VOLUME SIX
THE MANAGEMENT OF CREDIT: CASE STUDIES

 

 

CHAPTER 13
CASE STUDY IN CREDIT MANAGEMENT: SOMERLEY PTY LTD

 

 

TABLE OF CONTENTS

13.1 REFERENCE INFORMATION

13.2 BACKGROUND TO THE ACCOUNT
13.2.1 COMPANY HISTORY AND STRUCTURE
13.2.2 BACKGROUND TO THE FACILITY
13.2.3 ORIGINAL $30.0M BRIDGING LOAN
13.2.4 $55.0M PARTICIPATION IN A $190.0M FIRST TIER SYNDICATED LOAN FACILITY
13.2.5 $91.5M FACILITY ARISING FROM THE BUY OUT OF THE FIRST TIER SYNDICATE IN JULY 1990 AND SUBSEQUENT FUNDING OF THE PROJECT

13.3 CHRONOLOGY

13.4 COMPLIANCE WITH POLICIES AND PROCEDURES
13.4.1 INITIATION OF FACILITY
13.4.2 APPROVAL OF FACILITY
13.4.3 SECURITY
13.4.4 HINDSIGHT OVERVIEW
13.4.5 ADVANCE OF FUNDS
13.4.6 MANAGEMENT OF FACILITY
13.4.7 MANAGEMENT OF NON-PERFORMING FACILITY
13.4.8 CREDIT INSPECTION

13.5 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT
13.5.1 TERMS OF APPOINTMENT A
13.5.2 TERM OF APPOINTMENT C
13.5.3 TERM OF APPOINTMENT D

13.6 RECOMMENDATION ON FURTHER INVESTIGATION OR ACTION

13.7 APPENDICES
A Summary of Movements in Facilities
B Chronology of Events

 

 

13.1 REFERENCE INFORMATION

The following information on the facility in favour of Somerley Pty Ltd (Receivers and Managers Appointed), which facility is referred to in this Chapter as "the Somerley facility", is set out for reference purposes:

REFERENCE INFORMATION
Account Name . Somerley Pty Ltd (Receivers and Managers Appointed)    
Directors

at 8 April 1988

(being date of initial proposal)

. Mr A Gostin; and

. Mrs J Gostin.

   
Industry Sector . Property Construction and Development    
Facility Type . Construction Facility    
Principal Outstanding at 31 March 1991 . $69.7M    
Unrecognised Income at 31 March 1991 . $9.5M    
Provision for Loss

at 31 March 1991

. $39.6M    
Estimated Loss

at 31 March 1991

. $29.7M    

 

 

 

13.2 BACKGROUND TO THE ACCOUNT

 

13.2.1 COMPANY HISTORY AND STRUCTURE

(a) Somerley Pty Ltd (Receivers and Managers Appointed) was incorporated in Victoria on 14 June 1984. The company came to be used as a specific purpose vehicle through which was to be undertaken the development and construction of a four to five star hotel/carpark/retail complex on a site situated at the corner of Bourke and Exhibition Streets, Melbourne. The hotel was originally to be known as the Palladium Hotel, but, by the time of the Bank's first involvement, was intended to be named either the Eden Hotel or the Eden Melbourne Hotel, and was then expected to be managed by a subsidiary of the Interwest Group.

(b) The ownership structure of Somerley at the point of inception of the initial facility was as follows:

The ownership structure of Somerley at the point of inception of the initial facility

(c) Somerley owned all the land on which the hotel complex was to be erected. That land was contained in 15 Certificates of Title and physically comprised three separate parcels. The major portion was known as the Palladium site and fronted Bourke and Little Bourke Streets. Another two parcels had frontages onto Exhibition Street.

(d) Eblana Nominees Pty Ltd ("Eblana") was at all material times the trustee of the Gostin family trust. Mr A Gostin was a director of Somerley from about the time of its incorporation. Prior to his involvement in property development, he had founded the San Remo liquor chain, which he sold to the Coles Myer Ltd Group. Mr Gostin had previously been engaged in property trading activities in Melbourne.

(e) Pac Prop Developments Ltd ("Pac Prop") was a publicly listed company 50 per cent owned by Interwest Ltd ("Interwest"). Pac Prop was a property developer in the tourism and leisure sector.

(f) Interwest was also a publicly listed company, controlled by the Avram family. Interwest's activities were mainly in hotel ownership and hotel operation through its interests in Pac Prop and two other listed entities, Tourism and Leisure Corporation Ltd ("Tourism and Leisure Corporation") and Australian Tourism Property Trust. It owned or controlled a substantial number of hotels operating under various names throughout Australia. It had no income sources external to the tourism industry. It was part of a group of companies known as the Interwest Group which comprised, in addition, Pac Prop Developments Ltd, Australian Tourism Property Trust, Tourism and Leisure Corporation and MGH Ltd. Mr J Avram was a Director of Somerley from 1 August 1988.

(g) A unit trust known as the Somerley Unit Trust was also involved. Units in it were held by the same entities and in the same proportions as shares in Somerley. Little is disclosed by the Bank's files about its affairs.

(h) Tourism and Leisure Corporation was involved in the management of hotels, resorts and serviced apartment buildings. At the commencement of the Somerley facility, Tourism and Leisure Corporation managed twelve properties, and had contracted to manage a further five. Tourism and Leisure Corporation was also the designated operator for the hotel component of the development being undertaken by Somerley.

(i) Australian Tourism Property Trust invested in tourism and leisure related freehold properties.

(j) Interwest's involvement in the Somerley development, therefore, was not restricted to its interest, through Pac Prop, in Somerley. Its subsidiary, Tourism and Leisure Corporation, was intended to be the operator of the completed hotel. Interwest had given certain cost overrun guarantees in favour of Beneficial Finance Corporation Ltd ("Beneficial Finance Corporation").

(k) Tricontinental Group held a 10 per cent interest on a "special" equity basis. It was, unlike the other shareholders in Somerley, not exposed to recourse under Somerley's borrowings. Its 10 per cent holding was held at the request of Eblana and Pac Prop in order to enable a senior representative of Tricontinental Group to mediate in any disputes between those joint venturers. The shareholding was to be transferred in equal proportions to the other shareholders at the termination of the facility. Ultimately, Tricontinental became a subsidiary of the State Bank of Victoria; it became totally reliant upon its parent Bank for support, and was absorbed into the State Bank of Victoria.

13.2.2 BACKGROUND TO THE FACILITY

The background to this facility is best described by reference to the three distinct advances made by the Bank. These were:

(a) An initial $30.0M bridging loan by the Bank drawn down in April 1988 before construction activities commenced.

(b) A $55.0M participation in a $190.0M First Tier Syndicated loan facility ("First Tier Syndicate" and/or "FTS"), effective from September 1989 being a syndicate formed to provide finance during the construction phase.

(c) A $91.5M facility arising from the buy-out of the First Tier Syndicate, in July 1990, after Somerley and Interwest had become insolvent, and the subsequent funding of the project throughout the construction phase.

The background as it relates to each of the above is set out below.

13.2.3 ORIGINAL $30.0M BRIDGING LOAN

The Bank's Melbourne office was invited by Beneficial Finance Corporation - then a wholly owned subsidiary of the Bank - to participate in a facility to finance the acquisition by Somerley of a commercial site situated on the corner of Bourke and Exhibition Streets, Melbourne.

The cost of the site, inclusive of capitalised interest and costs, was of the order of $60.0M. Somerley was to contribute $11.0M. Finance was sought for the remainder. The Beneficial Finance Corporation Board had approved funding of $49.0M, and was seeking the Bank's participation to the extent of $30.0M, thus reducing its own exposure to $19.0M.

A submission recommending the facility to the Lending Credit Committee was prepared by Mr P W Walkom, Senior Corporate Manager (supported by Mr J V Henderson, State Manager, Victoria and Tasmania). The Lending Credit Committee approved the recommendation and submitted the proposal to the Board Sub-Committee which, on 11 April 1988, approved the granting of the facility. The Board "confirmed" the approval on 20 April 1988.()

Under the terms of the facility, the Bank had a first charge over the site. The site had been valued by Colliers International Property Consultants Limited ("Colliers") at $55.0M. Finance was extended for a period of six months. The proposal stated that the Bank anticipated being paid out when the construction phase finance package was put in place. The lending submission, however, also referred to the possibility of the Bank being a member of the mooted syndicate by which construction finance would be provided.

Although the loan term was originally scheduled to terminate in October 1988, delays occurred in arranging the construction phase finance. As a result, successive extensions of the facility were granted through to September 1989. The syndicated loan was in fact settled, and the original loan repaid, on 26 September 1989.

13.2.4 $55.0M PARTICIPATION IN A $190.0M FIRST TIER SYNDICATED LOAN FACILITY

(a) On 9 August 1988, a proposal was submitted to the Lending Credit Committee that the $30.0M facility be replaced by a $60.0M facility to assist in financing the construction of the proposed hotel complex. The proposal was prepared by Mr P Davenport, Corporate Analyst, recommended by Mr Walkom, and supported by Mr Henderson.

(b) The $60.0M facility was to represent the Bank's participation in the First Tier Syndicate to which I referred in Section 13.2.2 (b). In turn, the First Tier Syndicate was to form part of the overall construction finance package envisaged in August 1988 to comprise the following:

$M

First Ranking - Syndicated Facility 180.0
Second Ranking - Beneficial Corporation and Tricontinental Corporation Ltd (ranking pari-pussu) 45.0
Third Ranking - Sponsors equity 11.0
236.0

(c) The term of the facility was to be 31 months with completion of the project estimated to be June 1991. Interest was to be capitalised during this time, with repayment of the principal to be effected from the sale proceeds. Total cost of the project, including interest, was estimated to be $236.0M. The submission of 9 August 1988 proceeded on an estimated value upon completion, based on a valuation by Colliers dated June 1988, of $275.0M. The Colliers valuation assumed that the whole of the hotel income would be available to the building owner, that is to say, that there would be no management agreement in favour of a third party. That assumption may have been applicable at the date of the original proposal in April 1988, but it was not applicable at the time when construction finance was approved. At that stage, it was given that the hotel would be managed by a third party (a publicly listed subsidiary of Interwest) and that the car park would be operated by a third party (Hoyts Carparks Pty Ltd). It was submitted to the Investigation on behalf of a number of Bank officers that the assumption made in the Colliers Valuation was appropriate because of the close corporate relationship between Interwest, Somerley and other entities involved (or to become involved) in the construction and (later) the operation and ownership of the hotel. I cannot accept that the assumption to which I have referred was appropriate simply because Somerley was partly owned by a member of the Interwest Group. The date of completion projected in the valuation was 1 July 1991.

(d) The Colliers valuation relied on and largely adopted a report, prepared by Peat Marwick Hungerfords in March 1988, on retainer from Somerley. The valuation and the report each projected an operating surplus for the hotel in its first year of operation of $1.6M, before interest. The Peat Marwick Hungerfords' report() noted that a 10 per cent shortfall in room occupancy would "constrain" both hotel profitability and owner returns. The operating surplus of $1.6M was arrived at after taking into account a payment by the operator to the owner of a guaranteed rental in the sum of $10.0M. The Peat Marwick Hungerfords' report() forecast increasingly fierce competition in the Melbourne hotel market over the period 1988-1993 and that room occupancy rates of approximately 55 per cent (in the first year of trading, 1991/92) and 69 per cent (in 1995-96) were achievable. Within the sensitivity analysis in the report(), the report noted that operating and overhead expenses were largely fixed in nature whilst revenue and departmental expenses were sensitive to changes in room occupancy rates. The report concluded that before depreciation, interest and tax, the hotel could be reasonably expected to generate strong profit and cash flows from its first operating year. It was stressed, however, that attainment of such results necessitated a targeted and well executed pre-opening and ongoing marketing campaign.() Returns were sensitive to occupancy rates and efficient management was said to be critical.()

(e) The report prepared by Peat Marwick Hungerfords was produced to the Bank and was referred to in lending submissions in 1988, but in a selective way. The lending submissions, prepared in 1988, did not adequately and in a balanced way disclose to the Lending Credit Committee the contents of that report. The report noted a noticeable fall in "domestic visitation" in Victoria(), accompanied nevertheless by an increase in the usage of hotels and motels in the 1980's. While expressing concern at the lack of strength inherent in the domestic tourism market in Victoria, it predicted that Victoria would maintain its share of international visitor nights. The report further forecasted a substantial increase in the supply of hotel accommodation in Melbourne, and, on that basis, expressed the view that it was unlikely that the hotel would sustain a substantial market premium.

(f) The Colliers valuation itself adopted the conclusion in the Peat Marwick Hungerfords' report that total additions to four and five star hotel room stock in Melbourne would increase by 43 per cent by 1991, the forecast year of completion of construction of the hotel, while long term room demand growth rate was forecast at 6.1 per cent per annum.() In its financial appraisal(), the Colliers valuation would appear to have assimilated the income of the owner and the operator of the hotel for the purposes of reaching its valuation of the hotel component of the project.

(g) The Lending Credit Committee approved the syndicated loan proposal for submission to the Bank's Board of Directors.() A paper() was subsequently prepared, and presented to the Board, which approved the Bank's participation in the syndicated facility.()

(h) Although the original facility of $30.0M granted by the Bank was due for expiry on 14 October 1988, the syndicated facility was not then finalised. It was stated in a submission dated 29 August 1988 to the Lending Credit Committee (to which submission I refer more fully later) that the sponsors of the proposed syndicated facility, the Tricontinental Group and Babcock and Brown, were experiencing some delays due to matters connected with income tax legislation. The proposed terms of the First Tier Syndicate and its intended composition changed a number of times. Ultimately, there was negotiated an extension of the syndicated facility term to the earlier of 31 March 1996 or the fifth anniversary of the date of practical completion of the building. The Tricontinental Group was also to provide a $50.0M promissory note to repay one syndicate member in full and (as far as concerns $20.0M) to reduce the exposure of certain members of the First Tier Syndicate on satisfactory completion of the project.

(j) Participation in this revised syndicated facility was approved in January 1989 by the Lending Credit Committee and the Board, on the recommendation of Corporate Banking, Melbourne Office and Mr D C Masters.()

(k) Significant delays were experienced in securing participants for the syndicated facility. The original facility, therefore, had to be extended several times by the Bank during this period. Prior to settlement, the Bank undertook a review to ensure that its security position remained unaltered. This included obtaining an updated valuation from Colliers International Property Consultants. Settlement eventually took place on 26 September 1989. The total Syndicated Facility was for an amount of $190.0M. The Bank reduced its participation from the proposed $60.0M to $55.0M for the reason that one of the other participants wished (for reasons not disclosed by the Bank's papers) to commit an extra $5.0M to the Syndicate. But for the reduction in the Bank's level of participation, the Syndicate would have been oversubscribed.

13.2.5 $91.5M FACILITY ARISING FROM THE BUY OUT OF THE FIRST TIER SYNDICATE IN JULY 1990 AND SUBSEQUENT FUNDING OF THE PROJECT

(a) On 30 October 1989, at the request of the Interwest Directors, the Australian Stock Exchange suspended Interwest shares from quotation. This followed market speculation on Interwest, which had seen a significant and sudden decline in its share price.

(b) Following the suspension of Interwest's shares, Mr Walkom and Mr Henderson met on 6 November 1989 with Mr S Schneider and Ms S Ewart, Chairman and Financial Controller of the Interwest Group respectively, to discuss the financial state of Interwest. Mr Schneider advised that State Bank of Victoria, Hong Kong Bank of Australia, Commonwealth Bank of Australia and Australian European Finance Corporation Limited (hereinafter referred to as `the Financiers'), were considering whether to provide further support for Interwest to meet its cash shortfall position. The cash shortfall related to the need, over the previous few months, to use group cash flow to continue work on the Twin Waters Resort which was then being constructed in Queensland by Interwest. Mr Schneider expressed confidence that support from the Financiers would be forthcoming upon Interwest's selling the Twin Waters Resort, the Old Melbourne Hotel and possibly two other smaller properties. Mr Schneider believed that, if the Financiers provided bridging facilities to allow the orderly sale of the properties, then Interwest would have sufficient cash to meet all facilities and to continue trading.()

(c) Subsequently, on or about 8 December 1989, Mr Walkom received from KPMG Peat Marwick Hungerfords Management Consultants a report reviewing the likely market position and room sales revenue of the proposed Eden Melbourne Hotel. The letter from KPMG Peat Marwick Hungerfords under cover of which the report was forwarded, itself expressed the view that the proposed site was well suited to a hotel development, specifically a hotel offering facilities of a four to five star standard. It also expressed the view that room occupancies were expected to improve in the longer term. The report itself noted:

(i) that demand for hotel and motel rooms with facilities in Melbourne had increased at approximately 5.8 per cent per annum in the six years leading up to June 1989, outstripping the 4.1 per cent per annum growth in room supply in inner Melbourne over the same period;

(ii) that equivalent data by star-grading was not available for the six year period concerned, but that the analysis of the data available for the past 2-3 years indicated that demand for four and five star accommodation had increased at more than 9 per cent per annum over that period, again out-stripping the growth in supply over the same period;

(iii) the decline in the level of domestic tourist room occupation in Melbourne in recent years;

(iv) that that trend would not have a significant impact upon demand for four and five star accommodation; and

(v) a decline in the average length of stay of international visitors in Victoria.()

The report forecast a slow-down in growth in the strength of the domestic economy, and, accordingly, in corporate demand for accommodation, the mid-week staple for the majority of inner Melbourne four and five star hotels.() Nevertheless, longer term growth was predicted. It also forecast growth in the convention and short-term holiday segments of the market. In paragraph 2.2, it predicted an increase in supply of four and five star rooms at 6 per cent per annum over the decade of the 1990's in contrast to a significantly higher growth rate in the medium term. It also forecast a rapid expansion in rooms to be supplied between 1989-90 and 1992-93; the majority of that expansion would be in the four star category concentrated in the inner Melbourne area. It noted a significant increase in the planned additions to the supply of rooms likely to compete directly with the Eden Melbourne since the completion of the March 1988 Report.() As of March 1988, some 1,603 competitive rooms were forecast to have been added to Melbourne's stock of rooms by 1990-91, whereas the December 1989 forecast predicted a supply of 2,482 additional rooms. In paragraph 2.3(), it was concluded that the rapid growth in room supply would impact upon the occupancy ratings of all four to five star establishments. Accordingly, it predicted that occupancy rates would be relatively low until the mid 1990's, but would improve over time.() The report pre-supposed that the Interwest group would operate the proposed hotel.() It expressed concern about the hotel's ability to achieve and maintain high room occupancy rates with 460 rooms, and predicted a need for substantial discounting. It projected occupancy rates of from 49 per cent in 1990-91 to only 53 per cent in 1994-95.() In particular, the hotel room occupancy rates were projected to be under 50 per cent for the hotel's first three full trading years, in light of the rapid growth of rooms supplied in Melbourne. Thus, the projected occupancy rates were significantly lower than those forecast in the March 1988 report.()

The report also forecast slow growth in room occupancy rate and room rates charged, resulting in poor revenue from the hotel's rooms department.

