation equity unit trusts to be a cause of the redemption rate. As discussed later in this report, management of Oceanic Capital Corporation had attributed the decline in funds under management to Oceanic Capital Corporation's association with the vendor and this explanation had been accepted by the Bank's management. The due diligence investigations undertaken by the Bank were deficient in that they relied on Oceanic management representation, without making adequate additional independent enquiries to confirm the accuracy of these representations.
Mr Reichert, in a letter dated 5 September 1991, informed the Investigation that the unbudgeted investment advisory fee of $1.2M (Item 6) related to a success fee paid to Oceanic Funds Management Limited ("Oceanic Funds Management") by Oceanic Life Limited. He advised the Investigation that Oceanic Capital Corporation had not budgeted for the advisory fee because it included an element related to investment performance which was considered as too uncertain for budget purposes at the time the budget was originally set.
The extraordinary or one-off items discussed above accounted for $3.9M of the unfavourable variance from budget in 1989. The causes of the balance of unfavourable variances was not reported on in detail in the Oceanic Capital's Managing Directors' Report, apart from the poor performance of the Australian Statutory Fund, which is quoted below:
"Australian Statutory Fund Operations
. Even after allowing for the extraordinary items, operating profit was $4.019m vs budget of $6.650m. This primarily reflects the poor sales results for insurance bonds and the fact that the original budget was much too optimistic."
In summary, in my opinion, the actual results for 1989 indicate the 1989 budget of $8.2M was unlikely to have been achievable because:
(a) The actual profit result was supported by significant unbudgeted items, namely:
(i) Release of New Zealand insurance reserves, $3.9M; and
(ii) Unbudgeted success fee $1.2M.
which largely offset the unbudgeted expense items of the valuation of policy reserves and unfavourable New Zealand exchange rate;
(b) The result was affected by losses, which in my opinion should have been foreseen in advance, including:
(i) Pendock losses (although the extent relating to pre-acquisition investments is not known); and
(ii) Write-off of agent loans and additional stamp duty.
(c) The initial budget was unrealistic. The Managing Director has subsequently acknowledged that the budget for the Australian Statutory Fund was "too optimistic".
17.5.3 YEAR ENDED 30 JUNE 1990
The net profit of $4.2M in 1990 compared with a budget of $4.4M. The financial statements of Oceanic Capital Corporation disclose that the 1990 result included the following significant items:
[insert table here
In the absence of other identifiable items, it would appear that a significant portion of the 1990 profit relates to the transfer of a tax loss, which is not considered an operating item. It would therefore appear that Oceanic Capital Corporation was not able to match its initial forecast level of profitability although it must be acknowledged that forecasts prepared in 1988 would be of limited relevance in 1990 because of the impact of subsequent events not capable of forecasting in 1988.
17.5.4 YEAR ENDED 30 JUNE 1991
Mr Reichert provided an analysis of the 1991 loss, which is summarised in the table below:
| Description of Loss Item | $M | Comments |
| Operating Loss | 0.1 |
| Loss as a result of investing in Oceanic Property Growth Trust units. | 32.4 | Oceanic Capital Corporation subscribed for $40.0M of Oceanic Property Growth Trust units in order to repay Westpac borrowings in the trust. The losses include loss in value of units, funding costs and losses on negatively geared loans to investors. These were loans provided by Oceanic Capital Corporation to enable people to purchase units in the Unit Trust. |
| Loss as a result of providing for guarantees to unitholders and policyholders. | 7.4 | Of this amount, $3.1M relates to the indemnity provided to the statutory fund in respect of Credit Card Sentinel. The unprofitability of Credit Card Sentinel was brought to the attention of Bank management sometime in April 1988 when Mr Copley consulted Mr Pitcher. |
| Loss as a result of writing off the Life Insurance Licence, the life agency network and the unit trust management contract. | 31.5 | As previously discussed, doubts had been raised over the value of these intangible assets in the due diligence investigation. |
| Loss as a result of additional tax assessed on the sale of the Martin Place property. | 1.5 | This exposure had been brought to the Bank's attention by the vendor and KPMG Peat Marwick Hungerfords in their due diligence inquiries. This matter is discussed in greater detail in subsequent Sections of this Chapter. |
| Loss as a result of altering assumptions in GAAP model. | 10.4 | This has arisen due to a reassessment of the expense assumptions on policies and a re-allocation of assets between participating and non-participating policies. |
| 83.3 |
The losses described above arise from a combination of factors in existence at the date of acquisition and factors arising post-acquisition. The exact quantum of all losses attributable solely to factors which could/would have been identified through a comprehensive due diligence examination as at acquisition date cannot be specifically separated from the contribution of subsequent events to the same losses. The items with respect to which there is evidence that management had been put on notice on or about the date of acquisition include:
(a) The unprofitability of Credit Card Sentinel, although with respect to this matter Mr Copley says that despite its unprofitability Mr Clark wanted it to continue to operate, as he saw opportunities for synergistic benefits with the retail operations of the Bank. Mr Clark denied this and said that, although Credit Card Sentinel may have been discussed, it would have been in the context of the Oceanic Board and not the Bank.
(b) The values of intangible assets.
(c) The taxation exposure in respect of the Martin Place property sale.
I am of the opinion that in all of the above cases, if the investigation ultimately conducted by the Bank had been made prior to the acquisition of Oceanic Capital Corporation on 31 March 1988, those investigations were likely to have revealed the prospect of future losses in respect of these items. Timely detection of these issues would have enabled appropriate action to have been taken.
17.6 EFFECTIVENESS ASSESSMENT: THE BANK'S DUE DILIGENCE PROCESS AS APPLIED TO OCEANIC CAPITAL CORPORATION
17.6.1 BUSINESS FUNDAMENTALS AND RISK ANALYSIS
In assessing the adequacy of the due diligence investigation of Oceanic Capital Corporation, the Investigation has reviewed the stated strategic objectives of the Bank and financial criteria described above. The Investigation has also reviewed the information on Oceanic Capital Corporation made available to the Bank at the time.
On the basis of the Investigation's review, an assessment of the business fundamentals of Oceanic Capital Corporation has been prepared around which a due diligence investigation should have been performed in order to ensure:
(a) financial and strategic objectives were capable of being met by the investment; and
(b) all material risks and exposures were identified.
The Oceanic recommendation clearly states the key strategic goal of the Bank was to acquire a funds management capability. Therefore, any due diligence examination would need to confirm the funds management and organisation capability of key personnel. Furthermore, the Bank had set performance standards for its investments, and the due diligence examination should have confirmed whether Oceanic Capital Corporation was financially capable of achieving those objectives. Finally, the due diligence examination should have addressed the underlying financial condition of Oceanic Capital Corporation to confirm that any past association with the vendor would not jeopardise the ability of Oceanic Capital Corporation to meet the required objectives of the Bank.
The fundamental issues which are relevant in the acquisition of Oceanic Capital Corporation are:
(a) volume of funds under management;
(b) quality/retention of key staff including funds managers;
(c) quality of reporting systems;
(d) insurance company issues;
(e) financial review; and
(f) reputation/circumstances of vendor.
The Investigation itemised the detailed investigations and inquires which would have been necessary to adequately resolve the key due diligence issues described above. The detailed due diligence steps referred to above in items (a) to (f) were provided to Mr Copley, who was requested to advise the Investigation whether or not the specific steps had been considered by the Bank in its due diligence. It is against this criteria, of the detailed due diligence examination, that the Investigation has compared and evaluated the due diligence conducted by the Bank. The Investigation's findings are discussed below.
17.6.2 VOLUME OF FUNDS UNDER MANAGEMENT
(a) Definition and Applicability of this Item to the Due Diligence Process
The objective of this analysis is to confirm the security of the revenue and forecast earnings growth of the funds management business of Oceanic Capital Corporation both of which are dependent on the maintenance and growth of the existing funds under management at the date of acquisition.
Because a key strategic objective of the Bank was to acquire a funds management capability, it was clearly essential that the due diligence investigation should have adequately confirmed the existence of the desired funds management capability which would have been necessary to both retain and expand the volume of funds managed. Given also, that the assessment of the purchase price appears to have been primarily based on the net asset backing of Oceanic Capital Corporation, which included management rights valued at $19.2M, it would, in my opinion, have been critical for the management of the Bank to have thoroughly reviewed the funds management business of Oceanic Capital Corporation, and confirmed the basis for the valuation of management rights, which was, in turn, dependent on at least the maintenance of the volume of funds under management.
