CHAPTER ONE
CONCLUSIONS, FINDINGS AND RECOMMENDATIONS OF THE INVESTIGATION
TABLE OF CONTENTS
1.1 INTRODUCTION
1.1.1 THE PURPOSE OF THIS CHAPTER
1.1.2 MY TERMS OF APPOINTMENT
1.2 THE FINANCIAL POSITION OF THE BANK
1.3 THE STRUCTURE OF MY REPORT
1.3.1 FINDING THE CAUSE OF THE BANK'S FINANCIAL POSITION
1.3.2 THE ADEQUACY OF POLICIES AND PROCEDURES, AND OF SUPERVISION AND CONTROL, ETC
1.3.3 THE MATTERS ADDRESSED IN MY REPORT
1.4 THE ESTABLISHMENT AND CONDUCT OF MY INVESTIGATION
1.4.1 APPOINTMENT OF THE AUDITOR-GENERAL TO CONDUCT AN INVESTIGATION
1.4.2 EXTENSIONS TO THE TERM OF THE INVESTIGATION
1.4.3 THE RELATIONSHIP WITH THE ROYAL COMMISSION
1.4.4 NATURAL JUSTICE OR PROCEDURAL FAIRNESS
1.4.5 HISTORY OF LITIGATION
1.4.6 MY APPROACH TO TWO KEY CONCEPTS
1.4.6.1 Causation
1.4.6.2 The Standards of "Adequately" and "Properly"
1.5 WHAT WENT WRONG AND WHY: AN OVERVIEW
1.5.1 INTRODUCTION
1.5.2 THE FORMATION OF THE BANK
1.5.3 THE GROWTH AND OPERATIONS OF THE BANK
1.5.4 THE BOARD OF DIRECTORS
1.5.5 THE CHIEF EXECUTIVE OFFICER
1.5.6 THE BANK'S EXECUTIVE MANAGERS
1.5.7 SUMMARY REPORT IN ACCORDANCE WITH MY TERMS OF APPOINTMENT
1.5.7.1 Term of Appointment A(a)
1.5.7.2 Term of Appointment A(b)
1.5.7.3 Term of Appointment A(c)
1.5.7.4 Term of Appointment A(d)
1.5.7.5 Term of Appointment A(e)
1.5.7.6 Term of Appointment A(f)
1.5.7.7 Term of Appointment A(g)
1.5.7.8 Term of Appointment A(h)
1.5.7.9 Term of Appointment C
1.5.7.10 Term of Appointment D
1.6 RECOMMENDATIONS
1.7 MY REPORT ON THE STATE BANK: A SYNOPSIS
1.7.1 INTRODUCTION
1.7.2 DIRECTION-SETTING AND DIVERSIFIABLE CREDIT RISK MANAGEMENT
(VOLUME III - CHAPTERS 4 AND 5)
1.7.2.1 Direction-Setting and Planning (Chapter 4)
1.7.2.2 The Management of the Bank Group's Diversifiable Credit Risk (Chapter 5)
1.7.3 FUNDING, AND ASSET AND LIABILITY MANAGEMENT (VOLUME IV - CHAPTERS 6 AND 7)
1.7.3.1 Funding of the State Bank (Chapter 6)
1.7.3.2 Treasury and the Management of Assets and Liabilities of the State Bank (Chapter 7)
1.7.4 THE MANAGEMENT OF CREDIT (Volume V - Chapter 8)
1.7.5 THE MANAGEMENT OF CREDIT: CASE STUDIES (Volume VI - Chapters 9 to 14)
1.7.5.1 Preliminary Observations
1.7.5.2 Case Study in Credit Management: The Adsteam Group (Chapter 9)
1.7.5.3 Case Study in Credit Management: Celtainer Limited (In Liquidation) (Chapter 10)
1.7.5.4 Case Study in Credit Management: The Collinsville Stud Group (Chapter 11)
1.7.5.5 Case Study in Credit Management: Halwood (Chapter 12)
1.7.5.6 Case Study in Credit Management: Somerley Pty Ltd (Chapter 13)
1.7.5.7 Case Study in Credit Management: The REMM Group (Chapter 14)
1.7.6 RELATIONSHIP WITH THE RESERVE BANK (VOLUME VII - Chapter 15)
1.7.7 THE MANAGEMENT OF ACQUISITIONS (Volume VIII - Chapters 16 to 18)
1.7.7.1 Case Study in Acquisition Management: The Oceanic Capital Corporation (Chapter 17)
1.7.7.2 Case Study in Acquisition Management: United Building Society (Chapter 18)
1.7.8 THE OVERSEAS OPERATIONS OF THE STATE BANK (Volume IX - Chapter 19)
1.7.9 MANAGEMENT ISSUES (Volume X - Chapters 20 to 22)
1.7.9.1 The Management of Senior Executives at the State Bank (Chapter 20)
1.7.9.2 The Relationship Between the Board and the Chief Executive (Chapter 21)
1.7.9.3 Executive Information Management at the State Bank (Chapter 22)
1.7.10 INTERNAL AUDIT OF THE STATE BANK (Volume XI - Chapter 23)
1.7.11 OTHER MATTERS CONSIDERED (Volume XII - Chapters 24 to 26)
1.7.11.1 State Bank Centre Project (Chapter 24)
1.7.11.2 Securities Dealings (Chapter 25)
1.7.11.3 Dealings Between State Bank and Equiticorp (Chapter 26)
1.8 APPENDIX - Terms of Appointment of Auditor-General under Section 25
of The State Bank of South Australia Act 1-120
_______________________________________________________________________________________________
1.1 INTRODUCTION
1.1.1 THE PURPOSE OF THIS CHAPTER
The purpose of this Chapter of my Report is to provide an overview and summary of the Chapters of my Report, and the key findings and conclusions that I have reached and recommendations I have made as a result of my Investigation of the reasons for the financial position of the State Bank of South Australia ("the Bank").
This Report, which is comprised of twenty six Chapters, deals only with those parts of my Terms of Appointment that relate to the operations of the Bank. I will later report separately in respect of:
(a) the reasons for the losses incurred by Beneficial Finance Corporation Limited ("Beneficial Finance");
(b) pursuant to Term of Appointment B, the appropriateness and adequacy of the external audits of the accounts of the Bank and Beneficial Finance; and
(c) other areas upon which it may become necessary for me to report in relation to the Bank at the stage of the finalisation of my whole Report.
This Chapter, it must be emphasised, is intended to present only an overview and summary of my key findings and conclusions. It is essential to read it in the context of the Report as a whole, because it is impossible to fully understand the nature and impact of my Report by only reading this overview and summary. To read this Chapter in isolation would be unfair to many named persons and to the Investigation, and contrary to my intention.
It should be noted too that nothing in this Report is intended to reflect on the comprehensive and dedicated work of the existing Board, executives and staff of the State Bank directed to raising the Bank to the position in the commercial world that is its due.
1.1.2 MY TERMS OF APPOINTMENT
On 9 February 1991, I was appointed by the Governor to undertake an Investigation of the reasons for the financial problems of the Bank and its subsidiaries (together with the Bank, the "Bank Group").
The Terms of Appointment in respect of which I am required to inquire and report are contained in the Instrument by which I was appointed by the Governor, as modified from time to time, and in Section 25 of the State Bank of South Australia Act 1983 ("the Act"). The full text of the Instrument by which I was appointed (as modified) is provided as an Appendix to this Chapter.
Shortly stated, the focus of my Investigation has been upon answering the questions:
. what caused the financial position of the Bank and Bank Group as described in February 1991?; and
. who, or what, is to blame?
The substance of my Terms of Appointment so far as they relate to the Bank can be summarised as follows:
(a) What matters or events caused the financial position of the Bank as described by the Bank and the Treasurer on 10 and 12 February 1991? (Term of Appointment A(a))
(b) What were the processes which led the Bank to engage in operations which resulted in material losses, or the holding of significant non-performing assets, and were those processes appropriate? (Terms of Appointment A(b) and (c))
(c) Were there adequate procedures, policies, and practices for managing the Bank's assets which became non-performing, and for identifying non-performing assets? (Terms of Appointment A(d), (e) and (f))
(d) Were the operations, affairs, and transactions of the Bank adequately or properly supervised, directed and controlled by its Board of Directors, officers and employees? (Term of Appointment C)
(e) Was there any possible failure to exercise proper care and diligence on the part of a director or officer of the Bank? (Term of Appointment A(h) and sub-section 25(2) of the Act)
(f) Was the Bank's Board of Directors given adequate information to enable it to fulfil its functions? (Term of Appointment D)
(g) Were the internal audits of the Bank appropriate and adequate? (Term of Reference A(g))
(h) Were the external audits of the Bank appropriate and adequate? (Term of Appointment B)
(i) Is there any evidence of any conflict of interest, breach of fiduciary duty or other unlawful, corrupt or improper activity that should be further investigated? (Terms of Appointment A(h) and E, and sub-section 25(2) of the Act)
1.2 THE FINANCIAL POSITION OF THE BANK
My Terms of Appointment required me to inquire into and report on the causes of and responsibility for the financial position of the Bank and Bank Group "as reported by the Bank and the Treasurer in public statements on 10th February 1991 and in a Ministerial Statement by the Treasurer on 12th February 1991". My Investigation focused on the reasons for that financial position.
The "financial position" as described in those public statements can be summarised as follows:
(a) The Net Present Value of the difference between the book value of the Bank Group's loans and related assets, and the realisable value of the principal amounts of those loans and assets, was estimated to be $990.0M.
(b) An internal analysis of the Bank Group's loan portfolio disclosed that non-accrual loans, predominantly those accounts which were in arrears, could reach $2,500.0M.
(c) The problem loans were almost entirely limited to the property and corporate sectors of the loan portfolio.
(d) As a result of the Government's financial support arrangements, the Bank reported a profit for the half year ended 31 December 1990 of $20.0M, and achieved a risk-weighted capital adequacy ratio on that date above the Reserve Bank's minimum requirements.
1.3 THE STRUCTURE OF MY REPORT
My Report has been structured to address, in a logical and coherent way, the key operations of the Bank that are relevant to answering my Terms of Appointment, and reflects the approach I took conducting my Investigation. A brief explanation will make this clear.
1.3.1 FINDING THE CAUSE OF THE BANK'S FINANCIAL POSITION
The key to my Investigation of the Bank was the non-performing assets of the Bank. Overwhelmingly, they are corporate and property-related loans made by the Bank, and to a lesser extent, its poorly performed investments in major subsidiaries acquired between 1985 and 1990.
Simply to have focused on the immediate or proximate causes of the Bank's coming to hold significant portfolios of non-performing loans and poorly performed investments in subsidiary companies would, however, have been to take far too narrow a view, and would not have allowed me to answer my Terms of Appointment.
The lending and the other asset acquisitions of the Bank did not take place in isolation from the rest of its business operations. Growth must be funded, with a mix of debt and, to satisfy capital adequacy requirements, capital. The nature of the debt of any lending institution - its term, currency and cost - must be managed and matched to the asset portfolio in order to ensure that interest rate risk and liquidity risk are properly managed, and that the assets are priced appropriately (taking account also of the associated credit or equity risk) so that, among other things, the institution can make an acceptable level of profits.
A failure adequately to manage these aspects of a lending institution's business can be - and, in the case of the Bank, was - a contributing cause of the institution's financial failure. Such consequence may be brought about in two ways:
(a) First, prudent and professional liability management can act as a brake upon the too-rapid growth of the asset portfolio. Prudent management requires that consideration be given to the nature of the funding - debt or equity - obtained by the Bank. If funds of the appropriate maturity and cost are not available, asset creation will need to slow, or cease, until such funds can be obtained. Rejection of this accepted principle of financial management may result in over rapid and hence imprudent growth of assets.
(b) Second, adequate and reliable information regarding the cost of funds is essential (but not by itself sufficient) to ensure that loans are appropriately priced to provide an acceptable level of profits. If that information is not available, loans may be underpriced, with the result that budgeted profits can only be achieved by rapidly expanding the size of the loan portfolio. Profitability budgets may come to drive the institution to make loans that should not have been made. It is clear, though it seems not to have been remembered in the 1980s, that rapid expansion of a loan portfolio is necessarily associated with low credit standards - the more rapid the growth, the lower the credit standard. To put the matter another way, in a highly competitive lending market, a lending institution can consistently grow its loans portfolio at an above average rate only by accepting above average risk.
The essential relationship between a financial institution's management of its funding and its asset creating activities - both lending, and acquisitions - has meant that I was required to examine the Bank's liability and treasury management, for two reasons:
(a) First, as described above, that management might have been a cause of the Bank's financial position. The causal connection is indirect, in that poor liability management does not directly cause bad lending decisions. It is, however, so related to the asset creation process that it must be regarded as a potentially indirect cause of the asset-related losses; and
(b) Second, my Term of Appointment A(b) directs me to investigate and report on the processes by which the Bank came to engage in activities resulting in losses. The Bank's liability management may be such a process, whether those losses are produced directly, or indirectly, or both.
1.3.2 THE ADEQUACY OF POLICIES AND PROCEDURES, AND OF SUPERVISION AND CONTROL, ETC
My Terms of Appointment require me to determine, among other things, whether the Bank's policies and procedures were appropriate and adequate, and whether the Bank's Board of Directors, Chief Executive Officer and other officers and employees performed their functions and duties adequately.
For this reason, each Chapter of this Report which examines a discrete part of the Bank's activities also includes my findings and conclusions with respect to the particular activities described in the Chapter. Each Chapter can be regarded as a sub-report with respect to those activities of the Bank.
Further, just as the factors identified in the various Chapters of this Report contributed in varying degrees to the cause of the financial failure of the Bank, so too did the policy and procedural inadequacies, and the lack of effective supervision and control of certain of the Bank's activities, contribute to the mismanagement of the business of the Bank as a whole.
1.3.3 THE MATTERS ADDRESSED IN MY REPORT
My Report's aim is to identify and analyse the reasons for the financial failure of the Bank. Accordingly, the Report:
(a) provides an overview of the Bank: its history, its growth, and the nature of its business activities, and discusses the directors, managers and key management committees that directed and supervised the Bank's affairs;
(b) describes the strategic business planning and budgeting undertaken by the Bank as a basis for the development of its business diversification and growth;
(c) examines the procedures and practices by which the Bank raised debt and equity to fund its lending and asset acquisition;
(d) describes in detail, assisted by case studies, the policies and practices relating to the primary cause of the losses: poor credit decisions, and the acquisition of subsidiary companies that became non-performing;
(e) describes the information reporting processes and the internal audit procedures, to explain how the problems of the Bank were able to develop without obvious early warnings;
(f) describes in detail the relationship between the Bank and the Reserve Bank of Australia; and
(g) examines, in respect of the matters described earlier, the organisation and management of the Bank.
As noted earlier, the adequacy of the external audits of the Bank will be examined in a separate Report.
1.4 THE ESTABLISHMENT AND CONDUCT OF MY INVESTIGATION
1.4.1 APPOINTMENT OF THE AUDITOR-GENERAL TO CONDUCT AN INVESTIGATION
On Sunday, 10 February 1991, the then Premier and Treasurer, the Honourable J C Bannon MP, announced that the South Australian Government had established a financial support arrangement for the Bank. The financial support, in the form of an indemnity in respect of the Bank Group's loan and related asset portfolios, was provided by the setting aside of $970.0M in a special fund, of which $500.0M had been already paid to the Bank.
Mr Bannon's announcement said that the financial problems faced by the Bank Group were "almost entirely limited to the property and corporate sectors" of the Bank Group's business, and had only recently become apparent following a review of the Bank's operations by J P Morgan.
In his Ministerial Statement on 12 February 1991, the Premier and Treasurer described the course of events leading up to the implementation of support arrangements for the Bank:
" On 8 November, I was advised by Treasury that according to the latest information it had received from the Bank it was virtually certain that a profit would not be achieved in 1990-91. Indeed, the Bank had advised it could record a post-tax loss of between $30 to $50 million and indicated to the Treasury that one of the problems faced by the Bank was its exposure to non-residential construction. I indicated to Treasury officials that this advice was of great concern and asked to be kept up-to-date on a monthly basis.
On 6 December I met with the Chairman of the Bank. Prior to that meeting I was advised by Treasury that the Bank's level of non-accrual loans were growing quickly and that it was concerned that the Bank was not providing sufficiently for bad debts. Treasury was also concerned that the capital adequacy ratio was likely to fall to a level which was only slightly above the Reserve Bank's minimum level.
In the light of these very serious concerns I advised the Chairman of the Bank that a joint Bank/Treasury working group should be established to review the profit outlook for the Bank. I was advised by the Group General Manager of the Bank in a letter dated 18 December that the Board of the Bank had agreed to the establishment of this working group.
Initial discussions were held between the Bank and Treasury and it was agreed that the Bank would commence detailed work on identifying the full extent of its financial problems. Concurrently, following discussions between the Chairman and myself, the Board agreed that an external consultant should also be appointed. JP Morgan was subsequently appointed on 18 January 1991 and started work on 21 January 1991. It was agreed that a further review of the Bank's position would be presented to me at the end of January when both I and the Chairman had returned from leave.
That meeting was held on 29 January. On that occasion I was advised by the Chairman of the potential problems facing the Bank. Following that meeting I asked the Chairman to arrange for Treasury officers to meet with the JP Morgan team. On the next day, 30 January, I received further advice from Treasury following their discussions with J P Morgan and was advised of the likely full extent of the problem ...
Having become aware of the extent of the problem on 30 January, on the following day I had discussions in Canberra with the Federal Treasurer, the Hon Paul Keating, during which we discussed the situation generally. I should record that his advice was very useful.
Amongst other processes, which included liaising with the Reserve Bank, I asked that the State Bank's officers undertake the most detailed and rigorous reassessment possible of their loan portfolio with a view to quantifying the magnitude of the problem as quickly as possible. On Monday 4 February - that is Monday of last week - I was advised that the present value of the gap between book values and estimated realisable values was of the order of $900 million to $1 billion.
It became clear at that point that decisive and substantial action was required to secure the financial base of the Bank. A detailed action plan was quickly formulated in consultation between myself, the Treasury Department, the Crown Solicitor and the State Bank and proposals submitted to and approved by the State Cabinet on Thursday 7 February."
On Saturday 9 February 1991, the day before the Premier and Treasurer's announcement of the support arrangements, I was appointed by the Governor to undertake an investigation of the reasons for the Bank's financial problems, and of the adequacy of the procedures and practices of the Bank. In the words of the Premier and Treasurer in his Ministerial statement: " To put it as bluntly as it can be, the purpose is to find out what went wrong and why. "
On 4 March 1991, the Governor appointed the Honourable Samuel Joshua Jacobs, AO QC, as a Royal Commissioner to inquire into and report upon certain matters relating to the Bank, particularly in respect of the relationship between the Bank and the Government of South Australia. Subsequently, on 28 March 1991, the Terms of Appointment of my Investigation were changed to accommodate the Inquiry of the Royal Commission. The revised Terms of Appointment were more detailed, and required me to report within six months of 28 March 1991 in respect of most parts of my Investigation. Amendments were also made to the Act to facilitate my Investigation. Further amendments to the Act on 3 December 1992, and to my Terms of Appointment on 23 December 1992, clarified the nature and extent of the matters in respect of which I was to investigate and report.
1.4.2 EXTENSIONS TO THE TERM OF THE INVESTIGATION
As indicated above, the Terms of my Appointment on 28 March 1991 directed me to report on most aspects of my Investigation within six months of the date of my appointment. The exception was my investigation of the external audits of the accounts of the Bank, which was subject to a reporting requirement of twelve months from 28 March 1991.
Extensions of the time frame of the Investigation have been necessary, with a final reporting date eventually set at 30 June 1993.
The Investigation has proved to be considerably more complicated and difficult than could have been envisaged when the reporting requirements of the Terms of Appointment were first established. As explained elsewhere in this Report, I have sought to limit the time and resources needed for my Investigation by confining it to the operations of the Bank and of Beneficial Finance, on the basis that it was those two corporations which overwhelmingly incurred the losses of the Group. Even with this limitation on the extent of my Investigation, the material which has been examined in respect of the Bank and Beneficial Finance has been both voluminous and complex.
Delays were caused by the exigencies of the natural justice procedure and the associated litigation which I have described in detail later in this Chapter, and which resulted in extensions to my reporting deadlines.
1.4.3 THE RELATIONSHIP WITH THE ROYAL COMMISSION
As stated above, on 4 March 1991 the Governor appointed the Honourable Samuel Joshua Jacobs, AO QC, as a Royal Commission to inquire into and report upon certain matters relating to the Bank. These matters principally concerned the relationship between the Bank and the Government, and the arrangements under the Act for the governance of the Bank.
In respect of its examination of the control exercised by the Bank's Board of Directors over the operations of the Bank and the Bank Group, the Royal Commission was to "receive and consider" my Report. Clause G of my Terms of Appointment required me to provide to the Royal Commission a copy of my Report, and any other information or interim reports that it might seek.
The Terms of Reference of the Royal Commission were amended in September 1992 to allow the Commission to report in respect of the supervision and control by the Bank's Board of Directors of the Bank Group's operations and Chief Executive Officer without necessarily receiving my Report before doing so. My Term of Appointment G was amended to require me to provide to the Commission:
" ... any interim report or any information including relevant documents and records and including any document containing tentative conclusions reached by the Auditor General or any document containing any information or comment to the Auditor General by any person engaged to assist him in his report, which interim report or information the Royal Commission may seek relating to the matters falling within its Terms of Reference" .
To enable the Commission to take into account my findings, and to facilitate the Commission's review of my Report, I felt it necessary to provide, in detail, as much source information as possible. It is for this reason that the individual Chapters contain detailed references and extensive footnotes.
1.4.4 NATURAL JUSTICE OR PROCEDURAL FAIRNESS
I have throughout my Investigation been acutely aware that my Report, when published, could adversely affect the reputations of parties named in it. Accordingly, I have endeavoured to observe the requirements of natural justice or procedural fairness in respect of those persons, firms and institutions that might be the subject of my Report. I have endeavoured to ensure that the Report is fair and balanced, and that all parties who might be affected adversely by my findings were given ample opportunity, personally or through their legal representatives, to make written and oral submissions and call evidence to refute or contradict any tentative findings.
At the commencement of my Investigation, I determined that where parties had engaged legal representation for the purposes of my Inquiry, they could have their legal representatives present at any examination, hearing or discussion, and that I and my authorised officers would communicate with those parties through their legal representatives.
In determining the measure of natural justice I should accord to persons potentially adversely affected by my Report, I took legal advice, and was guided by statements made by the courts on this topic. It was clear to me that I needed to inform the person concerned of the precise nature of all allegations made against him, her or it, and to support those allegations with supplementary statements of reasonable particularity so that, in all the circumstances, the person receiving the notice was given a fair opportunity to deny, explain, or refute the allegations, or any of them. I have also been concerned to conduct my Inquiry expeditiously.
In late 1991 and early 1992, consultants assisting me in my Inquiry prepared a draft report to me in respect of the activities of the Bank in connection with Celtainer Limited (in liquidation). I then wrote my Report in so far as Celtainer was concerned, so that it contained my own tentative findings of fact and tentative conclusions.
I provided to the affected parties particulars of the precise nature of all allegations as described above and I requested that they make any response that they considered appropriate. I invited them to do that in the form of written submissions to me.
Those parties were dissatisfied with the measure of procedural fairness that I accorded to them, and issued proceedings in the Supreme Court for judicial review.() Those proceedings have subsequently been discontinued. After their institution I was given an extension of time within which I should publish my Report. To enable me to comply with my Terms of Appointment and ensure procedural fairness to all who might be affected, I adopted the procedure of providing (with undertakings as to confidentiality) drafts of my investigators' reports to affected parties or their legal representatives. At the same time, I invited those parties to make informal submissions to counsel assisting me on matters contained in those draft reports. They were also invited to identify any evidence that they considered my counsel should have regard to when counsel came to write a final advice to me.
This procedure served several purposes. It was at that time the most expeditious way for me to proceed. It enabled me to limit the use of the resources then available to me to areas of real dispute. On occasion, it provided a further source of information to counsel assisting me with my Inquiry. For the procedure to be productive, however, it was necessary for the parties who were given such notice to accept and acknowledge that the tentative views set out in these draft reports were not my own tentative views.
The procedure adopted by me to provide natural justice to the directors, managers and employees of the Bank and Bank Group, and the difficulties experienced with that procedure, were summarised by the Full Court (at pp 8-10) in the case of Bakewell and Others v MacPherson:
"The plaintiffs in both actions were at all material times represented by solicitors and had the services of counsel including senior counsel. Over the period of the inquiry there has been a considerable exchange of correspondence between solicitors for the plaintiffs and solicitors for the defendant and frequent conferences between the respective legal representatives. Plaintiffs in these actions were among the witnesses interviewed.
During the course of the inquiry there has been considerable conflict between the defendant and his legal representatives on the one hand and the plaintiffs and their legal representatives on the other. In general it may be said that the latter have taken the stand that their clients have been denied access to information which is necessary to enable them to present their case. The defendant and his advisers have taken the stand that the plaintiffs, instead of endeavouring to supply the information sought from them, have met requests for information with demands which were excessive and which sought to take control of the investigation out of the hands of the defendant. It is clear moreover that the defendant took the view that the plaintiffs were giving insufficient attention to the time constraints imposed upon the defendant by the terms of his appointment.
There are clear indications that the defendant was experiencing difficulty in reconciling the constant demands of the plaintiffs for what they regarded as the requirements of natural justice and the time constraints imposed upon him. In an endeavour to meet the requirements of the plaintiffs without undue delay, the defendant adopted an informal procedure of consultation with the legal advisers of the plaintiffs. As part of that procedure, he furnished a number of reports by persons to whom he had delegated the responsibility of investigating certain facets of the Bank group's activities. He provided those reports on the basis that their conclusions did not represent his views and were not to be regarded even as his tentative views. The idea was to give the plaintiffs an early intimation of the sort of issues which had arisen and an early opportunity to consider what representations they wished to make in connection with them. The procedure broke down in July 1992 because of an impasse between the defendant and the plaintiffs as to the status of these investigators' reports. The defendant required from the plaintiffs, as a condition of receiving them, that they acknowledge that they did not represent the defendant's views and were not even his tentative conclusions. The plaintiffs refused to give this acknowledgment, apparently wishing to keep open an argument based upon these reports that they had been denied natural justice. The defendant thereupon discontinued the furnishing of those reports.
The defendant was critical of the plaintiffs' attitude and expressed the view that they were obstructing the investigation." [Emphasis added]
As will be seen from the above, the former non-executive directors of the State Bank and Beneficial Finance () refused to accept that the investigators' draft reports were only investigator's draft reports, and did not contain any views of mine, tentative or otherwise. This was despite the fact that I had expressly confirmed in correspondence with their solicitors that the views expressed were not my views. I point out here that no other affected party took such a stand.
I then adopted a different means of according persons a fair opportunity to be heard. The intermediate step of releasing investigators' draft reports and inviting informal submissions was abandoned. The method then adopted was to release to affected parties, or if so advised to their legal representatives, that part of my own tentative findings of fact and tentative conclusions, after obtaining the appropriate undertakings as to confidentiality, as was relevant to the party concerned. At the same time, I invited those parties to make written submissions to me, and adduce evidence in writing in the form of a statutory declaration in support of their submissions. The Full Court found that the method adopted by me up to the time of presenting draft Chapters of this Report to the parties potentially affected by the findings in the draft Chapters "was [a] perfectly proper procedure and probably the only way in which the defendant could have proceeded having regard to the nature of the Investigation" (p 19) and had "been proper and reasonable and has not involved any infringement of the plaintiffs' rights ... I think that he has taken a proper and reasonable course in making known his tentative conclusions to the plaintiffs in order to give them an opportunity of answering them" (p 24).
This natural justice process provided affected parties with an opportunity to consider my tentative findings of fact and tentative conclusions, together with the substance of the evidence, both oral and documentary, upon which I had relied in the formation of those tentative findings of fact and tentative conclusions. Indeed, in most instances the parties have been given two months, and where I have considered it appropriate, additional time, to make their written submissions to me. Thereafter, I have also heard further oral evidence called by some parties in support of their written submissions. They have been given the opportunity to put further argument in relation to such evidence. Further, I have agreed with a request of those parties who sought to have counsel assisting me in relation to my Inquiry engage in discussions with their legal representatives in an effort to limit the hearing of unnecessarily repetitive evidence. Where I have heard further evidence, that evidence has been given on oath. Where parties had legal representatives, I have permitted their representatives to be present with them and, where appropriate, conduct such examination.
As a fact finding exercise my Investigation has continued throughout and up until the publication of my Report, both substantively and in consequence of the natural justice process itself. That process, of course, has resulted in further facts, evidence and submissions being presented to me, and I have taken all that additional material into account.
I have endeavoured throughout the above process to provide affected parties with an appropriate measure of natural justice. On many occasions I have had to make a judgment in relation to the question of procedural fairness. In doing so, I have been required to keep in mind my duty to proceed expeditiously with my Inquiry, and the circumstances of each case.
1.4.5 HISTORY OF LITIGATION
As I have already mentioned, my initial steps to accord affected parties with a fair opportunity to be heard were challenged by the Bank and two of its former employees, Mr K S Matthews and Mr T Gale, as being inadequate. Those proceedings were instituted in early February 1992, and had the effect of diverting resources which would have otherwise been directed towards continuing with my Inquiry and reporting in a substantive sense. At the same time the former non-executive directors() intervened in the action brought by the Bank and Mr Gale and Mr Matthews, and instituted their own action for judicial review, alleging a concern that I was not and would not, in the future, be according them a proper measure of natural justice. All of those proceedings were eventually discontinued.
Subsequently, in August 1992, the former non-executive directors (except Mr Prowse) instituted further proceedings. () In those proceedings they sought certain Orders, including an injunction to prevent me from publishing any report, an Order prohibiting me from continuing with my Inquiry, and declarations that the procedure I had adopted to date had been in breach of the rules of natural justice. The former Managing Director, Mr T M Clark, made application to the Court for similar Orders at about the same time.() The actions were heard by the Full Court of the Supreme Court on 7 September 1992, and that Court delivered its judgment on 25 September 1992.
In respect of the rights of the directors to respond to my tentative findings, the Full Court made the following declarations (p 28-29):
"1. (a) that the plaintiffs were entitled to an extension of time within which to respond in writing to the tentative findings and conclusions contained in the draft chapters of the defendant's proposed report, which have been furnished to them, to a date not earlier than two months after the dates on which such chapters were respectively delivered to them;
(b) that the plaintiffs were entitled to be notified of any other tentative findings or conclusions which might reflect on their conduct or affect their reputations and are entitled to a reasonable time within which to respond to them;
(c) that the plaintiffs are entitled to appear before the defendant, accompanied by their counsel, at a time and place appointed by the defendant, to give evidence on oath or affirmation in refutation of such of the tentative findings and conclusions as are identified in the written responses to be in dispute, to have put to them the substance of any evidence information or documents founding such tentative findings, and to be examined or re-examined by their counsel;
(d) that the plaintiffs are entitled to place before the defendant, either orally or in writing as directed by the defendant, any arguments as to the aforementioned disputed tentative findings and conclusions and any other matters which might reflect on their conduct or affect their reputation."
One of the consequences of this litigation was to further divert the resources which I would have otherwise utilised in pursuing my substantive Inquiry. My Terms of Appointment were subsequently varied and I was granted a further extension of time within which I should publish my Report. I then continued with my Inquiry and adopted a natural justice process which enabled me to comply with the Orders of the Full Court of the Supreme Court.
On 24 November 1992, the former non-executive directors instituted further proceedings seeking, inter alia, declarations that I had acted ultra vires by making tentative findings in relation to acting without " proper care and diligence " or tentative findings as to " reasonable and prudent bankers " and declarations that they were entitled to further and greater amounts of natural justice than they had already received. Those proceedings were filed at a time when Counsel assisting me had commenced further discussions with the legal representatives of the former non-executive directors, in an effort to limit the necessity for me to hear, and for those persons to give, unnecessarily repetitive evidence.
After the institution by the former non-executive directors of their proceedings in November 1992, Parliament, on 3 December 1992, enacted Section 4 of the State Bank of South Australia (Investigations) Amendment Act 1992 which states in sub-section 3:
"No decision, determination or other act or proceeding of the Auditor-General or an authorised person or act or omission or proposed act or omission by the Auditor-General or an authorised person, may, in any manner whatsoever, be questioned or reviewed, or be restrained or removed by prohibition, injunction, certiorari, or in manner whatsoever. "
On 7 December 1992 the former non-executive directors issued a further set of proceedings in the Supreme Court making the same allegations but in addition seeking a declaration that the above Section 4 had no application.
I have filed the necessary documents in those proceedings to defend them before the Full Court of the Supreme Court. Furthermore, the Crown Solicitor has intervened in those proceedings on behalf of the Attorney General, pursuant to the Crown Proceedings Act. The Crown Solicitor has also made an Application that the proceedings of the former non-executive directors be struck out on the basis that they fail to show on the face of the documents already filed, any cause of action. I have supported the Crown Solicitor in that application. I believe that the matters of which the former non-executive directors now complain have already been comprehensively dealt with by the Full Court of the Supreme Court in its decision in Bakewell & Others v MacPherson.()
The former non-executive directors have not sought to have the Applications filed by them set down for hearing. The November and December proceedings remain unresolved.
1.4.6 MY APPROACH TO TWO KEY CONCEPTS
1.4.6.1 Causation
As noted above, the key feature of my Terms of Appointment is its focus upon the matters and events which caused loss. It is important therefore that I briefly describe the approach I have taken to the issue of causation.
There are two quite distinct concepts of causation, both of which must be addressed by my Investigation. There is the concept of causation used by scientists, and there is the concept of causation used by lawyers.
These two concepts of causation are important elements of my Investigation. In the course of this Report, I have identified a number of matters and events which caused or contributed to the Bank's and the Bank Group's losses in the "scientific" sense that the losses may not have occurred, or at least would not have been as great, but for those matters or events.
Answering my Terms of Appointment requires more, however. It requires me to identify those matters and events that were the real and effective cause of the losses in the legal sense of causation: who or what was really to blame for the losses?
Accordingly, in answering my Terms of Appointment, I have:
(a) identified those matters and events which caused, in the scientific sense of being necessary conditions for, the financial position of the Bank and Bank Group; and
(b) identified from those necessary conditions, the matters and events that were the "real and effective" cause of the losses, in the sense that they were really to blame for the losses of the Bank Group.
The most contentious issue of causation faced by me in my Investigation was the role of financial deregulation and economic events in causing the financial position of the Bank and Bank Group. It is, of course, beyond question that deregulation and the economic environment of the 1980s had profound implications for both the rapid growth of the Bank Group, and for its eventual financial position. In purely "scientific" terms of causation, financial deregulation and the economic events of 1984-1991 unquestionably were a cause of the Bank's and the Bank Group's rapid growth, and of their resultant financial position as at February 1991.
Notwithstanding this, the question I have to answer is whether, and to what extent, economic events and financial deregulation were a real and effective cause of the Bank's and Bank Group's financial position within the Terms of my Appointment. In other words, were financial deregulation and economic events to blame, in whole or in part, for the Bank Group's losses?
The key to answering this question is to be found in the extent to which the Bank adopted sound policies and practices which were calculated to protect it from any reasonably foreseeable economic downturn. If the policies and practices actually applied were so inadequate that they would not protect the Bank from the effects of any reasonably anticipated economic downturn, then that inadequacy will be the real and effective cause of the losses.
The fact that other financial institutions also suffered losses after 1989 does not mean that economic events are to be blamed for the Bank's financial position. The losses incurred by other financial institutions are significant to my Investigation, but not for reasons of causation. Rather, the activities of other financial institutions are relevant to determining whether the Bank's operations were "adequately" and "properly" supervised, directed and controlled.
1.4.6.2 The Standards of "Adequately" and "Properly"
I am also required to determine whether the operations of the Bank were " adequately and properly " supervised by the Directors, management and employees. I have discussed the standard of conduct applied to the Bank's Board of Directors, management and employees in Chapter 2 - "Reference Information on the Investigation" of this Report. Briefly stated, in setting out the standards of whether a relevant person's performance of his function was "adequate" and "proper", I have proceeded on the view that:
(a) The obligations and duties of directors, officers and employees of the Bank are those contained in the general (non-statutory) law regarding the governance of commercial companies, and in statutory provisions applicable to the Bank;
(b) In respect of the Bank's Board of Directors, the adequacy of its action is to generally be considered and evaluated on a collective or collegiate basis, unless I formed the opinion that a particular director did not act with proper care and diligence in which case I am required to investigate that director's actions; and
(c) The allocation of responsibility to the Board and to management to perform particular functions in respect of the Bank is to be found in the State Bank Act, and in the delegations by the Board and the Chief Executive Officer under that Act. In this regard, the Act fulfils the function usually played by a company's Memorandum of Association and Articles of Association.
1.5 WHAT WENT WRONG AND WHY: AN OVERVIEW
1.5.1 INTRODUCTION
The one thing that all parties giving evidence to my Investigation agreed upon was that the Bank failed because "it grew too fast".
I agree. There is an analogy which, I think, assists in understanding what that involved.
There are chemicals which kill trees by forcing them to grow. They contain a growth hormone that stimulates and forces even a mature tree to produce new leaves and branches, expanding its canopy. For a while, the tree seems to thrive. But its growth is uncontrolled and wildly excessive, outstripping the ability of the tree to support and sustain itself. The tree's systems cannot keep up. The new growth withers, and the tree dies.
The Bank's inaugural Chief Executive Officer, Mr Clark, was the Bank's growth hormone. The Board of Directors did not impose constraints or control on the growth he stimulated and drove. Many of the Bank's senior managers weren't up to the task - they lacked the judgment, experience and banking skills that together comprise competence. The Bank's growth was almost universally lauded and applauded, but its appearance of vigour and health was illusory. Now the leaves have turned.
Most of the new growth took the form of corporate loans. The Bank failed mainly because too many of those loans were bad: loans that it should never have made. Growth that should not have occurred. The Bank's Corporate Lending business was incompetently conducted in almost every respect, from the procedures used in initiating loan proposals to the approval of loans by the Board of Directors.
There is, however, more to the causes of the Bank's losses than sloppy lending. The term "main cause" is perhaps better expressed as "proximate cause".
The story of the Bank is one of a professionally aggressive and entrepreneurial Chief Executive without sufficient appreciation of the need for prudent banking controls and management; of an incompetent Executive Management happy to follow where their Chief led without independent professional judgment; of a Board of Directors out of its depth and, on many occasions, unable or unwilling to exercise effective control; and, ultimately, of a Bank that thrived on the full faith and credit of the people of South Australia.
1.5.2 THE FORMATION OF THE BANK
The Bank was formed in the euphoria and excitement of 1984. The economy was rebounding from the recession of 1982, and asset prices in particular were rising rapidly. The Government enthused about the new Bank being an "engine of economic growth" for South Australia.
It is, in a very real sense, misleading to think of the Bank as having been a "new" Bank at the time of its formation on 1 July 1984. It was new in form only. In substance, it was an amalgamation of the two predecessor State-owned banks - essentially thrift institutions with their activities largely confined to South Australia, and with the management skills and systems suited to those activities. Immediately after its formation, the Bank expanded rapidly into new financial markets for which its management and its systems were wholly inadequate. The Bank's Executive managers pursued growth as though that didn't matter. It did. Warnings from the Reserve Bank were simply ignored. The Board of Directors lost control.
The Board of Directors appointed by the Government in 1984 and largely maintained thereafter may have been adequate to the task of overseeing the merger of two safe South Australian retail banks. But as the new Bank was launched on a path of extraordinary expansion, the Board was left floundering. It tried to understand, and complained a number of times about the "technical" nature of the papers containing banking jargon that it was asked to review. The tragedy is that the Board did not call a halt to the growth that it did not understand. It would not have been an easy thing in the euphoria of the 1980s, and in the face of Mr Clark's driving ambitions. But that was the Board's job. It acquiesced in its unmanaged growth. The Board's efforts to exercise control from 1989 were too little, too weak, and too late.
Mr Clark came from a senior management position at Westpac, and was given the job as Chief Executive Officer of the Bank. He was determined to compete, and compete hard. Only the four major trading banks would be bigger.
Mr Clark's imperative was to diversify and grow, and there was nothing to stand in his way. The economic environment of the day was ideal. Deregulation opened up new markets and new opportunities. As a State bank, the Bank was not subject to the formal supervision of the Reserve Bank - Mr Clark chafed under the informal arrangement for supervision that did exist. He was the only director with any banking experience, enabling him to dominate the Board. There was no share price to worry about - just profits. There was an unlimited supply of money to fund the Bank's expansion - the Government guarantee meant that it could borrow whatever funds it needed, as and when it required them, without any real need to plan.
1.5.3 THE GROWTH AND OPERATIONS OF THE BANK
And so, the Bank grew. In its first year, total assets increased by 27.5 per cent. They increased by an extraordinary 55.5 per cent in 1986. The nascent London branch expanded rapidly, and built up a large loan portfolio, heavily exposed to commercial property. Branches were opened in New York, Hong Kong and Auckland, and representative offices in Los Angeles and Chicago. Branches were established in most Australian capitals, holding large corporate loan portfolios. The Bank bought a stockbroking firm, a trustee company, a half-interest in a real estate agent, established a merchant bank and bought a life insurance company. It bought Security Pacific New Zealand and, in 1990, United Building Society in New Zealand.
By 1990, the Bank's assets had grown from $2,690.6M at formation, to $17,299.8M, an increase of 543 per cent. (Total assets of the Bank Group increased over the same period by 572.7 per cent, from $3,142.8M to $21,142.1M.) The real increase in the Bank's total assets was in fact even greater, because in 1989 the Bank's portfolio of concessional housing loans was transferred to the South Australian Government Financing Authority. Excluding that portfolio, the increase in assets of the Bank was 700.1 per cent - from $2,162.3M to $17,299.8M. From an essentially South Australian institution, it had expanded so that two-thirds of its assets were located interstate and overseas. Corporate loans grew to represent about 38 per cent of lending assets. The Bank's funding changed as well: wholesale funds increased as a proportion of the Bank's total funds from 15 per cent in 1984 to 82 per cent in 1990(), and by 1990 the Bank had interest bearing deposits overseas totalling $2,214.7M.()
Much of this growth was, in dollar terms at least, unplanned. Between 1985 and 1990, 38.7 per cent of the Bank's actual growth in assets was not budgeted in the annual profit plans. Growth was unconstrained, unplanned and highly opportunistic.
The opportunities were often not profitable. In March 1988 the Bank purchased Oceanic Capital Corporation, a life insurance and funds management group of companies for $60.0M, without first undertaking an adequate due diligence investigation. In June 1990, the United Building Society was purchased for $150.0M while the due diligence was half completed. The Bank moved quickly to acquire the Society, a move it soon regretted.
The major part of the growth in the Bank's assets was the expansion of its corporate loan portfolio. It is here too that most of the losses were suffered. With hindsight at least, this is no coincidence. In a highly competitive environment, there is really only one way that a bank can expand its loan portfolio much more rapidly than its competitors - by accepting lower credit standards, and making loans that other lenders would not make, at least at the same price. There is a connection between above average growth, and above average losses.
My examination of the Bank's corporate lending has shown that it was poorly organised, badly managed and badly executed. Credit risk evaluation was shoddy. Corporate lending policies and procedures were not even compended into a credit policy manual until 1988, and even then contained serious omissions. The ultimate loan approval authority - the Board of Directors - lacked the necessary skills and experience to perform its function adequately. Senior management's emphasis was on doing the deal, and doing it quickly.
The growth in the loan portfolio is explained in part by the profit imperative. While the Bank's budgeted asset growth was exceeded in every year, its budgeted profit was not. The Bank's lending practices included taking a significant portion of its income in the form of up-front fees, part of which represented, in substance, interest on the loan. For a significant period, these up-front fees were shown as income in the year they were received. This meant that the easiest way to increase profits was simply to make more loans. Make a loan, book the profit, and make another loan. It was the excesses of the 1980s at its worst, conducted by a State Bank guaranteed by the people of South Australia.
The organisational structure of the Bank meant that there were no internal checks or controls on the growth. The Bank was organised into highly autonomous business units, with the objective of making those divisions accountable for their profitability. There was no overall authority which exercised control. The Executive Committee was mired in detail, and ineffective. Mr Clark's focus was not on prudent control, but on growth and profitability.
Those departments of the Bank which should have acted as internal regulators were isolated and without authority. The Information Systems department was expected to do no more than provide those services demanded by the business units. The result was that the Bank developed disparate information systems across its business units which could not communicate properly. It was not until 1990 that the Bank was able to measure its total loan exposure to commercial property. Lending was conducted without any regard to the cost of funds, or to the Bank's liquidity position.
Where was the Reserve Bank? It was watching, often with alarm. It warned and cajoled at prudential consultations, wrote letters, complained, cautioned and threatened. It received bland assurances from the Bank's management - assurances that were hollow, if not ingenuous. Many of the Reserve Bank's warnings and concerns were not passed on to the Board of Directors.
1.5.4 THE BOARD OF DIRECTORS
Throughout this, the Bank's Board of Directors was, for the most part, ineffective.
I have some sympathy for the Bank's non-executive directors. They lacked both banking experience and, in most cases, hard-headed business acumen. They were manipulated, and not properly informed of what was going on. The information given to them was voluminous, but obscure. It took an expert and practised eye to sort the wheat from the chaff, and to know what information was not there. The Board lacked that.
But whatever sympathy one may have for its predicament, the Board of Directors was the governing body of the Bank, charged with responsibility to administer the Bank's affairs and to control the Chief Executive in his performance of his management function. A reasonably prudent Board - whatever its skills - would have done much more than the Bank's Board did. It was not beyond the capabilities of the non-executive directors to take commonsense measures, and to stand no nonsense.
To be blunt, there is nothing esoteric about asking questions, seeking information, demanding explanations and extracting further details. There is nothing unduly burdensome in expecting each director, to the best of his or her ability, to insist on understanding what was laid before them, even at the risk of becoming unpopular. Both the law, and a basic sense of duty and responsibility, demand it.
The non-executive directors submitted to me that they did these things. Sometimes they did. But not often enough, and not strongly enough.
I have repeatedly found that the Board of Directors of the Bank failed to adequately or properly supervise, direct and control the operations, affairs and transactions of the Bank.
Whilst in many individual cases the Board might well have been entitled to rely on the advice, expertise and assurances of the Chief Executive Officer and senior management, members of the Board were not entitled to abandon their statutory responsibility and accept recommendations without giving them appropriate consideration and, if necessary, meaningful and critical questioning. They were required to exercise an independent judgment, placing only such reliance on advice as their common sense should have told them was prudent. They did not do so on many important occasions.
1.5.5 THE CHIEF EXECUTIVE OFFICER
Mr Clark bears a heavy share of blame for the Bank's losses. It was he, as Chief Executive Officer and a member of the Board of Directors, who set the Bank on its course of unmanaged growth. Mr Clark drove the Bank to grow and diversify, but he paid too little attention to the need to manage it prudently. He seemed oblivious to the risks he was running, and ignored words of warning and caution.
Again and again, the evidence shows Mr Clark to have been impatient with opposition and easily affronted. His personality and position were such that his banking philosophy and strategies, and his attitude to particular transactions being processed by the Bank, would have been known to all. It would have been a courageous member of staff who expressed views in a manner likely to come into conflict with the wishes of such a formidable superior.
There would, in my opinion, have permeated through the Bank, the aura of a domineering leader who exerted a strong influence on senior staff members. They would have been likely as a (usually sub-conscious) matter of self-protection, to have been moved to bring their judgments and opinions into a form that would not attract the Chief Executive Officer's disapproval. All of this would, over a period of years, have been seriously inimical to rigorous investigation, objective appraisal, and plain talking.
I have repeatedly found that Mr Clark failed to adequately or properly supervise, direct and control the operations, affairs and transactions of the Bank, and that he failed to provide the Board with information that was timely, reliable and adequate.
1.5.6 THE BANK'S EXECUTIVE MANAGERS
As a group, the Bank's senior managers were not up to the job. Worse, they acquiesced in and abetted, without any adequate expression of professional judgment, the course set for the Bank. If the managers had any conception of what was required to safely manage the Bank, they did not display it. Instead, they displayed a cavalier approach to the Board, to the Reserve Bank and to the principles of sound business management that speaks ill of their professionalism and judgment, let alone their banking skills.
In the course of my Investigation and Report I have had occasion to criticise many of the Bank's senior managers. They have, in varying degrees, been responsible for some of the most irresponsible, reckless and imprudent decisions made by the Bank.
In their dealings with both the Board and external agencies one or more of these officers:
(a) failed to inform the Board of the results of advice received from independent consultants and other critical information relevant to decision-making;
(b) supplied positively misleading information to the Reserve Bank;
(c) failed to convey to the Board concerns being expressed by the Reserve Bank of the Bank's growth and prudential policies; and
(d) provided information to the Board which the officers knew to be wrong.
There are numerous examples of senior officers, for a variety of reasons not the least of which was to the perceived need or desire " to do the deal ", inadequately and in some cases recklessly assessing proposals and failing to act in a responsible and prudent manner. The attitude that there was a need to complete the transaction quickly because if they did not, someone else would, seemed to pervade and characterise senior management's actions. The spectre of the competitor always waiting in the wings was constantly put forward as the reason for rushing so many transactions, many of which involved millions of dollars.
There was a failure by the Bank's senior management to display the skills, professionalism and judgment that was reasonably required of them. Several factors were at work. Many simply lacked the skills and experience that is required of senior bank executives. Many, if not all, were swept along in the euphoria that characterised the financial markets in the 1980s. And then there was the formidable influence of Mr Clark. None of these factors exculpates the officers.
I have repeatedly found that the Bank's senior managers, at various times, failed to adequately or properly supervise, direct and control the operations, affairs and transactions of the Bank, and that they failed to provide the Board with information that was timely, reliable and adequate.
1.5.7 SUMMARY REPORT IN ACCORDANCE WITH MY TERMS OF APPOINTMENT
The nature of my Investigation means that it is necessary to answer my Terms of Appointment separately in respect of the discrete parts of the Bank's operations. Accordingly, each Chapter of this Report contains a report in accordance with my Terms of Appointment as they relate to the particular aspect of the Bank's operations described in the relevant Chapter.
Nevertheless, based on the evidence described in my Report, it is possible to provide some general answers that describe accurately and fairly the features of the Bank relevant to my Terms of Appointment.
1.5.7.1 Term of Appointment A(a)
The matters and events that caused the financial position of the Bank as reported by the Bank and the Treasurer in public statements on 10 February 1991 and in a Ministerial Statement by the Treasurer on 12 February 1991 were:
(a) The failure of the Bank to establish adequate policies and procedures for the evaluation and management of credit risk associated with its corporate lending activities.
(b) The poor quality of the conduct of the Bank's credit risk assessment and management functions, which resulted in the Bank making too many bad loans that should not have been made.
(c) The failure of the Bank to establish any guidelines, procedures or policies for the conduct of due diligence investigations and evaluations of potential acquisitions of businesses.
(d) The poor quality of the processes and practices by which the Bank acquired Oceanic Capital Corporation and United Building Society.
(e) The Bank's excessive exposure to commercial property.
(f) The inadequacies and deficiencies of the Bank's information systems.
(g) The inadequacies and deficiencies of the internal audits of the Bank.
(h) The failure of certain of the Bank's senior managers to accept and respond positively to the advice provided to them by the Reserve Bank of Australia.
(i) The failure of the Board of Directors to adequately or properly supervise, direct and control the Bank's operations, affairs and transactions, as particularised in my Report.
(j) The failure of the Chief Executive Officer to adequately or properly supervise, direct and control the Bank's operations, affairs and transactions, as particularised in my Report.
(k) The failure of certain of the officers and employees of the Bank to adequately or properly supervise, direct and control the Bank's operations, affairs and transactions, as particularised in my Report.
Other matters and events that provided the essential pre-conditions for the financial position, but which were not a cause in the sense of being responsible or to blame for the losses, were:
(a) Financial deregulation and the economic events of the 1980s.
(b) The fact and incidents of the ownership of the Bank by the Government, including the existence of the Government guarantee of the Bank's liabilities.
1.5.7.2 Term of Appointment A(b)
The processes which led the Bank to engage in operations which have resulted in material losses or in the Bank holding significant assets which are non-performing are too numerous to list here. Particular processes are identified and described in relevant Chapters of this Report.
1.5.7.3 Term of Appointment A(c)
For the reasons described in those Chapters, those processes were not appropriate.
1.5.7.4 Term of Appointment A(d)
The procedures, policies and practices adopted by the Bank in the management of significant assets which are non-performing are too numerous to list here. Particular procedures, policies and practices are identified and described in relevant Chapters of this Report.
1.5.7.5 Term of Appointment A(e)
For the reasons described in those Chapters, those procedures, policies and practices were not adequate.
1.5.7.6 Term of Appointment A(f)
I will report on whether the Bank had adequate and proper procedures for the identification of non-performing assets and assets in respect of which a provision for loss should be made in my separate Report in respect of Term of Appointment B regarding the appropriateness and adequacy of the external audits of the Bank and Beneficial Finance.
1.5.7.7 Term of Appointment A(g)
For the reasons described in Chapter 23 - "Internal Audit of the State Bank" of this Report, the internal audits of the accounts of the Bank were not appropriate and adequate.
1.5.7.8 Term of Appointment A(h)
Instances of directors and officers having failed to act with proper care and diligence are identified in various Chapters of this Report. Possible conflicts of interest, breaches of fiduciary duty or other unlawful, corrupt or improper activity on the part of directors or officers of the Bank are the subject of comment and recommendations in my Report, and in a separate confidential Report to be presented by me with my final Report.
1.5.7.9 Term of Appointment C
For the reasons described in my Report, the operations, affairs and transactions of the Bank and the bank Group were not adequately or properly supervised, directed and controlled by:
(a) the Board of Directors of the Bank;
(b) the Chief Executive Officer of the Bank; and
(c) certain other officers and employees of the Bank as identified in my Report.
1.5.7.10 Term of Appointment D
For the reasons described in my Report, the information and reports given by the Chief Executive Officer and other Bank officers to the Bank Board:
(a) were under all the circumstances, not timely, reliable and adequate; and
(b) were not sufficient to enable the Board to discharge adequately its functions under the Act.
1.6 RECOMMENDATIONS
The recommendations made in various Chapters of this Report are of two types.
First, I have recommended in respect of the six credit risk management case studies (Chapter 9 to Chapter 14) that the deficiencies identified in those Chapters should be the subject of administrative action within the Bank to ensure proper supervision and competence in understanding and executing the lending policies and procedures of the Bank.
Second, I have recommended matters for further investigation in Chapters 10, 17 and 26 of this Report.
1.7 MY REPORT ON THE STATE BANK: A SYNOPSIS
1.7.1 INTRODUCTION
This Section provides a synopsis of the various Chapters of this Report, and brings together the findings and conclusions which I have reached in relation to my investigation of the Bank's operations and of the role played by the Bank Board, its Chief Executive Officer and relevant other officers and employees.
My findings and conclusions, in summary form, are set out in this Section by grouping them according to the following parts of my Report:
(a) Direction Setting and Planning, and Management of the Bank and Bank Group's Diversifiable Credit Risk (Chapters 4 and 5);
(b) Funding, and Treasury and Asset and Liability Management (Chapters 6 and 7);
(c) The Management of Credit Risk (Chapter 8);
(d) Case Studies on the Management of Credit Risk (Chapters 9 to 14);
(e) Relationship with the Reserve Bank (Chapter 15);
(f) Management of Acquisitions (Chapters 16, 17 and 18);
(g) Overseas Operations of the Bank (Chapter 19);
(h) Management Issues (Chapters 20, 21 and 22);
(i) Internal Audit of the Bank (Chapter 23); and
(j) Other Matters (Chapters 24, 25 and 26).
The description of the Bank's operations provided in the following synopsis should be read in the context of the growth and diversification of the Bank's businesses from 1984.