(d) On 9 January 1990, a syndicate of lenders, of which the Bank was not a participant, issued a Notice of Demand upon Interwest to immediately repay an amount exceeding $80.0M. Interwest was unable to do so and accordingly, on 9 January 1990, Interwest was placed into receivership, with KPMG Peat Marwick appointed as Receivers and Managers.

The appointment of Receivers and Managers to Interwest was a default under the Syndicated Facility Agreement in respect of the Somerley transaction, to which the Bank was a party. Consequently the Bank, as Agent for the First Tier Syndicate advised Somerley of its termination of the "Total Commitments" of the First Tier Syndicate under that facility, and of all other obligations of the syndicators. It made written demands on 11 January 1990 for the immediate payment of all amounts due or owing under the Syndicated Facility Agreement.() On the failure of Somerley to comply with the demand upon it, Coopers & Lybrand were appointed to act on behalf of the Syndicate and to take possession of, and realise, the secured property. Building work thereupon ceased. The First Tier Syndicate required the Second Mortgage Syndicate (Beneficial Finance Corporation and the State Bank of Victoria) to repay the amount actually advanced by the First Tier Syndicate, some $45.0M. At that stage, the Second Mortgage Facility was fully advanced at $45.0M.

(e) On 10 January 1990, Mr Walkom received from KPMG Peat Marwick Management Consultants an updated financial analysis of the Eden Melbourne Hotel development. The letter under cover of which this analysis was received concluded that the hotel was well sited and was likely to draw support from a number of markets in the long term. The letter expressed the view that, on the premise that the hotel's guaranteed rental, as presented in the analysis, incorporated provision for financing costs, KPMG Peat Marwick expected the hotel to provide "acceptable returns by industry standards". This report concluded() that the hotel was unlikely to generate substantial profits and cash flows in its initial years of operation.

(f) On 2 January 1990, Mr Walkom had received an updated valuation from Colliers.() This was in response to his letter of request of 14 November 1989. Colliers expressed the view that it was unlikely that a "buyer would be attracted to the present property at more than approximately $50.0M". It also expressed the view() that a value on completion could not be put at more than $200.0M, based on the revised figures in the December 1989 Peat Marwick Report. It referred to a fall of property values of up to 30 per cent during previous economic downturns in Australia, and expressed the view that "virtually all properties have fallen in value by at least 10 per cent and many have fallen up to 30 per cent" since early 1989. At page 3(), it expressed the view that, with full excavation of the basement having occurred, a point of no return had been reached as far as construction of the car park was concerned, and that one option available was to construct the car park and perhaps the retail component, and then suspend works for the time being on the hotel component. The letter of valuation then indicated that Colliers knew of certain possible purchasers of the hotel. A final comment in the letter was that it was a very bad time to contemplate the sale of the property, for the reason that property market conditions had deteriorated markedly, and the income projections in the most recent Peat Marwick Report had magnified the reduction in value of the hotel. It expressed the view that the present value of the site, including that of work done to date, was extremely difficult to determine, and was further complicated by what Colliers understood to be a very advantageous building contract.

(g) Beneficial Finance Corporation then conducted an analysis of the various options available to it to recover its exposure, and concluded that the best option was to make an offer for the First Tier Syndicate debt, and to continue the project to completion. An initial offer of fifty cents in the dollar was put forward. This was rejected by the First Tier Syndicate. Coopers & Lybrand prepared a report to the First Tier Syndicate, commenting on the state of the project, the cost of completion to various stages, and the likely selling values of the hotel.() The report concluded that Beneficial Finance Corporation and State Bank of Victoria should be allowed the opportunity to take out the First Tier at or very close to the total exposure of the First Tier Syndicate. If this was not forthcoming, urgent consideration was to be given to completing the contract to an intermediate or final stage, whilst at the same time seeking buyers for the separate stages of the total project.

In February 1990, Jones Lang Wootton had prepared a report and valuation of the proposed Hotel complex for the State Bank of Victoria. A copy of this report and valuation was found on the State Bank file. Its contents and purport were known to Mr Walkom by 7 February 1990.()

The Jones Lang Wootton report imputed two alternative values to the project as at the estimated completion date, namely 1 April 1991. The two alternative values each approximated to $145.0M. The alternative values were derived from competing assumptions as to the management arrangements made in relation to the hotel. One basis of valuation was that the hotel would be available for sale with vacant possession. The alternative basis was that the hotel would be offered for sale with a management agreement in place). But each basis of valuation made the further assumptions (i) that the retail component of the site was fully let and (ii) that the car park was subject to a lease to a car park operator. It valued the car park component at $28.0M.() The report expressed some doubt() as to whether the level of room rates projected by KPMG Peat Marwick in their more recent reports, would be achieved. It expressed the view that cost estimates suggested by KPMG Peat Marwick in respect of the food and beverage department might be too low.()

(h) Recommendations were subsequently made (on 26 February 1990() and 20 March 1990)() to the Bank's Board of Directors to approve the provision of facilities to Beneficial Finance Corporation to enable it to pursue what it perceived to be its best option -that of paying out the First Tier Syndicate and proceeding with construction of the hotel. By the second of those two recommendations, the Board was asked to formalise an offer to the First Tier Syndicate to purchase its existing debt at the rate of 95 cents in the dollar, with discretion to pay up to 100 cents in the dollar being given to the Group Managing Director, at a total consideration of $42.7M to $45.9M. Approval was also recommended for the provision of additional facilities of $19.5M to enable completion of the car park and partial retail components of the project. The second proposal stated that Beneficial Finance Corporation's exposure of $24.0M could be recouped only by completion of the project in full. The First Tier Syndicate, the proposal claimed, would not adopt that approach and, therefore, Beneficial Finance Corporation's only avenue to ensure maximum debt recovery was to take control of the project by paying out the First Tier Syndicate. The recommendations of 26 February 1990 and 20 March 1990 were each approved by the Board.() Mr M G Hamilton then took over management of the Somerley facility() exercising what he described as "an overall watching brief and co-ordinating role over the account".

The offer of 100 cents in the dollar was subsequently accepted by the First Tier Syndicate, which included the Bank. The Bank was therefore "repaid" an amount of the order of $13.0M, being the extent of the funds which it had advanced as a member of the Syndicate.

The approval of the Board having been gained for the lending of moneys to Beneficial Finance Corporation to facilitate the First Tier Syndicate buy-out and continued construction of the first stage of the hotel, it was decided to proceed with the project to car park and retail component stage, but to suspend the hotel component of the project pending the finding of a new hotel operator. The Bank embarked on recommencement of building activity. Before building work recommenced, an increase in facilities of $8.3M was sought to enable completion of the car park and partial completion of retail components of the project. The recommendation was approved by the Board. This increased the amount extended under the facilities to $81.0M. Building work resumed in September 1990.

In November 1990, a further increase in the facility limit was sought from $81.0M to $91.5M to allow for further variations and holding cost increases in respect of the car park/retail component of the project. To accommodate the major options required by various prospective hotel operators, variations to the car park component had been suggested by the consultant architects so as to ensure that maximum options were available within the hotel design to suit the potential operators. The increase sought of $10.5M was approved.

In January 1991, the Bank's Board approved the decision to forego the construction of the hotel component of the project. Given the combination of the economic environment, the projections provided by hotel operators (confirmed by KPMG Peat Marwick) and the projected cost to complete, it was considered prudent not to proceed with construction of the hotel at that stage. It was, therefore, proposed to place the hotel segment of the project on hold, and to continue negotiations with possible purchasers and potential hotel operators.

The options which were available to the Bank, as a member of the First Tier Syndicate, in January and February 1990 were, on the one hand, to withdraw further funding from the project and put the property up for sale, and, on the other hand, to continue with construction, either to retail level, or to full completion.()

Matters relevant to the first option were that the property, in its then condition, was difficult to value. Its value lay in the range $15.0M - $50.M. If the property sold at the lower end of the range, the First Tier Syndicate would suffer a principal loss of some two thirds of its current exposure. By contrast, if the property sold at the top end of the range, the First Tier Syndicate would fully recoup its exposure. The Bank had advice from Colliers to the effect that it was unwise to contemplate the sale of the property, first, because the property market had changed dramatically and, secondly, because the lowering of Peat Marwick's income projections had magnified the reduction in value which had flowed from the collapse of the property market.() A further matter relevant to the first option was that, if funding had been withdrawn, the building contractor might have abandoned the project. Industrial action might have followed, and the site could have been made virtually unsaleable. Equally, planning authorities could have required the First Tier Syndicate, as mortgagee in possession, to keep the site safe and that might have involved the construction of shoring works at a potential cost of some $4.0M - $10.0M. Again, if the First Tier Syndicate had taken possession, then its members might have been exposing themselves to a liability at the suit of adjoining owners should some instability have arisen from the excavation site.

The benefit of pursuing the second option, that of continuing with construction, was that the site would be rendered safe. If the construction project was completed to at least retail level, it could be brought into a condition where it was capable of generating income. The risks attached to the further construction of the building were, first, that costs of completion had not been fully quantified but were estimated to be of the order of $25.0M - $27.0M; secondly, the value of the project, on the hypothesis that it were taken to retail stage, was uncertain. Equally uncertain was the value to be attributed to development rights. On a best case result, the building having been taken to retail stage, the First Tier Syndicate would make a profit on completion (and sale after completion) of $12.0M. On a worst case result, it would make a loss of $22.0M. Were the project to be taken to full completion, then, on estimates then available, the First Tier Syndicate would suffer a loss on ultimate realisation of $4.0M, on its best case, and $50.0M, on its worst case. Given the magnitude of this potential worst case loss, completion of construction of the proposed hotel beyond carpark/retail stage was not deserving of serious consideration. Thus, if the Bank did decide to pursue continuation of construction activities, it was logical to construct only to carpark/retail stage.

Perhaps the strongest factor in favour of continuing with construction to the carpark/retail stage was that there was, on the advice given to the Bank, some possibility, at least, of a profit accruing to the first mortgagee, as I have said, after sale upon completion, of $12.0M. This potential profit had to be weighed up against the probability of a loss flowing from sale of the property at the lower end of the range to which I have referred in the preceding paragraph. The Bank's papers record that the State Bank of Victoria, which had taken over Tricontinental's obligations, had given up hope of recovery of its exposure, and was not willing to provide any further support for the project.()

 

13.3 CHRONOLOGY

 

Appendix A of this Section of the Report contains a Summary of Movements in the Facility and, where applicable, details of amendments to financial covenants and security.

Appendix B of this Section of the Report sets out a detailed Chronology of Events in respect of the facility.

 

13.4 COMPLIANCE WITH POLICIES AND PROCEDURES

 

Chapter 8 - "Credit and its Management: Guidelines, Policies, Processes, Procedures and Organisational Delivery Mechanisms" of this Report examines the lending policies and procedures that applied over time within the Bank.

The following Section identifies and comments upon departures which occurred from the applicable policies and procedures of the Bank.

Other departures of a minor nature from the Bank's policies and procedures were noted by the Investigation. They do not warrant mention in this Report.

13.4.1 INITIATION OF FACILITY

(a) Bridging Loan of $30.0M

A proposal, dated 8 April 1988, was prepared by Mr Walkom, and recommended by Mr Henderson, recommending that the Lending Credit Committee approve the Bank's participation in a facility to enable the acquisition, by Somerley, of a site in the Melbourne Central Business District. I am of the opinion that the proposal to the Lending Credit Committee was deficient in a number of respects:

(i) Non-Aggregation of Exposures

First, in its risk assessment, the proposal took comfort from the fact that the overall loan/security ratio was 54.5 per cent. The proposal noted that:

"SBSA's exposure is a 54.5% Loan/Security maximum and consequently our position appears satisfactory."

Further, it stated:

"The Board of BFC has recently approved the funding of the interim package ($49m) and this commitment by BFC provides a solid safety margin to SBSA's involvement in the interim proposal."

I note that, whilst deriving comfort from the 54.5 per cent loan/security ratio, the proposal did not explicitly draw attention to the overall exposure of the "Bank Group". Given the intended participation of Beneficial Finance Corporation, the loan/security ratio of the Bank Group was effectively at a much inferior level, namely 89 per cent. In the event of a need to realise the security, it was important that the Bank, when acting as first mortgagee, should be able to have primary regard to its own interests. Given the relationship between the Bank and Beneficial Finance Corporation, those involved in preparation and consideration of this application would have known that it was unlikely that the Bank could act independently, without having regard to the exposure of the second Mortgagee (Beneficial Finance Corporation) in the event of a default by the borrower. In these circumstances, the manner of realisation of the security could have differed from that which would ordinarily have been contemplated if the full Bank Group exposure was limited to the funds advanced by the Bank. The members of the Lending Credit Committee and of the Board Sub-Committee should have foreseen that a security realisation strategy designed to best protect the overall Bank Group position may have rebounded, as it did in fact, to the detriment of the Bank itself. The members of the Lending Credit Committee and of the Board Sub-Committee seem not to have given sufficient weight to the Bank's "group concentration risk" inherent in the proposal. The Bank has submitted that joint financing by the Bank and Beneficial Finance Corporation was not necessarily imprudent. I accept this. However, in forming the opinion which I have expressed that the joint financing in this case was imprudent, I have had regard to the very high asset/security ratio applicable to the loan, once one aggregated the loan intended to be made by the Bank and by Beneficial Finance Corporation, to the fact that the site was producing no income, and to the fact that, if construction finance was not able to be procured by Somerley, the site would have to be sold.

It is clear that the main burden of the risk in this financing package was on Beneficial Finance Corporation which, because it held second ranking security, advanced funds effectively at a loan/security ratio of 89 per cent. The examination of the decision by Beneficial Finance Corporation to take part in the funding of this acquisition falls outside the scope of this Chapter of the Report. Given, however, that overall Bank Group exposure could not be ignored, the proposal to the Lending Credit Committee was imbalanced in its omission of adequate consideration of the Bank Group Exposure and in holding out a loan/security ratio applicable solely to the Bank's component of the advance. A greater emphasis on the Bank Group's total exposure, and an early expression of concern may have persuaded the Bank's decision-making organs not to commit, to the level of funding to which the project arrangements, as of April 1988, exposed the Bank Group. In favour of the authors of the lending submission, however, it must be said, first, that the proposal explicitly disclosed the intended loan by Beneficial Finance Corporation, and, secondly, that the relationship between the Bank and Beneficial Finance Corporation must have been known to the Lending Credit Committee and Board Sub-Committee, whose members could have calculated the true loan/security ratio.

The Bank, in its submission to the Investigation, has accepted that the Lending Credit Committee submissions should have shown the size of the Group exposure and given weight to the risk concentration being undertaken by the Group. The Bank submitted that "a higher rather than a lower loan to security ratio as caused by grouping does not necessarily imply that a loan is "much inferior" or imprudent. The relationship between a loan and the security, while relevant to judgements about the quality of the loan, is also only one component in (sic) the manner in which a credit and its repayment and safety may be viewed." () I entirely accept that a high loan/security ratio does not necessarily require a conclusion that a loan is imprudent. But, the loan security ratio is, in all cases, an important component of a credit provider's analysis of an intended transaction. A high asset to security ratio erodes the safety margin of the loan and tends necessarily to reduce the prudence of entering into the transaction. In this particular case, the site to be secured in favour of the Bank and in favour of Beneficial Finance Corporation was not income-producing at any material time. It was an intended construction site. If construction finance had not been able to be procured by Somerley, then the site would have to have been sold. That being so, in this particular case, the loan/security ratio was more important than it may have been in other cases.

(ii) Tenancy Arrangements

The proposal to the Lending Credit Committee asserted() that the sponsors had already procured two major tenants (Interwest Ltd and Hoyts Group Ltd) who had committed for approximately 75 per cent of the lettable space of the completed project. Further() there were references to "the signing of two major tenants." In fact, no leases had been signed. No agreement for lease had been signed by Interwest at that stage, that is to say, 8 April 1988. An agreement for lease was executed by Hoyts prior to 14 April 1988, but had not been sighted by the Bank by 8 April 1988. Inevitably, the recommendation to the Board dated, 19 April 1988, from the Board Sub-Committee, that the Board Sub-Committee's approval be confirmed implied(), contrary to the fact, that Interwest had signed a lease or a tenancy agreement. To that point, as I have said, the Bank had not sighted either a lease, or an agreement to lease, executed by Interwest. There was no reasonable basis for the assertions, in the proposal to the Lending Credit Committee, and in the recommendation to the Board, as to the existence of arrangements with Interwest. This was a most material assertion() given the close connection between the contemplated income from the hotel, post-completion, and its value at completion. The assertion should not have been made in the absence of personal verification by the authors of the proposal. It would have been quite proper for the authors of the lending proposal to have informed the Committee that the sponsors of the project had concluded negotiations with two major tenants, and to have proposed that production of signed leases be a condition of settlement of the loan transaction. The proposal to which I am referring, however, goes further than that, and implicitly asserts that legally enforceable letting arrangements had already been made.

Mr Walkom has submitted to the Investigation that the Hoyts Group and Interwest:

"did commit to the project and had verbally indicated their intentions to do so to both the sponsors and BFC when this proposal was submitted to LCC.