The Investigation's review of the Information Profile of Oceanic Capital Corporation (the background memorandum on Oceanic Capital Corporation, prepared for the purposes of the sale dated 10 December 1987, and prepared by the management of Oceanic Capital Corporation) and the Oceanic recommendation revealed that:
(i) Funds under management were in decline at the date of acquisition (Oceanic recommendation Attachment 2 disclosed that funds under management declined from $527.0M at 31 May 1987 to $376.0M at 31 December 1987).
(ii) The management team was relatively new and untried in Oceanic Capital Corporation, although, as submitted by Mr Copley, their backgrounds indicated experience in funds management and life insurance.
(iii) The stockmarket crash of 1987 would have caused a rundown in equity funds and would also have threatened other relatively high risk profile investment products.
When considering the $19.2M valuation placed on the management rights of Oceanic Capital Corporation, I believe it would have been logical to endeavour to reconcile this valuation with the following important business circumstances:
(i) The worth of the management rights were directly related to the performance of the funds under the present management team employed by Oceanic Capital Corporation. At the date of acquisition, the key management of Oceanic Capital Corporation had only been recruited within the previous six months, and therefore did not have a proven performance record at Oceanic Capital Corporation. The senior management identified in the Oceanic recommendation were:
. Mr J Purvis, Chief Executive and Managing Director;
. Mr I Brown, Deputy Managing Director;
. Mr W Hawkins, Chief Investment Officer;
. Mr G Talbot, Director of Sales and Marketing; and
. Ms A West, Development and Service Manager.
(ii) The results of the Oceanic funds management company, reported in the Oceanic Finance Report (an Oceanic Board Paper) for the six months ended 31 March 1988, indicated that it was operating at below a break-even level (I further note that Mercers in their report, dated 6 April 1988, advised the Bank management that with respect to Oceanic Capital Corporation there were foreseeable losses of approximately $1.2M per annum).
(iii) The Information Profile revealed little objective evidence to support the growth expectations in the forecast generally, and particularly in relation to funds management.
In my opinion, these factors would not have supported the funds management rights valuation at $19.2M (upon which the acquisition price was based in part), and would normally have led to a more detailed scrutiny of the valuation basis and its probable write-down.
(b) Specific Actions Required
Having regard to the above, I would have expected the due diligence process to have included the following significant steps:
(i) Review the asset composition and related performance of each fund under management, and compare the position against general industry trends.
(ii) Identify the funds experiencing recent decline, and obtain full explanations for the underlying causes, in particular, identifying the impact of the October 1987 stockmarket collapse.
(iii) Analyse the business plans and forecasts of Oceanic Capital Corporation, and identify the sources of assumed growth in funds under management. This should then have been compared with industry trends and assessments of opportunities, threats, market share and key strengths of competitors. Furthermore, to the extent that forecast growth was anticipated to be derived from new product launches, the due diligence examination would have to confirm the basis and appropriateness of the reliance on new products.
(c) Specific Actions Performed and the Shortcomings of the Bank's Due Diligence
Interviews with Mr Copley and Mr Macky indicated that this aspect of the review was primarily the responsibility of Mr Macky. Although Mr Macky stated that he would have expected file notes of his interviews to have been retained, the Investigation has, despite searches being undertaken, been unable to locate these documents. The Investigation has reviewed handwritten notes made by Mr Copley on the Information Profile, which do not provide detail on the questions and answers raised on these interviews. I have therefore based my assessments on the representations made by Mr Macky and Mr Copley in interviews with the Investigation.
Mr Macky and Mr Copley have stated in interviews with the Investigation that they basically accepted the representations of management of Oceanic Capital Corporation, who attributed the decline in funds under management to the loss of investor confidence arising from the Oceanic Capital Corporation association with the vendor. They accepted that the growth expectations in the funds under management were largely based on the renewal of investor confidence after the association with the vendor was discontinued. I acknowledge, as has been pointed out by Mr Copley, that following the acquisition, there was a fall in the Australian economy which would have contributed to the decline in funds under management.
Information reviewed, however, indicates that this aspect of the due diligence process was not adequately performed. No evidence has been provided by Mr Macky or Mr Copley, nor discovered in their document files to indicate that the Bank team had fully explored the relative performances of the Oceanic Capital Corporation funds. This area was not pursued, and the due diligence team failed to identify other critical factors causing a decline in funds which ultimately had to be rectified at the cost of the Bank.
In particular, investments of the managed funds, other than the statutory insurance funds, had not been independently valued. Mr Copley has indicated in his interviews with the Investigation that soon after the acquisition of Oceanic Capital Corporation the Managing Director, Mr Purvis, explained to the Oceanic Capital Corporation Board that one of the causes for the decline in funds was due to performance problems arising from the presence of pre-crash non-performing investments. These investments were generically referred to as "dog stocks". The Oceanic Capital Corporation Board took corrective action by creating a new subsidiary, Pendock, into which were transferred (at book value) the "dog stocks" of the managed funds. Losses realised on these investments were therefore directly incurred by Oceanic Capital Corporation, and not the unitholders of the funds.
These losses could have been anticipated through due diligence enquires which should have established the major causes for the declining funds under management. The reviewers should not (and it would not be normal practice to) have relied solely on the representations of management regarding the influence of the association with the vendor on the level of funds under management. The fund performance issue could have been identified by statistical analysis comparing the relative performance of Oceanic Capital Corporation unit trusts against its competitors. Furthermore, the problem may also have been identified by reviewing the investment portfolios of the funds under management.
On the basis of the matters referred to above, I am of the opinion that Mr Copley and Mr Macky failed to exercise proper care and diligence in assessing the volume of funds under management.
17.6.3 QUALITY AND RETENTION OF KEY STAFF
(a) Definition and Applicability of this Item to the Due Diligence Process
The key objective of this step is to appraise the skill and ability of key management and assess the likely retention of key individuals upon whom growth and related profitability was seen to depend.
As such, the due diligence investigation would need to assess and evaluate the key skills of the relevant management in the conception of products, possibly measured by their past achievements in funds management, generally, and in product conception and launches, in particular. The process, would also assess the basis of remuneration and other benefits, career history, and any employment contracts.
The acquisition price for Oceanic Capital Corporation implied a substantial intangible value for the management capabilities in Oceanic Capital Corporation, whereas the Information Profile indicated that the management were a relatively new team. The due diligence examination would accordingly focus on confirming the management performance and capabilities of key individuals, and assessing whether their skills were both relevant for Oceanic Capital Corporation and supported the forecast funds management performance for which they would be largely responsible. In particular, the due diligence examination of key Oceanic Capital Corporation personnel would normally have confirmed:
(i) Whether they had acted in similar positions of authority and responsibility?
(ii) What results had been achieved?
(iii) Whether they had been instrumental in developing funds management growth and performance in post stockmarket crash conditions?
(iv) Whether they had management styles compatible with the nature of the intended future operations of Oceanic Capital Corporation and the Bank?
Having identified which individuals were important to the future operations, the due diligence team would then normally judge whether the Bank would be capable of retaining them, or, alternatively, assess the cost of their termination and replacement.
(b) Specific Action Required
In order to achieve the above objectives the due diligence enquires would need to have considered:
(i) The resumes and references of all senior management.
(ii) The compatibility of management's business plans and stated proposed innovations for the organisation with the skills and experience of the senior management.
(iii) The management style and its compatibility with both the needs of the organisation post-acquisition and the management style and operations of the Bank.
(iv) The costs of terminating unwanted management and availability of replacements.
(v) The adequacy and appropriateness of existing remuneration and employment conditions.
(vi) The vulnerability of the Oceanic Capital Corporation business prosperity to key individuals.
(vii) Actuarial valuation of the superannuation fund.
(viii) The adequacy of Oceanic Capital Corporation recruitment and training policies in relation to specialised and senior staff.
(c) Specific Actions Performed and the Shortcomings of the Bank's Due Diligence
It is difficult to objectively assess, in detail, the adequacy of the due diligence performed in these areas. The investigations were largely performed by direct interviews between the senior management of the Bank including Mr Macky, Mr Copley and Mr Clark, and the senior management of Oceanic Capital Corporation. The Investigation has reviewed the files retained by Mr Macky, Mr Copley and Mr Clark, but have not located any records of these interviews, and, according to Mr Copley, it was not usual for such notes to be made or retained. Mr Clark has told the Investigation that his involvement was limited to speaking to senior management of Oceanic Capital Corporation only in relation to salary packages in order to ensure confidentiality.
There is, however, evidence (ie, specific service agreements with Mr Purvis and Mr Brown executed contemporaneously with the Sale Agreement) confirming that the executive option scheme of Oceanic Capital Corporation was fully renegotiated, along with other employment terms and conditions of key management, to be on a basis compatible with and acceptable to the Bank.
