SECOND REPORT PURSUANT TO TERMS OF
AND THE STATE BANK ACT
CONCLUSIONS, FINDINGS AND RECOMMENDATIONS
OF THE INVESTIGATION INTO
BENEFICIAL FINANCE CORPORATION LIMITED AND
THE EXTERNAL AUDITS OF STATE BANK AND
BENEFICIAL FINANCE CORPORATION LIMITED
TABLE OF CONTENTS
27.2 THE INVESTIGATION INTO, AND REPORT ON, BENEFICIAL
27.2.1 TERMS OF APPOINTMENT
27.2.2 THE SCOPE AND CONDUCT OF MY INVESTIGATION
27.3 AN OVERVIEW OF MY REPORT ON BENEFICIAL FINANCE
27.3.1 SUMMARY REPORT IN ACCORDANCE WITH MY TERMS OF APPOINTMENT
126.96.36.199 Term of Appointment A(a)
188.8.131.52 Terms of Appointment A(b) and A(c)
184.108.40.206 Term of Appointment A(d) and A(e)
220.127.116.11 Term of Appointment A(f)
18.104.22.168 Term of Appointment A(g)
22.214.171.124 Term of Appointment A(h)
126.96.36.199 Term of Appointment C
27.3.2 THE LOSSES SUSTAINED BY BENEFICIAL FINANCE
27.3.3 WHAT WENT WRONG AND WHY: BENEFICIAL FINANCE
188.8.131.52 The Structured Finance and Projects Division
184.108.40.206 The Operating Joint Ventures
220.127.116.11 The Corporate Culture
18.104.22.168 The Board of Directors
22.214.171.124 The Chief Executive Officer
126.96.36.199 The Senior Management
27.3.4 A SYNOPSIS OF MY REPORT
188.8.131.52 Chapter 28: Overview of Beneficial Finance Corporation Limited
184.108.40.206 Chapter 29: Direction-Setting and Planning
220.127.116.11 Chapter 30: Credit and its Management: Guidelines, Policies, Processes and
18.104.22.168 Chapter 31: Case Study in Credit Management: East-End Market
22.214.171.124 Chapter 32: Case Study in Credit Management: Mindarie Keys
126.96.36.199 Chapter 33: Case Study in Credit Management: Pegasus Leasing
188.8.131.52 Chapter 34: The Funding of Beneficial Finance
184.108.40.206 Chapter 35: Beneficial Finance - Prospectus 65
220.127.116.11 Chapter 36: Treasury and the Management of Assets and Liabilities at Beneficial
18.104.22.168 Chapter 37: Internal Audit of Beneficial Finance
22.214.171.124 Chapter 38: Equiticorp Receivables
126.96.36.199 Chapter 39: Mortgage Acceptance Nominees Limited
188.8.131.52 Chapter 40: Paper Meetings of Directors
184.108.40.206 Chapter 41: Management and Financial Information Reporting
220.127.116.11 Chapter 42: Bank and Bank Group Provisioning
18.104.22.168 Chapter 43: Other Matters Investigated within the State Bank and Beneficial
22.214.171.124 Chapter 44: Reports from the State Bank's External Auditors to the Reserve Bank
27.4 THE LAW APPLICABLE TO BENEFICIAL FINANCE
27.4.2 WHAT THE LAW REQUIRED OF DIRECTORS AND EMPLOYEES OF BENEFICIAL FINANCE
126.96.36.199 The Important Features of the Standards Required by the Law
188.8.131.52 The Allocation of Functions and Powers in Beneficial Finance
184.108.40.206 Reliance by Non-Executive Directors on the Managing Director and Senior Managers
220.127.116.11 The Obligations of the Board of the State Bank for the Conduct of the Affairs of
18.104.22.168 The Role and Duties of Common Directors on the Boards of the Bank and Beneficial
27.4.3 RELEVANT PROVISIONS OF THE COMPANIES CODE
22.214.171.124 Section 229(2): The Duty to Exercise Reasonable Care and Diligence
126.96.36.199 Section 229(1): The Duty to Act Honestly in the Best Interests of the Company
188.8.131.52 Section 229(3): The Duty Not to Make Improper Use of Company Information
184.108.40.206 Section 229(4): The Duty Not to Make Improper Use of Position in the Company
220.127.116.11 Potential Penalties and Liabilities Under Section 229
27.4.4 MY POWER TO MAKE FINDINGS IN RESPECT OF MATTERS OF LAW
18.104.22.168 The Issue
22.214.171.124 The Non-Judicial Nature of my Investigation
126.96.36.199 The Law Regarding Non-Judicial Investigations
188.8.131.52 Section 25 of the State Bank Act
184.108.40.206 My Terms of Appointment
27.5 AN OVERVIEW OF MY REPORT ON THE EXTERNAL AUDITS
27.5.1 MY TERMS OF APPOINTMENT
27.5.2 A SYNOPSIS OF MY REPORT ON THE EXTERNAL AUDITS
220.127.116.11 Chapters 45 to 53: The External Audits of the State Bank
18.104.22.168 Chapters 54 to 60: The External Audits of Beneficial Finance
This is the second of my essentially self-contained Reports
in respect of my inquiry into the State Bank of South Australia and its subsidiaries and
In my First Report, comprised by Chapters 1 to 26, I
presented the results of my inquiry into the operations of the State Bank of South
Australia. This Second Report, comprised by Chapters 27 to 60, contains two distinct
parts. It presents the results of my inquiry into:
(a) the operations of the other main entity in the State
Bank Group, Beneficial Finance Corporation Limited and its associated entities, and some
further matters relating to the State Bank (Chapters 27 to 44); and
(b) the adequacy and appropriateness of the external audits
of the State Bank and of Beneficial Finance (Chapters 45 to 60).
A separate confidential report has also been presented to
the Governor, dealing with a variety of matters, most of which require further
The purpose of this Chapter is to provide an overview and
summary of this Second Report, and of the key findings and conclusions that I have
reached, as a result of my inquiry into Beneficial Finance and the external audits of the
Bank and Beneficial Finance.
This Chapter, it must be emphasised, is intended to
present only an overview and summary of my key findings and conclusions. It is essential
to read it in the context of this Report as a whole, because it is impossible to fully
understand the nature and impact of my Report by only reading this overview and summary.
To read this Chapter in isolation would be unfair to many named persons and to the
Investigation, and contrary to my intention.
Much of the background to my inquiry, including the
circumstances of my appointment and the nature and conduct of my investigation, was
described in detail in Chapters 1 and 2 of my First Report, to which the reader is
referred. I have not reproduced that information in this Report except to the limited
extent that is necessary to make this Report comprehensible without needing to refer to
the First Report.
INVESTIGATION INTO, AND REPORT ON, BENEFICIAL FINANCE
TERMS OF APPOINTMENT
The Terms of Appointment in respect of which I am required
to inquire and report are contained in the Instrument by which I was appointed by the
Governor, as modified from time to time, and in Section 25 of the State Bank of South
Australia Act 1983 ("the Act"). The full text of the Instrument by which I was
appointed (as modified) is provided as an Appendix to this Chapter.
Shortly stated, the focus of my Investigation into
Beneficial Finance has been upon answering the questions:
(a) What caused the losses of Beneficial Finance which
contributed to the financial position of the Bank and Bank Group as described in February
(b) Who, or what, is to blame?
The substance of my Terms of Appointment relating to
Beneficial Finance which are answered in this Report can be summarised as follows:
(a) What matters or events caused the losses sustained by
Beneficial Finance that contributed to the financial position of the Bank and Bank Group
as reported in February 1991? (Term of Appointment A(a));
(b) What were the processes which led Beneficial Finance to
engage in operations which resulted in material losses, or the holding of significant
non-performing assets, and were those processes appropriate? (Terms of Appointment A(b)
(c) Were there adequate procedures, policies, and practices
for managing Beneficial Finance's assets which became non-performing, and for identifying
non-performing assets? (Terms of Appointment A(d), (e) and (f));
(d) Were the operations, affairs, and transactions of
Beneficial Finance adequately or properly supervised, directed and controlled by its
directors, officers and employees? (Term of Appointment C);
(e) Was there any possible failure to exercise proper care
and diligence on the part of a director or officer of Beneficial Finance? (Term of
Appointment A(h) and sub-section 25(2) of the Act);
(f) Were the internal audits of Beneficial Finance
appropriate and adequate? (Term of Appointment A(g)); and
(g) Is there any evidence of any conflict of interest,
breach of fiduciary duty or other unlawful, corrupt or improper activity that should be
further investigated? (Terms of Appointment A(h) and E, and sub-section 25(2) of the Act).
Readers of my Terms of Appointment will have noticed that
Term of Appointment D does not refer to Beneficial Finance. That Term of Appointment
required me to examine whether the reports given by officers of the Bank to the Bank's
Board of Directors were timely, reliable, adequate, and sufficient to enable the Board to
discharge its functions under the Act.
Although Term of Appointment D does not refer to Beneficial
Finance, an examination of the adequacy of the reporting to Beneficial Finance's Board of
Directors is an important and essential part of answering my Terms of Appointment
generally, and Term of Appointment C in particular. Any judgment as to whether the
directors of Beneficial Finance adequately performed their functions must take into
account what they were told, and what they were not told, about the company's activities.
Accordingly, although this Report does not make any findings regarding the reporting to
the Beneficial Finance Board as a discrete topic in answer to my Terms of Appointment, it
does deal with that reporting as an integral part of answering Term of Appointment C.
It is appropriate that I acknowledge here the limited
tenure of some of the non-executive directors of Beneficial Finance on the Board of
Directors. Where in this Report reference is made to the Board of Directors of Beneficial
Finance, it must be kept in mind that:
(a) Mr C H Rennie CBE retired on 30 June 1985;
(b) Mr A G Summers was appointed on 28 July 1989; and
(c) Mr M G Hamilton and Mr A R Prowse were appointed on 29
THE SCOPE AND CONDUCT OF MY INVESTIGATION
In the course of my Investigation into the Bank and Bank
Group, the State Government provided adequate resources, particularly funding and time, to
enable me to fully inquire into and answer all material aspects of my Terms of
My Terms of Appointment neither require me, nor authorise
me, to examine all areas of the Bank Group's operations. Generally speaking, my
Investigation was limited to those areas of the Bank Group's operations which, in one way
or another, caused or contributed to the losses of the Group. As I explained in my First
Report, one consequence was that I limited my examination to the two entities in the Bank
Group which reported most of the Group's losses, the Bank and Beneficial Finance.
Even within those two entities, it was essential for me to
exercise my professional judgment about which parts of their operations should be
examined. It was simply not possible within any reasonable limits of time and cost, and
was unnecessary, to examine every part of their extensive activities in detail.
Some business activities were not examined because they did
not result in significant losses. In the case of the Bank, for example, I did not examine
the retail and housing loan businesses. In the case of Beneficial Finance, I did not
examine non-real estate lending of the so-called "core" business divisions.
Accordingly, my Reports must be regarded as being essentially in the nature of exception
reports, describing those areas in which the operations of the Bank and Beneficial Finance
were inadequately managed and controlled. Many parts of the Bank Group's activities were
professionally and competently conducted, but are not described in my Reports because they
are not relevant to explaining the reasons for the Bank and Bank Group's financial
position as described by the Bank and the Treasurer in February 1991.
Some matters that did not result in significant losses were
examined, because they were matters that, in my opinion, may have involved unlawful,
corrupt or improper activity within the meaning of Terms of Appointment A(h) and E, and
sub-section 25(2) of the Act.
The matters which I have examined, and have not examined,
were carefully considered and selected by me having regard to a wide range of
considerations related to my Terms of Appointment. There were some more difficult
judgments to be made. Beneficial Finance's motor vehicle leasing business known as Luxcar
is an example. Despite the suggestions made by some parties that the operations of Luxcar
resulted in material losses and may have involved some activities that bore investigation,
I decided not to examine the Luxcar business for three reasons:
(a) First, Luxcar is already the subject of investigation
by the Federal Police, Australian Taxation Authorities and the Commonwealth Director of
Public Prosecutions. An investigation by me would be a wasteful duplication of effort.
(b) Second, because of the Federal inquiry, the relevant
files were not readily available to my Investigation. Obtaining access to those files
would have been problematic at least, and may have hindered the Federal inquiry. Term of
Appointment H directed me to conduct my inquiry so far as practicable to avoid prejudicing
any pending or prospective criminal or civil proceedings.
(c) Third, even if I had examined Luxcar, I would very
probably have been required by my Terms of Appointment to keep that part of my Report
confidential, and not present it to Parliament. Term of Appointment H directs me to report
so far as practicable so as to avoid prejudicing any pending or prospective criminal or
civil proceedings, and to report by way of a confidential report if I consider that to be
appropriate. Section 25(5) of the Act directs me to present to Parliament only those parts
of my Report that I consider need not remain confidential. It is likely then that the
results of my inquiry into Luxcar would have remained confidential, and not available to
the public for an indefinite period of time.
