VOLUME EIGHT THE MANAGEMENT OF ACQUISITIONS

CHAPTER 18
CASE STUDY IN ACQUISITION MANAGEMENT: THE UNITED BUILDING SOCIETY

 

 

TABLE OF CONTENTS

18.1 INTRODUCTION 18-7
18.1.1 UNITED BANKING GROUP MAJOR SUBSIDIARIES 18-7
18.1.2 OTHER ABBREVIATIONS 18-8

18.2 KEY PARTICIPANTS AND CHRONOLOGY 18-10
18.2.1 PARTICIPANTS AND THEIR ROLE 18-10
18.2.2 CHRONOLOGY OF KEY EVENTS 18-13

18.3 BASIS FOR ACQUISITION 18-16
18.3.1 STRATEGIC RATIONALE 18-16
18.3.2 INVESTMENT CRITERIA 18-16
18.3.2.1 Cost of Acquisition 18-16
18.3.2.2 Assets and Liabilities 18-18
18.3.2.3 Profitability 18-20

18.4 SEQUENCE OF EVENTS SURROUNDING DUE DILIGENCE INVESTIGATION BY BANK MANAGEMENT 18-22
18.4.1 KEY DATES 18-23
18.4.1.1 20 April 1990 18-24
18.4.1.2 3 May 1990 18-25

18.5 FINANCIAL PERFORMANCE OF INVESTMENT 18-28
18.5.1 BACKGROUND 18-28
18.5.2 PRE-ACQUISITION HISTORIC AND FORECAST TRADING RESULTS 18-29
18.5.2.1 Trading Results for Two Years Ended 30 September 1989 18-30
18.5.2.2 Trading Results for the Six Months Ended 31 March 1990 18-31
18.5.2.3 Relevance of Historic Actual Trading Results to Due Diligence Process 18-32
18.5.2.4 Forecast Trading Results for the Year Ended 30 September 1990 18-33
18.5.2.5 Comparison of Forecast with Actual Results for the Year Ended 30 September 1990 18-34

18.5.3 POST ACQUISITION TRADING RESULTS 18-36
18.5.3.1 Forecast Trading Results For The Year Ended 30 June 1991 18-36
18.5.3.2 Actual Trading Results for the Year Ended 30 June 1991 18-38
18.5.4 ASSETS AND LIABILITIES 18-41
18.5.4.1 Comparison of Adjustments Identified by Bank Management at time of acquisition with Actual Purchase Accounting Adjustments Made 18-43
18.5.4.2 Notes on differences between adjustments identified in the due diligence and actual pre-acquisition adjustments 18-44
18.5.4.3 Summary of Financial Performance Against the Bank Performance Criteria 18-46

18.6 EFFECTIVENESS ASSESSMENT: THE DUE DILIGENCE PROCESS AS APPLIED TO UNITED BUILDING SOCIETY 18-47
18.6.1 BUSINESS FUNDAMENTALS AND RISK ANALYSIS 18-48
18.6.2 INDUSTRY BACKGROUND AND REGULATORY COMPLIANCE 18-48
18.6.2.1 Definition and Applicability of this Item to the Due Diligence Process 18-48
18.6.2.2 Specific Actions Required 18-49
18.6.2.3 Specific Actions Performed 18-49
18.6.2.4 Losses Arising from the Non-Execution of Identified Actions 18-50
18.6.3 QUALITY OF MANAGEMENT AND CONTROL SYSTEMS 18-50
18.6.3.1 Specific Actions Required 18-51
18.6.3.2 Specific Actions Performed and their Shortcomings 18-51
18.6.3.3 Losses Arising from the Non-Execution of Identified Actions 18-53
18.6.4 REVIEW OF RECEIVABLES 18-54
18.6.4.1 Definition and Applicability of the Item to the Due Diligence Process 18-54
18.6.4.2 Specific Action Required 18-54
18.6.4.3 Specific Actions Performed and their Shortcomings 18-55
18.6.4.4 Losses Arising from the Non-Execution of Identified Actions 18-64
18.6.4.5 Financial Review 18-66
18.6.4.6 Losses Arising from Non-Execution of Identified Actions 18-93

18.7 MAJOR DEFICIENCIES OF "THE RECOMMENDATION" AND OTHER RELEVANT MATTERS 18-94
18.7.1 INACCURATE IMPRESSIONS CREATED 18-94
18.7.1.1 Description of Due Diligence Undertaken 18-95
18.7.1.2 Costs and Benefits of Acquisition 18-95
18.7.1.3 Non Bank Loss-making Subsidiaries 18-96
18.7.1.4 Inadequacies of Financial Information 18-96
18.7.1.5 Valuation of the Business 18-97
18.7.1.6 Co-ordination of Due Diligence 18-97
18.7.2 AYERS FINNISS CONFLICT OF INTEREST 18-98
18.7.3 POST-ACQUISITION REVIEW OF DUE DILIGENCE 18-98

18.8 FINDINGS AND CONCLUSIONS 18-100
18.8.1 FORECASTS 18-100
18.8.2 RECEIVABLES 18-101
18.8.3 PROPERTIES 18-102
18.8.4 INTERNAL CONTROLS 18-102
18.8.5 CONTINGENT LIABILITIES 18-103
18.8.6 LACK OF FOLLOW-UP 18-103
18.8.7 PRIMARY RESPONSIBILITIES FOR DUE DILIGENCE 18-104
18.8.8 JUDGEMENT BY THE BANK MANAGEMENT OF UNITED BANKING GROUP VALUE 18-105
18.8.9 INADEQUACIES OF BOARD PAPERS 18-105
18.8.10 CONFLICTS OF INTEREST 18-106
18.8.11 SPECIFIC FINDINGS WITH RESPECT TO MANAGEMENT 18-106

18.9 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT 18-108
18.9.1 TERMS OF APPOINTMENT A 18-108
18.9.2 TERM OF APPOINTMENT C 18-108
18.9.3 TERM OF APPOINTMENT D 18-109

 

 

 

18.1 INTRODUCTION

 

On 29 June 1990, United Building Society of New Zealand converted from a building society to a limited liability company, and changed its name to United Banking Group Limited ("United Banking Group"), operating under a banking licence. On the same day, the Bank acquired United Banking Group Limited, and all of its subsidiaries, for an acquisition price, publicly announced, of $NZ 150.0M. This price was, in fact, the amount of capital in United Banking Group subscribed by the Bank upon the conversion of United Building Society to a licensed Bank. The Bank emerged from the conversion and capital subscription process as 100 per cent shareholder of United Banking Group.

At the time of the acquisition, the major operations of United Building Society comprised mortgage and commercial lending, real estate broking, retirement village development, insurance, and sharebroking. An organisational chart of the arrangements is as follows:

Insert chart here .............................

To assist in the presentation of this report, the following abbreviations have been adopted:

United Banking Group - United Banking Group Ltd and its subsidiaries. United Bank Group was the holding company for the following major wholly owned subsidiary operations at the date of acquisition.

18.1.1 UNITED BANKING GROUP MAJOR SUBSIDIARIES

United Realty - United Realty World Holding Company Ltd -real estate agent network.

United Lifecare - United Lifecare Ltd - retirement village development company.

Allied Mortgage - Allied Mortgage Guarantee Company Ltd - the business

Guarantee of this company involved participation in the contributory mortgage market, making loans, credit insuring loans, and selling loans to investors. Allied Mortgage Guarantee was also involved in the credit insurance business for other than the contributory mortgage book.

United Sharebrokers - United Sharebrokers Ltd - sharebroking operations.

18.1.2 OTHER ABBREVIATIONS

The Bank - The State Bank of South Australia.

United Bank - United Banking Group Ltd, the company entity which comprises solely the banking operations of United Banking Group.

United Building - United Building Society and its subsidiaries,

Society Group the group which immediately preceded United Banking Group prior to its conversion to company status.

United Building Society - The building society entity which comprised solely the building society operations of United Building Society.

State Bank (NZ) - The State Bank (NZ) Holdings Ltd, the entity which acquired United Banking Group.

Ayers Finniss - Ayers Finniss Limited.

The acquisition was presented to the Bank Board of Directors on 9 May 1990 in a United Building Society Recommendation Paper (hereinafter referred to as the "Recommendation"), which set out the background and strategic rationale for the acquisition.

The key financial features described in the Recommendation were:

(a) Cost of Acquisition - the $NZ 150.0M capital injection would be "passed straight back"() to the Bank, such that the Bank would have "no funding cost." () The actual cost was described as being the net present value of the interest incentives to United Building Society depositors - estimated at between $NZ 10.0M to $NZ 25.0M.()

(b) Net Assets - Bank management estimated that, after taking full writedowns into account, the Bank would acquire reserves estimated, at 30 September 1990, to be $NZ 40.2M, for the cost described above.()

(c) Profitability - although the United Building Society was trading unprofitably at the date of acquisition, the Recommendation included the following "Most Likely Management Case" () forecast of contribution to the Bank net profit after tax. The results anticipated for the year ended 30 September 1990, as included in Attachments 1.1 and 1.4 of the Recommendation are set out hereunder:


Year Ended 30 September

1990
$NZ M

  

1991
$NZ M

  

1992
$NZ M

  

1993
$NZ M

Group Profit/(Loss) Before Tax

(31.1)

  

37.0

  

41.0

  

47.0

Introduced Capital

-

  

(19.5)

  

(19.5)

  

(19.5)

Incentive Payments

-

  

(9.7)

  

(6.6)

  

(4.8)
 

(13.1)

  

7.8

  

14.9

  

22.7

Tax

(8.4)

  

(2.6)

  

(4.9)

  

(7.5)
Group Profit/(Loss) After Tax

(21.5)

  

5.2

  

10.0

  

15.2

The acquisition was achieved by the following steps:

(a) the Bank subscribed for $NZ 50.0M of ordinary share capital in United Banking Group after it registered its conversion scheme with the Registrar of Building Societies and immediately before conversion to a limited liability company;

(b) United Building Society converted from a building society to a limited liability company and gained a banking licence. United Building Society shareholders became depositors in the new company and the Bank remained as the only shareholder of United Banking Group; and

(c) the Bank subscribed for $NZ 100.0M of ordinary shares in the new United Banking Group company, completing the $NZ 150.0M "purchase price".

The conversion offer to former United Building Society "shareholders" gave them additional interest premium "incentives" on their United Building Society deposits.

The Recommendation was not specific as to how the $NZ 150.0M capital injection into United Banking Group would be "passed back". The passing back of the $NZ 150.0M was to be by way of loans from United Banking Group to the Bank's Auckland branch.

Subsequent events have shown that:

(a) The $NZ 150.0M funds were not "passed back" to the Bank.

(b) The net asset value at acquisition was not $NZ 40.2M, but, in my opinion, a deficiency of approximately $NZ 17.9M.

(c) The forecasts were overstated, which became evident within 3 months of the acquisition when the original 1991 forecast pre-tax profit of $NZ 36.0M* was revised to $NZ 4.4M, which did not include any extraordinary items. The actual comparable result for the year ended 30 June 1991 for the original United Banking Group was a pre-tax loss of$NZ 73.0M. (* This forecast was provided by United Building Society to Ayers Finniss prior to the acquisition. This differs from the amount of Group profit before tax disclosed to the Board in the Recommendation of $37.0M which includes a $1.0M extraordinary item - see Table at 18.5.2 hereunder).

The acquisition of United Banking Group by the Bank has resulted in:

(a) the Bank recording a post-tax loss of $123.3M in respect of its investment for the year ended 30 June 1991; and

(b) further losses associated with the potential writedown in the carrying value of the Bank's investment in United Banking Group.

 

18.2 KEY PARTICIPANTS AND CHRONOLOGY

 

18.2.1 PARTICIPANTS AND THEIR ROLE

The following table sets out the key participants both in the pre-acquisition review of United Banking Group and in subsequent reviews.

 

Organisation/Name/Title Description of Role
THE BANK  
Mr D W Simmons, Chairman of the Bank Board Chairman of the Bank Board.
Mr T M Clark, Group Managing Director Group Managing Director of the Bank.
Mr T L Mallett, Chief General Manager, International Banking Project Leader, presenter to the executive committee and Board of Directors.
Mr K L Copley, General Manager, Group Finance Limited involvement in due diligence review in the area of financial analysis.
Mr J B Macky, General Manager, Information Systems and Subsidiaries Present at one of the relevant meetings.
Mr R J Morrison, Manager Banking, Auckland Reviewed commercial lending activities and mortgage guarantee activities.
Mr B T McCulloch, Chief Manager, IS Services and Support Reviewed information systems.
Ms L M Teefey, Senior Manager, IS Operations Reviewed information systems.
Mrs M Chin, Senior Manager, Internal Audit Reviewed internal audit function. Her terms of reference were very limited, and she (by direction) carried out less work than she considered necessary.
Mr D R Hammond, Chief Manager , NZ Operations Initial link with United Building Society, established by existing banking relationship with United Building Society.
Mr S G Paddison, Chief General Manager, Australian Banking Mr Paddison was not directly involved in the acquisition, but prepared a report (dated 13 September 1990) to the Bank Board on the inadequacy of the due diligence performed on the acquisition of United Banking Group. His report was based on Dr Stone's report.
Dr S J Stone, General Manager Personal and Business Banking Dr Stone was not involved in the acquisition, but prepared a report (dated 10 September 1990) entitled "United Banking Group - Review of Retail Bank". Reported to Mr Paddison.
Mr T G Morgan, Financial Controller, International Banking Mr Morgan was not involved in the acquisition, but conducted a detailed post acquisition review of United Banking Group. Reported to Dr Stone.
Mr J T Hazel, Chief General Manager, Financial Services Chief General Manager, Financial Services, participated in meetings involved in Ayers Finniss fee negotiations.
AYERS FINNISS (A Wholly Owned Subsidiary of the Bank)

Mr T D Janes, Executive Director (Auckland)

  


Project Leader, Ayers Finniss co-ordinator of due diligence assignment, financial adviser to the Bank.
Mr J M Collins, Manager Asset/Liability Management Strategy Ayers Finniss team member and financial adviser.
Mr R A Glenn, Senior Counsel Responsible for taxation review.
Mr R G Steel Financial analysis.
Mr P S Johnstone, Managing Director Mr Johnstone was not involved in the acquisition, but prepared a report which encompassed a review of the due diligence carried out on the acquisition of United Banking Group (dated 12 October 1990) which was presented to the Bank Board.
UNITED BANKING GROUP

Mr C Jenkins, Managing Director

  

Chief executive of United Building Society.
Mr N Cooper, General Manager, Finance Chief financial officer of United Building Society.
KPMG PEAT MARWICK

Ms J Dawson, Audit Partner

  

External auditor of the State Bank (NZ). Responsible for review of external audit work papers. Prepared a draft report (dated 3 May 1990) addressed to Mr Copley based on her review.
DELOITTE HASKINS & SELLS

Mr Rowley, Audit Partner

  

Auditor of United Building Society, and prepared a report as to the fairness and reasonableness of the conversion proposal both to, and as among, the various classes of members of United Building Society.
JOHN PEEBLES ASSOCIATES LIMITED

Mr Peebles

  


Conducted senior management audit.
WD SCOTT DELOITTE Prepared a review of United Sharebrokers for Ayers Finniss (authors of report not identified)
CHAPMAN TRIPP SHEFFIELD YOUNG (SOLICITORS)

Mr Franks, Partner

  


Mr Franks assisted United Building Society in the preparation of the conversion documents etc.
BUDDLE FINDLAYS (SOLICITORS)

Mr Ross, Partner

  


Legal adviser to the Bank in respect of the transaction.
BT AUSTRALIA LIMITED Prepared United Building Society information memorandum.
TREASURER AND TREASURY DEPARTMENT  
Mr J C Bannon, Premier and Treasurer of South Australia Required to approve acquisitions pursuant to Section 19(7) of State Bank of South Australia Act, 1983.
Mr A G Prowse, Under Treasurer, South Australia Advised Treasurer as to whether approval should be granted for acquisitions.
Mr R Schwarz, Assistant Under Treasurer, Department of Revenue and Economics, Treasury department. Conducted Treasury review process on Mr Prowse's instructions.

 

18.2.2 CHRONOLOGY OF KEY EVENTS

The following table sets out the key events which are fundamental to understanding the circumstances of the transaction.

Date Event
August 1988 "Run" on United Building Society with around $NZ 170.0M being withdrawn in three days.
December 1988 to 31 December 1989 United Building Society was experiencing trading difficulties, planned for conversion to a bank, and set about identifying a merger partner.
Late 1989 BT Australia Ltd was appointed to advise the United Building Society Board on the method by which a banking licence, conversion to limited liability status, and the involvement of a shareholder partner, could best be obtained. A report was prepared entitled "Business and Capital Strategies".
January 1990 Mr Cooper identified the serious financial deterioration in United Building Society's position.
22 January 1990 Meeting attended by Mr Bannon, Mr Clark and Mr Mallet, advising Mr Bannon of the Bank's intention to investigate a potential acquisition of United Building Society.
21 February 1990 United Building Society draft Information Memorandum provided to Ayers Finniss.
March 1990 United Building Society Information Memorandum finalised by BT Australia Ltd, and provided to Ayers Finniss.
13 March 1990 Ayers Finniss provided with a sensitivity analysis of United Banking Group's trading results under positive and negative yield curve assumptions by Mr Cooper.
March-May 1990 Period in which majority of "due diligence" carried out by the Bank. Preliminary work had been carried out in 1989.
20 April 1990 Ayers Finniss receive pre-acquisition profit forecasts from United Building Society for the six years ending 30 September 1995.

Mr Mallett submitted a Recommendation to the Bank Board to send an expression of a non-binding indicative offer to United Building Society.
24 April 1990 Ayers Finniss receive key assumptions underlying profit forecast from United Building Society.
26 April 1990 Bank Board approved sending letter contained in Mr Mallett's Recommendation of 20 April 1990, to United Building Society.
3 May 1990 Meeting attended by Mr Prowse and Mr Clark, at which Mr Prowse received the Recommendation, dated 20 April 1990.
4 May 1990 Ayers Finniss receive revised forecast trading results for year ended 30 September 1990. These trading results separately show the actual trading results for the five months ended 28 February 1990.
8 May 1990 Meeting between Mr Clark, Mr Mallet, Mr Prowse and Mr Schwarz, to discuss acquisition. Minute from Mr Prowse to Mr Bannon stating that "Treasury has reviewed the proposal and does not wish to object [sic] it ..."
9 May 1990 Meeting between Mr Clark, Mr Prowse and Mr Bannon, at 10.30 am. Mr Bannon noted the acquisition and stated, on a minute located by the Investigation on a Treasury Department file, his support for the proposed acquisition. Mr Mallett presented a Recommendation Paper (the "Recommendation") to the Bank Board of Directors, recommending Bank Board approval of the acquisition of 100 per cent of the United Building Society Group. Bank Board approval of acquisition.
10 May 1990 Heads of Agreement signed, which was subject to the successful conversion of United Building Society to a bank and the capital injection by the Bank.
31 May 1990 Mr Cooper prepared profit forecast for the year ended 30 June 1991 to submit to the Bank. A Memorandum from Mr Cooper to Mr Jenkins, shows that primary consideration was given to the expected return that the Bank would require on their $NZ 150.0M capital injection.
5 June 1990 Mr Cooper prepared a briefing paper for Mr Jenkins, on forecast profits for the year ended 30 June 1991. The paper states that "all of the factors creating the increased profitability within the bank [United Building Society] arise as a direct result of the conversion, and taking advantage of bank licence status". This is further discussed later in this report.
29 June 1990 Conversion by United Building Society to a bank and acquisition by the Bank.
1 July 1990 and
28 September 1990		 The Bank plans and carries out a reorganisation of the United Banking Group to make the United Bank profitable. The reorganisation involved the transfer of certain United Banking Group subsidiaries and other non performing assets to the State Bank (NZ) (the holding company for United Banking Group) and related companies. Management fees and backdated interest charges were made by United Bank which increased the United Bank profit. (This is discussed in more detail later in this report).
August 1990 United Banking Group prepared a budget for year to 30 June 1991 which showed profit before tax of $NZ 4.4M, which was substantially lower than the pre-acquisition forecast provided to the Bank of $NZ 36.0M before tax, incentives and service of introduced capital. The substantial downgrade in forecast trading results is discussed later in this report.
10 September 1990 Dr Stone prepared a detailed report on United Banking Group, including a review of the profit forecasts provided by United Building Society to the Bank.
September 1990 The managing director of Ayers Finniss, Mr Johnstone, carried out review of the adequacy of due diligence performed on the United Banking Group acquisition, at the request of the Bank Board of Directors. The review encompassed a perusal of all relevant files held by Ayers Finniss and the Bank, discussions with Mr Janes, and discussions with the Chairman of the Bank.
25 October 1990 The Bank Board of Directors receive a Board Paper from Mr Paddison, which stated that there were serious lessons to be learnt from the acquisition program, and suggested that the appropriate questions were not asked during the acquisition process. The Directors were advised that the Bank group did not have the expertise to acquire businesses and make judgements about the viability of future acquisitions.
23 November 1990 United Bank reported profits after tax of $NZ 20.6M for the three months to 30 September 1990. These results are for the banking operations only and exclude the results of the subsidiaries transferred to the State Bank (NZ).

 

 

18.3 BASIS FOR ACQUISITION

 

18.3.1 STRATEGIC RATIONALE

The strategic rationale of acquiring United Banking Group was set out in the Recommendation as follows:

(a) to reinforce the Bank's stated objective of becoming a regional bank in Australasia, and build its core business within a merged Australian and New Zealand marketplace;

(b) to allow the existing New Zealand business of the Bank to diversify risk into the alternative financial markets available, e.g. retail and mortgage banking. This diversification would be more readily achieved by creating a balance sheet that was equally divided between corporate (wholesale and commercial) and retail (mortgage and personal) banking products. Of vital importance was access to United Banking Group's retail deposit base which included an eighty four branch network; and

(c) to acquire shareholders' funds of at least $NZ 40.0M, and a positive future profit stream at extremely low cost (the cost of the acquisition is discussed in detail below).

18.3.2 INVESTMENT CRITERIA

Set out below is a discussion of the investment criteria under the following headings:

(a) Cost of Acquisition.

(b) Assets and Liabilities.

(c) Profitability.

18.3.2.1 Cost of Acquisition

The cost of acquisition was described in the Recommendation as follows:

(a) the acquisition would be structured in such a way that the $NZ 150.0M capital injection into United Banking Group would be "passed straight back to State Bank in such a way that we have no funding cost..."; and

(b) the actual cost to the Bank of the acquisition was stated as being "... effectively the incentives to UBS depositors over a three year period..." (estimated by management to be between $NZ 10.0M and $NZ 25.0M with the most likely cost being $NZ 14.6M on a net present value basis).