Furthermore, there is evidence that Mercers were engaged to perform an actuarial assessment of the superannuation fund and confirmed its surplus.
I note from the Investigation's interview with Mr Macky that, in his opinion, the most significant weakness in the due diligence investigation of Oceanic Capital Corporation was not obtaining third party references for the key Oceanic Capital Corporation management. Mr Macky advised the Investigation that the major problems of Oceanic Capital Corporation were attributable to the performance of key management, who did not meet the expectations of the Bank. Whilst third party references for senior incumbent management are not necessarily sought as a matter of course during due diligence investigations, the recent recruitment of the Oceanic Capital Corporation management team and their importance to the ongoing performance of Oceanic Capital Corporation (and achievement of the Bank objectives), should have led to more exhaustive enquires than those of which evidence is available.
There were also other areas of the Oceanic Capital Corporation due diligence investigation which flagged questions over the quality of management, and, in my opinion, should have led to a more comprehensive independent assessment of the management. Had these issues been pursued, the shortcomings of management are likely to have become apparent to the due diligence team. Such issues would include:
(i) The unreliability of management records and weaknesses noted by KPMG Peat Marwick Hungerfords in their correspondence 26 and 29 April 1988.
(ii) The sale of Credit Card Sentinel to the statutory fund, which potentially prejudiced the interests of the statutory fund policyholders and was generally questioned by KPMG Peat Marwick Hungerfords and the Bank. I do, however, note that Mr Copley says that he raised the propriety of this with a senior insurance auditor in Sydney who assured him the practice was quite common amongst insurance companies.
(iii) The questions raised by Mercers over the business plans of the fund management operation in their report of 6 April 1988, also raised questions over the ability of management to realistically budget and plan for the operations of Oceanic Capital Corporation.
(d) Losses Arising from the Non-Execution of Identified Actions
It is not possible to explicitly attribute any dollar value loss to shortcomings in this due diligence area.
17.6.4 QUALITY OF REPORTING SYSTEMS
(a) Definition and Applicability of this Item to the Due Diligence Process
The key objective of this step is to determine the effectiveness of management by reference to the information and control systems, that have been implemented within the organisation.
Evidence of unreliable management reports, delays in processing or accessing information, and general lack of organisation can indicate that one or more of the following situations can apply:
(i) Efficient and competent business management is not possible because timely and useful business information is not available.
(ii) Management are not controlling the business because they are not capable of identifying problems revealed in the management information.
(iii) Management are ineffectual at addressing fundamental organisational problems.
Similarly, the quality of reporting systems reflects on the reliance, particularly during the financial due diligence review, which can be placed on the systems and their output.
(b) Specific Actions Required
The specific steps involved in satisfying these objectives would be to:
(i) Identify the key management reports of Oceanic Capital Corporation and confirm that the timing and detail of the reports were relevant and appropriate to the management needs.
(ii) Identify major internal controls, and assess whether they were operating effectively (eg ensuring that all the items appearing on exception/error reports were being followed up and properly actioned on a timely basis).
(iii) Determine whether the reports were considered reliable or beneficial by the relevant users within the management.
Weaknesses in this area can evidence themselves in many ways, including:
(i) Evidence that numerous versions of key reports are required before being finalised (eg month end trading statements, budgets etc).
(ii) Evidence that management rely on alternate sources for key operational information other than that generated by their own systems.
(iii) Evidence that management reporting is only performed on an ad-hoc basis rather than on an organised, systematic approach.
(iv) Evidence of surplus and unnecessary reports produced by the management information systems.
Given the nature of the funds management business, the due diligence review would also need to ensure that the necessary statutory registers and records are being properly kept.
(c) Specific Actions Performed and the Shortcomings of the Bank's Due Diligence
Mr Copley and Mr Macky stated in the interviews with the Investigation that they briefly reviewed this area. Mr Copley acknowledged, however, that "the management review process was not extensively looked at". He stated in interviews with the Investigation that, in his opinion, it was not necessary to exhaustively cover this aspect of due diligence because any systems-related problems could be properly assessed and rectified after the acquisition.
In my opinion, this aspect of the due diligence investigation was inadequately addressed and Mr Copley's comments above indicate his failure to appreciate the full ramifications of weaknesses in the control systems. The management of the Bank received adequate notice from KPMG Peat Marwick Hungerfords in their draft report dated 21 April 1988, their letter dated 26 April 1988, and the final report dated 29 April 1988, of the serious management systems problems. The KPMG Peat Marwick Hungerfords letter of 26 April 1988 strongly recommended further examination of management reports and other affairs of the Oceanic Group. They specifically referred to the unreliability of the management accounts. I believe that the lack of follow-up on these important recommendations was a major failing of the Bank's due diligence, irrespective of it being conducted after initial settlement on 31 March 1988.
I believe that, in failing to conduct this follow-up, Mr Copley failed to make the connection that:
(i) The year to date profit, which was used by Bank management to confirm the achievability of the 1988 forecast and to support the value of the Oceanic Capital Corporation business and price paid, was uncertain because of the underlying unreliability of the management accounts.
(ii) The Oceanic Capital Corporation management ability was questionable, given the evidence of the poor condition and unreliability of the financial records.
(d) Losses Arising from the Non-Execution of Identified Actions
In my opinion, had the recommendations of KPMG Peat Marwick Hungerfords been acted upon there would have been a high probability that:
(i) The true financial position of Oceanic Capital Corporation would have been revealed, and the year to date profitability placed under more detailed scrutiny.
(ii) The achievability of the forecast for 1988 and 1989 may have been subject to more thorough examination.
(iii) Management deficiencies (as referred to earlier) would have been exposed.
Clearly these shortcomings contributed to the losses ultimately incurred, but particular levels of loss cannot be reliably attributed to any individual shortcoming in the review of management systems. These observations also confirm, as in other Chapters of this Report, the shortcomings and risks obviously inherent in purchasing a business before due diligence has been completed.
On the basis of the matters referred to above, I am of the opinion that Mr Copley and Mr Macky failed to exercise proper care and diligence in assessing the quality of reporting systems. Furthermore, I am of the opinion that Mr Copley failed to exercise proper care and diligence in failing to follow up on the advice given by KPMG Peat Marwick Hungerfords.
17.6.5 FINANCIAL POSITION OF INSURANCE COMPANY
(a) Definition and Applicability of this Item to the Due Diligence Process
The objective of this step is to determine the actuarial stability of the insurance businesses conducted by Oceanic Capital Corporation, as follows:
(i) Determining the adequacy of insurance reserves.
(ii) Identifying key vulnerabilities in the valuation of reserves and the related impact on profit recognition.
The Actuary's Report on the Financial Condition of APA Life Assurance as at 30 September 1987 (signed by Mr J A Broderick, Chief Actuary, APA Life Assurance) noted that:
(i) The company had been enjoying substantial investment returns which "masked" expense losses. The expense losses were considered to be due to the company falling below the minimum size necessary to support the traditional distribution system.
(ii) The company needed to upgrade its insurance products and its distribution system.
(iii) The company had substantial reserves in relation to the in-force business.
(iv) If the high investment returns fell, profitability of the Life Company would be particularly affected because of the high expense levels (a key vulnerability).
(b) Specific Actions Required
In order to address this objective I would have expected the due diligence investigation to incorporate expert and independent actuarial advice. The actuaries would be required to review the past actuarial assessments of the insurance businesses, and provide their own up-to-date assessment.
Furthermore, the actuary should have been requested to confirm that all insurance businesses had complied with the necessary regulations, particularly in respect of profit recognition, and to ask the Insurance and Superannuation Commission to determine whether there were any concerns held over the various insurance companies in the Oceanic Group.
The actuary would also be able to advise on the value ascribed to the insurance business and described as intangible assets on the Oceanic Capital Corporation balance sheet used to determine the acquisition price.
(c) Specific Actions Performed and the Shortcomings of the Bank's Due Diligence
The Bank engaged Mercers (after initial settlement) to provide the actuarial advice and enquires suggested above, but there is no documented evidence that the Bank management made any enquires of the Insurance and Superannuation Commission, or that they attempted to reconcile historical reported financial statements (prepared under Generally Accepted Accounting Policies ("GAAP")) to statutory insurance returns, in order to confirm both an adequate starting point for their review and the existence of such a reconciliation as would indicate an orderly and controlled approach to accounts preparation and presentation.