The conduct of my Investigation of Beneficial Finance was,
like my Investigation of the Bank, subject to the requirement that I provide a full
measure of natural justice and procedural fairness to all those parties that might be the
subject of my Report. The procedures followed by me in doing so were described in sections
1.4.4 and 1.4.5 of my First Report.
The natural justice process was important both to ensure
that my Report was fair, and as an accurate representation of facts which were not always
apparent from my examination of documents and records.
A good example of the benefits sometimes associated with
the natural justice process is the evidence obtained by me in respect of certain matters
dealt with in two internal audit reports dated 19 July 1990 and 3 August 1990, prepared by
the Bank Group's Internal Audit department, regarding loans granted by Beneficial Finance
to its executives. Upon investigation, those reports were found to contain significant
errors of fact and reasoning which, had I placed reliance on them, would have seriously
misdirected my Investigation of the matters with which they dealt. The results of my
examination of this matter are described in Section 43.3 of Chapter 43 - "Other
Matters Investigated within the State Bank and Beneficial Finance" of this
Finally in relation to the conduct of my Investigation of
Beneficial Finance, it is appropriate that I acknowledge the co-operation provided to my
inquiry by the former Managing Director of Beneficial Finance, Mr J A Baker, who spent
considerable time and effort giving evidence.
27.3 AN OVERVIEW OF MY REPORT ON BENEFICIAL FINANCE
27.3.1 SUMMARY REPORT IN ACCORDANCE WITH MY TERMS OF
The nature of my Investigation means that it is necessary
to answer my Terms of Appointment separately in respect of discrete aspects of the
operations of Beneficial Finance. Accordingly, each Chapter of this Report dealing with
Beneficial Finance contains a report in accordance with my Terms of Appointment as they
relate to the particular aspect of Beneficial Finance's operations described in the
It is, however, possible to provide, accurately and fairly,
some general answers to my Terms of Appointment.
Term of Appointment A(a)
The matters and events that caused or contributed to the
losses sustained by of Beneficial Finance were:
(a) Beneficial Finance's excessive exposure to commercial
property development, both as a lender and as an equity participant.
(b) The failure of Beneficial Finance to establish adequate
policies and procedures for the evaluation and management of credit risk associated with
the business conducted by Beneficial Finance's Structured Finance and Projects division
and its predecessor divisions.
(c) The inadequacies in the management and conduct of the
Structured Finance and Projects division and its predecessor divisions.
(d) The failure of Beneficial Finance to establish adequate
policies and procedures for the evaluation, acquisition, control and funding of its
interests in operating joint ventures.
(e) The failure of Beneficial Finance to adequately control
the operations and activities of operating joint ventures.
(f) The inadequacies and deficiencies of Beneficial
Finance's management information systems.
(g) The failure of the Directors of Beneficial Finance to
adequately or properly supervise, direct and control Beneficial Finance's operations,
affairs and transactions, as particularised in this Report.
(h) The failure of the Chief Executive Officer to
adequately or properly supervise, direct and control Beneficial Finance's operations,
affairs and transactions, as particularised in this Report.
(i) The failure of certain of the officers and employees of
Beneficial Finance to adequately or properly supervise, direct and control its operations,
affairs and transactions, as particularised in this Report.
(j) The substantial rise, and subsequent dramatic fall, of
real estate prices in the period after 1985.
Other matters and events that provided the essential
pre-conditions for the losses, but that were not a cause of the losses in the sense of
being to blame for the losses, were:
(a) Financial deregulation and the general economic events
of the 1980's.
(b) The ownership of Beneficial Finance by the State Bank,
which was in turn guaranteed by the Government.
Terms of Appointment A(b) and A(c)
The processes which led Beneficial Finance to engage in
operations that have resulted in material losses, or in Beneficial Finance holding
significant assets which are non-performing are identified and described in relevant
Chapters of this Report. For the reasons described in those Chapters, those processes were
Term of Appointment A(d) and A(e)
The procedures, policies and practices adopted by
Beneficial Finance in the management of significant assets which are non-performing are
identified and described in relevant Chapters of this Report. For the reasons described in
those Chapters, those procedures, policies and practices were not adequate.
Term of Appointment A(f)
Beneficial Finance's procedures for the identification of
non-performing assets and assets in respect of which a provision for loss should be made
were generally adequate and proper.
Term of Appointment A(g)
The internal audits of the accounts of Beneficial Finance
were generally appropriate and adequate. The Board's response to some important matters
raised by the Internal Audit reports was inadequate.
Term of Appointment A(h)
Instances of directors and officers having failed to act
with proper care and diligence are identified in various Chapters of this Report. Possible
conflicts of interest, breaches of fiduciary duty or other unlawful, corrupt or improper
activity are the subject of comment and recommendations in my Report, and in a separate
Term of Appointment C
For the reasons described in my Report, the operations,
affairs and transactions of Beneficial Finance were not adequately or properly supervised,
directed and controlled by the directors, officers and employees of Beneficial Finance.
THE LOSSES SUSTAINED BY BENEFICIAL FINANCE
My Terms of Appointment require me to inquire into and
report on the causes of and responsibility for the financial position of the Bank and Bank
Group "as reported by the Bank and the Treasurer in public statements on 10th
February 1991 and in a Ministerial Statement by the Treasurer on 12th February 1991".
In those statements, both the Treasurer and the Bank
emphasised that the "problems being experienced by the State Bank Group, including
those of its subsidiary Beneficial Finance, are almost entirely limited to the property
and corporate sectors." The Bank noted that Beneficial Finance had refocussed its
activities on "a limited number of core businesses in which it has the expertise and
experience to compete effectively".
Accordingly, my investigation of Beneficial Finance focused
on the company's corporate lending and commercial property-related businesses which
contributed to the financial position of the Bank and Bank Group. The losses of Beneficial
Finance were not quantified separately by the Bank or the Treasurer in the statements made
in February 1991. The source of the losses that have contributed to the financial position
of the Bank and Bank Group can, however, be broadly seen from the details of the use of
the State Government's Indemnity by the Bank, as described in the Bank's Annual Report for
the year ended 30 June 1991, and in its submission to my Investigation:
Bank of South Australia
for loan losses
for subsidiary companies:
- Oceanic Capital Corporation
Bank provisions on equity holdings
and Other Provisions
These figures show that Beneficial Finance's losses
contributed to the financial position of the Bank Group in a proportion that significantly
exceeded its relative size, based on total assets. Although Beneficial Finance's total
assets represented only about 13 per cent of the total assets of the State Bank Group, its
loan losses represented about 43 per cent of the Group's total loan losses, and its total
losses were about 42 per cent of total Group losses (excluding general and other
WHAT WENT WRONG AND WHY: BENEFICIAL FINANCE
When the State Bank was formed on 1 July 1984, its
wholly-owned subsidiary, Beneficial Finance, was a modest finance company specialising in
small real estate loans, equipment leasing and consumer finance. It had total assets of
$502.2M, capital of $58.1M, and made a profit from operations in 1984 of $4.2M.
After 1984, there were, in effect, `two' Beneficial
The core of the old Beneficial Finance remained. Conducted
by the company's general business divisions, the core business continued to be generally
well managed, observing policies and procedures that encompassed the fundamental basics of
prudent credit risk management. By March 1990, the total on-balance sheet assets of the
core businesses were $1,172.4M, a relatively modest annual growth of 15 per cent since
There was, however, another Beneficial Finance. The
Structured Finance and Projects division (as it was called in 1989), headed throughout its
existence by Mr E P Reichert, was established in March 1986 to consolidate Beneficial
Finance's pursuit of new business opportunities in response to the deregulation of the
financial system. The fear was that, if it stuck to its core businesses, Beneficial
Finance would not be competitive in the newly deregulated environment. With its ability to
obtain both capital and debt funds assured by its ownership by a Government-owned Bank,
Beneficial Finance was ideally placed to diversify and grow into new areas of the finance
market, essentially unimpeded by funding constraints.
The Structured Finance and Projects division's strategy for
growth of the new, non-core Beneficial Finance had two key planks:
(a) First, the Structured Finance and Projects division
would pursue opportunities involving large financing transactions, very different from
those with which Beneficial Finance had any previous experience. The idea was to act as a
corporate adviser to clients on how to structure the financing arrangements for a project,
and then to provide the finance for the project, often including taking an equity
interest. Even if it did not provide the finance, Beneficial Finance would facilitate the
financing of the project by providing guarantees to other lenders, thereby taking the
(b) Second, Beneficial Finance would look for opportunities
to form partnerships with small, entrepreneurial financiers operating in specialised,
niche financial markets, again outside the areas in which Beneficial Finance had
experience or expertise. The idea was to form operating joint ventures that combined the
expertise and business contacts of the entrepreneurs, with the financial strength of
Beneficial Finance, to grow substantial business from which both partners would profit.
This new Beneficial Finance grew very rapidly. From
essentially nothing, the assets of the non-core businesses grew to exceed those of the old
core businesses. By March 1990, 60 per cent of Beneficial Finance's risk assets were
non-core business, as follows:
and Projects Division
In 1990, the new, non-core Beneficial Finance collapsed,
with ruinous losses. In May 1990, the Structured Finance and Projects division was
disbanded, and an Asset Management division was established to try and mitigate its
losses. In August 1990, the process of winding up the joint ventures got under way. The
people of South Australia were called on to bail out Beneficial Finance, saving the core
businesses of the old Beneficial Finance from the ashes.
The Structured Finance and Projects Division
Formed in March 1986 as the Corporate Services division,
the Structured Finance and Projects division operated beyond the pale of any reasonable
principles of proper financial management. It paid no attention to the basic principles of
credit risk management, blithely assumed the continual availability of unlimited funding
regardless of the term of its exposures or their cash flows, and assumed that commercial
property development was eternally and unerringly profitable. The division was run by
irresponsible managers who speculated wildly in commercial property, driven by little more
than thought for the next sale.
The division was responsible for most of Beneficial
Finance's large credit exposures, and by March 1990 its facilities represented about 75
per cent of Beneficial Finance's exposures to clients of more than $5.0M. No effort was
made to ensure any balance in the portfolio. Beneficial Finance's traditional speciality
had been real estate financing, and major investment opportunities in the second half of
the 1980's were associated with commercial property development. In combination, these
factors meant that the Structured Finance and Projects division's exposures were almost
entirely related to commercial property development projects. In essence, its business
involved little more than property speculation, of an extreme kind.
The Structured Finance and Projects division effectively
observed no set policies or procedures. Although it did have some regard to those policies
and procedures applicable to the business divisions, the Division was regarded as being
highly skilled and specialised, engaged in business activities to which Beneficial
Finance's normal policies did not apply. The division would live and die according to the
skills and expertise of its senior managers who controlled its activities.
Decisions were made by senior management often without
careful or independent analysis by credit risk analysts, or by other relevant internal or
external experts. The managers placed far too much faith in the expertise of their
clients, and of themselves, without regard to the basic tenets of credit risk analysis.
The division's credit risk analysis consisted of little
more than an unquestioning faith in the inevitable profitability of commercial property
development projects. Even the division's internal procedures were commonly over-ridden by
senior management, who made financing decisions in pursuit of ever-increasing asset
growth. The mixture of equity and debt participation in such projects committed Beneficial
Finance to long-term involvement in projects that were cash flow negative. The business
could survive only because of the continuing ability of Beneficial Finance to obtain
capital from the State Bank, and to borrow funds based on its status as a wholly owned
subsidiary of a Bank guaranteed by the Government of South Australia.
Even in normal circumstances, the business of the
Structured Finance and Projects division was unsustainable. As soon as the property market
turned down, it collapsed.
The Operating Joint Ventures
The strategy and implementation of Beneficial Finance's
participation in the operating joint ventures was, in my opinion, irresponsible to the
point of recklessness.
The fundamental strategy of the joint ventures was
flawed. Providing a small, entrepreneurial business in a niche financing market with
unlimited finance to grow, uncontrolled by normal funding constraints, involves taking an
unacceptable risk that is tantamount to gambling.
Put simply, the most senior management of Beneficial
Finance - Mr Baker and Mr Reichert - would identify a small, entrepreneurial financier
operating in a specialised market, and provide that entrepreneur with essentially
unlimited funding to grow a financing business that Beneficial Finance and its partner
would jointly own. Operating in markets that were outside the experience and expertise of
Beneficial Finance, these joint venture partners had the real and effective control over
the joint venture business, and the risks being run. Despite that, it was Beneficial
Finance that bore the risk of losses.
With the funding provided by Beneficial Finance, these
businesses rapidly grew beyond the scope of the experience and business skills of the
joint venture partners to properly manage. Credit standards were lowered, as the joint
ventures could make loans unrestricted by funding limitations that, in normal
circumstances, provide some brake upon lending to less credit-worthy applicants. The
result was that Beneficial Finance was providing unlimited funding to businesses that it
neither understood, nor controlled. The very nature of the relationship between Beneficial
Finance and its joint venture partners encouraged profligate lending, and the growth of
businesses beyond the capacity of the partners to manage. Inevitably, significant losses
resulted, and equally inevitably, it was Beneficial Finance, as the financing partner,
that paid the cost.