The Recommendation contained the following conclusion, and an assessment that United Building Society had shareholder reserves of approximately $NZ 40.0M:

"The value of reserves to be acquired by State Bank, as summarized on Page 12, are $NZ67 million reassessed by the Bank to $NZ40.2 million. In the most likely case, acquisition cost will be NZ$14.6 million on a net present value basis after tax effect. The acquisition therefore provides a net benefit based on State Bank's assessment of NZ$25.6 million."

It is important to note that, after the conversion from a building society to a bank, and in the absence of any capital injection from the Bank, United Banking Group would have had shareholder funds (comprised of accumulated reserves) estimated by the Bank management at only $NZ 40.2M. In my opinion, given the unprofitable circumstances of United Building Society, and with total assets of some $NZ 1.5B, such a level of capital is unlikely to have been sufficient for United Banking Group to sustain itself long term as a stand alone entity.

I would therefore have expected the Bank management to have recognised the need to recapitalise United Banking Group, having regard to:

(a) future profitability requirements;

(b) future cash flow requirements;

(c) the availability of future funding sources; and

(d) the prudential levels of capital and liquidity.

I also note that there are established capital adequacy guidelines promulgated by the Reserve Banks of Australia and New Zealand. In my opinion, it would not be appropriate to assume that these guidelines were being satisfied by the United Banking Group at the time of acquisition. The following circumstances were important matters to be taken into account in assessing the situation regarding capital adequacy:

(a) the group was unprofitable;

(b) the group had significant non-bank investments; and

(c) certain restructuring was envisaged (eg depositor incentives with unknown cost and cashflows effects; the sale or closure of certain ancillary businesses) which would have material cash flow consequences (as set out in the Recommendation).

In my opinion, the Recommendation failed to address the reality that:

(a) the $NZ 150.0M capital injection was equity placed at risk in United Banking Group; and

(b) it was likely that some portion, if not the majority, of the $NZ 150.0M would have had to remain as permanent capital reasonably required to sustain United Banking Group long term as a stand alone entity.

The Recommendation, therefore, failed to explain objectively the likely cost and related financial consequences of acquiring United Building Society. I would also have expected the due diligence performed by the Bank to have included the necessary investigations and thorough financial analysis of the recapitalisation, in order to provide reliable advice to the Bank Board on the real cost of acquisition. My Investigation sought evidence to confirm whether this type of analysis had been performed. These enquiries were made in interviews, reviews of document files retained in respect of the purchase, and Bank Board Papers and minutes. These enquiries did not reveal any evidence that such an analysis had been performed.

18.3.2.2 Assets and Liabilities

The Recommendation stated that, on a "conservative" basis, $NZ 40.2M of shareholders funds would be acquired. This value of shareholders' funds was derived from the published value of United Building Society's reserves at 30 September 1989 (see below), adjusted for items identified as part of the due diligence process and without any allowance for increased capital (that is, the $NZ 150.0M to be injected by the Bank).

The Investigation noted that the opening value of shareholders' funds of $NZ 83.2M at that date, used in the Recommendation, did not reconcile with the statutory accounts ($NZ 92.8M). The unexplained difference between the value of United Banking Group's shareholders' funds included in the Recommendation, and the audited value of United Banking Group's shareholders' funds at 30 September 1989, is $NZ 9.6M, and relates to "Investments in Subsidiaries and Associates". As at 30 September 1989, the assets and liabilities were:

   

Holding

Company

  

Group
Per

 

Item

  

Per
United Building
Society
Recommendation
$NZ’000


Per
Statutory
Accounts
$NZ,000

  


Statutory
Accounts
$NZ,000

ASSETS

          

Current Assets

          

Residential mortgages )

  

965,802

      

Commercial mortgages )

  

131,700

1,097,503

  

1,109,758

Liquid assets

  

393,789

393,789

  

451,548
           

Fixed Assets

          

Land and buildings

)

  

65,731

  

72,229

Other

)

102,872

37,142

  

42,558

Investment properties and
Properties intended for sale

-

-

  

62,415

Investment in subsidiaries
and associates

132,328

141,935

  

4,874

Goodwill on consolidation

-

-

  

14,327

Total Assets

1,726,491

1,736,100

  

1,757,709

LIABILITIES

        

Shares

1,047,538

1,047,538

  

1,047,487

Deposits

559,850

559,850

  

560,100

Creditors and deferred tax

35,903

35,903

  

41,935

Advances from residents of
Lifecare villages

-

-

  

25,257

Lifecare fund

-

-

  

683

Total liabilities

1,643,291

1,643,291

  

1,675,462

NET ASSETS

83,200

92,809

  

82,247

Note: The consolidated balance sheet was not disclosed in the Recommendation.

The Recommendation, in calculating the level of net assets being acquired, referred only to the net assets of United Building Society, rather than to the consolidated net assets of the United Building Society and its subsidiaries. In my opinion, the Recommendation should have disclosed the consolidated accounts of United Building Society which would have allowed the Bank directors to consider the extent to which goodwill arose on consolidation in the context of the Group financial statements (a breakdown of which was disclosed as an attachment to the Recommendation) and the assets and liabilities of the subsidiaries under their appropriate classifications (ie investment properties and properties intended for sale would have been separately identified).

The above table demonstrates the variation between the Net Assets disclosed in the Recommendation and the Net Assets disclosed in the audited accounts. This variation was $NZ 9.6M and represented a material amount having regard to the Net Assets of United Building society.

In my opinion, the nature of the adjustments made to the audited accounts in preparing the Recommendation should have been disclosed to the Board because of the materiality, in aggregate, of the adjustments, and because the adjustments related to matters which were relevant for the consideration of the Board.

18.3.2.3 Profitability

The Recommendation showed that the acquisition would result in a positive overall impact on the Bank's profits for the three years ending 30 September 1993 (based on the "most likely case" adjusted forecast) as set out below:()

 

Bank Management Forecast
For Year Ended

 

Item

  

30 Sept
1991
$NZ’000

  

30 Sept
1992
$NZ’000

  

30 Sept
1993
$NZ’000
Consolidated Net Operating Profit
Before Tax		  

37,000

  

41,000

  

47,000
Adjusted for;            
Bank funding costs on $NZ $150.0m
capital injection (13 Per Cent of $NZ 150.0M)		  

(19,500)

  

(19,500)

  

(19,500)
Incentive payments to United Building Society            
depositors ("at most likely" assessed level)  

(9,746)

  

(6,596)

  

(4,774)
   

7,754

  

14,904

  

22,726
Less Taxation (at the New Zealand
corporate tax rate of 33 per cent)		  

(2,558)

  

(4,918)

  

(7,499)
Contribution to Bank Net Profit After Tax  

5,196

  

9,986

  

15,227

As part of the review of profit forecasts, I would have expected the Bank's due diligence team to have critically reviewed the reasonableness of the assumptions underlying the profit forecasts, because the prospective earnings of United Building Society were a crucial factor to be considered in an evaluation of the investment. The achievement of future profits was also acknowledged by Mr Clark, in interviews with the Investigation, as being of critical importance to the investment decision.

In my opinion, an examination of forecasts would also have necessitated a sensitivity analysis on the operating profit forecasts. Such a sensitivity analysis would have assessed the impact on the forecasts of varying key assumptions, including the retail funds mix, new mortgage originations, levels of non-accrual loans, wholesale funds margins etc.

The only sensitivity analysis included in the Recommendation was in respect of the impact of differing levels of interest premium incentives paid to United Building Society depositors on the forecast trading results. Three scenarios were produced, using differing assumptions as to the likely level of interest premium incentives, although each analysis was based on the same forecast `consolidated net operating profit before tax' ie the sensitivity analysis was not performed on the operating profit forecasts.

The Recommendation also noted two other benefits of the acquisition which, in my opinion, were only valid if the forecast earnings were achieved. In my opinion, the Recommendation failed to adequately disclose that the above benefits would only be realised if the forecast earnings were achieved. These other benefits are:

(a) "no allowance has been made for the enormous benefit of acquiring a 84 branch network for effectively no cost": (page 1; paragraph 4). Mr Clark and Mr Mallet have stated, in interviews with the Investigation, that the benefit referred to here, was the saving of costs to establish a branch network of this size, which would have been tens of millions of dollars. In my opinion, the only benefit which could be attributed to acquiring a branch network is the value of prospective future earnings, which that network would generate for the Bank. The cost saving is irrelevant if the network will not be capable of generating profit, which serves to emphasise the fundamental importance of projected earnings in the evaluation of the acquisition of United Building Society; and

(b) "While not fully quantified, the future profit streams identified will have substantial tax effect benefit in view of the losses in our loan book in New Zealand": (page 1; paragraph 6). Realisation of tax benefits was subject to the ability of United Banking Group to generate future profit. This further emphasises the fundamental importance of forecast profitability in the evaluation of the United Building Society acquisition.

In my opinion, the Recommendation should have included a summary of the investigation undertaken of the assumptions underlying the profit forecasts, and the results of that investigation, including the likelihood of future profits being achieved. The Recommendation should also have included the effects on profit, net assets, and cash adequacy, of variations in key forecast profit assumptions. As this information was not included, the Recommendation was, in my opinion, deficient in material respects, in that it failed to convey to the Board financial information fundamental to their decision on the prospective acquisition of United Building Society Group.

Mr Mallett was primarily responsible for the preparation of the Recommendation, although the document itself was originally drafted by Ayers Finniss (Mr Janes) and presented to the Bank Executive Committee (although no record of the Executive Committee considering the Recommendation has been located amongst the minutes and meeting papers of the Executive Committee). Mr Copley also advised the Investigation that he overviewed draft versions of the document, without direct participation in the writing. Mr Clark in interviews with the Investigation, confirmed he had supported the Board recommendation, thought it was complete, and gave an adequate description of the cost of acquisition. Mr Clark did acknowledge, however, that, with the benefit of hindsight, the Recommendation was deficient, in that it failed to adequately describe the work conducted on forecast profitability.

The extent of due diligence has been variously described on the one hand in the Recommendation as "extensive" and in the Board Minute of 9 May 1990 as "exhaustive". For the reasons stated in this Chapter I am of the opinion that the due diligence process was neither "extensive" nor "exhaustive".

On the basis of the matters referred to above, I am of the opinion that Mr Mallett, as Chief General Manager, International Banking, who had primary responsibility for the preparation of the Recommendation, and Mr Clark, failed to exercise proper care and diligence, in that they presented to the Board an acquisition proposal that was deficient in material respects.

 

18.4 SEQUENCE OF EVENTS SURROUNDING DUE DILIGENCE INVESTIGATION BY BANK MANAGEMENT

 

Several references made by Bank executives indicate that the due diligence on United Building Society was curtailed prior to completion in order to avoid losing "preferred suitor" status with United Building Society. These items were:

(a) A memorandum from Mr Paddison to Mr Clark, dated 13 September 1990, which stated at page 5:

"We were out negotiated with what was probably a false competitive bid strategy to accelerate our decision timeframe ..."

(b) A Board Paper, dated 12 October 1990, prepared by Mr Johnstone, reviewing the due diligence conducted on United Building Society. At page 2 it stated:

"The due diligence process revealed concerns as to the level of reserves in UBS and a meeting of the Board of SBSA was cancelled in early May to allow more time for further investigation of critical areas. At the same time State Bank was advised that a competing bidder was in the wings and that State Bank could lose its negotiating exclusivity. The Bank's position, clearly documented, was that it should not "rush into any form of indicative offer until the Bank had completed its investigation". However, notwithstanding this, the Bank Board approved the acquisition on 9 May, 1990 on the basis that an exhaustive due diligence process had been undertaken ...

... The compressed timeframe in which the due diligence process took place was too limiting."

(c) Interviews by the Investigation with Mr Hazel, who indicated that the process of due diligence ended when it was three quarters done.

These statements raise substantial doubts as to whether the due diligence was actually completed before the Board approval of 9 May 1990, even though the Board approved the acquisition on the basis that an exhaustive due diligence process had already been undertaken. It should be noted that these are serious allegations, because they imply that Mr Mallett, together with Mr Clark and Mr Janes, were responsible for leading the Board to believe on 9 May 1990 that exhaustive due diligence had been undertaken, when in fact it had not.

On the evidence as stated in this Chapter I am of the opinion that an exhaustive due diligence had not been undertaken prior to the acquisition of United Banking Group. As a result, in my opinion the Reserve Bank of Australia was misled by a letter from the Bank's Chairman dated 24 May 1990, which also contained assurances of "extensive due diligence". I do not believe, however, that Mr Simmons realised that his assurances were ill founded.

18.4.1 KEY DATES

The Investigation has produced the following detailed chronology of the key due diligence events in an endeavour to clarify the extent of due diligence investigations. The dates listed below (being 20 April 1990 and 3 May 1990) are `landmark' dates in the chronology and a detailed discussion of the events which occurred on, and between these dates, is set out below.

18.4.1.1 20 April 1990

On the basis of a paper, dated 20 April 1990, prepared by Mr Mallett, on advice from Mr Janes (memorandum dated 17 April 1990), the Board approved sending a letter to United Building Society expressing a "non-binding indicative offer for an investment in United Building Society". The Board Paper set out an update on the progress of the acquisition, and a list of the due diligence enquiries yet to be completed. The relevant sections of that paper are quoted below:

"On the 26th October 1989 the Board endorsed Executive Committee's recommendation that the Bank, supported by Ayers Finniss, investigate in detail the potential to acquire UBS in New Zealand.

This investigation has involved detailed consultations between Ayers Finniss, our Auckland Branch and UBS; a visit to the head office of UBS by the Group Managing Director; and meetings over the 26th and 28th March in Adelaide, with Mr. Colin Jenkins, Managing Director, UBS and Mr Nic. Cooper, Chief Financial Officer, UBS which involved, at various times, most members of the Executive Committee.

Our investigations to date have confirmed that there is considerable benefit in us acquiring UBS to build a strong banking operation in the New Zealand market.

It is proposed that we continue our investigation process particularly -

a) A tax audit, by Ayers Finniss.

b) A structure and management audit by Hay Associates.

c) Systems review by the Bank's Information Systems staff.

d) Valuation of subsidiary companies.

e) Due diligence of lending by SBSA Auckland.

f) Financial investigation by Group Finance/Internal Audit/Peats Auckland, supported by a review of internal and external audit files. (Financial Statements to 30.9.89 are attached).

It is proposed to bring to a special meeting of the Bank's Board, a formal proposal for the acquisition of UBS as soon as possible after the 1st May 1990. It is emphasized that no commitment has been made or will be made by the Bank until the full acquisition proposal is approved by the Board."

A diary note dated 27 April 1990 made by a Mr Austin, the Head of the Bank Supervision department of the Reserve Bank of Australia in relation to a meeting with Mr Mallett in respect of United Building Society noted at page 2:

"A very preliminary due diligence has been undertaken and further work is being carried out."

The above statement, in the context of the Board Paper prepared by Mr Mallett quoted above suggests that a substantial portion of the due diligence was yet to be completed.

The actual due diligence undertaken after 20 April was as follows:

Dates

Event

24-26 April 1990

Review of information systems - Mr McCulloch and Ms Teefey

25-27 April 1990

Review of receivables - Mr Morrison (revised 5 May 1990)

30 April 1990

Report on the review of management by John Peebles Associated Limited. This report referred to the review being prepared under time limitation although it did not specify the period over which the review was conducted.

30 April - 2 May 1990

Review of external audit work papers - Ms Dawson (Peat Marwick)
Review of internal audit - Mrs Chin
Overview of assignment - Mr Copley

Essentially, all this due diligence work was contained in the period from 24 April to 2 May 1990, although each specific assignment lasted an average of only two to three days. In my opinion, it is unrealistic to expect that an "exhaustive due diligence" investigation could have been conducted in such a limited period.

18.4.1.2 3 May 1990

According to statements given by Mr Copley to the Investigation, by 3 May 1990 Mr Copley had returned from New Zealand and expressed, to Mr Clark and Mr Mallett his serious concerns in relation to the financial condition of the United Building Society. Mr Copley also advised the Investigation that he had also told Mr Paddison, Mr Hammond, and Mr Janes, of these concerns. Mr Hammond says that Mr Copley's concerns were made known to him only informally and not as a member of the due diligence team. I do not understand why such concerns in such circumstances should be simply disregarded.

The reports of Mrs Chin and Peat Marwick (draft only) were submitted on 3 May 1990. There is some dispute over who in the Bank received the Peat Marwick report. Mr Janes and Mr Mallett stated that they did not see it, and there is no evidence that they did. Mr Janes did, however, advise the Investigation that the issues referred to by Ms Dawson were identified and addressed in the due diligence process. Mr Copley stated that he also does not recall having seen the document. Ms Dawson advised the Investigation that the report was faxed to Mr Copley, and that she believed that he was already aware of the issues raised in that report from his meetings with her in Christchurch.

A file note, prepared by Mr Mallett, records a meeting on 3 May 1990 with Mr Clark, Mr Copley, Mr Hazel, and Mr Macky, and is quoted in full below:

"Following a meeting of the Group Managing Director, Messrs Macky, Hazel, Copley and Mallett it was agreed that the information that was coming out of the early stages of the due diligence process has caused sufficient concerns that not only a prudent approach be taken to reserves but more work was required, particularly in the subsidiary area.

It was also agreed that the paper should incorporate a more detailed strategy in regard to the ongoing management of the Group as well as traditional financial performance criteria, business objectives, etc.

On this basis, it was necessary to cancel the Board meeting on Monday to allow us to complete the Board "approval" process.

I then conveyed this decision to Messrs Janes and Hammond and while overall they understood the rationale, they did comment as follows:-

They had been advised unofficially, by Nic Cooper that UBS Board would receive an indicative offer (from an unnamed party) subject to due diligence tomorrow. The receipt of this offer would (without us at the same time putting in an offer), prejudice our position and remove our number one party status. My opinion later supported by the Group Managing Director, was that from our point of view, this was not an issue. We have identified concerns and we cannot be rushed into any form of indicative offer until we have completed our own investigation. This was particularly so as the stated reserves of the Society were disappearing in front of our eyes. It is also relevant that the new parties [sic] indicative offer would be subject to due diligence and I fail to see how a seven day delay in all reality, prejudices our position.

I agreed that I would ring Colin Jenkins at 9-00 am on Friday to appraise him of our need for some additional time, in light of the fact that we were half way through the due diligence and this has raised more issues; also payments to deposit holders required more consideration."

Reviews by the Investigation of the documents retained by Ayers Finniss and the Bank in respect of United Building Society, did not reveal any additional work performed on the due diligence after 3 May 1990, with the exception of an update on the receivables by Mr Morrison. The revision by Mr Morrison was submitted, on 5 May 1990, in response to United Building Society management disputing his initial assessment.

This limited additional due diligence contrasts with the statement in Mr Mallett's file note of 3 May 1990 that "... we were half way through our due diligence and this has raised more issues; ...".

Mr Clark told the Investigation that he did not recall receiving a copy of the file note, but felt that the phrase "half-way through" was a loose use of the phrase, because they were clearly further advanced.

The Investigation was advised by Mr Copley that drafting of the Board proposal occurred over the weekend of 5-6 May 1990. The Board Paper containing the Recommendation was dated 7 May 1990 (the original date of the Board meeting referred to by Mr Mallett on 3 May 1990) and was presented to the Board on 9 May 1990 by Mr Mallett. He has referred to an Executive Committee meeting which discussed, debated, amended, and approved, the final paper. The Investigation has searched the Executive Committee minutes, papers, and agendas, but failed to locate any references to the United Building Society paper being discussed.

In summary, the due diligence processes recorded as necessary in the submission to the Bank Board meeting dated, 20 April 1990, was proposed to be conducted in a very limited time, that was unrealistic having regard to the issues involved. No evidence has been found (despite searches) to confirm the nature and extent of due diligence investigations which might reasonably have been expected to follow the meeting recorded in Mr Mallett's file note of 3 May 1990.

These circumstances are inconsistent with the completion of exhaustive due diligence. I have found no other evidence which would support the fact that a proper due diligence process had been undertaken, and I am therefore of the opinion that the description of "exhaustive due diligence" used in the Board Minute of 9 May 1990 is both incorrect in fact, and reflects an incorrect understanding by the Bank Board of the extent, nature, and results, of the due diligence process.

On the basis of the matters referred to above, I am of the opinion that Mr Mallett and Mr Clark did not exercise proper care and diligence in:

(a) proceeding with the United Building Society acquisition and presenting the Recommendation to the Board when concerns arising from investigations had not been fully resolved or reported to the Board; and

(b) creating an inaccurate impression for the Board that exhaustive due diligence had been conducted on United Building Society. Whilst I do not believe that they deliberately intended to mislead the Board there is no doubt in my mind that their actions had this result.

 

18.5 FINANCIAL PERFORMANCE OF INVESTMENT

 

This Section contains a technical and detailed analysis of the financial performance of the Bank's investment in United Banking Group which highlights the shortcomings in the Bank's due diligence process.

I have assessed the financial performance of United Banking Group under the following sub headings:

(a) Pre-acquisition Historic and Forecast Trading Results: The historic and forecast trading results which were available to members of the Bank due diligence team;

(b) Post Acquisition Trading Results: The post acquisition trading results for United Banking Group, and compares the reported results with the forecasts included in the Recommendation paper;

(c) Assets and Liabilities: The net asset adjustments which were identified as part of the due diligence process, and compares these with actual adjustments made both at 30 June 1990 (the acquisition date), and subsequently; and

(d) Summary of Financial Performance: Compares the actual financial consequences of the investment in United Banking Group with the initial investment criteria contained in the Recommendation.

18.5.1 BACKGROUND

A "run" on funds was experienced by United Building Society in August 1988, and some $NZ 170.0M was withdrawn over a three day period. This led to a subsequent reduction in profitability, as United Building Society had to rely more heavily on expensive wholesale funding, and pay high rates to attract "retail funds" because of a perceived risk associated with the United Building Society not being a bank. In January 1990, United Building Society's retail funds stood at some $NZ 30.0M lower than they were in December 1988. Against this background, the following commentary on the United Building Society financial position is relevant.

