VOLUME FIFTEEN BENEFICIAL FINANCE - FUNDING, ASSET AND LIABILITY MANAGEMENT, INTERNAL AUDIT, AND OTHER MATTERS CONSIDERED

CHAPTER 34
THE FUNDING OF BENEFICIAL FINANCE

TABLE OF CONTENTS

34.1 INTRODUCTION
34.1.1 GENERAL
34.1.2 SCOPE AND FORMAT OF THIS CHAPTER

34.2 FUNDING AND ITS MANAGEMENT BY THE BENEFICIAL FINANCE GROUP
34.2.1 SOURCES OF ON-BALANCE SHEET FUNDS
34.2.1.1 General
34.2.1.2 Capital Contribution by the Bank
34.2.1.3 Retention of Profits
34.2.1.4 Debentures
34.2.1.5 Debt Funding by the Bank
34.2.1.6 External Domestic and Overseas Wholesale Borrowings
34.2.2 COST OF ON-BALANCE SHEET FUNDS
34.2.2.1 Credit Ratings
34.2.2.2 Dividend Payments
34.2.3 MATURITY STRUCTURE OF ON-BALANCE SHEET DEBT FUNDING
34.2.4 FUNDING OF OFF-BALANCE SHEET ENTITIES
34.2.5 IMPLICATIONS OF THE BANK PARENTAGE
34.2.6 ANALYSIS OF THE BENEFICIAL FINANCE GROUP'S FUNDING AND DEBT-TO-EQUITY RATIOS
34.2.6.1 Asset Growth and Funding Increases
34.2.6.2 Debt-to-Equity Ratios of the Beneficial Finance Group
34.2.6.3 Debt-to-Equity Ratios of the Off-Balance Sheet Entities
34.2.6.4 Summary
34.2.7 CORPORATE RESTRUCTURING OF THE BENEFICIAL FINANCE GROUP
34.2.8 THE ALLOCATION OF CAPITAL AND FUNDS
34.2.8.1 Beneficial Finance's Allocation of Capital
34.2.8.2 Portfolio Composition

34.3 CONCLUSIONS ON FUNDING AND ITS MANAGEMENT

34.4 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT
34.4.1 TERM OF APPOINTMENT A
34.4.1.1 Term of Appointment A (b)
34.4.1.2 Term of Appointment A (c)
34.4.2 TERM OF APPOINTMENT C

34.1 INTRODUCTION

34.1.1 GENERAL

Finance companies generally obtain a portion of the funds required for their operations from the public by way of the issue of a security called a "debenture". Companies and Securities Law⁽⁾ requires that debentures are issued pursuant to a Trust Deed. The law also requires the appointment of a Trustee for debenture holders, independent from the company issuing the debentures, the responsibilities of such Trustee being to act as required by law in the interests of debenture holders, and in accordance with the terms of the Trust Deed. In addition, the document by which the offer to invest is made, generally referred to as a "prospectus", is registered by the Corporate Affairs Commission⁽⁾ in order to ensure that minimum disclosure levels set by Companies and Securities Law are met in the document as issued to the public.

Debentures have proven an attractive investment medium in Australia. The term "Debenture" is usually applied to an investment which is secured by a registered charge over the assets and undertakings of the borrowing company.

Finance companies also obtain funds from the public by way of the issue of Unsecured Notes and similar instruments. These notes normally carry a higher rate of interest than that applying to debentures, reflecting their unsecured status. Where Unsecured Notes are offered to the public, the law requires that a prospectus be registered and that there be a Trust Deed appointing a Trustee to act in the interests of note holders in accordance with the Trust Deed and relevant requirements of the Companies and Securities Law.

In their normal public fund-raising activities, banks are not required to issue a prospectus or maintain a Trust Deed. Banks are, however, subject to prudential regulation by the Reserve Bank of Australia which requires compliance with certain capital adequacy and liquidity ratios. There are, in relation to finance companies, no similar specific capital adequacy or liquidity requirements imposed by legislation or by the regulatory authorities. Trust Deeds are required by Companies and Securities Law to contain a limitation on the amount that the company may borrow pursuant to the Trust Deed.⁽⁾ Trust Deeds contain various ratios of a general prudential nature that must be complied with by the borrowing corporation and reported upon, at periodic intervals, by the borrowing corporation to the Trustee for debenture holders, and the Corporate Affairs Commission. Examples of such prudential ratios, as appeared in Beneficial Finance's various Debenture Trust Deeds,⁽⁾ include:

(a) total debenture stock not to exceed six times shareholders' funds;

(b) no mortgage or security to be created ranking prior to or equally with the debentures;

(c) no subsidiary company to be formed or acquired by the borrowing corporation without the consent of the Trustee for debenture holders; and

(d) total borrowings not to exceed 14.5 times the value of shareholders' funds (ie a debt-to-equity ratio of 14.5:1).

Although, Companies and Securities Law does not stipulate the nature of these "gearing ratios",⁽⁾ trustee companies acting as trustees for debenture holders have, over a long period of time, tended to adopt minimum levels below which they are unlikely to accept an appointment to act as trustee. In addition, the expectations of the marketplace as to the level of security offered by a debenture and/or an unsecured note (which is generally reflected in the interest rate applicable to these securities) may be seen as the most influential factor affecting the levels at which prudential ratios are set. A too highly geared finance company is likely to be perceived in the marketplace as a risky investment, thus requiring a higher interest rate to be offered to attract investors. A higher interest rate means a higher cost of borrowing to the company with a consequential adverse impact on profits.

Appropriate gearing levels for financial institutions vary according to the nature of the business activities being undertaken. Gearing levels are also influenced by the type of facilities they offer and the mix of different facilities within the total portfolio of assets. The need to match the gearing level of the business with the level of risk to which the business is exposed was acknowledged by Beneficial Finance management in Special Submission No 289 which was presented to the Beneficial Finance Board in October 1989. This Submission recommended that a more "risky" profile and mix should be matched with lower levels of debt-to-equity and stated that where a finance company provided only secured debt facilities, debt-to-equity levels of around 10:1 to 12.5:1 were appropriate, whereas debt-to-equity ratios of 1:1 to 3:1 were appropriate for those financial institutions undertaking equity or other higher risk investments. In evidence to the Investigation, the former Managing Director, Mr J A Baker, accepted the need for prudent gearing levels to be maintained. He acknowledged that in the event of Beneficial Finance being inadequately geared "the problems for downturn in the economy are going to be felt more acutely if you have got a high level of debt".⁽⁾ The issue of the appropriateness of the gearing levels of the Beneficial Group is dealt with in Section 34.2.6.2 of this Chapter.

Apart from debenture and unsecured note borrowings from the public, finance companies traditionally also rely on the following sources of funding:

(a) funding provided by shareholders in the form of equity, ie share capital;

(b) funding retained from profitable operations; and

The major finance companies in Australia, during the period covered by this Investigation, were subsidiaries of banks. Their share capital (equity) was generally provided by their parent bank. Undistributed profits earned by finance companies are credited to retained earnings after the distribution of dividends to share holders. So far as concerns external borrowings, other than debentures and unsecured notes, such borrowings are undertaken pursuant to Bills of Exchange, Promissory Notes, Eurobonds, and similar security instruments with which the wholesale markets are familiar.

Finance companies in Australia generally conduct their operations as "continuous borrowing corporations" in that, at the expiration of the term during which an offer to the public of investment in debentures is open⁽⁾ a new prospectus is issued to the public. It has not been common experience in Australia for debenture and unsecured note offerings to be made to fund specific projects. Generally speaking, funds raised from the public are employed in the general operations of the borrowing company. Funds raised must be employed profitably in order to enable the company to pay the rate of interest applicable on the debentures (and, at the end of the term of the investment, the principal thereof) and also to secure profits from which dividends may be paid to shareholders in the company.

This Chapter, considers not only the fund-raising arrangements undertaken by Beneficial Finance, but also certain features of its management of the funds so raised. In particular, attention is paid to prudential criteria for the management of these funds, given the diverse risk profile of assets appearing in Beneficial Finance's balance sheet. Beneficial Finance was required to manage its funds, and its balance sheet, not only to satisfy the requirements of good financial management, but also to satisfy the covenants contained in its various Debenture Trust Deeds.⁽⁾

In this Chapter, I also examine matters relating to the off-balance sheet entities of Beneficial Finance. For the purpose of this Chapter, I shall refer to the Beneficial Finance Group as including Beneficial Finance and its subsidiary companies as reported in its financial statements. I shall, however, use the phrase "Beneficial Finance Aggregated Group" where I am referring to Beneficial Finance, its subsidiaries as reported in its financial statements, and its off-balance sheet entities.

34.1.2 SCOPE AND FORMAT OF THIS CHAPTER

I am required by paragraphs A(a), A(b) and A(c) of my Terms of Appointment to investigate and report on matters and events with respect to the financial position of the Bank and the Bank Group as at February 1991, and the processes leading to the Bank or a member of the Bank Group engaging in operations which have resulted in material losses, or the holding of significant assets which are non-performing.

In this context, I have examined the funding activities and subsequent allocation of funds by Beneficial Finance between 1984 and February 1991 including funds raised for the off-balance sheet entities of the Beneficial Finance Group.

In this Chapter, I report on the following issues:

(a) sources, and cost, of on-balance sheet funds;

(b) off-balance sheet funding;

(d) funding, and gearing, of Beneficial Finance;

(e) corporate restructuring of Beneficial Finance; and

(f) the allocation of capital and funds.

34.2 FUNDING AND ITS MANAGEMENT BY THE BENEFICIAL FINANCE GROUP

34.2.1 SOURCES OF ON-BALANCE SHEET FUNDS

34.2.1.1 General

Over the period covered by the Investigation, Beneficial Finance Group raised funds from a variety of sources. These were:

(a) capital through equity subscribed by the Bank;

(b) the retention of profits;

(d) other borrowings, including debt funding provided by the Bank, and external domestic and overseas borrowings.⁽⁾

Table 34.1 shows the changes in the level of each type of on-balance sheet funding in the period 30 June 1984 to 31 December 1990 for Beneficial Finance Group:

Table 34.1 Beneficial Finance Group On-Balance Sheet funding 30 June 1984 to 31 December 1990
As at 30 June									As at 31 December
Item	1984 $M	1985 $M	1986 $M	1987 $M	1988 $M	1989 $M	1990 $M			1990 $M

Capital	41.7	41.4	50.0	50.0	85.0	125.0	150.0			210.0
Reserves
Capital	12.0	12.8	17.2	17.2	17.2	6.8		6.8		6.8
Retained Profits	4.4	10.8	13.2	16.9	24.8	36.0		32.7		30.7

Equity	58.1	65.0	80.4	84.1	127.0	167.8	189.5			247.4

Debentures	225.6	316.5	425.4	510.9	689.0	943.2	1026.1			838.6
Unsecured Borrowings	208.5	335.9	478.9	483.2	770.9	1011.3	1338.4			1037.1

Borrowings	434.1	652.4	904.3	994.1	1459.9	1054.5	2364.5			1875.7

Total Funds	492.2	717.4	984.7	1078.2	1586.9	2122.3	2554.0			2123.2

Other Liabilities	10.2	30.0	58.2	50.8	68.3	128.1	120.6			144.7

Total Assets	502.4	747.4	1042.9	1129.0	1655.2	2250.4	2674.6			2267.9

In the period from 30 June 1984 to 31 December 1990, $168.5M of additional capital was subscribed by the Bank. In addition, retained profits increased by $26.3M. Secured borrowings in the form of debentures issued under the trust deeds increased by $613.0M, while unsecured borrowings, from both the Bank and external lenders, increased by $828.6M.

