CHAPTER 33
CASE STUDY IN CREDIT MANAGEMENT: PEGASUS LEASING

 

 

TABLE OF CONTENTS

33.1 INTRODUCTION
33.1.1 REFERENCE INFORMATION
33.1.2 BASIC CONCEPTS RELEVANT TO PEGASUS LEASING'S BUSINESS
33.1.2.1 The Nature of Pegasus Leasing's Leases
33.1.2.2 "Reverse Principal and Agency" Agreements
33.1.3 OVERVIEW
33.1.3.1 The Basic Premise of Beneficial Finance's Operating Joint Ventures
33.1.3.2 The Pegasus Leasing Joint Venture

33.2 THE FIRST JOINT VENTURE: AUGUST 1985 TO DECEMBER 1987
33.2.1 INTRODUCTION
33.2.2 INITIATION OF THE FIRST JOINT VENTURE
33.2.3 THE STRUCTURE AND MANAGEMENT OF THE FIRST JOINT VENTURE
33.2.4 THE BUSINESS ACTIVITIES OF THE FIRST JOINT VENTURE
33.2.4.1 The Nature of the Business
33.2.4.2 Reverse Principal and Agency Business
33.2.5 THE PERFORMANCE OF THE FIRST JOINT VENTURE
33.2.6 SUMMARY AND CONCLUSIONS

33.3 THE PEGASUS LEASING JOINT VENTURE: JANUARY 1988 TO MAY 1990
33.3.1 INTRODUCTION
33.3.2 INITIATION OF THE PEGASUS LEASING JOINT VENTURE
33.3.3 THE STRUCTURE AND MANAGEMENT OF THE PEGASUS LEASING JOINT VENTURE
33.3.4 THE BUSINESS ACTIVITIES OF THE PEGASUS LEASING JOINT VENTURE
33.3.5 THE PERFORMANCE OF THE PEGASUS LEASING JOINT VENTURE
33.3.6 RESTRUCTURING OF THE PEGASUS LEASING JOINT VENTURE
33.3.7 SUMMARY AND CONCLUSIONS

33.4 PEGASUS LEASING AFTER MAY 1990
33.4.1 RESTRUCTURING OF THE JOINT VENTURE
33.4.2 TERMINATION OF THE JOINT VENTURE
33.4.3 THE LOSSES ARISING FROM PEGASUS LEASING
33.4.4 A HINDSIGHT REVIEW BY BENEFICIAL FINANCE

33.5 RELATED PARTY TRANSACTIONS

33.6 FINDINGS AND CONCLUSIONS

33.7 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT

33.7.1 TERM OF APPOINTMENT A
33.7.1.1 Term of Appointment A(b)
33.7.1.2 Term of Appointment A(c)
33.7.1.3 Term of Appointment A(d)
33.7.1.4 Term of Appointment A(e)
33.7.2 TERM OF APPOINTMENT C

 

 

33.1 INTRODUCTION

 

33.1.1 REFERENCE INFORMATION

REFERENCE INFORMATION
Account Name	. Pegasus Leasing
Participants	. Beneficial Finance . Pegasus Securities Limited ("Pegasus Securities")
Industry Sector	. Bloodstock Leasing and General Finance . Debt Factoring . Insurance Broking
Facility Type (including contingent)	. Leasing finance involving a large volume of transactions.
Principal Outstanding at 31 January 1991	. Pegasus Leasing . Pegasus Securities	$M 97.7 14.1
Estimated Loss at 31 January 1991	. Pegasus Leasing . Pegasus Securities	$M 40.0-46.0() 7.1

33.1.2 BASIC CONCEPTS RELEVANT TO PEGASUS LEASING'S BUSINESS

This Chapter reports the results of my Investigation of Pegasus Leasing, a joint venture between Beneficial Finance and Pegasus Securities Limited, a public company effectively controlled at all material times by Mr J A McGregor.

Established in August 1985, Pegasus Leasing was an operating joint venture (as opposed to a project-specific joint venture) that carried on business as a financier, principally to the bloodstock industry, until about December 1990. Beneficial Finance's involvement in the joint venture was regarded by it as an extension of its core business activities into a new and specialised area. The rationale of the joint venture was to combine the specialised bloodstock leasing experience and expertise of Pegasus Securities with the financial resources of Beneficial Finance, to grow a business from which both partners would profit.

Before reporting the results of my examination of the Pegasus Leasing joint venture, it is necessary to briefly explain two important features of its business, an understanding of which is fundamental to the events described in this Chapter.

33.1.2.1 The Nature of Pegasus Leasing's Leases

First, it is important to appreciate that the leasing carried on by the joint venture was, in substance, a form of lending.

Shortly stated, there are two types of leases, called operating leases and finance leases. Operating leases are familiar to anyone who has ever hired a car or paid rent. The asset is owned by the lessor, who lets the lessee use or operate the asset, usually for a short period of time relative to the life of the asset, in return for lease payments colloquially called rent. The lessor owns the asset, and subject to special agreements, enjoys the benefits and runs the risks of the asset going up or down in value.

In contrast, finance leases are a specialised form of lending. Instead of a person borrowing money from a finance company to buy an asset, the finance company buys the asset, commonly plant and equipment or motor vehicles, and leases it to the person. The lease payments made by the lessee/borrower represent, in substance, the payment of interest and part repayment of the principal amount of the "loan". At the end of the lease/loan period, the lessee pays a "residual" amount to become the owner of the asset. The residual is, in substance, the unrepaid principal balance of the loan, and is not related to the actual value of the asset at the time. Loans are structured as finance leases principally for taxation reasons.

The leased asset usually provides security for the "loan" represented by the finance lease, with the finance company's "ownership" representing a form of legal mortgage over the asset. If the lessee/borrower fails to make the lease payments representing interest and part repayment of principal, the lessor/lender will "repossess" the asset to recover the unrepaid loan amount.

In the case of Pegasus Leasing, the assets being leased were principally thoroughbred horses. In evidence to my Investigation, Mr E P Reichert, the General Manager of Beneficial Finance's Structured Finance and Projects division, agreed that the leases granted by Pegasus Leasing were similar to motor vehicle leases, and that the horses were the security for the loans.⁽⁾

The value of the horses was not included in Pegasus Leasing's balance sheet. Instead, Pegasus Leasing's assets were the amounts to be received from the lessee/borrowers. The amounts were called "receivables", and were the total of the lease payments (representing interest and part repayment of the principal), and the residual (representing repayment of the balance of the loan), to be received by Pegasus Leasing from its clients, the lessees/borrowers. In this Chapter, references to leases should be thought of as being references to loans.

33.1.2.2 "Reverse Principal and Agency" Agreements

As well as carrying on business in its own right, Pegasus Leasing made some loans, in the form of finance leases, as an undisclosed agent of both Beneficial Finance and the State Bank, pursuant to what were called "Reverse Principal and Agency" Agreements.

Although the terms of such agreements can be complicated, their basic elements are simple. Instead of carrying on a financing business in its own name and with its own managers and staff, a finance company (such as Beneficial Finance) appoints an agent to carry on the business on its behalf. The loans are still loans of the finance company, and will appear in its balance sheet. The loans are, however, arranged and managed by the agent. Indeed, the borrower may not even be aware that the "real" lender - the finance company bearing the credit risk of the loan not being repaid - is someone other than the agent.

A finance company will enter into such an arrangement as a means of expanding its business into new and specialised areas. The agent may have particular expertise, and an established reputation and clientele, in the type of financing that the principal wants to engage in, such as providing finance leases for bloodstock.

The agent will enter into the arrangement as a method of growing its business beyond the limits that would apply if it had to rely on its own financial resources.

The terms of a Reverse Principal and Agency Agreement can vary widely. For example, the agent could be made liable to indemnify the principal for some or all of any bad debts resulting from the loans. The agent might receive a commission on new loans, a management fee based on the total loan portfolio, or a profit share. Variations to these terms can affect the fundamental nature of the arrangement. For example, if the agent is responsible for approving the loan and for any bad debts that result, and receives a profit share, is it really acting as an agent, or is it in substance making loans on its own account, funded by the finance company?

As I shall describe, this confusion arose in the case of Pegasus Leasing, which provided leases as the sub-agent of Beneficial Finance under a Reverse Principal and Agency Agreement between Beneficial Finance and the State Bank. That Agreement was entered into as a result of a taxation ruling by the Commissioner of Taxation in 1985 which effectively prevented finance companies from providing both finance leases and operating leases to their clients. To overcome that restriction on its business, Beneficial Finance provided finance leases ostensibly as the agent of the State Bank. In legal form, Beneficial Finance was the agent of the Bank. In substance, however, the Reverse Principal and Agency Agreement was simply a funding arrangement. Under that Agreement, the Bank provided funds at an interest rate unrelated to the rate charged by Beneficial Finance, did not pay any commission or management fee, had no input into or control over the credit risk associated with Beneficial Finance's leases, did not keep any record of the clients, and did not bear the credit risk. In short, for taxation reasons the agreement had the legal form and effect of an agency agreement, but was in substance a funding arrangement, and was treated as such by the management of Beneficial Finance. That treatment eventually resulted in the State Bank, rather than Beneficial Finance, bearing the losses resulting from the Pegasus Leasing joint venture's lease portfolio.

33.1.3 OVERVIEW

33.1.3.1 The Basic Premise of Beneficial Finance's Operating Joint Ventures

Basic to the operations of the Pegasus Leasing joint venture were the joint venturers' intentions in entering into the joint venture, and their expectations of how it would operate.

Beneficial Finance's objective in entering into the joint venture was to expand its business activities into new areas which, although they were an extension of Beneficial Finance's own core businesses, were outside the scope of its experience and expertise. Beneficial Finance was to provide the financial backing, and Pegasus Securities the expertise, to carry on the joint venture business. In the words of a Joint Venture Quarterly Report presented to the Board of Directors of Beneficial Finance at its meeting on 16 December 1986, the joint venture was "seen as a vehicle to pool the market knowledge and expertise on bloodstock leasing of Pegasus Securities with the financial resources of Beneficial Finance."

Pegasus Securities' understanding of the responsibilities of the joint venture partners was stated in the minutes of a meeting of that company's Board of Directors held on 13 May 1985:

"Pegasus Securities would be responsible for identifying and writing business, particularly in bloodstock leasing, to the extent of between $1.75M and $2.0M per month.

Beneficial Finance is to be responsible for the obtaining of wholesale funding at rates expected to allow a spread of up to 4 per cent per annum. Beneficial to charge a guarantee fee of up to 1 per cent per annum where applicable."

This understanding was confirmed by Beneficial Finance's letter dated 16 May 1985 to the directors of Pegasus Securities, which stated that Pegasus Securities was to be responsible for sourcing business for the joint venture, and for the granting of leases and the maintenance of the receivables portfolio. The letter was co-signed by Mr Reichert, then Beneficial Finance's General Manager, Asset Acquisition and Control.

A file note dated November 1986 prepared by Price Waterhouse of a discussion with Mr G O'Brien, a Beneficial Finance executive who was a member of the Joint Venture Management Committee, records Mr O'Brien's advice that:

"Pegasus Securities required funds for expansion, which has resulted in Beneficial Finance becoming part of the business, as financier ... Beneficial Finance are well aware of the opportunities that exist in such areas as bloodstock leasing, however they are also conscious of the fact that they are not as able to identify the value of such animals on their own. To enter into a venture on their own would expose the possibility of significant losses being made."

This basis of the joint venture was common to most, if not all, of Beneficial Finance's operating joint ventures. A Joint Venture Status Report dated 16 October 1989 prepared by Beneficial Finance's Management stated that "the premise" of the joint ventures was that "Beneficial Finance has the financial strength and the joint venture parties have the expertise". The Report stated that Beneficial Finance often had total responsibility for funding the joint ventures:

"... the strong growth of some of the joint ventures was not anticipated, and given that none of the joint venture partners have the financial capacity to support the growth they were achieving through continual capital injections to maintain gearing at acceptable levels, there has been an expectation that Beneficial will provide the additional funding required. Whilst Beneficial can choose to limit the funds lent, as there is no legal requirement to provide all funding, it is our objective to not restrict profitable growth of the joint venture. However, notwithstanding this objective, considerable difficulty is being experienced in attracting non-recourse external borrowings with existing joint venture gearing levels." [Emphasis added]

In his submission to my Investigation, Mr D J Tucker, a partner of Thomson Simmons & Co who was a director of Pegasus Securities and of Pegasus Leasing, stated that Beneficial Finance facilitated all of the joint venture's debt funding, either by direct loans or by guaranteeing third party loans, and accordingly "it stood the commercial risk of any losses in the joint venture." Mr Tucker's view is that Beneficial Finance effectively functioned as a non-recourse lender to the joint venture:

"Although there were provisions (in the joint venture agreements) contemplating loss sharing, it was clear to all parties that Pegasus Securities' representation in the joint venture was through Lanceti Pty Ltd, which had a paid up capital of $2."

The evidence of the Managing Director of Beneficial Finance, Mr J A Baker, to my Investigation in respect of the Pegasus Leasing joint venture, highlighted the reliance placed by Beneficial Finance on the expertise of its joint venture partners, and the need for Beneficial Finance to carefully assess that expertise. Mr Baker said:

"The philosophy was that the joint venture partner would put up its equity and Beneficial would do so, but Beneficial really ultimately understood that it would pick up any loss ... the Beneficial Board would have been quite aware, with all the joint ventures, whether or not there was a guarantee from the other party in relation to credit losses ... those people, we knew, could not stand up ... they were small entrepreneurs but we were prepared to go into joint venture business with them because they had skills and access to business. We weren't asking them to guarantee credit losses." [Emphasis added]

In a submission to my Investigation⁽⁾, the former Non-Executive Directors of Beneficial Finance disputed Mr Baker's assessment of the nature of the company's relationship with its joint venture partners. They said that:

(a) there was a standing direction from the Board of Directors that all joint venture partners of Beneficial Finance were to provide guarantees in respect of the liabilities of the joint ventures in which they participated; and

(b) Beneficial Finance's funding of any joint venture had to be assessed using the same criteria, and subjected to the same policies and procedures, as applied to its general lending business.

In his submission, Mr Baker disputed the suggestion that there was such a standing direction, and no such direction has been found in any documents provided to or reviewed by my Investigation, including minutes of Board of Directors' meetings. Although I accept that the absence of any reference to the direction does not necessarily mean that the direction was not given, the absence of any documentation of such an important matter in the minutes, at the very least, reflects poorly on the Board's reporting practices. The management of Beneficial Finance were unaware of any such direction.

Whether or not such a standing direction was given, the reality of the operating joint ventures in which Beneficial Finance participated was that, in practical terms, the joint venture partners lacked the financial resources to meet anything like one-half of the potential losses of the venture. The directors were told that the rationale for the Pegasus Leasing joint venture was a partnership between Beneficial Finance's financial strength, and its partner's business connections and skills. That rationale was clearly stated in the submission for the establishment of the Pegasus Leasing joint venture in May 1985.

Beneficial Finance did eventually obtain a guarantee from Mr McGregor, who effectively controlled Pegasus Securities, and Pegasus Securities was required to bear one-half of any losses of the Pegasus Leasing joint venture. The Non-Executive Directors submitted to my Investigation that they were assured by Mr Baker that Mr McGregor's assets were "substantial", and I accept that they received that assurance. Even so, it should have been apparent to the directors that:

(a) Mr McGregor's personal wealth may have depended to a significant degree upon the value of Pegasus Securities; and

(b) Pegasus Securities' net assets were nowhere near sufficient to provide anything more than a small contribution to an exposure that came to total $111.0M. Pegasus Securities' lack of financial strength was the very reason why it entered into the joint venture.

In short, the Pegasus Leasing joint venture, like Beneficial Finance's other operating joint ventures, was based on the premise that Beneficial Finance bankrolled a small entrepreneur operating in a niche financial market that Beneficial Finance perceived could, with financial support, build a profitable and successful business. It would bear most of the financial cost of failure.

33.1.3.2 The Pegasus Leasing Joint Venture

Although the details of the Pegasus Leasing joint venture are complex, there are a number of quite basic issues that are fundamental to understanding the events that occurred.

First, it is useful to regard the Pegasus Leasing joint venture as effectively having been established on 1 January 1988. A joint venture was actually established with effect from 1 August 1985, and some aspects of that first joint venture's operations are important to understanding the events that subsequently transpired. I have described those important aspects in Section 33.2 of this Chapter. In substance, however, the activities that resulted in significant losses for the State Bank Group were conducted after 1 January 1988 by Pegasus Leasing Pty Ltd, a company jointly owned by Beneficial Finance and its joint venture partner, Pegasus Securities.