18.5.2 PRE-ACQUISITION HISTORIC AND FORECAST TRADING RESULTS

The following table summarises the reported results of United Building Society for the two years ended 30 September 1988 and 1989, and includes the forecasts provided to the Bank by United Building Society for the four years ending 30 September 1993:

 

Year Ending 30 September

 

Item

1988
Actual
$NZ’000

  

1991
Forecast
$NZ’000

  

1992
Forecast
$NZ’000

  

1993
Forecast
$NZ’000
United Building Society

15.0

  

33.0

  

37.0

  

43.0
United Realty

2.0

  

3.0

  

4.0

  

4.0
United Lifecare

(3.0)

  

-

  

-

  

-
United Sharebrokers

(2.0)

  

-

  

-

  

-
Allied Mortage Guarantee

(1.0)

  

-

  

-

  

-
Net Operating Profit/(Loss)              
Before Tax & Extraordinary items

11.0

  

36.0

  

41.0

  

47.0
Extraordinary and other
items (including goodwill)

5. 0

  

1.0

  

-

  

-
Subtotal

16.0

  

37.0

  

41.0

  

47.0
Income Tax (forecast at 33
per cent)

(2.0)

  

(12.2)

  

(13.5)

  

(15.5)
Net Operating Profit/(Loss)              
After Tax & Extraordinary items

14.0

  

24.8

  

27.5

  

31.5

The following general observations may be made in respect of the table above:

(a) United Building Society subsidiary operations had historically traded unprofitably, with the exception of United Realty;

(b) The subsidiary operations, other than United Realty, were forecast to have no impact on United Building Society's profitability beyond 1990, because they were recommended to be disposed of, or wound up (a review of subsidiary operations was included in the Recommendation);

(c) United Building Society had reported declining profitability, but was forecast to return to profitability by 1991 which, according to the Recommendation, would be achieved by:

(i) reduced cost of funds due to the conversion to bank status. Details of these reduced costs were not specified, although the Recommendation did refer to United Banking Group being able to accept trust fund deposits which would give an "immediate profit improvement of $NZ4.0M per annum"; and

(ii) synergies in respect of expense savings available from the Bank.

(d) The forecast tax expense for 1990 of $NZ 8.4M is inconsistent with the forecast pre-tax loss of $NZ 13.1M. There was no reconciliation of the tax expense on the Ayers Finniss due diligence files, but, a file note suggested that it comprised $NZ 15.0M of income tax expense in relation to the Lifecare operations, offset by income tax credits of $NZ 6.6M.

I have analysed the reported and forecast trading results for the United Building Society over a number of separate periods. These trading results are analysed under the following headings:

(i) Trading results for two years ended 30 September 1989;

(ii) Trading results for the six months ended 31 March 1990; and

(iii) Forecast trading results for the year ended 30 September 1990.

In addition, I have set out below the relevance of the historic actual trading results to the due diligence process, and a comparison of forecast, with actual, results for the year ended 30 September 1990.

18.5.2.1 Trading Results for Two Years Ended 30 September 1989

The Recommendation stated that United Building Society had reported net operating profits, before extraordinary items and tax, of $NZ 11.0M and $NZ 4.0M for the two years ended 30 September 1988 and 30 September 1989, respectively. The Recommendation disclosed slightly different profit figures from those actually reported by United Building Society. The differences, however, are not material.

These results were subject to review by the Bank Lending Credit Committee and Peat Marwick. The table below sets out the "one-off" items identified in those reviews:

 

Year Ended 30 September


Item

  

1988
$NZ M

  

1989
$NZ M
Net Operating Profit before tax, extra-ordinaries and goodwill per United Building Society Recommendations (see above table)  

 

11.0

  

 

4.0
Actual reported Operating Profit before tax, extraordinary items and goodwill amortisation per audited accounts  

 

10.3

  

 

4.2
Identified "One-off" items;        
  • Profit on sale of properties to NZPST
      

(7.6)
  • Change in accounting policy on investments
      

(3.2)
  • Gain on sale of government bonds
      

(2.0)
  • Securitisation costs
      

1.0

Adjusted Operating Profit/(Loss) Before Tax

  

10.3

  

(7.6)

In a report entitled "Call Report" dated 15 June 1989, Mr Morrison stated that "the second six months [to 30 September 1989] will show a profit of $15-16 million but I gather that UBS are working on a couple of "profit related deals" which will have the effect of exaggerating the actual trading performance. The split of actual earnings and generated earnings was unable to be ascertained." The view that these observations should have resulted in a critical analysis of trading results being carried out by the due diligence team is discussed later in this report.

18.5.2.2 Trading Results for the Six Months Ended 31 March 1990

United Building Society issued a prospectus dated 29 June 1990, which included results for the six months ended 31 March 1990 which showed:

(a) an operating loss before abnormal items and tax of $NZ 9.6M; and

(a) an after tax loss of $NZ 17.5M.

18.5.2.3 Relevance of Historic Actual Trading Results to Due Diligence Process

Based on the available historic trading results, the Bank due diligence team was clearly on notice that United Building Society was trading unprofitably, because:

(a) The Bank Lending Credit Committee had previously reviewed the reported results for the year ended 30 September 1989, and was on notice (for reasons explained in Section 18.6.4.5(i) hereunder) the reported profit was unsustainable.

(b) Mr Morrison, of the Bank, who was involved in both the due diligence review of United Building Society's receivables and Allied Mortgage Guarantee, was aware of the circumstances of the United Building Society, as evidenced by his "Call Report" of the 15 June 1989.

(c) Peat Marwick's draft report, dated 3 May 1990, specifically referred the "one-off" items to the attention of Mr Copley (although he states he has no recollection of sighting this report).

(d) United Building Society had reported losses for the five months ended 28 February 1990 (see below) and for the six months ended 31 March 1990.

Accordingly, the due diligence team would have been aware that the reported and forecast results were fundamental risk areas. Based on this evidence, I would have expected the financial due diligence review to encompass the following:

(a) a detailed review and analysis of the historical results of the United Building Society Group in order to identify the underlying causes for the trend in earnings;

(b) an analysis of the basis of forecast profitability in order to identify the specific key assumptions which contributed to the forecast reversal of trading losses; and

(c) a critical assessment of the reasonableness and achievability of the key assumptions in order to identify their vulnerable areas, particularly on the basis of the findings in (a) above. I would have expected any identified vulnerabilities to have been quantified accordingly in the Recommendation.

18.5.2.4 Forecast Trading Results for the Year Ended 30 September 1990

As disclosed in the Recommendation, the Bank had expected United Banking Group to report an operating loss before extraordinary items, goodwill, and tax, of $NZ 11.3M for the year ended 30 September 1990.

On 4 May 1990, Ayers Finniss were provided by Mr Cooper with the following financial information for the year ended 30 September 1990. I have included in the table below the comparative full year forecasts included in the Recommendation.



Entity/Item

5 months
to
28/02/90
Actual

  

4 months
to
30/06/90
Forecast

  

3 Months
to
30/09/90
Forecast

  

Year
Ended
30/09/90
Forecast

  


Year Ended
30/09/90
Recommendation

Banking

(6.9)

  

-

  

1.0

  

(5.9)

  

(5.9)

Capital

-

  

-

  

5.0

  

5.0

  

-

United Realty

0.3

  

0.7

  

0.7

  

1.7

  

1.7

United Lifecare

(2.2)

  

(1.3)

  

1.5

  

(2.0)

  

(4.5)

United Shareholders

(0.6)

  

(0.4)

  

-

  

(1.0)

  

(1.0)

Allied Mortgage Guarantee

(1.6)

  

-

  

-

  

(1.6)

  

(1.6)
                   

Profit/(Loss) before
goodwill and tax

(11.0)

  

(1.0)

  

8.2

  

(3.8)

  

(11.3)

Goodwill

(0.8)

  

(0.5)

  

(0.5)

  

(1.8)

  

(1.8)
                   

Profit/(Loss) before tax

(11.8)

  

(1.5)

  

7.7

  

(5.6)

  

(13.1)

Taxation

            

(10.0)

  

(8.4)
                   

Loss after tax

            

(15.6)

  

(21.5)

The above actual and forecast trading results were received by Ayers Finniss five days before the submission of the Recommendation to the Bank Board. The due diligence work performed on these forecasts is discussed later in this report.

The above table highlights the following:

(a) Ayers Finniss were in receipt of actual trading results for the five months to 28 February 1990 prior to the preparation of the Recommendation.

(b) The profit and loss forecasts for the year ended 30 September 1990 included in the Recommendation accords with the financial information provided by United Building Society with the exception of:

(i) the exclusion of `capital' income presumably related to the $NZ 150.0M capital injection by the Bank; and

(ii) a possible reclassification (or adjustment) of $NZ 2.5M of the Life Care loss as taxation expense.

It is important to bear in mind that United Building Society was forecasting a significant turnaround in trading results before the acquisition by the Bank. A trading loss before goodwill and tax of $NZ 11.0M was recorded for the five months ended 28 February 1990, whereas the comparative forecast result for the four months ended 30 June 1990 was a loss of only $NZ 1.0M. I would expect that this assumed turnaround would have been subject to critical review, because it indicated a turnaround in trading results prior to the conversion to a bank, and prior to the capital injection by the Bank.

18.5.2.5 Comparison of Forecast with Actual Results for the Year Ended 30 September 1990

It is not possible to directly compare the actual results for the year ended 30 September 1990 against the forecast presented to the Bank directors because of changes brought about by the restructure of the United Banking Group. Consolidated trading results for the United Banking Group were not prepared for this period.

In the post acquisition period between 30 June 1990 and 30 September 1990 United Bank was restructured in an endeavour to restore it to profitability. A series of transactions were arranged to:

(a) Sell unprofitable subsidiaries and non performing assets to the State Bank (NZ) and related companies. This resulted in United Bank not recording any losses for the three months ended 30 September 1990 in relation to the unprofitable subsidiaries which were sold. The losses of these companies are, however, included in the consolidated results of the Bank post acquisition. Each subsidiary was sold for the book value of the investment in United Bank's books of account at the time of sale, which represented the original cost of the investment except for United Lifecare Limited where a $NZ 10.0M provision for diminution in the value of the United Banking Group's investment had been made prior to the acquisition of United Banking Group by the Bank. This $NZ 10.0M provision is discussed in more detail later in this report. Those subsidiaries and non-performing assets disposed of were:()

(i) Disposed on 1 July 1990

United Realty and its subsidiaries and associates; Marac Building Society; United Sharebrokers.

(ii) Disposed on 28 September 1990:

United Group Securities Limited and its subsidiary - Allied Mortgage Guarantee Company; United Lifecare and its subsidiary - United Lifecare (Nelson) Ltd;

The subsidiary companies were sold for $NZ 117.3M, and consideration was paid in cash, on 28 September 1990. The transaction resulted in a corresponding reduction in United Banking Group's investment in subsidiary companies of $NZ 117.3M.

Two properties (Mayoral Drive and Customhouse Quay) were sold to Bank related companies on 28 September 1990, which generated a profit of $NZ 13.2M. The disposal values were based on independent valuations, obtained as at 30 June 1990. As at 30 June 1991, these two properties, which were still owned by the Bank, were devalued by $NZ 8.7M based on current property valuations.

(b) Create additional income in United Bank by charging additional interest and "one-off" charges to former subsidiaries and to the State Bank (NZ). The charges were made to ensure that commercial charges were being made for intercompany transactions. As a result of these charges, profits of United Bank were increased by approximately $4.7M for the three month period, and an equivalent level of additional expenditure was included in the trading results of former United Building Society subsidiaries.

As a result of the above action, United Bank reported a profit for the three months to 30 September 1990 of $NZ 20.6M compared to the forecast profit for the same period of $NZ 1.0M.

A Bank Board Paper, prepared by Mr Morgan and presented by Mr Paddison, dated 26 September 1990, contained financial projections for the quarter to 30 September 1990. These projections were:

Item

$NZ M
Losses for July, August, September (1990)

(4.4)
Interest and "one-off" charges to former subsidiaries
and to the State Bank (NZ)

4.7
Change in accounting policy

1.1
Establishment of deferred tax asset

7.0
Gain on sale of properties

13.2
Revaluation reserve transfer against profit

(3.0)
   
Profit for the quarter

18.6
   
Unexplained difference between schedule of profit forecast
and actual results included in prospectus

2.0
   
Profit for the quarter

20.6

18.5.3 POST ACQUISITION TRADING RESULTS

18.5.3.1 Forecast Trading Results For The Year Ended 30 June 1991

After the acquisition, United Banking Group prepared a budget for the year ended 30 June 1991 (as opposed to the forecasts in the Recommendation which were for years ending 30 September) showing a forecast profit before tax of $NZ 4.4M. This compares with the pre-acquisition forecast profit, before tax and extraordinary items, of $NZ 36.0M for the year ended 30 September 1991 included in the Recommendation paper, Attachment 1.1.

The forecast in the Recommendation assumed, amongst other things, that the launch of the bank, and the introduction of new bank products, would take place early in September 1990. The budget was based on the year ended 30 June 1991, and the bank launch and cheque product launch were deferred to November 1990. Mr Cooper stated in a memorandum obtained by the Investigation that:

"... this clearly has a significant effect on many of the assumptions made in the forecast. This can be rather crudely adjusted for as follows:

Current budget $4.4m

eliminate losses of July, August, September 1990 4.0m

add back profits for July, August, September 1991 4.5m

Adjusted profit (pre and post tax) 12.9m

..."

The above analysis indicates that the original forecast of $36.0M for the year ended 30 September 1991 is appropriately comparable with Mr Cooper's budgeted "adjusted profit" for the same period of $12.9M.

Mr Cooper prepared an analysis of the differences between the 1991 budget (a pre-tax profit of $4.4M) and the original forecast profit of $NZ 36.0M provided to the Bank. This analysis was contained in an undated reconciliation, signed by Mr Cooper (an earlier version of which was contained in an Ayers Finniss facsimile, dated 12 September 1990), and the reconciliation has been summarised as follows:

 

 

Item $NZ M
Pre-tax profit originally forecast (year ended 30 September 1991) 36.0
   
Retail funds mix adjustment  
The forecast assumed an early move to a low cost of retail funds, based on a new cheque account and a new serious saver account. The budget showed a "no-change" position. (6.0)
Origination  
The forecast assumed mortgage originations of $NZ 14.0M per week, compared with $NZ 10.0M per week in the budget. (4.7)
Non accrual loans  
The forecast assumed that all advances were earning at mortgage rate, and non-accrual loans were not recognised. (3.5)
Index linked stock  
The forecast assumed a tax effected income on $NZ 77.0M of preference shares presumably resulting from the realisation of carried forward tax losses. The budget, however, showed the income stream to be post tax. (4.5)
Opening reserves  
The forecast assumed $NZ 33.0M of opening reserves in United Building Society, whereas the budget shows $NZ 11.0M (ie the financing cost at 13 per cent on the shortfall of $NZ 22.0M). (2.8)
Property development income lower than forecast. (1.5)
United Sharebrokers profit of $NZ 1.0M per forecast not in budget. (1.0)
United Lifecare profit forecast was $NZ 1.4M higher than budget. (1.4)
Wholesale fund margins:

a. The forecast assumed that all wholesale funds were immediately repaid, whereas the budget showed that two facilities could not be unwound until maturity.

 (0.5)

b. The forecast assumed a 1.4 per cent margin between wholesale rates and mortgage rates, whereas the budget used an average margin of 1.1 per cent.

 (1.2)
Overheads  
Budgeted overheads were $NZ 4.0M higher than the forecast. (4.0)
Other (sundry) (0.5)
   
Budgeted pre-tax profit (year ended 30 June 1991) 4.4

The most significant items above relate to "core" banking related items: retail funds mix adjustment, origination, non accrual loans, and overheads. Given that the underlying premise of the forecast return to profitability related to the impact of the conversion to a bank, those items should have been the subject of rigorous due diligence analysis. The forecast shortcomings were not detected in this way.

The overstatement on income from the index linked stock arose from the inclusion in the forecast of pre-tax profit, which should have been post tax. In my opinion, a detailed line-by-line review of the forecasts during the due diligence review should have detected such a mistake.

In my opinion, given that the adjustments noted above were identified only three months after the due diligence examination, their nature and magnitude indicates that the due diligence process had not adequately investigated the forecasts of United Building Society.

18.5.3.2 Actual Trading Results for the Year Ended 30 June 1991

I have received an analysis of the State Bank (NZ)'s consolidated trading results for the year ended 30 June 1991 from Mr G Clifford (Group Financial Controller of the Bank's Auckland branch). The analysis separately identified the results of the State Bank (NZ) and the entities which formerly comprised United building Society, prior to the restructure referred to above.

Mr Clifford's analysis is summarised as follows:

 

$NZ M

Consolidated loss before tax

118.1

Income tax expense

5.2
   

Consolidated loss after tax

123.3

Included in the 1991 result, however, are two items of expense which are effectively acquisition costs and had been identified as such in the Recommendation. These are:

(a) Funding costs of some $NZ 20.8M, associated with the $NZ 150.0M purchase price, which was borrowed internally by the State Bank (NZ), and injected into United Banking Group.

(b) Provisions of $NZ 24.3M for interest premium payments to United Building Society depositors.

These items should be excluded from the recorded result for the purposes of comparison with the original forecast included in the Recommendation. Excluding these items, the pre-tax loss of the United Banking Group for the year ended 30 June 1991 was $NZ 73.0M.

This result should be compared to the original (pre-acquisition) pre-tax forecast profit of $NZ 36.0M for the year ended 30 September 1991, and the budgeted pre-tax profit of $NZ 4.4M (discussed above), for the year ended 30 June 1991, which was prepared within two months of the acquisition on 30 June 1990.

The above analysis highlights the dramatic turnaround in the fortunes of United Building Society/United Banking Group as is summarised below:

(a) On 20 April 1990 Ayers Finniss were provided with a pre-tax profit forecast of $NZ 36.0M for the year ended 30 September 1991.

(b) Within two months after the acquisition, United Banking Group budgeted pre-tax profit of $NZ 4.4M for the year ended 30 June 1991.

(c) United Banking Group's actual comparable result for the year ended 30 June 1991 was a pre-tax loss of $NZ 73.0M.

The adequacy of the due diligence in assessing the reasonableness of the assumptions underlying the profit forecast of $NZ 36.0M is discussed in this report in the topic of "Financial Review" hereunder.

I have received an analysis of the 1991 results from Mr Clifford, which sets out the abnormal items included in the trading results for 1991. A summary of this analysis is presented below:

Abnormal Items

$NZ M

Loss on revaluation of properties

27.4

Provision for interest premium incentives to United Building
Society depositors


24.3

Redundancy and retrenchment

3.2

Bank launch expense

1.6
 

56.5

Other items

14.2
 

Total

70.7

The above items have been represented to the Investigation by Mr Clifford as being on a post-tax basis. Therefore, by excluding these amounts from the reported loss of $NZ 123.3M, it is implied that the United Banking Group incurred an operating loss before abnormal items, of $NZ 52.6M.

In my opinion, given the nature and timing of the abnormal losses in the table above, it is reasonable to expect that they should, in large part, have been identified in the due diligence investigation, and been taken to account in the Recommendation. Other material items included in the above table are discussed below. Of the items above, only the interest premiums incentives were reviewed and identified in the Recommendation.

Loss on Revaluation of Property

I would have expected property valuations for part or all of the property portfolio to have been reviewed or requested as part of the due diligence, given:

(a) the book value of land and buildings at 30 September 1989 was a substantial amount ($NZ 134.6M), of which $NZ 62.4M related to investment properties (Lifecare $NZ 62.2M) and properties held for resale ($NZ 0.2M); and

(b) the depressed state of the property market; property valuations prepared for purchase accounting purposes for United Building Society in June 1990 having referred to the "sluggish" state of the investment market, "particularly for properties exceeding $NZ 3.0M in value".

The Investigation has reviewed the due diligence files provided to them by the Bank and Ayers Finniss, and these files contained no documentary evidence that independent valuations were obtained on United Banking Group properties as part of the due diligence conducted. It is not possible to specifically identify the losses which might reasonably have been anticipated even if valuations had been obtained (for properties other than Lifecare and those held for resale) in the due diligence process. Given the magnitude of the writedowns noted above, however, and the fact that they were recognised within twelve months of acquisition, in my opinion, further write-downs (of properties other than Lifecare and those held for resale) would have been detected in a comprehensive due diligence review.

Without valuations at the date of acquisition, however, it is not possible to allocate the loss between those which had already accrued at acquisition date and those brought on by subsequent events.

Redundancy and Retrenchment Costs and Bank Launch Expenses

I would have expected these items to have been taken into consideration in the due diligence review of forecast trading results. Given the nature and circumstances of the transaction, these expenses should have been anticipated, estimated, and included in the forecast trading results. To this extent part of, if not all, the aggregate of the $4.8M cost of these items could be attributed to inadequate due diligence.

18.5.4 ASSETS AND LIABILITIES

In analysing the investment in United Banking Group, a review was undertaken by my Investigation of the assets and liabilities as follows:

(a) Initial book value of the assets and liabilities, that is the values at which they were carried in the accounts of United Banking Group prior to the acquisition.

(b) Bank assessed values, that is the values which Bank management placed on the assets and liabilities of United Banking Group on the basis of their due diligence investigations. These values were stated in the Recommendation and I have assumed they therefore represented the genuine Bank assessment of the value of net assets of United Banking Group.

(c) Written down values for the purchase accounting(), that is the balance sheet reflecting all the pre-acquisition writedowns and accruals, as at the date of acquisition.

(d) Written down values reflecting a hindsight view of specific under provisioning at acquisition for items which, in my opinion, were reasonably capable of detection in the due diligence process.

The following analysis sets out the United Banking Group net asset position, as disclosed in the Recommendation, and shows the impact of specific writedowns which, in my opinion, were capable of being anticipated, at least to some extent, in the due diligence review:

 

$NZ M
Net assets at 30 September 1989 per Recommendation

83.0
   
Adjustments identified in due diligence investigation

(42.8)
   
Net assets at the Bank/Ayers Finniss assessment

40.2
Additional adjustments made for accounting purposes which,
in my opinion, should have been identified in the due diligence
investigation (see Section 18.5.4.1)

 

(25.9)
   
Specific post acquisition losses which are likely to have been capable
of anticipation through pre-acquisition due diligence:

14.3
   
- Loss on revaluation of properties

(27.4)
   
- Redundancy and bank launch expense

(4.8)
   
Implied net asset value on acquisition adjusted for specific writedowns

(17.9)

18.5.4.1 Comparison of Adjustments Identified by Bank Management at time of acquisition with Actual Purchase Accounting Adjustments Made

Set out below is a comparison of the net asset adjustments identified in the due diligence review, and the actual pre-acquisition adjustments made in the nine months ended 30 June 1990. As a result of this comparison, exclusive of the additional adjustments totalling $NZ 8.7M effected in relation to Goodwill write-offs, an additional $NZ 25.9M of adjustments were identified, which, in my opinion, were capable of identification in large part by the due diligence investigation.

