VOLUME THIRTEEN SECOND REPORT PURSUANT TO TERMS OF APPOINTMENT AND THE STATE BANK ACT

CHAPTER 27
CONCLUSIONS, FINDINGS AND RECOMMENDATIONS OF THE INVESTIGATION INTO BENEFICIAL FINANCE CORPORATION LIMITED AND THE EXTERNAL AUDITS OF STATE BANK AND BENEFICIAL FINANCE CORPORATION LIMITED

TABLE OF CONTENTS

27.1 INTRODUCTION

27.2 THE INVESTIGATION INTO, AND REPORT ON, BENEFICIAL FINANCE
27.2.1 TERMS OF APPOINTMENT
27.2.2 THE SCOPE AND CONDUCT OF MY INVESTIGATION

27.3 AN OVERVIEW OF MY REPORT ON BENEFICIAL FINANCE
27.3.1 SUMMARY REPORT IN ACCORDANCE WITH MY TERMS OF APPOINTMENT
27.3.1.1 Term of Appointment A(a)
27.3.1.2 Terms of Appointment A(b) and A(c)
27.3.1.3 Term of Appointment A(d) and A(e)
27.3.1.4 Term of Appointment A(f)
27.3.1.5 Term of Appointment A(g)
27.3.1.6 Term of Appointment A(h)
27.3.1.7 Term of Appointment C
27.3.2 THE LOSSES SUSTAINED BY BENEFICIAL FINANCE
27.3.3 WHAT WENT WRONG AND WHY: BENEFICIAL FINANCE
27.3.3.1 Introduction
27.3.3.2 The Structured Finance and Projects Division
27.4.2.3 The Operating Joint Ventures
27.4.2.4 The Corporate Culture
27.4.2.5 The Board of Directors
27.4.2.6 The Chief Executive Officer
27.4.2.7 The Senior Management
27.3.4 A SYNOPSIS OF MY REPORT
27.3.4.1 Introduction
27.3.4.2 Chapter 28: Overview of Beneficial Finance Corporation Limited
27.3.4.3 Chapter 29: Direction-Setting and Planning
27.3.4.4 Chapter 30: Credit and its Management: Guidelines, Policies, Processes and Delivery Systems
27.3.4.5 Chapter 31: Case Study in Credit Management: East-End Market
27.3.4.6 Chapter 32: Case Study in Credit Management: Mindarie Keys
27.3.4.7 Chapter 33: Case Study in Credit Management: Pegasus Leasing
27.3.4.8 Chapter 34: The Funding of Beneficial Finance
27.3.4.9 Chapter 35: Beneficial Finance - Prospectus 65
27.3.4.10 Chapter 36: Treasury and the Management of Assets and Liabilities at Beneficial Finance
27.3.4.11 Chapter 37: Internal Audit of Beneficial Finance
27.3.4.12 Chapter 38: Equiticorp Receivables
27.3.4.13 Chapter 39: Mortgage Acceptance Nominees Limited
27.3.4.14 Chapter 40: Paper Meetings of Directors
27.3.4.15 Chapter 41: Management and Financial Information Reporting
27.3.4.16 Chapter 42: Bank and Bank Group Provisioning
27.3.4.17 Chapter 43: Other Matters Investigated within the State Bank and Beneficial Finance
27.3.4.18 Chapter 44: Reports from the State Bank's External Auditors to the Reserve Bank of Australia

27.4 THE LAW APPLICABLE TO BENEFICIAL FINANCE
27.4.1 INTRODUCTION
27.4.2 WHAT THE LAW REQUIRED OF DIRECTORS AND EMPLOYEES OF BENEFICIAL FINANCE
27.4.2.1 The Important Features of the Standards Required by the Law
27.4.2.2 The Allocation of Functions and Powers in Beneficial Finance
27.4.2.3 Reliance by Non-Executive Directors on the Managing Director and Senior Managers
27.4.2.4 The Obligations of the Board of the State Bank for the Conduct of the Affairs of Beneficial Finance
27.4.2.5 The Role and Duties of Common Directors on the Boards of the Bank and Beneficial Finance
27.4.3 RELEVANT PROVISIONS OF THE COMPANIES CODE
27.4.3.1 Introduction
27.4.3.2 Section 229(2): The Duty to Exercise Reasonable Care and Diligence
27.4.3.3 Section 229(1): The Duty to Act Honestly in the Best Interests of the Company
27.4.3.4 Section 229(3): The Duty Not to Make Improper Use of Company Information
27.4.3.5 Section 229(4): The Duty Not to Make Improper Use of Position in the Company
27.4.3.6 Potential Penalties and Liabilities Under Section 229
27.4.4 MY POWER TO MAKE FINDINGS IN RESPECT OF MATTERS OF LAW
27.4.4.1 The Issue
27.4.4.2 The Non-Judicial Nature of my Investigation
27.4.4.3 The Law Regarding Non-Judicial Investigations
27.4.4.4 Section 25 of the State Bank Act
27.4.4.5 My Terms of Appointment

27.5 AN OVERVIEW OF MY REPORT ON THE EXTERNAL AUDITS
27.5.1 MY TERMS OF APPOINTMENT
27.5.2 A SYNOPSIS OF MY REPORT ON THE EXTERNAL AUDITS
27.5.2.1 Chapters 45 to 53: The External Audits of the State Bank
27.5.2.2 Chapters 54 to 60: The External Audits of Beneficial Finance

27.6 APPENDIX

_______________________________________________________________________________________________

27.1 INTRODUCTION

This is the second of my essentially self-contained Reports in respect of my inquiry into the State Bank of South Australia and its subsidiaries and related entities.

In my First Report, comprised by Chapters 1 to 26, I presented the results of my inquiry into the operations of the State Bank of South Australia. This Second Report, comprised by Chapters 27 to 60, contains two distinct parts. It presents the results of my inquiry into:

(a) the operations of the other main entity in the State Bank Group, Beneficial Finance Corporation Limited and its associated entities, and some further matters relating to the State Bank (Chapters 27 to 44); and

(b) the adequacy and appropriateness of the external audits of the State Bank and of Beneficial Finance (Chapters 45 to 60).

A separate confidential report has also been presented to the Governor, dealing with a variety of matters, most of which require further investigation.

The purpose of this Chapter is to provide an overview and summary of this Second Report, and of the key findings and conclusions that I have reached, as a result of my inquiry into Beneficial Finance and the external audits of the Bank and Beneficial Finance.

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 this 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.

Much of the background to my inquiry, including the circumstances of my appointment and the nature and conduct of my investigation, was described in detail in Chapters 1 and 2 of my First Report, to which the reader is referred. I have not reproduced that information in this Report except to the limited extent that is necessary to make this Report comprehensible without needing to refer to the First Report.

27.2 THE INVESTIGATION INTO, AND REPORT ON, BENEFICIAL FINANCE

27.2.1 TERMS OF APPOINTMENT

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 into Beneficial Finance has been upon answering the questions:

(a) What caused the losses of Beneficial Finance which contributed to the financial position of the Bank and Bank Group as described in February 1991? and

(b) Who, or what, is to blame?

The substance of my Terms of Appointment relating to Beneficial Finance which are answered in this Report can be summarised as follows:

(a) What matters or events caused the losses sustained by Beneficial Finance that contributed to the financial position of the Bank and Bank Group as reported in February 1991? (Term of Appointment A(a));

(b) What were the processes which led Beneficial Finance 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 Beneficial Finance'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 Beneficial Finance adequately or properly supervised, directed and controlled by its 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 Beneficial Finance? (Term of Appointment A(h) and sub-section 25(2) of the Act);

(f) Were the internal audits of Beneficial Finance appropriate and adequate? (Term of Appointment A(g)); and

(g) 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).

Readers of my Terms of Appointment will have noticed that Term of Appointment D does not refer to Beneficial Finance. That Term of Appointment required me to examine whether the reports given by officers of the Bank to the Bank's Board of Directors were timely, reliable, adequate, and sufficient to enable the Board to discharge its functions under the Act.

Although Term of Appointment D does not refer to Beneficial Finance, an examination of the adequacy of the reporting to Beneficial Finance's Board of Directors is an important and essential part of answering my Terms of Appointment generally, and Term of Appointment C in particular. Any judgment as to whether the directors of Beneficial Finance adequately performed their functions must take into account what they were told, and what they were not told, about the company's activities. Accordingly, although this Report does not make any findings regarding the reporting to the Beneficial Finance Board as a discrete topic in answer to my Terms of Appointment, it does deal with that reporting as an integral part of answering Term of Appointment C.

It is appropriate that I acknowledge here the limited tenure of some of the non-executive directors of Beneficial Finance on the Board of Directors. Where in this Report reference is made to the Board of Directors of Beneficial Finance, it must be kept in mind that:

(a) Mr C H Rennie CBE retired on 30 June 1985;

(b) Mr A G Summers was appointed on 28 July 1989; and

27.2.2 THE SCOPE AND CONDUCT OF MY INVESTIGATION

In the course of my Investigation into the Bank and Bank Group, the State Government provided adequate resources, particularly funding and time, to enable me to fully inquire into and answer all material aspects of my Terms of Appointment.

My Terms of Appointment neither require me, nor authorise me, to examine all areas of the Bank Group's operations. Generally speaking, my Investigation was limited to those areas of the Bank Group's operations which, in one way or another, caused or contributed to the losses of the Group. As I explained in my First Report, one consequence was that I limited my examination to the two entities in the Bank Group which reported most of the Group's losses, the Bank and Beneficial Finance.

Even within those two entities, it was essential for me to exercise my professional judgment about which parts of their operations should be examined. It was simply not possible within any reasonable limits of time and cost, and was unnecessary, to examine every part of their extensive activities in detail.

Some business activities were not examined because they did not result in significant losses. In the case of the Bank, for example, I did not examine the retail and housing loan businesses. In the case of Beneficial Finance, I did not examine non-real estate lending of the so-called "core" business divisions. Accordingly, my Reports must be regarded as being essentially in the nature of exception reports, describing those areas in which the operations of the Bank and Beneficial Finance were inadequately managed and controlled. Many parts of the Bank Group's activities were professionally and competently conducted, but are not described in my Reports because they are not relevant to explaining the reasons for the Bank and Bank Group's financial position as described by the Bank and the Treasurer in February 1991.

Some matters that did not result in significant losses were examined, because they were matters that, in my opinion, may have involved unlawful, corrupt or improper activity within the meaning of Terms of Appointment A(h) and E, and sub-section 25(2) of the Act.

The matters which I have examined, and have not examined, were carefully considered and selected by me having regard to a wide range of considerations related to my Terms of Appointment. There were some more difficult judgments to be made. Beneficial Finance's motor vehicle leasing business known as Luxcar is an example. Despite the suggestions made by some parties that the operations of Luxcar resulted in material losses and may have involved some activities that bore investigation, I decided not to examine the Luxcar business for three reasons:

(a) First, Luxcar is already the subject of investigation by the Federal Police, Australian Taxation Authorities and the Commonwealth Director of Public Prosecutions. An investigation by me would be a wasteful duplication of effort.

(b) Second, because of the Federal inquiry, the relevant files were not readily available to my Investigation. Obtaining access to those files would have been problematic at least, and may have hindered the Federal inquiry. Term of Appointment H directed me to conduct my inquiry so far as practicable to avoid prejudicing any pending or prospective criminal or civil proceedings.

(c) Third, even if I had examined Luxcar, I would very probably have been required by my Terms of Appointment to keep that part of my Report confidential, and not present it to Parliament. Term of Appointment H directs me to report so far as practicable so as to avoid prejudicing any pending or prospective criminal or civil proceedings, and to report by way of a confidential report if I consider that to be appropriate. Section 25(5) of the Act directs me to present to Parliament only those parts of my Report that I consider need not remain confidential. It is likely then that the results of my inquiry into Luxcar would have remained confidential, and not available to the public for an indefinite period of time.

The conduct of my Investigation of Beneficial Finance was, like my Investigation of the Bank, subject to the requirement that I provide a full measure of natural justice and procedural fairness to all those parties that might be the subject of my Report. The procedures followed by me in doing so were described in sections 1.4.4 and 1.4.5 of my First Report.

The natural justice process was important both to ensure that my Report was fair, and as an accurate representation of facts which were not always apparent from my examination of documents and records.

A good example of the benefits sometimes associated with the natural justice process is the evidence obtained by me in respect of certain matters dealt with in two internal audit reports dated 19 July 1990 and 3 August 1990, prepared by the Bank Group's Internal Audit department, regarding loans granted by Beneficial Finance to its executives. Upon investigation, those reports were found to contain significant errors of fact and reasoning which, had I placed reliance on them, would have seriously misdirected my Investigation of the matters with which they dealt. The results of my examination of this matter are described in Section 43.3 of Chapter 43 - "Other Matters Investigated within the State Bank and Beneficial Finance" of this Report.

Finally in relation to the conduct of my Investigation of Beneficial Finance, it is appropriate that I acknowledge the co-operation provided to my inquiry by the former Managing Director of Beneficial Finance, Mr J A Baker, who spent considerable time and effort giving evidence.

27.3 AN OVERVIEW OF MY REPORT ON BENEFICIAL FINANCE

27.3.1 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 discrete aspects of the operations of Beneficial Finance. Accordingly, each Chapter of this Report dealing with Beneficial Finance contains a report in accordance with my Terms of Appointment as they relate to the particular aspect of Beneficial Finance's operations described in the relevant Chapter.

It is, however, possible to provide, accurately and fairly, some general answers to my Terms of Appointment.

27.3.1.1 Term of Appointment A(a)

The matters and events that caused or contributed to the losses sustained by of Beneficial Finance were:

(a) Beneficial Finance's excessive exposure to commercial property development, both as a lender and as an equity participant.

(b) The failure of Beneficial Finance to establish adequate policies and procedures for the evaluation and management of credit risk associated with the business conducted by Beneficial Finance's Structured Finance and Projects division and its predecessor divisions.

(c) The inadequacies in the management and conduct of the Structured Finance and Projects division and its predecessor divisions.

(d) The failure of Beneficial Finance to establish adequate policies and procedures for the evaluation, acquisition, control and funding of its interests in operating joint ventures.

(e) The failure of Beneficial Finance to adequately control the operations and activities of operating joint ventures.

(f) The inadequacies and deficiencies of Beneficial Finance's management information systems.

(g) The failure of the Directors of Beneficial Finance to adequately or properly supervise, direct and control Beneficial Finance's operations, affairs and transactions, as particularised in this Report.

(h) The failure of the Chief Executive Officer to adequately or properly supervise, direct and control Beneficial Finance's operations, affairs and transactions, as particularised in this Report.

(i) The failure of certain of the officers and employees of Beneficial Finance to adequately or properly supervise, direct and control its operations, affairs and transactions, as particularised in this Report.

(j) The substantial rise, and subsequent dramatic fall, of real estate prices in the period after 1985.

Other matters and events that provided the essential pre-conditions for the losses, but that were not a cause of the losses in the sense of being to blame for the losses, were:

(a) Financial deregulation and the general economic events of the 1980's.

(b) The ownership of Beneficial Finance by the State Bank, which was in turn guaranteed by the Government.

27.3.1.2 Terms of Appointment A(b) and A(c)

The processes which led Beneficial Finance to engage in operations that have resulted in material losses, or in Beneficial Finance holding significant assets which are non-performing are identified and described in relevant Chapters of this Report. For the reasons described in those Chapters, those processes were not appropriate.

27.3.1.3 Term of Appointment A(d) and A(e)

The procedures, policies and practices adopted by Beneficial Finance in the management of significant assets which are non-performing are identified and described in relevant Chapters of this Report. For the reasons described in those Chapters, those procedures, policies and practices were not adequate.

27.3.1.4 Term of Appointment A(f)

Beneficial Finance's procedures for the identification of non-performing assets and assets in respect of which a provision for loss should be made were generally adequate and proper.

27.3.1.5 Term of Appointment A(g)

The internal audits of the accounts of Beneficial Finance were generally appropriate and adequate. The Board's response to some important matters raised by the Internal Audit reports was inadequate.

27.3.1.6 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 are the subject of comment and recommendations in my Report, and in a separate confidential Report.

27.3.1.7 Term of Appointment C

For the reasons described in my Report, the operations, affairs and transactions of Beneficial Finance were not adequately or properly supervised, directed and controlled by the directors, officers and employees of Beneficial Finance.

27.3.2 THE LOSSES SUSTAINED BY BENEFICIAL FINANCE

My Terms of Appointment require 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".

In those statements, both the Treasurer and the Bank emphasised that the "problems being experienced by the State Bank Group, including those of its subsidiary Beneficial Finance, are almost entirely limited to the property and corporate sectors." The Bank noted that Beneficial Finance had refocussed its activities on "a limited number of core businesses in which it has the expertise and experience to compete effectively".

Accordingly, my investigation of Beneficial Finance focused on the company's corporate lending and commercial property-related businesses which contributed to the financial position of the Bank and Bank Group. The losses of Beneficial Finance were not quantified separately by the Bank or the Treasurer in the statements made in February 1991. The source of the losses that have contributed to the financial position of the Bank and Bank Group can, however, be broadly seen from the details of the use of the State Government's Indemnity by the Bank, as described in the Bank's Annual Report for the year ended 30 June 1991, and in its submission to my Investigation:

	Indemnity Use
Entity	$M		%
State Bank of South Australia

Provisions for loan losses		980		44
Provision for subsidiary companies:
Oceanic Capital Corporation		101		5
United Banking Limited		87		4
Others		5		-
Property Asset Writedowns		65		3
		1238		56
Beneficial Finance Group

Provisions for losses		726		33
State Bank provisions on equity holdings		99		4
Taxation effects		57		3
		882		40
General and Other Provisions		81		4
		2201		100

These figures show that Beneficial Finance's losses contributed to the financial position of the Bank Group in a proportion that significantly exceeded its relative size, based on total assets. Although Beneficial Finance's total assets represented only about 13 per cent of the total assets of the State Bank Group, its loan losses represented about 43 per cent of the Group's total loan losses, and its total losses were about 42 per cent of total Group losses (excluding general and other provisions).

27.3.3 WHAT WENT WRONG AND WHY: BENEFICIAL FINANCE

27.3.3.1 Introduction

When the State Bank was formed on 1 July 1984, its wholly-owned subsidiary, Beneficial Finance, was a modest finance company specialising in small real estate loans, equipment leasing and consumer finance. It had total assets of $502.2M, capital of $58.1M, and made a profit from operations in 1984 of $4.2M.

After 1984, there were, in effect, `two' Beneficial Finances.

The core of the old Beneficial Finance remained. Conducted by the company's general business divisions, the core business continued to be generally well managed, observing policies and procedures that encompassed the fundamental basics of prudent credit risk management. By March 1990, the total on-balance sheet assets of the core businesses were $1,172.4M, a relatively modest annual growth of 15 per cent since July 1984.

There was, however, another Beneficial Finance. The Structured Finance and Projects division (as it was called in 1989), headed throughout its existence by Mr E P Reichert, was established in March 1986 to consolidate Beneficial Finance's pursuit of new business opportunities in response to the deregulation of the financial system. The fear was that, if it stuck to its core businesses, Beneficial Finance would not be competitive in the newly deregulated environment. With its ability to obtain both capital and debt funds assured by its ownership by a Government-owned Bank, Beneficial Finance was ideally placed to diversify and grow into new areas of the finance market, essentially unimpeded by funding constraints.

The Structured Finance and Projects division's strategy for growth of the new, non-core Beneficial Finance had two key planks:

(a) First, the Structured Finance and Projects division would pursue opportunities involving large financing transactions, very different from those with which Beneficial Finance had any previous experience. The idea was to act as a corporate adviser to clients on how to structure the financing arrangements for a project, and then to provide the finance for the project, often including taking an equity interest. Even if it did not provide the finance, Beneficial Finance would facilitate the financing of the project by providing guarantees to other lenders, thereby taking the credit risk.

(b) Second, Beneficial Finance would look for opportunities to form partnerships with small, entrepreneurial financiers operating in specialised, niche financial markets, again outside the areas in which Beneficial Finance had experience or expertise. The idea was to form operating joint ventures that combined the expertise and business contacts of the entrepreneurs, with the financial strength of Beneficial Finance, to grow substantial business from which both partners would profit.

This new Beneficial Finance grew very rapidly. From essentially nothing, the assets of the non-core businesses grew to exceed those of the old core businesses. By March 1990, 60 per cent of Beneficial Finance's risk assets were non-core business, as follows:

	On-Balance Sheet ($M)		Off-Balance Sheet ($M)		Total ($M)	% of Total Risk Assets
Core Business		1,172.4		196.2	1,368.6		40.2
Structured Finance and Projects Division		1,279.9		177.4	1,457.3		42.8
Joint Ventures		575.3		-	575.3		16.9
		3,027.6		373.6	3,401.2		100.0

In 1990, the new, non-core Beneficial Finance collapsed, with ruinous losses. In May 1990, the Structured Finance and Projects division was disbanded, and an Asset Management division was established to try and mitigate its losses. In August 1990, the process of winding up the joint ventures got under way. The people of South Australia were called on to bail out Beneficial Finance, saving the core businesses of the old Beneficial Finance from the ashes.

27.3.3.2 The Structured Finance and Projects Division

Formed in March 1986 as the Corporate Services division, the Structured Finance and Projects division operated beyond the pale of any reasonable principles of proper financial management. It paid no attention to the basic principles of credit risk management, blithely assumed the continual availability of unlimited funding regardless of the term of its exposures or their cash flows, and assumed that commercial property development was eternally and unerringly profitable. The division was run by irresponsible managers who speculated wildly in commercial property, driven by little more than thought for the next sale.

The division was responsible for most of Beneficial Finance's large credit exposures, and by March 1990 its facilities represented about 75 per cent of Beneficial Finance's exposures to clients of more than $5.0M. No effort was made to ensure any balance in the portfolio. Beneficial Finance's traditional speciality had been real estate financing, and major investment opportunities in the second half of the 1980's were associated with commercial property development. In combination, these factors meant that the Structured Finance and Projects division's exposures were almost entirely related to commercial property development projects. In essence, its business involved little more than property speculation, of an extreme kind.

The Structured Finance and Projects division effectively observed no set policies or procedures. Although it did have some regard to those policies and procedures applicable to the business divisions, the Division was regarded as being highly skilled and specialised, engaged in business activities to which Beneficial Finance's normal policies did not apply. The division would live and die according to the skills and expertise of its senior managers who controlled its activities.

Decisions were made by senior management often without careful or independent analysis by credit risk analysts, or by other relevant internal or external experts. The managers placed far too much faith in the expertise of their clients, and of themselves, without regard to the basic tenets of credit risk analysis.

The division's credit risk analysis consisted of little more than an unquestioning faith in the inevitable profitability of commercial property development projects. Even the division's internal procedures were commonly over-ridden by senior management, who made financing decisions in pursuit of ever-increasing asset growth. The mixture of equity and debt participation in such projects committed Beneficial Finance to long-term involvement in projects that were cash flow negative. The business could survive only because of the continuing ability of Beneficial Finance to obtain capital from the State Bank, and to borrow funds based on its status as a wholly owned subsidiary of a Bank guaranteed by the Government of South Australia.

Even in normal circumstances, the business of the Structured Finance and Projects division was unsustainable. As soon as the property market turned down, it collapsed.

27.4.2.3 The Operating Joint Ventures

The strategy and implementation of Beneficial Finance's participation in the operating joint ventures was, in my opinion, irresponsible to the point of recklessness.

The fundamental strategy of the joint ventures was flawed. Providing a small, entrepreneurial business in a niche financing market with unlimited finance to grow, uncontrolled by normal funding constraints, involves taking an unacceptable risk that is tantamount to gambling.

Put simply, the most senior management of Beneficial Finance - Mr Baker and Mr Reichert - would identify a small, entrepreneurial financier operating in a specialised market, and provide that entrepreneur with essentially unlimited funding to grow a financing business that Beneficial Finance and its partner would jointly own. Operating in markets that were outside the experience and expertise of Beneficial Finance, these joint venture partners had the real and effective control over the joint venture business, and the risks being run. Despite that, it was Beneficial Finance that bore the risk of losses.