Second, like Beneficial Finance's other operating joint ventures, Pegasus Leasing was established on the premise that Beneficial Finance would provide the financial backing needed to allow Pegasus Securities to grow a business from which both participants would profit. Beneficial Finance's reliance on the expertise of Pegasus Securities, and the certainty that it would bear the financial cost of the joint venture's failure, meant that it was vital from Beneficial Finance's point of view that it do two things:

(a) It must ensure that Pegasus Securities in fact had the necessary experience and expertise to operate the business.

(b) It must ensure that if the joint venture business might expand beyond the size or scope of that in which Pegasus Securities had experience and expertise, Beneficial Finance would carefully monitor and control the joint venture's activities. With the funding provided by Beneficial Finance, it was more likely than not that the business would expand beyond the limits of Pegasus Securities' experience and expertise. The expansion of the business was, after all, the basic reason for the joint venture.

The first joint venture, which commenced business in December 1985, was established as the result of an approach from Pegasus Securities. It was essentially a partnership between Beneficial Finance and Pegasus Securities, with the joint venture company, Pegasus Leasing Pty Ltd, acting as a nominee for the partners. The first joint venture's business was largely limited to the granting of finance to the thoroughbred horse industry, in the form of leases. The partners contributed $0.1M each as capital to the venture, and were to share profits and losses equally. Those profits and losses were calculated after payment of management fees to Pegasus Securities for conducting the business, and of interest and guarantee fees to Beneficial Finance for providing or facilitating funding for the venture.

As well as carrying on business on behalf of the partners, Pegasus Leasing also granted leases as the sub-agent of Beneficial Finance under the Reverse Principal and Agency Agreement between Beneficial Finance and the State Bank. The leases granted as sub-agent were treated for accounting purposes as belonging to the State Bank, and so were not shown in the accounts of the joint venture. Those leases were funded by the Bank through loans to Beneficial Finance, which on-lent the funds to the joint venture.

The first joint venture was not successful. From early in 1987, the Beneficial Finance Board of Directors expressed dissatisfaction with the performance of the joint venture, and resolved that the venture should be terminated if its performance did not improve.

In December 1987, the first joint venture was terminated. It granted no new leases, and its portfolio of receivables was wound down, under the management of Pegasus Leasing, over the following eighteen months. In July 1989, the remaining receivables of the first joint venture were transferred to the new.

On 1 January 1988, however, Beneficial Finance and Pegasus Securities entered into a new Pegasus Leasing joint venture. This was, in effect, the real beginning of Pegasus Leasing. It was an incorporated joint venture, with Pegasus Leasing Pty Ltd carrying on business in its own name, and not as nominee for the partners.

The new joint venture was established despite the express recommendation of Beneficial Finance's Joint Venture Committee that it should not be formed. No formal submission was presented to the Board of Directors of Beneficial Finance in respect of its formation.

The new joint venture essentially took over the business activities of Pegasus Securities. It purchased Pegasus Securities' insurance broking business, and its debt factoring business carried on by a subsidiary of Pegasus Securities, Rivlin Pty Ltd. Pegasus Leasing employed the staff of Pegasus Securities to conduct the business, and used that company's accounting systems.

The business of Pegasus Leasing expanded very rapidly over the following two years. Bloodstock Leasing operations were established in New Zealand and the United Kingdom, and the venture acquired a 75 per cent interest in Bloodstock Management International Ltd, a company carrying on business as manager of bloodstock investment syndicates. It also invested in, and financed, two investment syndicates, and acquired a number of other minor investments. Pegasus Leasing's total assets grew from less than $1.0M in January 1988, to $85.0M in November 1989, an extraordinary increase.

The rapid expansion of Pegasus Leasing's portfolio was funded entirely by Beneficial Finance with unsecured, ninety day loans. Although Pegasus Leasing was established with capital of $0.4M in January 1988, subsequent losses meant that, by 30 June 1989, the company had no capital whatsoever, with its liabilities exceeding its assets. Nevertheless, its business continued to expand, funded by loans from Beneficial Finance. As at June 1989 Beneficial Finance's unsecured loans to Pegasus Leasing totalled $62.0M, and increased to $79.0M in November 1989, and $85.0M in February 1990. By January 1991, the State Bank Group's exposure to the joint venture totalled $97.7M, with a further exposure to the Pegasus Securities group of $14.1M.

In August 1989, Mr Baker became concerned at the size of Beneficial Finance's exposure to Pegasus Leasing. The efforts of Beneficial Finance to reduce that exposure, or at least to take it off the balance sheet, eventually resulted in the State Bank becoming the owner of Pegasus Leasing's portfolio of receivables. The method suggested by the Chief General Manager of Beneficial Finance's Treasury and Capital Markets division, Mr F R Horwood, was to refinance Beneficial Finance's loans to Pegasus Leasing through the Reverse Principal and Agency Agreement with the State Bank. Mr Horwood apparently regarded that arrangement as being little more than a funding mechanism for Beneficial Finance's tax-based leasing business. In fact, however, the Agreement was an agency agreement under which Beneficial Finance granted leases as agent for the State Bank, with the State Bank owning the lease receivables. After almost a year of extensive consideration and negotiations, it was eventually agreed that the State Bank would assume ownership of all of Pegasus Leasing's portfolio of lease receivables.

In May 1990, a new joint venture was established between Pegasus Securities and Beneficial Finance, which was a partnership of the type that operated between 1985 and 1987. Pegasus Leasing's non-receivables assets were transferred to the new unincorporated joint venture, which also managed the portfolio of lease receivables then treated as owned by the State Bank.

Within three months Beneficial Finance decided to end the joint venture. A series of adverse internal audit reports, a report from the external auditors of Pegasus Leasing and Beneficial Finance, Price Waterhouse, and reports from Beneficial Finance's own management, prompted Beneficial Finance to take control of the activities of the joint venture, and to wind it up. Guarantees were obtained from Mr McGregor and from Pegasus Securities in respect of the State Bank Group's loans to the joint venture.

In late 1990 and early 1991, values of thoroughbred horses fell dramatically. Many customers of Pegasus Leasing were unable or unwilling to meet their obligations. In February 1991, a report from Ernst & Young, Chartered Accountants, confirmed an estimate from Beneficial Finance's management that the losses associated with the Pegasus Leasing business might total between $40.0M and $46.0M.

The fundamental failing of Beneficial Finance was to provide essentially unlimited finance to a business that it did not adequately monitor, and certainly did not control. Pegasus Securities may have had the experience and expertise to conduct a modest thoroughbred leasing business, the company having total receivables of $5.5M in 1985. With the finance provided by Beneficial Finance, however, the business grew rapidly, unrestrained by any lack of funds. Without that restraint, leases could be provided to borrowers who might otherwise have been excluded from consideration. With ambitious growth budgets set, the downward pressure on credit standards is obvious. In fact, even those growth budgets were exceeded.

The result was that credit standards fell, and the business grew to a size and diversity beyond the experience or expertise of Pegasus Securities. Inevitably, very large losses resulted, and the State Bank paid the bill.

 

33.2 THE FIRST JOINT VENTURE: AUGUST 1985 TO DECEMBER 1987

 

33.2.1 INTRODUCTION

Established with effect from 1 August 1985, the first joint venture carried on business from December 1985 until December 1987, when it ceased new leasing and its portfolio of receivables was wound down. It was essentially a partnership between a wholly-owned subsidiary of Beneficial Finance, Malary Pty Ltd, and a wholly-owned subsidiary of Pegasus Securities, Lanceti Pty Ltd, with each company owning one-half of the assets of the unincorporated venture, and being liable for one-half of its liabilities.

The first joint venture made little direct contribution to the losses eventually incurred by the State Bank Group. Some aspects of its activities were, however, important in explaining the later activities of Pegasus Leasing.

33.2.2 INITIATION OF THE FIRST JOINT VENTURE

Pegasus Securities was a publicly listed company that carried on business as a financier to the bloodstock industry, specialising in providing loans in the form of leases over thoroughbred horses used by the lessees for racing and breeding.

In May 1985, Beneficial Finance was invited to acquire an interest in Pegasus Securities when a shareholder and director had made a takeover bid for the company. As a defensive move, the other directors of Pegasus Securities approached Beneficial Finance to purchase a shareholding in the company. Beneficial Finance had previously provided some loans to Pegasus Securities, and Pegasus Securities acted as an agent for Beneficial Finance in writing some bloodstock leasing business.

A submission was presented to the Beneficial Finance Board of Directors at its meeting on 21 May 1985, proposing that Beneficial Finance both purchase 19.9 per cent of Pegasus Securities, and set up a joint venture with that company. The purpose of the joint venture was to exploit fully the market potential of the business of Pegasus Securities, and to provide Beneficial Finance with new business and income. The submission stated:

"Pegasus Securities Limited is a relatively small lease broker/financier specialising primarily in bloodstock leasing.

Formed in February 1982 by a number of South Australia businessmen, it has grown to a receivable base of $5.5 million, although growth restraints have meant that substantial volume has been handled on a brokerage basis to main stream financiers.

Beneficial Finance presently has an undisclosed Principal & Agency Agreement in place, where bloodstock receivables total $1.53 million (11 accounts).

As well as banking lines, the company borrows on public debenture issues, the most recent (No 2) in December 1984.

As of 1 May 1985, a shareholder/director, Mr Michael Harrison, has made a takeover bid for the company, as he has plans to re-capitalise the company and grow more quickly than is desired by the other directors. Accordingly, they have sought Beneficial's assistance to buy him out, and set up this financing joint venture to accommodate the growth."

In essence, the financial backing provided by Beneficial Finance, principally in the form of guarantees, was to be combined with the business expertise of Pegasus Securities to expand the bloodstock leasing business. The joint venture would "enable Pegasus Securities to fully exploit their market potential, as well as provide Beneficial with incremental finance volume and fee income."

The submission stated that the receivables portfolio of the joint venture would be administered by Pegasus Securities, for which it would receive a monthly fee of 1 per cent of the total end of month receivables. It was intended that Beneficial Finance would provide as little debt funding for the venture as possible, relying instead on third-party financiers whose loans would be guaranteed by Beneficial Finance, for which it would receive a 1 per cent guarantee fee.

The credit submission included projections, prepared by Beneficial Finance on the basis of assumptions agreed with Pegasus Securities, of the joint venture's profitability, and of its assets and liabilities, over the three years of operations to 30 June 1988. These projections made clear both dependence of the joint venture on Beneficial Finance's financial backing, and the risk to Beneficial Finance of any substantial losses. It was projected that, by 30 June 1988, the joint venture's total assets would be $43.9M, with capital of only $0.2M. That represents a gearing ratio of 99.5 per cent, or a debt to equity ratio of 220:1. The credit submission stated that Pegasus Securities' net tangible assets as at 31 December 1984 was only $1.1M, and that part of its funding was in the form of debentures.

Although the submission was approved by the Board, Beneficial Finance did not acquire any shares in Pegasus Securities, as a result of written advice given to Mr Reichert by Pegasus Securities that another buyer had been found for the shares. It did, however, enter into the joint venture.

On 4 July 1985 a new company, Pegasus Leasing Pty Limited was incorporated to act as nominee for the proposed joint venture. The shareholders were Malary Pty Ltd, an off-balance sheet company of Beneficial Finance, and Lanceti Pty Ltd, a wholly-owned subsidiary of Pegasus Securities.

Beneficial Finance established a group of its senior staff, called the `Pegasus Leasing Task Force', to assist Pegasus Securities in setting up the business operations of the Pegasus Leasing joint venture as a financier to the bloodstock industry.

33.2.3 THE STRUCTURE AND MANAGEMENT OF THE FIRST JOINT VENTURE

The joint venture was unincorporated, which means that its assets and liabilities were jointly owned by Beneficial Finance through its off-balance sheet company, Malary Pty Ltd, and Pegasus Securities through its wholly owned subsidiary, Lanceti Pty Ltd. In carrying on its business activities, Pegasus Leasing acted as nominee for Beneficial Finance (Malary) and Pegasus Securities (Lanceti), the real owners of the business.

The joint venture was established with an initial capital contribution of $0.2M, contributed equally by Pegasus Securities and Beneficial Finance. The Joint Venture Agreement provided that Beneficial Finance and Pegasus Securities would contribute equally to any additional capital needed by the joint venture, and that any losses would be shared equally. Profits were to be distributed first to Beneficial Finance at an effective rate of 25 per cent per annum on funds contributed by it, then to Pegasus Securities at the same rate. Any remaining profits were to be shared equally.

A Management Committee, consisting of six members, with three nominated by each of Beneficial Finance and Pegasus Securities, was responsible for the management of the joint venture business. Beneficial Finance was to appointed the Chairman of the Management Committee, who had the casting vote in the event of deadlock. Although Pegasus Securities was responsible for performing all secretarial, managerial and accounting functions for the joint venture, Beneficial Finance was entitled to nominate the auditors and solicitors. Each joint venturer had the right to nominate two persons to be directors of Pegasus Leasing Pty Ltd, the nominee company.

Authority to approve leases by the joint venture was to be granted by the Management Committee. Initially, all leases of more than $0.1M were to be approved by Beneficial Finance in accordance with its delegated loan approval authority system. Leases of more than $0.75M required the approval of the Managing Director of Beneficial Finance, or its Board of Directors. Leases of up to $0.1M were to be subject to approval by the Pegasus Credit Committee, which was a committee of the Board of Directors of the nominee company, Pegasus Leasing Pty Ltd.

Shortly after the joint venture commenced business, however, authority was granted to the directors of Pegasus Leasing to approve all loans to be granted by the joint venture. At a meeting of the joint venture Management Committee meeting held on 24 March 1986, the delegated authorities were changed to require transactions of more than $0.5M to be approved by three directors of Pegasus Leasing, including both of the directors nominated by Beneficial Finance.

Most leases were for less than $0.5M, and a Joint Venture Quarterly Report presented to the Beneficial Finance Board of Directors in December 1986 reported that loan approvals were performed by Pegasus Securities:

"There are no staff employed by the joint venture and this minimises direct expenses. Loan approval (within limits approved by Beneficial Finance) is performed by Pegasus Securities staff, as is the collection on all accounts. Accounting and statutory records and subsequent financial reporting is performed by Beneficial staff."

In March 1987, the Board of Directors of Beneficial Finance directed management to impose a limit on Beneficial Finance's exposure to the joint venture. An "Action Report" prepared by Mr B Barton, the company secretary of Beneficial Finance, summarised a number of items requiring action as a result of resolutions of the Beneficial Finance Board at its meeting on 27 March 1987. One of the items for action required of Management by the Board was:

"An exposure limit is required in relation to the bloodstock leasing on behalf of Pegasus Leasing."

I have found no evidence of any documented exposure limit being established. The Non-Executive Directors submitted to my Investigation that they received assurances from Mr Baker that the matter was being attended to, and Mr Baker said in his submission that he had "an understanding" with Mr McGregor that total receivables of about $100.0M was an appropriate level that would generate adequate profits for the joint venture partners, and that the level of $100.0M was less than 5 per cent of Beneficial Finance's total assets, and was therefore not, by itself, an excessive exposure to bloodstock leasing. Beneficial Finance did, however, have other exposures to the bloodstock industry, including its participation in another joint venture, Mortgage Acceptance Nominees Ltd. An undocumented "understanding" is hardly an adequate basis for managing Beneficial Finance's exposure, and did not address Beneficial Finance's total exposure to the bloodstock leasing industry.

Although the 1987 Corporate Plan stated that the total receivables of all joint ventures was limited to 20 per cent of Beneficial Finance's total receivables, that is clearly inadequate as a limit on the exposure to the bloodstock leasing of Pegasus Leasing because:

(a) it did not limit Beneficial Finance's exposure to the bloodstock leasing industry, which might include exposures other than through joint ventures; and

(b) it is unrelated to any measure of the financial strength of the joint venture partners, and so is unrelated to their capacity to bear one-half of joint venture losses.

One of the "action items" to be taken in October 1990, as the problems associated with the Pegasus Leasing joint venture began to fully emerge, was to finally establish a prudential limit for Beneficial Finance's exposure to the bloodstock industry.

33.2.4 THE BUSINESS ACTIVITIES OF THE FIRST JOINT VENTURE

33.2.4.1 The Nature of the Business

As noted, the joint venture carried on business as a financier to the bloodstock industry, providing loans in the form of finance leases over thoroughbred horses used by the lessee-borrowers for racing and breeding.