BFC had verbally indicated to SBSA Melbourne that the two tenants were committed to the project." ()

It is, in my opinion, entirely unsatisfactory that a lending proposal contain the unequivocal assertion set out in the proposal of 8 April 1988 based merely on oral information. The position is even more unsatisfactory when the information relied upon comes from a party regarded, as I shall show, both by the Bank and by the officer concerned, as being at arm's length to the Bank, and which had at the same time an interest in selling down a commitment to the Bank.

The Board Sub-Committee members were Mr A G Summers, Mrs M V Byrne and (purportedly) Mr K S Matthews. (Strictly speaking, only members of the Board were eligible to act as members of the Board Sub-Committee, for reasons explained in Chapter 11 - "Case Study in Credit Management: The Collinsville Stud Group".) Mr Summers and Mrs Byrne may have been misled as to the existence of tenancy arrangements. By contrast, the minutes of Lending Credit Committee Meeting No 348, at which the lending proposal was approved for recommendation to the Board Sub-Committee, record that "Members noted that two tenants (75 per cent of available leased space) have been procured, with the necessary legal documentation in the process of being executed". This implies that the Lending Credit Committee was informed that neither Interwest nor Hoyts had, in fact, executed a lease or an agreement for lease in respect of the site, as of 8 April 1988.

At settlement of the original loan, on 14 April 1988, the Bank's solicitors sighted an executed agreement to lease executed by Hoyts, but only a letter of offer from Interwest to Somerley in relation to management of the hotel. Mr Walkom and Mr Henderson authorised settlement on this basis, and then sought ratification by Mr Masters.()

(iii) Beneficial Finance Corporation Exposures to Project Promoters

Thirdly, the proposal did not inform the Lending Credit Committee of existing loans by Beneficial Finance Corporation to Interwest and Hoyts. I refer below to the existence and extent of these loans. The existing exposures of Beneficial Finance Corporation to Interwest - a joint venture party in Somerley and the holding company of the intended operator of the hotel - and to Hoyts - the parent of the intended operator of the car park - would, or should, have been material in the assessment, by the Lending Credit Committee, of the prudence of the intended loan, having regard to matters relevant to risk concentration.

The Bank's lending manuals did not, at the time of preparation of the lending proposal, require that the proponents disclose to the Lending Credit Committee either the intended or the existing exposures of Beneficial Finance Corporation to the borrower or a related party such as Interwest. This was an inadequacy in the Bank's credit assessment process which ought to be rectified.

It has been submitted to the Investigation that officers of the Bank were instructed by the Lending Credit Committee to treat Beneficial Finance Corporation as if it were a totally independent entity with no relationship to the Bank, and, where Beneficial Finance Corporation was acting as a second mortgagee behind the Bank as first mortgagee, that Beneficial Finance Corporation was to be regarded in the same manner as any other financial institution subordinated to the Bank's position.() It has further been submitted to the Investigation that the Bank had no clear policy in relation to loans made jointly with, or in priority to, Beneficial Finance Corporation. It was submitted that this was a topic which was discussed informally at times by the Lending Credit Committee, and referred by members of the Committee to the Managing Director on occasions. It was submitted to the Investigation that the Managing Director's view was:

"That if the Lending Credit Committee would be prepared to fund a transaction with back end second mortgage finance provided by another financial institution then if that institution happened to be Beneficial Finance why would the Bank consider the transaction to be different to one in which the subsequent lender was an institution other than Beneficial Finance." ()

The Investigation has also been informed that certain members of the Lending Credit Committee voiced concerns to several Bank Executive Committee members on a number of occasions in the period between 1988 and 1990 in relation to the significant level of "back end" risks being undertaken by Beneficial Finance Corporation in property and project financings, and that these members of the Lending Credit Committee were consistently informed by members of the Executive Committee that their role as Lending Credit Committee members was to consider lending proposals solely from the Bank's view point and that they were not to become involved in Group policy issues, as that was the province of the Executive Committee and Bank Board and of the Bank's subsidiaries(). One can say, with hindsight, that it is most regrettable that the expression of concern by members of the Lending Credit Committee was not acted upon.

It is also regrettable that there was no Bank policy regulating loans made, or to be made, by the Bank jointly with or in priority to Beneficial Finance Corporation. It was, in my opinion, irrational and unreasonable to treat Beneficial Finance Corporation as being completely at arms length to the Bank. It was imprudent on the part of the Bank not to have adopted a policy requiring aggregation of exposures of Beneficial Finance Corporation to its actual and intended customers with actual and intended exposures of the Bank to the same customer or customers.

The Bank's position in relation to Beneficial Finance Corporation was quite inconsistent and ambiguous. Beneficial Finance Corporation was treated as being at arms length to the Bank whilst organs of the Bank were preparing and considering loan applications, yet officers of the Bank treated Beneficial Finance Corporation as being a reliable source of information because of its close relationship with the Bank, and acted on the footing that information from Beneficial Finance Corporation was not required to be verified or corroborated by independent inquiry on the part of Bank officers.() I shall refer in passing in later pages to instances of this.

(iv) Site Valuation

The proposal to the Lending Credit Committee also asserted that Colliers had given an opinion on the current value at $55.0M. The Bank's file does not contain any written valuation by Colliers as of 8 April 1988.() By letter of 8 March 1988 to Beneficial Finance Corporation, Sallman Barrington Laurance (Vic) Pty Ltd, licensed estate agents, auctioneers and registered valuers, of Melbourne, had provided an opinion on the current market value of the order of $55.0M. The proposal also referred to the "lack of competition and a reported shortage of hotel rooms both now and in the future in the Melbourne CBD." () Those assertions were contradicted by the Peat Marwick Hungerford report of March 1988, to which I have referred above and which was in the possession of the Bank. That report was in fact referred to in the very next paragraph of the Lending Proposal.()

(v) The Building Contract

The proposal also asserted() that the contract entered into by a company called Grocon Pty Ltd (a member of the Grollo Group of Companies) with the project developer, Somerley, was a fixed price/fixed term contract. The Bank's file does not indicate that, at that stage, the Bank had analysed the building contract. Later events showed that the contract was neither fixed price nor fixed term. These assertions were therefore made without sufficient investigation and analysis of material available to the Bank. In his submission to the Investigation, Mr Walkom has conceded that the building contract between Somerley and Grocon was not analysed by himself or any other Bank officer. Mr Walkom informed the Investigation that "information provided to SBSA Melbourne from BFC was that the building contract with Grocon was a Fixed Term Fixed Price Contract. It was therefore assumed by the writer that the contract had been reviewed by BFC on the basis of the above information." () This is but one example of the Bank's ambivalent attitude to Beneficial Finance Corporation to which I have already referred in passing.

The assertion made in the lending proposal naturally reads as being the result of an independent assessment by an officer of the Bank. It is not put forward as an assessment relayed to the Bank by Beneficial Finance Corporation. That being so, it was implicitly misleading. Mr Walkom further submitted that, as the lending proposal of March 1988 was merely a bridging loan for the purchase of land, it was not normal banking practice at that stage to analyse the building contract. I accept that. The fact remains, however, that at no later stage did the Bank conduct its own scrutiny of the terms and conditions of the building contract with Grocon. It should certainly have been, but was not, analysed at the time of preparation of the August 1988 submission. In saying this, I have had regard to the fact that it was a condition of the subsequent Lending Credit Committee approval of the proposal of 9 August 1988 that the building contract be reviewed by a quality surveyor acceptable to the Bank. The point which I wish to emphasise is that it is unacceptable for unqualified submissions of fact to be put by a Bank officer to a lending organ when those facts have not been verified by the proponent of the submission, yet are put in terms of a personal assessment by the proponent of the particular proposition.

(vi) Promoter's Ability to Meet Interest Commitment

At the time of this application, the existing building on the site had been demolished. The site was, therefore, not in an income producing condition. The Bank's files do not indicate what information was held at that stage in relation to the financial status of Somerley and its promoters, or of Interwest, and of their ability to service the loan should the syndicated facility not be arranged. By letter to the Bank dated 14 April 1988 from the Regional Manager for Victoria and Tasmania of Beneficial Finance Corporation, Beneficial Finance Corporation undertook to service the Bank's interest requirement during the "six month term of this facility". There was, however, no undertaking by Beneficial Finance Corporation in relation to interest after the six month term of the facility. There should, therefore, have been some analysis by Bank officers of the ability of Somerley, and of Interwest to service the loan should construction finance not have been able to be arranged at the end of the six-month period. As it turned out, there was no default under the bridging facility.

Mr Walkom has submitted to the Investigation that, because Somerley was a "project specific" company, and because both the Gostins' and Interwest's financial details had been appraised by him, there was no requirement to include any formal assessment of Gostin and Interwest in the proposal. I do not accept this. Somerley was a $2 company. It had been in existence for some four years and may have incurred trading debts. It had procured the demolition of an existing building on the construction site. Its financial position was material to a proper consideration by the Lending Credit Committee of the proposal, as was Interwest's, and such appraisal as Mr Walkom had carried out should have been summarised in the lending proposal.

(vii) Feasibility Report

In addition, as I have already said, the Lending submission referred, in only a selective way, to the contents of the report prepared by Peat Marwick Hungerfords in relation to the viability of the proposed hotel.()

For the reasons given above and on the basis of the material to which I have referred, I am of the opinion that Mr Henderson and Mr Walkom failed to exercise proper care and diligence in preparation of the lending proposal dated 8 April 1988.

In my opinion, for the reasons set out above:

(a) The decision of the Lending Credit Committee to recommend to the Board Sub-Committee the approval of the bridging loan was imprudent.

(b) The members of the Board Sub-Committee who resolved to approve the bridging loan (Mrs Byrne and Mr Summers) should not have approved it and did not, in approving the loan, adequately and properly supervise, direct, and control, the operations, affairs, and transactions, of the Bank for the following reasons:

(i) If one aggregated the exposures of the Bank and Beneficial Finance Corporation, the loan/security ratio was imprudently high (89 per cent).

(ii) The joint financing of the acquisition by the Bank and its subsidiary created a position where the Bank could well be unable to act principally in its own interest if the borrower defaulted.

The former Non-Executive Directors of the Bank do not accept that the Board Sub-Committee acted imprudently in approving the $30.0M Bridging Loan facility. The former directors have submitted that it cannot be said to be imprudent to rely upon responsible and (at least to the knowledge of the Board) competent Senior Management to prepare and present accurate papers for the consideration of the Non-Executive Directors.() In this particular case, however, the grounds upon which I have formed the view that the members of the Board Sub-Committee ought not to have approved the loan and, in approving it, did not adequately and properly supervise, direct, and control the operations, affairs, and transactions, of the Bank, have nothing to do with the accuracy or inaccuracy of the lending submission upon which the Board Sub-Committee acted.

The former directors have also submitted() that the members of the Board Sub-Committee were entitled to rely on information contained in the proposal submitted to the Board Sub-Committee, and should not be criticised because the proposal was, in fact, not correct, and further, that the Board Sub-Committee were entitled to rely on the fact that the Lending Credit Committee had considered the proposal, and to rely on the judgement and skill of the Lending Credit Committee in analysing the adequacy and accuracy of the information contained in such a proposal. I am not persuaded by this submission in the particular circumstances of the facility to which I have referred. As I have indicated elsewhere in this Report and as the former non-executive directors have accepted(), the Board constituted the Board Sub-Committee as a lending organ of the Bank. Members of Board Sub-Committees actively involved themselves in the lending business of the Bank. To that extent, as I have said elsewhere in the Report, members of the Board Sub-Committee undertook a personal and independent responsibility, properly and adequately to consider the terms of lending proposals put before them for consideration.

(b) Participation in Syndicated Facility

A proposal to the Lending Credit Committee, dated 9 August 1988, prepared by Mr Davenport, recommended by Mr Walkom and supported by Mr Henderson, recommended the Bank's participation in the syndicated financing of the construction stage. A subsequent proposal was prepared by Mr Walkom on 13 January 1989, and supported by Mr Henderson, incorporating certain changes to the conditions originally envisaged and submitted to the Lending Credit Committee for approval. The latter proposal - made before settlement of the Syndicated Facility - sought approval principally to change the term for which the loan would be outstanding. This change was to be accompanied by a commitment by Tricontinental to pay $40.0M to several of the First Tier participants at practical completion of the project. I refer to this in more detail at Section 13.4.2(b). I am of the opinion that these proposals to the Lending Credit Committee were deficient in the respects referred to below:

(i) Colliers International Property Consultants Valuation:

A critical factor in ensuring adequate security for this facility was the estimated end value of the completed project. Given the critical importance of this aspect in the overall evaluation of the viability of the project, a prudent banker would have:

. examined in detail the valuation prepared by Colliers International Property Consultants ("Colliers") Valuation and considered the appropriateness of the valuation assumptions; and

. undertaken a sensitivity analysis to assess the impact of changes in the assumptions on the valuation.

Neither of the above procedures would appear to have been undertaken by Mr Davenport or Mr Walkom. Furthermore, the Colliers valuation had been procured by the project sponsor, Somerley. The Bank did not ascertain what specific instructions and information were given to Colliers by, or on behalf of, Somerley.

The lending proposal of 9 August 1988 put forward as a precondition that the Colliers valuation be confirmed by an independent valuer deemed suitable to the Bank.() This precondition was adopted by the Lending Credit Committee. Given the existence of that precondition, it was reasonable for Bank officers not to engage in scrutiny and analysis of the contents of and the assumptions underlying the Colliers valuation when the loan was approved and at the time of proposing it for approval. The precondition, however, was never satisfied. In the lending proposal of 13 January 1989, the fifth suggested precondition was that:

"5. The current valuation to be confirmed by Colliers to SBSA." ()

This amending proposal was approved by the Lending Credit Committee. The Bank thus decided in January 1989 to settle the First Tier Syndicate transaction in reliance upon the Colliers valuation. It did so settle the transaction after receiving letters from Colliers indicating that Colliers was "prepared to accept responsibility to your organisation, for our valuation of the above property carried out for Beneficial Finance Corporation on 14 June 1988." ()

When it was decided by Mr Walkom and Mr Henderson, the authors of the submission of 13 January 1989, that the Colliers valuation would be relied upon by the Bank as a member of the First Tier Syndicate, then it became both necessary and prudent, in my opinion, for that valuation to be subjected to close analysis and scrutiny.

An examination of the Colliers valuation and inquiry into its underlying assumptions would have revealed that the valuation made no allowance for amounts that would be payable to the hotel operator. In fact, this was clearly spelt out under "REPORT SUMMARY"(), where the following statement was made:

"Our valuation is for mortgage purposes and is on the basis that the whole of the hotel income is available to the Building owner i.e. that there is no management agreement with another party."

It further stated on the same page of the report the following:

"In our opinion the estimated completed value of the proposed development, subject to the management agreement and to other matters referred to in this report, is $275,000,000 ..."

In practical terms, as scrutiny of the Colliers valuation would have revealed, Colliers had aggregated the value of the building to the owner and the value of the building to the assumed operator in order to reach a figure of $275.0M. Given that a Hotel operator would be involved, the basis underlying the valuation was inappropriate for, and inapplicable to, an assessment of the likely realisable value of the completed project. Colliers had, in projecting the income stream of the hotel, taken into account both the net return to the owner and the net return to the operator. This was confusing because it was contradictory, as was the discounted cash flow analysis.() In these circumstances, a revised valuation should have been sought from Colliers or, alternatively, the Bank should have assessed the impact of making allowance for an Operator. Such an assessment could have been made without difficulty. It could have been based upon information on the Operator's share of income contained in the Colliers valuation. It would have indicated a need for a reduction in the assessed value by an amount of the order of $43.0M. This would have had the impact of reducing the valuation to approximately $232.0M, compared with projected construction costs of $236.0M. A valuation at this lower level should have raised serious questions about the Bank Group's participation in this project.()

Mr Walkom has disputed this conclusion. He has submitted that, as the hotel operator was a 100 per cent owned subsidiary of Tourism & Leisure Corporation which, in turn, was a company related to Interwest, the income from the hotel was perceived to be controlled "essentially by the sponsors". Similarly, as Mr Walkom has submitted, as part of the Bank's security, the lenders had both a charge over the income stream to Tourism & Lesiure Corporation from the hotel operator, Eden Melbourne, and also a guarantee from Tourism & Lesiure Corporation. Therefore, Mr Walkom has submitted, all the income both to the owners and the operators was perceived to be controlled by the Bank in an event of a default by the borrower.

I am not persuaded by this. The fact is that part of the value of the contemplated hotel, once it was operational, would lie in its goodwill. Part of that goodwill, if not the whole of it, would be the property of the operator. That component of the goodwill simply could not be sold by the First Tier Syndicate in the event of default by Somerley. Unless the lending documents contained a provision entitling the Syndicate to terminate the management agreement on default by Somerley, then the First Tier Syndicate may not even have been able to obtain vacant possession of the hotel. Thus, in practical terms, it was foreseeable that the income stream of the operator could not, in fact, be diverted by the First Tier Syndicate to itself. It was, for those reasons, erroneous to have regard to the operator's income stream at the time of hypothetical default by Somerley.()

Mr Walkom has further submitted that, even if one makes the reductions in value referred to above, the exposure of the First Tier Syndicate would have been $140.0M on completion, giving a loan/security ratio of 60.3 per cent, well under the Bank's extendable loan amount of 75 per cent. That assertion became true once Tricontinental had committed to the project in January 1989, but it was not true as of August 1988. Moreover, it still ignores the exposure of Beneficial Finance Corporation in relation to the funding of construction activity.

In addition, none of the Bank's staff would appear to have conducted an assessment as to a number of issues relevant to the valuation, being matters arising out of the management agreement relied upon by Colliers, and in particular:

. whether the proposed management agreement with Tourism and Leisure Corporation actually added value to the project;

. whether the lending documents should contain a provision entitling the Syndicate to terminate the management agreement should that, in fact, become an obstacle to orderly realisation of the hotel, on default by Somerley;

. the likely existence of willing and capable purchasers of the completed hotel, and the likely number of potential purchasers of such a substantial project in Melbourne, in the event of default by Somerley, and as to whether such purchasers, or a majority of them, would wish to purchase the completed hotel with or without an operator and manager in place; and

. whether the management agreement was reasonable as between the developer and the intended operator or whether, on the other hand, it was favourable to the intended operator to the extent that it would be an obstacle to sale if it were on foot after default by Somerley. If it was, its existence would decrease the selling value of the hotel. The fact that the intended hotel operator was jointly developing the hotel should have alerted Bank officers to the possibility that the agreement was not reasonable and usual.