As has been noted, the operations of the Bank changed very significantly after July 1984.
The Bank's total assets increased from $2,683.0M at 1 July 1984, to $17,300.0M by 30 June 1990, an increase of 543 per cent, substantially larger than that of both the major private banks and other State banks. The major increase was in the area of corporate lending, which represented about 38 per cent of total loans as at 31 December 1990. Lending for housing (excluding concessional housing) fell from 62.5 per cent of the Bank's portfolio on 1 July 1984, to 22.8 per cent by 31 December 1990. There was, too, a dramatic increase in loans to overseas borrowers - by 31 December 1990, such loans represented 34.8 per cent of the Bank's loan portfolio.
The change in nature of the Bank's business was reflected in its funding base - between July 1984 and June 1990, the use of wholesale funds increased as a proportion of total funding from just 15 per cent, to 82 per cent.
1.7.2 DIRECTION-SETTING AND DIVERSIFIABLE CREDIT RISK MANAGEMENT (VOLUME III - CHAPTERS 4 AND 5)
1.7.2.1 Direction-Setting and Planning (Chapter 4)
(a) Overview and Summary
The Bank's Board of Directors approved the basic elements of the procedures for the Bank's long-term strategic planning and annual budgets at its inaugural meeting on 28 June 1984.
The procedures utilised by the Bank involved a specialised planning department, an annual planning conference attended by all senior managers (including representatives of subsidiary groups), the annual preparation and approval of a five year strategic plan, and the subsequent preparation and approval of a budget for the ensuing financial year to implement the strategic plan.
Fundamental to the philosophy underlying the strategic plans was the Board of Directors' and Management's interpretation of the Bank's charter as involving primarily commercial objectives, particularly increased profitability. The growth and diversification of its business was seen as being an essential prerequisite to meeting those objectives.
The strategic plans and budgets, as drafted and approved, were reasonably comprehensive. They were prepared with input from, and were apparently endorsed by, the Bank's senior management, and included information regarding the plans of the Bank's major subsidiary groups.
The plans outlined in general terms the proposed growth and diversification of the Bank's business activities, and addressed, also in general terms, its internal infrastructure needs (including information systems, staff and funding) essential to managing that planned development. The Bank's planned rate of growth, judged against the actual growth rates of other banks, was not necessarily excessive.
However, as extensive as the procedures for preparing the plans and budgets seemed, the strategic planning and budgeting processes had a critical failing: an absence of effective implementation and control systems. In each year after 1984, the actual growth of the Bank's assets far exceeded that which was planned or budgeted. In the years 1986 to 1990 inclusive, the Bank's assets grew by more than $5,400.0M, or 38.7 per cent, in excess of that which was planned or budgeted. The actual rate of growth in the Bank's assets was, despite the planning, significantly higher than that of most other banks, including other State banks.
The rate of growth of the Bank's assets, both through lending and by takeovers, was so in excess of that which was planned as to render the planning procedures largely irrelevant to the Bank's actual business development. The excessive rate of growth over and above that which was planned, projected or budgeted meant that the planning procedures did not operate as an effective management control in the Bank.
By itself, this excessive rate of growth should have raised a real suspicion on the part of the Board that the Bank's internal systems and resources may not have been adequate or appropriate to prudently manage and support its growth.
There were, in addition, other factors which should have put the Board on notice that it could not rely on the planning and budgeting procedure in undertaking its function of governing the Bank. They were:
(i) repeated references in the strategic plans themselves to the need to take action to ensure that the annual budgets were consistent with the Bank's long-term objectives; and
(ii) the inability of Management to provide any meaningful strategic monitoring reports, culminating in April 1988 with express advice given to the Board of inadequacies in the procedures for implementing the plans, including a lack of deadlines, lack of delegation to Management, insufficient communication to business units, and an excess of strategic programs.
The failure of the strategic planning and budgeting procedures as a management device does not necessarily mean that the Bank's Board of Directors and Management did not take other action to ensure that the asset growth and diversification of the Bank was prudently managed. However, the essential irrelevance of the strategic plans and budgets to the Bank's actual growth gave rise, in particular, to an obligation on the Board of Directors and management to take some reasonable action to ensure that the Bank was being properly and adequately managed. It was submitted to me on behalf of the Non-Executive Directors of the Bank that the Board had "clearly discharged " its obligation by " regularly querying management about the adequacy of the Bank's staff and systems to cope with the growth of the Bank ."() As is described in later Chapters of this Report, it is an obligation that the Board of Directors failed to satisfy , and accordingly I reject that submission.
(b) Findings and Conclusions
(i) The processes that led the Bank to engage in operations which have resulted in material losses, or holding significant assets which are non-performing, included the strategic planning and budgeting of the Bank, which expressly planned to engage in most aspects of the business activities which resulted in the acquisition of such assets. However, the actual acquisition of the majority of assets was, in quantitative terms at least, unplanned.
(ii) The procedure of strategic planning and budgeting did not amount to an adequate or proper system for supervision, direction and control of the Bank's activities. The excessive rate of growth over and above that budgeted, essentially meant that the strategic plans and budgets were largely irrelevant to the procedure of supervision, direction and control of the Bank's operations.
1.7.2.2 The Management of the Bank Group's Diversifiable Credit Risk (Chapter 5)
(a) Overview and Summary
An important aspect of the prudent management of any financial institution is the establishment of, and adherence to, prudential policies that will ensure that the loan portfolio does not involve an excessive concentration of credit risk. Such policies must ensure that the portfolio is not overly exposed to particular borrowers, particular industries, or particular geographic areas. Where a parent company is in reality committed to supporting a subsidiary, such prudential policies need to be established and adhered to on a global or group basis.
A significant contributing factor to the Bank Group's losses was its excessive and imprudent exposure to commercial property, caused in large part by the absence of:
(i) a group-wide prudential policy limiting that exposure; and
(ii) an information system to measure the exposure.
Until 1990, the State Bank and Beneficial Finance established independent prudential policies in respect of their respective loan portfolios. In accordance with the Reserve Bank Prudential Statement G1, the Bank sought to manage its potential exposure to Beneficial Finance by appointing its own representatives to constitute a majority of the Beneficial Finance Board. The Bank did not seek to establish prudential policies to apply on a group basis until October 1990.
The need for an effective system for controlling Group-wide risk had been recognised from as early as 1985, when the objective of establishing such a system was included in the 1985 strategic plan. There were repeated references to this need over the following three years. Despite this, it was not until 1988 that even the first steps were taken to establish information systems that would enable the Bank's and the Bank Group's total exposure to particular clients, industries or geographic areas to be determined. The Bank not only lacked an information system to measure the total Group exposure, but it was unable even to determine the total exposure of the Bank's own divisions to various clients, industries and geographic areas. As the Bank's Chief General Manager, Mr Matthews reported to the Executive Committee in August 1988, the Bank did "not have any mechanisms to accurately assess our total exposure as a Bank or a Group to any one individual, business entity, industry, region or country ."() Progress in developing an adequate information system after 1988 was slow - it was not until 1990 that reports relating to Group exposures became regularly available to the Bank's Board of Directors.
The absence of any effective system for the monitoring and control of the Bank and Group-wide credit risk exposure of the Bank and Bank Group was a serious deficiency in the Bank's management systems. The business activities of the Bank's divisions and subsidiaries, and of Beneficial Finance in particular, created a real risk that the Bank might be over-exposed to particular borrowers, or over-exposed to particular industries, particularly property and construction.
Both the Bank and Beneficial Finance established prudential policies regarding the maximum exposure to a particular borrower (or borrowing group) by reference to their respective capital bases. Although these policies were relatively aggressive, and J P Morgan stated in 1991 that it believed that the Bank's "exposures to many individual borrowers represent an unduly high percentage of SBSA's capital and reserves", the Bank Group's client exposures were, with some exceptions, within the prudential guidelines established by the Reserve Bank.
The Reserve Bank raised its concerns regarding the Bank's exposure to commercial property with the Bank's management, particularly with Mr Matthews, on a number of occasions. Despite the repeated raising of the issue by the Reserve Bank, no effective steps were taken by the Bank to address the large property exposure in its loan portfolio. Indeed, between June 1988 and June 1989, the Corporate Banking exposure to commercial property increased by $1,008.6M, from $801.1M to $1,809.7M, an increase of 125.9 per cent. The increase in the exposure to Developers and Contractors was 154.8 per cent.
Moreover, no effective action was taken to identify exactly what the Bank's total exposure to commercial property was. Mr Matthews is recorded as advising the Reserve Bank, on 30 January 1990, that the Bank's "System for measuring exposures by industry group, including property, was not yet completed but could be ready by mid-year."()
The excessive exposure of the Bank Group to the commercial property market was caused by:
(i) the failure of the Bank to implement any system to monitor its total exposure to commercial property;
(ii) the failure of the Bank to implement any system to monitor the Bank Group's exposure to commercial property;
(iii) the rapid increase in the Bank's lending for commercial property during the year ended 30 June 1989, resulting in 31.8 per cent of the Corporate Banking portfolio being exposed to commercial property;
(iv) the failure of the Board of Directors of Beneficial Finance to establish an adequate prudential policy to limit its exposure to commercial property; and
(v) the excessive exposure of Beneficial Finance to commercial property, of about 60 per cent of its risk portfolio.
The responsibility for the Bank Group's excessive exposure to commercial property lies with both the Bank's, and Beneficial Finance's, Board of Directors and Management.
(b) Findings and Conclusions
(i) The Bank's Board of Directors failed to take adequate steps to implement reasonable prudential policies relating to the risk exposure of the loan portfolio, particularly to commercial property, and failed to take adequate steps to satisfy itself that the exposure was monitored and controlled.
(ii) The Reserve Bank raised, at regular intervals, concerns regarding the Bank's and Beneficial Finance's exposures to commercial property. There is no evidence of any action being taken by the Bank in response to these concerns from the Reserve Bank. To the contrary, the Corporate Banking exposure to commercial property increased by $1,008.6M in the year ended 30 June 1989.
(iii) The Chief Executive of the Bank, Mr Clark, failed to take any timely and effective action to review and recommend updating of the Bank's prudential policies, or to ensure that an effective system was established to monitor the Bank's and Bank Group's exposures.
(iv) Mr Matthews, Chief General Manager of the Bank from 1986 to 1988, and from 1 July 1989 Chief General Manager Group Risk Management, assumed responsibility in August 1988 to develop a system to monitor Bank-wide and Group-wide risk. Having assumed that responsibility, Mr Matthews did not ensure that the development of essential systems occurred in a timely manner, and failed to ensure that the Board of Directors was informed of the dangers associated of the absence of Bank-wide and Group-wide risk management systems.
(v) The operations, affairs and transactions of the Bank in this respect were not adequately or properly supervised, directed or controlled by the Bank's Board of Directors, the Chief Executive Officer and Mr Matthews.
1.7.3 FUNDING, AND ASSET AND LIABILITY MANAGEMENT (VOLUME IV - CHAPTERS 6 AND 7)
1.7.3.1 Funding of the State Bank (Chapter 6)
(a) Overview and Summary
The financial position of the Bank in February 1991 was overwhelmingly related to the poor quality of its assets. The Bank made too many bad loans, and paid too much to acquire other businesses that performed badly.
There was, however, a prerequisite to lending, and spending, the money that has been lost - the Bank had to obtain that money in the first place. Shortly stated, the Bank obtained money in the form of capital and borrowings which it lent to its customers, and spent on business acquisitions. The Bank had no trouble borrowing money because, in effect, the people of South Australia guaranteed that, if the Bank could not repay its borrowings, they would. This is, of course, precisely what happened - when the Bank could not meet its obligations because it had lost so much of the money it borrowed, the people of South Australia were required effectively to pay the Bank's obligations.
Broadly speaking, the Bank obtained its funds from three sources. They were:
(i) retail deposits in the form of savings accounts held, in large part, by South Australians;
(ii) wholesale deposits and other loans from businesses and other financial institutions; and
(iii) capital contributions from the Government, arranged and provided by the Treasurer and by the South Australian Government Financing Authority ("SAFA").
There was nothing about the way that the Bank obtained retail or wholesale funds that contributed to its failure. Indeed, with the benefit of the Government guarantee, the Bank had few problems borrowing money on favourable terms.
The non-executive directors of the Bank (other than Mr Prowse) - and particularly Mr D W Simmons - submitted to me however that the dividend rate applicable to the majority of the Bank's contributed capital was a significant cause of the Bank's losses.
In essence, the non-executive Directors' argument was that the capital provided by SAFA was so expensive - it carried a fixed dividend rate of 0.65 per cent above the bank bill rate - that the Bank was forced to grow rapidly in pursuit of profits just to be able to meet its dividend obligations to the Government. The implication is that the Bank's failure was not the Board's fault. Rather, the Bank was forced to grow rapidly by the Government's exorbitant and unreasonable demand for profits, manifested in the form of a fixed obligation on the Bank to pay excessively high dividends. This compelled the Bank to take risks that it should not have taken, resulting in losses.
This submission from the non-executive directors compelled me to investigate in considerable detail the nature and terms of the Bank's capital structure. Having done so, I have concluded that there is no substance to their submission. Indeed, that submission demonstrates the paucity of financial knowledge that was a characteristic of the Bank's Board of Directors.
Over the period covered by my Investigation, the capital of the Bank increased very significantly, from $165.5M at 1 July 1984, to $1,340.6M at 30 June 1990. Most of this increase - $1,070.9M of the total increase of $1,175.0M - was in the form of additional subscribed capital and subordinated loans. All but $US 100.0M of that additional capital was provided, directly or indirectly, by the South Australian Government through SAFA.
A feature of the capital contributed to the Bank was said to be that most of it was not "free". This expression was used, in submissions and evidence to me, to mean that it carried an obligation to pay a dividend at a determined rate. In June 1989, the Bank's capital was made up of the following components:
| "Free" capital (including reserves and retained earnings) | 301.9M | |
| SAFA contributed capital | 538.9M | |
| Subordinated debt | 472.0M | |
| Total Capital | $1,312.8M |
As can be seen, of the total "capital" of $1,312.8M, only $301.9M, or 23.0 per cent, was "free". The SAFA contributed capital of $538.9M carried an obligation to pay a fixed dividend equal to the bank bill rate plus 0.65 per cent per annum. The subordinated debt involved interest obligations related to LIBOR (London Interbank Offer Rate).
Mr Simmons made a detailed submission in respect of the Bank's cost of capital and its implications. He identified the essential problem as:
(i) the fixed dividend rate of bank bill plus 0.65 per cent payable on the SAFA contributed capital was excessive;
(ii) the rate was particularly onerous because it had to be paid from after-tax profits - that is, the dividends were not deductible for the purpose of determining the Corporations Tax Equivalent payable to the State Government pursuant to Section 22 of the Act. The result, Mr Simmons submitted, was that the Government got " two bites of the cherry ", and was " being paid more than it was legitimately entitled ";
(iii) the result was to drive the Bank's Management to pursue profits in a manner that necessarily involved taking higher risks than it otherwise would have;
(iv) those risks are now evident in the poor quality of the Bank's assets.
I do not accept Mr Simmons' submission, for a number of reasons:
(i) First, there is no such thing as "free" capital. Every company incurs a cost for its capital represented by the return demanded by its shareholders, either in the form of dividends or capital gains associated with retained earnings. All contributed capital carries an effective obligation on the company to derive profits, whether distributed as dividends or not. Based on information provided to me by the South Australian Treasury, I am satisfied that the State Bank's cost of capital was not excessive;
(ii) Second, Mr Simmons' statement that the dividends were to be paid from after-tax profits is wrong. As shown clearly in the Bank's 1990 Annual Report, the Corporations Tax Equivalent was in fact calculated after allowing the dividends paid to SAFA as a deductible expense. There were no "two bites at the cherry";
(iii) Third, the Bank's officers expressly denied in evidence to me that the dividend rate was a factor which influenced the Bank's business growth. Mr Clark described the argument regarding the Bank's cost of capital as a " furphy raised by the directors ". I am inclined to agree with Mr Clark;
(iv) Fourth, the Board of Directors sanctioned a profitability target of a 15 per cent return on shareholders' funds, which was at least as demanding as that reflected in the "fixed" cost of capital; and
(v) Finally, the terms on which capital was provided to the Bank by SAFA included a provision that the dividends were not payable if profits were insufficient to fund the dividends.
The fact that this submission could be put by the former non-executive directors (other than Mr Prowse, who expressly disassociated himself from it), and particularly by Mr Simmons, speaks volumes for the difficulty those directors had in grasping even this basic element of the Bank's capital structure. I accept that their submission was made in good faith. It was, however, factually incorrect and logically flawed in a way that demonstrates, as clearly as anything else, their inadequacy for the task of governing a bank.
In the course of reviewing the Bank's funding, I investigated particularly the terms of a $US 150.0M floating rate note facility entered into by the Bank, and arranged by J P Morgan. Although this facility, which was in effect simply a form of borrowing by the Bank did not result in significant losses, the circumstances of its implementation highlights the shoddy way in which the Bank was managed.
Shortly stated, I cannot understand why the Bank entered into the transaction. The loan was more expensive than funds that could have been obtained from SAFA (which, in the end, effectively provided the funding by subscribing for the notes). Indeed, the South Australian Treasury asked Mr Matthews, in writing, not to undertake the transaction. Mr Matthews did not tell the Board of Directors about that request.
The Board was largely uninformed regarding the transaction, and did not approve it before Management committed the Bank to it. Although some directors were given an oral briefing on the transaction by Mr T L Mallett, the transaction entered into was quite different from that described. A Board Paper informing the Board that the transaction had been mandated by the Bank contained errors which made the paper not only misleading, but essentially incomprehensible. Mr Mallett, with the authorisation of Mr Clark, committed the Bank to the transaction without Board authority.
The only possible advantage to the Bank from the transaction was illusory, depending as it did upon an accounting device that involved treating repayments of the loan principal as though they were interest. The result was to appropriate profits above the line to build up "capital" which was, in fact, retained earnings. This accounting treatment was not only inappropriate - it was contrary to an accounting standard promulgated at the time the transaction was undertaken.
(b) Findings and Conclusions
(i) The manner in which the Bank was funded was not a matter that caused the financial position of the Bank. In particular, the Bank's "cost of capital", represented by the dividend obligation in respect of the capital contributed by SAFA, was not excessive, and did not cause the Bank to aggressively pursue profits.
(ii) Bluntly stated, the Board of Directors did not understand the capital structure of the Bank. Their submissions to my Investigation show that, even now, they appear confused.
(iii) Mr Clark, as the Bank's Chief Executive Officer, should have ensured that adequate information regarding the Bank's capital and funding arrangements was placed before the Board to enable it to discharge its functions as the governing body of the Bank.
(iv) In respect of the perpetual note issue arranged by J P Morgan, the transaction was undertaken without the approval of the Board of Directors. The information provided to the Board "for noting" defied comprehension. The Board was not informed of the State Treasury's opposition to the transaction. The transaction was not in the best interests of the Bank. It involved a higher cost of funds than was available from SAFA, and depended for its effectiveness on an inappropriate accounting treatment.
(v) In respect of the funding of the Bank generally, and the J P Morgan transaction in particular, the operations, affairs and transactions of the Bank were not adequately or properly supervised, directed and controlled by the Board of Directors, the Chief Executive Officer and other certain officers of the Bank identified in Chapter 6.
1.7.3.2 Treasury and the Management of Assets and Liabilities of the State Bank (Chapter 7)
(a) Overview and Summary
The business of banking can be described in very simple terms as involving the borrowing and on-lending of money. A bank borrows money at one interest rate, and on-lends at a higher rate: the difference between the two rates represents its gross profit or margin.
This simplistic statement of a lending business disguises a number of complications that cannot be ignored in carrying on large-scale borrowing and lending activities. In particular:
(i) First, it should be self evident that the lending officers responsible for making loans should know what the cost of the bank's funds is. If they do not, there is a risk that they will make loans at a price which will mean that the business is unprofitable.
(ii) Second, it is important that a bank's borrowings and its loans are reasonably matched and managed in terms of their maturity dates. There are significant risks involved in, for example, using short-term borrowings to fund long-term loans.
These aspects of the management of a bank's lending business are commonly referred to as its asset and liability management. They are an essential feature of the prudent management of any lending business.
The most significant - and startling - feature of this aspect of the State Bank's operations, is that before late 1990, it did not exist. Until 1990, there simply was no overall management of the Bank's assets and liabilities. This part of the Bank's activities was completely without co-ordination. The emphasis was on growth and profits.
There was until 1990 no person or committee which had or exercised any responsibility for the general management of the Bank's assets and liabilities. Although the Bank did have an asset and liability management committee ("ALMAC") from the time of its establishment in July 1984, that Committee was abolished by the Executive Committee on 31 July 1987. The reasons stated were a perceived need for "quickness of decisions and the ability to react quickly to the economic environment" .
There is little evidence available of the functions performed by the first ALMAC, and the Bank's managers had little recollection of their involvement with it. It appears, however, to have been little more than a pricing committee: it "considered the cost of funds, what the market was doing and set the rates" .
The ALMAC was reconstituted in September 1988, following a recognition of the potential implications of failing to adequately address asset and liability management. The new committee's responsibility and focus were, however, unclear. The evidence I examined shows that it was not until 1990 that some co-ordinated management was established in respect of the Bank's assets and liabilities.
The absence of any attention to this function was in part related to the Bank's status as a State Bank. With the benefit of the Government guarantee, the Bank was always able to borrow funds as it required them, and usually at favourable interest rates. The Bank therefore paid little or no attention to managing its liquidity. Nor did it price its loans according to its actual cost of funds. Rather, its loans were priced at whatever level was necessary to be competitive in the market - that is, to do the deal.
The essential result was that prudent considerations of loan pricing and liquidity management did not act as a constraint upon the rapid expansion of the Bank's loan portfolio. Had the Bank adopted prudent asset and liability management practices, its growth may have been constrained. The absence of those practices allowed the Bank to grow much too quickly, ahead of its own management resources, capabilities and reporting systems.
The absence of any adequate assessment of the cost of the Bank's funds for the purpose of pricing its corporate loans, and the pricing of those loans instead by reference to market forces rather than to the cost of funds, meant that the position with respect to unprofitable lending transactions was never highlighted. The position was disguised by the Bank's use of disproportionate front end fees in respect of its corporate loans, and the accounting procedures that recognised those fees as income at the time of receipt. If the practice of charging inappropriate front end fees had not been followed, or if those fees had been recognised as income over the life of the loan, the reported profitability of the Bank would have been significantly lower.
Asset and liability management is a function commonly carried on by the Treasury division of banks. Other Treasury operations include:
(i) Managing the various financial risks faced by a bank, including interest rate risks and foreign exchange risks;
(ii) Ensuring that the bank optimises the use of its short-term cash surpluses, and that it has access to funds to meet short-term cash deficiencies;
(iii) Managing the bank's liquidity, ensuring that it will have funds available to meet its obligations as they fall due; and
(iv) Active dealing in financial markets with a view to earning profits for the bank.
As I have described, the Bank's Treasury did not have, or exercise, responsibility for managing the Bank's assets and liabilities before 1990. Neither did any other division or manager.
There were other deficiencies in the Treasury operations of the Bank that were identified in the course of my Investigation, including:
(i) The absence of any cashflow forecasting system.
(ii) The failure to adopt the practice of valuing the Treasury portfolio at its market value on a day-to-day basis until 1989. Before then, the absence of the "marking to market" policy enabled the profit on assets to be selectively realised, while losses on corresponding liabilities were allowed to remain hidden.
Perhaps the most important reason for the shortcomings in the Bank's Treasury function was, as in the case of other areas, the Bank's very rapid growth and development from an essentially thrift institution to become a diversified financial institution with extensive operations in most segments of the financial markets. The Bank's growth was such that it quickly outgrew the capacity of the Treasury division to satisfy the increasingly sophisticated functions it should have performed.
The Bank's Treasury division lacked the skilled and experienced Treasury staff that were needed to conduct effective Treasury operations. Eventually, part of the Treasury function was established in Sydney where skilled and experienced staff could be obtained. Although the Bank employed a well qualified manager in the money market area in 1987, her responsibilities were limited, and her initiatives to improve the information systems were at least not supported by, and probably actively thwarted by, some of the Bank's senior managers. It was not until early in 1989 that an appropriately experienced manager was appointed to head the Treasury division.
(b) Findings and Conclusions
(i) While the absence of prudent asset and liability management within the Bank cannot be said to have been a direct cause of the Bank's financial position, its absence meant that there was no constraint upon the rapid growth of the Bank's assets. Accordingly, in my opinion, the absence of prudent asset and liability management practices within the Bank was a matter which contributed to the financial position of the Bank as reported in February 1991.
(ii) The manner in which the Treasury operations of the Bank were conducted, particularly the absence of prudent asset and liability management practices, played an important part in the processes which led the Bank to engage in operations which resulted in losses, and in the Bank holding significant non-performing assets. The conduct of the Bank's Treasury operations was inappropriate.
(iii) The Board of Directors took no active role in the asset and liability management of the Bank. The real problem was that none of the directors had the specialised knowledge or experience of banking practice that would have enabled them to understand what was required in the area of asset and liability management, and to realise that what was being done at the Bank in that area was inadequate. The Board would not have appreciated the problem unless the deficiencies were pointed out to the Board and explained. They were not.
(iv) The Board of Directors acquiesced in the dissolution of the first ALMAC, after having been told by Management that its dissolution was appropriate. The Board believed that asset and liability management responsibility would be assumed by the Finance department. In fact, it was not.
(v) Nevertheless, the basic principles of asset and liability management, as described above, are not difficult to grasp. A prudent Board of Directors would, having regard to the importance of those principles to the operations of a banking business, have taken steps to obtain a better understanding at least of the principles of asset and liability management, and of the Bank's activities in that area. It was not sufficient for the directors to permit themselves to remain in ignorance of the reality of the situation.
(vi) As Chief Executive Officer of the Bank, Mr Clark was the one person in a position to take an overview of the whole of the Bank's activities. That is one of the principal reasons for the existence of the office of Chief Executive Officer. However, Mr Clark displayed neither sufficient interest nor the level of expertise that is required of the Chief Executive Officer of a Bank in the area of asset and liability management. As a consequence, he did not give the priority to this area that it required.
(vii) The Treasury and asset and liability management aspects of the Bank's operations were not adequately or properly supervised, directed and controlled by the Board of Directors of the Bank, the Chief Executive Officer of the Bank, or by certain other officers and employees of the Bank as identified in Chapter 7 of my Report.
(viii) The information provided to the Board of Directors with respect to the asset and liability management and Treasury operations of the Bank was not timely, reliable, adequate or sufficient to enable the Board to discharge adequately its functions under the Act. The absence of appropriate asset and liability management policies and procedures gave rise to deficiencies in the information provided to the Board - and to senior management and the lending divisions of the Bank - that meant that there was an inability to:
. identify changes in the nature of the business which made possible the losses which the Bank has suffered; and
. identify that the Bank was actually entering into many lending transactions which were, from the outset, destined to be unprofitable.
1.7.4 THE MANAGEMENT OF CREDIT (Volume V - Chapter 8)
Credit and its Management: Guidelines, Policies, Processes, Procedures and Organisational Delivery Mechanisms (Chapter 8)
(a) Overview and Summary
The single most important reason for the losses of the Bank was the poor quality of its corporate lending decisions. Put simply, the Bank made too many loans that it should never have made. Those loans were high risk - beyond a level acceptable to any prudent banker. The result was the catastrophic losses reported by the Bank, and all of the consequences which have flowed from them.
My Investigation of the Bank's lending policies and procedures has led me to the conclusion that the Bank's corporate lending business was poorly managed in almost every respect: its policies were inadequate, the approval processes were inappropriate and poorly defined, lending decisions were made on the basis of inadequate and incomplete information, and once a loan had been made it was not adequately monitored.
In short, the Bank's corporate lending displayed the characteristics of being driven by the need to do the deal. The application of sound policies and procedures was sacrificed to the desire to write new business. The Bank's policies and procedures failed to act as a check against making unacceptably risky loans, and failed to protect the Bank from the implications of doing so.
Under the State Bank Act, the ultimate authority to transact the business of the Bank lies with the Board of Directors. The Board is, however, authorised by the Act to delegate its powers and functions, and it did so in relation to the approval of loans. In July 1984, the Board established a series of delegated lending authorities, including authority for individual managers to approve loans below a certain dollar value, and for a management Lending Credit Committee to approve loans of up to $2.5M. Loans in excess of that amount were to be approved by the Board of Directors. Over the years, the dollar-value limits of these delegated authorities were increased.
The Bank's Board of Directors was not well qualified to prudently evaluate and approve loans. Only the Managing Director, Mr Clark, had any previous commercial banking experience. I am satisfied that the former non-executive directors' lack of experience in relation to lending impeded them in the discharge of their responsibility to exercise the necessary degree of judgment in approving loans.
The Bank's non-executive directors were involved in approving loans in ways other than at a Board meeting. These related to the approval of "urgent" loan proposals:
(i) Urgent lending proposals were sometimes circularised to directors individually. Directors were required to consider the loan proposal on an individual basis, and to contact the particular lending officer to indicate his approval or rejection of the loan proposal. No rules or policies were ever adopted by the Board, or by Management, to regularise this "round robin" procedure. Although it sometimes complained about the procedure, the Board acquiesced in it. A number of very significant loans were made by the Bank on the basis of approvals obtained using the round robin procedure. Apart from the obvious dangers associated with requiring an urgent decision from individual directors with little banking experience, the round robin procedure was of doubtful validity under the terms of the State Bank Act.
(ii) The Board of Directors authorised a sub-committee of the Board to consider and approve urgent proposals. Over time, the sub-committee came to be regarded as being authorised to give final approval for loans, whether or not they were urgent. In so acting, the sub-committee exceeded the authority expressly granted to it by the Board of Directors.
The Lending Credit Committee was a committee of management authorised by the Board of Directors to approve loans within the limit of its delegated lending authority, to consider other loan proposals with a view to providing a recommendation to the Board of Directors, and to conduct half-yearly reviews of loan quality and report the results to the Board.
There were a number of significant shortcomings in the constitution and operation of the Lending Credit Committee which meant that it did not adequately discharge its functions. In particular:
(i) The Lending Credit Committee was dominated by managers whose departments had initiated, and were sponsoring, credit proposals. An important deficiency in the Bank's lending procedures was the absence of the internal control represented by the segregation of duties. At Lending Credit Committee level and below, the Bank should have had a procedure under which lending decisions would be rigorously and objectively analysed by a person not having a commitment to the approval of the loan.
(ii) The low level of delegated lending authorities to individual managers meant that the Lending Credit Committee simply had too many loan proposals to consider. Its workload was such that it could not adequately consider individual loan proposals.
I have seen no evidence that the Lending Credit Committee effectively addressed its responsibility to conduct half-yearly reviews of the quality of the loan portfolio, and to provide reports to the Board of Directors in respect of those reviews.
The Bank's credit management policies and processes were, through most of the period subject to my Investigation, inadequate.
An important deficiency with the Bank's policies and processes was, quite simply, that they were not documented and compended in a credit policy manual until 1988.
The documented policies and processes which I have reviewed contain a variety of omissions and inadequacies which were serious. This was particularly so having regard to the fact that the Bank was, following its formation in 1984, expanding its activities to include extensive corporate lending for the first time. The lack of a depth of experience that this implies made the documentation of clear and comprehensive policies and processes particularly important.
More important than the policies and processes of the Bank, at least in determining the cause of its losses, was what the Bank actually did in respect of particular loans. Accordingly, I examined nineteen non-performing loans of the Bank to identify what the Bank actually did in initiating, approving, granting and subsequently managing loans (six of these loans were examined in greater detail, and are reported as Credit Risk Management Case Studies in Chapters 9-14). This review disclosed a plethora of inadequacies in the workings of the Bank's corporate lending business, including:
(i) Initiation of loans: inadequate gathering and analysis of financial information relating to the borrower; failure to analyse the borrower's ability to service the loan; failure to analyse the value and realisability of security to be taken for the loan; failure to adequately review or confirm asset values; failure to undertake, or at least to record and document on the file, interviews with loan applicants; failure to independently confirm financial information provided by the applicant; failure to undertake sensitivity analyses.
(ii) Approval of loans: approval of loans on the basis of proposal documents containing information that was manifestly deficient; procedural irregularities in the approval process, including purported approval of loans by the Board Sub-Committee when a quorum was not present, and breaches by the Lending Credit Committee of its delegated lending authority limit.
(iii) The taking of security : inadequate security cover (as determined by the Bank's own policies); security taken was different from that described in the credit proposal.
(iv) Advance of funds: funds advanced before security was perfected; funds advanced before pre-conditions to drawdown had been satisfied.
(v) Management of performing loans : review procedures, including the performance of annual reviews, often not performed at all, or not performed on a timely basis; inadequate monitoring by Bank officers of compliance by the borrower with covenants and conditions of the loan; failure to monitor the continuing credit worthiness of the borrower.
(vi) Management of non-performing loans : failure to undertake required reviews; failure to develop an action plan for resolving problem loans; failure to report relevant information to Management; commonly, the officer responsible for managing a non-performing loan had sponsored the original lending submission.
In examining the Bank's lending activities, I have not ignored the difficulties associated with the economic and business conditions of the time. Many banks and other financial institutions were overly-aggressive in their pursuit of business following the deregulation of the banking industry, and the licensing of fifteen foreign-owned banks. The particular economic conditions at the time, including rapidly increasing asset values and an expectation that that would continue, encouraged imprudent lending practices.
However, common practice is not necessarily good practice. Further, in my opinion the Bank's lending practices were sadly deficient, even judged by the standards of the day. The Bank's corporate loan portfolio grew more rapidly than those of most other banks in Australia, which is often a good indication of lower credit standards. The extent of the Bank's losses corroborates that conclusion.
(b) Findings and Conclusions
(i) The conduct by the Bank of its lending business was among the matters which caused the financial position of the Bank as reported in February 1991. The poor quality of the Bank's lending decisions was the single most important cause of the Bank's losses.
(ii) The Bank's lending policies and processes were inappropriate. The Bank's policies were not compended in a single credit policy manual until 1988. Even then, those policies contained omissions and deficiencies that were serious.
(iii) The Board of Directors lacked the necessary experience to properly fulfil its obligations in approving loans, and did not effectively delegate or discharge its statutory powers in relation to lending.
(iv) The involvement of the Board Sub-Committee in approving loan proposals which were not urgent was outside the express authority granted by the Board of Directors. The Sub-Committee was not really a committee at all, but a fluctuating group of individuals. It was an unsafe and unsatisfactory body for the approval of loans.
(v) The use of the "round robin" decision making process to obtain approval of directors meant that they were denied an appropriate forum in which to discuss and assess loan proposals. The "round robin" procedure was never the subject of formal adoption or approval.
(vi) The Bank's Board of Directors failed to adequately or properly supervise the Bank's lending activities. Before April 1989, the Board took no effective action to ensure that the Bank had adequate policies and processes for the conduct of its lending business, or that the lending business was in fact being conducted prudently and in accordance with accepted principles of financial management.
(vii) The Chief Executive Officer, Mr Clark, neither discharged nor effectively delegated his duties in relation to the management of the Bank's lending business. Although he was aware of the defects outlined in the November 1987 review paper and foresaw difficult years ahead for the Bank, he failed to take positive steps to ensure an adequate review and upgrading of the Bank's credit risk management processes.
(viii) The corporate lending business of the Bank was not adequately or properly supervised, directed or controlled by the Board of Directors, the Chief Executive Officer or by other officers or employees of the Bank.
1.7.5 THE MANAGEMENT OF CREDIT: CASE STUDIES (Volume VI - Chapters 9 to 14)
1.7.5.1 Preliminary Observations
One of the major tasks undertaken by the Investigation was an inquiry into specific non-performing loans written by the Bank. The Investigation did not analyse all of the Bank's non-performing loans. Rather, the Investigation was supplied by the Bank with a list of non-performing loans as at March 1991. The Investigation selected a sample of 19 from that list, after performing some initial testing of information supplied by the Bank, which proved to be accurate.() The Investigation then chose six loans from the sample of 19 non-performing loans to be investigated in particular detail. The analysis of those six loans had, as its objectives, the investigation of:
(a) the application or non-application by Bank officers of the guidelines, policies, and procedures laid down by the Bank;
(b) the implications of the absence of clearly described rules that had been identified by my review of the Bank's documented policies and processes; and
(c) other matters relating to the Bank's lending policies.
In selecting the six non-performing loans which are reported upon in detail in Chapters 9 to 14, I had regard first and foremost to the Terms of Appointment. In particular, I have had regard to the need to preserve confidentiality in the Bank's affairs. As a corollary of this, I have had regard to the need that existing and future customers of the Bank be confident that their affairs and dealings with the Bank will not be disclosed to the public save in special circumstances. Secondly, I have had regard to the stipulation in my Terms of Appointment that I not prejudice the course of future civil or criminal proceedings. Thirdly, I have had regard to the need to avoid, as far as practicable, prejudice to and interference with the ongoing operations of the Bank and the Bank Group. Finally, I have had regard to the public interest in publication of the results of my Investigation. I have weighed, against the desirability of preserving confidentiality in the Bank's affairs, the legitimate expectation of the public generally that the results of my Investigation into the Bank will be made generally available to the citizens of South Australia, so that they be accurately and adequately informed of my findings and conclusions, and of the reasons in support of those findings and conclusions.
Having regard to those and other matters, the six customers and groups of customers named in the following Chapters were selected because:
(a) it was generally a matter of public record that they were in liquidation or receivership; or
(b) either there had been substantial press coverage in relation to their dealings with the Bank, or their dealings with the Bank had been, by some other means, well and truly ventilated in the public domain prior to publication of this Report.
I also had regard to the following factors in selecting the six case studies:
(a) the need to assess the quality of the Bank's lending decisions and, where lending quality was unsatisfactory, to demonstrate which matters, events, and circumstances, led to poor lending decisions being made by the Bank and to poor management of loans;
(b) the size of the loans;
(c) the desirability of reviewing various types of loans in order to test the general applicability of specific conclusions across more than one area of lending activity (viz Consumer, Commercial, Corporate);
(d) the materiality of the loss expected;
(e) the possibility of breach of prudential guidelines and, incidentally thereto, the geographic location of the borrower, the branch of the Bank by which the loan was made, and the field of activity of the borrower;
(f) the possibility of fraudulent activity;
(g) potential conflicts of interests which affected decisions made by the Bank.
Particular loans were selected for detailed examination based on a methodology which involved:
(a) Review and consideration of information obtained during the `Preliminary Investigation Phase';
(b) Review and consideration of additional information acquired and assessed subsequent to the `Preliminary Investigation Phase', particularly the Bank's policies and procedures; and
(c) Establishment of a computerised data base of non-performing loan information, recording specific data relative to each non-performing loan (including client details, loan facility type, movements in the loan facility, and security details).
The reports on the six selected non-performing loans comprise Chapters 9 to 14 of this Report. It has not been possible in a summary of this kind to do justice to the detailed analysis which I have carried out in each of the case studies. It is for that reason that I have not set out my findings and conclusions for the case studies in this Chapter. I direct the reader to each of the relevant Chapters for a fuller appreciation of those case studies.
1.7.5.2 Case Study in Credit Management: The Adsteam Group (Chapter 9): Estimated Loss at 31 March 1991, $83.4M
(a) Overview and Summary
The Adelaide Steamship Company Limited ("Adsteam") was formed in 1875 to operate in the Australian coastal trade. In the early 1970s, the company commenced a programme of diversification, both by acquisition and expansion. By 1990, the company ceased to be a trading company and assumed the character of a holding and investment company. Its subsidiaries and associates operated in a wide range of industries which included retailing, manufacturing, real estate, food and wine. The Adsteam Group of companies was large and complex, and its membership fluctuated over the period reviewed (1984-1990). The relationship between Adsteam and those companies which can be considered to be associated with it was carefully structured so as to avoid in many instances establishing a parent-subsidiary relationship in terms of the Companies Codes (which were in force for the greater part of the period).
During 1990, the Adsteam Group was the subject of a number of adverse media reports and press criticism. Credit providers exposed to the group restricted its access to credit. Companies in the Group suffered a consequential liquidity crisis in mid-1990. The crisis was aggravated by the acquisition by the Adsteam Group (through a subsidiary, Dextran) of the Industrial Equity Ltd group of companies. Early in 1990, the Bank had curtailed provision of finance to the Adsteam Group. Nevertheless the Bank was in 1990 the fifth largest lender to the Adsteam Group. The loans extended by the Bank to Adsteam were generally unsecured and were protected only by negative pledge covenants and, in a number of instances, by guarantees by member companies of the Adsteam Group.
The Bank's involvement with the Adsteam Group began in June 1984 with a small facility. The Bank's exposure gradually increased. By April 1990, the Bank's exposure to the Adsteam Group had reached $456.0M. The Bank's exposure to the Adsteam Group was one of the largest in the Bank's corporate lending portfolio.
The principal focus in this case study is on the manner in which the Bank applied its own large exposures prudential guidelines. While certain departures from approved lending practices are touched on in the Report, the Investigation concentrated on the attitude adopted by the Bank in deciding to approve exposures to companies within the Adsteam Group; particularly whether an intended exposure should be aggregated with existing exposures to other members of the Group for prudential purposes, and how those exposures were reported.
The Bank first adopted a large exposure prudential policy in June 1984. Thereafter, the bank's prudential policy comprised two key planks. First, credit limits were to be applied to any one entity or "group" of entities. Secondly, a definition of "group" was formulated for the purposes of aggregation of exposures.
Generally speaking, for credit assessment purposes proposed loans to members of the Adsteam Group were treated by the Bank's management and Board on a "stand alone basis", meaning that, for one reason or another, an intended exposure did not need to be aggregated with existing exposures to other members of the Adsteam Group. In general, the process of reasoning which led to this result was inappropriate. There was a continued failure on the part of the Bank at all levels to fully analyse the Bank's total exposure to the Adsteam Group. Given the way in which the Adsteam Group was structured, this was unacceptable. There were a number of departures from the Bank's prudential limits in 1986 and on successive occasions from June 1988 until June 1990 in relation to facilities extended to members of the Adsteam Group.
The Board had power to approve loans to the Adsteam Group that exceeded the limit of 20 per cent of shareholders' funds prescribed by the Board for prudential purposes. The guidelines adopted by the Board contemplated that transactions otherwise in breach of the guidelines could be put before the Board for consideration. The principal question is whether it was prudent and advisable in the circumstances confronting the Bank from time to time for the 20 per cent ceiling to be exceeded in relation to the Adsteam Group. In my opinion it was neither prudent nor advisable.
In addition, there were occasions when the Lending Credit Committee treated intended facilities as not requiring aggregation and so approved them. These loans should have been aggregated and therefore approved, if at all, only by the Board or Board Sub Committee. The Lending Credit Committee wrongly resolved the issue of how the Bank's prudential policies regarding the definition of a "group" should be applied to the Adsteam Group. The Bank Board erred in accepting management's recommendations from time to time on the issue of how the prudential policies, particularly the definition of a "group", should be applied to the Adsteam Group. The Lending Credit Committee and the Board continued to approve new and increased or extended facilities which, on a group basis, exceeded the limit defined in the Bank's prudential guidelines.
The processes of reasoning adopted by the Lending Credit Committee and the Board, as recorded in contemporaneous documents, are illogical and unpersuasive. At the same time as the Lending Credit Committee, the Board and Bank management were treating intended facilities as "stand alone" and therefore not requiring aggregation, they accepted that the association between an intending customer and Adsteam was a factor in favour of approval of a particular facility. The Bank's analysis was clearly inconsistent, and self-serving.
Accordingly, on a number of occasions the Lending Credit Committee failed to exercise proper care and diligence, and the Bank Board failed adequately and properly to direct, supervise and control the operations, affairs and transactions of the Bank, in approving certain facilities to members of the Adsteam Group. They measured the total exposure to the Adsteam Group against incorrect prudential limits; did not aggregate exposures to one member of the group with exposures to the group as a whole as required by the Bank's prudential policies; and approved facilities in excess of the maximum credit limit that could be granted to any one customer under the Bank's prudential policies from time to time.
I have summarised above the manner in which the Bank's Board of Directors and Lending Credit Committee and management from time to time imprudently and inadvisably departed from prudential guidelines which the Board had approved. It is necessary however to call attention to some of the detailed departures which occurred from the policies and procedures of the Bank which should have been followed at each stage of the loan approval procedure.
In March 1988 the Lending Credit Committee agreed to recommend a letter of credit facility to support the issue of preference shares by Adsteam to National Westminster Bank Plc. The Lending Credit Committee recommended this proposal to the Bank Board for approval. One effect of the proposed facility would be to nearly double the Bank's then drawn down exposure to Adsteam . A paper was presented to the Board by Mr D C Masters, Chief Manager Corporate Banking, noting that Adsteam required urgent approval of the letter of credit by the 23 March 1988 and that directors had been contacted by telephone. It set out who the approving directors were in the paper. The minutes of the Bank Board meeting of the 24 March 1988 indicate that the Board approved the letter of credit facility of $35.0M. It is highly probable that Adsteam was informed of the approval on the 23 March 1988, that is before the Bank Board meeting on the 24 March 1988.
The consideration and approval of the proposal by individual directors was transacted in the course of telephone conversations on the 23 March 1988. This business was not transacted at a Board meeting, nor was the transaction properly recorded in accordance with Section 12(6) of the Act. The purported approval of the facility was thus irregular.
It is not at all clear that the approving Board members received Mr Master's paper. Even if they did, it is unlikely that they would have been given sufficient information upon which to base their decision, or had sufficient time in which to consider the proposal. The paper submitted to the Board contained inadequate financial information, a common feature of proposals relating to Adsteam.
There were other examples of approvals being given in this fashion.
In May 1988, Adsteam applied for a deferred interest facility to be made available to Buckley and Nunn, a joint venture company owned equally by Adsteam and David Jones. The Bank's initial participation of $87.5M was contemplated to increase to approximately $115.0M over three years due to the agreed deferral of interest over that period. At the time of the application existing direct facilities to Adsteam and David Jones were $81.0M and $55.1M respectively. Indirect facilities available to Adsteam were $60.0M.
The Lending Credit Committee and the Board approved the application in May 1988. The deferred interest facility granted to Buckley and Nunn was transferred to Adsteam as from 7 April 1989. Lending Credit committee members present at the meeting on 10 May 1988 at which the facility of $115.0M to Buckley and Nunn was approved were Mr Matthews, Mr G S Ottaway, Mr Masters, Mr V R Pfeiffer and Mr R L Wright.
Notwithstanding that the Bank had taken specific security for the loan, the borrowing company was a directly held subsidiary of Adsteam and there was an increased exposure to Adsteam. It did not matter that specific security had been taken. The submission that " the first recourse " was against the security reflects a view with which I cannot agree. It is a view which has been criticised by J P Morgan in its review of the Bank's credit policies and procedures, and which has since February 1991 been disavowed by the Bank. It is a view which, I am satisfied, contributed to the Bank's participation in many of the non-performing loans investigated by the Inquiry. A lender's first recourse is in practical terms always against the borrower and the borrower's income. A lender must regard the enforcement of security as his last recourse rather than his first recourse.
Accordingly, members of the Lending Credit Committee failed to exercise proper care and diligence and the members of the Bank Board failed adequately and properly to supervise, direct and control the relevant operations, affairs and transactions of the Bank in approving the deferred interest facility of $115.0M to Buckley and Nunn. The Bank could not lend to an Adsteam group company, hold a guarantee from Adsteam and consistently assert that there was no recourse or exposure to the Adsteam Group.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Board, the Board Sub-Committee , the members of the Lending Credit Committee and certain other officers of the Bank are set out in detail in Chapter 9 - "Case Study in Credit Management: The Adsteam Group" of this Report.
1.7.5.3 Case Study in Credit Management: Celtainer Limited (In Liquidation) (Chapter 10): Estimated Loss at 31 March 1991, $3.52M
(a) Overview and Summary
This Chapter deals with the initiation, approval and settlement stages of the credit transaction with a view to identify errors made as a consequence of the Bank's established procedures being inadequate.
Celtainer Ltd was a public company registered and having its operations in South Australia. Its principal business was the design and manufacture of specialised products, mainly for the shipping and mining industries.
Celtainer extended an invitation to the Bank to take equity in the company, and applied for a loan from the Bank. Concurrently with that loan application, the Bank began to take steps towards acquisition of equity in Celtainer.
A written proposal was prepared for consideration by the Bank's Lending Credit Committee by a Bank officer and his subordinate staff, and was endorsed as " supported " by another Bank officer. It is clear however that the " supporter " of the proposal had not reviewed the supporting analysis or scrutinised the factual basis of the information provided by Celtainer.
The proposal recommended a grant of credit facilities totalling $2.75M, as well as acquisition of one million shares in Celtainer at 5 per cent less than current market price. Such an investment involved proposed expenditure of approximately $0.627M and would have made the Bank the holder of 7.1 per cent of the issued capital of Celtainer. The author of the proposal warned, in listing the disadvantages of the transactions:
"...
3 Heavy reliance on mortgage debenture and outwardly moving Gearing Ratio.
4 Company is relatively immature when viewed against the business cycle. 1986/87 is the first profit turnaround.
5 Assessment is based on future outlook as historical results do not inspire financial confidence. "
The proposal concerning the equity acquisition did little more than describe the equity acquisition transaction, and provide some of the factual material and the basic opinion as to the future value of the shares in Celtainer contained in an investment memorandum from SVB Day Porter. It did not contain any further assessment of the investment opportunity beyond that stated in the investment memorandum.
The proposals were considered on the 15 July 1987 by the Lending Credit Committee. The Committee approved lending totalling $2.75M, subject to conditions requiring, amongst other things, the monitoring of cash flow projections which had been made by Celtainer, and verification of Celtainer's compliance with a negative pledge requirement that its net worth not be less than $3.5M. The advances on this loan were not made until December 1987. In the period between approval by the Lending Credit Committee and the making of the initial advance, the financial position of Celtainer deteriorated to the extent that its activities were unprofitable. Any decision to extend credit on the terms proposed at this stage would have been unthinkable. Neither the deterioration of Celtainer's financial position, nor the deterioration in its profits, were detected prior to the Bank advancing the funds. This occurred because there was a failure on the part of the Bank to adequately verify the net worth of Celtainer and further there was no verification of its cash flow and profitability for the period July 1987 to December 1987. The account became problematical almost immediately although it was not classified as non-performing until March 1989.
The acquisition of shares in Celtainer at an actual cost to the Bank of about $0.52M was made after only a superficial examination of the merits of that acquisition by the Lending Credit Committee, which, although endorsing the acquisition, recommended consideration of the matter by the Equities and Underwriting group of the Bank. That group did not consider the merits of acquisition. Purchase of the shares took place in the mistaken belief by the Bank officer involved that the Lending Credit Committee recommendation was all that was required, and that the merits of the acquisition had been thoroughly assessed. The acquisition was never approved by an authorised delegate of the Board. As at the 31 March 1991 the shares were worthless.
Prior to submitting the proposal to the Lending Credit Committee, the officers responsible for its preparation made no attempt to inspect the banking records of Celtainer.
The practices and procedures in place at the relevant time did not provide adequate guidance with respect to analysis of information. The result, which is so clearly evident in this matter, is that whilst the proposal had the appearance of a document prepared after careful investigation and judgment, the proposal was a superficial document and in many respects inadequate.
The Lending Credit Committee's approval was subject to a number of conditions. These conditions were not all clearly set out in a resolution or a decision of the Committee and had to be extracted from both the proposal and the "decision" stated in the minutes of the Lending Credit Committee meeting.
The deliberations of the Lending Credit Committee and the form in which it approved the proposal left a fundamental decision as to whether or not this loan should be made to someone other than the designated decision maker. It does not help to characterise this decision as an abrogation of responsibility or something else. The point is that the designated decision maker did not, in the end result, make the decision. The decision was ultimately made by someone at a lower level and by someone who had insufficient training and experience to make it. The way in which the Lending Credit Committee conducted itself facilitated a circumvention of the system which had been put in place in order to ensure proper credit decision-making.
In relation to the decision by the Lending Credit Committee to purchase shares and the reference by that Committee of the matter to the Bank's Equities and Underwriting Committee, the Lending Credit Committee thought it was considering the equity acquisition as a matter of formality and therefore referred it to the Equities and Underwriting Committee. The latter Committee did not have power to authorise a transaction of that size. In fact it never considered this transaction. Nevertheless, the purchase of the shares was made on the basis of the superficial approval of the matter by the Lending Credit Committee. This episode reveals substantial weaknesses in the Bank's management. Lines of authority were not well understood. Communication in the form of reports and resolutions were of a poor standard.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Bank, members of the Lending Credit Committee and certain other officers of the Bank are set out in detail in Chapter 10 - "Case Study in Credit Management: Celtainer Limited" of this Report.
I have in the course of investigating the affairs of the Bank in relation to Celtainer Ltd as required by my Terms of Appointment considered a matter which may disclose improper activity by an officer of Celtainer Ltd. I am of the opinion that that matter ought to be further investigated. In order that that investigation will not be prejudiced and in order to protect the reputation of the officer concerned pending the outcome of more extensive investigations, I have determined to report confidentially with respect to my consideration of the matter.
1.7.5.4 Case Study in Credit Management: The Collinsville Stud Group (Chapter 11): Estimated Loss at 31 March 1991, $31.3M
(a) Overview and Summary
The Collinsville Stud Group of Companies operated, until November 1991, the world renowned Collinsville Stud's properties in the mid north of South Australia. Collinsville Stud's business was the breeding and sale of Merino sheep. In 1985, the ownership of the Collinsville Stud Group of properties changed and the properties were acquired by Mr N L Garnett. The Bank appointed receivers and managers to the Collinsville Stud operations in November 1991. This Case Study concerns a transaction undertaken within the Commercial and Rural Banking division of the Bank in 1989. The loss resulting from the transaction is the most substantial loss sustained by the Bank outside its Corporate Banking lending portfolio.
It has been necessary for me to examine the conduct of Bank officers who initiated the lending transaction and who analysed an Information Memorandum submitted to the Bank by Ayers Finniss Limited on behalf of Collinsville Stud; the way in which the proposed transaction was presented to the Lending Credit Committee for approval; and the merits of the proposed lending transaction as put to the Lending Credit Committee and to the Board Sub-Committee, each of which approved the transaction on 20 July 1989. In my opinion the transaction was one which should not have been recommended by the Lending Credit Committee or approved by the Board Sub-Committee.
The three bank officers who were most closely involved in proposing the transaction to the Lending Credit Committee did not exercise proper care and diligence in the preparation of the lending proposal submitted to that Committee. In approving the proposed facility, the
Lending Credit Committee members did not exercise proper care and diligence and the members of the Board Sub-Committee did not adequately and properly direct and control the affairs, operations and transactions of the Bank. They permitted their enthusiasm for expansion of the Bank's lending business to cloud their professional judgment. In the circumstances, they should have required further information and explanation in relation to the proposed transaction before approving it and they should not have approved the facilities made available to the Collinsville Stud in the absence of an injection of substantial capital into the business.
An officer in charge of the process of settlement of the transaction did not exercise proper care and diligence in that the officer permitted the loan to be settled whilst conditions of the Bank's approval were unsatisfied and permitted variations in the security arrangements which were not documented. In addition, the Letter of Approval of the facility was not expressed in terms calculated to protect the proper interests of the Bank or to reflect the spirit of the decision of the Lending Credit Committee.
More importantly, management of the loan after December 1989 was most unsatisfactory. The facility became irregular in January 1990. It remained irregular thereafter. Those officers of the Bank involved in managing the account did not take adequate steps to protect the Bank's position and in particular failed to impose a sufficiently strict financial discipline on Collinsville Stud's expenditures after 30 January 1990.