The Corporate Culture
The 1980's has become known as the period of corporate
excesses. Beneficial Finance's Corporate behaviour must rank as an example of the worst
kind of excesses that were prevalent during that period.
In the course of my Investigation, I have come across
examples of spending by Beneficial Finance on a scale which must cause concern to the
people of this State who are now, and for years to come, required to pay the cost.
For example, by June 1990, Mr Baker's total remuneration
package stood at nearly $525,000, which was more than double the packages for the then
heads of the Commonwealth Bank and the State Banks of New South Wales and Victoria. In
addition, the salary packages for another six senior executives stood at $200,000, or
In one instance, Beneficial Finance had an apartment unit
on the Gold Coast which it put on the market for sale. Beneficial Finance was persuaded to
furnish this apartment for $120,000, including with a baby grand piano, to make it
more attractive for potential purchasers. Whilst on the market, it was available for
members of the Executive Committee when they visited Queensland on business, and if they
wanted to stay on for a few days for their own recreation purposes. In a joint venture for
a resort development in Western Australia, Beneficial Finance financed the purchase of a
motor launch for the sum of $850,000, with an annual maintenance cost of $80,000.
I point to these examples not to highlight anything
unlawful or improper, but to point to the culture at the time of spending money as if
there was no tomorrow.
Other activities on the part of Beneficial Finance
management in two instances are, however, of greater concern.
From about 1983 until the introduction of Fringe Benefits
Tax in 1986, Beneficial Finance remunerated its senior executives in part by means of a
"shadow" salary. This practice provided the opportunity for executives to
minimise their taxable income by not including the shadow salary component in their income
In August 1989 certain senior executives borrowed a total
of $475,000 from Beneficial Finance to fund their investment in the Jolen Court Project as
part of a joint venture with Viaduct Services Pty Ltd, a member of the Tribe and
Crisapulli Group of companies. Those of the executives involved in the credit approval
process in respect of applications by the Tribe and Crisapulli Group for loans from
Beneficial Finance exposed themselves to the potential for a serious conflict of interest.
The Board of Directors
The directors did an adequate and proper job in
supervising, directing and controlling the core businesses of what I have categorised
above as the `old' Beneficial Finance. Those businesses had established policies and
procedures, and the directors involved themselves in reviewing those policies and
procedures, ensuring they were adequate, and that they were followed.
When it came to the new, non-core business, however, the
directors were left floundering. The Structured Finance and Projects division operated
without regard to the policies and procedures laid down by the directors, and the
directors were unable to control it. The division professed to be highly skilled and
expert "financial engineers", operating in the new era of deregulated financial
markets. In that circumstance, the directors were placed in a position of essentially
having to rely upon the skills of the senior managers of that division. The directors'
questioning of the growth rate of Beneficial Finance was met with assurances from Mr Baker
and Mr Reichert.
The Board of Directors did not take action to impose any
reasonable level of control upon the activities of the Structured Finance and Projects
division. The Board seemed to be either unable, or unwilling, to insist that growth be
controlled to within reasonable limits, or at least budgeted limits. Most importantly,
the directors approved almost all of the transactions of the division. Those submissions
commonly had not been subject to Beneficial Finance's usual credit approval procedures,
and obviously did not comply with the policies applicable to the core business.
The directors did not get to grips with the reality of
the operation of Beneficial Finance's operating joint ventures. The Board never seemed to
appreciate, until too late, that the arrangement involved little more than Beneficial
Finance handing over funding to an entrepreneur, with no more detailed control being
exercised by management than the simple objective of growth.
The procedures adopted by the Board in response to matters
raised by quarterly summarised internal audit reports were inadequate. It had deprived
itself of a means of indepth analysis of the detailed reports by the Internal Auditors
concerning the strengths and weaknesses of Beneficial Finance's operations by allowing its
Audit Committee to disband, effectively from August 1984.
The Board's attention and effort were focused on growing
the business of Beneficial Finance, and so failed to recognise the need for a co-ordinated
approach to the critical task of asset and liability, liquidity, interest rate risk, and
As I have noted later in this Chapter, Beneficial
Finance produced minutes of Directors' meetings that had not been held. These were
referred to as "paper meetings", and the practice developed as a convenient
alternative to convening a board meeting at short notice. This type of practice is a
further example of the Board placing itself in a position which made it difficult for it
to impose a reasonable level of control upon the activities of management.
The Chief Executive Officer
Mr Baker was the Managing Director, and must bear the
heaviest share of the blame.
As Managing Director, he was in a far better position than
the rest of the Board to assess the accuracy and worth of the management submissions
coming to the Board.
Whether out of a mistaken sense of loyalty to the rest of
management, a disdain for the Board, or for reasons which have escaped my Investigation,
he failed on occasions to convey vital information to the Board.
In so doing he displayed a serious lack of understanding
of his duties as Managing Director.
As management's senior executive, he failed to take steps
to ensure that the policies and procedures introduced by the company for prudential
management were effectively implemented, and seemed to regard the activities of the
Structured Finance and Projects division, and of the operating joint ventures, as being
beyond the scope of any need for policies or procedures that might inhibit their growth.
The Senior Management
Mr Reichert was the Chief General Manager for the
Structured Finance and Projects division from its formation in March 1986, until it was
disbanded in May 1990.
Mr Reichert must take a heavy share of the
responsibility for the financial position of Beneficial Finance in February 1991. Mr
Reichert single-mindedly pursued asset growth, with a one-dimensional faith in
high-profile property developments that bordered on recklessness. I am simply at a loss to
understand how the second most senior executive in Beneficial Finance could then, and
judged by his submissions to my Investigation, still now, pay such complete disregard to
the realities of the cyclical nature of the commercial property market, and to the need
for a financial institution to be able to fund its activities. Mr Reichert seemed to have
only one thought - that commercial property investment was good. The risks associated with
the fact that the investment was long-term, with long-term negative cash flows, seemed
never to enter his head.
Decisions regarding credit risk management were too
often made by senior management, without regard to the need for observing structured and
sound procedures for the identification and evaluation of risk. The division was
characterised by the imperative of asset growth, without adequate attention to the risks
The arrangements applying to the operating joint ventures,
which were managed by the Structured Finance and Projects division until 1 July 1989, were
a disgrace. It was not until responsibility for managing the joint ventures was taken over
by a new Investment Banking division in July 1989, headed by Dr R N Sexton, that
Beneficial Finance took any action to take control of its exposure to the joint ventures,
which were creating risks that Beneficial Finance did not control.
Senior management failed to appropriately plan and monitor:
(a) the company's growth;
(b) the mix of its portfolio of assets; and
(c) the need for adequate capitalisation of off-balance
Those failures were compounded by having no effective
reporting of those important management issues.
The result was that management, and thus the Board, did
not have a sound basis for decision making.
A SYNOPSIS OF MY REPORT
This Section provides a synopsis of the various Chapters of
this Report dealing with Beneficial Finance. It brings together the findings and
conclusions which I have reached as a result of my investigation of Beneficial Finance's
operations and of the role played by the Directors, Managing Director, and other relevant
officers and employees.
My findings and conclusions, in summary form, are set out
in this Section in the same order as they are dealt with in detail in later Chapters of
this Report in respect of Beneficial Finance:
(a) Chapter 28 provides an overview of Beneficial Finance's
business development and growth, and of its management and organisational structure;
(b) Chapter 29 describes the formal procedures by which
Management prepared, and the Board of Directors reviewed and approved, plans for
Beneficial Finance's business development;
(c) Chapters 30 to 33 (inclusive), and Chapter 39, examine
Beneficial Finance's management of credit risk, including a detailed analysis of
(d) Chapters 34, 35 and 36 describe Beneficial Finance's
funding, and its treasury and asset and liability management, and includes a detailed
examination of the issue in 1989 and subsequent withdrawal in 1990 of Prospectus Number 65
for an issue of debentures;
(e) Chapter 37 examines the internal audit of Beneficial
(f) Chapter 38 describes Beneficial Finance's acquisition
of a portfolio of receivables from Equiticorp;
(g) Chapter 40 examines the practice of documenting minutes
and resolutions of purported meetings of directors that in fact had not been held -
so-called "paper meetings";
(h) Chapter 41 describes Beneficial Finance's management
and financial information reporting systems, particularly the implications of the use of
off-balance sheet entities;
(i) Chapter 42 examines the adequacy of the provisioning
for bad and doubtful debts in both Beneficial Finance and the Bank; and
(j) Chapter 43 examines certain remuneration practices of
the Bank and of Beneficial Finance, and a transaction involving a conflict of interest on
the part of certain managers of Beneficial Finance.
Finally, Chapter 44 examines the reporting by the external
auditors of the Bank to the Reserve Bank.
Chapter 28: Overview of Beneficial Finance Corporation Limited
At the time of its acquisition by the Savings Bank of South
Australia in April 1984, Beneficial Finance specialised principally in smaller real estate
and housing loans, and vehicle and equipment leases and consumer lending. Beneficial
Finance continued to carry on these "core" businesses throughout the 1980's.
After 1984, however, the company embarked upon new,
"non-core" businesses. It did so in order to remain competitive following the
deregulation of Australia's financial system. These new businesses were conducted by the
Corporate Services division that was established in March 1986, and by its successor
divisions, the Investment Banking division (1 July 1988 to 30 June 1989) and the
Structured Finance and Projects division (1 July 1989 to May 1990). When the Structured
Finance and Projects division was disbanded in May 1990, the non-core business comprised
about 60 per cent of Beneficial Finance's total risk assets.
Broadly stated, the new business activities carried on
after 1984 were:
First, Beneficial Finance engaged in corporate lending
after July 1984, almost all of it property-related. The 1984 Annual Report did not mention
corporate finance among its primary areas of business. The 1985 Report, however, described
corporate finance as the "fastest growing sector of Beneficial's business",
representing 11.8 per cent of year-end receivables, compared to only 1.1 per cent as at 30
June 1984. The 1986 Annual Report again described corporate finance as the fastest growing
sector, representing 6 per cent of total lending during the year (up from 2 per cent at 30
June 1985). Corporate finance receivables totalled $411.0M at 30 June 1987, and increased
to $766.0M by 30 June 1988, a rise of 86 per cent. Corporate lending in 1988 represented
39 per cent of new lending, up from 11 per cent in 1987, 6 per cent in 1986, and 2 per
cent in 1985.
Second, Beneficial Finance's business expanded after 1984
to include the financing of, and equity participation in, large structured finance
property projects. This business was an extension of Beneficial Finance's traditional
lending for real estate, but differed in the size of the exposures, the nature of the
projects, and the structuring of the financing arrangements usually on a tax-effective
basis, a widely used arrangement until 1988 when the Australian Taxation Office issued a
ruling effectively banning its use.
Third, Beneficial Finance expanded its business activities
by entering into joint ventures with small, specialist financiers to conduct financing
operations in areas that, although they were an extension of Beneficial Finance's core
business activities, lay outside the area of its own experience and expertise. The premise
of these operating joint ventures was that, with the strong financial backing of
Beneficial Finance, the specialist financiers could grow businesses from which both
partners would profit.
This expansion of Beneficial Finance's operations into new,
non-core businesses had a number of implications for the general nature of its operations.
(a) Reflecting the change in the type of financing
transactions, there was a dramatic increase in the size of the financing transactions
undertaken by Beneficial Finance after 1984. A half-yearly exposure review presented to
the Board of Directors on 5 September 1984 showed that, as at 26 July 1984, Beneficial
Finance had only five exposures to clients or groups of clients of $5.0M or more, the
largest being $5.9M, or about 10 per cent of the company's capital base. Exposures of more
than $2.0M for real estate, and other exposures of more than $1.5M, totalled only $87.0M
out of net receivables of $469.2M. The 1984 Annual Report showed that the average size of
the company's receivables at 30 June 1984 was only $25,000.
By 30 September 1990, the credit risks by exposure to
client groups as shown in the Quarterly Report on Risk Exposure were:
The September 1990 Quarterly Report showed that, as at
September 1990, Beneficial Finance had twenty four client exposures in excess of $25.0M.
Of the total exposure of $870.9M to those clients, $428.9M, or 49.2 per cent, was
non-performing. The three largest non-performing loans were $60.4M, $50.3M and $46.2M.
(b) Beneficial Finance expanded its activities through the
acquisition of other companies, businesses and loan portfolios. The principal acquisitions
(i) 1988 - Purchase of portfolios of receivables from
Equiticorp, both in Australia and New Zealand.
- Acquisition of a majority interest in First Pacific
- Acquisition of Campbell Capital Limited, an investment
bank with a significant commercial property portfolio.
- Acquisition of 100 per cent ownership of Asset Risk
(ii) 1989 - Establishment of Southstate Corporate Finance
Ltd in New Zealand.
- Acquisition of IBIS Information International Limited, a
business information and corporate advisory firm.