The proposal of 8 August 1988 (and the proposal of 13 January 1989) put forward a number of preconditions. The fourth precondition was the review of the agreement to lease entered into between Somerley and Hoyts Car Parks Pty Ltd and of the management agreement between Somerley and Tourism and Leisure Corporation. Despite this, there was no indication in the Bank's files that the management agreement was even inspected by Bank officers, prior to settlement of the syndicated loan, let alone analysed. I am satisfied that Bank officers neither inspected nor analysed the management agreement. It has been submitted to the Investigation that the Bank officers involved in the preparation of the August 1988 submission were informed by employees of Beneficial Finance Corporation in Melbourne that they, (the Beneficial Finance Corporation employees), had reviewed the management agreement and were satisfied with it. Officers of the Bank have submitted to the Auditor-General that, because Beneficial Finance Corporation was a second mortgagee and therefore at greater risk than the Bank, the Bank's Melbourne officers relied on the assessment by employees of Beneficial Finance Corporation.()

This is a further example of the inconsistency and ambiguity in the Bank's attitude to Beneficial Finance Corporation to which I have previously referred in passing. The Bank's officers, in my opinion, were not entitled to abdicate their professional responsibility to the Bank to employees of Beneficial Finance Corporation if, as they have submitted, Beneficial Finance Corporation was regarded as being at arms length to the Bank.

For those reasons, in my opinion, the failure on the part of the Bank officers to inspect and analyse the management agreement was a serious breach of duty on their part. I express that view, notwithstanding that I am satisfied that the Bank's Melbourne solicitors would have perused the management agreement prior to settlement of the First Tier Syndicate. Those solicitors would, in the ordinary course of things, merely have inspected the agreement for conformity with the Bank's instructions. They would not, and could not, be expected to scrutinise it as if they were valuers. They would not have been required by their retainer to inspect it with an eye to the impact of its terms and conditions on the likely value of the hotel project at completion. That assessment was entirely and exclusively a matter for the Bank's officers to carry out.

In addition, close scrutiny of the Colliers valuation would have revealed that it took no account of fixed expenses including rates and taxes, building insurance, and of the need for a furniture, fixtures, and equipment replacement reserve.

Given the subjectivity of the assumptions underlying the valuation, sensitivity analysis calculations should have been undertaken on the report's assumptions. In particular, the following significant differentials in occupancy rates, as projected by Peat Marwick Hungerfords and Colliers respectively, should have been taken into account by those preparing the lending submission. These discrepancies were not brought to the attention of the Lending Credit Committee or the Board. Sensitivity calculations should then have been undertaken at the lower rates projected by Peat Marwick Hungerfords.

Peat Marwick
Hungerfords
Base Case
%

 

Colliers
%

1991/92

54.8

63.0

1992/93

58.1

67.0

1993/94

61.7

73.0

1994/95

65.4

75.0

1995/96

69.4

77.5

Appendix C to the lending proposal contained a document extracted from the Peat Marwick Hungerfords' report, namely the Peat Marwick Hungerfords' Sensitivity Analysis of the Projected Five Year Cash Flow to Somerley from the Hotel. However, this does not constitute a sensitivity analysis of the valuation. The impact on the Colliers valuation of the base case figures of Peat Marwick Hungerfords should have been assessed. By closer scrutiny of the Colliers valuation report and by undertaking sensitivity calculations, the Bank would probably have been led to reassess downwards the value of $275.0M relied upon by the Bank in its analysis of this project.

I also observe that serious concerns were expressed by Pacific Rim Leisure Pty Ltd ("Pacific Rim Leisure"), a consultancy firm engaged by Beneficial Finance Corporation to comment on Colliers valuation. Pacific Rim Leisure was of the opinion that the attributed value was overstated.

In particular, Pacific Rim Leisure made adverse comments including the following on Colliers valuation:

. occupancy rate projections exceeded by nearly 15 per cent the Fair Market Share calculated by Peat Marwick Hungerfords in its report. The maximum occupancy forecast by Colliers exceeded by 8 per cent the maximum occupancy predicted by Peat Marwick Hungerfords;

. the average room rate for 1991/92 assumed by Colliers was overstated;

. room revenue had been understated by Colliers;

. room service labour costs had also been understated by Colliers;

. salaries attributable to "overhead departments" had been understated;

. no provision had been made for furniture, fittings and equipment refurbishment: normally 2-3 per cent of gross revenue is allowed in this respect;

. it was inappropriate, in a valuation procured for mortgage purposes, to discount costs of operation (thereby increasing the value of the completed hotel) so as to reflect savings which Interwest might have been able to make through economies of scale available to Interwest through centralised purchasing and contract administration. Colliers had applied such a discount. The intending mortgagee, it was argued by Pacific Rim Leisure, should value the property as if it were what was described as a "stand alone operation", carrying its full share of administrative and marketing overhead, as the hotel might one day have to be operated on that basis;

. contrary to the recital in the summary of the valuation of 14 June 1988 that the valuation was on a "walk in walk out" basis, the valuation was in fact based entirely upon the particular relationships between Interwest and the Gostin interests in Somerley, and on the management arrangements being proposed by Interwest;

. Australian based institutions have not, since the property crash in the mid 1970s, been major buyers of hotels. The institutional market in Australia lacked (in 1988) the investment and capital base to provide "take outs" for hotel projects then under development. Therefore, any buyer of the hotel would in all probability be a foreign interest. This reinforced the conclusion that a prudent mortgagee would insist on a "stand alone" valuation of the hotel;

. the gross revenue percentage provided for in the management agreement with Interwest was "extremely high"; and

. the guaranteed minimum return provisions in the management agreement had the capacity to impair the selling value of the owner's interest in the hotel. It also prejudiced the value of the Gostin interests in Somerley.()

According to Mr Walkom, the Bank was not made aware of these concerns until 16 November 1989, many months after the initial concerns were expressed by Pacific Rim Leisure.

It has been submitted to the Investigation that, whilst Bank staff were expected to do their own analysis, they were entitled to rely on external valuations by reputable parties; that Colliers fell into that category; and that it was not the duty of Bank staff to second guess professional valuers.() I reject the third component of this submission. It was, in my opinion, the duty of Bank officers to check both the persuasiveness and the appropriateness of assumptions underlying a valuation report, particularly in the case of an intended loan on a non-income producing property which was to be very highly geared, which was particularly vulnerable to economic downswings and where the loan was to be secured on a property which, if construction activities prematurely faltered, would suffer a dramatic fall in value. I also observe that Beneficial Finance Corporation, which was lending a substantially smaller sum than the Bank, subjected the Colliers valuation to very detailed analysis.

(ii) Analysis of Interwest Group

The proposal contained insufficient analysis of the financial status of the Interwest Group. References made to Interwest in the submissions related to its involvement as operator of the hotel. Mr Walkom has submitted to the Investigation that the Melbourne Office reviewed and assessed the financial position of both Interwest and of Mr and Mrs Gostin from information supplied by both State Bank of Victoria and Tricontinental, and that a precis of the information furnished was set out in the proposal to the Lending Credit Committee. It was further submitted by Mr Walkom that, prior to settlement, and on receiving Interwest's figures for June 1989, he conducted an analysis of the information in those figures. Mr Walkom did concede, however, that a full analysis of Interwest's cash flow position was not undertaken.() Given the importance of the Interwest group to the project as investor (through Pac Prop), as guarantor of cost overruns and eventually as operator, this was a serious omission.()

The explanations proffered for the failure to conduct a full analysis of Interwest's cash flow position were, first, that the Bank had been provided with projected income streams by both Colliers International and Peat Marwick Management Consultants indicating that the project was expected to be self servicing within approximately two years of completion, completion being expected in July 1991; and secondly, that the First Tier Syndicate had specifically allowed for a short fall in the initial years income by providing a further $5.0M interest capitalisation facility following the proposed $50.0M part repayment of the First Tier Syndicate debt by Tricontinental or Interwest, arising out the January 1989 variations. It was submitted that once the First Tier Syndicate was paid down to $140.0M that Somerley could draw up to $145.0M to meet any interest short fall. I do not accept that these are sufficient reasons for not undertaking a full analysis of the cash flow position of the Interwest Group.()

Appendix A to the submission did contain some information about Interwest. In particular, it included a financial profile and a statement of financial ratios. The financial profile showed that in the 1986-87 year the assets and liabilities of the Interwest group had grown four-fold. There was, however, no analysis of the income position of Interwest nor of its ability to service its liabilities out of cash flow, as opposed to asset sales.

The Appendix does not disclose that Interwest was an integrated hotel developer, owner, and operator. The Bank should have known or should, in the alternative, have ascertained, that Interwest answered that description. Interwest was particularly susceptible to economic down-swings. Its financial health was all the more likely to be jeopardised by increases in interest rates. It was dependant for survival upon a healthy tourist trade.

Scrutiny by Bank staff of the management accounts of Interwest at 30 June 1989 -before the syndicated loan was settled - would have shown that the Interwest Group relied upon property sales for its cash flow, that Interwest had a negative projected cash flow in 1989-90, and that it relied upon surplus income from other group entities. Officers and the Beneficial Finance Corporation Board knew these matters before the syndicated loan was settled. The Bank had notice on 29 August 1989, by virtue of a facsimile communication from Beneficial Finance Corporation, of the state of knowledge of Beneficial Finance Corporation.() The Bank's files do not disclose whether the Bank staff made an independent assessment of the impact of this information on the wisdom of the proposed loan, or relayed it to the Lending Credit Committee or to senior management.

The Bank has submitted to the Investigation that there was no need for any additional analysis of the financial position of the Interwest Group, for the following reasons:

"...

(ii) "Interwest's financial profile was not atypical of other property developers/hotel operators";

(iii) "Interwest's vulnerability to economic downsizing (sic) and high interest rates was not unique to that company";

(iv) "the real risk to the Bank was its exposure to a Melbourne Hotel construction project and not its indirect exposure (or possible dependence) on Interwest"."

I reject this reasoning. I regard the second and third propositions as irrelevant. The fourth proposition is fallacious. The risk against which the Bank had to guard was a risk of loss. A risk of loss would crystallise upon Interwest becoming unable to operate the hotel, because that would have an immediate impact upon the value of the project.

Mr Walkom has informed the Investigation that the facsimile to which I have referred:

"Was assessed by SBSA Melbourne staff, however, given the final recommendation of the paper to the Board of BFC viz, to continue to provide the funding by BFC on a second ranking basis, behind the Bank's exposure, it was considered that the risks outlined had been adequately covered, given respective guarantees, a further tangible equity commitment ($3.0M) and the fact that an independent quantity surveyor's (sic) was controlling the provision of the project's funding on a cost to complete basis." ()

If these are the matters to which Mr Walkom had regard in August 1989 in conducting the "full review" contemplated by his memorandum of 1 August 1989 on the topic of pre-settlement review, to which I refer below, and in reporting to Mr Masters, then in my opinion he misdirected himself. He committed a breach of duty in not bringing to the attention of Mr Masters, the Lending Credit Committee, and the Bank Board the information faxed to him in relation to Interwest on 29 August 1989.

(iii) Peat Marwick Hungerfords Report

The proposal was also misleading in that it failed to reflect a number of qualifications contained in the Peat Marwick Hungerford Report of March 1988, referred to in the proposal.() The proposal simply noted that "profit figures will depend largely on the hotel's occupancy levels thus placing much importance on the pre-opening and ongoing marketing campaign". This simply emphasised the need (to which I have previously referred) for an analysis of the financial strength of the Interwest group. The operation of the hotel by that group successfully and profitably was crucial to the achievement of the value projected by Colliers.

(iv) Financial Position of Gostin Group

The proposal to the Lending Credit Committee was, in effect, one for limited recourse financing. Security was proposed to be a first registered mortgage over the construction site, a registered first fixed and floating charge over Somerley (which company was of no value), and joint and several guarantees by Mr and Mrs J Gostin. The limited recourse nature of the transaction required that the Bank be satisfied both as to the stability of Interwest and as to the enforceability and reasonableness of the management agreement.

The papers produced by the Bank to the Investigation included a "Statement of Assets and Liabilities of the Gostin Group" as at 1 December 1987, showing net assets of $15.65M. The statement showed that $2.5M had been paid by way of deposit on the project site. It is not clear whether this statement was received by the Bank before the loan application of April 1988 and, if so, whether it was updated to reflect the Gostins' position after settlement of the purchase of the project site or whether its contents were verified by Bank officers. Be that as it may, the proposal to the Lending Credit Committee does not contain a statement of position in relation to Mr and Mrs Gostin. It contained no information on their ability, to service the debt on completion of the project (should arrangements with Interwest and Hoyts have faltered), or on their ability to meet cost overruns should the amounts to be advanced by the lenders prove inadequate to complete the project.

Mr Walkom has submitted to the Investigation:

"Gostin's (sic) financial position was considered of minimal value when the assessment by the Sponsors' financial position was made by SBSA Melbourne.

Gostin had contributed $11 million to the purchase of the land and had liquidated the majority of this investments (sic) to complete this purchase.

His financial capacity to meet ongoing costs was realised by the Bank to be minimal.

Therefore, the major reliance for the financial support of the project was on the Interwest Group. This was ensured by the obtaining of the relevant joint and several guarantees from Interwest and related companies." ()

This submission is, in part, inconsistent with Mr Walkom's memorandum of 30 August 1989 to Mr Masters, to which I refer below, in which Mr Walkom asserted of both Interwest and of Mr and Mrs Gostin that "their ability to meet any cost overruns ... remains satisfactory". It is also inconsistent with the tenor of the original lending submission and the submission of 8 August 1988. Mr Walkom's assessment of the Gostins' financial position, as set out above, was not relayed to the Lending Credit Committee in Appendix A of his submission of 13 January 1989. None of the three lending submissions, to which I have previously referred, proposed an unlimited guarantee by Interwest of the First Tier Syndicate debt. Those lending submissions, therefore, proceed on a basis inconsistent with the submission by Mr Walkom that the major reliance of the Bank was on the Interwest Group.

While none of the three principal lending proposals to which I have referred suggested that the direct support of Interwest for the construction project be required, it transpired that, at the stage in January 1989 when Somerley was seeking a variation of the Bank's approval, (to enable the term of the syndicated facility to be extended), the Lending Credit Committee was advised - by whom is not clear - that "a guarantee by Interwest will be sought".() That guarantee was procured.()

(v) Non-Aggregation of Beneficial Finance Corporation Exposure

In its risk assessment(), the proposal to the Lending Credit Committee cited a Loan/Security ratio of 65 per cent, and took comfort from this level of cover. The proposal noted that:

"Given the adequate security cover provided for this facility (LSR of 65%), the fixed price/fixed term provision in the construction contract, the sponsors business acumen, the project's repayment ability, a substantial equity outlay by the sponsors ($11.0M) and the involvement and support of respected financial and property consultants, SBSA's involvement in this debt syndication is recommended for approval." ()

The proposal, however, did not adequately draw attention to the overall exposure of the Bank Group. At that time, it was envisaged that Beneficial Finance Corporation would fund $22.5M, ranking equally with a similar amount to be provided by the Tricontinental Group. The overall Bank Group effective loan/security ratio would, therefore, have been at the much inferior level of 82 per cent. I have already commented on the imprudence of the Bank lending in conjunction with Beneficial Finance Corporation, but in different tiers, and on the risk of conflict between the Bank and Beneficial Finance Corporation which that created. That foreseeable risk of conflict between the interests of the Bank and those of Beneficial Finance Corporation was aggravated by the fact that the Bank was lending as member of a syndicate. It was foreseeable that, in the events that happened, the other First Tier lenders would be able to exploit the desire of the Bank to shield Beneficial Finance Corporation from loss. As it turned out, after the Interwest Group collapsed, the other First Tier lenders persuaded the Bank to pay them out at 100 per cent of funds lent.

The proposal to the Lending Credit Committee of 8 August 1988 did not expressly calculate the loan/security ratio that would have been applicable if one assimilated the Beneficial Finance Corporation debt to the first ranking syndicated facility. No policy or procedure of the Bank required that it record such a calculation. The members of the Lending Credit Committee are recorded to have taken comfort from the Loan/Security ratio of 65.5 per cent.() The members of the Lending Credit Committee must have been aware of the relationship between the State Bank and Beneficial Finance Corporation. They were expressly informed by the proposal of the extent of Beneficial Finance Corporation's involvement. Accordingly, they could have calculated for themselves the real loan/security ratio applicable as against the State Bank Group. The proposal was not in that sense misleading. It is regrettable, however that the Bank's policies and procedures at the time did not require the aggregation in lending proposals of intended exposures of the Bank with those of other members of the Bank Group. It is also regrettable that the Bank's prudential guidelines did not require exposures to subsidiaries of the Bank to be aggregated with those of the Bank for prudential purposes. Given the Bank's policies at the time, however, I do not direct any criticism to the authors of the proposal, or to the members of the Lending Credit Committee in this regard.

(vi) Non-Disclosure of Existing Exposure

Reflecting this deficiency in the Bank's prudential guidelines, the lending proposal of 8 August 1988 did not disclose to the Lending Credit Committee or to the Board Sub-Committee that Beneficial Finance Corporation had existing loans to both Interwest and Hoyts of $16.3M and $15.9M respectively. The carpark in the project (and thus Hoyts) was to have been a key source of cash flow to Somerley in the short term, after completion of the hotel. The Colliers valuation of 14 June 1988, upon which the Bank came to rely, attributed $44.685M to the carpark, almost 20 per cent of the total value of the completed project. Thus, even though Hoyts was to be merely a tenant of the building, its role, and thus financial position, deserved consideration.