The Mercers report of 6 April 1988 reviewed the book value of life statutory funds, which were stated as follows:
|
Item |
$M |
|
|
GAAP retained earings |
39.6 |
|
|
Value of agency |
17.4 |
|
|
Value of life licence |
3.0 |
|
|
Total |
60.0 |
|
The Mercers report raises the following concerns in respect of each item:
(i) GAAP retained earnings were overstated because of the inclusion of unrealised property gains, without reflection of the appropriate apportionment between participating and non-participating policies:
"This would give a retained earnings amount at 30/9/87 of $32.0 million." [Paragraph C1(a)]
(ii) Values of agency force and life licence:
The Mercers report states:
"I am advised that this description has been used so it becomes a "tangible asset" rather than goodwill and does not need to be depreciated. I regard the values as highly optimistic (although it is clear that, at least before October 1987, the life offices which had changed hands in the recent past had been brought at a price between 30% and 100% rather [sic] than a realistic appraisal value). [Paragraph C2(a)]
There have been several new licenses issued recently. The costs involved are perhaps of the order of $300,000, plus a delay of between six months and a year. I would regard a license as being worth no more than $500,000." [Paragraph C2(b)]
Mercers did point out, however, that there was a proposal being made to the Life Insurance Commissioner to increase the non-participating portion of the surplus. If accepted, it would have increased the GAAP retained earnings by $5.0M. The Investigation understands from Mr Reichert that this re-apportionment of the surplus was not subsequently made.
(d) Losses Arising from Non-Execution of Identified Actions
By not following up the issues raised by Mercers, the intangibles on the balance sheet of Oceanic Capital Corporation remained potentially overstated by approximately $5.5M (in respect of the life agency) and $2.0M (in respect of the Life licence). The adjustment to the GAAP retained earnings was ultimately quantified at $7.8M, and reflected in the 31 March 1988 balance sheet. Mr Copley stated that he heeded the comments of Mercers, but chose not to write-down the value of the insurance related intangible assets because he believed that there were other "hidden benefits" in the accounts of Oceanic Capital Corporation which more than compensated for the suggested write-downs (eg tax losses, the participating/ non-participating split). Based on the evidence examined by the Investigation, it is not possible to attribute losses arising out of the Oceanic Capital Corporation purchase to the specific omissions discussed above.
On all evidence and material available to me, I am of the opinion that Mr Copley failed to exercise proper care and diligence in failing to follow up on the advice provided to him by Mercers.
17.6.6 FINANCIAL REVIEW
(a) Definition and Applicability of this Item to the Due Diligence Process
The key objective of the financial review is to undertake the necessary enquires to confirm the financial position of Oceanic Capital Corporation and to assess the future maintainable earnings of the group. These are primary goals for reviewing or valuing companies or businesses. These aspects would be reviewed with the benefit of the other enquires made in the course of the due diligence investigation. It should be emphasised that many of the issues raised in the preceding Sections would also be relevant to the consideration of the financial position and future maintainable earnings.
Key financial risks that could reasonably have been identified as applicable to Oceanic Capital Corporation would have been:
(i) Financial linkages and exposures, if any, to the APA Holdings Group and any other company controlled or associated with Mr Carter.
(ii) The impact of reorganisation, management turnover, and the stockmarket collapse, on the future earnings of Oceanic Capital Corporation.
(iii) Balance sheet values of intangible assets.
(iv) Contingent or undisclosed liabilities, if any, (especially in respect of guaranteed redemptions), the adequacy of liquidity reserves and undisclosed charges over assets.
(v) Inexperienced management in the Oceanic Capital Corporation operations and added risk that forecast profitability would not be achieved.
(vi) Historic and forecast profit not being an appropriate basis for determining or assessing acquisition price (ie, the forecast may have contained items which are not of a maintainable nature or which represent erroneous treatment of key income/expense items).
(b) Specific Actions Required
The specific actions which should be taken in performing a financial review of a company are too numerous to present in the body of this report. Broadly, the financial review would address:
(i) The historic reported results, in order to identify:
. Levels of profitability and trends in results.
. Causes for abnormal or extraordinary items.
. Unprofitable operations or products of the organisation.
. The specific accounting treatments which are relevant to an interpretation of reported and forecast results.
(ii) The financial position, in order to confirm the values of the assets and liabilities acquired and identify any undisclosed liabilities.
(iii) The profit forecasts, in order to assess the key vulnerabilities in the achievement of the results.
(c) Specific Actions Performed and the Shortcomings of the Bank's Due Diligence
Historical and Forecast Profitability
Mr Copley acknowledged in interviews with the Investigation that the review of historical and forecast profit and loss was the primary responsibility of Bank management.
Mr Copley informed the Investigation that, in his opinion, a detailed review of historical results was not relevant because of the difficulty of year to year comparison due to:
(i) the corporate restructures of the Oceanic Group;
(ii) the impact of the management changes in 1987;
(iii) the impact of the stockmarket crash in October 1987; and
(iv) the impact of the association with Mr Carter owned corporations.
Mr Copley confirmed to the Investigation that the Bank reviewed the Information Profile, and in this way conducted a general review of reported results. This review was performed in conjunction with interviews with Oceanic Capital Corporation management, but not a detailed examination of books and records. Mr Copley advised the Investigation that he held discussions with Mr Reichert at Oceanic Capital Corporation designed for him to conclude whether he could trust what he was being told; he has confirmed that he did conclude that he could trust this information. Mr Copley also advised the Investigation that, in this way, he identified operations of Oceanic Capital Corporation which were unprofitable and potentially required future attention.
In my opinion, a detailed analysis of historical performance was relevant for the following reasons:
(i) By subjecting the general statements of profitability to detailed analysis, it is possible to independently confirm the assessment of profitability of the individual operations and products, and as well test management's knowledge and understanding of their own business.
(ii) The historical performance, properly adjusted for abnormal or non-recurring items, provides the most meaningful basis upon which an evaluation of forecast profitability could be performed.
(iii) The high intangible asset value in the purchase price should have required a greater scrutiny and assessment of the forecast earnings, and the key assumptions upon which they have been based.
I have been advised by Mr Copley and Mr Macky that the projections of "profit" and "cash flow" were reviewed. In interviews with the Investigation, Mr Copley confirmed that he relied on the year-to-date profit (at January 1988) to assess the achievability of the forecast for the year ending 30 September 1988 without any detailed review of the underlying records. He also advised that he interviewed Mr Reichert in connection with this task.
Mr Copley reviewed the 1989 forecast on a comparison basis with 1988 and revised the 1989 result down by 30 per cent. The 30 per cent adjustment was made on an arbitrary basis in order to present a more realistic growth from 1988 to 1989. He advised the Investigation that the forecasts were discussed generally with management of Oceanic Capital Corporation, and he felt justified in relying on the management of Oceanic Capital Corporation because they had an interest in presenting the forecasts on a realistic basis, as ultimately the forecasts would become the standard against which the future management performance would be measured. Despite searches of Mr Copley's files, the only working paper found was a half page summary of profit per management accounts to 31 January 1988 from which had been excluded certain non-recurring items, the resultant profit having been extrapolated by multiplying the four months to January 1988, by three. The Investigation has not, however, uncovered any notes of interviews, questions to be asked, summaries of key issues arising, or other evidence of the interview process to which Mr Copley has referred.
In my opinion, the conduct of due diligence on the forecasts was inadequate because:
(i) The Bank management did not follow-up the issues raised by Mercers in their letter of 6 April 1988 which questioned the achievability of the profit plan for the fund management operation, as prepared by Mr Purvis.
(ii) There is no evidence that the projections, and their underlying assumptions, were subject to a rigorous critical scrutiny either by the Bank, or any other advisers.
(iii) Mr Copley failed to follow up the significant issues raised by KPMG Peat Marwick Hungerfords in their letter of 26 April 1988, which expressed concerns over the reliability of management accounts. Further investigation of those records, as recommended by KPMG Peat Marwick Hungerfords, would probably have led to questioning the basis of the year to date profit, and therefore the basis upon which the achievability of the forecasts had been assessed.
Financial Position
As previously discussed, the management of the Bank failed to follow up the issues raised by their actuarial and accounting advisers following their respective reviews of the financial position of Oceanic Capital Corporation. KPMG Peat Marwick Hungerfords, in their letter to Mr Copley of 26 April 1988, and their final report of 29 April 1988, made forceful comments concerning such fundamental issues as the veracity of the base accounting records, and the lack of time available to conduct their enquires. In their 29 April report, substantial adjustments to the purchase price were recommended. Mr Copley has advised the Investigation that specific action was not taken on several of these points as there were believed to be other benefits which would accrue to the Bank through the Oceanic Capital Corporation acquisition which offset the adjustments recommended by KPMG Peat Marwick Hungerfords and the other comments made by them. Despite searches of Mr Copley's files, the Investigation has not found any working papers evidencing the orderly assessment of benefits and disadvantages which had been reported by KPMG Peat Marwick Hungerfords in their letters.