- Purchase of an interest in Pacific Rim Leisure Limited, a
property developer specialising in tourist facilities.
(c) A consequence of these business developments was a
rapid increase in the company's total assets, at a rate well in excess of the average rate
of asset growth of other finance companies. The total growth in Beneficial Finance's net
receivables between 1984 and 1989 was 326.6 per cent, compared to the average of its
finance company peers of 103.9 per cent. The average annual growth in Beneficial Finance's
net receivables over the period was 34.3 per cent, while the average of its finance
company peers was 15.7 per cent. The rate of growth of Beneficial Finance's lending assets
was more than double that of other finance companies, and this was reflected in the
increase in its market share, from 3.9 per cent in 1984 to 8.1 per cent in 1989.
(d) Finally, the increase in total assets and net
receivables was facilitated by an accumulation of assets held "off-balance
sheet" in a complex structure of off-balance sheet companies and trusts through which
Beneficial Finance carried on a significant proportion of its business activities,
including its participation in joint ventures, and its acquisition of some new assets.
Beneficial Finance's 1990 Annual Report announced the
company's intention to "refocus the Company on its core business", noting
that Beneficial Finance had been affected by the finance industry being "too
aggressive", and by the rapid growth in property development funding, particularly
larger structured property business which was causing most concern. The Report attributed
Beneficial Finance's problems to "over aggressiveness, particularly in the area of
structured property finance".
Beneficial Finance's growth required significant capital
contributions from the State Bank: between 1986 and 1990, the Bank contributed a total of
$108.6M of additional capital to Beneficial Finance. As at 30 June 1990, Beneficial
Finance's total assets represented 12.7 per cent of the assets of the consolidated State
Chapter 29: Direction-Setting and Planning
(a) Overview and Summary
The dramatic change in the nature of Beneficial Finance's
business, and its rapid growth, naturally raises the issue of the strategic planning and
budgeting undertaken by Beneficial Finance in respect of that change and growth.
Beneficial Finance's strategic planning and budgeting
procedure was extensive. It involved the commitment of considerable resources, and
included work by a specialised planning department, a management conference attended by
senior management, consultations with the management of the State Bank, and review and
approval by Beneficial Finance's Executive Committee. The result of the process was the
production of two planning documents which were presented annually to the Board of
Directors for its review and approval: a five-year strategic plan which addressed
long-term objectives and strategies, and a budget for the ensuing year. Once approved the
plans and budgets were communicated to individual business units for implementation.
The strategic planning and budgeting procedure was
therefore a potentially important part of the means by which the Board of Directors set
policy for Beneficial Finance, reviewed Management's plans for the commitment of resources
to implement that policy, and reviewed the progress of Beneficial Finance in meeting its
In the absence of suspicion that the planning and budgeting
procedure was deficient, the Directors were entitled to rely on the extensive procedure to
produce plans which had been thoroughly discussed and reviewed by all senior management,
and which had the support and commitment of senior management.
The strategic plans were high-level documents, drafted in
broad and general terms. Although the strategic plans did identify the principal features
of the development of Beneficial Finance's business, details regarding the evaluation and
implementation of strategies and strategic programs were not included in the plans. The
plans performed the functions of identifying and summarising the strengths and weaknesses
of the company and the opportunities and threats confronting it, focusing attention upon
the preferred direction of its business development, forging a business culture, and
focusing attention on key objectives.
The budgeted rate of asset growth was, in most years only
slightly ahead of that actually achieved by other finance companies. Judged on that basis,
the planned growth was not necessarily unreasonably aggressive or imprudent.
Implementation of the strategies and programs identified in
the strategic plans and budgets was the responsibility of management. Again, in the
absence of suspicion, the Directors were entitled to rely on management to implement all
aspects of the plans in a timely and prudent manner.
The most significant feature of Beneficial Finance's
strategic planning and budgeting, however, is the extent to which actual growth exceeded
that which was planned, as shown in the following table:
Actual Asset Growth
As the table shows, over the three years 1988-1990, the
actual growth in total assets of $1,534.4M exceeded the planned growth of $726.8M by
$807.6M, or 111.1 per cent. Actual asset growth for those three years was more than double
that which was budgeted.
Beneficial Finance's Board of Directors was aware of the
rapid and unplanned growth, and occasionally expressed concerns regarding the implications
of the growth, particularly for the quality of loan assets. Nevertheless, the rate of
asset accumulation continued: in 1989, total assets increased by 36.0 per cent, compared
to a budgeted increase of only 13.2 per cent. That rapid and unplanned growth rate, which
was significantly in excess of that of its competitors, should reasonably have given rise
to doubts about the adequacy of Beneficial Finance's internal systems for identifying
appropriate assets for acquisition, including its evaluation of credit risk, and should
have raised questions as to whether the systems essential to managing its portfolio and
planning for long-term profitable growth had kept pace with the unplanned growth.
The directors had before them information which should,
in my opinion, have been sufficient to raise a reasonable suspicion that they could not
rely on the strategic planning and budgeting procedure in undertaking the functions of
policy setting, overseeing Management and reviewing the company's progress. That
(i) repeated references in the strategic plans to key
weaknesses in Beneficial Finance's internal systems;
(ii) the failure of Management to provide any strategic
monitoring reports to the Board of Directors describing the progress being made in
implementing the key internal systems requirements identified in the strategic plans; and
(iii) most importantly, the actual growth of Beneficial
Finance's total assets very substantially exceeded that which was planned.
In the circumstances, the Board was not able to place
reliance on the strategic plans and budgets, and their implementation by Management, in
discharging its functions of setting policy, overseeing plans and adequately and properly
monitoring progress. The excessive rate of growth was such as to render the strategic
plans and budgets largely irrelevant as any reasonable basis for reviewing the detailed
planning of Beneficial Finance. It necessarily gives rise to doubt that the implementation
of the plans was adequate or effective.
The rapid growth over and above that which was planned, and
which exceeded that of other finance companies in Australia, gave rise to an increased
obligation of care and diligence on the directors in undertaking their task of approving
asset acquisitions and loans by Beneficial Finance. In particular:
(i) the rapid growth in assets at a rate in excess of that
of other finance companies and most other financial institutions in new market areas where
Beneficial Finance had little previous experience, clearly raises a suspicion that
Beneficial Finance's credit assessment standards were imprudently low. This was a concern
expressly raised by the Beneficial Finance Board in respect of the excessive growth;
(ii) the unplanned growth had clear implications for the
ability of Beneficial Finance to adequately manage its asset portfolio; and
(iii) the rapid growth, particularly in the increasingly
diversified businesses, had clear implications for the adequacy of Beneficial Finance's
(b) Findings and Conclusions
(i) The matters examined in Chapter 29 do not, by
themselves, allow me to make conclusive findings regarding my Terms of Appointment, since
any of the deficiencies in respect of the strategic planning and budgeting procedure might
conceivably have been compensated for by other aspects of the Board's and Management's
(ii) The processes which led Beneficial Finance to engage
in operations which have resulted in material losses, or holding significant assets which
are non-performing, included, very broadly, the strategic planning of Beneficial Finance,
which expressly proposed to engage in most types of the business activities which resulted
in the acquisition of such assets. The actual acquisition of a majority of assets was,
however, in quantitative terms, unplanned.
(iii) I am unable to conclude, on the basis of the evidence
reviewed in Chapter 29 for the reasons expressed above, whether the operations, affairs
and transactions of Beneficial Finance were adequately or properly supervised, directed
and controlled by the directors, officers and employees of Beneficial Finance.
I find, however, that the procedure of strategic planning
and budgeting did not amount to any adequate or proper system for supervision, direction
and control of Beneficial Finance's activities. The excessive rate of growth over and
above that budgeted essentially meant that the strategic plans and budgets became largely
irrelevant to the procedure of supervision, direction and control.
(iv) In evaluating in later Chapters the adequacy of the
supervision, direction and control of Beneficial Finance's operations, affairs and
transactions, that adequacy is to be measured having regard to the lack of effective
strategic planning and budgeting, and to the suspicions that should reasonably have been
raised by the strategic plans, and by the excessive growth, as to whether Beneficial
Finance's internal systems for evaluating and managing growth were adequate.
22.214.171.124 Chapter 30: Credit and its Management:
Guidelines, Policies, Processes and Delivery Systems
(a) Overview and Summary
This Chapter reports the results of my examination of
Beneficial Finance's management of the credit risk associated with its business operations
between July 1984 and February 1991. Simply stated, credit risk is the risk that a
borrower will be unable or unwilling to repay its loan as and when it is required to do
so. The management of credit risk encompasses the processes of initiation, approval,
settlement, monitoring, and recovery of finance facilities provided by Beneficial Finance
to its customers.
There are two distinct aspects of the credit risk faced by
a financial institution that must be managed:
(i) The first is the risk associated with each particular
loan, that the borrower will be unable or unwilling to repay the loan, and pay interest,
as and when it is due.
(ii) The second is the risk associated with the overall
nature of the loan portfolio. A lender must ensure that the portfolio does not involve a
concentration of risk upon particular borrowers, industries or geographic areas. If, for
example, a large proportion of the portfolio is comprised of loans granted for use in
commercial property development, then a downturn in the property market can have
disastrous implications for the financial institution, as a large proportion of its
borrowers will be unable to repay their loans. As I shall describe, that is precisely what
occurred in the case of Beneficial Finance.
The management of credit risk is of fundamental importance
to a financial institution like Beneficial Finance. A finance company faces a variety of
risks in carrying on its business, including the risk of changes in interest rates, the
risk of running out of cash (liquidity risk), and, usually, foreign exchange risk. In the
end, though, it is credit risk that is most fundamental. It is the risk that, if realised,
can most quickly and completely ruin the company.
The realisation of credit risk was the single most
important cause of Beneficial Finance's contribution to the financial position of the Bank
Group as described by the Bank and the Treasurer in February 1991. It lies at the very
heart of my Investigation.
Although this Chapter is titled "Credit and its
Management" and generally refers to loans, Beneficial Finance's risk exposures were
often more in the nature of equity than debt. The distinction between equity and debt is
not always clear, and was especially obscure in respect of Beneficial Finance's non-core
business activities. Fundamentally, a lender expects to be repaid the amount of the loan,
and to receive a set rate of return, called interest, as compensation or "rent"
for the use of the money. The prudent management of credit risk involves ensuring, so far
as possible, that the lender will in fact be repaid, and receive the agreed rate of
return. For an equity participant or owner, there are no such assurances. An owner enjoys
the benefits, and runs the risks, of an asset going up or down in value, or of a business
being successful or not.
Beneficial Finance's risk exposures that were intended
to be loans often involved the equity risk of assets going up or down in value, and some
equity investments were structured with the intention of ensuring an agreed rate of
The complex mix of equity and debt exposures was
particularly present in Beneficial Finance's participation in joint ventures, where it
both held an equity interest and provided the financial backing, if not the actual
funding, for the venture.
The activities of Beneficial Finance that involved the
incurring of credit risk can accordingly be regarded as comprising:
(i) The general business divisions that carried on
Beneficial Finance's so-called core business activities of smaller loans, usually secured
by real estate mortgages, and motor vehicle and equipment leasing.
(ii) The Structured Finance and Projects division, and
its predecessors, the Corporate Services division and the Investment Banking division,
which carried on the so-called non-core businesses of large structured finance
transactions, and corporate lending.
(iii) Beneficial Finance's operating joint ventures,
which resulted in the creation of credit risks outside Beneficial Finance's own systems
The management of credit risk was a critically important
aspect of the supervision, direction and control of Beneficial Finance's business
operations. Beneficial Finance was a financial institution, and, of all the risks it
faced, credit risk was the most fundamental. It was the failure of Beneficial Finance to
adequately manage that risk that was the single most important cause that contributed to
its financial position in February 1991.
The general "organisation" of Beneficial
Finance's credit risk management function, as distinct from the "execution" of
that function was, in my opinion, adequate and appropriate. The Board of Directors gave
attention to the important matters of credit risk management policies and procedures, and
a Credit Policy Committee was established to ensure that policies and procedures were
Generally speaking, Beneficial Finance's delegated credit
approval authorities, and the credit approval process, were adequate. The system of
delegated credit approval authorities was established by the Board of Directors, which
retained the ultimate approval authority. All major loans required approval by directors,
and some others had to be submitted to the Board for ratification. The approval authority
limits were stated in terms of the percentage that the loan represented of Beneficial
Finance's shareholders' funds. The percentage limits were higher in the case of loans
secured by real estate.
My opinion regarding the adequacy of the credit approval
process is, however, subject to three vital exceptions:
(i) the established credit approval procedure was not
followed in the case of some major transactions of the Structured Finance and Projects
(ii) there was no structured procedure to evaluate
Beneficial Finance's participation in operating joint ventures; and
(iii) the loan approval procedure was not applied in
respect of Beneficial Finance's funding of the operating joint ventures in which it
participated as a joint venture party.