From 30 June 1984 to 30 June 1990, total funds increased from $492.2M to $2,554.0M. In the following six months to 31 December 1990, total funds declined by $430.8M in conjunction with a restructure of the Beneficial Finance Group and the transfer of assets to Southstate Corporate Holdings Limited (which is discussed in Section 34.2.7 of this Chapter).

34.2.1.2 Capital Contribution by the Bank

Throughout the period from 1984 to February 1991, the Bank held all issued shares in Beneficial Finance, except for 64,400 preference shares held by Executor Trustee and Agency Co of SA Ltd. The preference shares were redeemed in December 1988, in accordance with their terms of issue.

Table 34.2 shows the Bank's subscriptions of additional capital.

Table 34.2 Bank Capital Subscriptions to Beneficial Finance
Date	Amount $M	Purpose
30 June 1986	8.3	To promote the fund raising image of Beneficial Finance both domestically and overseas, and to improve the likelihood of an upgrade in the company’s credit rating by Australian Ratings.

1 July 1987 1 October 1987	5.2} 5.0}	To enable Beneficial Finance to meet its profit objectives and ensure Debenture Trust Deed requirements were not breached.

31 December 1987	10.0	To compensate for Beneficial Finance’s business levels being higher than budgeted.

30 June 1988	15.0	To enable Beneficial Finance to meet its projected growth and profit objectives for the 1989 financial year and to ensure that obligations under the debenture Trust Deed were met.

30 December 1988	10.0	To replace $10.0M of preference share capital redeemed on 30 December 1988.

30 June 1989	30.0	To enable Beneficial Finance to continue to grow and retain its credit ratings.

30 June 1990	25.0	To reduce Beneficial Finance’s gearing and to assist in maintaining its existing credit rating.

20 December 1990	60.0	To enable Beneficial Finance to continue to comply with the requirements of the Debenture Trust Deed.

Total	168.5

All capital injections by the Bank were approved by the Beneficial Finance Board and the Bank Board.

34.2.1.3 Retention of Profits

In general, the Bank permitted Beneficial Finance to retain a proportion of its after tax profits to fund its expansion. Table 34.1 in Section 34.2.1.1 of this Chapter shows the growth in retained profits over the period 1984 to June 1990.

34.2.1.4 Debentures

General

During the period under review, Beneficial Finance operated under the constraints of several Debenture Trust Deeds.⁽⁾ The following trust deeds were operative at various times during the period under review:

(a) The First Charge Debenture Stock Trust Deed (Consolidated 10 June 1960 and 1 June 1968);

(b) The Unsecured Deposit Note Trust Deed of 19 July 1974;

(d) The 1989 Trust Deed.

From 1985 onwards all new debentures were issued pursuant to the 1985 deed. There were, however, still debentures and notes outstanding that had been issued under the two previous deeds. It was intended that as those debentures and notes issued under the earlier deeds matured or were redeemed, the company's operations would eventually be governed only under the 1985 deed.⁽⁾

The various Debenture Trust Deeds were similar in terms of their prudential ratios, and of their effect on the extent of borrowings by Beneficial Finance and its on-balance sheet subsidiaries. They also limited the security that could be provided to other lenders. These limitations were not applied to the Beneficial Finance Aggregated Group's accounts as the off-balance sheet entities were not recognised by Beneficial Finance as subsidiaries. The manner in which these limitations were stated differed in each of the deeds. In summary, the borrowing limitations under the deeds were⁽⁾:

(a) Deeds of 1960 and 1974:

(i) The value of debenture stock on issue was not to exceed six times the value of shareholders' funds;

(ii) The value of "secondary liabilities"⁽⁾ was not to exceed 40 per cent of the value of liquid assets; and

(iii) The value of total borrowings was not to exceed 14.5 times the value of shareholders funds (effectively, a debt-to-equity ratio of 14.5:1).

(b) Deed of 1985:

(i) The value of total liabilities was not to exceed 93.75 per cent of "total tangible assets" (effectively a debt-to-equity ratio of 15:1); and

(ii) The value of total debenture stock and notes on issue was not to exceed 80 per cent of "total tangible assets".

The limits set by the various deeds were able to be varied with the consent of the Trustee.

Mr P J Erskine gave evidence that, in September 1989, there were no borrowings outstanding under the 1960 and 1974 deeds. At that stage, a deed was entered into that varied the conditions of the older deeds so that the conditions were exactly the same as the 1985 deed. From that time on, only the limitations under the 1985 deed applied.⁽⁾

Beneficial Finance was required, under Companies and Securities Law, to provide the Trustee with a quarterly report which included, amongst other details, a statement regarding compliance with the Debenture Trust Deed provisions.

Compliance with the Trust Deed Provisions

The on-balance sheet growth and capital adequacy of Beneficial Finance were effectively controlled by the provisions of the various Debenture Trust Deeds. This was recognised by Beneficial Finance in its corporate strategic plans which stated:

"... Beneficial's growth will continue to be controlled by the operation of the Trust Deeds ... capital injections from State Bank will be required to ensure Beneficial's expansion of operations will be within the trust deed requirements." ⁽⁾

It was the function of the company secretary to ensure that the Debenture Trust Deed provisions were complied with, and that reporting obligations under the provisions of the deed were satisfied. The Accounting division, and the Treasury divisions, provided the Company Secretary with information to assist with that task.⁽⁾

This Investigation noted one breach of the covenants of the Debenture Trust Deed. In September of 1988 the value of debenture stock and notes on issue exceeded the limits set by the Trustee for a period of eleven business days.⁽⁾ New limits were, however, consented to by the Trustee on 1 October 1988, which brought the value of debenture stock and notes within the required limits.

That breach was promptly brought to the attention of the Board, the Trustee, and the Corporate Affairs Commission and rectified.⁽⁾ No action was taken by either the Trustee or the Corporate Affairs Commission. I accept that the breach of the Trust Deed was inadvertent, and relatively minor.⁽⁾

Amounts Raised by Debenture Issues

Debentures and unsecured notes were generally issued by Beneficial Finance pursuant to a prospectus for terms ranging from three months to five years. Between 1984 and 1990, eleven prospectuses were issued by Beneficial Finance. It was Beneficial Finance's strategy to have a prospectus continually on issue.

The useful life of many of the prospectuses on issue was limited, because of rapidly increasing interest rates. Mr T D Auld, Treasury Accountant for Beneficial Finance, stated in evidence:

"If you were in a rapidly interest rate rising environment, so you put a prospectus on the market today with say a top rate of 3 years at 14% and tomorrow rates suddenly jump up to 14.3% ... you're caught in a leap frog movement because a prospectus was a very traditional way of raising money but because of the constraints of the Companies Code its quite an inefficient way of raising money so, you've spent $5,000 just producing a whole series of new applications and then one of your opponents or competitors comes out with a new rate." ⁽⁾

The amount of funds raised by prospectus issues varied markedly between $25.0M and $100.0M. The last prospectus issued during the period under review, No 65, opened on 2 November 1989. This was the most successful of Beneficial Finance's prospectus issues, and raised $100.0M within about a nine month period. This may be contrasted with an average prospectus raising of $30.0M or $40.0M per year.⁽⁾ The one year rate of 18 per cent for Prospectus No 65 was the maximum ever offered by any Bank or Finance Company.⁽⁾ Prospectus No 65 was withdrawn in August 1990, and matters relating to this issue are discussed in Chapter 35 - "Beneficial Finance - Prospectus 65" of this Report.

Off-shore Prospectus

Mr F R Horwood⁽⁾ stated in evidence that funds were also raised by means of off-shore prospectuses. Beneficial Finance produced eight of these off-shore prospectuses. The borrower, in all cases, was the wholly owned subsidiary of Beneficial Finance, SBSA Finance Limited (or, as it was re-named, Finance Company of South Australia Limited). Beneficial Finance was a guarantor. The prospectuses were registered in Luxembourg. Mr Horwood's evidence was that the funds raised by these means were significantly cheaper than prospectus funds raised inside Australia. The success of these issues was guaranteed, as they were, on all occasions, being underwritten by a syndicate of banks.

Debenture Raisings Comparison

Over the period covered by the Investigation, the level of debenture funding for finance companies was, in general, decreasing as a proportion of total liabilities. Beneficial Finance decreased its reliance on debentures, although to a greater extent than the majority of its competitors. Table 34.3 shows the comparison of the level of debenture funding to total liabilities for Beneficial Finance and its subsidiaries, compared to its major competitors.

Table 34.3 Finance Companies Percentage of Debentures to Total Liabilities
As at 30 June
Entity	1984 %	1985 %	1986 %	1987 %	1988 %	1989 %	1990 %

Beneficial Finance Group	54	49	47	52	55	44	42
AGC (1)	63	61	55	55	48	43	45
Esanda (1)	68	63	60	57	58	64	64
CBFC (1)	-	60	56	52	51	51	63
Custom Credit (1)	-	71	81	81	74	65	66

(1) Year ended 30 September

The Reserve Bank of Australia issued prudential guidelines dealing with the exposure of banks to non-banks. These recommended that a bank's financial dealings with such non-banks should be on a commercial basis, and that any explicit financial commitment should be limited in amount. It was the policy of the Bank to comply with these Reserve Bank of Australia requirements, and to limit the Bank's commitment to Beneficial Finance to 30 per cent of the Bank's capital.

In March 1990, the Bank management expressed concern to the Bank Board about the liquidity of the Beneficial Finance Group. A memorandum submitted to the Bank's Board concluded that:

"... If difficulties are experienced with the loan portfolio, particularly in the current climate, adverse reaction may arise from credit providers which in turn may affect the liquidity of the Group. As decreasing reliance is being placed on the debenture market and increasing reliance on other lenders' facilities (which are all subject to annual review), some uncertainty regarding the Group's liquidity would result should (some of) these lines be withdrawn or not renewed. It would therefore be a prudent strategy to encourage Beneficial to utilise and develop other credit lines now thus keeping SBSA's capacity in reserve should it be required. SBSA needs to balance market perception to be seen to have a significant lending exposure to Beneficial and at the same time ample reserve capacity to provide additional support." ⁽⁾

Debt funding by the Bank to the Beneficial Finance Group included both domestic and overseas facilities, some of which were allocated against specific projects. Approved limits under these facilities increased from $9.5M in December 1984 to $212.3M in June 1990⁽⁾, with a significant portion allocated to off-balance sheet entities. As a result of the transfer of assets to Southstate Corporate Holdings Limited ("Southstate Corporate Holdings"), the approved facilities for the Beneficial Finance Group fell to $137.2M by 31 October 1990. Southstate Corporate Holdings had additional facilities totalling $396.6M at this date. The cost of these facilities to Beneficial Finance was at commercial rates. The transfer of assets to Southstate Corporate Holdings is considered in Section 34.2.7 of this Chapter.

34.2.1.6 External Domestic and Overseas Wholesale Borrowings

Mr Horwood stated in evidence that Beneficial Finance's access to the unsecured wholesale funding markets improved when it became fully owned by the Bank.⁽⁾ Wholesale funding in the local market was sourced mainly through merchant and licensed banks. Off-shore funding facilities included Australian dollar and US dollar note-issuing facilities, together with term borrowings in US dollars, New Zealand dollars, Japanese Yen and Swiss Francs. Borrowings in foreign currencies were generally swapped into Australian dollars in order to minimise foreign exchange risks. These off-shore term raisings enabled Beneficial Finance to lengthen its liability maturity structure and improve its asset/liability mix.