   


Per
United Building
Society
Recommendation
May 1992

  

Actual
Adjustments
Made in
United Building
Society ‘s
Accounts

  

Additional
Writedowns
Capable of
Identifications
in Due
Diligence

  


Refer
Comments
in
Paragraph
18.5.4.2
   

(1)
$NZ M

  

(2)
$NZ M

  

(3)
$NZ M

  

Below
Reserves at 30/09/89  

83.0

  

82.2

        
Losses (pre-tax)                
Year to 30/09/90 (forecast)  

(10.6)

            
9 months to 30/06/90      

(17.8)

  

(7.2)

  

(a)
Lifecare tax provision  

(15.0)

  

(8.3)

        
Goodwill write-off                
- United Realty  

(2.0)

  

(7.5)

        
- Allied Mortgage Guarantee  

(3.3)

  

(3.3)

        
- Marac Building Society (a non-operating subsidiary of United Building Society)  

-

  

(1.6)

      

(b)
- United Shareholders  

-

  

(0.7)

        
- Other  

-

  

(0.9)

        
Lifecare write-down
Bad debt provisions and write offs		  

(10.0)

  

-

      

(c)
- Commercial  

(6.7)

  

(14.4)

        
- Mortgage  

-

  

(1.1)

        
- Allied Mortgage Guarantee provisions  

-

  

(3.0)

        
- General provisions
(commercial and mortgage)		  

-

  

(5.8)

  

(17.6)

  

(d)
Net Present Value of future profits to terminating members (prior
year under provisions)		  

(4.3)

  

-

        
Loss from Realty Guarantee Scheme  

(1.0)

  

-

        
Losses on "off-balance sheet" structures on basis of marking to market  

(5.0)

  

-

        
Accounting policy change-                
Associates  

-

  

(1.1)

        
Property writedowns  

-

  

(1.1)

  

(1.1)

    
Loss on sale of assets  

-

  

(0.8)

        
Tax effect of above  

15.1

  

-

      

(e)
Various minor writeoffs  

-

  

(2.6)

        
                 
Total adjustments  

(42.8)

  

(70.0

  

(25.9)

    
                 
Adjusted Researves                
-At 30/09/90  

40.2

            
                 
-At 30/06/90      

12.2

        

It is important to note the following points in respect of the numbered columns in the above table:

(1) The adjustments made by the Bank due diligence team in arriving at the value of net assets on acquisition were in respect of the United Building Society balance sheet rather than the consolidated United Building Society Group balance sheet. The Recommendation (May 1990) referred to the adjusted value of forecast net assets being acquired as at 30 September 1990, rather than as at the date of acquisition, being 29 June 1990.

(2) This column sets out the actual adjustments made to the United Building Society net assets during the nine months ended 30 June 1990. These are based on the schedule of movements in reserves, provided by Mr Cooper on 19 August 1991, and subsequent supporting schedules, provided on 29 August 1991.

(3) I have only identified those items which, due to their underlying nature, I would have expected to have been recognized and taken into account in the due diligence investigation.

18.5.4.2 Notes on differences between adjustments identified in the due diligence and actual pre-acquisition adjustments

(a) Additional Operating Losses

United Banking Group's pre-tax operating losses, for the nine months to 30 June 1990, were $NZ 17.8M, based on a schedule of reserve movements for the same period provided to me by Mr Cooper. I have not discovered any evidence which provides the basis for the estimate of the pre-tax losses of $NZ 10.6M given in Attachment 1.5 of the Recommendation. Given that the due diligence investigation was conducted in early May 1990, I would have expected the review to uncover further losses where these were as material as those incurred within 8 weeks of 9 May 1990.

(b) Goodwill Write-off

The due diligence review did not anticipate the full extent to which goodwill was to be written down at 30 June 1990. In a memorandum from Mr Cooper to Mr Sylvester Riddell (the Bank Auckland branch) dated 22 August 1991 it was noted that at 30 June 1990 goodwill was written off in accordance with the Bank's request.

Goodwill on consolidation was written off by an additional $NZ 8.7 million in excess of the writedown identified by the bank due diligence team. Mr Copley has stated that the motivation behind the write-off was to "clean up" the balance sheet prior to acquisition, writing goodwill off against pre-acquisition reserves and thereby obviating the need for post-acquisition amortisation of goodwill against operating profits. The intention to write off further goodwill in this way and for this reason, however, was not disclosed to the Bank directors in the Recommendation, although the method of valuation of United Realty was disclosed, and a recommendation made that goodwill on United Realty ($NZ 2.0M) and Allied Mortgage Guarantee ($NZ 3.3M) be written off. The absence of any reference in the Recommendation to the intention to "clean up" the balance sheet in this way, whilst not necessarily the responsibility of the immediate due diligence team, reflects poorly on the quality of communication, generally, between the senior executives of the Bank and the Board.

(c) Lifecare Writedown

The writedown made to the United Building Society accounts in respect of United Lifecare was to recognise prior year losses in the parent company's balance sheet which had been recognised on consolidation prior to 30 June 1990 in the Group accounts. As a result of this, no equivalent adjustment was made to the consolidated group results as at 30 June 1990. This adjustment is further discussed under the topic heading "Write-down of Investment in Lifecare." ()

(d) Increase in Bad Debt Provisions

Additional bad debt provisions of $NZ 17.6M were made at 30 June 1990. I would have expected the majority of the provision to have been identified as part of a thorough due diligence review of receivables, as this review was fundamental to the due diligence, and the adjustment was identified only a short period (two months) after the review. Mr Morrison told the Investigation that of the $NZ 17.6M:

(i) $NZ 3.0M relates to the guaranteed house sale product promoted by Allied Mortgage Guarantee. Mr Morrison stated that he had identified a potential liability for a sum of this magnitude and that if the due diligence team chose to discount his findings in this regard it should not be held against him. I accept his assertions on this matter.

(ii) $NZ 5.8M relates to receivables other than the commercial portfolio which he was only to review. I accept his assertions on this matter.

(iii) $NZ 3.1M relates to additional provisions to provide for the exposures of the Bank to holding and realisation costs which Mr Morrison states he was instructed to ignore by Mr Steel. Mr Steel says that he did not instruct Mr Morrison to exclude any items he identified.

(e) Reversal of Tax Benefit

The Recommendation assumed that the majority of write-offs required to reserves and retained earnings pre-acquisition, would give rise to a $NZ 15.1M tax benefit to United Building Society. A thorough review of United Banking Group's historical and forecast trading results, however, would have raised serious questions as to the realisability of such future taxation benefits. In accordance with generally accepted accounting practice, a future tax benefit should only be recognised where there are reasonable grounds to expect it will be recovered. This item has not been taken into consideration in my calculation of the adjusted level of United Banking Group's net assets at 30 June 1990, as it cannot be categorically stated that there were no reasonable grounds for recognising the future income tax benefits. I further note, however, that all future income tax benefits, were written off in the year ended 30 June 1991.

18.5.4.3 Summary of Financial Performance Against the Bank Performance Criteria

The following factors demonstrate that the investment in United Banking Group did not achieve the performance targets set out in the Recommendation, which provided the basis for the investment decision:

(a) United Banking Group significantly under-performed the forecast results provided in the Recommendation, as evidenced by:

(i) the revision of the 1991 operating profit forecast from $NZ 36.0M to $NZ 4.4M (or an "adjusted profit" for the comparative period of $12.6M) which occurred in August 1990, some 3 months after the due diligence review; and

(ii) the actual comparable result for the year ended 30 June 1991 was a pre-tax loss of $NZ 73.0M, compared with the original forecast pre-tax profit for the year ending 30 September 1991 of $NZ 36.0M.

(b) United Banking Group's forecast net asset position of $NZ 40.2M as at 30 September 1990, as assessed by the Bank management in the Recommendation was overstated, as evidenced by:

(i) the pre-acquisition adjustments made for the purposes of purchase accounting, included writedowns of $NZ 34.6M in addition to writedowns identified in the Recommendation. In my opinion, $NZ 25.9M of these writedowns were capable of being detected in the due diligence review; and

(ii) certain of the writedowns and losses recorded in the year ending 30 June 1991 relating to items and circumstances which, in my opinion, were capable of detection and should by reasonable competence have been detected in the due diligence investigation prior to acquisition (revaluation of properties, redundancy and bank launch expenses and additional interest premium incentives).

(c) It is my opinion that, based on evidence available to my Investigation, there was a net deficiency in funds of the United Building Society of $NZ 17.9M instead of the assumed reserves of $NZ 40.2M as reflected in the Recommendation. Consequently, the assessment of the cost of the acquisition and the related conclusion that the net present value of the consideration paid to shareholders of the Building Society was substantially exceeded by its reserves, was incorrect.

 

18.6 EFFECTIVENESS ASSESSMENT: THE DUE DILIGENCE PROCESS AS APPLIED TO UNITED BUILDING SOCIETY

 

In assessing the adequacy of the due diligence investigation of United Banking Group, the Investigation reviewed the stated strategic objectives of the Bank and financial criteria described above. The Investigation also encompassed a review of the information on United Banking Group which was made available to the Bank at the time of carrying out their due diligence investigation. On the basis of that review, an assessment of the business fundamentals of United Banking Group has been prepared, around which a due diligence investigation should have been performed in order to ensure:

(a) that the financial and strategic objectives were capable of being met by the investment; and

(b) that all material risks and exposures were identified.

An important issue in relation to the acquisition was that United Building Society was to convert from a building society to a corporation, and to obtain a banking licence prior to the acquisition. Any due diligence examination would need to have confirmed that there would not be any legal impediments to United Building Society obtaining a banking licence. The Bank had set performance standards, generally, for its investments, and the due diligence investigation should have confirmed whether United Banking Group was financially capable of achieving those objectives. Another important area requiring attention was the review of receivables to ensure that adequate provisions for problem loans had been set up prior to acquisition.

18.6.1 BUSINESS FUNDAMENTALS AND RISK ANALYSIS

The fundamental issues assessed by this Investigation as relevant to the acquisition of United Banking Group are:

(a) industry background and regulatory compliance;

(b) management and control systems;

(c) review of receivables; and

(d) financial review.

The detailed investigations and inquiries which would have been necessary to adequately address the key due diligence issues described above, have been separately considered. It is against these due diligence issues that the Investigation has compared and evaluated the due diligence conducted by the Bank. Discussion and findings of this analysis are set out below.

18.6.2 INDUSTRY BACKGROUND AND REGULATORY COMPLIANCE

18.6.2.1 Definition and Applicability of this Item to the Due Diligence Process

The objective of this analysis is to confirm that the acquisition of United Building Society could proceed without legal impediment. As discussed above, the acquisition of United Building Society was complicated by the following unique circumstances:

(a) United Building Society was a building society constituted under a specific charter, and regulated by a specific statute.

(b) The transaction first required the conversion of the building society into a company and to be licensed to carry on business as a bank, requiring necessary approvals from:

(i) the Registrar of Building Societies; and

(ii) the Reserve Bank of New Zealand.

(c) The acquisition of United Building Society by the Bank required necessary foreign investment approvals in New Zealand.

18.6.2.2 Specific Actions Required

Having regard to the above, the due diligence process should have included the following steps:

(a) consultation with appropriate legal and industry experts, including a review of the relevant statute and regulations and constituent documents of United Building Society to identify and understand all relevant regulatory issues;

(b) taking appropriate legal advice to obtain an understanding of the steps required in the acquisition of a banking licence. This would identify any obligations that may arise for the Bank by virtue of its involvement in the transaction;

(c) enquiry of the Registrar of Building Societies and Reserve Bank of New Zealand as to whether they had any concerns in relation to United Building Society, or the proposed acquisition; and

(d) enquiry of the Reserve Bank of Australia ("Reserve Bank") as to whether they had any concerns with the proposed transaction.

18.6.2.3 Specific Actions Performed

Mr Janes advised the Investigation that Mr Franks of Chapman Tripp Sheffield Young, Solicitors, was seconded to United Building Society to assist in the preparation of the conversion documents. Furthermore, Mr Ross of Buddle Findlays, Solicitors, reviewed certain agreements and documentation on behalf of the Bank. Mr Janes also advised the Investigation that a review of the "legislation etc" had been carried out by Ayers Finniss and the State Bank (NZ) in late 1989, and that Chapman Tripp Sheffield Young had reviewed the "Act".

Mr Mallett advised the Investigation that he approached the Reserve Bank of New Zealand and the Reserve Bank of Australia to formally gain approval for the transaction to proceed on 24 May 1990. The Reserve Bank of Australia obtained an assurance from Mr Simmons in a letter, dated 24 May 1990, that "...on the basis of the extensive due diligence undertaken and the associated reports provided to the Board, we are satisfied that the information supplied by the appointed consultants concludes that UBS is both sound in its financial structure and viable in its operation..."

The Acquisition Agreement between the Bank and United Building Society dated, 10 May 1990, which was subject to the conversion of United Building Society to a bank, and the capital injection of $NZ 150.0M by the Bank, was reviewed by the Legal department of the Bank.

There is considerable correspondence on the Ayers Finniss files, including letters from both Buddle Findlays and Chapman Tripp Sheffield Young in respect of:

(a) the conversion;

(b) obtaining a banking licence; and

(c) the acquisition by the Bank.

This correspondence refers to the following parties (amongst others):

(a) the Reserve Bank of New Zealand;

(b) the Reserve Bank of Australia;

(c) the Registrar of Building Societies;

(d) the Overseas Investment Commission; and

(e) the New Zealand Commerce Commission.

Mr Janes advised the Investigation that "all relevant/necessary consent" was obtained. Based on the review of the due diligence files, adequate steps appear to have been taken to have uncovered any problems with regulatory compliance.

18.6.2.4 Losses Arising from the Non-Execution of Identified Actions

Mr Janes advised the Investigation that the transaction, conversion, and acquisition, proceeded smoothly, and that no legal impediments arose in relation to the acquisition. The Investigation's review of the due diligence files and documents obtained from the files of Mr Copley, Mr Clark, and Mr Mallett, support Mr Janes's assertion that no legal impediments arose in relation to the acquisition.

18.6.3 QUALITY OF MANAGEMENT AND CONTROL SYSTEMS

The key objective of this step is to assess the strengths and weaknesses of management and internal control systems, to assess the apparent reliability of these systems, and to evaluate the ability of the organisation to convert to a subsidiary of the Bank.

Accordingly, the due diligence team investigation should evaluate the key skills of the management team, and the integrity and adequacy of the system of internal control, which existed at the time of acquisition.

One area where internal controls would be particularly important is receivables. The adequacy of internal controls have a direct impact on the quality of the loan book, and the level of provisioning required for problem loans over the maturity term of the loan portfolio. These internal controls will also influence the reliance which can be placed on the systems and information provided by these systems in the due diligence review of receivables.

18.6.3.1 Specific Actions Required

In order to achieve the above objectives, the due diligence investigation would need to have considered:

(a) the approach of management to, and the extent of, centralisation/ decentralisation of authority;

(b) whether the past management approach would be suited to the new organisation;

(c) the past record of the management team;

(d) the career histories and performance of key individuals;

(e) the quality of the budgetary and planning process, and whether long term plans existed; and

(f) the extent to which basic internal controls operate in the organisation, and the reliance which could be placed on them.

18.6.3.2 Specific Actions Performed and their Shortcomings

(a) Management

An independent firm of consultants, John Peebles Associates, was engaged by Ayers Finniss to undertake a review of management at United Building Society. Mr Janes stated to the Investigation that Mr Peebles had recently completed a similar review for another New Zealand company which had resulted in the dismissal/retrenchment of approximately 26 out of 45 senior management, and that this review of United Banking Society was completed against the background of concerns that Ayers Finniss had expressed on several members of the management team, including the Chief Executive. Mr Janes advised the Investigation that all the available evidence on acquisition of building societies and mutuals had indicated that acquirers must have management support to succeed. He indicated to the Investigation that Ayers Finniss's reservations and concerns about management were therefore handled with great care.

He also advised the Investigation that Ayers Finniss was not satisfied with the approach and record of the management team. This was primarily because of the attempt by United Building Society to "go it alone" in the face of a severe loss of competitive advantage enjoyed by building societies in New Zealand, which had been based around "provision of housing" rather than banking; hence the emphasis on the real estate agency business and United Lifecare. He also stated that it was clear that this attempt had not succeeded, and it was the Bank's intention that United Building Society would develop and function as a retail bank.

Mr Janes advised the Investigation that it was considered that on acquisition, considerable changes would be made to management, and that the non-retail activities of United Building Society would be absorbed into the State Bank (NZ). He also stated that the unfavourable conclusions reached in relation to management were reflected in the purchase price that was anticipated at the time.

The Investigation was unable to find evidence of how the concerns raised in the report of Mr Peebles ("the Peebles Report") were to be dealt with other than by the transfer of Bank staff to New Zealand and the use of the Executive Committee Structure meeting each month to which senior management could report as disclosed in the Recommendation. For example, the Peebles report suggested certain redundancies, but there was no evidence of how these recommendations would be implemented, or what the ultimate cost of these redundancies would be.

(b) Budget Planning

Mr Janes advised the Investigation that the budgeting and planning processes were discussed at length when Mr Jenkins and Mr Cooper visited Adelaide. He told the Investigation that:

"No detailed review of the past budgetary and planning process was undertaken by Ayers Finniss because:

1. The projections for the core business were being done on such radically altered assumptions as to render previous forecasts meaningless.

2. We had come to our own conclusion about subsidiaries (with independent advice where appropriate).

3. We had no great regard for UBS forecasting ability.

4. Considerable effort was, however, applied to understanding and interrogating the CFO of UBS on the projected cost of bonus interest payments to existing shareholders - this representing the true cost of acquisitions - and many sensitivities were run. Only those considered relevant appear on the file copied by you."

(c) Internal Controls

Mr Janes told the Investigation that internal controls and EDP functions were subject to separate reports by Ms Chin (Internal Audit) and Mr McCulloch/Ms Teefey (Information Systems) although he was not provided with copies of these reports. However, Ms Chin's report only addressed the internal audit function.

Ms Chin has stated that she carried out less work that she considered necessary to assess internal controls, but that she was only allowed two days by Mr Mallett to conduct her review. The Investigation has reviewed her report, and has formed the opinion that it did not address critical areas of internal controls, although it did comply with its limited scope. Given Mr Janes' role of co-ordinating the due diligence investigation, and particularly in view of his letter to the Bank Board (dated 9th May 1990 - discussed below under the heading "Other Matters") which stated that Ayers Finniss had arranged the due diligence examination, I would have expected him to receive and review all reports prepared as part of the due diligence investigation. Mr Janes has stated that he was refused a copy of Ms Chin's report. The responsibility for this area of due diligence therefore rested with Mr Mallett.

Mr Mallett advised the Investigation that there was adequate evidence that some deficiencies existed in the organisation, but that none were considered to be "deal breakers".

Mr Morrison and Mr Mallett became aware of certain internal control deficiencies as part of their review of receivables but the implications of these deficiencies were not adequately followed up in the due diligence investigation (refer below for instances of these deficiencies).

In summary, the Investigation found no evidence in its enquiries and review of relevant document files that an adequate and relevant review of internal controls was conducted in the due diligence investigation.

18.6.3.3 Losses Arising from the Non-Execution of Identified Actions

It is not possible to identify losses arising through shortcomings in this due diligence area.

On the basis of the matter referred to above, I am of the opinion that Mr Mallett failed to exercise proper care and diligence in that he did not ensure that United Building Society internal controls were adequately reviewed.

18.6.4 REVIEW OF RECEIVABLES

18.6.4.1 Definition and Applicability of the Item to the Due Diligence Process

The objective of this analysis is to confirm the book value of receivables, as recorded in the books of United Building Society, and to ensure that adequate provisions had been set up for problem loans. This is a basic objective of any due diligence review of a bank or lending institution.

The purpose of the review of receivables is to confirm:

(a) recoverability;

(b) performance;

(c) pricing; and

(d) adequacy of security documentation of the loan book.

Once the review of receivables was completed, it would be necessary to assess any additional level of provisioning required against the loan book for problem loans, given the current provisions included in the books of account of United Building Society.

18.6.4.2 Specific Action Required

In order to achieve the above objectives, the due diligence investigation would need to have considered:

(a) the type of receivables (commercial, residential etc) and the history of those receivables;

(b) the lending criteria for each type of receivable identified;

(c) the pricing policies for each type of receivable identified, confirming whether they are consistent with the policies of the Bank, and whether they are appropriate for the risk profiles of the loan type;

(d) a review of management and control systems to ensure that they cover controls over lending and risk management. This review would need to ensure that the information system is capable of identifying non-performing, irregular or problematic loans;

(e) the adequacy of account management procedures;

(f) a review of the organisational structure to confirm whether there were adequate resources in United Building Society to monitor and control receivables;

(g) a review of a sample of accounts selected on the basis of account type, materiality, subject of borrowings, history of arrears or other problems;

(h) expansion of the investigation in above where significant problems become apparent;

(i) a review of United Building Society criteria for specific provisioning, and confirmation that criteria is adequate and appropriate in the circumstances;

(j) an assessment of the adequacy of specific provisioning on the basis of the findings above;

(k) an assessment of the adequacy of general provisions;

(l) a review of recent loss histories, and an assessment of whether underlying causes of losses present risks for the portfolio of remaining facilities; and

(m) any legal implications of the purchase by the Bank.

18.6.4.3 Specific Actions Performed and their Shortcomings

As at 30 September 1989, the United Building Society loan book comprised:()

 

$NZ M

Residential mortgage loans

965.8

Commercial loans

1311.7
 

1,097.5

(a) Residential Mortgage Loans

A detailed review of the residential mortgage book was not carried out. Mr Janes advised the Investigation that the general distribution/pattern of residential lending and default records were examined. He also noted that, because of the credit rating of the securitisation program, Standard and Poors had examined, and reported on, the quality of the mortgage portfolio. The examination of the Ayers Finniss files revealed no evidence which had been retained of such a review having been carried out.

Mr Mallett advised the Investigation that mortgage receivables were reviewed on a portfolio basis, which included comparing United Building Society's problem loan and write-off experience with the industry as a whole, rather than review the loan portfolio on a loan by loan basis. Because of the on-going internal credit reviews conducted by the Bank in their role as lender to United Building Society, the Bank was aware of the relevant reports on the mortgage book, the lending criteria of United Building Society and they had a good knowledge of the past lending history and management performance.

Even though the Bank was familiar with the residential mortgage portfolio, I would have expected the due diligence team to have selected a representative sample of residential mortgage loans for detailed review due to the significant size of the residential mortgage loan book. Given that testing of this balance was limited, in my opinion, a detailed review of the internal controls associated with the residential mortgage book should have been required, to establish the degree of reliance which could be placed on the stated book value of the portfolio being acquired. The review of the due diligence files uncovered no evidence that such a detailed review of either individual residential loans and/or internal controls in this area had been carried out.