With the funding provided by Beneficial Finance, these businesses rapidly grew beyond the scope of the experience and business skills of the joint venture partners to properly manage. Credit standards were lowered, as the joint ventures could make loans unrestricted by funding limitations that, in normal circumstances, provide some brake upon lending to less credit-worthy applicants. The result was that Beneficial Finance was providing unlimited funding to businesses that it neither understood, nor controlled. The very nature of the relationship between Beneficial Finance and its joint venture partners encouraged profligate lending, and the growth of businesses beyond the capacity of the partners to manage. Inevitably, significant losses resulted, and equally inevitably, it was Beneficial Finance, as the financing partner, that paid the cost.

27.4.2.4 The Corporate Culture

The 1980's has become known as the period of corporate excesses. Beneficial Finance's Corporate behaviour must rank as an example of the worst kind of excesses that were prevalent during that period.

In the course of my Investigation, I have come across examples of spending by Beneficial Finance on a scale which must cause concern to the people of this State who are now, and for years to come, required to pay the cost.

For example, by June 1990, Mr Baker's total remuneration package stood at nearly $525,000, which was more than double the packages for the then heads of the Commonwealth Bank and the State Banks of New South Wales and Victoria. In addition, the salary packages for another six senior executives stood at $200,000, or more.

In one instance, Beneficial Finance had an apartment unit on the Gold Coast which it put on the market for sale. Beneficial Finance was persuaded to furnish this apartment for $120,000, including with a baby grand piano, to make it more attractive for potential purchasers. Whilst on the market, it was available for members of the Executive Committee when they visited Queensland on business, and if they wanted to stay on for a few days for their own recreation purposes. In a joint venture for a resort development in Western Australia, Beneficial Finance financed the purchase of a motor launch for the sum of $850,000, with an annual maintenance cost of $80,000.

I point to these examples not to highlight anything unlawful or improper, but to point to the culture at the time of spending money as if there was no tomorrow.

Other activities on the part of Beneficial Finance management in two instances are, however, of greater concern.

From about 1983 until the introduction of Fringe Benefits Tax in 1986, Beneficial Finance remunerated its senior executives in part by means of a "shadow" salary. This practice provided the opportunity for executives to minimise their taxable income by not including the shadow salary component in their income tax returns.

In August 1989 certain senior executives borrowed a total of $475,000 from Beneficial Finance to fund their investment in the Jolen Court Project as part of a joint venture with Viaduct Services Pty Ltd, a member of the Tribe and Crisapulli Group of companies. Those of the executives involved in the credit approval process in respect of applications by the Tribe and Crisapulli Group for loans from Beneficial Finance exposed themselves to the potential for a serious conflict of interest.

27.4.2.5 The Board of Directors

The directors did an adequate and proper job in supervising, directing and controlling the core businesses of what I have categorised above as the `old' Beneficial Finance. Those businesses had established policies and procedures, and the directors involved themselves in reviewing those policies and procedures, ensuring they were adequate, and that they were followed.

When it came to the new, non-core business, however, the directors were left floundering. The Structured Finance and Projects division operated without regard to the policies and procedures laid down by the directors, and the directors were unable to control it. The division professed to be highly skilled and expert "financial engineers", operating in the new era of deregulated financial markets. In that circumstance, the directors were placed in a position of essentially having to rely upon the skills of the senior managers of that division. The directors' questioning of the growth rate of Beneficial Finance was met with assurances from Mr Baker and Mr Reichert.

The Board of Directors did not take action to impose any reasonable level of control upon the activities of the Structured Finance and Projects division. The Board seemed to be either unable, or unwilling, to insist that growth be controlled to within reasonable limits, or at least budgeted limits. Most importantly, the directors approved almost all of the transactions of the division. Those submissions commonly had not been subject to Beneficial Finance's usual credit approval procedures, and obviously did not comply with the policies applicable to the core business.

The directors did not get to grips with the reality of the operation of Beneficial Finance's operating joint ventures. The Board never seemed to appreciate, until too late, that the arrangement involved little more than Beneficial Finance handing over funding to an entrepreneur, with no more detailed control being exercised by management than the simple objective of growth.

The procedures adopted by the Board in response to matters raised by quarterly summarised internal audit reports were inadequate. It had deprived itself of a means of indepth analysis of the detailed reports by the Internal Auditors concerning the strengths and weaknesses of Beneficial Finance's operations by allowing its Audit Committee to disband, effectively from August 1984.

The Board's attention and effort were focused on growing the business of Beneficial Finance, and so failed to recognise the need for a co-ordinated approach to the critical task of asset and liability, liquidity, interest rate risk, and systems management.

As I have noted later in this Chapter, Beneficial Finance produced minutes of Directors' meetings that had not been held. These were referred to as "paper meetings", and the practice developed as a convenient alternative to convening a board meeting at short notice. This type of practice is a further example of the Board placing itself in a position which made it difficult for it to impose a reasonable level of control upon the activities of management.

27.4.2.6 The Chief Executive Officer

Mr Baker was the Managing Director, and must bear the heaviest share of the blame.

As Managing Director, he was in a far better position than the rest of the Board to assess the accuracy and worth of the management submissions coming to the Board.

Whether out of a mistaken sense of loyalty to the rest of management, a disdain for the Board, or for reasons which have escaped my Investigation, he failed on occasions to convey vital information to the Board.

In so doing he displayed a serious lack of understanding of his duties as Managing Director.

As management's senior executive, he failed to take steps to ensure that the policies and procedures introduced by the company for prudential management were effectively implemented, and seemed to regard the activities of the Structured Finance and Projects division, and of the operating joint ventures, as being beyond the scope of any need for policies or procedures that might inhibit their growth.

27.4.2.7 The Senior Management

Mr Reichert was the Chief General Manager for the Structured Finance and Projects division from its formation in March 1986, until it was disbanded in May 1990.

Mr Reichert must take a heavy share of the responsibility for the financial position of Beneficial Finance in February 1991. Mr Reichert single-mindedly pursued asset growth, with a one-dimensional faith in high-profile property developments that bordered on recklessness. I am simply at a loss to understand how the second most senior executive in Beneficial Finance could then, and judged by his submissions to my Investigation, still now, pay such complete disregard to the realities of the cyclical nature of the commercial property market, and to the need for a financial institution to be able to fund its activities. Mr Reichert seemed to have only one thought - that commercial property investment was good. The risks associated with the fact that the investment was long-term, with long-term negative cash flows, seemed never to enter his head.

Decisions regarding credit risk management were too often made by senior management, without regard to the need for observing structured and sound procedures for the identification and evaluation of risk. The division was characterised by the imperative of asset growth, without adequate attention to the risks that involved.

The arrangements applying to the operating joint ventures, which were managed by the Structured Finance and Projects division until 1 July 1989, were a disgrace. It was not until responsibility for managing the joint ventures was taken over by a new Investment Banking division in July 1989, headed by Dr R N Sexton, that Beneficial Finance took any action to take control of its exposure to the joint ventures, which were creating risks that Beneficial Finance did not control.

Senior management failed to appropriately plan and monitor:

(a) the company's growth;

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

Those failures were compounded by having no effective reporting of those important management issues.

The result was that management, and thus the Board, did not have a sound basis for decision making.

27.3.4 A SYNOPSIS OF MY REPORT

27.3.4.1 Introduction

This Section provides a synopsis of the various Chapters of this Report dealing with Beneficial Finance. It brings together the findings and conclusions which I have reached as a result of my investigation of Beneficial Finance's operations and of the role played by the Directors, Managing Director, and other relevant officers and employees.

My findings and conclusions, in summary form, are set out in this Section in the same order as they are dealt with in detail in later Chapters of this Report in respect of Beneficial Finance:

(a) Chapter 28 provides an overview of Beneficial Finance's business development and growth, and of its management and organisational structure;

(b) Chapter 29 describes the formal procedures by which Management prepared, and the Board of Directors reviewed and approved, plans for Beneficial Finance's business development;

(c) Chapters 30 to 33 (inclusive), and Chapter 39, examine Beneficial Finance's management of credit risk, including a detailed analysis of particular transactions;

(d) Chapters 34, 35 and 36 describe Beneficial Finance's funding, and its treasury and asset and liability management, and includes a detailed examination of the issue in 1989 and subsequent withdrawal in 1990 of Prospectus Number 65 for an issue of debentures;

(e) Chapter 37 examines the internal audit of Beneficial Finance;

(f) Chapter 38 describes Beneficial Finance's acquisition of a portfolio of receivables from Equiticorp;

(g) Chapter 40 examines the practice of documenting minutes and resolutions of purported meetings of directors that in fact had not been held - so-called "paper meetings";

(h) Chapter 41 describes Beneficial Finance's management and financial information reporting systems, particularly the implications of the use of off-balance sheet entities;

(i) Chapter 42 examines the adequacy of the provisioning for bad and doubtful debts in both Beneficial Finance and the Bank; and

(j) Chapter 43 examines certain remuneration practices of the Bank and of Beneficial Finance, and a transaction involving a conflict of interest on the part of certain managers of Beneficial Finance.

Finally, Chapter 44 examines the reporting by the external auditors of the Bank to the Reserve Bank.

27.3.4.2 Chapter 28: Overview of Beneficial Finance Corporation Limited

At the time of its acquisition by the Savings Bank of South Australia in April 1984, Beneficial Finance specialised principally in smaller real estate and housing loans, and vehicle and equipment leases and consumer lending. Beneficial Finance continued to carry on these "core" businesses throughout the 1980's.

After 1984, however, the company embarked upon new, "non-core" businesses. It did so in order to remain competitive following the deregulation of Australia's financial system. These new businesses were conducted by the Corporate Services division that was established in March 1986, and by its successor divisions, the Investment Banking division (1 July 1988 to 30 June 1989) and the Structured Finance and Projects division (1 July 1989 to May 1990). When the Structured Finance and Projects division was disbanded in May 1990, the non-core business comprised about 60 per cent of Beneficial Finance's total risk assets.

Broadly stated, the new business activities carried on after 1984 were:

First, Beneficial Finance engaged in corporate lending after July 1984, almost all of it property-related. The 1984 Annual Report did not mention corporate finance among its primary areas of business. The 1985 Report, however, described corporate finance as the "fastest growing sector of Beneficial's business", representing 11.8 per cent of year-end receivables, compared to only 1.1 per cent as at 30 June 1984. The 1986 Annual Report again described corporate finance as the fastest growing sector, representing 6 per cent of total lending during the year (up from 2 per cent at 30 June 1985). Corporate finance receivables totalled $411.0M at 30 June 1987, and increased to $766.0M by 30 June 1988, a rise of 86 per cent. Corporate lending in 1988 represented 39 per cent of new lending, up from 11 per cent in 1987, 6 per cent in 1986, and 2 per cent in 1985.

Second, Beneficial Finance's business expanded after 1984 to include the financing of, and equity participation in, large structured finance property projects. This business was an extension of Beneficial Finance's traditional lending for real estate, but differed in the size of the exposures, the nature of the projects, and the structuring of the financing arrangements usually on a tax-effective basis, a widely used arrangement until 1988 when the Australian Taxation Office issued a ruling effectively banning its use.

Third, Beneficial Finance expanded its business activities by entering into joint ventures with small, specialist financiers to conduct financing operations in areas that, although they were an extension of Beneficial Finance's core business activities, lay outside the area of its own experience and expertise. The premise of these operating joint ventures was that, with the strong financial backing of Beneficial Finance, the specialist financiers could grow businesses from which both partners would profit.

This expansion of Beneficial Finance's operations into new, non-core businesses had a number of implications for the general nature of its operations.

(a) Reflecting the change in the type of financing transactions, there was a dramatic increase in the size of the financing transactions undertaken by Beneficial Finance after 1984. A half-yearly exposure review presented to the Board of Directors on 5 September 1984 showed that, as at 26 July 1984, Beneficial Finance had only five exposures to clients or groups of clients of $5.0M or more, the largest being $5.9M, or about 10 per cent of the company's capital base. Exposures of more than $2.0M for real estate, and other exposures of more than $1.5M, totalled only $87.0M out of net receivables of $469.2M. The 1984 Annual Report showed that the average size of the company's receivables at 30 June 1984 was only $25,000.

By 30 September 1990, the credit risks by exposure to client groups as shown in the Quarterly Report on Risk Exposure were:

	Amount of Risk
		$M		% Total
Less than $20.0M			2,387.0		71.8
$20.0M to $24.9M			67.6		2.0
$25.0M to $29.9M			548.0		16.5
Greater than $40.0M			322.9		9.7
			$3,325.5		100.0

The September 1990 Quarterly Report showed that, as at September 1990, Beneficial Finance had twenty four client exposures in excess of $25.0M. Of the total exposure of $870.9M to those clients, $428.9M, or 49.2 per cent, was non-performing. The three largest non-performing loans were $60.4M, $50.3M and $46.2M.

(b) Beneficial Finance expanded its activities through the acquisition of other companies, businesses and loan portfolios. The principal acquisitions were:

(i) 1988 - Purchase of portfolios of receivables from Equiticorp, both in Australia and New Zealand.

- Acquisition of a majority interest in First Pacific Mortgage Limited.

- Acquisition of Campbell Capital Limited, an investment bank with a significant commercial property portfolio.

- Acquisition of 100 per cent ownership of Asset Risk Management Limited.

(ii) 1989 - Establishment of Southstate Corporate Finance Ltd in New Zealand.

- Acquisition of IBIS Information International Limited, a business information and corporate advisory firm.

- Purchase of an interest in Pacific Rim Leisure Limited, a property developer specialising in tourist facilities.

(c) A consequence of these business developments was a rapid increase in the company's total assets, at a rate well in excess of the average rate of asset growth of other finance companies. The total growth in Beneficial Finance's net receivables between 1984 and 1989 was 326.6 per cent, compared to the average of its finance company peers of 103.9 per cent. The average annual growth in Beneficial Finance's net receivables over the period was 34.3 per cent, while the average of its finance company peers was 15.7 per cent. The rate of growth of Beneficial Finance's lending assets was more than double that of other finance companies, and this was reflected in the increase in its market share, from 3.9 per cent in 1984 to 8.1 per cent in 1989.

(d) Finally, the increase in total assets and net receivables was facilitated by an accumulation of assets held "off-balance sheet" in a complex structure of off-balance sheet companies and trusts through which Beneficial Finance carried on a significant proportion of its business activities, including its participation in joint ventures, and its acquisition of some new assets.

Beneficial Finance's 1990 Annual Report announced the company's intention to "refocus the Company on its core business", noting that Beneficial Finance had been affected by the finance industry being "too aggressive", and by the rapid growth in property development funding, particularly larger structured property business which was causing most concern. The Report attributed Beneficial Finance's problems to "over aggressiveness, particularly in the area of structured property finance".

Beneficial Finance's growth required significant capital contributions from the State Bank: between 1986 and 1990, the Bank contributed a total of $108.6M of additional capital to Beneficial Finance. As at 30 June 1990, Beneficial Finance's total assets represented 12.7 per cent of the assets of the consolidated State Bank Group.

27.3.4.3 Chapter 29: Direction-Setting and Planning

(a) Overview and Summary

The dramatic change in the nature of Beneficial Finance's business, and its rapid growth, naturally raises the issue of the strategic planning and budgeting undertaken by Beneficial Finance in respect of that change and growth.

Beneficial Finance's strategic planning and budgeting procedure was extensive. It involved the commitment of considerable resources, and included work by a specialised planning department, a management conference attended by senior management, consultations with the management of the State Bank, and review and approval by Beneficial Finance's Executive Committee. The result of the process was the production of two planning documents which were presented annually to the Board of Directors for its review and approval: a five-year strategic plan which addressed long-term objectives and strategies, and a budget for the ensuing year. Once approved the plans and budgets were communicated to individual business units for implementation.

The strategic planning and budgeting procedure was therefore a potentially important part of the means by which the Board of Directors set policy for Beneficial Finance, reviewed Management's plans for the commitment of resources to implement that policy, and reviewed the progress of Beneficial Finance in meeting its objectives.

In the absence of suspicion that the planning and budgeting procedure was deficient, the Directors were entitled to rely on the extensive procedure to produce plans which had been thoroughly discussed and reviewed by all senior management, and which had the support and commitment of senior management.

The strategic plans were high-level documents, drafted in broad and general terms. Although the strategic plans did identify the principal features of the development of Beneficial Finance's business, details regarding the evaluation and implementation of strategies and strategic programs were not included in the plans. The plans performed the functions of identifying and summarising the strengths and weaknesses of the company and the opportunities and threats confronting it, focusing attention upon the preferred direction of its business development, forging a business culture, and focusing attention on key objectives.

The budgeted rate of asset growth was, in most years only slightly ahead of that actually achieved by other finance companies. Judged on that basis, the planned growth was not necessarily unreasonably aggressive or imprudent.

Implementation of the strategies and programs identified in the strategic plans and budgets was the responsibility of management. Again, in the absence of suspicion, the Directors were entitled to rely on management to implement all aspects of the plans in a timely and prudent manner.

The most significant feature of Beneficial Finance's strategic planning and budgeting, however, is the extent to which actual growth exceeded that which was planned, as shown in the following table:

Budgeted and Actual Asset Growth
	Budget		Actual
Year Ended 30 June	$M	%	$M	%
1985	104.3	20.1	245.1	48.8
1986	N/A	N/A	295.7	39.6
1987	84.0	8.4	95.5	9.1
1988	204.0	18.0	526.3	46.6
1989	204.1	13.2	595.2	36.0
1990	318.7	14.0	412.9	18.3

As the table shows, over the three years 1988-1990, the actual growth in total assets of $1,534.4M exceeded the planned growth of $726.8M by $807.6M, or 111.1 per cent. Actual asset growth for those three years was more than double that which was budgeted.

Beneficial Finance's Board of Directors was aware of the rapid and unplanned growth, and occasionally expressed concerns regarding the implications of the growth, particularly for the quality of loan assets. Nevertheless, the rate of asset accumulation continued: in 1989, total assets increased by 36.0 per cent, compared to a budgeted increase of only 13.2 per cent. That rapid and unplanned growth rate, which was significantly in excess of that of its competitors, should reasonably have given rise to doubts about the adequacy of Beneficial Finance's internal systems for identifying appropriate assets for acquisition, including its evaluation of credit risk, and should have raised questions as to whether the systems essential to managing its portfolio and planning for long-term profitable growth had kept pace with the unplanned growth.

The directors had before them information which should, in my opinion, have been sufficient to raise a reasonable suspicion that they could not rely on the strategic planning and budgeting procedure in undertaking the functions of policy setting, overseeing Management and reviewing the company's progress. That information included:

(i) repeated references in the strategic plans to key weaknesses in Beneficial Finance's internal systems;

(ii) the failure of Management to provide any strategic monitoring reports to the Board of Directors describing the progress being made in implementing the key internal systems requirements identified in the strategic plans; and

(iii) most importantly, the actual growth of Beneficial Finance's total assets very substantially exceeded that which was planned.

In the circumstances, the Board was not able to place reliance on the strategic plans and budgets, and their implementation by Management, in discharging its functions of setting policy, overseeing plans and adequately and properly monitoring progress. The excessive rate of growth was such as to render the strategic plans and budgets largely irrelevant as any reasonable basis for reviewing the detailed planning of Beneficial Finance. It necessarily gives rise to doubt that the implementation of the plans was adequate or effective.

The rapid growth over and above that which was planned, and which exceeded that of other finance companies in Australia, gave rise to an increased obligation of care and diligence on the directors in undertaking their task of approving asset acquisitions and loans by Beneficial Finance. In particular:

(i) the rapid growth in assets at a rate in excess of that of other finance companies and most other financial institutions in new market areas where Beneficial Finance had little previous experience, clearly raises a suspicion that Beneficial Finance's credit assessment standards were imprudently low. This was a concern expressly raised by the Beneficial Finance Board in respect of the excessive growth;

(ii) the unplanned growth had clear implications for the ability of Beneficial Finance to adequately manage its asset portfolio; and

(iii) the rapid growth, particularly in the increasingly diversified businesses, had clear implications for the adequacy of Beneficial Finance's information systems.

(b) Findings and Conclusions

(i) The matters examined in Chapter 29 do not, by themselves, allow me to make conclusive findings regarding my Terms of Appointment, since any of the deficiencies in respect of the strategic planning and budgeting procedure might conceivably have been compensated for by other aspects of the Board's and Management's activities.

(ii) The processes which led Beneficial Finance to engage in operations which have resulted in material losses, or holding significant assets which are non-performing, included, very broadly, the strategic planning of Beneficial Finance, which expressly proposed to engage in most types of the business activities which resulted in the acquisition of such assets. The actual acquisition of a majority of assets was, however, in quantitative terms, unplanned.

(iii) I am unable to conclude, on the basis of the evidence reviewed in Chapter 29 for the reasons expressed above, whether the operations, affairs and transactions of Beneficial Finance were adequately or properly supervised, directed and controlled by the directors, officers and employees of Beneficial Finance.

I find, however, that the procedure of strategic planning and budgeting did not amount to any adequate or proper system for supervision, direction and control of Beneficial Finance's activities. The excessive rate of growth over and above that budgeted essentially meant that the strategic plans and budgets became largely irrelevant to the procedure of supervision, direction and control.

(iv) In evaluating in later Chapters the adequacy of the supervision, direction and control of Beneficial Finance's operations, affairs and transactions, that adequacy is to be measured having regard to the lack of effective strategic planning and budgeting, and to the suspicions that should reasonably have been raised by the strategic plans, and by the excessive growth, as to whether Beneficial Finance's internal systems for evaluating and managing growth were adequate.

27.3.4.4 Chapter 30: Credit and its Management: Guidelines, Policies, Processes and Delivery Systems

(a) Overview and Summary

This Chapter reports the results of my examination of Beneficial Finance's management of the credit risk associated with its business operations between July 1984 and February 1991. Simply stated, credit risk is the risk that a borrower will be unable or unwilling to repay its loan as and when it is required to do so. The management of credit risk encompasses the processes of initiation, approval, settlement, monitoring, and recovery of finance facilities provided by Beneficial Finance to its customers.

There are two distinct aspects of the credit risk faced by a financial institution that must be managed:

(i) The first is the risk associated with each particular loan, that the borrower will be unable or unwilling to repay the loan, and pay interest, as and when it is due.

(ii) The second is the risk associated with the overall nature of the loan portfolio. A lender must ensure that the portfolio does not involve a concentration of risk upon particular borrowers, industries or geographic areas. If, for example, a large proportion of the portfolio is comprised of loans granted for use in commercial property development, then a downturn in the property market can have disastrous implications for the financial institution, as a large proportion of its borrowers will be unable to repay their loans. As I shall describe, that is precisely what occurred in the case of Beneficial Finance.

The management of credit risk is of fundamental importance to a financial institution like Beneficial Finance. A finance company faces a variety of risks in carrying on its business, including the risk of changes in interest rates, the risk of running out of cash (liquidity risk), and, usually, foreign exchange risk. In the end, though, it is credit risk that is most fundamental. It is the risk that, if realised, can most quickly and completely ruin the company.

The realisation of credit risk was the single most important cause of Beneficial Finance's contribution to the financial position of the Bank Group as described by the Bank and the Treasurer in February 1991. It lies at the very heart of my Investigation.

Although this Chapter is titled "Credit and its Management" and generally refers to loans, Beneficial Finance's risk exposures were often more in the nature of equity than debt. The distinction between equity and debt is not always clear, and was especially obscure in respect of Beneficial Finance's non-core business activities. Fundamentally, a lender expects to be repaid the amount of the loan, and to receive a set rate of return, called interest, as compensation or "rent" for the use of the money. The prudent management of credit risk involves ensuring, so far as possible, that the lender will in fact be repaid, and receive the agreed rate of return. For an equity participant or owner, there are no such assurances. An owner enjoys the benefits, and runs the risks, of an asset going up or down in value, or of a business being successful or not.

Beneficial Finance's risk exposures that were intended to be loans often involved the equity risk of assets going up or down in value, and some equity investments were structured with the intention of ensuring an agreed rate of return.

The complex mix of equity and debt exposures was particularly present in Beneficial Finance's participation in joint ventures, where it both held an equity interest and provided the financial backing, if not the actual funding, for the venture.

The activities of Beneficial Finance that involved the incurring of credit risk can accordingly be regarded as comprising:

(i) The general business divisions that carried on Beneficial Finance's so-called core business activities of smaller loans, usually secured by real estate mortgages, and motor vehicle and equipment leasing.

(ii) The Structured Finance and Projects division, and its predecessors, the Corporate Services division and the Investment Banking division, which carried on the so-called non-core businesses of large structured finance transactions, and corporate lending.

(iii) Beneficial Finance's operating joint ventures, which resulted in the creation of credit risks outside Beneficial Finance's own systems and procedures.

