CHAPTER 32
CASE STUDY IN CREDIT MANAGEMENT: MINDARIE KEYS
TABLE OF CONTENTS
32.1 INTRODUCTION
32.1.1 REFERENCE INFORMATION
32.1.2 OVERVIEW
32.2 INITIATION, APPROVAL AND ESTABLISHMENT OF THE FACILITY
32.2.1 BACKGROUND
32.2.2 REVIEW OF THE PROPOSAL
32.2.3 THE CREDIT SUBMISSION
32.2.4 APPROVAL OF THE FACILITY
32.2.5 NEGOTIATION AND ESTABLISHMENT OF THE FACILITY
32.2.5.1 The Conditions Precedent to Beneficial Finance's Participation
32.2.5.2 Beneficial Finance's Security
32.2.5.3 The Third-Party Finance
32.2.5.4 Valuation and Feasibility Study
32.2.5.5 The Terms of the Joint Venture Agreement
32.2.5.6 Documentation of the Joint Venture Agreements
32.2.6 SUMMARY AND CONCLUSIONS
32.2.7 A REVIEW BY BENEFICIAL FINANCE OF THE ESTABLISHMENT OF THE FACILITY
32.3 MANAGEMENT OF THE FACILITY
32.3.1 OCTOBER 1987 TO DECEMBER 1988
32.3.2 JANUARY 1989 TO DECEMBER 1989
32.3.3 JANUARY 1990 TO FEBRUARY 1991
32.3.4 SUMMARY AND CONCLUSIONS
32.4 FINDINGS AND CONCLUSIONS
32.5 REPORT IN ACCORDANCE WITH MY TERMS OF APPOINTMENT
32.5.1 TERM OF APPOINTMENT A
32.5.1.1 Term of Appointment A(b)
32.5.1.2 Term of Appointment A(c)
32.5.1.3 Term of Appointment A(e)
32.5.1.4 Term of Appointment A(h)
32.5.2 TERM OF APPOINTMENT C
32.1 INTRODUCTION
32.1.1 REFERENCE INFORMATION
| REFERENCE INFORMATION | |||
| Account Name | Mindarie Keys Joint Venture | ||
| Participants | . Beneficial Finance;
. Entrad Limited; and . Smith Corporation Pty Ltd. |
||
| Industry Sector | . Real Estate Development | ||
| Facility Type | . Equity Investment;
. Development Loans; and . Working Capital Advances Guarantee. |
||
| Principal Outstanding
at 28 February 1991 |
$M
. Loans and Advances 52.57 . Leasing Facility 0.05 . Guarantee Facility 1.50 . Equity 7.50 61.62 . Capitalised Interest and Charges 3.98 65.60 |
||
| Estimated Loss
at 28 February 1991 |
. $15.0M | ||
32.1.2 OVERVIEW
This Chapter examines the participation by Beneficial Finance in a joint venture to acquire and develop land known as the Mindarie Keys development in Western Australia.
Beneficial Finance was involved in the project both as a financier, and notionally at least as a part owner of the Mindarie Keys land. The other joint venture participants were Smith Corporation Pty Ltd ("Smith Corporation"), and Entrad Limited ("Entrad").
Although it was in legal form an owner of the land, Beneficial Finance's interest was, in substance, that of a financier. The joint venture arrangements entitled Beneficial Finance, at its option, to require the other partners to buy its equity interest at a price which provided Beneficial Finance with a minimum rate of return on its investment.
The project, which involved the development of 316 hectares of ocean-front land located approximately 35 kilometres north of Perth, was promoted by Smith Corporation and its Managing Director, Mr R Smith. The development of Mindarie Keys was the subject of a State Agreement with the Western Australian Government, which permitted Smith Corporation to undertake a major harbour and marina development, and the sub-division of 2,000 residential allotments. In return for these development rights, Smith Corporation was required to pay all costs associated with the construction of the harbour, breakwater, marina, navigation aids, roads and drainage facilities, and to construct a water supply and a sewerage treatment works. Those assets would then become the property of the State Government.
Smith Corporation proposed that the development would be undertaken in several stages. Stage 1 of the project was the most important because it included the harbour, marina and a hotel, that were intended to be the main attraction of the development. The cost of Stage 1 was estimated by Smith Corporation to be $40.0M, including $12.0M for the purchase by the joint venture participants of the Mindarie Keys land from Smith Corporation. After the completion of Stage 1, further residential allotments were to be developed. Depending upon the rate of land sales, it was estimated that the development would take up to twelve years to complete, and cost a further $76.0M.
In about February 1986, Smith Corporation approached Beneficial Finance for a short term development loan of $0.55M pending the commitment of joint venture participants to the Mindarie Keys project. Subsequently, Smith Corporation proposed that Beneficial Finance participate in the joint venture formed to purchase the Mindarie Keys land and to develop Stage 1 of the project. It was intended that Beneficial Finance would, as part owner of the land, participate in the development of later stages.
After examining Smith Corporation's proposal for several months, Beneficial Finance management presented a submission to the Beneficial Finance Board of Directors seeking approval for Beneficial Finance to become a joint venture participant in, and a financier to, the development. The submission was approved by the Board on 16 December 1986, and an unincorporated joint venture was established by agreement between Beneficial Finance, Smith Corporation and Entrad, signed on 19 October 1987.
The parties to the Mindarie Keys joint venture agreements were nominees of Beneficial Finance, Entrad and Smith Corporation. In particular, Beneficial Finance used two off-balance sheet companies as its joint nominees, Namtok Pty Ltd ("Namtok") and Gumflower Pty Ltd ("Gumflower"). Smith Corporation's nominee was Biddenham Pty Ltd, ("Biddenham"). Entrad Ltd's nominee was Mindarie Investments Pty Ltd ("Mindarie Investments"). Unless necessary to explain a particular issue, I have referred to Beneficial Finance, Entrad and Smith Corporation as the joint venture participants, and have not differentiated between the legal interests of those companies and their nominees.
The structure of the Mindarie Keys joint venture can be shown diagrammatically as follows:
[insert chart here]
The joint venture was not an incorporated entity. The joint venture participants had separate legal rights and interests. For example, Beneficial Finance (Gumflower) was registered as a part owner of the Mindarie Keys land as a tenant in common with Entrad and Smith Corporation, and had a several liability to creditors.
During the period from January 1988 to December 1990, the joint venture developed Stage 1 of the Mindarie Keys land in accordance with the requirements of the State Agreement. The development encountered problems from the outset, including cost over-runs, lack of project control, low sales of subdivided residential allotments, increased borrowings, and poor accounting and financial control.
In the first half of 1990, Entrad's financial position deteriorated to the point that it was unable to continue to contribute its portion of the joint venture's financial requirements. In December 1990, following protracted negotiations with the joint venture participants and financiers, Beneficial Finance became the sole owner of the development by acquiring both Smith Corporation's and Entrad's 25 per cent interests in the joint venture. As a result of the transfer of Beneficial Finance's business operations to the Bank, the Mindarie Keys land is now controlled by the Bank's Group Asset Management division.
As a result of my Investigation into the establishment of the joint venture and the management of Beneficial Finance's participation, I have identified the following as the principal factors that contributed to Beneficial Finance's exposure and to its resultant losses:
(a) Inadequate analysis of the development and joint venture by Beneficial Finance Management.
(b) Inadequate consideration of the project by the Beneficial Finance Board of Directors.
(c) The failure by Beneficial Finance management to ensure that the joint venture agreements were adequate to protect the interests and entitlements of Beneficial Finance having regard to its position as a financier and majority equity participant.
(d) The inadequate supervision of the facility and of the joint venture activities by Beneficial Finance management.
32.2 INITIATION, APPROVAL AND ESTABLISHMENT OF THE FACILITY
32.2.1 BACKGROUND
Smith Corporation was the third largest property developer and home builder operating in Western Australia, specialising particularly in the sub-division of broadacre land for residential housing. Its net assets at 30 June 1986 were $1.174M.() Smith Corporation was a customer of Beneficial Finance's Perth office before the Mindarie Keys venture, with loans of $2.514M in the form of both real estate loans and equipment leases.
Entrad Ltd was a subsidiary of Entrad Corporation Ltd, a public company associated with the Linter Group of Companies, controlled at all material times by Melbourne businessman Mr A Goldberg. As at 30 June 1986, Entrad Ltd's published accounts showed it to have a net worth of $54.5M. Entrad Corporation Ltd had an estimated net worth of $122.7M.()
Smith Corporation bought the Mindarie Keys land from Entrad for $5.5M in 1981. From 1981 to December 1985, Smith Corporation prepared a plan for the development of Mindarie Keys, and negotiated the State Agreement which was signed in December 1985.()
The State Agreement required Smith Corporation to comply with an agreed development plan for Mindarie Keys, including an extensive capital works program involving construction of a new harbour and marina that, it was claimed, would be the largest artificial harbour in Australia.
Two aspects of the State Agreement are worth noting. First, items such as the breakwater, navigation aids, roads and sewerage treatment works were to be constructed to specifications approved by the Western Australian government. The specifications were not, however, contained in the State Agreement, and they had not been determined prior to Beneficial Finance agreeing to become a participant in the joint venture.() A clear understanding of the specifications was important, as this matter directly impacted on the ultimate profitability, and possibly the viability, of the project. Second, ownership of various parts of the development to be constructed by the developer such as the breakwater, harbour area, navigational aids, main roads and the sewerage treatment works was to be transferred to the Western Australian government upon completion.
32.2.2 REVIEW OF THE PROPOSAL
After signing the State Agreement in December 1985, Smith Corporation sought funds from various investors and financiers to begin development of the Mindarie Keys land. The discussions between Smith Corporation and Beneficial Finance that resulted in the establishment of the joint venture appear to have begun in February 1986, when Smith Corporation requested a $0.55M loan from Beneficial Finance for future costs associated with the development. The loan application included a valuation report prepared by Peet and Co, who in a covering letter to Beneficial Finance emphasised the "pioneer and entrepreneurial nature of the marina", and noted that:
"... the land may effectively be deemed to be urban and suitable for residential subdivision and the marina development as approved, but it is non-income producing and speculative to the extent that failing the marina development, the rate of subdivision and lot values will depend upon the health of the market in Perth. Accordingly, you should assess suitably safe margins of security for any loan which you may contemplate." ()
Negotiations were then held with Smith Corporation and Entrad by Mr E P Reichert and Mr G L Martin of Beneficial Finance's newly established Corporate Services division, assisted by management in the Perth office.() In October 1986, a credit submission was presented to the Board of Directors seeking "in principle" approval for Management to negotiate participation by Beneficial Finance in the Mindarie Keys development. No detailed analysis of the project had been undertaken by Beneficial Finance at that time. In his evidence, Mr Martin said:
"The recommendation to the Board was subject to a detailed evaluation being prepared and presented to the Board for approval. I think we were looking for an idea from the Board to say: is this sort of project, in principle, if it stacks up, okay for us to continue working on? At that point I doubt if we would have gone into - we would have done some work, but I do not know how much. I cannot remember how much at the time." ()
The submission contained a short summary of the Mindarie Keys development and the joint venture proposal. It stated that the $40.0M cost of acquiring the land and developing Stage 1 would be financed with $10.0M of equity from the joint venture participants, and a $30.0M loan from a third party lender. Beneficial Finance's intended financial obligation as a joint venture participant was to contribute $5.0M by way of equity, and to undertake a liability for 50 per cent of the third party loan to be raised by the joint venturers.