In their draft report dated 3 May 1990, Peat Marwick stated:

"UBS has recently introduced a new product called U95, where they will lend on first mortgage up to 95% of a valuation. The 20% in excess of the normal 75% LVR is required to be insured at the mortgagees cost through AMG. The provision of this product would raise questions regarding the adequacy of the general provision against residential mortgages. (Currently 0.5% on non-insured mortgages and nil on insured mortgages)."

The review of the due diligence files uncovered no evidence that the level of provisions included in the residential mortgage portfolio had been reviewed to ensure that they were adequate. As discussed below, additional residential mortgage provisions were raised in the year ended 30 June 1991, although it is not possible to identify the quantum of these residential provisions as they have been combined with certain commercial provisions raised in the same period.

(b) Commercial Loan Book

Mr Janes advised the Investigation that he did not consider that there was a large exposure on commercial lending as United Building Society had only recently entered this area.

Mr Morrison carried out a detailed review of the commercial loan book. Mr Mallett told the Investigation that Mr Hammond and a Mr Dyke, from the Bank's New Zealand branch, were also involved in the review, and supported the findings arising from it. Mr Hammond says that neither he nor Mr Dyke (a member of Mr Hammond's staff) were involved in the review, nor did they have the knowledge upon which to support its findings. Whilst I do not have the information to conclusively resolve this matter I would accept that whatever role Mr Hammond played it was limited. Mr Morrison was familiar with the lending criteria of United Building Society as he was the United Building Society Account Manager at the Bank. He had previously prepared submissions to the Bank Lending Credit Committee (in a paper dated 3 January 1990 which is discussed under the topic heading "Accounting Policies and Historic Trading Results"()) and was the author of a "call report" on United Building Society's activities, dated 15 June 1989 (also discussed under the topic heading "Accounting Policies and Historic Trading Results"()).

The Investigation questioned Mr Mallett on the review of receivables conducted as part of the due diligence. A substantial proportion of the Investigation's queries of Mr Mallett were put to him in writing to which a response was received again in writing. Subsequent to the Investigation's receipt of this response, Mr Mallett has advised the Investigation that the response provided in writing to the Investigation was not prepared by him, but was actually prepared by Mr Morrison. Mr Mallett has, however, advised the Investigation that he has reviewed the response and agrees with its content.

A discussion of the review of the Commercial Loan Book undertaken as part of the due diligence is set out below under the following headings:

(i) Lending Criteria and Pricing Policy;

(ii) Management and Control Systems;

(iii) Account Management Procedures;

(iv) Organisation Structure;

(v) Review of Sample of Accounts;

(vi) Provisioning; and

(vii) Legal Implications of Acquisition.

(i) Lending Criteria and Pricing Policy

In 1989, the Bank acquired part of United Building Society's commercial loan portfolio. Mr Morrison advised the Investigation that, at this time, the Bank was familiar with United Building Society's lending criteria, and, as a result of this, a review of United Building Society's lending criteria was not specifically carried out as part of the due diligence process. He advised the Investigation that the only significant weakness identified in the lending assessment process was the absence of a standard format for the credit assessment process, and this led to a variety of approaches being adopted.

He stated that the loan pricing was generally above the levels being achieved by the Bank and margins were appropriate for the risks associated with the loans. Mr Morrison has advised the Investigation that although he had not performed a formal review of pricing, his assessment was based on his knowledge and experience from commercial lending done by the Bank and Southstate Corporate Finance Limited.

(ii) Management and Control Systems

Mr Morrison advised the Investigation that, both from his due diligence review and from earlier findings (in relation to the ongoing credit reviews conducted by the Bank as lender to United Building Society), he had formed the view that a management system was in place that reviewed problem accounts on a regular basis. His review was based on copies of various reports obtained from United Building Society, including United Building Society Credit Committee meeting minutes and a review of loan files. The United Building Society loan portfolio was monitored on a personal computer based system, and Mr Morrison advised the Investigation that one weakness of this system was that it was unable to put foreign currency loans on to non-accrual. The system accrued interest daily on foreign currency loans that were non-accrual and this interest needed to be reversed monthly by journal entry.

A review of the Bank and Ayers Finniss due diligence files by the Investigation found no evidence to indicate that management systems and internal controls were tested in any detail. Instead, reliance appears to have been placed on reports provided by United Building Society, such as arrears reports, and credit review meeting minutes, and a review of numerous loan files.

(iii) Account Management Procedures

In relation to the adequacy of account management procedures, Mr Morrison advised the Investigation that the major weakness was that the loan files contained no up-to-date financial data on the borrower, tenants, or guarantors. If a loan had not caused problems, then there may have been no correspondence on the file subsequent to the original approval. This led to property valuations on the file being dated well before the 1987/88 property decline, and updated rental figures were not available on the loan files. Mr Morrison advised the Investigation that estimated values using "best guess" capitalisation rates were used to measure loan safety in these cases. He further noted that lack of an annual loan review process was a major weakness in loan management procedures. Given the findings of Mr Morrison in relation to the inadequacies of account management procedures, in my opinion, it would be reasonable to have expected:

. additional work to be carried out to confirm the underlying security values associated with a number of the larger loans; and

. a review of legal documentation by the Bank's solicitors to ensure that the documentation was current and enforceable at the time of acquisition.

Mr Morrison advised the Investigation that one procedure that had been discontinued at the date of the review related to the treatment of penalty interest. Traditionally, penalty interest had been charged in all appropriate cases, and taken to income. United Banking Group has been unable to provide further details in relation to the quantum of penalty interest which was written off pre-acquisition.

Mr Morrison advised the Investigation that an element of this was irrecoverable, but remained on the books as an amount due. Mr Riddell of the Bank's Auckland branch, has advised the Investigation that, on termination of the loan, any irrecoverable balance was written off. Mr Morrison advised the Investigation that at the date of his review, penalty interest remained on the books as an amount due, and was being taken to income on a cash received basis. The unpaid penalty interest previously charged was taken into account when calculating the commercial loan provisions. The Investigation's review of the relevant document files produced no evidence to indicate that this item was taken into consideration in:

. the review of historic trading results; or in

. the review of United Building Society's accounting policies.

(iv) Organisation Structure

Mr Morrison advised the Investigation that the organisational structure and staffing was reviewed in 1989 as part of the Bank's decision to acquire a number of commercial loans from United Building Society. The Peebles report, which was commissioned as part of the due diligence process, discussed the abilities of a number of key United Building Society staff. This area was adequately covered.

(v) Review of Sample of Accounts

The commercial loan portfolio comprised 455 loans, with outstandings of $NZ 166.6M at the time of the review, and a period of two and one half days was allocated to the assessment of the portfolio. Mr Morrison indicated to the Investigation that the approach adopted was to review:

. all files where current arrears existed;

. files where there was evidence, from the provided schedules, of penalty interest having been charged in the past;

. files where loans were of a significant amount; and

. recently approved loans.

At the time of Mr Morrison's review, the commercial portfolio comprised the following:()


Type of Loan

No. of
Loans

  

$NZ’000

  

Files
Reviewed

Rural

9

  

1,475

  

9

Foreign Currency

63

  

46,108

  

58

Local Currency

216

  

109,578

  

134

Small Loans

167

  

8,422

  

NIL
 

455

  

166,583

  

[sic]

His review did not take account of the following:

. A loan to Buckcorp of $NZ 3.3M which was secured by a largely vacant building, the head lessee of which is United Building Society (Mr Morrison initially questioned whether a $NZ 1.0M write-down was required);

. any realisation costs; and

. any holding costs, where income of the property does not service the cost of funds.

After discussions with United Building Society management on the level of provisioning required, Mr Morrison's initial assessment of $NZ 10.3M of additional provisioning was reduced to $NZ 6.7M (taking into consideration provisions already in place of $NZ 2.4M). The final provision established was therefore $NZ 9.1M.

Mr Morrison advised the Investigation that he was unable to question United Building Society staff in any depth on the loans, as only a few key staff were aware of the reasons for his review.

He advised the Investigation that the value of the portfolio upon which the level of provisioning required was assessed excluded estimates of future holding costs, recovery costs, and legal costs. He understood that these costs were to be accounted for in the projection of future profits and noted that, as his review was performed in order to estimate loan provisioning under a Bank regime, no review of legal documentation was carried out. This is contrary to what I would have expected to have taken place as part of the due diligence investigation. In assessing the level of provisions required, the methodology adopted should have reflected the Bank's provisioning guidelines applicable at that time.

He further advised the Investigation that, as a result of his review, additional provisioning of $NZ 6.7M was identified. The findings of his review were discussed with United Building Society management on a loan by loan basis, although not all files were available for review as some were with solicitors at that time.

Based on the above, certain limitations of scope have been identified in the due diligence investigation. These included:

. the short timeframe under which the review was carried out (2.5 days);

. access to key staff was restricted; and

. access to certain loan files was restricted (as these were at the solicitors).

These limitations contrast with the description of "exhaustive due diligence" contained in the Bank Board Minute of 9 May 1990. I also note that these limitations were not explicitly stated in Mr Morrison's report on the receivables review, dated 30 April 1990. In my opinion, Mr Morrison's report was deficient in that it failed to identify these limitations, and to state the likely consequences of the limitation on the assignment, particularly given the importance of the receivables review to the overall due diligence investigation.

Mr Mallett has told the Investigation that he was not made aware of any limitation on the receivables review. He advised the Investigation that he understood Mr Morrison had a detailed familiarity of the United Building Society loan portfolio, lending management, and United Building Society credit procedures, because of Mr Morrison's involvement in past United Building Society credit appraisals. He also advised the Investigation that the first time he became aware of the limitations on Mr Morrison's review was when he read Mr Morrison's response to the Investigation's inquiry.

In my opinion, the failure of Mr Morrison to notify Mr Mallett of these limitations was a material omission. Furthermore, it evidences a lack of communication and co-ordination among senior Bank management in a key risk area in the due diligence process.

Moreover, Mr Morrison had identified that future costs associated with problem loans were not considered as part of his review, and that he understood these would be taken into consideration in the projection of future profits. The review of the due diligence files uncovered no evidence to confirm that these costs were actually taken into consideration in the review of the profit forecasts provided to the Bank.

(vi) Provisioning

Mr Morrison has advised the Investigation that United Building Society regularly calculated the expected loss on its loan portfolio. He advised the Investigation that an optimistic view was generally taken as a result of there being virtually no commercial property sales being recorded at that time, and the difficulty in determining a true capitalisation rate. Based on these concerns over the state of the property market in New Zealand, I would have expected the due diligence team to question the carrying value of the properties owned by United Building Society (which had a book value of $NZ 134.6M at 30 September 1989).

Mr Morrison has advised the Investigation that, based on his review of the commercial loan portfolio, it was clear that provisioning by United Building Society was inadequate. After discussing with Mr Cooper and Mr Steel the intended purpose of the review, the recommended provision was reduced to $NZ 9.1M, while a general provision of $NZ 3.0M was to remain (in addition to the specific provisions which he had identified) in order to cover small losses not identified by the Bank's review. Mr Morrison held the belief based on his past experience and the then state of the property market, that this level of general provision was adequate.

Overall, Mr Morrison believed that adequate provisions had been raised in the due diligence investigation due to:

. the high percentage of files reviewed;

. the way the files were selected; and

. the existence of the $NZ 3.0M general provision.

Mr Morrison advised the Investigation that, at the time of his review, he believed that a plateau had been reached in property values because of the major deterioration seen prior to the acquisition. My review of the Ayers Finniss due diligence files and the relevant document files reveal no evidence that a thorough review was undertaken of the state of and prospects for the New Zealand property market.

(vii) Legal Implications of Acquisition

Mr Morrison advised the Investigation that because the review of the commercial loan book was a credit assessment only, and the intention was to acquire United Building Society (rather than the actual portfolio of loans), there was no reason to review the legal implications of the purchase by the Bank in relation to:

. stamp duty;

. default/trigger clauses;

. assignability of debt and security; and

. credit legislation/regulation.

The Investigation's review of the due diligence files retained by Ayers Finniss and the Bank uncovered no evidence to confirm that a general legal due diligence was undertaken on the acquisition of United Building Society. Although I would normally have expected such a review to have been conducted as part of the due diligence investigation to confirm whether there were any legal implications of the purchase by the Bank, I am not aware of any subsequent problems in this regard.

18.6.4.4 Losses Arising from the Non-Execution of Identified Actions

A review was conducted by the Investigation of

(a) the additional level of provisioning recommended by the Bank due diligence team of $NZ 6.7M;

(b) the level of actual provisions made during the nine months ended 30 June 1990 of $NZ 24.3M; and

(c) subsequent provisioning of this portfolio of loans.

In addition to the provisioning identified in (a) above, a further amount of $NZ 17.6M was brought to account at 30 June 1990 as follows:()

 

Provisions

 

Item


Identified
by Due
Diligence
Team

  

Raised
during the
9 months
to 30 June
1990

  

Excess
over
Due
Diligence
Provisions
 

$NZ M

  

$NZ M

  

$NZ M
Commercial loan provisions

6.7

  

14.4

  

7.7
Residential mortgage loan provisions

-

  

1.1

  

1.1
General (a breakdown between commercial, residential and other was not provided)

-

  

5.8

  

5.8
Allied Mortgage Guarantee Residential

-

  

3.0

  

3.0
Provisions

6.7

  

24.3

  

17.6

The additional provisions raised at 30 June 1990 include a number of loans on which specific provisions were raised by the due diligence team as set out below:

 

Loan to Company

  

Provisions
Required as
Identified by
Due Diligence
Team
$NZ M

  



Actual
Provision at
30 June 1990
$NZ M

A

  

0.8

  

0.7

B

  

0.6

  

0.8

C

  

0.5

  

3.1

D

  

1.3

  

2.1

E

  

Nil

  

0.5

F

  

0.8

  

0.8

G

  

0.2

  

2.0

H

  

1.8

  

2.0

I

      

1.0

J

      

0.8

Various smaller provisions
(each of less that $0.5M)

  

n/a

  

4.6

Various other provisions raised by due diligence team

  

3.1

  

n/a
         

Gross provision required

  

9.1

  

18.4

Less provisions previously raised

  

(2.4)

  

(4.0)
         

Provision raised

  

6.7

  

14.4

The above table highlights that a number of the loans, where relatively large provisions were raised at 30 June 1990 (2 months after the due diligence examination), were specifically reviewed as part of the due diligence investigation. In my opinion, the due diligence review could reasonably have been expected to identify the additional provisions related to specific loans, particularly as the additional provisions needed were established soon after the due diligence was completed.

Whilst Mr Morrison acknowledged the deficiencies in his report, he said that its limitations were well known by Ayers Finniss and Mr Hammond. Mr Janes and Mr Steel denied imposing or being aware of, any limitations. Mr Hammond denied giving him any instructions on how to undertake his review.

On the state of the evidence I am unable to come to any firm conclusion on the scope or ambit of his instructions. In my opinion, Mr Morrison's report should have expressly adverted to these limitations, and, in the absence of a specific disclaimer to that effect the recipients of his report were entitled to assume that his conclusions were reliable. Accordingly, whilst elsewhere in this report I have accepted some of Mr Morrison's assertions, he cannot be completely exonerated for its deficiencies.

Provisions totalling $NZ 14.6M were raised against these loans by the Bank's Auckland branch (the acquirer of the portfolio) as at 30 June 1991, which were in addition to those raised at 30 June 1990. It is not possible to apportion the above losses between those which should have been detected as part of the due diligence investigation and those which have arisen due to changed borrower circumstances post acquisition. I believe however, that the additional provisions raised at 30 June 1990 of $NZ 17.6M are likely to have been identifiable as part of a thorough due diligence investigation where there was no limitation on the scope of the review. It is significant that these additional provisions were made within two months of the completion of the due diligence review, and that they are large in comparison with the provisions recommended by the due diligence team.

The $NZ 14.6M of additional provisioning raised at 30 June 1991 would probably not have been identifiable prior to acquisition, although details are not available as to what proportion of this provision relates to changed borrower circumstances after the completion of the due diligence review.

Based on the matters referred to above, I am of the opinion that Mr Morrison failed to exercise proper care and diligence in the review of receivables in that:

(a) he failed to report that his review involved only a limited access to United Building Society management and files; and

(b) the review failed to identify that at least $NZ 17.6M of additional provisioning was required against receivables, of which at least $NZ 4.6M is attributable specifically to Mr Morrison.

18.6.4.5 Financial Review

(a) Definition and Applicability of the Item to the Due Diligence Process

The key objective of the financial review would be to undertake the necessary inquiries to confirm, in all material respects, the financial position of United Banking Group, and to assess the future maintainable earnings of the group. These are primary goals for reviewing or valuing any company or business, which would be undertaken with the benefit of knowledge gained in undertaking other inquiries made in the course of the due diligence investigation. It should be emphasised that many of the inquiries pursued in the preceding Sections would also be relevant to the consideration of the financial position and future maintainable earnings of United Banking Group.

Key considerations in such a review would encompass:

(i) an assessment of the value of net assets being acquired, taking into consideration the need for additional provisioning identified in the due diligence investigation;

(ii) an assessment of whether the historic and forecast profitability was an appropriate basis for determining or assessing the acquisition price (ie the forecast trading results may contain items which were not of a maintainable nature or may represent erroneous treatment of key income/expense items);

(iii) an assessment of any contingent or undisclosed liabilities;

(iv) the valuation of any intangible assets identified;

(v) the accounting policies of United Building Society and a quantification of any differences to the Bank's accounting policies;

(vi) an assessment of the impact of the conversion from a building society to a bank on the forecast trading results for United Banking Group; and

(vii) an assessment of the liquidity position of United Building Society, and the forecast cash flows of United Banking Group.

(b) Specific Actions Required

The specific actions required in performing a financial review of a business such as United Banking Group are too numerous to present in the body of this report. Broadly, the financial review would address:

(i) The historic reported results, to identify:

. levels of profitability and trends in results;

. causes for abnormal and extraordinary items;

. unprofitable operations or products of the organisation; and

. industry specific accounting treatments which are relevant to an interpretation of the reported and forecast results. This would include a qualitative and quantitative assessment of any contrasting Australian and New Zealand accounting standards.

(ii) The financial position of United Building Society Group with respect to the values of the assets and liabilities acquired as well as identifying any undisclosed liabilities.

(iii) The pre-acquisition profit forecasts (and associated cash flows) in order to understand and assess the key vulnerabilities which may be relevant to the achievement of the forecast results.

(c) Specific Actions Performed and their Shortcomings

The review of historical and forecast profitability was the primary responsibility of Ayers Finniss. Mr Copley undertook certain parts of the financial review, but only to a limited extent.

In carrying out their due diligence review, Ayers Finniss referred to the following sources of financial information:

(i) the financial Section of the Information Memorandum provided by United Building Society in draft and subsequently revised by BT Australia Limited;

(ii) annual accounts for the previous five years;

(iii) the Bank's credit approval/analysis file, which had detailed analysis of the accounts for loan approval purposes, and interview notes from visits by bank officers; and

(iv) copies of recent financial reports to the Reserve Bank of New Zealand.

Mr Janes advised the Investigation that the work that was carried out was focussed on:

(i) an analysis of the core business and the separate subsidiaries;

(ii) the tax position, given that United Building Society would not be able to carry forward tax losses, and therefore should ensure that no revenue deferral was occurring;

(iii) the relevant industry data in terms of Ayers Finniss' own view of the current developments in the New Zealand banking industry; and

(iv) a review of the audit files of United Building Society's auditors (Deloitte, Haskins & Sells) by the Bank's New Zealand auditor Ms Jan Dawson of KPMG.

Mr Janes advised the Investigation the following:

"Review of Management Accounts and Historic, UBS Forecasting Ability

Although this area was handled by Richard Steel I am aware that, over the relatively short period of due diligence, management accounts were reviewed as they became available and an extensive section of the files ......"

The review of the Ayers Finniss due diligence files by the Investigation did not reveal any evidence that a detailed review of management accounts had been carried out although in a memorandum from Mr Janes to Mr Mallett dated 8 March 1990, Mr Janes stated:

"CFO's visit 7 March 1990

Subsidiary company results did not "turn around" (as projected) in the December quarter. The Banking division in fact incurred a loss as a result of squeezed margins. This reflects an increased reliance on wholesale funding, the rates for which rebounded in the December quarter, culminating eventually in a decision to increase lending rates from 14.9% to 15.25%. This lead to a group loss of $2.3M for the quarter compared with a budgeted profit of $0.7M."

Mr Janes was therefore aware of the results of United Building Society for the three months ended 31 December 1989, and had discussed the underlying reasons for these results with Mr Cooper.

Mr Janes advised the Investigation of a schedule which was headed "Final Forecast without $150.0M capital" and which summarises the pre-tax profit forecast for the year ended 30 September 1990. The Investigation did not uncover any supporting work papers which reconciled the differences between the profit forecasts on this schedule and those provided by United Building Society. The differences were in respect of the forecast for United Lifecare, and the exclusion of a "capital" adjustment (of $NZ 5.0M) which presumably related to the planned capital injection by the Bank. This "capital" adjustment is set out in a detailed breakdown of the profit forecast for the three months ended 30 September 1990, which is further discussed under the topic heading, "Accounting Policies and Historic Trading Results".()

Mr Mallett advised the Investigation that Mr Copley was very critical of the financial position of United Building Society, and caused the write-down made to the United Building Society Shareholder Reserves. Mr Copley advised the Investigation that, in his opinion, United Building Society was in a "financial mess", and that he had advised several Bank executives, including Mr Clark, of his concerns over United Building Society. Mr Copley said that by "financial mess" he meant that, by taking the one-off activities out, he could demonstrate that there was no profit in the organisation at the time of acquisition. Nevertheless, he felt that if, strategically, the Bank wanted to proceed then the deal could be a good one. Mr Copley advised the Investigation that he only learned subsequently that the Bank Board of Directors were not informed of his views.

The financial review undertaken as part of the due diligence process included the following reviews:

(i) Accounting Policies and Historic Trading results;

(ii) Cashflow;

(iii) Property, Plant and Equipment;

(iv) Intangibles;

(v) Writedown of Investment in Lifecare;

(vi) Creditors;

(vii) Borrowings;

(viii) Off-balance Sheet Ventures;

(ix) Contingencies;

(x) Taxation;

(xi) Capital Structure;

(xii) Forecasts; and

(xiii) Other Matters.

(i) Accounting Policies and Historic Trading Results

Mr Janes advised the Investigation that Mr Copley joined in a number of the meetings at which accounting policy was investigated, and Mr Copley received reports from Ms Dawson of Peat Marwick and Ms Chin (the Bank's Internal Auditor).