Mr Macky and Mr Copley performed initial assessments of the valuations of the intangible assets of Oceanic Capital Corporation referred to in their Board Papers of 16 February 1988. The due diligence process, including the enquires made by KPMG Peat Marwick Hungerfords and Mercers, revealed further questions over the values attributed to certain intangible assets, namely, the values attributed to the management rights ($19.2M), Life agency ($17.4M) and Life licence ($3.0M). The Investigation has found no evidence that these comments or questions were followed up with a view to re-examining the values attributed to Oceanic Capital Corporation as a whole or individual intangible assets, in particular.
The examination by the Investigation of the acquisition balance sheet of Oceanic Capital Corporation at 31 March 1988, revealed that it included additional accruals of $3.6M which turned the reported profit into a trading loss for the period ended 31 March 1988. If the expense accruals were actually required and appropriate at 31 March 1988, then the year-to-date profitability for Oceanic Capital Corporation for this and previous periods was materially overstated, and the forecasts would have been seen to be unachievable. Furthermore, this information would also have cast doubt on the net asset value of Oceanic Capital Corporation, upon which the purchase price of Oceanic Capital Corporation was based.
KPMG Peat Marwick Hungerfords notified the Bank, in their report dated 29 April 1988, that there were serious taxation exposures in respect of the sale of a property located in Martin Place, Sydney. (Mr Copley says it was previously brought to his attention by the vendor). The KPMG Peat Marwick Hungerford's report alerted Bank management to the potential capital gains and possible income tax liabilities of the transaction which had not been provided for in the accounts of Oceanic Capital Corporation. KPMG Peat Marwick Hungerfords suggested that the Bank clarify the tax position of Oceanic Capital Corporation by obtaining a taxation ruling from the Australian Tax Office. Bank management did not follow this suggestion, and chose to rely on representations of the vendor. Mr Copley submitted to my Investigation that it had been agreed that there would be no reference to taxation authorities without the consent of the vendor. It has subsequently been discovered that the warranties upon which the Bank relied were inadequate to recover the substantial subsequent assessments made by the Australian Tax Office. In addition, Oceanic Capital Corporation was at risk of a further assessment of approximately $12.5M, plus interest, which it will also not be able to recover from the vendor. In my opinion, the lack of follow-up, on this, and other, significant issues raised by KPMG Peat Marwick Hungerfords, was a major shortcoming in the due diligence performed by the Bank.
On the basis of the matters referred to above, I am of the opinion that Mr Copley failed to exercise proper care and diligence in conducting the financial review of Oceanic Capital Corporation.
17.6.7 ASSESSMENT OF VENDOR REPUTATION
(a) Definition and Applicability of this Item to the Due Diligence Process
The purpose of this step is to assess whether the financial distress of the vendor had created any financial weaknesses or exposure for the Oceanic Group, or had represented an opportunity of which advantage could be taken by the purchaser in negotiations.
At the time, it was publicly believed that the vendor of Oceanic Capital Corporation and its related companies were under financial pressure. A primary focus of any due diligence investigation of Oceanic Capital Corporation would therefore be to determine whether the financial problems of Oceanic Capital Corporation's parent company had weakened the financial position or jeopardised the operations of Oceanic Capital Corporation.
Furthermore, it would be necessary to establish whether the Oceanic Group could be acquired without exposure to any prior liabilities and claims against the vendor, particularly claims for debts and outstanding taxation.
(b) Specific Actions Required
In order to adequately pursue this inquiry the due diligence investigation would need to obtain details of all related party transactions between the vendor and Oceanic Capital Corporation. In particular, all existing financial linkages between Oceanic Capital Corporation and the vendor would need to be identified, and an assessment made of the effectiveness of the release of Oceanic Capital Corporation from any encumbrances.
The due diligence investigation would also need to assess whether Oceanic Capital Corporation had been prepared for sale, and whether the financial problems of the vendor had restricted important discretionary spending, such as product development, advertising, capital expenditure and so forth. Furthermore, the due diligence examination would need to assess whether it was appropriate for the Bank to rely on vendor warranties to protect the value of its investment in Oceanic Capital Corporation. In other words, whether the vendor would have sufficient financial resources to pay any warranty claims.
The due diligence inquiry would also have needed to determine whether the Oceanic Capital Corporation agency force and distribution network had suffered a loss of confidence in Oceanic Capital Corporation or its products through lost reputation due to its association with the vendor.
(c) Specific Actions Performed and the Shortcomings of the Bank's Due Diligence
Mr Copley advised the Investigation that no losses or problems had been experienced in severing ties with APA Holdings. He said that Bank management specifically addressed all the issues raised above, and had satisfied themselves that the reputation of the vendor would not adversely affect the transaction or the ongoing value of the investment in Oceanic Capital Corporation. The Investigation has not, however, received or found any documentary evidence in support of this advice, how the opinion was formed, and whether it was verified in any way. Mr Copley did, however, point out that the fact that the Bank's ownership was used by Oceanic Management in presentations to investment advisors immediately after the acquisition would indicate that the effect of the vendor's reputation was somewhat offset by the new ownership.
I note, however, that the Bank relied on taxation warranties from the vendor which ultimately were not pursued. As discussed previously, I believe that the treatment of the tax exposure on the Martin Place property was inadequately followed up, and that this failure left the Bank with an unnecessary exposure.
On the basis of the matters referred to above, I am of the opinion that Mr Copley failed to exercise proper care and diligence in addressing the taxation exposure on the Martin Place property with the vendor.
17.7 OTHER RELEVANT MATTERS
17.7.1 BOARD INFORMATION
In conducting this inquiry, the Investigation has necessarily reviewed the Board Papers presented by Bank management recommending the investment in Oceanic Capital Corporation to the Bank Board. Summarised below are the major deficiencies of the Oceanic recommendation and other related Board Papers.
(a) General Impression of Oceanic Capital Corporation
The Oceanic recommendation did not emphasise that as Oceanic Capital Corporation was under a new management team (which fact was disclosed), the future performance of this team was a key risk area. Furthermore, the activity of greatest strategic attraction to the Bank was funds management and as this activity was operating at below break-even level, it required substantial growth before being able to return an appropriate profit to the State Bank Group, and was dependent for this growth on a new management team which had not been comprehensively interviewed and past performance investigated. This should have been made very clear in the Oceanic recommendation, because it went to the heart of the reason for acquisition, and affected the risk of the investment, the likelihood of achieving an adequate return on the investment, and, therefore, the price (if any) to be offered.
(b) Quality of Reporting Systems
Board Papers subsequent to the Oceanic recommendation failed to disclose the serious questions raised by KPMG Peat Marwick Hungerfords on the control and management systems of Oceanic Capital Corporation.
(c) Assessment of Intangible Valuation
The Oceanic recommendation and subsequent Bank Board Papers gave no indication that the initial valuation assessment, by Mr Copley and Mr Macky, of intangible assets (reported in the initial proposal dated 16 February 1988) had changed in the course of their investigations. Furthermore, there was no indication given to the Board that the final purchase accounting entries bore little resemblance to the original valuation assessments. In defence of the information provided, Mr Copley advised the Investigation that, at the time of reporting to the Board, he had formed the opinion that, the hidden benefits within the Oceanic Group outweighed the additional write-downs being identified. It was not, therefore, necessary to notify the Bank Board of the new issues raised in the due diligence.
Given that the overall net asset value of Oceanic Capital Corporation (including substantial intangible assets) was used to originally justify the purchase price for Oceanic Capital Corporation, in my opinion, the Bank Board should have been provided with any material updates on the initial valuation assessments, together with reasons. Furthermore, in my opinion, Bank management should have fully explained to the Bank Board the basis of the valuations of intangible assets used on the acquisition balance sheet of Oceanic Capital Corporation, as these same valuations would, in turn, be incorporated in the accounts of the Bank.
(d) Additional Pre-Acquisition Accruals
The Bank Board Papers were silent on the additional $3.6M of expense accruals identified by Oceanic Capital Corporation management to be necessary in the pre-acquisition balance sheet of Oceanic Capital Corporation as at 31 March 1988. These additional accruals had a material bearing on the year to date profitability of Oceanic Capital Corporation and would have materially changed any reasonable assessment of the financial position of Oceanic Capital Corporation, but particularly its profitability.
Furthermore, as previously discussed under the heading "Financial Performance of Investment", there is evidence that the additional accruals were in fact, a transfer of pre to post-acquisition profit of Oceanic Capital Corporation. If this were, indeed, the case, then there is no evidence that the Bank directors were informed that up to $3.6M of 1988 consolidated trading profit for the Bank was attributable to this incorrect accounting treatment.