Interwest, as intended operator of the hotel, deserved, as I have already said, even closer consideration. The existence of the debt due by Interwest was material to a balanced assessment of the exposure of the Bank Group. (By the time the syndicated loan was settled, Beneficial Finance Corporation exposure to Interwest had grown to $24.3M.() By the time of settlement of the First Tier Syndicated Loan, the Bank itself had an exposure to Interwest of $10.0M in relation to the World Trade Centre Hotel in Melbourne. The aggregate Group exposure to those involved in the hotel project was, on settlement of the Syndicated Loan, therefore approximately $110.0M).()

The Lending Credit Committee were not required by the Bank's policies and procedures at the time to be informed of, or to have regard to, this aggregate exposure. I am satisfied that the Bank officers involved in preparation of the lending proposal of 9 August 1988 were not aware of the exposures of Beneficial Finance Corporation to Interwest. I accept that it may not have been proper for Beneficial Finance Corporation, as a matter of course, to disclose to the Bank financial information relevant to consideration by the Bank of a loan application. In my opinion, however, the Bank officers should have been required by the Bank's policies to make inquiry of Somerley and Interwest as to existing loans by Beneficial Finance Corporation to either of those companies or to their associates and subsidiary companies.

The Bank's lending manuals did not, at the time of preparation of any of the three lending proposals on which I make comment in this Chapter, require that the proponents disclose to the Lending Credit Committee either the intended exposure of Beneficial Finance Corporation or the existing exposures of the Bank and of Beneficial Finance Corporation to the borrower or a related party such as Interwest, except where the proposed loan, if advanced, would involve a breach of the Bank's prudential guidelines. This was an inadequacy in the Bank's credit assessment process which ought to be rectified.

(vii) No Market Research: Carparks

As I have said, the proposal to the Lending Credit Committee did not contain any analysis whatsoever of the financial state of affairs of Hoyts Car Parks Pty Ltd or the Hoyts Group, or of its intrinsic strength or otherwise.() Nor did the Bank's files contain any indication that the Bank had carried out, or caused to be carried out, market research into demand for carparks in the Melbourne Central Business District, or into the related question how easy it would have been to find an alternative operator of the carpark should Hoyts have withdrawn from the project or become financially unable to operate the carpark.()

(viii) Pre-Settlement Review

By internal memorandum of 1 August 1989 to Mr Masters, Mr Walkom advised that the Bank's Melbourne office would be "undertaking a full review of the project during the next two weeks and ensuring that the Bank's original security and credit position are unaltered". The proposal that there be a review was relayed to the Lending Credit Committee.() Mr Walkom has informed the Investigation that the review is embodied in his memorandum of 30 August 1989 to Mr Masters and Mr N Matthews. This is a document of some four pages recommending continued participation in the project. At page 3 of Mr Walkom's memorandum, he asserted, as I have already remarked, that the ability of the sponsors (Gostin and Interwest) to meet any cost overruns (both for interest and variations to the building) "remains satisfactory". Mr Walkom did not indicate in the memorandum how he reached this state of satisfaction.

The Bank has produced to the Investigation no materials which could reasonably have lead Mr Walkom to make the assertions which he did. In my opinion, as a review, this document was wholly inadequate and was misleading. It did not disclose to Mr Masters the information received from Beneficial Finance Corporation on the previous day (to which I refer below). Mr Walkom did not dispute that he was aware, when forwarding his memorandum to Mr Masters, that he was aware of the information from Beneficial Finance Corporation (to which I refer in the next paragraph). The memorandum did not contain any comment on the acceptability of the Colliers valuation, on which the Bank was now relying. It did not inform Mr Masters of Mr Walkom's then assessment, as referred to above, of the financial position of Mr Gostin. It did not inform Mr Masters of the second exposure which the Bank had contracted, through its Melbourne office, to Interwest on another hotel construction project in Melbourne. No updated information had been procured from Peat Marwick, or from an independent consultant, as to the impact of the airline strike on the tourist economy. Mr Walkom is not recorded in the memorandum as having done his own assessment of the impact, on the viability of the project, of increased interest rates, which had become applicable since the project was first approved by the Lending Credit Committee. (Some twelve months had elapsed since the Lending Credit Committee and the Board had approved participation in the First Tier Syndicate). Mr Walkom's analysis was extremely superficial. There is no evidence of his having conducted any market research into the likely availability of a buyer for the hotel, the likely availability of a manager for the hotel (should Interwest or its subsidiary become unable or unwilling to manage the hotel), or the existence and availability of a replacement for Hoyts (should that company become unwilling or unable to operate the carpark within the project). Another matter not touched upon by Mr Walkom's report to Mr Masters was that the configuration of the hotel had changed; originally, it was to contain 503 guest rooms; that was subsequently reduced, prior to 30 August 1989, to 459 rooms.

But the most significant flaw in the review was its omission of information recently received from Beneficial Finance Corporation. A letter of 25 August 1989 from Mr E P Reichert to the Beneficial Finance Corporation Board was faxed to Corporate Banking, Melbourne, on 29 August 1989. It asserted, of the Somerley/Grocon building contract, that "there is scope for cost and time overruns. The contract, therefore, is not a true fixed price/fixed term contract." Notwithstanding this, Mr Walkom's memorandum to Mr Masters asserted (page 2) that "Grocon has a fixed time, fixed price contract for A$105.0M (not including FF&E)". Again, Mr Reichert's letter recorded, as I have said, that Beneficial Finance Corporation had reviewed the management accounts of the Interwest Group to 30 June 1989 and projected cash flows for the years ended 30 June 1990 and 1991, it continued:

"The projected position of the Group remains sound but it is reliant upon property sales. If these sales are not achieved, capital raising or debt funding will be required to support the cash flow. At present, Interwest Limited have a credit line of $120 million drawn to $100 million, supported by negative pledge ..."

"As Interwest Limited is a major borrowing entity for the group, it has a negative projected cash flow in 1989/90 and relies upon the surplus from other group entities."

The letter did conclude by asserting that the strength of the project itself remained unchanged, and that, under the structure involving Tricontinental's obligations as third mortgagee, the risk of Beneficial Finance Corporation was "minimised" (page 3).

It is not within the scope of this Chapter to comment upon the accuracy of all of the information in Mr Reichert's letter. It is pertinent, however, that I observe that Mr Masters was not told by Mr Walkom's memorandum that Interwest was "reliant upon property sales."

Mr Walkom has submitted to the Investigation that:

"In regard to the financial position of the sponsors, no material change in their previously analysed financial position had occurred and therefore no further assessment was considered to be required."

I find this to be inconsistent with the information transmitted by facsimile by Beneficial Finance Corporation to the Bank on 29 August 1989. In my opinion, Mr Walkom and other officers of Corporate Banking in Melbourne had an obligation to undertake their own assessment of Interwest's financial position prior to completing and transmitting their "full review", and that, in the circumstances, they misled both Mr Masters and, through him, the Lending Credit Committee.

There was yet another shortcoming in Mr Walkom's "full review." In September 1988, the Bank adopted a Credit Policy Manual which required, among other things, that, in the case of asset-based lending, the asset's market value, currently and at the point of foreseeable liquidation, must be realistically appraised by knowledgeable persons. The policy required that a readily identifiable and measurable market be pinpointed in relation to assets to be charged in favour of the Bank.() This stipulation was not on foot at the time of the lending submission in support of the Bank's participation in the bridging loan (April 1988) or at the time of the preparation of the submission in support of the Bank's participation in the First Tier Syndicated Loan Facility (August 1988). It was, however in force at the time of the "full review" referred to in the internal memorandum of 1 August 1989 to Mr Masters, and on the occasions, in January 1989, May 1989, June 1989 and July 1989, when further submissions were prepared for the Lending Credit Committee; on 1 August 1989 (when Mr Walkom submitted a memorandum to Mr Masters summarising the current status of the Bank's involvement in the facility); and at the date of the "full review" of 30 August 1989. I am satisfied that, at each of those times, the project should have been valued on a liquidation basis as part and parcel of a proper consideration of the Bank's position within the First Tier Syndicated Facility.

On 24 November 1988, the Bank had approved a $10.0M loan to a further subsidiary of Interwest known as N&B Estates. This loan (which was secured and which was the subject of a "take out" arrangement with a credit provider unrelated to the Bank) was in connection with the World Trade Centre Hotel, about to be constructed for N&B Estates, in Melbourne, for operation by a second subsidiary of Interwest.() The existence of this exposure to Interwest was material to an adequate and balanced review of the Bank's position in relation to the Somerley project in August 1989. There is, however, no indication that this exposure was taken into account by any of the Bank officers in their submissions to the Lending Credit Committee after January 1989 or in preparation of the review of 30 August 1989. The Bank staff failed to weigh the risks to the Bank in lending to Interwest simultaneously on two construction projects in the same city. Both the Somerley loan and the loan on the World Trade Centre Hotel site were secured on non-income producing sites. Nor did the Bank analyse the strain which these and other construction projects would place on Interwest's cash flow. According to the Peat Marwick Hungerford Report of March 1988, to which I have already referred, Melbourne was not on the main tourist circuit in Australia. Having regard to the existing and the projected competitive position in the high quality sector of the hotel market in Melbourne, it was imprudent for the Bank to lend concurrently on two hotel construction projects in the Melbourne Central Business District being developed by, or for operation by, the same entity, namely, the Interwest Group.

On 30 August 1989, the Melbourne Herald carried a report of a speech delivered by Mr B Gross, Managing Director of the Hotel division of Colliers International, to a conference on tourism held in Sydney on the previous day. A copy of the Herald report was in the Bank's Melbourne office file on Somerley. Mr Gross was reported as having said that:

. "Developers and operators could face bankruptcy if, despite looming oversupply, they keep building hotels" ;

. there was not the market demand in Melbourne for the 90 per cent increase in rooms proposed to occur in the next three to four years;

. Melbourne had 3,680 inner city rooms with seven new hotels in the construction phase. These hotels, with about 2,000 rooms, were to come onto the market in 1991 (the year of projected completion of the hotel to be erected by Somerley); and

. occupancy rates in Melbourne would decline in the next three years.

The press report of this speech came too late to be included in the pre-settlement review. It should, however, have been the subject of a supplementary submission to Mr Masters. There is no indication in the Bank's files that, in the light of this prognosis, it sought a fresh valuation from Colliers or the independent valuation referred to in the loan proposal, before its funds were committed to the First Tier Syndicate.

By his memorandum of 31 August 1989 to Mr Masters, Mr M Fildes (Manager, Credit Policy and Quality) reported that:

. the Bank's position had "considerably improved since the initial proposal some 8 months ago"; and

. "there are no material adverse changes in any of the information provided to us."

In the light of matters communicated to the Bank by Beneficial Finance Corporation, this assessment was quite inaccurate. Within 5 weeks of settlement, trading in Interwest shares was suspended by the Australian Stock Exchange at the request of the directors.

None of the documents produced to the Investigation by the Bank lead me to think that, armed with this information, the Bank would not have been able to withdraw from the contemplated First Tier Syndicate. In this regard, I observe that the Syndicated Bill Acceptance and Discount Facility Agreement was not, in fact, executed until 21 September 1989. Even if that agreement, or a preliminary agreement, had been on foot in August 1989 at the time of receipt of the information to which I have referred in the preceding pages, the Bank would, in my opinion, have been entitled by virtue of the provisions of the Syndicated Agreement to withdraw from the transaction. In forming this conclusion, I have had regard, in particular, to the provisions of Clause 13.1 of the Syndicated Bill Acceptance and Discount Facility.

For the reasons given above, on the basis of the facts to which I have referred, I am of the opinion:

(a) that Mr Davenport, Mr Walkom, and Mr Henderson did not exercise proper care and diligence in the preparation of the proposal submitted to the Lending Credit Committee for approval on 9 August 1988, and in the steps leading up to settlement of the Syndicated advance. The lending submission was imbalanced and did not adequately disclose all information in the possession of the Bank. In the respects previously referred to, it contained assertions not verified by independent inquiry on the part of the Bank's officers; and

(b) the full review carried out by Mr Walkom was inadequate and misleading, and Mr Walkon did not exercise proper care and diligence in preparing it.

(c) Buy-out of Syndicated Facility and Granting of Additional Construction Finance

A proposal, dated 26 February 1990, recommended that the Board approve the provision by the Bank of facilities to Beneficial Finance Corporation to enable it to acquire the First Tier Syndicate debt at the rate of 50 cents in the dollar, with discretion being given to the Group Managing Director to pay up to 75 cents in the dollar, and to grant additional facilities of $25.0M to enable completion of the car park/retail stage of the project. This submission was prepared by Mr Hamilton on the recommendation of the Lending Credit Committee.() On the grounds of urgency, Mr K S Matthews circulated the submission to the Board (by memorandum dated 26 February 1990), and requested that directors read the proposal and telephone either him or Mr Masters to advise their decision by 27 February 1990. The proposal was approved by the Board. Accordingly, this `approval' was given on a "round robin" basis on 27 February 1990.

A submission, dated 1 March 1990, was prepared by Mr Masters, General Manager, Corporate Banking, recommending that the Board confirm its previous "round robin" decision. The minutes of the Board meeting following the date of the submission make no reference to such a submission having gone to the Board for confirmation. Reference to the flawed nature of the "round robin" process is made elsewhere in this Report. The Bank has not produced any note or memorandum, prepared by Mr K S Matthews, recording the response of the seven members of the Board noted as having responded to his request for a round robin meeting.

At the time of this submission, the Bank's commitment to the First Tier Syndicate ($55.0M) was drawn to only $13.0M. Beneficial Finance Corporation had committed itself to paying $22.5M to State Bank of Victoria, as part of the second mortgage facility. The total draw-down under the First Tier Syndicate was $46.75M.

The February proposal indicated that, if the First Tier Syndicate lenders were willing to exit at a 50 per cent discount, the State Bank Group would fully recover its exposure. The proposal recommended, however, that the Group Managing Director have a discretion to offer up to 75 cents to the First Tier Syndicate lenders. There was no analysis in the proposal of the loss which acceptance of such an offer would inflict on the Bank or on the Bank Group. The approval of the Bank to this proposal was required because Beneficial Finance Corporation was unable to fund the project to the stage of completion of retail level. The Beneficial Finance Corporation Board had on 23 February 1990 agreed to proceed with the construction of the project to retail level, but resolved to look to the Bank to provide such funding. It was quite clear by early February 1990, and it is beyond argument now, that continuation of construction was the only avenue by which Beneficial Finance Corporation might recover its exposure. The initial choice for the Bank was whether to limit its exposure then and there, by selling the site at the highest price offered or whether to risk increasing the Group exposure. The Bank chose the latter, quite imprudently in my opinion. If the Bank had subscribed to the views of the other First Tier Syndicate lenders, and had marketed the property as was, and if that had yielded $45.0M, as predicted, then the Bank itself would have suffered no loss. The loss sustained by the Bank Group would have been a loss of $22.5M, being the exposure of Beneficial Finance Corporation.

The proposal of 26 February 1990, and the submission by Mr Masters of 1 March 1990, did not inform the Board of the contents of the two reports prepared for the Bank by KPMG Peat Marwick Management Consultants in December 1989 and January 1990, to which I have already referred.

In its conclusion, the proposal of 26 February 1990 observed that Interwest was considered to have a negative net worth whilst Mr Gostin was believed to have a net worth of between $10-20.0M. No papers produced by the Bank justify that latter assertion. Subsequently (in February 1991) Mr Gostin lodged with the Bank a declaration to the effect that his net assets were between $10,000-$20,000. (This led to the Bank's decision not to pursue bankruptcy proceedings against Mr Gostin. The Bank did not sue Mrs Gostin and it did not elicit information from Mr and Mrs Gostin, when terminating proceedings against Mr Gostin, as to the net worth of the Gostin family trusts.).

In both Mr Hamilton's proposal and the later proposal of Mr Masters by way of confirmation, it is noted that Beneficial Finance Corporation was firmly of the view that the project in its present state was virtually unsaleable. Beneficial Finance Corporation was of the view that the current realisable value of the property was closer to $20.0M than $50.0M as anticipated by the First Tier Syndicate lenders. The Bank's officers had cause to be sceptical of the valuations submitted by Colliers, which were the justification for the $50.0M figure being put forward. First, Colliers had conducted the pre-loan valuation for the lenders, and would naturally be hesitant to depart from an existing position. Secondly, in early January 1990, Mr Walkom received a verbal on-completion valuation from Colliers of $250.0M.() The written valuation report of Colliers, however, dated 2 January, indicated that the on-completion value of the project would be "no more than $200M" (page 2). In the circumstances, and particularly in the light of the reports from KPMG Peat Marwick, and their antecedent firms, a conservative approach to valuation was required.

The offer by the Bank and Beneficial Finance Corporation as contemplated in the proposal of 26 February 1990 was rejected by the First Tier Syndicate. A further proposal (dated 20 March 1990) was put to the Board. This submission, as recommended by the Beneficial Finance Corporation Board and Mr T M Clark, was presented by Mr Hamilton. It recommended that the Board approve the provision, by the Bank, of facilities to Beneficial Finance Corporation to enable it to acquire the First Tier Syndicate debt at the rate of 95 cents in the dollar, with discretion up to 100 cents being given to the Group Managing Director. Further approval was sought for additional facilities of $19.5M, to enable completion of the carpark/retail stage of the project.

The Investigation has been informed that the lending submissions of 26 February and 1 March 1990 were prepared, not by Corporate Banking but, by Mr Hamilton, on behalf of Beneficial Finance Corporation, and that Mr Clark, the Chief Executive Officer of the Bank, had directed Mr Hamilton to take control of the account.() This information is consistent with the text of the two lending submissions. I am, therefore, satisfied that Corporate Banking had no responsibility for the accuracy of the contents of those two lending proposals.

As I have said elsewhere, the second proposal to the Board - that dated 1 March 1990 - was not channelled through the Lending Credit Committee. I have not been able to ascertain why the Lending Credit Committee was by-passed, but I infer that this came about because the proposal emanated, not from within the Bank, but from Beneficial Finance Corporation. It is most irregular that the Board should have been asked to approve a lending proposal that had not been considered by the Lending Credit Committee, particularly given the different financial consequences of acceptance of the proposal of 1 March 1990 as opposed to those underlying the proposal of 26 February 1990.