Concerns raised by Peat Marwick and, previously, by Mr Morrison, over a number of significant "one-off" items included in historic trading results, appear not to have been adequately considered as part of the due diligence investigation. These items were identified in the following documents:

. the draft report by Ms Dawson of Peat Marwick, dated 3 May 1990;

. a "call report" on United Building Society, dated 15 June 1989, prepared by Mr Morrison; and

. the Bank Lending Credit Committee paper, dated 3 January 1990

Extracts from each of these documents are presented below:

. The draft report by Ms Dawson of Peat Marwick dated 3 May 1990 Peat Marwick stated that:

"The earnings of the group [UBS] and parent [UBS] for the period ended 30 September 1989 contained two one off items which significantly changed the reported result and raised queries over the maintainable earnings of UBS

   

Group

  

Parent
Net profit before tax  

2,444

  

11,304
Profit on sale of properties to NZPST  

(7,598)

  

(7,589)
Change in accounting policy on investment
(inc. reversal of devaluation of index
 linked stock)		  

(3,170)

  

(3,170)
   

(8,324)

  

(536)"

. A "call report" on United Building Society dated 15 June 1989 which stated:

"Met to discuss the swap on the second offshore bond issue and to review UBS results as part of the portfolio review.

1. 31 March 1989 result will be out in a few weeks now that audit signoff is completed. A poor answer of a loss of $500,000 will be shown ...

... The second 6 months will show a profit of $15-16 million but I gather that UBS are working on a couple of "profit related deals" which will have the effect of exaggerating the actual trading performance. The split of actual earnings and generated earnings was unable to be ascertained."

. The Bank Lending Credit Committee paper dated 3 January 1990 (prepared by Mr Morrison). The paper stated:

"A reported net operating loss of $5.1M [being profit of $NZ 2.4M shown above less extraordinary profits of $NZ 7.5M] is not sustainable and it is of some concern that included in that result are several one off items which have the effect of improving the result. A restated result excluding known extraordinary items is:

Report net income

(5,126)

ADD:

  

i) gain on change in accounting policy

(3,170)

ii) gains on sale of Government bonds

(2,000)

DEDUCT:

  

i) Secruritisation costs

1,000
   

Maintainable net income

($9,296)"

The review of the due diligence files by the Investigation uncovered no evidence to suggest that the due diligence review properly took account of the above-mentioned "one-off" items included in the historic trading results, which, after exclusion of these non- maintainable items, resulted in a loss being recorded for the year ended 30 September 1989.

On 4 May 1990, Ayers Finniss were provided with the financial information shown in the table below.() It clearly indicates that United Building Society was trading unprofitably for the five months to 28 February 1990, and indicates a significant turnaround in trading results, both in the four months ended 30 June 1990, and subsequently.()





Entity/Item

  

5 months
to
28 Feb
1990
Actual
$NZ M

  

4 months
to
30 June
1990
Forecast
$NZ M

  

3 months
to
30 Sept
1990
Forecast
$NZ M

  

Year
Ended
30 Sept
1990
Forecast
$NZ M
United Building Society  

(6.9)

  

-

  

1.0

  

(5.9)
"Capital"  

-

  

-

  

5.0

  

5.0
United Realty  

0.3

  

0.7

  

0.7

  

1.7
United Lifecare  

(2.2)

  

(1.3)

  

1.5

  

(2.0)
United Shareholders  

(0.6)

  

(0.4)

  

-

  

(1.0)
Allied Mortgage Guarantee  

(1.6)

  

-

  

-

  

(1.6)
                 
Loss before Goodwill and Tax  

(11.0)

  

(1.0)

  

8.2

  

(3.8)
Goodwill  

(0.8)

  

(0.5)

  

(0.5)

  

(1.8)
                 
Loss before Tax  

(11.8)

  

(1.5)

  

7.7

  

(5.6)
Taxation              

(10.0)
                 
Loss after Tax              

(15.6)

The Investigation uncovered no explanations for the turnaround in trading results in the four months ended 30 June 1990 on the Ayers Finniss files. The above pre-tax forecasts prepared by United Building Society for the year ended 30 September 1990 (with the exception of the "capital" item and having included the United Lifecare losses at $NZ 4.5M) were included in the Recommendation.

Based on the available historic trading results, the Bank's due diligence investigation team were clearly on notice that United Building Society was trading unprofitably, because:

. The Bank Lending Credit Committee had previously reviewed the reported results for the year ended 30 September 1989, and referred to "maintainable net income" which was actually a loss of $NZ 9.3M.

. Peat Marwick's draft report, dated 3 May 1990, was faxed to Mr Copley.

. United Building Society had reported losses, for the five months ended 28 February 1990 (which were known to Ayers Finniss), and for the six months ended 31 March 1990 (as disclosed in the prospectus dated 29 June 1990).

Accordingly, the Bank due diligence team would have been aware that the financial review of reported and forecast results were fundamental risk areas. Based on this evidence, I would have expected the due diligence review to include:

. An analysis and detailed review of the historical results of United Building Society, in order to identify the underlying causes for the trend in earnings. This review would encompass a comparison of prior year budget versus actual results, and the identification of any non-maintainable (non-recurring) items.

. An analysis of the basis of forecast profitability, in order to identify and evaluate the specific key assumptions which contributed to the reversal of trading losses; and

. A critical assessment of the reasonableness and achievability of the key assumptions, in order to identify their vulnerable areas, particularly on the basis of the findings of the analysis and review of historical results for the United Building Society. I would have expected any identified vulnerabilities to have been quantified accordingly.

The Investigation uncovered no evidence on the due diligence files or in other relevant document files, of a detailed review of historical trading results having been carried out.

(ii) Cash Flow

Mr Janes advised the Investigation that Source and Use of Funds Statements were examined, but were considered of less relevance than the analysis of the funding mix. It is, however, evident, from a review of the reconciliation of the pre-acquisition forecast for the year ending 30 September 1991 with the post acquisition budget for the year ended 30 June 1991, that errors were made in the forecast concerning the improvement in the funding mix, notwithstanding the due diligence investigation.

(iii) Property, Plant and Equipment

As at 30 September 1989, the audited book value of property, plant, and equipment, comprised the following:()



Item		  

In accounts
of United Building
Society
$NZ M

  


Consolidated
Accounts
$NZ M
Fixed assets        
- Land & Buildings

)

    

72.2
- Other

)

102.9

  

42.6
Investment properties and
properties held for resale		  

-

  

62.4
   

102.9

  

177.2

Mr Janes told the Investigation that the principal items of plant and property related to the data processing equipment and real estate (branch) assets. He noted that data processing was subject to a separate, specific review. A review was undertaken of the information systems report that he referred to in his letter to the Investigation (dated 22 August 1991); this report did not address the carrying values of the data processing equipment, or the appropriateness of the United Building Society depreciation policy in respect of those items.

The Investigation uncovered no evidence on the Ayers Finniss due diligence files or on any other relevant document files, that formal valuations of properties were obtained as part of the due diligence investigation. Mr Janes advised the Investigation that values for real estate were carried in the accounts at market value, and therefore formed part of the investigation by the auditors. The work carried out by Peat Marwick, however, was described in their draft report, dated 3 May 1990, as follows:

"As requested by the Bank I have performed a review of the Deloitte Ross Tohmatsu audit files for the United Building Society Group for the year ended 30 September 1989.

My review was limited to matters contained in those files and discussions with the audit partner, George Rowley of Deloittes [sic] Ross Tohmatsu, and did not include any review of matters arising subsequent to that audit.

In addition there were certain areas which I did not review as I understand the review of these areas are being performed by State Bank personnel or other consultants:

. the adequacy of the provisioning against advances

. valuations of assets held as fixed assets

. service contracts with executives

. internal audit work"

The report clearly states that Peat Marwick did not review "valuations of assets held as fixed assets".

In commenting on his review of receivables, Mr Morrison advised the Investigation:

"Based on past experience and the then state of the property market the level of the general provision was thought to be adequate.

Because of the reasonably [sic] high percentage of the files reviewed, the way the files were selected and the existence of the NZ$3M general provision the worsening trend in the portfolio was recognised but no further provisioning for the non reviewed portfolio was felt necessary. It was generally accepted that a plateau had been reached in property values because of the major deterioration already seen".

These comments show that Mr Morrison was aware of a "major deterioration" of property values, and the then state of the property market in New Zealand.

United Building Society management obtained independent valuations for all properties, as at 30 June 1990, for purchase accounting purposes, and copies of a number of these valuations have been received by the Investigation. One valuation relates to High Street, Christchurch, and was carried out by Darroch and Co Ltd on 25 June 1990. This valuation evidences the poor market conditions then prevailing:

"Current Market Rent

... In respect of office the oversupply of accommodation has led to a two tier office rental market and a distinction between rentals achieved on occupied premises subject to review and rentals on new or vacant available space. In sitting tenant situations, effectively the case at hand, it is our policy to reference the market as derived from rental reviews, our view being that first such rents represent the greater weight of evidence and second, it is not appropriate that inducements and rent concessions on vacant space impact through the rental market as a whole ... The majority of comparables reference the new wave of office buildings which entered the market during 1987. Rent reviews almost without exception are at two year rests and hence the majority of evidence relates to the 1989 year. We are therefore unable to reference recent relevant comparables nonetheless there is no growth in the market at the present time and the 1989 rents are relevant ..."

Capitalisation Rates

The investment market is sluggish, particularly for properties exceeding $3,000,000 in value. The National Mutual portfolio sold late 1989, several office buildings on the city core periphery under long term leases by institutional type lessees commanded yields of between 11% and 12%. The Triangle Centre and National Mutual was also purchased, the sum $11,300,000 indicating 10.50% on net contract rent, alternatively 10% on the newer component of the development, 12% on the obsolete. The building intended for National Mutual Bank corner Hereford and Manchester Streets sold October 1989 $6,600,000, a yield 9.50%. Southstate Tower corner Cashel Street and Oxford Terrace sold mortgagee auction September 1989 $6,900,000, the yield 7.83% but with additional income potential from vacant space. Rural Bank House corner Colombo Street and Cathedral Square is available for purchase, the asking price $13,500,000, the yield 9.38%. The rents are high, growth will be negligible.

In view of the subject quality in terms of building and collateral lease security and at rent levels adopted, the required investment yield is 8.75%.

Valuation

  

Focus Travel at contract

$36,944

Pet Shop at contract

$25,000

United Bank at market

$1,990,063
 

$2,052,007

Capitalise @ 8.75%

  

Investment Value

$23,450,000

I would have expected that formal property valuations for the larger properties (or at worst "curbside assessments") would have been obtained as part of the due diligence process based on the following:

. The significant book value of $NZ 134.6M for land and buildings at 30 September 1989, which included $NZ 62.4M of investment properties and properties held for resale. Land and buildings, therefore, were material to the due diligence, given their values and risk, particularly in respect of investment properties. Of the value of investment properties and properties held for resale, $NZ 62.2M relates to United Lifecare as set out below:

 

Entity

As at
30 September
1989
$NZ M

United Group Securities Ltd (part of Lifecare Group)

1.0

United Lifecare Ltd

55.4

United Lifecare (Nelson) Ltd

5.8
 

62.2

The write-downs made in respect of United Lifecare are discussed later in this Section under the topic heading "Write-down of Investment in Lifecare", although the $NZ 10.0M write-down suggested in the Recommendation (page 9) relates to a writeoff in the parent company's books only, which had previously been made on consolidation.

. The "sluggish" state of the investment market, "particularly for properties exceeding $3,000,000 in value" which resulted in the lack of up to date comparable sales information being available. The full text from which these comments have been extracted is shown above.

Mr Janes advised the Investigation that capital expenditure needs were reviewed on the basis of minimal levels required for maintaining the existing operations. The Investigation uncovered no evidence on the Ayers Finniss due diligence files, or any other relevant document files of such a review being undertaken.

(iv) Intangibles

Mr Janes advised the Investigation that a full review of the subsidiary companies and the relevant levels of intangible assets was completed, and the results were included in the Recommendation. In particular, Mr Janes advised the Investigation that:

"United Realty was reviewed and a recommendation made that the goodwill should be written down to a level consistent with a comparable sale (of Harcourts to Tower).

United Lifecare was reviewed and a recommendation made that an additional write-down of [NZ]$10.0M be made, to give a residual value to the equity of zero.

United Sharebrokers was reviewed and the carry forward of past losses as an asset questioned with a recommendation that goodwill be written off."

In respect of the value of investments, Peat Marwick stated in their draft report dated 3 May 1990:

"Valuation of investments in subsidiaries

There are a number of subsidiaries, in particular, Life Care, where the net tangible asset backing of the underlying assets are significantly less than the cost carried in the books of UBS. This does not create a problem as on consolidation the group picks up this deficit through consolidation of the retained earnings. It does however, lead to queries over the value of the goodwill in the consolidated accounts against these investments. The investments where NTA is less than cost are:

 

COST

NTA

Life Care

$15,000

4,834

Sharebrokers

$1,255

(1,918)

URW [United Realty]

$1,000

431

There was concern raised by the Company's Office in registering the prospectus of UBS, the parent company as at 31 March 1989. However, discussions with George [Presumably Mr George Rowley, auditor of UBS] indicate that the September prospectus was registered with no comment despite there having been no adjustment to the cost of the investments."

Set out below is a comparison of the goodwill writedowns recommended by the due diligence team and the actual writedowns which have been made, both as part of the purchase accounting adjustments and subsequently:




Entity/Item

  

As
recommended
by Due
Diligence
Team
$NZ M

  

Actual
adjustment
made at
30 June
1990
$NZ M

  

Adjustment
not required to
consolidated
results at
30 June 1990
$NZ M

  

Excess of
subsequent
write-off over
due diligence
assessment
$NZ M

  
                   
United Lifecare (see below)  

(10.0)

  

-

  

(10.0)

  

-

  
Allied Mortgage Guarantee  

(3.3)

  

(3.3)

      

-

  
United Realty  

(2.0)

  

(7.5)

      

(5.5)

  
Marac Building Society      

(1.6)

      

(1.6)

  
United Shareholders      

(0.7)

      

(0.7)

  
Lodge Real Estate      

(0.5)

      

(0.5)

  
Other      

(0.2)

      

(0.2)

  
   

(15.3)

  

(13.8)

  

(10.0)

  

(8.5)

  
Unidentified adjustments
required to arrive at
actual write-down		  

n/a

  

(0.2)

  

-

  

(0.2)

  
                   
Goodwill write-down and amortisation for nine months to 30 June 1990
as included in reconciliation of Reserve movements		  

(15.3)

  

(14.0)

  

(10.0)

  

(8.7)

  

Note: The above figures were conveyed to the Investigation by Mr Cooper in a facsimile dated 29 August 1991.

(v) Write-down of Investment in Lifecare

In the United Banking Group prospectus dated 29 June 1990, note 6 to the accounts refers to "write-down in value of investment in a subsidiary company" of an amount of $NZ 10.0M.

In a memorandum from Mr Cooper to Mr Jenkins, dated 30 July 1990, entitled "Investment in Subsidiary Companies", Mr Cooper states:

"Lifecare

As at March, 1990 we wrote-off $10m of our investment in Lifecare. This was justified as a permanent impairment of the investment.

Since March I believe the situation has improved, especially in relation to tax recovery, and I see no reason to need to extend the write-off as at June 1990."

In a memorandum from Mr Cooper to Mr Mead (United Building Society Chief Executive Officer, Banking Services), dated 28 June 1990, Mr Cooper states:

"The abnormal item of $10m represents the recognition in the Society's accounts of the losses made in previous years in United Lifecare Ltd. These losses have already been recognised in the consolidated accounts and are now being reflected in the investing vehicle - the Society (emphasis added). The item does not reduce the net worth of United as a Group of Companies."

The above comments explain why the $NZ 10.0M write-down does not appear in the itemised schedule of United Banking Group consolidated reserve movements between 30 September 1989 and 30 June 1990, as a write off to consolidated reserves was not required. This schedule is separately discussed in Section 18.5.4.1 of this Chapter.

The Investigation uncovered no evidence, on the due diligence files, of valuations being performed for each subsidiary, nor did the Investigation find evidence of calculations supporting the recommended goodwill writedowns, although the method of valuation of United Realty was disclosed in the Recommendation. As previously mentioned, goodwill of $NZ 8.7M was written off as at 30 June 1990 at the instigation of Mr Copley. This write-off, however, was not considered as an issue of valuation.

(iv) Creditors

Mr Janes has advised the Investigation that analysis of creditors was not done by Ayers Finniss, but would be expected to form part of the evaluation of internal and external (audit) files undertaken by Ms Chin and Peat Marwick. Mr Copley advised the Investigation that access was not given to accounts payable information by United Building Society management prior to the acquisition, as very few people in United Building Society were aware of the negotiations that were taking place.

Even though it may be arguable that the Bank was familiar with the financial results of United Building Society from its ongoing client relationship, in my opinion, this limitation on scope of the due diligence investigation was not adequately resolved by the due diligence team, and should have been separately reported in the Recommendation.

(vii) Borrowings

Mr Janes advised the Investigation that all information on borrowings and facilities was obtained as part of the due diligence review, and he referred to:

. a Lending Credit Committee review, dated 3 January 1990; and

. a report from Mr Cooper, dated 11 May 1990. A copy of this report was not located on the due diligence files the Investigation has reviewed.

Based on the reasons stated in the Recommendation, for the downgrade in the operating profit forecast of $NZ 36.0M, to the post acquisition budgeted profit, of $NZ 4.4M, as described above in Section 18.5.3.1 of this Chapter, it is apparent that the due diligence investigation failed to adequately address the maturities of certain relatively expensive tranches of term debt. The ability to retire expensive debt, and replace that debt with cheaper funds, was one of the underlying assumptions of the forecast improvement in United Building Society's profitability included in the Recommendation. The delay in being able to retire this debt led to a downward revision of the pre-acquisition forecast of $NZ 0.5M in arriving at the post acquisition budgeted profit.

(viii) Off-Balance Sheet Ventures

Mr Janes advised the Investigation that all information in respect of off-balance sheet ventures was already available to and known by the Bank as a provider of several United Building Society facilities. Buckcorp and Remco were two off-balance sheet ventures and are discussed below.

Based on the results of the Investigation's review, I am of the opinion, for the reasons discussed below, that the due diligence investigation failed to adequately address the inflated carrying values for properties in the Buckcorp Trust.

Buckcorp

Buckcorp is a trust vehicle which was used by United Building Society to realise and bring to profit upward movements in the value of Bank properties. A secondary role was to "quarantine the potential loss situation on one property acquired as the result of default on a commercial loan" (described as such in a draft of the Bank Board Paper dated 26 September 1990).

Some 70 per cent of the trust assets (excluding $NZ 3.3M relating to the commercial loan property) was financed by first mortgage investors and the investments were "due to roll" on 15 October 1990. Given the decrease in value of the underlying securities, it was proposed that public participation in this trust would cease from 15 October 1990 (Source: draft of the Bank Board Paper dated 26 September 1990).

In a facsimile, dated 19 March 1991, from Mr Cooper to Mr Copley titled "Property Values in New Zealand", details were given of various properties sold into the Buckcorp trust. The memorandum compares the carrying value of each property with an estimate of its valuation at 31 December 1990. One such property was referred to as the "Dairy Board" property. The memorandum describes this property as follows:

"This property was transferred to Buckcorp at $3.3m although there is valuation of $1.850M dated 17/10/1988. The property has a demolition order for 1996 over it. The existing land value is $611,000 and the property is running at net loss at present. Prospects for letting all the space in the short term are poor. A head lease for 6 years at 13% could be worth $2.0m on a discounted basis."

The paper concluded:

"The major portion of the writedowns ($4,162,000) are attributable to two properties namely 98 Greys Avenue and the Diary [sic] Board Property. The value of both these properties could be propped up by taking head leases and reducing the write off by say $1.8m".

Mr Janes advised the Investigation that Mr Morrison reviewed Buckcorp, but the review of the due diligence files uncovered no evidence of a detailed review of the operations, assets, and liabilities, of Buckcorp having been carried out by Mr Morrison.

Mr Morrison did review a $NZ 3.3M loan to Buckcorp as part of his review of receivables. This loan related to a property on the corner of London and Victoria Streets, Hamilton. In his initial report, dated 30 April 1990, Mr Morrison questioned whether a provision of $NZ 1.0M was required against the receivable although a provision for this loan was not eventually included in the Recommendation, nor were relevant details relating to Buckcorp included as, in my opinion, would have been appropriate.

The property writedowns at 30 June 1991 of $NZ 27.7M included $NZ 7.2M relating to eight properties owned by Buckcorp.

In their draft report dated 3 May 1990 Peat Marwick stated:

"New Zealand Property Securitization Trust (NZPST)/Buckcorp

In the 1989 year United sold properties, with a book value of $6.0M, to a company (Buckcorp) which is owned by a charitable trust (NZPST). The trust was eventually to be funded by contributory mortgage investors in AMG. A profit on this sale amounting to $7.5M, was recorded in the net profit before tax for the year.

The majority of the premises are tenanted either wholly or partially by UBS. In connection with this transaction, United Realty World have guaranteed a return of 13.5% to New Zealand Property Securitisation Trust for the next three years (or 13.5 x 13.5% = $1.82M). There was no quantification of this contingent liability and no provision was made against the gain on sale for the liability under the guarantee.

From discussions with George Rowley it would appear that the records of NZPST and Buckcorp, both of which are maintained by United personnel, are in a shambles and it would be difficult to readily assess the liability under the guarantee to date and the potential liability for the remaining period. He also mentioned that he understood a number of the properties had subsequently sold at prices which may or may not have reached the valuation at which the properties were transferred to Buckcorp. He was also unsure as to who would wear any loss on the subsequent sale of the properties. George has undertaken to investigate this matter and provide me with an estimate of the contingent liability under the guarantee.

However given the existence of the guarantee and the funding through AMG investors (guaranteed 100% by AGM) it appears that the properties could be said to have merely been refinanced as opposed to sold."

Peat Marwick further stated that "the [Allied Mortgage Guarantee audit] files contained no mention of the Buckcorp property deal (refer 1.2) and the audit partner suggested we ask the company".

The above-mentioned contingent liability was not mentioned in the Recommendation, nor were relevant details relating to Buckcorp included as, in my opinion, would have been appropriate.

Remco

Another off-balance sheet entity of which I am aware is REMCO which was a vehicle used to raise funds by United Building Society. Mr Morgan advised the Investigation that REMCO allowed United Building Society access to funding, at rates of around one percent over the Bank Bill rate.