The Bank's management of the transaction at all stages was characterised by ineptitude. The judgment of the Bank officers and the former directors was influenced by the glamour supposedly attaching to the winning of the Collinsville Stud account from its previous credit provider. Decisions taken by the Bank in relation to the transaction lacked objectivity and detachment from the outset through to the time when the Bank appointed receivers and managers.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Board, the Board Sub-Commitee, the members of the Lending Credit Committee and certain other officers of the Bank are set out in Chapter 11 - "Case Study in Credit Management: The Collinsville Stud Group" of this Report.
1.7.5.5 Case Study in Credit Management: Halwood (Chapter 12): Estimated Loss at 31 March 1993, $78.5M
(a) Overview and Summary
In this Case Study I have examined the circumstances surrounding the granting by the Bank during the period from May 1986 to February 1991 of certain facilities to Halwood Corporation Limited, a real estate and property development company formerly known as Hooker Corporation Limited.
In particular, I have examined in detail the shortcomings and deficiencies of the loan proposals in respect of the following facilities which were recommended for approval by the Lending Credit Committee, approved by the Board Sub-Committee and confirmed by the Board:
|
Date |
Amount of |
|
| 15 May 1986 | $20.0M (Syndicated) | |
| 6 May 1987 | $14.5M (Syndicated) | |
| 22 September 1987 | $20.0M | |
| 28 June 1988 | $19.0M (Syndicated) | |
| 4 October 1988 | $73.0M (Australis Centre) | |
| 1 November 1988 | $33.0M (Henry Waymouth Centre) | |
| 14 February 1989 | $6.0M (Aspenair Ltd) | |
An examination of the loan proposals submitted to the Lending Credit Committee revealed that the financial information shown in the proposals was frequently inadequate. There was an inadequate analysis of profit forecasts, and where there were profit forecasts, they were out of date and not relevant. There was generally a lack of future cashflow analysis, and a lack of adequate security as the Bank frequently had only limited recourse to the assets of the borrower.
In the case of the May 1987 facility, the purpose was to facilitate a debt defeasance of Halwood Corporation's secured borrowings by means of debentures. The ultimate success of a defeasance transaction is dependent on acceptance by the Commissioner of Taxation for its cost effectiveness. No regard was had by the Bank to the taxation consequences of this transaction.
A further general deficiency in the proposals was that the assessment of the Halwood Corporation's ability to repay the facility was predominantly based upon an assessment of its balance sheet and past performance, and implicitly assumed a continuation of the value of assets in the balance sheet over the life of the facility.
In the case of the October 1988 facility for the "Australis Centre" in the Adelaide Central Business District, the project was 100 per cent debt funded. The Bank was dependent on the sale of the project for the repayment of the facility. Such a sale would have been made at a time when there was an abundance of unlet office space in this district.
The November 1988 facility proposal for the "Henry Waymouth Centre", also in the Adelaide Central Business District, should have been considered in light of the Bank's exposure to the Halwood Group and not simply as a project funding exercise.
On 14 March 1989, a memorandum was sent to the General Manager Corporate Banking, Mr Masters, noting the details of facilities provided to Halwood Corporation. This recorded that the Lending Credit Committee's decision of 31 January 1989 in relation to the conversion of a $20.0M syndicated facility to a two year "evergreen basis" was withheld pending the General Manager Corporate Banking's "assessment of [Halwood Corporation's] cash flow liquidity and negative pledge covenants to determine the suitability to a two year evergreen facility ".
The memorandum also made it clear that the Bank was still awaiting information from the company regarding its three year strategic plan and cash flow projections. This memorandum was considered at the Lending Credit Committee meeting of 21 March 1989 at which it was noted that no information regarding cash flow or the company's strategic plan had been received. Further, the Committee noted that Australian Ratings had downgraded Halwood Corporation's credit rating.
In a memorandum to Mr Masters, dated the 24 April 1989 regarding Halwood Corporation's compliance with its negative pledge covenants, the authors referred to "recent adverse media reports" and observed:
" It is acknowledged that Halwood Corporation over the past 12-18 months has made significant changes to its asset structure which detrimentally affected both profitability and performance. Whilst corrective action has been taken we consider that the company is some 6 months away from providing clear evidence of a turnaround.
... At this point we are unable to independently assess whether or not Halwood Corporation is outside of the negative pledge covenants as suggested in one of the media reports. "
Notwithstanding all the adverse indications reported in this memorandum, the authors, in a spirit of almost reckless optimism, recommended the extension of the State Bank of New South Wales syndicated facility which was to expire on 29 September 1989 to 29 September 1990.
Mr Masters responded to that memorandum by rejecting the recommendation, and the concerns which he expressed were proven to be fully justified.
All of the proposals shown above lacked merit, were not justified by the terms of the proposals and should not have been recommended by the Bank's Lending Credit Committee, nor approved by the Board Sub-Committee or confirmed by the Board. In relation to the October 1988 proposal (the "Australis Centre") members of the Lending Credit Committee, failed to exercise proper care and diligence in recommending to the Board that the facility be approved.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Board, the Board Sub-Committee, members of the Lending Credit Committee and certain other officers of the Bank are set out in Chapter 12 - "Case Study in Credit Management: Halwood" in this Report.
1.7.5.6 Case Study in Credit Management: Somerley Pty Ltd (Chapter 13): Estimated Loss at 31 March 1991, $29.7M
(a) Overview and Summary
Somerley was a Victorian company which, prior to 1988, acquired a site situated at the corner of Bourke and Exhibition Streets in Melbourne upon which it proposed to construct a 4.5 star hotel/carpark/retail complex. Somerley was partly owned by Mr and Mrs Gostin, Victorian developers, and partly by companies ultimately controlled by the Interwest Group of companies. In addition, the former subsidiary of the State Bank of Victoria, the Tricontinental Group, had a small interest in Somerley.
This Case Study analyses the losses and the causes of those losses sustained by the Bank and, incidentally, by Beneficial Finance, as providers of credit to Somerley Pty Ltd and a related company (Interwest Ltd) in connection with the project's construction.
The Bank's first involvement in relation to the construction project undertaken by Somerley was by way of making a $30.0M bridging loan to Somerley in April 1988. At the same time, Beneficial Finance advanced $19.0M to Somerley, again as a bridging loan. At the time, the value of the site was assessed at approximately $55.0M. The amount advanced to Somerley which had no substantial assets other than the construction site to which I have referred, thus approximated to 89 per cent of the value of the security.
The second transaction entered into by the Bank in relation to Somerley was participation by the Bank (to the extent of $55.0M) in a $190.0M first tier syndicated facility which became effective in September 1989 and which was intended to fund the construction phase of the project. Again, Beneficial Finance was involved in this phase of the project as a second mortgagee together with the State Bank of Victoria. The decision by the Bank to participate in the first tier syndicate proved to be most unwise.
In January 1990, the Interwest Group was placed into receivership. Somerley became insolvent as a consequence. The first tier syndicate refused to advance any further funds to Somerley. Beneficial Finance approached the Bank to seek funds to buy out the other members of the first tier syndicate. Ultimately, the Bank Board approved a facility in the sum $91.5M to enable Beneficial Finance to buy out the members of the first tier syndicate (other than the Bank) and to carry on with construction activities to the carpark/retail stage. The decision of the Bank Board to enable Beneficial Finance to buy out the other members of the first tier syndicate was imprudent and unwarranted. Once again the Bank was to find itself taking on the role and obligations of a property developer
More specifically, I have identified a lack of care and diligence on the part of Bank officers involved in preparation of the lending proposals relating to the bridging loan facility and to the Bank's participation in the first tier syndicate and subsequent construction funding.
The Bank's lending policies and procedures were inadequate. They did not in 1988 and 1989 require authors of lending submissions to disclose to lending organs, and they did not require the Bank's lending organs to have regard to, aggregated Bank Group exposures where the Bank was proposing to lend to a particular customer or on a particular project jointly with or in priority to Beneficial Finance. I report that a particular Bank officer did not conduct with adequate care and diligence a pre-settlement review carried out shortly before finalisation of the first tier syndicate in August 1989.
The Bank's management of the facility once it became non-performing was unsatisfactory.
The members of the Board who approved the first tier syndicate buy out on 22 March 1990 erred in doing so and in that respect did not adequately and properly direct, supervise and control the affairs, operations and transactions of the Bank.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Board, the Board Sub-Committee, members of the Lending Credit Committee and certain other officers of the Bank are set out in Chapter 13 - "Case Study in Credit Management: Somerley Pty Ltd" of this Report.
1.7.5.7 Case Study in Credit Management: The REMM Group (Chapter 14): Provision for Loss at 31 March 1991, $185.0M
(a) Overview and Summary
The Bank sustained a huge loss as a provider of credit facilities to REMM Group Limited in connection with the development of the Myer Rundle Mall project. Early in 1988 the Bank was approached by another lending institution which was attempting to put together syndicated financing for the project. This would have involved the Bank in a participation (approximately $40.0M in the overall project) and exposed it to limited risks. That proposal fell through and it was then proposed that the Bank undertake syndication and also provide "back end " finance.
The proposal to provide finance for the entire project was contained in two Stages. Stage 1 was a transitional step towards Stage 2 which envisaged that the Stage 2 financing debt would be discharged either upon sale of the complex or through refinancing.
Although the Stage 2 financing involved facilities of up to $490.0M, it was coupled with certain guarantees, and the effect of this was to commit the Bank to financing the completion of the project whatever the cost.
The time frame envisaged by the proposal was that Stage 1 would take place immediately upon approval and would be superseded by Stage 2. The time frame envisaged by this proposal for Stage 2 was not expressed in precise terms, it being acknowledged, that this depended upon a number of variable factors, such as delay in completion of the project; whether or not a purchaser could be found and if so, when after completion of the works; and other matters. The time frame stated in the " Disaster Scenario " in the July 1988 proposal envisaged that the financiers might still be involved in the period 1994-95. Whilst this was the "Disaster Scenario", the proposal generally postulated a construction period of 18-24 months and that financing would be completed within five years with a provision for early repayment.
The proposal also involved a direct relationship between the Bank as head financier and Myer Stores Ltd as the principal lessee of the completed complex. When the REMM Group acquired the site, it did so, subject to the rights of Myer Stores Ltd, which occupied a major portion of the development site pursuant to a lease. In order to procure Myer Stores to vacate the site and move elsewhere pending development and in order to secure a long term lease of the premises after redevelopment by REMM Group to Myer Stores Ltd, two agreements known respectively as the "Rundle Mall Performance Guarantee" and "Surrender Compensation Agreement " were required by Myer Stores Ltd.
The parties to the Rundle Mall Performance Guarantee were the Bank, Myer Stores Ltd and two REMM Group companies. The effect of the agreement as between the Bank and Myer Stores Ltd was in broad terms that if REMM Group failed to complete the project then its obligations to do so would be undertaken by the Bank. It is stating the obvious, but it is necessary to observe, that this meant that, if the estimate of costs made by REMM Group was inadequate and if the finance arrangements provided insufficient capital, then the Bank would have to provide the necessary additional funds to complete the project in the event that REMM Group could not do so.
Under the terms of the Surrender Compensation Agreement and as an inducement to Myer Stores Ltd to relocate, REMM Group underwrote the profits of Myer Stores during the financial years 1988-1989 and 1989-1990 to the extent of $27.0M. This was designed to ensure that Myer would not suffer any loss of profitability arising from its relocation to Centrepoint and Miller Anderson sites whilst the Rundle Mall site was being redeveloped. The Bank as the guarantor of REMM Group, pursuant to the Rundle Mall Performance Guarantee, became liable as guarantor of REMM Group, in the event that REMM Group failed to compensate Myer for the loss of profits as provided by the Surrender Compensation Agreement.
The proposal was recommended for approval on 27 July 1988 by the Lending Credit Committee subject to certain conditions and on the following day the proposal was approved subject to conditions by the Board of Directors.
Despite the fact that the condition of approval of the Board had required as a condition precedent to the advancement of funds, documentation (including a " Put Option ") to be to the satisfaction of the Bank's legal advisers, the terms of the Put Option were only agreed in very broad outline and documented by way of an exchange of letters.
Despite the fact that the risk underpin involved $200.0M risk to the Bank no formal documentation in connection with it was ever prepared. Most importantly and notwithstanding that the Board's approval had been conditional on it, no confirmation "as to the accuracy of the project costings and construction time table based on final approved plans to be provided by WT Partnership" was obtained.
Syndication of the project as envisaged by Stage 2 of the July 1988 proposal, did not occur, nor were any steps taken immediately to put it in place, other than the dispatch on 12 August 1988, of an indicative letter setting out the terms and conditions of the proposed syndicated facilities.
Despite the shortcomings in the immediate implementation of the Board's decision, Mr P F Mullins and another officer of the Bank, executed (under Power of Attorney) the Rundle Mall Performance Guarantee. This was done on the 29 August 1988. The importance of this step should be recognised. Its effect was that even though the Bank was limited in its obligation to REMM Group to the extent of financing the project up to $500.0M, its obligations to Myer Stores Ltd, were not limited to that figure, and the terms of the guarantee agreement effectively committed the Bank to Myer Stores Ltd in a way which was legally enforceable to provide sufficient finance for the project to be completed. This was notwithstanding the fact that the cost might exceed $500.0M and might well do so to a very substantial extent.
The enormity of the risk which the Bank took by signing the Rundle Mall Performance Guarantee must be appreciated. If the cost of the development " blew out ", the Bank was liable to Myer Stores Ltd to make the additional funds available to complete it. If the value of the development project was substantially less than expected, the Bank would suffer loss if it was forced to sell it. The " Disaster Scenario " stated in the July 1988 proposal, envisaged that the Bank might hold the asset until:
" ... the Centre value equated to the outstanding debt and it could be sold. "
What the " Disaster Scenario " did not envisage was that a combination of factors might occur. In particular it failed to recognise, that the cost over-runs might be greatly in excess of the amount estimated and that this might coincide with the diminution in the rental income anticipated from use of premises after completion. If this combination of events occurred, the rental income might be insufficient to meet the financing requirement of the debt and consequently the debt would simply grow bigger and bigger. Moreover, a diminution in rental income could be expected adversely to affect the valuation of the building and in these circumstances, if it were to be sold, it was likely to realise an amount that was significantly less than the expected valuation.
It was of course important to all parties that the project proceed quickly. If it did not, the holding charges associated with maintaining the Stage 1 funding would become a significant additional expense to the project, eating into the safety margins contained in it for other adverse eventualities. Inevitably there were delays and by mid July 1989 the management of the Bank realised that the original funding arrangements could no longer work. By now the Bank had considerably increased its bridging finance. The REMM Group could not provide additional funds and the Bank would either have to provide them in order to enable the REMM Group to continue or alternatively embark upon the hazardous course of becoming a mortgagee in possession of a partially completed major building site.
In September 1989, a completely new funding concept and proposal was put to the Board as a means by which the Bank would acquire greater control over the cost and progress of the project and as a means of facilitating syndication and thus a reduction of the Bank's exposure to risk on the project.
The September 1989 proposal envisaged a debt one year after completion of the project, now of approximately $575.0M as compared with previously a debt of $450.0M. The concept of the September 1989 proposal envisaged that, by 31 March 1992, REMM Group would either have refinanced the project or introduced additional equity into it or alternatively have sold it. If these things had not occurred by that date, then the Bank would have a call option, permitting it to acquire total ownership on discharge of the debt of REMM Group on the project as secured in the arrangements between the Bank and REMM Group.
By mid November 1989 the funding requirements of the project were dangerously close to the level of the bridging finance. The situation which had occurred in connection with the July 1988 proposal was repeating itself, ie bridging finance was insufficient, more finance was required unless the project be delayed and thus become more expensive and syndication was still not in place.
By mid December 1989 the position was again reached where the commitment to syndication by other banks was well short of the targeted level and it was necessary for bridging finance to be extended yet again.
By January 1990 it was proposed that the Bank immediately effect syndication of those banks which had already made a commitment and for the Bank itself to participate in the first ranking syndicate by a contribution of $70.0M. This proposal represented a significant variation to the September 1989 proposal and increased the Bank's direct exposure to REMM Group by a further $70.0M. It also sought an increase in bridging finance, this time from $290.0M to $300.0M and until the 28 February 1990 in order that the project could proceed whilst syndication was effected. The proposal was approved by the Board in January 1990.
The amended September 1989 proposal, as it was finally implemented, provided credit facilities totalling $580.0M of which $290.0M was provided by the Bank. $70.0M of the Bank's contribution was first tier financing and the remainder second ranking to the rights of first tier financiers.
In October 1990, the Board was requested by management to approve a further increase in funding of $45.0M to complete the project and this was approved. The Board faced a situation which it had faced several times before. It either had to approve funding or run the risk of causing a substantial delay in the completion of the work. If it caused an additional delay, this in turn would mean yet a further need for funding in order to finally complete the works. Meanwhile it was committed by reason of the Myer Rundle Mall Performance Guarantee to see that the works were in fact completed.
A consultant who the Board had instructed reported in December 1990 that the works would not be completed until June 1991. The impact of the delays and the revised building costs together caused management of the Bank to make a revised estimate of the overall funds required to complete the project which was now $684.0M. The funding required to finance the project to 31 March 1992 (when REMM's syndicated arrangements were due to expire) was estimated by the management of the Bank to be $744.2M.
This dire state of affairs was reported to the Board in December 1990 in a paper prepared by Mr J V Henderson and presented by Mr Mullins. Of major importance is the fact that this report, written by Mr Henderson, disclosed that if the Bank were to fund the additional requirements of the project through to 31 March 1992, such funding requirements would exceed the prudential limits applicable to the Bank. The Board agreed to increase the facility available to REMM Group from $335.0M to $398.0M.
As at February 1991 it is unlikely that the value of the building then exceeded $450.0M and if the costs incurred in order to complete the project were in excess of $700.0M then even without holding charges beyond the date of completion, the loss to date could reasonably be well in excess of $250.0M.
Undoubtedly this was a complex transaction and even reduced to its simplest form involved a tangled web of legal rights and obligations. The Bank as head financier was at the centre of this tangle. The assessment of the financing needs of the project, the capacity of the customer to service and repay the financial requirements of the project and the adequacy of security involved assessments of the most complicated kind.
When considering the matter of compliance with the Bank's prudential guidelines, whilst the Bank undertook obligations to provide finance up to certain limits to REMM Group, there was no such limit in connection with the Bank's obligations under the provisions of the Rundle Mall Performance Guarantee. By their very nature, those obligations were limitless and the Bank's exposure thereby was also limitless and plainly in breach of prudential guidelines imposing limits of exposure to any one entity and to any one sector of the economy.
The Bank and in particular the Board of Directors and the Lending Credit Committee, ought to have been aware of the fact that it was undertaking obligations which exposed it to enormous losses in the event that REMM Group could not satisfy its obligations, especially if there was a downturn in the economy generally and in the retail property market in particular.
For the reasons set out in more detail in the Chapter, in my opinion the July 1988 proposal was defective in five major respects, each of which was material to the assessment of credit risk at the time and each of which was causative of loss to the Bank.
In the ordinary course of events in the case of approval of a facility, the Lending Credit Committee would consider a proposal and prepare a recommendation for the Board, which would be forwarded to the Board in the form of a detailed proposal, usually at least three or four days before the Board meeting. In this instance the proposal was finally documented on 27 July 1988 and forwarded in the same form to both the Lending Credit Committee and members of the Board who were to meet the following day. There was urgency in the consideration of the matter. A delay in approval of the finance would result in additional holding charges, not just for the period until approval was given, but also having regard to the estimated construction period, to the next opening date thereafter on which Myer would relocate. The fact that the project might not be able to survive if those holding charges were to be incurred, was an excellent reason for the belief that the margins for error in project estimates were very slight. It ought to have been appreciated that the financial liabilities of the project were no more than finely balanced.
The worst case presented was not finely balanced. Given the uncertainties in the assessment of risk, it was far too risky to undertake. It was or ought to have been obvious to members of the Lending Credit Committee and the Board of Directors who had considered this proposal, that the worst case presented in the sensitivity analysis was not an extreme. If there was only a minor variation of the events said to be likely to occur, the worst case " was barely profitable".
In this case the Lending Credit Committee members did not have time for deep reflection on this complicated matter before making their recommendation. Lengthy discussion is no substitute for careful consideration of the calculations and that was what ought to have been undertaken.
In so far as the members of the Board of Directors who approved the July 1988 proposal are concerned, if they had had insufficient time in which to carefully consider the estimates, it was their duty to require more time no matter what the urgency of the decision may have been. This was not a matter of life and death no matter how it was presented. Moreover, if they considered the information provided to be unsatisfactory or insufficient, it was their duty to seek information upon which they could rely. This was the biggest project of this kind on which the Bank had ever embarked!
The proposal itself was dangerous. There was a substantial prospect that a loss would be sustained by the Bank if it accepted it. Moreover the risk which was involved in the danger was substantial. A loss which the Bank might sustain could well have been very great.
The obligation on the Board of Directors to consider " the maximum advantage to the people of the State " in the management of its affairs, did not provide a sufficient counter-balance to the risks which were inherent in the proposal. The Board also had a clear statutory duty to administer the affairs of the Bank in accordance with the accepted principles of financial management and with a view to achieving a profit. The decision to approve the July 1988 proposal was extremely ill advised. The responsibility for that decision must be shared between the management of the Bank, which prepared the July 1988 proposal; the members of the Lending Credit Committee which considered and recommended it; and finally the members of the Board of Directors meeting which considered and approved it.
Whilst members of the Board were entitled to rely on the recommendation of the Lending Credit Committee, they were not entitled to abandon their statutory responsibility and accept those recommendations without giving them appropriate consideration. Members of the Board were required to exercise an independent judgment placing such reliance on advices that their experience and knowledge told them was prudent.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Board, members of the Lending Credit Committee and certain other officers of the Bank are set out in Chapter 14 - "Case Study in Credit Management: The REMM Group" .
1.7.6 RELATIONSHIP WITH THE RESERVE BANK (VOLUME VII - Chapter 15)
(a) Overview and Summary
A fundamentally important element in the State Bank's external operating environment was the prudential supervision framework used by the Reserve Bank for those banks established under the Banking Act. Although not legally subject to the Reserve Bank's control, the State Bank was perceived as being supervised by the Reserve Bank and stated publicly that it complied with the Reserve Bank's prudential guidelines.
Prudential supervision does not seek to immunise banks (or their owners) from the risk of loss, the economic cycle, or the mistakes of their managers. Underpinning the Reserve Bank approach is its belief that the main responsibility for the prudent conduct of a bank's operations rests with the board and management of that bank. The Reserve Bank has developed a set of general guidelines against which to assess a bank's operations, and, through statistical collections, consultation, and assessment of a bank's risk management systems, the Reserve Bank monitors each bank's performance.
The Reserve Bank's key prudential standards seek to ensure that banks maintain adequate capital, that banks keep their large credit exposures under close review, and that banks hold an adequate stock of high quality, liquefiable assets. In addition, a Bank's external auditors report to the Reserve Bank on each bank's observance of the prudential guidelines, and, in particular, on whether its management systems are effective, statistical reports are reliable, and statutory requirements are being met. The Reserve Bank relies heavily on the integrity of bank management to comply with prudential standards, and to provide accurate and timely information to the Reserve Bank. The Reserve Bank does not see its role as being to protect inefficient or unprofitable banks, but rather to help such banks leave the industry in an orderly and timely manner, and in such a way as will avoid losses to depositors and maintain stability in the rest of the banking system.
The State Bank's relationship with the Reserve Bank was summarised by Mr Clark (during an interview on 28 January 1992) in the following terms:
"... We had no legal liability to the Reserve Bank. It was purely an arrangement that was a gentleman's agreement. We had no liability or no legal reason to follow any request from the Reserve Bank. Even though that was the legal significance, we certainly didn't act that way. We bent over backwards to try to act as if we were a nationally operating bank fully under the control of the Reserve Bank."
In my view, that summary correctly states the strict legal position. The last sentence, however, does not accord with my understanding of the facts. The more correct description of the State Bank's approach to Reserve Bank supervision is set out in a much earlier letter from Mr Clark to the Reserve Bank, in September 1984. In that letter Mr Clark acknowledged the importance of the public having confidence in the banking system and says:
" ... for this reason we are also keen to co-operate with the Reserve Bank to ensure that we are perceived as meeting and maintaining prudential standards consistent with those of the other banks. "
The State Bank did not, in a number of important respects, act as if it was fully under the de facto control of the Reserve Bank and, furthermore, that fact was known only to some of the State Bank's most senior managers and to the Reserve Bank.
As noted above, the State Bank was clearly aware of the commercial advantage attached to the perception that it was meeting the same prudential standards and requirements applying to banks authorised under the Banking Act and has, in many respects, complied voluntarily with the Reserve Bank's prudential guidelines . In my opinion, however, the State Bank was able to create such a perception without actually and fully complying with the Reserve Bank's prudential requirements, and without responding appropriately to concerns raised by the Reserve Bank in the course of its supervision arrangements.
It is clear that the State Bank provided the Reserve Bank with appropriate statistical data, volunteered additional useful information to the Reserve Bank about the State Bank's strategies and operations, and encouraged the secondment of a Reserve Bank officer during 1985. The State Bank (eventually) allocated appropriately qualified staff to produce the statistical data; it sent its most senior managers (except for Mr Clark's absences in 1988 and 1989) to prudential consultations; it instructed external auditors (eventually) to produce the reports required by the Reserve Bank; and, it did consider the Reserve Bank's prudential requirements when developing strategies, processes, and prudential policies.
On the other hand, the State Bank regularly reminded the Reserve Bank that the State Bank was not subject to the Reserve Bank's control, and often expressly reserved its strict legal rights in that regard. In addition to reminding the Reserve Bank about the legal position, the State Bank actively resisted the Reserve Bank's prudential guidelines or advice in each of the following four areas of prudential concern.
(i) Liquidity Management
The Reserve Bank prudential objective is to engender public confidence in the banking industry by requiring banks to hold a defined amount of assets which can be converted into cash quickly and assuredly.
In May 1985, the Reserve Bank asked the State Bank to co-operate with the Reserve Bank's liquidity management prudential guideline. The State Bank's qualified undertaking to comply was not given until November 1987 . In the interim, the State Bank purported to adopt the guideline, but did so subject to an interpretation that suited the State Bank's perception of its own needs.
The Reserve Bank was never concerned that the State Bank did not hold an adequate amount of readily liquefiable assets, but the Reserve Bank was concerned about the State Bank's delay in giving the undertaking, and was concerned about the State Bank including assets which did not conform to the Reserve Bank's definition of "Prime Assets".
Those concerns were not adequately communicated to their Board by State Bank managers, but the conduct of senior State Bank officers created the impression, from the Reserve Bank's perspective, that the Board was a party to the relevant correspondence and discussions. As a result the Reserve Bank would have seen no point in taking up the matter with the State Bank Board and did not take it up.
Even when the Bank did eventually agree to co-operate, its undertaking to comply was given not as a result of an acceptance on the part of the State Bank as to the appropriateness of the Reserve Bank's guidelines, but rather because the State Bank needed the Reserve Bank's endorsement to open a New York office.
(ii) External Auditor's Report
The Reserve Bank first asked the State Bank to provide annual prudential reports from its external auditors in December 1985, and repeated the request in March 1986. In March 1987 the State Bank (through Mr Matthews) agreed to comply. At the prudential consultation in October 1987, the Reserve Bank enquired about the first such report, which was then due. Mr Clark told the Reserve Bank that, because he had reservations about the arrangement, particularly the question of costs, the State Bank had not instructed its external auditors to prepare the report for the Reserve Bank.
In December 1987, the day after the Reserve Bank threatened to reconsider its undertaking to provide the Bank with emergency liquidity support arrangements, and at a time when the Bank needed the Reserve Bank's endorsement to enable it to open a New
York office, the Bank Board, whose members had not been informed of the history of Reserve Bank requests, was asked to, and did, agree that the Bank would comply with the Reserve Bank prudential requirement.
Nevertheless it was not until November 1989, however, that the Reserve Bank received a report which both considered a full financial year, and reviewed all of the relevant State Bank operations.
Here again compliance was achieved more as a result of the commercial necessity for the State Bank to have the Reserve Bank's endorsement in order that the State Bank could operate in overseas jurisdictions rather than of any desire by the State Bank to co-operate fully with the Reserve Bank.
(iii) Large Credit Exposures
The Reserve Bank encouraged banks to have and maintain loan portfolios which are appropriately diversified and do not contain credit exposures that are unduly large in proportion to the capital of the bank. Consistent with this approach the Reserve Bank sought in May 1986 to receive from the State Bank, details of all exposures of clients above 10 per cent of shareholders funds, and an undertaking to keep all exposures to non bank or non government clients under 30 per cent of shareholders funds on a banking group basis.
Although the Bank provided the statistical data sought by the Reserve Bank, the State Bank only ever gave a qualified undertaking to abide by this Reserve Bank prudential requirement.
In keeping with its qualified undertaking, the State Bank, when it was so minded, treated the Reserve Bank requirement with disdain . This is amply illustrated by the Bank's purported consultation with the Reserve Bank on 1 June 1987 and the Bank's decision, made the same day, to ignore the Reserve Bank's strong advice in connection with the Bank's proposed $200.0M exposure to the Equiticorp Group. In this instance, at least, the attitude of management received Board endorsement.
When the Reserve Bank had its Governor write, in strong terms, directly to the Bank's Chairman of Directors, the Board elected to support management.
In December 1987, Bank management structured a further $200.0M exposure to Equiticorp in an artificial way, and in a manner designed to avoid the Reserve Bank prudential requirement. When the Reserve Bank became aware of this exposure, it made enquiries, but was given information by the Bank's then Chief General Manager (Mr Matthews) which was positively misleading.
(iv) Capital Adequacy
The Reserve Bank's primary objective with respect to prudential guidelines on minimum capital adequacy is to ensure that there will be sufficient capital to provide against losses and to provide reassurance to depositors.
The State Bank was the last bank in Australia to give an undertaking to meet the Reserve Bank's 1986 minimum capital adequacy requirements and, even then, its November 1987 undertaking was qualified.
It is appropriate to emphasise that the State Bank's Chief Executive Officer and its Board did not see (and did not ask to see) at least the key prudential returns submitted to the Reserve Bank. That was so even though the Reserve Bank had said to State Bank managers at prudential consultations that the Reserve Bank thought the Chief Executive Officer and the Board should see such returns.
The striking features which emerge from an examination of these four areas are an inadequately informed Board, dominated by a Chief Executive Officer who, whether by reason of experience, judgment or personality, did not adequately discharge his responsibilities in this area of the State Bank's affairs and operations. Mr Clark was, with respect to some of the Bank's operations, as much concerned to limit effective Reserve Bank supervision as he was to promote it.
He did not welcome at least some of the Reserve Bank's arrangements with the State Bank and although he accepted that compliance was largely inevitable he still sought to ensure the Reserve Bank was kept at bay where that was, in his view, appropriate. His belief in his own vision for the Bank, and in his own capacity, seem to have obscured his ability to appreciate the significance of the Reserve Bank's recommendations. His dominance and influence in the organisation, however, was such that other Bank officers found it difficult to question, or depart from that strategy.
The main point of contact between the State Bank and the Reserve Bank was Mr Matthews. Although Mr Matthews had had many years banking experience, and was a member of the Lending Credit Committee and of the Executive Committee, he was not sufficiently aware of operational matters to adequately perform his task, especially in the last two years before his retirement in July 1990. Mr Clark's dominance in the organisation was such that Mr Matthews would sometimes act in accordance with his perception of Mr Clark's requirements. By way of example, Mr Matthews' involvement with the State Bank's funding of Equiticorp in the period June 1987 to January 1988 demonstrates, in my view, that he was not equipped to recognise and resist the inappropriate conduct described above.
In addition to providing an understanding of the role of the Reserve Bank and of how the State Bank conducted its relationship with the Reserve Bank, the Investigation's review of that relationship proved useful in other respects. The Reserve Bank supervision processes require the Reserve Bank to maintain an extensive and detailed written record of its dealings with banks with which it has any form of supervisory relationship. That documentation, together with other State Bank documents considered by the Investigation, allowed an insight into the State Bank's affairs and operations that would not have been possible if the Investigation had to rely solely upon the recollection of the various people involved. The review has revealed much about the way the State Bank's senior managers, especially Mr Clark and Mr Matthews, operated, and how the State Bank's Chief Executive Officer and other senior Bank officers dealt with the Bank's Board of Directors. In particular, the review demonstrated that:
(i) State Bank's most senior managers (including Mr Clark) did not adequately appreciate or accept the role of the Reserve Bank, the supervision objectives of the Reserve Bank, or the purpose of the prudential consultations;
(ii) State Bank preparations for the prudential consultations (consistent with its lack of understanding) were generally inadequate ;
(iii) although their practice improved during the period, State Bank officers did not adequately record either the matters raised at prudential consultations by the Reserve Bank, or the discussion of those matters ;
(iv) the State Bank's most senior officers at prudential consultations did not attach adequate importance to the concerns expressed by the Reserve Bank, and did not make proper use of the Reserve Bank's advice ; and
(v) State Bank senior officers, in particular Mr Clark and Mr Matthews, did not provide adequate reports to their Board of the matters raised by and discussed with the Reserve Bank at prudential consultations.
This behaviour had two consequences:
(i) the Board received inadequate information; and
(ii) there was no documentary evidence and no audit trail to illustrate the failure.
In my opinion, the responsibility for those inadequate management practices should be attributed primarily to Mr Clark and, to a lesser extent, Mr Matthews. It is difficult to resist the inference that Mr Clark's view of the State Bank's relationship with the Reserve Bank permeated through most of the State Bank's senior management level.
As an example of the failure of the State Bank's senior managers to attach sufficient importance to Reserve Bank advice and recommendations, I refer to the several Reserve Bank warnings for the State Bank to ensure that its management information systems were able to properly monitor and control risks, particularly given the State Bank's rate of growth.It is now apparent that the State Bank did not ensure that its key management information systems kept pace with the growth of the Bank and, in my view, the State Bank's senior managers never properly appreciated the importance of that task, or of the Reserve Bank's views.
When the Reserve Bank raised a concern about a matter of management practice, senior State Bank executives typically responded that State Bank management was aware of the concern, and was addressing it.
The State Bank's inadequate compliance with the Reserve Bank's prudential guidelines did not, taken in isolation, cause material loss. More significant is the failure by some of the State Bank's most senior managers to properly appreciate the concerns which were expressed by the Reserve Bank in the course of the prudential consultations. That failure is an important management shortcoming; ultimately it is management shortcomings which are critical causes of the State Bank's financial difficulties. The State Bank's financial position in February 1991 would assuredly have been very different if the State Bank had taken proper account of the Reserve Bank's warnings that the State Bank's growth be adequately supported by appropriate management systems and suitably skilled managers.
It is appropriate to note at this point that, in their responses to my provisional conclusions, Mr Clark and Mr Matthews emphasised that any failure on their part to ensure that concerns expressed by the Reserve Bank were fully conveyed to the Board was not an attempt to conceal information from, or mislead, the Board.
I appreciate I am looking at this after the event. Even so, I have found it difficult to understand how anyone with ordinary perception would not have properly understood the Reserve Bank concerns and appreciated the requirement to provide comprehensive reports on those matters to the Board.
Mr Clark's and Mr Matthews' failure to properly appreciate the significance of the Reserve Bank messages demonstrate an inexcusable lack of competence.
Another matter for consideration in this context is the role of the Board. It is a fact that the Board was kept in the dark on those matters of major strategic and operational concern communicated to senior management by the Reserve Bank.
Notwithstanding the fact that the Board was kept in the dark on some important matters, the material before the Investigation reveals that the directors did receive warning signs which should have prompted them to adopt a more assertive position . Whilst the directors' lack of response to warning signs may now appear a relatively minor issue when contrasted with the seriously inept practices of those State Bank senior managers who were closely involved with the Reserve Bank relationship, the fact remains, that the Board could, and should, have adopted a different course when they were faced with management behaviour that was clearly inappropriate
I have noted in this Chapter that the Board did not appreciate the need for it to insist on detailed reports from management on the result of its prudential consultations with the Reserve Bank in 1985, 1986 and 1987. Nevertheless, it was still incumbent on the directors to have sought, independently of management, an understanding of the Reserve Bank's supervision objectives and procedures. Had they done so, it is likely that they would have recognised that the reports in 1985, 1986 and 1987 were plainly inadequate. In short, the directors should have been more concerned about the environment in which the State Bank conducted its business. The State Bank's 1991 financial difficulties may have been much reduced had the directors been more alert to that business environment, and if they had sought (and received) more information on the role of the Reserve Bank and of the discussions at prudential consultations. The acceptance by the Board, in November 1985, of a brief oral report set an unfortunate standard.
Although the reports to the Board of the prudential consultations were generally inadequate, there were some occasions when the reports did contain specific warning signs. For example, the report to the Board of the November 1989 prudential consultation advised that the Reserve Bank expected a reduction in the rate of growth of the State Bank Group. That report called for action by the Board at a policy or strategic level. There was no such Board response.
The Board is the governing body of the Bank (Section 14(1) of the State Bank Act) and, the management of the Bank remained subject to its control (Section 16(2)). The Act thereby imposes on the Board the obligations of ensuring competent management, and of having adequate means to monitor the operations of the Bank. In this important area of the Bank's operations the Board of Directors did not adequately or properly supervise, direct, or control, State Bank's relationship with the Reserve Bank.
During 1991, the Reserve Bank, the State Bank and the Government of South Australia negotiated a new agreement to supersede earlier voluntary understandings between the Reserve Bank and State Bank. The terms of this new voluntary arrangement between the Government and Reserve Bank are set out in a letter from the Reserve Bank to the Premier dated 30 August 1991. The new arrangement significantly increases the Reserve bank's powers in respect of the supervision of the State Bank, provides for a representative of the State Government to attend annual prudential consultations, and also explicitly provides for discussions between the Government and the Reserve bank on matters of significance involving the State Bank. I understand the basic intent of the new arrangement to be that the Reserve Bank will exercise prudential supervision of the State Bank in the same way that it does for banks authorised under Commonwealth legislation.
(b) Findings and Conclusions
In the respects identified in this Chapter, the operations, affairs and transactions of the Bank were not adequately and properly supervised, directed and controlled by:
(i) The Board of Directors of the Bank.
(ii) The Chief Executive Officer of the Bank.
(iii) The other Bank officers identified in that regard in this Chapter and, in particular, Mr Matthews.
The information and reports referred to in this Chapter and given to the Bank Board by the Chief Executive Officer, and other Bank officers, were not timely, reliable or adequate. Those reports and other information were not sufficient to enable the Board to discharge adequately its functions under the Act.
As to the matters and events which caused the financial losses, the Bank's inadequate compliance did not directly cause specifically identifiable losses. However, the failures by some of the Bank's most senior managers from time to time, to properly appreciate, or respond to or report various Reserve Bank concerns, were significant management shortcomings.
Those sorts of shortcomings in the top echelons of management were, ultimately, critical causes of the State Bank's financial difficulties.
1.7.7 THE MANAGEMENT OF ACQUISITIONS (Volume VIII - Chapters 16 to 18)
(a) Overview and Summary
It is convenient to combine, in one summary my examination of the Bank acquisitions of Oceanic Capital Corporation Limited and the United Building Society, together with some general observations in relation thereto.
As part of its inadequately controlled and regulated pursuit of growth, the Bank embarked upon the acquisition of two significant businesses, namely Oceanic Capital Corporation Limited (Oceanic) and the United Building Society (later renamed the "United Banking Group") (UBS).
These two acquisitions represented material investments (by value) of the Bank outside its core banking activity. They were both the cause of substantial losses to the Bank. Oceanic, acquired in March 1988, contributed a net loss to the State Bank Group of $83.3M in 1991 . UBS acquired in May 1990 incurred a loss of $123.0M in 1991.
In undertaking acquisitions of this kind, it was incumbent upon management to undertake adequate due diligence to avoid obvious risks of loss to the Bank. The Bank did not have any formal policy which stated the processes and procedures governing the acquisition of new businesses and companies. Any checks or precautionary investigations undertaken by management in assessing prospective acquisitions were made on an `ad hoc' basis, largely at the discretion of the executive officer who was responsible for the transaction.
A number of features of both these acquisitions stood out as demanding extensive due diligence examination prior to any Bank decision as to the desirability of the acquisition.
In the case of Oceanic:
(i) its activities were outside the traditional banking operations of the Bank;
(ii) its operations were principally located outside South Australia;
(iii) the vendor was known to be under financial pressure, and was a debtor of the Equiticorp Group, of which Mr Clark was both a Director and shareholder;
(iv) it had a relatively low net tangible asset backing ($6.0M) and the Bank was outlaying $59.0M.
In the case of UBS:
(i) being a building society, it operated in a different regulatory and commercial environment to the Bank;
(ii) it was located and operated in a foreign market (New Zealand);
(iii) it was trading unprofitably at the time of purchase; and
(iv) the Bank was outlaying $NZ 150.0M.
1.7.7.1 Case Study in Acquisition Management: The Oceanic Capital Corporation (Chapter 17)
(a) Overview and Summary
A key feature of the Oceanic acquisition was that it was made prior to completion of a detailed due diligence investigation .
Mr K L Copley (Chief Manager Finance and Planning) and Mr J B Macky (General Manager - Information Systems) relied upon a report by CIBC Australia to confirm the value of the management rights to support their valuation methodology. This was extraordinary, given that the report had been prepared for the vendor for specific purposes that were not related to the Bank's transaction. Furthermore, the CIBC Australia valuation was prepared prior to the October 1987 stock market crash and it should have been obvious to any prudent banker that it would have required revision.
The Board had resolved that the Sale Agreement be subject to:
" The preparation of a legal agreement in a form acceptable to our respective advisers incorporating the above conditions and such other terms as are normal in this type of transaction. "
The Bank's solicitors, in a memo, expressed the view that they " were most unhappy about the form of the document and considered that it potentially left the Bank exposed on a number of issues ".
Mr Copley decided to proceed with settlement notwithstanding the solicitor's "unhappiness", because he believed the deal had to be completed and consummated on 31 March 1988, and because he considered the suggested amendments to be minor.
As a result, the already disadvantaged position of the Bank was markedly worsened because it was left exposed to potentially inadequate warranties in the Sale Agreement.
No clear statement of the nature, extent and timing of the due diligence required was made by either the Board (as evidenced by minutes of meetings on 17 February 1988 and 24 March 1988), or by management in either of the two Oceanic recommendations submitted to the Board (dated respectively 16 February 1988 and 22 March 1988). Ambiguous references were made (in the Oceanic recommendation to the Board) to valuations and to due diligence, in consequence of which the intent of management regarding both due diligence and the use of external advisers was unclear. The due diligence requirements were also confused in these submissions in that no clear reference was made to whether due diligence was to be undertaken prior, or subsequent, to settlement. In the event of it being done after settlement there would necessarily need to be arrangements for an adjustment to the purchase price with respect to issues identified in the due diligence process.
(b) Findings and Conclusions
(i) Mr Macky and Mr Copley failed to exercise proper care and diligence;
. in valuing Oceanic for purchase by the Bank;
. in agreeing to terms of sale which left the Bank exposed to potential loss;
(ii) Mr Copley failed to exercise proper care and diligence in agreeing to complete the sale prior to the completion of any detailed due diligence investigation.
(iii) Mr Copley failed to exercise proper care and diligence in failing to follow up on advice received from the Bank's advisers which indicated serious issues of concern, and in releasing the vendor from warranties before their expiration under the Sale Agreement, without the concurrence of the Board.
(iv) Mr Copley, Mr Macky and Mr Clark failed to exercise proper care and diligence in that they did not adequately report to the Board on material features of the transaction.
(v) Mr Clark failed to disclose a direct or indirect pecuniary interest in the transaction which may constitute an offence pursuant to Section 11 of the State Bank Act. This matter should be further investigated.
1.7.7.2 Case Study in Acquisition Management: United Building Society (Chapter 18)
(a) Overview and Summary
(i) The forecasts presented to the Bank Board in support of the Bank's purchase of the United Building Society investment were significantly overstated. This became clear within three months of the acquisition when the original 1991 forecast pre-tax profit of $NZ 36.0M was revised to $NZ 4.4M.
(ii) The Board had been advised by Bank management that the $NZ 150.0M capital injection would be "passed straight back" to the Bank such that the Bank would have no " funding costs ".
$NZ 150.0M was not " passed back " to the Bank. Furthermore, the net asset value at acquisition was not $NZ 40.0M as estimated by management but rather a deficiency of approximately $NZ 18.0M.
(iii) The due diligence investigation conducted by the Bank in relation to this transaction was seriously deficient for the following reasons:
. inadequate financial review and assessment of historical and forecast earnings and related assumptions, cashflows, receivables, property values and contingent liabilities;
. the investigations were poorly co-ordinated and controlled, and several crucial parts of the review - in particular, the review of internal controls - had not been completed;
. Ayers Finniss, who were responsible for completing major parts of the due diligence, and who were entitled to a "success fee", had a vested interest in ensuring that the acquisition was completed successfully (and were therefore affected by a conflict of interest); and
. the Board was not provided by management with an adequate standard of information upon which to base an investment judgment.
The deficiencies in the due diligence process are amply illustrated hereunder. In a memo from Mr Mallett (Chief General Manager - International Banking) to the Managing Director dated 3 May 1990, he says:
"We were half way through our due diligence and this has raised more issues. "
No evidence has been found (despite searches) of anything beyond a very limited further due diligence following the meeting recorded in Mr Mallett's memo of 3 May 1990 and yet only six days later the Board Minutes of 9 May 1990 record the completion of "an exhaustive due diligence".
(iv) Despite the above, the Reserve Bank of Australia obtained an assurance from the Chairman of the Bank Board dated 24 May 1990 that " on the basis of the extensive due diligence undertaken and the associated reports provided to the Board, we are satisfied that the information supplied by the appointed consultants concludes that UBS is both sound in its financial structure and viable in its operation. " I do not believe that the Chairman realised that his assurances were ill founded. However the Reserve Bank was misled into thinking that "extensive due diligence" had been carried out.
Some four months later, in a memo from Mr S G Paddison to the Group Managing Director regarding the post acquisition review of UBS he concluded:
" ... there is no point in crying over spilt milk. However, once the shock subsides the questions will certainly be raised as to how this occurred. Simply our due diligence failed. It failed because we looked for reasons to say yes ." [Emphasis added]
The Board itself in its minutes of a meeting in the following month, on 25 October 1990, provided one explanation for the failure:
"... Directors stated that the Group did not have the expertise to acquire businesses and make judgments on the viability of future acquisitions, therefore Directors would be cautious of any future acquisition proposals."
(b) Findings and Conclusions
(i) Mr Mallett (Chief General Manager - International Banking) and Mr Janes (Executive Director (Auckland) Ayers Finniss) failed to exercise proper care and diligence in that they did not identify key investigation areas or ensure that they were fully explored.
(ii) Mr Morrison (Manager Banking (Auckland)) failed to exercise proper care and diligence in his assessment of the receivables.
(iii) Mr Mallett and Mr Clark failed to exercise proper care and diligence by proceeding with the United Building Society acquisition and presenting the recommendation to the Board in circumstances where concerns arising from investigations had not been fully resolved or reported to the Board.
1.7.8 THE OVERSEAS OPERATIONS OF THE STATE BANK (Volume IX - Chapter 19)
(a) Overview and Summary
I have already commented on the bank's pursuit of growth and diversification but nowhere is it more dramatic than in the Bank's strategy of growth and diversification overseas. After its establishment, the Bank maintained the London branch previously conducted by the Savings Bank of South Australia. This branch had been a minor retail banking operation. In January 1985, the Bank Board approved an "International Banking Strategy", as a result of which, in October 1985, the London branch was upgraded to a wholesale banking operation. London branch's assets grew rapidly reaching $395.6M by June 1986, $613.6M by December 1986, and $1,037.2M by December 1987.
In 1987, the Bank opened an office in Hong Kong, and, in 1988, established a branch in New York. In December 1988, the Bank acquired Security Pacific Bank New Zealand, and thereby established its Auckland branch. Whilst the Hong Kong Office did not, during the period under review, grow significantly, the New York and Auckland branches did so. In March 1988, management sought the Board's confirmation of their approval of the establishment of a managed branch in the Cayman Islands.
Overall, the Bank's growth in its overseas assets was rapid and significant. From an overseas asset base of $22.6M, as at December 1985, overseas assets grew to $5,270.0M, as at February 1991. Indeed, by September 1990, during a phase of exceptional overseas growth, overseas assets reached $7,999.7M.
This significant and rapid growth and diversification into markets in which the Bank had no prior relevant experience placed marked strains on internal control systems, and on the Bank Board's and Management's ability to supervise and control the business risks arising from these operations. It is therefore questionable whether or not the Bank should have established, and having established, should have maintained, its significant overseas operations.
As noted above, in 1988, the Bank acquired Security Pacific Bank New Zealand and thereby established its Auckland branch. Mr Mallett (Chief General Manager - International Banking) presented a paper to the Board recommending that he be authorised to proceed with negotiations
to purchase an unnamed " major international bank " (later identified as Security Pacific Limited). Prior to this, in July of 1988 Mr Mallett presented a paper to the Board, seeking the establishment of the Auckland branch, which paper followed on from a " Concept Paper " in May of 1988, which he had put to the Executive committee, with a recommendation to establish a branch in New Zealand.
Neither the Board Paper in July of 1988 nor the one in October of 1988 contained any of the economic information and views expressed in the Concept Paper of May of 1988.
At about the time the Board was first considering establishing a branch in New Zealand, ie July of 1988, Mr Macky (General Manager, Group Information Systems) was visiting New Zealand. In a memorandum to Mr Mallett (copied to Mr Clark) dated the 5 August 1988, Mr Macky stated:
" ... the general impression is that many NZ'ers believe the New Zealand economy is headed for a major disaster. There is an overall pervading atmosphere of pessimism. The feeling is that Mr Douglas' policies are driving a lot of previously highly protected firms out of business and generating high levels of unemployment without there being a clear direction from the government as to what is going to take its place and how this replacement is going to be achieved.
Those that I spoke to when asked if there was an opportunity for another bank to enter the market, all commented that they felt this would be very difficult because of existing loyalties. "
Mr Mallett's cavalier response to this was to do no more than note on the memorandum " read with interest ". Neither Mr Mallett nor Mr Clark saw fit to present Mr Macky's report, or even a summary of it, or any of the economic information contained in the May 1988 Concept Paper, to the Bank Board, when it was asked to consider the acquisition of Security Pacific. This was nothing short of a dereliction of their duties to the Bank and to the Bank Board.
To suggest, as Mr Mallett did, that the state of the New Zealand economy was understood by all, begs the question why he saw fit to present the information to the Executive Committee, but not to the Bank Board. It is open to be inferred from management's failure to present to the Bank Board the economic information which was presented in the Concept Paper of May of 1988 that the economic views expressed did not suit management's arguments and that they could have prompted the Board to probe management on the wisdom of opening a branch in Auckland.
The asset growth in respect to the Bank's overseas branches during the period under review is the most striking feature of the Bank's overseas operations. The operating reviews presented to the Bank Board clearly indicated the asset growth in relation to all of the Bank's overseas operations, which until the second half of 1990, continually outstripped budget and planning projections. The 1988-1989 profit plan noted that the International division's contribution to the Bank's profit and loss account represented an average earning on assets of 0.1 per cent. As the Bank Board had noted that the Bank Group's return on assets target for 1988/1989 was 0.81 per cent, given their approval of the profit plan, it is apparent that the Bank board was content for the International division to achieve a return on average earning assets of one eighth of that expected for the Bank group as a whole. Indeed the profit plan itself noted that the 1988/1989 return on asset projection was a 72.06 per cent reduction on the previous year's return on assets of 0.57 per cent.
In the 1989-1990 profit plan, net profit for the off-shore offices was forecast to be $8.9M compared to an actual $0.2M in 1988-1989. This represented a staggering turnaround. How it was to be achieved, is not explained in the 1989-1990 profit plan. Furthermore, this profit plan gave no explanation for overseas operations' failure in the previous year to achieve anything more than one tenth of the projected return on assets, which itself was approximately one fifth of the prior year's actual return on assets.
In fact, instead of a profit of $8.9M as forecast, the Bank recorded a loss of $6.396M.
Incredibly the 1990-1991 profit plan forecast a profit of $2.74M for the overseas branches. Once again there is no explanation in this profit plan:-
(i) For the disastrous loss figure for the year 1989-1990 as against the previously projected substantial profit;
(ii) In support of a continuation of overseas operations given the negative return on assets for the year 1989-1990 and a very modest profit for the previous year; and
(iii) Of how the Bank would turn a substantial loss into a projected substantial profit given that in the previous year the Bank had turned a projected substantial profit into an actual substantial loss.
In responding to my tentative findings in relation to the approval of the profit plans for the years ended 1989, 1990 and 1991, the non-executive directors submitted:
" ... It was in just this very period that a number of Board members began to have serious doubts about the wisdom of the Bank's off-shore activities and the justifications which it had hitherto received from management. "
Even if these " serious doubts " were entertained at the time of the approval of the various profit plans (a matter on which I am not persuaded from the evidence of the non-executive directors), the non-executive directors should not have approved the profit plans in relation to the Bank's overseas operations, until such time as management had prepared and presented a detailed and substantiated review of these operations, demonstrating to their satisfaction, the benefit to South Australia of the maintenance of these operations and their future ability to achieve a profit. The Board should not have simply relied upon assurances or justifications proffered by management, without positively satisfying itself, that these assurances and justifications were well founded in fact and were proven to be consistent with the Bank's charter under Section 15.
At least by July 1988, the Bank Board was on notice that the Bank's overseas branches were then operating at a level of profitability significantly below that applicable to the Bank's overall operations. The Board could not have failed to see the correlation between the over budget asset growth and the overseas branches' significantly inferior profitability. Whatever above budget profits for the overseas branches may have been reported to the Board in the operating reviews, such profit figures were achieved only by the Bank pursuing an aggressive asset growth strategy in its overseas branches.
The circumstances of the Bank's overseas operations called for immediate and definite action by the Board. Circumstances called for the Board to direct management to conduct a full review of the justification for maintaining the Bank's overseas operations and for a report on that review to be presented to the Board so that the Bank Board could determine whether or not the Bank should continue its overseas operations.
During the period under review the group Managing Director made an oral presentation to the Bank Board at its monthly meetings. As from April 1990 these reviews were presented in the form of a Board Paper and in addition Mr Mallett generally attended during the Board's deliberations on matters relating to the overseas branches.
It was incumbent on Mr Clark to provide regular detailed and accurate reports on the Bank's overseas operations in order to enable the Board to fully appreciate the risk profiles presented by the operations conducted by the overseas branches and to determine for itself, whether or not the Board should give appropriate directions to management in order to protect the interests of the Bank. He failed to do so.
As I have noted earlier the Bank had set maximum exposure limits (both actual and contingent) on any particular account. In July 1985 this limit was 20 per cent of the Bank's "capital base", limited to $33.0M with exposure to a group of related accounts being required to be included within the maximum of $33.0M exposure, unless specific Board approval was held. The Bank also maintained prudential policies limiting off-shore exposure. From time to time over the period under review, the Executive Committee and the Bank Board considered, and approved, increases to these prudential exposure limits.
The Bank Board should have ensured that at all times prudential limits for industry exposure within the London branch corporate loan portfolio were in force. These limits should have been approved by the Bank Board, on the basis of a reasoned and substantiated recommendation from management, and such limits, once established, should have been regularly reviewed and re-assessed for relevance and effectiveness. Management failed to submit to the Board recommendations for industry exposure limits for the London branch. The Board at least should have directed management to consider and recommend appropriate limits.
That the Board did not require the establishment of industry exposure limits for the overseas branches' loan portfolios is evidence of the Board's failure to address prudential issues associated with the operation of remote branches and to deal appropriately with management. By 1988 these branches theoretically could represent an exposure of 35 per cent of the Bank's total assets. The Bank Board's inaction in this regard left it open to management to act without Board directions on prudential matters concerning industry exposure within portfolios. As appears from the February 1991 report to the Bank Board on non-productive assets, the Bank's exposure to property was a substantial factor in the recording of significant non-performing assets by the London branch.