The management of credit risk was a critically important aspect of the supervision, direction and control of Beneficial Finance's business operations. Beneficial Finance was a financial institution, and, of all the risks it faced, credit risk was the most fundamental. It was the failure of Beneficial Finance to adequately manage that risk that was the single most important cause that contributed to its financial position in February 1991.

The general "organisation" of Beneficial Finance's credit risk management function, as distinct from the "execution" of that function was, in my opinion, adequate and appropriate. The Board of Directors gave attention to the important matters of credit risk management policies and procedures, and a Credit Policy Committee was established to ensure that policies and procedures were adequate.

Generally speaking, Beneficial Finance's delegated credit approval authorities, and the credit approval process, were adequate. The system of delegated credit approval authorities was established by the Board of Directors, which retained the ultimate approval authority. All major loans required approval by directors, and some others had to be submitted to the Board for ratification. The approval authority limits were stated in terms of the percentage that the loan represented of Beneficial Finance's shareholders' funds. The percentage limits were higher in the case of loans secured by real estate.

My opinion regarding the adequacy of the credit approval process is, however, subject to three vital exceptions:

(i) the established credit approval procedure was not followed in the case of some major transactions of the Structured Finance and Projects division;

(ii) there was no structured procedure to evaluate Beneficial Finance's participation in operating joint ventures; and

(iii) the loan approval procedure was not applied in respect of Beneficial Finance's funding of the operating joint ventures in which it participated as a joint venture party.

A critical failing of Beneficial Finance's credit risk management policies was the absence of any prudential policy limiting the company's total exposure to commercial property. Although it adopted various policies intended to ensure that the property-related loan portfolio included a diverse range of projects, there simply was no cap placed on the total exposure, which grew to be about 60 per cent of the portfolio by the end of 1989. That excessive and imprudent exposure inevitably meant that Beneficial Finance was seriously damaged financially by the collapse of the commercial property market in 1990.

I am satisfied that the credit risk management policies and procedures that applied to Beneficial Finance's core business operations conducted by the business divisions were generally adequate and appropriate, and that they were usually observed in practice. The losses realised in respect of the core business were principally the result of a general over-reliance on the continuing strength of the property market when exercising judgments in respect of a loan, and more particularly of the excessive exposure to real estate. The rise in property values, particularly after 1987, encouraged over-investment. Beneficial Finance had traditionally specialised in property-related loans, which combined with the absence of a prudential limit on its exposure, meant that the core businesses were over-exposed to an over-heated market. The policies and procedures could not protect Beneficial Finance from the collapse of that market. Simply stated, Beneficial Finance did not recognise the unsustainable nature of the market prices for property in 1988 and 1989.

The business strategy of the Structured Finance and Projects division was to undertake larger transactions involving often complicated mixes of equity participation, debt funding, and the provision of guarantees. The fundamental failures of the division in undertaking that business were:

(i) an excessive concentration on commercial property development, accompanied by an apparently absolute faith in the profitability of such projects;

(ii) a failure to have regard to the basic principles of credit risk evaluation and management; and

(iii) a tendency of senior management to initiate and recommend deals based on their own judgment and in the pursuit of new business, essentially ignoring the need for careful analysis through a structured evaluation and approval procedure.

Beneficial Finance's business development strategy included the formation of joint ventures with small, entrepreneurial financiers operating in specialised niche markets that, although they were an extension of Beneficial Finance's core business activities, were outside its experience and expertise. It was hoped that, with Beneficial Finance's financial support, the partner could use its expertise to grow a business from which both would profit.

The joint ventures resulted in the creation of credit risks outside the framework of Beneficial Finance's own policies and procedures. Although Beneficial Finance approved larger loans made by the joint ventures, there was a tendency to rely on the recommendations of the joint venture partners who, after all, were perceived to have skill and expertise that Beneficial Finance did not possess. In practice, it was Beneficial Finance's joint venture partners, and not Beneficial Finance, that made the decisions relevant to management of the joint ventures' credit risks.

It was Beneficial Finance, however, that essentially bore that risk. In most cases, its joint venture partners did not have anywhere near the financial capacity to meet their share of any significant losses associated with the joint ventures' loan portfolios. Indeed, the partners' lack of financial strength was the very reason that they entered into the joint ventures.

Beneficial Finance did not impose any prudential limits on its exposure to particular joint ventures. Even more importantly, there was no credit review and approval mechanism within Beneficial Finance in respect of the provision of funds to the joint ventures. With almost unlimited funding available to them, the joint ventures grew rapidly, as they were able to make loans unconstrained by funding limits. That inevitably placed downward pressure on credit standards.

(b) Findings and Conclusions

(i) Beneficial Finance's exposure to real estate generally, and commercial property development in particular, was imprudent and excessive. The Board of Directors and senior management failed to adequately monitor and control that exposure. In particular, no overall prudential limit on the exposure was set. The imprudent and excessive exposure was an important cause that contributed to the financial position of the Bank Group as reported by the Bank and by the Treasurer in February 1991.

(ii) The general organisation and structure of the credit risk management function in respect of the core businesses of Beneficial Finance was adequate and appropriate. The Board of Directors and Management adequately and properly supervised, directed and controlled the policies, procedures and conduct of Beneficial Finance's core business divisions. In particular, the policies and procedures applicable to the core businesses were adequate, and were generally observed in practice. The losses realised in respect of the core business real estate lending activities were the result of the rapid increase in, and subsequent collapse of, property values, and of the over-exposure of the core businesses to that over-heated market. Although the policies were adequate and generally observed, there was a tendency for judgments made within the discretions provided by the policies to be influenced by an over-reliance on the continuation of the buoyant property market.

(iii) The Structured Finance and Projects division did not observe the basic principles of credit risk evaluation and management. Its management of the credit risks associated with the non-core businesses was wholly inadequate, being based on little more than assumptions of the inevitable profitability of commercial property development projects.

The Board of Directors failed to adequately control, supervise and direct the business operations of the Structured Finance and Projects division. It was too willing to approve submissions that did not comply with, or even refer to, the policies established by the Board in respect of the real estate lending of Beneficial Finance's core business divisions.

Mr Baker, as Managing Director, and Mr Reichert, as Chief General Manager of the Structured Finance and Projects division throughout its four year existence, failed to apply to the non-core business activities the skill and judgment reasonably to be expected of executive officers of a financial institution.

(iv) The structure and operation of Beneficial Finance's participation in, and funding of, the operating joint ventures, meant that Beneficial Finance was subject to the risk of losses in respect of credit risks that it did not effectively control. Both the initiation and subsequent management of the credit risk was, in practical terms, in the hands of Beneficial Finance's joint venture partners. The risks associated with the operating joint ventures were exacerbated by the almost unrestricted funding provided to them by Beneficial Finance. For these deficiencies, Mr Baker and Mr Reichert are principally responsible.

27.3.4.5 Chapter 31: Case Study in Credit Management: East-End Market

(a) Overview and Summary

In May 1988, the directors of Beneficial Finance approved its participation in a joint venture to acquire the East End Market Company Limited, a publicly listed company that owned the East End Market.

Beneficial Finance's participation in the venture arose from a proposal presented to it in early May 1988 by Ayers Finniss, the merchant bank subsidiary of the State Bank. Ayers Finniss was acting for the Emmett Group.

The Emmett Group was controlled by its Managing Director, Mr A Emmett. It traded as a builder and developer, mostly of medium-size commercial and industrial projects. In May 1988 the Emmett Group controlled 8.6 per cent of the issued shares in the East End Market Company Limited, a publicly listed company whose principal asset was the East End Market site. Mr Emmett was a director of that company, whose major shareholder was the New Zealand Insurance Group, with control of 67.9 per cent of its shares.

The East End Market site has certain unique features. It is a largely contiguous site in excess of 3.5 hectares, situated on both the north and south sides of Rundle Street in the Central Business District of Adelaide. Its size and locality are such that the site is likely, in time, to be redeveloped as an important part of the City of Adelaide.

During 1987 and early 1988, the East End Market Company prepared concept plans for the redevelopment of the site involving various uses, including carparking, office buildings, hotels, retailing and entertainment.

Mr Emmett became disenchanted with the handling of the development by the East End Market Company. He thought that a public company was an unsuitable vehicle for carrying out the development of the site, and concluded that the best way to bring about the development was to privatise the East End Market Company. The Emmett Group lacked the financial strength to do that, so Mr Emmett engaged Ayers Finniss to assist in procuring finance for the acquisition and development.

A Proposal Document prepared by Ayers Finniss was presented first to the State Bank, on 7 May 1988. The Bank declined, but apparently suggested that Beneficial Finance might be interested. Ayers Finniss then sent the Proposal Document to Beneficial Finance on the 9th or 10th of May.

In essence, the proposal was that Beneficial Finance and the Emmett Group would jointly acquire all of the shares of the East End Market Company. The part ownership of the project by Beneficial Finance would not only provide a potential source of finance for the venture, but would also enable the venture to obtain funds from other financiers who would lend to the venture on the basis that Beneficial Finance, a subsidiary of a State Bank, would ensure that they would be repaid. The Emmett Group would provide the project management and construction expertise to bring the project to fruition. Each would contribute about $1.5M in equity, and Beneficial Finance would provide a subordinated loan of $4.0M. The joint venture would borrow a further $28.1M to fund the acquisition. Ayers Finniss would receive a 2 per cent shareholding in the joint venture company as its fee for acting for the Emmett Group. The Proposal Document stated that the matter was urgent, claiming that there were other unnamed parties interested in acquiring the East End Market Company.

The proposal was well received by the Senior Management of Beneficial Finance, particularly the Managing Director Mr Baker, and Mr Reichert, General Manager of the Corporate Services division. A credit submission, based almost entirely on the Proposal Document prepared by Ayers Finniss, was circulated to the directors of Beneficial Finance on 11 May 1988 with a covering letter written by Mr Reichert. A Board meeting was convened for the next day to consider the submission. The submission referred to the East End Market Company by the code name "Mousetrap".

The Board meeting was attended by only three Directors - Mr D W Simmons, who acted as Chairman, Mr Baker, and Mr G S Ottaway, an alternate Director. Mr Simmons disclosed to the meeting that he and other partners in his law firm, Thomson Simmons & Co, held shares in the East End Market Company, and that his law firm acted as solicitors for the Emmett Group of Companies. Although Mr Simmons chaired the meeting, he did not vote.

Comments from each of the directors who were not present (other than Mr T M Clark, who was overseas, and Mr K S Matthews), obtained by telephone calls to the directors before the meeting, were reported to the meeting. The meeting resolved to accept the proposal to enter into a joint venture with the Emmett Group.

On 13 May 1988, Beneficial Finance, Ayers Finniss and a subsidiary of the Emmett Group, Nettishall Pty Ltd ("Nettishall"), entered into a Joint Venture Agreement. The three joint venturers agreed to incorporate a new joint venture company, Chepstow Pty Ltd ("Chepstow"), for the purpose of acquiring all of the issued shares of the East End Market Company. On the same day, Chepstow issued a Part C Statement offering to purchase all shares in the East End Market Company at a price equivalent (including rights) to $4.25 per share. Within hours, it had received acceptances of the take-over offer in respect of 86 per cent of the issued shares of the East End Market Company, and shortly after acquired the balance of the shares.

The venture soon encountered problems. Although it had been assumed that development approval would be obtained quickly, the Management of Beneficial Finance had not conducted any independent evaluation of the existing plans for the project before committing to the venture. Subsequent revisions to the plans meant that the development approvals that were obtained had to be abandoned.

The joint venture partner, the Emmett Group, then announced its desire to quit the project, because of a "lack of fit" with its own plans. The East End Market project was more than ten times the size of anything the Emmett Group had undertaken, and yet Beneficial Finance undertook no critical evaluation of the Emmett Group's ability to successfully see the project to fruition before committing to the venture.

Beneficial Finance sought new partners for the venture, but a requirement of the potential partners that were identified was that Beneficial Finance provide the funding for their purchase of Nettishall's interest in the venture. Beneficial Finance's Board of Directors declined to approve the provision of the funding. Eventually, Beneficial Finance purchased Nettishall's interest, and so became the sole owner of the East End Market Company.

Despite much effort and activity, Beneficial Finance was unable to proceed with a viable development of the East End Market site. As at 31 March 1991, the total investment by Beneficial Finance in the venture was $48.8M, with a specific provision for loss of $21.06M. Interest foregone was $12.8M. In June 1992, the South Australian Government acquired the portion of the East End Market site still controlled by Beneficial Finance for $17.4M.

(b) Findings and Conclusions

(i) The essential failing of Beneficial Finance was that it participated in the East End Market joint venture without first undertaking any adequate analysis or evaluation of the project. Beneficial Finance simply accepted at face value the conclusions suggested to it by Ayers Finniss. A reasonable and considered evaluation of the proposal should have made clear the real risks associated with participation in the venture.

(ii) Management of Beneficial Finance, particularly Mr Baker, Mr Reichert and Mr G L Martin, failed to make proper, reasonable and necessary enquiries into the contents of the proposal received from Ayers Finniss, in that they did not subject to scrutiny the statements, assumptions and analyses contained in the Proposal Document. Management adopted without adequate enquiry, and recommended to the Board, the proposal received from Ayers Finniss. The proposal had been prepared by Ayers Finniss to advance the interests of its client, the Emmett Group of companies. The Proposal Document minimised the difficulties of the project, and risks attaching to the project were ignored or minimised. The consequence was that the credit submission presented to the directors failed to point out the risks inherent in the proposal.

No effort was made by Beneficial Finance Management to determine whether the price at which the shares were offered was the lowest price at which the existing shareholders would sell. Inadequate consideration was given to the various risks associated with the project that, in the event, imposed lengthy delay on the development. No adequate consideration was given to a cyclical reduction in property values, or to Beneficial Finance's total property exposure.

(iii) The directors of Beneficial Finance (with the exception of Mr Baker) had a difficult decision forced upon them at little more than twenty four hours notice. The timing of the submission to the Board, linked to the threat of competitive bids from other unidentified interested parties, forced the Board to deal with the proposal urgently. The Board meeting at which the decision to participate in the Joint Venture for the take-over was approved, was attended by only three directors; the Managing Director, the Chairman who did not participate in the decision, and an alternate director. Eight other directors expressed opinions about the proposal; two warned of the risks associated with planning requirements and opposition from heritage groups; seven were prepared to endorse the proposal.

The Directors failed to adequately assess the submission from Management. A careful assessment by the directors was particularly important, because the submission had not been reviewed and recommended by the credit committee as required by Beneficial Finance's internal procedures. It was incumbent upon the directors to ensure that adequate time was made available for their examination of the matter. If they had considered that further time was required then consideration of the submission should have been deferred or the submission refused.

27.3.4.6 Chapter 32: Case Study in Credit Management: Mindarie Keys

(a) Overview and Summary

This Chapter examines the participation by Beneficial Finance in a joint venture to acquire and develop land known as the Mindarie Keys development in Western Australia.

Beneficial Finance was involved in the project both as a financier, and notionally at least as a part owner of the Mindarie Keys land. The other joint venture participants were Smith Corporation Pty Ltd ("Smith Corporation"), and Entrad Limited ("Entrad").

Although it was in legal form an owner of the land, Beneficial Finance's interest was, in substance, that of a financier. The joint venture arrangements entitled Beneficial Finance, at its option, to require the other partners to buy its equity interest at a price which provided Beneficial Finance with a minimum rate of return on its investment.

The project, which involved the development of 316 hectares of ocean-front land located approximately thirty five kilometres north of Perth, was promoted by Smith Corporation and its Managing Director, Mr R Smith. The development of Mindarie Keys was the subject of a State Agreement with the Western Australian Government, which permitted Smith Corporation to undertake a major harbour and marina development, and the sub-division of 2,000 residential allotments. In return for these development rights, Smith Corporation was required to pay all costs associated with the construction of the harbour, breakwater, marina, navigation aids, roads and drainage facilities, and to construct a water supply and an effluent treatment works. Those assets would then become the property of the State Government.

Smith Corporation proposed that the development would be undertaken in several stages. Stage 1 of the project was the most important because it included the harbour, a marina and a hotel, that were intended to be the main attraction of the development. The cost of Stage 1 was estimated by Smith Corporation to be $40.0M, including $12.0M for the purchase by the joint venture participants of the Mindarie Keys land from Smith Corporation. After the completion of Stage 1, further residential allotments were to be developed. Depending upon the rate of land sales, it was estimated that the development would take up to twelve years to complete, and cost a further $76.0M.

In about February 1986, Smith Corporation approached Beneficial Finance for a short term development loan of $0.55M pending the commitment of joint venture participants to the Mindarie Keys project. Subsequently, Smith Corporation proposed that Beneficial Finance participate in the joint venture formed to purchase the Mindarie Keys land and to develop Stage 1 of the project. It was intended that Beneficial Finance would, as part owner of the land, participate in the development of later stages.

After examining Smith Corporation's proposal for several months, Beneficial Finance management presented a submission to the Beneficial Finance Board of Directors seeking approval for Beneficial Finance to become a joint venture participant in, and a financier to, the development. The submission was approved by the Board on 16 December 1986, and an unincorporated joint venture was established by agreement between Beneficial Finance, Smith Corporation and Entrad, signed on 19 October 1987.

The joint venture was not an incorporated entity. The joint venture participants had separate legal rights and interests. For example, Beneficial Finance was registered as a part owner of the Mindarie Keys land as a tenant in common with Entrad and Smith Corporation, and had a several liability to creditors.

During the period from January 1988 to December 1990, the joint venture developed Stage 1 of the Mindarie Keys land in accordance with the requirements of the State Agreement. The development encountered problems from the outset, including cost over-runs, lack of project control, low sales of subdivided residential allotments, increased borrowings, and poor accounting and financial control.

In the first half of 1990, Entrad's financial position deteriorated to the point that it was unable to continue to contribute its portion of the joint venture's financial requirements. In December 1990, following protracted negotiations with the joint venture participants and financiers, Beneficial Finance became the sole owner of the development by acquiring both Smith Corporation's and Entrad's 25 per cent interests in the joint venture. As a result of the transfer of Beneficial Finance's business operations to the Bank, the Mindarie Keys land is now controlled by the Bank's Group Asset Management division. The provision for loss at February 1991 was $15.0M.

(b) Findings and Conclusions

In my opinion, the principal deficiencies in the processes by which Beneficial Finance entered into and managed the Mindarie Keys facility were:

(i) Neither the Beneficial Finance Board of Directors nor Management established adequate guidelines for the assessment of joint venture projects. The initiation, review and supervision of credit proposals associated with the Mindarie Keys joint venture were conducted by the Corporate Services division and its successors, subject to the control of a relatively small group of Senior Executives, namely Mr Baker, Mr Reichert and Mr Martin. Apart from internal audit procedures, there was no adequate system of policies, procedures and internal control applicable to the decisions made within the Corporate Services division.

(ii) An inadequate evaluation was undertaken by Beneficial Finance of:

. the viability of the Mindarie Keys development;

. the terms and conditions of Beneficial Finance's participation;

. the financial risks and returns associated with Beneficial Finance's participation;

. the financial strength of the other joint venture partners;

. Smith Corporation's capacity as joint venture participant and manager; and

. the terms and conditions of the State Agreement, and its implications for the project.

(iii) Beneficial Finance's execution of the joint venture agreements, nine months after Board approval, was not subject to a consolidated submission to the Beneficial Finance Board incorporating the substantial revisions to the facility that had taken place during that period and that raised serious questions regarding the viability of the project. Beneficial Finance did not have credit inspection procedures for the purpose of reviewing the transaction prior to settlement to ensure that the terms and conditions of approval had been complied with by the documentation. Having regard to the time that had elapsed since the approval of Beneficial Finance's participation in the project, and to the changes to the project, an updated submission should have been prepared before the joint venture agreements were signed.

(iv) Mr Reichert, Mr Martin and Mr G J Yelland did not instruct independent solicitors to act on behalf of Beneficial Finance to prepare the joint venture agreements. They permitted Smith Corporation to instruct its own solicitors to prepare the joint venture agreements contrary to the letters of approval. Further, they failed to examine the joint venture agreements to ensure that they contained provisions for the proper and adequate protection of Beneficial Finance's interests. One result was that Beneficial Finance's representatives on the joint venture Board of Management did not have adequate power to control the activities of the joint venture.

(v) Beneficial Finance Management failed to promptly identify and react to problems associated with the joint venture. The financial and management problems associated with the conduct of the Mindarie Keys project were identified and reported to Beneficial Finance's Management in an Internal Audit Report in 1989. Management failed to take any adequate action to remedy the problems referred to in the report. In my opinion, Mr Reichert as General Manager of the Corporate Services division and its successors, who was the senior officer of Beneficial Finance participating in management of Beneficial Finance's involvement in the joint venture, is principally responsible for that failure.

(vi) The information contained in the Internal Audit Report put the Beneficial Finance Board on notice of the substantial problems identified in the Mindarie Keys project. The Beneficial Finance Board did not take appropriate "follow-up" action to ensure that the problems referred to in the Internal Audit Report had been remedied. In so failing to act, the Board failed to discharge its obligation to adequately and properly supervise, direct and control the business activities of Beneficial Finance.

27.3.4.7 Chapter 33: Case Study in Credit Management: Pegasus Leasing

(a) Overview and Summary

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(b) Findings and Conclusions

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

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

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

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

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

Beneficial Finance failed to do either of these things.

Mr Reichert told my Investigation both that:

. insufficient control was exercised over Mr McGregor in his conduct of the business; and

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

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

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

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

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

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

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

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

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

27.3.4.8 Chapter 34: The Funding of Beneficial Finance

(a) Overview and Summary

The methods used by Beneficial Finance to raise funds were generally consistent with those of its competitors. Throughout the period under review, it increasingly relied on the the wholesale financial markets to fund its operations, particularly wholesale funds sourced from off-shore. This increased reliance by Beneficial Finance on wholesale funds, rather than funds raised by way of public debenture issues, was also consistent with the experience of some other finance companies.

Although Beneficial Finance's Debenture Trust Deeds imposed various gearing limits, including a maximum debt-to-equity ratio of 15:1, Beneficial Finance management aimed for an on-balance sheet debt-to-equity ratio of 12.5:1. At the same time, however, Beneficial Finance implemented arrangements, through a series of off-balance sheet entities that were intended to avoid the gearing limits imposed by its Debenture Trust Deeds. The arrangements were implemented with the approval of Beneficial Finance's Board of Directors.

These off-balance sheet entities were, in many instances, seriously undercapitalised. Mr Baker acknowledged that one consequence of the inadequate capitalisation of those entities was that Beneficial Finance suffered greater losses than otherwise would have been the case.

Beneficial Finance did not establish a risk weighted capital allocation arrangement, with the result that Management and the Board did not have available information relevant to the decisions they made in approving new facilities and ventures, and in their ongoing management of existing activities. More specifically, without a risk weighted capital allocation arrangement, Management and the Board assessed new proposals without having regard to appropriate risk-adjusted performance targets, and the performance measures against which existing activities were judged were inappropriately low because they did not reflect appropriate premiums for higher risk.

Nevertheless, while the information provided by a risk adjusted capital allocation arrangement was relevant to decisions made by Beneficial Finance Management and Directors, it is unlikely that, in all the circumstances, decisions made by either would have changed in any material respect. For instance, the performance targets which had been set for the Pegasus Leasing joint venture joint venture without regard to the high risk nature of the venture were not, over a period of time, met. Rather than withdrawing from the venture, the company substantially increased its commitment to it. When the Beneficial Finance Board was first asked to approve participation in this joint venture in 1985, it did so on the basis that only a minimal amount of equity would be subscribed to the joint venture by Beneficial Finance and its joint venture partner.

By September 1989, Management identified serious concerns with the capitalisation of much of Beneficial Finance's business, and particularly the funding of joint ventures. After considering the issues involved, the Executive Committee decided not to act on these matters until the next financial year. It did not refer that decision to the Board of Directors.

The Board considered the need to implement improved capital allocation procedures late in 1989, when a submission was presented containing recommendations for a risk-weighted capital allocation system. Implementation of the recommendations in the submission required the development of new systems and reporting arrangements which, having regard to other initiatives, were not given high priority. Mr Baker submitted to my Investigation that it was inappropriate for the company to implement the procedures until the end of 1989-90 financial year. The difficulty faced by Beneficial Finance in implementing the recommendations were described by Mr Horwood, Chief General Manager Treasury and Capital Markets division, in his submission to my Investigation. He said that the systems for providing information on assets were so deficient that the proposed arrangements could only be implemented with a total re-development of the existing systems.