Although the horses provided security for the loans, it was apparently regarded by Beneficial Finance as important that the credit worthiness of the borrowers should be carefully evaluated, so that the joint venture would not be totally reliant on the value of bloodstock for repayment of its loans. In evidence to my Investigation, Mr Baker said that the "philosophy and thrust" underlying the business was that loans should be provided only to "high net worth individuals".

The Beneficial Finance Lending Policy Manual, which was used by the joint venture until a Credit Policy Manual was prepared specifically for Pegasus Leasing in April 1990, stated that leasing business is "high risk" because 100 per cent of the cost of the leased goods is being financed, and that accordingly the credit assessment should:

"Give emphasis to applicants' financial strength. It is essential that they can meet rental payments and residual, independent of expected income from the animal. The value of our security depends upon the animal's continuing health and performance, so verify its worth and fitness and ensure adequate insurance cover is arranged."⁽⁾

33.2.4.2 Reverse Principal and Agency Business

As stated in the credit submission proposing the establishment of the joint venture, Beneficial Finance had, at the time, receivables of $1.53M that were managed by Pegasus Securities as undisclosed agent for Beneficial Finance pursuant to a Principal and Agency Agreement.

On 27 September 1985, Beneficial Finance and the State Bank entered into a Reverse Principal and Agency Agreement, pursuant to which Beneficial Finance was appointed as agent of the State Bank for the purpose of entering into lease transactions involving "commercial goods". The arrangement was entered into principally for the benefit of Beneficial Finance as a result of a change in the interpretation of taxation law by the Commissioner of Taxation. Pursuant to a ruling of the Commissioner of Taxation, having effect from 1 July 1985, finance companies were required to treat all leases granted by them as either finance leases, or as operating leases, for taxation purposes. By acting as agent for the State Bank, Beneficial Finance was able to provide both types of leases to its customers without suffering any taxation disadvantage which would adversely affect the price at which it could provide such "loans". A report to the Board of Directors of Beneficial Finance in December 1986 stated that:

"The need for the Reverse Principal and Agency Agreement arose because of the Taxation Department ruling, effective 1 July 1985, restricting the use of both taxation methods of income reporting on lease transactions within the same group of companies ... because of the unique tax paying position of the State Bank (to the State rather than Federal Government) clearance was obtained from the Taxation Office for Beneficial to use a different method from the State Bank. For those leases that show a disbenefit using the operating lease method, the (so called) reverse Principal and Agency Agreement is used.

The benefit of this arrangement to Beneficial Finance is a presence in both tax based and non-tax based leasing markets. To our knowledge, none of our competitors is able to match this dual presence."

The Report stated that the benefit of the arrangement to the State Bank was "its ability to build a significant leasing portfolio with a minimum of administrative overheads." In substance, however, the State Bank neither enjoyed the benefits, or bore the risks, of the leasing portfolio. Although called a Reverse Principal and Agency Agreement, the terms of the Agreement more closely resembled a funding arrangement for Beneficial Finance's conduct of chattel leasing business using the finance lease method of tax accounting. Beneficial Finance was responsible for approving new leasing transactions, and was to bear the credit risk on those transactions. The Agreement required Beneficial Finance to deposit with the State Bank an amount equal to 0.25 per cent of the total receivables as a provision against possible losses. The State Bank was to bear the credit risk only on leases of up to $50,000 which were approved by the State Bank. Beneficial Finance was to manage and administer the lease facilities, including the preparation of security documents, ensuring that the leased equipment was adequately insured, collecting lease payments and keeping the records of the lessees/borrowers. Under the arrangement, the State Bank made a loan once a month to Beneficial Finance, at a fixed rate of interest, to reimburse it for the advances made during the month. The interest rate earned by the State Bank was not related to the rate earned by Beneficial Finance from the leasing business.

The Agreement authorised Beneficial Finance to appoint "such other persons as it deems suitable ... to act as its own agents in relation to this Agreement". On 9 April 1986, Beneficial Finance entered into a Sub-Agency Agreement with Pegasus Leasing to transact business authorised by the Reverse Principal and Agency Agreement. The Sub-Agency Agreement was endorsed by the State Bank. Although the Reverse Principal and Agency Agreement was limited to "commercial goods", Beneficial Finance obtained a legal opinion that bloodstock fell within the scope of the Reverse Principal and Agency Agreement. In any event, Mr G J Yelland, General Counsel of Beneficial Finance, said in a submission to me that State Bank, Beneficial Finance and Pegasus Leasing appeared by their conduct to have accepted livestock as acceptable subject matter of the Reverse Principal and Agency Agreement, and that the parties subsequently formally agreed to accept the writing of leasing business in relation to horses as falling within the Agreement.

The Sub-Agency Agreement provided that Pegasus Leasing was to bear the credit risk in respect of all loans granted by it as the sub-agent of Beneficial Finance under the Reverse Principal and Agency Agreement.

Perhaps because the terms of the Reverse Principal and Agency Agreement resembled, in substance, a funding arrangement, the management of Beneficial Finance quickly came to regard the Agreement as a cost-efficient method of funding new leasing business. The Joint Venture Quarterly Report presented to the Board of Directors at its meeting on 16 December 1986 stated in respect of the Pegasus Leasing joint venture that:

"From July 1986, the joint venture has utilised the SBSA reverse P&A as a more efficient method of funding its portfolio. Beneficial charges an additional 0.5% above the State Bank rate to the joint venture as a guarantee/facility fee. The National Australia Bank has refinanced $5.0M of the joint venture receivables."

Nevertheless, Beneficial Finance did separately identify those lease receivables funded by the State Bank under the Reverse Principal and Agency Agreement. The Joint Venture Quarterly Report stated that, as at September 1986, the lease receivables funded by the State Bank totalled $57.3M, of which $4.2M were receivables of the Pegasus Leasing joint venture.

The view of the auditors of Beneficial Finance and the joint venture, Price Waterhouse, was that where leases were granted by the joint venture under the Sub-Agency Agreement, the related receivables should not appear in the joint venture's balance sheet. Rather, the receivables should be included in the State Bank's balance sheet. An audit planning memorandum for the 1987 audit prepared by Price Waterhouse, stated:

"A number of the joint venture receivables are written as SBSA deals. There exists a P & A arrangement with the State Bank which acts as principal, and the joint venture as agent. Although these receivables do not appear in the joint venture balance sheet, commission is earned on the deals."

In fact, the joint venture did not earn a commission in the usual sense of that term. The joint venture received its profit in respect of leases granted under the Sub-Agency Agreement in the form of the spread between the interest rate it charged on the leases, and the interest rate paid to Beneficial Finance. By 30 June 1986, the total receivables relating to leases granted by the joint venture under the Sub-Agency Agreement were $4.2M, comprised by forty separate leases. An analysis by Price Waterhouse showed that in July 1986 the Reverse Principal and Agency business written by the joint venture totalled $1.2M while its other business totalled $8.7M. In December 1986, Reverse Principal and Agency business totalled $5.8M, and other business totalled $7.7M.

The working papers of Price Waterhouse for the audit of the joint venture for the year ended 30 June 1988 contains an analysis of receivables into "SBSA Reverse Principal and Agency" receivables and other business. The analysis identified an error in the allocation of receivables, in that the balance shown as "SBSA Reverse Principal and Agency" receivables in the accounts of the joint venture was shown as $13.3M, whereas it should have been $15.6M. The working papers contain this explanation:

"These deals were incorrectly recorded as belonging to Pegasus when they are SBSA Reverse P & A deals. Corrected in January. Correct balances have been disclosed in balance sheets ... This problem was ... due to a keying error by the client and so we can accept it as an isolated incident."

In a sense, so long as Beneficial Finance was liable to bear the credit risk associated with leases granted under the Reverse Principal and Agency Agreement, it was not of major significance to the State Bank if a particular lease was incorrectly shown or not shown as having been made pursuant to that Agreement. In either case, the risk of loss lay with Beneficial Finance, and not with the State Bank, which had an indemnity from Beneficial Finance for the full amount of any losses. As noted, the substance of the Reverse Principal and Agency Agreement much more resembled a funding arrangement than an agency agreement. Similarly, so long as the joint venture was liable to indemnify Beneficial Finance for any losses, a mis-allocation of receivables to the Sub-Agency Agreement had no major credit risk implications.

The allocation of receivables to the Reverse Principal and Agency Agreement could, however, have implications for Beneficial Finance's balance sheet, and so for its gearing ratios and compliance with the terms of its debenture Trust Deeds. Where leases were funded under the Reverse Principal and Agency Agreement, Beneficial Finance's practice was to exclude from its balance sheet both the liability represented by the loan from the State Bank, and the asset in the form of Beneficial Finance's loan to the joint venture or the related lease receivables. The liabilities and assets were simply netted off, reflecting Beneficial Finance's capacity as a mere agent, or conduit to the sub-agent. As I shall describe, the Reverse Principal and Agency Agreement was used in 1990 to move Beneficial Finance's exposure to Pegasus Leasing off its balance sheet, with the result that the Pegasus Leasing receivables portfolio came to be owned by the State Bank.

Even though the liabilities and assets related to the Reverse Principal and Agency Agreement were not included on Beneficial Finance's balance sheet, it was technically necessary for Beneficial Finance to show the full amount of the receivables as a contingent liability in the notes to its accounts, because it was liable to indemnify the State Bank for any losses in respect of the receivables portfolio. Such a contingent liability could have implications for Beneficial Finance's debenture Trust Deeds.

Accordingly, on 30 June 1987 Mr K S Matthews, Chief General Manager of the State Bank, sent a letter to Beneficial Finance limiting Beneficial Finance's obligation to indemnify the State Bank for any losses under the Reverse Principal and Agency Agreement to a maximum of 10 per cent of the total receivables under the Agreement. The purpose of the letter was to prevent Beneficial Finance having to disclose in its accounts a contingent liability, essentially in the form of a guarantee, for the full amount of all of the Reverse Principal and Agency receivables. In a submission to my Investigation, the State Bank noted that such a contingent liability "would not have been representative of the actual contingent liability or risk." ⁽⁾ A file note dated 27 November 1990 from Mr A Parkinson, General Manager of Beneficial Finance's Taxation and Corporate Planning department, stated that the risk borne by Beneficial Finance was limited to 10 per cent because of the requirements of the trustee for Beneficial Finance's debenture holders, and for "tax reasons". I understand the reference to "tax reasons" to mean that, with the State Bank potentially at risk in respect of the receivables portfolio, the terms of the Reverse Principal and Agency Agreement would more strongly support the position that the receivables in substance belonged to the State Bank. Subsequent Agreements expressly included a term limiting Beneficial Finance's indemnity to the first 10 per cent of losses.

From the State Bank's perspective, such a limit would have no implications provided that the actual losses realised in respect of leases written under the Reverse Principal and Agency Agreement did not exceed 10 per cent of the total receivables portfolio. If it did, the State Bank would be required to bear the loss. The limitation of Beneficial Finance's liability to indemnify the State Bank to a maximum of 10 per cent of the total Reverse Principal and Agency Agreement lease receivables did not, however, affect the position of the State Bank Group, since the indemnities obtained by Beneficial Finance from its sub-agents were unaffected.

33.2.5 THE PERFORMANCE OF THE FIRST JOINT VENTURE

The Beneficial Finance Board of Directors expressed some dissatisfaction with the profit performance of the joint venture from early in 1987. The minutes of a meeting of the Beneficial

Finance Board on 27 March 1987 record that:

"... Concern was expressed at the poor results achieved by Pegasus Leasing. This will be given a further 12 months and if the overall performance is not improved, consideration will be given to discontinuing the venture."

The audited financial statements of the joint venture for the year ended 30 June 1987 showed an operating loss for the year of $0.12M. After a loss of $31,405 for the period ended 30 June 1986, the accumulated losses to 30 June 1987 were $0.15M.

In April, a report informed the Board that sales for the month had been "disappointing", and in May a report stated that a "disappointing level of arrears ($1.27M at 31 March) has caused concern and steps have been taken to substantially reduce the arrears outstanding". The minutes of the Board of Directors meeting held on 29 May record that "forecast sales for 1987/88 for Pegasus are $30.0 million, but there is concern at the continuing poor performance."

A joint venture report presented to the Beneficial Finance Board of Directors' meeting on 31 July 1987 reported:

"Considering that Beneficial virtually assumes most of the risks on receivables of $22.6M through guarantees to National Australia Bank and through the State Bank Reverse P&A Arrangement, a return of:

(a) $27,000 being a 50 per cent share of profit, plus

(b) receipt of a management fee of $24,000 for the year; and

(c) receipt of a guarantee fee of $70,000,

cannot, at this stage, be considered satisfactory. The continued high level of arrears also reflects unsatisfactorily on the joint venture's performance. The future operation of the joint venture requires careful review."

The minutes of that meeting record that:

"Concern was expressed at the poor performance and possible bad debts of Pegasus Leasing. Mr Graham reported that the profit budget for 1987-1988 had been referred back for further review to seek ways of improving profitability. This should be completed by 14 August. The Board considered the matter should either be fixed to assure a profitable return to Beneficial, or the operation should be dissolved over the next 12 months."

The audited financial statements of the joint venture for the year ended 30 June 1987 showed an operating loss for the year of $0.12M. After a loss of $31,405 for the period ended 30 June 1986, the accumulated losses to 30 June 1987 were $0.15M.

At its meeting on 25 September 1987, the Board was advised by management that:

"... a new structure is being considered to embrace a wider range of financing activities in conjunction with Mr Alistair McGregor. We are continuing with the negotiations and will keep the Board advised."

The Board was also advised that the performance of the joint venture was improving. The September report stated that the joint venture "continued to be conducted to Beneficial Finance's satisfaction", and the October Joint Venture Quarterly Report said:

"September saw a record result for Pegasus Leasing where a profit of $54,000 was recorded ... Concentration on reducing the number and level of arrears has been made over the past three months with total arrears reducing by 2.3 per cent in the last two months."

The Report informed the Board that new terms for the sharing of commissions on new joint venture business introduced to the joint venture by the joint venture participants had been agreed between Beneficial Finance and Pegasus Securities, and that those new terms " in the long run, should see Beneficial Finance receive an adequate return from the joint venture (subject to adequate sales being achieved)." The current level of sales was not considered adequate, with sales of $1.06M since 1 August 1987 compared to budgeted sales of $5.28M.

On 27 November 1987, Mr Baker advised the Board that the joint venture was to be restructured. The minutes of the Board meeting record that:

"The Managing Director advised that a Heads of Agreement is being considered to form a new 50/50 joint venture operation and to acquire the interests of Mr Alistair McGregor and the existing joint venture company. Price Waterhouse is currently valuing McGregor's companies, including an insurance factoring operation. A 20 per cent After Tax Return On Equity will be a minimum requirement for the arrangement to proceed. Mr Baker was asked to discuss the final recommendation with Messrs Barrett and Clark, or in their absence, other members of the Board to seek approval, if required."

For the six months ended 31 December 1987, the joint venture reported a profit before tax of $32,000, which was $30,000 below budget. The Joint Venture Quarterly Report stated that:

"Main savings appear in the area of losses (which were nil for the half). However, the gross margin achieved of $0.253M is well behind budget as a result of the lower than budget level of receivables ... Sales for the six months reached only $5.1M, which was lower when compared to the same period for 1986, and a large $10.4M lower than budget."

The minutes of the Board of Directors' meeting held on 29 January 1988 record that "it is reported that a new joint venture arrangement had been entered into with Mr A McGregor, effective from 1 January 1988."

33.2.6 SUMMARY AND CONCLUSIONS

The first joint venture, which operated for two years until December 1987, was essentially a partnership between Pegasus Securities and Beneficial Finance, based on the premise that Pegasus Securities would manage and operate the business, and Beneficial Finance would fund it. Profits and losses were to be shared equally. Pegasus Securities received management fees for conducting the business, and Beneficial Finance received interest and guarantee fees in respect of its funding of the business.

As well as conducting business on behalf of the joint venture partners, Pegasus Leasing also granted leases on behalf of the State Bank, in its capacity as a sub-agent of Beneficial Finance under the Reverse Principal and Agency Agreement. The Principal and Agency Agreement was regarded by the management of Beneficial Finance as a mechanism for funding its leasing business, and in economic substance it was. That does not mean, of course, that the legal effect of the Agreement could be ignored.

Although the joint venture agreement provided Beneficial Finance with joint control of the joint venture, and required that larger leasing transactions be approved by Beneficial Finance, in my opinion the effective day-to-day operation of the joint venture was controlled by Pegasus Securities. Pegasus Securities had the responsibility for the conduct of the joint venture business, including the introduction of new business, the approval of new leases, and management of the receivables portfolio.