The Bank Board approved policies relating to Treasury dealing limits during the period under review. The information provided to the Board for money market limits was brief. It is doubtful whether a Board presented with such limited information could have made a reliable and/or informed decision on the matter; more detailed information regarding limits would have been necessary for an informed approval by the Bank Board.
It is clear that the Bank took or adopted a "hands off " approach to control and supervision in its overseas branches. It was fundamental to ensure that the highest level of relevant internal control systems were in force at all times in relation to control and supervision of the Bank's overseas branches, but this was not done. There was no on site internal audit conducted of the London branch for some 3 and a half years after its establishment. There was no credit inspection function independent of management in the London branch for some 4 and a half years after the branches commencement of wholesale banking operations. In addition delegated lending authorities did not restrict lending activities in relation to industry exposures within portfolios. Essential management information stopped at Mr Mallett's desk. That information should have been communicated to the Bank Board.
A number of reports to the Bank Board on operational matters concerning the overseas branches,omitted information that was material and that had been primarily provided to the Executive Committee. These omissions were serious and material omissions and deprived the Board of the opportunity to assess the risk profile of the branches, to give appropriate directions to management for prudential management of those risks, and generally to discharge its obligations.
The significant delay in securing adequate and effective on-site inspection by internal audit department of the overseas branches internal control systems is another serious failure on the part of the Bank Board, Mr Clark and Mr Mallett to discharge their obligation for the prudential management of the Bank's assets.
The Reserve Bank of Australia also expressed its concern to the Bank as to the growth of the Bank's overseas operations generally. Mr Mallett said in evidence, that he was aware, at least by 1988, that the Bank of England was concerned with the bank's exposure to the United Kingdom property market.
In November 1989, the Reserve Bank of Australia's New York representative attended a prudential consultation with the head of the Bank's New York operations. The Reserve Bank sounded a warning concerning the New York branch's spectacular growth in assets pointing out:
" ... We drew out the great risks that exist in rapid development of lending business and the need to be sure that the pace of growth does not exceed the capacity of systems, management resources and experience in the markets and lending business being developed ... The striking growth in lending which has been achieved initially must be a cause for some reservations. "
There is no evidence that this record of the meeting was presented to the Bank Board.
At a meeting in November 1990 between the Bank of England, the Reserve Bank of Australia and the Bank, the Bank of England presented statistics, comparing the Bank's London branch's performance with that of 66 other overseas banks under its supervision. The London branch's return on assets, its operating expenses as a proportion of total assets, and its bad debt expense as a proportion of average receivables, were all considerably worse than the average for the 66 other overseas banks.
There is no evidence of a report on proceedings of this meeting being presented to the Bank Board. This clearly was information that should have been presented to the Bank Board by Mr Clark, in order to enable the Board to consider the continuation of the Bank's London branch operations.
It is clear that there was a substantial flow of information to Mr Clark, Mr Mallett and other Bank executives in Adelaide regarding the concerns of both the Bank of England and the Reserve Bank about the state of the Bank's overseas operations generally. This was particularly so in relation to the growth in the Bank's overseas assets and the level of property exposure in the London branch.
These expressions of concern by the regulatory authorities for the level of exposure in the London branch to property, were first recorded as being raised in the Reserve Bank of Australia's prudential consultations in November 1988 and were repeated regularly thereafter.
Neither Mr Clark, Mr Mallett, Mr Matthews nor Mr C W Guille (a senior Bank officer involved in Reserve Bank consultations) fully and adequately related to the Bank Board the expressions of concern, and accordingly the Bank Board was denied the opportunity of assessing the Bank's overseas risk profile and of setting appropriate prudential controls in place in order to protect the interests of the Bank.
It was a serious omission on the part of Mr Clark and of Mr Mallett, to have failed specifically to bring to the Bank Board's attention, the fact that the London branch's portfolio was deliberately biased in favour of property, in spite of the express concerns of the prudential regulators.
Nevertheless, the reports presented to the Bank Board contained warning signals sufficient to put it on notice that it was required to obtain further information from management about the Bank's overseas operations, in particular the London branch. Moreover, the Bank Board should have been put on notice as to the pressing need for prudential supervision and control issues arising in respect of the Bank's operations, having regard to what was reported to the Bank Board in relation to the prudential consultation held on 16 November 1989. The Bank Board should have demanded a greater level of detail from management in order for it to properly discharge its responsibilities to the Bank.
The fact that prudential regulators found it necessary to draw the Managing Director's attention to concerns about the control and supervision of the London branch, is indicative of a serious deterioration in such control and supervision, which put at risk the Bank's assets. Both Mr Clark and Mr Mallett must bear responsibility for this situation.
The Bank Board submitted that it had " regard at all times to its responsibilities under Section 15 ". If that is so, then the Bank Board could not have failed to appreciate that rapidly increasing assets with poor profitability raised such serious doubts about the maintenance of the Bank's overseas operations, that more positive action was called for than simply asking management and being given assurances. It was only towards the end of 1989, that the Bank Board took action to require management to produce a comprehensive written review of the performance of and justification for overseas operations. Such a review was called for given the circumstances of the Bank's overseas operations, at least on an annual basis from the end of 1986 onwards and most certainly from 1988 onwards in light of the significant profitability problems in relation to the Bank's overseas operations revealed in the 1988 profit plan. It was not good enough for the Board to rely upon a simple " question and answer " process with management. It should have undertaken a comprehensive probing of management against the background of a detailed review of the Bank's overseas operations, based on much fuller information than was then being provided.
(b) Findings and Conclusions
(i) The Board was motivated to establish the Bank as a participant in the international banking arena. The apparent and overriding consideration for doing so was the perceived profitable growth opportunities in overseas markets. By June 1988 however, the Bank Board should have called for a thorough review of the Bank's overseas operations and, if appropriate, on the basis of marginal strategic relevance and substandard profitability, should have seriously considered the withdrawal of the Bank from those operations. But the Board did not do this or even consider doing it. The Bank's operations continued to grow and grow rapidly, and to diversify into new areas.
(ii) Mr Clark and Mr Mallett presented papers to the Bank Board that did not fully and accurately convey information concerning the Bank's overseas operations and omitted information that was material for the Bank Board's deliberations.
(iii) In relation to the matters of consultations with the Reserve Bank, Mr Matthews and Mr Guille prepared and/or presented papers to the Bank Board that did not fully and accurately convey information concerning those consultations.
(iv) The Bank's management had a strong sense of management's prerogative in those areas where it had delegated authority. Whilst this is a defensible position for management to take in the day to day operations of the Bank, it was not defensible when wider issues of policy were involved and the nature and extent of risks were not adequately made known to the Board.
(v) The weakness of the Bank's control and supervision of its overseas branches was exacerbated by the seriously late introduction of internal audit department reviews and independent credit inspections.
(vi) Pre-occupation on the part of Mr Clark and of senior management with growth of the overseas operations at the expense of attention to prudential controls and ongoing credit assessment, was a cause of the losses reported in February 1991.
(vii) The operations affairs and transactions of the Bank with reference to its overseas operations were not adequately or properly supervised, directed and controlled by the Board of Directors of the Bank, the Chief Executive Officer, Mr Clark and Mr Mallett.
1.7.9 MANAGEMENT ISSUES (Volume X - Chapters 20 to 22)
1.7.9.1 The Management of Senior Executives at the State Bank (Chapter 20)
(a) Overview and Summary
Proper management of its lending business, and effective planning and internal controls were essential to the sound operation of the Bank. Under the State Bank Act the Bank Board, as the governing body of the Bank, was bound to administer the affairs of the Bank. The Board exercised its management powers through its delegations to the Managing Director, Mr Clark. In turn, Mr Clark delegated certain responsibilities to senior executives within the Bank. Accordingly, the Bank's senior executives were required to monitor and manage its day-to-day business. The competence and diligence of those senior executives was essential to the proper functioning of the Bank.
The Bank was formed by the merger of two small parochial banks, one a rural bank and one a savings bank. It was obvious at the outset, that the existing staff of the merged banks would not have the skills and expertise, at least initially, to develop a dynamic and comprehensive bank competing with major banks interstate and eventually, overseas. The Board and the Managing Director were aware of the need to develop a suitably qualified and experienced management team, and of the limitations on the management resources in the predecessor institutions.
In those circumstances, it was necessary to turn to external recruitment of senior executives with specialist skills in areas such as Treasury, Corporate Banking and International Banking. The excessively rapid growth in the Bank's lending activities made the requirement to recruit such a management team all the more imperative.
Recruitment of those senior executives was delegated by the Board to Mr Clark. The Board retained a theoretical veto over the recommendations made by Mr Clark in respect of such appointments. The Board exercised that right of veto on only one occasion. The recruitment of senior executives at the next level was delegated by Mr Clark to those reporting directly to him. When the Managing Director made those delegations he did so without providing a set of guidelines or a definite policy, and without providing his subordinates with the support of a strong human resources function.
The Managing Director determined to apply a "new broom" to the "outdated" culture of the organisation. That, combined with the effect of a tight labour market (in a deregulated banking industry) and with the absence of any specifically defined recruitment plan or standards, resulted in a number of instances in the appointment and later the promotion of individuals with either limited potential or inadequate banking experience.
Mechanisms which existed to review the performance of senior executives were ineffective. They were subjective, and conducted by Mr Clark alone, on an informal basis, without any documentation being retained for reference purposes, and future reviews.
Similarly, there was no apparent objective and formal process for the setting of rewards and remuneration of those senior executives. Mr Clark set the remuneration as a result of his subjective assessment. The criteria for remuneration setting for these executives were never defined, and the Board had little or no information other than what the Managing Director had provided. Neither did it seek any such information.
Frequently, remuneration increases and bonuses which were granted to the senior executives, were in excess of the commensurate increase in Bank profitability for the relevant financial year, or were in fact shown to have been granted at a time when the Bank was recording decreases in profitability, or actual losses. An inference to be drawn from the available evidence, is that remuneration was tied to achievement of growth rather than to profitability. Moreover, significant increases in salary and remuneration, and substantial bonuses, were granted to senior executives in spite of the astounding growth in the Bank Group's non-performing assets and substantially reduced profits.
The reliability of the assessment for the performance of senior executives made by Mr Clark was of critical importance. The Board had delegated that role to him, and did not, other than in a theoretical sense, question or veto his assessments. The concentration of power arising from the informality, secretiveness, and subjectivity of the performance assessment process created an unusually strong and far reaching dependency on the part of the senior executive echelon on the Managing Director and on the satisfaction of his expectations. It further determined the basis for promotion and remuneration review.
The Managing Director and his team of senior executives, with the explicit or implicit approval of the Board, effected substantial and frequent structural changes within the Bank. Those restructures resulted in the redistribution of responsibility, and had a substantial and generally adverse impact on the capacity of the organisation to effectively address the conduct of its business. They may have distracted senior management from attending to and carrying out tasks that were more pressing, and in effect, from "getting on with the job". In effecting these continuing and far reaching upheavals of the structure of the Bank, the Managing Director displayed a level of managerial competency well below what was to be expected of one holding his office and responsibility, and receiving his remuneration.
(b) Findings and Conclusions
(i) The Board did not adequately involve itself in the recruitment of senior executives.
(ii) The Managing Director displayed a lack of understanding of the role and functions of Human Resources Management, and of the need for common procedures and standards across the organisation.
(c) copied to "5" of hand written notes
(iii) The skills of the staff of the Bank were inadequate for the efficient and successful conduct of the business of the Bank. This widespread lack of banking skills, experience, and expertise led the Bank to enter into transactions which lacked intrinsic merit, and which were not appropriately reviewed for soundness and quality. It thus contributed to the Bank's position as declared in February 1991, and to the Bank's holding substantial assets which are non-performing.
(iv) The Managing Director adopted an informal, secretive and subjective method of assessing the performance of senior executives, which vitiated and undermined the integrity of the process of the promotion and placement of senior executives in the organisation, and of their remuneration setting.
(v) In spite of the Bank's and Bank Group's substantially reduced profits, and the alarming growth in non-performing assets in 1989 and 1990, significant increases in salary and remuneration and substantial bonuses were granted to senior executives in those years, on the recommendation of the Managing Director and with the approval of the Board.
(vi) The Board failed adequately and properly to supervise, direct, and control the processes of remuneration setting and adjustment, and bonus determination in that, by delegating as it did to Mr Clark, it permitted the existence of a process of approval of remuneration increases and of bonuses which lacked adequate justification.
(vii) The processes which led to the Bank or a member of the Bank Group to engage in operations which have resulted in material losses in the Bank or members of the Bank Group holding significant assets which are non-performing, included the monitoring and review of the performance of senior executives. These processes were neither appropriate nor adequate to ensure the effective guidance and control of these executives in the exercise of their duties.
(viii) The continual and far-reaching upheavals of the structure of the Bank were presumably affected in order to enable it to meet the demands of a swiftly expanding business. These changes prevented the development of both the infrastructure and the skills that would have assisted the Bank better to control the quality of its lending, and thus to limit the extent of unsafe and imprudent lending decisions.
(ix) Neither the Board of Directors nor the Chief Executive Officer adequately or appropriately supervised, directed and controlled the operations and affairs of the Bank with respect to the management of its senior executives.
1.7.9.2 The Relationship Between the Board and the Chief Executive (Chapter 21)
(a) Overview and Summary
Under the governance of the Board, the Chief Executive Officer was responsible, through delegated powers and authorities, for the day-to-day management of the affairs of the Bank.
This day-to-day management took place through a range of functionaries, the most important of whom reported directly to Mr Clark.
Throughout the period under review, numerous deficiencies existed in the management of the functions performed. The existence of those deficiencies called into question the quality of Mr Clark's management, and the manner in which the Board directed, controlled and monitored his actions.
The Board failed to exercise its authority and the appropriate degree of control over the activities of Mr Clark, and in so doing allowed the Bank to engage in operations which resulted in material losses and to hold significant assets which are non-performing.
Mr Clark was initially appointed by the Board to fulfil a specific and time-limited mandate (from 1984 to 1987), focused on the execution of the merger and the setting of the new Bank on a commercial footing and the establishment of a management team for the Bank's operations. Beyond 1987, it was envisaged that a longer-term Chief Executive Officer would be appointed.
Mr Clark was selected primarily for his suitability to fulfil that first mandate; he had had prior merger experience, acquired during the part he played in the merger of the Commercial Bank of Australia Ltd with the Bank of NSW, which led to the formation of Westpac Banking Corporation. However, he had limited experience in mainstream banking operations. The Board was aware of his lack of experience both in mainstream banking and as a chief executive officer. This lack of experience combined with a personality directed towards aggressive expansion, made for a profile that needed "balancing", "controlling" or "restraining".
However, satisfied with the early performance of Mr Clark (ie between 1984 and 1986), the Board did little to develop any succession plans, and re-appointed Mr Clark in May 1986, before the expiry of his first contract, for a further term, ie until June 1989.
No formal assessment of the performance of the Chief Executive Officer was conducted prior to the renewal of his contract, and no new mandate was imposed on him. At no time did the Board state its expectations of the Bank, or of its Managing Director, other than those of increased growth and profitability for the organisation. The means by which those ill-defined goals were to be achieved were left, in essence, to the Managing Director to determine.
The stance of the Board in this regard is incompatible with its responsibilities under Section 16(2) of the State Bank Act particularly in the light of later comments made by Directors that Mr Clark was " running riot " on the Board or taking the Bank on a " destructive path".
In February 1988, more than one year before his second contract was due to expire, the Board again renewed his engagement, this time until June 1992. Again there was no revised or substitute brief.
This time however,the decision regarding re-appointment was the object of some opposition,with questions being raised as to Mr Clark's suitability for the longer haul. In the words of Mr R D E Bakewell:
" ... it was time to cut the painter and do something else ".
The decision to reappoint Mr Clark was due as much as anything else to the lack of an available successor within the Bank. That this situation was allowed to arise is indicative of the fact that the Board, prior to 1988, paid only casual attention to the issue of succession planning and was ill-prepared to address the matter in any structured fashion in February 1988 when the issue arose.
This is so, despite the fact that, had it chosen to do so, the Board had ample opportunity to familiarise itself with the ability and aptitudes of the senior executive team. From 1988 onwards there is ample evidence that the Board was increasingly dissatisfied with the performance of Mr Clark. With regard to the specific actions of Mr Clark in 1989 and 1990 the file notes of Mr Simmons record adverse criticisms of:
(i) Mr Clark's handling of the provisioning for the Hooker account;
(ii) the expected level of profits for 1989;
(iii) the difficulties with Beneficial;
(iv) the REMM, Equiticorp and National Safety Council of Australia accounts;
(v) the acquisition and subsequent management of Oceanic Capital Corporation and United Building Society;
(vi) the establishment of an audit committee; and
(vii) the appointment of staff with suitable financial management skills:
to name but some of the salient ones.
With regard to his management style and attitude, Mr Simmons' notes record trenchant adverse criticism of Mr Clark on issues such as the information provided to the Board, his dismissive stance towards the Board which reduced that body to the role of a " rubber stamp" or " a plaything " over which he could " run riot ", his failure to accept questioning or suggestions from the Board, his failure to act upon suggestions from the Board with required diligence and lastly his failure to accept the practical exercise by the Directors - and the Chairman in particular - of their responsibilities as members of the Bank's " governing body".
Many of the Directors interviewed in the course of the Investigation repeated these criticisms and expanded upon them in instances too numerous to quote.
In face of such strong and increasing displeasure, I am critical of the Board's action in three respects: first, it did not formally and regularly monitor and control the performance of the Chief Executive, whether as a necessary process in its own right, or as part of an obligatory remuneration review process; secondly it did not confront him with a number of its serious concerns with a view to having those rectified in a forthright and expeditious manner; and thirdly, it failed to exercise its authority and control over the activities of the Managing Director, thus allowing an inappropriate and damaging relationship to exist from 1988.
I have also considered in some detail the remuneration of Mr Clark and the processes which applied to its determination.
The remuneration setting process as it applied to Mr Clark was one undertaken primarily by the Chairman (either alone, when Mr L Barrett was Chairman or as part of a sub-committee when Mr Simmons was Chairman) and Mr Clark, with the result that their deliberations were presented to the Board for practical purposes as a "fait accompli".
At no time was the Board process anything other than an informal one; nor did it provide a consistent basis for decision making given the virtual absence of any form of records or documentation regarding the deliberations carried out and conditions set by the Board.
The remuneration of Mr Clark, as is often the practice for senior executive salaries, comprised two elements: a base salary and a range of benefits packaged so as to be tax effective. Although the types of benefits paid to Mr Clark varied to a small extent over the years, their value increased substantially.
By way of example, the first service agreement entered into between Mr Clark and the Bank provided the following benefits, in addition to the base salary: a fully maintained motor vehicle with the option to purchase the same at book value at the termination of the appointment; an interest free housing loan; a sum for expenses in the performance of business duties; a range of other lesser benefits (removal expenses, first class travel and accommodation while on business, annual leave entitlements) and so on. In addition this agreement provided for payment by the Bank of a sum initially equal to 24 per cent (but subsequently varied by agreement) of salary, in a fully vesting superannuation fund.
In subsequent years the range and structure of benefits were modified or expanded. For instance after the negotiation of Mr Clark's housing requirements in 1986, the Bank agreed to the provision of a house costing up to $650,000 at a rental of $20,000 per annum.
From 1988 onwards, Mr Clark also entered into a bonus scheme based on the achievement of budget and over budget profits by the Bank. These bonuses did not form part of the total remuneration package and represented amounts paid over and beyond salary and other benefits.
The remuneration paid to Mr Clark from 1988 (at the time when problems with the Bank were beginning to emerge) is disquieting.
In 1988 his salary was increased by $70,000 and his benefits and allowances increased by a further $70,000, making a total remuneration package of $400,000.
In addition, the Board approved the implementation of a results-based bonus plan for Mr Clark whereby he would be entitled to a bonus of $30,000, $45,000 or $60,000 should the State Bank Group meet the budgeted profit target of $60.0M, or exceed it by $5.0M or $10.0M respectively.
For the financial year ended June 1988 the Bank reported an increase in operating profit of 36.0 per cent over its 1987 results, but for the first time the accounts also showed a startling leap in the level of bad debts written off, and a provision for doubtful debts of nearly $7.0M.
In 1989 Mr Clark's salary increased by nearly $56,000 or 40 per cent. The benefits and allowances component was increased by $46,000 for a total remuneration increase of approximately $102,000.
In addition to the increase in remuneration described above, and in accordance with the bonus plan described earlier, Mr Clark received a bonus of some $49,000 based on the Group having achieved an operating profit of nearly $70.0M in the year ended 1988.
The provision for doubtful debts in 1989 represented a 290 per cent increase over that in 1988. The Bank reported a $56.0M item for net bad debts written off. In 1990 Mr Clark's salary was increased by $16,000 and his benefits and allowances by some $34,000, making a total remuneration increase of $50,000.
In 1990 the Bank reported a fall in operating profit from $78.0M to $35.0M and an increase in the provision for doubtful debts of over $100.0M.
In response to this the Board resolved to " trim " Mr Clark's bonus (which related to the 1989 year) to $50,000.
As a matter of plain commonsense and business principles, it is impossible to reconcile statements by Board members regarding their mounting concerns about Mr Clark's performance, a rise in key non-performing assets and a 290 per cent increase in the level of provisioning on the one hand and a bonus, however " trimmed", on the other.
Mr Clark resigned from the Bank in February 1991.
It is an inescapable conclusion that between 1988 and 1990 the Board rewarded Mr Clark beyond reasonable expectations and requirements.
(b) Findings and Conclusions
(i) The Board failed to exercise effective control and supervision of the Chief Executive between 1984 and 1989, these being critical years of growth in the Bank's history; and whilst the Board endeavoured to exercise a closer degree of control from 1989 onwards, that endeavour was not, in practical terms, effective, or timely. Once the Board was alerted by the increase in non-performing assets, and other matters, to shortcomings in the Bank's management the Board's efforts to resume control were of limited effect. It was beyond the ability of the Board to reverse the trend in the Bank's performance to the extent necessary to stave off the financial position reported in February 1991.
(ii) The processes which led the Bank to engage in operations which have resulted in material losses, or in the Bank, holding significant assets which are non-performing included the inadequate monitoring and review by the Board of the performance of the Chief Executive.
(iii) The operations and affairs of the Bank were not adequately or appropriately supervised, directed and controlled by:
. the Board of Directors of the Bank; and
. the Chief Executive Officer of the Bank.
1.7.9.3 Executive Information Management at the State Bank (Chapter 22)
(a) Overview and Summary
A key requirement for managing any business, and particularly that of a bank, is the availability to the Board of Directors and senior management of accurate, reliable and timely information relevant to the risks faced by the business. The information required by the Board of Directors and by management will be different, according to their different functions in the governance and management of the business. It is critical, though, that the business have information systems in place to collect, collate and summarise that information critical to managing business risk.
Various Chapters of this Report identify and describe, in considerable detail, where the information systems of the Bank failed. Shortly stated, the Bank's Board of Directors and management did not have some critically important information that was essential to running the Bank. For example, it was not until 1990 that the Bank was able to measure its total exposure to commercial property, an exposure that was a material cause of the Bank's losses. Deficiencies in the information flows relevant to the management of the Bank's assets and liabilities meant that its growth was unconstrained by considerations of the cost of funds and prudent liquidity management.
The Board and management recognised, from the time of the formation of the Bank in July 1984, the need for adequate and reliable information systems, including those for measuring risk across all divisions of the Bank. Mr Clark referred to this need in his memorandum recommending the 1985-1986 profit plan to the Board of Directors. The strategic plan approved in 1985 referred to the need for information systems that would withstand the scrutiny of the Reserve Bank, including systems needed for asset and liability management. In a paper presented to the Executive Committee in October 1985, the Acting Chief Manager Planning, Mr Guille, pointed to the need to establish systems for the Bank-wide monitoring of exposures to customers, industries and geographic areas.
Despite this awareness - an awareness reinforced by regular advice from the Reserve Bank - the Bank's information systems were inadequate. This inadequacy resulted in critical information deficiencies that contributed to the Bank's failure.
There were two basic causes of the deficiencies in the Bank's information systems:
(i) The first was the Bank's very rapid growth and diversification of its operations from the time of its formation in 1984. Put simply, the Bank's development outpaced the ability of its information systems to cope. While the Bank developed quickly from an essentially retail bank with its operations limited to South Australia to become a diverse financial group with operations around the world, its information systems did not keep up. The Bank's Board of Directors and Management did not restrain the growth of the Bank to a level that could be prudently managed.
(ii) The second cause related to the Bank's organisational structure. The various business units of the Bank were given considerable autonomy to plan and manage their business activities, including expenditure on information technology. The Bank's Information Systems department, headed by Mr Macky, operated as a service department to meet the needs of the various business units, as identified by those units. The result was that the Bank lacked a coherent, Bank-wide information system that could collect and collate information on a Bank-wide basis.
The Bank's Management received repeated warnings of the importance of adequate information systems, and of the inadequacies of the Bank's existing systems. Indeed, the Bank's strategic plan approved by the Board of Directors in 1986 stated that "the huge internal and external technological requirements being placed on the Bank are currently outgrowing its capacity to satisfy them ... this situation may become extremely dangerous" .
A Reserve Bank diary note dated 24 October 1985 recorded that the Bank's executives were "conscious of the risks inherent in diversifying their business rapidly and of the need for adequate management systems to control those risks" .
A year later, in September 1986, Mr Clark is recorded by the Reserve Bank as acknowledging that the Bank had "a lot of catching up" to do in its management information systems. In March 1987, the joint auditors of the Bank warned that, in their opinion, the Bank had "not yet come to terms with the data management, systems controls and personnel expertise required to provide adequate internal control over the exposures created by operating in global deregulated markets, rather than the Bank's historically familiar locally controlled domain" .
Steps were taken in late 1988 by the Board and by Management to address the information systems deficiencies, particularly relating to the absence of information regarding the risks faced by the Bank on a Bank and Group-wide basis.
On 1 July 1989, a specialised Group Risk Management division was established, headed by Mr Matthews, to devise and implement systems to collect and collate information from across the Bank, and the Group, regarding the risks that the Bank faced. Progress, however, was slow, due in part to the disparate systems that had been established by the Bank's various business units. Accordingly, development was evolutionary, and no regular reporting system was in place until the end of 1990.
The group risk management initiative taken in 1989 was very necessary. It was, however, too little, too late. The Bank had been growing, and growing rapidly, for more than four and a half years. During that time, its information systems had been inadequate, resulting in critical information deficiencies. By the time action was taken, the damage had been done.
(b) Findings and Conclusions
(i) The information systems deficiencies of the Bank were among the matters that caused the financial position of the Bank as reported in February 1991.
(ii) Far too little attention was paid by the Board of Directors, the Chief Executive Officer, and Management, to the need to constrain the growth of the Bank to that which could be prudently monitored and managed. Either the growth of the Bank had to be slowed, or much more significant resources needed to be devoted to the development of adequate information systems. Neither happened.
(iii) The Board of Directors was aware, or should have been aware, that some critically important information was not being provided to them. Information regarding the Bank's total exposure to commercial property is the most significant example. The Board knew, too, that the Bank was growing very rapidly - well in excess of that which was budgeted - and had seen repeated references in the strategic plans to the need to improve the Bank's information systems. Despite these warning signs, the Board took no effective action to ensure that the Bank's information systems were adequate.
(iv) The Bank's senior managers, including Mr Clark, who were involved in prudential consultations with the Reserve Bank, heard the repeated expressions of concern from the Reserve Bank regarding the need for adequate information systems. Management did not react to those expressions of concern, and did not pass them on to the Board of Directors.
(v) Mr Clark, as Chief Executive Officer of the Bank, did not give sufficient attention to the Bank's information systems requirements. If nothing else, it should have been apparent to him that some important information critical to the management of the Bank was simply not available.
(vi) The operations, affairs and transactions of the Bank were not adequately or properly supervised, directed and controlled by the Board of Directors and by the Chief Executive Officer of the Bank. Both failed to take adequate steps to ensure that the Bank's information systems were reasonably appropriate to the rapidly changing nature of the Bank's operations.
1.7.10 INTERNAL AUDIT OF THE STATE BANK (Volume XI - Chapter 23)
(a) Overview and Summary
Internal Audit is an organisational function designed to assist management to achieve the most efficient operation of the business, by determining whether the system of internal controls is functioning effectively in all units of the entity.
There was rapid and significant growth and diversification in the Bank's assets over the period under review. The growth of the Bank's assets overseas is, in one sense, more dramatic than that on-shore as the Bank's overseas assets grew from some $200.0M as at December 1985 to $5,270.0M as at February 1991. This called for a standard of internal audit that was responsive and capable of assessing the emerging risks and exposures associated with such rapid growth and diversification.
At the time of the establishment of the Bank, the internal audit function was essentially a "tick and check" function, with that Department's attention being focused primarily on a branch network and computer systems issues arising out of the merger. In the early years after the Bank's establishment, Internal Audit recognised the need to include as part of the audit programme, the operational and systems issues arising from the merger itself.
Mr H Gates a former head of Internal Audit in the Bank, gave evidence that:
" ... in the first years - at least 3 years - it was just a battle to stay afloat for the organisation because of the large unprecedented, or how we say, astronomical growth and totally inadequate system. "()
Over time, the Internal Audit department moved to focus attention on the high risk areas of the Bank's operations, namely, Corporate Banking, International Banking, and Treasury. There were a variety of deficiencies in the Internal Audit coverage of these high risk areas. These deficiencies included: its approach and methodology; its inability to gain access to certain information, and its lack of resources and expertise.
For the whole of the period under review, the Internal Audit department reported to a divisional executive who was also potentially an auditee. This situation gave rise to the possibility that the independence of the Internal Audit department could be compromised.
Whilst there is no evidence of any interference in or compromise of the department's functions, such a reporting line is structurally unsound especially in a State Bank with public responsibilities.
The internal audit coverage of the Bank's overseas operations has been of particular concern to me. From January 1985 the Bank actively pursued a strategy of growth and diversification overseas. The materiality, mix of assets and rapid growth in overseas operations, together with their remoteness from South Australia, demanded the highest achievable standard of control to be exercised over their operations. Internal audit was a critical element of management control in this matter. The growth and diversification of the overseas branches and the difficulties for effective management of these operations called for the introduction, at an early stage, of an adequate and appropriate internal audit `on-site' activity.
In October 1987 the Reserve Bank of Australia had expressed directly to Mr Clark its concern about monitoring of internal control systems in the London branch. In May 1988 the Reserve Bank advised Mr Matthews of its concerns for the effectiveness of internal control systems given the bank's growth particularly in overseas operations.
The London branch commenced its wholesale banking operations in October 1985 . The first time an Internal Audit department review of that office was conducted was in April/May 1989. By this time the London branch assets had grown to approximately GBP 540.0M providing full wholesale banking services with particular emphasis on off-balance sheet trading, corporate lending and foreign exchange.
Hong Kong operations were commenced in April 1987 . The first internal audit review was not carried out until June 1990.
The New York branch was opened in November 1988. The first internal audit review of the operations of that office occurred in May 1989 by which time the total assets of that office had grown to $US 483.0M (as against a budget of $US 240.0M).
It was put to me that the external auditors could be relied upon by management in reviewing internal systems and controls in a general sense. However, representations from the external auditors in their letters of engagement made it clear to management that the Bank was not entitled to rely upon the external auditors as a substitute for an effective internal audit function in respect of the overseas branches.
The seriousness of management's failure to ensure an adequate and appropriate internal audit function for the overseas branches of the Bank is compounded by the fact that no asset quality review was conducted by any function independent of management until mid 1990. This failure demonstrated a lack of appreciation that the State Bank was an institution that was publicly accountable to the people of South Australia and that the highest standards of internal review and accountability should have been operative at all times.
The absence of on-site audit of the overseas branches by the Internal Audit department, and in particular London until May 1989 and the failure to actively monitor and be satisfied as to the effective discharge of this responsibility is a substantial failure by the Bank Board, Mr Clark and Mr Matthews in relation to their respective duties to the Bank.
In the case of corporate banking, it was not until June 1990 that the Internal Audit department undertook an overview survey of the Corporate Banking department for the purpose of identifying the auditable areas of risk and to formulate audit plans for subsequent review of those risk areas. Lending increased in this area from $400.0M in 1984 to $5,000.0M at June 1990.
The Internal Audit department's involvement in the asset quality issues in the corporate banking area was a matter of substantial contention between Mrs M Chin (Manager - Internal Audit) and Mr Paddison (Chief General Manager - Australian Banking). Mr Paddison's opposition to Internal Audit department's review of " asset quality " in corporate banking, coupled with his failure to secure a review of " asset quality " by a function independent of management, reflects adversely on the discharge by Mr Paddison of his responsibilities for the prudential management of this portfolio. His actions do not reflect what would be expected of a senior executive on an important matter of accountability.
The failure by management to secure an adequate and appropriate internal audit coverage of the high risk areas of the Bank's operations, namely Corporate Banking, International and Treasury until the times indicated in this Report is a substantial non-compliance with management's obligations to ensure the protection of the Bank's assets and the maintenance of an effective and relevant internal control system. Management was too busy concentrating on growth and profits to worry about the prudential controls necessary to ensure the protection of the Bank's assets.
Another telling example of management's failure in relation to internal audit can be seen when an operational review was prepared in September 1987. This highlighted significant organisational, staffing and operational concerns. That review was not presented to the Bank Board. An internal audit half-yearly report for the period ended 31 December 1987 was presented to the Board but it did not provide to the Board any details of the concerns identified in the operational review.
The failure by Mr Clark and Mr Matthews to report the findings of the operational review to the Bank Board deprived the Board of the opportunity to give directions to management for remedying the identified deficiencies.
The importance of the need to give urgent attention to these findings, can hardly be overestimated, given that the deficiencies were associated with areas of the highest risk. Mr Clark as the Chief Executive Officer, should have been aware of the need for a greater level of urgency in attending to the deficiencies in the Internal Audit department. He failed to demonstrate an appreciation of the critical importance of the need for a comprehensive and effective internal audit function within the Bank and remained indifferent to the shortcomings identified in the reports.
Mr Matthews was the executive responsible for the Internal Audit department. The striking feature of his management is the absence of a sense of urgency in bringing Internal Audit "up to the mark". He, like Mr Clark, failed to respond with the required level of urgency, to deal with the issues. Accordingly, he failed to demonstrate an appreciation of the critical importance of the need for a comprehensive and effective internal audit function within the Bank.
Having regard to the Bank's growth and diversification, the Bank Board did not take a sufficiently active interest in the internal audit function. It was placated by management assurances in circumstances when a vigilant Board, probing those assurances, would have elicited information to demonstrate that there were serious gaps in the internal audit coverage of important risk areas within the Bank. The deficiencies with respect to internal audit were of a serious nature having regard to the type of business being transacted by the Bank .
(b) Findings and Conclusions
(i) The processes relating to the discharge of the internal audit function were not appropriate and were not adequate during the periods indicated in this Chapter. When taken into account with other functional deficiencies the failure of the Internal Audit function, was a contributing factor to the Bank's losses and the holding of significant non-performing assets.
(ii) The operations, affairs and transactions of the Bank with reference to the Internal Audit function were not adequately or properly supervised, directed or controlled by the Board of Directors of the Bank, Mr Clark and Mr Matthews. The operations, affairs and transactions of the Bank with reference to internal audits of corporate banking, were not adequately or properly supervised, directed and controlled by Mr Paddison.
(iii) The information and reports given by Mr Clark and Mr Matthews to the Bank Board were not, under all the circumstances, timely, reliable and adequate and were not sufficient to enable the Board to discharge adequately its functions under the Act.
1.7.11 OTHER MATTERS CONSIDERED (Volume XII - Chapters 24 to 26)
1.7.11.1 State Bank Centre Project (Chapter 24)
(a) Overview and Summary
In November 1985 the Bank decided to exercise options which it held on three properties at 91 King William, 19 Currie and 23 Currie Street. It convened a project team to proceed with development of the site to accommodate a multi-storey building, that would become the headquarters of the Bank and a landmark in the City of Adelaide.
The Bank's representative on the project team was Mr K P Rumbelow, who was at the time, Chief Manager Administrative Services. (He subsequently became Chief Manager-Property). Few of the members of the planning group had been concerned in the construction of a building of similar size to the proposed building. The Bank's adviser, Baillieu Knight Frank (SA) Pty Ltd, whose representative was also on the planning group, was strongly of the opinion (accepted by the Bank) that the construction of the Centre had to be completed and ready for occupation by the end of 1988. It was said that the Centre had to be completed before several other large buildings, eg the ASER development on North Terrace and a building at 45 Pirie Street, so that the Bank could take advantage of anticipated demand for high quality premises.
This perception was important because it influenced the project in a number of significant ways.
The most important consequence was the decision made to construct a building by what has been called " a fast track " method. In essence, it meant that the construction work had to be commenced before all the technical documents were done. There was a degree of risk in employing such a method.
The estimated net cost at the beginning of 1986 was $82.0M. In March 1986, the Board resolved to proceed on a construction management basis, which was part of the fast track method. This method meant the Bank would be proceeding with a project for which the final sum was not set. The Board, however, when it resolved to proceed on this basis, had been informed that the quantity surveyors had indicated a possible 2.25 per cent overall cost saving by following this construction management method.
The Board resolved to embark on a project to construct a building of a size that had never before been built in this State. With the exception of advisers from Construction Services (SA), none of the project team had been involved in a building project of this magnitude. The project, it was perceived, had to be finished before the end of 1988 to meet a " window of opportunity ". The Bank sought no formal second opinion about whether such a "window of opportunity" existed.
Having regard to the nature of this project, it would have been prudent to have obtained a second formal opinion. If there was no such " window of opportunity " it would have been unnecessary to complete the project by the end of 1988, and therefore a fast track method would not have been necessary and more detailed planning could have been completed before the commencement of construction. Neither management nor the Board requested an independent audit of cost estimates for the project. Such an audit review would have been prudent because there was a substantial risk of cost escalation from the fast track method.
However, the decision to proceed with the project was a commercial decision made by the Board on expert advice.
Mr Rumbelow was the Bank officer responsible for making final decisions about this very large construction project. I do not doubt his integrity and application but he had negligible experience in building construction, his only previous experience with building construction being related to Bank branch buildings. From the very nature of such a project, the Bank should not have left it to the consultants alone to advise, but rather should have appointed an appropriately experienced project manager for and on behalf of the Bank. Such a person would have been equipped to deal with whatever advice was received and wherever necessary to make independent judgments on behalf of the Bank. Not only should the Bank not have allowed Mr Rumbelow with his lack of experience in this complex area to make important decisions on its behalf, but the respective responsibilities of the consultants should have been more clearly defined.
Thus, in my opinion the management structure for the project was inadequate.
In July 1988 the Board considered a paper submitted by the project control group that indicated that the total development outlay, would then be approximately $120.0M. Following this, the Board agreed that the Bank would establish an independent inquiry into the management and the `cost blow out' of the project. This inquiry was to report its findings to the Board.
Mr T Ellis, an independent building consultant, with management experience of multi-storey building projects, was appointed to perform that inquiry. He reported his findings two months later. Those findings corroborate the view that I have expressed about the inadequacy of the management of the project. By that late stage, however, there was very little effective action the Board could have taken.
At the outset the Board resolved to establish a tax effective off-balance sheet company structure for the purposes of financing the project.
Whilst the cost of funds raised under the eventual financing package was considered to be lower than could be obtained by other means, the financing package was based upon a number of assumptions that could have reasonably been expected to vary. The impact of such variation should have been considered more carefully. Ultimately, the underlying assumptions did vary. This resulted in substantial additional cost to the Bank; the total cost cannot be ascertained until 1996 because of the funding arrangements.
Correspondence provided to me illustrates the inadequate monitoring of the financing package by the Bank and the lack of appropriate communication between Beneficial Finance and the Bank when it must have become aware that the "assumptions" had varied.
This inadequacy was unacceptable and negligent because the Bank was carrying the risk of an underlying guarantee to external financiers. Current indications are that this will result in significant losses to the Bank. This should have moved the Bank to seek a full and detailed understanding of the financing arrangements.
Doubts still exist as to certain taxation matters which are not discussed in detail in this report as they have not yet been dealt with by the Commissioner of Taxation.
The consequences of this development have been:
(i) Funds totalling $23.5M advanced by the Bank to the off-balance sheet associated entities were designated non accrual from October 1990.
(ii) The Bank is subsidising entities associated with the State Bank Centre on an annual basis in consequence of a deficiency of income to outgoings, ie total annual expenses exceed rental received.
(iii) The tax structured financing package has not been as effective as originally planned owing to changes in corporate tax rates and capital gains tax issues which can be resolved only in 1996. It is only then that the finance package will be finalised and when the Commissioner of Taxation assesses the financiers of the project. As the financiers had an agreed after tax rate of return this has resulted in a substantial increase in the anticipated final cost to the Bank.
(iv) Significant doubts still exist on certain capital gains tax matters which affect the ultimate payment (compensatory payment) required to be paid to the financiers by April 1996. This payment is guaranteed by the Bank.
(v) Original predictions for a significant capital gain for the Bank should the land and building be sold have been replaced by an expected loss if sold, or if in April 1996 the amount of the compensatory payment exceeds the market value. At 30 June 1991 the estimated compensatory payment was $154.2M whilst the market value of the building at that date was $93.4M.
(b) Findings and Conclusions
(i) The processes that led the Bank to acquire a significant asset that is non-performing, ie the State Bank Centre, were inappropriate and the management of the Bank neglected to ensure that the Bank's interests were adequately protected.
(ii) The operations of the Bank were not adequately or properly supervised, directed and controlled by the Board of Directors and the Chief Executive Officer of the Bank.
1.7.11.2 Securities Dealings (Chapter 25)
(a) Overview and Summary
In November 1984 the Board resolved that the Bank participate in the purchase of shares and the underwriting of share issues subject to certain guidelines and restrictions.
By dealing in shares the Bank exposed itself to a number of attendant risks. They were:
(i) First, the risk of losses.
(ii) A potential loss of objectivity in the conduct of the Bank's lending to those companies in which it acquired shares; and
(iii) Importantly where the shares traded were those of a borrower from the Bank, the Bank, if appropriate procedures were not in place, might breach the insider trading provisions of the Securities Industry Code.
At least up to July 1990 no effective system had been put in place to ensure that the Bank met important requirements of the Code despite the obvious risk that the insider trading provisions might have been breached inadvertently.
The inadequate state of documentation made available to me with respect to approvals of share purchases has made it impossible to determine whether all share transactions were properly authorised or provisions of the Code breached.
(b) Findings and Conclusions
The Bank's procedure for dealing in securities were inadequate.
The Bank's trading in securities was not adequately supervised, directed and controlled by the officers and employees of the Bank.
1.7.11.3 Dealings Between State Bank and Equiticorp (Chapter 26)
(a) Overview and Summary
Mr Clark was the Chief Executive Officer and Group Managing Director of the Bank Group. He was also the director of various companies in the Equiticorp Group. Because of that fact, but more particularly because the Equiticorp Group was a significant customer of the Bank Group before the Equiticorp Group's highly publicized collapse in January 1989, the dealings between the Bank Group and the Equiticorp Group have been the subject of inquiry pursuant to paragraph A(h) of my Terms of Appointment.
In examining those dealings, one area of focus has been the conduct of Mr Clark. He was under a duty to avoid a conflict of interest. Mr Clark had to ensure that he did not allow a situation to develop where his duty to the Bank Group conflicted with, or appeared to conflict with, his personal interest in the Equiticorp Group.
Some of the Bank Group's more significant dealings with Equiticorp are to be seen in the light of a major transaction that occurred in New Zealand in the period from late 1987 through to March 1988.
The Equiticorp Group purchased shares in New Zealand Steel Ltd, to the value of $NZ 327.0M only a matter of days before the stock market crash of October 1987. The effect on Equiticorp was that it was obliged to pay approximately $NZ 3.00 for shares that were now valued at approximately $NZ 1.00 per share.
There are other notable features of this transaction ("the New Zealand Steel Purchase"):
(i) the shares were purchased from the New Zealand Government, and represented 89 per cent of the issued share capital of New Zealand Steel Ltd;
(ii) Equiticorp paid for the shares by issuing 92.9M shares in Equiticorp Holdings Ltd to the New Zealand Government, at $NZ 3.52 per share;
(iii) The New Zealand Government did not propose to hold those Equiticorp shares as a long term investor. An integral part of the share sale and purchase arrangements was that a local firm of stockbrokers would either purchase or procure the purchase of the 92.9M Equiticorp shares, at a price of not less than $3.52 per share, on or before 20 March 1988 ("the Take-out Agreement");
(iv) The Take-out Agreement provided that, if the stockbrokers could not purchase or procure another purchaser, two companies controlled by the then Chairman of the Equiticorp Group (Mr A Hawkins) would purchase the shares;
(v) It was further agreed that , in the event Mr Hawkins' companies became obliged to purchase the shares, Equiticorp Group companies would lend the necessary funds to those companies to finance the $NZ 327.0M share purchase;
(vi) In the event, one of Mr Hawkin's companies was required to purchase the shares for $NZ 327.0M. Of that sum, $NZ 222.0M came from within the Equiticorp Group;
(vii) When ownership of New Zealand Steel Ltd passed to the Equiticorp Group, it was no longer supported by New Zealand Government ownership. Significant credit facilities were, accordingly, discontinued by several Japanese banks. That created a pressing need for working capital and liquidity quite apart from funding the $NZ 220.0M share purchase; and
(viii) A Board Paper presented to a meeting of directors of Equiticorp Holdings (including Mr Clark) held on 27 October 1987, records that there was an anticipated cash outflow, in March 1988, of $NZ 327.0M. A Board Minute of that meeting records that the Board was told a major cash flow issue was "the funding of the New Zealand Steel payment on 20 March 1988".
Bearing those features of the New Zealand Steel Purchase in mind, I turn to look at what was happening in Adelaide at about that time in relation to the Bank Group's relationship with Equiticorp.
In the period December 1987 to end March 1988, the Bank Group was involved in four major transactions involving the Equiticorp Group that are remarkable not only because of the large amount of money involved, but also because they were all either ineptly managed (often as a result of being pursued with inexplicable haste), or they were inappropriately and artificially structured by management so as to avoid prudential considerations (such as prior consultations with the Reserve Bank and large exposure policies), or both. Those four transactions are, in very brief outline, as follows:
(i) During December 1987 to March 1988, the Bank purchased, for $60.0M, a funds management and insurance business - Oceanic Capital Corporation. Mr Clark introduced the transaction to the Bank knowing that Equiticorp had a loan facility in place with the owner of Oceanic Capital Corporation. He was also aware that Equiticorp would receive significant funds directly from the sale proceeds. The due diligence performed by Bank management was inept. Important conditions stipulated by the Board were not adhered to. The Board was informed that the owner of Oceanic Capital Corporation did have a time pressure because it had debts outstanding requiring settlement by the end of March. The Board was not informed that that debt (nearly half the purchase price) was owed to the Equiticorp Group.
(ii) In December 1987 the Bank lent Equiticorp $200.0M using a facility that was structured in a highly unusual way, designed to circumvent the requirements of the Reserve Bank, and, in particular, designed to ensure that Equiticorp received the funds urgently. Of this amount, $150.0M was ostensibly for the `purchase', by the Bank, of Equiticorp receivables. These receivables were `re-purchased' by Equiticorp after the agreed term of 30 days. Bank management (without the awareness of the Board) arranged the facility in that way in the face of previous advice and warnings from the Reserve Bank, and despite external legal advice that the Bank was not adhering to normal prudential requirements.
(iii) In January 1988, the Bank agreed to repeat the above described `asset-purchase facility', this time for a standby amount of $100.0M for consecutive terms of thirty days for a total term of six months. Although this was recommended to, and approved by the Board, management decided not to proceed with the offer when the Bank's legal department repeated the same concerns that had been expressed (by external advisors) during the December transaction. Further concerns were recorded in writing within the Bank's Corporate Lending department, including the Bank's significant exposure to the Equiticorp Group, and the relationship of the Bank's Managing Director with Equiticorp.
(iv) Following Bank management's decision not to proceed with the above described January 1988 asset purchase facility, Beneficial Finance, using subsidiaries of off-balance sheet companies, purchased five portfolios of receivables from the Equiticorp Group. These purchases, concluded before the end of March 1988, resulted in the injection into Equiticorp of something in excess of $NZ 220.0M.
Another of the transactions reviewed is a useful illustration of Mr Clark's dominating influence within the Bank Group.
Late in 1988, when it had been clear to Mr Clark for some time that the Equiticorp Group was experiencing financial difficulties, Mr Clark approached Beneficial Finance with the request that Beneficial Finance assume $10.0M of the Bank's exposure to Equiticorp. Beneficial was to receive a fee of $0.1M.
There was no sensible commercial reason for the transaction. It seems that Mr Clark saw the underpinning as a way of reducing the Bank's book losses. The Beneficial Finance Executive Committee initially objected but eventually consented, albeit reluctantly.
The Investigation focused on two of the transactions; the Oceanic Capital Corporation purchase and the Equiticorp Receivables purchase. The significance of these transactions is not so much that they were made, or that they were consistent with the Bank's strategic objectives, but how the deals came to be made, and when they were made.
It is impossible to resist the inference that the liquidity problems then facing the Equiticorp Group are associated with the events leading to the transactions. Mr Clark has denied it, but, in my opinion, he had a motive to relieve the financial burden on Equiticorp. It is also my opinion that Mr Clark's motive to relieve the financial burden on Equiticorp was founded on his position as a director and shareholder of Equiticorp.
For the reasons set out in Chapter 26 - "Dealings between the State Bank and Equiticorp" , the matters reported may disclose a conflict of interest and a breach of fiduciary duty by Mr Clark. In my opinion, the matters reported should be further investigated.
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APPENDIX
APPOINTMENT (AS AMENDED) OF AUDITOR-GENERAL
UNDER SECTION 25 OF
THE STATE BANK OF SOUTH AUSTRALIA ACT
WHEREAS
(1) I am advised that the Bank has a significant amount of non-performing assets for which there had been inadequate provision by way of specific or general reserves.
(2) I am advised that by reason of the above, the Bank faced substantial financial difficulties which have led to an indemnity being granted to the Bank by the Government.
(3) I am advised that it is in the public interest that the causes of the financial difficulties at the Bank should be identified.
(4) By Instrument dated the 9th day of February 1991 I appointed the Auditor-General to investigate and report on certain matters relating to the Bank.
(5) I am advised that it is desirable that the matters which the Auditor-General is to investigate and report on should be varied.
I, THE HONOURABLE DAME ROMA FLINDERS MITCHELL , Companion of the Order of Australia, Dame Commander of the Most Excellent Order of the British Empire, Governor in and over the State of South Australia acting pursuant to the powers given me by Section 25 of the State Bank of South Australia Act, 1983 and all other enabling powers and with the advice and consent of the Executive Council do hereby revoke the said appointment and now hereby appoint the Auditor-General to investigate and report on the following matters:
A. The Auditor-General is to investigate and inquire into and report on:
(a) what matters and events caused the financial position of the Bank and the Bank Group as reported by the Bank and the Treasurer in public statements on 10th February 1991 and in a Ministerial Statement by the Treasurer on 12th February 1991;
(b) what were the processes which led the Bank or a member of the Bank Group to engage in operations which have resulted in material losses or in the Bank or a member of the Bank Group holding significant assets which are non-performing;
(c) whether those processes were appropriate;
(d) what were the procedures, policies and practices adopted by the Bank and the Bank Group in the management of significant assets which are non-performing;
(e) were those procedures, policies and practices adequate;
(f) whether adequate or proper procedures existed for the identification of non-performing assets and assets in respect of which a provision for loss should be made;
(g) whether the internal audits of the accounts of the Bank and Beneficial Finance Corporation Ltd (and of such other subsidiary of the Bank that the Auditor-General considers should be subject to investigation, inquiry and report under this subparagraph) were appropriate and adequate;
(h) such of the following matters that in his opinion he should investigate, inquire into and report on;
(i) any possible conflict of interest or breach of fiduciary duty or other unlawful, corrupt or improper activity on the part of a director or officer of the Bank or a subsidiary of the Bank; or
(ii) any possible failure to exercise proper care and diligence on the part of a director or officer of the Bank or a subsidiary of the Bank.
The Auditor-General is directed to report on the above matters on or before 30 June 1993.
B. The Auditor-General is to investigate and inquire into and report on whether the external audits of the accounts of the Bank and Beneficial Finance Corporation Ltd (and of such other subsidiary of the Bank that he considers should be subject to investigation, inquiry and report under this paragraph) were appropriate and adequate. The Auditor-General is directed to report on this matter on or before 30 June 1993.
C. The Auditor-General is to investigate and inquire into and report, with reference to the above matters, whether the operations, affairs and transactions of the Bank and the Bank Group were adequately or properly supervised, directed and controlled by:
(a) the Board of Directors of the Bank;
(b) the Chief Executive Officer of the Bank;
(c) other officers and employees of the Bank; and
(d) the Directors, officers and employees of the members of the Bank Group.
The Auditor-General is directed to report on the above matters on or before 30 June 1993.
D. The Auditor-General is to investigate and inquire into and report, in relation to the matters set out in paragraphs A and B above, whether the information and reports given by the Chief Executive Officer and other Bank officers to the Board of the Bank:
(a) were under all the circumstances, timely, reliable and adequate;
(b) sufficient to enable the Board to discharge adequately its functions under the Act.
The Auditor-General is directed to report on the above matters at the same time as he reports in relation to paragraphs A and B above respectively.
E. Having regard to the material considered by him in respect of the matters set out in paragraphs A to D above, the Auditor-General is in any report on such matter, to report on any matters which in his opinion may disclose a conflict of interest or breach of fiduciary duty or other unlawful, corrupt or improper activity and the Auditor-General is to report whether in his opinion, such matters should be further investigated.
F. The Auditor-General is authorised to seek and obtain such advice or assistance on matters relating to banking, accounting and auditing practice relevant to this appointment as he may consider necessary for the purpose of his inquiry.
G. The Auditor-General is directed to provide to the Royal Commission appointed by me on the 4th day of March 1991;
(a) a copy of any report made by the Auditor-General as directed in paragraphs A to D above;
(b) any interim report or any information including relevant documents and records and including any document containing tentative conclusions reached by the Auditor-General on any document containing any information or comment to the Auditor-General by any person engaged to assist him in his report which interim report or information the Royal Commission may seek relating to the matters falling within its Terms of Reference.
H. The Auditor-General is directed in conducting his inquiry and his report so far as practicable to avoid prejudicing pending or prospective criminal or civil proceedings, and to report in part by way of confidential report if he considers it appropriate.
I. The Auditor-General is directed so far as practicable:
(a) in any information provided or report made by him to protect the confidentiality of information which could properly be regarded as confidential information of the Bank or of a member of the Bank Group or of a customer or person dealing with the Bank or a member of the Bank Group;
(b) in any report prepared by him when it is necessary in his opinion to disclose or refer to such information, to present the report in a manner which enables the findings and recommendations in the report to be considered separately from the confidential information, the confidential information where practicable being presented in a separate report or appendix.
J. The Auditor-General is directed to avoid as far as practicable prejudicing or interfering with the ongoing operations of the Bank and the Bank Group.
K. The Auditor-General may perform his functions under paragraphs A, B, C and D by preparing one or more separate reports.
In this Instrument:
"the Act" means the State Bank of South Australia Act, 1983 ;
"the Bank" means the State Bank of South Australia constituted by the Act;
"the Bank Group" has the same meaning as in Section 25 of the Act as amended from time to time;
"operations" of the Bank or Bank Group has the same meaning as in Section 25 of the Act as amended from time to time;
"the report" includes one or more separate reports but unless the context otherwise requires does not include interim reports.
DATED the 28th day of March 1991.