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

(b) Findings and Conclusions

(i) Management and the Beneficial Finance Board should have identified the significant defect in the Beneficial Finance performance measuring arrangements which followed from the absence of a risk weighted capital allocation process. The realisation that performance measurement arrangements were defective required no more than a basic appreciation of the calculation involved, and that the "After Tax Return on Earnings" measure could be manipulated by changing the denominator, equity. The Board should have identified the need for, at the very least, strict guidelines for the capitalisation of company activities, both on and off-balance sheet.

(ii) The failure by management to appropriately plan and monitor:

. the growth of the company;

. the mix of its portfolio of assets; and

. the need for adequate capitalisation of off-balance sheet entities;

when combined with the failure to provide effective reporting on these important management issues, meant that the Board and management did not have a sound basis for decision making. This situation resulted in Beneficial Finance holding significant non-performing assets.

(iii) In failing to attend to these matters, the Board and management failed to adequately or properly supervise, direct and control the affairs of Beneficial Finance.

27.3.4.9 Chapter 35: Beneficial Finance - Prospectus 65

(a) Overview and Summary

Prospectus 65 (issued on 2 November 1989) was the last prospectus issued by Beneficial Finance during the period under review.

The Companies Code prohibited a company from issuing debentures on the basis of a prospectus after the expiration of six months from the date of issue of the prospectus. However, pursuant to other provisions of the Code, Beneficial Finance sought and was granted an exemption from the six months limitation to enable it to issue debentures under Prospectus 65 for a period of twelve months from the date of issue.

To meet Corporate Affairs Commission requirements, the directors of Beneficial Finance provided a written undertaking to the Commission in support of their application for this "Extended life prospectus". The directors undertook, inter alia, to immediately inform the Commission's delegate of:

(i) any material deterioration in the financial condition of Beneficial Finance or its subsidiaries; and

(ii) any occurrence which may result in the prospectus containing or omitting information that is false in a material particular or materially misleading.

As a condition of exemption, the directors were required to submit a report to the Commission (within two weeks after the expiry of six months from the date of issue of Prospectus 65) stating whether, after making all reasonable enquiries, they were of the view that any material statement included in the prospectus was untrue or misleading or whether any material matter had been omitted from the prospectus.

Both management and the Board of Beneficial Finance were, therefore, charged with a heavy responsibility to ensure that the general public, via the Commission, was kept fully informed as to whether there was any material deterioration in the condition of the company during the life of the Prospectus.

The financial condition of Beneficial Finance did deteriorate, and Prospectus 65 was eventually withdrawn.

Prior to its withdrawal, however, the directors provided a report to the Corporate Affairs Commission on 27 April 1990, wherein they indicated that, after making all reasonable enquiries in relation to the interval between 30 June 1989 and 27 April 1990:

(i) they had not become aware of any circumstances which in their opinion had affected or would affect the trading or profitability of the corporation or its subsidiaries or the value of it's assets; and

(ii) there was nothing in or omitted from the Prospectus which could result in it being materially false or misleading.

The following developments, all of which occurred during the life of this prospectus, were in my opinion particularly relevant to the financial condition of Beneficial Finance about which it was the respective obligation of both the Board and of Mr Baker to keep the Commission properly informed:

(i) the aggregate accounting exercise reported to the Board in February and March of 1990 disclosed off-balance sheet losses;

(ii) the downgrade of Beneficial Finance's debenture rating by Australian ratings reported to the Board in February of 1990;

(iii) the deteriorating profit of Beneficial Finance, which was evident to Mr Baker as at December 1989;

(iv) the reported decline in profit forecast as reported to the Board in monthly Board Papers;

(v) the increasing extent of non-performing loans and their effect upon profit before tax as disclosed in Board Papers particularly in April, May and June of 1990; and

(vi) the need for a provision of some $22.0M to be raised in respect of the Somerley Eden Hotel which was apparent to Mr Baker in February of 1990.

The combined effect of these developments should have led to the withdrawal of the prospectus at the very latest in May of 1990, but it was not withdrawn until 7 August 1990.

(b) Findings and Conclusions

(i) At the Board meeting of 23 February 1990, the Board was advised of an off-balance sheet loss of $12.5M for the half year ended 31 December 1989. This was revised to a loss of $7.3M in a further paper presented to the Board in March 1990. In addition, aggregate accounts attached to February Board Papers disclosed an additional $7.4M off-balance sheet loss for the period ended 30 June 1990 which had not been previously recognised. The directors of Beneficial Finance did not report these losses to the Commission.

(ii) In February 1990 Australian Ratings downgraded its rating of Beneficial Finance from "AA" to "A". The directors failed to advise the Commission of this "downgrade" until May 1990.

(iii) The April, May and June Board Papers described a sustained increase in the non-performing loans of the company. By way of example, the Board Papers for the 27 April 1990 Board meeting disclosed that off-balance sheet non-performing loans at 31 March 1990 were an additional $49.9M, and that the company had suffered a net loss before tax of $0.6M for the month of March 1990.

(iv) By the meeting of 27 April 1990, the directors had received sufficient information to put them on notice of the declining state of the financial health of Beneficial Finance.

(v) In the circumstances, it was inappropriate for the Board to rely upon assurances from management and thereafter proceed to execute undertakings asserting that there was no material deterioration in the company's financial condition. Instead the Board should have called for a report from an investigating accountant.

(vi) I am of the opinion that the Board failed to exercise proper care and diligence in relation to matters leading to its execution of the undertakings it was required to provide to the Corporate Affairs Commission.

(vii) By the time of its Board meeting in May 1990, the Board was clearly on notice of a significant deterioration in Beneficial's financial condition. Immediately after the May Board meeting, the directors should have notified the Commission in accordance with their undertakings and taken steps to withdraw the prospectus.

(viii) In failing to do so, the Board again failed to exercise proper care and diligence.

(ix) In September 1989 and January of 1990, Mr Baker reviewed reports which disclosed that the true underlying profit of Beneficial was well below the reported profit of the company and that the level of reported profits was being boosted by reserves built up in more profitable periods (a practice known as "shock-proofing"). Mr Baker failed to disclose the contents of these reports (together with important correspondence from Beneficial's external auditors in April 1990) to the Board and thereby withheld vital information from the Board.

Mr Baker, as Managing Director, was in a better position than the other directors to appreciate the deteriorating condition of Beneficial Finance. He was privy to information indicating this possible deterioration as early as the beginning of 1990. His conduct in withholding important information from the Board and executing the undertakings may disclose unlawful or improper activity, and should be further investigated.

27.3.4.10 Chapter 36: Treasury and the Management of Assets and Liabilities at Beneficial Finance

(a) Overview and Summary

The Treasury division's role was to ensure funds required were available as and when required, and to ensure that funds were managed efficiently. As co-ordinator of the Company's assets and liabilities, Treasury also took responsibility for the management of important non-credit financial risks facing Beneficial Finance.

Although the Treasury division met its primary objective of ensuring that funds were available to meet operational requirements, it did not fulfil other basic fund management needs. Beneficial Finance Treasury did not regularly prepare cash flow reports for the information of senior management and the Board. Further, the Treasury division was unable to communicate appropriate information concerning the cost of funds to operational divisions to Beneficial Finance, Management, and the Board.

Although a transfer-pricing system was used by Beneficial Finance, it did not use accurate or reliable Cost of Funds information. It was not until 1990, when Beneficial Finance was already in financial difficulty, that a system was implemented which identified and charged operating divisions with an accurate Cost of Funds figure for the funds they used. Before 1990, Beneficial Finance was unable to reliably calculate the cost of funds used, a vital component of the assessment of the profitability of specific transactions, and of the operating divisions.

The Beneficial Finance Treasury division, in part by default, took responsibility for the co-ordination of the Company's assets and liabilities and, consequently, responsibility for managing important financial risks. The evidence shows that the circumstances in which the division performed this role were most difficult.

In its capacity as manager of the Company's liquidity risk, the Treasury pursued a strategy of maintaining excessive liquidity in the short term. In developing medium term funding strategies, it faced the difficulty of not knowing, with reasonable certainty, what funds would flow into Beneficial Finance from interest payments on existing assets or from maturing assets, or what funds would be required for new business.

Similar problems affected the Treasury division's capacity to manage Beneficial Finance's interest rate risk. To manage that risk, it needed to know, in aggregate, whether loans were advanced on a fixed or floating interest rate basis, and when interest rates were recalculated. This information was not readily available in a reliable form.

There is a common element in the difficulty experienced by Treasury in managing liquidity and interest rate risk, in preparing cash flow reports, and in determining the cost of funds. In each case, Treasury required information regarding the nature of the company's assets and cash receipts in order to do its job. It is evident that Beneficial Finance's core management information system was unable to provide the Treasury with the information it required.

The Managing Director and the senior managers of the asset generating divisions, did not support Mr Horwood and the Treasury division. As a result, the overall requirements of Beneficial Finance for co-ordinated management of critical areas were neglected. In particular:

(i) The ability of the Treasury division to prepare short and long term cash flow forecasts was limited. This hindered effective liquidity management, resulting, on occasions, in excessive funding costs.

(ii) Treasury division did not have access to appropriate systems or information regarding the asset structure of the company, to enable it to adequately manage the mis-match of the maturity profile of the assets and liabilities, or the interest rate risk, associated with the assets and liabilities.

(iii) Prior to the introduction of the Cost of Funds system in 1990, the profitability of the asset generating divisions, and individual lending transactions entered into by those divisions, could not be reliably measured.

(iv) Problems were encountered in calculating the monthly borrowings expense figure, and this adversely affected the reliability of the monthly reported profit position.

(b) Findings and Conclusions

(i) Beneficial Finance underwent significant growth during the period covered by this Investigation. The extent and implications associated with this growth, which included diversification in lending activities and funding responsibilities, required that appropriate emphasis be accorded by the Board and the senior management to the critical task of asset and liability, liquidity, interest rate risk, and systems management matters.

(ii) The Board of Directors, the Managing Director and senior management of the asset generating divisions failed to recognise the need for a co-ordinated high level approach to these matters within Beneficial Finance. Rather, their attention and effort was directed to growing the business. During the period under investigation there was no specific person or organ within the company that, at all times, had responsibility for the overall management of asset and liability, liquidity and interest rate risk management. The Treasury division of Beneficial Finance, undertook, by default, many of the aspects associated with this management task. Although a formalised asset and liability committee was established at certain times during the period under investigation, it had, as its focus, Treasury related matters, and was not concerned with overall risk systems management.

(iii) The Board of Directors of Beneficial Finance failed to adequately or properly supervise, direct, and control, the affairs of the company with respect to this matter, in that they did not provide direction regarding the limits of permissible risk, this being a major matter that must be managed in the operations of a finance company.

(iv) Mr Baker created an environment within Beneficial Finance that allowed asset generating divisions to ignore the demands for information to meet asset and liability management requirements, which meant that the needs of the Treasury division were not met. As Managing Director, it was his responsibility to ensure that information needs and sound management practices which transcended the needs of individual divisions of the company were met. Mr Baker failed to adequately or properly discharge his responsibilities in respect of asset and liability, liquidity, interest rate risk, and systems management.

(v) During the period under Investigation, there was no overall co-ordinated and responsible management control exercised over the asset and liability, liquidity, interest rate risk, and systems management responsibilities of the company, and the processes adopted with respect to the management of each of these matters were inappropriate.

(vi) It cannot be said that the financial position of Beneficial Finance was directly caused by the manner in which the company managed its assets and liabilities, and conducted its Treasury operations. Nevertheless, management and systems deficiencies in Treasury operations, when aggregated with other deficiencies examined in other Chapters of this Report, resulted in the financial position reported at February 1991.

27.3.4.11 Chapter 37: Internal Audit of Beneficial Finance

(a) Overview and Summary

Internal Audit, as an instrument of higher management, provides an "early warning signal" to management where a lack of, or a breakdown in, systems and internal controls threatens the assets of an organisation. Well managed organisations view Internal Audit as an indispensable aid to achieving effective controls.

The Internal Audit function in Beneficial Finance was established prior to the Company becoming a subsidiary of the Bank and it continued, independently of the Bank's Internal Audit function until 1990 when it was incorporated into the Bank's Group Internal Audit function.

Beneficial Finance held significant amounts of money invested by members of the public pursuant to its debenture and unsecured note issues. As such, the public was entitled to expect that proper standards of internal control would be operative at all times.

Furthermore, the business activities of Beneficial Finance underwent significant changes during the period under review. The change in the nature of business activities was accompanied by a number of organisational, management, and major system changes. The nature, complexity, and size, of some of the transactions that were entered into, when aggregated, were significant with respect to both on-balance sheet and off-balance sheet matters. These transactions gave rise to new and significant risk exposures for the Company.

Throughout the period under review, the Internal Audit function within Beneficial Finance was adequately resourced and was focused on high risk areas of the Company's operations. Whilst there is no evidence that the Internal Audit department was denied access to areas in relation to which it had a mandate, the Audit Manual governing the department's activities provided for limitation of the department's mandate in relation to payrolls, secretarial, and legal departments. These areas of audit review were the responsibility of the external auditors.

Internal Audit can make its most valuable contribution to an organisation when it has unrestricted authority to effect audit coverage over all important areas of the organisation. The limitation in the Beneficial Finance audit mandate was wrong in principle. Whilst I regard the arrangements in relation to Internal Audits of payrolls, secretarial, and legal departments as inappropriate, I make it clear that there is no evidence before the Investigation to suggest that these areas were not properly audited by the external auditors.

During the period under review the Internal Audit department conducted some three hundred audits and, with very few exceptions, substantive Audit Reports were issued to auditees in relation to those audits.

Each quarter, the substantive Audit Reports generated during that period were summarised into the Internal Audit department's Quarterly Report for submission to the Beneficial Finance Board. The substantive Reports underwent a heavy editing process in order to present concise summaries in the Quarterly Reports to the Board. Despite certain difficulties inherent in a summary reporting process, (including in some cases not conveying in the Quarterly Reports every concern raised in the substantive Reports), I am satisfied that the Quarterly Reports were sufficient to put the Board on notice as to the essential issues raised in the substantive Reports. The Quarterly Audit reporting process was facilitated by the use of a grading system of audit findings, which put the Board specifically on notice in relation to matters reported as carrying a grading of "Unsatisfactory" or "Satisfactory Minus".

The Board's response to certain "Unsatisfactory" or "Satisfactory Minus" gradings by the Internal Audit department was inadequate. The constraints imposed by reporting in summary form on a quarterly basis and the complex findings contained in the substantive Reports, required of the Board a far more inquiring approach than was in fact adopted by it. Summary Reports of complex findings contained in various substantive Internal Audit Reports were presented to the full Board on a quarterly basis, at which heads of Internal Audit were not in attendance and principal responsibility for responding to matters raised in connection with the Reports rested with the Managing Director. This situation provided a very limited forum for dealing with matters relating to Internal Audit. The Board relied on Management's representations relating to the matters summarised in the Quarterly Reports, without appropriate independent inquiry of outcomes from the heads of the Internal Audit department.

Prior to 1984 Beneficial Finance had an established Audit Committee of the Board, which directed specific attention to Internal Audit matters, and meetings of the Committee were attended by the head of Internal Audit. As I have indicated in Chapter 23 - "Internal Audit of the State Bank" in relation to the Bank's Audit Committee, an Audit Committee provides a far more focused and dedicated environment for dealing with Internal Audit and related accountability matters. The Beneficial Finance Board, knowing that the Audit Committee (which operated until August 1984) enhanced its awareness of the Company's operations, allowed itself to be persuaded by the reasoning of Mr Clark to disband the Committee. The abolition of the Committee deprived the Board of a forum which would have facilitated greater in-depth analysis of Internal Audit reports, which clearly put the Board on notice that breakdowns in internal control systems had been identified and that the assets of the Company were at risk.

(b) Findings and Conclusions

(i) Whilst the execution of the Internal Audit function can, in general, be said to have been adequate, the procedures adopted by the Board in response to important matters raised by the Internal Audit Reports were inadequate.

(ii) The disbandment of the Audit Committee placed the Board in a position whereby, through its own act, it was handicapped in its ability to manage the Company. The Board deprived itself of a specific forum that would have facilitated in-depth analysis of Internal Audit Reports' findings and discussion concerning the strengths and weaknesses of the Company's operation. In so doing, the Board dispensed with an accountability arrangement important to its role of adequately and properly supervising, directing, and controlling the operations, affairs and transactions of Beneficial Finance.

27.3.4.12 Chapter 38: Equiticorp Receivables

(a) Overview and Summary

Between January and March 1988, Beneficial Finance acquired five portfolios of receivables (ie loans), from various Equiticorp companies. Four, with a book value of $165.8M, were acquired in Australia. One, with a book value of approximately $100.0M, was acquired in New Zealand. In Chapter 26 of my First Report - "Dealings Between the State Bank and Equiticorp" I reported on a series of transactions between Equiticorp and the State Bank between late 1987 and 1988. This Chapter should be read in the context of matters that I have already reported upon in Chapter 26.

Whilst the four Australian portfolios acquired through two subsidiaries of Beneficial Finance's off-balance sheet company, Kabani Pty Ltd, have, generally speaking, been profitable, certain features of these acquisitions were inappropriate. Management used its delegated powers to approve individual transactions which were within its delegated approval limits. The aggregate of the value of those individual transactions, however, clearly exceeded management's delegated approval limits. Management did not, but should have, obtained Board approval for each of the three transactions as their aggregate exceeded the limit on Beneficial Finance's cumulative exposure to a particular borrower.

The second, third and fourth Australian portfolios were acquired in two transactions, in such haste that the review process was compromised. Whilst no loss resulted, there was a serious risk of loss, and such risk ought not to have been taken.

The New Zealand portfolio was acquired in three tranches (ie lots) through Ravlick Holdings Ltd, a New Zealand shelf company acquired through Beneficial Finance's off-balance sheet structure. The portfolio suffered difficulties, in that a number of the borrowers experienced financial problems. The first borrower had a receiver appointed in June 1988. By 29 March 1989, twelve borrowers were either in receivership, liquidation or some other form of statutory management. The principal cause of this, was the collapse of three major New Zealand groups of companies. Six of the borrowers in the New Zealand portfolio were directly related to these groups of companies. Losses were incurred in relation to the New Zealand portfolio, both as a result of writing off amounts and by way of forgone interest.

Mr Baker, Managing Director, had stated in the proposal to the Board on 9 February 1988 for acquisition of the New Zealand portfolio, that Equiticorp had not analysed the borrowers' cash flows in depth, and a downturn in the New Zealand real estate market was anticipated. These two factors should have indicated to Beneficial Finance the potential for higher than normal levels of default by the borrowers. Further, Equiticorp had difficulty in providing loans of a quality acceptable to Beneficial Finance, which was the reason for the first tranche of New Zealand receivables being of a value less than that which had been anticipated. In my opinion, security values, therefore, would be crucial to the review, particularly if the existing evaluations had been performed when the property market had been more buoyant.

The available evidence includes reports on the New Zealand receivables from Beneficial Finance's property consultant, which refer to individual loans. The Beneficial Finance Board had told management at its meeting on 10 February 1988 to "obtain commercially realistic valuations." The reports from the property consultant did not comprise valuations of the individual properties, but consisted of general comments concerning the properties and, in some cases, comments on valuations previously prepared by Equiticorp. These reports do not constitute "commercially realistic valuations".

The lack of certain records relating to the New Zealand acquisition is a matter of deep concern. The minimum records required to be maintained should have recorded the reasons why each receivable was accepted. These should have noted any representations made by the vendor, and would have provided the basis for any claim against the vendor should this have been required. A report summarising the results of all aspects of the inquiries should have been produced. There is no evidence that one was made. Mr Baker cannot recall whether a written report was produced or not. The lack of such a report casts doubt on the quality of decisions made by personnel who were not familiar with detailed stages of the review and results of inquiries that had been carried out by other personnel.

In the proposal to the Board dated 9 February 1988, Mr Baker had sought approval from the Board to acquire the New Zealand portfolio. On 10 February 1988, the Board accepted a recommendation that management proceed to New Zealand to conduct further negotiations to enable firm recommendations to be made to the Board. There is no evidence that approval to acquire the portfolio was given at a subsequent meeting of the Board on 26 February 1988. Mr Baker has acknowledged to my Investigation that no approval was given by the Board before Beneficial Finance proceeded to acquire the portfolio. At its next meeting on 25 March 1988, the Board was informed that the acquisition of $100.0M New Zealand of receivables had taken place and was given assurances by management. Management, and in particular Mr Baker, failed to comply with the Board's direction to bring a firm recommendation to it after further investigation. Mr Baker's conduct was in excess of his powers, and the Board ought to have censured him. Further, the Board ought not to have been so easily reassured. The Board ought to have required a detailed recommendation as it had originally directed.

The procedures followed in the acquisition of the second New Zealand tranche particularly concern me. Although Beneficial Finance was not satisfied with the quality of the receivables, Mr Baker wanted to proceed with settlement by 16 May 1988. Settlement of the second tranche of New Zealand receivables occurred on 15 March 1988 before the due diligence process was completed, and on the condition that Beneficial Finance had fourteen days to reject any receivables it considered unsuitable.

In order for the second tranche to proceed, Beneficial Finance provided $NZ 30.0M of additional security to the Bank of New Zealand. Whilst the provision of a guarantee was referred to in Mr Baker's proposal to the Board, the amount of the guarantee was not stated, and therefore the provision of this guarantee was not approved by the Board on 10 February, and the Board was uninformed about an additional exposure to Equiticorp.

(b) Findings and Conclusions

(i) The processes that led to Beneficial Finance engaging in the acquisition of the Equiticorp Receivables were inappropriate.

(ii) The Managing Director, Mr Baker, did not exercise proper care and diligence, in that he authorised the settlement of the second tranche of the New Zealand Receivables prior to the completion of review of those receivables.

(iii) The operations, affairs and transactions of Beneficial Finance, with reference to the acquisition of the portfolios of receivables from the various Equiticorp companies, were not adequately or properly supervised, directed or controlled by Mr Baker (Managing Director) and the Beneficial Finance Board.

(iv) The failure of Beneficial Finance Management to maintain and safeguard proper records relating to the acquisition of the portfolio of New Zealand Receivables may have constituted a breach of applicable companies or taxation legislation, and this matter should be further investigated.

(v) Mr Baker acted improperly and was in breach of his duty as a director in disregarding the direction of the Board by proceeding to acquire receivables without presenting a firm recommendation to the Board for its approval, as he had been directed to do.

27.3.4.13 Chapter 39: Mortgage Acceptance Nominees Limited

(a) Overview and Summary

Mortgage Acceptance Corporation was a mortgage broker. Its business consisted of identifying businesses in need of finance, and then identifying a financial institution that would be prepared to provide that finance. It earned its income from bringing together businesses needing funds, with lenders prepared to provide those funds. In some cases, Mortgage Acceptance Corporation would provide temporary loans, called bridging finance, to the businesses until a lender could be found. It specialised particularly in arranging finance for businesses in the real estate and bloodstock industries. Mortgage Acceptance Corporation was controlled by an entrepreneur who, for confidentiality reasons, I will call Mr Green.

Beneficial Finance was one of the financial institutions invited by Mortgage Acceptance Corporation to provide loans to its clients, and Beneficial Finance was appreciative of the opportunities. Before the proposal to establish a joint venture in June 1988, Mortgage Acceptance Corporation introduced business totalling $15.0M to Beneficial Finance's Parramatta branch, and made loans as the agent of Beneficial Finance under a Principal and Agency Agreement. The Managing Director of Beneficial Finance, Mr Baker, described Mortgage Acceptance Corporation as a "very strong new business referee" at the Beneficial Finance Board of Directors' meeting on 27 May 1988. Indeed, so impressed were the Management of Beneficial Finance that, in May 1988, it agreed to establish a joint venture with Mortgage Acceptance Corporation.

The joint venture was established, and commenced operations, before a submission to establish the joint venture was presented to the Beneficial Finance Board of Directors. When a submission seeking approval for the joint venture was submitted to the Board at its meeting on 24 June 1988, it was rejected. Nevertheless, the basic elements of the joint venture, particularly the management of loan accounts by Mortgage Acceptance Corporation, were left in place, without the knowledge of the Board of Directors.