(e) Taxation Exposures
The Bank Board Papers did not include references to the taxation exposure in respect of the sale of the Martin Place property. The Investigation was advised by Mr Copley that the Bank did not seek a taxation ruling from the Australian Tax Office because of an agreement with APA Holdings, whereby disclosures to Australian Tax Office required the prior approval of APA Holdings. In my opinion, given the substantial taxation exposure in respect of this transaction, this agreement to restrict disclosure was a bad mistake, and placed the Bank at substantial risk.
(f) Assessment of Forecasts
The Oceanic recommendation gave the impression that the Oceanic Capital Corporation forecasts were achievable. Mr Copley and Mr Macky were quoted in the penultimate paragraph of page 5 of the Oceanic recommendation, thus; "The new management of the group are extremely confident in improving the profitability of the company. That confidence is shared by Messrs Macky and Copley". In my opinion, insufficient detailed independent scrutiny of the profits had been performed (and evidenced), and reservations should have been expressed pending completion of further enquires, given the fundamental importance of profit forecasts to the value of Oceanic Capital Corporation and its attraction to the Bank.
On the basis of all the evidence and material available to me, I am of the opinion that Mr Copley and Mr Macky failed to exercise proper care and diligence in providing the Board with adequate information on the Oceanic Capital Corporation acquisition. Mr Clark acknowledged that he reviewed and supported the Oceanic recommendation and, as the Managing Director, I am of the opinion that he failed to exercise proper care and diligence in providing the Board with adequate information on the Oceanic Capital Corporation acquisition.
17.7.2 CONFLICT OF INTEREST
The Sale Agreement with APA Holdings provided for Equiticorp to become a direct beneficiary of the sale of Oceanic Capital Corporation to the Bank. It was apparent from the Sale Agreement that Equiticorp was a secured creditor of APA Holdings. Undated file notes of Mr Copley indicated that Equiticorp was to receive approximately $27.6M directly from the sale proceeds of Oceanic Capital Corporation.
I note that at the time of the Oceanic Capital Corporation acquisition, Mr Clark was a director and shareholder of Equiticorp Holdings Limited, the ultimate holding company of Equiticorp. This was confirmed in a statement enclosed with a letter dated 29 January 1992 submitted to me from Mr Clark, quoted below.
"Around the time of the Oceanic transaction and continuing until my resignation as a director of Equiticorp in July of 1988, my shareholding was in the order of 500,000 shares and 50,000 options, plus a further 70,000 odd options which had been issued to me through a staff share trust."
The relevant Bank Board Papers did not refer to Mr Clark's interest, or the interest of Equiticorp. Mr Clark submitted the following in the same statement referred to above in relation to this issue:
"As mentioned above, from Equiticorp's point of view, the APA/Unity facility was adequately secured and not a problem loan. At the time, I did not perceive a conflict of interest between my role as an Equiticorp director and a State Bank CEO/director for the simple reason that, given that Equiticorp was not at risk and would be repaid its debt one way or another, the acquisition by SBSA of Oceanic did not assist Equiticorp in any way that brought it into conflict with the interests of State Bank."
In hindsight, I acknowledge (as I did in evidence at page 8) that there was a technical conflict of interest which should have been disclosed to the Board. I note that Messrs Macky and Copley were aware of the Equiticorp debt prior to settlement of the Oceanic transaction, and as they did not mention this fact in any of the Board Papers, I can only assume that they also failed to appreciate that this technical conflict should have been disclosed."
Whilst it is difficult to understand, both Mr Copley and Mr Macky have told the Investigation that they had no knowledge of the Equiticorp debt prior to settlement.
On the basis of the matters referred to above, I am of the opinion that Mr Clark failed to disclose a direct or indirect pecuniary interest in the Oceanic Capital Corporation purchase, which may constitute an offence pursuant to Section 11 of the Act.()
17.7.3 UNDERLYING CLARITY OF BOARD INFORMATION AND QUALITY OF COMMUNICATION WITH BANK EXECUTIVE
The Investigation's review of the Piper Alderman Submission (on behalf of certain past and present Directors) and statements of senior management highlighted a significant conflict in views and understanding of:
(a) the nature and extent of due diligence intended to be performed by the Bank;
(b) whether due diligence investigations had been completed before the Board meeting of 24 March 1988; and
(c) whether the due diligence investigation was to have been conducted before or after the settlement of the purchase.
In my opinion, no clear statement of the nature, extent, and timing, of the due diligence required was made by either the Board (as evidenced by minutes of meetings on 17 February 1988 and 24 March 1988) or by management in either of the two Oceanic recommendations submitted to the Board (dated respectively, 16 February 1988 and 22 March 1988). Ambiguous references were made in the Oceanic recommendation to valuations and due diligence, in consequence of which the intent of management regarding both due diligence and the use of external advisers was unclear. The due diligence requirements were also confused in these submissions, in that no clear reference was made to whether due diligence was to be undertaken prior to or subsequent to initial settlement.
No explicit references to due diligence required by the Board to be undertaken by the Bank were made in the minutes of the Board meetings of 17 February 1988 or 24 March 1988. The only direct reference to due diligence was in the paragraph numbered 5 on page 7 of the submission provided to the Board (dated 16 February 1988), as set out below:
"At the same time, we would enter into negotiation regarding the price. Such price to be subject to due diligence and adjusted according to any discoveries made during the investigations."
This reference to due diligence was presumably in relation to price adjustments, but it is unclear whether the reference is to adjustments to the price before or after the price had been paid. The Board was also advised in the recommendation dated 16 February 1988 that the Bank management would:
"Commission an independent valuation by Consulting Actuaries and Accountants."
This was noted in the minutes of the Board meeting. The recommendation, however, does not refer to what would be valued (ie Oceanic Capital Corporation as a whole or its components). Nor does it explicitly state that these valuations were intended to comprise due diligence. "Due diligence" and "valuation" assignments are separate and distinct, and the conduct of a valuation is certainly not (and should never have been assumed to be by the Board) predicated on the conduct of a comprehensive due diligence examination. If this minute was intended to embrace the conduct of due diligence, then, in my opinion, it failed.
A further reference to financial investigations was made in the submission dated 16 February 1988 as set out below:
"Should approval to proceed be received and the price submitted be acceptable, we would propose a detailed examination of the financial records be undertaken by suitably experienced accountants to check that the accounts accurately portray the financial position of the group at this time."
This statement could be construed as a commitment to due diligence, and in my opinion, it would be logical to expect the due diligence to be conducted before any money was paid (or committed to be paid).
There is no reference, in the Board Minutes of 17 February 1988 or 24 March 1988, to the risk areas of the due diligence that were likely to be encountered or had been identified and investigated. On the overall subject of due diligence, its timing, definition and outcome, the Board submissions in my opinion contain information that is inadequate in important respects.
The Piper Alderman Submission, dated 19 November 1991, on behalf of certain past and present directors stated:
"... the Board assumed that the original condition relating to due diligence had already been met."
In other words, the Board assumed due diligence on Oceanic Capital Corporation had been performed prior to their approval given on 24 March 1988. This understanding was based on the fact that their approval in principle, given on 17 February 1988, was subject to the condition of requiring "independent valuations" prior to acquisition which they submitted was equivalent to "due diligence". I refer to my comments above on the comparisons of "valuations" with "due diligence" responsibilities, and cite the directors submission as further evidence of confusion and lack of knowledge of the due diligence function so far as it related to the Oceanic Capital Corporation acquisition. This submission is also further evidence that the Directors assumed the approval to purchase Oceanic Capital Corporation, in March 1988, was still subject to conditions (however unclear) given at 17 February 1988, a misunderstanding which the Oceanic recommendation to the Board, on 24 March 1988, should have resolved.
In interviews with the Investigation, Mr Copley has disputed this interpretation of the accuracy of the earlier Board submission, and stated that the approval in principle given by the Board on 17 February 1988, and the relevant terms and conditions, ceased having effect when the offer by the Bank on 25 February 1988 was rejected and negotiations were discontinued. Mr Copley argued that the Oceanic recommendation of 22 March 1988 was in relation to a separate and distinct transaction, the basis of which was adequately explained to the Board.
Even if one accepts Mr Copley's statements at face value, they, at the very least, in my opinion, demonstrate that communication between the Bank executive management and the Board was seriously defective.