THE HONOURABLE DAME ROMA FLINDERS MITCHELL
VOLUME ONE
REPORT PURSUANT TO TERMS OF APPOINTMENT
AND THE STATE BANK ACT
CHAPTER ONE
CONCLUSIONS, FINDINGS AND RECOMMENDATIONS OF THE INVESTIGATION
TABLE OF CONTENTS
1.1 INTRODUCTION
1.1.1 THE PURPOSE OF THIS CHAPTER
1.1.2 MY TERMS OF APPOINTMENT
1.2 THE FINANCIAL POSITION OF THE BANK
1.3 THE STRUCTURE OF MY REPORT
1.3.1 FINDING THE CAUSE OF THE BANK'S FINANCIAL POSITION
1.3.2 THE ADEQUACY OF POLICIES AND PROCEDURES, AND OF SUPERVISION AND CONTROL, ETC
1.3.3 THE MATTERS ADDRESSED IN MY REPORT
1.4 THE ESTABLISHMENT AND CONDUCT OF MY INVESTIGATION
1.4.1 APPOINTMENT OF THE AUDITOR-GENERAL TO CONDUCT AN INVESTIGATION
1.4.2 EXTENSIONS TO THE TERM OF THE INVESTIGATION
1.4.3 THE RELATIONSHIP WITH THE ROYAL COMMISSION
1.4.4 NATURAL JUSTICE OR PROCEDURAL FAIRNESS
1.4.5 HISTORY OF LITIGATION
1.4.6 MY APPROACH TO TWO KEY CONCEPTS
1.4.6.1 Causation
1.4.6.2 The Standards of "Adequately" and "Properly"
1.5 WHAT WENT WRONG AND WHY: AN OVERVIEW
1.5.1 INTRODUCTION
1.5.2 THE FORMATION OF THE BANK
1.5.3 THE GROWTH AND OPERATIONS OF THE BANK
1.5.4 THE BOARD OF DIRECTORS
1.5.5 THE CHIEF EXECUTIVE OFFICER
1.5.6 THE BANK'S EXECUTIVE MANAGERS
1.5.7 SUMMARY REPORT IN ACCORDANCE WITH MY TERMS OF APPOINTMENT
1.5.7.1 Term of Appointment A(a)
1.5.7.2 Term of Appointment A(b)
1.5.7.3 Term of Appointment A(c)
1.5.7.4 Term of Appointment A(d)
1.5.7.5 Term of Appointment A(e)
1.5.7.6 Term of Appointment A(f)
1.5.7.7 Term of Appointment A(g)
1.5.7.8 Term of Appointment A(h)
1.5.7.9 Term of Appointment C
1.5.7.10 Term of Appointment D
1.6 RECOMMENDATIONS
1.7 MY REPORT ON THE STATE BANK: A SYNOPSIS
1.7.1 INTRODUCTION
1.7.2 DIRECTION-SETTING AND DIVERSIFIABLE CREDIT RISK MANAGEMENT
(VOLUME III - CHAPTERS 4 AND 5)
1.7.2.1 Direction-Setting and Planning (Chapter 4)
1.7.2.2 The Management of the Bank Group's Diversifiable Credit Risk (Chapter 5)
1.7.3 FUNDING, AND ASSET AND LIABILITY MANAGEMENT (VOLUME IV - CHAPTERS 6 AND 7)
1.7.3.1 Funding of the State Bank (Chapter 6)
1.7.3.2 Treasury and the Management of Assets and Liabilities of the State Bank (Chapter 7)
1.7.4 THE MANAGEMENT OF CREDIT (Volume V - Chapter 8)
1.7.5 THE MANAGEMENT OF CREDIT: CASE STUDIES (Volume VI - Chapters 9 to 14)
1.7.5.1 Preliminary Observations
1.7.5.2 Case Study in Credit Management: The Adsteam Group (Chapter 9)
1.7.5.3 Case Study in Credit Management: Celtainer Limited (In Liquidation) (Chapter 10)
1.7.5.4 Case Study in Credit Management: The Collinsville Stud Group (Chapter 11)
1.7.5.5 Case Study in Credit Management: Halwood (Chapter 12)
1.7.5.6 Case Study in Credit Management: Somerley Pty Ltd (Chapter 13)
1.7.5.7 Case Study in Credit Management: The REMM Group (Chapter 14)
1.7.6 RELATIONSHIP WITH THE RESERVE BANK (VOLUME VII - Chapter 15)
1.7.7 THE MANAGEMENT OF ACQUISITIONS (Volume VIII - Chapters 16 to 18)
1.7.7.1 Case Study in Acquisition Management: The Oceanic Capital Corporation (Chapter 17)
1.7.7.2 Case Study in Acquisition Management: United Building Society (Chapter 18)
1.7.8 THE OVERSEAS OPERATIONS OF THE STATE BANK (Volume IX - Chapter 19)
1.7.9 MANAGEMENT ISSUES (Volume X - Chapters 20 to 22)
1.7.9.1 The Management of Senior Executives at the State Bank (Chapter 20)
1.7.9.2 The Relationship Between the Board and the Chief Executive (Chapter 21)
1.7.9.3 Executive Information Management at the State Bank (Chapter 22)
1.7.10 INTERNAL AUDIT OF THE STATE BANK (Volume XI - Chapter 23)
1.7.11 OTHER MATTERS CONSIDERED (Volume XII - Chapters 24 to 26)
1.7.11.1 State Bank Centre Project (Chapter 24)
1.7.11.2 Securities Dealings (Chapter 25)
1.7.11.3 Dealings Between State Bank and Equiticorp (Chapter 26)
1.8 APPENDIX - Terms of Appointment of Auditor-General under Section 25
of The State Bank of South Australia Act 1-120
_______________________________________________________________________________________________
1.1 INTRODUCTION
1.1.1 THE PURPOSE OF THIS CHAPTER
The purpose of this Chapter of my Report is to provide an overview and summary of the Chapters of my Report, and the key findings and conclusions that I have reached and recommendations I have made as a result of my Investigation of the reasons for the financial position of the State Bank of South Australia ("the Bank").
This Report, which is comprised of twenty six Chapters, deals only with those parts of my Terms of Appointment that relate to the operations of the Bank. I will later report separately in respect of:
(a) the reasons for the losses incurred by Beneficial Finance Corporation Limited ("Beneficial Finance");
(b) pursuant to Term of Appointment B, the appropriateness and adequacy of the external audits of the accounts of the Bank and Beneficial Finance; and
(c) other areas upon which it may become necessary for me to report in relation to the Bank at the stage of the finalisation of my whole Report.
This Chapter, it must be emphasised, is intended to present only an overview and summary of my key findings and conclusions. It is essential to read it in the context of the Report as a whole, because it is impossible to fully understand the nature and impact of my Report by only reading this overview and summary. To read this Chapter in isolation would be unfair to many named persons and to the Investigation, and contrary to my intention.
It should be noted too that nothing in this Report is intended to reflect on the comprehensive and dedicated work of the existing Board, executives and staff of the State Bank directed to raising the Bank to the position in the commercial world that is its due.
1.1.2 MY TERMS OF APPOINTMENT
On 9 February 1991, I was appointed by the Governor to undertake an Investigation of the reasons for the financial problems of the Bank and its subsidiaries (together with the Bank, the "Bank Group").
The Terms of Appointment in respect of which I am required to inquire and report are contained in the Instrument by which I was appointed by the Governor, as modified from time to time, and in Section 25 of the State Bank of South Australia Act 1983 ("the Act"). The full text of the Instrument by which I was appointed (as modified) is provided as an Appendix to this Chapter.
Shortly stated, the focus of my Investigation has been upon answering the questions:
. what caused the financial position of the Bank and Bank Group as described in February 1991?; and
. who, or what, is to blame?
The substance of my Terms of Appointment so far as they relate to the Bank can be summarised as follows:
(a) What matters or events caused the financial position of the Bank as described by the Bank and the Treasurer on 10 and 12 February 1991? (Term of Appointment A(a))
(b) What were the processes which led the Bank to engage in operations which resulted in material losses, or the holding of significant non-performing assets, and were those processes appropriate? (Terms of Appointment A(b) and (c))
(c) Were there adequate procedures, policies, and practices for managing the Bank's assets which became non-performing, and for identifying non-performing assets? (Terms of Appointment A(d), (e) and (f))
(d) Were the operations, affairs, and transactions of the Bank adequately or properly supervised, directed and controlled by its Board of Directors, officers and employees? (Term of Appointment C)
(e) Was there any possible failure to exercise proper care and diligence on the part of a director or officer of the Bank? (Term of Appointment A(h) and sub-section 25(2) of the Act)
(f) Was the Bank's Board of Directors given adequate information to enable it to fulfil its functions? (Term of Appointment D)
(g) Were the internal audits of the Bank appropriate and adequate? (Term of Reference A(g))
(h) Were the external audits of the Bank appropriate and adequate? (Term of Appointment B)
(i) Is there any evidence of any conflict of interest, breach of fiduciary duty or other unlawful, corrupt or improper activity that should be further investigated? (Terms of Appointment A(h) and E, and sub-section 25(2) of the Act)
1.2 THE FINANCIAL POSITION OF THE BANK
My Terms of Appointment required me to inquire into and report on the causes of and responsibility for the financial position of the Bank and Bank Group "as reported by the Bank and the Treasurer in public statements on 10th February 1991 and in a Ministerial Statement by the Treasurer on 12th February 1991". My Investigation focused on the reasons for that financial position.
The "financial position" as described in those public statements can be summarised as follows:
(a) The Net Present Value of the difference between the book value of the Bank Group's loans and related assets, and the realisable value of the principal amounts of those loans and assets, was estimated to be $990.0M.
(b) An internal analysis of the Bank Group's loan portfolio disclosed that non-accrual loans, predominantly those accounts which were in arrears, could reach $2,500.0M.
(c) The problem loans were almost entirely limited to the property and corporate sectors of the loan portfolio.
(d) As a result of the Government's financial support arrangements, the Bank reported a profit for the half year ended 31 December 1990 of $20.0M, and achieved a risk-weighted capital adequacy ratio on that date above the Reserve Bank's minimum requirements.
1.3 THE STRUCTURE OF MY REPORT
My Report has been structured to address, in a logical and coherent way, the key operations of the Bank that are relevant to answering my Terms of Appointment, and reflects the approach I took conducting my Investigation. A brief explanation will make this clear.
1.3.1 FINDING THE CAUSE OF THE BANK'S FINANCIAL POSITION
The key to my Investigation of the Bank was the non-performing assets of the Bank. Overwhelmingly, they are corporate and property-related loans made by the Bank, and to a lesser extent, its poorly performed investments in major subsidiaries acquired between 1985 and 1990.
Simply to have focused on the immediate or proximate causes of the Bank's coming to hold significant portfolios of non-performing loans and poorly performed investments in subsidiary companies would, however, have been to take far too narrow a view, and would not have allowed me to answer my Terms of Appointment.
The lending and the other asset acquisitions of the Bank did not take place in isolation from the rest of its business operations. Growth must be funded, with a mix of debt and, to satisfy capital adequacy requirements, capital. The nature of the debt of any lending institution - its term, currency and cost - must be managed and matched to the asset portfolio in order to ensure that interest rate risk and liquidity risk are properly managed, and that the assets are priced appropriately (taking account also of the associated credit or equity risk) so that, among other things, the institution can make an acceptable level of profits.
A failure adequately to manage these aspects of a lending institution's business can be - and, in the case of the Bank, was - a contributing cause of the institution's financial failure. Such consequence may be brought about in two ways:
(a) First, prudent and professional liability management can act as a brake upon the too-rapid growth of the asset portfolio. Prudent management requires that consideration be given to the nature of the funding - debt or equity - obtained by the Bank. If funds of the appropriate maturity and cost are not available, asset creation will need to slow, or cease, until such funds can be obtained. Rejection of this accepted principle of financial management may result in over rapid and hence imprudent growth of assets.
(b) Second, adequate and reliable information regarding the cost of funds is essential (but not by itself sufficient) to ensure that loans are appropriately priced to provide an acceptable level of profits. If that information is not available, loans may be underpriced, with the result that budgeted profits can only be achieved by rapidly expanding the size of the loan portfolio. Profitability budgets may come to drive the institution to make loans that should not have been made. It is clear, though it seems not to have been remembered in the 1980s, that rapid expansion of a loan portfolio is necessarily associated with low credit standards - the more rapid the growth, the lower the credit standard. To put the matter another way, in a highly competitive lending market, a lending institution can consistently grow its loans portfolio at an above average rate only by accepting above average risk.
The essential relationship between a financial institution's management of its funding and its asset creating activities - both lending, and acquisitions - has meant that I was required to examine the Bank's liability and treasury management, for two reasons:
(a) First, as described above, that management might have been a cause of the Bank's financial position. The causal connection is indirect, in that poor liability management does not directly cause bad lending decisions. It is, however, so related to the asset creation process that it must be regarded as a potentially indirect cause of the asset-related losses; and
(b) Second, my Term of Appointment A(b) directs me to investigate and report on the processes by which the Bank came to engage in activities resulting in losses. The Bank's liability management may be such a process, whether those losses are produced directly, or indirectly, or both.
1.3.2 THE ADEQUACY OF POLICIES AND PROCEDURES, AND OF SUPERVISION AND CONTROL, ETC
My Terms of Appointment require me to determine, among other things, whether the Bank's policies and procedures were appropriate and adequate, and whether the Bank's Board of Directors, Chief Executive Officer and other officers and employees performed their functions and duties adequately.
For this reason, each Chapter of this Report which examines a discrete part of the Bank's activities also includes my findings and conclusions with respect to the particular activities described in the Chapter. Each Chapter can be regarded as a sub-report with respect to those activities of the Bank.
Further, just as the factors identified in the various Chapters of this Report contributed in varying degrees to the cause of the financial failure of the Bank, so too did the policy and procedural inadequacies, and the lack of effective supervision and control of certain of the Bank's activities, contribute to the mismanagement of the business of the Bank as a whole.
1.3.3 THE MATTERS ADDRESSED IN MY REPORT
My Report's aim is to identify and analyse the reasons for the financial failure of the Bank. Accordingly, the Report:
(a) provides an overview of the Bank: its history, its growth, and the nature of its business activities, and discusses the directors, managers and key management committees that directed and supervised the Bank's affairs;
(b) describes the strategic business planning and budgeting undertaken by the Bank as a basis for the development of its business diversification and growth;
(c) examines the procedures and practices by which the Bank raised debt and equity to fund its lending and asset acquisition;
(d) describes in detail, assisted by case studies, the policies and practices relating to the primary cause of the losses: poor credit decisions, and the acquisition of subsidiary companies that became non-performing;
(e) describes the information reporting processes and the internal audit procedures, to explain how the problems of the Bank were able to develop without obvious early warnings;
(f) describes in detail the relationship between the Bank and the Reserve Bank of Australia; and
(g) examines, in respect of the matters described earlier, the organisation and management of the Bank.
As noted earlier, the adequacy of the external audits of the Bank will be examined in a separate Report.
1.4 THE ESTABLISHMENT AND CONDUCT OF MY INVESTIGATION
1.4.1 APPOINTMENT OF THE AUDITOR-GENERAL TO CONDUCT AN INVESTIGATION
On Sunday, 10 February 1991, the then Premier and Treasurer, the Honourable J C Bannon MP, announced that the South Australian Government had established a financial support arrangement for the Bank. The financial support, in the form of an indemnity in respect of the Bank Group's loan and related asset portfolios, was provided by the setting aside of $970.0M in a special fund, of which $500.0M had been already paid to the Bank.
Mr Bannon's announcement said that the financial problems faced by the Bank Group were "almost entirely limited to the property and corporate sectors" of the Bank Group's business, and had only recently become apparent following a review of the Bank's operations by J P Morgan.
In his Ministerial Statement on 12 February 1991, the Premier and Treasurer described the course of events leading up to the implementation of support arrangements for the Bank:
" On 8 November, I was advised by Treasury that according to the latest information it had received from the Bank it was virtually certain that a profit would not be achieved in 1990-91. Indeed, the Bank had advised it could record a post-tax loss of between $30 to $50 million and indicated to the Treasury that one of the problems faced by the Bank was its exposure to non-residential construction. I indicated to Treasury officials that this advice was of great concern and asked to be kept up-to-date on a monthly basis.
On 6 December I met with the Chairman of the Bank. Prior to that meeting I was advised by Treasury that the Bank's level of non-accrual loans were growing quickly and that it was concerned that the Bank was not providing sufficiently for bad debts. Treasury was also concerned that the capital adequacy ratio was likely to fall to a level which was only slightly above the Reserve Bank's minimum level.
In the light of these very serious concerns I advised the Chairman of the Bank that a joint Bank/Treasury working group should be established to review the profit outlook for the Bank. I was advised by the Group General Manager of the Bank in a letter dated 18 December that the Board of the Bank had agreed to the establishment of this working group.
Initial discussions were held between the Bank and Treasury and it was agreed that the Bank would commence detailed work on identifying the full extent of its financial problems. Concurrently, following discussions between the Chairman and myself, the Board agreed that an external consultant should also be appointed. JP Morgan was subsequently appointed on 18 January 1991 and started work on 21 January 1991. It was agreed that a further review of the Bank's position would be presented to me at the end of January when both I and the Chairman had returned from leave.
That meeting was held on 29 January. On that occasion I was advised by the Chairman of the potential problems facing the Bank. Following that meeting I asked the Chairman to arrange for Treasury officers to meet with the JP Morgan team. On the next day, 30 January, I received further advice from Treasury following their discussions with J P Morgan and was advised of the likely full extent of the problem ...
Having become aware of the extent of the problem on 30 January, on the following day I had discussions in Canberra with the Federal Treasurer, the Hon Paul Keating, during which we discussed the situation generally. I should record that his advice was very useful.
Amongst other processes, which included liaising with the Reserve Bank, I asked that the State Bank's officers undertake the most detailed and rigorous reassessment possible of their loan portfolio with a view to quantifying the magnitude of the problem as quickly as possible. On Monday 4 February - that is Monday of last week - I was advised that the present value of the gap between book values and estimated realisable values was of the order of $900 million to $1 billion.
It became clear at that point that decisive and substantial action was required to secure the financial base of the Bank. A detailed action plan was quickly formulated in consultation between myself, the Treasury Department, the Crown Solicitor and the State Bank and proposals submitted to and approved by the State Cabinet on Thursday 7 February."
On Saturday 9 February 1991, the day before the Premier and Treasurer's announcement of the support arrangements, I was appointed by the Governor to undertake an investigation of the reasons for the Bank's financial problems, and of the adequacy of the procedures and practices of the Bank. In the words of the Premier and Treasurer in his Ministerial statement: " To put it as bluntly as it can be, the purpose is to find out what went wrong and why. "
On 4 March 1991, the Governor appointed the Honourable Samuel Joshua Jacobs, AO QC, as a Royal Commissioner to inquire into and report upon certain matters relating to the Bank, particularly in respect of the relationship between the Bank and the Government of South Australia. Subsequently, on 28 March 1991, the Terms of Appointment of my Investigation were changed to accommodate the Inquiry of the Royal Commission. The revised Terms of Appointment were more detailed, and required me to report within six months of 28 March 1991 in respect of most parts of my Investigation. Amendments were also made to the Act to facilitate my Investigation. Further amendments to the Act on 3 December 1992, and to my Terms of Appointment on 23 December 1992, clarified the nature and extent of the matters in respect of which I was to investigate and report.
1.4.2 EXTENSIONS TO THE TERM OF THE INVESTIGATION
As indicated above, the Terms of my Appointment on 28 March 1991 directed me to report on most aspects of my Investigation within six months of the date of my appointment. The exception was my investigation of the external audits of the accounts of the Bank, which was subject to a reporting requirement of twelve months from 28 March 1991.
Extensions of the time frame of the Investigation have been necessary, with a final reporting date eventually set at 30 June 1993.
The Investigation has proved to be considerably more complicated and difficult than could have been envisaged when the reporting requirements of the Terms of Appointment were first established. As explained elsewhere in this Report, I have sought to limit the time and resources needed for my Investigation by confining it to the operations of the Bank and of Beneficial Finance, on the basis that it was those two corporations which overwhelmingly incurred the losses of the Group. Even with this limitation on the extent of my Investigation, the material which has been examined in respect of the Bank and Beneficial Finance has been both voluminous and complex.
Delays were caused by the exigencies of the natural justice procedure and the associated litigation which I have described in detail later in this Chapter, and which resulted in extensions to my reporting deadlines.
1.4.3 THE RELATIONSHIP WITH THE ROYAL COMMISSION
As stated above, on 4 March 1991 the Governor appointed the Honourable Samuel Joshua Jacobs, AO QC, as a Royal Commission to inquire into and report upon certain matters relating to the Bank. These matters principally concerned the relationship between the Bank and the Government, and the arrangements under the Act for the governance of the Bank.
In respect of its examination of the control exercised by the Bank's Board of Directors over the operations of the Bank and the Bank Group, the Royal Commission was to "receive and consider" my Report. Clause G of my Terms of Appointment required me to provide to the Royal Commission a copy of my Report, and any other information or interim reports that it might seek.
The Terms of Reference of the Royal Commission were amended in September 1992 to allow the Commission to report in respect of the supervision and control by the Bank's Board of Directors of the Bank Group's operations and Chief Executive Officer without necessarily receiving my Report before doing so. My Term of Appointment G was amended to require me to provide to the Commission:
" ... any interim report or any information including relevant documents and records and including any document containing tentative conclusions reached by the Auditor General or any document containing any information or comment to the Auditor General by any person engaged to assist him in his report, which interim report or information the Royal Commission may seek relating to the matters falling within its Terms of Reference" .
To enable the Commission to take into account my findings, and to facilitate the Commission's review of my Report, I felt it necessary to provide, in detail, as much source information as possible. It is for this reason that the individual Chapters contain detailed references and extensive footnotes.
1.4.4 NATURAL JUSTICE OR PROCEDURAL FAIRNESS
I have throughout my Investigation been acutely aware that my Report, when published, could adversely affect the reputations of parties named in it. Accordingly, I have endeavoured to observe the requirements of natural justice or procedural fairness in respect of those persons, firms and institutions that might be the subject of my Report. I have endeavoured to ensure that the Report is fair and balanced, and that all parties who might be affected adversely by my findings were given ample opportunity, personally or through their legal representatives, to make written and oral submissions and call evidence to refute or contradict any tentative findings.
At the commencement of my Investigation, I determined that where parties had engaged legal representation for the purposes of my Inquiry, they could have their legal representatives present at any examination, hearing or discussion, and that I and my authorised officers would communicate with those parties through their legal representatives.
In determining the measure of natural justice I should accord to persons potentially adversely affected by my Report, I took legal advice, and was guided by statements made by the courts on this topic. It was clear to me that I needed to inform the person concerned of the precise nature of all allegations made against him, her or it, and to support those allegations with supplementary statements of reasonable particularity so that, in all the circumstances, the person receiving the notice was given a fair opportunity to deny, explain, or refute the allegations, or any of them. I have also been concerned to conduct my Inquiry expeditiously.
In late 1991 and early 1992, consultants assisting me in my Inquiry prepared a draft report to me in respect of the activities of the Bank in connection with Celtainer Limited (in liquidation). I then wrote my Report in so far as Celtainer was concerned, so that it contained my own tentative findings of fact and tentative conclusions.
I provided to the affected parties particulars of the precise nature of all allegations as described above and I requested that they make any response that they considered appropriate. I invited them to do that in the form of written submissions to me.
Those parties were dissatisfied with the measure of procedural fairness that I accorded to them, and issued proceedings in the Supreme Court for judicial review.() Those proceedings have subsequently been discontinued. After their institution I was given an extension of time within which I should publish my Report. To enable me to comply with my Terms of Appointment and ensure procedural fairness to all who might be affected, I adopted the procedure of providing (with undertakings as to confidentiality) drafts of my investigators' reports to affected parties or their legal representatives. At the same time, I invited those parties to make informal submissions to counsel assisting me on matters contained in those draft reports. They were also invited to identify any evidence that they considered my counsel should have regard to when counsel came to write a final advice to me.
This procedure served several purposes. It was at that time the most expeditious way for me to proceed. It enabled me to limit the use of the resources then available to me to areas of real dispute. On occasion, it provided a further source of information to counsel assisting me with my Inquiry. For the procedure to be productive, however, it was necessary for the parties who were given such notice to accept and acknowledge that the tentative views set out in these draft reports were not my own tentative views.
The procedure adopted by me to provide natural justice to the directors, managers and employees of the Bank and Bank Group, and the difficulties experienced with that procedure, were summarised by the Full Court (at pp 8-10) in the case of Bakewell and Others v MacPherson:
"The plaintiffs in both actions were at all material times represented by solicitors and had the services of counsel including senior counsel. Over the period of the inquiry there has been a considerable exchange of correspondence between solicitors for the plaintiffs and solicitors for the defendant and frequent conferences between the respective legal representatives. Plaintiffs in these actions were among the witnesses interviewed.
During the course of the inquiry there has been considerable conflict between the defendant and his legal representatives on the one hand and the plaintiffs and their legal representatives on the other. In general it may be said that the latter have taken the stand that their clients have been denied access to information which is necessary to enable them to present their case. The defendant and his advisers have taken the stand that the plaintiffs, instead of endeavouring to supply the information sought from them, have met requests for information with demands which were excessive and which sought to take control of the investigation out of the hands of the defendant. It is clear moreover that the defendant took the view that the plaintiffs were giving insufficient attention to the time constraints imposed upon the defendant by the terms of his appointment.
There are clear indications that the defendant was experiencing difficulty in reconciling the constant demands of the plaintiffs for what they regarded as the requirements of natural justice and the time constraints imposed upon him. In an endeavour to meet the requirements of the plaintiffs without undue delay, the defendant adopted an informal procedure of consultation with the legal advisers of the plaintiffs. As part of that procedure, he furnished a number of reports by persons to whom he had delegated the responsibility of investigating certain facets of the Bank group's activities. He provided those reports on the basis that their conclusions did not represent his views and were not to be regarded even as his tentative views. The idea was to give the plaintiffs an early intimation of the sort of issues which had arisen and an early opportunity to consider what representations they wished to make in connection with them. The procedure broke down in July 1992 because of an impasse between the defendant and the plaintiffs as to the status of these investigators' reports. The defendant required from the plaintiffs, as a condition of receiving them, that they acknowledge that they did not represent the defendant's views and were not even his tentative conclusions. The plaintiffs refused to give this acknowledgment, apparently wishing to keep open an argument based upon these reports that they had been denied natural justice. The defendant thereupon discontinued the furnishing of those reports.
The defendant was critical of the plaintiffs' attitude and expressed the view that they were obstructing the investigation." [Emphasis added]
As will be seen from the above, the former non-executive directors of the State Bank and Beneficial Finance () refused to accept that the investigators' draft reports were only investigator's draft reports, and did not contain any views of mine, tentative or otherwise. This was despite the fact that I had expressly confirmed in correspondence with their solicitors that the views expressed were not my views. I point out here that no other affected party took such a stand.
I then adopted a different means of according persons a fair opportunity to be heard. The intermediate step of releasing investigators' draft reports and inviting informal submissions was abandoned. The method then adopted was to release to affected parties, or if so advised to their legal representatives, that part of my own tentative findings of fact and tentative conclusions, after obtaining the appropriate undertakings as to confidentiality, as was relevant to the party concerned. At the same time, I invited those parties to make written submissions to me, and adduce evidence in writing in the form of a statutory declaration in support of their submissions. The Full Court found that the method adopted by me up to the time of presenting draft Chapters of this Report to the parties potentially affected by the findings in the draft Chapters "was [a] perfectly proper procedure and probably the only way in which the defendant could have proceeded having regard to the nature of the Investigation" (p 19) and had "been proper and reasonable and has not involved any infringement of the plaintiffs' rights ... I think that he has taken a proper and reasonable course in making known his tentative conclusions to the plaintiffs in order to give them an opportunity of answering them" (p 24).
This natural justice process provided affected parties with an opportunity to consider my tentative findings of fact and tentative conclusions, together with the substance of the evidence, both oral and documentary, upon which I had relied in the formation of those tentative findings of fact and tentative conclusions. Indeed, in most instances the parties have been given two months, and where I have considered it appropriate, additional time, to make their written submissions to me. Thereafter, I have also heard further oral evidence called by some parties in support of their written submissions. They have been given the opportunity to put further argument in relation to such evidence. Further, I have agreed with a request of those parties who sought to have counsel assisting me in relation to my Inquiry engage in discussions with their legal representatives in an effort to limit the hearing of unnecessarily repetitive evidence. Where I have heard further evidence, that evidence has been given on oath. Where parties had legal representatives, I have permitted their representatives to be present with them and, where appropriate, conduct such examination.
As a fact finding exercise my Investigation has continued throughout and up until the publication of my Report, both substantively and in consequence of the natural justice process itself. That process, of course, has resulted in further facts, evidence and submissions being presented to me, and I have taken all that additional material into account.
I have endeavoured throughout the above process to provide affected parties with an appropriate measure of natural justice. On many occasions I have had to make a judgment in relation to the question of procedural fairness. In doing so, I have been required to keep in mind my duty to proceed expeditiously with my Inquiry, and the circumstances of each case.
1.4.5 HISTORY OF LITIGATION
As I have already mentioned, my initial steps to accord affected parties with a fair opportunity to be heard were challenged by the Bank and two of its former employees, Mr K S Matthews and Mr T Gale, as being inadequate. Those proceedings were instituted in early February 1992, and had the effect of diverting resources which would have otherwise been directed towards continuing with my Inquiry and reporting in a substantive sense. At the same time the former non-executive directors() intervened in the action brought by the Bank and Mr Gale and Mr Matthews, and instituted their own action for judicial review, alleging a concern that I was not and would not, in the future, be according them a proper measure of natural justice. All of those proceedings were eventually discontinued.
Subsequently, in August 1992, the former non-executive directors (except Mr Prowse) instituted further proceedings. () In those proceedings they sought certain Orders, including an injunction to prevent me from publishing any report, an Order prohibiting me from continuing with my Inquiry, and declarations that the procedure I had adopted to date had been in breach of the rules of natural justice. The former Managing Director, Mr T M Clark, made application to the Court for similar Orders at about the same time.() The actions were heard by the Full Court of the Supreme Court on 7 September 1992, and that Court delivered its judgment on 25 September 1992.
In respect of the rights of the directors to respond to my tentative findings, the Full Court made the following declarations (p 28-29):
"1. (a) that the plaintiffs were entitled to an extension of time within which to respond in writing to the tentative findings and conclusions contained in the draft chapters of the defendant's proposed report, which have been furnished to them, to a date not earlier than two months after the dates on which such chapters were respectively delivered to them;
(b) that the plaintiffs were entitled to be notified of any other tentative findings or conclusions which might reflect on their conduct or affect their reputations and are entitled to a reasonable time within which to respond to them;
(c) that the plaintiffs are entitled to appear before the defendant, accompanied by their counsel, at a time and place appointed by the defendant, to give evidence on oath or affirmation in refutation of such of the tentative findings and conclusions as are identified in the written responses to be in dispute, to have put to them the substance of any evidence information or documents founding such tentative findings, and to be examined or re-examined by their counsel;
(d) that the plaintiffs are entitled to place before the defendant, either orally or in writing as directed by the defendant, any arguments as to the aforementioned disputed tentative findings and conclusions and any other matters which might reflect on their conduct or affect their reputation."
One of the consequences of this litigation was to further divert the resources which I would have otherwise utilised in pursuing my substantive Inquiry. My Terms of Appointment were subsequently varied and I was granted a further extension of time within which I should publish my Report. I then continued with my Inquiry and adopted a natural justice process which enabled me to comply with the Orders of the Full Court of the Supreme Court.
On 24 November 1992, the former non-executive directors instituted further proceedings seeking, inter alia, declarations that I had acted ultra vires by making tentative findings in relation to acting without " proper care and diligence " or tentative findings as to " reasonable and prudent bankers " and declarations that they were entitled to further and greater amounts of natural justice than they had already received. Those proceedings were filed at a time when Counsel assisting me had commenced further discussions with the legal representatives of the former non-executive directors, in an effort to limit the necessity for me to hear, and for those persons to give, unnecessarily repetitive evidence.
After the institution by the former non-executive directors of their proceedings in November 1992, Parliament, on 3 December 1992, enacted Section 4 of the State Bank of South Australia (Investigations) Amendment Act 1992 which states in sub-section 3:
"No decision, determination or other act or proceeding of the Auditor-General or an authorised person or act or omission or proposed act or omission by the Auditor-General or an authorised person, may, in any manner whatsoever, be questioned or reviewed, or be restrained or removed by prohibition, injunction, certiorari, or in manner whatsoever. "
On 7 December 1992 the former non-executive directors issued a further set of proceedings in the Supreme Court making the same allegations but in addition seeking a declaration that the above Section 4 had no application.
I have filed the necessary documents in those proceedings to defend them before the Full Court of the Supreme Court. Furthermore, the Crown Solicitor has intervened in those proceedings on behalf of the Attorney General, pursuant to the Crown Proceedings Act. The Crown Solicitor has also made an Application that the proceedings of the former non-executive directors be struck out on the basis that they fail to show on the face of the documents already filed, any cause of action. I have supported the Crown Solicitor in that application. I believe that the matters of which the former non-executive directors now complain have already been comprehensively dealt with by the Full Court of the Supreme Court in its decision in Bakewell & Others v MacPherson.()
The former non-executive directors have not sought to have the Applications filed by them set down for hearing. The November and December proceedings remain unresolved.
1.4.6 MY APPROACH TO TWO KEY CONCEPTS
1.4.6.1 Causation
As noted above, the key feature of my Terms of Appointment is its focus upon the matters and events which caused loss. It is important therefore that I briefly describe the approach I have taken to the issue of causation.
There are two quite distinct concepts of causation, both of which must be addressed by my Investigation. There is the concept of causation used by scientists, and there is the concept of causation used by lawyers.
These two concepts of causation are important elements of my Investigation. In the course of this Report, I have identified a number of matters and events which caused or contributed to the Bank's and the Bank Group's losses in the "scientific" sense that the losses may not have occurred, or at least would not have been as great, but for those matters or events.
Answering my Terms of Appointment requires more, however. It requires me to identify those matters and events that were the real and effective cause of the losses in the legal sense of causation: who or what was really to blame for the losses?
Accordingly, in answering my Terms of Appointment, I have:
(a) identified those matters and events which caused, in the scientific sense of being necessary conditions for, the financial position of the Bank and Bank Group; and
(b) identified from those necessary conditions, the matters and events that were the "real and effective" cause of the losses, in the sense that they were really to blame for the losses of the Bank Group.
The most contentious issue of causation faced by me in my Investigation was the role of financial deregulation and economic events in causing the financial position of the Bank and Bank Group. It is, of course, beyond question that deregulation and the economic environment of the 1980s had profound implications for both the rapid growth of the Bank Group, and for its eventual financial position. In purely "scientific" terms of causation, financial deregulation and the economic events of 1984-1991 unquestionably were a cause of the Bank's and the Bank Group's rapid growth, and of their resultant financial position as at February 1991.
Notwithstanding this, the question I have to answer is whether, and to what extent, economic events and financial deregulation were a real and effective cause of the Bank's and Bank Group's financial position within the Terms of my Appointment. In other words, were financial deregulation and economic events to blame, in whole or in part, for the Bank Group's losses?
The key to answering this question is to be found in the extent to which the Bank adopted sound policies and practices which were calculated to protect it from any reasonably foreseeable economic downturn. If the policies and practices actually applied were so inadequate that they would not protect the Bank from the effects of any reasonably anticipated economic downturn, then that inadequacy will be the real and effective cause of the losses.
The fact that other financial institutions also suffered losses after 1989 does not mean that economic events are to be blamed for the Bank's financial position. The losses incurred by other financial institutions are significant to my Investigation, but not for reasons of causation. Rather, the activities of other financial institutions are relevant to determining whether the Bank's operations were "adequately" and "properly" supervised, directed and controlled.
1.4.6.2 The Standards of "Adequately" and "Properly"
I am also required to determine whether the operations of the Bank were " adequately and properly " supervised by the Directors, management and employees. I have discussed the standard of conduct applied to the Bank's Board of Directors, management and employees in Chapter 2 - "Reference Information on the Investigation" of this Report. Briefly stated, in setting out the standards of whether a relevant person's performance of his function was "adequate" and "proper", I have proceeded on the view that:
(a) The obligations and duties of directors, officers and employees of the Bank are those contained in the general (non-statutory) law regarding the governance of commercial companies, and in statutory provisions applicable to the Bank;
(b) In respect of the Bank's Board of Directors, the adequacy of its action is to generally be considered and evaluated on a collective or collegiate basis, unless I formed the opinion that a particular director did not act with proper care and diligence in which case I am required to investigate that director's actions; and
(c) The allocation of responsibility to the Board and to management to perform particular functions in respect of the Bank is to be found in the State Bank Act, and in the delegations by the Board and the Chief Executive Officer under that Act. In this regard, the Act fulfils the function usually played by a company's Memorandum of Association and Articles of Association.
1.5 WHAT WENT WRONG AND WHY: AN OVERVIEW
1.5.1 INTRODUCTION
The one thing that all parties giving evidence to my Investigation agreed upon was that the Bank failed because "it grew too fast".
I agree. There is an analogy which, I think, assists in understanding what that involved.
There are chemicals which kill trees by forcing them to grow. They contain a growth hormone that stimulates and forces even a mature tree to produce new leaves and branches, expanding its canopy. For a while, the tree seems to thrive. But its growth is uncontrolled and wildly excessive, outstripping the ability of the tree to support and sustain itself. The tree's systems cannot keep up. The new growth withers, and the tree dies.
The Bank's inaugural Chief Executive Officer, Mr Clark, was the Bank's growth hormone. The Board of Directors did not impose constraints or control on the growth he stimulated and drove. Many of the Bank's senior managers weren't up to the task - they lacked the judgment, experience and banking skills that together comprise competence. The Bank's growth was almost universally lauded and applauded, but its appearance of vigour and health was illusory. Now the leaves have turned.
Most of the new growth took the form of corporate loans. The Bank failed mainly because too many of those loans were bad: loans that it should never have made. Growth that should not have occurred. The Bank's Corporate Lending business was incompetently conducted in almost every respect, from the procedures used in initiating loan proposals to the approval of loans by the Board of Directors.
There is, however, more to the causes of the Bank's losses than sloppy lending. The term "main cause" is perhaps better expressed as "proximate cause".
The story of the Bank is one of a professionally aggressive and entrepreneurial Chief Executive without sufficient appreciation of the need for prudent banking controls and management; of an incompetent Executive Management happy to follow where their Chief led without independent professional judgment; of a Board of Directors out of its depth and, on many occasions, unable or unwilling to exercise effective control; and, ultimately, of a Bank that thrived on the full faith and credit of the people of South Australia.
1.5.2 THE FORMATION OF THE BANK
The Bank was formed in the euphoria and excitement of 1984. The economy was rebounding from the recession of 1982, and asset prices in particular were rising rapidly. The Government enthused about the new Bank being an "engine of economic growth" for South Australia.
It is, in a very real sense, misleading to think of the Bank as having been a "new" Bank at the time of its formation on 1 July 1984. It was new in form only. In substance, it was an amalgamation of the two predecessor State-owned banks - essentially thrift institutions with their activities largely confined to South Australia, and with the management skills and systems suited to those activities. Immediately after its formation, the Bank expanded rapidly into new financial markets for which its management and its systems were wholly inadequate. The Bank's Executive managers pursued growth as though that didn't matter. It did. Warnings from the Reserve Bank were simply ignored. The Board of Directors lost control.
The Board of Directors appointed by the Government in 1984 and largely maintained thereafter may have been adequate to the task of overseeing the merger of two safe South Australian retail banks. But as the new Bank was launched on a path of extraordinary expansion, the Board was left floundering. It tried to understand, and complained a number of times about the "technical" nature of the papers containing banking jargon that it was asked to review. The tragedy is that the Board did not call a halt to the growth that it did not understand. It would not have been an easy thing in the euphoria of the 1980s, and in the face of Mr Clark's driving ambitions. But that was the Board's job. It acquiesced in its unmanaged growth. The Board's efforts to exercise control from 1989 were too little, too weak, and too late.
Mr Clark came from a senior management position at Westpac, and was given the job as Chief Executive Officer of the Bank. He was determined to compete, and compete hard. Only the four major trading banks would be bigger.
Mr Clark's imperative was to diversify and grow, and there was nothing to stand in his way. The economic environment of the day was ideal. Deregulation opened up new markets and new opportunities. As a State bank, the Bank was not subject to the formal supervision of the Reserve Bank - Mr Clark chafed under the informal arrangement for supervision that did exist. He was the only director with any banking experience, enabling him to dominate the Board. There was no share price to worry about - just profits. There was an unlimited supply of money to fund the Bank's expansion - the Government guarantee meant that it could borrow whatever funds it needed, as and when it required them, without any real need to plan.
1.5.3 THE GROWTH AND OPERATIONS OF THE BANK
And so, the Bank grew. In its first year, total assets increased by 27.5 per cent. They increased by an extraordinary 55.5 per cent in 1986. The nascent London branch expanded rapidly, and built up a large loan portfolio, heavily exposed to commercial property. Branches were opened in New York, Hong Kong and Auckland, and representative offices in Los Angeles and Chicago. Branches were established in most Australian capitals, holding large corporate loan portfolios. The Bank bought a stockbroking firm, a trustee company, a half-interest in a real estate agent, established a merchant bank and bought a life insurance company. It bought Security Pacific New Zealand and, in 1990, United Building Society in New Zealand.
By 1990, the Bank's assets had grown from $2,690.6M at formation, to $17,299.8M, an increase of 543 per cent. (Total assets of the Bank Group increased over the same period by 572.7 per cent, from $3,142.8M to $21,142.1M.) The real increase in the Bank's total assets was in fact even greater, because in 1989 the Bank's portfolio of concessional housing loans was transferred to the South Australian Government Financing Authority. Excluding that portfolio, the increase in assets of the Bank was 700.1 per cent - from $2,162.3M to $17,299.8M. From an essentially South Australian institution, it had expanded so that two-thirds of its assets were located interstate and overseas. Corporate loans grew to represent about 38 per cent of lending assets. The Bank's funding changed as well: wholesale funds increased as a proportion of the Bank's total funds from 15 per cent in 1984 to 82 per cent in 1990(), and by 1990 the Bank had interest bearing deposits overseas totalling $2,214.7M.()
Much of this growth was, in dollar terms at least, unplanned. Between 1985 and 1990, 38.7 per cent of the Bank's actual growth in assets was not budgeted in the annual profit plans. Growth was unconstrained, unplanned and highly opportunistic.
The opportunities were often not profitable. In March 1988 the Bank purchased Oceanic Capital Corporation, a life insurance and funds management group of companies for $60.0M, without first undertaking an adequate due diligence investigation. In June 1990, the United Building Society was purchased for $150.0M while the due diligence was half completed. The Bank moved quickly to acquire the Society, a move it soon regretted.
The major part of the growth in the Bank's assets was the expansion of its corporate loan portfolio. It is here too that most of the losses were suffered. With hindsight at least, this is no coincidence. In a highly competitive environment, there is really only one way that a bank can expand its loan portfolio much more rapidly than its competitors - by accepting lower credit standards, and making loans that other lenders would not make, at least at the same price. There is a connection between above average growth, and above average losses.
My examination of the Bank's corporate lending has shown that it was poorly organised, badly managed and badly executed. Credit risk evaluation was shoddy. Corporate lending policies and procedures were not even compended into a credit policy manual until 1988, and even then contained serious omissions. The ultimate loan approval authority - the Board of Directors - lacked the necessary skills and experience to perform its function adequately. Senior management's emphasis was on doing the deal, and doing it quickly.
The growth in the loan portfolio is explained in part by the profit imperative. While the Bank's budgeted asset growth was exceeded in every year, its budgeted profit was not. The Bank's lending practices included taking a significant portion of its income in the form of up-front fees, part of which represented, in substance, interest on the loan. For a significant period, these up-front fees were shown as income in the year they were received. This meant that the easiest way to increase profits was simply to make more loans. Make a loan, book the profit, and make another loan. It was the excesses of the 1980s at its worst, conducted by a State Bank guaranteed by the people of South Australia.
The organisational structure of the Bank meant that there were no internal checks or controls on the growth. The Bank was organised into highly autonomous business units, with the objective of making those divisions accountable for their profitability. There was no overall authority which exercised control. The Executive Committee was mired in detail, and ineffective. Mr Clark's focus was not on prudent control, but on growth and profitability.
Those departments of the Bank which should have acted as internal regulators were isolated and without authority. The Information Systems department was expected to do no more than provide those services demanded by the business units. The result was that the Bank developed disparate information systems across its business units which could not communicate properly. It was not until 1990 that the Bank was able to measure its total loan exposure to commercial property. Lending was conducted without any regard to the cost of funds, or to the Bank's liquidity position.
Where was the Reserve Bank? It was watching, often with alarm. It warned and cajoled at prudential consultations, wrote letters, complained, cautioned and threatened. It received bland assurances from the Bank's management - assurances that were hollow, if not ingenuous. Many of the Reserve Bank's warnings and concerns were not passed on to the Board of Directors.
1.5.4 THE BOARD OF DIRECTORS
Throughout this, the Bank's Board of Directors was, for the most part, ineffective.
I have some sympathy for the Bank's non-executive directors. They lacked both banking experience and, in most cases, hard-headed business acumen. They were manipulated, and not properly informed of what was going on. The information given to them was voluminous, but obscure. It took an expert and practised eye to sort the wheat from the chaff, and to know what information was not there. The Board lacked that.
But whatever sympathy one may have for its predicament, the Board of Directors was the governing body of the Bank, charged with responsibility to administer the Bank's affairs and to control the Chief Executive in his performance of his management function. A reasonably prudent Board - whatever its skills - would have done much more than the Bank's Board did. It was not beyond the capabilities of the non-executive directors to take commonsense measures, and to stand no nonsense.
To be blunt, there is nothing esoteric about asking questions, seeking information, demanding explanations and extracting further details. There is nothing unduly burdensome in expecting each director, to the best of his or her ability, to insist on understanding what was laid before them, even at the risk of becoming unpopular. Both the law, and a basic sense of duty and responsibility, demand it.
The non-executive directors submitted to me that they did these things. Sometimes they did. But not often enough, and not strongly enough.
I have repeatedly found that the Board of Directors of the Bank failed to adequately or properly supervise, direct and control the operations, affairs and transactions of the Bank.
Whilst in many individual cases the Board might well have been entitled to rely on the advice, expertise and assurances of the Chief Executive Officer and senior management, members of the Board were not entitled to abandon their statutory responsibility and accept recommendations without giving them appropriate consideration and, if necessary, meaningful and critical questioning. They were required to exercise an independent judgment, placing only such reliance on advice as their common sense should have told them was prudent. They did not do so on many important occasions.
1.5.5 THE CHIEF EXECUTIVE OFFICER
Mr Clark bears a heavy share of blame for the Bank's losses. It was he, as Chief Executive Officer and a member of the Board of Directors, who set the Bank on its course of unmanaged growth. Mr Clark drove the Bank to grow and diversify, but he paid too little attention to the need to manage it prudently. He seemed oblivious to the risks he was running, and ignored words of warning and caution.
Again and again, the evidence shows Mr Clark to have been impatient with opposition and easily affronted. His personality and position were such that his banking philosophy and strategies, and his attitude to particular transactions being processed by the Bank, would have been known to all. It would have been a courageous member of staff who expressed views in a manner likely to come into conflict with the wishes of such a formidable superior.
There would, in my opinion, have permeated through the Bank, the aura of a domineering leader who exerted a strong influence on senior staff members. They would have been likely as a (usually sub-conscious) matter of self-protection, to have been moved to bring their judgments and opinions into a form that would not attract the Chief Executive Officer's disapproval. All of this would, over a period of years, have been seriously inimical to rigorous investigation, objective appraisal, and plain talking.
I have repeatedly found that Mr Clark failed to adequately or properly supervise, direct and control the operations, affairs and transactions of the Bank, and that he failed to provide the Board with information that was timely, reliable and adequate.
1.5.6 THE BANK'S EXECUTIVE MANAGERS
As a group, the Bank's senior managers were not up to the job. Worse, they acquiesced in and abetted, without any adequate expression of professional judgment, the course set for the Bank. If the managers had any conception of what was required to safely manage the Bank, they did not display it. Instead, they displayed a cavalier approach to the Board, to the Reserve Bank and to the principles of sound business management that speaks ill of their professionalism and judgment, let alone their banking skills.
In the course of my Investigation and Report I have had occasion to criticise many of the Bank's senior managers. They have, in varying degrees, been responsible for some of the most irresponsible, reckless and imprudent decisions made by the Bank.
In their dealings with both the Board and external agencies one or more of these officers:
(a) failed to inform the Board of the results of advice received from independent consultants and other critical information relevant to decision-making;
(b) supplied positively misleading information to the Reserve Bank;
(c) failed to convey to the Board concerns being expressed by the Reserve Bank of the Bank's growth and prudential policies; and
(d) provided information to the Board which the officers knew to be wrong.
There are numerous examples of senior officers, for a variety of reasons not the least of which was to the perceived need or desire " to do the deal ", inadequately and in some cases recklessly assessing proposals and failing to act in a responsible and prudent manner. The attitude that there was a need to complete the transaction quickly because if they did not, someone else would, seemed to pervade and characterise senior management's actions. The spectre of the competitor always waiting in the wings was constantly put forward as the reason for rushing so many transactions, many of which involved millions of dollars.
There was a failure by the Bank's senior management to display the skills, professionalism and judgment that was reasonably required of them. Several factors were at work. Many simply lacked the skills and experience that is required of senior bank executives. Many, if not all, were swept along in the euphoria that characterised the financial markets in the 1980s. And then there was the formidable influence of Mr Clark. None of these factors exculpates the officers.
I have repeatedly found that the Bank's senior managers, at various times, failed to adequately or properly supervise, direct and control the operations, affairs and transactions of the Bank, and that they failed to provide the Board with information that was timely, reliable and adequate.
1.5.7 SUMMARY REPORT IN ACCORDANCE WITH MY TERMS OF APPOINTMENT
The nature of my Investigation means that it is necessary to answer my Terms of Appointment separately in respect of the discrete parts of the Bank's operations. Accordingly, each Chapter of this Report contains a report in accordance with my Terms of Appointment as they relate to the particular aspect of the Bank's operations described in the relevant Chapter.
Nevertheless, based on the evidence described in my Report, it is possible to provide some general answers that describe accurately and fairly the features of the Bank relevant to my Terms of Appointment.
1.5.7.1 Term of Appointment A(a)
The matters and events that caused the financial position of the Bank as reported by the Bank and the Treasurer in public statements on 10 February 1991 and in a Ministerial Statement by the Treasurer on 12 February 1991 were:
(a) The failure of the Bank to establish adequate policies and procedures for the evaluation and management of credit risk associated with its corporate lending activities.
(b) The poor quality of the conduct of the Bank's credit risk assessment and management functions, which resulted in the Bank making too many bad loans that should not have been made.
(c) The failure of the Bank to establish any guidelines, procedures or policies for the conduct of due diligence investigations and evaluations of potential acquisitions of businesses.
(d) The poor quality of the processes and practices by which the Bank acquired Oceanic Capital Corporation and United Building Society.
(e) The Bank's excessive exposure to commercial property.
(f) The inadequacies and deficiencies of the Bank's information systems.
(g) The inadequacies and deficiencies of the internal audits of the Bank.
(h) The failure of certain of the Bank's senior managers to accept and respond positively to the advice provided to them by the Reserve Bank of Australia.
(i) The failure of the Board of Directors to adequately or properly supervise, direct and control the Bank's operations, affairs and transactions, as particularised in my Report.
(j) The failure of the Chief Executive Officer to adequately or properly supervise, direct and control the Bank's operations, affairs and transactions, as particularised in my Report.
(k) The failure of certain of the officers and employees of the Bank to adequately or properly supervise, direct and control the Bank's operations, affairs and transactions, as particularised in my Report.
Other matters and events that provided the essential pre-conditions for the financial position, but which were not a cause in the sense of being responsible or to blame for the losses, were:
(a) Financial deregulation and the economic events of the 1980s.
(b) The fact and incidents of the ownership of the Bank by the Government, including the existence of the Government guarantee of the Bank's liabilities.
1.5.7.2 Term of Appointment A(b)
The processes which led the Bank to engage in operations which have resulted in material losses or in the Bank holding significant assets which are non-performing are too numerous to list here. Particular processes are identified and described in relevant Chapters of this Report.
1.5.7.3 Term of Appointment A(c)
For the reasons described in those Chapters, those processes were not appropriate.
1.5.7.4 Term of Appointment A(d)
The procedures, policies and practices adopted by the Bank in the management of significant assets which are non-performing are too numerous to list here. Particular procedures, policies and practices are identified and described in relevant Chapters of this Report.
1.5.7.5 Term of Appointment A(e)
For the reasons described in those Chapters, those procedures, policies and practices were not adequate.
1.5.7.6 Term of Appointment A(f)
I will report on whether the Bank had adequate and proper procedures for the identification of non-performing assets and assets in respect of which a provision for loss should be made in my separate Report in respect of Term of Appointment B regarding the appropriateness and adequacy of the external audits of the Bank and Beneficial Finance.
1.5.7.7 Term of Appointment A(g)
For the reasons described in Chapter 23 - "Internal Audit of the State Bank" of this Report, the internal audits of the accounts of the Bank were not appropriate and adequate.
1.5.7.8 Term of Appointment A(h)
Instances of directors and officers having failed to act with proper care and diligence are identified in various Chapters of this Report. Possible conflicts of interest, breaches of fiduciary duty or other unlawful, corrupt or improper activity on the part of directors or officers of the Bank are the subject of comment and recommendations in my Report, and in a separate confidential Report to be presented by me with my final Report.
1.5.7.9 Term of Appointment C
For the reasons described in my Report, the operations, affairs and transactions of the Bank and the bank Group were not adequately or properly supervised, directed and controlled by:
(a) the Board of Directors of the Bank;
(b) the Chief Executive Officer of the Bank; and
(c) certain other officers and employees of the Bank as identified in my Report.
1.5.7.10 Term of Appointment D
For the reasons described in my Report, the information and reports given by the Chief Executive Officer and other Bank officers to the Bank Board:
(a) were under all the circumstances, not timely, reliable and adequate; and
(b) were not sufficient to enable the Board to discharge adequately its functions under the Act.
1.6 RECOMMENDATIONS
The recommendations made in various Chapters of this Report are of two types.
First, I have recommended in respect of the six credit risk management case studies (Chapter 9 to Chapter 14) that the deficiencies identified in those Chapters should be the subject of administrative action within the Bank to ensure proper supervision and competence in understanding and executing the lending policies and procedures of the Bank.
Second, I have recommended matters for further investigation in Chapters 10, 17 and 26 of this Report.
1.7 MY REPORT ON THE STATE BANK: A SYNOPSIS
1.7.1 INTRODUCTION
This Section provides a synopsis of the various Chapters of this Report, and brings together the findings and conclusions which I have reached in relation to my investigation of the Bank's operations and of the role played by the Bank Board, its Chief Executive Officer and relevant other officers and employees.
My findings and conclusions, in summary form, are set out in this Section by grouping them according to the following parts of my Report:
(a) Direction Setting and Planning, and Management of the Bank and Bank Group's Diversifiable Credit Risk (Chapters 4 and 5);
(b) Funding, and Treasury and Asset and Liability Management (Chapters 6 and 7);
(c) The Management of Credit Risk (Chapter 8);
(d) Case Studies on the Management of Credit Risk (Chapters 9 to 14);
(e) Relationship with the Reserve Bank (Chapter 15);
(f) Management of Acquisitions (Chapters 16, 17 and 18);
(g) Overseas Operations of the Bank (Chapter 19);
(h) Management Issues (Chapters 20, 21 and 22);
(i) Internal Audit of the Bank (Chapter 23); and
(j) Other Matters (Chapters 24, 25 and 26).
The description of the Bank's operations provided in the following synopsis should be read in the context of the growth and diversification of the Bank's businesses from 1984.