The proposal of 1 March 1990 was recommended to the Bank Board by the Beneficial Finance Corporation Board and by Mr Clark, who was also a member of the Beneficial Finance Corporation Board. Several members of the Bank Board, apart from Mr Clark were also directors of Beneficial Finance Corporation at the time. The position was, therefore, that the Bank Board was considering a recommendation not endorsed by Corporate Banking, not considered by the Lending Credit Committee of the Bank, and a proposal of benefit largely, if not exclusively, to Beneficial Finance Corporation, as opposed to the Bank. The proposal was not preceded by any credit analysis by Corporate Banking. Its receipt by the Board was thus procedurally irregular.

I am of the opinion that each of these proposals to the Board was deficient in the following substantive respects:

(i) At the time of approval of the participation in the syndicated facility, the Bank's documents assessed a loan/security ratio of 65.5 per cent and took comfort from the margin afforded by the security. The effective loan/security ratio of the Bank Group of around 82 per cent was neither referred to nor did it appear to be a matter of concern.

Following the appointment of a Receiver and Manager to Interwest, in January 1990, however, all analysis centred upon recovery of the Bank Group's exposure and particularly that of Beneficial Finance Corporation. Whilst the rationale behind this strategy was understandable, it was nevertheless inconsistent with the manner in which the loan/security ratio was assessed at the inception of the facility. It demonstrated the imprudence of the Bank's attitude to the making of loans jointly with, or in priority to, Beneficial Finance Corporation. In addition, the Bank's papers indicate a willingness on the part of both Bank officers and Beneficial Finance Corporation staff to court losses larger than the inevitable, if the larger loss is one likely to accrue or crystallise in the future, as opposed to one requiring immediate recognition and provision.

Notwithstanding the merits of pursuing the best overall result for the Bank Group, any strategy pursued or recommended by a prudent banker should follow careful analysis and should clearly emphasise the risks involved. Furthermore, the taking of undue risk by the Bank merely to recover the Beneficial Finance Corporation debt cannot be justified. The strategy for recovery of Beneficial Finance Corporation's debt of $24.0M, as viewed by Beneficial Finance Corporation, required the completion of the project. In order to achieve the objective of recovery of the Beneficial Finance Corporation debt, it was proposed, by management, that the Bank Group increase its exposure from its then level of $37.0M (comprising the Bank's funding as part of the syndicated facility of $13.0M and Beneficial Finance Corporation's loan of $24.0M) to a funding level of up to $191.6M (comprising the full project cost of up to $167.6M to be funded by the Bank, and, Beneficial Finance Corporation's debt of $24.0M). At this level of funding, full recovery could be achieved if the completed project were able to be sold at Colliers revised valuation of $200.0M. By contrast, a sale at Jones Lang Wootton's valuation of $146.0M would have resulted in a loss of $45.6M. That loss would exceed by some $8.0M to $23.0M the projected loss likely to be incurred if the First Tier Syndicated debt was not acquired as proposed. (There was, as I have said, a possibility that sale of the site in its actual condition in March 1990 may have cleared the First Tier Syndicate debt. On that footing, the Bank Group's exposure may have fallen to $24.0M.) Further, had the required funding level increased to the "worst case" scenario included in the proposal, the loss to the Bank Group would have increased to $64.2M.

In particular, the recommendation in the proposal of 20 March 1990, failed to draw sufficient attention to the increased loss that could result from the proposed acquisition of the Syndicated debt. Indeed, the manner in which it did present certain information in its Annexure "A" was both incorrect and misleading. This is commented upon in paragraph (v) hereunder.

(ii) The proposals of 26 February 1990 and 20 March 1990 failed to draw attention to certain other events, known to Bank staff, which had happened since the loan was drawn down, which had an impact on the risk associated with the project, including the following:

. in the wake of the collapse of the Interwest Group, the Hotel no longer had an appointed operator;

. KPMG Peat Marwick Hungerfords had updated their previous review, and presented a report, dated 8 December 1989, which noted a marked decline in projected occupancy rates, which it explained as follows:

"We note that our projected occupancy rates are significantly lower than in our March 1988 report. This difference reflects the large increase in planned additions to supply, which has the effect of reducing the Eden Melbourne's share of room nights demanded. The lower occupancy levels also reflect a small reduction in the rate of growth in demand expected during the forecast period."

. KPMG Peat Marwick Hungerfords had updated a previous financial analysis prepared by them, and had presented a report to the Bank, dated 10 January 1990, in which they projected income and profit levels significantly lower than their previous report*. A careful study of these figures should have led Bank officers to the view that the Hotel value had declined markedly.

This information was highly relevant to the determination to be made by the Board.

(iii) In the 20 March proposal prepared by Mr Hamilton and submitted to the Board, recommending the acquisition of the First Tier Syndicate debt, Mr Hamilton noted the following:

"The rejection of the above offers (ie to the First Tier Syndicate of 50 c and 82.5 c) and the possible necessity to pay-out the first mortgagees in full to gain control of the project is a direct result of investigations carried out by Coopers & Lybrand as to the best possible course of action for the first mortgagees.

These investigations have revealed the most likely scenarios at various stages of "completion" which are detailed in Annexure "A".

Coopers & Lybrand are therefore advising the first mortgage syndicate to negotiate a best offer from Beneficial or State Bank Victoria with the minimum acceptable offer being 95 cents in the dollar. Alternatively, should such an offer not be forthcoming, development should proceed to carpark/partial retail level (Option 2) whilst at the same time seeking buyers for the separate stages or the total project."

These were references to a Coopers and Lybrand Report of 15 March 1990, which was sent to Mr Walkom on the same day. The March 20 proposal did not accurately summarise the Coopers & Lybrand report to the First Tier Syndicate members which in fact stated the following:

"If this is not forthcoming, then urgent consideration should be given to completing the contract to an intermediate or final stage whilst at the same time seeking buyers for the separate stages or for the total project."

The misrepresented view expressed in the proposal could well have had the effect of placing greater pressure on the Board to approve the recommendation.

Further, Mr Walkom has informally advised the Investigation that it was the intention of the First Tier Syndicate to proceed with the project to completion should Beneficial Finance Corporation not make a reasonable offer. Mr Walkom was the agent for the First Tier Syndicate and had been requested by Mr Clark to avoid involvement in the deliberations over buying out the First Tier Syndicate because of his position as agent.

(iv) The proposal to the Board of 20 March 1990 included an appendix marked "Annexure `A'". This annexure set out a summary of alternative stages of completion and the estimated costs and recovery scenarios. The annexure also noted the following:

"Based upon valuations provided ranging from AUD 146.0M to AUD 200.0M, the maximum loss to which the Bank Group exposes itself by taking out the First Tier Syndicate lenders and building to ultimate completion would be AUD 21.6M (equals Beneficial potential loss under Option 2 by coincidence only) with the upside being a profit of AUD 37.3M."

The disclosures in the proposal, including the Annexure "A", were both incorrect and misleading. In order to demonstrate this proposition, I set out best and worst case scenarios which are based upon information extracted from Annexure "A" (in the case of the italicised information) and (as to the balance) from other parts of the proposal.


Scenario

 

Carpark
Only


(2)
Carpark
& Partial
Retail


(3)
Corporate
& Addt.
Retail

(4)
Full
Project
Early
Completion

(5)
Full
Project
Late
Completion

Best Case

$M

$M

$M

$M

$M

Total cost of first tier

67.6

72.7

89.7

162.7

167.6

Estimated value on completion

58.4

75.1

88.6

200.0

200.0

Surplus/(shortfall)

(9.2)

2.4

(1.1)

37.3

32.4

Beneficial exposure

24.0

24.0

24.0

24.0

24.0

Group surplus/(shortfall)

(33.2)

(21.6)

(25.1)

13.3

8.4

 

Carpark
Only


(2)
Carpark
& Partial
Retail


(3)
Corporate
& Addt.
Retail

(4)
Full
Project
Early
Completion

(5)
Full
Project
Late
Completion

Worst Case
Total cost of first tier

67.6

72.7

89.7

162.7

167.6

Estimated value on completion

58.4

75.1

88.6

146.0

146.0

Surplus/(shortfall)

(9.2)

2.4

(1.1)

(16.7)

(21.0)

Beneficial exposure

24.0

24.0

24.0

24.0

24.0

Group surplus/(shortfall)

(33.2)

(21.6)

(25.1)

(40.7)

(45.6)

The disclosures in the proposal, including Annexure "A", were both incorrect and misleading in that:

. the statement referring to a maximum loss exposure, of the Bank Group, of $21.6M was incorrect and therefore misleading. The table above, in Column 5 of the "Worst Case" scenario, demonstrates that this loss of $21.6M is reached before making allowance for Beneficial Finance Corporation's loss of $24.0M. After inclusion of the Beneficial Finance Corporation loss, the Bank Group maximum exposure would have been a potential loss of $45.6M. For purposes of further clarification, I note that this amount is derived by deducting from $167.6M (being the total cost to First Tier of taking the full project to "late completion") $146.0M (being the lower valuation of the full project) giving a result of $21.6M to the Bank alone, to which must be added the Beneficial Finance Corporation exposure of $24.0M;

. the statement referring to an upside profit to the Bank Group of $37.3M is incorrect and misleading. The table above, in Column 4 of the "Best Case" scenario, demonstrates that this implied profit of $37.3M is reached before making allowance for Beneficial Finance Corporation's loss of $24.0M. After inclusion of the Beneficial Finance Corporation loss, the Bank Group upside profit would have been limited to $13.3M. In any event, it is likely that this would not have been a profit accruing to the Bank Group, as implied by Annexure A, in that any surplus on sale, after recovery of the Beneficial Finance Corporation debt, would have accrued to the State Bank of Victoria as joint second mortgagee; and

. the statement further confuses the issue and misleads by making a comparison between the "potential loss under option 2" of $21.6M and the maximum Bank Group exposure, which is stated as being $21.6M. The former, as demonstrated by Column 2 of the above table, is calculated after deducting the Beneficial Finance Corporation loss, whereas the Bank Group exposure is calculated before deducting such loss.

(v) The proposal, dated 20 March 1990 included a recommendation of additional net expenditure of $19.5M to be funded to enable completion of the car park and partial retail components of the project. There is no documentation in the Bank's files which indicates that, prior to the First Tier Syndicate buy-out, officers of the Bank assessed:

. current demand for car parks in the Melbourne Central Business District;

. likely growth in supply and demand for car parks;

. current demand for retail space in the Central Business District;

. likely growth in supply and demand for retail space in Central Business District; and

. whether the Council would permit the car park to be operated in the absence of the hotel.

If, as appears to have been the case, evidence on these topics was not procured, then the recommendation that the Bank buy out the First Tier Syndicate was imprudent, because it was, I am satisfied, ill-informed and based on inadequate material.

Nevertheless, by November 1990, additional sums of $8.3M and $10.5M had been sought for completion of the project to the retail and car park stage. The main costs to be met by these funds were:

Item

$M

Increased Holding Costs

3.7

Fees, Rates and Taxes

3.0

Structural Alterations

3.5

Contract Break Costs

3.5

Other Fees

1.5

Prior to the Bank making the decision to acquire the First Tier Syndicate debt, a more detailed and accurate assessment should have been made of the costs of completion to the carpark/retail stage. The accumulation of a further $18.8M of required funding within eight months of the First Tier Syndicate buy-out suggests that a full and proper review of required expenditure levels was not conducted prior to formulation of the buy-out recommendation in February 1990. This conclusion is also supported by the following extract from the proposal dated 19 July 1990, in which Bank officers sought the first of the two additional sums to which I have referred. The proposal was prepared by Mr Walkom and Mr I C McLennan (Regional Manager Victoria and Tasmania, Asset Management division, Beneficial Finance Corporation), presented by Mr Hamilton, supported by Mr Henderson and submitted for approval to the Board of Directors:

"Following a detailed reassessment of both the direct costs for construction of this project and interest capitalisation costs it is obvious that the current level of funding allocated by SBSA is not sufficient to complete the project as originally proposed."

Had the additional expenditure levels required been properly assessed when the First Tier Syndicate buy-out was being contemplated, it may well have led to a different decision as to how best to recover the Bank Group's debt. The submissions dated 26 February and 20 March 1990 were thus deficient in that they were based on an inadequate assessment of the likely cost of taking construction to the carpark/retail stage.

(vi) In addition, "Annexure A" to the 20 March 1990 proposal asserted various estimated "values on completion". The values were said to be "based upon" valuations provided. This was a reference to the widely discrepant valuations of Colliers and Jones Lang Wootton. There is no firm basis in those valuations or in the Bank's papers for the estimated "values on completion".

Each of the 26 February 1990 and 20 March 1990 proposals was based on inadequate valuation material. The Bank staff were confronted with irreconcilable valuations. The proposal would, if the more conservative valuation was correct, immediately lock the Bank into a loss position. A more precise valuation of the project, as completed to the proposed car park/retail stage, should have been procured.

A Coopers & Lybrand report to the First Tier Syndicate dated 15 March 1990, page 3, set out the following information:

"12. Beneficial has had valuations done to a partial stage by JLW and by Richard Ellis. We have seen the former but not the latter. A valuation has also been done on behalf of the Syndicate by BKF, which is in course of completion. In summary these valuations show the following:-

Valuation (based on completion to Retail Level)

Car Park

Retail

Airspace

Total

$M

$M

$M

$M

JLW

34.5

16.7

15.0

66.2

RE

43.4

12.1

15.0

70.5

BKF
Car Park Only

48.8

-

22.5

71.3

Minimum Retail

48.8

19.2

12.5

80.5

Additional Retail

48.8

40.2

7.5

96.5

13. We have not had an opportunity to discuss the scope of the valuations with all the individual valuers, and hence we cannot be certain that they have been carried out in a similar manner or whether the relevant factors are the same.

14. In the case of BKF we have provided the valuer with details of the number of car spaces and the lettable retail area as advised by the quantity surveyors. The extent to which similar information has been provided to the others is not certain.

15. In examining the matter of the car park there is a range of between 720 and 730 spaces. There is a 12% difference between RE and BKF with a significant lower figure by JLW. We propose for review purposes to adopt the RE lower figure of $43.3 million.

16. In reference to the retail component, the variations may well be due to different information on lettable area. On our view it is unlikely to decide (sic) to go to the additional retail unless it is intended to proceed with the construction of the hotel. In the circumstance (sic) for review purposes we propose to adopt the valuation of $16.7 million as advised by JLW."

There were further shortcomings in the way in which the buy-out was implemented. For example, satisfactory arrangements with the State Bank of Victoria and Tricontinental were not made. Furthermore, no proper scrutiny of the cost implications of the terms of the building contract had been carried out. These two matters inter-acted. One result of this was that, when it was realised (as it was within a week of the buy-out) that the Grocon contract was not satisfactory, was "substantially flawed"(), and was not, strictly speaking, a fixed price/fixed term contract (as had been held out in the Bank's lending proposals), the Bank's position had, by virtue of its buy-out of the First Tier Syndicate, irretrievably deteriorated. Beneficial Finance Corporation and its directors were aware, in August 1989, that the terms of the Grocon contract were "such that there is scope for cost and time overruns." () This assessment was, as I have said, relayed to Bank officers. When the Bank sought to vary the building contract, the State Bank of Victoria and Tricontinental objected, as they were entitled to do. The contract was nevertheless varied, notwithstanding that this jeopardised the Tricontinental guarantee of $50.0M to which I have previously referred. Furthermore, Grocon insisted upon, and the Bank provided, a full and unlimited indemnity against claims on Grocon by the State Bank of Victoria or Tricontinental.() The Bank did not obtain any legal advice in respect of the building contract prior to contracting to pay out the First Tier Syndicate.

By letter from Mr Walkom dated 29 August 1989, the Bank had retained a firm of Quantity Surveyors and Construction Cost Consultants called WT Partnership as the expert under the bill facility, among other things:

"(3) to review the ... fixed price building contract with Grocon ...;

...

(8) to review the building agreement conditions, particularly as they relate to potential scope for the builder to increase to (sic) the Contract Sum."

It is not clear that this review was carried out before settlement of the Syndicated Facility.()

In addition, as acknowledged by the Bank's documents, the Bank's calculations of completion costs were inaccurate. This is evidenced by the proposal of 19 July 1990 for an increase in the facility of $8.8M and the proposal of 14 November 1990 for an increase of $10.5M, to which I have already referred in passing. The latter was attributed to a need to amend the car park design so as to ensure that the maximum options were available in the hotel design to suit potential purchasers (page 1). The increase of $8.8M proposed on 19 July 1990 was approved by the Board at its meeting 13/90 on 26 July 1990 (item 90/230). The minutes of that meeting record that the Managing Director, Financial Services Group (Mr Hamilton) gave an update of the Group's involvement in the project. It was recommended that the Group's best course of action would be to revert to the original contract and recommence work to avoid any need to have the State Bank of Victoria approve a variation to the building contract. It was emphasised to the Board that State Bank Group's negotiating ability was being constrained each day with a potentially high liability if work was not recommenced. The Chairman of the Board considered, if Mr Malouf was unable to resolve the dispute between the two Banks, that it would be appropriate for him to discuss the matter directly with the Chairman of the State Bank of Victoria. It was also noted that a progress report on the situation would be compiled by Mr Hamilton for distribution to directors before the next Board meeting.

Yet another aspect of the difficulties with the contract was that work was unable to recommence on the site until September 1990. Thus, interest was accruing on the sum paid to the First Tier Syndicate for some 6 months while the site was idle. In this period, holding costs of $3.7M accrued. I am satisfied that inaccurate and superficial assessments of matters relevant to the building contract were carried out by Bank staff before the First Tier Syndicate buy out. And the Bank would appear not to have apprised itself of all facts and information in the hands of Beneficial Finance Corporation.