Beneficial Finance and the Bank competed with each other in off-shore markets. As explained in Section 34.2.5 of this Chapter, separate approaches to the off-shore markets created problems for both the Bank and the market. Mr Clark was anxious for a common approach to funding to be developed but this was only partially successful.⁽⁾

Table 34.4 shows Beneficial Finance's increased reliance on wholesale funds, and more particularly off-shore funds during the period covered by the Investigation.

Table 34.4 Beneficial Finance’s Sources of Funds

Funds Source	1985 %	1986 %	1987 %	1988 %	1989 %	1990 %

Retail	55	47	49	34	25	26
Wholesale
Domestic	32	25	21	30	39	36
Off-shore	13	28	30	36	36	38

Total	100	100	100	100	100	100

An important element in the cost of borrowed funds to an organisation is its "credit rating" by an organisation recognised, for the purpose of such ratings, by the marketplace. Australian Ratings is an organisation which is prominent in providing market acceptable credit ratings. The highest rating which can be awarded by Australian Ratings is AAA. The credit rating of a finance company also affects the cost of its funds in the wholesale market.

From at least June 1986, the Beneficial Finance Board and the Bank Board were both concerned to maintain or improve the credit rating of Beneficial Finance. As I have noted in Section 34.2.1.2, equity was provided by the Bank specifically for the purposes of upgrading or maintaining the credit rating of Beneficial by Australian Ratings; this was done on at least three occasions between 30 June 1986 and 30 June 1990. In 1986, Mr G S Ottaway, Chief Manager, Finance and Planning, reported as follows to the Bank Board:

"Beneficial wishes to improve its fund raising image both locally and very importantly overseas with a view to attracting large parcels of funds at more competitive interest rates. It is considered a critical objective to improve Beneficial's `A' rating by Australian Ratings Pty Ltd which will assist in reducing the marginal cost of borrowing". ⁽⁾

The importance of the rating was also recognised by Beneficial Finance in its strategic plan for 1989-1994 which states:

"In the wholesale markets Beneficial's rating through Australian Ratings is of vital importance in the Australian and Offshore market. ⁽⁾"

Table 34.5 shows Beneficial Finance's corporate credit rating.

Table 34.5 Beneficial Finance’s Corporation Credit Rating

	Nov 1986	Dec 1987	Nov 1988	May 1989	Feb 1990	Jan 1991

Company (3 Years Unsecured)	A	A+	A+	A+	A	A
Commercial Paper	B.1	A.2	A.1	A.1	A.1	A.1
Debenture	AA	AA-	AA-	AA-	A+	A+

The "Company (3 Years Unsecured)" and "Debenture" ratings given to Beneficial Finance were lower than those for its major competitors Esanda, AGC, Custom Credit, and CBFC. From November 1988, Beneficial Finance's "Commercial Paper" rating was the same as those competitors.

In its February 1990 report, Australian Ratings expressed concern about Beneficial Finance's rapid rate of growth and development within the context of the less favourable economic outlook, and about the sensitivities this raised with regard to asset quality. This resulted in Beneficial Finance's rating for Debenture and Company (3 Years Unsecured) being downgraded, although the rating for Commercial Paper remained the same.

In the case of Beneficial Finance, its costs of funds was also favourably influenced by its ownership by the Bank. As a result of the Bank's ownership, it was able to obtain relatively cheap funds in the market place. This is dealt with more fully in Section 34.2.5.

34.2.2.2 Dividend Payments

The dividend expectations of the Bank on its capital investment in Beneficial Finance are the measure of the cost to the company of those funds. Mr Baker stated in evidence that Mr T M Clark pushed Beneficial Finance to increase its return on equity to the Bank.⁽⁾ The higher the profit, the higher the return to the Bank. Further, it was Mr Baker's evidence that the push for Beneficial Finance to provide returns to the Bank on equity reflected the Bank's efforts to maximise its own income, and pay dividends to the Government.

The Company's 1987-1992 Strategic Plan stated that Beneficial Finance had to achieve two objectives in determining the level of dividend payment to the Bank. These were:

"... 1. Provide the State Bank/State Government with an adequate cash payment for funds invested in Beneficial.

2. Ensure adequate injection is made to Beneficial's free reserves via retained earnings on an annual basis." ⁽⁾

The assumptions used in forecasting dividend payments varied throughout the period under investigation.

Beneficial Finance's 1987-92 strategic plan commented that the policy, stated in the previous plan, of paying inflated management fees to the Bank equal to 20 per cent of net profit after tax, was no longer considered appropriate. Future profit distribution was to be through dividend payments. Management fees were to be paid for arms length transactions only, rather than used as a profit distribution mechanism. A dividend payment of 11 per cent return on capital (par value) was assumed for the plan period.⁽⁾

In Beneficial Finance's 1988-1993 strategic plan, dividend payments were proposed to be 50 per cent of net profit after tax and preference dividends throughout the plan period.⁽⁾ In the Company's 1989-94 strategic plan, dividend payments were proposed to be equivalent to 60 per cent of net profit after tax.⁽⁾ Table 34.6 summarises Beneficial Finance's forecast and actual dividend payments to the Bank.

Table 34.6 Beneficial Finance’s Dividend Payments to the Bank As at 30 June

	1984 $M	1985 $M	1986 $M	1987 $M	1988 $M	1989 $M	1990 $M

Corporate Strategic Plan Forecast

1986-91			6.1	-	-	-	-
1987-92				6.5	7.4	8.5	9.1
1988-93					9.3	11.5	13.0
1989-94						21.0	25.2

Actual Payments

Ordinary	-	-	5.0	5.0	10.0	18.0	8.0
Preference	0.6	0.6	0.9	1.1	1.1	0.6	-

Total	0.6	0.6	5.9	6.1	11.1	18.6	8.0

According to the Company's 1987-92 and 1988-93 strategic plans, the proposed dividend payments were to provide to the Bank an acceptable and increasingly commercial rate of return.

34.2.3 MATURITY STRUCTURE OF ON-BALANCE SHEET DEBT FUNDING

Table 34.7 shows the debt maturity structure of Beneficial Finance Group for the 1984-1990 financial years.

Table 34.7 Beneficial Finance Group Maturity Structure As at 30 June
Time Period	1984 %	1985 %	1986 %	1987 %	1988 %	1989 %	1990 %

Call	10	9	9	7	7	4	5
0 - 1 Year	50	43	39	46	40	49	52
1 - 2 Years	16	20	22	26	16	24	15
2 Years Plus	23	28	29	21	37	24	27

Total	100	100	100	100	100	100	100

The Australian Finance Conference publishes a monthly "Maturity of Borrowings, Interest Rate Sensitivity" which compares the maturity structure of the industry to that of the individual market participants. Thus, Beneficial Finance was able to compare itself to the industry.

A review of these monthly publications showed that Beneficial Finance's maturity structure was in line with that of the industry from 1986-90. The industry maturity structure began to lengthen in May 1987, whereas Beneficial Finance's structure began to lengthen in 1988. Beneficial Finance's 1987-92 and 1988-93 Corporate Strategic Plans both stated that the average term of borrowings would be lengthened to three years as a risk averse strategy.⁽⁾ After 1988, there was a general shortening in the maturity profile of Beneficial Finance Group as longer term funds became harder to obtain in the market place. I discuss this in more detail in Chapter 36 - "Treasury and the Management of Assets and Liabilities at Beneficial Finance".

34.2.4 FUNDING OF OFF-BALANCE SHEET ENTITIES

One of the reasons for the creation of individual off-balance sheet entities was to avoid the Debenture Trust Deed gearing restrictions that subsidiaries of Beneficial Finance were to be guarantors for the borrowings under the trust deeds.⁽⁾ The off-balance sheet entities were, in many cases, inappropriately geared, in that they had high debt equity ratios.⁽⁾

This was acknowledged by senior management of Beneficial Finance in its special Submission No 344 to the Board, presented in March 1991:

"This capital rationing approach is quite different to that used over the past few years. Artificially high gearing levels were achieved in some areas, notably off balance sheet, finance associates (Pegasus, Equus, AWFL, etc) by treating equity in associates as loan funds in the books of the parent. As a result, base receivables were geared at 150:1 in some cases, leading to massive losses of parent capital when markets turned down. In short, the company regarded gearing levels as something to be circumvented rather than acknowledging the fundamental reasoning for their existence." ⁽⁾

The former Directors of the Bank and Beneficial Finance, who had resigned at the time this submission was put before the new Board, observed that the information and analysis contained in this submission was not put before the Board prior to March of 1991.

Beneficial Finance's off-balance sheet entities were principally operating businesses or single purpose property developments, either structured as joint ventures or unit trusts. Funding was provided to Beneficial Finance Group's off-balance sheet entities by Beneficial Finance in the form of equity and debt. The off-balance sheet entities were funded by Beneficial Finance itself, or by third parties supported by guarantees or letters of comfort from Beneficial Finance. Over the period from 1984 to 1991 the company sought to obtain non recourse external funding of off-balance sheet activities. By way of example, a paper to the Board in support of a Proposal to enter the Pegasus Leasing joint venture proposed that the joint venture would not be funded by Beneficial Finance. My investigation has been advised that it was very difficult for the Beneficial Finance Treasury division to find third party financiers prepared to fund the off-balance sheet entities.⁽⁾

The Company's 1987-1992 strategic plan aimed to restrict the growth of off-balance sheet joint ventures by limiting the average net receivables of joint ventures to 20 per cent of overall Beneficial Finance average net receivables throughout the plan period. The plan stated:

"Adopting this approach should satisfy any prudential requirements imposed by the Reserve Bank and will ensure Beneficial Finance Corporation Limited will continue to control the direction the Beneficial Group will move in the future." ⁽⁾

In fact, this policy was not adhered to, and joint venture receivables increased from 9.8 per cent in April 1987 to 25.9 per cent of average net receivables in April 1989.

The following Table 34.8 shows debt-to-equity and related figures for Beneficial Finance on balance sheet activities compared with the position of the Beneficial Finance on and off-balance sheet activities. The position of the on and off-balance sheet activities was calculated by Beneficial Finance as part of a process described by the company as "aggregate accounting". The results of the Company's "aggregate accounting" processes were reviewed by the Investigation and are included, with some adjustments in the following table.

Table 34.8 Funding and debt-to-equity Ratio of the Beneficial Finance Group and Beneficial Finance Aggregated Group As at 30 June
	1989				1990
Item	On-Balance Sheet $M		Aggregate $M		On-Balance Sheet $M		Aggregate $M
Total Assets	2250.4		2454.7		2674.6		2751.7

Total Liabilities		2082.6		2282.0		2485.1		2562.3

Shareholder’s Funds		167.8		172.7		189.5		189.4

Debt-to-equity Ratio		12.4		13.2		13.1		13.5

These figures indicate that, although on an aggregate basis the off-balance sheet entities increased the overall assets of the Beneficial Finance Aggregated Group, in 1989 they increased Beneficial Finance Aggregated Group capital only marginally, and in 1990 decreased this capital.⁽⁾ The Beneficial Finance Aggregated Group debt-to-equity ratio is in excess of the target on-balance sheet debt-to-equity ratios set by Beneficial Finance management. It must be noted that, if the Company had obtained external funding for the off-balance sheet activities, as was its intention, the Aggregate gearing ratio would have increased materially.