The Board of Directors declined to give in-principle approval. At its meeting on 21 October 1986, the Board resolved that:
"Approval should not be given to a participation in a joint venture with Smith Corporation Pty Ltd and Entrad Corporation Ltd to develop a site known as Mindarie Keys located 35 kilometres north of Perth. Management will look at an alternative financing/equity basis to see whether a more acceptable participation can be submitted for further consideration."()
Beneficial Finance Management continued negotiations with Smith Corporation and Entrad. They reviewed the financial structure of the proposed joint venture, and approaches were made to third party financiers to provide finance in a manner which accommodated the revised financial arrangements. The minutes of the Beneficial Finance Board meeting of 18 November 1986 record:
"Mindarie Keys Joint Venture: the Managing Director advised that Corporate Services Division is continuing to work on the proposal and may resubmit it to the Board for further consideration." ()
The negotiations resulted in the preparation of a new submission by Mr Reichert and Mr Martin to the Beneficial Finance Board.() Although the information contained in the submission was substantially similar to that in the earlier preliminary submission, it differed from the earlier submission in two key respects:
(a) it proposed a revised financial structure for the joint venture; and
(b) it sought formal approval from the directors for Beneficial Finance's participation in the joint venture.
32.2.3 THE CREDIT SUBMISSION
The submission proposed that the joint venture participants would contribute a total of $15.0M of equity, with Beneficial Finance contributing $7.5M for a 50 per cent interest in the joint venture. Smith Corporation and Entrad were each to contribute $3.75M. In addition, Beneficial Finance and Entrad would each lend $2.5M to the joint venture. The balance of $20.0M was to be borrowed from a third party financier.
Although not disclosed in the submission, part of Smith Corporation's equity was to be financed by a $2.0M loan from Entrad, secured by a charge over two thirds of its 25 per cent interest in the joint venture. The balance of Smith Corporation's contribution was to come from the profit from the sale of the Mindarie Keys land to the joint venture.()
The revised financial structure therefore retained Beneficial Finance's participation at 50 per cent, but increased its equity contribution from $5.0M to $7.5M, and required it to provide a loan of $2.5M. Importantly:
(a) Under the revised arrangement, Entrad was to guarantee a minimum rate of return to Beneficial Finance on its equity contribution by granting it a put option, pursuant to which Entrad undertook to buy Beneficial Finance's share of the joint venture for a price equivalent to the $7.5M contributed, plus an "interest" rate of 30 per cent per annum, should Beneficial Finance require it to do so. Beneficial Finance's investment was, therefore, more in the nature of debt than equity.
(b) Beneficial Finance was no longer to be liable for one-half of the liabilities of the joint venture to third-party financiers. All external loans obtained were to be non-recourse to Beneficial Finance and the other joint venture participants.
The expected financial returns to Beneficial Finance were stated to be interest at current lending rates on the debt of $2.5M and, upon exercising the put option, interest at 30 per cent per annum on the equity of $7.5M. If the put option was not exercised, Beneficial Finance would receive a potential profit share of $27.0M, being a return of about 30 per cent per annum. Security for Beneficial Finance's $10.0M contribution was proposed to include a registered second mortgage of the Mindarie Keys land for the $2.5M of debt finance, and the put option to Entrad for the equity of $7.5M. The submission relied upon a put option to Entrad as the "first way out ", and to provide a guaranteed financial return to Beneficial Finance regardless of the financial viability of the Mindarie Keys project.
The submission concluded with a firm recommendation by Mr Reichert and Mr Martin that Beneficial Finance should participate in the Mindarie Keys joint venture:
"... We believe this is a strong viable development opportunity to be undertaken with experienced and substantial partners."()
Despite the statement that the project was "viable", the submission did not contain any detailed financial analyses for consideration by the Board of Directors. Beneficial Finance had been provided with various studies of the project, prepared by Smith Corporation, including studies described as a Property Exchange Plan, a Structure Plan, a sub-division Guide Plan, a Zoning Plan, an Environmental Review and Management Plan, and a Valuation, together with a project cost estimate and financial analysis.() The information contained in the studies was, however, little more than broad projections. The cost estimate and analysis were deficient in that the specifications referred to in the State Agreement had not been determined at that time, and were based on preliminary engineering studies that had not been verified by tender prices.
I have attempted to ascertain what investigation and analysis of the Mindarie Keys project was undertaken by Beneficial Finance between the time of the submission in October 1986 seeking approval in principle subject to a detailed evaluation being undertaken, and December 1986 when the submission seeking approval to participate in the joint venture was prepared. I have found no evidence that a detailed evaluation and feasibility study was conducted during that time, and I conclude that none was conducted.
In rejecting the October submission seeking in-principle approval, the Board of Directors directed Management only to consider an "alternative financing/equity basis to see whether a more acceptable participation" could be considered. There was no requirement laid down to conduct an evaluation of the project. In November, the Board was told simply that the Corporate Services division "is continuing to work on the proposal".
Although the December submission sought approval to participate in the venture, it was Management's view that a detailed evaluation of the project would be conducted after the Board of Directors approved the submission. Mr Martin said in evidence that it was not Beneficial Finance's usual practice to verify costings contained in submissions until after approval by the Board. Indeed, the letter sent by Beneficial Finance to Smith Corporation in January 1987 advising it of the approval of Beneficial Finance's participation, stated that a condition to its participation was the conduct of a "Valuation/Feasibility" satisfactory to Beneficial Finance. Further, a detailed feasibility study could not have been completed before December 1986, because the terms of the State Agreement relating to major infrastructure capital works of the project had not then been settled.
32.2.4 APPROVAL OF THE FACILITY
The submission was distributed to the directors of Beneficial Finance by Mr J A Baker. In his covering letter to each of the directors, Mr Baker wrote that the submission was in response to an indication by the Beneficial Finance Board that it would consider joint ventures with strong partners.()
The submission was considered and approved by the Beneficial Finance Board on 16 December 1986. Mr Reichert and Mr Martin attended the meeting, and made a presentation and provided details to the Board in support of the submission, including drawings, plans and photographs of the project site, and a market survey of future land demand in Perth. Reference was also made to the State Agreement, and to the necessity to verify all local government and statutory consents.
According to the submission to my Investigation on behalf of the Non-Executive Directors, the Board engaged in lengthy and detailed discussions of the Mindarie Keys project during the meeting.() Approval for participation was minuted as follows:
"... Approval was given to take a 50% participation in a Joint Venture to undertake a staged development on a site known as Mindarie Keys located 35k north of Perth, on 316 hectares of ocean front land. Entrad Ltd and Smith Corporation Pty Ltd will hold the other 50% of the Mindarie Keys Joint Venture. The proposal has previously been circulated to the directors on 11 December 1986."
In their submission to me(), the Non-Executive Directors of Beneficial Finance asserted that, as noted in the November Board Minutes referred to above, they were advised by management that the Corporate Services division was continuing to work on the Mindarie Keys proposal. The Non-Executive Directors said that the presentation given to the Board at its December meeting was extensive, and gave the impression that management had undertaken the necessary feasibility study of the project. Although the Non-Executive Directors could not recall asking whether a feasibility study had been undertaken, they believed that it had been.
In my opinion, any such belief was not reasonably based. If the Non-Executive Directors had asked, they would have been told that a detailed evaluation of the project had not yet been undertaken by Management. According to Mr Martin, who attended the meeting, it was usual practice to conduct a valuation of a project after receiving Board approval. In his submission to my Investigation, he said, in respect of the December 1986 submission, that "an assessment was made by the Board whether or not to approve the submission as a matter of principle, and then an assessment was made thereafter (if approved)."() The letter subsequently sent to Smith Corporation stated that Beneficial Finance's participation was subject to the conduct of a satisfactory "Valuation/Feasibility". In my opinion, having taken upon itself the role of approving large financial commitments by Beneficial Finance, it was incumbent upon the Board of Directors to do more to satisfy itself that all aspects of the proposed facility had been adequately assessed by management.
32.2.5 NEGOTIATION AND ESTABLISHMENT OF THE FACILITY
32.2.5.1 The Conditions Precedent to Beneficial Finance's Participation
Beneficial Finance advised Smith Corporation of the approval of Beneficial Finance's participation in the joint venture in a letter dated 8 January 1987. The letter stated that Beneficial Finance's participation in the joint venture was subject to a number of conditions regarding the taking of security, the completion of a valuation and feasibility study satisfactory to Beneficial Finance, the preparation of satisfactory documentation, and Beneficial Finance performing the accounting and administration functions for the joint venture. The letter read in part:
"... (4) Security
(a) Third party lender will have a registered first mortgage over the property. The loans will have no recourse to Beneficial or any equity party.
(b) Registered second mortgage to secure our debt component of $2.5M. This will also secure our $7.5M equity in the event of default by Entrad under the put option.
(c) Beneficial will have a put option to Entrad Ltd exercisable after four years and payable after five years. The put option is to cover Beneficial's equity of $7.5M plus a compounded rate of 30% per annum and debt of $2.5M plus interest on the debt.
(d) To further secure the put option, Entrad Corporation Ltd are to give a strong letter of comfort in respect of the performance of Entrad Ltd.
(e) In the event that the audited net worth of Entrad Ltd falls below $45M then Entrad Corporation Ltd are to guarantee the performance of Entrad Ltd in respect to the put option.
...
(7) Valuation/Feasibility
To be undertaken by valuer nominated by Beneficial. Result to be satisfactory to Beneficial prior to entering into joint venture and costs to be your account.
(8) Accounting/Administration
To be performed by Beneficial.
...
(11) Legal Documentation
To be prepared by Beneficial solicitors at your cost which can be reimbursed by the joint venture. Beneficial to have the right not to proceed with documentation and contents thereof if not satisfactorily agreed between the parties."
From January 1987 until October 1987, protracted negotiations took place between Beneficial Finance, Smith Corporation, Entrad and third party financiers regarding the structure and terms of the joint venture.
32.2.5.2 Beneficial Finance's Security
Beneficial Finance's security for its $2.5M loan and $7.5M equity contribution was to consist of a second mortgage over the land (the external financier would take the first mortgage), and a put option granted by Entrad that essentially amounted to a guarantee from Entrad of Beneficial Finance's investment, and of minimum rate of return on that investment. Entrad's "guarantee" was to be supported by a strong letter of comfort from its parent company, Entrad Corporation Limited, and, if Entrad's net worth fell below $45.0M, by a guarantee from the parent company.
In February 1987, Entrad requested that Beneficial Finance waive the requirement that its parent company provide a guarantee in respect of Entrad's obligations under the put option. According to Entrad, such a guarantee would be a contingent liability that Entrad Corporation wanted to avoid showing in its accounts.
Mr Martin submitted a memorandum dated 25 February 1987 to the Board of Directors proposing to agree to Entrad's request, subject to two conditions:
(a) Entrad and Smith Corporation would agree not to withdraw interest or profits from the joint venture for the period of the put option; and
(b) in the event that Beneficial Finance exercised the put option at the end of year four and was still not paid at the end of year five, Beneficial Finance's entitlement under the put option would be secured by a second mortgage over the joint venture assets for a period of three years, during which time Entrad and Smith Corporation would not withdraw interest or profits from the joint venture unless the project's asset to security ratio reduced to 60 per cent or less.