As has been noted, the operations of the Bank changed very significantly after July 1984.
The Bank's total assets increased from $2,683.0M at 1 July 1984, to $17,300.0M by 30 June 1990, an increase of 543 per cent, substantially larger than that of both the major private banks and other State banks. The major increase was in the area of corporate lending, which represented about 38 per cent of total loans as at 31 December 1990. Lending for housing (excluding concessional housing) fell from 62.5 per cent of the Bank's portfolio on 1 July 1984, to 22.8 per cent by 31 December 1990. There was, too, a dramatic increase in loans to overseas borrowers - by 31 December 1990, such loans represented 34.8 per cent of the Bank's loan portfolio.
The change in nature of the Bank's business was reflected in its funding base - between July 1984 and June 1990, the use of wholesale funds increased as a proportion of total funding from just 15 per cent, to 82 per cent.
1.7.2 DIRECTION-SETTING AND DIVERSIFIABLE CREDIT RISK MANAGEMENT (VOLUME III - CHAPTERS 4 AND 5)
1.7.2.1 Direction-Setting and Planning (Chapter 4)
(a) Overview and Summary
The Bank's Board of Directors approved the basic elements of the procedures for the Bank's long-term strategic planning and annual budgets at its inaugural meeting on 28 June 1984.
The procedures utilised by the Bank involved a specialised planning department, an annual planning conference attended by all senior managers (including representatives of subsidiary groups), the annual preparation and approval of a five year strategic plan, and the subsequent preparation and approval of a budget for the ensuing financial year to implement the strategic plan.
Fundamental to the philosophy underlying the strategic plans was the Board of Directors' and Management's interpretation of the Bank's charter as involving primarily commercial objectives, particularly increased profitability. The growth and diversification of its business was seen as being an essential prerequisite to meeting those objectives.
The strategic plans and budgets, as drafted and approved, were reasonably comprehensive. They were prepared with input from, and were apparently endorsed by, the Bank's senior management, and included information regarding the plans of the Bank's major subsidiary groups.
The plans outlined in general terms the proposed growth and diversification of the Bank's business activities, and addressed, also in general terms, its internal infrastructure needs (including information systems, staff and funding) essential to managing that planned development. The Bank's planned rate of growth, judged against the actual growth rates of other banks, was not necessarily excessive.
However, as extensive as the procedures for preparing the plans and budgets seemed, the strategic planning and budgeting processes had a critical failing: an absence of effective implementation and control systems. In each year after 1984, the actual growth of the Bank's assets far exceeded that which was planned or budgeted. In the years 1986 to 1990 inclusive, the Bank's assets grew by more than $5,400.0M, or 38.7 per cent, in excess of that which was planned or budgeted. The actual rate of growth in the Bank's assets was, despite the planning, significantly higher than that of most other banks, including other State banks.
The rate of growth of the Bank's assets, both through lending and by takeovers, was so in excess of that which was planned as to render the planning procedures largely irrelevant to the Bank's actual business development. The excessive rate of growth over and above that which was planned, projected or budgeted meant that the planning procedures did not operate as an effective management control in the Bank.
By itself, this excessive rate of growth should have raised a real suspicion on the part of the Board that the Bank's internal systems and resources may not have been adequate or appropriate to prudently manage and support its growth.
There were, in addition, other factors which should have put the Board on notice that it could not rely on the planning and budgeting procedure in undertaking its function of governing the Bank. They were:
(i) repeated references in the strategic plans themselves to the need to take action to ensure that the annual budgets were consistent with the Bank's long-term objectives; and
(ii) the inability of Management to provide any meaningful strategic monitoring reports, culminating in April 1988 with express advice given to the Board of inadequacies in the procedures for implementing the plans, including a lack of deadlines, lack of delegation to Management, insufficient communication to business units, and an excess of strategic programs.
The failure of the strategic planning and budgeting procedures as a management device does not necessarily mean that the Bank's Board of Directors and Management did not take other action to ensure that the asset growth and diversification of the Bank was prudently managed. However, the essential irrelevance of the strategic plans and budgets to the Bank's actual growth gave rise, in particular, to an obligation on the Board of Directors and management to take some reasonable action to ensure that the Bank was being properly and adequately managed. It was submitted to me on behalf of the Non-Executive Directors of the Bank that the Board had "clearly discharged " its obligation by " regularly querying management about the adequacy of the Bank's staff and systems to cope with the growth of the Bank ."() As is described in later Chapters of this Report, it is an obligation that the Board of Directors failed to satisfy , and accordingly I reject that submission.
(b) Findings and Conclusions
(i) The processes that led the Bank to engage in operations which have resulted in material losses, or holding significant assets which are non-performing, included the strategic planning and budgeting of the Bank, which expressly planned to engage in most aspects of the business activities which resulted in the acquisition of such assets. However, the actual acquisition of the majority of assets was, in quantitative terms at least, unplanned.
(ii) The procedure of strategic planning and budgeting did not amount to an adequate or proper system for supervision, direction and control of the Bank's activities. The excessive rate of growth over and above that budgeted, essentially meant that the strategic plans and budgets were largely irrelevant to the procedure of supervision, direction and control of the Bank's operations.
1.7.2.2 The Management of the Bank Group's Diversifiable Credit Risk (Chapter 5)
(a) Overview and Summary
An important aspect of the prudent management of any financial institution is the establishment of, and adherence to, prudential policies that will ensure that the loan portfolio does not involve an excessive concentration of credit risk. Such policies must ensure that the portfolio is not overly exposed to particular borrowers, particular industries, or particular geographic areas. Where a parent company is in reality committed to supporting a subsidiary, such prudential policies need to be established and adhered to on a global or group basis.
A significant contributing factor to the Bank Group's losses was its excessive and imprudent exposure to commercial property, caused in large part by the absence of:
(i) a group-wide prudential policy limiting that exposure; and
(ii) an information system to measure the exposure.
Until 1990, the State Bank and Beneficial Finance established independent prudential policies in respect of their respective loan portfolios. In accordance with the Reserve Bank Prudential Statement G1, the Bank sought to manage its potential exposure to Beneficial Finance by appointing its own representatives to constitute a majority of the Beneficial Finance Board. The Bank did not seek to establish prudential policies to apply on a group basis until October 1990.
The need for an effective system for controlling Group-wide risk had been recognised from as early as 1985, when the objective of establishing such a system was included in the 1985 strategic plan. There were repeated references to this need over the following three years. Despite this, it was not until 1988 that even the first steps were taken to establish information systems that would enable the Bank's and the Bank Group's total exposure to particular clients, industries or geographic areas to be determined. The Bank not only lacked an information system to measure the total Group exposure, but it was unable even to determine the total exposure of the Bank's own divisions to various clients, industries and geographic areas. As the Bank's Chief General Manager, Mr Matthews reported to the Executive Committee in August 1988, the Bank did "not have any mechanisms to accurately assess our total exposure as a Bank or a Group to any one individual, business entity, industry, region or country ."() Progress in developing an adequate information system after 1988 was slow - it was not until 1990 that reports relating to Group exposures became regularly available to the Bank's Board of Directors.
The absence of any effective system for the monitoring and control of the Bank and Group-wide credit risk exposure of the Bank and Bank Group was a serious deficiency in the Bank's management systems. The business activities of the Bank's divisions and subsidiaries, and of Beneficial Finance in particular, created a real risk that the Bank might be over-exposed to particular borrowers, or over-exposed to particular industries, particularly property and construction.
Both the Bank and Beneficial Finance established prudential policies regarding the maximum exposure to a particular borrower (or borrowing group) by reference to their respective capital bases. Although these policies were relatively aggressive, and J P Morgan stated in 1991 that it believed that the Bank's "exposures to many individual borrowers represent an unduly high percentage of SBSA's capital and reserves", the Bank Group's client exposures were, with some exceptions, within the prudential guidelines established by the Reserve Bank.
The Reserve Bank raised its concerns regarding the Bank's exposure to commercial property with the Bank's management, particularly with Mr Matthews, on a number of occasions. Despite the repeated raising of the issue by the Reserve Bank, no effective steps were taken by the Bank to address the large property exposure in its loan portfolio. Indeed, between June 1988 and June 1989, the Corporate Banking exposure to commercial property increased by $1,008.6M, from $801.1M to $1,809.7M, an increase of 125.9 per cent. The increase in the exposure to Developers and Contractors was 154.8 per cent.
Moreover, no effective action was taken to identify exactly what the Bank's total exposure to commercial property was. Mr Matthews is recorded as advising the Reserve Bank, on 30 January 1990, that the Bank's "System for measuring exposures by industry group, including property, was not yet completed but could be ready by mid-year."()
The excessive exposure of the Bank Group to the commercial property market was caused by:
(i) the failure of the Bank to implement any system to monitor its total exposure to commercial property;
(ii) the failure of the Bank to implement any system to monitor the Bank Group's exposure to commercial property;
(iii) the rapid increase in the Bank's lending for commercial property during the year ended 30 June 1989, resulting in 31.8 per cent of the Corporate Banking portfolio being exposed to commercial property;
(iv) the failure of the Board of Directors of Beneficial Finance to establish an adequate prudential policy to limit its exposure to commercial property; and
(v) the excessive exposure of Beneficial Finance to commercial property, of about 60 per cent of its risk portfolio.
The responsibility for the Bank Group's excessive exposure to commercial property lies with both the Bank's, and Beneficial Finance's, Board of Directors and Management.
(b) Findings and Conclusions
(i) The Bank's Board of Directors failed to take adequate steps to implement reasonable prudential policies relating to the risk exposure of the loan portfolio, particularly to commercial property, and failed to take adequate steps to satisfy itself that the exposure was monitored and controlled.
(ii) The Reserve Bank raised, at regular intervals, concerns regarding the Bank's and Beneficial Finance's exposures to commercial property. There is no evidence of any action being taken by the Bank in response to these concerns from the Reserve Bank. To the contrary, the Corporate Banking exposure to commercial property increased by $1,008.6M in the year ended 30 June 1989.
(iii) The Chief Executive of the Bank, Mr Clark, failed to take any timely and effective action to review and recommend updating of the Bank's prudential policies, or to ensure that an effective system was established to monitor the Bank's and Bank Group's exposures.
(iv) Mr Matthews, Chief General Manager of the Bank from 1986 to 1988, and from 1 July 1989 Chief General Manager Group Risk Management, assumed responsibility in August 1988 to develop a system to monitor Bank-wide and Group-wide risk. Having assumed that responsibility, Mr Matthews did not ensure that the development of essential systems occurred in a timely manner, and failed to ensure that the Board of Directors was informed of the dangers associated of the absence of Bank-wide and Group-wide risk management systems.
(v) The operations, affairs and transactions of the Bank in this respect were not adequately or properly supervised, directed or controlled by the Bank's Board of Directors, the Chief Executive Officer and Mr Matthews.
1.7.3 FUNDING, AND ASSET AND LIABILITY MANAGEMENT (VOLUME IV - CHAPTERS 6 AND 7)
1.7.3.1 Funding of the State Bank (Chapter 6)
(a) Overview and Summary
The financial position of the Bank in February 1991 was overwhelmingly related to the poor quality of its assets. The Bank made too many bad loans, and paid too much to acquire other businesses that performed badly.
There was, however, a prerequisite to lending, and spending, the money that has been lost - the Bank had to obtain that money in the first place. Shortly stated, the Bank obtained money in the form of capital and borrowings which it lent to its customers, and spent on business acquisitions. The Bank had no trouble borrowing money because, in effect, the people of South Australia guaranteed that, if the Bank could not repay its borrowings, they would. This is, of course, precisely what happened - when the Bank could not meet its obligations because it had lost so much of the money it borrowed, the people of South Australia were required effectively to pay the Bank's obligations.
Broadly speaking, the Bank obtained its funds from three sources. They were:
(i) retail deposits in the form of savings accounts held, in large part, by South Australians;
(ii) wholesale deposits and other loans from businesses and other financial institutions; and
(iii) capital contributions from the Government, arranged and provided by the Treasurer and by the South Australian Government Financing Authority ("SAFA").
There was nothing about the way that the Bank obtained retail or wholesale funds that contributed to its failure. Indeed, with the benefit of the Government guarantee, the Bank had few problems borrowing money on favourable terms.
The non-executive directors of the Bank (other than Mr Prowse) - and particularly Mr D W Simmons - submitted to me however that the dividend rate applicable to the majority of the Bank's contributed capital was a significant cause of the Bank's losses.
In essence, the non-executive Directors' argument was that the capital provided by SAFA was so expensive - it carried a fixed dividend rate of 0.65 per cent above the bank bill rate - that the Bank was forced to grow rapidly in pursuit of profits just to be able to meet its dividend obligations to the Government. The implication is that the Bank's failure was not the Board's fault. Rather, the Bank was forced to grow rapidly by the Government's exorbitant and unreasonable demand for profits, manifested in the form of a fixed obligation on the Bank to pay excessively high dividends. This compelled the Bank to take risks that it should not have taken, resulting in losses.
This submission from the non-executive directors compelled me to investigate in considerable detail the nature and terms of the Bank's capital structure. Having done so, I have concluded that there is no substance to their submission. Indeed, that submission demonstrates the paucity of financial knowledge that was a characteristic of the Bank's Board of Directors.
Over the period covered by my Investigation, the capital of the Bank increased very significantly, from $165.5M at 1 July 1984, to $1,340.6M at 30 June 1990. Most of this increase - $1,070.9M of the total increase of $1,175.0M - was in the form of additional subscribed capital and subordinated loans. All but $US 100.0M of that additional capital was provided, directly or indirectly, by the South Australian Government through SAFA.
A feature of the capital contributed to the Bank was said to be that most of it was not "free". This expression was used, in submissions and evidence to me, to mean that it carried an obligation to pay a dividend at a determined rate. In June 1989, the Bank's capital was made up of the following components:
| "Free" capital (including reserves and retained earnings) | 301.9M | |
| SAFA contributed capital | 538.9M | |
| Subordinated debt | 472.0M | |
| Total Capital | $1,312.8M |
As can be seen, of the total "capital" of $1,312.8M, only $301.9M, or 23.0 per cent, was "free". The SAFA contributed capital of $538.9M carried an obligation to pay a fixed dividend equal to the bank bill rate plus 0.65 per cent per annum. The subordinated debt involved interest obligations related to LIBOR (London Interbank Offer Rate).
Mr Simmons made a detailed submission in respect of the Bank's cost of capital and its implications. He identified the essential problem as:
(i) the fixed dividend rate of bank bill plus 0.65 per cent payable on the SAFA contributed capital was excessive;
(ii) the rate was particularly onerous because it had to be paid from after-tax profits - that is, the dividends were not deductible for the purpose of determining the Corporations Tax Equivalent payable to the State Government pursuant to Section 22 of the Act. The result, Mr Simmons submitted, was that the Government got " two bites of the cherry ", and was " being paid more than it was legitimately entitled ";
(iii) the result was to drive the Bank's Management to pursue profits in a manner that necessarily involved taking higher risks than it otherwise would have;
(iv) those risks are now evident in the poor quality of the Bank's assets.
I do not accept Mr Simmons' submission, for a number of reasons:
(i) First, there is no such thing as "free" capital. Every company incurs a cost for its capital represented by the return demanded by its shareholders, either in the form of dividends or capital gains associated with retained earnings. All contributed capital carries an effective obligation on the company to derive profits, whether distributed as dividends or not. Based on information provided to me by the South Australian Treasury, I am satisfied that the State Bank's cost of capital was not excessive;
(ii) Second, Mr Simmons' statement that the dividends were to be paid from after-tax profits is wrong. As shown clearly in the Bank's 1990 Annual Report, the Corporations Tax Equivalent was in fact calculated after allowing the dividends paid to SAFA as a deductible expense. There were no "two bites at the cherry";
(iii) Third, the Bank's officers expressly denied in evidence to me that the dividend rate was a factor which influenced the Bank's business growth. Mr Clark described the argument regarding the Bank's cost of capital as a " furphy raised by the directors ". I am inclined to agree with Mr Clark;
(iv) Fourth, the Board of Directors sanctioned a profitability target of a 15 per cent return on shareholders' funds, which was at least as demanding as that reflected in the "fixed" cost of capital; and
(v) Finally, the terms on which capital was provided to the Bank by SAFA included a provision that the dividends were not payable if profits were insufficient to fund the dividends.
The fact that this submission could be put by the former non-executive directors (other than Mr Prowse, who expressly disassociated himself from it), and particularly by Mr Simmons, speaks volumes for the difficulty those directors had in grasping even this basic element of the Bank's capital structure. I accept that their submission was made in good faith. It was, however, factually incorrect and logically flawed in a way that demonstrates, as clearly as anything else, their inadequacy for the task of governing a bank.
In the course of reviewing the Bank's funding, I investigated particularly the terms of a $US 150.0M floating rate note facility entered into by the Bank, and arranged by J P Morgan. Although this facility, which was in effect simply a form of borrowing by the Bank did not result in significant losses, the circumstances of its implementation highlights the shoddy way in which the Bank was managed.
Shortly stated, I cannot understand why the Bank entered into the transaction. The loan was more expensive than funds that could have been obtained from SAFA (which, in the end, effectively provided the funding by subscribing for the notes). Indeed, the South Australian Treasury asked Mr Matthews, in writing, not to undertake the transaction. Mr Matthews did not tell the Board of Directors about that request.
The Board was largely uninformed regarding the transaction, and did not approve it before Management committed the Bank to it. Although some directors were given an oral briefing on the transaction by Mr T L Mallett, the transaction entered into was quite different from that described. A Board Paper informing the Board that the transaction had been mandated by the Bank contained errors which made the paper not only misleading, but essentially incomprehensible. Mr Mallett, with the authorisation of Mr Clark, committed the Bank to the transaction without Board authority.
The only possible advantage to the Bank from the transaction was illusory, depending as it did upon an accounting device that involved treating repayments of the loan principal as though they were interest. The result was to appropriate profits above the line to build up "capital" which was, in fact, retained earnings. This accounting treatment was not only inappropriate - it was contrary to an accounting standard promulgated at the time the transaction was undertaken.
(b) Findings and Conclusions
(i) The manner in which the Bank was funded was not a matter that caused the financial position of the Bank. In particular, the Bank's "cost of capital", represented by the dividend obligation in respect of the capital contributed by SAFA, was not excessive, and did not cause the Bank to aggressively pursue profits.
(ii) Bluntly stated, the Board of Directors did not understand the capital structure of the Bank. Their submissions to my Investigation show that, even now, they appear confused.
(iii) Mr Clark, as the Bank's Chief Executive Officer, should have ensured that adequate information regarding the Bank's capital and funding arrangements was placed before the Board to enable it to discharge its functions as the governing body of the Bank.
(iv) In respect of the perpetual note issue arranged by J P Morgan, the transaction was undertaken without the approval of the Board of Directors. The information provided to the Board "for noting" defied comprehension. The Board was not informed of the State Treasury's opposition to the transaction. The transaction was not in the best interests of the Bank. It involved a higher cost of funds than was available from SAFA, and depended for its effectiveness on an inappropriate accounting treatment.
(v) In respect of the funding of the Bank generally, and the J P Morgan transaction in particular, the operations, affairs and transactions of the Bank were not adequately or properly supervised, directed and controlled by the Board of Directors, the Chief Executive Officer and other certain officers of the Bank identified in Chapter 6.
1.7.3.2 Treasury and the Management of Assets and Liabilities of the State Bank (Chapter 7)
(a) Overview and Summary
The business of banking can be described in very simple terms as involving the borrowing and on-lending of money. A bank borrows money at one interest rate, and on-lends at a higher rate: the difference between the two rates represents its gross profit or margin.
This simplistic statement of a lending business disguises a number of complications that cannot be ignored in carrying on large-scale borrowing and lending activities. In particular:
(i) First, it should be self evident that the lending officers responsible for making loans should know what the cost of the bank's funds is. If they do not, there is a risk that they will make loans at a price which will mean that the business is unprofitable.
(ii) Second, it is important that a bank's borrowings and its loans are reasonably matched and managed in terms of their maturity dates. There are significant risks involved in, for example, using short-term borrowings to fund long-term loans.
These aspects of the management of a bank's lending business are commonly referred to as its asset and liability management. They are an essential feature of the prudent management of any lending business.
The most significant - and startling - feature of this aspect of the State Bank's operations, is that before late 1990, it did not exist. Until 1990, there simply was no overall management of the Bank's assets and liabilities. This part of the Bank's activities was completely without co-ordination. The emphasis was on growth and profits.
There was until 1990 no person or committee which had or exercised any responsibility for the general management of the Bank's assets and liabilities. Although the Bank did have an asset and liability management committee ("ALMAC") from the time of its establishment in July 1984, that Committee was abolished by the Executive Committee on 31 July 1987. The reasons stated were a perceived need for "quickness of decisions and the ability to react quickly to the economic environment" .
There is little evidence available of the functions performed by the first ALMAC, and the Bank's managers had little recollection of their involvement with it. It appears, however, to have been little more than a pricing committee: it "considered the cost of funds, what the market was doing and set the rates" .
The ALMAC was reconstituted in September 1988, following a recognition of the potential implications of failing to adequately address asset and liability management. The new committee's responsibility and focus were, however, unclear. The evidence I examined shows that it was not until 1990 that some co-ordinated management was established in respect of the Bank's assets and liabilities.
The absence of any attention to this function was in part related to the Bank's status as a State Bank. With the benefit of the Government guarantee, the Bank was always able to borrow funds as it required them, and usually at favourable interest rates. The Bank therefore paid little or no attention to managing its liquidity. Nor did it price its loans according to its actual cost of funds. Rather, its loans were priced at whatever level was necessary to be competitive in the market - that is, to do the deal.
The essential result was that prudent considerations of loan pricing and liquidity management did not act as a constraint upon the rapid expansion of the Bank's loan portfolio. Had the Bank adopted prudent asset and liability management practices, its growth may have been constrained. The absence of those practices allowed the Bank to grow much too quickly, ahead of its own management resources, capabilities and reporting systems.
The absence of any adequate assessment of the cost of the Bank's funds for the purpose of pricing its corporate loans, and the pricing of those loans instead by reference to market forces rather than to the cost of funds, meant that the position with respect to unprofitable lending transactions was never highlighted. The position was disguised by the Bank's use of disproportionate front end fees in respect of its corporate loans, and the accounting procedures that recognised those fees as income at the time of receipt. If the practice of charging inappropriate front end fees had not been followed, or if those fees had been recognised as income over the life of the loan, the reported profitability of the Bank would have been significantly lower.
Asset and liability management is a function commonly carried on by the Treasury division of banks. Other Treasury operations include:
(i) Managing the various financial risks faced by a bank, including interest rate risks and foreign exchange risks;
(ii) Ensuring that the bank optimises the use of its short-term cash surpluses, and that it has access to funds to meet short-term cash deficiencies;
(iii) Managing the bank's liquidity, ensuring that it will have funds available to meet its obligations as they fall due; and
(iv) Active dealing in financial markets with a view to earning profits for the bank.
As I have described, the Bank's Treasury did not have, or exercise, responsibility for managing the Bank's assets and liabilities before 1990. Neither did any other division or manager.
There were other deficiencies in the Treasury operations of the Bank that were identified in the course of my Investigation, including:
(i) The absence of any cashflow forecasting system.
(ii) The failure to adopt the practice of valuing the Treasury portfolio at its market value on a day-to-day basis until 1989. Before then, the absence of the "marking to market" policy enabled the profit on assets to be selectively realised, while losses on corresponding liabilities were allowed to remain hidden.
Perhaps the most important reason for the shortcomings in the Bank's Treasury function was, as in the case of other areas, the Bank's very rapid growth and development from an essentially thrift institution to become a diversified financial institution with extensive operations in most segments of the financial markets. The Bank's growth was such that it quickly outgrew the capacity of the Treasury division to satisfy the increasingly sophisticated functions it should have performed.
The Bank's Treasury division lacked the skilled and experienced Treasury staff that were needed to conduct effective Treasury operations. Eventually, part of the Treasury function was established in Sydney where skilled and experienced staff could be obtained. Although the Bank employed a well qualified manager in the money market area in 1987, her responsibilities were limited, and her initiatives to improve the information systems were at least not supported by, and probably actively thwarted by, some of the Bank's senior managers. It was not until early in 1989 that an appropriately experienced manager was appointed to head the Treasury division.
(b) Findings and Conclusions
(i) While the absence of prudent asset and liability management within the Bank cannot be said to have been a direct cause of the Bank's financial position, its absence meant that there was no constraint upon the rapid growth of the Bank's assets. Accordingly, in my opinion, the absence of prudent asset and liability management practices within the Bank was a matter which contributed to the financial position of the Bank as reported in February 1991.
(ii) The manner in which the Treasury operations of the Bank were conducted, particularly the absence of prudent asset and liability management practices, played an important part in the processes which led the Bank to engage in operations which resulted in losses, and in the Bank holding significant non-performing assets. The conduct of the Bank's Treasury operations was inappropriate.
(iii) The Board of Directors took no active role in the asset and liability management of the Bank. The real problem was that none of the directors had the specialised knowledge or experience of banking practice that would have enabled them to understand what was required in the area of asset and liability management, and to realise that what was being done at the Bank in that area was inadequate. The Board would not have appreciated the problem unless the deficiencies were pointed out to the Board and explained. They were not.
(iv) The Board of Directors acquiesced in the dissolution of the first ALMAC, after having been told by Management that its dissolution was appropriate. The Board believed that asset and liability management responsibility would be assumed by the Finance department. In fact, it was not.
(v) Nevertheless, the basic principles of asset and liability management, as described above, are not difficult to grasp. A prudent Board of Directors would, having regard to the importance of those principles to the operations of a banking business, have taken steps to obtain a better understanding at least of the principles of asset and liability management, and of the Bank's activities in that area. It was not sufficient for the directors to permit themselves to remain in ignorance of the reality of the situation.
(vi) As Chief Executive Officer of the Bank, Mr Clark was the one person in a position to take an overview of the whole of the Bank's activities. That is one of the principal reasons for the existence of the office of Chief Executive Officer. However, Mr Clark displayed neither sufficient interest nor the level of expertise that is required of the Chief Executive Officer of a Bank in the area of asset and liability management. As a consequence, he did not give the priority to this area that it required.
(vii) The Treasury and asset and liability management aspects of the Bank's operations were not adequately or properly supervised, directed and controlled by the Board of Directors of the Bank, the Chief Executive Officer of the Bank, or by certain other officers and employees of the Bank as identified in Chapter 7 of my Report.
(viii) The information provided to the Board of Directors with respect to the asset and liability management and Treasury operations of the Bank was not timely, reliable, adequate or sufficient to enable the Board to discharge adequately its functions under the Act. The absence of appropriate asset and liability management policies and procedures gave rise to deficiencies in the information provided to the Board - and to senior management and the lending divisions of the Bank - that meant that there was an inability to:
. identify changes in the nature of the business which made possible the losses which the Bank has suffered; and
. identify that the Bank was actually entering into many lending transactions which were, from the outset, destined to be unprofitable.
1.7.4 THE MANAGEMENT OF CREDIT (Volume V - Chapter 8)
Credit and its Management: Guidelines, Policies, Processes, Procedures and Organisational Delivery Mechanisms (Chapter 8)
(a) Overview and Summary
The single most important reason for the losses of the Bank was the poor quality of its corporate lending decisions. Put simply, the Bank made too many loans that it should never have made. Those loans were high risk - beyond a level acceptable to any prudent banker. The result was the catastrophic losses reported by the Bank, and all of the consequences which have flowed from them.
My Investigation of the Bank's lending policies and procedures has led me to the conclusion that the Bank's corporate lending business was poorly managed in almost every respect: its policies were inadequate, the approval processes were inappropriate and poorly defined, lending decisions were made on the basis of inadequate and incomplete information, and once a loan had been made it was not adequately monitored.
In short, the Bank's corporate lending displayed the characteristics of being driven by the need to do the deal. The application of sound policies and procedures was sacrificed to the desire to write new business. The Bank's policies and procedures failed to act as a check against making unacceptably risky loans, and failed to protect the Bank from the implications of doing so.
Under the State Bank Act, the ultimate authority to transact the business of the Bank lies with the Board of Directors. The Board is, however, authorised by the Act to delegate its powers and functions, and it did so in relation to the approval of loans. In July 1984, the Board established a series of delegated lending authorities, including authority for individual managers to approve loans below a certain dollar value, and for a management Lending Credit Committee to approve loans of up to $2.5M. Loans in excess of that amount were to be approved by the Board of Directors. Over the years, the dollar-value limits of these delegated authorities were increased.
The Bank's Board of Directors was not well qualified to prudently evaluate and approve loans. Only the Managing Director, Mr Clark, had any previous commercial banking experience. I am satisfied that the former non-executive directors' lack of experience in relation to lending impeded them in the discharge of their responsibility to exercise the necessary degree of judgment in approving loans.
The Bank's non-executive directors were involved in approving loans in ways other than at a Board meeting. These related to the approval of "urgent" loan proposals:
(i) Urgent lending proposals were sometimes circularised to directors individually. Directors were required to consider the loan proposal on an individual basis, and to contact the particular lending officer to indicate his approval or rejection of the loan proposal. No rules or policies were ever adopted by the Board, or by Management, to regularise this "round robin" procedure. Although it sometimes complained about the procedure, the Board acquiesced in it. A number of very significant loans were made by the Bank on the basis of approvals obtained using the round robin procedure. Apart from the obvious dangers associated with requiring an urgent decision from individual directors with little banking experience, the round robin procedure was of doubtful validity under the terms of the State Bank Act.
(ii) The Board of Directors authorised a sub-committee of the Board to consider and approve urgent proposals. Over time, the sub-committee came to be regarded as being authorised to give final approval for loans, whether or not they were urgent. In so acting, the sub-committee exceeded the authority expressly granted to it by the Board of Directors.
The Lending Credit Committee was a committee of management authorised by the Board of Directors to approve loans within the limit of its delegated lending authority, to consider other loan proposals with a view to providing a recommendation to the Board of Directors, and to conduct half-yearly reviews of loan quality and report the results to the Board.
There were a number of significant shortcomings in the constitution and operation of the Lending Credit Committee which meant that it did not adequately discharge its functions. In particular:
(i) The Lending Credit Committee was dominated by managers whose departments had initiated, and were sponsoring, credit proposals. An important deficiency in the Bank's lending procedures was the absence of the internal control represented by the segregation of duties. At Lending Credit Committee level and below, the Bank should have had a procedure under which lending decisions would be rigorously and objectively analysed by a person not having a commitment to the approval of the loan.
(ii) The low level of delegated lending authorities to individual managers meant that the Lending Credit Committee simply had too many loan proposals to consider. Its workload was such that it could not adequately consider individual loan proposals.
I have seen no evidence that the Lending Credit Committee effectively addressed its responsibility to conduct half-yearly reviews of the quality of the loan portfolio, and to provide reports to the Board of Directors in respect of those reviews.
The Bank's credit management policies and processes were, through most of the period subject to my Investigation, inadequate.
An important deficiency with the Bank's policies and processes was, quite simply, that they were not documented and compended in a credit policy manual until 1988.
The documented policies and processes which I have reviewed contain a variety of omissions and inadequacies which were serious. This was particularly so having regard to the fact that the Bank was, following its formation in 1984, expanding its activities to include extensive corporate lending for the first time. The lack of a depth of experience that this implies made the documentation of clear and comprehensive policies and processes particularly important.
More important than the policies and processes of the Bank, at least in determining the cause of its losses, was what the Bank actually did in respect of particular loans. Accordingly, I examined nineteen non-performing loans of the Bank to identify what the Bank actually did in initiating, approving, granting and subsequently managing loans (six of these loans were examined in greater detail, and are reported as Credit Risk Management Case Studies in Chapters 9-14). This review disclosed a plethora of inadequacies in the workings of the Bank's corporate lending business, including:
(i) Initiation of loans: inadequate gathering and analysis of financial information relating to the borrower; failure to analyse the borrower's ability to service the loan; failure to analyse the value and realisability of security to be taken for the loan; failure to adequately review or confirm asset values; failure to undertake, or at least to record and document on the file, interviews with loan applicants; failure to independently confirm financial information provided by the applicant; failure to undertake sensitivity analyses.
(ii) Approval of loans: approval of loans on the basis of proposal documents containing information that was manifestly deficient; procedural irregularities in the approval process, including purported approval of loans by the Board Sub-Committee when a quorum was not present, and breaches by the Lending Credit Committee of its delegated lending authority limit.
(iii) The taking of security : inadequate security cover (as determined by the Bank's own policies); security taken was different from that described in the credit proposal.
(iv) Advance of funds: funds advanced before security was perfected; funds advanced before pre-conditions to drawdown had been satisfied.
(v) Management of performing loans : review procedures, including the performance of annual reviews, often not performed at all, or not performed on a timely basis; inadequate monitoring by Bank officers of compliance by the borrower with covenants and conditions of the loan; failure to monitor the continuing credit worthiness of the borrower.
(vi) Management of non-performing loans : failure to undertake required reviews; failure to develop an action plan for resolving problem loans; failure to report relevant information to Management; commonly, the officer responsible for managing a non-performing loan had sponsored the original lending submission.
In examining the Bank's lending activities, I have not ignored the difficulties associated with the economic and business conditions of the time. Many banks and other financial institutions were overly-aggressive in their pursuit of business following the deregulation of the banking industry, and the licensing of fifteen foreign-owned banks. The particular economic conditions at the time, including rapidly increasing asset values and an expectation that that would continue, encouraged imprudent lending practices.
However, common practice is not necessarily good practice. Further, in my opinion the Bank's lending practices were sadly deficient, even judged by the standards of the day. The Bank's corporate loan portfolio grew more rapidly than those of most other banks in Australia, which is often a good indication of lower credit standards. The extent of the Bank's losses corroborates that conclusion.
(b) Findings and Conclusions
(i) The conduct by the Bank of its lending business was among the matters which caused the financial position of the Bank as reported in February 1991. The poor quality of the Bank's lending decisions was the single most important cause of the Bank's losses.
(ii) The Bank's lending policies and processes were inappropriate. The Bank's policies were not compended in a single credit policy manual until 1988. Even then, those policies contained omissions and deficiencies that were serious.
(iii) The Board of Directors lacked the necessary experience to properly fulfil its obligations in approving loans, and did not effectively delegate or discharge its statutory powers in relation to lending.
(iv) The involvement of the Board Sub-Committee in approving loan proposals which were not urgent was outside the express authority granted by the Board of Directors. The Sub-Committee was not really a committee at all, but a fluctuating group of individuals. It was an unsafe and unsatisfactory body for the approval of loans.
(v) The use of the "round robin" decision making process to obtain approval of directors meant that they were denied an appropriate forum in which to discuss and assess loan proposals. The "round robin" procedure was never the subject of formal adoption or approval.
(vi) The Bank's Board of Directors failed to adequately or properly supervise the Bank's lending activities. Before April 1989, the Board took no effective action to ensure that the Bank had adequate policies and processes for the conduct of its lending business, or that the lending business was in fact being conducted prudently and in accordance with accepted principles of financial management.
(vii) The Chief Executive Officer, Mr Clark, neither discharged nor effectively delegated his duties in relation to the management of the Bank's lending business. Although he was aware of the defects outlined in the November 1987 review paper and foresaw difficult years ahead for the Bank, he failed to take positive steps to ensure an adequate review and upgrading of the Bank's credit risk management processes.
(viii) The corporate lending business of the Bank was not adequately or properly supervised, directed or controlled by the Board of Directors, the Chief Executive Officer or by other officers or employees of the Bank.
1.7.5 THE MANAGEMENT OF CREDIT: CASE STUDIES (Volume VI - Chapters 9 to 14)
1.7.5.1 Preliminary Observations
One of the major tasks undertaken by the Investigation was an inquiry into specific non-performing loans written by the Bank. The Investigation did not analyse all of the Bank's non-performing loans. Rather, the Investigation was supplied by the Bank with a list of non-performing loans as at March 1991. The Investigation selected a sample of 19 from that list, after performing some initial testing of information supplied by the Bank, which proved to be accurate.() The Investigation then chose six loans from the sample of 19 non-performing loans to be investigated in particular detail. The analysis of those six loans had, as its objectives, the investigation of:
(a) the application or non-application by Bank officers of the guidelines, policies, and procedures laid down by the Bank;
(b) the implications of the absence of clearly described rules that had been identified by my review of the Bank's documented policies and processes; and
(c) other matters relating to the Bank's lending policies.
In selecting the six non-performing loans which are reported upon in detail in Chapters 9 to 14, I had regard first and foremost to the Terms of Appointment. In particular, I have had regard to the need to preserve confidentiality in the Bank's affairs. As a corollary of this, I have had regard to the need that existing and future customers of the Bank be confident that their affairs and dealings with the Bank will not be disclosed to the public save in special circumstances. Secondly, I have had regard to the stipulation in my Terms of Appointment that I not prejudice the course of future civil or criminal proceedings. Thirdly, I have had regard to the need to avoid, as far as practicable, prejudice to and interference with the ongoing operations of the Bank and the Bank Group. Finally, I have had regard to the public interest in publication of the results of my Investigation. I have weighed, against the desirability of preserving confidentiality in the Bank's affairs, the legitimate expectation of the public generally that the results of my Investigation into the Bank will be made generally available to the citizens of South Australia, so that they be accurately and adequately informed of my findings and conclusions, and of the reasons in support of those findings and conclusions.
Having regard to those and other matters, the six customers and groups of customers named in the following Chapters were selected because:
(a) it was generally a matter of public record that they were in liquidation or receivership; or
(b) either there had been substantial press coverage in relation to their dealings with the Bank, or their dealings with the Bank had been, by some other means, well and truly ventilated in the public domain prior to publication of this Report.
I also had regard to the following factors in selecting the six case studies:
(a) the need to assess the quality of the Bank's lending decisions and, where lending quality was unsatisfactory, to demonstrate which matters, events, and circumstances, led to poor lending decisions being made by the Bank and to poor management of loans;
(b) the size of the loans;
(c) the desirability of reviewing various types of loans in order to test the general applicability of specific conclusions across more than one area of lending activity (viz Consumer, Commercial, Corporate);
(d) the materiality of the loss expected;
(e) the possibility of breach of prudential guidelines and, incidentally thereto, the geographic location of the borrower, the branch of the Bank by which the loan was made, and the field of activity of the borrower;
(f) the possibility of fraudulent activity;
(g) potential conflicts of interests which affected decisions made by the Bank.
Particular loans were selected for detailed examination based on a methodology which involved:
(a) Review and consideration of information obtained during the `Preliminary Investigation Phase';
(b) Review and consideration of additional information acquired and assessed subsequent to the `Preliminary Investigation Phase', particularly the Bank's policies and procedures; and
(c) Establishment of a computerised data base of non-performing loan information, recording specific data relative to each non-performing loan (including client details, loan facility type, movements in the loan facility, and security details).
The reports on the six selected non-performing loans comprise Chapters 9 to 14 of this Report. It has not been possible in a summary of this kind to do justice to the detailed analysis which I have carried out in each of the case studies. It is for that reason that I have not set out my findings and conclusions for the case studies in this Chapter. I direct the reader to each of the relevant Chapters for a fuller appreciation of those case studies.
1.7.5.2 Case Study in Credit Management: The Adsteam Group (Chapter 9): Estimated Loss at 31 March 1991, $83.4M
(a) Overview and Summary
The Adelaide Steamship Company Limited ("Adsteam") was formed in 1875 to operate in the Australian coastal trade. In the early 1970s, the company commenced a programme of diversification, both by acquisition and expansion. By 1990, the company ceased to be a trading company and assumed the character of a holding and investment company. Its subsidiaries and associates operated in a wide range of industries which included retailing, manufacturing, real estate, food and wine. The Adsteam Group of companies was large and complex, and its membership fluctuated over the period reviewed (1984-1990). The relationship between Adsteam and those companies which can be considered to be associated with it was carefully structured so as to avoid in many instances establishing a parent-subsidiary relationship in terms of the Companies Codes (which were in force for the greater part of the period).
During 1990, the Adsteam Group was the subject of a number of adverse media reports and press criticism. Credit providers exposed to the group restricted its access to credit. Companies in the Group suffered a consequential liquidity crisis in mid-1990. The crisis was aggravated by the acquisition by the Adsteam Group (through a subsidiary, Dextran) of the Industrial Equity Ltd group of companies. Early in 1990, the Bank had curtailed provision of finance to the Adsteam Group. Nevertheless the Bank was in 1990 the fifth largest lender to the Adsteam Group. The loans extended by the Bank to Adsteam were generally unsecured and were protected only by negative pledge covenants and, in a number of instances, by guarantees by member companies of the Adsteam Group.
The Bank's involvement with the Adsteam Group began in June 1984 with a small facility. The Bank's exposure gradually increased. By April 1990, the Bank's exposure to the Adsteam Group had reached $456.0M. The Bank's exposure to the Adsteam Group was one of the largest in the Bank's corporate lending portfolio.
The principal focus in this case study is on the manner in which the Bank applied its own large exposures prudential guidelines. While certain departures from approved lending practices are touched on in the Report, the Investigation concentrated on the attitude adopted by the Bank in deciding to approve exposures to companies within the Adsteam Group; particularly whether an intended exposure should be aggregated with existing exposures to other members of the Group for prudential purposes, and how those exposures were reported.
The Bank first adopted a large exposure prudential policy in June 1984. Thereafter, the bank's prudential policy comprised two key planks. First, credit limits were to be applied to any one entity or "group" of entities. Secondly, a definition of "group" was formulated for the purposes of aggregation of exposures.
Generally speaking, for credit assessment purposes proposed loans to members of the Adsteam Group were treated by the Bank's management and Board on a "stand alone basis", meaning that, for one reason or another, an intended exposure did not need to be aggregated with existing exposures to other members of the Adsteam Group. In general, the process of reasoning which led to this result was inappropriate. There was a continued failure on the part of the Bank at all levels to fully analyse the Bank's total exposure to the Adsteam Group. Given the way in which the Adsteam Group was structured, this was unacceptable. There were a number of departures from the Bank's prudential limits in 1986 and on successive occasions from June 1988 until June 1990 in relation to facilities extended to members of the Adsteam Group.
The Board had power to approve loans to the Adsteam Group that exceeded the limit of 20 per cent of shareholders' funds prescribed by the Board for prudential purposes. The guidelines adopted by the Board contemplated that transactions otherwise in breach of the guidelines could be put before the Board for consideration. The principal question is whether it was prudent and advisable in the circumstances confronting the Bank from time to time for the 20 per cent ceiling to be exceeded in relation to the Adsteam Group. In my opinion it was neither prudent nor advisable.
In addition, there were occasions when the Lending Credit Committee treated intended facilities as not requiring aggregation and so approved them. These loans should have been aggregated and therefore approved, if at all, only by the Board or Board Sub Committee. The Lending Credit Committee wrongly resolved the issue of how the Bank's prudential policies regarding the definition of a "group" should be applied to the Adsteam Group. The Bank Board erred in accepting management's recommendations from time to time on the issue of how the prudential policies, particularly the definition of a "group", should be applied to the Adsteam Group. The Lending Credit Committee and the Board continued to approve new and increased or extended facilities which, on a group basis, exceeded the limit defined in the Bank's prudential guidelines.
The processes of reasoning adopted by the Lending Credit Committee and the Board, as recorded in contemporaneous documents, are illogical and unpersuasive. At the same time as the Lending Credit Committee, the Board and Bank management were treating intended facilities as "stand alone" and therefore not requiring aggregation, they accepted that the association between an intending customer and Adsteam was a factor in favour of approval of a particular facility. The Bank's analysis was clearly inconsistent, and self-serving.
Accordingly, on a number of occasions the Lending Credit Committee failed to exercise proper care and diligence, and the Bank Board failed adequately and properly to direct, supervise and control the operations, affairs and transactions of the Bank, in approving certain facilities to members of the Adsteam Group. They measured the total exposure to the Adsteam Group against incorrect prudential limits; did not aggregate exposures to one member of the group with exposures to the group as a whole as required by the Bank's prudential policies; and approved facilities in excess of the maximum credit limit that could be granted to any one customer under the Bank's prudential policies from time to time.
I have summarised above the manner in which the Bank's Board of Directors and Lending Credit Committee and management from time to time imprudently and inadvisably departed from prudential guidelines which the Board had approved. It is necessary however to call attention to some of the detailed departures which occurred from the policies and procedures of the Bank which should have been followed at each stage of the loan approval procedure.
In March 1988 the Lending Credit Committee agreed to recommend a letter of credit facility to support the issue of preference shares by Adsteam to National Westminster Bank Plc. The Lending Credit Committee recommended this proposal to the Bank Board for approval. One effect of the proposed facility would be to nearly double the Bank's then drawn down exposure to Adsteam . A paper was presented to the Board by Mr D C Masters, Chief Manager Corporate Banking, noting that Adsteam required urgent approval of the letter of credit by the 23 March 1988 and that directors had been contacted by telephone. It set out who the approving directors were in the paper. The minutes of the Bank Board meeting of the 24 March 1988 indicate that the Board approved the letter of credit facility of $35.0M. It is highly probable that Adsteam was informed of the approval on the 23 March 1988, that is before the Bank Board meeting on the 24 March 1988.
The consideration and approval of the proposal by individual directors was transacted in the course of telephone conversations on the 23 March 1988. This business was not transacted at a Board meeting, nor was the transaction properly recorded in accordance with Section 12(6) of the Act. The purported approval of the facility was thus irregular.
It is not at all clear that the approving Board members received Mr Master's paper. Even if they did, it is unlikely that they would have been given sufficient information upon which to base their decision, or had sufficient time in which to consider the proposal. The paper submitted to the Board contained inadequate financial information, a common feature of proposals relating to Adsteam.
There were other examples of approvals being given in this fashion.
In May 1988, Adsteam applied for a deferred interest facility to be made available to Buckley and Nunn, a joint venture company owned equally by Adsteam and David Jones. The Bank's initial participation of $87.5M was contemplated to increase to approximately $115.0M over three years due to the agreed deferral of interest over that period. At the time of the application existing direct facilities to Adsteam and David Jones were $81.0M and $55.1M respectively. Indirect facilities available to Adsteam were $60.0M.
The Lending Credit Committee and the Board approved the application in May 1988. The deferred interest facility granted to Buckley and Nunn was transferred to Adsteam as from 7 April 1989. Lending Credit committee members present at the meeting on 10 May 1988 at which the facility of $115.0M to Buckley and Nunn was approved were Mr Matthews, Mr G S Ottaway, Mr Masters, Mr V R Pfeiffer and Mr R L Wright.
Notwithstanding that the Bank had taken specific security for the loan, the borrowing company was a directly held subsidiary of Adsteam and there was an increased exposure to Adsteam. It did not matter that specific security had been taken. The submission that " the first recourse " was against the security reflects a view with which I cannot agree. It is a view which has been criticised by J P Morgan in its review of the Bank's credit policies and procedures, and which has since February 1991 been disavowed by the Bank. It is a view which, I am satisfied, contributed to the Bank's participation in many of the non-performing loans investigated by the Inquiry. A lender's first recourse is in practical terms always against the borrower and the borrower's income. A lender must regard the enforcement of security as his last recourse rather than his first recourse.
Accordingly, members of the Lending Credit Committee failed to exercise proper care and diligence and the members of the Bank Board failed adequately and properly to supervise, direct and control the relevant operations, affairs and transactions of the Bank in approving the deferred interest facility of $115.0M to Buckley and Nunn. The Bank could not lend to an Adsteam group company, hold a guarantee from Adsteam and consistently assert that there was no recourse or exposure to the Adsteam Group.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Board, the Board Sub-Committee , the members of the Lending Credit Committee and certain other officers of the Bank are set out in detail in Chapter 9 - "Case Study in Credit Management: The Adsteam Group" of this Report.
1.7.5.3 Case Study in Credit Management: Celtainer Limited (In Liquidation) (Chapter 10): Estimated Loss at 31 March 1991, $3.52M
(a) Overview and Summary
This Chapter deals with the initiation, approval and settlement stages of the credit transaction with a view to identify errors made as a consequence of the Bank's established procedures being inadequate.
Celtainer Ltd was a public company registered and having its operations in South Australia. Its principal business was the design and manufacture of specialised products, mainly for the shipping and mining industries.
Celtainer extended an invitation to the Bank to take equity in the company, and applied for a loan from the Bank. Concurrently with that loan application, the Bank began to take steps towards acquisition of equity in Celtainer.
A written proposal was prepared for consideration by the Bank's Lending Credit Committee by a Bank officer and his subordinate staff, and was endorsed as " supported " by another Bank officer. It is clear however that the " supporter " of the proposal had not reviewed the supporting analysis or scrutinised the factual basis of the information provided by Celtainer.
The proposal recommended a grant of credit facilities totalling $2.75M, as well as acquisition of one million shares in Celtainer at 5 per cent less than current market price. Such an investment involved proposed expenditure of approximately $0.627M and would have made the Bank the holder of 7.1 per cent of the issued capital of Celtainer. The author of the proposal warned, in listing the disadvantages of the transactions:
"...
3 Heavy reliance on mortgage debenture and outwardly moving Gearing Ratio.
4 Company is relatively immature when viewed against the business cycle. 1986/87 is the first profit turnaround.
5 Assessment is based on future outlook as historical results do not inspire financial confidence. "
The proposal concerning the equity acquisition did little more than describe the equity acquisition transaction, and provide some of the factual material and the basic opinion as to the future value of the shares in Celtainer contained in an investment memorandum from SVB Day Porter. It did not contain any further assessment of the investment opportunity beyond that stated in the investment memorandum.
The proposals were considered on the 15 July 1987 by the Lending Credit Committee. The Committee approved lending totalling $2.75M, subject to conditions requiring, amongst other things, the monitoring of cash flow projections which had been made by Celtainer, and verification of Celtainer's compliance with a negative pledge requirement that its net worth not be less than $3.5M. The advances on this loan were not made until December 1987. In the period between approval by the Lending Credit Committee and the making of the initial advance, the financial position of Celtainer deteriorated to the extent that its activities were unprofitable. Any decision to extend credit on the terms proposed at this stage would have been unthinkable. Neither the deterioration of Celtainer's financial position, nor the deterioration in its profits, were detected prior to the Bank advancing the funds. This occurred because there was a failure on the part of the Bank to adequately verify the net worth of Celtainer and further there was no verification of its cash flow and profitability for the period July 1987 to December 1987. The account became problematical almost immediately although it was not classified as non-performing until March 1989.
The acquisition of shares in Celtainer at an actual cost to the Bank of about $0.52M was made after only a superficial examination of the merits of that acquisition by the Lending Credit Committee, which, although endorsing the acquisition, recommended consideration of the matter by the Equities and Underwriting group of the Bank. That group did not consider the merits of acquisition. Purchase of the shares took place in the mistaken belief by the Bank officer involved that the Lending Credit Committee recommendation was all that was required, and that the merits of the acquisition had been thoroughly assessed. The acquisition was never approved by an authorised delegate of the Board. As at the 31 March 1991 the shares were worthless.
Prior to submitting the proposal to the Lending Credit Committee, the officers responsible for its preparation made no attempt to inspect the banking records of Celtainer.
The practices and procedures in place at the relevant time did not provide adequate guidance with respect to analysis of information. The result, which is so clearly evident in this matter, is that whilst the proposal had the appearance of a document prepared after careful investigation and judgment, the proposal was a superficial document and in many respects inadequate.
The Lending Credit Committee's approval was subject to a number of conditions. These conditions were not all clearly set out in a resolution or a decision of the Committee and had to be extracted from both the proposal and the "decision" stated in the minutes of the Lending Credit Committee meeting.
The deliberations of the Lending Credit Committee and the form in which it approved the proposal left a fundamental decision as to whether or not this loan should be made to someone other than the designated decision maker. It does not help to characterise this decision as an abrogation of responsibility or something else. The point is that the designated decision maker did not, in the end result, make the decision. The decision was ultimately made by someone at a lower level and by someone who had insufficient training and experience to make it. The way in which the Lending Credit Committee conducted itself facilitated a circumvention of the system which had been put in place in order to ensure proper credit decision-making.
In relation to the decision by the Lending Credit Committee to purchase shares and the reference by that Committee of the matter to the Bank's Equities and Underwriting Committee, the Lending Credit Committee thought it was considering the equity acquisition as a matter of formality and therefore referred it to the Equities and Underwriting Committee. The latter Committee did not have power to authorise a transaction of that size. In fact it never considered this transaction. Nevertheless, the purchase of the shares was made on the basis of the superficial approval of the matter by the Lending Credit Committee. This episode reveals substantial weaknesses in the Bank's management. Lines of authority were not well understood. Communication in the form of reports and resolutions were of a poor standard.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Bank, members of the Lending Credit Committee and certain other officers of the Bank are set out in detail in Chapter 10 - "Case Study in Credit Management: Celtainer Limited" of this Report.
I have in the course of investigating the affairs of the Bank in relation to Celtainer Ltd as required by my Terms of Appointment considered a matter which may disclose improper activity by an officer of Celtainer Ltd. I am of the opinion that that matter ought to be further investigated. In order that that investigation will not be prejudiced and in order to protect the reputation of the officer concerned pending the outcome of more extensive investigations, I have determined to report confidentially with respect to my consideration of the matter.
1.7.5.4 Case Study in Credit Management: The Collinsville Stud Group (Chapter 11): Estimated Loss at 31 March 1991, $31.3M
(a) Overview and Summary
The Collinsville Stud Group of Companies operated, until November 1991, the world renowned Collinsville Stud's properties in the mid north of South Australia. Collinsville Stud's business was the breeding and sale of Merino sheep. In 1985, the ownership of the Collinsville Stud Group of properties changed and the properties were acquired by Mr N L Garnett. The Bank appointed receivers and managers to the Collinsville Stud operations in November 1991. This Case Study concerns a transaction undertaken within the Commercial and Rural Banking division of the Bank in 1989. The loss resulting from the transaction is the most substantial loss sustained by the Bank outside its Corporate Banking lending portfolio.
It has been necessary for me to examine the conduct of Bank officers who initiated the lending transaction and who analysed an Information Memorandum submitted to the Bank by Ayers Finniss Limited on behalf of Collinsville Stud; the way in which the proposed transaction was presented to the Lending Credit Committee for approval; and the merits of the proposed lending transaction as put to the Lending Credit Committee and to the Board Sub-Committee, each of which approved the transaction on 20 July 1989. In my opinion the transaction was one which should not have been recommended by the Lending Credit Committee or approved by the Board Sub-Committee.
The three bank officers who were most closely involved in proposing the transaction to the Lending Credit Committee did not exercise proper care and diligence in the preparation of the lending proposal submitted to that Committee. In approving the proposed facility, the
Lending Credit Committee members did not exercise proper care and diligence and the members of the Board Sub-Committee did not adequately and properly direct and control the affairs, operations and transactions of the Bank. They permitted their enthusiasm for expansion of the Bank's lending business to cloud their professional judgment. In the circumstances, they should have required further information and explanation in relation to the proposed transaction before approving it and they should not have approved the facilities made available to the Collinsville Stud in the absence of an injection of substantial capital into the business.
An officer in charge of the process of settlement of the transaction did not exercise proper care and diligence in that the officer permitted the loan to be settled whilst conditions of the Bank's approval were unsatisfied and permitted variations in the security arrangements which were not documented. In addition, the Letter of Approval of the facility was not expressed in terms calculated to protect the proper interests of the Bank or to reflect the spirit of the decision of the Lending Credit Committee.
More importantly, management of the loan after December 1989 was most unsatisfactory. The facility became irregular in January 1990. It remained irregular thereafter. Those officers of the Bank involved in managing the account did not take adequate steps to protect the Bank's position and in particular failed to impose a sufficiently strict financial discipline on Collinsville Stud's expenditures after 30 January 1990.