Peat Marwick discussed REMCO in their draft report dated 3 May 1990 as follows:

"UBS is the manager for the mortgages securitised under the Remco facility for which they are paid 50 basis points or 50c a mortgage pa. (George Rowley to check as he was unsure as to the fee). This securitisation has been treated as a sale as there is no recourse under the documentation. The facility is a three year facility and has a guaranteed take out by another financial institution (the Bank) at the end of this period. There was no profit or loss on the portfolio booked at the date of sale, however a facility fee/commission amounting to $2.7M is being amortised straight line over the three year period.

It should be noted that UBS has invested in $NZ35.0M of subordinated bonds issued by Remco at a yield of BBR + 125bp."

The review of the due diligence files uncovered no evidence of a review having been carried out on the activities of this off-balance sheet vehicle.

(ix) Contingencies

In relation to inquiries of the Investigation as to the review of contingent liabilities, Mr Janes advised:

"Reviewed as relating to lending and insurance/guarantee functions by Mr Morrison (see especially AMG) and in discussion with N Cooper (funding) especially relating to change of ownership, effects on facilities, memberships building Lifecare obligations etc. Also with EDP/Systems analysis."

Set out below are instances where queries with respect to actual and potential contingent liabilities were referred to in the course of work on the due diligence review. The Investigation review of the due diligence files has uncovered no evidence that these queries were resolved, and there was no discussion of any contingent liabilities in the Recommendation.

In their draft report dated 3 May 1990, Peat Marwick stated:

"Sale of index linked stock portfolio

Prior to 30 September 1989 UBS held approximately $50.0M in government issued index linked stock (ILS). This stock, with maturity dates 1991/1992, has a fixed coupon, between 4.95% and 6%, and a semi-annual CPI index adjustment. The market for this index linked stock is exceedingly thin and while it may be theoretically able to be traded, I would consider that given the unavailability of an independent, unbiased market that ILS was most appropriately carried at cost plus accrued purchase yield in the accounts. However in 1988, UBS revalued their ILS holdings by revaluing the fixed coupon portion to a market yield (provided by Jarden Morgan). Jarden Morgan, I believe, arrived at a market yield by applying a factor against the current government stock yield.

This revaluation in 1988 resulted in a loss of $2.75M being booked through the revaluation reserve. In 1989 the accounting policy for the treatment of the unrealised revaluation on trading investments was changed to reflect the revaluation in the profit and loss account for the year.

Due to the sale of $47.0M of the ILS book, at UBS's cost price, to a third party company, the previous devaluation was no longer required and $2.75 [sic] was reversed through net profit before tax.

The purchase was funded by a redeemable preference share issued to United Group Securities by the purchaser. The interest received on the redeemable preference shares is non-assessable income to the United Group. The transaction had the end result of sharing the benefit of the tax losses carried in the purchasing company by converting the percentage of income (85%) received on the ILS to an after tax basis.

There is another agreement for an interest rate option whereby UBS effectively guarantees that the purchaser will receive a coupon of not less than the Bank Bill Rate (BBR) on the ILS. This means that United is guaranteeing that the CPI top-up together with the fixed coupon will not be less than the BBR. No provision was made for any possible further guarantee payable under this agreement by United Building Society as Deloittes examined a model showing that the net return after the transaction is greater. I reviewed the numbers based on a guaranteed return of 13% and if this was the case then the net return to United Building Society would be greater under the new arrangement.

On review of the documentation there had been a late change in the agreement from a fixed guaranteed rate of 13% to BBR. Therefore there could be a much greater differential as the floating rate does not put a cap on the difference between the coupon and the amount payable under the guarantee. However it should be noted that under the details of the structure this top-up effectively flows back as a return on the RPS.

To ascertain if a write-down is required 85% of the revalued ILS should be compared with equivalent security revaluation after tax.

The documentation also did not indicate the basis for the calculation of the interest on the redeemable preference shares and I was unable to ensure that United will receive their share of the tax savings.

George Rowley is to follow up the change in the guarantee to bank bill rate and the documentation on the calculation of interest and send them to me in Auckland."

Attachment 1.5 to the Recommendation noted that the investments were marked to market.

No evidence was uncovered that the interest rate guarantee was followed up. Nor was the guarantee disclosed as a contingent liability in the Recommendation.

In their draft report dated 3 May 1990, Peat Marwick stated:

"Allied Mortgage Guarantee

4.1 This company manages/brokers investments in mortgages (contributory) and also insures mortgage and other risks.

The primary focus of the mortgage insurance has been in respect of the contributory mortgages advanced by the company.

4.2 The investors in the contributory mortgages are guaranteed principal and interest repayments by AMG irrespective of the performance of the mortgage. Although the mortgages are reinsured there is still a problem in the timing of the cash flows, as the reinsurance cannot be claimed until a foreclosure and sale takes place. The company funds this through working capital and capital.

The contributory mortgages and liability to investors once matched, are held off balance sheet in a nominee company and at 30 September amounted to $105,407,000.

This netting of balances is questionable as the guarantee given by Allied Mortgage Guarantee results in AMG bearing the risks of ownership of the mortgages and the liability to the investors.

4.3 We were not shown the trust account audit files and we have some concern that the insurance and contributory mortgage businesses are conducted by the same company.

4.4 It was not possible to ascertain from the file the uninsured risk (after all reinsurance) nor was it possible to review all reinsurance policies to ascertain their validity.

The gross amount of mortgages for which AMG have insured total:

 

$000
  • Contributory mortgages (AMG)

105,407
  • House repurchases

24,390
  • Other mortgages

26,443
 

156,240

Phil Newberry indicated that the reinsurance limited the companys [sic] risk to $50,000 per customer with a stop loss insurance based on a percentage of gross reinsurance premiums.

For the 1990 year, he said, this percentage puts a cap on the potential losses of $877,000 (PN to follow up with more detail).

The company has an estimated provision for claims, based on loans in arrears, of approximately $200,000 and a premium income deferral of $1.3M.

We consider it may be appropriate to have one of your insurance people carry out a review of the reinsurance policies to ensure the reinsurance is appropriate and enforceable ...

4.8 The house sale guarantee program had commenced shortly before year end and only two properties where AMG had been called under the guarantee. [sic]

A contingent liability of $26 443 405 was noted in respect of this program. There was no indication in the file as to the timing of commissions however we understand that you have discussed this with Evan Vertue."

There is no evidence (in the paper on the review of Allied Mortgage Guarantee prepared by Mr Morrison) that a review of the reinsurance policies was carried out to ensure that they were appropriate and enforceable. Mr Morrison has said that although a review was not carried out, copies of all the policies were attached to his report for further analysis/review at the "appropriate time".

In his report on Allied Mortgage Guarantee, dated 1 May 1990, Mr Morrison states:

"Contingencies at 31/2/90 were as follows:

 

      
 

31/3/90

  

30/9/89
       

Guarantees of repayments to investors

$105.3M

  

$105.4M

Guarantees to other mortgage lenders

$37.9M

  

$24.4M

Guarantees under the House Sale Guarantee

$15.9M

  

$26.4M

Neither these amounts nor any other contingencies were adequately disclosed or discussed in the Recommendation. In my opinion, this was a material omission.

(x) Taxation

Mr Janes advised the Investigation that:

"Past tax returns were reviewed by the auditors. A substantial review was undertaken regarding Lifecare within the context of the United Group and as this was the principle area in which disputes were likely. This review was conducted/arranged by R Glenn and detailed notes and reports are on the files ... 1989 return had not been filed. Tax losses carried forward were available, but would not be able to be carried forward to the Bank because of ownership continuity requirement."

In their draft report dated 3 May 1990, Peat Marwick stated:

"Tax Returns have recently been submitted for the 1987 and 1988 tax years and no assessments have yet been received from the Inland Revenue Department. There have been losses available for carry forward in these years which will have been fully utilised by 1989/90."

In an internal Ayers Finniss memorandum, from Mr Glenn to Mr Janes, dated 23 March [1990], Mr Glenn stated that:

"Until last year no one in Benefit [UBS] actually had responsibility for Group tax. Anything that was done, was between advisers and Colin Jenkins.

Last year, after Cooper was appointed, he was given responsibility. He has appointed Phil Newberry Group Accountant to handle the administrative responsibility for returns etc. The last return "accepted" by the Revenue is 1986.

1987 return in done but not yet filed.

1988 return is still being prepared.

In other words tax position has some mild element of uncertainty and would require further due diligence. Benefit is currently the subject of an IRD tax audit with an inspector present off and on for the last 3 months and expected to be around for 2/3 months further. They have had absolutely no feedback on the matters she has investigated."

Mr Janes advised the Investigation that the review of taxation was targeted specifically to the Lifecare exposure. He stated that Ayers Finniss reviewed "the tax position, given that [United Building Society] would not be able to carry forward tax losses and therefore should ensure that no revenue deferral was occurring".

Although taxation returns had only recently been lodged for 1987 and 1988, and tax returns had not been submitted for 1989, the review of the due diligence files uncovered no evidence that a review of the group tax position had been carried out.

I would have expected the due diligence review to have encompassed a review of the group's tax affairs and I consider this to be a fundamental exercise in any due diligence review.

Included in the abnormal items recorded in the profit and loss statement of United Banking Group for the year ending 30 June 1991 is an amount of $0.5M relating to penalty interest for underpayments of prior year tax.

(xi) Capital Structure

The Recommendation includes a discussion of the various classes of depositors and shareholders in United Building Society. Included is an analysis of the likely payout associated with the interest premium incentives that were due to the various classes of depositors on the conversion of United Building Society to a bank. This analysis, however, refers to the present value of the likely payouts required to the various depositors, and is not as detailed as I would have expected to be included in a recommendation being made to the Board, in that it does not show what the gross payments were likely to be.

(xii) Forecasts

Mr Mallett advised the Investigation that, because of the relationship developed with the management of United Building Society and the strategic desire to win over the senior management, the Bank relied substantially on statements made by directors/management in respect of the projections of United Building Society. He advised the Investigation, with the benefit of hindsight, this reliance was probably a mistake. He further stated that, in hindsight, more information (sensitivity analysis etc.) should have been available to the Executive Committee.

In a Bank Board Paper dated 17 August 1990 (written by Mr Mallett) it was stated that:

"... During the due diligence process, the ongoing profitability of United Banking Group was formally assessed by Ayers Finniss with the assistance of the Chief Financial Officer, United Banking Group. This due diligence process indicated that the Bank could expect United to achieve a return for this financial year of some $NZ20.0M plus. The Group budget for United, now presented, indicates a figure of $NZ4.3M ..."

In relation to forecasts Mr Janes advised the Investigation that:

"This area was handled by Richard Steel, working with Nic Cooper (CFO of UBS).

The "State" model was run on stipulated assumptions that were discussed/developed with the Bank. Various sensitivities were run, not all of which have been retained."

In relation to assessing vulnerabilities, Mr Janes advised the Investigation:

"In particular attention was paid to the 2% interest premium to be paid to existing deposition for the acquisition, as this would clearly:

(a) effect margins; and/or

(b) require adjustment for the NPV to the value of the business."

Mr Janes's comments, however, do not address any vulnerabilities in the assumptions underlying the forecast operating profit.

Mr Copley advised the Investigation that he was very concerned, after the acquisition, when discussing one aspect of the transaction with Mr Cooper. The acquisition proposal stated that real estate agency trust funds of some $NZ 25.0M would be available to be transferred and held on deposit by United Building Society, after United Building Society had received its banking licence. Subsequent enquiries revealed that trust funds were never to be of this magnitude, and that Mr Cooper acknowledged to him that United Building Society had only guessed the value of the trust funds.

The due diligence team would have been aware that the achievement of forecast trading results was a fundamental risk area, primarily as a result of:

. the inclusion of "one-off items" in the trading results for the year ended 30 September 1989, the exclusion of which had the effect of turning the reported group profit into a loss;

. the fact that all group businesses (with the exception of United Realty) had recorded losses during the five months to 28 February 1990;

. when compared to the trading results for the five months ended 28 February 1990, a turnaround in trading results was forecast for the three months ended 30 June 1990, which was prior to the conversion of United Building Society to a bank; and

. the fact that United Building Society had forecast a significant turnaround in its trading results from a pre-tax operating loss for the year ending 30 September 1990, of $NZ 11.3M, to a pre-tax operating profit of $NZ 36.0M for the year ending 1991.

Accordingly, I would have expected the due diligence investigations to include:

. an analysis of the basis of forecast profitability in order to identify the specific key assumptions which contributed to the reversal of trading losses; and

. a critical assessment of the reasonableness and achievability of the key assumptions in order to identify their vulnerable areas, particularly when they were compared with the detailed historical results. I would have expected any identified vulnerabilities to have been quantified accordingly.

The Investigation's review of the due diligence files of the Bank and Ayers Finniss uncovered no evidence that a detailed review of the forecast trading results (as included in the Recommendation) had been carried out. The absence of evidence of any downgrading in forecast trading results is consistent with the statement in the Recommendation which refers to the projections of United Building Society as follows:

"The ability of United to sustain their profit projections has been questioned. We believe income levels on the management most likely case are supportable. Expense levels are adequate but do make assumptions in regard to synergies available from State Bank (in the Information Systems area) which have yet to be fully proved".

The Recommendation shows that the subsidiary businesses, other than United Realty, would have no profit impact after 30 September 1990, as these businesses would be disposed of or closed. I would have expected a discussion of the implications of these assumptions not coming to fruition to be included in the Recommendation ie the profit and cashflow impact of not being able to dispose of these businesses by the nominated time, or not reversing the losses on schedule.

The `Conversion Plan' document issued by United Building Society publicly stated that:

"United Banking Group Limited is forecast to earn a profit after tax of $26 million in the 12 months to 30 June 1991 - the first full 12 months of operation as a Bank. This represents a pre-tax profit of $35 million of which the United Bank contributes $30 million.

The profit forecasts do not incorporate the cost of bonus payments to terminating and Permanent Members as provided in the Scheme for Conversion, or property revaluation gains on [sic] losses for the year".

In their report entitled "Report on a Proposal for Conversion of United Building Society to a company and a Registered Bank" (dated 11 May 1990, and included in the Conversion Plan), Deloitte Ross Tohmatsu ("Deloittes") stated:

"We have reviewed the financial forecasts set out on page 17. [These include the forecast pre tax profit of $NZ35 million referred to above]. In our opinion the forecasts, so far as the accounting policies and calculations are concerned, have been properly compiled on the basis of the assumptions made and adopted by the Directors. The financial forecasts are presented on a basis consistent with the accounting policies adopted in the most recently completed financial year of the Society. Since anticipated events frequently do not occur as expected, actual results may differ from forecasts."

No reliance could have been placed on the work carried out by Deloittes, as they do not comment on the reasonableness of the assumptions which underlay the forecasts.

In my opinion, the conduct of due diligence on the forecasts was inadequate because:

. Bank management did not follow-up:

- the issues raised by Peat Marwick in their draft report of 3 May 1990, which "raised queries over the maintainable earnings of United Building Society";

- the impact of the Lending Credit Committee report, dated 3 January 1990, which referred to a "maintainable net income", which was actually a loss of $NZ 9.3M;

. Although Ayers Finniss may not have reviewed or read the Peat Marwick report, Mr Janes has stated that the issues addressed in that report had been identified and addressed in the due diligence. The Investigation's review of the Ayers Finniss file did not confirm that questions "over the maintainable earnings" of United Building Society had been identified or followed up; and

. the underlying assumptions on which the forecasts were based, and which led to a substantial turnaround in trading performance, were not subjected to a rigorous critical scrutiny by the Bank, Ayers Finniss, or any other advisers.

In forming a view on the adequacy of the due diligence review of profit forecasts I have taken into consideration:

. that there were no material adjustments made to the forecast trading results prepared by the United Building Society and submitted to Ayers Finniss;

. a comparison of the forecast pre-tax profit of $NZ 36.0M (or post-tax profit of $NZ 27.0M), for the year ended 30 September 1991, as disclosed in the Recommendation, (Attachment 1.1), with:

- the actual pre-tax loss (determined on a comparable basis) for the year ended 30 June 1991 of $NZ 73.0M; the actual recorded result was a post-tax loss of $NZ 123.3M; and

- the post acquisition budget for the year ended 30 June 1991, prepared in August 1990, which showed a pre-tax profit forecast of $NZ 4.4M (or an "adjusted profit" for the year ended 30 September 1991 of $NZ 12.6M); and

. that the substantial turnaround in profitability foreshadowed in the Recommendation was a major feature of the business, and consequently a major risk area.

(xiii) Other Matters

A major shortcoming of the due diligence review was the lack of co-ordination of the activities being carried out by the various parties involved. For example, the Bank Board were informed (see extract of Board Minutes below) that Ayers Finniss were co-ordinating the due diligence investigation, although Mr Janes has advised the Investigation that certain reports of the Bank officials (for example, data processing and internal audit reports) and the report of Peat Marwick were not made available to Ayers Finniss.

In a letter to the Bank Board of Directors dated 9 May 1990, Mr Janes stated:

"I confirm that Ayers Finniss Limited has acted for the State Bank in negotiating and arranging the purchase of the above named company, and in arranging due diligence examination.

We have had a limited amount of time to complete due diligence. We have therefore arranged for other parties to handle various sections of the examination..."

"On the basis of the information and reports available to us we have assisted in the preparation of a report to the Board of the State Bank. This report indicates that the business of United Building Society has a positive net present value after allowance for all likely losses and write down, and for the assessed likely cost of acquisition.

We are satisfied that the purchase represents a strong strategic initiative in the New Zealand banking industry at minimum cost." [Emphasis added]

The Bank Board Minutes of 9 May 1990 state that:

"over the past month, an exhaustive due diligence process had been undertaken..."

"Ayers Finniss had coordinated the [due diligence] investigation over the last six months, with Mr Trevor Janes, General Manager, Ayers Finniss, New Zealand having concentrated solely on this project over the last three months".

It is evident from the above when the Board resolved to acquire United Building Society that the Bank Board of Directors assumed (or had been told) that Ayers Finniss had coordinated the due diligence performed on United Building Society, and had taken this to account in their decision to acquire the United Building Society.

18.6.4.6 Losses Arising from Non-Execution of Identified Actions

The failure to properly evaluate historic and forecast trading results has led to significant losses being incurred on the investment. In my opinion a thorough analysis of historic trading results would have put the due diligence team on notice in reviewing the forecast trading results due to:

(a) the inclusion of significant one-off items in the trading results for the year ended 30 September 1989;

(b) the losses that were incurred between 30 September 1989 and the date of the acquisition; and

(c) the turnaround in forecast trading results prior to the conversion of United Building Society to a bank.

Based on the reasons given for the downgrade in the forecast profit for the year ending 30 September 1991, I would have expected a line-by-line review of the pre-acquisition forecasts to have led to the identification of significant over-optimism on virtually all of the items subsequently ascribed to this downgrading of the pre-acquisition forecasts included in the Recommendation.

It is not possible to quantify what those vulnerabilities would have been at the time, given the information that was available to the due diligence team, although, in my opinion, a substantial reduction in forecast profit would have been required. The pre-tax profit forecast of $NZ 36.0M, included in the Recommendation for the year ended 30 September 1991, compares with the actual pre-tax loss of United Banking Group for the year ending 30 June 1991 of some $NZ 73.0.

Independent and up to date property valuations were not obtained as part of the due diligence investigation, and subsequent property devaluations, as at 30 June 1991, amounted to $NZ 27.4M. It is not possible to assess what, if any, portion of this devaluation would have been identified had formal valuations been obtained as part of the due diligence investigation.

Other trading items, which were not specifically identified and adjusted in the review of forecasts, but which in my opinion should have been identified during such a review, are:



Trading Items

Post
Acquisition
Loss
($NZ M)
   

Redundancy costs not included in the Bank forecasts

3.2

Costs of converting to a Bank and "bank launch" costs

1.6
 

4.8

On the basis of the matters referred to above, I am of the opinion that Mr Mallett and Mr Janes failed to exercise proper care and diligence in planning and conducting the financial review of United Building Society.

 

18.7 MAJOR DEFICIENCIES OF "THE RECOMMENDATION" AND OTHER RELEVANT MATTERS

 

In conducting this inquiry, a review of the papers presented by Mr Mallett to the Bank Board which recommended the investment in United Banking Group, has been carried out. Based on the results of that review, I have set out below the major deficiencies of the Recommendation, and other related Board Papers.

18.7.1 INACCURATE IMPRESSIONS CREATED

Based on my understanding of United Building Society and the due diligence review, the Recommendation created a number of impressions to the reader which, in my opinion, are not justified.

The inaccurate impressions created are discussed under the following headings:

18.7.1.1 Description of Due Diligence Undertaken;

18.7.1.2 Costs and Benefits of Acquisition;

18.7.1.3 Extent of Investigation Undertaken;

18.7.1.4 Non-Bank Loss Making Subsidiaries;

18.7.1.5 Inadequacies of Financial Information;

18.7.1.6 Valuation of the Business; and

18.7.1.7 Co-ordination of Due Diligence.

18.7.1.1 Description of Due Diligence Undertaken

The Recommendation provided a list and description of the areas included in the due diligence investigation. This list and description, however, did not identify investigations which were not undertaken in the review. In my opinion, the Recommendation was deficient in not presenting an accurate description of the scope of the due diligence actually undertaken.

The major steps of the due diligence Review which, in my opinion, were not performed, or not adequately performed, or the description of which was not accurate, included:

(a) review of internal controls;

(b) review of contingent liabilities;

(c) commissioning of independent property valuations; and

(d) inadequate follow up of some recommendations made by outside consultants.

The Recommendation did not specify the limitations on the scope of certain aspects of the review, a number of which subsequently have been referred to by Mr Copley, Ms Chin and Mr Morrison.

I would have expected that these inadequacies, omissions, and limitations, would have been communicated to the Board in the Recommendation. They should also have been informed of the potential financial risks arising out of these inadequacies, limitations, and omissions. In my opinion, in the absence of any proper information, it is reasonable to infer that the Board assumed that there existed no scope limitations of significance.

18.7.1.2 Costs and Benefits of Acquisition

In my opinion, whilst it is true that the purchase of all the issued capital of United Building Society by subscription does not result in a cost to the Bank through payments to vendors, the description of the cost of acquiring United Building Society in the Recommendation was incorrect, as it failed to take account of the fact that the $NZ 150.0M capital injection was, in fact, equity placed at risk in the United Building Society, and the further fact that some portion of this amount was likely to have to remain as permanent capital required to sustain United Banking Group as a stand alone entity. Mr Mallett and Mr Clark have stated, in interviews with the Investigation, that they assumed the Board would have appreciated the implications of subscribing capital into United Building Society. Mr Clark also pointed out in this context that the Bank Board included a leading accountant, leading lawyer, and leading businessmen. In my opinion, it was a mistake to make such assumptions and the Recommendation should have been more explicit to avoid any misunderstandings.