The Beneficial Finance Board approved Mr Martin's recommendation subject to the condition that three controls be included in the joint venture agreements:()
(a) the advance to security ratio was not to exceed 60 per cent;
(b) the accounting for the joint venture was to be controlled by Beneficial Finance or by Price Waterhouse; and
(c) cheque payments were to be controlled by Beneficial Finance.
These conditions were incorporated in a letter of approval from Beneficial Finance to Smith Corporation dated 18 May 1987.
The importance of these controls was noted by Mr Baker in a memorandum to Mr Reichert, in which he stated:
"... in approving this paper, the Board insisted that Beneficial controls the bank accounts. In due course we should define the various operating procedures and controls for this major project." ()
In March 1987, Entrad requested a further variation to the terms of the put option.() Entrad proposed that:
(a) it should be liable for only one-half of the put option price, with Smith Corporation being liable for the other half; and
(b) in the event that Beneficial Finance exercised the put option at the end of the fourth year and was not paid at the end of the fifth year, Beneficial Finance was to lend the amount of the put option purchase price to both Entrad and Smith Corporation for a period of three years. The security offered by Entrad and Smith Corporation was a second mortgage over their respective interests in the Mindarie Keys land.()
To better secure Beneficial Finance's exposure, Smith Corporation offered Beneficial Finance a charge over its 25 per cent interest in the project. Although that interest was already subject to a charge by Entrad, Smith Corporation subsequently renegotiated its security and financial arrangements with Entrad to enable it to provide the charge to Beneficial Finance.
A special submission was sent to the directors on 30 July 1987 seeking approval for the further variation to the put option arrangement. The submission included two analyses of Beneficial Finance's likely position if the put option was exercised by Beneficial Finance but not paid at the end of year 5. The first analysis was based on Smith Corporation's updated cash flow projection. The second varied those figures by assuming a 10 per cent reduction in sales, a 10 per cent reduction in property values and a 10 per cent increase in expenses. Those assumptions were regarded by Management as extremely conservative.
The Board of Directors approved the changes to the put option arrangement at its meeting on 31 July 1987. The effect of the combined changes to the terms of the put option on the security offered to Beneficial Finance was significant. The original proposal entitled Beneficial Finance to sell its joint venture interests to Entrad, and to be paid at the end of year five. Entrad's purchase was guaranteed by its holding company Entrad Corporation. Beneficial Finance, therefore, had a reasonable expectation that it need not have any continuing financial exposure to the project after the exercise of the put option. Smith Corporation, however, was in a much weaker position, with a net worth of only $4.8M, and the variation to the put option arrangement to make it liable to pay one half of the purchase price was a significant weakening of the value to Beneficial Finance of the option.
Further, the revised terms of the put option entirely changed the basis of the option agreement. In my opinion, the put option ceased to be a sale agreement, and became what can more accurately be described as a "debt for equity" conversion agreement.() Although the put option still contained a provision for the sale of Beneficial Finance's joint venture interests to Entrad and Smith Corporation, Beneficial Finance was unconditionally obliged to lend Entrad and Smith Corporation the whole of the purchase price. In effect, Beneficial Finance could not demand payment of the put option purchase price until the end of year eight.() Not only was the capacity of Beneficial Finance to terminate its financial exposure deferred by three years to the eighth year of the project, but the second mortgage security for the ongoing loan had an uncertain future value.
In my opinion, the restructuring of the put option had the effect of significantly disadvantaging Beneficial Finance in several respects. Although it was not unusual for Beneficial Finance to act as a second mortgage financier, its commitment to provide the whole of the put option price five years in advance, with the uncertainties that necessarily involved in respect of the value of the second mortgage and the capacities of Smith Corporation and Entrad at that time, was imprudent. At the very least, Beneficial Finance's obligation to finance the purchase price under the put option should have been made subject to a satisfactory credit review at the time the option was exercised.
32.2.5.3 The Third-Party Finance
During the period from January to June 1987, applications were made to several financiers for loans to the joint venture. In July 1987, Tricontinental Corporation Ltd ("Tricontinental") agreed to arrange a syndicated lending facility to the joint venture participants for a total of $33.0M, including a $3.0M stand-by facility for "cost over-runs".() The Tricontinental letter of approval identified the purpose of the facility and cost of Stage 1 in the following terms:
"Drawdowns in years one and two of the facility will be assessed against cost of the first stage of the development which is estimated to be approximately $50.0M. Funds will not be made available for stage two and beyond without Tricontinental being satisfied that sufficient sales proceeds will be received from stage one to meet payment of projected developments costs as incurred." ()
The total cost of $50.0M for Stage 1 of the development referred to in the Tricontinental letter represents a significant increase over the cost of $40.0M estimated in December 1986. The non-recourse third-party debt had increased from the $20.0M estimated in December, to $33.0M. Beneficial Finance's Board of Directors was advised of the increase in the total financing commitment for the project to $53.0M by the special submission dated 30 July 1987 regarding variation of the put option.
32.2.5.4 Valuation and Feasibility Study
Beneficial Finance's letter to Smith Corporation dated 8 January 1987 stated that Beneficial Finance's commitment to the joint venture was conditional upon a "valuation/feasibility", to be undertaken by a valuer nominated by Beneficial Finance, being "satisfactory to Beneficial".
The submission to the Board dated 30 July 1987 stated that the value of the Mindarie Keys land had increased "from $12.0M to an estimated $15.0M on a broadacre basis due to inflation and demand ". The source of that estimate was apparently Mr Smith.() Despite enquiries at the time by Mr Chapman to Mr J Francks as to the basis of the valuation,() I am not satisfied that the estimate of $15.0M referred to in the submission was made on reasonable grounds. Beneficial Finance has not produced to the Investigation any evidence to support the increased valuation of $15.0M.() None of the valuation reports prepared by Peet & Co refer to a valuation in excess of $12.0M.()
An essential part of any valuation of the project was an evaluation of the viability of the Mindarie Keys development in the terms specified in the State Agreement. Management should not only have reviewed the Smith Corporation studies in detail, but having regard to the size and complexity of the project, should also, in my opinion, have engaged independent professional advisers to assess all aspects of the development. For example, it would have been appropriate to engage engineers, cost estimators, marketing consultants and valuers to provide an independent assessment of the development. Such an examination would have either confirmed or rejected the financial analysis and studies presented by Smith Corporation. As a result of that examination, Beneficial Finance would have been better able to make an informed decision about the merits of its proposed commitment as a joint venture participant.
There was a period in excess of nine months from the date of the approval of the submission by the Beneficial Finance Board until the signing of the joint venture agreements in October 1987. During that period, there existed ample opportunity to review completely all aspects of the Mindarie Keys Project. Mr Reichert and Mr Martin have both said in evidence that a detailed review of the Mindarie Keys Project was undertaken prior to October 1987. Both of them assert that detailed valuations, market demand studies and financial analysis, were undertaken.() Mr Reichert submitted that:
"Management had the necessary expertise (Beneficial had been a land developer for many years) and where deficiencies in skills were identified, the required internal and external appointments were made."
Notwithstanding the assertions by key senior management, on the evidence available to me I am of the opinion that Beneficial Finance did not undertake an adequate review or feasibility study of the Mindarie Keys development, or of the functions of Beneficial Finance as a joint venture participant and as a financier.
I have made specific requests to Beneficial Finance for the production of management files and documents relating to any financial analysis undertaken by Beneficial Finance concerning the Mindarie Keys project.() Despite searches by current officers of Beneficial Finance, no such documents were located. Mr Baker's evidence to me was that Beneficial Finance did not conduct any feasibility studies.() While I accept that Beneficial Finance did undertake a limited review of the Mindarie Keys project, I consider that those reviews were inadequate for a project of the size and complexity of Mindarie Keys. Three examples demonstrate this point.
First, Beneficial Finance relied upon Smith Corporation's financial projections when preparing its own analysis. Those projections were not based on specifications required by the State Agreement. There was no effective challenge to Smith Corporation's financial projections, which changed frequently. No adequate sensitivity studies were conducted by Beneficial Finance to determine how the profitability of the project might be affected by a range of foreseeable external factors.
Secondly, in assessing the viability of the project, Beneficial Finance, in my opinion, accorded inappropriate emphasis to the valuations of the completed development. Those valuations were supported by market research demonstrating future demand for residential allotments in the Perth metropolitan areas.() Despite a recommendation by Peet & Co that consultant engineers be engaged to verify construction costs, Beneficial Finance did not engage independent engineers or quantity surveyors at that time. The first Stage of the project included extensive capital works, the cost of which was intended to be recouped over the entire development. Beneficial Finance did not give adequate consideration to the impact of the increased development costs of Stage 1 on the viability of the whole project.
Finally, there was a failure to conduct an adequate investigation of the resources and capacity of Smith Corporation as the joint venture manager. The only evidence of such an investigation is an internal memorandum from Mr Francks to Mr Martin, which reported the results of a two hour meeting with Smith Corporation executives. The memorandum summarised in two and a half pages Smith Corporation's business history and personnel(). There was no assessment of the abilities of Smith Corporation as project manager of an undertaking of the size and complexity of the Mindarie Key joint venture.
32.2.5.5 The Terms of the Joint Venture Agreement
A number of agreements were executed to constitute the joint venture and regulate its affairs, including the Joint Venture Agreement, Joint Venture Management Agreement, Put Option Agreement, and the Tricontinental Syndicated Loan Facility Agreement.() The Non-Executive Directors of Beneficial Finance did not have knowledge of the details of the agreements, and were entitled to rely on management to comply with, and to implement, the terms of the Board's approval to ensure that Beneficial Finance's position was adequately protected.
The main operating agreement was the Joint Venture Agreement, by which the participants agreed to form an unincorporated joint venture to develop Mindarie Keys in accordance with the State Agreement. The joint venture was not limited to Stage 1, but was stated to be for a period of fifteen years.
The Joint Venture Agreement was important for several reasons. It contained provisions regarding the ownership of joint venture assets, the liabilities of the joint venture participants, and their entitlement to profits, each of which was to be apportioned according to the participants' respective interest in the venture.
The Joint Venture Agreement also defined the joint venture management structure. Management of the joint venture was to be undertaken by Smith Corporation as the Joint Venture Manager, subject to the control and supervision of a Joint Venture Board of Management comprised of five members appointed by the participants and by the Joint Venture Manager. The representatives were entitled to exercise the following voting rights:
(a) Gumflower (Beneficial Finance) - two voting representatives
(b) Mindarie Investments (Entrad) - one voting representative
(c) Biddenham (Smith Corporation) - one voting representative
(d) The Joint Venture Manager (Smith Corporation) - one non-voting representative
Resolutions of the Board of Management could be passed by a simple majority of votes. If there was an equality of votes, the representatives of Entrad and Smith Corporation voting together were granted a deciding and casting vote, thereby overriding Beneficial Finance. In the event that Beneficial Finance exercised the put option at the end of year four of the joint venture, then the Chairman of the Board of Management was granted a casting vote. The representative of the Joint Venture Manager was designated as the Chairman of the Board of Management.