A further submission to establish the joint venture was presented to the Board at its meeting on 25 November 1988, and approved. The fact that the joint venture had been established, and had commenced operations before the Board meeting on 24 June, was not adequately disclosed to the Board in either June or November.

Such conduct by management, in settling transactions prior to the Board meeting at which the proposal was to be considered, demonstrates an attitude that the Board would "rubber stamp" management's recommendations. In the event, management's expectation was wrong. The approval eventually given in November 1988 was given retrospective effect by management to include the business conducted from June 1988.

The joint venture grew rapidly, and by 30 June 1989 had total assets of $88.9M. By 30 June 1990 total assets were $97.3M, including $27.0M funded by the State Bank under the Reverse Principal and Agency Agreement.

Beneficial Finance provided the great majority of the funding for the joint venture, with the exception of the business written by the joint venture as a sub-agent of Beneficial Finance under the State Bank of South Australia Reverse Principal and Agency Agreement, and a $4.5M loan from the State Bank relating to a particular receivable.

I have examined the Reverse Principal and Agency Agreement in detail in Chapter 33 - "Case Study in Credit Management: Pegasus Leasing". Shortly stated, in legal form the Agreement appointed Beneficial Finance as the agent of the Bank for the purpose of writing tax-effective finance leases, which are a form of lending. The Agreement authorised Beneficial Finance to appoint sub-agents. Although the legal form of the Agreement was that of a principal and agency arrangement, in substance, however, the Agreement was a funding arrangement, and was used as such by Beneficial Finance to fund some of the activities of its joint ventures, including Mortgage Acceptance Nominees.

By 30 June 1990, Beneficial Finance's loans to the joint venture totalled $74.8M. When combined with the funding provided by the Bank pursuant to the Reverse Principal and Agency Agreement, the total Bank Group exposure was at that time $101.8M. There had effectively been no capital contributed to the joint venture by either partner.

Despite the rapid growth of the joint venture and Beneficial Finance's exposure to it, no joint venture agreement was executed by the partners. Beneficial Finance did not impose any prudential limit on its exposure to the joint venture, and did not exercise effective control over its operations. Although Beneficial Finance had authority to approve all large loans made by Mortgage Acceptance Nominees, the effective day-to-day control of the joint venture's activities was in the hands of its joint venture partner.

The Mortgage Acceptance Nominees Joint Venture experienced significant problems with respect to a major real estate loan to a borrower that, for confidentiality reasons, I shall refer to as "Hotel Pty Ltd", and more recently with its bloodstock loan portfolio. In July 1990, Beneficial Finance decided to wind down its joint venture operations. Real estate lending by the Mortgage Acceptance Nominees joint venture ceased in June 1990, and bloodstock financing ceased in October 1990. The joint venture has not been profitable, and, in May 1991, a State Bank internal audit found that 63.4 per cent of its portfolio was in arrears. As at 28 February 1991, the exposure of Beneficial Finance, including its off-balance sheet companies, and of the State Bank, to Mortgage Acceptance Nominees and related parties, was $109.0M, and a specific provision of $10.2M was raised.

I have been informed by Beneficial Finance that a dispute had arisen in respect of the termination of the joint venture. Accordingly, as required by my Terms of Appointment, I have excluded from my Report any matters that may have a direct bearing upon any possible litigation.

(b) Findings and Conclusions

The monitoring and control of Beneficial Finance's participation in, and funding of, the Mortgage Acceptance Nominees joint venture was highly unsatisfactory in a number of respects:

(i) No written joint venture agreement was ever entered into between Beneficial Finance and Mortgage Acceptance Corporation. Nor was a sub-agency agreement entered into in respect of the State Bank Reverse Principal and Agency Agreement.

(ii) Mortgage Acceptance Corporation did not contribute any capital to the joint venture, other than its share of profits totalling $0.245M. Beneficial Finance effectively provided all of the funding for the joint venture. Beneficial Finance was, as well, a lender to Mortgage Acceptance Corporation, and did not obtain any guarantees from Mr Green in respect of its exposures until new loans were made to Mortgage Acceptance Corporation in 1990. In those circumstances, Beneficial Finance bore almost the entire risk associated with the joint venture's loan portfolio, which grew to total $106.0M.

(iii) No prudential limit was placed on Beneficial Finance's exposure to the Mortgage Acceptance Nominees joint venture, despite the fact that:

. in practical terms, it bore the risk of losses; and

. it was already heavily exposed to the real estate industry and, through Pegasus Leasing, had an exposure to the bloodstock industry.

27.3.4.14 Chapter 40: Paper Meetings of Directors

(a) Overview and Summary

Throughout the period covered by my Investigation, Beneficial Finance produced `minutes' of directors meetings that had not been held. The minutes were drawn up by the Company Secretary of Beneficial Finance, and signed by the Chairman of the Board of Directors, to document decisions that were required to be made by the directors, but which in fact were not.

Pursuant to Beneficial Finance's Articles of Association, the management and control of the business and affairs of the company are vested in the directors. The directors were to exercise that power in meeting, at which a quorum was two directors. Any director could convene a meeting of directors. The directors could delegate powers and duties to the Managing Director, and to sub-committees of the Board.

The Board of Directors met on the last Friday of each month (other than December) to deal with the business of the company. There was frequently, however, a need for the directors to approve transactions at times other than the last Friday of the month. The practice adopted by Beneficial Finance was not to convene a meeting of directors to give the necessary approvals, but simply to produce minutes as though such a meeting had been held. The minutes evidencing what Mr Baker was pleased to call "paper meetings" were prepared by the company secretary at the request of the senior manager who required the directors' approval, and would be signed by the Chairman of the Board, Mr L Barrett. The minutes were sometimes included in the Board Papers for the next Board meeting, but they were usually not discussed, and rarely was the "decision" of the paper meeting referred to in the minutes of a subsequent full Board meeting.

An analysis of the business recorded in these minutes as having been conducted at the paper meetings reveals that it falls into one of the following three broad categories:

(i) Borrowing by Beneficial Finance: eight of these minutes record resolutions by the Beneficial Finance Board to accept, enter into or renew finance facilities, and contain authorisations for various officers of the company, including at times Mr Baker, to execute the relevant facility agreements;

(ii) Lending by Beneficial Finance: two of these minutes contain resolutions by Beneficial Finance to lend amounts of $5.0M, $49.0M and $67.0M to associated companies, together with resolutions to appoint Attorneys to execute the loan agreements (the last two amounts relate to the acquisition of a portfolio of receivables from the Equiticorp Group); and

(iii) Provision of Guarantees by Beneficial Finance for the financial obligations of a third party: seven of these minutes record resolutions by the Beneficial Finance Board to guarantee, underwrite or underpin financial obligations of third parties, together with authorisations for certain officers to execute the required documentation on behalf of the company.

Other minutes record various resolutions and authorisations. For example, a minute dated 22 December 1988 documents a non-existent meeting of the Chairman, Mr Barrett, and the Managing Director Mr Baker, resolving to declare interim dividends, redeem preference shares, and issue ordinary shares to the Bank.

The practice of documenting non-existent approvals meant that Beneficial Finance entered into transactions that were not reviewed or approved by the directors. Even when the directors subsequently adopted the resolution at a full Board meeting, that was sometimes after Beneficial Finance had already entered into the relevant transaction. A $200.0M debenture program was falsely documented as having been approved by Mr Barrett and Mr K D Williams on 5 September 1988. Although the minutes were adopted by the Board of Directors at its meeting on 29 September 1988, that was after $76.0M had already been raised by Beneficial Finance pursuant to the non-existent approval.

It is not entirely clear whether all of Beneficial Finance's directors were fully aware of this practice. Certainly the Managing Director Mr Baker, and the Chairman Mr Barrett, were fully aware. They are the two directors most commonly recorded as being present at non-existent meetings, and Mr Barrett signed the minutes.

Other directors recorded as being present at such paper meetings were Mr Matthews, Mr Simmons and, on one occasion, Mr Williams. Those directors should have been aware, from the copies of the minutes included in the Board Papers, that they were shown as being present at a meeting that was not held. Directors not recorded as having attended such meetings should at least have been aware that they had not received any notice of the meetings. In April 1989, the Board requested that proper notification of all meetings, including "Special" meetings, be provided to all directors.

(b) Findings and Conclusions

(i) There was a practice within Beneficial Finance of preparing minutes to record meetings of directors of the company which had not taken place, either formally or informally.

(ii) The practice developed as a convenient alternative to convening a Board meeting at short notice.

(iii) The practice was of long standing.

(iv) That accordingly the affairs of the company were not always conducted in accordance with its Articles of Association, in that matters which required approval by a properly convened meeting of directors were not put to such a meeting, either for initial approval or for ratification.

The persons concerned in producing each set of minutes made, or caused or procured to be made, a false document which purported to be an important company record. It was false in that it purported to be a formal minute of a meeting which did not take place. The directors who were aware of the practice, particularly Mr Barrett and Mr Baker, condoned a practice that had the effect of allowing Beneficial Finance to engage in transactions involving significant obligations without the approval, or often even the knowledge of the directors.

In my opinion, the practice of documenting meetings of directors that did not exist amounted to improper activity in the limited sense that it enabled Beneficial Finance to enter into transactions that were not reviewed or authorised by the Board of Directors.

There is nothing to suggest however that there was any ulterior purpose in holding these "paper meetings", nor is there any evidence before me to suggest that the Board of the Bank or of Beneficial Finance were misled as a result of the practice.

27.3.4.15 Chapter 41: Management and Financial Information Reporting

(a) Overview and Summary

The debenture trust deeds under which Beneficial Finance operated prior to 1985 were considered by both management and the Board to be restrictive and even commercially unrealistic for sophisticated financing transactions prevalent during the mid to late 1980's.

The restrictions imposed by the terms of these trust deeds were designed to protect the interests of the debenture holders of Beneficial Finance.

In early 1985, following advice from its solicitors Thomson Simmons & Co, Beneficial Finance established an off-balance sheet structure created principally to avoid the restrictions imposed by these trust deeds.

The off-balance sheet structure thus created was intended to provide Beneficial Finance with unofficial control over these entities whilst at the same time avoiding the provisions of the Code as they applied to subsidiaries.

During the period under review the off-balance sheet entities sustained substantial losses which contributed to the financial position into which Beneficial Finance had fallen by early 1991.

The proposal to establish the off-balance sheet structure, which became known as "Kabani", was approved subject to a condition, inter alia, that the structure be submitted to Price Waterhouse to ensure they were satisfied from the point of view of the auditors.

The Board was informed that the conditions had been met. In this matter, the Board was misled because the auditors were not asked to give an opinion on the proposed structure.

The off-balance sheet entities operated and controlled through the Kabani type trust structures were not consolidated into the accounts of Beneficial Finance. Beneficial Finance was advised that those entities did not fall within the definitions of a subsidiary under the code. As a result, management of Beneficial Finance, resisted attempts by the auditors to provide disclosure of the results and affairs of these entities and insisted on disclosure being kept to a minimum.

Regardless of the legal efficacy of the proposed structures, in my opinion, management should have known that the use of such structures had given rise to some controversy with regard to proper accounting treatment and disclosure.

From the outset, Thomson Simmons & Co had informed management that the use of off-balance sheet structures could be perceived as a contrivance to avoid the provisions of the Companies Code.

Management again, did not see fit to inform the Board of this warning given by Thomson Simmons & Co.

Shortly stated, the affairs of the Kabani type companies were in fact controlled by Beneficial Finance and conducted for its own benefit and at its own risk pursuant to a variety of legal and practical commercial powers.

It follows, therefore, that the affairs and results of these entities were relevant to the position of Beneficial Finance and, if material, should have been disclosed in the accounts of Beneficial Finance in order to show a true and fair view in accordance with Section 269 of the Companies Code.

Furthermore, the internal management accounts of the Beneficial Finance Group did not consolidate the results and affairs of the off-balance sheet entities. Accordingly, for most of the period under review, the Beneficial Finance Board did not receive financial information clearly setting out the impact of these entities on the overall Beneficial Finance position.

Given the extent of growth in the off-balance sheet entities over the period of this investigation it would have been difficult, at any given moment, to know the true financial position of the Group.

In response to these problems Beneficial Finance eventually moved in January 1989 to introduce a system of "Aggregate Accounting" (a term used to describe the notional consolidation of off-balance sheet entities into the consolidated financial statements of Beneficial Finance.)

(b) Findings and Conclusions

(i) The affairs of the Kabani type companies were in fact controlled by Beneficial Finance and were conducted for the benefit and, at the risk, of Beneficial Finance, pursuant to a variety of legal and practical commercial powers created under the off-balance sheet structure.

(ii) Consequently, at all relevant times, the results and affairs of the off-balance sheet entities would, if material to the results and affairs of Beneficial Finance, be required to be disclosed in order for the accounts of Beneficial Finance, and the consolidated accounts of Beneficial Finance and its subsidiaries, to show a true and fair view in accordance with Section 269 of the Companies Code.

(iii) The results and affairs of the off-balance sheet entities of Beneficial Finance were such as to have a material effect on the financial position of the Beneficial Finance Group reported, at balance dates, from 30 June 1988 to 30 June 1990 (inclusive).

(iv) Without accurate aggregate accounts, the Board and Management of Beneficial Finance were not properly informed as to the extent of the assets and operations under its control and responsibility. Accordingly, without such information, the Board and Management of Beneficial Finance were unable to, and did not, adequately or properly supervise, direct and control the operations, affairs and transactions, of the Beneficial Finance Group.

(v) By April 1989, when it received the first aggregate accounting figures, the Beneficial Finance Board was put on notice that the operations of the off-balance sheet entities potentially had a material effect upon the financial position of the Beneficial Finance Group.

(vi) The aggregate accounts produced in respect of each six month trading period showed, as they became available, a deterioration in the financial position of Beneficial Finance, as a result of the activities of the off-balance sheet entities.

(vii) The aggregate accounts which were presented to the Beneficial Finance Board on 29 June 1990, and which forecast aggregate accounting results to 30 June 1990, contained forecasts which were substantially inaccurate. The Beneficial Finance Board was not aware of the true financial position or performance of the off-balance sheet entities under its control until August 1990 when further aggregate accounts were prepared.

27.3.4.16 Chapter 42: Bank and Bank Group Provisioning

(a) Overview and Summary

This Chapter of my Report provides, in answer to my Term of Appointment A(f), a description and evaluation of the procedures used by the Bank and Beneficial Finance to identify bad and doubtful debts. Although some aspects of this matter were dealt with in my First Report, I was not then in a position to answer that Term of Appointment in respect of the Bank because the natural justice process was not complete. Accordingly, this Chapter deals with both the Bank and Beneficial Finance.

The State Bank

From early 1986, the Bank's internal procedures required Managers to complete a "Potential Bad Debt" report on a quarterly basis. It was the manager's decision whether a Potential Bad Debt report was required or not, based on their assessment of whether it was likely that a loss would accrue to the Bank. The Senior Manager was to be advised immediately of defaults by borrowers, or where the Manager suspected that the borrower was in financial trouble or intended to default. Where necessary, the Senior Manager was required to refer the account to the Chief Manager, with a recommendation regarding the action to be taken. In practice, the "suggested criteria" for identifying potential bad debts were vague, and resulted in haphazard reporting and treatment of problem loans. Without strict criteria for identification, the procedure for recognition of problem loans was, at that time, inadequate.

Further, until March 1988, the Bank did not have a policy of separately classifying potential problem loans as they were identified. Instead, a review of the entire loan portfolio for potential bad debts was conducted on a quarterly basis. In March 1988, the policy of classifying bad and doubtful accounts into three categories - Irregular, Non-Performing and Non-Accrual - was introduced.

Upon an account being classified as non-accrual, the Manager was to prepare a full report for the Chief Manager, Corporate Banking, detailing the circumstances. The report was required to advise the amount of the potential loss, and recommend whether a specific provision should be made. All non-accrual loans were also to be listed in the Monthly Operating Review for reporting to the Board of Directors. Non-performing loans were identified monthly, and separately identified on the Monthly Excess Report. A Bad and Doubtful Debts report was to be prepared quarterly, and include details of all non-performing loans with an excess of more than $25,000 outstanding for more than one month.

Responsibility for identification of non-performing loans remained solely with the line managers in the division which had originally recommended or approved the facility. This was unsatisfactory. In situations where a Manager has had a long association with a customer before the loan becomes non-performing, there can be reluctance on the part of the Manager to acknowledge the severity of the situation.

At its meeting on 23 March 1989, the Board of Directors expressed concern that, given the growth of the Bank and the Bank Group, it would be important "to continue to ensure that information in relation to the Group exposure [to particular clients or client groups] was available for management purposes". According to the minutes, the "directors were advised that the Bank was giving a high priority in continuing to develop its Group Global Risk Management techniques in order that it could accurately assess its group risk."

In April 1989, the first report of the Bank Group's exposures to clients or client groups was presented to the Board. This included the exposures of Beneficial Finance Corporation and various divisions of the Bank. The Board was told that, in future, this information would be available quarterly. Although this report to the Board made no mention of the problems encountered in its preparation, a progress report to the Executive Committee in May 1989 commented:

"This exercise highlighted the difficulties in obtaining accurate and timely information from current records and data bases. This exercise also emphasised the urgent need for common terminology and systems to permit electronic downloading of the required information."

After the report in April 1989, the Board regularly received a variety of information concerning non-accrual loans, including a listing of group non-accrual loans in the Monthly Operating Review. Before then, the Board received information on non-accrual loans for the Corporate Banking division only.

The establishment of the Group Risk Management division on 1 July 1989 was directed at the development of an integrated and computerised commitment register, to record and monitor risks on a Bank-wide, rather than a divisional, basis. Mr J B Macky, General Manager Group Information Systems told the Jacobs' Royal Commission that:

"Well into 1989 we started work on the commitment register, among many other projects, because there was a clear acknowledgment that we didn't have enough analysis or reporting tools. We weren't getting things like bad and doubtful debts quickly enough. We didn't have a group-wide exposure reporting system that enabled us to look at an individual customer and say; Corporate Banking have got some, International has got some, Treasury has got some, Beneficial has got some, etc. and Z is the Group's total exposure. That capability emerged gradually over time, from early 1990 because we decided to take an evolutionary development approach to it. We did a broad data base design, and we evolved programmes as we went along.

I am unsure when I initially formed the view that there needed to be better reporting systems on a global basis for non-accruals and bad and doubtful debts except to say for a long time I had been saying that there wasn't enough management information. We didn't have enough executive information and we needed more systems." [Emphasis added]

In July 1989, Group Credit Policy Statement No. 3 addressed the remedial actions that the Bank should take when a customer was classified as non-performing. This statement also introduced a policy concerning the need for a Group perspective on the control of higher risk customers. The policy postulated the need for a "controlling point" to ensure that the State Bank Group's overall best interests were served where several entities within the State Bank Group were exposed to a single customer group in financial difficulty.

The mechanism for setting specific provisions for doubtful debts was first described comprehensively in Group Credit Policy Statement No 3 issued in July 1989. It was stated in this document that:

"An appropriate provision is to be established as soon as it is recognised that there is a likelihood of a loss of principal and interest, fees, etc. resulting after realisation of any security and after exhaustion of all possible courses of action for recovery.

The position of all higher risk customers is to be reviewed periodically to establish whether a provision is necessary or whether a change is required in the level of any existing provision (and whether there is any consequent need for a change in the risk grading of a customer).

Officers are to ensure that they do not delay setting a provision either until the end of the Group's financial year or half-year in the unrealistic hope of an improvement in a particular customer's situation, but equally are not to be over-zealous in setting a provision at too early a stage." [Emphasis added]

In January 1990, the Chief General Manager, Group Risk Management, presented to the Board meeting an assessment of the accounts relating to the Bank, and the current position relating to recovery. This was the first report to the Board that presented comprehensively the Group's exposure, likely recovery position, and current provisioning level, in a single document.

This report presented the views of Management in relation to the matters noted and, on the basis of the information presented, the Board would have been, in some instances, unable to form their own view as to the adequacy or otherwise of the Bank's or the Bank Group's provisioning.

Beneficial Finance

The arrangements utilised by Beneficial Finance for the identification and classification of problem loans varied between the different areas of the company. Different arrangements applied to the Branch operations which engaged in the company's core businesses, from those used in respect of the operating joint ventures undertaken by the company, and from those used in respect of the transactions undertaken by the Structured Finance and Projects division.

Systems and procedures for the identification and classification of problem loans in the branches which conducted Beneficial Finance's core business were well developed. Computer systems identified and reported problem loans, and provided support for the ongoing management of the problem loans and for the review of that management. Organisational arrangements and review processes were implemented to support the management and monitoring of problem loans.

The operating joint ventures in which Beneficial Finance participated generally utilised the company's Finance Receivable System and collections systems. The exception was the Pegasus Leasing joint venture, which between 1988 and 1990 used its own collection system. The use of the Beneficial Finance systems was intended to provide the same system controls over the identification and classification of problem loans as applied to the company's own receivables.

Management of the collections function, the classification of loans, the determination of action with respect to specific problem accounts and assessment of provisions was, however, the responsibility of joint venture personnel. Provisioning for problem loans and management of specific problem loans was reported upon to the Board of Management of each joint venture quarterly, when the Board received lists of non-performing loans and details of proposed provisions and action plans for specific loans. Beneficial Finance was represented on the Board of Management, and by a joint venture manager who acted as Secretary to the Joint Venture Board. A representative from Beneficial Finance was also assigned to each joint venture, with responsibility to manage Beneficial Finance's exposure to the joint venture. The representative had access to the joint venture's records held on Beneficial Finance's Receivable System and collections systems.

The internal controls of the joint venture operations were subject to periodic review by Beneficial Finance Internal Audit.

Each joint venture adopted a policy of establishing a general provision equivalent to 1 per cent of receivables. This provision was proposed to be established progressively.

Over time, Beneficial Finance entered into increasingly large and complex transactions, specifically through the activities of the Structured Finance and Projects division. While the loans and other assets arising from these transactions were, with some exceptions, recorded on the Finance Receivable System, they were not controlled by the Beneficial Finance's collections system. The nature of the loans and assets meant it was not possible for the loans and assets to be subject to the same problem loan identification criteria as were used in the company's core businesses. Most of the assets of the Structured Finance and Projects division were property related and identification of problems with property related loans often depended upon a comparison of the total facility with an estimate of the valuation of the property at the maturity of the facility. Further, many of the facilities provided for the capitalisation of interest, so that no moneys were payable to Beneficial Finance until the maturity of the facility. In neither of these two instances was the identification of arrears, which was the basis of identifying problem loans in the company's collection system, possible.

The identification and classification of problem loans or assets in these situations, and the subsequent assessment of provisions, required the review of each loan or asset by Beneficial Finance officers. The effectiveness with which these tasks were performed depended to a large extent upon the information available to Beneficial Finance regarding the loan or asset, and the judgement of its officers.

Beneficial Finance developed a system to facilitate the management of these loans or assets. The system provided for the recording of action taken by officers responsible for the account, and allowed for the independent review of action taken by those officers. A procedure was also implemented by Beneficial Finance that required status reports to be prepared each month for each of these assets or loans. The status reports were subject to review by a Senior Manager within the Structured Finance and Project's division, and by the division's National Credit Manager, who assessed credit processes and provisioning.

(b) Findings and Conclusions

The Bank

(i) Before July 1989, the procedures adopted by the Bank for the identification of non-performing assets, and assets in respect of which a provision for loss should be made, were not adequate and proper.

(ii) The Bank's procedures after July 1989 were adequate.

(ii) I am not in a position to make any finding as to whether the systems and procedures of the Bank with regard to the identification of bad and doubtful debts satisfactorily led to the identification of all bad and doubtful debts and the creation of adequate provisions for loss. However, as noted in Chapter 53 - "The External Audits of the State Bank: Findings and Conclusions", I have concluded that:

. the Bank's exposures to National Safety Council and Equiticorp were exposures in respect of which a further provision for loss should have been, but was not, made in the accounts of the Bank at 30 June 1989; and

. the Bank's exposures on certain accounts including Somerley and Equiticorp were exposures in respect of which a provision for loss or a further provision for loss should have been made but was not made in the accounts of the Bank at 30 June 1990.

The systems and procedures adopted by the Bank adequately and properly brought these exposures to the attention of Management and the Board.

Beneficial Finance

(i) The procedures adopted by Beneficial Finance in the period under review were generally adequate and proper for the identification of non-performing assets, and assets in respect of which a provision for loss should be made.