The debt-to-equity ratios on-balance sheet were in line with normal industry levels. On a Beneficial Finance Aggregated Group basis they were higher. This is shown by Table 34.13 in Section 34.2.6.2 of this Chapter.

Table 34.9 shows the level of gearing, calculated as the ratio of total liabilities to shareholders' funds, for three off-balance sheet entities.

Table 34.9 Off-Balance Sheet Entities Debt-to-Equity Ratios As at 30 June

Entity	1987	1988	1989	1990

Allied Westralian Finance	212.8:1	90.0:1	105.8:1	N/A
Pagasus Leasing	160.1:	97.1:1	N/A	N/A
Equus	16.4:	6.6:1	25.6:1	58.2:1

N/A - Not Available

Gearing levels for Pegasus Leasing in 1989 and for 1990 and Allied Westralian Finance in 1990 could not be calculated on the available information.

The figures in Table 34.9 further reflect the fact that the off-balance sheet entities were often geared at levels far in excess of those adopted by Beneficial Finance and its subsidiaries. This is best illustrated by the levels of gearing of Allied Westralian Finance Limited (Allied Westralian Finance), Pegasus Leasing Limited (Pegasus Leasing) and Equus Financial Services Limited (Equus).⁽⁾ The gearing levels of the off-balance sheet entities, and of the Beneficial Finance Aggregated Group as a whole, far exceeded the limits recommended in Special Submission No 289 to the Board in September 1989.⁽⁾

The inadequate capitalisation of the Beneficial Finance Aggregated Group, and allocation of capital to the off-balance sheet entities, are examined in Section 34.2.8 of this Chapter.

34.2.5 IMPLICATIONS OF THE BANK PARENTAGE

The Bank's liabilities were guaranteed by the government of South Australia. As this guarantee did not extend to the liability of the Bank's wholly owned subsidiaries, the liabilities of Beneficial Finance were not guaranteed by the government. Notwithstanding that the Bank's guarantee did not extend to its subsidiaries, Beneficial Finance's association with the Bank assisted it to raise external funds. On its acquisition by the Bank, Beneficial Finance's credit rating was "BBB". This rating was increased to "A" on its acquisition by the Bank. This gave Beneficial Finance access to new off-shore funding markets and improved access to domestic funds.

The Bank's ownership enabled Beneficial Finance to acquire cheaper funds than would otherwise have been the case if there was no Bank ownership. As Mr Horwood observed:

"The image of the company being owned by a sovereign was very powerful when it came to negotiating pricing." ⁽⁾

The Bank name also indirectly assisted Beneficial Finance to acquire funds. Beneficial Finance established a company, in May 1985, named SBSA Finance Corporation Ltd, a wholly owned subsidiary of Beneficial Finance. It was established for the sole purpose of accessing the public markets off-shore. Beneficial Finance was not able to use its own name in some markets because of a prior agreement with a United States company of the same name. Consequently, Beneficial Finance looked for a name which would link it with the Bank and the State of South Australia.⁽⁾

In April 1988, SBSA Finance Corporation Ltd was renamed The Finance Company of South Australia. The Bank insisted on the change of name as a result of its perception that there was confusion in the market between the credit standing of Beneficial Finance and the Bank. Mr T L Mallett, General Manager, Treasury and International, was concerned that the use of the name "SBSA" by a company which did not bear the government guarantee had been construed by the market as an attempt to cause confusion as to its true credit standing and that many investors believed that the company was guaranteed. He was also concerned that Beneficial Finance competed directly with the Bank for funding opportunities and that, consequently, the Bank's pricing was adversely affected.⁽⁾

Subsequently, Beneficial Finance, with the approval of the Treasury department used the name "Finance Company of South Australia" for its off shore issues. Many successful off-shore issues were raised under this name.⁽⁾

The Bank and Beneficial Finance had an informal arrangement that, if either was going to gain access to an off-shore market, each should let the other know in advance.⁽⁾ The major conflict between the funding operations of Bank and Beneficial Finance arose in 1989 and 1990. At that time Beneficial Finance was having difficulty in accessing sufficient funds, and the Bank and Beneficial Finance competed in the Euro Australian Dollar markets. It was the view of the State Bank Treasury that the Beneficial Treasury should not be competing with it in the same market. Mr Horwood reported in evidence that he vigorously resisted this view, as he had to gain access to those markets to obtain the money to fund Beneficial Finance's growth.⁽⁾

As I have discussed in Chapter 6 - "The Funding of the State Bank" of my first Report, the Reserve Bank of Australia had various requirements relating to the sufficiency of capital of Australian banks, including effective minimum debt-to-equity ratios. Although the Bank was not legally obliged to abide by these requirements, it, generally speaking, did so.

As a wholly owned subsidiary, the value of Beneficial Finance's assets were incorporated into the Bank's capital adequacy calculations. The Treasury division supplied monthly details of its risk weighted assets to the Bank, but did not monitor compliance with the Reserve Bank guidelines in any other way.

Throughout the period under investigation, the Bank had a substantial financial exposure to Beneficial Finance and its off-balance sheet activities in terms of equity investments, loans, and other credit facilities. If the Bank had allowed Beneficial Finance to fail for any reason, this exposure would have resulted in substantial loss to the Bank.

The Bank was concerned that failure by the Bank to support Beneficial Finance could have caused further financial problems for the Bank and the government of South Australia. It was widely known that Beneficial Finance was wholly owned by the Bank. If Beneficial Finance had defaulted on any of its liabilities, this would have had an adverse impact on the reputation of the Bank and the government. It would also have increased the cost of borrowings for both the Bank and other government bodies.⁽⁾ In this regard see also Chapter 31 - "Case Study in Credit Management: East-End Market".

Mr Horwood gave evidence to the Jacobs Royal Commission of a meeting between himself and Mr Clark in early 1989.

"Mr Marcus Clarke asked me what my view was should Beneficial have significant funding difficulties. I pointed out that the Bank had no choice but to support the company with liquidity. There was some discussion at the time but I think those who were there eventually agreed, including Mr Marcus Clarke ... should this occur the damage that could be done to the Bank by failing to support the 100 per cent subsidiary and one significant in size was immense and, in truth, that would be the most appropriate course of action." ⁽⁾

The Bank publicly stated its support for Beneficial Finance in August 1990 in media releases and its annual report, and this statement of support was referred to by Beneficial Finance in its private offer to debenture holders in August 1990.

As is discussed in Chapter 6 - "The Funding of the State Bank" of my first Report, there were few constraints imposed on the capital raising of the Bank Group. As the Bank had virtually unlimited access to funds, there was little pressure on it to ration the capital it supplied to Beneficial Finance. Accordingly, there was little constraint on the capital available to Beneficial Finance from the Bank.⁽⁾

34.2.6 ANALYSIS OF THE BENEFICIAL FINANCE GROUP'S FUNDING AND DEBT-TO-EQUITY RATIOS

34.2.6.1 Asset Growth and Funding Increases

Table 34.10 shows the planned level of assets for Beneficial Finance Group, as reflected in the Company's strategic plans for the period 1986 to 1989, compared with reported total assets of Beneficial Finance Group.

Table 34.10 Beneficial Finance Asset Levels As at 30 June
	1987 $M	1988 $M	1989 $M	1990 $M	1991 $M
Corporate Strategic Plan Forecasts for the Beneficial Finance Group

1986-91	1081	1140	1233	1344	1470
1987-92	N/A	1337	1602	1866	2132
1988-93	N/A	N/A	1752	2219	2444
1989-94	N/A	N/A	N/A	2588	2994

Reported Assets for Beneficial Finance Group	1129	1655	2262	2675	1802

N/A - Not Applicable

Whilst growth in assets was expected, Beneficial Finance Group assets actually grew faster than planned. The growth of Beneficial Finance Group led to a demand for additional capital from the Bank so that Debenture Trust Deed requirements would not be breached.

The following Table 34.11 shows the projected capital requirements for Beneficial Finance as incorporated in the Company's strategic plans, compared with the actual capital provided by the Bank.

Table 34.11 Provisions of Capital to Beneficial Finance As at 30 June
	1987 $M	1988 $M	1989 $M	1990 $M	1991 $M
Corporate Strategic Plan Forecasts

1987-92	N/A	10	10	10	5
1988-93	N/A	N/A	20	10	5
1989-94	N/A	N/A	N/A	15	15

Actual Equity Injected by the Bank	-	35	40	25	60

N/A - Not Applicable

Table 34.12 shows the plans' forecast increases in borrowings for the Beneficial Finance Aggregated Group compared with reported increases in borrowings by Beneficial Finance Group.

Table 34.12 Beneficial Finance Increases in Borrowings As at 30 June
	1987 $M	1988 $M	1989 $M	1990 $M	1991 $M
Corporate Strategic Plan Forecasts for the Beneficial Finance Aggregated Group

1986-91	66	47	67	82	91
1987-92	N/A	178	252	214	210
1988-93	N/A	N/A	249	273	177
1989-94	N/A	N/A	N/A	267	366

Reported Increases in Borrowings by Beneficial Finance Group	90	466	495	410	N/A

N/A - Not Applicable

As I have discussed in Chapter 36 - "Treasury and the Management of Assets and Liabilities at Beneficial Finance", the operations of Beneficial Finance were driven by the lending divisions of the company. The lending divisions within Beneficial Finance and the off-balance sheet entities wrote as much business as they could without reference to the availability of funds.⁽⁾ It was left to the Treasury division to obtain the funds required. As a result, the Treasury division was often under internal pressure to find the required funds.⁽⁾

34.2.6.2 Debt-to-Equity Ratios of the Beneficial Finance Group

During the period 1984-1991, the reported debt-to-equity ratios of Beneficial Finance Group increased in line with market trends and was consistently greater than the majority of its major competitors.

Table 34.13 illustrates these debt-to-equity ratios. These ratios, however, take no account of the application of funds; the risk associated with the different types of investments and activities conducted by Beneficial Finance may be significantly different to the risks associated with the investments and activities conducted by its competitors. This table also illustrates the effect of the debt-to-equity ratio of the off-balance sheet entities on the Beneficial Finance Aggregated Group.

Table 34.13 Ratio of Debt-to-equity As at 30 June
Entity	1984 $M	1985 $M	1986 $M	1987 $M	1988 $M	1989 $M	1990 $M

Beneficial Finance Group	7.6	10.5	12.0	12.4	12.0	12.2	13.1
AGC (1)	7.0	7.2	8.4	9.0	8.7	10.2	10.9
Esanda (1)	7.8	8.5	9.0	8.7	9.0	11.9	13.7
CBFC (1)	13.6	14.6	14.6	14.5	12.2	12.9	12.5
Custom Credit	7.4	9.2	8.9	8.4	8.5	11.6	11.3
Beneficial Finance Aggregate Group	-	-	-	-	-	13.2	13.5

(1) Year ended 30 September

In its February 1990 report on Beneficial Finance, Australian Ratings observed that the gearing ratio of Beneficial Finance was high compared to that of its major peers in the industry. The report also observed that Beneficial Finance had a:

"... complex and unwieldy corporate structure with a number of associated companies held off-balance sheet through trust structures". ⁽⁾

The report continued:

"... we view this structure as artificial and not representing the underlying commercial substance of the group position." ⁽⁾

This was also the view put forward, by Beneficial Finance management to the Beneficial Finance Board, in Special Submission 344, and was recognised in the Beneficial Board decision referred to in the 1989-94 Corporate Strategic Plan to bring all off-balance sheet entities on balance sheet.⁽⁾

34.2.6.3 Debt-to-Equity Ratios of the Off-Balance Sheet Entities

In the period from 1984 to 1991 the type of business undertaken by Beneficial Finance changed significantly as the Company increasingly participated in equity investments and joint ventures, many of which were undertaken through off-balance sheet structures. It was appropriate at all times that the Company understood the impact of this off-balance sheet business upon the Company's finances and particularly its gearing ratio. The arrangements pursuant to which the Company gave effect to the off-balance sheet business are discussed in detail in Chapter 41 - "Management and Financial Information Reporting".