The Joint Venture Agreement made provision for the appointment, duties and removal of the Joint Venture Manager. The Agreement required Smith Corporation to be appointed as the Joint Venture Manager and its representative, Mr Smith, thereby became Chairman of the Board of Management. A separate Joint Venture Management Agreement appointed Smith Corporation as the Joint Venture Manager for a period of ten years. The Management Agreement provided that, as the Joint Venture Manager, Smith Corporation was, "subject to the directions from time to time of the Board of Management and in accordance with the program and approved budget",() responsible for the day to day management and control of the joint venture development, including banking, accounting, preparation of cash flows, budgets, the development program, and control of contracts.
The terms by which Smith Corporation was appointed as Joint Venture Manager and given responsibility for day to day management and administration of the project were a direct and obvious breach of the stipulations of the Beneficial Finance Board of Directors that the joint venture accounting was to be controlled by Beneficial Finance or by Price Waterhouse, and that cheque payments were to be controlled by Beneficial Finance.() Far from being "performed" by Beneficial Finance as stipulated in Beneficial Finance's letter dated 8 January 1987, or "controlled" by Beneficial Finance as required by the Board of Directors, the accounting and administration functions were to be performed and controlled by Smith Corporation.
The Management Agreement specified the following fees payable to Smith Corporation as the Joint Venture Manager:
(a) An annual administration fee of $0.1M per annum;
(b) An initial development fee equal to 5 per cent of the estimated gross sales value of Stage 1;
(c) A development fee equal to 5 per cent of the estimated value of each subsequent stage;
(d) A building supervisory fee of 3 per cent of the value of any building forming part of the development; and
(e) A sale fee equal to 5 per cent of the sale price of any portion of the development.
The fees and commissions payable to Smith Corporation were the subject of comment in a report of an internal audit conducted by Beneficial Finance in June 1989.() The report noted while it had been estimated in March 1987 that Smith Corporation would receive total management fees of $26.1M over the twelve year life of the project, projections made in April 1989 suggested the management fees for the period would actually be $39.5M.
The joint venture management fees and sales commission payable to Smith Corporation were payable in priority to other forms of distribution to the joint venture participants, and were to be deducted from gross revenue prior to deductions for development costs, and prior to any distribution of net profit.()
The Joint Venture Agreement limited the participants' rights to terminate the appointment of Smith Corporation as manager. A decision or resolution to terminate the Joint Venture Manager's appointment was required to be passed by a three quarter majority of votes of the Board of Management, and might have been subject to a substantial financial penalty.() When Entrad defaulted in the performance of its financial obligations in December 1989, it lost its entitlement to vote at any meeting of the Board of Management.() This had the effect of altering the ratio of the voting rights of the two remaining members of the Board of Management. Although Beneficial Finance had two of the three remaining voting members of the Board of Management, it could not, without Entrad's support, achieve the three quarters majority required by the Joint Venture Agreement to terminate Smith Corporation's appointment as manager. The termination clause therefore became ineffective, and the joint venture agreements did not contain any alternative arrangements.
32.2.5.6 Documentation of the Joint Venture Agreements
A condition of Beneficial Finance's participation in the joint venture, stipulated in its letter dated 8 January 1987, was that all legal documentation was to be prepared by "Beneficial solicitors". Beneficial Finance had the "right not to proceed with documentation and the contents thereof if not satisfactorily agreed between the parties."
The joint venture agreements were in fact prepared by Smith Corporation's solicitors, Robinson Cox. Within Beneficial Finance, Mr Reichert and Mr Martin, the executives responsible for the oversight of Beneficial Finance's participation in the joint venture, instructed Mr G J Yelland, Beneficial Finance's Legal Officer, to provide advice on, and to settle the terms and conditions of, the joint venture agreements.
In March 1987, Mr Yelland provided a preliminary review and advice of the legal structure and documentation required for the joint venture.() Mr Yelland's advice identified the necessity to protect Beneficial Finance's interests, including the need for provisions regarding the assignment of joint venture interests, management committee voting entitlements, defaults, termination and accounting.
The evidence of Beneficial Finance's Management disclosed a disagreement as to the responsibility for the content of the joint venture agreements, and their compliance with the terms and conditions of the approvals of the Beneficial Finance Board.() Mr Reichert and Mr Martin() acknowledged that they were responsible for providing instructions to Mr Yelland concerning the terms and conditions of the joint venture. They both assert, however, that Mr Yelland, as Beneficial Finance's in-house solicitor, was responsible for ensuring that the agreements contained adequate protection of Beneficial Finance's interests, and complied with the Board directions. Mr Reichert said:
"... I am not going to pretend to be a lawyer, nor would I expect a lawyer to pretend to be a commercial expert on matters. I certainly would expect my people ... to review the document and make comments, and I believe Mr Martin and Mr Francks were involved in that regard.
As to the ultimate acceptability of the document or otherwise, I believe it is a lawyer who has got to be satisfied, based on the commercial reading of it by the other parties, that Beneficial's interests are adequately protected." ()
Beneficial Finance's legal officer, Mr Yelland, stated however that he was an employee subject to the control of Mr Reichert and Mr Martin, and that he acted on their instructions. He said that his primary function as Beneficial Finance's solicitor was to ensure that the joint venture arrangements did not breach the terms of the Beneficial Finance debenture trust deeds. For example, Mr Yelland was responsible for ensuring that the off-balance sheet companies Namtok and Gumflower were properly established as part of the Kabani structure.
Mr Yelland submitted that the principal terms and conditions of the Joint Venture Agreement and Joint Venture Management Agreement were commercial issues decided by Mr Reichert and Mr Martin, and that he was required only to ensure that the agreements properly reflected the commercial terms agreed between the parties. He was not required to provide advice on the sufficiency of what was agreed, or to ensure that the terms complied with the approvals of the Beneficial Finance Board.() In my opinion, Mr Yelland's submission is contradicted by the nature of his advice in March 1987, and by his obligations as Beneficial Finance's assistant company secretary and solicitor.
During the period from March 1987 to December 1987, Mr Yelland was engaged in reviewing and settling all of the joint venture agreements. Given the complexity of those agreements, it would have been prudent, particularly if Mr Yelland's submission is accepted, for Beneficial Finance to engage appropriately qualified and experienced external solicitors to prepare the joint venture agreements, and to advise Beneficial Finance with respect to the adequacy of the terms and conditions of those agreements. Instead, Mr Yelland continued to act as Beneficial Finance's solicitor.
Mr Yelland was, in my opinion, bound by the usual professional obligations of a legal adviser to Beneficial Finance. As a qualified legal practitioner, Mr Yelland had an obligation to ensure that he had adequate instructions to discharge the responsibilities imposed upon him. As Beneficial Finance's in-house solicitor and assistant company secretary, he had a further duty to exercise the care and diligence expected of a lawyer in ensuring that the joint venture agreements both adequately protected Beneficial Finance's interests, and complied with the terms of the approval granted by the Beneficial Finance Board. In my opinion, Mr Yelland failed to perform those duties.
The consequences of the failure to prepare adequate joint venture agreements were compounded by the failure of the Beneficial Finance Management to review and assess the terms and conditions of the joint venture agreements before they were signed. I am satisfied that Mr Reichert, Mr Martin, and Mr Yelland had ample opportunity to ensure that the joint venture agreements complied with the conditions of the Beneficial Finance Board approval, but failed to do so.
The failure to ensure that the joint venture agreements complied with the terms and conditions of approval is a manifestation of the lack of any established or effective settlement procedures for transactions of this type. There were no policies or guidelines by which the Corporate Services division was required to undertake an independent review of the transaction before settlement to ensure that all the terms and conditions of approval had been complied with.
In my opinion, the submissions of Mr Baker, Mr Reichert, Mr Martin and Mr Yelland as to the function of the Legal Services division demonstrate a lack of definition within the members of senior management as to their respective functions. The Mindarie Keys project was a complex commercial and financial transaction. There were no policies, and insufficient safeguards, in place to ensure that the Legal Services division was independent from Management.
32.2.6 SUMMARY AND CONCLUSIONS
In my opinion, there are a number of serious deficiencies in the processes by which Beneficial Finance became committed to the Mindarie Keys joint venture.
There was a misunderstanding by the Board of Directors of the status of Beneficial Finance's evaluation of the Mindarie Keys project in December 1986, when the Board approved Beneficial Finance's participation in the venture. The Non-Executive Directors told my Investigation that they believed that a detailed evaluation and feasibility study had been carried out at that time, but that belief appears to have been based on little more than an assumption. Had they asked Mr Reichert or Mr Martin, the Non-Executive Directors would have been told that such an evaluation had yet to be done, and that Beneficial Finance's participation would be conditional upon a satisfactory valuation and feasibility study being performed.
The credit submission having been approved by the Board of Directors, Management commenced the task of evaluating the project, and negotiating the details of Beneficial Finance's participation. That process took nine months, and the outcome was far from satisfactory from Beneficial Finance's point of view.
The evaluation of the project by Beneficial Finance's Management was, in my opinion, far from adequate. Although some work was done, it was such that Mr Baker said in evidence that no feasibility study was undertaken. No adequate sensitivity analyses were performed by Beneficial Finance, and reliance was placed upon projections prepared by Smith Corporation without any adequate evaluation of Smith Corporation's ability to successfully bring the project to fruition. Inappropriate reliance was placed by Beneficial Finance upon valuations of the land, with inadequate consideration of the costs and risks of the development. In my opinion, the failure of Beneficial Finance to undertake an adequate feasibility study of the project amounted to a failure by Mr Reichert and Mr Martin to exercise proper care and diligence in the performance of their duties.
In the absence of a detailed feasibility study, Beneficial Finance was particularly reliant upon the guaranteed take-out provided by Entrad in the form of the put option, and yet the value of the put option was substantially reduced by changes after January 1987. From being a commitment from an apparently substantial public company to buy Beneficial Finance's interest, the put option was reduced to an arrangement that enabled Beneficial Finance to convert its equity interest into loans to Entrad and Smith Corporation, repayable at least eight years after the joint venture was established.
Further, the terms of the joint venture agreements placed the effective control of the joint venture in the hands of Smith Corporation. As Joint Venture Manager, Smith Corporation was granted effective control over the day to day operations of the project, in direct contravention of conditions laid down by Beneficial Finance's Board of Directors, and by Management in the letter to Smith Corporation dated 8 January 1987. The agreements provided potentially lucrative fees for Smith Corporation, and did not provide a practical mechanism for its replacement as Joint Venture Manager. In my opinion, Mr Reichert and Mr Yelland failed to exercise proper care and diligence in respect of the terms of the joint venture agreements, in that they failed to ensure that the interests of Beneficial Finance were adequately protected.
There were, as well, significant changes to the projected costs of Stage 1 of the project. The total cost of Stage 1 increased from $28.0M to $38.0M, excluding the cost of the land. The third party finance increased from the projected $20.0M to $33.0M. Although that debt was non-recourse to the joint venture parties, the significant increase in the projected development cost and debt would clearly require a reappraisal of the economics of the project from any evaluation undertaken before December 1986.
Beneficial Finance's Board of Directors were aware of the changes in the projected cost and financing of the project, and approved the changes to the put option.
In my opinion, the changes which occurred during the period from December 1986 to July 1987 to the budget, finance, and security arrangements of the joint venture, constituted a major variation of the terms of the joint venture from those approved in December 1986. Given these changes, and the nine month period that elapsed from the time of the Board's approval until the joint venture agreements were executed, a consolidated re-statement of the revised joint venture arrangements should have been referred to the Beneficial Finance Board by Management for re-assessment before the agreements were signed.