17.7.4 BOARD FOLLOW UP
The approval in principle to proceed with negotiations to purchase Oceanic Capital Corporation was noted in the minutes of the Board meeting of 17 February 1988 (Minute 88/31). At a later meeting (25 February 1988) it was noted that an offer was to be made containing certain terms and conditions. In particular, the Board Minute indicated that an escrow amount of $10.0M was to be a term of the offer being made. The minutes of the Board meeting of 24 March 1988 indicated that the Board approval was subject to an escrow amount of $2.0M.
The Investigation was informed by Mr Copley that the Board did not seek any explanation for the reduced escrow amount, and there was no evidence in the minutes of such enquires. The acceptance by the Board of an escrow amount of $2.0M, in contrast with the previously approved amount of $10.0M without a documented explanation as to why this amount had been selected would be imprudent because $2.0M was immaterial relative to the acquisition price of $60.0M and insufficient to protect the Bank from any material breach of warranty.
In general terms, the Board's recollection on this issue differs from that of Mr Copley. However, because of the conclusions which I have reached hereunder I do not need to resolve this issue.
The Board Recommendation, dated 16 February 1988, referred to "valuations" being commissioned (as set out above). The Board Minutes do not refer to any valuation of Oceanic Capital Corporation having been received or considered by the Board. If the Board believed that these valuations were sufficiently important to be a condition of the 17 February 1988 approval in principle to negotiate, it is surprising that they did not enquire as to the outcome of the valuations when the subject of Oceanic Capital Corporation was raised again on 24 March 1988. Against the submissions, by certain members of the Board, that they believed the conditions placed on the 17 February 1988 approval in principle had been fulfilled, the absence of follow up is even more surprising.
The Oceanic recommendation dated 22 March 1988 contained the following condition to which the purchase price of $60.0M was stated to be subject:
"If the Board approves the recommendations, it is proposed to appoint Mr R.G. Pitcher of Peat Marwick Hungerfords, as investigating accountant, and Mr P.K. Luk, of William M. Mercer, Campbell Cook & Knight Pty. Ltd., as investigating actuary, to provide assurances that the matters raised in the warranties have been met."
It is clear that these appointments are being proposed to ensure that warranties are fulfilled. There is no mention that these appointments were made, and reports were received before payment of $60.0M and it is difficult to imagine directors misunderstanding the role of these consultants. In any event, the Board Minutes do not indicate that the results of these investigations were requested, received, or considered, by the Board. The receipt and consideration of the results of these investigations may have made the Board aware of the magnitude of the problems existing in Oceanic Capital Corporation, although there would have been little capacity to take action in view of the inadequacy of the $2.0M escrow amount.
I have critically analysed the information provided to the Board and the Board's response to that information and its actions or lack of action in relation thereto.
I must be careful not to apply the benefit of hindsight to the actions of the Board and must appreciate that the minutes of Board meetings would not always contain all of the matters discussed, and would rarely include particulars of questions asked at the meetings.
The duty of non-executive directors and the extent to which they fulfil that duty is a question of fact and degree, but they are entitled to rely upon the information provided to them by management, subject to certain limitations.
In this case, taking into account the fact that Mr Copley was expressed to be experienced at acquisitions, Mr Clark reviewed and supported the Oceanic recommendation, and the Board Papers, albeit in a confused way, expressed some commitment to due diligence, I do not make any specific adverse finding against the Board on this particular transaction.
Mr Clark, however, was an executive member of the Board and the Managing Director. He has acknowledged that he reviewed the Board submissions prepared by senior executives, and supported them when presented to the Board. I consider that he had a greater degree of responsibility than the non-executive directors, because he was under a clear duty, and possessed the power, to acquaint himself with relevant information. He must also accept responsibility for the inadequacy of the reports presented to the Board, and, in this case, for the inadequacies outlined in the Oceanic recommendation.
On the basis of the matters referred to above, I am of the opinion that Mr Clark, Mr Macky and Mr Copley failed to exercise proper care and diligence in adequately reporting to the Board in respect of the Oceanic Capital Corporation acquisition.
17.7.5 SUPPORTING WORKING PAPERS
The Investigation has reviewed the files of Mr Copley, Mr Clark and Mr Macky and has sought working papers from Mr Copley and Mr Macky in an attempt to obtain details to support the decisions and recommendations made by them to the Board.
The working papers found, and the records reviewed, by the Investigation were deficient in the following significant areas:
(a) No working papers were found to explain why $2.0M was chosen as the escrow amount in the Oceanic recommendation dated 22 March 1988. As previously stated, in my opinion, the escrow sum of $2.0M was insufficient to cover any material adjustments to a price of $60.0M. I note that Mr Pitcher suggested to Mr Macky and Mr Copley that the escrow amount should be 20 per cent of the consideration and Mr Macky's original offer for Oceanic Capital Corporation, dated 25 February 1988, provided for an escrow amount of $10.0M.
(b) No working papers were found to justify Mr Copley's assertion that "hidden benefits" in Oceanic Capital Corporation outweighed the negative issues identified by KPMG Peat Marwick Hungerfords in their report dated 29 April 1988. Mr Copley has recently submitted to my Investigation that the report deliberately highlighted the negatives in order to assist in negotiations with the vendor as to the return of the amount held in escrow. Mr Copley has pointed out that he received a draft of Mr Pitcher's report in April, in which Mr Pitcher highlighted the benefits to the Bank. Notwithstanding these benefits, however, there can be no doubt that the report of 29 April 1988 pointed to significant negatives. This analysis should have been conducted, given Mr Copley's advice to the Board meeting on 28 April 1988 that "we are satisfied that the price paid is a fair and reasonable one given the future opportunities for the company". Mr Copley has advised the Investigation that the "hidden benefits" in Oceanic Capital Corporation were also a factor which he considered when deciding (he says with the approval of Mr Clark) to release the vendor from warranties (except the ultimately ineffective taxation warranty) ten months prior to termination of the warranty period. Mr Clark denies that he gave any such approval, and on this matter I prefer the evidence of Mr Clark.
(c) No interview notes were made and retained of staff evaluations.
(d) No working papers were found by the Investigation which indicated that all significant issues raised in consultants' reports had been cleared.
(e) Mr Copley has advised the Investigation that he was confident of the earning's projections in the Oceanic recommendations being met, based on his own analysis and interviews with Mr Reichert. This confidence was expressed in the penultimate paragraph of page 5 of the Oceanic recommendation (22 March 1988). The Investigation has, however, only identified a half page of notes produced by Mr Copley which evidences an analysis of forecasts; no interview notes of discussions with Mr Reichert or others have been located.
The lack of supporting papers, highlighted above, limits the extent to which I can evaluate and confirm the basis of significant decisions made by Bank management, and the evidence before me leads me to doubt the thoroughness of the enquiry and analysis performed by Mr Copley and Mr Macky on the Oceanic Capital Corporation acquisition.
On the basis of the matters referred to above, I am of the opinion that Mr Copley and Mr Macky failed to exercise proper care and diligence by failing to create or retain adequate documentation of their investigations and enquiries.
17.8 FINDINGS AND CONCLUSIONS
I have investigated the circumstances surrounding the acquisition of Oceanic Capital Corporation in March 1988. In the course of my Investigation, there have been occasions (which I have referred to earlier) when there has been a conflict between versions of significant events surrounding the acquisition.
Of particular concern is the allegation by Mr Copley that his decisions and actions were made on the basis of his understanding of a "handshake" deal between Mr T M Clark and Mr T P Carter, the latter representing the vendor, which placed the purchase of Oceanic Capital Corporation on a "walk in - walk out" basis. Mr T M Clark denies the existence of such an agreement. Mr J B Macky was unaware of such an agreement. If this agreement did exist, then it was clearly not communicated to, or approved by, the Board.
On the basis of the conflicting evidence, it is clear that there was at least poor communication in the Bank amongst members of the executive management. There was also poor communication between the executive management and the Board. A further example of poor communication is the submission by certain of the directors (Piper Alderman submission dated 19 November 1991) that the recommendation from the Bank executives (dated 22 March 1988) that Oceanic Capital Corporation be acquired was received by the Board at the actual meeting at which the decision was to be made.
Based on the evidence and material as stated in this Chapter, I am of the opinion that:
(a) So far as concerns the assessment of the value of Oceanic Capital Corporation and importance of future earnings, Mr J B Macky and Mr K L Copley failed to exercise proper care and diligence to appropriately assess the value of Oceanic Capital Corporation.
Oceanic Capital Corporation had net tangible assets of only $6.0M compared with a purchase price of $60.0M. In my opinion, the Bank executives failed to appreciate the importance of future earnings to their assessment of Oceanic Capital Corporation and its underlying value. In my opinion, this reflected a lack of business acumen and poor commercial judgement on behalf of the Bank management.