The Bank's management of the transaction at all stages was characterised by ineptitude. The judgment of the Bank officers and the former directors was influenced by the glamour supposedly attaching to the winning of the Collinsville Stud account from its previous credit provider. Decisions taken by the Bank in relation to the transaction lacked objectivity and detachment from the outset through to the time when the Bank appointed receivers and managers.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Board, the Board Sub-Commitee, the members of the Lending Credit Committee and certain other officers of the Bank are set out in Chapter 11 - "Case Study in Credit Management: The Collinsville Stud Group" of this Report.
1.7.5.5 Case Study in Credit Management: Halwood (Chapter 12): Estimated Loss at 31 March 1993, $78.5M
(a) Overview and Summary
In this Case Study I have examined the circumstances surrounding the granting by the Bank during the period from May 1986 to February 1991 of certain facilities to Halwood Corporation Limited, a real estate and property development company formerly known as Hooker Corporation Limited.
In particular, I have examined in detail the shortcomings and deficiencies of the loan proposals in respect of the following facilities which were recommended for approval by the Lending Credit Committee, approved by the Board Sub-Committee and confirmed by the Board:
|
Date |
Amount of |
|
| 15 May 1986 | $20.0M (Syndicated) | |
| 6 May 1987 | $14.5M (Syndicated) | |
| 22 September 1987 | $20.0M | |
| 28 June 1988 | $19.0M (Syndicated) | |
| 4 October 1988 | $73.0M (Australis Centre) | |
| 1 November 1988 | $33.0M (Henry Waymouth Centre) | |
| 14 February 1989 | $6.0M (Aspenair Ltd) | |
An examination of the loan proposals submitted to the Lending Credit Committee revealed that the financial information shown in the proposals was frequently inadequate. There was an inadequate analysis of profit forecasts, and where there were profit forecasts, they were out of date and not relevant. There was generally a lack of future cashflow analysis, and a lack of adequate security as the Bank frequently had only limited recourse to the assets of the borrower.
In the case of the May 1987 facility, the purpose was to facilitate a debt defeasance of Halwood Corporation's secured borrowings by means of debentures. The ultimate success of a defeasance transaction is dependent on acceptance by the Commissioner of Taxation for its cost effectiveness. No regard was had by the Bank to the taxation consequences of this transaction.
A further general deficiency in the proposals was that the assessment of the Halwood Corporation's ability to repay the facility was predominantly based upon an assessment of its balance sheet and past performance, and implicitly assumed a continuation of the value of assets in the balance sheet over the life of the facility.
In the case of the October 1988 facility for the "Australis Centre" in the Adelaide Central Business District, the project was 100 per cent debt funded. The Bank was dependent on the sale of the project for the repayment of the facility. Such a sale would have been made at a time when there was an abundance of unlet office space in this district.
The November 1988 facility proposal for the "Henry Waymouth Centre", also in the Adelaide Central Business District, should have been considered in light of the Bank's exposure to the Halwood Group and not simply as a project funding exercise.
On 14 March 1989, a memorandum was sent to the General Manager Corporate Banking, Mr Masters, noting the details of facilities provided to Halwood Corporation. This recorded that the Lending Credit Committee's decision of 31 January 1989 in relation to the conversion of a $20.0M syndicated facility to a two year "evergreen basis" was withheld pending the General Manager Corporate Banking's "assessment of [Halwood Corporation's] cash flow liquidity and negative pledge covenants to determine the suitability to a two year evergreen facility ".
The memorandum also made it clear that the Bank was still awaiting information from the company regarding its three year strategic plan and cash flow projections. This memorandum was considered at the Lending Credit Committee meeting of 21 March 1989 at which it was noted that no information regarding cash flow or the company's strategic plan had been received. Further, the Committee noted that Australian Ratings had downgraded Halwood Corporation's credit rating.
In a memorandum to Mr Masters, dated the 24 April 1989 regarding Halwood Corporation's compliance with its negative pledge covenants, the authors referred to "recent adverse media reports" and observed:
" It is acknowledged that Halwood Corporation over the past 12-18 months has made significant changes to its asset structure which detrimentally affected both profitability and performance. Whilst corrective action has been taken we consider that the company is some 6 months away from providing clear evidence of a turnaround.
... At this point we are unable to independently assess whether or not Halwood Corporation is outside of the negative pledge covenants as suggested in one of the media reports. "
Notwithstanding all the adverse indications reported in this memorandum, the authors, in a spirit of almost reckless optimism, recommended the extension of the State Bank of New South Wales syndicated facility which was to expire on 29 September 1989 to 29 September 1990.
Mr Masters responded to that memorandum by rejecting the recommendation, and the concerns which he expressed were proven to be fully justified.
All of the proposals shown above lacked merit, were not justified by the terms of the proposals and should not have been recommended by the Bank's Lending Credit Committee, nor approved by the Board Sub-Committee or confirmed by the Board. In relation to the October 1988 proposal (the "Australis Centre") members of the Lending Credit Committee, failed to exercise proper care and diligence in recommending to the Board that the facility be approved.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Board, the Board Sub-Committee, members of the Lending Credit Committee and certain other officers of the Bank are set out in Chapter 12 - "Case Study in Credit Management: Halwood" in this Report.
1.7.5.6 Case Study in Credit Management: Somerley Pty Ltd (Chapter 13): Estimated Loss at 31 March 1991, $29.7M
(a) Overview and Summary
Somerley was a Victorian company which, prior to 1988, acquired a site situated at the corner of Bourke and Exhibition Streets in Melbourne upon which it proposed to construct a 4.5 star hotel/carpark/retail complex. Somerley was partly owned by Mr and Mrs Gostin, Victorian developers, and partly by companies ultimately controlled by the Interwest Group of companies. In addition, the former subsidiary of the State Bank of Victoria, the Tricontinental Group, had a small interest in Somerley.
This Case Study analyses the losses and the causes of those losses sustained by the Bank and, incidentally, by Beneficial Finance, as providers of credit to Somerley Pty Ltd and a related company (Interwest Ltd) in connection with the project's construction.
The Bank's first involvement in relation to the construction project undertaken by Somerley was by way of making a $30.0M bridging loan to Somerley in April 1988. At the same time, Beneficial Finance advanced $19.0M to Somerley, again as a bridging loan. At the time, the value of the site was assessed at approximately $55.0M. The amount advanced to Somerley which had no substantial assets other than the construction site to which I have referred, thus approximated to 89 per cent of the value of the security.
The second transaction entered into by the Bank in relation to Somerley was participation by the Bank (to the extent of $55.0M) in a $190.0M first tier syndicated facility which became effective in September 1989 and which was intended to fund the construction phase of the project. Again, Beneficial Finance was involved in this phase of the project as a second mortgagee together with the State Bank of Victoria. The decision by the Bank to participate in the first tier syndicate proved to be most unwise.
In January 1990, the Interwest Group was placed into receivership. Somerley became insolvent as a consequence. The first tier syndicate refused to advance any further funds to Somerley. Beneficial Finance approached the Bank to seek funds to buy out the other members of the first tier syndicate. Ultimately, the Bank Board approved a facility in the sum $91.5M to enable Beneficial Finance to buy out the members of the first tier syndicate (other than the Bank) and to carry on with construction activities to the carpark/retail stage. The decision of the Bank Board to enable Beneficial Finance to buy out the other members of the first tier syndicate was imprudent and unwarranted. Once again the Bank was to find itself taking on the role and obligations of a property developer
More specifically, I have identified a lack of care and diligence on the part of Bank officers involved in preparation of the lending proposals relating to the bridging loan facility and to the Bank's participation in the first tier syndicate and subsequent construction funding.
The Bank's lending policies and procedures were inadequate. They did not in 1988 and 1989 require authors of lending submissions to disclose to lending organs, and they did not require the Bank's lending organs to have regard to, aggregated Bank Group exposures where the Bank was proposing to lend to a particular customer or on a particular project jointly with or in priority to Beneficial Finance. I report that a particular Bank officer did not conduct with adequate care and diligence a pre-settlement review carried out shortly before finalisation of the first tier syndicate in August 1989.
The Bank's management of the facility once it became non-performing was unsatisfactory.
The members of the Board who approved the first tier syndicate buy out on 22 March 1990 erred in doing so and in that respect did not adequately and properly direct, supervise and control the affairs, operations and transactions of the Bank.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Board, the Board Sub-Committee, members of the Lending Credit Committee and certain other officers of the Bank are set out in Chapter 13 - "Case Study in Credit Management: Somerley Pty Ltd" of this Report.
1.7.5.7 Case Study in Credit Management: The REMM Group (Chapter 14): Provision for Loss at 31 March 1991, $185.0M
(a) Overview and Summary
The Bank sustained a huge loss as a provider of credit facilities to REMM Group Limited in connection with the development of the Myer Rundle Mall project. Early in 1988 the Bank was approached by another lending institution which was attempting to put together syndicated financing for the project. This would have involved the Bank in a participation (approximately $40.0M in the overall project) and exposed it to limited risks. That proposal fell through and it was then proposed that the Bank undertake syndication and also provide "back end " finance.
The proposal to provide finance for the entire project was contained in two Stages. Stage 1 was a transitional step towards Stage 2 which envisaged that the Stage 2 financing debt would be discharged either upon sale of the complex or through refinancing.
Although the Stage 2 financing involved facilities of up to $490.0M, it was coupled with certain guarantees, and the effect of this was to commit the Bank to financing the completion of the project whatever the cost.
The time frame envisaged by the proposal was that Stage 1 would take place immediately upon approval and would be superseded by Stage 2. The time frame envisaged by this proposal for Stage 2 was not expressed in precise terms, it being acknowledged, that this depended upon a number of variable factors, such as delay in completion of the project; whether or not a purchaser could be found and if so, when after completion of the works; and other matters. The time frame stated in the " Disaster Scenario " in the July 1988 proposal envisaged that the financiers might still be involved in the period 1994-95. Whilst this was the "Disaster Scenario", the proposal generally postulated a construction period of 18-24 months and that financing would be completed within five years with a provision for early repayment.
The proposal also involved a direct relationship between the Bank as head financier and Myer Stores Ltd as the principal lessee of the completed complex. When the REMM Group acquired the site, it did so, subject to the rights of Myer Stores Ltd, which occupied a major portion of the development site pursuant to a lease. In order to procure Myer Stores to vacate the site and move elsewhere pending development and in order to secure a long term lease of the premises after redevelopment by REMM Group to Myer Stores Ltd, two agreements known respectively as the "Rundle Mall Performance Guarantee" and "Surrender Compensation Agreement " were required by Myer Stores Ltd.
The parties to the Rundle Mall Performance Guarantee were the Bank, Myer Stores Ltd and two REMM Group companies. The effect of the agreement as between the Bank and Myer Stores Ltd was in broad terms that if REMM Group failed to complete the project then its obligations to do so would be undertaken by the Bank. It is stating the obvious, but it is necessary to observe, that this meant that, if the estimate of costs made by REMM Group was inadequate and if the finance arrangements provided insufficient capital, then the Bank would have to provide the necessary additional funds to complete the project in the event that REMM Group could not do so.
Under the terms of the Surrender Compensation Agreement and as an inducement to Myer Stores Ltd to relocate, REMM Group underwrote the profits of Myer Stores during the financial years 1988-1989 and 1989-1990 to the extent of $27.0M. This was designed to ensure that Myer would not suffer any loss of profitability arising from its relocation to Centrepoint and Miller Anderson sites whilst the Rundle Mall site was being redeveloped. The Bank as the guarantor of REMM Group, pursuant to the Rundle Mall Performance Guarantee, became liable as guarantor of REMM Group, in the event that REMM Group failed to compensate Myer for the loss of profits as provided by the Surrender Compensation Agreement.
The proposal was recommended for approval on 27 July 1988 by the Lending Credit Committee subject to certain conditions and on the following day the proposal was approved subject to conditions by the Board of Directors.
Despite the fact that the condition of approval of the Board had required as a condition precedent to the advancement of funds, documentation (including a " Put Option ") to be to the satisfaction of the Bank's legal advisers, the terms of the Put Option were only agreed in very broad outline and documented by way of an exchange of letters.
Despite the fact that the risk underpin involved $200.0M risk to the Bank no formal documentation in connection with it was ever prepared. Most importantly and notwithstanding that the Board's approval had been conditional on it, no confirmation "as to the accuracy of the project costings and construction time table based on final approved plans to be provided by WT Partnership" was obtained.
Syndication of the project as envisaged by Stage 2 of the July 1988 proposal, did not occur, nor were any steps taken immediately to put it in place, other than the dispatch on 12 August 1988, of an indicative letter setting out the terms and conditions of the proposed syndicated facilities.
Despite the shortcomings in the immediate implementation of the Board's decision, Mr P F Mullins and another officer of the Bank, executed (under Power of Attorney) the Rundle Mall Performance Guarantee. This was done on the 29 August 1988. The importance of this step should be recognised. Its effect was that even though the Bank was limited in its obligation to REMM Group to the extent of financing the project up to $500.0M, its obligations to Myer Stores Ltd, were not limited to that figure, and the terms of the guarantee agreement effectively committed the Bank to Myer Stores Ltd in a way which was legally enforceable to provide sufficient finance for the project to be completed. This was notwithstanding the fact that the cost might exceed $500.0M and might well do so to a very substantial extent.
The enormity of the risk which the Bank took by signing the Rundle Mall Performance Guarantee must be appreciated. If the cost of the development " blew out ", the Bank was liable to Myer Stores Ltd to make the additional funds available to complete it. If the value of the development project was substantially less than expected, the Bank would suffer loss if it was forced to sell it. The " Disaster Scenario " stated in the July 1988 proposal, envisaged that the Bank might hold the asset until:
" ... the Centre value equated to the outstanding debt and it could be sold. "
What the " Disaster Scenario " did not envisage was that a combination of factors might occur. In particular it failed to recognise, that the cost over-runs might be greatly in excess of the amount estimated and that this might coincide with the diminution in the rental income anticipated from use of premises after completion. If this combination of events occurred, the rental income might be insufficient to meet the financing requirement of the debt and consequently the debt would simply grow bigger and bigger. Moreover, a diminution in rental income could be expected adversely to affect the valuation of the building and in these circumstances, if it were to be sold, it was likely to realise an amount that was significantly less than the expected valuation.
It was of course important to all parties that the project proceed quickly. If it did not, the holding charges associated with maintaining the Stage 1 funding would become a significant additional expense to the project, eating into the safety margins contained in it for other adverse eventualities. Inevitably there were delays and by mid July 1989 the management of the Bank realised that the original funding arrangements could no longer work. By now the Bank had considerably increased its bridging finance. The REMM Group could not provide additional funds and the Bank would either have to provide them in order to enable the REMM Group to continue or alternatively embark upon the hazardous course of becoming a mortgagee in possession of a partially completed major building site.
In September 1989, a completely new funding concept and proposal was put to the Board as a means by which the Bank would acquire greater control over the cost and progress of the project and as a means of facilitating syndication and thus a reduction of the Bank's exposure to risk on the project.
The September 1989 proposal envisaged a debt one year after completion of the project, now of approximately $575.0M as compared with previously a debt of $450.0M. The concept of the September 1989 proposal envisaged that, by 31 March 1992, REMM Group would either have refinanced the project or introduced additional equity into it or alternatively have sold it. If these things had not occurred by that date, then the Bank would have a call option, permitting it to acquire total ownership on discharge of the debt of REMM Group on the project as secured in the arrangements between the Bank and REMM Group.
By mid November 1989 the funding requirements of the project were dangerously close to the level of the bridging finance. The situation which had occurred in connection with the July 1988 proposal was repeating itself, ie bridging finance was insufficient, more finance was required unless the project be delayed and thus become more expensive and syndication was still not in place.
By mid December 1989 the position was again reached where the commitment to syndication by other banks was well short of the targeted level and it was necessary for bridging finance to be extended yet again.
By January 1990 it was proposed that the Bank immediately effect syndication of those banks which had already made a commitment and for the Bank itself to participate in the first ranking syndicate by a contribution of $70.0M. This proposal represented a significant variation to the September 1989 proposal and increased the Bank's direct exposure to REMM Group by a further $70.0M. It also sought an increase in bridging finance, this time from $290.0M to $300.0M and until the 28 February 1990 in order that the project could proceed whilst syndication was effected. The proposal was approved by the Board in January 1990.
The amended September 1989 proposal, as it was finally implemented, provided credit facilities totalling $580.0M of which $290.0M was provided by the Bank. $70.0M of the Bank's contribution was first tier financing and the remainder second ranking to the rights of first tier financiers.
In October 1990, the Board was requested by management to approve a further increase in funding of $45.0M to complete the project and this was approved. The Board faced a situation which it had faced several times before. It either had to approve funding or run the risk of causing a substantial delay in the completion of the work. If it caused an additional delay, this in turn would mean yet a further need for funding in order to finally complete the works. Meanwhile it was committed by reason of the Myer Rundle Mall Performance Guarantee to see that the works were in fact completed.
A consultant who the Board had instructed reported in December 1990 that the works would not be completed until June 1991. The impact of the delays and the revised building costs together caused management of the Bank to make a revised estimate of the overall funds required to complete the project which was now $684.0M. The funding required to finance the project to 31 March 1992 (when REMM's syndicated arrangements were due to expire) was estimated by the management of the Bank to be $744.2M.
This dire state of affairs was reported to the Board in December 1990 in a paper prepared by Mr J V Henderson and presented by Mr Mullins. Of major importance is the fact that this report, written by Mr Henderson, disclosed that if the Bank were to fund the additional requirements of the project through to 31 March 1992, such funding requirements would exceed the prudential limits applicable to the Bank. The Board agreed to increase the facility available to REMM Group from $335.0M to $398.0M.
As at February 1991 it is unlikely that the value of the building then exceeded $450.0M and if the costs incurred in order to complete the project were in excess of $700.0M then even without holding charges beyond the date of completion, the loss to date could reasonably be well in excess of $250.0M.
Undoubtedly this was a complex transaction and even reduced to its simplest form involved a tangled web of legal rights and obligations. The Bank as head financier was at the centre of this tangle. The assessment of the financing needs of the project, the capacity of the customer to service and repay the financial requirements of the project and the adequacy of security involved assessments of the most complicated kind.
When considering the matter of compliance with the Bank's prudential guidelines, whilst the Bank undertook obligations to provide finance up to certain limits to REMM Group, there was no such limit in connection with the Bank's obligations under the provisions of the Rundle Mall Performance Guarantee. By their very nature, those obligations were limitless and the Bank's exposure thereby was also limitless and plainly in breach of prudential guidelines imposing limits of exposure to any one entity and to any one sector of the economy.
The Bank and in particular the Board of Directors and the Lending Credit Committee, ought to have been aware of the fact that it was undertaking obligations which exposed it to enormous losses in the event that REMM Group could not satisfy its obligations, especially if there was a downturn in the economy generally and in the retail property market in particular.
For the reasons set out in more detail in the Chapter, in my opinion the July 1988 proposal was defective in five major respects, each of which was material to the assessment of credit risk at the time and each of which was causative of loss to the Bank.
In the ordinary course of events in the case of approval of a facility, the Lending Credit Committee would consider a proposal and prepare a recommendation for the Board, which would be forwarded to the Board in the form of a detailed proposal, usually at least three or four days before the Board meeting. In this instance the proposal was finally documented on 27 July 1988 and forwarded in the same form to both the Lending Credit Committee and members of the Board who were to meet the following day. There was urgency in the consideration of the matter. A delay in approval of the finance would result in additional holding charges, not just for the period until approval was given, but also having regard to the estimated construction period, to the next opening date thereafter on which Myer would relocate. The fact that the project might not be able to survive if those holding charges were to be incurred, was an excellent reason for the belief that the margins for error in project estimates were very slight. It ought to have been appreciated that the financial liabilities of the project were no more than finely balanced.
The worst case presented was not finely balanced. Given the uncertainties in the assessment of risk, it was far too risky to undertake. It was or ought to have been obvious to members of the Lending Credit Committee and the Board of Directors who had considered this proposal, that the worst case presented in the sensitivity analysis was not an extreme. If there was only a minor variation of the events said to be likely to occur, the worst case " was barely profitable".
In this case the Lending Credit Committee members did not have time for deep reflection on this complicated matter before making their recommendation. Lengthy discussion is no substitute for careful consideration of the calculations and that was what ought to have been undertaken.
In so far as the members of the Board of Directors who approved the July 1988 proposal are concerned, if they had had insufficient time in which to carefully consider the estimates, it was their duty to require more time no matter what the urgency of the decision may have been. This was not a matter of life and death no matter how it was presented. Moreover, if they considered the information provided to be unsatisfactory or insufficient, it was their duty to seek information upon which they could rely. This was the biggest project of this kind on which the Bank had ever embarked!
The proposal itself was dangerous. There was a substantial prospect that a loss would be sustained by the Bank if it accepted it. Moreover the risk which was involved in the danger was substantial. A loss which the Bank might sustain could well have been very great.
The obligation on the Board of Directors to consider " the maximum advantage to the people of the State " in the management of its affairs, did not provide a sufficient counter-balance to the risks which were inherent in the proposal. The Board also had a clear statutory duty to administer the affairs of the Bank in accordance with the accepted principles of financial management and with a view to achieving a profit. The decision to approve the July 1988 proposal was extremely ill advised. The responsibility for that decision must be shared between the management of the Bank, which prepared the July 1988 proposal; the members of the Lending Credit Committee which considered and recommended it; and finally the members of the Board of Directors meeting which considered and approved it.
Whilst members of the Board were entitled to rely on the recommendation of the Lending Credit Committee, they were not entitled to abandon their statutory responsibility and accept those recommendations without giving them appropriate consideration. Members of the Board were required to exercise an independent judgment placing such reliance on advices that their experience and knowledge told them was prudent.
(b) Findings and Conclusions
My specific findings and conclusions with respect to the Board, members of the Lending Credit Committee and certain other officers of the Bank are set out in Chapter 14 - "Case Study in Credit Management: The REMM Group" .
1.7.6 RELATIONSHIP WITH THE RESERVE BANK (VOLUME VII - Chapter 15)
(a) Overview and Summary
A fundamentally important element in the State Bank's external operating environment was the prudential supervision framework used by the Reserve Bank for those banks established under the Banking Act. Although not legally subject to the Reserve Bank's control, the State Bank was perceived as being supervised by the Reserve Bank and stated publicly that it complied with the Reserve Bank's prudential guidelines.
Prudential supervision does not seek to immunise banks (or their owners) from the risk of loss, the economic cycle, or the mistakes of their managers. Underpinning the Reserve Bank approach is its belief that the main responsibility for the prudent conduct of a bank's operations rests with the board and management of that bank. The Reserve Bank has developed a set of general guidelines against which to assess a bank's operations, and, through statistical collections, consultation, and assessment of a bank's risk management systems, the Reserve Bank monitors each bank's performance.
The Reserve Bank's key prudential standards seek to ensure that banks maintain adequate capital, that banks keep their large credit exposures under close review, and that banks hold an adequate stock of high quality, liquefiable assets. In addition, a Bank's external auditors report to the Reserve Bank on each bank's observance of the prudential guidelines, and, in particular, on whether its management systems are effective, statistical reports are reliable, and statutory requirements are being met. The Reserve Bank relies heavily on the integrity of bank management to comply with prudential standards, and to provide accurate and timely information to the Reserve Bank. The Reserve Bank does not see its role as being to protect inefficient or unprofitable banks, but rather to help such banks leave the industry in an orderly and timely manner, and in such a way as will avoid losses to depositors and maintain stability in the rest of the banking system.
The State Bank's relationship with the Reserve Bank was summarised by Mr Clark (during an interview on 28 January 1992) in the following terms:
"... We had no legal liability to the Reserve Bank. It was purely an arrangement that was a gentleman's agreement. We had no liability or no legal reason to follow any request from the Reserve Bank. Even though that was the legal significance, we certainly didn't act that way. We bent over backwards to try to act as if we were a nationally operating bank fully under the control of the Reserve Bank."
In my view, that summary correctly states the strict legal position. The last sentence, however, does not accord with my understanding of the facts. The more correct description of the State Bank's approach to Reserve Bank supervision is set out in a much earlier letter from Mr Clark to the Reserve Bank, in September 1984. In that letter Mr Clark acknowledged the importance of the public having confidence in the banking system and says:
" ... for this reason we are also keen to co-operate with the Reserve Bank to ensure that we are perceived as meeting and maintaining prudential standards consistent with those of the other banks. "
The State Bank did not, in a number of important respects, act as if it was fully under the de facto control of the Reserve Bank and, furthermore, that fact was known only to some of the State Bank's most senior managers and to the Reserve Bank.
As noted above, the State Bank was clearly aware of the commercial advantage attached to the perception that it was meeting the same prudential standards and requirements applying to banks authorised under the Banking Act and has, in many respects, complied voluntarily with the Reserve Bank's prudential guidelines . In my opinion, however, the State Bank was able to create such a perception without actually and fully complying with the Reserve Bank's prudential requirements, and without responding appropriately to concerns raised by the Reserve Bank in the course of its supervision arrangements.
It is clear that the State Bank provided the Reserve Bank with appropriate statistical data, volunteered additional useful information to the Reserve Bank about the State Bank's strategies and operations, and encouraged the secondment of a Reserve Bank officer during 1985. The State Bank (eventually) allocated appropriately qualified staff to produce the statistical data; it sent its most senior managers (except for Mr Clark's absences in 1988 and 1989) to prudential consultations; it instructed external auditors (eventually) to produce the reports required by the Reserve Bank; and, it did consider the Reserve Bank's prudential requirements when developing strategies, processes, and prudential policies.
On the other hand, the State Bank regularly reminded the Reserve Bank that the State Bank was not subject to the Reserve Bank's control, and often expressly reserved its strict legal rights in that regard. In addition to reminding the Reserve Bank about the legal position, the State Bank actively resisted the Reserve Bank's prudential guidelines or advice in each of the following four areas of prudential concern.
(i) Liquidity Management
The Reserve Bank prudential objective is to engender public confidence in the banking industry by requiring banks to hold a defined amount of assets which can be converted into cash quickly and assuredly.
In May 1985, the Reserve Bank asked the State Bank to co-operate with the Reserve Bank's liquidity management prudential guideline. The State Bank's qualified undertaking to comply was not given until November 1987 . In the interim, the State Bank purported to adopt the guideline, but did so subject to an interpretation that suited the State Bank's perception of its own needs.
The Reserve Bank was never concerned that the State Bank did not hold an adequate amount of readily liquefiable assets, but the Reserve Bank was concerned about the State Bank's delay in giving the undertaking, and was concerned about the State Bank including assets which did not conform to the Reserve Bank's definition of "Prime Assets".
Those concerns were not adequately communicated to their Board by State Bank managers, but the conduct of senior State Bank officers created the impression, from the Reserve Bank's perspective, that the Board was a party to the relevant correspondence and discussions. As a result the Reserve Bank would have seen no point in taking up the matter with the State Bank Board and did not take it up.
Even when the Bank did eventually agree to co-operate, its undertaking to comply was given not as a result of an acceptance on the part of the State Bank as to the appropriateness of the Reserve Bank's guidelines, but rather because the State Bank needed the Reserve Bank's endorsement to open a New York office.
(ii) External Auditor's Report
The Reserve Bank first asked the State Bank to provide annual prudential reports from its external auditors in December 1985, and repeated the request in March 1986. In March 1987 the State Bank (through Mr Matthews) agreed to comply. At the prudential consultation in October 1987, the Reserve Bank enquired about the first such report, which was then due. Mr Clark told the Reserve Bank that, because he had reservations about the arrangement, particularly the question of costs, the State Bank had not instructed its external auditors to prepare the report for the Reserve Bank.
In December 1987, the day after the Reserve Bank threatened to reconsider its undertaking to provide the Bank with emergency liquidity support arrangements, and at a time when the Bank needed the Reserve Bank's endorsement to enable it to open a New
York office, the Bank Board, whose members had not been informed of the history of Reserve Bank requests, was asked to, and did, agree that the Bank would comply with the Reserve Bank prudential requirement.
Nevertheless it was not until November 1989, however, that the Reserve Bank received a report which both considered a full financial year, and reviewed all of the relevant State Bank operations.
Here again compliance was achieved more as a result of the commercial necessity for the State Bank to have the Reserve Bank's endorsement in order that the State Bank could operate in overseas jurisdictions rather than of any desire by the State Bank to co-operate fully with the Reserve Bank.
(iii) Large Credit Exposures
The Reserve Bank encouraged banks to have and maintain loan portfolios which are appropriately diversified and do not contain credit exposures that are unduly large in proportion to the capital of the bank. Consistent with this approach the Reserve Bank sought in May 1986 to receive from the State Bank, details of all exposures of clients above 10 per cent of shareholders funds, and an undertaking to keep all exposures to non bank or non government clients under 30 per cent of shareholders funds on a banking group basis.
Although the Bank provided the statistical data sought by the Reserve Bank, the State Bank only ever gave a qualified undertaking to abide by this Reserve Bank prudential requirement.
In keeping with its qualified undertaking, the State Bank, when it was so minded, treated the Reserve Bank requirement with disdain . This is amply illustrated by the Bank's purported consultation with the Reserve Bank on 1 June 1987 and the Bank's decision, made the same day, to ignore the Reserve Bank's strong advice in connection with the Bank's proposed $200.0M exposure to the Equiticorp Group. In this instance, at least, the attitude of management received Board endorsement.
When the Reserve Bank had its Governor write, in strong terms, directly to the Bank's Chairman of Directors, the Board elected to support management.
In December 1987, Bank management structured a further $200.0M exposure to Equiticorp in an artificial way, and in a manner designed to avoid the Reserve Bank prudential requirement. When the Reserve Bank became aware of this exposure, it made enquiries, but was given information by the Bank's then Chief General Manager (Mr Matthews) which was positively misleading.
(iv) Capital Adequacy
The Reserve Bank's primary objective with respect to prudential guidelines on minimum capital adequacy is to ensure that there will be sufficient capital to provide against losses and to provide reassurance to depositors.
The State Bank was the last bank in Australia to give an undertaking to meet the Reserve Bank's 1986 minimum capital adequacy requirements and, even then, its November 1987 undertaking was qualified.
It is appropriate to emphasise that the State Bank's Chief Executive Officer and its Board did not see (and did not ask to see) at least the key prudential returns submitted to the Reserve Bank. That was so even though the Reserve Bank had said to State Bank managers at prudential consultations that the Reserve Bank thought the Chief Executive Officer and the Board should see such returns.
The striking features which emerge from an examination of these four areas are an inadequately informed Board, dominated by a Chief Executive Officer who, whether by reason of experience, judgment or personality, did not adequately discharge his responsibilities in this area of the State Bank's affairs and operations. Mr Clark was, with respect to some of the Bank's operations, as much concerned to limit effective Reserve Bank supervision as he was to promote it.
He did not welcome at least some of the Reserve Bank's arrangements with the State Bank and although he accepted that compliance was largely inevitable he still sought to ensure the Reserve Bank was kept at bay where that was, in his view, appropriate. His belief in his own vision for the Bank, and in his own capacity, seem to have obscured his ability to appreciate the significance of the Reserve Bank's recommendations. His dominance and influence in the organisation, however, was such that other Bank officers found it difficult to question, or depart from that strategy.
The main point of contact between the State Bank and the Reserve Bank was Mr Matthews. Although Mr Matthews had had many years banking experience, and was a member of the Lending Credit Committee and of the Executive Committee, he was not sufficiently aware of operational matters to adequately perform his task, especially in the last two years before his retirement in July 1990. Mr Clark's dominance in the organisation was such that Mr Matthews would sometimes act in accordance with his perception of Mr Clark's requirements. By way of example, Mr Matthews' involvement with the State Bank's funding of Equiticorp in the period June 1987 to January 1988 demonstrates, in my view, that he was not equipped to recognise and resist the inappropriate conduct described above.
In addition to providing an understanding of the role of the Reserve Bank and of how the State Bank conducted its relationship with the Reserve Bank, the Investigation's review of that relationship proved useful in other respects. The Reserve Bank supervision processes require the Reserve Bank to maintain an extensive and detailed written record of its dealings with banks with which it has any form of supervisory relationship. That documentation, together with other State Bank documents considered by the Investigation, allowed an insight into the State Bank's affairs and operations that would not have been possible if the Investigation had to rely solely upon the recollection of the various people involved. The review has revealed much about the way the State Bank's senior managers, especially Mr Clark and Mr Matthews, operated, and how the State Bank's Chief Executive Officer and other senior Bank officers dealt with the Bank's Board of Directors. In particular, the review demonstrated that:
(i) State Bank's most senior managers (including Mr Clark) did not adequately appreciate or accept the role of the Reserve Bank, the supervision objectives of the Reserve Bank, or the purpose of the prudential consultations;
(ii) State Bank preparations for the prudential consultations (consistent with its lack of understanding) were generally inadequate ;
(iii) although their practice improved during the period, State Bank officers did not adequately record either the matters raised at prudential consultations by the Reserve Bank, or the discussion of those matters ;
(iv) the State Bank's most senior officers at prudential consultations did not attach adequate importance to the concerns expressed by the Reserve Bank, and did not make proper use of the Reserve Bank's advice ; and
(v) State Bank senior officers, in particular Mr Clark and Mr Matthews, did not provide adequate reports to their Board of the matters raised by and discussed with the Reserve Bank at prudential consultations.
This behaviour had two consequences:
(i) the Board received inadequate information; and
(ii) there was no documentary evidence and no audit trail to illustrate the failure.
In my opinion, the responsibility for those inadequate management practices should be attributed primarily to Mr Clark and, to a lesser extent, Mr Matthews. It is difficult to resist the inference that Mr Clark's view of the State Bank's relationship with the Reserve Bank permeated through most of the State Bank's senior management level.
As an example of the failure of the State Bank's senior managers to attach sufficient importance to Reserve Bank advice and recommendations, I refer to the several Reserve Bank warnings for the State Bank to ensure that its management information systems were able to properly monitor and control risks, particularly given the State Bank's rate of growth.It is now apparent that the State Bank did not ensure that its key management information systems kept pace with the growth of the Bank and, in my view, the State Bank's senior managers never properly appreciated the importance of that task, or of the Reserve Bank's views.
When the Reserve Bank raised a concern about a matter of management practice, senior State Bank executives typically responded that State Bank management was aware of the concern, and was addressing it.
The State Bank's inadequate compliance with the Reserve Bank's prudential guidelines did not, taken in isolation, cause material loss. More significant is the failure by some of the State Bank's most senior managers to properly appreciate the concerns which were expressed by the Reserve Bank in the course of the prudential consultations. That failure is an important management shortcoming; ultimately it is management shortcomings which are critical causes of the State Bank's financial difficulties. The State Bank's financial position in February 1991 would assuredly have been very different if the State Bank had taken proper account of the Reserve Bank's warnings that the State Bank's growth be adequately supported by appropriate management systems and suitably skilled managers.
It is appropriate to note at this point that, in their responses to my provisional conclusions, Mr Clark and Mr Matthews emphasised that any failure on their part to ensure that concerns expressed by the Reserve Bank were fully conveyed to the Board was not an attempt to conceal information from, or mislead, the Board.
I appreciate I am looking at this after the event. Even so, I have found it difficult to understand how anyone with ordinary perception would not have properly understood the Reserve Bank concerns and appreciated the requirement to provide comprehensive reports on those matters to the Board.
Mr Clark's and Mr Matthews' failure to properly appreciate the significance of the Reserve Bank messages demonstrate an inexcusable lack of competence.
Another matter for consideration in this context is the role of the Board. It is a fact that the Board was kept in the dark on those matters of major strategic and operational concern communicated to senior management by the Reserve Bank.
Notwithstanding the fact that the Board was kept in the dark on some important matters, the material before the Investigation reveals that the directors did receive warning signs which should have prompted them to adopt a more assertive position . Whilst the directors' lack of response to warning signs may now appear a relatively minor issue when contrasted with the seriously inept practices of those State Bank senior managers who were closely involved with the Reserve Bank relationship, the fact remains, that the Board could, and should, have adopted a different course when they were faced with management behaviour that was clearly inappropriate
I have noted in this Chapter that the Board did not appreciate the need for it to insist on detailed reports from management on the result of its prudential consultations with the Reserve Bank in 1985, 1986 and 1987. Nevertheless, it was still incumbent on the directors to have sought, independently of management, an understanding of the Reserve Bank's supervision objectives and procedures. Had they done so, it is likely that they would have recognised that the reports in 1985, 1986 and 1987 were plainly inadequate. In short, the directors should have been more concerned about the environment in which the State Bank conducted its business. The State Bank's 1991 financial difficulties may have been much reduced had the directors been more alert to that business environment, and if they had sought (and received) more information on the role of the Reserve Bank and of the discussions at prudential consultations. The acceptance by the Board, in November 1985, of a brief oral report set an unfortunate standard.
Although the reports to the Board of the prudential consultations were generally inadequate, there were some occasions when the reports did contain specific warning signs. For example, the report to the Board of the November 1989 prudential consultation advised that the Reserve Bank expected a reduction in the rate of growth of the State Bank Group. That report called for action by the Board at a policy or strategic level. There was no such Board response.
The Board is the governing body of the Bank (Section 14(1) of the State Bank Act) and, the management of the Bank remained subject to its control (Section 16(2)). The Act thereby imposes on the Board the obligations of ensuring competent management, and of having adequate means to monitor the operations of the Bank. In this important area of the Bank's operations the Board of Directors did not adequately or properly supervise, direct, or control, State Bank's relationship with the Reserve Bank.
During 1991, the Reserve Bank, the State Bank and the Government of South Australia negotiated a new agreement to supersede earlier voluntary understandings between the Reserve Bank and State Bank. The terms of this new voluntary arrangement between the Government and Reserve Bank are set out in a letter from the Reserve Bank to the Premier dated 30 August 1991. The new arrangement significantly increases the Reserve bank's powers in respect of the supervision of the State Bank, provides for a representative of the State Government to attend annual prudential consultations, and also explicitly provides for discussions between the Government and the Reserve bank on matters of significance involving the State Bank. I understand the basic intent of the new arrangement to be that the Reserve Bank will exercise prudential supervision of the State Bank in the same way that it does for banks authorised under Commonwealth legislation.
(b) Findings and Conclusions
In the respects identified in this Chapter, the operations, affairs and transactions of the Bank were not adequately and properly supervised, directed and controlled by:
(i) The Board of Directors of the Bank.
(ii) The Chief Executive Officer of the Bank.
(iii) The other Bank officers identified in that regard in this Chapter and, in particular, Mr Matthews.
The information and reports referred to in this Chapter and given to the Bank Board by the Chief Executive Officer, and other Bank officers, were not timely, reliable or adequate. Those reports and other information were not sufficient to enable the Board to discharge adequately its functions under the Act.
As to the matters and events which caused the financial losses, the Bank's inadequate compliance did not directly cause specifically identifiable losses. However, the failures by some of the Bank's most senior managers from time to time, to properly appreciate, or respond to or report various Reserve Bank concerns, were significant management shortcomings.
Those sorts of shortcomings in the top echelons of management were, ultimately, critical causes of the State Bank's financial difficulties.
1.7.7 THE MANAGEMENT OF ACQUISITIONS (Volume VIII - Chapters 16 to 18)
(a) Overview and Summary
It is convenient to combine, in one summary my examination of the Bank acquisitions of Oceanic Capital Corporation Limited and the United Building Society, together with some general observations in relation thereto.
As part of its inadequately controlled and regulated pursuit of growth, the Bank embarked upon the acquisition of two significant businesses, namely Oceanic Capital Corporation Limited (Oceanic) and the United Building Society (later renamed the "United Banking Group") (UBS).
These two acquisitions represented material investments (by value) of the Bank outside its core banking activity. They were both the cause of substantial losses to the Bank. Oceanic, acquired in March 1988, contributed a net loss to the State Bank Group of $83.3M in 1991 . UBS acquired in May 1990 incurred a loss of $123.0M in 1991.
In undertaking acquisitions of this kind, it was incumbent upon management to undertake adequate due diligence to avoid obvious risks of loss to the Bank. The Bank did not have any formal policy which stated the processes and procedures governing the acquisition of new businesses and companies. Any checks or precautionary investigations undertaken by management in assessing prospective acquisitions were made on an `ad hoc' basis, largely at the discretion of the executive officer who was responsible for the transaction.
A number of features of both these acquisitions stood out as demanding extensive due diligence examination prior to any Bank decision as to the desirability of the acquisition.
In the case of Oceanic:
(i) its activities were outside the traditional banking operations of the Bank;
(ii) its operations were principally located outside South Australia;
(iii) the vendor was known to be under financial pressure, and was a debtor of the Equiticorp Group, of which Mr Clark was both a Director and shareholder;
(iv) it had a relatively low net tangible asset backing ($6.0M) and the Bank was outlaying $59.0M.
In the case of UBS:
(i) being a building society, it operated in a different regulatory and commercial environment to the Bank;
(ii) it was located and operated in a foreign market (New Zealand);
(iii) it was trading unprofitably at the time of purchase; and
(iv) the Bank was outlaying $NZ 150.0M.
1.7.7.1 Case Study in Acquisition Management: The Oceanic Capital Corporation (Chapter 17)
(a) Overview and Summary
A key feature of the Oceanic acquisition was that it was made prior to completion of a detailed due diligence investigation .
Mr K L Copley (Chief Manager Finance and Planning) and Mr J B Macky (General Manager - Information Systems) relied upon a report by CIBC Australia to confirm the value of the management rights to support their valuation methodology. This was extraordinary, given that the report had been prepared for the vendor for specific purposes that were not related to the Bank's transaction. Furthermore, the CIBC Australia valuation was prepared prior to the October 1987 stock market crash and it should have been obvious to any prudent banker that it would have required revision.
The Board had resolved that the Sale Agreement be subject to:
" The preparation of a legal agreement in a form acceptable to our respective advisers incorporating the above conditions and such other terms as are normal in this type of transaction. "
The Bank's solicitors, in a memo, expressed the view that they " were most unhappy about the form of the document and considered that it potentially left the Bank exposed on a number of issues ".
Mr Copley decided to proceed with settlement notwithstanding the solicitor's "unhappiness", because he believed the deal had to be completed and consummated on 31 March 1988, and because he considered the suggested amendments to be minor.
As a result, the already disadvantaged position of the Bank was markedly worsened because it was left exposed to potentially inadequate warranties in the Sale Agreement.
No clear statement of the nature, extent and timing of the due diligence required was made by either the Board (as evidenced by minutes of meetings on 17 February 1988 and 24 March 1988), or by management in either of the two Oceanic recommendations submitted to the Board (dated respectively 16 February 1988 and 22 March 1988). Ambiguous references were made (in the Oceanic recommendation to the Board) to valuations and to due diligence, in consequence of which the intent of management regarding both due diligence and the use of external advisers was unclear. The due diligence requirements were also confused in these submissions in that no clear reference was made to whether due diligence was to be undertaken prior, or subsequent, to settlement. In the event of it being done after settlement there would necessarily need to be arrangements for an adjustment to the purchase price with respect to issues identified in the due diligence process.
(b) Findings and Conclusions
(i) Mr Macky and Mr Copley failed to exercise proper care and diligence;
. in valuing Oceanic for purchase by the Bank;
. in agreeing to terms of sale which left the Bank exposed to potential loss;
(ii) Mr Copley failed to exercise proper care and diligence in agreeing to complete the sale prior to the completion of any detailed due diligence investigation.
(iii) Mr Copley failed to exercise proper care and diligence in failing to follow up on advice received from the Bank's advisers which indicated serious issues of concern, and in releasing the vendor from warranties before their expiration under the Sale Agreement, without the concurrence of the Board.
(iv) Mr Copley, Mr Macky and Mr Clark failed to exercise proper care and diligence in that they did not adequately report to the Board on material features of the transaction.
(v) Mr Clark failed to disclose a direct or indirect pecuniary interest in the transaction which may constitute an offence pursuant to Section 11 of the State Bank Act. This matter should be further investigated.
1.7.7.2 Case Study in Acquisition Management: United Building Society (Chapter 18)
(a) Overview and Summary
(i) The forecasts presented to the Bank Board in support of the Bank's purchase of the United Building Society investment were significantly overstated. This became clear within three months of the acquisition when the original 1991 forecast pre-tax profit of $NZ 36.0M was revised to $NZ 4.4M.
(ii) The Board had been advised by Bank management that the $NZ 150.0M capital injection would be "passed straight back" to the Bank such that the Bank would have no " funding costs ".
$NZ 150.0M was not " passed back " to the Bank. Furthermore, the net asset value at acquisition was not $NZ 40.0M as estimated by management but rather a deficiency of approximately $NZ 18.0M.
(iii) The due diligence investigation conducted by the Bank in relation to this transaction was seriously deficient for the following reasons:
. inadequate financial review and assessment of historical and forecast earnings and related assumptions, cashflows, receivables, property values and contingent liabilities;
. the investigations were poorly co-ordinated and controlled, and several crucial parts of the review - in particular, the review of internal controls - had not been completed;
. Ayers Finniss, who were responsible for completing major parts of the due diligence, and who were entitled to a "success fee", had a vested interest in ensuring that the acquisition was completed successfully (and were therefore affected by a conflict of interest); and
. the Board was not provided by management with an adequate standard of information upon which to base an investment judgment.
The deficiencies in the due diligence process are amply illustrated hereunder. In a memo from Mr Mallett (Chief General Manager - International Banking) to the Managing Director dated 3 May 1990, he says:
"We were half way through our due diligence and this has raised more issues. "
No evidence has been found (despite searches) of anything beyond a very limited further due diligence following the meeting recorded in Mr Mallett's memo of 3 May 1990 and yet only six days later the Board Minutes of 9 May 1990 record the completion of "an exhaustive due diligence".
(iv) Despite the above, the Reserve Bank of Australia obtained an assurance from the Chairman of the Bank Board dated 24 May 1990 that " on the basis of the extensive due diligence undertaken and the associated reports provided to the Board, we are satisfied that the information supplied by the appointed consultants concludes that UBS is both sound in its financial structure and viable in its operation. " I do not believe that the Chairman realised that his assurances were ill founded. However the Reserve Bank was misled into thinking that "extensive due diligence" had been carried out.
Some four months later, in a memo from Mr S G Paddison to the Group Managing Director regarding the post acquisition review of UBS he concluded:
" ... there is no point in crying over spilt milk. However, once the shock subsides the questions will certainly be raised as to how this occurred. Simply our due diligence failed. It failed because we looked for reasons to say yes ." [Emphasis added]
The Board itself in its minutes of a meeting in the following month, on 25 October 1990, provided one explanation for the failure:
"... Directors stated that the Group did not have the expertise to acquire businesses and make judgments on the viability of future acquisitions, therefore Directors would be cautious of any future acquisition proposals."
(b) Findings and Conclusions
(i) Mr Mallett (Chief General Manager - International Banking) and Mr Janes (Executive Director (Auckland) Ayers Finniss) failed to exercise proper care and diligence in that they did not identify key investigation areas or ensure that they were fully explored.
(ii) Mr Morrison (Manager Banking (Auckland)) failed to exercise proper care and diligence in his assessment of the receivables.
(iii) Mr Mallett and Mr Clark failed to exercise proper care and diligence by proceeding with the United Building Society acquisition and presenting the recommendation to the Board in circumstances where concerns arising from investigations had not been fully resolved or reported to the Board.
1.7.8 THE OVERSEAS OPERATIONS OF THE STATE BANK (Volume IX - Chapter 19)
(a) Overview and Summary
I have already commented on the bank's pursuit of growth and diversification but nowhere is it more dramatic than in the Bank's strategy of growth and diversification overseas. After its establishment, the Bank maintained the London branch previously conducted by the Savings Bank of South Australia. This branch had been a minor retail banking operation. In January 1985, the Bank Board approved an "International Banking Strategy", as a result of which, in October 1985, the London branch was upgraded to a wholesale banking operation. London branch's assets grew rapidly reaching $395.6M by June 1986, $613.6M by December 1986, and $1,037.2M by December 1987.
In 1987, the Bank opened an office in Hong Kong, and, in 1988, established a branch in New York. In December 1988, the Bank acquired Security Pacific Bank New Zealand, and thereby established its Auckland branch. Whilst the Hong Kong Office did not, during the period under review, grow significantly, the New York and Auckland branches did so. In March 1988, management sought the Board's confirmation of their approval of the establishment of a managed branch in the Cayman Islands.
Overall, the Bank's growth in its overseas assets was rapid and significant. From an overseas asset base of $22.6M, as at December 1985, overseas assets grew to $5,270.0M, as at February 1991. Indeed, by September 1990, during a phase of exceptional overseas growth, overseas assets reached $7,999.7M.
This significant and rapid growth and diversification into markets in which the Bank had no prior relevant experience placed marked strains on internal control systems, and on the Bank Board's and Management's ability to supervise and control the business risks arising from these operations. It is therefore questionable whether or not the Bank should have established, and having established, should have maintained, its significant overseas operations.
As noted above, in 1988, the Bank acquired Security Pacific Bank New Zealand and thereby established its Auckland branch. Mr Mallett (Chief General Manager - International Banking) presented a paper to the Board recommending that he be authorised to proceed with negotiations
to purchase an unnamed " major international bank " (later identified as Security Pacific Limited). Prior to this, in July of 1988 Mr Mallett presented a paper to the Board, seeking the establishment of the Auckland branch, which paper followed on from a " Concept Paper " in May of 1988, which he had put to the Executive committee, with a recommendation to establish a branch in New Zealand.
Neither the Board Paper in July of 1988 nor the one in October of 1988 contained any of the economic information and views expressed in the Concept Paper of May of 1988.
At about the time the Board was first considering establishing a branch in New Zealand, ie July of 1988, Mr Macky (General Manager, Group Information Systems) was visiting New Zealand. In a memorandum to Mr Mallett (copied to Mr Clark) dated the 5 August 1988, Mr Macky stated:
" ... the general impression is that many NZ'ers believe the New Zealand economy is headed for a major disaster. There is an overall pervading atmosphere of pessimism. The feeling is that Mr Douglas' policies are driving a lot of previously highly protected firms out of business and generating high levels of unemployment without there being a clear direction from the government as to what is going to take its place and how this replacement is going to be achieved.
Those that I spoke to when asked if there was an opportunity for another bank to enter the market, all commented that they felt this would be very difficult because of existing loyalties. "
Mr Mallett's cavalier response to this was to do no more than note on the memorandum " read with interest ". Neither Mr Mallett nor Mr Clark saw fit to present Mr Macky's report, or even a summary of it, or any of the economic information contained in the May 1988 Concept Paper, to the Bank Board, when it was asked to consider the acquisition of Security Pacific. This was nothing short of a dereliction of their duties to the Bank and to the Bank Board.
To suggest, as Mr Mallett did, that the state of the New Zealand economy was understood by all, begs the question why he saw fit to present the information to the Executive Committee, but not to the Bank Board. It is open to be inferred from management's failure to present to the Bank Board the economic information which was presented in the Concept Paper of May of 1988 that the economic views expressed did not suit management's arguments and that they could have prompted the Board to probe management on the wisdom of opening a branch in Auckland.
The asset growth in respect to the Bank's overseas branches during the period under review is the most striking feature of the Bank's overseas operations. The operating reviews presented to the Bank Board clearly indicated the asset growth in relation to all of the Bank's overseas operations, which until the second half of 1990, continually outstripped budget and planning projections. The 1988-1989 profit plan noted that the International division's contribution to the Bank's profit and loss account represented an average earning on assets of 0.1 per cent. As the Bank Board had noted that the Bank Group's return on assets target for 1988/1989 was 0.81 per cent, given their approval of the profit plan, it is apparent that the Bank board was content for the International division to achieve a return on average earning assets of one eighth of that expected for the Bank group as a whole. Indeed the profit plan itself noted that the 1988/1989 return on asset projection was a 72.06 per cent reduction on the previous year's return on assets of 0.57 per cent.
In the 1989-1990 profit plan, net profit for the off-shore offices was forecast to be $8.9M compared to an actual $0.2M in 1988-1989. This represented a staggering turnaround. How it was to be achieved, is not explained in the 1989-1990 profit plan. Furthermore, this profit plan gave no explanation for overseas operations' failure in the previous year to achieve anything more than one tenth of the projected return on assets, which itself was approximately one fifth of the prior year's actual return on assets.
In fact, instead of a profit of $8.9M as forecast, the Bank recorded a loss of $6.396M.
Incredibly the 1990-1991 profit plan forecast a profit of $2.74M for the overseas branches. Once again there is no explanation in this profit plan:-
(i) For the disastrous loss figure for the year 1989-1990 as against the previously projected substantial profit;
(ii) In support of a continuation of overseas operations given the negative return on assets for the year 1989-1990 and a very modest profit for the previous year; and
(iii) Of how the Bank would turn a substantial loss into a projected substantial profit given that in the previous year the Bank had turned a projected substantial profit into an actual substantial loss.
In responding to my tentative findings in relation to the approval of the profit plans for the years ended 1989, 1990 and 1991, the non-executive directors submitted:
" ... It was in just this very period that a number of Board members began to have serious doubts about the wisdom of the Bank's off-shore activities and the justifications which it had hitherto received from management. "
Even if these " serious doubts " were entertained at the time of the approval of the various profit plans (a matter on which I am not persuaded from the evidence of the non-executive directors), the non-executive directors should not have approved the profit plans in relation to the Bank's overseas operations, until such time as management had prepared and presented a detailed and substantiated review of these operations, demonstrating to their satisfaction, the benefit to South Australia of the maintenance of these operations and their future ability to achieve a profit. The Board should not have simply relied upon assurances or justifications proffered by management, without positively satisfying itself, that these assurances and justifications were well founded in fact and were proven to be consistent with the Bank's charter under Section 15.
At least by July 1988, the Bank Board was on notice that the Bank's overseas branches were then operating at a level of profitability significantly below that applicable to the Bank's overall operations. The Board could not have failed to see the correlation between the over budget asset growth and the overseas branches' significantly inferior profitability. Whatever above budget profits for the overseas branches may have been reported to the Board in the operating reviews, such profit figures were achieved only by the Bank pursuing an aggressive asset growth strategy in its overseas branches.
The circumstances of the Bank's overseas operations called for immediate and definite action by the Board. Circumstances called for the Board to direct management to conduct a full review of the justification for maintaining the Bank's overseas operations and for a report on that review to be presented to the Board so that the Bank Board could determine whether or not the Bank should continue its overseas operations.
During the period under review the group Managing Director made an oral presentation to the Bank Board at its monthly meetings. As from April 1990 these reviews were presented in the form of a Board Paper and in addition Mr Mallett generally attended during the Board's deliberations on matters relating to the overseas branches.
It was incumbent on Mr Clark to provide regular detailed and accurate reports on the Bank's overseas operations in order to enable the Board to fully appreciate the risk profiles presented by the operations conducted by the overseas branches and to determine for itself, whether or not the Board should give appropriate directions to management in order to protect the interests of the Bank. He failed to do so.
As I have noted earlier the Bank had set maximum exposure limits (both actual and contingent) on any particular account. In July 1985 this limit was 20 per cent of the Bank's "capital base", limited to $33.0M with exposure to a group of related accounts being required to be included within the maximum of $33.0M exposure, unless specific Board approval was held. The Bank also maintained prudential policies limiting off-shore exposure. From time to time over the period under review, the Executive Committee and the Bank Board considered, and approved, increases to these prudential exposure limits.
The Bank Board should have ensured that at all times prudential limits for industry exposure within the London branch corporate loan portfolio were in force. These limits should have been approved by the Bank Board, on the basis of a reasoned and substantiated recommendation from management, and such limits, once established, should have been regularly reviewed and re-assessed for relevance and effectiveness. Management failed to submit to the Board recommendations for industry exposure limits for the London branch. The Board at least should have directed management to consider and recommend appropriate limits.
That the Board did not require the establishment of industry exposure limits for the overseas branches' loan portfolios is evidence of the Board's failure to address prudential issues associated with the operation of remote branches and to deal appropriately with management. By 1988 these branches theoretically could represent an exposure of 35 per cent of the Bank's total assets. The Bank Board's inaction in this regard left it open to management to act without Board directions on prudential matters concerning industry exposure within portfolios. As appears from the February 1991 report to the Bank Board on non-productive assets, the Bank's exposure to property was a substantial factor in the recording of significant non-performing assets by the London branch.