Several issues should have been apparent to the Beneficial Finance Board in considering those submissions that were presented to it. There was, for example, a changing relationship between the joint venture parties. Entrad was in effect withdrawing its support, with Smith Corporation being introduced to replace Entrad's obligations without necessarily having the financial resources to do so. There was clearly a change of security arrangements, and a necessity for Beneficial Finance to assess the value of a second mortgage security which had the effect of downgrading its other security arrangements if enforced. Most importantly, the 35 per cent increase in the cost of developing Stage 1 (excluding the cost of the land) required a assessment of the viability of the project, and of the risks and returns to Beneficial Finance, upon which the Board's approval in December 1986 had been based.
32.2.7 A REVIEW BY BENEFICIAL FINANCE OF THE ESTABLISHMENT OF THE FACILITY
In September 1990, the Management of Beneficial Finance prepared a report titled "Lessons Learned from Problem Loans", and provided the report to the Board of Directors. The report included the results of a review of ten problem loans, including the Mindarie Keys facility, and identified "the major elements of weakness" evident in the ten problem loans. The report stated:
"The indicators, whilst by no means exhaustive, clearly demonstrate where we went wrong in each relationship. Whilst there is a degree of subjectivity in this identification process, it is evidence that had we paid greater heed to the fundamentals of analysis and critical evaluation, many of these problems may have been avoided."
The review identified the following matters as major weaknesses in the initiation, approval, and establishment, of Mindarie Keys facility:
(a) Inadequate quantitative and financial analysis of the project.
(b) An "unquestioning willingness to approve" the facility.
(c) Inadequate critical analysis of the project.
(d) The focus on the potentially high rewards from participation in the project.
(e) Attraction to the project as a "big ticket deal".
(f) Reliance on security as a primary determinant of the decision to participate in the project.
(g) An over-reliance on the continuation of favourable economic conditions.
(h) Substandard and/or inexpert sponsors of the project.
(i) Documentation of the facility "skewed" in favour of the client.
(j) A lack of monitoring "triggers" in respect of the performance of the facility.
(k) Beneficial Finance's lack of previous experience with similar projects.
As described above, my Investigation has confirmed most of the weaknesses identified by Beneficial Finance's own internal review of the facility.
32.3 MANAGEMENT OF THE FACILITY
32.3.1 OCTOBER 1987 TO DECEMBER 1988
Preliminary development work commenced almost immediately after the execution of the joint venture agreements in October 1987. On 2 December 1987, the sale of the Mindarie Keys land by Smith Corporation to Biddenham, Gumflower and Mindarie Investments as tenants in common was completed. Beneficial Finance advanced $2.5M as a loan to the joint venture.
During the latter part of 1987 and in early 1988, Smith Corporation, as the Joint Venture Manager, prepared revised budgets and cash flows, and sought tenders for the major civil construction works associated with the development, including the construction of the harbour, breakwater and marina. Each of those items was presented to the Board of Management for approval, and construction commenced in February 1988.
By 30 June 1988, some six months after the commencement of the project, problems began to emerge. Cost over-runs were estimated to be $3.43M. The monthly reports presented by Smith Corporation to the Board of Management neither adequately explained the reasons for the cost overruns, nor identified their impact on the development budget, the cash flow requirements of the joint venture, or the projected profits.
The development cost overruns were apparently off-set by better than budgeted sale prices reported by Smith Corporation for some residential allotments. The residential allotments in Stage 1 were released for sale on 1 August 1988, before completion of the construction of the breakwater, harbour, marina and hotel. These were mainly higher priced allotments adjoining the marina, listed for sale at prices in excess of $0.1M Almost two months after the release of Stage 1, the Beneficial Finance Board Minutes noted the sale of sixty one residential allotments for a total of $5.1M, including five pending contracts valued at $0.5M. This represented an average sale price of approximately $83,600 per allotment.()
After the initial sales of allotments priced between $50,000 and $100,000 reported by Smith Corporation, the Joint Venture Board of Management decided to accelerate the development program and to release additional stages according to the following schedule:
Stage |
Number |
Release |
|
1 |
22 Residential |
August 1988 |
|
10 Commercial |
||
|
20 Unit |
||
|
2A |
49 Residential |
October 1988 |
|
Marina Precinct |
21 |
December 1988 |
|
Peninsula Precinct |
22 |
December 1988 |
|
3A |
213 Residential |
January 1989 |
|
3B |
74 Residential |
February 1989 |
|
2B |
108 Residential |
Late 1989 |
|
4 |
300 Residential |
May 1990 |
|
5 |
109 Residential |
June 1990 |
In September 1988, however, Beneficial Finance management identified inconsistencies in the sales reported by Smith Corporation. An internal memorandum noted that of sixty five reported sales, contracts had been exchanged on only twenty two, valued at about $1.7M. The remainder were, it was reported, best described as expressions of interest.() By November, sales had decreased to about six allotments per month.
Many of the unsold allotments in Stages 1 and 2A were priced in excess of $0.1M, and experienced buyer resistance.() The decision to accelerate the development programme was based on then current expectations about the demand for vacant allotments in the Perth market. The timing of the various stages was intended to ensure that there were adequate allotments available in a broad price range. Stage 3 was intended to cater for the lower priced bracket, with a price range of $58,000 to $90,000 and an average price of $70,000. Those prices were, however, above those of the original project estimates, and were higher than those available at the nearby Quinns Rock development, which was also being developed by Smith Corporation.
The Marina Precinct comprised twenty one allotments with a price range of $0.14M to $0.3M. The Peninsular Precinct comprised twenty two allotments with a price range of $0.35M to $1.4M. Mindarie Keys was marketed towards second and third home buyers. The prices of allotments were significantly higher than the price range within which the strongest demand existed. The decision to accelerate the development programme had the effect not only of increasing expenditure, but also increasing the stock of unsold allotments, especially the higher priced allotments. ()
In September 1988, Beneficial Finance agreed to finance the purchase of a luxury motor cruiser by the joint venture at a cost of $0.82M, thereby increasing its loan exposure to the joint venture by a similar amount, and by fifty per cent of the projected operating cost of approximately $82,000 per annum.() The credit submission was approved by Beneficial Finance Management in Adelaide without reference to the Board of Directors.
Increases in expenditure for items such as the cruiser, a $48,500 grand piano, sponsorship of a powerboat race and the increased level of fitout for the Mindarie Keys Hotel were justified on the basis of "intangible benefits", including increased hotel accommodation rates, increased bar and food sales, and an increase in the number of visitors to the development, all likely to result in increased land sales.()
Monthly reports prepared by Smith Corporation in its capacity as the joint venture manager were submitted to the joint venture Board of Management. The reports provided information regarding the day-to-day activities of the project, and the obligations of the joint venture participants. In my opinion, the presentation of the financial information in the reports was inadequate. It did not provide a clear and consistent picture of the performance of the joint venture, and failed to adequately address problems experienced by the project as the development progressed, including cost overruns, under-budget sales, increasing losses and cash flow deficiencies.
Smith Corporation, as the Joint Venture Manager, was reluctant to accept criticisms concerning budget overruns and sales performance. It contended that sales and income were substantially in excess of the original budget.() Beneficial Finance's Management were also inclined to justify the performance of the project by comparison with the original development budget prepared in March 1987. In my opinion, it was inappropriate for Beneficial Finance's management to compare the sales and income which resulted from a revised or accelerated development program with the projected income in the original budget. The real issue was whether the revised sales conformed with the expectations upon which the decision to accelerate development was based and budgeted.
Beneficial Finance's representatives on the Joint Venture Board of Management were subject to eleven changes during the period October 1987 to February 1991. The lack of continuity of Beneficial Finance representatives may have contributed to a failure to develop effective strategies to manage and protect Beneficial Finance's interests as a joint venture participant and financier.
The developing problems associated with the Mindarie Keys development were summarised by Mr A Scott, Beneficial Finance Project Manager, in an internal memorandum dated 8 December 1988, written in anticipation of a submission for additional funding of $6.0M.() Mr Scott's memorandum was critical of several aspects of the development, including construction cost overruns, reduced land sales and budget shortfalls. According to Mr Scott, budgeted sales of allotments did not appear to be achievable. Based on current sales levels of six lots per month, Mr Scott projected a shortfall against budget for the period to 30 June 1989 of $17.5M. Even based on sales of fifteen lots per month, he projected a shortfall of $12.0M. Further, Mr Scott alleged that sales of lower-priced lots were being lost to Smith Corporation's adjoining development at Quinns Rock. When these factors were combined with the accelerated development program and the slow sales of higher-priced lots at Mindarie Keys, the result was a stockpile of residential allotments and high debt levels.
One of the main concerns expressed in Mr Scott's memorandum was the reliability of Smith Corporation's monthly reports to the Board of Management. The November 1988 report projected a $7.8M net shortfall of income against costs for the period from December 1987 to June 1989. Mr Scott's report identified unfavourable budget revisions for the period from August 1988 to November 1988 of $13.0M, including $11.0M due to increased anticipated costs. Part of the increase was no doubt due to the accelerated development program. The monthly reports to the Board of Management did not, however, differentiate between cost overruns and accelerated development costs.
In response to Mr Scott's memorandum, Mr Reichert and Mr F Piovesan flew to Perth on 10 December 1988 and met with Mr Smith and Mr A R Carr, the Corporate Finance Manager of Smith Corporation, to discuss the issues referred to in Mr Scott's memorandum.
The meeting recognised that due to changes in the scope and timing of the Mindarie Keys project which had altered expenditure and income projections, the budget approved in March 1987 was no longer adequate. In addition, Smith Corporation's practice of making monthly variations to that budget to reflect actual income and expenditure was unacceptable, since it meant that the monthly budgets did not provide an accurate measure of either past or current performance against budget, or of future projections.
Mr Piovesan said in his submission to my Investigation that the concerns raised in Mr Scott's memorandum were addressed at the meeting, and resolved to his and Mr Reichert's satisfaction. Their main concern was to ensure a continuing supply of medium priced allotments, which had been projected to have the strongest market demand.
Mr Reichert and Mr Piovesan were aware of doubts about the reliability of budgets, projections and sales reports prepared by Smith Corporation. Despite those doubts the meeting agreed, without Entrad's participation, to adopt the revised December 1988 budget prepared by Smith Corporation to replace that approved in March 1987.
No evidence has been found by my Investigation of the basis upon which the December 1988 budget was prepared. The Joint Venture Agreement required the joint venture Board of Management to approve project budgets. It would have been reasonable to have expected each of the joint venture participants to have participated in the preparation of the budget, and to have undertaken their own independent analysis of the revised budget.
Mr Piovesan has told my Investigation that Beneficial Finance did not undertake an independent analysis of the December 1988 budget. There was, for example, no analysis of project expenditure and income. Having regard to the concerns raised in Mr Scott's memorandum, I would have thought that such an analysis was essential. Furthermore, there was no analysis by Beneficial Finance of changes to the financial risks and returns associated with the project as a result of the revised budget. In my opinion, the adoption of the December 1988 budget did not resolve the substantive issues referred to in Mr Scott's memorandum, nor address the cause or the allocation of past budget overruns. Those matters required a detailed analysis of the fundamental assumptions upon which the viability of this project was being assessed.