More importantly, the fundamental basis of the joint venture was that the specialised business would be conducted by Pegasus Securities. Shortly stated, if Beneficial Finance had the experience and expertise to carry on a bloodstock financing business, it would not have needed to enter the partnership with Pegasus Securities. Fundamental to the arrangement was the understanding that Beneficial Finance would rely on the experience and judgment of Pegasus Securities in the conduct of the business. Similarly, if Pegasus Securities had the financial strength to grow the business, it would not have needed to enter into an equity partnership with Beneficial Finance. Pegasus Securities purpose in entering into the partnership was to obtain financial support that would not otherwise have been available to it.

The Board of Directors of Beneficial Finance was expressly told in December 1986 that Pegasus Securities was responsible for the introduction of business, the approval of new leases, and management of the portfolio.

Despite the express direction by the Board of Directors, no relevant limit was placed on Beneficial Finance's exposure to either the Pegasus Leasing joint venture, or to the bloodstock industry generally.

The first joint venture was not successful, and in December 1987 it was terminated, and its portfolio allowed to run down, under the management of Pegasus Leasing.

 

33.3 THE PEGASUS LEASING JOINT VENTURE: JANUARY 1988 TO MAY 1990

 

33.3.1 INTRODUCTION

Pursuant to Heads of Agreement dated 31 December 1987, Beneficial Finance and Pegasus Securities agreed to enter into a new joint venture with effect from 1 January 1988. The Heads of Agreement recited that Beneficial Finance and Pegasus Securities:

"... now wish to wind up the operations of the existing joint venture and to conduct the joint venture business and the business presently conducted by Pegasus Securities either directly or through Rivlin, together with such other business as they shall hereafter agree to conduct ... through a corporate entity to be owned in equal shares by Pegasus Securities and Beneficial."

The proposal to change the structure of the joint venture may be seen as a response to the criticism of the past performance of the joint venture. It was, in effect, to be a fresh start. The portfolio of receivables of the first joint venture would not be transferred to the new venture, but would instead be run down, under the management of Pegasus Leasing.

The new joint venture was essentially based on the business activities of Pegasus Securities, Beneficial Finance's partner in the first joint venture. The joint venture company, Pegasus Leasing, was to purchase the existing businesses of Pegasus Securities, employ that company's staff, and carry on the business in its own right. Pegasus Leasing was owned in equal shares by Pegasus Securities and Beneficial Finance. Again, however, the basic premise of the joint venture was the same - a combination of the skills and expertise of Pegasus Securities, with the financial backing of Beneficial Finance.

33.3.2 INITIATION OF THE PEGASUS LEASING JOINT VENTURE

In December 1987, Beneficial Finance's Joint Venture Committee recommended against entering into the new joint venture. The Committee had been formed in July 1987 to:

(a) review monthly results of each joint venture;

(b) review the risks associated with each joint venture, and the returns to Beneficial Finance from participation in the joint ventures;

(c) review joint venture budgets and forecasts; and

(d) establish criteria for the assessment of new joint ventures.

The Joint Venture Committee was to approve any new ventures prior to execution of documentation.

The minutes of the meeting of the Joint Venture Committee in early December 1987 record:

"Pegasus Re-organisation. The Committee queried the validity of the restructure and whether it was achieving its objective of lowering the Joint Venture's borrowing cost. Some benefits would arise from the restructure namely improved efficiency and improved relationships between the parties. The Committee felt that the best course of action would be closure of the Joint Venture."

Despite this recommendation, Heads of Agreement were signed by Mr Baker on behalf of Beneficial Finance, and by Mr McGregor on behalf of Pegasus Securities, to form a new joint venture.

Further, the establishment of the new Pegasus Leasing joint venture with effect from 1 January 1988 was not the subject of a formal submission to the Beneficial Finance Board of Directors. As shown by the minutes of the Board of Directors' meetings quoted earlier, however, the Board was informed of the intention to terminate the first joint venture and to establish a new joint venture with a wider range of businesses, and Mr Baker was asked to discuss the recommendation with Mr L Barrett and Mr T M Clark.

The evidence available to my Investigation is that the new Pegasus Leasing joint venture was essentially the result of negotiations between Mr Baker and Mr McGregor. The joint venture was established despite the recommendation of, and without the approval or endorsement of, the Joint Venture Committee, and was not the subject of a formal submission to, or review by, the Board of Directors.

The unsatisfactory nature of the procedures by which the new joint venture was established hardly needs to be pointed out. Mr Baker's disregard of the express and documented advice of the Joint Venture Committee displays a dangerous distain for the professional judgment of others. The absence of a formal submission to the Board of Directors bearing the recommendation of the Joint Venture Committee was equally unsatisfactory.

33.3.3 THE STRUCTURE AND MANAGEMENT OF THE PEGASUS LEASING JOINT VENTURE

The principal elements of the Pegasus Leasing joint venture were set down in the Heads of Agreement dated 31 December 1987.  The terms of the Heads of Agreement became binding, with effect from 1 January 1988, upon the execution of a Deed on 29 January 1988.

The new joint venture involved the use of Pegasus Leasing Ltd as the joint venture company to carry on business in its own right, and not as nominee. (Pegasus Leasing Ltd became an unlisted public company in October 1988, and its name was changed from Pegasus Securities Leasing Pty Ltd to Pegasus Leasing Ltd.)

In accordance with the Heads of Agreement, Pegasus Securities and Beneficial Finance each contributed $0.2M of capital to Pegasus Leasing. As under the first joint venture, Beneficial Finance and Pegasus Securities were to bear any joint venture losses equally, in this case by contributing additional capital to the joint venture company. Profits of Pegasus Leasing were to be paid to Pegasus Securities and Beneficial Finance in the form of dividends, determined by its Board of Directors. Beneficial Finance was to provide a guarantee of the indebtedness of Pegasus Leasing, for which Beneficial Finance would be entitled to a guarantee fee of 1 per cent per annum.

The business of Pegasus Leasing was to be carried on from the premises of Pegasus Securities. The initial directors of Pegasus Leasing were Mr McGregor and Mr Tucker nominated by Pegasus Securities, and Mr Baker and Mr M Chakravarti nominated by Beneficial Finance. Mr McGregor was Executive Chairman. Beneficial Finance appointed one of its staff, Mr T Waller, to be the company secretary of Pegasus Leasing, and provided the services of its internal audit department.

The Heads of Agreement provided that all lease approvals were to be made by the Pegasus Leasing Board of Directors, subject to any delegations to an appropriate committee.

The staff of Pegasus Securities were transferred to, and subsequently employed by, Pegasus Leasing. The General Manager of Pegasus Leasing was Mr T Knox, who had joined Pegasus Securities in 1983 after working for Beneficial Finance. Beneficial Finance was entitled to nominate one of its staff to become a full-time employee of Pegasus Leasing, and Mr J Gore, Beneficial Finance's Leasing Manager for South Australia, was seconded to Pegasus Leasing. He subsequently became a full-time employee of the joint venture. The Heads of Agreement provided that all accounting records were to be maintained by Pegasus Leasing, using Pegasus Securities' accounting system. Beneficial Finance was to review the Pegasus Securities accounting system and records, and "be satisfied that adequate controls exist". The accounts of Pegasus Leasing were audited by Price Waterhouse, the auditors of Beneficial Finance.

In practice, the day-to-day activities of Pegasus Leasing, including the approval of leases, management of the receivables portfolio, and accounting functions, were controlled by Mr McGregor and his Pegasus Securities staff. Mr G M Hewitt, who became the General Manager of Pegasus Leasing late 1990 or early 1991, said in a briefing paper⁽⁾ prepared for the Jacobs Royal Commission on behalf of Beneficial Finance that, in practice, significant matters in the conduct of the business of Pegasus Leasing were probably discussed by Mr McGregor with Mr Baker or other senior managers of Beneficial Finance, or were raised at Board meetings of Pegasus Leasing.

The practical reality was, however, that the day-to-day conduct of Pegasus Leasing's business was undertaken by Pegasus Securities personnel. Beneficial Finance's control was essentially limited to its representation on the Board of Directors of Pegasus Leasing.

Such an approach was consistent with the basic premise of the joint venture that Beneficial Finance placed reliance on Pegasus Securities' experience and expertise in the bloodstock industry. Beneficial Finance simply lacked the relevant industry skills. Its role was to ensure finance for the joint venture.

In his evidence to my Investigation, Mr Reichert, who was the General Manager of Beneficial Finance's Investment Banking division and was a director of Pegasus Leasing from June 1988 to November 1989, said that he believes that "too much latitude" was given to Mr McGregor in respect of the operations of the joint venture, and that he "certainly believed at the time and still believed" that "too much reliance was placed on Mr McGregor". Mr Reichert also said that he did not believe that Mr McGregor had the "credentials" to adequately manage the joint venture's business.⁽⁾

Mr Reichert's evidence is a frank admission of Beneficial Finance's failure to exercise effective control over the conduct of Pegasus Leasing's business, and of his own failure to do so as a nominee of Beneficial Finance on the Board of Directors of Pegasus Leasing. There is no evidence that Mr Reichert expressed his concerns to the other directors nominated by Beneficial Finance, or took any other action to impose greater control, even though he believed that Mr McGregor lacked the necessary expertise and experience.

Beneficial Finance provided the debt funding for Pegasus Leasing from its inception in January 1988, until early 1990 when the joint venture was again restructured. The National Australia Bank's $5.0M loan to finance the old joint venture, guaranteed by Beneficial Finance, was repaid in June 1988, after which Beneficial Finance also funded that portfolio of receivables. By the end of 1989, Beneficial Finance's unsecured loans to Pegasus Leasing totalled $79.0M.

The procedure for the drawdown of funds by Pegasus Leasing was discussed at a meeting of that company's Board of Directors on 9 May 1988. The minutes record that:

"The Board approved that Mr J Gilgen [the Financial Controller of Pegasus Leasing] be authorised as a funding authority to initiate drawdowns through Beneficial Finance in addition to Messrs McGregor and Knox. In future, all drawdowns from Beneficial must be supported by a list showing either the deals to be settled or deals that have been settled. Details should include date of settlement, lessee and the amount to be financed. The list should be countersigned by an approved authority."

In October 1989, Beneficial Finance took action to both increase its control over its various joint ventures, and to reduce its funding commitment to them. A draft letter dated 2 October 1989 prepared by the Investment Banking division stated in part:

"On 1 July 1989, Beneficial Finance Corporation implemented a top level restructure to provide stronger divisional focus in strategic and major business areas.

A new division, Structured Finance and Projects, was formed to control all of the company's structured facilities, overseas operations and major property accounts. This division is headed by Erich Reichert.

The Investment Banking Division is now headed by Roger Sexton and, inter alia, focus on Beneficial's strategic equity investments. The Investment Banking Division is now responsible for strategic and policy issues relating to Beneficial's Joint Ventures [JVs] while the Business Divisions are responsible for the day to day operations of the JVs.

IBD has appointed an account manager for each JV. This person will be involved in the strategic direction of the JV and will assist with policy issues as they arise. Roger Sexton will be appointed to the board of each JV, with the appropriate Account manager being the alternate board member."

A draft letter of the same date from Dr R N Sexton to the Beneficial Finance personnel responsible for its various joint ventures stressed the need to place greater emphasis on the monitoring and control of joint venture operations. The letter identified a number of factors for "consideration and implementation":

"(a) One of the most critical areas that needs to be addressed is Credit Standards. Attached is a summary of the Approval limits which apply to your company, and it is essential that these limits are adhered to.

In particular, Group exposure to clients must be closely monitored, and as a matter of procedure, no credit approval should be given without first confirming the extent of Beneficial's exposure, if any, to the client.

The level of Beneficial exposure, or, if applicable, the fact that no exposure exists must be included as part of the approval process. Information concerning Beneficial's client exposures can be sourced through the joint ventures account manager in the relevant Business Division.

(b) Any major variation in expenditure by the joint venture outside of the approved budget, must be referred to the Board of the Venture.

(c) In order to ensure that Beneficial is fully informed of the performance of each joint venture, and can therefore provide the necessary support, it is essential that all financial and secretarial reports are prepared in a timely manner.

It is appreciated that the responsibility for day to day running of the business is that of the Joint Venture Manager. However, the level of Beneficial's capital and funding commitment to the Venture necessitates the provision of regular information to Joint Venture Accounting, the Business Divisions and Investment banking Division. The provision of this information on a timely basis will assist in Beneficial's continued support to the venture.

Secretarial matters should be referred to Beneficial's Company Secretary, who is joint company secretary for all Joint Ventures.

There is no doubt that the financial climate has changed, and that the successful companies will be those that adapt to the changing environment and place more emphasis on monitoring and control.

Adherence to the above criteria will assist with the continuing strength of our Joint Venture operations."

Despite this initiative, the effective control of most new leasing of Pegasus Leasing, and the management of the portfolio, remained with Pegasus Securities personnel. The minutes of the meeting of the Board of Pegasus Leasing on 25 October 1989 record that:

"After discussion, it was agreed that the Pegasus Leasing Limited Board be substituted for the Beneficial Finance Credit Committee. Once applications exceed that limit, they must then go to the Beneficial Finance Board for approval. Mr O'Brien is to advise Mr McGregor of the limits and these will be circulated with these Minutes. A resume is to be circulated to Board members giving relevant details of all transactions."

Beneficial Finance's reliance on Mr McGregor or another bloodstock leasing expert to run the joint venture business was expressly stated in September 1990 by Mr F Piovesan and Mr Chakravarti, both senior managers of Beneficial Finance who had been directors of Pegasus Leasing. In a memorandum dated 18 September 1990, they reported:

"We consider Beneficial Finance to have limited expertise in the bloodstock industry, and therefore we will need to rely on Mr McGregor or another independent authority to manage the investments, partnership accounts and any problem loans involving decisions on the bloodstock held."

33.3.4 THE BUSINESS ACTIVITIES OF THE PEGASUS LEASING JOINT VENTURE

The Heads of Agreement provided that Pegasus Leasing would acquire from Pegasus Securities the business of Pegasus Insurance Brokers, and all of the shares of Rivlin, a company that carried on a debt factoring business to the crash repair industry. Debt factoring is a specialised form of lending based on the security of the borrowers' trade receivables. On 29 January 1988, Pegasus Leasing and Rivlin entered into an Agreement for Rivlin to trade as agent of Pegasus Leasing, and not upon its own account.

Although Pegasus Leasing acquired the businesses of Pegasus Securities, it was not to purchase that company's receivables portfolio, or the existing portfolio of receivables of the first joint venture. The Heads of Agreement stated that:

"None of the existing receivables in the existing joint venture or Pegasus Securities are to be assigned or transferred to Pegasus Leasing, which shall hereafter as agent and manager collect, account for and report to the joint venture parties or Pegasus Securities their, respective receivables ..."

Despite this term in the Heads of Agreement, Pegasus Leasing did purchase a portfolio of receivables from Pegasus Securities, and take over the first joint venture's portfolio, in May and July 1989 respectively.

In about May 1989, Pegasus Leasing acquired a portfolio of receivables totalling about $0.75M from Pegasus Securities. A letter dated 7 March 1991 from Kelly & Co, Solicitors acting for Beneficial Finance to Piper Alderman, Solicitors acting for Pegasus Securities (Receiver & Manager appointed), stated that the receivables were written into the books of Pegasus Leasing upon settlement of the transaction, but responsibility for administration of the receivables, and for collection of amounts due, remained with Pegasus Securities. A report prepared by Mr Hewitt stated that:

"Little information could be located with respect to the sale of Pegasus Securities' receivables to the joint venture. It does not appear to have received Board approval. The transaction in total was handled very poorly from the Joint Venturers' point of view, with seemingly no documentation formally executed to effectively assign the receivables to the Joint Venturers. Reconstruction of events have indicated the intent of the transaction, however the Joint Venture has been disadvantaged by the "deal" and its accounting."

On 1 July 1989, the assets and liabilities of the first joint venture were transferred to Pegasus Leasing at book value, and the first joint venture ceased to exist. The financial statements of Pegasus Leasing for the year ended 30 June 1989 said of the transfer that:

"The company also assumed the management of receivables totalling $7.6M previously managed by the Joint Venture. The company also assumed the liability for the funding of those receivables.

Since the year end a receivable in this portfolio of approximately $2.0M has gone into arrears. The eventual outcome of this situation is uncertain, however an adequate provision for any loss will have been made by 30 June 1990."

The reference to the managed portfolio of receivables of $7.6M is apparently a reference to the leases granted by the old joint venture on behalf of the State Bank as the sub-agent of Beneficial Finance under the Reverse Principal and Agency Agreement. These receivables, which belonged to the State Bank, were not to be shown in the joint venture's balance sheet. The reference to the need for a provision in the accounts of Pegasus Leasing relates to the fact that Pegasus Leasing was required to indemnify the State Bank for any losses arising from the managed portfolio.