At the time Beneficial Finance first established the off-balance sheet arrangements, in April 1985, the basis upon which such business would be funded, and specifically the gearing levels, was considered. The solicitors who advised on arrangements to take business off-balance sheet provided a memorandum of advice describing the proposed arrangements. The memorandum included the following specific conclusion with respect to the gearing of the off-balance sheet business, and particularly with respect to the borrowing limits imposed by the Trust Deeds':-

"Establishment of JFC in the manner above advised will take it outside the disclosure requirements of the Companies Code and its liabilities outside of the range of liabilities to be included in calculations for the purpose of determining borrowing limits under Beneficial's Trust Deeds and is likely also to remove JFC from consideration under the Deeds relating to Euro Bond borrowings and any negative pledge arrangements which Beneficial may have.

Such companies are not uncommon but it will be apparent that skill has been employed to construct JFC in a manner calculated to have the above effect. Consideration must therefore be given to the perception of JFC if constructed as advised, in the context of the general commercial operations of Beneficial and its relationship with persons and groups who may be effected by the formation of such a company."

The advice from Thomson Simmons is evidence that the avoidance of borrowing limits was a significant matter considered by the solicitors in formulating the arrangements as proposed. The arrangements proposed by Thomson Simmons were implemented by Beneficial Finance. As a consequence a structure was established whereby the prudent requirements of the Trust Deeds were able to be circumvented.

In May 1985, the Beneficial Finance Board considered a proposal to enter a joint venture with Pegasus Securities Limited. The following extract from the paper, sent to Board members in support of the proposal indicates Beneficial Finance's intention with respect to this relationship:

"(2) Joint Venture Proposal

It is proposed to set up a joint venture finance company similar in concept to the recently approved Centrelease proposal. It will have the following features.

. Ownership will be 50% Pegasus and 50% Beneficial.

. Via the corporate structure pioneered in the Centrelease transaction, the company will remain off Beneficial's balance sheet.

. Initial capital requirement will be $100,000 from each partner.

. Intention will be for Beneficial to provide as little debt funding as possible, gearing the company as highly as possible, basing the borrowings on Guarantees wherever appropriate ..."

The proposal included financial projections which showed the following summary balance sheet for the three years from the inception of the joint venture:

" Balance sheet at June 30	1986 $000	1987 $000	1988 $000

Receivables	22219	37673	43945
Equity	200	200	200
Loss Provision	31	109	212"

Two elements of the Pegasus Proposal are significant. It was proposed that the joint venture would be funded from external sources rather than by Beneficial Finance and gearing would be as high as possible. Further, as evidenced by the Proforma Balance Sheet attached to the Board Papers, the projections for the joint venture were for a debt-to-equity ratio after one year of 110:1 and after three years of 220:1. Effective implementation of these two elements of the Pegasus Proposal would have the result of increasing the overall gearing of the business undertaken by Beneficial Finance.

The events of April and May 1985 demonstrate that Beneficial Finance was prepared to circumvent the prudent borrowing limitations incorporated in the Debenture Trust Deeds and the implicit restrictions on the Company's gearing that the Trust Deeds imposed. The approval of the off-balance sheet arrangements provided the mechanism to achieve this result. The entering of the Pegasus Joint Venture demonstrated that the company was prepared to utilise the arrangements that had been implemented.

The establishment of the arrangements to take business off-balance sheet, and the decision to enter into highly geared off-balance sheet business undertakings, was not accompanied by the implementation of a management information framework to monitor the impact of the off-balance sheet activities upon the Company's overall gearing levels. It was not until 1988 that the Board identified the need to obtain information regarding the total of the groups' on and off-balance sheet business. This initiative lead to Beneficial Finance undertaking, in 1988, the Aggregate Accounting exercise. It was not until 1990 that the exercise resulted in the provision of reliable information on the impact of the off-balance sheet business on the company's finances. The Aggregate accounting arrangements are discussed more fully in Chapter 41 - "Management and Financial Information Reporting".

As Beneficial Finance moved increasingly into equity investments and joint ventures, the appropriate funding structure and need for capital changed. These activities required a higher level of capital, both to fund investments that were non-income producing for a period of time, and also to absorb any potential losses on the more risky projects.⁽⁾ In other words, these projects required a lower level of debt-to-equity than the 12.5:1 previously recognised by Beneficial Finance management as appropriate.⁽⁾

This issue was recognised by Dr R N Sexton, Executive Director Asset Management and Corporate division, in his report to the Executive Committee which formed the basis of Special Submission No 289 to the Board. The submission was accepted by the Board in September 1989.

It recommended that:

"... 1) To establish an appropriate overall gearing level for Beneficial, on an ongoing basis, it is recommended that notional gearing ratios be applied to different categories for investments as follows:

. Non income earning equity investment

- notionally geared at 2:1

. Income earning equity investments

- notionally geared at 3:1

. Debt facilities

- notionally geared at 12.5:1.

Implementation of this recommendation will generate a lower gearing level than traditionally achieved by Beneficial (eg 12.6:1 at 30 June 1988).

2) A target level of equity investments be set such that the required capital allocation notionally ascribed to equity investments be around 25% and not to exceed 30% of total SHF [Shareholders' Funds]. On this basis equity investments would represent around 7.5% of total Assets and not to exceed 10%.

3) Allocation of capital as in 1) be applied internally to respective categories of investments for the allocation of borrowing costs and calculation of individual investments and divisional ATROE's [After Tax Return on Equity]". ⁽⁾

Special Submission No 289 notes the importance of internally allocating capital and debt-equity ratios to projects according to the risk involved in those projects.

34.2.6.4 Summary

It is evident that Beneficial Finance deliberately sought to circumvent the prudent requirements of the Company's debenture Trust Deeds for limiting gearing levels. In doing so, the Company failed to consider that the risks associated with the off-balance sheet activities were greater than those undertaken on-balance sheet and that prudence required that the higher risk activity should be funded with lower gearing.

Having put in place arrangements to circumvent the Trust Deed gearing restrictions, the Company failed to implement appropriate arrangements to measure and report upon the financial position of the Company and its off-balance sheet activities. Specifically, it failed to monitor the Aggregate gearing ratio.

That the impact of the off-balance sheet activities upon the aggregate gearing ratio was limited is attributable to the unwillingness of external financiers to fund excessively geared off-balance sheet activities. This matter is discussed in Section 34.2.4 above.

34.2.7 CORPORATE RESTRUCTURING OF THE BENEFICIAL FINANCE GROUP

The Beneficial Finance Board, at its meeting on 24 November 1989, approved a corporate re-structure of the Beneficial Finance Group whereby a new holding company, Beneficial Holdings Limited (Beneficial Holdings), would be interposed between Beneficial Finance and the Bank. It was intended that Beneficial Holdings would be managed by Beneficial Finance, but be a wholly owned subsidiary of the Bank. It was intended also that assets of Beneficial Finance, including some of the off-balance sheet entities, would be transferred to Beneficial Holdings, and that other off-balance sheet entities would be brought on to the balance sheet of Beneficial Finance.

The reasons for the restructure as set out by the Board in a Memorandum to the Bank Board were:

"... The growth of existing off-balance sheet companies has resulted from the need to maintain these operations outside the restraints of Beneficial's Trust Deeds, particularly where outside shareholders are concerned. There was also the need to provide unit trust structures to service tax effective finance transactions and, more recently, to overcome problems associated with the use of the Beneficial name and cater for the borrowing requirements of the New Zealand operations.

Among the many problems which have become apparent with the existing structure and which would be further accentuated through growth in the future are the following:

(i) Trustee concern at the external and increasing exposure of the off-balance sheet operations in view of Beneficial's apparent control and funding of these operations. Total assets of the off-balance sheet companies will exceed $1.0 Billion at June, 1990 and these will be largely funded directly by BFCL or indirectly through guarantees.

(ii) ...

(iii) ...

(iv) Unwieldy and, at times, distant Board and Management control of the off-balance sheet entities increasing the risk of adverse exposure for the Company and the Group.

(v) Efficient consolidated funds management, including the provision of lines of credit, is more difficult under the existing on and off-balance sheet arrangements." ⁽⁾

It was recognised, at the same time that a capital injection would be required to assist in the task of allowing Beneficial Finance to comply with its trust deed conditions, and to bring the off-balance sheet companies back on-balance sheet.⁽⁾

On 21 December 1989, the Bank Board approved the proposed corporate restructure. It also approved a capital injection of $40.0M to Beneficial Holdings in addition to any incremental amounts of capital required by Beneficial Finance to provide for its budgeted growth in 1990-91. The proposal approved by the Board, which involved the transfer of the shareholding in Beneficial Finance from the Bank to Beneficial Holdings, did not proceed in that form due to unacceptable stamp duty implications.

Two separate proposals were, however, subsequently put to the Board for the down-sizing of Beneficial Finance by the transfer of assets to the Bank and to its subsidiary Beneficial Holdings (which later changed its name to Southstate Corporate Holdings Limited.)⁽⁾

In March and April 1990, submissions were made to the Bank's Lending Credit Committee and Executive Committee at the request of the Beneficial Finance Board. The submissions sought approval for the Bank to purchase various receivables of the Beneficial Group up to a maximum of $400.0M.⁽⁾ The purpose behind the transfer was to assist Beneficial to meet its Trust Deed requirements, and, at the same time, to reduce its real estate exposure and provide additional liquidity.⁽⁾ The State Bank Executive Committee approved the proposal.

The Bank Executive Committee minutes record that the decision to acquire various Beneficial receivables was undertaken as a matter of policy and not credit assessment. The minutes also record that the receivables that were to be transferred pursuant to the arrangement were to be performing real estate assets only.⁽⁾

The transfer of assets pursuant to this arrangement commenced, at the request of Beneficial Finance, on 21 August 1990. $150.0M of assets were transferred pursuant to this arrangement prior to the arrangement being approved by the State Bank Board. The State Bank Board ratified the arrangement at its meeting in September 1990.⁽⁾ Notwithstanding the common directors of the Bank and Beneficial Finance, I would have expected, in the furtherance of procedural regulatory, that the full Bank Board would have formally approved of this matter before the commencement of the transfer of the receivables concerned. At that meeting in September 1990, a submission was put to the Bank Board for a further transfer of $600.0M of Beneficial Finance assets in addition to the $150.0M already transferred.⁽⁾

Prior to the September 1990 Board meeting, Beneficial Holdings had changed its name to Southstate Corporate Holdings Ltd (Southstate Corporate Holdings). The submission⁽⁾ proposed that these assets would be transferred to Southstate Corporate Holdings and to the Bank. The submission stated that it would be necessary to transfer non-performing assets. The submission, which was presented by Mr S G Paddison, at that meeting, stated:

"For some time Beneficial Finance has faced the problem of meeting the requirements of its trust deed. The disastrous structured finance activities of Beneficial have largely been the reason for the erosion of Beneficial's asset and capital base. Therefore, the Bank has little choice but to fund the removal of the non-performing activities from the finance company balance sheet.