A critical failing of Beneficial Finance's credit risk
management policies was the absence of any prudential policy limiting the company's total
exposure to commercial property. Although it adopted various policies intended to ensure
that the property-related loan portfolio included a diverse range of projects, there
simply was no cap placed on the total exposure, which grew to be about 60 per cent of the
portfolio by the end of 1989. That excessive and imprudent exposure inevitably meant that
Beneficial Finance was seriously damaged financially by the collapse of the commercial
property market in 1990.
I am satisfied that the credit risk management policies and
procedures that applied to Beneficial Finance's core business operations conducted by the
business divisions were generally adequate and appropriate, and that they were usually
observed in practice. The losses realised in respect of the core business were
principally the result of a general over-reliance on the continuing strength of the
property market when exercising judgments in respect of a loan, and more particularly of
the excessive exposure to real estate. The rise in property values, particularly after
1987, encouraged over-investment. Beneficial Finance had traditionally specialised in
property-related loans, which combined with the absence of a prudential limit on its
exposure, meant that the core businesses were over-exposed to an over-heated market. The
policies and procedures could not protect Beneficial Finance from the collapse of that
market. Simply stated, Beneficial Finance did not recognise the unsustainable nature of
the market prices for property in 1988 and 1989.
The business strategy of the Structured Finance and
Projects division was to undertake larger transactions involving often complicated mixes
of equity participation, debt funding, and the provision of guarantees. The fundamental
failures of the division in undertaking that business were:
(i) an excessive concentration on commercial property
development, accompanied by an apparently absolute faith in the profitability of such
(ii) a failure to have regard to the basic principles of
credit risk evaluation and management; and
(iii) a tendency of senior management to initiate and
recommend deals based on their own judgment and in the pursuit of new business,
essentially ignoring the need for careful analysis through a structured evaluation and
Beneficial Finance's business development strategy included
the formation of joint ventures with small, entrepreneurial financiers operating in
specialised niche markets that, although they were an extension of Beneficial Finance's
core business activities, were outside its experience and expertise. It was hoped that,
with Beneficial Finance's financial support, the partner could use its expertise to grow a
business from which both would profit.
The joint ventures resulted in the creation of credit
risks outside the framework of Beneficial Finance's own policies and procedures. Although
Beneficial Finance approved larger loans made by the joint ventures, there was a tendency
to rely on the recommendations of the joint venture partners who, after all, were
perceived to have skill and expertise that Beneficial Finance did not possess. In
practice, it was Beneficial Finance's joint venture partners, and not Beneficial Finance,
that made the decisions relevant to management of the joint ventures' credit risks.
It was Beneficial Finance, however, that essentially bore
that risk. In most cases, its joint venture partners did not have anywhere near the
financial capacity to meet their share of any significant losses associated with the joint
ventures' loan portfolios. Indeed, the partners' lack of financial strength was the very
reason that they entered into the joint ventures.
Beneficial Finance did not impose any prudential limits
on its exposure to particular joint ventures. Even more importantly, there was no credit
review and approval mechanism within Beneficial Finance in respect of the provision of
funds to the joint ventures. With almost unlimited funding available to them, the joint
ventures grew rapidly, as they were able to make loans unconstrained by funding limits.
That inevitably placed downward pressure on credit standards.
(b) Findings and Conclusions
(i) Beneficial Finance's exposure to real estate generally,
and commercial property development in particular, was imprudent and excessive. The Board
of Directors and senior management failed to adequately monitor and control that exposure.
In particular, no overall prudential limit on the exposure was set. The imprudent and
excessive exposure was an important cause that contributed to the financial position of
the Bank Group as reported by the Bank and by the Treasurer in February 1991.
(ii) The general organisation and structure of the credit
risk management function in respect of the core businesses of Beneficial Finance was
adequate and appropriate. The Board of Directors and Management adequately and properly
supervised, directed and controlled the policies, procedures and conduct of Beneficial
Finance's core business divisions. In particular, the policies and procedures applicable
to the core businesses were adequate, and were generally observed in practice. The losses
realised in respect of the core business real estate lending activities were the result of
the rapid increase in, and subsequent collapse of, property values, and of the
over-exposure of the core businesses to that over-heated market. Although the policies
were adequate and generally observed, there was a tendency for judgments made within the
discretions provided by the policies to be influenced by an over-reliance on the
continuation of the buoyant property market.
(iii) The Structured Finance and Projects division did not
observe the basic principles of credit risk evaluation and management. Its management of
the credit risks associated with the non-core businesses was wholly inadequate, being
based on little more than assumptions of the inevitable profitability of commercial
property development projects.
The Board of Directors failed to adequately control,
supervise and direct the business operations of the Structured Finance and Projects
division. It was too willing to approve submissions that did not comply with, or even
refer to, the policies established by the Board in respect of the real estate lending of
Beneficial Finance's core business divisions.
Mr Baker, as Managing Director, and Mr Reichert, as Chief
General Manager of the Structured Finance and Projects division throughout its four year
existence, failed to apply to the non-core business activities the skill and judgment
reasonably to be expected of executive officers of a financial institution.
(iv) The structure and operation of Beneficial Finance's
participation in, and funding of, the operating joint ventures, meant that Beneficial
Finance was subject to the risk of losses in respect of credit risks that it did not
effectively control. Both the initiation and subsequent management of the credit risk was,
in practical terms, in the hands of Beneficial Finance's joint venture partners. The risks
associated with the operating joint ventures were exacerbated by the almost unrestricted
funding provided to them by Beneficial Finance. For these deficiencies, Mr Baker and Mr
Reichert are principally responsible.
Chapter 31: Case Study in Credit Management: East-End Market
(a) Overview and Summary
In May 1988, the directors of Beneficial Finance approved
its participation in a joint venture to acquire the East End Market Company Limited, a
publicly listed company that owned the East End Market.
Beneficial Finance's participation in the venture arose
from a proposal presented to it in early May 1988 by Ayers Finniss, the merchant bank
subsidiary of the State Bank. Ayers Finniss was acting for the Emmett Group.
The Emmett Group was controlled by its Managing Director,
Mr A Emmett. It traded as a builder and developer, mostly of medium-size commercial and
industrial projects. In May 1988 the Emmett Group controlled 8.6 per cent of the issued
shares in the East End Market Company Limited, a publicly listed company whose principal
asset was the East End Market site. Mr Emmett was a director of that company, whose major
shareholder was the New Zealand Insurance Group, with control of 67.9 per cent of its
The East End Market site has certain unique features. It is
a largely contiguous site in excess of 3.5 hectares, situated on both the north and south
sides of Rundle Street in the Central Business District of Adelaide. Its size and locality
are such that the site is likely, in time, to be redeveloped as an important part of the
City of Adelaide.
During 1987 and early 1988, the East End Market Company
prepared concept plans for the redevelopment of the site involving various uses, including
carparking, office buildings, hotels, retailing and entertainment.
Mr Emmett became disenchanted with the handling of the
development by the East End Market Company. He thought that a public company was an
unsuitable vehicle for carrying out the development of the site, and concluded that the
best way to bring about the development was to privatise the East End Market Company. The
Emmett Group lacked the financial strength to do that, so Mr Emmett engaged Ayers Finniss
to assist in procuring finance for the acquisition and development.
A Proposal Document prepared by Ayers Finniss was presented
first to the State Bank, on 7 May 1988. The Bank declined, but apparently suggested that
Beneficial Finance might be interested. Ayers Finniss then sent the Proposal Document to
Beneficial Finance on the 9th or 10th of May.
In essence, the proposal was that Beneficial Finance and
the Emmett Group would jointly acquire all of the shares of the East End Market Company.
The part ownership of the project by Beneficial Finance would not only provide a potential
source of finance for the venture, but would also enable the venture to obtain funds from
other financiers who would lend to the venture on the basis that Beneficial Finance, a
subsidiary of a State Bank, would ensure that they would be repaid. The Emmett Group would
provide the project management and construction expertise to bring the project to
fruition. Each would contribute about $1.5M in equity, and Beneficial Finance would
provide a subordinated loan of $4.0M. The joint venture would borrow a further $28.1M to
fund the acquisition. Ayers Finniss would receive a 2 per cent shareholding in the joint
venture company as its fee for acting for the Emmett Group. The Proposal Document stated
that the matter was urgent, claiming that there were other unnamed parties interested in
acquiring the East End Market Company.
The proposal was well received by the Senior Management of
Beneficial Finance, particularly the Managing Director Mr Baker, and Mr Reichert,
General Manager of the Corporate Services division. A credit submission, based almost
entirely on the Proposal Document prepared by Ayers Finniss, was circulated to the
directors of Beneficial Finance on 11 May 1988 with a covering letter written by Mr
Reichert. A Board meeting was convened for the next day to consider the submission. The
submission referred to the East End Market Company by the code name "Mousetrap".
The Board meeting was attended by only three Directors - Mr
D W Simmons, who acted as Chairman, Mr Baker, and Mr G S Ottaway, an alternate Director.
Mr Simmons disclosed to the meeting that he and other partners in his law firm, Thomson
Simmons & Co, held shares in the East End Market Company, and that his law firm acted
as solicitors for the Emmett Group of Companies. Although Mr Simmons chaired the meeting,
he did not vote.
Comments from each of the directors who were not present
(other than Mr T M Clark, who was overseas, and Mr K S Matthews), obtained by telephone
calls to the directors before the meeting, were reported to the meeting. The meeting
resolved to accept the proposal to enter into a joint venture with the Emmett Group.
On 13 May 1988, Beneficial Finance, Ayers Finniss and a
subsidiary of the Emmett Group, Nettishall Pty Ltd ("Nettishall"), entered into
a Joint Venture Agreement. The three joint venturers agreed to incorporate a new joint
venture company, Chepstow Pty Ltd ("Chepstow"), for the purpose of acquiring all
of the issued shares of the East End Market Company. On the same day, Chepstow issued a
Part C Statement offering to purchase all shares in the East End Market Company at a price
equivalent (including rights) to $4.25 per share. Within hours, it had received
acceptances of the take-over offer in respect of 86 per cent of the issued shares of the
East End Market Company, and shortly after acquired the balance of the shares.
The venture soon encountered problems. Although it had
been assumed that development approval would be obtained quickly, the Management of
Beneficial Finance had not conducted any independent evaluation of the existing plans for
the project before committing to the venture. Subsequent revisions to the plans meant that
the development approvals that were obtained had to be abandoned.
The joint venture partner, the Emmett Group, then
announced its desire to quit the project, because of a "lack of fit" with its
own plans. The East End Market project was more than ten times the size of anything
the Emmett Group had undertaken, and yet Beneficial Finance undertook no critical
evaluation of the Emmett Group's ability to successfully see the project to fruition
before committing to the venture.
Beneficial Finance sought new partners for the venture,
but a requirement of the potential partners that were identified was that Beneficial
Finance provide the funding for their purchase of Nettishall's interest in the venture.
Beneficial Finance's Board of Directors declined to approve the provision of the funding.
Eventually, Beneficial Finance purchased Nettishall's interest, and so became the sole
owner of the East End Market Company.
Despite much effort and activity, Beneficial Finance was
unable to proceed with a viable development of the East End Market site. As at 31 March
1991, the total investment by Beneficial Finance in the venture was $48.8M, with a
specific provision for loss of $21.06M. Interest foregone was $12.8M. In June 1992, the
South Australian Government acquired the portion of the East End Market site still
controlled by Beneficial Finance for $17.4M.
(b) Findings and Conclusions
(i) The essential failing of Beneficial Finance was that it
participated in the East End Market joint venture without first undertaking any adequate
analysis or evaluation of the project. Beneficial Finance simply accepted at face value
the conclusions suggested to it by Ayers Finniss. A reasonable and considered evaluation
of the proposal should have made clear the real risks associated with participation in the
(ii) Management of Beneficial Finance, particularly Mr
Baker, Mr Reichert and Mr G L Martin, failed to make proper, reasonable and necessary
enquiries into the contents of the proposal received from Ayers Finniss, in that they did
not subject to scrutiny the statements, assumptions and analyses contained in the Proposal
Document. Management adopted without adequate enquiry, and recommended to the Board, the
proposal received from Ayers Finniss. The proposal had been prepared by Ayers Finniss to
advance the interests of its client, the Emmett Group of companies. The Proposal Document
minimised the difficulties of the project, and risks attaching to the project were ignored
or minimised. The consequence was that the credit submission presented to the directors
failed to point out the risks inherent in the proposal.
No effort was made by Beneficial Finance Management to
determine whether the price at which the shares were offered was the lowest price at which
the existing shareholders would sell. Inadequate consideration was given to the various
risks associated with the project that, in the event, imposed lengthy delay on the
development. No adequate consideration was given to a cyclical reduction in property
values, or to Beneficial Finance's total property exposure.
(iii) The directors of Beneficial Finance (with the
exception of Mr Baker) had a difficult decision forced upon them at little more than
twenty four hours notice. The timing of the submission to the Board, linked to the threat
of competitive bids from other unidentified interested parties, forced the Board to deal
with the proposal urgently. The Board meeting at which the decision to participate in the
Joint Venture for the take-over was approved, was attended by only three directors; the
Managing Director, the Chairman who did not participate in the decision, and an alternate
director. Eight other directors expressed opinions about the proposal; two warned of the
risks associated with planning requirements and opposition from heritage groups; seven
were prepared to endorse the proposal.