The new project budget was the subject of a memorandum dated 22 December 1988 from Mr Francks to Mr Piovesan. The memorandum reported on the joint venture Board of Management meeting held on 14 December 1988, at which Entrad expressed concern about the "budget blow-out ", and what appeared to be Smith Corporation's development of the project without reference to the other joint venture participants. The revised project budget had been the subject of a short discussion at the meeting, as a result of which Entrad agreed to review the budget. In particular, Mr Francks reported that:
"I indicated that they had been reviewed by Eric (Reichert) and yourself (Mr Piovesan) and that you were happy with them".
However, on a copy of Mr Francks memorandum, Mr Reichert wrote the following note to Mr Piovesan on 29 December 1988:
"Frank Piovesan
If we do not see a marked improvement as evidenced by performance in line with projections we should meet with Entrad as soon as possible.
Eric Reichert 29/12 "
On 30 December 1988, a credit submission was sent to the directors seeking approval for additional advances to the joint venture. The submission sought finance for two new facilities which were subsequently referred to by Beneficial Finance as "Facility A" and "Facility B".
"Facility A" comprised:
(a) a cash advance of $4.9M, including $0.45M of capitalised interest, to fund the accelerated development program "to ensure the potential of the current high level of market demand for land is fully utilised over the next 18 months" (); and
(b) a $1.5M guarantee to provide bonds to local statutory authorities to enable the early release of Certificates of Title for residential allotments.
Security for Facility A included an unregistered second mortgage over the Mindarie Keys land and a guarantee from Mindarie Keys Resort Hotel Pty Ltd, a company wholly owned by the joint venture participants. The facility was to be repaid by re-drawing the Tricontinental facility to an amount of $33.0M. If there were insufficient sales of allotments to obtain Tricontinental's consent to re-draw the loan, then Facility A was to be repaid from the sale proceeds of other stages, in which case the unregistered mortgage would be registered as a second mortgage, and the existing second mortgage of Beneficial Finance and Entrad would become a third mortgage.
Facility B was a development loan facility of $5.6M, including capitalised interest. Its purpose was to obtain a partial release of the Tricontinental mortgage to the extent of $2.0M, and to provide development funding for Stage 2B comprising 108 residential units. The security for Facility B included a registered first mortgage over Stage 2B, and a guarantee from Mindarie Keys Resort Hotel Pty Ltd.
The Mindarie Keys project was subject to a first mortgage to Tricontinental that entitled it to receive the net revenue from all allotment sales. Beneficial Finance and Entrad both had second mortgages over the project to secure their respective loans to the joint venture. Those second mortgages ranked equally. The development of each stage of the project required special arrangements between Tricontinental, Beneficial Finance and Entrad as to the rankings of securities and the repayment of advances.
The credit submission was presented to the directors with a covering letter from Mr Reichert, which provided an overview of the joint venture development to date, and included the following comments:
"Original term of the project was twelve years, however due to the acceleration of development, which has been driven by market demand, term will now reduce to around 8 years. ...
The original estimate of profit to be realised on this project if Beneficial Finance did not exercise the put option was $27.0M over twelve years. However, this has now been revised up to $40.0M over eight years due to increased lot prices resulting from the improved market."
Neither Mr Reichert's letter nor the credit submission brought to the attention of the Board of Directors the problems that had been encountered with the performance of Smith Corporation as the Joint Venture Manager, and the limitations upon the ability of Beneficial Finance to exercise effective control. This was, in my opinion, a serious deficiency, since it meant that the Board was being asked to approve additional funding for the venture without being made aware of the serious problems that existed in monitoring and controlling the development. That was important information, directly relevant to the decision, and should have been given to the Directors.
Mr Reichert's letter and the credit submission were distributed to members of the Beneficial Finance Board individually on 30 December 1988. There was not a formal meeting of the Board. Each of the board members was telephoned to obtain approval of the proposal. There was no opportunity for discussion, and board members were entirely dependent upon the written material distributed to them. The Beneficial Finance Board() approved the credit submission subject to monthly sales reports being provided to Mr Matthews and Mr Studdy to ensure adequate progress of sales of higher-priced lots.
32.3.2 JANUARY 1989 TO DECEMBER 1989
Throughout the following year, Beneficial Finance management had continuing concerns about several aspects of the development. The opening of the Mindarie Keys hotel in May 1989 caused additional financial problems. The hotel was a joint venture asset that was intended to be the focal point of the Mindarie Keys Marina development. There is substantial evidence that the hotel was one of the primary causes of cost overruns and operating losses. The original budgeted cost of the hotel was $6.7M. In March 1988, the Board of Management approved an increase in costs to $7.7M. The final cost of the hotel and associated shops, including fit-out, was $12.9M,() compared with a valuation of only $6.88M().
Management of the Mindarie Keys hotel was undertaken by Smith Corporation despite the fact that it had no prior experience as hotel manager. Smith Corporation's appointment as the hotel manager removed control and supervision of the hotel operation from the joint venture Board of Management, and from Beneficial Finance.
After the opening of the Mindarie Keys hotel, operational problems became apparent. The hotel was perceived to be poorly designed. For example, although it had only seventeen accommodation units, it was staffed by more than 230 full and part-time staff. The hotel suffered from poor mid-week patronage, and operated at a substantial loss.
A report regarding the hotel operations prepared by independent consultants, Brookes Laughton in May 1990 supports the conclusion that the losses accruing from the hotel operation were due to the failure of the joint venture to undertake an adequate feasibility study of the hotel as a stand-alone business, and to construct a more appropriate facility. The hotel was located in an isolated new development area without any surrounding established residential areas to support trade. Beneficial Finance, by its representatives on the Joint Venture Board of Management, approved increased construction costs without adequate financial information concerning the viability of the hotel or the impact of its operating costs on the joint venture finances.
In June 1989, an Internal Audit Report was prepared by Mr K Sedun, auditor of Beneficial Finance's Investment Banking division, concerning Beneficial Finance's participation in the Mindarie Keys joint venture.() The Report was submitted to Mr Mudge, Mr Martin and Mr Baker, and copies were distributed to other senior Beneficial Finance management.() The Audit Report contained several substantial criticisms of Beneficial Finance's participation in the joint venture.
The Report challenged the critical assumption that the Mindarie Keys development was a unique project, noting that there were competing projects in the area which could service the anticipated market for the Mindarie Keys land. The Report also challenged the assumptions concerning the use of the put option as security for Beneficial Finance's investment, stating:
"With the put option in place, the project is operating primarily as a finance deal, not an equity investment. As such, the Mindarie Keys project is effectively being developed outside of firm Beneficial control." ()
Beneficial Finance's lack of control over the management and finances of the joint venture was apparent. There was, according to the Audit Report, a lack of sufficient information about the joint venture activities to enable Beneficial Finance to adequately assess the performance of the joint venture, and the reason for cost overruns. For example, it was not possible to determine if the $4.5M advanced as part of Facility A for accelerated work was in fact used for that purpose. The report also noted that the anticipated control arising from Beneficial Finance acting as a co-signatory to cheques was not being achieved because of the lack of proper budgets and forecasts, which meant that it was unable to check expenditure against budgets.
The Audit Report rated the project as "satisfactory" only in respect of limited audit criteria such as the registration of security, and the documentation of procedures. It was distributed widely amongst Beneficial Finance management, and was sent to Beneficial Finance's external auditors, Price Waterhouse.
A summary of the Audit Report was presented to the Beneficial Finance Board of Directors on 28 July 1989, as part of the quarterly internal audit reporting to the Board.() The Board report contained a concise summary of the problems affecting the Mindarie Keys Project identified by the Audit Report:
"The documentation which granted Beneficial a put option guaranteeing a return of 30% on equity over 5 years if exercised also appointed Smith Corporation as the joint venture manager with extensive rights to develop the project. With this put option in place, the project is operating as a finance deal rather than an equity investment. As such, the project is effectively being developed outside of firm Beneficial control. The overall cost increases to 30 June 1989 are estimated to be $23M, a 38% increase over the December 1987 budget. Detailed cost reporting from the project managers (Smith Corporation) have not been in sufficient detail to allow us to determine whether the significant additional expenditures are due to either accelerated development, project scope changes or cost overruns. While sales revenue is also well ahead of the December 1987 budget, a recommendation was accepted for more meaningful information on project expenditure and detailed cost to be obtained and provided to senior management." ()
In my opinion, the issues summarised in the report put the Board on notice of the substantial problems associated with the Mindarie Keys development and joint venture finances. In their submission to me, the Non-Executive Directors said that when the audit report was presented to the Board, they were assured by Management that any problems uncovered would be attended to, and that further information on project expenditure and detailed costs would be obtained. Having received those assurances, the Beneficial Finance Board was not later advised that the problems remained unresolved.()
This information, nonetheless, placed the Beneficial Finance Board in the position of being aware of matters that were material to the proper management of the project. I accept that the Board was provided with certain information and assurances by Management. In my opinion, however, the matters raised were, of sufficient importance to require some follow-up by the Board. I have found no evidence that it did so.
Before the submission of the Internal Auditor's Report to the Board, Mr Reichert had received other information which identified the problems referred to in the Report. On 28 April 1989, the Investment Banking division had presented a memorandum to the Credit Committee which stated that Smith Corporation had requested, on behalf of the joint venture, that Beneficial Finance extend Facility A for a period of twelve months to 26 July 1990. Mr Reichert made the following hand written note on a copy of that memorandum:
"Frank Piovesan
Before approving, I would like to see a detailed breakdown of sales by months by Smith's Quinns Rock Project and would like to see him put on notice that the trigger point also precipitated a review of management responsibilities. I am not convinced that the analysis of sales is other than "broad brush" statements - what corrective actions have been taken such as low interest loans to stimulate demand? Should we drop prices by 25 to 33% (would cramp his other project)? Please prepare a report with Rod Hare following the May meeting and discuss with Gary [Martin] and I the following week.
Erich 29/4" ()
Despite those concerns, Mr Reichert disputed the internal auditor's rating and comments contained in the Report, and in the summary presented to the Beneficial Finance Board. Mr Reichert asserted in a memorandum to Mr Sedun that the auditor's comments did not fairly reflect the management of the transaction, and were made without a full and proper assessment of the project and the likely benefit to Beneficial Finance.() Mr Reichert did, however, recognise the inadequate control and protection which Beneficial Finance had in the administration of the project:
"... we must take into account substantial management rights in line with our approval vested in Smith Corporation under the various agreements. The extent of these rights cannot be changed but will not be repeated in any similar facilities in the future. This is a matter of learning from experience ...
In summary, I am personally very satisfied with the success of the project to date albeit I would prefer to have greater management control in the documentation. The audit does not reflect the actual results nor the implications of the contracted management responsibilities." ()
Although Mr Reichert continued to receive information that the performance of the joint venture was unsatisfactory, Beneficial Finance's response was both slow, and limited. Attempts by Beneficial Finance's representatives on the Joint Venture Board of Management to exercise more control over the joint venture activities and the Joint Venture Manager were limited by the terms of the Joint Venture Agreements, which did not contain adequate protection of Beneficial Finance's interests. The concerns expressed in the Internal Audit Report were subsequently vindicated. Beneficial Finance had to overcome complex legal issues to obtain control of the management of the joint venture, delaying the implementation of adequate remedial action.