(ii) I am not in a position to make any finding as to whether the systems and procedures of Beneficial Finance with regard to the identification of bad and doubtful debts satisfactorily led to the identification of all bad and doubtful debts and the creation of adequate provisions for loss. However, as noted in Chapter 60 - "The External Audits of Beneficial Finance: Findings and Conclusions", I have concluded that Beneficial Finance's exposure to Somerley was one in respect of which a provision for loss should have been but was not made in the accounts of Beneficial Finance at 30 June 1990. The systems and procedures adopted by Beneficial Finance adequately and properly brought this exposure to the attention of Management and the Board.

27.3.4.17 Chapter 43: Other Matters Investigated within the State Bank and Beneficial Finance

(a) Overview and Summary

This Chapter reports the result of my examination of a variety of matters including the remuneration of officers of the Bank, and of Beneficial Finance.

Remuneration Arrangements in London and New York

The Chapter briefly describes the remuneration arrangements that applied to the most senior executives of the Bank's United States and United Kingdom operations. This report is supplementary to the observations made in my First Report regarding the Bank's remuneration practices. Shortly stated, my conclusion is that, similar to the remuneration of the Bank's officers in Australia, the remuneration arrangements in respect of the senior executives in the Bank's New York and London branches were excessive.

Principal features of Beneficial Finance's policies and procedures regarding the provision of loans to its executives

This matter has been the subject of considerable public comment, based in part at least on the contents of two reports prepared by the Bank's Internal Audit department. My Investigation has examined this matter exhaustively, and it is now clear that those reports were misleading and inaccurate. I have concluded that, although there were some irregularities in the administration of the provision of loans to executives of Beneficial Finance, the matter does not attract any adverse findings.

Section 43.4 of the Chapter reports a particular remuneration arrangement, called "shadow" salaries, used by Beneficial Finance until June 1986. Section 43.5 reports the evidence found by my Investigation regarding the participation by certain executives of Beneficial Finance in a joint venture project called the Jolen Court Project with a client of Beneficial Finance, in circumstances which involved a conflict of interest on the part of some of those executives.

Shadow Salaries

The "shadow salary" arrangements, which were used until July 1986, involved the provision of benefits to senior executives in circumstances apparently calculated to facilitate the non-disclosure of those benefits in the executives' personal income tax returns.

Before the introduction of fringe benefits tax with effect from 1 July 1986, Section 26(e) of the Income Tax Assessment Act required employees to declare in their personal income tax return, as part of their taxable income, the value to them of any benefit provided to them by their employers, other than reimbursements of purely business expenses.

From about 1983 until the introduction of fringe benefits tax in 1986, Beneficial Finance remunerated its senior executives, including the managing director, with a combination of salary and "shadow" salary.

Under the "shadow" salary arrangements, an executive would present accounts relating to expenditure incurred by the executive, which would then be paid by Beneficial Finance and deducted from the executive's "shadow" salary entitlement. The amounts deducted were debited to an expense ledger account within Beneficial Finance, and not against its wages and salaries ledger account. Records of the "shadow" salary proportion of the executives' remuneration and of the application of the "shadow" salary were kept by Mr G B Strutton, the Personnel Manager and later the Manager of the Human Resources department of Beneficial Finance.

Pursuant to the arrangement, executives could elect to take a proportion of their annual increase in remuneration as "shadow" salary. The proportion of the total remuneration that could be taken as "shadow" salary increased over time.

The salaries of executives were established in about March of each year for the ensuing period 1 April - 31 March. In 1984, the proportion of total remuneration that could be taken as "shadow" salary was 10 per cent. By the time of the salary review of March 1986, for the year from 1 April 1986 to 31 March 1987, the proportion of total salary that could be taken as "shadow" salary had increased to about 20 per cent of an executive's total remuneration, and "shadow" salaries totalling $365,322 were provided to forty-four executives.

The "shadow" salary arrangement was discontinued in July 1986 when fringe benefits tax came into operation. Fringe benefits tax places on employers the liability to pay tax in respect of benefits granted to employees as part of their remuneration.

Jolen Court Project

The Jolen Court Project involved the participation by certain Beneficial Finance executives in proposed property development with a client of Beneficial Finance.

In April 1989, these executives and a company called Viaduct Services Pty Ltd (Viaduct Services), a member of the Tribe and Crisapulli Group of Companies, entered into an arrangement to acquire and develop land located at 57-65 Springvale Road, Donvale, Victoria. The purchase price of the property was $2.5M, with $0.5M payable as a deposit on 28 July 1989, and the balance of $2.0M payable in April 1990.

In August 1989, the executives borrowed a total of $475,000 from Beneficial Finance to fund their investment in the Jolen Court Project. That money was used to pay the deposit to buy the land. The balance of the purchase price, payable in April 1990, was to be raised by Viaduct Services. Viaduct Services was also to provide the expertise to develop the project.

The ability of Viaduct Services to obtain the $2.0M to purchase the land depended upon the continuing financial strength of the Tribe and Crisapulli Group. Viaduct Services had given guarantees in respect of other companies in the Tribe and Crisapulli Group with respect to borrowings by those other companies from Beneficial Finance. Any failure of that Group would affect the ability of Viaduct Services to obtain the $2.0M needed to complete the purchase of the land. That could, in turn, result in the Beneficial Finance executives forfeiting the $0.5M they had contributed as the deposit for the property, unless they could obtain $2.0M from other sources.

By September 1989, the Tribe and Crisapulli Group was experiencing financial difficulties. Certainly, the Beneficial Finance Board of Directors was concerned about Beneficial Finance's exposure to that Group. The Board imposed a limit of $33.5M on the exposure to the Tribe and Crisapulli Group.

There was a potential for a conflict of interest on the part of the executives involved in the Jolen Court project who were also involved in the credit approval process in respect of applications by the Tribe and Crisapulli Group for loans from Beneficial Finance. Without the continuing financial support of Beneficial Finance to the Tribe and Crisapulli Group, Viaduct Services may not have been able to perform its part in the Jolen Court Project, potentially resulting in the executives losing their investment, itself funded by Beneficial Finance. The end result was that the executives did lose their investment.

(b) Findings and Conclusions

Shadow Salaries

(i) Both business and non-business expenses were paid by Beneficial Finance on behalf of executives, and notionally deducted against the executives' entitlements to "shadow" salary.

(ii) In the accounting records of Beneficial Finance, the "shadow" payments were charged to various expense accounts in the Profit and Loss Account, depending on the nature of the goods or services obtained by the employees and paid for by Beneficial Finance.

The payments of those expenses relating to non-business or part business expenditure should have been charged to the Wages and Salaries Ledger Account in the Profit and Loss Account, and not to other expense accounts.

(iii) The accounting by Beneficial Finance of the "shadow" salary payments was, to say the least, irregular. Whether for reasons of convenience or otherwise, the reconciliation statements recording the utilisation of "shadow" salary entitlements was performed by Mr Strutton at his private residence, and the reconciliation records kept there. The records were then destroyed within a matter of months following the annual reconciliation, and the only record which then remained was the expense voucher and accompanying sundry cheque requisition, recorded simply as part of Beneficial Finance's operating costs.

The accounting procedures in relation to "shadow" salaries did not provide an adequate system for ensuring that "shadow" payments were always included in Mr Strutton's listings and therefore taken into account in the reconciliations. A situation was created in which Beneficial Finance was not able to ensure that amounts were not paid on behalf of executives in excess of their entitlements.

(iv) The application of "shadow" salary to non-business expenditure by various executives was known to Mr Strutton, Manager of the Human Resources department, and to Mr Baker, Managing Director, and was recognised by the external auditors, Price Waterhouse, in their report dated 10 June 1986.

(v) In my opinion, the treatment of the "shadow" salary benefits in Beneficial Finance's accounting records was undertaken so that they could not be identified as having benefited the particular executives. It provided the opportunity for executives to minimise their taxable income by not including the "shadow" salary component in their income tax returns. It must be stated, however, that I have not examined the personal income tax returns of the executives of Beneficial Finance who received "shadow" salaries, and so no inference can necessarily be drawn that the executives involved did not fully disclose the benefit in their personal income tax returns. All that can be said is that the arrangement provided them with the opportunity to not disclose the benefit. I have been advised that the matter of the disclosure or non-disclosure of the "shadow" salary benefits by executives is currently being investigated by the Federal Police.

(vi) In accordance with section 25(2) of the Act and Terms of Appointment A(h) and E, I report that, on the basis of the evidence described in this Chapter, I am of the opinion that the actions of Mr Baker and Mr Strutton may have constituted offences against the Companies Code, and the Taxation Administration Act 1953.

Whether any further action should be taken is, in the first instance, a matter for the Royal Commission to consider and recommend.

Jolen Court

(i) Executives of Beneficial Finance entered into a personal dealing in the form of participation in a venture with a client of Beneficial Finance, Viaduct Services Pty Ltd, a member company of the Tribe and Crisapulli Group, to which Beneficial Finance had a significant exposure. Viaduct Services had provided guarantees in respect of the liabilities of other companies in the Tribe and Crisapulli Group.

(ii) The success of the venture depended heavily upon the Tribe and Crisapulli Group's capacity to arrange finance to complete the purchase of the land that was the subject of the project.

Over the period of twelve months from the initial proposal and payment of the $0.5M deposit, to the date for settlement of the contract, it became apparent that the Tribe and Crisapulli Group was having difficulties in meeting its commitment to obtain $2.0M to fund the settlement payment. Certainly, the exposure of Beneficial Finance to the Tribe and Crisapulli Group was increasing.

(iii) In a situation where the Beneficial Finance executives were at risk of losing their investment in the event that Tribe and Crisapulli Group were not able to obtain ongoing funding from Beneficial Finance to meet commitments, a conflict of interest arose whereby those executives involved in managing the exposure to the Tribe and Crisapulli Group, and in recommending that facilities be extended to the Tribe and Crisapulli Group, had a direct interest in ensuring that Beneficial Finance continued to provide financial support to that Group.

(iv) In accordance with Section 25(2) of the Act and my Terms of Appointment A(h) and E, I report that, on the basis of the evidence described in this Chapter, I am of the opinion that the involvement of the Beneficial Finance Executives Mr Baker, Mr Reichert and Mr Martin in a proposed venture with a company in the Tribe and Crisapulli Group was, or amounted to, a conflict of interest or breach of fiduciary duty, and therefore illegal or improper conduct. I recommend that the matter should be further investigated.

27.3.4.18 Chapter 44: Reports from the State Bank's External Auditors to the Reserve Bank of Australia

(a) Overview and Summary

A significant factor contributing to the Bank Group losses was its excessive exposure to the commercial property industry. This imprudent exposure was caused, in large part, by the Bank's failure to implement an effective system to monitor its total exposure to the commercial property industry.

The Reserve Bank knew that an undue concentration of loans in a particular industry, in a particular geographic region, or to any one client, increases the risk of a bank incurring losses, and a diminution of capital. Accordingly, the Reserve Bank's prudential supervision arrangements at all times sought to ensure that banks had appropriate management systems to monitor, and thus limit, total loans to prudent levels.

In January 1985, the Reserve Bank described a new regime for the "Prudential Supervision of Banks", stating that:

"The Reserve Bank's system of supervision is directed towards satisfying itself that individual banks are following management practices which limit risks to prudent levels and that banks' prudential standards are being observed and kept under review to take account of changing circumstances."

The Reserve Bank required each licensed bank to describe, among other things:

(i) its prudential policies for limiting credit risk exposures to particular borrowers and particular industries; and

(ii) the systems used by the bank to ensure that those policies were in fact observed in practice. Such systems would include information systems to enable the bank to measure, at any point in time, its total credit exposure to a particular borrower, or to a particular industry such as commercial property construction and development.

Apart from introducing its own inspection arrangements which the Reserve Bank determined that it would not do, the Reserve Bank's only source of information as to whether a bank's systems were being effectively used in practice was to ask the bank's management, which is hardly satisfactory. Management might be very reluctant to admit to deficiencies in the operation of its systems, or might conceivably be unaware of some deficiencies.

Accordingly, in April 1986, the Reserve Bank issued Prudential Statement H1, titled "Relationship Between Banks, their External Auditors and the Reserve Bank". The Prudential Statement noted that the Reserve Bank was unable to determine whether banks in fact complied with the systems that they had described to the Reserve Bank for monitoring and controlling risk. To remedy that situation, the Prudential Statement stated that the Reserve Bank would:

"... seek the external auditor's opinion as to whether a bank's internal management systems and controls are generally adequate, and specifically ... whether management systems to control exposures and limit risks outlined to the Reserve Bank are effective, and are being observed." [Emphasis added]

In summary, the key steps in the arrangements for the reporting by the external auditors on the operation of a bank's risk management systems were:

(i) First, the bank would tell the Reserve Bank what its prudential policies for limiting its credit risk exposures were. The Reserve Bank would review those policies, and decide whether or not they were adequate.

(ii) Second, but ideally at the same time, the bank would tell the Reserve Bank what systems it had in place to monitor and control those risks. Again, the Reserve Bank would review those systems, and decide whether or not they were adequate.

(iii) Third, upon receiving instructions from the bank to do so, the external auditors would review the actual operation of those systems, and express an opinion as to whether the systems were being observed, and were adequately providing a means of monitoring and controlling exposures to within the limits set by the prudential policies.

The Reserve Bank made it clear in Prudential Statement H1 that its prudential supervision requirements would extend the scope of a bank auditor's usual statutory audit role. The auditing profession were concerned to understand, and to agree with the Reserve Bank, what that meant in practice. Accordingly, discussions were held between the auditing profession and the Reserve Bank, and in December 1987, the Australian Accounting Research Foundation released Auditing Guidance Release No 4, titled 'Audit Implications of Reserve Bank Prudential Reporting Requirements'. The important clause in the Auditing Guidance Release was Paragraph 41, which said:

"Auditors will ... have the written description of each system which client banks are to prepare and agree with the Reserve Bank. These descriptions will detail the major controls in the respective areas, set by management to control exposures and limit risks to the level determined by management."

To cut a long story short, the State Bank did not give the Reserve Bank a description of its system of monitoring the Bank's total exposure to particular clients or industries, for the simple reason that it did not have one to describe. As I reported in detail in Chapter 5 of my First Report, the Bank was unable to measure those exposures until December 1989, and then only by manually collating information from its various divisions.

The absence of any description of the system was regarded by the external auditors, consistent with the Reserve Bank's Prudential Statement H1 and Auditing Guidance Release No 4, as precluding them from expressing any opinion to the Reserve Bank in respect of the system, or lack of it. An essential first step was that the system both be described by the State Bank, and be evaluated as adequate or inadequate by the Reserve Bank. Indeed, the State Bank's external auditors went one step further. Their view was that not only must the system be described and approved, but it must also be included in the Audit Manual prepared by the Reserve Bank to assist the external auditors in undertaking their review and report.

Even when the external auditors did eventually report to the Reserve Bank on the State Bank's credit management systems, their opinions (purportedly based on their specific examination of the relevant management systems, and on appropriate tests and reviews of those systems) were that the State Bank was generally observing those systems, and that the systems were adequate to limit risks to the prudent levels set by management.

For the reasons identified in the Chapter, my conclusion is that the auditors' opinions were not correct. On the evidence before the Investigation, there were, at all material times, serious deficiencies with the Bank's credit management systems for monitoring Bank-wide exposures. The auditors should have reported that:-

(i) The Bank was not capable of monitoring its Bank-wide industry exposure in an effective or efficient way.

(ii) Even in the one division of the Bank which had at least a rudimentary system to monitor its aggregated exposures (the Corporate Banking division) it was not possible to be confident of the accuracy of relevant data. It necessarily followed, therefore, that management could not be confident it had accurate information on the Bank's loan portfolio.

(iii) There was inadequate control over determining, or monitoring, the Bank's total exposure to any one client. Total exposure to any one debtor was not easily and efficiently obtainable.

These are the very sort of inadequacies and weaknesses which the Reserve Bank assumed and expected would be reported to it. Furthermore, there are no grounds for the external auditors to misapprehend that expectation.

One of the best early indicators of significant weaknesses in any bank, but particularly in a bank expanding quickly, is when management systems for assessing and controlling credit risk become stretched and ineffective. The opportunity to signal those very weaknesses at State Bank was lost. As it was, the absence of reports in 1987 and 1988, and the content of the 1989 and 1990 reports, seriously impeded the Reserve Bank's ability to appreciate the true extent of management shortcomings at the State Bank.

The Investigation sought to understand how the external auditors could have come to the opinions they reported to the Reserve Bank. My conclusion is that the auditors arrived at their incorrect opinions because they failed to undertake their task properly. Rather than perform specific tests and reviews of relevant Bank systems, the external auditors seemed to have relied primarily on their general knowledge of the Bank, which general knowledge arose out of the work they had done for the purpose of their statutory audits.

(b) Findings and Conclusions

(i) Because of the general recalcitrance of the State Bank's management to comply with the Reserve Bank's prudential supervision regime, it was not until 1988 that the auditors were given instructions by the State Bank to prepare a report in accordance with Prudential Statement H1.

Even then, the report prepared in 1988 amounted to no report at all in respect of the risk exposure systems. The auditors expressly disavowed providing an opinion, because they were waiting for the Reserve Bank to give its approval to the State Bank's description of the system. As unsatisfactory as that situation was, in my opinion the blame cannot be laid at the feet of the external auditors. Both Prudential Statement H1, and Auditing Guidance Release No 4, said that the auditor's report would be based on a written description of the system that had been provided to, and approved by, the Reserve Bank.

(ii) The reports provided in 1989 and 1990 expressed opinions regarding the adequacy of the Bank's systems that were, bluntly stated, wrong. For example, in respect of the year ended 30 June 1989, the report stated that the State Bank's credit management systems were generally observed during the year under review, and adequately provided a means to control exposure and limit risk to the prudent levels determined by management. That opinion was incorrect. It did not identify that one of the Bank's most important credit policies, its industry exposure policy, could not be effectively monitored, and that it was, therefore, not possible for the Bank to measure its aggregate industry exposure.

The inadequacies of the systems were recognised in the bank from late in 1988. A paper presented by Mr Matthews to the Executive Committee in February 1989 reported that the timely and accurate reporting of aggregate risk exposure in the Bank was effectively impossible, because of the different classification systems in place even within the Bank.

For the reasons set out in Chapter 15, the relevant State Bank officers, particularly Mr Matthews, saw fit not to volunteer the true position to the Reserve Bank. Even when the Reserve Bank raised the matter specifically, Mr Matthews responded in a way which had the effect of suppressing the extent of the inadequacies in the State Bank's credit management systems.

(iv) If the external auditors had reported in 1988, or earlier, that the State Bank did not have management systems to enable it to comply with its policies on industry exposure, the Reserve Bank would clearly have been put on notice that there was a significant management inadequacy at the State Bank. It is the fault of the Bank's management, not the auditors, that that did not happen.

As it was, the absence of any report in 1987 or 1988, followed in 1989 and 1990 by the auditor's incorrect opinion on the Banks credit management systems, seriously impeded the Reserve Bank's ability to appreciate the true extent of management shortcomings at the State Bank. By the time of the 1989 report, however, no action by the Reserve Bank could have reduced the losses that the State Bank was to realise.

27.4 THE LAW APPLICABLE TO BENEFICIAL FINANCE

27.4.1 INTRODUCTION

Although my Investigation is established by an Act of Parliament and by an Instrument of Appointment from the Governor, my findings and expressions of opinion do not affect anyone's legal rights. My Investigation is a purely administrative inquiry, and not a court of law.

Nevertheless, my Investigation of Beneficial Finance could not be undertaken without regard to the laws that applied to Beneficial Finance and its directors, management and staff. Most obviously, Terms of Appointment A(h) and E, and sub-section 25(2) of the Act, require me to investigate and report on such of the following matters as, in my opinion, I should investigate and report:

(a) 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 Beneficial Finance; and

(b) any possible failure to exercise proper care and diligence on the part of a director or officer of Beneficial Finance.

Term of Appointment C requires me to investigate and report whether the "operations, affairs and transactions" of Beneficial Finance were "adequately or properly supervised, directed and controlled" by the directors, officers and employees of Beneficial Finance. In order to answer my Terms of Appointment, it was obviously necessary for me to use an objective standard of what is an "adequate and proper" performance of their duties by the directors, managers and employees. For the reasons stated in my First Report, I believe that the only acceptable standard of what is "adequate and proper" is that established by the law. To apply my own subjective standards would be unsound, and to apply a higher standard would be unfair. Common sense dictates that a standard that is less than that demanded by the law is not acceptable.

Accordingly, for example, in forming an opinion as to whether the directors and employees of Beneficial Finance performed their respective functions adequately and properly, I have applied the tests described, among others, by Mr Justice Rogers in AWA v Daniels (1992 10 ACLC 933).

It is appropriate, therefore, that I describe in some detail the tests laid down by the law as to what is expected of directors and employees in performing their duties.

27.4.2 WHAT THE LAW REQUIRED OF DIRECTORS AND EMPLOYEES OF BENEFICIAL FINANCE

27.4.2.1 The Important Features of the Standards Required by the Law

The standard of performance required by the law is usually described as being that of "reasonable care and diligence". The important features of the standard of reasonable care and diligence required of directors and officers can be stated, at least in broad terms, as follows:

(a) First, there is no objectively-determined standard of skill which must be attained by non-executive directors in meeting their obligation of reasonable care and diligence. It is for the shareholders - in Beneficial Finance's case, the State Bank - to determine what skills they want on the Board, and to appoint appropriately skilled and experienced directors accordingly. The law does not require non-executive directors to display a level of skill and experience that they do not possess. If, however, a non-executive director does have particular skills, he or she must utilise them in the performance of their functions as a director.

In respect of executive directors and officers, however, the law requires that a person must perform his or her functions with an objectively determined level of skill. Full-time employees of a company who accept appointment to a particular office for which recognised skills are required impliedly promise that they have those skills that are reasonably necessary to perform the functions of the office. In AWA v Daniels, Rogers J said:

"Generally a chief executive is a director to whom the board of directors has delegated its powers of management of the Corporation's business. Usually he is employed under a contract of service which will either include an express term or, in the absence of an express term, an implied term, that the chief executive will exercise the care and skill to be expected of a person in that position. The degree of skill required of an executive director is measured objectively".

(b) Second, it is clear that the standard of reasonable care and diligence that is required of directors - both non-executive and executive directors - is higher now than it was when some of the earlier court decisions regarding the obligations of directors were made.

In AWA v Daniels, Rogers J expressed the changing content of the obligation of care and diligence in the following terms:

"Of necessity, as the complexities of commercial life have intensified the community has come to expect more than formerly from directors whose task is to govern the affairs of companies to which large sums of money are committed by way of equity capital or loan. The affairs of a company with a large annual turnover, large stake in assets and liabilities, the use of very substantial resources and hundreds, if not thousands of employees demand an appreciable degree of diligent application by its directors if they are to attempt to do their duty ... One of the most striking features of the law concerning directors duties is the insistence that directors accept more and more responsibility for oversight of a company's affairs at the same time as the affairs of companies become more and more complex and diverse ... More recent wisdom has suggested that it is of the essence of the responsibilities of directors that they take reasonable steps to place themselves in a position to guide and monitor the management of the company (cf Commonwealth Bank v Freidrich [1991] 5 ACSR 115, 187). A director is obliged to obtain at least a general understanding of the business of the company and the effect that a changing economy may have on that business. Directors should bring an informed and independent judgment to bear on the various matters that come to the Board for decision. (cf Sir Douglas Menzies "Company Directors" [1959] 33 ALJ 156, 164)."

In Commonwealth Bank v Friedrich (1991) 5 ACSR 115, Tadgell J said at page 126:

"As the complexity of commerce has gradually intensified ... the community has of necessity come to expect more than formerly from directors ... In response, the parliament and the courts have found it necessary in legislation and litigation to refer to the demands made on directors in more exacting terms.

In particular, the stage has been reached when a director is expected to be capable of understanding his company's affairs to the extent of actually reaching a reasonably informed opinion of its financial capacity."

In a subsequent judgment regarding the AWA case (AWA v Daniels (No2) (1992) ACLC 1643, Rogers J said at page 1,658:

"It is essential for the purposes of corporate law that the courts rigorously enforce the obligations of those who seek and obtain high corporate office. Shareholders are entitled to look to the law and to the courts to ensure that loss to the company, due to negligence in the administration of their company, is compensated by the negligent actors, be they auditors, executives or senior management ... honest bungling is no appropriate basis for relief from liability."