(b) So far as concerns the sale and setting the escrow sum, Mr K L Copley and Mr J B Macky, failed to exercise proper care and diligence in agreeing to terms of the sale which left the Bank exposed to potential loss from not being able to recover material warranty claims. In so far as Mr T M Clark is the Managing Director and an Executive Board member, he failed to exercise proper care and diligence in agreeing to the sale which left the Bank exposed to potential loss.
A key feature of this transaction was the decision to complete the sale before any detailed due diligence investigation. This decision, which I have attributed to the Bank executives, placed the Bank at a considerable disadvantage and was compounded by the decision to have only $2.0M set aside as an escrow amount. Against the background of an initial purchase price of $60.0M, this escrow amount was unlikely to be sufficient to recover any material claims arising from post purchase due diligence. These claims would only be recoverable through warranties. Such recovery would be time consuming, costly and uncertain, particularly given the difficult financial circumstances of the vendor, which were known to the Bank and its executives at that time.
(c) So far as concerns the follow-up action on professional advice, Mr K L Copley failed to exercise proper care and diligence in that he did not adequately follow up on professional legal, accounting, and actuarial, advice provided to him in the course of the acquisition.
A major deficiency of the acquisition and due diligence process was the lack of follow up on key advice which Mr K L Copley had received from the Bank's advisors: Westgarth Baldwick (legal); KPMG Peat Marwick Hungerfords (accounting) and Mercers (actuarial). These advisors had been involved, consistent with the requests of the Board recorded in the minutes of the meetings on 17 February 1988 and 24 March 1988.
There is evidence that Westgarth Baldwick recommended particular warranties for the Sale Agreement. Mr K L Copley decided that the warranties proposed by Westgarth Baldwick were not necessary that there was insufficient time and he considered the issues raised by them were "point taking" against their opponents. He should have realised that there was at least an appreciable risk that his decision was outside the conditions of the Board approval to purchase as recorded in the minutes of the meeting of 24 March 1988.
KPMG Peat Marwick Hungerfords raised numerous issues in their limited investigation, and strongly recommended to Mr K L Copley that further examinations and enquiries should be undertaken which would have been directed at identifying and pursuing warranty claims. In addition, the further enquiries were intended to confirm accuracy of the year to date accounts at March 1988, and clarify concerns surrounding transactions involving the statutory insurance funds, material taxation exposures, and other operational issues. In my opinion, Mr K L Copley was imprudent in not implementing these recommendations.
Mercers questioned the value of certain intangible assets and the achievability of the profit forecasts. In my opinion, neither the concerns of KPMG Peat Marwick Hungerfords nor Mercers were adequately communicated to the Board by Mr K L Copley, or adequately followed up by him.
(d) So far as concerns the premature release of vendor warranties, Mr K L Copley failed to exercise proper care and diligence in that he released the vendor from warranties before their expiration under the Sale Agreement.
The failures discussed at point (c) above were compounded by the decision to release the vendor from its warranties at the settlement of the escrow sum. Mr K L Copley has acknowledged responsibility for this action to the Investigation, but states it was consistent with the "walk in - walk out" understanding between Mr T M Clark and the vendor. Mr T M Clark denies this allegation. This decision was, in my opinion, imprudent, particularly in the circumstances where the Bank had been informed by its advisors of issues which might have enabled it to pursue warranty claims. Mr K L Copley advised the Investigation that his decision to release the vendor from warranties at final settlement (except the tax warranty) was based on his assessment of the "upsides" to the transaction as identified by him in the early stages of the transaction and later (after initial settlement of $58.0M) confirmed by KPMG Peat Marwick Hungerfords. He has been unable to produce working papers in support of the evaluation alleged to have been undertaken and nor has the investigation, despite a comprehensive search of files.
(e) So far as concerns reliance on Oceanic Capital Corporation management forecasts, Mr K L Copley and Mr J B Macky failed to exercise proper care and diligence in that they placed reliance on the forecasts provided by Oceanic Capital Corporation management without an independent critical appraisal being conducted.
In my opinion, the due diligence conducted in respect of forecasts was inadequate, and the reliance placed on Oceanic Capital Corporation management was inappropriate in the circumstances.
(f) So far as concerns the adequacy and standards of reports provided to the Board, Mr K L Copley, Mr J B Macky and Mr T M Clark failed to exercise proper care and diligence in that they did not report to the Board on material aspects of the transaction.
The papers presented to the Board in respect of Oceanic Capital Corporation failed to present fully and accurately the nature and extent of pre-acquisition investigations and due diligence, nor did they comprehensively identify the key risks associated with the investment. The reporting to the Board was also deficient in the following respects:
(i) assessing the capabilities of the new management team at Oceanic Capital Corporation;
(ii) assessing the likelihood that future profitability would be achieved;
(iii) in failing to inform the Board of the value of intangible assets, and the subsequent accounting treatment in the State Bank Group accounts;
(iv) in failing to inform the Board that the escrow sum finally proposed ($2.0M) was less than the amount initially considered $10.0M, (included in first bank offer on 25 February 1988) and less than the amount (20 per cent of purchase price or $12.0M) suggested by their adviser, Mr Pitcher, KPMG Peat Marwick Hungerfords;
(v) not informing the Board of an accounting practice to effectively transfer pre-acquisition to post-acquisition profit, causing overstatement of reported Bank operating profit by more than $3.0M in the year ended 30 June 1988;
(vi) in failing to disclose the extent of taxation exposures in Oceanic Capital Corporation;
(vii) in failing to advise the Board of the results of advice received from independent consultants, earlier identified, by the Board as necessary;
(viii) in failing to inform the Board of the decision to release the vendor from the warranties given in the Sale Agreement; and
(ix) failing to advise the Board that the terms and conditions of their earlier approval in principle (Board Meeting 17 February 1988) for the investigation of Oceanic Capital Corporation to proceed had not been completed as the offer originally made by the Bank (25 February 1988) was rejected.
(g) So far as concerns the retention of documentary records of due diligence enquiries, Mr K L Copley and Mr J B Macky failed to exercise proper care and diligence in that they did not create or retain adequate documentation of their investigations and inquiries.
17.9 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT
17.9.1 TERMS OF APPOINTMENT A
In the course of this Investigation, I have investigated and inquired into matters relating to the processes which led the Bank engaging in the acquisition of Oceanic Capital Corporation as directed in Terms of Appointment A(a), A(b) and A(c). Having regard to the evidence and for the reasons indicated in this Chapter, I report that, in my opinion, the processes which led to the Bank engaging in the acquisition of Oceanic Capital Corporation were inappropriate.
I have also, as directed by Terms of Appointment A(h) investigated and inquired into any possible failure to exercise proper care and diligence on the part of a director or officer of the Bank or a subsidiary of the Bank and report that in my opinion the Chief Executive Officer (Mr T M Clark), Mr J B Macky and Mr K L Copley did not exercise proper care and diligence with reference to this organisation.
17.9.2 TERM OF APPOINTMENT C
I have also, as directed by Term of Appointment C investigated and inquired into matters relating to the supervision, direction and control of the operations, affairs and transactions of the Bank. Having regard to the evidence and for the reasons indicated in this Chapter, I report that, in my opinion, the operations, affairs and transactions of the Bank, with reference to the acquisition of Oceanic Capital Corporation, were not adequately or properly supervised, directed, or controlled, by Mr T M Clark (Chief Executive Officer), Mr J B Macky and Mr K L Copley.
17.9.3 TERM OF APPOINTMENT D
I have further, as directed by Term of Appointment D investigated and inquired into whether the information and reports given by Mr T M Clark (Chief Executive Officer) and other Bank officers to the Bank Board:
(a) were, under all the circumstances, timely, reliable and adequate; and
(b) sufficient to enable the Board to discharge adequately its functions under the Act.
Having regard to the evidence and for the reasons indicated in this Chapter, I report that, in my opinion, the information and reports given by Mr T M Clark (Chief Executive Officer), Mr J B Macky, and Mr K L Copley were not, under all the circumstances, timely, reliable or adequate, nor were they sufficient to enable the Board to discharge adequately its functions under the Act.
17.9.4 TERM OF APPOINTMENT E
As directed by Term of Appointment E, having regard to the evidence and for the reasons indicated in this Chapter, I report that I am of the opinion that Mr T M Clark failed to disclose a direct or indirect pecuniary interest in the acquisition of Oceanic Capital Corporation which may constitute an offence pursuant to Section 11 of the Act and I am of the opinion that this matter should be further investigated.
17.10 APPENDIX:
ORGANISATION CHART : Effective March 1988