By November 1989, several issues of conflict existed between the joint venture participants and Smith Corporation as Manager of both the joint venture and the Mindarie Keys hotel. In particular, difficulties had emerged concerning the ability or willingness of the joint venture participants to make additional capital contributions to the projected operating deficit.
In the absence of capital contributions, Smith Corporation paid $0.63M in loan funds into the joint venture. Smith Corporation also agreed to purchase one of the development stages from the joint venture for an amount of $3.8M, and to release the sum of $0.95M paid by it as a deposit for that stage to the joint venture for working capital requirements.
On 21 November 1989, following what Mr Reichert described to my Investigation as "incessant questioning and pressure by Beneficial Finance Management", Mr Smith submitted his resignation as Chairman of the Joint Venture Board of Management(). Copies of Mr Smith's letter were widely distributed to senior executives of both Entrad and Beneficial Finance. Mr D W Simmons, Chairman of Beneficial Finance, and Mr T M Clark, a director of Beneficial Finance, also received copies. Mr Smith's resignation was subsequently withdrawn pending a meeting of the Board of Management in December 1989().
At the Board of Management meetings on 6 December 1989 and 20 December 1989, it was agreed that Mr Smith would continue as Chairman, subject to a complete review of the hotel operation, a "risk asset" review by Beneficial Finance of the joint venture, and to the preparation of a new project feasibility study and valuations.
In December 1989, the joint venture was projected to have a cash flow deficit for the period December 1989 to 28 February 1990 of $4.0M. Each of the joint venture participants was therefore required to make a pro-rata payment to cover the deficiency: Beneficial Finance $2.0M, Entrad $1.0M and Smith Corporation $1.0M.()
Entrad then advised both Beneficial Finance and Smith Corporation that it was unable to make its capital contribution of $1.0M to the deficit. Entrad requested Beneficial Finance to lend it sufficient funds to comply with its joint venture obligations and contributions up to June 1990. Beneficial Finance's contribution of $2.0M and Entrad's contribution of $1.0M were considered by Beneficial Finance to be "essential to the short-term viability of the project" ().
In my opinion, the events of 1989 provide a clear indication not only that the viability of the Mindarie Keys development was doubtful, but also that the operational and financial structure of the joint venture was inadequate. The very existence of the joint venture was threatened. Despite the warning signs, Beneficial Finance management still regarded the put option as effective security, and did not consider that Beneficial Finance was exposed to the risk of not getting the put option purchase price and interest. Beneficial Finance management still regarded both Entrad and Smith Corporation as having the apparent financial strength to perform their obligations under the put option, particularly when Beneficial Finance's second mortgages were taken into account. Based on then current allotment prices, Beneficial Finance management stated that the asset to security ratio was approximately 48 per cent, and that the net joint venture equity was at least $50.0M.() Acting on these assumptions, Beneficial Finance management made further submissions to the Board of Directors for additional advances to the joint venture participants.
32.3.3 JANUARY 1990 TO FEBRUARY 1991
In January 1990, Mr Reichert and Mr Hare presented a special submission seeking approval for new advances, and ratification of additional advances already made to Gumflower.() The submission provided a summary of the Mindarie Keys joint venture and of the facilities that had been provided by Beneficial Finance, and included a recent history addressing all the key issues associated with project management, including the inadequate level of land sales, the hotel/commercial complex performance, and future funding and working capital requirements. In particular, the submission explicitly drew to the attention of the Board the inadequate trading results, highlighted by the under-achievement of land sales, which were $5.17M below budget.
The submission reported that the meeting of obligations to creditors of the joint venture was being extended beyond normal credit terms to 90 days, and that $1.0M was required by 15 December 1989 to bring those creditors into line, including $0.6M for interest due to Tricontinental. In addition, a further $1.0M of interest was due to be paid to Tricontinental at the end of December 1989.
The issues referred to in the special submission were similar to those identified in June 1989 by the Internal Audit Report. Both were concerned with the inadequate control of project budgets and cashflows by the Joint Venture Manager. The Internal Audit Report constituted a warning to Beneficial Finance Board of potential problems. The resignation of Mr Smith as Chairman of the Board of Management, and the requirements for the advances requested in the special submission, were in effect a realisation of the problems referred to in the Internal Audit report.
Entrad's financial problems were by now fully disclosed to the Board. The special submission informed the Beneficial Finance Board that "Mindarie Investments (Entrad) had declared absolutely" its inability to contribute to any shortfalls in joint venture funding requirements. Despite this, the special submission recommended that Beneficial should make additional loans to Entrad to cover past and future contribution requirements up to June 1990.
The following is a summary of the loans that were the subject of the special submission:
For ratification:
(a) $0.95M loan by Gumflower (Beneficial Finance) to Mindarie Keys Joint Ventures during the period 15 December 1989 to 8 January 1990;
(b) $0.47M loan by Gumflower to the Mindarie Keys Joint Venture on behalf of Mindarie Investments (Entrad) during the period 15 December 1989 to 8 January 1990;
(c) $0.45M loan by Gumflower to the Mindarie Keys Joint Venture to enable the joint venture participants to meet interest payments to Tricontinental on 13 January 1990; and
(d) Extension of the term of the $4.95M facility (known as "Facility A") from 5 January 1989 to 30 June 1990. This facility was secured by a registered second ranking mortgage over the project and had priority for repayment over the further capital contributions and loans of the other participants.
For approval:
(e) Provision of a $0.074M loan by Gumflower to the Mindarie Keys Joint Venture to be secured by the put option;
(f) Provision of up to $1.0M as additional loans to the Mindarie Keys Joint Venture by Gumflower on behalf of Mindarie Investments secured by the put option; and
(g) Subordination of the repayment of the additional loans funds to Beneficial Finance's existing $4.95M working capital facility referred to in (d) above.
Security for each of the loans referred to in (a), (b) and (c) above was stated to be the put option exercisable by Beneficial Finance against Smith Corporation and Entrad. Despite mounting evidence to the contrary, Beneficial Finance Management continued to assert that the put option was capable of providing adequate security for any additional advances.() The special submission also sought approval from the Board for amendments to the put option to ensure that the moneys advanced and to be advanced to cover Entrad's past and future contributions would be protected and secured by the put option.
In my opinion, the value of the put option against Entrad as security for both 50 per cent of the original Beneficial Finance debt contribution to, and equity investment in, the joint venture (now $14.9M), and for the additional advances, was at least questionable at the date of the special submission. A realistic commercial assessment at this stage would have concluded that Entrad was incapable of performing its obligations pursuant to the put option, and that the additional loans to Entrad were being advanced without any security of substance.
The Beneficial Finance Board considered the special submission at its meeting on 26 January 1990. It recognised that it was likely that Entrad would withdraw from the joint venture, and was not prepared to approve the submission until a complete review of the Mindarie Keys project had been undertaken for presentation at the next Board meeting in February 1990. The Board resolved that the provision of further funds to the joint venture would be approved only if secured against the assets of the joint venture.() An updated report was presented to the Beneficial Finance Board in February 1990.()
During the period from January to April 1990, Beneficial Finance undertook a review of its participation in, and financing of, the Mindarie Keys joint venture. The evidence made available to me indicates that the review undertaken by Beneficial Finance at this stage was the first attempt to evaluate the problems associated with the joint venture in a co-ordinated manner, and the first attempt to properly assess Beneficial Finance's exposure. As a result of the review, Management recognised that the project had stalled, and that the put option to Entrad and Smith Corporation was valueless.()
In about March 1990, Beneficial Finance established an Asset Management division to provide and undertake specialist work out solutions for problem transactions. The Structured Finance and Projects division was disbanded, and Mr Reichert and Mr Martin reassigned to other duties within Beneficial Finance.()
A valuation of the Mindarie Keys land prepared by Jones Lang Wootton in March 1990 indicated a total value of $90.0M.() The valuation was predicated upon an orderly sale of the land over a period of from six to twelve months, and stated that in the event of a "forced sale", the value would be reduced by between 10 and 15 per cent.
In April 1990, the Beneficial Finance Board received a special report concerning the Mindarie Keys Joint Venture.() The report noted that the total advances by Beneficial Finance to the joint venture were $27.0M, secured by the put option and various first, second and third ranking mortgages. The total facilities from all financiers to the project were $85.35M, which had been drawn down to an amount of $76.55M.
As a result of the internal reviews undertaken by Beneficial Finance, proposals were formulated for:
(a) the refinancing of the Tricontinental facility of $33.0M plus interest at its maturity date on 31 December 1990;
(b) the purchase of Entrad's 25 per cent share in the joint venture; and
(c) the removal of Smith Corporation as the Joint Venture Manager.
The proposals were the subject of a Special Board Report dated 17 April 1990.() The report was presented to the April meeting of the Beneficial Finance Board, but consideration of the report was deferred until the next Board meeting to enable the preparation of an independent report by the Beneficial Finance Asset Management division.
The Asset Management division report was contained in a special submission dated 21 May 1990, which gave a concise and informative summary of the project, its background, the problems that had emerged, the feasibility of the project and the action which had been taken to date. The submission also summarised a strategy to enable Beneficial Finance to take effective control of the project and its management, with a view to its ongoing maintenance pending the marketing of the project as a whole.
The Beneficial Finance Board approved the proposed strategies and the recommended actions, with the exception of the recommendation that Beneficial Finance purchase Entrad's 25 per cent share of the joint venture.() The recommendation proposed a purchase price of "no more than $4.0M plus settlement of outstanding loan amounts (principal only)". The Beneficial Finance Board did not agree with the valuation placed on Entrad's shareholding.
In September 1990, a joint venture audit report stated that, as at 30 June 1990, the current liabilities of the joint venture exceeded current assets by $45.45M.() The Group Asset Management division monthly status reports for August, September and October noted that the value of the Mindarie Keys land could be as little as $65.0M.() The October report of the Group Asset Management division stated:
"Risk prognosis. Difficult to assess on the grounds that the value of such a unique project is not certain. No tentative interest is evident at the figure of $112.0M needed for all to get out intact, whilst a straight fire sale englobo could realise as little as $65.0M. Realistically it is unlikely that Beneficial will recoup 100 per cent of equity."
The November status report contained a revised fire sale value of $50.0M. The report stated that on that basis Beneficial Finance was unlikely to recoup either 100 per cent of its equity or 100 per cent of its debts without retail sales.()
Beneficial Finance provided ongoing funding to maintain its interest in the project,() and eventually acquired the interests of both Entrad and Smith Corporation in the joint venture, and removed Smith Corporation as the Joint Venture Manager.() Thereafter Beneficial Finance alone financed the Mindarie Keys development.
The refinancing of Beneficial Finance's existing and projected obligations as the 100 per cent owner of the Mindarie Keys development was the subject of a special submission to the Beneficial Finance Board in January 1991.() This submission requested approval for a maximum funding increment of $40.4M to repay the Tricontinental facility, and to pay other costs of the Mindarie Keys joint venture. Although the Tricontinental facility was non-recourse, there was a risk that Tricontinental would have sold the development as Mortgagee in Possession, with the result that Beneficial Finance may have received little, if any, repayment of its facilities. The repayment of the Tricontinental Facility was intended to give Beneficial Finance full and unencumbered ownership of the project. The special submission estimated that Beneficial Finance would have a total projected exposure to the Mindarie Keys development of $88.4M, against an estimated valuation of the project as at December 1990 of $72.2M.()
The special submission emphasised that, depending upon the negotiation of a settlement with the Tricontinental lending syndicate, the amount requested might not be required. It recommended that future control of negotiations with Tricontinental and decision-making concerning the development should be placed in the hands of Beneficial Finance Chief Manager in Perth, in conjunction with the Asset Management division.