(c) Third, of particular importance in determining the required standard of care and diligence is the division of responsibility within a particular company between the non-executive directors and management. As stated by Rogers J in the AWA Case, the "responsibility of the non-executive directors needs to be examined in the light of the proper division of functions between directors, management and auditors". In Friedrich's Case, Tadgell J said:

"What constitutes the proper performance of the duties of a director of a particular company will be dictated by a host of circumstances, including no doubt the type of company, the size and nature of its enterprise, the provisions of its articles of association, the composition of its board and the distribution of work between the board and other officers."

(d) Finally, the law recognises that conducting a commercial enterprise involves some risk-taking, and will not hold a director or officer to have breached his or her duty for mere errors of judgement. As stated in the explanatory memorandum to the Corporate Law Reform Bill (at para 87):

"The courts have in the past recognised that directors and officers are not liable for honest errors of judgement: Ford's Principles of Company Law (6th ed, 1992) at p 528-9. They have also shown a reluctance to review business judgements taken in good faith. Thus, in Harlowe's Nominees Pty. Limited v. Woodside 121 CLR 483 at 493, the High Court said:

`Directors in whom is vested the right and duty of deciding where the company's interests lie and how they are to be served may be concerned with a wide range of practical considerations, and their judgment, if exercised in good faith and not for irrelevant purposes, is not open to review in the courts.'"

27.4.2.2 The Allocation of Functions and Powers in Beneficial Finance

Any evaluation of the performance by directors, officers and employees of their functions and powers naturally requires, as a first step, that those functions and powers be identified and defined. As noted earlier, the particular functions and powers of the directors and officers of a company will, to a considerable extent, depend upon the allocation of functions and powers within the particular company.

There are some functions which, broadly stated, are generally recognised as being properly the role of the Board of Directors. In the AWA Case, Rogers J said:

"A Board's functions, apart from statutory ones, are said to be usually four fold:

1. to set goals for the corporation

2. to appoint the corporation's chief executive

3. to oversee the plans of managers for the acquisition and organisation of financial and human resources towards attainment of the corporation's goals, and

4. to review, at reasonable intervals, the corporation's progress towards attaining its goals."

In performing these functions, the Board of Directors is entitled to rely on Management:

"The directors rely on management to manage the corporation. The Board does not expect to be informed of the details of how the corporation is managed. They would expect to be informed of anything untoward or anything appropriate for consideration by the Board.

The particular allocation of functions within Beneficial Finance is set down first in its Articles of Association.

Article 25(1) provides that the management and control of the business and affairs of Beneficial Finance are vested in the directors. Pursuant to Article 27(1), the directors' powers under the Articles are exercisable in a duly convened meeting of directors at which a quorum of at least two directors is present.

Article 26(1) provides for the directors to appoint one (or more) of their number to be the Managing Director, who is subject to the control of the Board.

Article 26(2) empowers the directors to delegate their powers and duties under the Articles to the Managing Director. Such a delegation can be for a limited time or indefinitely, upon such conditions as the directors think fit, and can be to the exclusion of the directors' powers and duties under the Articles.

Apart from authorities regarding credit approvals, capital expenditure approvals and the appointment of consultants, there were no formal delegations to the Managing Director pursuant to Article 26(2).

Article 27(5) authorises the directors to delegate any of their powers to a committee or committees consisting of one or more directors.

27.4.2.3 Reliance by Non-Executive Directors on the Managing Director and Senior Managers

It is obvious that, in performing their functions in governing a company, the directors must be able to entrust functions and powers to Management, and rely on Management to perform those functions and exercise those powers competently, diligently and honestly. As stated by Rogers J in the AWA case:

"The Board of a large public corporation cannot manage the corporation's day to day business. That function must by business necessity be left to the corporation's executives. If the director of a large public corporation were to be immersed in the details of day to day operations the director would be incapable of taking more abstract, important decisions at board level."

While directors are generally able to rely on Management, the directors must carefully appoint the managing director, carefully delegate functions and powers to the appointee, and monitor the managing director's performance of his functions. The directors are not entitled to rely on management if there are reasons to suspect that such reliance is misplaced.

Among the functions of a Board of Directors is the selection and appointment of a Chief Executive Officer or Managing Director of the company. As noted above, Article 26(1) of Beneficial Finance's Articles provided for the directors to appoint one or more of the directors to be the Managing Director.

In exercising the power to appoint a managing director the directors must act with reasonable care and diligence. The directors are entitled to the benefit of the principle that matters of business judgment will not be reviewed by the courts if the directors have acted as a reasonable board might have acted.

Similarly, in delegating functions and powers to the managing director, the Board must act reasonably. The delegation of functions and powers is also a matter of business judgment. In Re City Equitable Fire Insurance Company Ltd (1925) Ch 407 v 426-7 Romer J said:

"The larger the business carried on by the company the more numerous, and the more important, the matters that must of necessity be left to the managers, the accountants and the rest of the staff. The manner in which the work of the company is to be distributed between the board of directors and the staff is in truth a business matter to be decided on business lines."

Having made the kind of appointment that could be made by a reasonable board, and having made the delegations that could be made by a reasonable board, the directors are then entitled to rely on the managing director to perform his duties adequately, competently and honestly until such time as they were put on enquiry as to his or her honesty or competence. In the AWA case, Rogers J said:

"A director is justified in trusting officers of the corporation to perform all duties that, having regard to the exigencies of business, the intelligent devolution of labour and the articles of association, may properly be left to such officers (Dovey v Cory; in re Brazilian Rubber Plantations & Estates Ltd; Huckerby v Elliot [1970] 1 AER 189, 193, 195). A director is entitled to rely without verification on the judgment, information and advice of the officers so entrusted. A director is also entitled to rely on management to go carefully through relevant financial and other information of the corporation and draw to the board's attention any matter requiring the board's consideration. The business of a corporation could not go on if directors could not trust those who are put into a position of trust for the express purpose of attending to details of management (American Law Institute "Principles of Corporate Governments, Analysis and Recommendations" pp 175, 176). Reliance would only be unreasonable where the director was aware of circumstances of such a character, so plain, so manifest and so simple of appreciation that no person, with any degree of prudence, acting on his own behalf, would have relied on the particular judgment information and advice of the officers (In Re City Equiticable Fire Insurance Co). A non-executive director does not have to turn him or herself into an auditor, managing director, chairman or other officer to find out whether management are deceiving him or her (Graham v Allis-Chalmers Manufacturing Co 188 A 2nd 125, 130).

The managing director is obliged to keep the board informed in relation to matters which need the board's attention. The board may, in the absence of suspicion, rely on the managing director to do that. Reliance by a director following a delegation by the board will not remain permissible once there are circumstances known to the director which would put a reasonable director on enquiry.

What constitutes sufficient circumstances to put a reasonable director on notice that he cannot rely on management must be judged in the light of the increased standard of performance now required from directors. In particular, as noted by both Tadgell J in Friedrich's case and Rogers J in the AWA case, directors are now expected to take reasonable steps to enable them to understand the company's affairs so that they can guide and monitor the management of the company. Although a non-executive director need not turn himself into an auditor to review management's performance, he must bring an informed and independent judgement to bear on the matters that come to the Board for decision.

Further, it is axiomatic that persons charged with fiduciary administration of large amounts of money cannot simply make a delegation under authority and then be unconcerned as to the results of the delegation. A Board which makes delegations must establish a system of checks by which the use of the authority given by the delegations can be monitored. The practice of setting up internal audit procedures is an example. The practice of conducting reviews of management is another. The board has the responsibility of satisfying itself that adequate checks exist. In the process of approving a system of checks the Board is expected to deploy whatever relevant skills its members possess. If they lack the necessary skills, the board is expected to obtain professional assistance at a level and cost consistent with the scale of the company's operations and resources.

In summary, provided the Board of Directors with appropriate authority in the Articles makes a proper appointment of a managing director, delegates within reasonable limits and institutes the necessary checks, the Board can rely on the managing director to act properly within the scope of the powers delegated to him or her. Whether the Board has so acted as to reach the point where it can so rely depends on whether the Board has done what a reasonable Board could have done.

The Board's reliance on management cannot however be passive. The directors must take reasonable steps to understand the company's business operations, and must bring an informed and independent judgment to bear in performing their functions. They must ensure too that adequate arrangements are made to monitor the performance of management. It is against those obligations that the reasonableness of the directors' reliance on management is to be judged.

27.4.2.4 The Obligations of the Board of the State Bank for the Conduct of the Affairs of Beneficial Finance

The Bank as shareholder of Beneficial Finance had the power to appoint the directors of Beneficial Finance. That power was exercised by the Bank's Board of Directors. In doing so, the Board was under a duty at common law to exercise a reasonable degree of care and diligence in making the appointments, and in ensuring that the composition of Beneficial Finance's Board as a whole was appropriate taking into account the qualifications and knowledge of all the directors appointed.

Once the directors of Beneficial Finance were appointed, however, the Bank's Board of Directors was entitled to leave the direction of the management of Beneficial Finance to its Board. If the directors of a parent company have made proper appointments but the directors of the subsidiary do not perform their duty, the directors of the parent corporation are, in general, not liable for that default. However, directors of a parent corporation are under a duty to consider the results of the subsidiary corporation's operations and to take action to try to improve the performance of the subsidiary if it produces unsatisfactory results.

The relationship between the Bank and its subsidiary companies was described in my First Report as one of co-operative independence.

The Bank exercised control over its subsidiary groups by appointing its own representatives - directors of the Bank including the Chairman and the Managing Director, and a Bank executive - to the Board of Directors of the subsidiary companies. For example, at its meeting on 28 June 1984, the Bank's Board of Directors appointed a Board of Directors for Beneficial Finance which comprised ten directors, five of whom represented the Bank - Mr Barrett, Mr Clark, Mr Simmons, Mr R P Searcy and an executive of the Bank, Mr Matthews. It expressly appointed Bank representatives to the Beneficial Board "to ensure the new Bank control of the operations of Beneficial Finance." It was the Bank's policy that its Chairman was also the Chairman of the Board of Directors of subsidiary companies, including Beneficial Finance.

At its meeting on 22 June 1989, in considering alternatives for the appointment of Directors to the Boards of subsidiary companies, the Bank Board "considered that the Boards (of subsidiaries) should remain independent and have outside Directors appointed, with the Bank continuing to maintain control mechanisms."

Although the subsidiaries of the Bank operated as semi-autonomous businesses, there was one respect in which they had the potential to profoundly affect the Bank - whatever the legal position, the Bank would act to meet a subsidiary's liabilities and obligations should the subsidiary itself be unable to do so.

While the Bank did not provide any formal guarantee of Beneficial Finance's obligations, it is beyond doubt that the Bank would not allow it to fail. As noted in the Bank's 1990 Annual Report, the Bank was "totally committed to maintaining full support for Beneficial." The Bank's advance of funds in respect of the East End Market commitments of Beneficial Finance (described in Chapter 31 of this Report), and its purchase of non-performing assets from Beneficial Finance in the 1991 financial year, are particular manifestations of that commitment.

The Bank Group apparently adopted a guideline which limited the size of Beneficial Finance relative to the Bank. The Bank's 1985 strategic plan proposed the establishment of limits on the size of subsidiaries:

". Beneficial Finance; receivables no greater than 20% of total bank assets;

. Other subsidiary operations no greater than 10% (total) of the total bank assets".

I have found no evidence that the Bank's Board of Directors formally considered or imposed any such limits. However, the limit is expressly referred to in the minutes of the Beneficial Finance Board of Directors' meeting held on 30 April 1985:

"Future plans to be produced on the basis of sales which can be written even though this may increase Company assets above the guideline of 20% of SBSA assets. Any excess receivables can then be sold off to SBSA or other sources."

The policy of the Bank in respect of its management of the risk represented by the activities of Beneficial Finance was broadly in accordance with the prudential guidelines of the Reserve Bank. Before August 1989, the Reserve Bank did not require that the large exposures of non-banking subsidiaries of a bank be reported. Instead, Reserve Bank Prudential Statement G1 required banks to ensure that a subsidiary had "sound and prudent management which is aimed at achieving undoubted viability within the capital resources of the (subsidiary) itself", and to ensure that the "size of its subsidiaries does not become unduly large relative to the bank itself." The Reserve Bank's guidelines was that the total assets of all subsidiaries should together not exceed 50 per cent of a bank's own assets.

In summary, the directors of the Bank had an obligation to exercise reasonable care and diligence in constituting the Board of Directors of Beneficial Finance, and to monitor its results. Having appointed the directors however, the directors of the Bank were under no duty to act as if they were directors of Beneficial Finance and their legal obligations, in general, did not extend to giving directions on matters of management to the Board of Beneficial Finance.

27.4.2.5 The Role and Duties of Common Directors on the Boards of the Bank and Beneficial Finance

As noted, the Bank's Board of Directors ensured that it appointed some of its own members to the Board of Directors of Beneficial Finance to facilitate the Bank's monitoring of the performance of Beneficial Finance.

The law gives very little recognition to the practice of common directorships in groups of companies. So far as their duties are concerned they do not differ from other directors. The common director will owe a set of duties to each corporation. He or she will be obliged to act in the interests of the parent corporation when acting as a director of the parent, and to act in the interests of the subsidiary when acting as a director of the subsidiary corporation. Where the subsidiary is wholly-owned, the common director when acting in each corporation will be acting properly if he or she has an honest belief that the interests of the parent and the subsidiary correspond.

27.4.3 RELEVANT PROVISIONS OF THE COMPANIES CODE

27.4.3.1 Introduction

An important point of distinction between the State Bank and Beneficial Finance is that Beneficial Finance was a company incorporated under the Companies Code. While the Bank was a statutory corporation and an instrumentality of the Crown, Beneficial Finance was a company like any other, and subject to the law accordingly. As a statutory corporation representing the Crown, however, the Bank and its directors, officers and employees were not subject to the Companies Code, or arguably to a number of other relevant laws.

It is relevant to note here too that the statutory immunity provided to the Bank's directors and officers by Section 29 of the State Bank Act does not apply to the directors and officers of Beneficial Finance. Even those directors of Beneficial Finance who were also directors and officers of the Bank are not entitled to the immunity in respect of the performance of their duties as directors of Beneficial Finance.

The importance of the application of the Companies Code to Beneficial Finance lies in the potential implications that might result from a breach of those laws. The Companies Code and other statutes that may be relevant to Beneficial Finance's activities commonly impose a liability to make restitution and pay damages, and in some cases can result in a criminal liability, for their breach.

It must be clearly understood that, although the Companies Code uses the term "reasonable care and diligence" in respect of the obligation of directors and officers, and the standard applied under the Code is the same as that of the general law described above, a simple failure to exercise reasonable care and diligence is not by itself enough to constitute an offence against the Code. The Companies Code applies only to a particular and specific act or omission, of such gravity as to attract a criminal penalty.

Whether any criminal or civil legal action should be initiated in respect of any of the matters addressed in my Report is not a question that I am empowered to answer. That issue is reserved for consideration by the Royal Commission following receipt of my Report.

27.4.3.2 Section 229(2): The Duty to Exercise Reasonable Care and Diligence

Section 229(2) of the Companies Code requires an "officer" of a company to exercise "a reasonable degree of care and diligence in the exercise of his powers and the discharge of his duties". Breach of the section is a criminal offence carrying a maximum penalty of $5,000.

The meaning of "reasonable care and diligence" was explained in my First Report, and its key features are summarised in Section 27.4.2 of this Chapter. Where-ever I have formed the opinion that a person did not act with proper care and diligence, I have provided my reasons for that opinion in the relevant Chapter of this Report. There are however two important features of the obligation imposed by Section 229(2) which require some brief explanation.

First, the obligation applies to each company "officer". An "officer" is defined to mean:

"... any person, by whatever name called and whether or not he is a director of the corporation, who is concerned or takes part, in the management of the corporation."

The meaning of that definition was explained by Ormiston J in Commissioner of Corporate Affairs v Bracht [1989] VR 821 as follows:

"It may be difficult to draw the line in particular cases, but in my opinion the concept of "management" for present purposes comprehends activities which involve policy and decision making, related to the business affairs of a corporation, affecting the corporation as a whole or a substantial part of that corporation, to the extent that the consequences of the formation of those policies or the making of those decisions may have some significant bearing on the financial standing of the corporation or the conduct of its affairs."

Although it is clear that all directors of Beneficial Finance were "officers" of the company, it is not necessarily the case that every employee of Beneficial Finance who was described as a "manager" was an "officer" within the meaning of the Code. In order to be an officer, the person's participation in decision-making must have occurred at a level and in areas of the corporation's operations where significant discretions and judgment were exercised.

For ease of reference, I have throughout this Report adopted the terminology of my Terms of Appointment in using the term "officer" to refer to officers other than directors.

Second, it is important to recognise that, because section 229(2) creates a criminal offence, any prosecution for a breach of the section must relate to a particular and specific act or omission, and not to some general failure over a period of time to exercise reasonable care and diligence in the performance of the person's functions and powers. In Bryne v Baker [1964] VR 443 at 453, the court said:

"The language used is appropriate and was designed, we think, to introduce one aspect of the concept of negligence, as known and acted upon for many years by the courts ... and this concept of negligence has reference to identifiable acts or omissions, not to any general characterisation of the conduct of a director over a selected period".

27.4.3.3 Section 229(1): The Duty to Act Honestly in the Best Interests of the Company

Section 229(1) requires an officer of a company to "act honestly in the exercise of his powers and the discharge of the duties of his office". The section sets a maximum penalty for its breach of $5,000 or, if there was an intention to deceive or defraud the company, a maximum penalty of $20,000 or imprisonment for five years, or both.

The term "act honestly" is not used in the sense of requiring probity or truthfulness. Rather, it means "act bona fide in the best interests of the company." As stated by King CJ in Australian Growth Resources Corporation Pty Ltd v van Reesema [1988] 6 ACLC 529:

"The section ... embodies a concept analogous to constructive fraud, a species of dishonesty which does not involve moral turpitude. I have no doubt that a director who exercises his powers for a purpose which the law deems to be improper, infringes this provision notwithstanding that according to his own lights he may be acting honestly."

Note that, like section 229(2) requiring reasonable care and diligence, section 229(1) applies only to directors and "officers" of a company, and not to employees who are not "officers".

27.4.3.4 Section 229(3): The Duty Not to Make Improper Use of Company Information

Section 229(3) provides that the directors, officers and employees of a company must not use company information for their own benefit. The section provides:

"An officer or employee of a corporation, or a former officer or employee of a corporation, shall not make improper use of information acquired by virtue of his position as such an officer or employee to gain, directly or indirectly, an advantage for himself or for any other person or to cause detriment to the corporation.

Penalty: $20,000 or imprisonment for 5 years, or both."

This section applies to all employees, not just directors and officers.

27.4.3.5 Section 229(4): The Duty Not to Make Improper Use of Position in the Company

Section 229(4) is closely related to Section 229(3). It provides that a director, officer or employee must not make improper use of his or her position to obtain a personal advantage or to benefit another person without the authority of the corporation. The section states:

"An officer or employee of a corporation shall not make improper use of his position as such an officer or employee, to gain, directly or indirectly, an advantage for himself or for any other person or to cause detriment to the corporation.

Penalty: $20,000 or imprisonment for 5 years, or both."

In Chew v R [1992] 10 ACLR 816, the High Court held that the actual obtaining of an advantage by the officer or employee or anyone else, or the suffering of a detriment by the company, was not a necessary element of the offence. A director, officer or employee who makes improper use of his or her office in an attempt to gain an advantage is guilty of an offence, even if he or she is unsuccessful. The majority of the High Court decided that is sufficient for section 229(4) that the accused must have the purpose of gaining an advantage or causing a detriment, and must believe that the intended result would be an advantage for himself or herself or for some other person or a detriment to the corporation.

27.4.3.6 Potential Penalties and Liabilities Under Section 229

Section 229 creates criminal offences. The penalty for breach of section 229(2) is monetary only, but breaches of other sections can result in imprisonment for up to five years. Being a criminal offence, the standard of proof required under section 229 is the criminal standard - proof beyond reasonable doubt. An allegation of breach of duty made under the general law needs to be proved only on the civil standard of proof on the balance of probability.

Section 229 also imposes a liability upon a person in breach of its provisions to pay compensation to the company.

Section 229(6) empowers a Court which convicts a person of an offence under section 229 to pay compensation to the company. The section states:

"Where-

(a) a person is convicted of an offence under this section; and

(b) the court is satisfied that the corporation has suffered loss or damage as a result of the act or omission that constituted the offence,

the court by which he is convicted may, in addition to imposing a penalty, order the convicted person to pay compensation to the corporation of such amount as the court specifies, and any such order may be enforced as if it were a judgment of that court."

Section 229(7) empowers the company to take court action to recover compensation from a person who has contravened section 229, whether or not the person has been convicted of an offence. The section states:

"Where a person contravenes or fails to comply with a provision of this section in relation to a corporation, the corporation may, whether or not the person has been convicted of an offence under this section in relation to that contravention or failure to comply, recover from the person as a debt due to the corporation by action in any court of competent jurisdiction -

(a) if that person or any other person made a profit as a result of the contravention or failure - an amount equal to that profit; and

(b) if the corporation has suffered loss or damage as a result of the contravention or failure - an amount equal to that loss or damage."

An action by the company under this section is a civil action, in which a breach of section 229 need be proved only on the balance of probability.

Section 542 of the Companies Code should also be noted. That Section allows any person authorised by the Australian Securities Commission to make an application to a Court that:

(a) a person is guilty of "fraud, negligence, default, breach of trust or breach of duty in relation to a corporation"; and

(b) that as a result the corporation has or is likely to suffer loss.

If the Court is satisfied that the person is guilty as alleged, the Court can make such orders as it thinks appropriate, including an order that the person pay compensation or damages to the corporation. The test of liability under this Section appears to be broadly the same as at general law and under Section 229. Note however that Section 542 applies to any person, and not only company directors, officers and employees.

Finally, Section 535(1) of the Companies Code provides for a court to excuse a person from civil liability where, although he or she has contravened the law, they acted honestly and ought fairly to be excused:

"If, in any civil proceedings against a person to whom this section applies for negligence, default, breach of trust or breach of duty in a capacity by virtue of which he is such a person, it appears to the court before which the proceedings are taken that the person is or may be liable in respect of the negligence, default or breach but that he has acted honestly and that, having regard to all the circumstances of the case, including those connected with his appointment, he ought fairly to be excused for the negligence, default or breach, the court may relieve him either wholly or partly from his liability on such terms as the court thinks fit."

Section 535 does not empower the court to grant relief from criminal liability, and so does not allow relief from a criminal prosecution under section 229.

27.4.4 MY POWER TO MAKE FINDINGS IN RESPECT OF MATTERS OF LAW

27.4.4.1 The Issue

In their submissions to me in response to the draft Chapters of my Report provided to them as part of the natural justice process, the non-executive directors of the Bank and of Beneficial Finance argued that I could not draw any conclusions or make any findings, in respect of any matter of law, or of mixed law and fact.

The submission was that I had "no power under Section 25(2) of the State Bank Act to make any finding on a matter of law or mixed fact and law or which may declare or affect or attempt to declare or affect legal rights", and that any finding I might make which involved me "reaching any finding based upon the legal construction of a Board directors' duty - whether common law or statutory ... or a legal instrument, is ultra vires". The submission cited three "factors" which, it was said, had this effect:

"(a) the proper construction of Section 25 of the State Bank Act;

(b) the proper construction of the Auditor-General's Terms of Appointment; and

(c) the decision of the full Court in Bakewell & Others ... in which the Chief Justice makes it clear that the Auditor-General is acting in his capacity as an investigator -he is not a judicial or quasi-judicial officer."

I do not accept this submission. It is my opinion, supported by legal advice, that not only am I able to make findings and reach conclusions in respect of matters of law, but that I am in fact expressly required to do so. Nevertheless, this submission, which was made after section 25 of the State Bank Act was amended on 3 December 1992, raises some issues regarding the nature of my Investigation and the effect of my Report which should be understood by readers of my Report.

27.4.4.2 The Non-Judicial Nature of my Investigation

It is important to recognise that I am not a judge, and my inquiry is not a court. This is an administrative investigation. My findings do not affect any person's legal rights. I cannot convict anyone of any offence, or impose any penalty for a breach of the law, or require anyone to make restitution or pay damages for a breach of an obligation or duty imposed on them by the law.