The essence of this proposal is that the Bank has little choice and this support is inevitably at the expense of the Bank's own reported profitability and financial position." ⁽⁾

At its September 1990 meeting, the Bank Board resolved that Beneficial Finance's balance sheet be down-sized by the transfer of up to a further $600.0M of assets and loans, including non-performing loans, from the Beneficial Finance balance sheet to Southstate Corporate Holdings or the Bank. The Bank further resolved that Southstate Corporate Holdings be provided with $600.0M in funding to acquire the Beneficial assets, with the option for $50.0M to be provided by capital injection. The directors noted "That the Bank had little choice but to support the proposal at the expense of the Bank's own reported profitability and financial position." ⁽⁾

The paper presented to the Board at that meeting forecast that the proposal would result in a deterioration in the Bank's net profit after tax, in the 1991 financial year, of $34.8M.

The paper presented to the Board at that meeting also forecast that the proposal would result in a deterioration in Southstate Corporate Holdings net profit after tax in the 1991 financial year of $29.0M. The former Directors of the Bank have submitted that the need to provide a letter of comfort to the Directors of Southstate Corporate Holdings was agreed at the September 1990 Bank Board meeting.

The Bank Board Minutes for 11 February 1991 record that:

"It would resolve to approve that the Board ratify the instructions already given to the respective Boards of directors of its wholly owned subsidiaries of Beneficial Finance Corporation Limited and Southstate Corporate Holdings Limited to transfer certain receivables from Beneficial to Southstate in the manner recorded in the books of account of each company during the six months to 1 December 1990."

The minutes of the Board meeting of Southstate Corporate Holdings on 29 April 1991 record that:

"The Board reviewed the paper prepared by Mr Yelland and confirmed that the directors were acting under the formal instructions of the Board of the holding company (State Bank of South Australia) in respect of the purchase of assets from Beneficial Finance Corporation Limited, as witnessed by the State Bank Board minute of 11 February 1991 which was tabled at the meeting"

In my opinion, the directors of Southstate Corporate Holdings in the known circumstances should have required an indemnity from the Bank to compensate it for any loss suffered by it due to the acquisition of non-performing assets at the direction of the Bank.

The directors, on the evidence available to this Investigation, appear not to have appreciated that, even within a group of companies (and with a 100 per cent owned subsidiary) it is the directors, and not the shareholder, who have management responsibility for the affairs of the company unless otherwise specifically authorised by law or under the articles of the company. They, ie the directors, must not, as a collegiate body, at the direction of the shareholder, act in a manner that is inconsistent with their fiduciary responsibilities. In short, subject to the provisions of the Companies Code and the articles of the company, it is the Board of directors that has the responsibility for the management of the company.

In a paper, presented to the Bank Board on 6 February 1991 by Mr K L Copley, General Manager, Group Accounting, the Board was told that:

"As of December 31 1990 Southstate Corporate Holdings Limited had a deficit of net assets of $126.3 million. The company is therefore insolvent.

Therefore, in order for the company to continue its activities support by the State Bank Group is required.

Accordingly , it is recommended that a letter of comfort in the form attached be provided to the directors of Southstate Corporate Holdings Limited prior to the signing of those accounts.

As you are aware, a proposition is being put together for the recapitalisation of Southstate, however it has not yet been completed as the figures for requirements are yet to be settled."

At the Board meeting on 6 February 1991, the Board accepted that recommendation and Mr Copley wrote to the directors of Southstate Corporate Holdings, on that day, in the following terms:

"You will note that the financial statements of the company for the year ended 31 December 1990 reflects a deficiency of net assets.

Subsequent to a resolution of the Board of Directors of the State Bank of South Australia dated 6 February 1991, I advise that the State Bank of South Australia will provide continual financial support to Southstate Corporate Holdings Limited to ensure that the company will be able to meet its financial commitments as and when they fall due."

That letter of support was soon superseded. As I have mentioned elsewhere in this report, at that Bank Board meeting on 6 February 1991, the Bank Board resolved to enter into a contract of indemnity with the Government of South Australia.

The minutes of the meeting of the Board of Southstate Corporate Holdings of 11 February 1991 record that:

"It was agreed that a letter be sent to the Chairman of the State Bank seeking the Chairman's assurance that Southstate Corporate Holdings Limited Group was encompassed by the indemnity.

Mr G Yelland drafted the letter and tabled it for discussion. Verbal advice on the letter was received from external solicitors and was to be confirmed in writing. After some amendments, the final letter was approved for signing by the Managing Director. Written assurance from the Bank Board that the State Government indemnity extended to cover the Southstate Corporate Holdings Limited Group was received subsequent to the meeting."

The transfer of assets took place over time and, as at December 1990, non-performing assets of $502.0M had been transferred to Southstate Corporate Holdings. In addition, $22.0M of guarantees and options and $152.0M of performing assets were transferred to the Bank.

34.2.8 THE ALLOCATION OF CAPITAL AND FUNDS

34.2.8.1 Beneficial Finance's Allocation of Capital

Two key elements in the effective and prudent management of a finance company are the establishment of processes for measuring performance and for ensuring that the funding of the company is soundly based.

It is appropriate that any company has in place a performance measurement regime which tests whether proposed new activity will provide an acceptable return to the company and to test whether existing activities continue to provide such returns.

A primary objective of the management of funding is to match the risk of the Company's business with the gearing of the company. Thus a company engaged in relatively risky activity, which activity may be expected to cause significant variations in income, or a greater likelihood of the loss of principal,should obtain a higher proportion of equity funding so that variations in income, or loss of principal, will not lead to the company's insolvency.

How Beneficial Finance managed these two matters is discussed below.

Return on Capital

The rate of return on capital for the company and for individual divisions was seen by the management of Beneficial Finance as being a key performance indicator. It is the evidence of Mr Baker, that he aimed to provide a return to Beneficial Finance's shareholder of 15 per cent or more, after tax, on the shareholder's funds. His focus on this performance measure reflected the priorities of the State Bank, and, in particular, the priorities of the Group Managing Director, Mr Clark.

The calculation of return on capital for different divisions required the company to allocate capital to these various divisions. Throughout the period 1984-1991, the Beneficial Finance Group employed a two step process for allocating capital to the various divisions for performance measurement purposes. Capital was allocated to divisions at the start of each financial year based, on the proportionate share of the Beneficial Finance Group's average net receivables controlled by that division, and was increased month by month based on the division's share of the total profit. This cycle was repeated annually.

The use of return on capital as a performance measure in conjunction with the capital allocation procedures as described above would not have been inappropriate if Beneficial Finance had engaged in a business that established a reasonably consistent risk profile for the different divisions of the company. The evidence before the Investigation, however, is that this was not the case throughout the period being investigated. The section of this Chapter dealing with portfolio composition shows clearly that the nature of the company's business changed over this period. It is further evident, that during this period, the company engaged in a range of activities, including joint ventures, that had varying risk characteristics.

In these circumstances, it would have been prudent for Beneficial Finance to have implemented a system to assess the relative risk weightings of the activities undertaken by different divisions, and to allocate capital to each division in proportion to the risk associated with that division's activities. Thus a greater amount of capital would notionally at least, have been applied to a division which engaged in riskier activities. By implementation of this process, the company would have been able to determine whether each division of the company had generated a sufficient after tax profit to be able to justify the allocation of the relevant amount of capital.

Implementation of this process would have applied a fundamental principle of financial management, which requires that, where additional risk is taken on by a company, that company should require a higher return than for an alternative lower risk activity.

The process described above with respect to measuring performance of the company's divisions should also have been applied to assessing the viability of projects and ventures proposed to be undertaken by the company, and to reviewing performance of those projects and ventures.

The evidence before this Investigation is that no system of internal risk weighted allocation of capital was introduced by Beneficial Finance until 1991. As a consequence, the company did not appropriately assess the after tax return on new activities and projects, nor was there an appropriate performance assessment of projects once undertaken, or of the company's own divisions.

Gearing of the Company

The control of the company's gearing ratio was a matter of some importance to Beneficial Finance. Prudent management required that, where the company engaged in higher risk activities it should fund those activities with a higher proportion of capital than was required for lower risk activities. Thus the adverse consequences of risk activity manifesting through variation in income or loss of principal, would not threaten the viability of the company.

The gearing of the company was a key constraint upon the company's management. As I have discussed earlier, the debt-to-equity ratio required by the 1960 and 1974 Debenture Trust Deeds was 14.5:1.⁽⁾ The gearing ratios specified in the 1985 Debenture Trust Deed was expressed in terms of assets relative to liabilities; but, the ratio, contrasted with the ratios specified in the 1960 and 1974 Debenture Trust Deeds, effectively imposed a debt-to-equity ratio of 15:1. As a matter of internal policy, Beneficial Finance aimed for an on-balance sheet debt-to-equity ratio of 12.5:1. This level of gearing was, in Mr Baker's view, a prudent level.⁽⁾

It is my view, that effective management of the company's gearing also required the company to implement a risk weighted capital allocation arrangement. Such an arrangement would have resulted in the allocation of capital, not only to each division, but, at least notionally, to each discrete activity or venture undertaken by the company. In allocating capital, the company should have adopted gearing ratios that reflected the level of risk associated with each division, activity, or venture, and with the gearings being lower for the relatively high risk activities.

By providing a notional capital allocation to each division, activity, or venture, it would have been possible for Beneficial Finance to determine whether the company's actual capital resources were sufficient to safely fund its various activities.

The evidence before this Investigation is that Beneficial Finance did not implement arrangements to monitor the capitalisation of the company, particularly when the company's off-balance sheet activities are considered. As discussed elsewhere, the Board identified the need for Beneficial Finance to periodically prepare financial statements that aggregated its off and on-balance sheet activities. Aggregate accounts were prepared each six months, from 30 June 1988, although this was on a less than timely basis, and the accuracy of information reflected in the accounts was at times doubtful. A significant factor contributing to the inaccuracy of the aggregated accounts was the quality of information available to Beneficial Finance from some of its off-balance sheet activities.

Beneficial Finance off-balance sheet business was not always appropriately capitalised. The Pegasus Leasing joint venture operated throughout with equity of only $0.2M supporting assets which, by June 1990 exceeded $100.0M. It is further evident that the use of the "After Tax Return on Earnings" measure without the concurrent application of a risk weighted capital allocation system, or a soundly based and vigorously applied gearing requirement for off-balance sheet activities, contributed to the provision of a misleading view of the company's performance. Beneficial Finance measured the company's "After Tax Return on Earnings" by including in earnings, dividends from its participation in off-balance sheet activities.

At the same time, the "After Tax Return on Earnings" for certain of its off-balance sheet activities was calculated by reference to the inadequate capital base of the particular activity. Thus the financial risk of the specific activity was misunderstood.

From 1988 onwards, it became evident to some of the company's senior management that performance measurement within the company was inappropriate, that the gearing of off-balance sheet activities was unsound, and that the capital allocation arrangements within the company were defective.

In October 1988, Mr J D Malouf identified problems with maintaining adequate capital within the Beneficial Finance Group in a memorandum to Mr J Suter, copies of which were provided to Mr Baker, Mr M Chakravarti, and Mr J O'Brien.⁽⁾ Mr Malouf made the following comments, in relation to the proposed 1989-1994 Corporate Strategic Plan.