For example, by memorandum dated 17 August 1989 to the Special Financial Projects division, Credit Committee of Beneficial Finance Corporation, Mr New, Mr McLennan, and Mr Hanson (of the Structured Finance and Project division of Beneficial Finance Corporation), reported that their review of the Grocon contract revealed potential for cost overruns of $15.0M to $25.0M. In the same memorandum (page 4), those officers detected an overstatement of Interwest's assets in its management accounts to 30 June 1989. Property sales accounted for 64 per cent of the revenue of Interwest in the 1988-89 year. The memorandum contained ground for suspecting that Interwest had no net worth. It is not clear whether this memorandum was made available to the Bank, or whether Bank officers conducted a similar review of the Grocon contract.

On 10 November 1989, in his memorandum to Mr Masters, Mr Walkom asserted that Grocon's contract was "fixed and that the probability of cost overruns (except for design changes) is considered minimal". This was misleading, as later events showed.

The Bank was aware, prior to settlement of the buy-out, by virtue of advice from its own solicitors, that "substantial changes" to the building contract were required to provide a fixed cost/fixed time contract.() At the meeting at which that advice was tendered, the Bank's solicitors estimated that "potential cost overruns could run as high as $30.0 - $40.0M if the project was completed under the existing contract". This information was not relayed to the Lending Credit Committee or to the Board by Mr Hamilton, who attended the meeting. The First Tier Syndicate buy-out was settled on 12 April 1990.

The Bank was thus aware before settlement of the First Tier buy-out that amendment of the building contract was required. It was also aware that such amendment would jeopardise the Tricontinental guarantee. The decision taken by Mr Hamilton was to "explore the possibility of entering a side agreement with Grocon Ltd which may improve the chances of maintaining the Promissory Note Obligation" (). I infer that this meant that the proposed variation agreement was not to be disclosed to Tricontinental.

A revised building contract was entered into in mid June 1990 (probably 19 June).() The need to amend the building contract caused delays which moved the completion date beyond the date proposed when Board approval to the First Tier Syndicate buy-out was obtained. This, in turn, caused additional interest to accrue and consequently "potentially greater loss".()

The possibility of a building variation agreement came to the knowledge of the State Bank of Victoria and Tricontinental, who then warned the Bank that such a variation would involve a breach of the security instruments executed by Somerley.() It appears from the Bank's papers that this warning led to a decision on the part of the Bank not to recommence construction under the varied agreement. Instead, a strategy meeting on 12 July 1990 resolved to recommence work under the original building contract of May 1988, to "neutralise" Tricontinental's objection to the variation.() This further delay of one month was a direct consequence of the failure by the authors of the First Tier Syndicate buy-out proposal:

. to come to a satisfactory arrangement with second and third tier lenders before the First Tier Syndicate buy-out was settled; and

. adequately to scrutinise the building contract before recommending the First Tier Syndicate buy-out to the Bank Board.

Subsequently, the variation agreement was disclosed to the State Bank of Victoria() and its consent thereto sought. By then, the Bank was aware that funds being expended on the site might not be immediately recoverable "as the added value of such expenditure is not beyond doubt." () The State Bank of Victoria offered its consent to the variation agreement, but on terms wholly disadvantageous to the Bank.() Negotiations with the State Bank of Victoria and Tricontinental had not been concluded even by 15 April 1991.

Work had still not recommenced by 6 August 1990. On that day, Beneficial Finance Corporation and the Bank communicated to Grocon a preparedness to waive certain rights and agree to a further variation of the Variation Agreement.() Work ultimately recommenced in the second half of September 1990, some five months after the First Tier Syndicate buy-out.

For the reasons given above, on the basis of the facts and information to which I have referred, I am of the opinion that Mr Hamilton did not exercise proper care and diligence in the preparation of the proposals submitted to the Board for approval on 26 February and 20 March 1990 in relation to the First Tier Syndicate buy-out.

13.4.2 APPROVAL OF FACILITY

(a) Bridging Loan of $30.0M

On 8 April 1988, the Lending Credit Committee recommended this facility for approval. Committee members present at the meeting were Mr K S Matthews, Mr G S Ottaway, Mr T L Mallett, and Mr S G Paddison. The minutes of the meeting of the Lending Credit Committee record that Mr K S Matthews, Mr Ottaway, Mr Mallett and Mr Paddison were present but that Mr Paddison "voted ex post facto". It is not clear whether this means that Mr Paddison left the meeting before the proposal was put to a vote. If that is what it means, then the meeting was irregular in that a quorum of four was not present at all material times during the Committee's deliberations. It has been submitted to the Investigation that "ex post facto approvals were an accepted practice" within the Bank but that "certainly no approvals were implemented prior to the approval by a "quorum"".() I have commented in the Adsteam report on the impropriety of ex post facto approvals, as they were called, and I will not repeat here my conclusions in that regard.

On 11 April 1988, the Board Sub-Committee approved this facility. Those present were Mr Summers and Mrs Byrne, assisted by Mr K S Matthews.() The approval may have been irregular for the reasons given in the report on Collinsville(), there being no recorded circumstances of urgency associated with the approval.

On 24 April 1988, the Board confirmed the approval of the facility. Board members present were Mr L Barrett, Mr D W Simmons, Mr R D E Bakewell, Mrs Byrne, Mr R E Hartley, Mr W F Nankivell, Mr R P Searcy, Mr Summers and Mr Clark.

I have, in Section 13.4.1(a), expressed the conclusion that this facility was one which should not have been approved.

(b) Participation in Syndicated Facility

On 11 August 1988, the Lending Credit Committee recommended for approval the proposal dated 9 August 1988 to which I have referred in Section 13.2.4 of this Chapter.() Committee members present at the meeting were Mr Ottaway, Mr V R Pfeiffer, Mr R L Wright, and Mr I R Tucker.

On 29 August 1988, the proposal to participate in the syndicated facility() was approved by the Board. Those present were Mr Barrett, Mr Simmons, Mr Bakewell, Mrs Byrne, Mr Nankivell, Mr Searcy, Mr Summers, and Mr Clark. The proposal to the Board was very superficial, and did not identify any of the deficiencies to which I have previously referred.

The proposal is one which, for the reasons I have given in Section 13.4.1 above should not have been approved either by the Board or by the Lending Credit Committee.

The Bank, in its submission to me, has admitted that the decision to approve participation in the syndicated facility was made without proper care and diligence.()

On 17 January 1989, a revision to the proposed facility was recommended for approval by the Lending Credit Committee. I have already referred to this proposal in passing in Section 13.4.1 (b). Those present were Mr Clark, Mr Mallett, Mr Mullins, and Mr Wright. The resolution of the Lending Credit Committee accepted a proposal prepared by Mr Walkom and supported by Mr Henderson dated 13 January 1989. As the proposal noted (page 1), it was recommending a "significant restructure" of the financing transaction in relation to the post-completion period. The main alteration was an extension of the term of the facility from construction period only to construction period plus 5 years beyond completion. This change was attributed by the proponents to "legislative uncertainty relating to the proposed tax effective take out funding" referred to in the proposal of August 1988. The proposal (page 1) noted that a second change was that Tricontinental Group would at completion provide a guarantee which would reduce "the overall debt" by $40.0M. For reasons not disclosed in the proposal, the Bank was not to benefit by a such payment by Tricontinental.() The funds to be provided by Tricontinental were to be paid in different amounts to all the members of the First Tier Syndicate save the Bank. The contribution by Tricontinental led to the Loan/Security Ratio being expressed (at completion) in the proposal as 50.9 per cent. That ratio may have been true for the First Tier as a whole, but it was not (in terms of the proposal dated 13 January 1989) true for the Bank or the Bank Group, given that the Bank was not to receive any share of the funds to be contributed by Tricontinental. Furthermore, by paragraph 3 of the Security Schedule attached to the proposal (page 6), Tricontinental's obligations were to be contingent upon "all leases being in place". The proposal contained (page 3) references to the Colliers valuation and the KPMG Peat Marwick Hungerfords report which references were of questionable accuracy. The proposal also failed to draw attention to the fact that, whereas the original proposal had put forward as a pre-condition that the Colliers valuation be confirmed by an independent valuer, it was now proposed simply that the current valuation "be confirmed by Colliers to SBSA" (page 7).

At page 8, the proposal referred to a value of the development on termination "of the holding phase of the order of $375.0M." No support appears in the Bank's papers for that estimate.

In other respects, the proposal shared the deficiencies identified in the proposal of 9 August 1988. The proposal was approved by the Lending Credit Committee. Whilst it is unfortunate that this proposal was approved, I do not extend any adverse criticism to the members of the Lending Credit Committee of 17 January 1989. In thus exonerating them, I have had regard to the fact that they were asked to consider and approve merely a variation of a facility approved by the Bank Board some four months previously; and that, given the demise of tax effective property financing in the latter part of 1988 and the take-out financing proposed as part of the First Tier Syndicate when it was originally approved, some revision of the end finance structure for the Somerley project had to be put before, and approved, by the Board. This revision was the very purpose of the submission considered and approved in January 1989. The amended proposal did not materially increase the Bank's risk in the post completion period; for it was reasonable to expect that the end value of the project would increase between the anticipated completion date (mid 1991) and the period ending five years beyond completion; and it was reasonable to expect that income to be generated by the completed hotel would also increase in that five year period.

Subsequently, Mr Masters prepared a proposal recommending that the Board approve the revisions to the First Tier Syndicate which had been approved by the Lending Credit Committee.

The proposal of 18 January 1989 from Mr Masters to the Board was itself defective in that:

(i) it shared the deficiencies in the previous proposal of 18 August 1988;

(ii) it referred to the Tricontinental Guarantee without indicating that it was conditional on the letting of the development and without indicating that the Bank itself would not benefit from the honouring of that guarantee; and

(iii) it did not refer at all to the involvement of Beneficial Finance Corporation, and thus did not alert the Board to the fact that the loan/security ratio referred to in the proposal was not reflective of the risk being undertaken by the Bank Group.

The members of the Lending Credit Committee have submitted to the Investigation that they were of the view:

"That the Bank "as the front end" lender did not need to consider the position of the "back-end" lenders even if it (sic) was a company which was part of the State Bank Group.

The Bank and Beneficial were two separate entities. The question of Bank Group exposure was a question to be taken up by the executives and the Board. It was not an issue to be dealt with by the Lending Credit Committee.

The Lending Credit Committee treated by Beneficial Finance (sic) as if it were a third party financier and in looking at the Bank's exposure were not concerned at the exposure of Beneficial Finance.

It was common procedure at the time not to take into account exposure by Beneficial Finance in a subsequent ranking advanced to the banker under the lending structure arranged for Somerley." ()

I have already in Section 13.4.1(a) of this Chapter referred to and expressed my view upon this topic.

On 26 January 1989, this revision was approved by the Board. Those present were Mr Barrett, Mr Simmons, Mr Bakewell, Mr Nankivell, Mr Searcy, and Mr Clark.

For the reasons to which I have previously referred, I have formed the opinion that the members of the Lending Credit Committee which resolved, on 11 August 1988, to approve the Bank's participation in the First Tier Syndicate did not exercise proper care and diligence in approving the Bank's participation in the Syndicated Facility to Somerley. The persons referred to should have scrutinised the proposals more closely and sought further information and explanations concerning those deficiencies in the proposal referred to in Section 13.4.1(b) of this Chapter. Had this occurred, those referred to may well have considered that the Bank should not participate in the Syndicated Facility.

(c) Buy-out of Syndicated Facility and Granting of Additional Construction Finance

On 27 February 1990, the Board approved the recommendation of the Lending Credit Committee to grant funds to Beneficial Finance Corporation to enable it to acquire the First Tier Syndicate debt at a rate of 50 cents in the dollar, with discretion up to 75 cents in the dollar, and grant additional facilities of $25.0M to enable completion of the car park/retail stage of the project. I have already referred to this approval in Sections 13.2.5 and 13.4.1(c) of this Chapter. The Board, consisting of Mrs Byrne, Mr Clark, Mr Bakewell, Mr Nankivell, Mr Searcy, Mr Summers and Mr Hartley approved the recommendation on a "round robin" basis.

A submission dated 1 March 1990, prepared by Mr Masters, recommended that the Board confirm its previous "round robin" approval. The Investigation has not been able to find evidence that such a submission was ever put to the Board, or was confirmed at any Board meeting following the date of the submission. I am satisfied that the proposal was, and was intended to be, approved by the Board on 27 February 1990, and that, in resolving to approve the proposal, the Board transacted business other than at a Board meeting.

On the basis of the facts to which I have referred, I am of the opinion that the Board's approval of 27 February 1990 may have been irregular in that it did not comply with Section 12 of the State Bank of South Australia Act, 1983 ("the Act"). Section 12 requires the members of the Board, subject to one exception, to transact business of the Bank at meetings. The one exception to this is found in Section 12(6) of the Act which provides:

"If all Directors entitled to vote on a proposed resolution express, in writing, their concurrence in the proposed resolution, it shall become a resolution of the Board notwithstanding that it has not been passed at a meeting of the Board."

Those Board members who responded to Mr Hamilton's proposal, along with Mr K S Matthews and Mr Hamilton (who had the carriage of the proposal) should have been alive to the need to regularise the resolution by way of an instrument in writing or by confirmation at a subsequent meeting (by way of passing an appropriate resolution of the Board).

The former directors of the Bank have submitted:

(i) That the "round robin" procedure was not a final procedure but merely gave "indicative" approval and was always subject to confirmation by the full Bank Board at a later stage.

(ii) Accordingly, Section 12(6) did not apply to the "round robin" procedure and there was no need for all directors to express in writing their concurrence in the proposed resolution.

(iii) That the only resolutions of the Board which were binding on the Bank were those which were passed at a full Board meeting as distinct from a "round robin".

(iv) That therefore all Board business was lawfully and regularly transacted and in particular all statutory procedures were adhered to.

Whilst I accept that members of the Board were of the view that the "round robin" procedure was not an attempt to take advantage of Section 12(6), I am of the view, for the reasons which I have given, that, in a procedural sense, the approval extended by the Board on 27 February 1990 to the buy-out of the syndicated facility was irregular and involved the Board in transacting business other than at a meeting, and thus other than in accordance with Section 12 of the Act. This matter is further discussed in Section 8.4.2 of Chapter 8 - "Credit and its Management: Guidelines, Policies, Processes, Procedures and Organisational Delivery Mechanisms" of this Report.

The proposal for the buy-out of the Syndicated Facility at 100 cents in the dollar and the financing of additional expenditure of $19.5M, was approved by the Board on 22 March 1990.() This proposal was recommended, not by the Lending Credit Committee (as was the proposal of 26 February 1990), but rather by the Beneficial Finance Corporation Board and the Group Managing Director. Those present were Mr Simmons, Mr Bakewell, Mrs Byrne, Mr Nankivell, Mr Searcy, and Mr Clark. Again, I have referred to this approval in Sections 13.2.5 and 13.4.1(c) of this Chapter. The buy-out of the First Tier Syndicate was financially detrimental to the Bank. Its adverse financial consequences far outweigh those of the two original lending decisions. As of 22 March 1990, group debt outstanding on the Somerley project was $33.3M. There were, in March 1990, some prospects of recovery of at least part of that amount. By 26 April 1991, debts due to the Bank had increased to $82.4M of which very little is regarded as recoverable.

I am satisfied that the decision of the Group Managing Director to recommend to the Board the buy-out of the syndicated facility at 100 cents in the dollar, and the financing of additional expenditure of $19.5M, as approved by the Board on 22 March 1990, was made without proper care and diligence, and that in approving that recommendation and proposal on 22 March 1990, the members of the Bank Board failed adequately and properly to supervise, direct and control the operations, affairs and transactions of the Bank and the Bank Group. I have reached that conclusion having regard to the factors operating for and against the proposal, as set out in Sub-Sections 13.2.5 and 13.4.1(c) of this Chapter. The Bank, in its submission to me, has accepted that this decision was made without proper care and diligence.()

The former non-executive directors of the Bank have submitted to the Investigation that they were entitled to rely upon the skill, judgment and integrity of both Mr Hamilton and the Lending Credit Committee with regard to the accuracy of the information provided to them in relation to this particular proposal and that the non-executive directors should not be required to "go behind" the information contained in the proposals in the absence of anything that would make them suspicious of or distrusting of the information and the advice of management.() Again, I have had regard to this submission, but I am not persuaded by it in the particular circumstances of the approval to which I have referred. Whilst I fully accept that the non-executive directors are not necessarily expected "to go behind" information in lending proposals forwarded to them, for reasons which I have given elsewhere in the report, I am of the view that, as members of the Board directly involved themselves in the lending business of the Bank, they had a responsibility to exercise an independent judgment in relation to all credit assessment matters.()

On the basis of the facts to which I have previously referred, I am of the opinion that the members of the Board referred to above did not, in approving the strategy of buying out the Syndicated Facility, and financing further expenditure, adequately and properly supervise, direct and control the operations, affairs, and transactions, of the Bank. Those named should have scrutinised the proposal more closely and sought further information and explanations concerning those deficiencies in the proposal referred to in Section 13.4.1(c).

13.4.3 SECURITY

No departures from the Bank's policies and procedures applicable to the security aspects of the loan occurred sufficient to warrant mention in this Section of the Report, other than matters referred to under Section 13.4.1.

13.4.4 HINDSIGHT OVERVIEW

No departures from the Bank's policies and procedures applicable to the Hindsight Overview process sufficient to warrant mention in this Section of the Report became known to the Investigation.

13.4.5 ADVANCE OF FUNDS

No departures from the Bank's policies and procedures in respect of advance of funds sufficient to warrant mention in this Section of the Report became known to the Investigation.

13.4.6 MANAGEMENT OF FACILITY

No departures from the Bank's policies and procedures applicable to the management of the facility whilst the loan was classified as performing became known to the Investigation.