The Board approved the request for additional funds in January 1991. Control of the $40.4M facility was delegated to the Beneficial Finance Asset Management division, with a requirement that it report directly to the Board.
32.3.4 SUMMARY AND CONCLUSIONS
The ability of Beneficial Finance to adequately monitor and control the operations of the joint venture was severely restricted by the terms of the Joint Venture Agreement, which gave Smith Corporation, as Joint Venture Manager, the responsibility for the conduct of the day to day activities of the venture. In practice, Beneficial Finance was largely reliant on Smith Corporation to perform its duties competently and diligently.
Even within that constraint, however, the Management of Beneficial Finance was far too slow to recognise the problems associated with Beneficial Finance's involvement in the venture, and to take action to address and remedy problems of which it was aware. As early as September 1988, Management identified serious deficiencies in the reports prepared by Smith Corporation, including overly optimistic statements of sales, inadequate identification of the source of cost over-runs, and inadequate budgeting practices.
There was a tendency for Management to dismiss expressions of concern, or at least not to act on them. In December 1988, Mr Reichert presented a submission to the Directors seeking approval for additional funding for the venture without informing the Directors of the problems associated with monitoring and controlling the project. An internal audit report in 1989, raising serious concerns regarding the project, was challenged by Mr Reichert, even though he was aware of the problems and had expressed concern himself.
A summary of the internal audit report was presented to the Board of Directors. Although the Directors were assured that the problems identified would be addressed, the matters raised by the report were, in my opinion, of sufficient gravity to require the Board to actively monitor what action was taken. It did not do so.
Indeed, further submissions were presented to the Board of Directors seeking approval for additional funding for the venture, and ratification of funding already provided. That approval was given.
The result was that Beneficial Finance's exposure to the joint venture continued to grow, despite the deterioration in the performance of the venture, and in the financial position of Entrad. Beneficial Finance's only security was second and third ranking mortgages, behind that of the Tricontinental syndicated facility. Although that facility was non-recourse to the joint venture parties, there was a real risk that Tricontinental would exercise its right to force the sale of the development to recover its own monies. Such a liquidation sale might have left Beneficial Finance with nothing. The failings of Beneficial Finance's management of its exposure inevitably obliged it to take over the project, repay Tricontinental, and begin a long-term work-out to maximise its recovery from the venture.
In his submission to my Investigation, Mr Reichert asserted, quite vigorously, that the Mindarie Key project will be a success. He wrote:
"I believe that it is totally inappropriate to assess the value of a project, and certainly one of the nature of Mindarie Keys, in the early stages of development and in the depths of the worst economic conditions in sixty years. To do so can only lead to inaccurate conclusions as are evident throughout the [Auditor-General's draft] report.
Due to the significant imbalance between supply and demand for land in the Perth metropolitan area, the project is still capable of, and likely to, producing a profit within the twelve year period stated in the initial submission. This particular belief was recently reinforced by a comment to me by a senior manager of the State Bank. As the general thrust of the report does not reach this conclusion, I challenge the level of analysis undertaken and request that reference be made to the expertise consulted to reach the conclusions."
and
"I still strongly assert that management undertook significant analysis, both before and after approval, at its own initiative and also in response to Board requests. Management had the necessary expertise (Beneficial Finance had been a land developer for many years) and where deficiencies in skills were identified the required internal and external appointments were made."
Mr Reichert's submission does not stand up against the other evidence before this Investigation. It is clear that the profitability of the project was always sensitive to a range of risks including, increases in development costs, construction delays causing increased holding costs, increased interest costs, delays in sales of properties and the failure to obtain projected prices for allotments sold. The long period of the project increased the uncertainty associated with these matters. The evidence is that, in the period subject to Investigation, which coincides largely with Mr Reichert's involvement in the project, everything that could go wrong did go wrong.
Further, Mr Reichert's submission that, over the long term, the development will be profitable must be regarded as spurious. The evidence before this Investigation is that to 28 February 1991, the estimated loss on the $65.6M exposure to the project was $15.0M. It is understood that the Bank Group has made further provisions for loss since that date.
When considered in isolation, the loss incurred by Beneficial Finance in connection with its exposure to Mindarie Keys would clearly have a material and detrimental effect upon the company's profitability. The evidence before the Investigation though is that the Mindarie Keys development was not an isolated aberration by the company. Indeed, Beneficial Finance lent money and provided equity funding to a number of property developments which have also provided capital losses and resulted in foregone income. All the evidence before this Investigation is that, as a property developer, Beneficial Finance was, by 1991, markedly unsuccessful.
It seems to me to be somewhat ingenuous of Mr Reichert to rely on valuations of the project in 1987 as justifying Beneficial Finance's involvement, and at the same time dismiss current valuations as misguided. More importantly, however, in my opinion Mr Reichert's submission discloses an apparently unshakeable faith in his own judgments of the value of investment in property development that are simply not shared by property experts and valuers, or by the market in which business must be conducted. Further, it reveals a failure to have any regard to the reality of having to fund a long-term investment in a project with no, or negative, cash flow. This faith in the value of property investments and his own evaluation of them, combined with the dismissal of the judgments made by experts and the market, and the failure to consider the realities of having to fund such investments, go to the very heart of why Beneficial Finance was in a serious financial position in February 1991 and required the support of an indemnity by the State Government.
32.4 FINDINGS AND CONCLUSIONS
In addition to the "Summary and Conclusions " referred to in sections 32.2.6 and 32.3.4 above, my general findings and conclusions are as stated hereunder.
In my opinion, the principal deficiencies in the processes by which Beneficial Finance entered into and managed the Mindarie Keys facility were:
(a) Neither the Beneficial Finance Board of Directors or Management established adequate guidelines for the assessment of joint venture projects. The initiation, review and supervision of credit proposals associated with the Mindarie Keys joint venture were conducted by the Corporate Services division and its successors, subject to the control of a relatively small group of Senior Executives, namely Mr Baker, Mr Reichert and Mr Martin. Apart from internal audit procedures, there was no adequate system of policies, procedures and internal control applicable to the decisions made within the Corporate Services division.
(b) An inadequate evaluation was undertaken by Beneficial Finance of:
(i) the viability of the Mindarie Keys development;
(ii) the terms and conditions of Beneficial Finance's participation;
(iii) the financial risks and returns associated with Beneficial Finance's participation;
(iv) the financial strength of the other joint venture partners;
(v) Smith Corporation's capacity as joint venture participant and manager; and
(vi) the terms and conditions of the State Agreement, and its implications for the project.
(c) Beneficial Finance's execution of the joint venture agreements, nine months after Board approval, was not subject to a consolidated submission to the Beneficial Finance Board incorporating the substantial revisions to the facility that had taken place during that period and that raised serious questions regarding the viability of the project. Beneficial Finance did not have credit inspection procedures for the purpose of reviewing the transaction prior to settlement to ensure that the terms and conditions of approval had been complied with by the documentation. Having regard to the time that had elapsed since the approval of Beneficial Finance's involvement in the project, and to the changes to the project, an updated submission should have been prepared before the joint venture agreements were signed.
(d) Mr Reichert, Mr Martin and Mr Yelland did not instruct independent solicitors to act on behalf of Beneficial Finance to prepare the joint venture agreements. They permitted Smith Corporation to instruct its own solicitors to prepare the joint venture agreements contrary to the letters of approval. Further, they failed to examine the joint venture agreements to ensure that they contained provisions for the proper and adequate protection of Beneficial Finance's interests. One result was that Beneficial Finance's representatives on the joint venture Board of Management did not have adequate power to control the activities of the joint venture.
(e) Beneficial Finance Management failed of promptly identify and react to problems associated with the joint venture. The financial and management problems associated with the conduct of the Mindarie Keys project were identified and reported to Beneficial Finance's Management in an Internal Audit Report in 1989. Management failed to take any adequate action to remedy the problems referred to in the report. In my opinion, Mr Reichert as General Manager of the Corporate Services division and its successors, who was the senior officer of Beneficial Finance participating in management of Beneficial Finance's involvement in the joint venture, is principally responsible for that failure.
(f) In my opinion, the information contained in the Internal Audit Report put the Beneficial Finance Board on notice of the substantial problems identified in the Mindarie Keys project. The Beneficial Finance Board did not take appropriate "follow-up" action to ensure that the problems referred to in the Internal Audit Report had been remedied. In so failing to act, the Board failed to discharge its obligation to adequately and properly supervise, direct and control the business activities of Beneficial Finance.
32.5 REPORT IN ACCORDANCE WITH MY TERMS OF APPOINTMENT
32.5.1 TERM OF APPOINTMENT A
I have investigated and inquired into matters relating to the participation of Beneficial Finance in the Mindarie Keys joint venture as directed in my Terms of Appointment A. For the reasons indicated in this Chapter I hereby report that with respect to these matters, my opinion is as stated hereunder.
32.5.1.1 Term of Appointment A(b)
The processes described in this Chapter in relation to the initiation, assessment, approval and establishment of Beneficial Finance's interest in the Mindarie Keys joint venture led Beneficial Finance to engage in operations which have resulted in material losses, and in Beneficial Finance holding significant assets which are non-performing.
32.5.1.2 Term of Appointment A(c)
For the reasons described in this Chapter, those processes were not appropriate.
32.5.1.3 Term of Appointment A(e)
The procedures, policies and practices adopted by Beneficial Finance in the management of significant assets which are non-performing as reported in this Chapter were not adequate.
32.5.1.4 Term of Appointment A(h)
In my opinion:
(a) Mr Reichert and Mr Martin failed to exercise proper care and diligence in the performance of their duties, in that they did not ensure that an adequate feasibility study of the Mindarie Keys project was undertaken before the joint venture agreements were signed.
(b) Mr Reichert and Mr Yelland failed to exercise proper care and diligence in the performance of their duties, in that they did not ensure that the terms of the joint venture agreements adequately protected the interests of Beneficial Finance, or that the terms complied with the conditions specified by the Board of Directors.
(c) Mr Reichert failed to exercise proper care and diligence in the performance of his duties, in that on 30 December 1988, he submitted to the Directors a credit submission seeking additional funding for the venture without disclosing to the Directors the problems associated with Beneficial Finance's ability to adequately control the development.
32.5.2 TERM OF APPOINTMENT C
I have also as directed by my Term of Appointment C investigated and inquired into matters relating to the supervision, direction and control of the operations, affairs and transactions of Beneficial Finance as a participant in the Mindarie Keys joint venture.
For the reasons indicated in this Chapter, in my opinion the operations, affairs and transactions of Beneficial Finance as a participant in Mindarie Keys joint venture were not adequately or properly supervised, directed and controlled by:
(a) the Directors of Beneficial Finance; and
(b) certain officers and employees of Beneficial Finance, in particular Mr Reichert, Mr Martin and Mr Yelland.