The Bank Board approved policies relating to Treasury dealing limits during the period under review. The information provided to the Board for money market limits was brief. It is doubtful whether a Board presented with such limited information could have made a reliable and/or informed decision on the matter; more detailed information regarding limits would have been necessary for an informed approval by the Bank Board.
It is clear that the Bank took or adopted a "hands off " approach to control and supervision in its overseas branches. It was fundamental to ensure that the highest level of relevant internal control systems were in force at all times in relation to control and supervision of the Bank's overseas branches, but this was not done. There was no on site internal audit conducted of the London branch for some 3 and a half years after its establishment. There was no credit inspection function independent of management in the London branch for some 4 and a half years after the branches commencement of wholesale banking operations. In addition delegated lending authorities did not restrict lending activities in relation to industry exposures within portfolios. Essential management information stopped at Mr Mallett's desk. That information should have been communicated to the Bank Board.
A number of reports to the Bank Board on operational matters concerning the overseas branches,omitted information that was material and that had been primarily provided to the Executive Committee. These omissions were serious and material omissions and deprived the Board of the opportunity to assess the risk profile of the branches, to give appropriate directions to management for prudential management of those risks, and generally to discharge its obligations.
The significant delay in securing adequate and effective on-site inspection by internal audit department of the overseas branches internal control systems is another serious failure on the part of the Bank Board, Mr Clark and Mr Mallett to discharge their obligation for the prudential management of the Bank's assets.
The Reserve Bank of Australia also expressed its concern to the Bank as to the growth of the Bank's overseas operations generally. Mr Mallett said in evidence, that he was aware, at least by 1988, that the Bank of England was concerned with the bank's exposure to the United Kingdom property market.
In November 1989, the Reserve Bank of Australia's New York representative attended a prudential consultation with the head of the Bank's New York operations. The Reserve Bank sounded a warning concerning the New York branch's spectacular growth in assets pointing out:
" ... We drew out the great risks that exist in rapid development of lending business and the need to be sure that the pace of growth does not exceed the capacity of systems, management resources and experience in the markets and lending business being developed ... The striking growth in lending which has been achieved initially must be a cause for some reservations. "
There is no evidence that this record of the meeting was presented to the Bank Board.
At a meeting in November 1990 between the Bank of England, the Reserve Bank of Australia and the Bank, the Bank of England presented statistics, comparing the Bank's London branch's performance with that of 66 other overseas banks under its supervision. The London branch's return on assets, its operating expenses as a proportion of total assets, and its bad debt expense as a proportion of average receivables, were all considerably worse than the average for the 66 other overseas banks.
There is no evidence of a report on proceedings of this meeting being presented to the Bank Board. This clearly was information that should have been presented to the Bank Board by Mr Clark, in order to enable the Board to consider the continuation of the Bank's London branch operations.
It is clear that there was a substantial flow of information to Mr Clark, Mr Mallett and other Bank executives in Adelaide regarding the concerns of both the Bank of England and the Reserve Bank about the state of the Bank's overseas operations generally. This was particularly so in relation to the growth in the Bank's overseas assets and the level of property exposure in the London branch.
These expressions of concern by the regulatory authorities for the level of exposure in the London branch to property, were first recorded as being raised in the Reserve Bank of Australia's prudential consultations in November 1988 and were repeated regularly thereafter.
Neither Mr Clark, Mr Mallett, Mr Matthews nor Mr C W Guille (a senior Bank officer involved in Reserve Bank consultations) fully and adequately related to the Bank Board the expressions of concern, and accordingly the Bank Board was denied the opportunity of assessing the Bank's overseas risk profile and of setting appropriate prudential controls in place in order to protect the interests of the Bank.
It was a serious omission on the part of Mr Clark and of Mr Mallett, to have failed specifically to bring to the Bank Board's attention, the fact that the London branch's portfolio was deliberately biased in favour of property, in spite of the express concerns of the prudential regulators.
Nevertheless, the reports presented to the Bank Board contained warning signals sufficient to put it on notice that it was required to obtain further information from management about the Bank's overseas operations, in particular the London branch. Moreover, the Bank Board should have been put on notice as to the pressing need for prudential supervision and control issues arising in respect of the Bank's operations, having regard to what was reported to the Bank Board in relation to the prudential consultation held on 16 November 1989. The Bank Board should have demanded a greater level of detail from management in order for it to properly discharge its responsibilities to the Bank.
The fact that prudential regulators found it necessary to draw the Managing Director's attention to concerns about the control and supervision of the London branch, is indicative of a serious deterioration in such control and supervision, which put at risk the Bank's assets. Both Mr Clark and Mr Mallett must bear responsibility for this situation.
The Bank Board submitted that it had " regard at all times to its responsibilities under Section 15 ". If that is so, then the Bank Board could not have failed to appreciate that rapidly increasing assets with poor profitability raised such serious doubts about the maintenance of the Bank's overseas operations, that more positive action was called for than simply asking management and being given assurances. It was only towards the end of 1989, that the Bank Board took action to require management to produce a comprehensive written review of the performance of and justification for overseas operations. Such a review was called for given the circumstances of the Bank's overseas operations, at least on an annual basis from the end of 1986 onwards and most certainly from 1988 onwards in light of the significant profitability problems in relation to the Bank's overseas operations revealed in the 1988 profit plan. It was not good enough for the Board to rely upon a simple " question and answer " process with management. It should have undertaken a comprehensive probing of management against the background of a detailed review of the Bank's overseas operations, based on much fuller information than was then being provided.
(b) Findings and Conclusions
(i) The Board was motivated to establish the Bank as a participant in the international banking arena. The apparent and overriding consideration for doing so was the perceived profitable growth opportunities in overseas markets. By June 1988 however, the Bank Board should have called for a thorough review of the Bank's overseas operations and, if appropriate, on the basis of marginal strategic relevance and substandard profitability, should have seriously considered the withdrawal of the Bank from those operations. But the Board did not do this or even consider doing it. The Bank's operations continued to grow and grow rapidly, and to diversify into new areas.
(ii) Mr Clark and Mr Mallett presented papers to the Bank Board that did not fully and accurately convey information concerning the Bank's overseas operations and omitted information that was material for the Bank Board's deliberations.
(iii) In relation to the matters of consultations with the Reserve Bank, Mr Matthews and Mr Guille prepared and/or presented papers to the Bank Board that did not fully and accurately convey information concerning those consultations.
(iv) The Bank's management had a strong sense of management's prerogative in those areas where it had delegated authority. Whilst this is a defensible position for management to take in the day to day operations of the Bank, it was not defensible when wider issues of policy were involved and the nature and extent of risks were not adequately made known to the Board.
(v) The weakness of the Bank's control and supervision of its overseas branches was exacerbated by the seriously late introduction of internal audit department reviews and independent credit inspections.
(vi) Pre-occupation on the part of Mr Clark and of senior management with growth of the overseas operations at the expense of attention to prudential controls and ongoing credit assessment, was a cause of the losses reported in February 1991.
(vii) The operations affairs and transactions of the Bank with reference to its overseas operations were not adequately or properly supervised, directed and controlled by the Board of Directors of the Bank, the Chief Executive Officer, Mr Clark and Mr Mallett.
1.7.9 MANAGEMENT ISSUES (Volume X - Chapters 20 to 22)
1.7.9.1 The Management of Senior Executives at the State Bank (Chapter 20)
(a) Overview and Summary
Proper management of its lending business, and effective planning and internal controls were essential to the sound operation of the Bank. Under the State Bank Act the Bank Board, as the governing body of the Bank, was bound to administer the affairs of the Bank. The Board exercised its management powers through its delegations to the Managing Director, Mr Clark. In turn, Mr Clark delegated certain responsibilities to senior executives within the Bank. Accordingly, the Bank's senior executives were required to monitor and manage its day-to-day business. The competence and diligence of those senior executives was essential to the proper functioning of the Bank.
The Bank was formed by the merger of two small parochial banks, one a rural bank and one a savings bank. It was obvious at the outset, that the existing staff of the merged banks would not have the skills and expertise, at least initially, to develop a dynamic and comprehensive bank competing with major banks interstate and eventually, overseas. The Board and the Managing Director were aware of the need to develop a suitably qualified and experienced management team, and of the limitations on the management resources in the predecessor institutions.
In those circumstances, it was necessary to turn to external recruitment of senior executives with specialist skills in areas such as Treasury, Corporate Banking and International Banking. The excessively rapid growth in the Bank's lending activities made the requirement to recruit such a management team all the more imperative.
Recruitment of those senior executives was delegated by the Board to Mr Clark. The Board retained a theoretical veto over the recommendations made by Mr Clark in respect of such appointments. The Board exercised that right of veto on only one occasion. The recruitment of senior executives at the next level was delegated by Mr Clark to those reporting directly to him. When the Managing Director made those delegations he did so without providing a set of guidelines or a definite policy, and without providing his subordinates with the support of a strong human resources function.
The Managing Director determined to apply a "new broom" to the "outdated" culture of the organisation. That, combined with the effect of a tight labour market (in a deregulated banking industry) and with the absence of any specifically defined recruitment plan or standards, resulted in a number of instances in the appointment and later the promotion of individuals with either limited potential or inadequate banking experience.
Mechanisms which existed to review the performance of senior executives were ineffective. They were subjective, and conducted by Mr Clark alone, on an informal basis, without any documentation being retained for reference purposes, and future reviews.
Similarly, there was no apparent objective and formal process for the setting of rewards and remuneration of those senior executives. Mr Clark set the remuneration as a result of his subjective assessment. The criteria for remuneration setting for these executives were never defined, and the Board had little or no information other than what the Managing Director had provided. Neither did it seek any such information.
Frequently, remuneration increases and bonuses which were granted to the senior executives, were in excess of the commensurate increase in Bank profitability for the relevant financial year, or were in fact shown to have been granted at a time when the Bank was recording decreases in profitability, or actual losses. An inference to be drawn from the available evidence, is that remuneration was tied to achievement of growth rather than to profitability. Moreover, significant increases in salary and remuneration, and substantial bonuses, were granted to senior executives in spite of the astounding growth in the Bank Group's non-performing assets and substantially reduced profits.
The reliability of the assessment for the performance of senior executives made by Mr Clark was of critical importance. The Board had delegated that role to him, and did not, other than in a theoretical sense, question or veto his assessments. The concentration of power arising from the informality, secretiveness, and subjectivity of the performance assessment process created an unusually strong and far reaching dependency on the part of the senior executive echelon on the Managing Director and on the satisfaction of his expectations. It further determined the basis for promotion and remuneration review.
The Managing Director and his team of senior executives, with the explicit or implicit approval of the Board, effected substantial and frequent structural changes within the Bank. Those restructures resulted in the redistribution of responsibility, and had a substantial and generally adverse impact on the capacity of the organisation to effectively address the conduct of its business. They may have distracted senior management from attending to and carrying out tasks that were more pressing, and in effect, from "getting on with the job". In effecting these continuing and far reaching upheavals of the structure of the Bank, the Managing Director displayed a level of managerial competency well below what was to be expected of one holding his office and responsibility, and receiving his remuneration.
(b) Findings and Conclusions
(i) The Board did not adequately involve itself in the recruitment of senior executives.
(ii) The Managing Director displayed a lack of understanding of the role and functions of Human Resources Management, and of the need for common procedures and standards across the organisation.
(c) copied to "5" of hand written notes
(iii) The skills of the staff of the Bank were inadequate for the efficient and successful conduct of the business of the Bank. This widespread lack of banking skills, experience, and expertise led the Bank to enter into transactions which lacked intrinsic merit, and which were not appropriately reviewed for soundness and quality. It thus contributed to the Bank's position as declared in February 1991, and to the Bank's holding substantial assets which are non-performing.
(iv) The Managing Director adopted an informal, secretive and subjective method of assessing the performance of senior executives, which vitiated and undermined the integrity of the process of the promotion and placement of senior executives in the organisation, and of their remuneration setting.
(v) In spite of the Bank's and Bank Group's substantially reduced profits, and the alarming growth in non-performing assets in 1989 and 1990, significant increases in salary and remuneration and substantial bonuses were granted to senior executives in those years, on the recommendation of the Managing Director and with the approval of the Board.
(vi) The Board failed adequately and properly to supervise, direct, and control the processes of remuneration setting and adjustment, and bonus determination in that, by delegating as it did to Mr Clark, it permitted the existence of a process of approval of remuneration increases and of bonuses which lacked adequate justification.
(vii) The processes which led to the Bank or a member of the Bank Group to engage in operations which have resulted in material losses in the Bank or members of the Bank Group holding significant assets which are non-performing, included the monitoring and review of the performance of senior executives. These processes were neither appropriate nor adequate to ensure the effective guidance and control of these executives in the exercise of their duties.
(viii) The continual and far-reaching upheavals of the structure of the Bank were presumably affected in order to enable it to meet the demands of a swiftly expanding business. These changes prevented the development of both the infrastructure and the skills that would have assisted the Bank better to control the quality of its lending, and thus to limit the extent of unsafe and imprudent lending decisions.
(ix) Neither the Board of Directors nor the Chief Executive Officer adequately or appropriately supervised, directed and controlled the operations and affairs of the Bank with respect to the management of its senior executives.
1.7.9.2 The Relationship Between the Board and the Chief Executive (Chapter 21)
(a) Overview and Summary
Under the governance of the Board, the Chief Executive Officer was responsible, through delegated powers and authorities, for the day-to-day management of the affairs of the Bank.
This day-to-day management took place through a range of functionaries, the most important of whom reported directly to Mr Clark.
Throughout the period under review, numerous deficiencies existed in the management of the functions performed. The existence of those deficiencies called into question the quality of Mr Clark's management, and the manner in which the Board directed, controlled and monitored his actions.
The Board failed to exercise its authority and the appropriate degree of control over the activities of Mr Clark, and in so doing allowed the Bank to engage in operations which resulted in material losses and to hold significant assets which are non-performing.
Mr Clark was initially appointed by the Board to fulfil a specific and time-limited mandate (from 1984 to 1987), focused on the execution of the merger and the setting of the new Bank on a commercial footing and the establishment of a management team for the Bank's operations. Beyond 1987, it was envisaged that a longer-term Chief Executive Officer would be appointed.
Mr Clark was selected primarily for his suitability to fulfil that first mandate; he had had prior merger experience, acquired during the part he played in the merger of the Commercial Bank of Australia Ltd with the Bank of NSW, which led to the formation of Westpac Banking Corporation. However, he had limited experience in mainstream banking operations. The Board was aware of his lack of experience both in mainstream banking and as a chief executive officer. This lack of experience combined with a personality directed towards aggressive expansion, made for a profile that needed "balancing", "controlling" or "restraining".
However, satisfied with the early performance of Mr Clark (ie between 1984 and 1986), the Board did little to develop any succession plans, and re-appointed Mr Clark in May 1986, before the expiry of his first contract, for a further term, ie until June 1989.
No formal assessment of the performance of the Chief Executive Officer was conducted prior to the renewal of his contract, and no new mandate was imposed on him. At no time did the Board state its expectations of the Bank, or of its Managing Director, other than those of increased growth and profitability for the organisation. The means by which those ill-defined goals were to be achieved were left, in essence, to the Managing Director to determine.
The stance of the Board in this regard is incompatible with its responsibilities under Section 16(2) of the State Bank Act particularly in the light of later comments made by Directors that Mr Clark was " running riot " on the Board or taking the Bank on a " destructive path".
In February 1988, more than one year before his second contract was due to expire, the Board again renewed his engagement, this time until June 1992. Again there was no revised or substitute brief.
This time however,the decision regarding re-appointment was the object of some opposition,with questions being raised as to Mr Clark's suitability for the longer haul. In the words of Mr R D E Bakewell:
" ... it was time to cut the painter and do something else ".
The decision to reappoint Mr Clark was due as much as anything else to the lack of an available successor within the Bank. That this situation was allowed to arise is indicative of the fact that the Board, prior to 1988, paid only casual attention to the issue of succession planning and was ill-prepared to address the matter in any structured fashion in February 1988 when the issue arose.
This is so, despite the fact that, had it chosen to do so, the Board had ample opportunity to familiarise itself with the ability and aptitudes of the senior executive team. From 1988 onwards there is ample evidence that the Board was increasingly dissatisfied with the performance of Mr Clark. With regard to the specific actions of Mr Clark in 1989 and 1990 the file notes of Mr Simmons record adverse criticisms of:
(i) Mr Clark's handling of the provisioning for the Hooker account;
(ii) the expected level of profits for 1989;
(iii) the difficulties with Beneficial;
(iv) the REMM, Equiticorp and National Safety Council of Australia accounts;
(v) the acquisition and subsequent management of Oceanic Capital Corporation and United Building Society;
(vi) the establishment of an audit committee; and
(vii) the appointment of staff with suitable financial management skills:
to name but some of the salient ones.
With regard to his management style and attitude, Mr Simmons' notes record trenchant adverse criticism of Mr Clark on issues such as the information provided to the Board, his dismissive stance towards the Board which reduced that body to the role of a " rubber stamp" or " a plaything " over which he could " run riot ", his failure to accept questioning or suggestions from the Board, his failure to act upon suggestions from the Board with required diligence and lastly his failure to accept the practical exercise by the Directors - and the Chairman in particular - of their responsibilities as members of the Bank's " governing body".
Many of the Directors interviewed in the course of the Investigation repeated these criticisms and expanded upon them in instances too numerous to quote.
In face of such strong and increasing displeasure, I am critical of the Board's action in three respects: first, it did not formally and regularly monitor and control the performance of the Chief Executive, whether as a necessary process in its own right, or as part of an obligatory remuneration review process; secondly it did not confront him with a number of its serious concerns with a view to having those rectified in a forthright and expeditious manner; and thirdly, it failed to exercise its authority and control over the activities of the Managing Director, thus allowing an inappropriate and damaging relationship to exist from 1988.
I have also considered in some detail the remuneration of Mr Clark and the processes which applied to its determination.
The remuneration setting process as it applied to Mr Clark was one undertaken primarily by the Chairman (either alone, when Mr L Barrett was Chairman or as part of a sub-committee when Mr Simmons was Chairman) and Mr Clark, with the result that their deliberations were presented to the Board for practical purposes as a "fait accompli".
At no time was the Board process anything other than an informal one; nor did it provide a consistent basis for decision making given the virtual absence of any form of records or documentation regarding the deliberations carried out and conditions set by the Board.
The remuneration of Mr Clark, as is often the practice for senior executive salaries, comprised two elements: a base salary and a range of benefits packaged so as to be tax effective. Although the types of benefits paid to Mr Clark varied to a small extent over the years, their value increased substantially.
By way of example, the first service agreement entered into between Mr Clark and the Bank provided the following benefits, in addition to the base salary: a fully maintained motor vehicle with the option to purchase the same at book value at the termination of the appointment; an interest free housing loan; a sum for expenses in the performance of business duties; a range of other lesser benefits (removal expenses, first class travel and accommodation while on business, annual leave entitlements) and so on. In addition this agreement provided for payment by the Bank of a sum initially equal to 24 per cent (but subsequently varied by agreement) of salary, in a fully vesting superannuation fund.
In subsequent years the range and structure of benefits were modified or expanded. For instance after the negotiation of Mr Clark's housing requirements in 1986, the Bank agreed to the provision of a house costing up to $650,000 at a rental of $20,000 per annum.
From 1988 onwards, Mr Clark also entered into a bonus scheme based on the achievement of budget and over budget profits by the Bank. These bonuses did not form part of the total remuneration package and represented amounts paid over and beyond salary and other benefits.
The remuneration paid to Mr Clark from 1988 (at the time when problems with the Bank were beginning to emerge) is disquieting.
In 1988 his salary was increased by $70,000 and his benefits and allowances increased by a further $70,000, making a total remuneration package of $400,000.
In addition, the Board approved the implementation of a results-based bonus plan for Mr Clark whereby he would be entitled to a bonus of $30,000, $45,000 or $60,000 should the State Bank Group meet the budgeted profit target of $60.0M, or exceed it by $5.0M or $10.0M respectively.
For the financial year ended June 1988 the Bank reported an increase in operating profit of 36.0 per cent over its 1987 results, but for the first time the accounts also showed a startling leap in the level of bad debts written off, and a provision for doubtful debts of nearly $7.0M.
In 1989 Mr Clark's salary increased by nearly $56,000 or 40 per cent. The benefits and allowances component was increased by $46,000 for a total remuneration increase of approximately $102,000.
In addition to the increase in remuneration described above, and in accordance with the bonus plan described earlier, Mr Clark received a bonus of some $49,000 based on the Group having achieved an operating profit of nearly $70.0M in the year ended 1988.
The provision for doubtful debts in 1989 represented a 290 per cent increase over that in 1988. The Bank reported a $56.0M item for net bad debts written off. In 1990 Mr Clark's salary was increased by $16,000 and his benefits and allowances by some $34,000, making a total remuneration increase of $50,000.
In 1990 the Bank reported a fall in operating profit from $78.0M to $35.0M and an increase in the provision for doubtful debts of over $100.0M.
In response to this the Board resolved to " trim " Mr Clark's bonus (which related to the 1989 year) to $50,000.
As a matter of plain commonsense and business principles, it is impossible to reconcile statements by Board members regarding their mounting concerns about Mr Clark's performance, a rise in key non-performing assets and a 290 per cent increase in the level of provisioning on the one hand and a bonus, however " trimmed", on the other.
Mr Clark resigned from the Bank in February 1991.
It is an inescapable conclusion that between 1988 and 1990 the Board rewarded Mr Clark beyond reasonable expectations and requirements.
(b) Findings and Conclusions
(i) The Board failed to exercise effective control and supervision of the Chief Executive between 1984 and 1989, these being critical years of growth in the Bank's history; and whilst the Board endeavoured to exercise a closer degree of control from 1989 onwards, that endeavour was not, in practical terms, effective, or timely. Once the Board was alerted by the increase in non-performing assets, and other matters, to shortcomings in the Bank's management the Board's efforts to resume control were of limited effect. It was beyond the ability of the Board to reverse the trend in the Bank's performance to the extent necessary to stave off the financial position reported in February 1991.
(ii) The processes which led the Bank to engage in operations which have resulted in material losses, or in the Bank, holding significant assets which are non-performing included the inadequate monitoring and review by the Board of the performance of the Chief Executive.
(iii) The operations and affairs of the Bank were not adequately or appropriately supervised, directed and controlled by:
. the Board of Directors of the Bank; and
. the Chief Executive Officer of the Bank.
1.7.9.3 Executive Information Management at the State Bank (Chapter 22)
(a) Overview and Summary
A key requirement for managing any business, and particularly that of a bank, is the availability to the Board of Directors and senior management of accurate, reliable and timely information relevant to the risks faced by the business. The information required by the Board of Directors and by management will be different, according to their different functions in the governance and management of the business. It is critical, though, that the business have information systems in place to collect, collate and summarise that information critical to managing business risk.
Various Chapters of this Report identify and describe, in considerable detail, where the information systems of the Bank failed. Shortly stated, the Bank's Board of Directors and management did not have some critically important information that was essential to running the Bank. For example, it was not until 1990 that the Bank was able to measure its total exposure to commercial property, an exposure that was a material cause of the Bank's losses. Deficiencies in the information flows relevant to the management of the Bank's assets and liabilities meant that its growth was unconstrained by considerations of the cost of funds and prudent liquidity management.
The Board and management recognised, from the time of the formation of the Bank in July 1984, the need for adequate and reliable information systems, including those for measuring risk across all divisions of the Bank. Mr Clark referred to this need in his memorandum recommending the 1985-1986 profit plan to the Board of Directors. The strategic plan approved in 1985 referred to the need for information systems that would withstand the scrutiny of the Reserve Bank, including systems needed for asset and liability management. In a paper presented to the Executive Committee in October 1985, the Acting Chief Manager Planning, Mr Guille, pointed to the need to establish systems for the Bank-wide monitoring of exposures to customers, industries and geographic areas.
Despite this awareness - an awareness reinforced by regular advice from the Reserve Bank - the Bank's information systems were inadequate. This inadequacy resulted in critical information deficiencies that contributed to the Bank's failure.
There were two basic causes of the deficiencies in the Bank's information systems:
(i) The first was the Bank's very rapid growth and diversification of its operations from the time of its formation in 1984. Put simply, the Bank's development outpaced the ability of its information systems to cope. While the Bank developed quickly from an essentially retail bank with its operations limited to South Australia to become a diverse financial group with operations around the world, its information systems did not keep up. The Bank's Board of Directors and Management did not restrain the growth of the Bank to a level that could be prudently managed.
(ii) The second cause related to the Bank's organisational structure. The various business units of the Bank were given considerable autonomy to plan and manage their business activities, including expenditure on information technology. The Bank's Information Systems department, headed by Mr Macky, operated as a service department to meet the needs of the various business units, as identified by those units. The result was that the Bank lacked a coherent, Bank-wide information system that could collect and collate information on a Bank-wide basis.
The Bank's Management received repeated warnings of the importance of adequate information systems, and of the inadequacies of the Bank's existing systems. Indeed, the Bank's strategic plan approved by the Board of Directors in 1986 stated that "the huge internal and external technological requirements being placed on the Bank are currently outgrowing its capacity to satisfy them ... this situation may become extremely dangerous" .
A Reserve Bank diary note dated 24 October 1985 recorded that the Bank's executives were "conscious of the risks inherent in diversifying their business rapidly and of the need for adequate management systems to control those risks" .
A year later, in September 1986, Mr Clark is recorded by the Reserve Bank as acknowledging that the Bank had "a lot of catching up" to do in its management information systems. In March 1987, the joint auditors of the Bank warned that, in their opinion, the Bank had "not yet come to terms with the data management, systems controls and personnel expertise required to provide adequate internal control over the exposures created by operating in global deregulated markets, rather than the Bank's historically familiar locally controlled domain" .
Steps were taken in late 1988 by the Board and by Management to address the information systems deficiencies, particularly relating to the absence of information regarding the risks faced by the Bank on a Bank and Group-wide basis.
On 1 July 1989, a specialised Group Risk Management division was established, headed by Mr Matthews, to devise and implement systems to collect and collate information from across the Bank, and the Group, regarding the risks that the Bank faced. Progress, however, was slow, due in part to the disparate systems that had been established by the Bank's various business units. Accordingly, development was evolutionary, and no regular reporting system was in place until the end of 1990.
The group risk management initiative taken in 1989 was very necessary. It was, however, too little, too late. The Bank had been growing, and growing rapidly, for more than four and a half years. During that time, its information systems had been inadequate, resulting in critical information deficiencies. By the time action was taken, the damage had been done.
(b) Findings and Conclusions
(i) The information systems deficiencies of the Bank were among the matters that caused the financial position of the Bank as reported in February 1991.
(ii) Far too little attention was paid by the Board of Directors, the Chief Executive Officer, and Management, to the need to constrain the growth of the Bank to that which could be prudently monitored and managed. Either the growth of the Bank had to be slowed, or much more significant resources needed to be devoted to the development of adequate information systems. Neither happened.
(iii) The Board of Directors was aware, or should have been aware, that some critically important information was not being provided to them. Information regarding the Bank's total exposure to commercial property is the most significant example. The Board knew, too, that the Bank was growing very rapidly - well in excess of that which was budgeted - and had seen repeated references in the strategic plans to the need to improve the Bank's information systems. Despite these warning signs, the Board took no effective action to ensure that the Bank's information systems were adequate.
(iv) The Bank's senior managers, including Mr Clark, who were involved in prudential consultations with the Reserve Bank, heard the repeated expressions of concern from the Reserve Bank regarding the need for adequate information systems. Management did not react to those expressions of concern, and did not pass them on to the Board of Directors.
(v) Mr Clark, as Chief Executive Officer of the Bank, did not give sufficient attention to the Bank's information systems requirements. If nothing else, it should have been apparent to him that some important information critical to the management of the Bank was simply not available.
(vi) The operations, affairs and transactions of the Bank were not adequately or properly supervised, directed and controlled by the Board of Directors and by the Chief Executive Officer of the Bank. Both failed to take adequate steps to ensure that the Bank's information systems were reasonably appropriate to the rapidly changing nature of the Bank's operations.
1.7.10 INTERNAL AUDIT OF THE STATE BANK (Volume XI - Chapter 23)
(a) Overview and Summary
Internal Audit is an organisational function designed to assist management to achieve the most efficient operation of the business, by determining whether the system of internal controls is functioning effectively in all units of the entity.
There was rapid and significant growth and diversification in the Bank's assets over the period under review. The growth of the Bank's assets overseas is, in one sense, more dramatic than that on-shore as the Bank's overseas assets grew from some $200.0M as at December 1985 to $5,270.0M as at February 1991. This called for a standard of internal audit that was responsive and capable of assessing the emerging risks and exposures associated with such rapid growth and diversification.
At the time of the establishment of the Bank, the internal audit function was essentially a "tick and check" function, with that Department's attention being focused primarily on a branch network and computer systems issues arising out of the merger. In the early years after the Bank's establishment, Internal Audit recognised the need to include as part of the audit programme, the operational and systems issues arising from the merger itself.
Mr H Gates a former head of Internal Audit in the Bank, gave evidence that:
" ... in the first years - at least 3 years - it was just a battle to stay afloat for the organisation because of the large unprecedented, or how we say, astronomical growth and totally inadequate system. "()
Over time, the Internal Audit department moved to focus attention on the high risk areas of the Bank's operations, namely, Corporate Banking, International Banking, and Treasury. There were a variety of deficiencies in the Internal Audit coverage of these high risk areas. These deficiencies included: its approach and methodology; its inability to gain access to certain information, and its lack of resources and expertise.
For the whole of the period under review, the Internal Audit department reported to a divisional executive who was also potentially an auditee. This situation gave rise to the possibility that the independence of the Internal Audit department could be compromised.
Whilst there is no evidence of any interference in or compromise of the department's functions, such a reporting line is structurally unsound especially in a State Bank with public responsibilities.
The internal audit coverage of the Bank's overseas operations has been of particular concern to me. From January 1985 the Bank actively pursued a strategy of growth and diversification overseas. The materiality, mix of assets and rapid growth in overseas operations, together with their remoteness from South Australia, demanded the highest achievable standard of control to be exercised over their operations. Internal audit was a critical element of management control in this matter. The growth and diversification of the overseas branches and the difficulties for effective management of these operations called for the introduction, at an early stage, of an adequate and appropriate internal audit `on-site' activity.
In October 1987 the Reserve Bank of Australia had expressed directly to Mr Clark its concern about monitoring of internal control systems in the London branch. In May 1988 the Reserve Bank advised Mr Matthews of its concerns for the effectiveness of internal control systems given the bank's growth particularly in overseas operations.
The London branch commenced its wholesale banking operations in October 1985 . The first time an Internal Audit department review of that office was conducted was in April/May 1989. By this time the London branch assets had grown to approximately GBP 540.0M providing full wholesale banking services with particular emphasis on off-balance sheet trading, corporate lending and foreign exchange.
Hong Kong operations were commenced in April 1987 . The first internal audit review was not carried out until June 1990.
The New York branch was opened in November 1988. The first internal audit review of the operations of that office occurred in May 1989 by which time the total assets of that office had grown to $US 483.0M (as against a budget of $US 240.0M).
It was put to me that the external auditors could be relied upon by management in reviewing internal systems and controls in a general sense. However, representations from the external auditors in their letters of engagement made it clear to management that the Bank was not entitled to rely upon the external auditors as a substitute for an effective internal audit function in respect of the overseas branches.
The seriousness of management's failure to ensure an adequate and appropriate internal audit function for the overseas branches of the Bank is compounded by the fact that no asset quality review was conducted by any function independent of management until mid 1990. This failure demonstrated a lack of appreciation that the State Bank was an institution that was publicly accountable to the people of South Australia and that the highest standards of internal review and accountability should have been operative at all times.
The absence of on-site audit of the overseas branches by the Internal Audit department, and in particular London until May 1989 and the failure to actively monitor and be satisfied as to the effective discharge of this responsibility is a substantial failure by the Bank Board, Mr Clark and Mr Matthews in relation to their respective duties to the Bank.
In the case of corporate banking, it was not until June 1990 that the Internal Audit department undertook an overview survey of the Corporate Banking department for the purpose of identifying the auditable areas of risk and to formulate audit plans for subsequent review of those risk areas. Lending increased in this area from $400.0M in 1984 to $5,000.0M at June 1990.
The Internal Audit department's involvement in the asset quality issues in the corporate banking area was a matter of substantial contention between Mrs M Chin (Manager - Internal Audit) and Mr Paddison (Chief General Manager - Australian Banking). Mr Paddison's opposition to Internal Audit department's review of " asset quality " in corporate banking, coupled with his failure to secure a review of " asset quality " by a function independent of management, reflects adversely on the discharge by Mr Paddison of his responsibilities for the prudential management of this portfolio. His actions do not reflect what would be expected of a senior executive on an important matter of accountability.
The failure by management to secure an adequate and appropriate internal audit coverage of the high risk areas of the Bank's operations, namely Corporate Banking, International and Treasury until the times indicated in this Report is a substantial non-compliance with management's obligations to ensure the protection of the Bank's assets and the maintenance of an effective and relevant internal control system. Management was too busy concentrating on growth and profits to worry about the prudential controls necessary to ensure the protection of the Bank's assets.
Another telling example of management's failure in relation to internal audit can be seen when an operational review was prepared in September 1987. This highlighted significant organisational, staffing and operational concerns. That review was not presented to the Bank Board. An internal audit half-yearly report for the period ended 31 December 1987 was presented to the Board but it did not provide to the Board any details of the concerns identified in the operational review.
The failure by Mr Clark and Mr Matthews to report the findings of the operational review to the Bank Board deprived the Board of the opportunity to give directions to management for remedying the identified deficiencies.
The importance of the need to give urgent attention to these findings, can hardly be overestimated, given that the deficiencies were associated with areas of the highest risk. Mr Clark as the Chief Executive Officer, should have been aware of the need for a greater level of urgency in attending to the deficiencies in the Internal Audit department. He failed to demonstrate an appreciation of the critical importance of the need for a comprehensive and effective internal audit function within the Bank and remained indifferent to the shortcomings identified in the reports.
Mr Matthews was the executive responsible for the Internal Audit department. The striking feature of his management is the absence of a sense of urgency in bringing Internal Audit "up to the mark". He, like Mr Clark, failed to respond with the required level of urgency, to deal with the issues. Accordingly, he failed to demonstrate an appreciation of the critical importance of the need for a comprehensive and effective internal audit function within the Bank.
Having regard to the Bank's growth and diversification, the Bank Board did not take a sufficiently active interest in the internal audit function. It was placated by management assurances in circumstances when a vigilant Board, probing those assurances, would have elicited information to demonstrate that there were serious gaps in the internal audit coverage of important risk areas within the Bank. The deficiencies with respect to internal audit were of a serious nature having regard to the type of business being transacted by the Bank .
(b) Findings and Conclusions
(i) The processes relating to the discharge of the internal audit function were not appropriate and were not adequate during the periods indicated in this Chapter. When taken into account with other functional deficiencies the failure of the Internal Audit function, was a contributing factor to the Bank's losses and the holding of significant non-performing assets.
(ii) The operations, affairs and transactions of the Bank with reference to the Internal Audit function were not adequately or properly supervised, directed or controlled by the Board of Directors of the Bank, Mr Clark and Mr Matthews. The operations, affairs and transactions of the Bank with reference to internal audits of corporate banking, were not adequately or properly supervised, directed and controlled by Mr Paddison.
(iii) The information and reports given by Mr Clark and Mr Matthews to the Bank Board were not, under all the circumstances, timely, reliable and adequate and were not sufficient to enable the Board to discharge adequately its functions under the Act.
1.7.11 OTHER MATTERS CONSIDERED (Volume XII - Chapters 24 to 26)
1.7.11.1 State Bank Centre Project (Chapter 24)
(a) Overview and Summary
In November 1985 the Bank decided to exercise options which it held on three properties at 91 King William, 19 Currie and 23 Currie Street. It convened a project team to proceed with development of the site to accommodate a multi-storey building, that would become the headquarters of the Bank and a landmark in the City of Adelaide.
The Bank's representative on the project team was Mr K P Rumbelow, who was at the time, Chief Manager Administrative Services. (He subsequently became Chief Manager-Property). Few of the members of the planning group had been concerned in the construction of a building of similar size to the proposed building. The Bank's adviser, Baillieu Knight Frank (SA) Pty Ltd, whose representative was also on the planning group, was strongly of the opinion (accepted by the Bank) that the construction of the Centre had to be completed and ready for occupation by the end of 1988. It was said that the Centre had to be completed before several other large buildings, eg the ASER development on North Terrace and a building at 45 Pirie Street, so that the Bank could take advantage of anticipated demand for high quality premises.
This perception was important because it influenced the project in a number of significant ways.
The most important consequence was the decision made to construct a building by what has been called " a fast track " method. In essence, it meant that the construction work had to be commenced before all the technical documents were done. There was a degree of risk in employing such a method.
The estimated net cost at the beginning of 1986 was $82.0M. In March 1986, the Board resolved to proceed on a construction management basis, which was part of the fast track method. This method meant the Bank would be proceeding with a project for which the final sum was not set. The Board, however, when it resolved to proceed on this basis, had been informed that the quantity surveyors had indicated a possible 2.25 per cent overall cost saving by following this construction management method.
The Board resolved to embark on a project to construct a building of a size that had never before been built in this State. With the exception of advisers from Construction Services (SA), none of the project team had been involved in a building project of this magnitude. The project, it was perceived, had to be finished before the end of 1988 to meet a " window of opportunity ". The Bank sought no formal second opinion about whether such a "window of opportunity" existed.
Having regard to the nature of this project, it would have been prudent to have obtained a second formal opinion. If there was no such " window of opportunity " it would have been unnecessary to complete the project by the end of 1988, and therefore a fast track method would not have been necessary and more detailed planning could have been completed before the commencement of construction. Neither management nor the Board requested an independent audit of cost estimates for the project. Such an audit review would have been prudent because there was a substantial risk of cost escalation from the fast track method.
However, the decision to proceed with the project was a commercial decision made by the Board on expert advice.
Mr Rumbelow was the Bank officer responsible for making final decisions about this very large construction project. I do not doubt his integrity and application but he had negligible experience in building construction, his only previous experience with building construction being related to Bank branch buildings. From the very nature of such a project, the Bank should not have left it to the consultants alone to advise, but rather should have appointed an appropriately experienced project manager for and on behalf of the Bank. Such a person would have been equipped to deal with whatever advice was received and wherever necessary to make independent judgments on behalf of the Bank. Not only should the Bank not have allowed Mr Rumbelow with his lack of experience in this complex area to make important decisions on its behalf, but the respective responsibilities of the consultants should have been more clearly defined.
Thus, in my opinion the management structure for the project was inadequate.
In July 1988 the Board considered a paper submitted by the project control group that indicated that the total development outlay, would then be approximately $120.0M. Following this, the Board agreed that the Bank would establish an independent inquiry into the management and the `cost blow out' of the project. This inquiry was to report its findings to the Board.
Mr T Ellis, an independent building consultant, with management experience of multi-storey building projects, was appointed to perform that inquiry. He reported his findings two months later. Those findings corroborate the view that I have expressed about the inadequacy of the management of the project. By that late stage, however, there was very little effective action the Board could have taken.
At the outset the Board resolved to establish a tax effective off-balance sheet company structure for the purposes of financing the project.
Whilst the cost of funds raised under the eventual financing package was considered to be lower than could be obtained by other means, the financing package was based upon a number of assumptions that could have reasonably been expected to vary. The impact of such variation should have been considered more carefully. Ultimately, the underlying assumptions did vary. This resulted in substantial additional cost to the Bank; the total cost cannot be ascertained until 1996 because of the funding arrangements.
Correspondence provided to me illustrates the inadequate monitoring of the financing package by the Bank and the lack of appropriate communication between Beneficial Finance and the Bank when it must have become aware that the "assumptions" had varied.
This inadequacy was unacceptable and negligent because the Bank was carrying the risk of an underlying guarantee to external financiers. Current indications are that this will result in significant losses to the Bank. This should have moved the Bank to seek a full and detailed understanding of the financing arrangements.
Doubts still exist as to certain taxation matters which are not discussed in detail in this report as they have not yet been dealt with by the Commissioner of Taxation.
The consequences of this development have been:
(i) Funds totalling $23.5M advanced by the Bank to the off-balance sheet associated entities were designated non accrual from October 1990.
(ii) The Bank is subsidising entities associated with the State Bank Centre on an annual basis in consequence of a deficiency of income to outgoings, ie total annual expenses exceed rental received.
(iii) The tax structured financing package has not been as effective as originally planned owing to changes in corporate tax rates and capital gains tax issues which can be resolved only in 1996. It is only then that the finance package will be finalised and when the Commissioner of Taxation assesses the financiers of the project. As the financiers had an agreed after tax rate of return this has resulted in a substantial increase in the anticipated final cost to the Bank.
(iv) Significant doubts still exist on certain capital gains tax matters which affect the ultimate payment (compensatory payment) required to be paid to the financiers by April 1996. This payment is guaranteed by the Bank.
(v) Original predictions for a significant capital gain for the Bank should the land and building be sold have been replaced by an expected loss if sold, or if in April 1996 the amount of the compensatory payment exceeds the market value. At 30 June 1991 the estimated compensatory payment was $154.2M whilst the market value of the building at that date was $93.4M.
(b) Findings and Conclusions
(i) The processes that led the Bank to acquire a significant asset that is non-performing, ie the State Bank Centre, were inappropriate and the management of the Bank neglected to ensure that the Bank's interests were adequately protected.
(ii) The operations of the Bank were not adequately or properly supervised, directed and controlled by the Board of Directors and the Chief Executive Officer of the Bank.
1.7.11.2 Securities Dealings (Chapter 25)
(a) Overview and Summary
In November 1984 the Board resolved that the Bank participate in the purchase of shares and the underwriting of share issues subject to certain guidelines and restrictions.
By dealing in shares the Bank exposed itself to a number of attendant risks. They were:
(i) First, the risk of losses.
(ii) A potential loss of objectivity in the conduct of the Bank's lending to those companies in which it acquired shares; and
(iii) Importantly where the shares traded were those of a borrower from the Bank, the Bank, if appropriate procedures were not in place, might breach the insider trading provisions of the Securities Industry Code.
At least up to July 1990 no effective system had been put in place to ensure that the Bank met important requirements of the Code despite the obvious risk that the insider trading provisions might have been breached inadvertently.
The inadequate state of documentation made available to me with respect to approvals of share purchases has made it impossible to determine whether all share transactions were properly authorised or provisions of the Code breached.
(b) Findings and Conclusions
The Bank's procedure for dealing in securities were inadequate.
The Bank's trading in securities was not adequately supervised, directed and controlled by the officers and employees of the Bank.
1.7.11.3 Dealings Between State Bank and Equiticorp (Chapter 26)
(a) Overview and Summary
Mr Clark was the Chief Executive Officer and Group Managing Director of the Bank Group. He was also the director of various companies in the Equiticorp Group. Because of that fact, but more particularly because the Equiticorp Group was a significant customer of the Bank Group before the Equiticorp Group's highly publicized collapse in January 1989, the dealings between the Bank Group and the Equiticorp Group have been the subject of inquiry pursuant to paragraph A(h) of my Terms of Appointment.
In examining those dealings, one area of focus has been the conduct of Mr Clark. He was under a duty to avoid a conflict of interest. Mr Clark had to ensure that he did not allow a situation to develop where his duty to the Bank Group conflicted with, or appeared to conflict with, his personal interest in the Equiticorp Group.
Some of the Bank Group's more significant dealings with Equiticorp are to be seen in the light of a major transaction that occurred in New Zealand in the period from late 1987 through to March 1988.
The Equiticorp Group purchased shares in New Zealand Steel Ltd, to the value of $NZ 327.0M only a matter of days before the stock market crash of October 1987. The effect on Equiticorp was that it was obliged to pay approximately $NZ 3.00 for shares that were now valued at approximately $NZ 1.00 per share.
There are other notable features of this transaction ("the New Zealand Steel Purchase"):
(i) the shares were purchased from the New Zealand Government, and represented 89 per cent of the issued share capital of New Zealand Steel Ltd;
(ii) Equiticorp paid for the shares by issuing 92.9M shares in Equiticorp Holdings Ltd to the New Zealand Government, at $NZ 3.52 per share;
(iii) The New Zealand Government did not propose to hold those Equiticorp shares as a long term investor. An integral part of the share sale and purchase arrangements was that a local firm of stockbrokers would either purchase or procure the purchase of the 92.9M Equiticorp shares, at a price of not less than $3.52 per share, on or before 20 March 1988 ("the Take-out Agreement");
(iv) The Take-out Agreement provided that, if the stockbrokers could not purchase or procure another purchaser, two companies controlled by the then Chairman of the Equiticorp Group (Mr A Hawkins) would purchase the shares;
(v) It was further agreed that , in the event Mr Hawkins' companies became obliged to purchase the shares, Equiticorp Group companies would lend the necessary funds to those companies to finance the $NZ 327.0M share purchase;
(vi) In the event, one of Mr Hawkin's companies was required to purchase the shares for $NZ 327.0M. Of that sum, $NZ 222.0M came from within the Equiticorp Group;
(vii) When ownership of New Zealand Steel Ltd passed to the Equiticorp Group, it was no longer supported by New Zealand Government ownership. Significant credit facilities were, accordingly, discontinued by several Japanese banks. That created a pressing need for working capital and liquidity quite apart from funding the $NZ 220.0M share purchase; and
(viii) A Board Paper presented to a meeting of directors of Equiticorp Holdings (including Mr Clark) held on 27 October 1987, records that there was an anticipated cash outflow, in March 1988, of $NZ 327.0M. A Board Minute of that meeting records that the Board was told a major cash flow issue was "the funding of the New Zealand Steel payment on 20 March 1988".
Bearing those features of the New Zealand Steel Purchase in mind, I turn to look at what was happening in Adelaide at about that time in relation to the Bank Group's relationship with Equiticorp.
In the period December 1987 to end March 1988, the Bank Group was involved in four major transactions involving the Equiticorp Group that are remarkable not only because of the large amount of money involved, but also because they were all either ineptly managed (often as a result of being pursued with inexplicable haste), or they were inappropriately and artificially structured by management so as to avoid prudential considerations (such as prior consultations with the Reserve Bank and large exposure policies), or both. Those four transactions are, in very brief outline, as follows:
(i) During December 1987 to March 1988, the Bank purchased, for $60.0M, a funds management and insurance business - Oceanic Capital Corporation. Mr Clark introduced the transaction to the Bank knowing that Equiticorp had a loan facility in place with the owner of Oceanic Capital Corporation. He was also aware that Equiticorp would receive significant funds directly from the sale proceeds. The due diligence performed by Bank management was inept. Important conditions stipulated by the Board were not adhered to. The Board was informed that the owner of Oceanic Capital Corporation did have a time pressure because it had debts outstanding requiring settlement by the end of March. The Board was not informed that that debt (nearly half the purchase price) was owed to the Equiticorp Group.
(ii) In December 1987 the Bank lent Equiticorp $200.0M using a facility that was structured in a highly unusual way, designed to circumvent the requirements of the Reserve Bank, and, in particular, designed to ensure that Equiticorp received the funds urgently. Of this amount, $150.0M was ostensibly for the `purchase', by the Bank, of Equiticorp receivables. These receivables were `re-purchased' by Equiticorp after the agreed term of 30 days. Bank management (without the awareness of the Board) arranged the facility in that way in the face of previous advice and warnings from the Reserve Bank, and despite external legal advice that the Bank was not adhering to normal prudential requirements.
(iii) In January 1988, the Bank agreed to repeat the above described `asset-purchase facility', this time for a standby amount of $100.0M for consecutive terms of thirty days for a total term of six months. Although this was recommended to, and approved by the Board, management decided not to proceed with the offer when the Bank's legal department repeated the same concerns that had been expressed (by external advisors) during the December transaction. Further concerns were recorded in writing within the Bank's Corporate Lending department, including the Bank's significant exposure to the Equiticorp Group, and the relationship of the Bank's Managing Director with Equiticorp.
(iv) Following Bank management's decision not to proceed with the above described January 1988 asset purchase facility, Beneficial Finance, using subsidiaries of off-balance sheet companies, purchased five portfolios of receivables from the Equiticorp Group. These purchases, concluded before the end of March 1988, resulted in the injection into Equiticorp of something in excess of $NZ 220.0M.
Another of the transactions reviewed is a useful illustration of Mr Clark's dominating influence within the Bank Group.
Late in 1988, when it had been clear to Mr Clark for some time that the Equiticorp Group was experiencing financial difficulties, Mr Clark approached Beneficial Finance with the request that Beneficial Finance assume $10.0M of the Bank's exposure to Equiticorp. Beneficial was to receive a fee of $0.1M.
There was no sensible commercial reason for the transaction. It seems that Mr Clark saw the underpinning as a way of reducing the Bank's book losses. The Beneficial Finance Executive Committee initially objected but eventually consented, albeit reluctantly.
The Investigation focused on two of the transactions; the Oceanic Capital Corporation purchase and the Equiticorp Receivables purchase. The significance of these transactions is not so much that they were made, or that they were consistent with the Bank's strategic objectives, but how the deals came to be made, and when they were made.
It is impossible to resist the inference that the liquidity problems then facing the Equiticorp Group are associated with the events leading to the transactions. Mr Clark has denied it, but, in my opinion, he had a motive to relieve the financial burden on Equiticorp. It is also my opinion that Mr Clark's motive to relieve the financial burden on Equiticorp was founded on his position as a director and shareholder of Equiticorp.
For the reasons set out in Chapter 26 - "Dealings between the State Bank and Equiticorp" , the matters reported may disclose a conflict of interest and a breach of fiduciary duty by Mr Clark. In my opinion, the matters reported should be further investigated.
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APPENDIX
APPOINTMENT (AS AMENDED) OF AUDITOR-GENERAL
UNDER SECTION 25 OF
THE STATE BANK OF SOUTH AUSTRALIA ACT
WHEREAS
(1) I am advised that the Bank has a significant amount of non-performing assets for which there had been inadequate provision by way of specific or general reserves.
(2) I am advised that by reason of the above, the Bank faced substantial financial difficulties which have led to an indemnity being granted to the Bank by the Government.
(3) I am advised that it is in the public interest that the causes of the financial difficulties at the Bank should be identified.
(4) By Instrument dated the 9th day of February 1991 I appointed the Auditor-General to investigate and report on certain matters relating to the Bank.
(5) I am advised that it is desirable that the matters which the Auditor-General is to investigate and report on should be varied.
I, THE HONOURABLE DAME ROMA FLINDERS MITCHELL , Companion of the Order of Australia, Dame Commander of the Most Excellent Order of the British Empire, Governor in and over the State of South Australia acting pursuant to the powers given me by Section 25 of the State Bank of South Australia Act, 1983 and all other enabling powers and with the advice and consent of the Executive Council do hereby revoke the said appointment and now hereby appoint the Auditor-General to investigate and report on the following matters:
A. The Auditor-General is to investigate and inquire into and report on:
(a) what matters and events caused the financial position of the Bank and the Bank Group as reported by the Bank and the Treasurer in public statements on 10th February 1991 and in a Ministerial Statement by the Treasurer on 12th February 1991;
(b) what were the processes which led the Bank or a member of the Bank Group to engage in operations which have resulted in material losses or in the Bank or a member of the Bank Group holding significant assets which are non-performing;
(c) whether those processes were appropriate;
(d) what were the procedures, policies and practices adopted by the Bank and the Bank Group in the management of significant assets which are non-performing;
(e) were those procedures, policies and practices adequate;
(f) whether adequate or proper procedures existed for the identification of non-performing assets and assets in respect of which a provision for loss should be made;
(g) whether the internal audits of the accounts of the Bank and Beneficial Finance Corporation Ltd (and of such other subsidiary of the Bank that the Auditor-General considers should be subject to investigation, inquiry and report under this subparagraph) were appropriate and adequate;
(h) such of the following matters that in his opinion he should investigate, inquire into and report on;
(i) any possible conflict of interest or breach of fiduciary duty or other unlawful, corrupt or improper activity on the part of a director or officer of the Bank or a subsidiary of the Bank; or
(ii) any possible failure to exercise proper care and diligence on the part of a director or officer of the Bank or a subsidiary of the Bank.
The Auditor-General is directed to report on the above matters on or before 30 June 1993.
B. The Auditor-General is to investigate and inquire into and report on whether the external audits of the accounts of the Bank and Beneficial Finance Corporation Ltd (and of such other subsidiary of the Bank that he considers should be subject to investigation, inquiry and report under this paragraph) were appropriate and adequate. The Auditor-General is directed to report on this matter on or before 30 June 1993.
C. The Auditor-General is to investigate and inquire into and report, with reference to the above matters, whether the operations, affairs and transactions of the Bank and the Bank Group were adequately or properly supervised, directed and controlled by:
(a) the Board of Directors of the Bank;
(b) the Chief Executive Officer of the Bank;
(c) other officers and employees of the Bank; and
(d) the Directors, officers and employees of the members of the Bank Group.
The Auditor-General is directed to report on the above matters on or before 30 June 1993.
D. The Auditor-General is to investigate and inquire into and report, in relation to the matters set out in paragraphs A and B above, whether the information and reports given by the Chief Executive Officer and other Bank officers to the Board of the Bank:
(a) were under all the circumstances, timely, reliable and adequate;
(b) sufficient to enable the Board to discharge adequately its functions under the Act.
The Auditor-General is directed to report on the above matters at the same time as he reports in relation to paragraphs A and B above respectively.
E. Having regard to the material considered by him in respect of the matters set out in paragraphs A to D above, the Auditor-General is in any report on such matter, to report on any matters which in his opinion may disclose a conflict of interest or breach of fiduciary duty or other unlawful, corrupt or improper activity and the Auditor-General is to report whether in his opinion, such matters should be further investigated.
F. The Auditor-General is authorised to seek and obtain such advice or assistance on matters relating to banking, accounting and auditing practice relevant to this appointment as he may consider necessary for the purpose of his inquiry.
G. The Auditor-General is directed to provide to the Royal Commission appointed by me on the 4th day of March 1991;
(a) a copy of any report made by the Auditor-General as directed in paragraphs A to D above;
(b) any interim report or any information including relevant documents and records and including any document containing tentative conclusions reached by the Auditor-General on any document containing any information or comment to the Auditor-General by any person engaged to assist him in his report which interim report or information the Royal Commission may seek relating to the matters falling within its Terms of Reference.
H. The Auditor-General is directed in conducting his inquiry and his report so far as practicable to avoid prejudicing pending or prospective criminal or civil proceedings, and to report in part by way of confidential report if he considers it appropriate.
I. The Auditor-General is directed so far as practicable:
(a) in any information provided or report made by him to protect the confidentiality of information which could properly be regarded as confidential information of the Bank or of a member of the Bank Group or of a customer or person dealing with the Bank or a member of the Bank Group;
(b) in any report prepared by him when it is necessary in his opinion to disclose or refer to such information, to present the report in a manner which enables the findings and recommendations in the report to be considered separately from the confidential information, the confidential information where practicable being presented in a separate report or appendix.
J. The Auditor-General is directed to avoid as far as practicable prejudicing or interfering with the ongoing operations of the Bank and the Bank Group.
K. The Auditor-General may perform his functions under paragraphs A, B, C and D by preparing one or more separate reports.
In this Instrument:
"the Act" means the State Bank of South Australia Act, 1983 ;
"the Bank" means the State Bank of South Australia constituted by the Act;
"the Bank Group" has the same meaning as in Section 25 of the Act as amended from time to time;
"operations" of the Bank or Bank Group has the same meaning as in Section 25 of the Act as amended from time to time;
"the report" includes one or more separate reports but unless the context otherwise requires does not include interim reports.
DATED the 28th day of March 1991.
THE HONOURABLE DAME ROMA FLINDERS MITCHELL