The Heads of Agreement provided that the business of Pegasus Leasing was to include:

(a) bloodstock and livestock leasing as previously undertaken by the existing joint venture and Pegasus Securities;

(b) other leasing business, including the leasing of art works and antiques and other types of specialist leasing business;

(c) the debt factoring business of Rivlin;

(d) leasing business of a type traditionally conducted by Beneficial Finance, but only for established clients of Pegasus Leasing or as agent for Beneficial Finance; and

(e) entrepreneurial finance business of such other descriptions as Pegasus Leasing may initiate or develop.

The Heads of Agreement expressly authorised Pegasus Leasing to carry on business in New Zealand and "elsewhere in the world as its Board of Directors may from time to time determine". The directors' report accompanying the financial statements of Pegasus Leasing for the year ended 30 June 1988 described the joint venture's activities for the six months ended 30 June 1988 as follows:

"The company commenced trading on 1 January 1988 in its own right in the finance industry providing funds mainly for bloodstock purposes. Previously the company acted as nominee for Pegasus Securities Leasing joint venture which is now in a run-down phase. Additionally, the company acquired an interest in Rivlin & Associates Pty Limited, a crash repair factoring entity and also Pegasus Insurance Brokers on 1 January 1988. The principal activities of the group during the course of the period from 1 January 1988 were general finance, leasing, factoring and insurance brokers."

Over the period from January 1988 until June 1990, with access to essentially unlimited funding from Beneficial Finance, the business of Pegasus Leasing diversified and expanded in size very significantly, well beyond the limits of Pegasus Securities' previous experience. In addition to bloodstock leasing in Australia and the businesses acquired from Pegasus Securities, Pegasus Leasing's operations after January 1988 included:

(a) bloodstock leasing in New Zealand and in the United Kingdom;

(b) ownership of a 75 per cent interest in Bloodstock Management International Limited;

(c) ownership of an 87.5 per cent interest in Bloodstock Trading International Limited, a United Kingdom bloodstock agent;

(d) participation in, and provision of finance to, two thoroughbred investment syndicates, the North-South Thoroughbred Investment Parcel and the Austral-Eire Thoroughbred Investment Parcel; and

(e) Various other investments and financing arrangements, including loans, equipment leases and interests in other companies and a partnership.

At its meeting on 9 May 1988, the Board of Directors of Pegasus Leasing resolved to commence leasing businesses in New Zealand and the United Kingdom, and to set a target of $3.0M of new leases in Australia each month. The minutes record:

"In principal Pegasus Leasing are to proceed with sourcing business in New Zealand. To enable business to be written, Pegasus Leasing are to liaise with Beneficial's Treasury Department with a view to establishing a NZ $5M line with the Bank of New Zealand. At this stage, business is only to proceed once a funding source has been secured.

Currently, the draft budget shows a sales level of $2 million per month. The Board considered this level inadequate and that a target of $3 million per month of business sourced in Australia must be achieved. Beneficial pointed out that its expectations for joint ventures were for a 20% profit and sales growth in each year with a minimum return after tax of 30% on capital employed.

A separate budget is to be drawn up for the proposed UK operations with the net result to be included in the Pegasus Leasing 88/89 budget as a one line entry. This result should include an administrative fee to be charged by the Australian Operations for work undertaken relating to UK sourced deals.

The Board approved that Pegasus Leasing are to be involved in the UK subject to an appropriate funding source being organised. State Bank are to be contacted with a view to arranging a funding line."

A dissection of Pegasus Leasing's receivables as at 30 June 1989 by Price Waterhouse showed both the diversity, and rapidly increasing size, of the portfolio:

	30 June 1989 $			31 December 1988 $
Livestock Leases	55,842,500			32,244,977
New Zealand Receivables	5,978,239			843,823
Receivables Acquired from
Pegasus Security	416,000			-
Equipment Leases	880,979			695,749
Mortgage Loans	1,166,430			1,786,739
Other Loans	4,873,288			-
TOTAL		$69,157,434			$35,571,288

The "other loans" granted by Pegasus Leasing were principally related to its promotion of the North-South Thoroughbred Investment Parcel. Simply stated, the "Investment Parcels" were arrangements which allowed members of the public to invest in thoroughbred horses, similar to the way in which public unit trusts allow small investors to invest in commercial real estate. Each Investment Parcel was divided into a number of "shares", and investors would lease a fractional interest in the thoroughbred bloodstock of the Investment Parcel. The Investment Parcels' activities were managed by a professional bloodstock management company.

A principal selling point of the Investment Parcels was the income tax deductions that were said to be available to the investors. Since each investor had a direct proportionate share of the bloodstock, the entire amount of the lease payments were tax deductible to the investor. Typically, as with the North-South Parcel, the investors would make an up-front payment of two or more years of lease payments, enabling the bloodstock to be purchased. The full amount of the payment was said to be tax deductible when paid. Further, some investors were able to borrow funds to make that payment, with the result that investing in the Investment Parcel could actually provide the investor with a cash benefit in the form of a taxation saving of up to half the amount invested. Of course, the leases and loans eventually had to be repaid, but investors relied on increases in value of the bloodstock, and income from breeding and racing, to provide the necessary funds.

At its meeting on 9 May 1988, the Board of Directors of Pegasus Leasing resolved to acquire an interest in a bloodstock management company, but it was not until 15 December 1988 that Pegasus Leasing purchased a 75 per cent interest in Bloodstock Management International Limited.

In October 1988, the Pegasus Leasing Board decided to establish an Investment Parcel in South Australia, to be called the North-South Thoroughbred Investment Parcel. Between October 1988 and April 1989 when the venture was to commence, Pegasus Leasing entered into contracts to purchase thoroughbred horses to be leased to the investors. The Investment Parcel was divided into forty shares, each with an initial cost of $80,000 to meet lease payments on the bloodstock, and pay the costs of maintaining the horses, for the first two years. Pegasus Leasing provided interest-only loans to some investors to pay that initial cost, and underwrote the venture. In June 1989, Pegasus Leasing itself purchased sixteen of the forty shares that were offered to investors. The North-South Investment Parcel was managed by Bloodstock Management International Ltd.

The Austral-Eire Thoroughbred Investment Parcel was a breeding venture which held bloodstock in Ireland, Australia and New Zealand. It was established in 1988, with Pegasus Leasing holding a 10 per cent interest. In December 1988 Pegasus Leasing increased its ownership to 20 per cent, and in September 1990 to 39 per cent of the Investment Parcel. Pegasus Leasing also provided finance to Austral-Eire, including a lease of $1.95M in December 1989 to fund new purchases of livestock.

The increasing complexity and diversity of Pegasus Leasing's operations was accompanied by a rapid increase in its total assets and liabilities. The joint venture was established with total assets of less than $1.0M, represented by the businesses of Pegasus Insurance Brokers and Rivlin purchased from Pegasus Securities. The audited financial statements of Pegasus Leasing for the year ended 30 June 1988 reported that, as at 30 June 1988, the company had total assets of $21.6M, including receivables of $20.6M. Total liabilities were $21.3M, including loans of $18.0M.

By 30 June 1989, total assets had increased to $78.3M, an increase of 263 per cent over the year. Receivables totalled $68.7M, an increase of 233 per cent. Pegasus Leasing's liabilities totalled $78.8M, or $0.5M greater than its total assets. Its borrowings totalled $73.1M. When the joint venture was re-organised in May 1990, its total assets were almost $100.0M, including receivables of about $90.0M.

The management problems associated with the large and diverse business operations were highlighted in a memorandum dated 18 September 1990 from Mr Chakravarti and Mr Piovesan, who stated:

"The magnitude of the operation, ie approximately $100.0M of receivables (over 50% of Beneficial Finance's South Australian and Northern Territory receivables) dictates that any solution must be of a longer term nature. In addition, the geographical spread further exacerbates our management thereof."

33.3.5 THE PERFORMANCE OF THE PEGASUS LEASING JOINT VENTURE

Although the operating revenue of Pegasus Leasing increased after January 1988 broadly in line with its increasing assets, the company incurred increasingly large losses in each year.

The Joint Venture Quarterly Report presented to the Board of Directors of Beneficial Finance in July 1988 reported that Pegasus Leasing incurred a loss of $141,000 for the six months ended 30 June 1988, which was $6,000 worse than budget. The Report stated:

"The loss includes a writeoff of goodwill of $66,000 and given that the company has been trading for only six months this is an excellent result. Future plans include an expansion into the UK and possible New Zealand.

Pegasus Insurance Brokers profit of $19,000 was $30,000 below budget. Gross premiums are better than budget by $417,000. The worse than budget performance is due primarily to no profit share being received from Union Insurance due to a large claim pending.

Rivlin profit is in line with budget and is primarily due to savings in operating costs. Sales were below budget. The result is satisfactory, given the level of accounts invoiced."

The audited financial statements of Pegasus Leasing for Pegasus Leasing the year ended 30 June 1988 reported that the company incurred a loss of $0.13M in the six months to 30 June 1988, leaving it with capital of only $0.27M.

(The audited financial statements for the old joint venture for the year ended 30 June 1988 reflected the winding-down of its business activities. Total receivables declined from $7.6M as at 30 June 1987, to $5.4M at 30 June 1988. The old joint venture reported a loss of $0.13M for the year, and at 30 June 1988 its liabilities exceeded its assets by $80,466. By 30 June 1989, the old joint venture's receivables had declined to $1.2M. It recorded a loss of $89,404 in 1989, and its liabilities exceeded its assets by $1.7M.)

Pegasus Leasing's operating revenue increased significantly in the year ended 30 June 1989, due largely to a large increase in interest income. Operating revenue for the year ended 30 June 1989 was $8.9M, compared to $1.0M for the six months ended 30 June 1988, an annualised increase of 335 per cent. The major increase in operating revenue was in interest receivable, which increased from $0.5M in the six months ended 30 June 1988, to $7.5M in the year ended 30 June 1989. Although operating revenue increased, so did Pegasus Leasings operating losses, from $0.1M in the six months ended 30 June 1988, to $0.8M in the year ended 30 June 1989.

Draft financial statements of Pegasus Leasing for the year ended 30 June 1990 showed that the company's operating revenue and interest income approximately doubled over the year from the amounts received in 1989. The draft accounts disclosed, however, that the company incurred an operating loss of $5.5M for the year.

The key operating results of the Pegasus Leasing venture from January 1988 to June 1990 can be summarised as follows:

	Year Ended 30 June 1990 $		Year Ended 30 June 1989 $		Year Ended 30 June 1988 $
Operating Revenue	17,203,663	8,882,429		1,020,862
Operating Loss After Tax	5,465,431	790,734		123,084
Interest Income	15,170,888	7,455,186		549,248
Interest Expense	15,191,543	6,458,898		466,413
Doubtful Debts Expense	(155,263)	685,336		141,533

In summary, although Pegasus Leasing expanded and diversified its operations rapidly after January 1988, it reported increasingly large losses each year. Indeed, the joint venture recorded a loss every year from the time of its formation in 1985.

That is not to say that the joint venturers did not derive any profits from the provision of services to the joint venture. Pegasus Securities and Beneficial Finance derived income in the form of management fees, commission, interest and guarantee fees from the joint venture for providing management and financial services. A report prepared by Mr Chakravarti and Mr Piovesan in October 1990 stated that each joint venturer had received profits of about $1.1M over the life of the joint venture. Nevertheless, assuming that the services were provided by the joint venturers on commercial terms, the reported results of the joint venture strongly suggest an underlying unprofitability.

In 1989 and early 1990, some signs began to emerge that Pegasus Leasing's business operations had outgrown the capacity of its internal management information and accounting systems to cope.

In a memorandum dated 4 September 1990 from Mr J R Devereaux to Mr Chakravarti, Dr Sexton and Mr G A Brown, Mr Devereaux reported that:

"In the monthly management report to the August 1989 Executive Committee meeting by the Finance, Credit & Personnel Division, a reference was made in the Equity Accounting Section to Pegasus "maintaining its chequered record" and further clarification has been requested.

From February, 1989 to August, 1989 we liaised with six non-Beneficial Accountants, who were involved in the provision of financial data for various entities, by specified deadlines, to enable preparation of Equity and Aggregate Accounting statements for periods ending December 31, 1988 and June 30, 1989.

The performance by Pegasus was easily the worst and we experienced none of the following problems with the other five entities:

1. No deadline was ever met, despite assurances they could be complied with. This also applied to monthly financials for the period February-May 1989.

2. Financials needed a number of alterations after we perused them.

3. On many occasions there was no response to our telephone messages.

Price Waterhouse provided accounting assistance for the June 1989 accounts and I believe they had similar frustration."

At its meeting on 26 January 1990, the Board of Directors of Beneficial Finance reviewed a summary of Internal Audit Report No 20, covering the period October to December 1989. The Report stated that issues raised in the previous audit report of Pegasus Leasing still had not been addressed; that deficiencies had been found in the lending area, and that these related mainly to the fact that correct approvals had not been obtained for transactions totalling $12.5M. Deficiencies were also reported in the securities area. It was stated that the debt factoring business generally lacked management and internal controls in both account management and administration. The insurance broking division had failed to pay accrued taxes and duty totalling $0.13M. There was a lack of account reconciliation between general and subsidiary ledgers, and inefficiency and increased potential for error by utilising two different computer systems to record and process information. The Report also severely criticised a wide range of financial and managerial practices of Pegasus Leasing.

33.3.6 RESTRUCTURING OF THE PEGASUS LEASING JOINT VENTURE

As I noted earlier, Beneficial Finance undertook an analysis, in about September 1989, of both the control and funding of its various joint ventures. A Joint Venture Status Report dated 16 October 1989, stated in respect of the funding of the joint ventures, that:

"Currently, Beneficial provides the bulk of the funds for most joint ventures, acting as Banker, achieving banker's margins but without the benefit of bank cost of funds. The provision of funds has an opportunity cost attached. A review of the shareholders' agreement for each of the joint ventures suggests that Beneficial's original intention was only to interim fund. In addition, non-recourse funding arrangements with external lenders are impacting on Beneficial/State Banks limits in some instances.

The environment which prevailed when the joint venture arrangements were first entered into has changed. While the premise that Beneficial has the financial strength and the joint venture parties have the expertise has not changed, the market requirements have since altered such that Beneficial's capital is now a scarce resource. In addition, the strong growth of some of the joint ventures was not anticipated and given that none of the joint venture partners have the financial capacity to support the growth they were achieving through continual capital injections to maintain gearing at acceptable levels, there has been an expectation that Beneficial will provide the additional funding required. Whilst Beneficial can choose to limit the funds lent, as there is no legal requirement to provide all funding, it is our objective to not restrict profitable growth of the joint venture. However, notwithstanding this objective, considerable difficulty is being experienced in attracting non-recourse external borrowings with existing joint venture gearing levels ...

Our current efforts are being directed mainly towards reducing Beneficial funding to joint ventures to the minimum required to secure non-recourse funding, thereby maximising both the joint venture profitability and Beneficial's overall ATROE from the joint venture involvement."

Even before that review, however, Mr Baker became concerned at the large loan exposure that Beneficial Finance had to Pegasus Leasing, and expressed that concern to Mr Horwood, Chief General Manager of Beneficial Finance's Treasury and Capital Markets division. Mr Horwood's proposed solution seemed simple. He proposed that the funding for Pegasus Leasing's business should be obtained from the State Bank through the Reverse Principal and Agency Agreement. By borrowing funds from the State Bank under that arrangement and on lending those funds to Pegasus Leasing, the loans would effectively disappear from Beneficial Finance's balance sheet, because it was Beneficial Finance's practice not to show in its accounts either the asset represented by its loan to its sub-agent, or the associated liability to the State Bank. The "back-to-back" loans were simply netted off.

A memorandum dated 28 August 1989 from Mr Horwood to Mr O'Brien stated:

"John Baker has noted that Pegasus has approximately $62m of Beneficial direct loans, a rather high figure despite our involvement.

Trevor Waller advises that many of these loans could have been set with the State Bank Reverse P&A Agreement but for various reasons were not.

The Reverse P&A costs Beneficial a premium of about 0.6 per cent (0.85 per cent less say 0.25 per cent margin on alternative Beneficial Finance funding). For this we get off balance sheet assets; further there is no profit or revenue leakage from a SBSA Group viewpoint. The allocation of provisions is likewise much easier on Beneficial Finance.

It thus makes sense to switch a portion of these Pegasus loans to the Reverse P&A; a figure of $30m to $40m would seem appropriate.