"Minimum ATROE (after tax return on equity) achievement at 20% will depend to a very large extent on the type of business we are in over the planned period. ... It should be recognised that much of our success to date relates to our ability to write off balance sheet business. The introduction of capital adequacy ratios will obviously have major impact on our balance sheet and hence on ATROE.

One issue which has been overlooked in this analysis is that notwithstanding the returns which are possible from an investment banking operation, there is an increased measure of risk over and above the normal lending risk. Therefore, I find it hard to reconcile some of the objectives relating to ATROE and net profit after tax with the statement that Beneficial will maintain capital adequacy of 8% of the sum of risk adjusted on balance sheet assets and off-balance sheet exposure. In some instances, these aims appear to be contradictory.

One aspect in particular which concerns me is the utilisation of joint ventures which in many cases have no apparent underlying strategic or financial rationale."

Mr Malouf's memorandum highlights:

(a) the increased risk of investment banking operations;

(b) that after tax returns on equity have been achieved by the utilisation of off-balance sheet entities outside the trust deed restrictions;

(d) the lack of financial rationale in many of the off-balance sheet ventures.⁽⁾

In 1989, Dr Sexton was requested by Mr Baker to provide a confidential report on the company's operations. Dr Sexton concluded his report entitled "First 100 Days Review" on 9 April 1989.

Following from his report to Mr Baker, Dr Sexton pursued two matters with the Company's Executive Committee. The first matter addressed by Dr Sexton was the funding of joint ventures undertaken by the company, and the second was the establishment of controls and guidelines for equity investments by the Company. Papers, prepared by Dr Sexton and considered by Executive Committee at its meeting of 25 July 1989, concluded that:

(a) prudential limits should be applied by Beneficial to its joint venture companies;

(b) the gearing levels of the various joint ventures was as high as 50:1 in a number of cases;

(c) considerable injections of equity were required for each joint venture to bring gearing into line with more appropriate gearing levels;

(d) that, even if joint ventures were capitalised to a more appropriate level, a number would be incapable of achieving a sufficient after tax return on equity to justify their continued existence;

(e) Beneficial's gearing ratio of 12.5:1 was appropriate for a financial institution engaged in providing secured debt facilities, but was not appropriate for an institution that regularly took equity positions;

(f) a notional gearing ratio of 2:1 should be applied to all equity investments;

(g) applying this gearing ratio to the Company's equity investments an injection of $31.0M would be required from the State Bank during 1989-1990 and 1990-1991; and

(h) a capital allocation policy should be adopted for all equity investments, and be extended also to lending products such as property loans, where the Beneficial Group was also taking a development role.

The minutes of Executive Committee for that date record the following with respect to Dr Sexton's paper on funding ventures:

"...

2. ACTION ITEMS 2.1 Joint Venture Funding

The meeting reviewed the discussion paper on the funding of Joint Ventures and discussion centered around the appropriate gearing levels.

Action

RNS/JDM/GO'B The 1989/90 budgets and strategic plans set for the Joint Ventures should not be altered. It was agreed that the Boards of the Joint Ventures be advised that Beneficial's prudential limits and trust deed restrictions will impact on the funding and gearing ratios ..."

With respect to equity investments by the Company, Executive Committee recommended the preparation of a paper to the Board dealing with the matter. Special Submission 289 was prepared by Dr Sexton and, after consideration and amendment by Executive Committee, was considered by the Board at its meeting on 29 September 1989. After consideration of the paper, the Board requested that a set of criteria be formulated to guide the company in considering equity investments. Special Submission 289 recommended that a risk weighted capital allocation process be implemented. Dr Sexton testified to the Jacobs Royal Commission that such a policy was approved on 8 December 1989. Mr Baker has confirmed this in evidence to this Investigation. I note Beneficial Finance Board Minutes do not record such a policy being approved.

By at least August 1989, the inadequate capitalisation of the off-balance sheet entities was a matter of concern to the Board. At August 1989, the Board was concerned by the aggregate accounting results which indicated that the current aggregate assets only marginally exceeded the current aggregate liabilities.⁽⁾

Despite the recommendation contained in Special Submission No 289 for capital to be allocated internally according to different risk categories, such a process was not adopted within Beneficial Finance until 1991.⁽⁾ In March 1991, Special Submission No 344 was presented to the Beneficial Finance Board.⁽⁾ This Special Submission deals with the matters referred to in Special Submission 289. In particular, according to Special Submission 344, Beneficial Finance had still not properly recognised its business risks, and had still not taken account of different risk profiles of divisional assets in its allocation of capital. The submission stated:

"... In short the company chose to ignore the phases of the business cycle, particularly after the October 1987 share-market crash (cyclical risk), it relied too heavily on real estate (product and security risk) allowing too much interest capitalisation (cash flow risk). Too much property was tourism related, speculative or CBD (industry risk), too much speculative real estate was in Victoria and Queensland (Geographic Risk) and too many large and illiquid deals were written (concentration and market risk). The company entered areas of the market where it had little experience (product risk) and was caught by failing developers, entrepreneurs and farmers (industry, event and seasonal risks). At no stage was the company's MIS adequate to allow proper and prudent decision making about loan portfolios (systems risk)."

The Submission continued:

"... Capital rationing involves the deliberate assessment of the business risk for each individual sub-product, the pricing of each sub-product with due regard for that risk and the maintenance, over all products, of an agreed level of portfolio risk. Any tendency to drift towards higher risk products will demand a rebalancing of the portfolio with lower risk products and vice versa.

The first step in this approach is to set a gearing level (or capital adequacy level) for each sub-product in the portfolio based on the risk characteristics of that product. The greater the risk the higher the level of allocated capital. Thus a low risk product (given the restraints of our Trust Deed and the State Bank's Capital Adequacy requirements) might have one unit of capital allocated to say 15 units of borrowings (gearing of 1:15). A higher risk product might have 3 units of capital allocated to 15 units of borrowing (gearing of 1:5).⁽⁾

The second step is to set up a prudent gearing level for the whole company. A finance company is clearly riskier at the margin than a bank. Thus the bank average gearing of 1:12.5 is an (inappropriate) upper limit. On the other hand a gearing ratio of say 1:6 might not provide the minimum required return on capital.

It is our belief that Beneficial's core business demands an average gearing limit of between 1:8 and 1:10 but further work is required in this area.

Having agreed the portfolio risk gearings above, Management's task is to control the product mix within gearing and other portfolio risk constraints, such that the average gearing level is achieved at all times. Should the company have a surplus of capital (as is Beneficial's current position) then the surplus should be set aside from the equation to cater for growth.

This "capital rationing" approach is quite different to that used over the past few years. Artificially high gearing levels were achieved in some areas, notably off balance sheet financing associates (Pegasus, Equus, AWFL etc.) by treating equity in associates as loan funds in the books of the parent. As a result, base receivables were geared over 150 to 1 in some cases, leading to massive losses of parent capital when markets turned down. In short the company regarded gearing levels as something to be circumvented rather than acknowledging the fundamental reasoning of their existence." ⁽⁾

It is acknowledged that the management team who prepared Special Submission 344, and the Board to whom it was addressed, were not the same as the management or Board, who were responsible for the Company throughout the period considered by my Investigation. I have received submissions which suggest the reliability of views expressed in the submission are questionable. I have considered the submissions and have concluded that the picture of Beneficial Finance reflected in Special Submission 344 may be relied upon. Further, the approach to capital rationing proposed in the submission was appropriately adopted by the Company well before 1991.

Mr Baker has conceded to this Inquiry that it was important that capital be allocated internally according to the risk of various ventures.⁽⁾ He also conceded that, if prudent levels of capital are not applied then the losses suffered by a company, in the event of a downturn in the economy, are likely to be more acute than otherwise.⁽⁾

The preceding matters regarding capitalisation of off-balance sheet activities and arrangements for allocation of capital were put to the Managing Director, Mr Baker, by the Investigation.

As Mr Baker said in his evidence to the Investigation:

"The management was also very cognisant of the fact that the higher the debt equity ratio for the total group, the better it was going to be to get an attractive return on Group equity, or even on equity as reported on balance sheet which is really the more - which is the one the analysts look at as such." ⁽⁾

Mr Baker also stated that:

"I am sure if there had not been a push for return on shareholders' funds to the level that there was, we would not have been encouraged to go off-balance sheet with some of the transactions." ⁽⁾

As I have discussed, in Section 34.2.4 of this Chapter, the debt-to-equity ratios of some of the off-balance sheet entities were excessive. I have also discussed, in that section, the extent to which the off-balance sheet entities as a whole increased the overall debt-to-equity ratio of the Beneficial Finance Aggregated Group.

Mr Baker has conceded that the Beneficial Finance Aggregated Group was inappropriately and inadequately capitalised.⁽⁾ This, he also conceded, was as a result of the concentration on achieving after tax return on equity.⁽⁾ He accepted that he was responsible for inappropriate gearing levels.⁽⁾ When asked how it was that the Beneficial Finance Aggregated Group had become inadequately capitalised, he said:

"Simply by virtue of the growth of the off-balance sheet entities." ⁽⁾

He has conceded to this Inquiry that management was in a position to control gearing of the off-balance sheet entities. He gave evidence that management allowed the capitalisation of the Beneficial Finance Aggregated Group as a whole, and of particular off-balance sheet entities, to become inadequate because the low gearing would not create a problem until or unless there was a massive downturn in the economy.⁽⁾

There were very few proposals, for off-balance sheet joint ventures, or for any large lending deals approved by the Beneficial Finance Board after the presentation of Special Submission No 289. By this time, the Board had already indicated its direction that the off-balance sheet structures be bought on-balance sheet.⁽⁾ Further, the deteriorating financial condition of Beneficial Finance at the time, and, particularly, during the second half of the 1990 financial year, resulted in less lending activity.⁽⁾

The overall debt-to-equity ratio of the Beneficial Finance Aggregated Group continued to increase throughout the financial year of 1990. This matter has been dealt with in Section 34.2.4 of this Chapter.

Mr Baker acknowledged many of the criticisms contained in Special submission No 344. He conceded that the mix of the portfolio structure was not prudent; that too many deals were illiquid; and that the management information systems were not adequate.⁽⁾ He accepted that Beneficial Finance, in some cases, regarded gearing levels as something to be circumvented rather than acknowledging the fundamental reasoning of their existence.⁽⁾ He accepted that the consequence of the inadequate gearing was that Beneficial Finance suffered greater losses as a result of the downturn in the economy than it would otherwise have.⁽⁾

Mr Baker conceded that risk-weighted capital allocation is important for the proper assessment of potential new ventures.⁽⁾ He stated in evidence that the process was relatively new in Australia and was being adopted by the Bank in about 1989. He maintained, however that it would not have been appropriate to introduce this system, after the approval of Special Submission No 289, until after 30 June 1990.

The former directors of Beneficial Finance submit that the matters referred to above by Mr Baker were not brought to their attention at any time while they were directors of the Company. I accept that this was the case but that it nevertheless was always their responsibility to ensure that the company was managed in accordance with sound financial procedures. On the basis of the evidence as stated in this Chapter, the Board, in my opinion failed to do this, and thereby failed to adequately or properly supervise, direct, and control, the affairs of the company.