Furthermore, the Recommendation concluded that the acquisition would provide a "net benefit based on State Bank's assessment of $NZ25.6 million". This assessment was based on subtracting the forecast level of interest premium incentives (at their net present value) from the assessed level of net assets being acquired. The assessment was only valid if the value of net assets was tested by the due diligence review, and was determined by that review to be reliable. In my opinion, this was not done. Contingent liabilities were also omitted from the Recommendation, despite the prospect that they could further erode the asset base.

18.7.1.3 Non Bank Loss-making Subsidiaries

The Recommendation gave the impression that all loss-making subsidiaries would be either disposed of or closed, and that ongoing losses would not have an impact on the group after 30 September 1990.

It was stated that United Lifecare would be sold, or, if this was not possible, consideration would be given to "donating" the ownership to a charitable trust at deemed value. Furthermore, it was stated that Allied Mortgage Guarantee would be integrated with the activities of the banking business, and that this would result in considerable cost rationalisation.

The comments in respect of United Lifecare and Allied Mortgage Guarantee do not canvas the alternative prospect that these subsidiaries may not be disposed of, or integrated into other activities, and may therefore be an ongoing detrimental impact on group profitability. Indeed, these operations were not sold or discontinued, and they have been the source of later losses.

18.7.1.4 Inadequacies of Financial Information

In my opinion, there were inadequacies in respect of the financial information included in the Recommendation, which are referred to below:

(a) it did not contain a consolidated balance sheet of the United Building Society, which I believe would be necessary for an assessment of all group assets and liabilities, particularly to identify classes of assets in the subsidiary companies;

(b) it did not include a description of the major accounting policies and practices;

(c) it contained no reconciliation of profit recovery forecasts with past achievement, no cash flow or funds flow statements, and no financial justification for the expectation that capital of $150.0M contributed at acquisition could be "passed back" to the Bank;

(d) there was no summary of property holding, and relative valuations; and

(e) there were inconsistencies in the financial data, such as:

(i) the United Building Society net assets included in the Recommendation as at 30 September 1989 differ by some $NZ 9.6M from the net assets shown in the statutory accounts as at that date. There is no description given of the adjustments made to arrive at the figures shown in the Recommendation; and

(ii) the Recommendation contains internally inconsistent financial information. Attachment 1.1 refers to a pre-tax loss for the year ended 30 September 1990 of $NZ 13.1M whereas Attachment 1.5 refers to a pre-tax loss for the same period of $NZ 10.6M.

18.7.1.5 Valuation of the Business

The Recommendation refers to the valuation of the business as being between $NZ 40.2M and $NZ 67.0M. These values are based on the adjusted level of net assets as at 30 September 1990. In my opinion, the value of a business acquired as a going concern should be assessed by reference to its future earnings and future earnings potential (capitalisation of earnings approach), rather than on asset values alone. This would not apply if the business was loss-making and was forecast to remain loss-making, in which case, the net assets of the business would be relevant in assessing its value. Given that the due diligence team accepted the profit forecasts provided by United Building Society, which show substantial levels of profitability post-acquisition, I would have expected them to value the business on the basis of its earnings, and of the cash likely to be available to the owner. I have not discovered any evidence to suggest that a valuation assessment had been performed on the basis of an assessment of the ongoing earnings and related liquidity.

18.7.1.6 Co-ordination of Due Diligence

The Bank Board of Directors were advised that Ayers Finniss were co-ordinating the due diligence process. However, Mr Janes has advised the Investigation that Ayers Finniss did not have access to certain reports prepared on the subsidiary companies (for example, the information systems review and the internal audit review). It would appear, therefore, that Ayers Finniss did not in fact control or direct all aspects of the due diligence review. This limitation on the extent of due diligence was not made apparent to the Board in the letter by Mr Janes to the Board of 9 May 1990 referred to above.

Conflicting responses were received in respect of the review of internal controls. Mr Janes advised the Investigation that this had been covered by the internal auditor, Ms Chin, whereas her report did not address relevant United Banking Group's internal controls.

This lack of co-ordination of the due diligence process may have led to a number of issues not being covered as part of the due diligence review, and therefore not being adequately resolved prior to acquisition. Such items would include the internal control deficiencies identified by Mr Morrison as part of his review of receivables, and the "one-off" items identified by both Peat Marwick and the Lending Credit Committee which were included in the results for the year ended 30 September 1989.

18.7.2 AYERS FINNISS CONFLICT OF INTEREST

As stated above, Ayers Finniss were retained to co-ordinate the due diligence process. Mr Mallett has confirmed to the Investigation that Ayers Finniss also received a success fee in the order of $NZ 1.0M for the transaction as advisers to the Bank. I believe this placed Ayers Finniss in a conflict of interest position. As due diligence advisers, they were required to dispassionately investigate United Building Society as the Bank's advisers. At the same time they had a financial interest in the transaction proceeding. In my opinion, it was improper for Ayers Finniss to continue to act for the Bank in circumstances where they were to receive a fee should the transaction be a success.

18.7.3 POST-ACQUISITION REVIEW OF DUE DILIGENCE

A review of the Ayers Finniss due diligence was carried out by Mr Johnstone (Ayers Finniss Managing Director) in order to assess the reliability of the due diligence process conducted by the Bank. This review was requested by Mr Hamilton in a memorandum to Mr Johnstone dated 7 September 1990 where he stated that "specifically there are serious concerns at Board level that the quality of assets may not have been correctly assessed and the profit projections may have been too optimistic"

Set out below is the conclusion of a report to the Bank Board of Directors dated 12 October 1990, prepared by Mr Johnstone and presented by Mr Hamilton:

"1. The areas covered by the due diligence were appropriate and broad enough.

2. The depth of required investigation in various areas was not well enough defined.

3. The strategy tended to drive the acquisition as opposed to agreement being reached on the strategic benefits and then ensuring that the acquisition would satisfy such strategies in real financial terms.

4. Because of the fragmented responsibilities of those involved in the various aspects of the due diligence they did not assume a sufficiently high level of accountability for what they were undertaking. In other words, the combination of non-specific instructions and insufficient accountability resulted in a perfunctory approach being adopted in some quarters and insufficient cynicism being applied to the whole exercise.

5. The failure to establish, pre-acquisition, a cohesive post-acquisition strategy implementation plan adversely impacting the manner in which the due diligence process was undertaken.

6. The compressed time frame in which the due diligence process took place was too limiting."

In a memorandum dated 13 September 1990 to the Group Managing Director from Mr Paddison regarding the post-acquisition review of United Banking Group, the following conclusions were noted in respect of the due diligence review:

"The capability and possible integrity of the CEO and CFO

Colin Jenkins and Nic Cooper clearly understood before we bought United of the magnitude of the problems they faced and the tenuousness of future prospects for a return to profitability. Our due diligence failed. Caveat emptor. However, they have clearly continued to avoid facing reality either unconsciously or in fear of recriminations ...

Due Diligence

... There is no point in crying over spilt milk. However, once the shock subsides the questions will certainly be raised as to how this occurred. Simply our due diligence failed. It failed because we looked for reasons to say yes. We did not critically and in detail question the reality of assumptions and sensitivities underlying the operating revenue stream projections on which the business case for acquisition was based. [Emphasis added]

We also failed to totally come to grips with subsidiary issues. Our credit due diligence looks (on the surface) weak. Our financial assessment process was not rigorous enough. We did not use our Retail Banking expertise to good effect in the investigation.

We were out negotiated with what was probably a false competitive bid strategy to accelerate our decision timeframe and we failed to appreciate the desperation of our United colleagues. We then compounded all this by not coming to terms in detail with what we bought on day one and by not putting our man clearly in charge at that time."

In a Bank Board Minute of 25 October 1990 (Minute 90/368), it was noted that:

"There were obviously serious lessons to be learnt from the acquisition program and experience suggested that the appropriate questions were not asked. Directors stated that the Group did not have the expertise to acquire businesses and make judgements on the viability of future acquisitions, therefore Directors would be cautious of any future acquisition proposals. [Emphasis added]

Prowse highlighted that failure of the due diligence process was actually a failure in the process generally and, notwithstanding that the Board did approve the acquisition, the analysis and the due diligence procedures had not identified related problems with United.

The lessons to be learnt were that the quantitative analysis was not carried out appropriately and that it was important to identify deficiencies and how these deficiencies could be avoided in future procedures. It was clear that Directors felt the Group did not possess the capability to conduct a proper Group due diligence process and that this should be recognised."

 

18.8 FINDINGS AND CONCLUSIONS

 

I have summarised below the principal findings of my review of the management of the acquisition of United Building Society.

In my opinion, for the reasons stated in this Chapter, the due diligence was inadequate. It was subject to inappropriate limitations in scope and timing, and suffered the following material shortcomings:

18.8.1 FORECASTS

The due diligence failed to adequately assess the assumptions underlying the forecasts made by State Bank management. The Bank placed reliance on the representations of United Building Society management without critical assessment. In my opinion, this reliance was inappropriate in the circumstances.

The management forecasts included in the Recommendation indicated a turnaround in profitability from a loss after tax, for the year ended 30 September 1990, of $NZ 21.5M to a profit the following year of $NZ 24.8M, a turnaround of $NZ 46.3M or over 200 per cent. A forecast recovery of such magnitude should have been scrutinised with a high degree of scepticism, particularly as key turnaround assumptions related to the core banking business and this was critical to the investment decision. The recovery was not reconciled, explained, or defended in any way, in the Recommendation.

These forecast earnings should have been subjected to close examination, because, in my opinion, the prospective earnings from the investment were a crucial element of the investment decision, an opinion with which Mr Clark has agreed in an interview with the Investigation.

There is no evidence that the profit forecasts provided by United Building Society management were amended, in any material respect by:

(a) Ayers Finniss acting as independent advisers to the Bank and with responsibility for due diligence;

(b) by Mr Mallett as the Bank executive with responsibility for management of the acquisition;

(c) by the Bank Executive Committee who considered the proposal before recommending it to the Bank Board; or

(d) by the Board who were required to and did approve the acquisition of the United Banking Group.

In my opinion, the Recommendation was deficient in that it failed to set forth the due diligence procedures performed to test the reliability of forecast profitability, the results of those procedures, and the conclusions of officers performing the due diligence. Discussion in the Recommendation of this information was essential having regard to the nature and extent of the forecast recovery in profits, the crucial relevance of future profit to the United Building Society investment decision, and the failure of the Recommendation to reconcile the forecast profit recovery with previous results.

Furthermore, the preparation of such a deficient document and its acceptance as the basis for the investment decision is an adverse reflection on the commercial acumen of those responsible for its preparation.

18.8.2 RECEIVABLES

In the nine months ended 30 June 1990, $NZ 24.3M was provided against receivables. The due diligence examination undertaken two months before the above balance date had only identified the need to provide $NZ 6.7M, leaving a shortfall of $NZ 17.6M. Furthermore, since 30 June 1990, additional provisions of $NZ 14.6M have been created against the original loan portfolio. In my opinion, the due diligence examination of United Building Society failed to identify at least $NZ 17.6M of provisioning against the residential and commercial loan book, which should have been evident at the date of the due diligence, given the due diligence examination occurred within two months of 30 June 1990.

The time available for the review of receivables was too short and access to relevant information was too restricted. Specifically, it was limited to a two and a half day review with limited access to United Building Society management and files.

The Investigation was advised of some of these limitations by Mr Morrison who performed the review of receivables. These limitations, however, were not referred to in his report of 30 April 1990. In my opinion, Mr Morrison's report was deficient as it failed to bring these material limitations to the attention of his superiors.

In my opinion, the fact Mr Mallett was not aware of any limitation on the receivables review, evidences a lack of communication amongst Bank executives in the acquisition process in areas fundamental to a competent due diligence review.

18.8.3 PROPERTIES

Independent valuations of properties were not obtained as part of the due diligence review, despite the fact that the New Zealand property market had experienced major deterioration at that time . In my opinion, subsequent property devaluations of $NZ 27.4M would, at least to some extent, have been anticipated by such due diligence. I consider that Mr Mallett and Mr Janes (Ayers Finniss), as the parties responsible for the co-ordination and the performance of due diligence, failed to adequately address property exposure as a risk area in the due diligence review.

18.8.4 INTERNAL CONTROLS

A review of internal controls was not adequately carried out. Mr Mallett advised the Investigation that he had instructed Ms Chin, Senior Manager Internal Audit, to review the United Building Society internal audit and internal controls.

Ms Chin has stated that her role in the due diligence review was limited to reviewing internal audit arrangements, and that she did not, due to time constraints and restrictions on her access to staff of United Building Society, review internal controls. Her report on the work for which she was responsible sets forth the limited scope of her review, and the findings arising from that limited review.

Mr Mallett advised that he was aware of concerns over time limitations but was not aware that this had meant Ms Chin's scope was less than he had instructed her to undertake or that significant findings had arisen from the work undertaken by Ms Chin.

In my opinion, Mr Mallett did not fulfil his responsibilities as the Bank Executive responsible for the execution of the acquisition in that he did not ensure that sufficient time was available to perform a planned element of the due diligence.

In my opinion, Mr Mallett, as the Bank Executive responsible for this element of the due diligence review, did not identify that the planned scope of work was not adequately addressed, nor indeed did he review the report on that review. As a consequence, there was effectively no review of internal controls as part of the due diligence review.

18.8.5 CONTINGENT LIABILITIES

A specific review of contingent liabilities, and the likelihood that they would become actual liabilities, was not carried out, although the existence of various contingent liabilities was revealed in the due diligence review. Contingent liabilities were not adequately covered in the Recommendation, despite the existence of a wholly owned subsidiary of United Building Society, Allied Mortgage Guarantee Limited, which conducted mortgage guarantee insurance. In their signed "draft" report, dated 3 May 1990, Peat Marwick noted that contingent liabilities of $NZ 156.2M existed within Allied Mortgage Guarantee. In my opinion, the Recommendation was deficient, because it failed to adequately disclose material contingent liabilities. The lack of due diligence conducted on contingent liabilities was a material omission in the examination.

18.8.6 LACK OF FOLLOW-UP

In my opinion, a further significant weakness in the due diligence undertaken by the Bank management was that they failed to follow-up and resolve important issues which had been raised by their advisers.

The (signed) draft Peat Marwick report dated 3 May 1990, raised the following key issues:

(a) the earnings of the group for the period ended 30 September 1989 contained two one-off items which significantly changed the reported result, and raised queries over the maintainable earnings of United Banking Group;

(b) certain contingent liabilities existed which required follow-up;

(c) Peat Marwick queried the value of goodwill in the consolidated accounts with respect to certain subsidiaries;

(d) Peat Marwick raised questions regarding the adequacy of the general provision against residential mortgages; and

(e) taxation assessments had not been received for the 1987, 1988 and 1989 years.

In my opinion, had these issues been adequately followed up, questions would have been raised as to the level of United Banking Group's maintainable earnings, the achievability of the profit forecasts included in the Recommendation, and the adequacy of the net asset adjustments included in the Recommendation.

More importantly, however, the Investigation has revealed evidence that the Bank executive committee decided to proceed with the acquisition in circumstances where serious concerns raised in the due diligence review remained unresolved.

18.8.7 PRIMARY RESPONSIBILITIES FOR DUE DILIGENCE

In my opinion, based on a review of the files of the Bank and Ayers Finniss obtained by the Investigation and the interviews with Mr Clark, Mr Copley and Mr Mallett, Mr Mallett was primarily responsible for the management of the acquisition, preparation of the Recommendation (although the document was initially drafted by Ayers Finniss and allegedly reviewed by the Bank's Executive Committee), and its presentation to the Board. Mr Clark has acknowledged that, as Managing Director, he reviewed Board submissions prepared by senior executives, and supported them when they were presented to the Board. In this position, he must accept some responsibility for the inadequacies in the due diligence process generally, and the Recommendation in particular. The Bank Board Minute of 9 May 1990 names those parties involved in the process, including both Bank management and outside consultants. The Minute then goes on:

"Ayers Finniss had co-ordinated the investigation over the last six months, with Trevor Janes, General Manager Ayers Finniss, New Zealand having concentrated solely on this project over the last three months."

The Board Minute concludes with a further reference to Ayers Finniss:

"It was resolved to approve the 100% acquisition of the United Building Society on the terms and conditions outlined in the paper, subject to an appropriate letter of recommendation being received from Ayers Finniss Limited, and subject to a satisfactory agreement being reached prior to the signing of documentation."

The Investigation has searched for a formal letter of instruction to Ayers Finniss without success. Mr Clark has also advised the Investigation that he cannot recall such a letter being sent. The role of Ayers Finniss as described in the Board Minute was integral in the acquisition process. Indeed, Ayers Finniss made representations to the Board regarding their involvement in the due diligence review, by Mr Janes's letter of 9 May 1990. In my opinion, Ayers Finniss must also share responsibility for the shortcomings in that process.

18.8.8 JUDGEMENT BY THE BANK MANAGEMENT OF UNITED BANKING GROUP VALUE

The Recommendation described the acquisition cost for United Banking Group as the present value of future interest premium incentives to be paid to United Building Society depositors which were expected to be $NZ 14.6M (on a net present value basis).

The Recommendation failed, however, to explain to the Bank directors that, although no purchase consideration was paid to outside parties, the assessment of the actual cost of acquiring United Banking Group must include consideration of the amount of equity capital required to be injected into United Banking Group to establish it, and keep it as a properly capitalised stand-alone entity.

In short, the Recommendation did not provide the Bank Directors with a balanced assessment of the merits of the proposed acquisition, in that it failed to explain:

(a) that the $NZ 150.0M capital injection was, in fact, equity placed at risk in United Building Society;

(b) that some portion of the $NZ 150.0M may have to remain as permanent capital required to sustain United Banking Group as a stand-alone entity depending on the success of trading activities; and

(c) that there were serious questions arising from the due diligence review which cast doubt as to the reliability of the $NZ 40.2M net book value on which basis the Recommendation supported the Acquisition.

18.8.9 INADEQUACIES OF BOARD PAPERS

In my opinion, the Recommendation and other Board Papers presented in support of United Banking Group failed to present accurately the risks associated with the $NZ 150.0M investment of equity in United Banking Group.

The Bank Board Papers were deficient in that they also failed to give adequate and relevant information and explanations on the following:

(a) profit forecasts;

(b) limitations of scope relating to the review of receivables and other areas of due diligence inquiry;

(c) concerns raised over management; and

(d) the carrying value of properties.

In my opinion, the Bank executive committee did not provide adequate information to the Board.

18.8.10 CONFLICTS OF INTEREST

Ayers Finniss co-ordinated the due diligence investigation carried out on United Building Society, and Mr Mallett has confirmed to the Investigation that they received a success fee of $NZ 1.0M for their role as financial advisers. In my opinion, the conduct of due diligence is incompatible with remuneration on a success fee basis and would give rise to a conflict of interest. Co-ordination of, or even limited participation in, the due diligence investigation would have required Ayers Finniss to carry out an independent and objective review of the financial position of United Building Society whereas the existence of the success fee would have given Ayers Finniss a vested interest in the transaction proceeding. In the circumstances, Ayers Finniss should not have been engaged by the Bank to participate in the due diligence review. In accepting this engagement, in my opinion, Ayers Finniss acted improperly.

18.8.11 SPECIFIC FINDINGS WITH RESPECT TO MANAGEMENT

On the evidence and material available to me, as indicated in this Chapter, I am of the opinion that:

(a) So far as concerns the planning and conducting of the due diligence inquiries for the United Building Society acquisition:

(i) Mr Mallett and Mr Janes failed to exercise proper care and diligence in identifying key investigation areas and ensuring they were fully addressed, in that:

. profit forecasts and their underlying assumptions were not adequately scrutinised and examined, despite the fact that prospective earnings of United Building Society were crucial to the investment decision;

. independent valuations of properties were not obtained, despite the fact the New Zealand property had experienced a major decline and United Building Society had a substantial property exposure of $NZ 134.6M (book value at 30 September 1989); and

. a specific review of contingent liabilities and the likelihood that they would become liabilities was not carried out in the due diligence review.

(ii) Mr Mallett failed to exercise proper care and diligence in the area of internal controls in that:

. he did not ensure that a review of internal controls was adequately completed.

(iii) Mr Morrison failed to exercise proper care and diligence in assessing the receivables of United Building Society in that:

. Mr Morrison failed to report that his review was subject to limited access to United Building Society files and management; and

. the review failed to identify at least $NZ 17.6M of additional provisioning against receivables, of which at least $NZ 4.6M is specifically attributable to Mr Morrison.

(b) So far as concerns the co-ordination and management of the acquisition process:

(i) Mr Mallett failed to adequately or properly supervise, direct and control the co-ordinating and management of the due diligence investigation in that there was poor communication among the executives involved in the process as evidenced by:

. the fact that Mr Mallett was not aware of the limitations placed on the review of receivables; and

. the fact Mr Mallett was not aware that Ms Chin did not review the United Building Society internal controls because she had not been given sufficient times and resources.

(c) So far as concerns reporting to the Board:

(i) Mr Mallett failed to exercise proper care and diligence presenting the Recommendation to the Board which, for reasons discussed above, was deficient in material respects; and

(ii) Furthermore, I am of the opinion that Mr Mallett and Mr T M Clark failed to exercise proper care and diligence by creating an inaccurate impression for the Board (and which was later communicated by Mr Simmons to the Reserve Bank of Australia) that "an exhaustive due diligence process had been undertaken".

Furthermore, on all the evidence and material available to me, I am of the opinion that Mr Mallett and Mr T M Clark failed to exercise proper care and diligence by proceeding with the United Building Society acquisition and presenting the Recommendation to the Board in circumstances where concerns arising from investigations (noted in Mr Mallett's file note dated 3 May 1990) had not been fully resolved or reported to the Board.

 

18.9 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT

 

18.9.1 TERMS OF APPOINTMENT A

In the course of the Investigation I have investigated and inquired into matters relating to the processes which led to the Bank engaging in the acquisition of the United Building Society 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 the United Building Society were flawed at many points and hence inappropriate.

I have also, as directed by Term 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 T L Mallett, Mr T D Janes, and Mr Morrison, did not exercise proper care and diligence with reference to the acquisition.

18.9.2 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 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 the United Building Society, were not adequately or properly supervised, directed or controlled, by the Chief Executive Officer (Mr T M Clark), Mr T L Mallett, Mr T D Janes, and Mr Morrison.

18.9.3 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 the Chief Executive Officer (Mr T M Clark) and other bank officers to the Bank Board:

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

(b) sufficient to enable the Board to discharge adequately it 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 the Chief Executive Officer (Mr T M Clark) and Mr T L Mallett were not, under all the circumstances, timely, reliable, or adequate, nor were they sufficient to enable the Board to discharge adequately its function under the Act.

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