13.4.7 MANAGEMENT OF NON-PERFORMING FACILITY

(a) The exposure to Somerley was classified as non-accrual as of 7 March 1990 by resolution of a Non-Accrual Loans Meeting on 19 March 1990. This followed the appointment of a Receiver and Manager to Interwest on 9 January 1990. As of January 1990, Bank policy was "that accounts are designated as non-accrual if they are more than 90 days in arrears or where a Receiver/Liquidator has been appointed and has indicated that interest payments will not be met".() Interwest was listed as a Non-Accrual Account in the report to the Board from Group Risk Management, Group Non-Accrual Accounts, dated 20 February 1990() to the extent of $23.4M, in respect of the Bank, and $24.0M, in respect of Beneficial Finance Corporation. On page 4 of the second attachment to that report, it was indicated that the Group may suffer a "possible loss" of $10.0M on the Somerley transaction. The Somerley facility, however, was transferred from non-accrual status to the current ledger on 12 April 1990 on the acquisition by the Bank of the First Tier Syndicated debt notwithstanding that Receivers and Managers of Somerley were appointed by the Bank by Deed dated 6 April 1990 and by notice dated the same day.

(b) On 1 January 1991, the facility was once again classified as non-accrual following receipt of evidence that significant doubt existed as to recoverability. By memorandum dated 17 January 1991 from Mr Henderson and Mr Mallett, the Board was asked to note the Bank's position in relation to Somerley. It was proposed to place the project "on hold" and to continue negotiations with possible purchasers. It was recommended:

(i) that the account be transferred to non-accrual status as from 1 January 1991;

(ii) that a full assessment be made prior to June 1991 as to what loss provision was required by the Bank;

(iii) that specific provision should be made for the full Beneficial Finance Corporation debt; and

(iv) that a decision to progress to hotel stage be deferred until the possibility of constructing a Casino was investigated.

The proposal drew on a report, by Mr New, of 9 January 1991, which disclosed information from selling agents that:

(i) demand for car parks in the Central Business District had "fallen dramatically" as a result of oversupply and Council timing restrictions; and

(ii) it was unlikely that Stage I would have an attainable sale price in excess of $40.0M (car parks, restaurants/retail and development rights) and that, if the car park was disposed of on completion, the loss to the Bank Group would be in the range of $75.0M to $85.0M.

The Lending Credit Committee at its meeting 3/91 held on 16 January 1991 noted that "present indications suggested that provisioning in the region of $20.0M to $40.0M may be required prior to 30 June 1991". At that meeting, the Committee conducted a review of the Bank's possible and probable losses, based on a verbal presentation by Mr Mallett.

I am of the opinion that the management of the non-performing facility was deficient in that establishment of a provision in respect of a possible loss was delayed until January 1991, despite the existence of strong evidence that consideration should have been given to making a provision as of 30 June 1990. This was contrary to Bank procedures, which required the establishment of a provision immediately upon its becoming evident that a loss was likely. In particular, I draw attention to the following:

(i) On 9 January 1990, a Receiver and Manager was appointed to administer Interwest. On 6 April 1990, the Bank appointed a Receiver and Manager to Somerley.

(ii) The proposal presented by Mr Hamilton dated 20 March 1990 to which I have already referred, which recommended the acquisition of the syndicated debt by the Bank, included certain analyses of costs and values on completion. From this it should have been evident that the Bank Group could sustain a loss of up to $64.0M, of which the Bank would have had to bear $40.0M. At page 2 of the proposal, it is concluded that completion of the construction project to carpark/retail would "result in the Bank recouping the majority, if not all, of its exposure" (emphasis added). This is an elliptical way of saying that a loss, both to the Bank and to the Bank Group, is a real possibility.

The body of the proposal itself foreshadowed a loss of $64.0M for the Bank Group, of which the Bank would have to bear $40.0M. In the Annexure, a loss of $21.0M was envisaged as the worst case Scenario.

I am prepared to infer that, in approving Mr Hamilton's proposal of 20 March 1990, and in deciding to proceed to acquire the First Tier Syndicate debt, the Board was desirous of avoiding a loss to the Bank Group. The Board must then, however, have been aware that the bank was running some risk of a loss and that, by buying out the First Tier Syndicate debt, it was increasing the magnitude of that possible loss. Accordingly, one would have expected that, after March 1990, the Board would have instructed management to monitor the position closely, and to report regularly management's perception of changes in the likely financial outcome of proceeding to car park/retail stage, and that the Board would subsequently have been alive to the need to make a provision in the accounts for the year ending 30 June 1990.

Mr Hamilton's proposal was more or less contemporaneous with a memorandum, dated 19 March 1990 from Mr Walkom to Mr Masters recommending that the Somerley account be treated as non-accrual, with effect from 7 March 1990.

(iii) A paper dated 28 June 1990 prepared by Mr McLennan for Mr Malouf (of Beneficial Finance Corporation) and which was in the possession of the Bank indicated a loss of $37.6M to the Bank Group, based upon development progressing to the approved level, namely car park and first level retail. Of such a loss, an amount of the order of $13.6M would have accrued to the Bank.

(iv) A memorandum, dated 12 June 1990, was received by Mr Walkom advising that Beneficial Finance Corporation were pursuing legal action against Colliers International Property Consultants. The memorandum (from Mr de Vries at Beneficial Finance Corporation) advised the Bank to take legal action against Colliers:()

"...given that there is now a possibility that SBSA may lose money on this transaction."

(v) The topic of provisioning in relation to the facility to Somerley should also have been addressed by the Board on 26 July 1990 when the Board was considering the proposal, to which I have already referred, dated 19 July 1990, for an increase in the facility of $8.8M.() The Board, however, was denied that opportunity by an alteration in the form and contents of the lending submission put to the Board. The relevant lending submission (ultimately designated Board Minute 90/230) had its genesis in a paper, apparently prepared by Mr Hamilton or under his direction, forwarded by facsimile to Mr Malouf of Beneficial Finance Corporation in Sydney on 9 July 1990. On the same day, Mr Malouf faxed the proposed paper to Mr New of Beneficial Finance Corporation in Melbourne. The draft paper contained, on page two, the following matter:

"POTENTIAL LOSS FOR SBSA GROUP

The "potential loss" situation to the SBSA Group can only be quantified if the valuations obtained by BFC in January 1990 are compared to the Group's cost of construction.

Valuer

Valuation 1/90
Value of Property with carpark JLW $66.0M
and retail component completed Richard Ellis $70.5M
Using these figures and excluding default interest and cash held the potential loss to the Group would be either:
(a) Estimated Group Debt on Completion

$105.2M

JLW Valuation

66.0

Estimated Loss

($39.2M)

(b) Estimated Group Debt on Completion

$105.2M

$70.5M

Estimated Loss

($34.7M)"

The version of the paper which was forwarded to the Board contained a segment entitled "SBSA Group Strategy" in lieu of the segment which I have set out above. As part of the substituted segment entitled SBSA Group Strategy, there appeared an assertion that if a proposed sale to an identified buyer was "firmed up" at about the suggested figure of $225.0M, the Group could recover its principal in full and a portion of the interest due to both the Bank and Beneficial Finance Corporation.

This variation in the content of the Board Paper was the subject of evidence at the Royal Commission into the State Bank of South Australia. It was not satisfactorily explained.

Mr Hamilton gave evidence before the Royal Commission that he did not direct the part of the paper which I have set out to be excluded from the proposal.()

As it turned out, therefore, the Board Paper of 19 July 1990 gave details of the Bank's exposure to Somerley without referring, in the body of the Paper, to the actual or potential value of the project as imputed by Bank management. Without information as to that imputed value, the Board could not form a view as to the likelyhood of loss and that a provision may be required. Mr Hamilton gave evidence to the Royal Commissioner that the topic of provisioning was discussed by both the Beneficial Finance Corporation Board and the Bank Board in June and July 1990, and that provision was decided against. Mr Hamilton, in his evidence, asserted that Mr Clark advised the Beneficial Finance Corporation Board, and subsequently the Bank Board that the Bank Group policy was that in the case of a project in the course of construction, interest would be capitalised and no provision would be considered until the project was completed. Mr Hamilton could not recall what response, if any, the other members of the Bank Board, or of the Beneficial Finance Corporation Board made in relation to this statement of Mr Clark's.()

The Paper that was submitted to the Board on 19 July 1990 was presented by Mr Hamilton, and supported by Mr Henderson. It was noted as having been prepared by Mr Walkom and Mr McLennan. I have not been able to ascertain who brought about the deletion of the omitted paragraph which I have set out. Given the amount of the loss shown as being estimated in the draft proposal, the change in the format of the report was most significant. It prevented the Board from actively considering the making of a provision in July and August 1990 in relation to Somerley which could well have equalled or exceeded the Bank's reported profit for the year ending 30 June 1990.

(vi) By December 1990, a loss was clearly foreseeable. By their recommendation of 14 December 1990 to the Board for noting, Mr Henderson and Mr Wilcox put before the Bank Board a report to the Beneficial Finance Corporation Board which predicted a potential Group loss of $60.0M - $80.0M.

In my opinion, Mr Hamilton, who was actively managing the account, should have taken steps to ensure that a provision was considered in relation to the 1989-90 year. The Bank's files indicate that no such steps were taken. In addition, the members of the Board who approved the First Tier Syndicate buy out on 22 March 1990 should have taken positive steps to ensure that proper consideration was given then, or at a subsequent meeting, to a provision, notwithstanding the fact that the project was still in its construction phase.

The matter of the adequacy of the Bank's provisioning is to be considered in a subsequent report.

For the reasons given above, on the basis of the facts to which I have referred, I am of the opinion:

(a) that Mr Hamilton did not exercise proper care and diligence in the conduct of his duties as concerns management of the facility when it was non-performing; and

(b) that the Bank Board, comprising Mr Bakewell, Mrs Byrne, Mr Clark, Mr Nankivell, Mr Searcy, and Mr Simmons, did not adequately and properly supervise, direct and control the operations, affairs and transactions of the Bank, in that they did not take any steps to ensure that proper consideration was given to making a provision in relation to the Somerley facility in respect of the 1989-1990 financial year.

13.4.8 CREDIT INSPECTION

The Credit Inspection process was not established until August 1990. Credit Inspection was not conducted on this facility.

 

13.5 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT

 

As directed by Terms of Appointment A(a) to (f) (inclusive) and A(h), C and D, I have investigated the circumstances that occurred over the period from April 1988 to March 1991 surrounding the loan facilities granted to Somerley.

For the reasons given elsewhere in this section of the report and on the basis of the findings which I have set out and the documents and information to which I have referred, I have formed the opinion that:

13.5.1 TERMS OF APPOINTMENT A

(a) So far as concerns the "Initiation of the Facility":

(i) As it relates to the $30.0M bridging loan facility, Mr P W Walkom and Mr J V Henderson did not exercise proper care and diligence in the preparation of the proposal submitted to the Lending Credit Committee in that the submission contained assertions, to which I have referred, which they had not personally verified.

The Bank's lending policies and procedures were inadequate in that they did not require authors of lending submissions to disclose, and they did not require the Bank's lending organs to have regard to, aggregated Bank Group exposures where the Bank was proposing to lend jointly with, or in priority, to Beneficial Finance Corporation, being exposures to the applicant and to entities associated with or a subsidiary of the applicant.

(ii) As it relates to the Bank's participation in the syndicated facility, Mr P Davenport, Mr P W Walkom, and Mr J V Henderson, did not exercise proper care and diligence when they respectively prepared, supported, or recommended, the submissions to the Lending Credit Committee, in that:

. they did not adequately scrutinise the valuation prepared by Colliers International Property Consultants. Had they done so they would have detected that the valuation made no allowance for amounts that would be payable to the hotel operator. This valuation basis, which resulted in a higher imputed value, was spelt out in the Colliers report. Adequate information was available to enable a recalculation of the value to be undertaken with relative ease. The named Bank officers should also have undertaken sensitivity calculations to assess the impact on the imputed valuation of varying certain key assumptions used by Colliers. Had the proper level of scrutiny been exercised, and had sensitivity calculations been undertaken, a reassessment downwards of the valuation is likely to have resulted. This would have raised serious questions on the merit of participating in the syndicated debt facility;

. the submissions contained insufficient analysis of the financial status of Interwest;

. the submissions either glossed over or omitted reference to information in the possession of the Bank from Peat Marwick Hungerfords which should have resulted in a more cautious and conservative approach to the valuation of the completed project;

. no assessment was conducted of the impact of the Interwest management agreement on the security position of the Bank;

. the proponents of the submission had not analysed the terms of the Grocon building contract;

. the submission of 13 January 1989 did not disclose existing exposures on the part of the Bank and Beneficial Finance Corporation to Interwest and Hoyts, and did not disclose that the Bank had an exposure to Interwest on a second hotel construction site in Melbourne;

. the submission of 13 January 1989, and the pre-settlement review by Mr P W Walkom of 30 August 1989, failed to include a value for the project on a liquidation basis, as was then required by the Bank's procedures;

. the submissions, in their risk assessment, took comfort from the Loan/Security ratio for the Bank in isolation. Inadequate attention was drawn to the Bank Group exposure level which was considerably higher; and

. Mr P W Walkom did not carry out with adequate care and diligence the pre-settlement review contemplated by his memorandum of 1 August 1989 and by the advice of the Lending Credit Committee meeting no 55/89.

(iii) As it relates to the facility to buy-out the First Tier Syndicate and finance the ongoing construction of the project, Mr M G Hamilton did not exercise proper care and diligence in the preparation of the proposals submitted to the Board, in that:

. the submissions did not draw sufficient attention to the increased level of loss that could result from the proposed acquisition of the syndicated debt;

. certain financial analyses, included in an Annexure to a proposal to the Board, included assessments of potential losses which were incorrect and misleading. This had the effect of significantly understating the potential loss;

. the submission was not preceded by any, or any adequate, research into demand for car park spaces in the Melbourne Central Business District, or by any analysis of the construction contract between Somerley and Grocon;

. no arrangements had been negotiated with State Bank of Victoria before the buy-out, with a view to facilitating the buy-out;

. the cost to complete the project to car park/retail level was significantly understated. A proper compilation of the costs to completion of this stage may well have led to a different decision as to how best to recover the Bank Group's debt;

. the submissions did not draw attention to various factors (to which I have already referred) which had the effect of increasing the risk associated with the project;

. the submission of 20 March 1990 did not accurately reflect the recommendation of Coopers & Lybrand to the First Tier Syndicate members; and

. the submissions did not disclose events (to which I have referred) which were known to Bank officers and which had happened since the syndicated loan was drawn down nor did they disclose the substance or effect of the revised projections by Peat Marwick Hungerford.

(b) So far as concerns the "Approval of the Facility":

(i) As it relates to the $30.0M bridging loan facility:

. the Lending Credit Committee (comprising Mr K S Matthews, Mr G S Ottaway, Mr T L Mallett and Mr S G Paddison) acted imprudently in recommending the loan for approval by the Board Sub-Committee; and

. the Board Sub-Committee (comprising Mr A G Summers and Mrs M V Byrne) did not, in approving the loan, adequately and properly supervise, direct and control the operations, affairs and transactions, of the Bank in that they should have given greater weight to the Bank Group exposure on this facility and should have declined the loan on the ground that Bank Group exposure was imprudently high.

(ii) As it relates to participation in the Syndicated Facility, the Lending Credit Committee (comprising Mr G S Ottaway, Mr V R Pfeiffer, Mr R L Wright, and Mr I R Tucker) on 9 August 1988 did not exercise proper care and diligence in approving the facility, in that:

. they should have required further information, analysis and explanation, covering deficiencies in the proposal; and

. they should have recognised and given greater weight to the Bank Group's exposure on the facility which was in excess of the Bank's exposure.

(iii) As it relates to the buy-out of the Syndicated Facility, and the granting additional construction finance:

. the Board, comprising Mrs M V Byrne, Mr T Clark, Mr R D E Bakewell, Mr W F Nankivell, Mr R P Searcy, Mr A G Summers and Mr R E Hartley did not adhere to Section 12 of the State Bank of South Australia Act in that they approved a submission on a "round robin" basis, and thus transacted business of the Bank other than at a Board meeting and other than in accordance with sub-section 12(6) of the Act;

. Mr M G Hamilton, who had carriage of the proposal, did not exercise proper care and diligence in that he failed to submit the submission dated 1 March 1990 to the Board for confirmation of the "round robin" approval; and

. the Board (comprising Mr D W Simmons, Mr R D E Bakewell, Mrs M V Byrne, Mr W F Nankivell, Mr R P Searcy and Mr T M Clark) did not, in approving the facility, adequately and properly supervise, direct and control the operations, affairs and transactions of the Bank, in that:

- they should have required further information, analysis and explanation to cover deficiencies in this proposal; and

- they should have recognised the increased level of risk that was involved in pursuing the proposal's recommendations.

(c) So far as concerns the "Management of the Non-performing Facility", Mr M G Hamilton did not exercise proper care and diligence, in that he should have taken steps to ensure that a provision against this loan was considered in relation to the 1989-1990 year.

The members of the Board who approved the First Tier syndicate buyout on 22 March 1990 did not adequately and properly direct, supervise and control the affairs, operations, and transactions, of the Bank in that, when approving the First Tier syndicate buy-out on 22 March 1990, they should have taken, but did not take, positive steps to ensure that proper consideration was given then, or at a subsequent meeting, to a provision in relation to the exposure to Somerley. The Directors present at that meeting were Mr R D E Bakewell, Mrs M V Byrne, Mr T M Clark, Mr Nankivell, Mr R P Searcy and Mr D W Simmons.

13.5.2 TERM OF APPOINTMENT C

For reasons which I have given, the operations, affairs and transactions of the Bank in reference to Somerley and Interwest were not adequately and properly supervised, directed or controlled by the Board of Directors of the Bank or by Mr M G Hamilton, in the respects mentioned in this Chapter. In this respect I must acknowledge that Mr M G Hamilton passed away in 1992 and was thus not able to make any submission to me in relation to this Chapter.

13.5.3 TERM OF APPOINTMENT D

For reasons which I have given, the information and reports given by officers of the Bank to the Bank Board and referred to in this Chapter were not, in all the circumstances, timely, reliable or adequate, nor were they sufficient to enable the Board adequately to discharge its functions under the Act.

 

13.6 RECOMMENDATION ON FURTHER INVESTIGATION OR ACTION

 

I recommend that each of the matters dealt with above should be the subject of administrative action within the Bank to ensure proper supervision and competence in understanding and executing the lending policies and procedures of the Bank.

 

13.7 APPENDICES