Conclusions with respect to Return on Capital Measurement and Gearing of the Company

The following conclusions can be drawn with respect to the Company's failure to implement a risk weighted capital allocation arrangement. It is evident that, without a risk weighted capital allocation arrangement, the officers and directors of Beneficial Finance Corporation did not have available information relevant to the decisions they made in approving new facilities and ventures, and in their ongoing management of existing activities. More specifically, it is evident that without a risk weighted capital allocation arrangement, management and directors assessed new proposals without having regard to appropriate risk adjusted performance targets, and that the performance measures against which existing activities were judged were inappropriately low, because they did not reflect appropriate premiums for higher risk. The proposition to be considered then is whether, the directors would have made a decision, having regard to this risk weighted information that would have led them to decline to participate in specific high risk activities, or to withdraw from high risk but low return business.

It is my opinion that, while the information provided by a risk adjusted capital allocation arrangement was relevant to decisions made by Beneficial Finance Management and Directors, it is unlikely that, in all the circumstances, decisions made by either party would have changed in any material respect. Indeed, in consideration of the Pegasus Leasing Joint Venture, the performance targets which had been set for that joint venture without regard to the high risk nature of the venture were not, over a period of time, met. The evidence is that, rather than withdrawing from the venture, the company substantially increased its commitment to the venture. In fact, when the Beneficial Finance Board was asked to approve participation in the joint venture in 1985, it did so on the basis that only a minimal amount of equity would be subscribed to the joint venture by Beneficial Finance and its joint venture partner.

The evidence considered by the Investigation shows that, by September 1989, the Management identified serious concerns with the capitalisation of much of the Company's business and particularly the funding of joint ventures. After consideration of the issues involved, the Executive Committee decided not to act on these matters until the next financial year. It did not refer this matter to the Board of Directors.

The Board did consider the need to implement improved capital allocation procedures. Implementation of the Board's requirements with respect to Special Submission 289 was a substantial exercise. It required the development of new systems and reporting arrangements which, having regard to other initiatives, were understandably not given high priority by the Company. Mr Baker has submitted that it was inappropriate for the company to implement the Special Submission 289 recommendations until the end of 1989-90 financial year. The difficulty faced by Beneficial Finance in implementing the recommendations of Special Submission 289 were described by Mr Horwood in his submission that the Company's systems for providing information on assets were so deficient that the proposed arrangements could only be implemented with a total re-development of the Company's existing systems.

While this explains the Company's failure to implement all of the Special Submission 289 recommendations, it does not explain why alternative action, specifically aimed at larger joint ventures in which the company was engaged, was not taken. I do not accept that it was beyond the resources of the company to identify the major joint ventures in which it was engaged, and to, quickly review the respective arrangements, particularly the capitalisation and on-going performance of those ventures.

It is acknowledged that, in a number of instances, the company was obliged, either by contractual arrangements or by commercial imperatives, to continue to advance funds to certain of these joint ventures. The Company's exposure to the Mindarie Keys Joint Venture is an example. On the other hand, it was open to the Company to review its participation in joint ventures such as the Pegasus Leasing Joint Venture, and the joint venture with the Mortgage Acceptance Corporation. In any event, approval of Special Submission 289 did not lead to the review or termination of these joint ventures.

On the basis of all the evidence, I have concluded that management and the Beneficial Finance Board should have identified the significant defect in the Company's performance measuring arrangements which followed from the absence of a risk weighted capital allocation process. The realisation that performance measurement arrangements were defective required no more than a basic appreciation of the calculation involved, and that the "After Tax Return on Earnings" measure could be manipulated by changing the denominator, that is equity. I believe the Board of the company could be expected to have identified the need for, at the very least, strict guidelines for the capitalisation of company activities, both on and off-balance sheet.

Further, I have concluded that management and the Board knew, at the time they entered specific transactions, that the prudent gearing limits imposed on the company by debenture trust deeds were being circumvented. It is a telling indictment of both the Board and management, that these requirements, instead of being considered a fundamental cornerstone of prudential management for a finance company, were seen as matters to be circumvented.

34.2.8.2 Portfolio Composition

The failure of Beneficial Finance to properly take into account the risks referred to in Special Submission No 344 is evidenced by an assessment of the assets portfolio of the company for the period under investigation. Table 34.14 illustrates that the composition and quality of assets changed during the period covered by the Investigation. Receivables from overseas are not reflected in Table 34.14, as they were held in an off-balance sheet entity structure.

Table 34.14 Net Recievables by Product/Business Sector
	Longer Term Advances on Established Properties %	Shorter Term Advances on Construction %	Vehicles & Equipment Leasing %	Commercial & Personal Loan %	Corporate Lending %	Real Estate Projects %

1985	15.5	37.6	39.2	1.2	5.1	1.4
1986	13.5	36.5	42.1	0.9	6.2	0.8
1987	14.5	32.8	38.0	0.9	12.3	1.5
1988	10.4	26.3	28.5	0.6	33.5	0.7
1989	14.3	32.9	27.6	0.3	24.1	0.8
1990	12.6	29.2	26.8	0.6	26.5	4.3

As reported by Australian Ratings in December 1987, all loans of average or above average size were adequately secured by real estate and/or charges over assets. The top ten loans had risen to account for approximately 10 per cent of the portfolio, while the largest individual exposure was about 25 per cent of shareholders' funds. At that time there were significant changes in portfolio composition, including increases in commercial lending and real estate projects, and a relative decline in construction and bridging finance, and vehicles and equipment.⁽⁾

In the November 1988 report, Australian Ratings further reported that the total assets of Beneficial Finance and its subsidiaries increased, by 46.6 per cent, and net receivables, by 42.2 per cent. With the focus on commercial and corporate sector lending, there was an increase in the size of transactions. The top ten loans had risen to account for around 14.7 per cent of the portfolio, with the largest individual exposure being about 31 per cent of shareholders' funds.

In May 1989, the Australian Ratings report of Beneficial Finance noted an increase in the risk profile of the loan portfolio after Beneficial Finance's expansion into corporate and commercial lending. The strong growth in corporate and commercial receivables was aided by a number of portfolio acquisitions from other financiers during the 1987-1988 year. There was an increase in the size of acquisitions. Whilst the majority of loans were supported by real estate and/or charges over assets, the strong property orientation of Beneficial Finance's loan portfolio and the security held over loans made Beneficial Finance dangerously susceptible to fluctuations in the property market.⁽⁾

The Australian Ratings report in February 1990 noted that a number of sensitivities regarding Beneficial Finance's business base and financial profile had emerged, including:

"... An increase in the risk profile. The outlook for the loan portfolio is less favourable due to Beneficial's high and increased exposure to the property market - approx. 58% of assets now represent property related transactions. Although asset quality measures improved in 1988/89 and there is currently no deterioration in asset quality, the less favourable outlook raises sensitivities." ⁽⁾

With high interest rates, an imminent slowdown in the economy, softer property values, and the economic fallout from the pilots' dispute, Beneficial Finance was susceptible to fluctuations in the property market.⁽⁾

The February 1990 report also noted that Beneficial Finance had appeared to strengthen its technical resources and skills as part of its expansion into larger property and specialised transactions. The report stated that this should moderate risk exposure, and result in better quality transaction exposures:

"... As a general rule, individual exposures are restricted to within 30% of capital with most being of less than $15 million (about 10% of equity). At 30 June 1989, there were about 35 individual exposures which exceeded the $15 million level." ⁽⁾

The statistics referred to in the various Australian Rating Reports were provided to Australian Ratings by Beneficial Finance.⁽⁾

The Bank also was concerned with Beneficial Finance's exposure to the real estate market. A memorandum approved by the Bank Board stated:

"... However, some concern is raised as to the quality of the loan portfolio due to the high level of loans secured by real estate, high risk position taken in some transactions, rapid asset growth and change in strategy to more emphasis on the commercial/corporate sectors, particularly in a difficult macro economic environment." ⁽⁾

34.3 CONCLUSIONS ON FUNDING AND ITS MANAGEMENT

On the basis of all the available evidence, I have come to the following conclusions in relation to the general issue of funding and its management within Beneficial Finance.

The methods used by Beneficial Finance to raise funds were not inconsistent with that of the company's competitors. Throughout the period under review, Beneficial Finance increasingly relied on wholesale financial markets to fund its operations, in particular, wholesale funds sourced from off-shore markets. This increased reliance by Beneficial Finance on wholesale funds, rather than funds raised by way of public debenture issues, was also consistent with the experience of some of the other finance companies.

Whilst Beneficial Finance's debenture trust deeds imposed various gearing limits, including a maximum debt-to-equity ratio of 15:1, Beneficial Finance management aimed for an on-balance sheet debt-to-equity ratio of 12.5:1. At the same time, the Company implemented arrangements through a structure of integrated unit trusts designed to circumvent the prudent gearing limits imposed by the Trust Deeds. The arrangements were implemented with the approval of Beneficial Finance's Board. The off-balance sheet arrangements were, in some cases, used to conduct business of a different type of risk than normal finance company activities, ie it involved an exposure to not only "credit risk", but also "market risk" arising from Beneficial Finance's equity participation in some of the ventures concerned.

The Company ignored the prudential requirement that high risk activities should be accompanied with lower gearing. I am of the view that management's, and the Beneficial Finance Board's, desire to avoid the trust deeds' gearing restrictions reflects a lack of appreciation of the fundamental prudential reasons for having in place appropriate debt-to-equity ratios ie the need to ensure the protection of the debenture and unsecured note holders.

In addition, the off-balance sheet entities were in many instances, seriously undercapitalised. This was a deliberate policy. It was undertaken so that the projects or activities could appear to provide a higher return on the equity investment made. I am satisfied that, as Mr Baker acknowledged, one consequence of the inadequate capitalisation of the Beneficial Finance Aggregated Group was that Beneficial Finance suffered greater losses as a result of the downturn in the economy than otherwise would have been the case.

The failure by management to appropriately plan and monitor:

(a) the growth of the company;

(b) the mix of its portfolio of assets; and

when combined with the failure to provide for timely reporting (or for that matter, any effective reporting at all), on these important management issues, resulted in a situation whereby the Board and management did not have a sound basis for decision making. This situation has resulted in Beneficial Finance holding significant non-performing assets.

In failing to attend to these matters, in my opinion, the Board and management failed to adequately or properly supervise, direct, and control, the affairs of Beneficial Finance.

34.4 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT

34.4.1 TERM OF APPOINTMENT A

34.4.1.1 Term of Appointment A (b)

The processes that led Benefical Finance, a member of the Bank Group, to engage in operations which have resulted in material losses, and in the Bank and Beneficial Finance holding significant assets that were non-performing, includes the processes described in this Chapter associated with the funding of Beneficial Finance, and the arrangements for the capitalisation of the business activities undertaken by off-balance sheet entities.

34.4.1.2 Term of Appointment A (c)

For the reasons described in this Chapter, these process were inadequate.

34.4.2 TERM OF APPOINTMENT C

In accordance with Term of Appointment C, I report that, in my opinion, for the reasons as stated in this Chapter, the Beneficial Finance Board failed to properly supervise, direct, and control, the operations of Beneficial Finance.

I am further of the opinion that, for the reasons stated in this Chapter, the Managing Director of Beneficial Finance, Mr Baker, and senior management within Beneficial Finance, failed to adequately or properly supervise, direct, and control, the operations of Beneficial Finance.

CHAPTER 34 THE FUNDING OF BENEFICIAL FINANCE

34.1 INTRODUCTION

34.2 FUNDING AND ITS MANAGEMENT BY THE BENEFICIAL FINANCE GROUP

34.3 CONCLUSIONS ON FUNDING AND ITS MANAGEMENT

34.4 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT

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CHAPTER 34
THE FUNDING OF BENEFICIAL FINANCE