This does not mean, however, that I cannot express an opinion in respect of the application of the law. I can, and indeed I am required, to make findings and reach conclusions regarding a variety of legal matters. The fact that my inquiry is not judicial or quasi-judicial does not mean that I cannot form opinions regarding matters of law, or make such findings or come to such conclusions. What it does mean is that those opinions, findings and conclusions have no legal implications - they affect no one's legal rights. They are, in the end, no more than an expression of my opinion, based on the evidence available to me.

Of course, the opinions expressed in my Report can potentially have serious implications for those persons who are subject to them, at least in terms of damage to those persons' reputations. My Report could result in the Attorney-General or the Australian Securities Commission deciding to institute legal proceedings, based upon whatever recommendations may be made by the Royal Commission. In any such legal proceedings however, the facts establishing liability under the law would have to be proved to the Court. My findings and conclusions, whether of fact or law, will not establish any liability.

Because of the serious implications which my Report could have for a person's reputation, I have ensured that my findings and conclusions are soundly based upon the established evidence, and fairly expressed, and are based upon detailed legal advice. My investigation has been exhaustive and thorough, including the taking of detailed and extensive advice, and the rigorous observance of the requirements of natural justice and procedural fairness.

In the end though, whatever may be the implications of the opinions expressed by me in my Report for people's lives, those implications do not include any affect on their legal rights or status.

27.4.4.3 The Law Regarding Non-Judicial Investigations

It is clearly settled law in Australia that a non-judicial investigation such as mine can reach conclusions regarding matters of law, including a person's apparent commission of a crime, or breach of any obligation or duty imposed upon them by the law. The Full High Court of Australia has ruled that a Royal Commission can be appointed by the Governor in Council to determine whether crimes have been committed: McGuinness v Attorney-General(Vic) (1940) 63 CLR 73; Clough v Leahy (1905) 2 CLR 139. The New South Wales Supreme Court held similarly in Ex parte Walker (1924) SR (NSW) 604. In the authoritative "Royal Commissions and Boards of Inquiry" (LA Hallett, The Law Book Company, 1982), the author states (at page 40-41):

"Whilst the power of the Governor General in Council to appoint a Board of Inquiry has never been challenged in the same way as the appointment of a Commission, it would appear that any challenge would be unsuccessful. The basis of the decisions upholding the validity of Commissions is that there is nothing contrary to law about an individual holding a voluntary inquiry. There is nothing in either Clough v Leahy: Ex parte Walker or McGuinness v Attorney-General which put Commissions in a special category, or attributed to them some special factor which would not apply to a Board of Inquiry. However, it is suggested that it would be prudent to provide a statutory power to appoint a Board of Inquiry, so that there would be absolutely no doubt that such a power exists."

As described below, section 25 of the State Bank Act is just such a statutory power.

At page 328-329 of "Royal Commissions and Boards of Inquiry", the author continues:

"The executive government has power to establish inquiries for the purpose of ascertaining whether there have been breaches of the criminal law. It can also require that Commissions and Boards report the names of persons who are found to have committed specific breaches of the law. Inquiries which have this function invariably adopt an inquisitorial procedure; and it is inquiries of this nature which are the most likely to cause injustice to or prejudice against individuals ... A strong argument that Commissions and Boards should not be used to ascertain whether individuals have committed crimes is the decision in Cock and Others v The Attorney-General and Another ((1909) 28 NZLR 405). The Court of Appeal in New Zealand held that it was unlawful for the Governor to appoint a Commission of Inquiry to investigate whether an offence had been committed. It has already been seen that in Australia the High Court has taken the opposite view."

The position in Australia is, then, that the Governor can validly appoint me to inquire into, and report on, a possible breach of legal duties and obligations by any person. As noted by the learned author quoted above, such an inquiry does involve a risk of injustice and prejudice, which is precisely why my inquiry has been so exhaustive, and why I have observed rigorously the principles of natural justice and procedural fairness.

Since the Governor has the power to appoint me to investigate and report in respect of legal matters, the issue of my power to conduct an investigation of, and to make findings and reach conclusions in respect of legal rights becomes one of the meaning of section 25 of the State Bank Act, and of my Terms of Appointment. In particular:

(a) is there any limitation in section 25 of the State Bank Act pursuant to which I was appointed which precludes the Governor from appointing me to make such findings or reaching such conclusions? and

(b) do my Terms of Appointment contain such a limitation?

27.4.4.4 Section 25 of the State Bank Act

I am firmly of the view that there is nothing in section 25 which, expressly or by implication, precludes the Governor from appointing me to report in respect of legal matters, including the legal rights, duties and possible breaches of legal duties by any relevant persons. Nor does that section constrain me from acting as the Governor directs.

Sub-section 25(1) provides that the Governor may appoint the Auditor-General, or some other suitable person, "to make an investigation and report under" the section. It is important to note that there are no limitations in sub-section 25(1) on the matters in respect of which the Governor may require an investigation and report. It is a grant of power, at large, to appoint an investigator. As was described above, the common law in Australia does not preclude the Governor from requiring an investigation of a person's compliance with the law.

Indeed, sub-section 25(2) (as amended on 3 December 1992) which requires me to investigate and report on such matters as are determined by the Governor, expressly provides that such matters may include questions of law. Sub-section 25(2)(a) provides:

"...(2) An investigator so appointed -

(a) must investigate such matters relating to the operations and financial position of the Bank or the Bank Group as are determined by the Governor, which matters may include -

(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,

(b) may investigate a matter of the kind referred to in sub-paragraph (i) or (ii) that the investigator has not been required by the Governor to investigate if, in his or her opinion, the matter should be investigated."

Thus, sub-section 25(2) is an express statutory requirement that I form an opinion in respect of whether a person has breached the law, or failed to exercise "proper care and diligence". Paragraph 25(2)(b) empowers me to do so in respect of matters not required by the Governor.

It is significant too that sub-section 25(7) provides me with the inquisitorial powers of the Public Finance and Audit Act 1987, powers of the kind associated with an investigation of legal rights, as noted by the author of "Royal Commissions and Boards of Inquiry" quoted above.

27.4.4.5 My Terms of Appointment

Since the Governor is not constrained either by common law or by section 25 from requiring me to investigate and report on potential breaches of legal duties or obligations, the issue becomes, simply, whether the Terms of Appointment require me to do so.

In my opinion, my Terms of Appointment both authorise and require me to report in respect of legal matters, including particularly the discharge by directors and officers in respect of their legal obligations of reasonable care and diligence.

Term of Appointment A(h) is expressed in precisely the same terms as sub-paragraphs 25(2)(a)(i) and (ii) of the Act, quoted above. The Governor has therefore expressly directed me to investigate and report in respect of legal matters, and is authorised by the State Bank Act to do so.

Further, Term of Appointment C requires me to investigate and inquire into, and report on, whether the operations, affairs and transactions of the Bank and the Bank Group were "adequately or properly" supervised, directed and controlled by, among others, the Board of Directors of the Bank and the directors and officers of Beneficial Finance.

This unavoidably raises the question of the standard of "adequate" and "proper" that will be applied in evaluating the performance of directors. The same question is raised by the use of the word "proper" in sub-paragraph 25(2)(a)(ii) of the State Bank Act.

In my opinion, fairness and reasonableness both require that the standard should be that established by the law. It would be unfair to the directors to apply some higher standard - for example, the standard of adequacy based on hindsight, or of some idealised expert banker - and it would be perverse and contrary to common sense to apply a standard of "adequate" and "proper" that was less than the law requires. The only reasonable standard of "adequate" and "proper", in my opinion, is the standard established by the law.

Further, the necessary implication of the submission on behalf of the non-executive directors in this respect is contrary to common sense. According to the submission, I cannot apply the standard prescribed by the law in evaluating whether the non-executive directors performed their functions adequately or properly, since to do so would involve an ultra vires exercise of quasi judicial powers. Accordingly, I can apply any standard of "adequate" and "proper", except that required by the law. A result so contrary to common sense cannot be accepted as correct.

27.5 AN OVERVIEW OF MY REPORT ON THE EXTERNAL AUDITS

27.5.1 MY TERMS OF APPOINTMENT

The Terms of Appointment of my Investigation require me to inquire into and report on the audits of the accounts of both the Bank and Beneficial Finance. Term of Appointment B states:

"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 ... were appropriate and adequate".

Answering Term of Appointment B required me to:

(a) investigate the procedures carried out by the external auditors, and to determine whether those procedures were proper; and

(b) determine whether the information elicited by the auditors provided a proper basis for the opinion which they expressed in each of the years under review.

I consider that Term of Appointment B requires me to have regard to the view which would be likely to prevail in the profession.

The Investigation was, conducted by way of a detailed review of the working papers of the auditors, with the co-operation and assistance of the auditors. I have approached the Investigation on the basis that I am not required to conduct a fresh audit of the accounts of the Bank or Beneficial Finance. As a result of matters arising out of the Investigation, however, I am able to make a finding that the accounts did not give a true and fair view by reason of exceptions specifically noted.

I draw support for my conclusions from the pronouncement of the Professional Accounting Bodies in Statement of Auditing Standards AUS1, which provides in part:

"3. This statement of Auditing Standards describes the basic principles which govern the auditor's professional responsibilities and which must be complied with whenever an audit is carried out ...

4. An audit is the independent examination of financial information of any entity ... when such examination is conducted with a view to expressing an opinion thereon ...

6. The Standards set out in this Statement are mandatory ...

21. Auditors shall obtain sufficient appropriate audit evidence through the performance of compliance and substantive procedures to enable them to draw reasonable conclusions therefrom on which to base their opinion on the financial information."

Apart from the statutory duties relevant to the auditors of Beneficial Finance, an external auditors' responsibilities concerning the audit process are set out in the applicable pronouncements of the Professional Accounting Bodies, and in the common law. The following is a summary of the salient points:

(a) In forming the audit opinion, the auditors must perform sufficient tests to obtain reasonable assurance that the financial information is properly stated in all material respects, that is, that transactions have been properly recorded in the accounting records, and that transactions have not been omitted.

(b) Internal controls may contribute to the reasonable assurance the auditor seeks, and audit procedures must include an evaluation of the accounting systems and internal controls upon which the auditor chooses to place reliance in determining the nature, timing and extent of substantive audit procedures.

(c) While it is not the purpose of the audit to determine the adequacy of internal controls for management purposes, the auditors must inform Management, or in certain cases the Board of Directors, of any material weaknesses in internal control and accounting procedures of which the auditors become aware during the course of the audit.

(d) The auditors must obtain appropriate and sufficient audit evidence through the performance of compliance and substantive procedures from which they could reasonably draw conclusions and base their opinion concerning the accounts and financial position of the reporting entity.

(e) The auditors must bring to bear on the work they have to perform that skill, care and caution which a reasonably competent, careful and cautious auditor would use. What is reasonable skill, care and caution will be all determined by the circumstances.

I have assessed the appropriateness and adequacy of the external audit by reference to what I consider to be the ordinary standard of skill, care and caution which a reasonably competent auditor would bring to bear. In forming my views, I have had regard to applicable professional standards and practices.

I have considered submissions from the Bank's external auditors that Term of Appointment B should be interpreted to mean that an adverse finding cannot be made unless I am able to conclude that no reasonably competent auditor could have expressed the opinion which the auditors expressed, and that the incorrect opinion was a contributing cause to the financial position of the Bank and Bank Group as reported in February 1991. Such a finding would, in my view, correspond with a finding on the principal elements of a cause of action against the auditors for negligence. In my opinion, Term of Appointment B does not require this. A professional person may be wrong without being negligent. In my opinion, Term of Appointment B requires me to assess the appropriateness and adequacy of the external audit having regard to what a reasonably competent auditor should have concluded to be proper in the circumstances. It is for others to determine whether there has been negligence on the part of the auditors which caused a loss.

27.5.2 A SYNOPSIS OF MY REPORT ON THE EXTERNAL AUDITS

27.5.2.1 Chapters 45 to 53: The External Audits of the State Bank

(a) Overview and Summary

There were a number of issues that were of particular significance to my Investigation of the external audits of the Bank's accounts in the years reviewed. They were:

Provision for Doubtful Debts

Financial institutions make provisions in their accounts for losses incurred in respect of loans and advances. These provisions are commonly divided into two types, specific and general. Specific provisions relate to identified loans where there is a recognition that a loss has probably been incurred. Where it is anticipated that the amount which is reasonably likely to be recovered will be less than the book value of the loan, then a specific provision should be raised for the shortfall.

General provisions are established to provide for losses within the loan portfolio which have not been specifically identified.

The provision for doubtful debts appearing in the State Bank's accounts was comprised by:

(i) A specific provision relating to an assessment of recoverability of individual loans; and

(ii) A general provision relating to the perceived credit risk inherent in the Bank's corporate, treasury and retail operations, calculated by applying risk percentages to outstanding balances and commitments for different categories of exposure.

Superannuation Provision

The 1987 accounts of the Bank recorded, at note 7, that the Provision for Superannuation of $57.7M, and the Provision for Retiring Allowances of $16.7M, were transferred to the State Bank of South Australia (Provisions) Trust as at 1 July 1987. Such a transfer never took place.

In March 1987, the Bank's Board had agreed to move the Bank's superannuation provisions off the balance sheet by transferring corresponding assets into a separate superannuation trust fund, and a draft trust deed to give effect to this was approved. The accounting procedures to transfer the assets off the balance sheet were implemented on 1 July 1987. The trust deed which had been prepared was not executed at that time. The Board then decided, late in July 1988, to rescind their earlier decision to approve a trust deed, and instead to operate the Fund as if it were a separate entity within the Bank's financial statements.

The external auditors have submitted that assets comprising land and buildings, investments in debentures, and deposits, were identified as being superannuation fund assets which were sufficient to cover the superannuation liabilities as determined by the public actuary. The external auditors also submitted that the income from these assets has, since 1988, always been credited to the Provision for Superannuation, and that the Provision for Superannuation has also borne the expenses of the property assets. The external auditors submitted that:

"In the joint auditors' opinion, all actions taken by the Board since 1988 have clearly demonstrated that the original intentions of the proposal have been put into effect. All rights and interests in the assets designated to meet the superannuation liabilities have been reserved, and all income and other benefits arising from those assets has been credited to the Fund. The details of the assets held to meet the superannuation liability are set out in the notes to the accounts. In summary, the Superannuation (Provisions) Trust Fund has operated and been accounted for as if it had been separately established outside the Bank, and the intention of the original proposal has been preserved".

The external auditors submitted that a trust had been created, which was effective to transfer beneficial title in the assets from the Bank for the benefit of employees entitled to superannuation benefits, such that the relevant assets would not have been available to creditors of the Bank, but that it was, nevertheless, appropriate for the Bank to include such assets in its own balance sheet.

Having reviewed these submissions, I am not satisfied that it was appropriate for the joint auditors to accept that the Provision for Superannuation, and corresponding assets in the books of the Bank, constituted a separate fund. In my opinion, it was inappropriate for the joint auditors to accept the Bank's treatment of income of the relevant assets and revaluation increments as an accretion to the Provision for Superannuation. The Provisions for Superannuation represented a liability of the Bank to pay superannuation benefits to employees. It follows, in my opinion, that the external auditors should have carried out appropriate procedures to ensure that the liability was not materially misstated in the accounts.

To the extent that the Provision for Superannuation may have been under-stated, it would have been appropriate to make an additional charge against profits for the year, and a failure to do so would mean that profits for the year would be over-stated.

State Government Taxation Charge

The Bank is required to pay, out of its profits, an amount to the State Government in lieu of Federal income tax. This a is statutory obligation, and is not a matter over which the Bank has a power to make recommendations, as is the case with other payments to the State Government representing returns on investment.

It is a generally accepted accounting principle that an entity's net profit for a reporting period should be presented after deduction of all expenses, including taxation.

The Profit and Loss Statement of the Bank for the years ended 30 June 1985 and 1986 disclosed the amount described as "State Government Tax" as a deduction from operating profit before tax in arriving at the operating profit after tax. The Bank calculated the future income tax benefit and the deferred tax liability appearing in the accounts for those years in accordance with Australian Accounting Standard "Accounting for Income Tax (Tax-effect Accounting)".

For the 1987, 1988 and 1989 years, however, the Bank changed the presentation of State Government tax in its accounts. Although the amount was calculated in the same manner as in 1985 and 1986, and the notes to the accounts stated that the Bank adopted tax- effect accounting principles, the State Government tax for those years was not shown as a deduction from the operating profit before tax, but rather included in the amount disclosed as a distribution to the State Government. As there was no State Government tax payable for 1990, there was no effect of this presentation on the 1990 accounts. The effect of this presentation for years 1987, 1988 and 1989 was to charge the tax relating to those years' profit against accumulated profits, rather than being taken into account when calculating the annual profit. This presentation is contrary to generally accepted accounting principles, and to the requirements of Australian Accounting Standard AAS1.

For the year ended 30 June 1991, the Bank reverted to its practice in 1985 and 1986, and disclosed the State Government tax as a deduction from the operating profit before tax, separately from the distribution to the Government.

In my view, the substance of the State Government tax payment is that of a charge in the nature of income tax and thus an expense, and that it was, therefore, appropriate that its treatment in the Bank's accounts should reflect that nature in the manner adopted by the Bank in its 1985, 1986 and 1991 accounts.

I have concluded the Bank's accounts for 1985, 1986 and 1991 were in accordance with the applicable accounting standards, while those of 1987, 1989 and 1990 did not follow the applicable standard.

The effect of treating the tax-equivalent payments as distributions of income was to overstate the operating profit after tax by the amount of the obligations so treated.

Concessional Housing Reserve

The Concessional Housing Reserve was raised in connection with the concessional housing scheme, a service provided by the Bank as part of the State Government's "House Ownership made Easy Program". The scheme provided low interest mortgage loans to assist low income earners to buy a home. Annual movements in the Reserve were meant to reflect the difference between the interest received by the Bank from loans under the scheme, and the interest paid on funds provided by the State Government, less administration and commission taken by the Bank.

The accounts of the Bank treated the surplus arising from the scheme as forming part of the capital and reserves of the Bank, when in fact that surplus should have been set aside in trust to be applied for housing purposes as directed by the State Government.

The joint auditors submitted, and I accept, that a trustee need not keep trust funds separate from its own assets if permitted by the terms of the trust. Nevertheless, in my opinion, it is not appropriate for the trustee to account for such funds as if the trustee were entitled to the whole of the benefit of the funds. In the case of the Concessional Housing Reserve, it appears that the Bank was obliged to apply the surplus for subsidies, remissions and further lending at concessional rates under the concessional housing scheme as directed by the State Government.

In my opinion, the subsequent application of the reserve, by way of transfer to the Bank's capital at the direction of the State Government, supports the view that the Bank was not otherwise entitled to the funds.

(b) Findings and Conclusions

(i) For the reasons set out in Chapters 45 - "Review of the 1985 External Audit of the State Bank" to Chapter 51 - "Review of the 1990 External Audit of the State Bank", the audit opinions expressed by the joint auditors, known on 30 June 1990 as KPMG Peat Marwick and Touche Ross & Co, on the accounts of the Bank and the Bank Group for the years ended 30 June 1985 to 1990 inclusive were inappropriate, and the carrying out of the audit process leading to those opinions was inadequate, in the specific respects set out in those Chapters.

(ii) For reasons set out in those chapters, the accounts of the Bank and the Bank Group for the years ended 30 June 1985 to 1990 inclusive failed to give a true and fair view of the results and affairs of the Bank and the Bank Group.

(iii) The more significant inadequacies were:

. Provision for Doubtful Debts - The provision was materially understated in 1989 and 1990. I am not satisfied that the provision was adequate in 1988.

. Superannuation Provision - The asset revaluation reserve of the Bank was materially understated, and it was likely that the Superannuation Provision was materially understated, with a consequent material overstatement in profits, in the years 1988 - 1990 inclusive.

. State Government Charge in Lieu of Federal Income Tax - The change in accounting treatment of this item resulted in a material overstatement of net profit for the years 1987 to 1990.

. Concessional Housing Reserve - The reserves of the Bank were materially overstated in the years 1985-1988 inclusive.

27.5.2.2 Chapters 54 to 60: The External Audits of Beneficial Finance

(a) Overview and Summary

The Investigation assessed the appropriateness and adequacy of the external audits of the accounts of Beneficial Finance Corporation Limited and its subsidiaries for the years ended 30 June 1985 to 30 June 1990.

It is important to emphasise that the year by year assessment of the audits undertaken by my Investigation did not take the form of a re-performance of the audits of the accounts. The investigation entailed the review and evaluation of the audit process applied by the external auditor in each year in relation to the accounting records and the accounts of Beneficial Finance, including the procedures adopted by the auditors with regard to planning of the audit, execution of the audit, and concluding and reporting on the audit.

It must also be borne in mind that the investigation of the external audit process is not the same as an assessment of the accuracy of the accounts of Beneficial Finance. For example, if the external auditor's conduct of the audit had been inadequate, the only conclusion that could be drawn with confidence would be that there was not a proper basis for the audit opinion expressed by the auditor. Whether the accounts comply with the statutory requirements, and give a true and fair presentation of the entity's results of operations and financial position, would depend upon other matters. Conversely, it is conceivable that the conduct of the audit might have been adequate, without the auditor detecting an error or irregularity in the accounts.

The review and evaluation of the annual audit process included an analysis of the external auditor's audit methodology, review of external audit evidence obtained and documented in the external auditor's working papers and correspondence between Beneficial Finance and the external auditor, and direct inquiry of external auditors engaged on the audits of Beneficial Finance. Conclusions drawn in relation to the appropriateness and adequacy of the external audits were made having regard to the Professional Accounting Bodies' Accounting and Auditing Standards and the statutory requirements applying at the relevant times.

(b) Findings and Conclusions

(i) For the reasons set out in Chapters 57 - "Review of the 1988 External Audit of Beneficial Finance" to Chapter 59 - "Review of the 1990 External Audit of Beneficial Finance", the audit opinions expressed by Price Waterhouse on the accounts of Beneficial Finance and of the Beneficial Finance Group for the years ended 30 June 1988 to 1990 inclusive were inappropriate, and the carrying out of the audit process leading to those opinions was inadequate, in the specific respects set out in the those Chapters.

(ii) For the reasons set out in those Chapters, the accounts of Beneficial Finance and the Beneficial Finance Group for the years ended 30 June 1988 to 1990 inclusive failed to give a true and fair view of the results and affairs of Beneficial Finance and the Beneficial Finance Group.

(iii) In summary, the inadequacies were:

. The failure to disclose, by way of a note to the accounts in each of the years ended 30 June 1988 to 1990 inclusive, the impact of the results and affairs of Beneficial Finance's off-balance sheet entities on the results and affairs of the Beneficial Finance Group, in particular the nature and extent of Beneficial Finance's direct property exposures through the off-balance sheet entities, and their contribution of a $7.7M loss to the Beneficial Finance Group result in 1990.

. The failure to disclose, in the accounts for the year ended 30 June 1988, the $8.3M profit from Blossom Park as an abnormal item.

. The failure to make a doubtful debt provision in the accounts for the year ended 30 June 1990 in respect of Beneficial Finance's $24.2M exposure in respect of Somerley.

(iv) Other than in the specific respects referred to above, the external audits of the accounts of Beneficial Finance and the Beneficial Finance Group for the years ended 30 June 1985 to 1990 inclusive were appropriate and adequate. Planning and execution of the audits, and preparation of working papers, was generally of a high professional standard.

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27.6 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;

(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;

(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

CHAPTER 27 CONCLUSIONS, FINDINGS AND RECOMMENDATIONS OF THE INVESTIGATION INTO BENEFICIAL FINANCE CORPORATION LIMITED AND THE EXTERNAL AUDITS OF STATE BANK AND BENEFICIAL FINANCE CORPORATION LIMITED

27.1 INTRODUCTION

27.2 THE INVESTIGATION INTO, AND REPORT ON, BENEFICIAL FINANCE

27.3 AN OVERVIEW OF MY REPORT ON BENEFICIAL FINANCE

27.4 THE LAW APPLICABLE TO BENEFICIAL FINANCE

27.5 AN OVERVIEW OF MY REPORT ON THE EXTERNAL AUDITS

27.6 APPENDIX

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CHAPTER 27
CONCLUSIONS, FINDINGS AND RECOMMENDATIONS OF THE INVESTIGATION INTO BENEFICIAL FINANCE CORPORATION LIMITED AND THE EXTERNAL AUDITS OF STATE BANK AND BENEFICIAL FINANCE CORPORATION LIMITED