The Directors failed to adequately assess the submission
from Management. A careful assessment by the directors was particularly important, because
the submission had not been reviewed and recommended by the credit committee as required
by Beneficial Finance's internal procedures. It was incumbent upon the directors to ensure
that adequate time was made available for their examination of the matter. If they had
considered that further time was required then consideration of the submission should have
been deferred or the submission refused.
Chapter 32: Case Study in Credit Management: Mindarie Keys
(a) Overview and Summary
This Chapter examines the participation by Beneficial
Finance in a joint venture to acquire and develop land known as the Mindarie Keys
development in Western Australia.
Beneficial Finance was involved in the project both as a
financier, and notionally at least as a part owner of the Mindarie Keys land. The other
joint venture participants were Smith Corporation Pty Ltd ("Smith Corporation"),
and Entrad Limited ("Entrad").
Although it was in legal form an owner of the land,
Beneficial Finance's interest was, in substance, that of a financier. The joint venture
arrangements entitled Beneficial Finance, at its option, to require the other partners to
buy its equity interest at a price which provided Beneficial Finance with a minimum rate
of return on its investment.
The project, which involved the development of 316 hectares
of ocean-front land located approximately thirty five kilometres north of Perth, was
promoted by Smith Corporation and its Managing Director, Mr R Smith. The development of
Mindarie Keys was the subject of a State Agreement with the Western Australian Government,
which permitted Smith Corporation to undertake a major harbour and marina development, and
the sub-division of 2,000 residential allotments. In return for these development rights,
Smith Corporation was required to pay all costs associated with the construction of the
harbour, breakwater, marina, navigation aids, roads and drainage facilities, and to
construct a water supply and an effluent treatment works. Those assets would then become
the property of the State Government.
Smith Corporation proposed that the development would be
undertaken in several stages. Stage 1 of the project was the most important because it
included the harbour, a marina and a hotel, that were intended to be the main attraction
of the development. The cost of Stage 1 was estimated by Smith Corporation to be $40.0M,
including $12.0M for the purchase by the joint venture participants of the Mindarie Keys
land from Smith Corporation. After the completion of Stage 1, further residential
allotments were to be developed. Depending upon the rate of land sales, it was estimated
that the development would take up to twelve years to complete, and cost a further $76.0M.
In about February 1986, Smith Corporation approached
Beneficial Finance for a short term development loan of $0.55M pending the commitment of
joint venture participants to the Mindarie Keys project. Subsequently, Smith Corporation
proposed that Beneficial Finance participate in the joint venture formed to purchase the
Mindarie Keys land and to develop Stage 1 of the project. It was intended that Beneficial
Finance would, as part owner of the land, participate in the development of later stages.
After examining Smith Corporation's proposal for several
months, Beneficial Finance management presented a submission to the Beneficial Finance
Board of Directors seeking approval for Beneficial Finance to become a joint venture
participant in, and a financier to, the development. The submission was approved by the
Board on 16 December 1986, and an unincorporated joint venture was established by
agreement between Beneficial Finance, Smith Corporation and Entrad, signed on 19 October
The joint venture was not an incorporated entity. The joint
venture participants had separate legal rights and interests. For example, Beneficial
Finance was registered as a part owner of the Mindarie Keys land as a tenant in common
with Entrad and Smith Corporation, and had a several liability to creditors.
During the period from January 1988 to December 1990, the
joint venture developed Stage 1 of the Mindarie Keys land in accordance with the
requirements of the State Agreement. The development encountered problems from the outset,
including cost over-runs, lack of project control, low sales of subdivided residential
allotments, increased borrowings, and poor accounting and financial control.
In the first half of 1990, Entrad's financial position
deteriorated to the point that it was unable to continue to contribute its portion of the
joint venture's financial requirements. In December 1990, following protracted
negotiations with the joint venture participants and financiers, Beneficial Finance became
the sole owner of the development by acquiring both Smith Corporation's and Entrad's 25
per cent interests in the joint venture. As a result of the transfer of Beneficial
Finance's business operations to the Bank, the Mindarie Keys land is now controlled by the
Bank's Group Asset Management division. The provision for loss at February 1991 was
(b) Findings and Conclusions
In my opinion, the principal deficiencies in the processes
by which Beneficial Finance entered into and managed the Mindarie Keys facility were:
(i) Neither the Beneficial Finance Board of Directors nor
Management established adequate guidelines for the assessment of joint venture projects.
The initiation, review and supervision of credit proposals associated with the Mindarie
Keys joint venture were conducted by the Corporate Services division and its successors,
subject to the control of a relatively small group of Senior Executives, namely
Mr Baker, Mr Reichert and Mr Martin. Apart from internal audit procedures, there was
no adequate system of policies, procedures and internal control applicable to the
decisions made within the Corporate Services division.
(ii) An inadequate evaluation was undertaken by Beneficial
. the viability of the Mindarie Keys development;
. the terms and conditions of Beneficial Finance's
. the financial risks and returns associated with
Beneficial Finance's participation;
. the financial strength of the other joint venture
. Smith Corporation's capacity as joint venture participant
and manager; and
. the terms and conditions of the State Agreement, and its
implications for the project.
(iii) Beneficial Finance's execution of the joint venture
agreements, nine months after Board approval, was not subject to a consolidated submission
to the Beneficial Finance Board incorporating the substantial revisions to the facility
that had taken place during that period and that raised serious questions regarding the
viability of the project. Beneficial Finance did not have credit inspection procedures for
the purpose of reviewing the transaction prior to settlement to ensure that the terms and
conditions of approval had been complied with by the documentation. Having regard to the
time that had elapsed since the approval of Beneficial Finance's participation in the
project, and to the changes to the project, an updated submission should have been
prepared before the joint venture agreements were signed.
(iv) Mr Reichert, Mr Martin and Mr G J Yelland did not
instruct independent solicitors to act on behalf of Beneficial Finance to prepare the
joint venture agreements. They permitted Smith Corporation to instruct its own solicitors
to prepare the joint venture agreements contrary to the letters of approval. Further, they
failed to examine the joint venture agreements to ensure that they contained provisions
for the proper and adequate protection of Beneficial Finance's interests. One result was
that Beneficial Finance's representatives on the joint venture Board of Management did not
have adequate power to control the activities of the joint venture.
(v) Beneficial Finance Management failed to promptly
identify and react to problems associated with the joint venture. The financial and
management problems associated with the conduct of the Mindarie Keys project were
identified and reported to Beneficial Finance's Management in an Internal Audit Report in
1989. Management failed to take any adequate action to remedy the problems referred to in
the report. In my opinion, Mr Reichert as General Manager of the Corporate Services
division and its successors, who was the senior officer of Beneficial Finance
participating in management of Beneficial Finance's involvement in the joint venture, is
principally responsible for that failure.
(vi) The information contained in the Internal Audit Report
put the Beneficial Finance Board on notice of the substantial problems identified in the
Mindarie Keys project. The Beneficial Finance Board did not take appropriate
"follow-up" action to ensure that the problems referred to in the Internal Audit
Report had been remedied. In so failing to act, the Board failed to discharge its
obligation to adequately and properly supervise, direct and control the business
activities of Beneficial Finance.
Chapter 33: Case Study in Credit Management: Pegasus Leasing
(a) Overview and Summary
The Pegasus Leasing venture, which commenced business in
December 1985, was established as the result of an approach from Pegasus Securities. It
was essentially a partnership between Beneficial Finance and Pegasus Securities, with the
joint venture company, Pegasus Leasing Pty Ltd, acting as a nominee for the partners. The
first joint venture's business was largely limited to the granting of finance to the
thoroughbred horse industry, in the form of leases. The partners contributed $0.1M each as
capital to the venture, and were to share profits and losses equally. Those profits and
losses were calculated after payment of management fees to Pegasus Securities for
conducting the business, and of interest and guarantee fees to Beneficial Finance for
providing or facilitating funding for the venture.
As well as carrying on business on behalf of the partners,
Pegasus Leasing also granted leases as the sub-agent of Beneficial Finance under the
Reverse Principal and Agency Agreement between Beneficial Finance and the State Bank. The
leases granted as sub-agent were treated for accounting purposes as belonging to the State
Bank, and so were not shown in the accounts of the joint venture. Those leases were funded
by the Bank through loans to Beneficial Finance, which on-lent the funds to the joint
The first joint venture was not successful. From early in
1987, the Beneficial Finance Board of Directors expressed dissatisfaction with the
performance of the joint venture, and resolved that the venture should be terminated if
its performance did not improve.
In December 1987, the first joint venture was terminated.
It granted no new leases, and its portfolio of receivables was wound down, under the
management of Pegasus Leasing, over the following eighteen months.
On 1 January 1988, however, Beneficial Finance and Pegasus
Securities entered into a new Pegasus Leasing joint venture. This was, in effect, the real
beginning of Pegasus Leasing. It was an incorporated joint venture, with Pegasus Leasing
Pty Ltd carrying on business in its own name, and not as nominee for the partners.
The new joint venture was established at the instigation
of Mr Baker despite the express recommendation of Beneficial Finance's Joint Venture
Committee that it should not be formed. No formal submission was presented to the Board of
Directors of Beneficial Finance in respect of its formation.
The new joint venture essentially took over the business
activities of Pegasus Securities. It purchased Pegasus Securities' insurance broking
business, and its debt factoring business carried on by a subsidiary of Pegasus
Securities, Rivlin Pty Ltd. Pegasus Leasing employed the staff of Pegasus Securities to
conduct the business, and used that company's accounting systems.
The business of Pegasus Leasing expanded very rapidly
over the following two years. Bloodstock Leasing operations were established in New
Zealand and the United Kingdom, and the venture acquired a 75 per cent interest in
Bloodstock Management International Ltd, a company carrying on business as manager of
bloodstock investment syndicates. It also invested in, and financed, two investment
syndicates, and acquired a number of other minor investments. Pegasus Leasing's total
assets grew from less than $1.0M in January 1988, to $85.0M in November 1989, an
The rapid expansion of Pegasus Leasing's portfolio was
funded entirely by Beneficial Finance by providing unsecured, ninety day loans. Although
Pegasus Leasing was established with capital of $0.4M in January 1988, subsequent losses
meant that, by 30 June 1989, the company had no capital whatsoever, with its liabilities
exceeding its assets. Nevertheless, its business continued to expand, funded by loans from
Beneficial Finance. As at June 1989 Beneficial Finance's unsecured loans to Pegasus
Leasing totalled $62.0M, and increased to $79.0M in November 1989, and $85.0M in February
1990. By January 1991, the State Bank Group's exposure to the joint venture totalled
$97.7M, with a further exposure to the Pegasus Securities group of $14.1M.
In August 1989, Mr Baker became concerned at the size of
Beneficial Finance's exposure to Pegasus Leasing. The efforts of Beneficial Finance to
reduce that exposure, or at least to take it off the balance sheet, eventually resulted in
the State Bank becoming the owner of Pegasus Leasing's portfolio of receivables. The
method suggested by the Chief General Manager of Beneficial Finance's Treasury and Capital
Markets division, Mr F R Horwood, was to refinance Beneficial Finance's
loans to Pegasus Leasing through the Reverse Principal and Agency Agreement with the State
Bank. Mr Horwood apparently regarded that arrangement as being little more than a funding
mechanism for Beneficial Finance's tax-based leasing business. In fact, however, the
Agreement was an agency agreement under which Beneficial Finance granted leases as agent
for the State Bank, with the State Bank owning the lease receivables. After almost a year
of extensive consideration and negotiations, it was eventually agreed that the State Bank
would assume ownership of all of Pegasus Leasing's portfolio of lease receivables.
In May 1990, a new joint venture was established between
Pegasus Securities and Beneficial Finance, which was a partnership of the type that
operated between 1985 and 1987. Pegasus Leasing's non-receivables assets were transferred
to the new unincorporated joint venture, which also managed the portfolio of lease
receivables then treated as owned by the State Bank.
Within three months Beneficial Finance decided to end the
joint venture. A series of adverse internal audit reports, a report from the external
auditors of Pegasus Leasing and Beneficial Finance, Price Waterhouse, and reports from
Beneficial Finance's own management, prompted Beneficial Finance to take control of the
activities of the joint venture, and to wind it up. Guarantees were obtained from Mr
McGregor and from Pegasus Securities in respect of the State Bank Group's loans to the
In late 1990 and early 1991, values of thoroughbred horses
fell dramatically. Many customers of Pegasus Leasing were unable or unwilling to meet
their obligations. In February 1991, a report from Ernst & Young, Chartered
Accountants, confirmed an estimate from Beneficial Finance's management that the losses
associated with the Pegasus Leasing business might total between $40.0M and $46.0M.