Could this be effected, with continuing advice to Treasury as to likely settlement date(s)."

Attached to the memorandum was a summary of Beneficial Finance's loans to Pegasus Leasing A hand-written annotation on the memorandum reads "SBSA agreed".

In fact, only $20.0M of Beneficial Finance's loans were refinanced at that time by the State Bank using the mechanism provided by the Reverse Principal and Agency Agreement. A further $20.0M of Beneficial Finance's loans to Pegasus Leasing were transferred to its off-balance sheet company, Kabani Pty Ltd, by way of a journal entry. In a memorandum dated 28 November 1989, Mr Horwood advised Mr Baker that:

"You will remember your concern about Beneficial's loans to Pegasus Leasing in the June 1989 accounts. At that stage we had $62.0M of direct loans, by far our largest loan exposure.

Since then $20.0M has been refinanced via Kabani ... and about $20.0M pushed through the SBSA Reverse Principal and Agency Agreement.

The balance of our loan to Pegasus, after reasonably strong growth in receivables since June, is now around $40.0M.

Do you want to reduce this $40.0M figure further by pushing more through the Reverse Principal and Agency Agreement? Should all new lending be via the Principal and Agency Agreement?"

Mr Baker subsequently gave an instruction that Beneficial Finance's loans were to be moved off its balance sheet, and that all new business by Pegasus Leasing was to be funded under the Reverse Principal and Agency Agreement.

There is a fundamental problem with the "solution" proposed and effected by Mr Horwood. The solution of refinancing Beneficial Finance's loans to Pegasus Leasing by borrowing from the State Bank under the Reverse Principal and Agency Agreement assumes that the Agreement was nothing more than a funding mechanism. As I have said, the terms of the Agreement were such that, in substance, it was a funding mechanism for Beneficial Finance's business, and Beneficial Finance had regarded it as such since 1986.

In legal form and effect, however, the Agreement was not a mechanism for funding Beneficial Finance's business. It was a Principal and Agency Agreement appointing Beneficial Finance to conduct business as the agent of the State Bank. That business, and the related receivables, belonged to the State Bank. The effect of Mr Horwood's solution, if it were effective, was that the State Bank became the owner of Pegasus Leasing's receivables to the extent of $20.0M. The problem was that no effort had been made to identify which of Pegasus Leasing's receivables "belonged" to the State Bank, or to the implications of an assignment of those receivables to the State Bank.

What followed was a series of meetings, discussions and memoranda, almost Pythonesque in character, as the Management of Beneficial Finance and of the State Bank tried to come to grips with the nature of the Reverse Principal and Agency Agreement, and the implications of the action initiated by Mr Horwood.

Briefly stated, on 21 January 1990, Dr Sexton of Beneficial Finance's Investment Banking division wrote a memorandum to Mr Baker in response to Mr Baker's request for "confirmation that all new Pegasus Leasing business is being booked through State Bank Reverse Principal and Agency Agreement". After noting that Beneficial Finance had transferred $20.0M of its loans to Pegasus Leasing to each of Kabani and the State Bank on 1 November 1989, Dr Sexton reported that since that time Beneficial Finance had continued to provide funds to Pegasus Leasing to finance new business. He wrote:

"It would appear that there may have been some confusion as to your requirement with respect to how the Pegasus Leasing business was to be written. At present, the total exposure to Pegasus Leasing stands at:

Kabani	$20.0M
SBSA Reverse P&A	$20.0M
Beneficial Finance	$45.0M
TOTAL	$85.0M"

Dr Sexton reported that Pegasus Leasing business could not be conducted under the Reverse Principal and Agency Agreement unless Pegasus Leasing was able to identify particular leases that were being granted as an agent for the State Bank. On 1 March 1990, Mr D Crichton of Beneficial Finance's Legal Services department noted that the purported transfer of $20.0M of Beneficial Finance's loans to Pegasus Leasing to the Reverse Principal and Agency Agreement could not be effective unless the particular leases funded with that loan were identified as belonging to the State Bank. Mr Crichton stated that the lack of identification of particular leases as belonging to the State Bank was the major reason why the Reverse Principal and Agency Agreement had not been used to fund Pegasus Leasing in the past.

In a memorandum dated 1 March 1990 to various officers of Beneficial Finance and Pegasus Leasing, Beneficial Finance's legal officer, Mr Yelland stated that before anything could be done to resolve the matter, the following action was required:

"1. Clarification of documentation of any Loan Facility arrangements between Beneficial Finance and Pegasus Leasing prior to November 1989, eg minutes, letters, journal entries etc.

2. Identification of "securities" (if any) backing that/those facilities.

3. Identification of separate advances and back to back receivables which were purportedly "transferred" to:

(i) Kabani (November 1989)

(ii) State Bank (December 1989)

4. Identification of the terms of those transfers whether they were with recourse to Pegasus/BFCL, the management of obligations transferred with them, i.e. is Pegasus to continue to collect, were the receivables absolutely sold or merely securitised, was the transfer notified to Pegasus, can it be deemed to be a new loan directly from the assignees? Other matters to be resolved are Collection/Management fees, terms of the loan which was transferred, yield thereon (query of guarantee) and other similar information.

Note: The lack of information about the foregoing, is an example of how badly neglected and/or casually this whole association has been treated in the past. Hopefully, under concerted effort of the Investment Banking division the current short comings will be remedied."

On 7 May 1990, Mr Yelland wrote to Mr M Dawes of the State Bank's legal department, expressing his belief that the problems had resulted from "some deplorable gaps in understanding/communication", and hoping that "we lawyers can save the day". Simply stated, the solution proposed by the lawyers was that:

(a) the State Bank would take over Beneficial Finance's loans to Pegasus Leasing;

(b) Pegasus Leasing would then transfer its portfolio of lease receivables to the State Bank in "repayment" of those loans; and

(c) Pegasus Leasing would then manage the portfolio of lease receivables on behalf of the State Bank.

The legal mechanism to be used to effect this solution was outlined in a memorandum dated 9 May 1990 from Mr Yelland to Mr Baker:

"The following will need to be submitted to the Bank, for approval.

(1) That the Reverse P & A Agreement between Beneficial and SBSA be ratified as extending to Pegasus Leasing as sub-agent of Beneficial, and formally approved to allow bloodstock leasing and that all future deals written by Pegasus Leasing be so written as agent for the Bank.

(2) That the Bank confirm its $20M "loan" direct to Pegasus Leasing (backed by receivables of the same amount) - "transferred" from Beneficial in December 1989, but since novated.

(3) That the Bank agree to accept a further $39.25M worth of loans currently being funded by Beneficial to Pegasus Leasing (also backed by bloodstock leases).

(4) That the Bank agree to accept a further $20M worth of loans currently being funded by Kabani to Pegasus Leasing.

(5) That instead of transferring the receivables represented by the loans referred to in (3) and (4) above, from Pegasus Leasing to the newly formed Pegasus (unincorporated JV); the Bank agree to take a transfer of these receivables (subject to a limited "recourse" of some sort to Beneficial) from Pegasus Leasing incorporated JV under a written offer/verbal acceptance arrangement direct to the Bank. The consideration from the Bank being the balance owing under the loan to Pegasus Leasing, now vested in SBSA.

(6) The end result of that exercise will be that:

(a) Pegasus Leasing will have no assets (receivables) other than a few "repossessed" bloodstock.

(b) SBSA will have $79.25M worth of bloodstock receivables written by Pegasus Leasing on its books.

(c) Beneficial will have a limited recourse obligation to SBSA in respect of those leased bloodstock receivables.

(d) Pegasus Leasing will be engaged by SBSA to "manage" the collection of these receivables and/or Beneficial will earn a fee for a recourse exposure probably on a variable basis, equal to the gross yield of the receivables less the Reverse P & A funding right.

(e) All future Pegasus Leasing transactions (i.e. predominantly bloodstock leasing) fitting under the P & A will be written by Pegasus Leasing as agent/sub-agent for SBSA and managed by them as in (b).

Beneficial Treasury has already anticipated the second transfer of $45M worth of loans (see (3) above) and awaits SBSA internal approval before allocation of the exact amount onto SBSA balance sheet."

The following handwritten note, dated 21 May 1990 and signed by Mr Baker, appears on the first page of Mr Yelland's memorandum:

"... Graham Yelland - Proceed with assistance from Rhys Horwood (if necessary) as regards SBSA Treasury."

A diary note dated 4 June 1990 by Mr S G Paddison, the Chief General Manager of the State Bank's Australian Banking division recorded that on 1 June 1990, the Executive Committee of the State Bank, after consultation with Mr Clark and Mr D W Simmons, approved a recommendation to the State Bank Board that the State Bank should "refinance Beneficial Finance's portfolio" of bloodstock receivables through the Reverse Principal and Agency Agreement.

In fact, the procedure outlined by Mr Yelland was not implemented. Instead, the Management of the State Bank and Beneficial Finance agreed on a simpler solution that amounted to a re-writing of history. On 27 September 1990, Mr Parkinson, General Manager of Beneficial Finance's Taxation and Corporate Planning department, made a file note recording an agreement between senior officers of the State Bank and Beneficial Finance to treat all of the leases granted by Pegasus Leasing as having been made as agent for the State Bank under the Reverse Principal and Agency Agreement. Accordingly, Pegasus Leasing would not include the lease receivables in its accounts because, being subject to the Reverse Principal and Agency Agreement, they were owned by the State Bank. A subsequent memorandum from Mr Parkinson and Mr Yelland to Mr J D Malouf (all of Beneficial Finance) stated that:

"8 November 1990 - After many discussions between Beneficial, Pegasus Leasing and SBSA, the position that the receivables from Pegasus Leasing were indeed SBSA receivables under the Reverse P&A was agreed. Draft acknowledgment document for execution by SBSA/Beneficial and Pegasus Leasing was prepared, ratifying the ownership of the receivables by SBSA and submitted for approval and execution. The document has not been signed but receivables treated by all parties as owned by SBSA not Pegasus."

This agreement appears to have been made in order to clarify the treatment of the receivables and related loans in the accounts of Pegasus Leasing, Beneficial Finance and the State Bank as at 30 June 1990. The memorandum by Mr Parkinson and Mr Yelland noted that the accounting treatment agreed upon between all parties did not accord with Pegasus Leasing's statutory accounts and taxation returns for 1988 and 1989. However, Mr Parkinson and Mr Yelland contended that the accounts and taxation returns were incorrect, since:

"... such an analysis would mean that Beneficial (SBSA) was effectively making unsecured loans to Pegasus Leasing.

In addition, if Beneficial was to be deemed to be the so-called owner of the receivables or a lender to Pegasus Leasing, it may have breached the 1960 and 1984 Trust Deeds gearing ratios in relation to assets and liabilities as at 30 June 1990."

On 23 November 1990, it was recorded in the minutes of a meeting of the State Bank's Finance and Treasury personnel that, in May 1990, the Group Executive of the State Bank had agreed to adopt, under the Reverse Principal and Agency Agreement, all business written by Pegasus Leasing. A Deed of Acknowledgment of the arrangements was forwarded to the State Bank by Mr Yelland on 16 January 1991.

33.3.7 SUMMARY AND CONCLUSIONS

The Pegasus Leasing Joint Venture effectively commenced operations in January 1988. The business was conducted by a joint venture company, Pegasus Leasing Ltd, which acquired the existing business of Pegasus Securities and employed that company's staff.

The Pegasus Leasing Joint Venture was formed despite the express and documented recommendation of the Joint Venture Committee of Beneficial Finance that it should not be established. No formal submission was presented to the Board of Directors of Beneficial Finance setting out in detail the terms and conditions of the new joint venture.

Pegasus Leasing grew and expanded its business rapidly after January 1988, funded by unsecured loans from Beneficial Finance. Its activities became increasingly diverse and complex, and in the thirty months to 30 June 1990, total assets grew by almost $100.0M. By June 1989, however, the losses incurred by Pegasus Leasing had wiped out its capital, and the company's liabilities exceeded its assets. Beneficial Finance's loans to Pegasus Leasing at the time totalled $62.0M, and by January 1990 were $85.0M. Signs began to emerge that Pegasus Leasing's operating and information systems might have not kept pace with the growth and diversification of its business activities.

In November 1989, Beneficial Finance sought to move its loans to Pegasus Leasing off its balance sheet, by refinancing the loans by borrowing from the State Bank under the Reverse Principal and Agency Agreement. This proposed solution, however, ignored the legal effect of the Reverse Principal and Agency Agreement, which was that the receivables portfolio of Pegasus Leasing would be owned by the State Bank. After months of investigation and negotiation, the State Bank agreed to take over Pegasus Leasing's receivables portfolio.

In my opinion, the growth and conduct of Pegasus Leasing's business after January 1988 was not effectively controlled or monitored by Beneficial Finance. In accordance with the basic premise of the joint venture, Beneficial Finance relied on Pegasus Securities staff, and particularly Mr McGregor, to conduct the business. Beneficial Finance provided unrestrained funding to Pegasus Leasing to finance its rapid expansion. In his evidence to my Investigation, Mr Reichert said that despite the fact that he had doubts regarding the credentials of Mr McGregor to carry on the business, insufficient control was exercised over Mr McGregor in expanding Pegasus Leasing's business.

In contrast to 1987, the minutes of the meetings of the Beneficial Finance Board of Directors do not document expressions of concern regarding the performance of the joint venture. This is despite the fact that the joint venture recorded losses in each year, and that by 30 June 1989 its liabilities exceeded its assets.

 

33.4 PEGASUS LEASING AFTER MAY 1990

 

33.4.1 RESTRUCTURING OF THE JOINT VENTURE

In about April 1990, it was decided to restructure the Pegasus Leasing joint venture, returning it to the form of an unincorporated partnership of the type used between August 1985 and December 1987. There were a number of reasons for the restructure:

(a) it facilitated the transfer of Pegasus Leasing's receivables to the State Bank under the Reverse Principal and Agency Agreement;

(b) the direct ownership of one-half the joint venture's non-receivables assets by Beneficial Finance would allow it to utilise any taxation losses arising from those assets; and

(c) the restructure would result in the assets coming onto Beneficial Finance's balance sheet, in accordance with its plans at the time.

On 29 May 1990, Pegasus Leasing transferred the majority of its non-receivable assets to the unincorporated joint venture for a total consideration of $8.0M. The joint venturers were Carcoar Pty Ltd, a wholly-owned subsidiary of Beneficial Finance, and Lanceti Pty Ltd, a wholly-owned subsidiary of Pegasus Securities. The recitals to the Joint Venture Agreement stated that Beneficial Finance and Pegasus Securities:

"... have agreed to constitute themselves into a joint venture for the purpose of carrying on a business of inter alia arranging and/or participating in operating finance leases and generally undertaking finance arrangements in their own right or as agents for and on behalf of Beneficial as principal or as agent or sub-agent for the State Bank of South Australia."

The directors of Pegasus Leasing in office at the time of the restructuring were Mr McGregor, Mr Tucker and Mr Knox nominated by Pegasus Securities, and Mr Piovesan, Mr O'Brien, and Dr Sexton of Beneficial Finance.

The terms of the new joint venture agreement dated 28 May 1990 were essentially the same as those of the first unincorporated joint venture. Pegasus Leasing reverted to acting as a nominee for the joint venture partners. Capital was to be contributed equally, and the partners would share profits and contribute equally to losses. The Agreement provided that the joint venture could be terminated by either party giving at least three months notice of its intention to terminate the venture.

33.4.2 TERMINATION OF THE JOINT VENTURE

Within three months of the restructure, however, Beneficial Finance decided to wind up the joint venture.

In July 1990, the Beneficial Finance Board of Directors decided to cease funding of all joint ventures, including Pegasus Leasing.

Beneficial Finance also moved to obtain a guarantee from Mr McGregor and his companies for its existing loans to the joint venture. The minutes of the Beneficial Finance Board of Directors' meeting on 27 July 1990 record that:

"The Board was advised that Mr A McGregor had consented to give a guarantee with regard to the Pegasus Leasing joint venture. Mr McGregor was currently overseas, but an exchange of faxes was to be arranged by 31 July 1990 to evidence a commitment to execute a guarantee."

At the same time, increasing evidence began to emerge of the inadequacies of Pegasus Leasing's operating and information systems. An interim internal audit report prepared in August by Mr A Kane and Ms B Holmes of Beneficial Finance's Internal Audit department, found that the "systems, controls and operations within the Pegasus Group are less than adequate," and noted deficiencies particularly in the assessment and management of credit risk, including:

"(i) Absence of credit checks.

(ii) Nil or minimal financial analysis of applicant's financial strength ...

(iii) Inability to confirm existence of current insurance from information retained on file.