The fundamental failing of Beneficial Finance was to
provide essentially unlimited finance to a business that it did not adequately monitor,
and certainly did not control. Pegasus Securities may have had the experience and
expertise to conduct a modest thoroughbred leasing business, the company having total
receivables of $5.5M in 1985. With the finance provided by Beneficial Finance, however,
the business grew rapidly, unrestrained by any lack of funds. Without that restraint,
leases could be provided to borrowers who might otherwise have been excluded from
consideration. With ambitious growth budgets set, the downward pressure on credit
standards is obvious. In fact, even those growth budgets were exceeded.
The result was that credit standards fell, and the
business grew to a size and diversity beyond the experience or expertise of Pegasus
Securities. Inevitably, very large losses resulted, and the State Bank paid the bill.
(b) Findings and Conclusions
(i) As with its other operating joint ventures, the
fundamental premise upon which the joint venture was based was that it would be a
partnership between the experience, expertise and reputation of Pegasus Securities in a
specialised area of finance, and the strong financial backing provided by Beneficial
Finance. Beneficial Finance hoped that, with its financial support, Pegasus Securities
could establish a significant portfolio of bloodstock lease receivables of about $100.0M,
that would provide a steady stream of profits for both partners.
(ii) With Beneficial Finance's financial backing, Pegasus
Securities was able to build a business of a size far beyond that which it could conduct
from its own financial resources. Pegasus Securities simply did not have the financial
strength to be able to borrow sufficient funds to grow a portfolio of receivables of
$100.0M. It could only do so by gaining finance from a joint venture partner. It
necessarily follows that Beneficial Finance's lending to the joint venture was not based
on its usual credit assessment policies and procedures, but was fundamentally influenced
by the fact that Beneficial Finance was itself joint owner of the borrower. Under those
circumstances, it was always going to be the case that Beneficial Finance would bear the
cost of a failure of the joint venture. The managing director of Beneficial Finance, Mr
Baker, candidly affirmed that this was the basis of the operating joint ventures of
Beneficial Finance in general, and of Pegasus Leasing in particular.
(iii) This reliance on its joint venture partner's
expertise required that Beneficial Finance do one of two things:
. First, it should have fully satisfied itself that Pegasus
Securities in fact had the experience and expertise to prudently and profitably manage the
. Second, Beneficial Finance should have carefully
monitored the activities of the business, to ensure that the business did not diversify
and expand beyond the experience and capacity of Pegasus Securities to prudently and
profitably manage the business.
Beneficial Finance failed to do either of these things.
Mr Reichert told my Investigation both that:
. insufficient control was exercised over Mr McGregor in
his conduct of the business; and
. Mr Reichert doubted Mr McGregor's credentials to conduct
Despite these concerns held at the time, Mr Reichert, who
was a director of Pegasus Leasing from June 1988 until November 1989, took no effective
steps to resolve that situation.
(iv) The very nature of the joint venture arrangement had
the effect that Beneficial Finance was forced to rely on Pegasus Securities to a
considerable degree. A basic premise of the joint venture was that it would conduct
business in a specialised area of finance in which Beneficial Finance lacked the necessary
experience and skills. If Beneficial Finance had had those skills, it would not have
needed to enter into a joint venture with Pegasus Securities. As late as October 1990,
when the decision was made to terminate the joint venture, Mr M Chakravarti and
Mr Piovesan, who had been directors of Pegasus Leasing, expressed the view that Beneficial
Finance still lacked the necessary expertise to conduct the business, and that reliance
would have to continue to be placed on Mr McGregor or on another external specialist.
(v) More importantly, the business activities of Pegasus
Leasing expanded to a size and diversity that was outside the experience of Pegasus
Securities, and beyond the capacity of its accounting and credit risk management systems
to cope. When the first joint venture was formed, Pegasus Securities had a total
receivables portfolio of only $5.5M. Between January 1988 and November 1989, the business
expanded rapidly to a receivables portfolio of $97.0M, including operations in New Zealand
and the United Kingdom, and participation in, and funding of, thoroughbred investment
(vi) This rapid growth of the business was made possible by
the apparently unrestrained funding provided by Beneficial Finance. No appropriate limit
was placed either on Beneficial Finance's exposure to the bloodstock industry, or on its
exposure to Pegasus Leasing. An inevitable result of the unrestrained access to funds was
a downward pressure on credit standards, since potential borrowers who might previously
have been excluded from consideration by the need to ration available funds, could now be
accepted as clients, in the pursuit of sales growth.
(vii) Even in August 1989, when Mr Baker expressed concern
regarding the size of Beneficial Finance's exposure to Pegasus Leasing, no action was
taken to restrain the growth of Pegasus Leasing's portfolio. Instead, the response of
Beneficial Finance Management was simply to try to pass the obligation to fund Pegasus
Leasing's business to the State Bank, through the Reverse Principal and Agency Agreement.
The end result of that attempt to refinance the lending to Pegasus Leasing was that the
State Bank assumed ownership of the receivables portfolio in 1990, and so bore the
(viii) The Non-Executive Directors of Beneficial Finance
failed to appreciate the reality of the operating joint ventures, even though the
rationale for the joint venture was expressly stated to the Board of Directors on a number
of occasions. If the Non-Executive directors had brought an independent and analytical
mind to bear on the structure of the Pegasus Leasing joint venture, it should have become
apparent to them that the risk of financial loss lay with Beneficial Finance. An
examination of the joint venture's balance sheet would have shown that the joint venture
was wildly overgeared, and that in June 1989 it had no capital at all, with its borrowings
actually exceeding its total assets. Such a funding arrangement could not have been
satisfactory within Beneficial Finance's established lending policies and procedures.
The Non-Executive Directors did not appreciate the
nature of the risks being run by Beneficial Finance, and the actions that needed to be
taken to ameliorate these risks. The failure of the Non-Executive Directors to come to
grips with the basic nature of the joint venture amounted, in my opinion, to a failure to
adequately or properly supervise, direct and control Beneficial Finance's participation in
the joint venture.
(ix) In my opinion, the fundamental failing of
Management of Beneficial Finance was its failure to recognise the deficiencies in the
joint venture strategy. Reliance upon the experience and expertise of a joint venture
partner within that partner's business experience is one thing. To provide that partner
with almost unlimited finance, enabling it to expand and grow the business beyond the
limits imposed by normal commercial constraints, is an invitation to disaster. For this
failing, the managing director of Beneficial Finance, Mr Baker, must accept the heaviest
blame. It was Mr Baker who proceeded with the establishment of the joint venture despite
the express recommendation of the Joint Venture Committee not to do so. Many other of the
officers and employees of Beneficial Finance involved in the Pegasus Leasing joint venture
could, however, be subject to criticism, including those officers who served as directors
of Pegasus Leasing without exercising an adequate level of control, and those managers who
allowed funds to flow to Pegasus Leasing without limitation.
Chapter 34: The Funding of Beneficial Finance
(a) Overview and Summary
The methods used by Beneficial Finance to raise funds were
generally consistent with those of its competitors. Throughout the period under review, it
increasingly relied on the the wholesale financial markets to fund its operations,
particularly wholesale funds sourced from off-shore. This increased reliance by Beneficial
Finance on wholesale funds, rather than funds raised by way of public debenture issues,
was also consistent with the experience of some other finance companies.
Although Beneficial Finance's Debenture Trust Deeds imposed
various gearing limits, including a maximum debt-to-equity ratio of 15:1, Beneficial
Finance management aimed for an on-balance sheet debt-to-equity ratio of 12.5:1. At the
same time, however, Beneficial Finance implemented arrangements, through a series of
off-balance sheet entities that were intended to avoid the gearing limits imposed by its
Debenture Trust Deeds. The arrangements were implemented with the approval of Beneficial
Finance's Board of Directors.
These off-balance sheet entities were, in many instances,
seriously undercapitalised. Mr Baker acknowledged that one consequence of the
inadequate capitalisation of those entities was that Beneficial Finance suffered greater
losses than otherwise would have been the case.
Beneficial Finance did not establish a risk weighted
capital allocation arrangement, with the result that Management and the Board did not have
available information relevant to the decisions they made in approving new facilities and
ventures, and in their ongoing management of existing activities. More specifically,
without a risk weighted capital allocation arrangement, Management and the Board assessed
new proposals without having regard to appropriate risk-adjusted performance targets, and
the performance measures against which existing activities were judged were
inappropriately low because they did not reflect appropriate premiums for higher risk.
Nevertheless, while the information provided by a risk
adjusted capital allocation arrangement was relevant to decisions made by Beneficial
Finance Management and Directors, it is unlikely that, in all the circumstances, decisions
made by either would have changed in any material respect. For instance, the performance
targets which had been set for the Pegasus Leasing joint venture joint venture without
regard to the high risk nature of the venture were not, over a period of time, met. Rather
than withdrawing from the venture, the company substantially increased its commitment to
it. When the Beneficial Finance Board was first asked to approve participation in this
joint venture in 1985, it did so on the basis that only a minimal amount of equity would
be subscribed to the joint venture by Beneficial Finance and its joint venture partner.
By September 1989, Management identified serious
concerns with the capitalisation of much of Beneficial Finance's business, and
particularly the funding of joint ventures. After considering the issues involved, the
Executive Committee decided not to act on these matters until the next financial year. It
did not refer that decision to the Board of Directors.
The Board considered the need to implement improved capital
allocation procedures late in 1989, when a submission was presented containing
recommendations for a risk-weighted capital allocation system. Implementation of the
recommendations in the submission required the development of new systems and reporting
arrangements which, having regard to other initiatives, were not given high priority. Mr
Baker submitted to my Investigation that it was inappropriate for the company to implement
the procedures until the end of 1989-90 financial year. The difficulty faced by Beneficial
Finance in implementing the recommendations were described by Mr Horwood, Chief General
Manager Treasury and Capital Markets division, in his submission to my Investigation. He
said that the systems for providing information on assets were so deficient that the
proposed arrangements could only be implemented with a total re-development of the
While this explains the Beneficial Finance's failure to
implement all of the recommended procedures, it does not explain why alternative action,
specifically aimed at the larger joint ventures in which it was engaged, was not taken. I
do not accept that it was beyond the resources of Beneficial Finance to identify the major
joint ventures in which it was engaged, and to quickly review the respective arrangements,
particularly the capitalisation and on-going performance of those ventures.
(b) Findings and Conclusions
(i) Management and the Beneficial Finance Board should
have identified the significant defect in the Beneficial Finance performance measuring
arrangements which followed from the absence of a risk weighted capital allocation
process. The realisation that performance measurement arrangements were defective required
no more than a basic appreciation of the calculation involved, and that the "After
Tax Return on Earnings" measure could be manipulated by changing the denominator,
equity. The Board should have identified the need for, at the very least, strict
guidelines for the capitalisation of company activities, both on and off-balance sheet.
(ii) The failure by management to appropriately plan and
. the growth of the company;
. the mix of its portfolio of assets; and
. the need for adequate capitalisation of off-balance sheet
when combined with the failure to provide effective
reporting on these important management issues, meant that the Board and management did
not have a sound basis for decision making. This situation resulted in Beneficial Finance
holding significant non-performing assets.
(iii) In failing to attend to these matters, the Board and
management failed to adequately or properly supervise, direct and control the affairs of
Chapter 35: Beneficial Finance - Prospectus 65
(a) Overview and Summary
Prospectus 65 (issued on 2 November 1989) was the last
prospectus issued by Beneficial Finance during the period under review.
The Companies Code prohibited a company from issuing
debentures on the basis of a prospectus after the expiration of six months from the date
of issue of the prospectus. However, pursuant to other provisions of the Code, Beneficial
Finance sought and was granted an exemption from the six months limitation to enable it to
issue debentures under Prospectus 65 for a period of twelve months from the date of issue.
To meet Corporate Affairs Commission requirements, the
directors of Beneficial Finance provided a written undertaking to the Commission in
support of their application for this "Extended life prospectus". The
directors undertook, inter alia, to immediately inform the Commission's delegate of:
(i) any material deterioration in the financial condition
of Beneficial Finance or its subsidiaries; and
(ii) any occurrence which may result in the prospectus
containing or omitting information that is false in a material particular or materially
As a condition of exemption, the directors were required to
submit a report to the Commission (within two weeks after the expiry of six months from
the date of issue of Prospectus 65) stating whether, after making all reasonable
enquiries, they were of the view that any material statement included in the prospectus
was untrue or misleading or whether any material matter had been omitted from the
Both management and the Board of Beneficial Finance were,
therefore, charged with a heavy responsibility to ensure that the general public, via the
Commission, was kept fully informed as to whether there was any material deterioration in
the condition of the company during the life of the Prospectus.
The financial condition of Beneficial Finance did
deteriorate, and Prospectus 65 was eventually withdrawn.
Prior to its withdrawal, however, the directors provided a
report to the Corporate Affairs Commission on 27 April 1990, wherein they indicated that,
after making all reasonable enquiries in relation to the interval between 30 June 1989 and
27 April 1990:
(i) they had not become aware of any circumstances which in
their opinion had affected or would affect the trading or profitability of the corporation
or its subsidiaries or the value of it's assets; and
(ii) there was nothing in or omitted from the Prospectus
which could result in it being materially false or misleading.