(iv) Other issues include cases of lack of formal approval; absence of veterinarian's certificate confirming the identity and fitness of our security; and waiving the requirement of insurance for the security."

In relation to Pegasus United Kingdom, the report referred to a review of all files kept by Pegasus Leasing in Adelaide and noted that:

"a) Applications are not always signed for approval.

b) No copies of supporting invoices on file to identify or support finance security.

c) All documentation in relation to assignment of security is located in UK.

d) Details of insurance cover is, at best, nominal.

e) Location of security is not always provided."

In August, Beneficial Finance began the task of transferring the accounting functions of the joint venture from Pegasus Leasing's systems to Beneficial Finance. Papers presented to the Board meeting of Beneficial Finance on 30 August 1990 record that:

"Pegasus Leasing's Management Information Systems and Accounting functions have been transferred to Beneficial Finance and a general provision of $1.5M against our funding lines has been raised as at 30 June 1990.

A thorough investigation of this joint venture is continuing with a report to be completed by end November 1990. Any further provisions or loss write-offs will be made progressively as identified.

In the meantime, funding of new sales has ceased and an action plan to sell assets, minimise operating costs and wind up the operations as quickly as possible is being implemented. This includes a restructure of the organisation with all possible functions being absorbed by Beneficial by 31 December 1990. Group assets currently under negotiation for sale are expected to net $1.1 million.

Total SBSA/BFCL exposure is $111.0 million and it is expected that full realisation will take a minimum of three years."

The minutes of the meeting of the Beneficial Finance Board held on 28 September 1990 record that "some difficulties were expected in the winding up of Equus and Pegasus. The Board requested a detailed action plan for the withdrawal from Pegasus to be submitted to the October Board meeting."

An Interim Management Report on the Pegasus Group dated 18 September 1990 was prepared for Beneficial Finance's Executive Committee by Mr Chakravarti and Mr Piovesan, both of whom had been directors of Pegasus Leasing. The purpose of the report was to provide a summary of the state of Pegasus Leasing's activities, and to make recommendations to protect Beneficial Finance's exposure. The report began by noting that:

"The capital of the Joint Venture is $0.4M, $0.2M from each partner, with returns since inception of $1.1M to each partner. The Joint Venture is divided into the following individual operating entities:

	Receivables A$M
Australian finance operations (bloodstock)	82.200
UK/Ireland finance operations	4.089
New Zealand finance operations	3.727
Pegasus Insurance Consultants Pty Ltd
(insurance brokers)	-
Rivlin $ Associates Pty Ltd
(crash repair factoring)	1.510
Bloodstock Management International
(breeding partnership manager)	-
Investments, bloodstock held & cash on hand	12.750
TOTAL		104.280
Operations are currently funded as follows:
SBSA Rev. P&A	85.25
Beneficial	8.83
Wheelease	4.40
SBSA (London) (guaranteed by Beneficial Finance)	4.60
		103.08

Rivlin and PIC are funded by Pegasus Leasing Limited."

The report went on to state that:

(a) "As a result of investigations to date by Joint Venture Accounting, further losses of $1.2M required adjustment following various accounting errors. It is anticipated that further negative adjustments will be necessary as the accounting functions are undertaken by Beneficial Finance. It should be noted that the Financial Controller of the Pegasus Group has resigned."

(b) "A recommendation for loss provisions on the Pegasus Leasing Joint Venture receivables and investment loan accounts of $2.2M is submitted.

Beneficial Finance State Collections Manager is now undertaking a full review of the receivables portfolio to ensure adequate collection processes."

(c) "As a result of the accounting adjustments abovementioned, the Joint Venture result to June 1990 is a loss in excess of $3.0M. To July 1990, the Joint Venture and Pegasus Leasing Ltd. on a consolidated basis, reported a loss of $0.21M. It is anticipated by Beneficial Finance that a smaller loss will be shown for August."

In respect of the workout strategy, the report noted two important constraints:

(a) first, the size and geographic spread of the business meant that any solution to the problem had to be long term; and

(b) second, Beneficial Finance's limited expertise in the bloodstock industry meant that it would need to rely on Mr McGregor, or another outside expert, to manage the investments, partnership accounts and problem loans that involved making decisions in respect of the bloodstock held.

The report identified a number of "Action Items" that had been, or would be, taken to rationalise the Pegasus Leasing business. After noting that the Sydney operations had already been closed, and that Pegasus Leasing was not to enter into any new partnership ventures or acquire any investments without Beneficial Finance's approval, the report stated that the following action was to be undertaken immediately:

(a) there would be no new funding of the joint venture. All new transactions were to be undertaken by Pegasus Securities as agent for Beneficial Finance;

(b) all credit approval limits of Pegasus Leasing were to be revoked, with all future transactions to be approved by Beneficial Finance in accordance with its approval policies and procedures;

(c) all cheques written by Pegasus Leasing were to be signed by at least one Beneficial Finance manager; and

(d) the New Zealand and United Kingdom operations were to be closed, and the portfolios sold.

Further actions to be taken included:

(a) the establishment of a prudential limit for Beneficial Finance's exposure to the bloodstock industry; and

(b) an assessment was to be undertaken by Beneficial Finance of Pegasus Leasing's receivables portfolio, including the securities held and the adequacy of insurance, to determine the feasibility of sale.

The report projected that an initial forecast, which "needs to be refined", indicated that the joint venture could operate at a profit over the following four years, after the payment of interest on funding provided by Beneficial Finance.

In October 1990, Price Waterhouse, the external auditors of Beneficial Finance and Pegasus Leasing, delivered a report severely criticising accounting practices of Pegasus Leasing, and pointing out a number of transactions between Pegasus Leasing and some directors and senior staff of both Beneficial Finance and Pegasus Leasing. The report, which was given to Mr Baker at the request of Mr McGregor, stated that an Assistant Manager from Price Waterhouse had spent approximately four weeks at Pegasus Leasing, and to the date of the report had raised more than 150 adjustments to the company's accounts. Price Waterhouse had previously pointed out problems in the quality of accounting records of Pegasus Leasing in three management letters in the previous twelve months.

Price Waterhouse reported, among other things, that:

(a) The quality of accounting at Pegasus Leasing had deteriorated since 30 June 1989.

(b) Accounting problems had not been resolved as they arose. Instead, problems were left unresolved for months until specific requirements, such as the annual audit, forced attention to be paid to them.

(c) Most of the adjustments that had been raised by Price Waterhouse had reduced profit and net assets.

(d) The poor performance of Pegasus Leasing in the year ended 30 June 1990 had been caused by a number of factors, including high interest rates, additional provisioning on receivables, and write-downs in the value of bloodstock due to a deflated market for horses.

(e) The information which had been produced for management of Pegasus Leasing was so inadequate that the progressive deterioration in the company's affairs was largely unidentified during the year.

(f) Price Waterhouse believed there was a general "hands-off Pegasus" attitude amongst senior management of Beneficial Finance.

Minutes of the Board meeting of Beneficial Finance held on 26 October 1990 recorded that:

"The audit conducted on the Pegasus Joint Venture had revealed significant accounting problems and errors. The Board was advised that the joint venture operations had been wound down and would cease by 30 November 1990. Funding had ceased and accounting and lending approvals were now being undertaken by Beneficial staff.

The Board considered that Beneficial should take a hard line in negotiations with Mr McGregor regarding his assistance in the management and wind back of the existing receivables. Management was requested to submit details of the further negotiations to the Board."

The review of Pegasus Leasing's securities and insurance arrangements foreshadowed in the Interim Management Report was undertaken by Mr Yelland. In a memorandum dated 25 October 1990, Mr Yelland reported the results of his review to Mr Devereaux, who had been appointed by Beneficial Finance as its representative to work with Mr McGregor to ensure that adequate controls were implemented, particularly in relation to the collection of receivables and assessment of the values of investments. The review covered about 40 out of 1,200 client files. Mr Yelland found that, although the documentation was basically sound, the settlement procedures and security operations had been undertaken by untrained personnel. Almost all files reviewed contained errors. The memorandum stated that the major problems which had been encountered were:

". Failure to fill in blanks in Schedules i.e. interest description;

. Improper use of "Livestock Leases" for leases of "shares" in livestock;

. Power of Attorney authorities post-date executions;

. Disregard for any interstate stamp duty liability;

. Failure to effect company, bankruptcy and other essential credit checks;

. Pre and post-settlement conditions not followed for action;

. Omission or inadequacy of insurance covers;

. Veterinary verifications missing;

. Failure to obtain manager's signature."

A Status Report presented to the Beneficial Finance Board of Directors in November 1990 stated that although no new leases had been approved since the Board's directive on 26 October, Beneficial Finance's plans to take over full control of the venture by controlling all bank accounts, retrenching surplus staff and running down the insurance and debt factoring businesses were being resisted by Mr McGregor, who claimed that:

(a) he gave his personal and corporate guarantees in August 1990 only because he was assured that the wind-down of the operations would not be so precipitous as to adversely affect his interests; and

(b) in any event, the joint venture agreement required the giving of three months notice for termination of the venture, which he would waive only if Beneficial Finance agreed to allow him to operate some of his joint ventures activities in his own right.

Beneficial Finance's legal counsel, Mr Yelland, advised that Beneficial Finance's action in seeking to terminate the joint venture "may well have been illegal", and that the "proper course would have been to give the required three month's notice, followed by an orderly wind down". Accordingly, the Status Report recommended that, in order to obtain Mr McGregor's co-operation and release from any claims he may have against Beneficial Finance, Beneficial Finance should:

(a) undertake not to enforce the termination of the joint venture on a formal basis, but let it run down by natural attrition under the management and control of Beneficial Finance;

(b) undertake not to appoint a receiver to any of Mr McGregor's companies;

(c) offer to sell Beneficial Finance's interest in the insurance and debt factoring businesses to Mr McGregor at their total assessed value of $0.155M; and

(d) engage Mr McGregor as a consultant to assist Beneficial Finance in running down the joint venture's assets.

The Board of Directors approved the recommendations of the Action Report.

A meeting was held on 7 December 1990 between Mr McGregor and Mr Devereaux, Mr Piovesan and Mr Yelland to review the financial position of Mr McGregor's companies. According to a report prepared in March 1991 by Mr Devereaux, Mr McGregor advised the meeting that he required finance of about $1.0M or he would be forced to put Pegasus Securities into receivership on 12 December 1990. His request was refused. On the same day, a number of Pegasus Leasing staff were retrenched, and on 10 December the files and records of Pegasus Leasing were transferred to Beneficial Finance's premises.

Mr McGregor took his own life on 11 December 1990. Pegasus Securities was placed into receivership on 24 December 1990.

The papers for the December 1990 meeting of the Board of Directors of Beneficial Finance documented the actions taken, and to be taken, by Beneficial Finance with respect to Pegasus Leasing and Pegasus Securities as follows:

" . A Price Waterhouse report investigating the Pegasus operations was commissioned in August 1990. The results of this report highlighted a number of inconsistencies in the historical accounting of the joint venture.

. Given the performance of the joint venture, Beneficial Finance advised the joint venture partner after the October Board meeting of the Beneficial Finance Board of Directors that it would no longer fund the venture.

. The venture is being wound up with a number of staff retrenchments already effected. The sudden death of the Joint Venture partner also has resulted in Beneficial moving to take full control of the operation, and has substantial ramifications for Beneficial as McGregor was to be an integral part of the Pegasus Leasing "work out".

. Following Mr McGregor's death, meetings have been held with the remaining Director of the joint venture party [Lanceti Pty Ltd], who has agreed to Beneficial taking control over the operations with Tim Knox, the general manager of Pegasus acting as the day to day representative for Lanceti. The possibility of purchasing Lanceti [for nominal cost] is also being examined so Beneficial has full control of the venture. However, this is dependent upon analysis of the legal and tax implications of this strategy.

. Knox is looking at the possibility of a MBO of part of the insurance and leasing operations.

. Beneficial has appointed a manager for the Pegasus operation. The manager, J Devereaux, has been closely involved in the winding up of the operation for several months. Devereaux is retiring in March 1991 and has declined to remain with Beneficial beyond this date. Consequently, a replacement will need to be found prior to his departure.

. The Pegasus finance operation is being shifted to Franklin Street and will be managed by Devereaux. The insurance operation will continue under Knox's operation at Greenhill road until its future is determined. Beneficial has organised the changing of the locks and access to the security system at Greenhill Road, and tenants are being sought for the space.

. Rivlin has ceased advancing funds and the portfolio will be wound down. The possibility of selling the operation has been investigated, but interest only at a substantially discounted price was indicated. Hence it was determined that running down the portfolio would result in the greatest return.

. Ernst & Young Equine division have met with AMCD re the possibility of selling the Pegasus operations on a success fee basis only. Excel Finance has also indicated preliminary interest in part of the operations.

. The full year profit/loss position of the year ended 30 June 1990 is yet to be finalised but is estimated at a loss of $4.5m. The fact that the annual accounts have not yet been signed presents substantial problems as the Companies Code requires disclosure of material changes which have occurred since balance date and prior to signing hence finalisation of the accounts is being actively pursued.

. The forecast profit for 1990/91 is also being further reviewed with a number of issues, including the level of general loss provisions being assessed."

(In a submission to me, Mr Knox denied that he ever examined the possibility of a management buy-out of the leasing operations of Pegasus Leasing.)

Mr Piovesan, who had been appointed to the Pegasus Leasing Board in May 1990, summarised in his submission to my Investigation the principal matters of which he became aware after joining the Board:

(a) Beneficial Finance had no security for its loans to Pegasus Leasing, and had been effectively capitalising interest on the loans by providing further loans to pay that interest.

(b) Pegasus Leasing staff handled all accounting and receivables management. There was a general "hands-off" attitude from senior management in respect of Pegasus Leasing.

(c) Pegasus Leasing had failed to institute and maintain proper procedures for the collection or write-off of receivables. As a result, there had been very inaccurate reporting of receivables arrears by Pegasus Leasing. When the transfer of the accounting and receivables to Beneficial Finance's computer system was completed in September 1990, the level of arrears "blew out" dramatically.

Mr Devereaux made much the same point in a memorandum dated 25 February 1991 to Mr Malouf, then the Managing Director of Beneficial Finance. He wrote:

"Mr McGregor, although using Beneficial's money, had absolute control and autonomy over:

(i) approval standards of new lease deals;

(ii) the subsidiary receivables ledger; and

(iii) accounting records for the Joint Venture.

With this background it was inevitable that there would be unsatisfactory delays in conveying adverse trends to middle/top management and the Board of Beneficial."

33.4.3 THE LOSSES ARISING FROM PEGASUS LEASING

Generally, lease transactions written by Pegasus Leasing did not begin to fall into default until the latter part of 1990 and into 1991, when there were major reductions in the value of thoroughbred horses. As a result, without security beyond the value of the horses, Pegasus Leasing became solely dependent on the propriety and perceived financial strength of the lessees. Many lessees were unable or unwilling to meet their obligations in declining economic conditions. In addition, some lessees sought to avoid their obligations by taking advantage of faulty documentation, or alleging misrepresentation by officers of Pegasus Leasing.

In a briefing paper dated 26 March 1991, the then General Manager of Pegasus Leasing, Mr Hewitt, concluded:

"With the greater majority of the receivables being secured by thoroughbreds, the ledger and its collectability is reliant on sales prices being obtained. Further to this the "investment" portion of the general ledger is directly reliant on the sales, particularly in respect of the involvement in the Thoroughbred Investment Parcels.

Thoroughbred sales attended during February in Auckland, New Zealand and Melbourne confirmed earlier trends of yearling falls in the 30% - 40% range and broodmares up to 90%. These price falls have left many syndicates without the working capital to continue and the participants either unable or unwilling to contribute. More and more horses are having to be sold just to stop the on-costs of agistment, servicing, vet expenses etc.

It is difficult to see the prices increasing for some time, with many factors that promoted the price boost no longer evident, ie:

1. Non-bloodstock participants, having been caught with poor investments, will not return to the markets.

2. Taxation benefits are in doubt, and the financial viability of the structures do not measure up commercially.

3. Lack of players in the market to finance the industry. Certainly it would be hard to envisage a financier getting involved to the extent Pegasus and Excel achieved.

The general consensus within the industry is to endeavour to maximise the return. However, selling is the best option to cut the ongoing expenses."

On 25 February 1991, Beneficial Finance sought an independent report from Ernst & Young, Chartered Accountants, on a number of financial issues concerning Pegasus Leasing. By letter dated 27 February 1991, Ernst & Young provided a preliminary report, which concluded that the following factors had adversely affected the business of Pegasus Leasing:

(a) the inability to the McGregor Group to meet its joint venture obligations;

(b) the depressed state of the bloodstock industry;

(c) doubt over the taxation status of bloodstock projects and investments;

(d) loss of popularity of syndication as a method of attracting investors in bloodstock; and

(e) doubt as to enforceability of documentation of loans and other transactions by Pegasus Leasing.

The report confirmed the estimate of Beneficial Finance's Management that the losses associated with Pegasus Leasing would total between $40.0M and $46.0M. The report provided the following details of the estimated losses:

	$M
Accumulated losses to 31 December 1990	8.4
Write-offs in January and February 1991	4.1
Loss from the portfolio of lease receivables	9.3-16.1
Loss on investments and bloodstock held	4.5
Loss on Austral-Eire investment and receivables	7.0
Loss on North-South investment and receivables	3.1
Loss on Rivlin investment and receivables	0.3
Other items	1.0
Cost of managing the portfolios for 18 months	2.0
	$39.7-46.5M

The review of Pegasus Leasing's exposure to the Austral-Eire Thoroughbred Investment Parcel expressly stated that the loss estimate took into account the nature of the investors that had borrowed from Pegasus Leasing:

"A review of the external investor files in Austral Eire indicates that in most cases they were professionals who at the time of investment were seen to be individuals of substance and with sufficient assets to cover the advances made. We understand from Mr Knox that the advances were made based on the assessment of the individuals net worth, and did not rely on the assets or income acquired by the syndicate.

Given the above and the damage that could occur to their professional status from any bankruptcy proceedings, a further return of $816,000 has been estimated as the recovery to be collected from these individuals' personal assets. This results in a loss to the Pegasus group of $2 million from these external receivables.

When combined with the loss on the Pegasus Leasing investment, the total loss relating to Austral Eire is estimated at approximately $7 million."

33.4.4 A HINDSIGHT REVIEW BY BENEFICIAL FINANCE

In November 1990, management prepared at the request of the Board of Directors, an evaluation of the lessons to be learned from Beneficial Finance's participation in joint ventures. The report included a summary of the "major elements of weakness" in particular joint venture arrangements, identifying the "key indicators which, whilst by no means exhaustive, clearly demonstrate where we went wrong in each relationship". In respect of Pegasus Leasing, the report identified the following factors:

(a) "Top down" approval of the joint venture, meaning approval by senior management without an analysis being undertaken at operational staff level.

(b) The joint venture agreement and related documents advantaged Pegasus Securities at the expense of Beneficial Finance.

(c) Inadequate written procedures were established at the commencement of the joint venture. There were high maximum credit limits that could be approved without reference to Beneficial Finance, and those credit limits and/or approval authorities were breached.

(d) Pegasus Securities was unable or unwilling to contribute adequate capital to the joint venture. Indeed, Beneficial Finance had provided financial support to Pegasus Securities.

(e) Pegasus Securities directly controlled the management of the joint venture, and its accounting and receivables systems. There was inadequate control by Beneficial Finance over the joint venture's cash receipts and expenditure.

(f) The businesses of the joint venture were outside Beneficial Finances "normal approved criteria", and some competed with the businesses of other joint ventures.

(g) Within Beneficial Finance there were unclear, shared and frequently changed account management responsibilities.

(h) The joint venture experienced high arrears, weak collections of receivables, and significant loss write-offs.

I am satisfied on the basis of the information in this Chapter that all of the points quoted from the Board Paper above are fair comments in relation to the Pegasus Leasing joint venture.

 

33.5 RELATED PARTY TRANSACTIONS

 

In its report dated 16 October 1990, Price Waterhouse listed a number of transactions that it had identified which "could be defined as "related" by ASRB1017." They were:

Name of Account	Relationship	30 June 1990 $
Bloodstock Management	J A McGregor ("JAM") was the	54,249*
Inte’l ("BMI") as	executive chairman
Trustee for AG McEwin Pty Ltd
JA McGregor & DJ	Members are directors
Tucker	of Pegasus Leasing Limited ("PLL")	337,279
BMI as trustee for	Directors of PLL	54,249*
JA McGregor & DJ Tucker
DJ Tucker	Director of PLL	1,409*
JA McGregor	Former director of PLL	65,000
JA Baker	Former director of PLL	80,800
Knox, Gilgen, Gore	Knox is director of PLL	135,198
and France	Gilgen is secretary
	of PLL
	Gore is officer of PLL
Knox, Gilgen and	Knox is director of PLL	173,662
others	Gilgen is secretary of
	PLL
TA Knox	Knox is director of PLL	21,302
G A O’Brien	Director of PLL	70,205
BMI as trustee	Director of PLL	54,249*
for M Chakravarti
BMI as trustee	Former Director of PLL	54,249*
for JA Baker
F Piovesan	Director of PLL	27,253
GEP Thoroughbreds	Martin & Reichert have
	been directors of PLL
Glefyne Pty Ltd	JAM was shareholder	683,400
Glenstrae Pastrol & Co	Relationship with JAM	12,460
Emmen Investments Pty Ltd	Relationship with JAM family	180,423
BGIS	Relationship with JAM	15,473
Gulftarget	Relationship with JAM	8,911
Guarantee	Relationship with JAM	201,241
GuarateeCleaners Ltd	Relationship with JAM	4,522
Pegaus Securities Ltd	JAM was shareholder	168,776
Pegaus Securities Ltd	JAM was shareholder	190,000
Pegaus Securities Ltd	JAM was shareholder	207,000

(The items marked * represent future lease payments due from Bloodstock Management International to Pegasus Leasing where the individuals named have paid to BMI all amounts due.
Thus, although a liability may exist between BMI and Pegasus Leasing, the individual has met all his obligations to BMI).

Bloodstock Management International Pty Ltd, which was 75 per cent owned by Pegasus Leasing, was manager of the Austral-Eire and North-South Thoroughbred Investment Parcels.

I have not located any statement of policy of Pegasus Leasing with respect to loans to officers of Beneficial Finance, Pegasus Securities or Pegasus Leasing. I consider that policies governing financial dealings by Pegasus Leasing with related persons were not adequately documented. The failure to have in place appropriate policies was, in my view, a serious administrative deficiency particularly having regard to the amount of money involved. I would have expected Pegasus Leasing to have had, and to have documented and enforced, a policy on financial dealings with its own directors and employees and with the officers and employees of Beneficial Finance.

Furthermore, I have not found any evidence that the Beneficial Finance Board had authorised and was monitoring transactions by Pegasus Leasing involving Mr Baker.

In my opinion, finance transactions between a company and its directors and senior employees involve issues of propriety and sensitivity. It is important that prudent policies governing such transactions are established and strictly enforced. I am of the opinion that, in relation to the Pegasus Leasing joint venture, such policies were not established and, as a result, that the directors of Beneficial Finance did not monitor and control financial transactions between Mr Baker and the joint venture. I am also of the opinion that Mr Baker and officers of Beneficial Finance who entered into financial dealings with the joint venture had potential conflicts of interest. Given that ordinary formalities which should have been observed with all transactions were not always carried out in transactions between Pegasus Leasing and the related parties mentioned in the tables set out above, I consider that in relation to financial dealings with related parties, directors of Beneficial Finance and officers of both Beneficial Finance and Pegasus Leasing who were responsible for the administration of the affairs of the joint venture failed adequately or properly to supervise, direct, and control, the operations, affairs and transactions of respectively Beneficial Finance and of Pegasus Leasing.

Mr Reichert, Mr Knox, and Mr Martin have all submitted to me that the transactions in relation to which they are mentioned in the particulars of related party transactions set out above were all approved by Mr Baker and by the Human Resources department, Beneficial Finance, and were on normal commercial terms. Additionally, Mr Reichert and Mr Martin have submitted to me that

they were requested by Mr Baker and Mr McGregor to place business with Pegasus Leasing rather than with one of its competitors.

I have not investigated each of the transactions identified by Price Waterhouse involving the above-named persons, and so make no finding concerning those transactions or the conduct of those persons.

The transactions described did, however, take place in the absence of a sufficiently well-defined policy to govern transactions with the directors, officers and employees of Pegasus Leasing and of Beneficial Finance.

The former Non-Executive Directors of Beneficial Finance submitted, and I accept, that there were policies laid down for the granting of loans by Beneficial Finance to its executives and staff from 1984. I have examined this matter further in Chapter 43 - "Other Matters Investigated within the State Bank and Beneficial Finance".

 

33.6 FINDINGS AND CONCLUSIONS

 

In essence, the important features of the Pegasus Leasing joint venture are simple.

As with its other operating joint ventures, the fundamental premise upon which the joint venture was based was that it would be a partnership between the experience, expertise and reputation of Pegasus Securities in a specialised area of finance, and the strong financial backing provided by Beneficial Finance. Beneficial Finance hoped that, with its financial support, Pegasus Securities could establish a significant portfolio of bloodstock lease receivables of about $100.0M, that would provide a steady stream of profits for both partners.

With Beneficial Finance's financial backing, Pegasus Securities could build a business of a size far beyond that which it could conduct from its own financial resources. Pegasus Securities simply did not have the financial strength to be able to borrow sufficient funds to grow a portfolio of receivables of $100.0M. It could only do so by gaining finance from a joint venture partner. It necessarily follows that Beneficial Finance's lending to the joint venture was not based on its usual credit assessment policies and procedures, but was fundamentally influenced by the fact that Beneficial Finance itself was joint owner of the borrower. Under those circumstances, it was always going to be the case that Beneficial Finance would bear the cost of a failure of the joint venture. The managing director of Beneficial Finance, Mr Baker, candidly affirmed that this was the basis of the operating joint ventures of Beneficial Finance in general, and of Pegasus Leasing in particular.

This reliance on its joint venture partner's expertise required that Beneficial Finance do one of two things:

(a) First, it should have fully satisfied itself that Pegasus Securities in fact had the experience and expertise to prudently and profitably manage the business.

(b) Second, Beneficial Finance should have carefully monitored the activities of the business, to ensure that the business did not diversify and expand beyond the experience and capacity of Pegasus Securities to prudently and profitably manage the business.

In my opinion, Beneficial Finance failed to do either of these things.

Mr Reichert told my Investigation both that:

(a) insufficient control was exercised over Mr McGregor in his conduct of the business; and

(b) Mr Reichert doubted Mr McGregor's credentials to conduct the business.

Despite these concerns held at the time, Mr Reichert, who was a director of Pegasus Leasing from June 1988 until November 1989, took no effective steps to address that situation.

The very nature of the joint venture arrangement had the effect that Beneficial Finance was forced to rely on Pegasus Securities to a considerable degree. A basic premise of the joint venture was that it would conduct business in a specialised area of finance in which Beneficial Finance lacked the necessary experience and skills. If Beneficial Finance had had those skills, it would not have needed to enter into a joint venture with Pegasus Securities. As late as October 1990, when the decision was made to terminate the joint venture, Mr Chakravarti and Mr Piovesan, who had been directors of Pegasus Leasing, expressed the view that Beneficial Finance still lacked the necessary expertise to conduct the business, and that reliance would have to continue to be placed on Mr McGregor or on another external specialist.

More importantly, the business activities of Pegasus Leasing expanded to a size and diversity that was outside the experience of Pegasus Securities, and beyond the capacity of its accounting and credit risk management systems to cope. When the first joint venture was formed, Pegasus Securities had a total receivables portfolio of only $5.5M. Between January 1988 and November 1989, the business expanded rapidly to a receivables portfolio of $97.0M, including operations in New Zealand and the United Kingdom, and participation in, and funding of, thoroughbred investment syndicates.

This rapid growth of the business was made possible by the apparently unrestrained funding provided by Beneficial Finance. No appropriate limit was placed either on Beneficial Fiance's exposure to the bloodstock industry, or its exposure to Pegasus Leasing. An inevitable result of the unrestrained access to funds was a downward pressure on credit standards, since potential borrowers who might previously been excluded from consideration by the need to ration available funds could now be accepted as clients, in the pursuit of sales growth.

Even in August 1989, when Mr Baker expressed concern regarding the size of Beneficial Finance's exposure to Pegasus Leasing, no action was taken to restrain the growth of Pegasus Leasing's portfolio. Instead, the response of Beneficial Finance Management was simply to try to pass the obligation to fund Pegasus Leasing's business to the State Bank, through the Reverse Principal and Agency Agreement. The end result of that attempt to refinance the lending to Pegasus Leasing was that the State Bank assumed ownership of the receivables portfolio in 1990, and so bore the associated losses.

In their submission to my Investigation, the former Non-Executive Directors of Beneficial Finance said that there was a standing direction that all joint venture partners must guarantee Beneficial Finance's loans, must be able to contribute to one-half of any of the losses of the joint venture, and that Beneficial Finance's lending to the joint venture must satisfy the normal criteria and policies applicable to Beneficial Finance's lending business.

In my opinion, the Non-Executive Directors of Beneficial Finance failed to appreciate the reality of the operating joint ventures, even though the rationale for the joint venture was expressly stated to the Board of Directors on a number of occasions. If the Non-Executive directors had brought an independent and analytical mind to bear on the structure of the Pegasus Leasing joint venture, it should have become apparent to them that the risk of financial loss lay with Beneficial Finance. An examination of the joint venture's balance sheet would have shown that the joint venture was wildly overgeared, and that in June 1989 it had no capital at all, with its borrowings actually exceeding its total assets. Such a funding arrangement could not have been satisfactory within Beneficial Finance's established lending policies and procedures.

The Non-Executive Directors did not appreciate the nature of the risks being run by Beneficial Finance, and the actions that needed to be taken to ameliorate these risks. The failure of the Non-Executive Directors to come to grips with the basic nature of the joint venture amounted, in my opinion, to a failure to adequately or properly supervise, direct and control Beneficial Finance's participation in the joint venture.

In my opinion, the fundamental failing of Management of Beneficial Finance was to fail to recognise the deficiencies in the joint venture strategy. Reliance upon the experience and expertise of a joint venture partner within that partner's business experience is one thing. To provide that partner with almost unlimited finance, enabling it to expand and grow the business beyond the limits imposed by normal commercial constraints, is an invitation to disaster. For this failing, the managing director of Beneficial Finance, Mr Baker, must accept the heaviest blame. It was Mr Baker who proceeded with the establishment of the joint venture despite the express recommendation of the Joint Venture Committee not to do so. Many other of the officers and employees of Beneficial Finance involved in the Pegasus Leasing joint venture could, however, be subject to criticism, including those officers who served as directors of Pegasus Leasing without exercising an adequate level of control, and those managers who allowed funds to flow to Pegasus Leasing without limitation.

In my opinion, the fundamental strategy of the joint venture was flawed. Providing a small, entrepreneurial business in a niche financing market with unlimited finance to grow, uncontrolled by normal funding constraints, involves taking an unacceptable risk that is tantamount to gambling. The use of the Reverse Principal and Agency Agreement in 1990 to transfer the Pegasus Leasing receivables portfolio to the State Bank simply meant that the State Bank paid the bill for Beneficial Finance's imprudence.

 

33.7 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT

 

33.7.1 TERM OF APPOINTMENT A

33.7.1.1 Term of Appointment A(b)

The processes which led the State Bank and Beneficial Finance, a member of the State Bank Group, to engage in operations which have resulted in material losses and in the State Bank and Beneficial Finance holding significant assets that were non-performing include the processes described in this Chapter in respect of the Pegasus Leasing joint venture and the Reverse Principal and Agency Agreement.

33.7.1.2 Term of Appointment A(c)

For the reasons described in this Chapter, those processes were inadequate.

33.7.1.3 Term of Appointment A(d)

The procedures, policies and practices adopted by the State Bank and by Beneficial Finance, a member of the State Bank Group, in the management of significant assets that are non-performing include those described in this Chapter in respect of the Pegasus Leasing Joint Venture and the Reverse Principal and Agency Agreement.

33.7.1.4 Term of Appointment A(e)

For the reasons described in this Chapter, those procedures, policies and practices were not adequate.

33.7.2 TERM OF APPOINTMENT C

For the reasons described in this Chapter, in my opinion, the operations, affairs, and transactions, of Beneficial Finance, a member of the State Bank Group, 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 as identified in this Chapter.

(In making this finding in respect of the directors, I note that, in addition to the usual qualifications in respect of the limited tenure of certain of the directors, it was submitted to my Investigation on behalf of Mr K D Williams that, as a director of Excel Finance Ltd, a company related to Pegasus Securities, Mr Williams "specifically declared an interest on each and every occasion that Pegasus Leasing was brought to the Beneficial Finance Board. On all those occasions, after declaring his interest, he took no part in any deliberation or decisions in respect of Pegasus Leasing.")