The following developments, all of which occurred during
the life of this prospectus, were in my opinion particularly relevant to the financial
condition of Beneficial Finance about which it was the respective obligation of both the
Board and of Mr Baker to keep the Commission properly informed:
(i) the aggregate accounting exercise reported to the Board
in February and March of 1990 disclosed off-balance sheet losses;
(ii) the downgrade of Beneficial Finance's debenture rating
by Australian ratings reported to the Board in February of 1990;
(iii) the deteriorating profit of Beneficial Finance, which
was evident to Mr Baker as at December 1989;
(iv) the reported decline in profit forecast as reported to
the Board in monthly Board Papers;
(v) the increasing extent of non-performing loans and their
effect upon profit before tax as disclosed in Board Papers particularly in April, May and
June of 1990; and
(vi) the need for a provision of some $22.0M to be raised
in respect of the Somerley Eden Hotel which was apparent to Mr Baker in February of 1990.
The combined effect of these developments should have led
to the withdrawal of the prospectus at the very latest in May of 1990, but it was not
withdrawn until 7 August 1990.
(b) Findings and Conclusions
(i) At the Board meeting of 23 February 1990, the Board was
advised of an off-balance sheet loss of $12.5M for the half year ended 31 December 1989.
This was revised to a loss of $7.3M in a further paper presented to the Board in March
1990. In addition, aggregate accounts attached to February Board Papers disclosed an
additional $7.4M off-balance sheet loss for the period ended 30 June 1990 which had not
been previously recognised. The directors of Beneficial Finance did not report these
losses to the Commission.
(ii) In February 1990 Australian Ratings downgraded its
rating of Beneficial Finance from "AA" to "A". The
directors failed to advise the Commission of this "downgrade" until May
(iii) The April, May and June Board Papers described a
sustained increase in the non-performing loans of the company. By way of example, the
Board Papers for the 27 April 1990 Board meeting disclosed that off-balance sheet
non-performing loans at 31 March 1990 were an additional $49.9M, and that the company had
suffered a net loss before tax of $0.6M for the month of March 1990.
(iv) By the meeting of 27 April 1990, the directors had
received sufficient information to put them on notice of the declining state of the
financial health of Beneficial Finance.
(v) In the circumstances, it was inappropriate for the
Board to rely upon assurances from management and thereafter proceed to execute
undertakings asserting that there was no material deterioration in the company's financial
condition. Instead the Board should have called for a report from an investigating
(vi) I am of the opinion that the Board failed to exercise
proper care and diligence in relation to matters leading to its execution of the
undertakings it was required to provide to the Corporate Affairs Commission.
(vii) By the time of its Board meeting in May 1990, the
Board was clearly on notice of a significant deterioration in Beneficial's financial
condition. Immediately after the May Board meeting, the directors should have notified the
Commission in accordance with their undertakings and taken steps to withdraw the
(viii) In failing to do so, the Board again failed to
exercise proper care and diligence.
(ix) In September 1989 and January of 1990, Mr Baker
reviewed reports which disclosed that the true underlying profit of Beneficial was well
below the reported profit of the company and that the level of reported profits was being
boosted by reserves built up in more profitable periods (a practice known as "shock-proofing").
Mr Baker failed to disclose the contents of these reports (together with important
correspondence from Beneficial's external auditors in April 1990) to the Board and thereby
withheld vital information from the Board.
Mr Baker, as Managing Director, was in a better position
than the other directors to appreciate the deteriorating condition of Beneficial Finance.
He was privy to information indicating this possible deterioration as early as the
beginning of 1990. His conduct in withholding important information from the Board and
executing the undertakings may disclose unlawful or improper activity, and should be
126.96.36.199 Chapter 36: Treasury and the Management of
Assets and Liabilities at Beneficial Finance
(a) Overview and Summary
The Treasury division's role was to ensure funds required
were available as and when required, and to ensure that funds were managed efficiently. As
co-ordinator of the Company's assets and liabilities, Treasury also took responsibility
for the management of important non-credit financial risks facing Beneficial Finance.
Although the Treasury division met its primary objective of
ensuring that funds were available to meet operational requirements, it did not fulfil
other basic fund management needs. Beneficial Finance Treasury did not regularly prepare
cash flow reports for the information of senior management and the Board. Further, the
Treasury division was unable to communicate appropriate information concerning the cost of
funds to operational divisions to Beneficial Finance, Management, and the Board.
Although a transfer-pricing system was used by Beneficial
Finance, it did not use accurate or reliable Cost of Funds information. It was not until
1990, when Beneficial Finance was already in financial difficulty, that a system was
implemented which identified and charged operating divisions with an accurate Cost of
Funds figure for the funds they used. Before 1990, Beneficial Finance was unable to
reliably calculate the cost of funds used, a vital component of the assessment of the
profitability of specific transactions, and of the operating divisions.
The Beneficial Finance Treasury division, in part by
default, took responsibility for the co-ordination of the Company's assets and liabilities
and, consequently, responsibility for managing important financial risks. The evidence
shows that the circumstances in which the division performed this role were most
In its capacity as manager of the Company's liquidity risk,
the Treasury pursued a strategy of maintaining excessive liquidity in the short term. In
developing medium term funding strategies, it faced the difficulty of not knowing, with
reasonable certainty, what funds would flow into Beneficial Finance from interest payments
on existing assets or from maturing assets, or what funds would be required for new
Similar problems affected the Treasury division's capacity
to manage Beneficial Finance's interest rate risk. To manage that risk, it needed to know,
in aggregate, whether loans were advanced on a fixed or floating interest rate basis, and
when interest rates were recalculated. This information was not readily available in a
There is a common element in the difficulty experienced
by Treasury in managing liquidity and interest rate risk, in preparing cash flow reports,
and in determining the cost of funds. In each case, Treasury required information
regarding the nature of the company's assets and cash receipts in order to do its job. It
is evident that Beneficial Finance's core management information system was unable to
provide the Treasury with the information it required.
The Managing Director and the senior managers of the asset
generating divisions, did not support Mr Horwood and the Treasury division. As a result,
the overall requirements of Beneficial Finance for co-ordinated management of critical
areas were neglected. In particular:
(i) The ability of the Treasury division to prepare short
and long term cash flow forecasts was limited. This hindered effective liquidity
management, resulting, on occasions, in excessive funding costs.
(ii) Treasury division did not have access to appropriate
systems or information regarding the asset structure of the company, to enable it to
adequately manage the mis-match of the maturity profile of the assets and liabilities, or
the interest rate risk, associated with the assets and liabilities.
(iii) Prior to the introduction of the Cost of Funds system
in 1990, the profitability of the asset generating divisions, and individual lending
transactions entered into by those divisions, could not be reliably measured.
(iv) Problems were encountered in calculating the monthly
borrowings expense figure, and this adversely affected the reliability of the monthly
reported profit position.
(b) Findings and Conclusions
(i) Beneficial Finance underwent significant growth during
the period covered by this Investigation. The extent and implications associated with this
growth, which included diversification in lending activities and funding responsibilities,
required that appropriate emphasis be accorded by the Board and the senior management to
the critical task of asset and liability, liquidity, interest rate risk, and systems
(ii) The Board of Directors, the Managing Director and
senior management of the asset generating divisions failed to recognise the need for a
co-ordinated high level approach to these matters within Beneficial Finance. Rather, their
attention and effort was directed to growing the business. During the period under
investigation there was no specific person or organ within the company that, at all times,
had responsibility for the overall management of asset and liability, liquidity and
interest rate risk management. The Treasury division of Beneficial Finance, undertook, by
default, many of the aspects associated with this management task. Although a formalised
asset and liability committee was established at certain times during the period under
investigation, it had, as its focus, Treasury related matters, and was not concerned with
overall risk systems management.
(iii) The Board of Directors of Beneficial Finance failed
to adequately or properly supervise, direct, and control, the affairs of the company with
respect to this matter, in that they did not provide direction regarding the limits of
permissible risk, this being a major matter that must be managed in the operations of a
(iv) Mr Baker created an environment within Beneficial
Finance that allowed asset generating divisions to ignore the demands for information to
meet asset and liability management requirements, which meant that the needs of the
Treasury division were not met. As Managing Director, it was his responsibility to ensure
that information needs and sound management practices which transcended the needs of
individual divisions of the company were met. Mr Baker failed to adequately or properly
discharge his responsibilities in respect of asset and liability, liquidity, interest rate
risk, and systems management.
(v) During the period under Investigation, there was no
overall co-ordinated and responsible management control exercised over the asset and
liability, liquidity, interest rate risk, and systems management responsibilities of the
company, and the processes adopted with respect to the management of each of these matters
(vi) It cannot be said that the financial position of
Beneficial Finance was directly caused by the manner in which the company managed its
assets and liabilities, and conducted its Treasury operations. Nevertheless, management
and systems deficiencies in Treasury operations, when aggregated with other deficiencies
examined in other Chapters of this Report, resulted in the financial position reported at
Chapter 37: Internal Audit of Beneficial Finance
(a) Overview and Summary
Internal Audit, as an instrument of higher management,
provides an "early warning signal" to management where a lack of, or a
breakdown in, systems and internal controls threatens the assets of an organisation. Well
managed organisations view Internal Audit as an indispensable aid to achieving effective
The Internal Audit function in Beneficial Finance was
established prior to the Company becoming a subsidiary of the Bank and it continued,
independently of the Bank's Internal Audit function until 1990 when it was incorporated
into the Bank's Group Internal Audit function.
Beneficial Finance held significant amounts of money
invested by members of the public pursuant to its debenture and unsecured note issues. As
such, the public was entitled to expect that proper standards of internal control would be
operative at all times.
Furthermore, the business activities of Beneficial Finance
underwent significant changes during the period under review. The change in the nature of
business activities was accompanied by a number of organisational, management, and major
system changes. The nature, complexity, and size, of some of the transactions that were
entered into, when aggregated, were significant with respect to both on-balance sheet and
off-balance sheet matters. These transactions gave rise to new and significant risk
exposures for the Company.
Throughout the period under review, the Internal Audit
function within Beneficial Finance was adequately resourced and was focused on high risk
areas of the Company's operations. Whilst there is no evidence that the Internal Audit
department was denied access to areas in relation to which it had a mandate, the Audit
Manual governing the department's activities provided for limitation of the department's
mandate in relation to payrolls, secretarial, and legal departments. These areas of audit
review were the responsibility of the external auditors.
Internal Audit can make its most valuable contribution to
an organisation when it has unrestricted authority to effect audit coverage over all
important areas of the organisation. The limitation in the Beneficial Finance audit
mandate was wrong in principle. Whilst I regard the arrangements in relation to Internal
Audits of payrolls, secretarial, and legal departments as inappropriate, I make it clear
that there is no evidence before the Investigation to suggest that these areas were not
properly audited by the external auditors.
During the period under review the Internal Audit
department conducted some three hundred audits and, with very few exceptions, substantive
Audit Reports were issued to auditees in relation to those audits.
Each quarter, the substantive Audit Reports generated
during that period were summarised into the Internal Audit department's Quarterly Report
for submission to the Beneficial Finance Board. The substantive Reports underwent a heavy
editing process in order to present concise summaries in the Quarterly Reports to the
Board. Despite certain difficulties inherent in a summary reporting process, (including in
some cases not conveying in the Quarterly Reports every concern raised in the substantive
Reports), I am satisfied that the Quarterly Reports were sufficient to put the Board on
notice as to the essential issues raised in the substantive Reports. The Quarterly Audit
reporting process was facilitated by the use of a grading system of audit findings, which
put the Board specifically on notice in relation to matters reported as carrying a grading
of "Unsatisfactory" or "Satisfactory Minus".
The Board's response to certain "Unsatisfactory"
or "Satisfactory Minus" gradings by the Internal Audit department was
inadequate. The constraints imposed by reporting in summary form on a quarterly basis and
the complex findings contained in the substantive Reports, required of the Board a far
more inquiring approach than was in fact adopted by it. Summary Reports of complex
findings contained in various substantive Internal Audit Reports were presented to the
full Board on a quarterly basis, at which heads of Internal Audit were not in attendance
and principal responsibility for responding to matters raised in connection with the
Reports rested with the Managing Director. This situation provided a very limited forum
for dealing with matters relating to Internal Audit. The Board relied on Management's
representations relating to the matters summarised in the Quarterly Reports, without
appropriate independent inquiry of outcomes from the heads of the Internal Audit
Prior to 1984 Beneficial Finance had an established Audit
Committee of the Board, which directed specific attention to Internal Audit matters, and
meetings of the Committee were attended by the head of Internal Audit. As I have indicated
in Chapter 23 - "Internal Audit of the State Bank" in relation to the
Bank's Audit Committee, an Audit Committee provides a far more focused and dedicated
environment for dealing with Internal Audit and related accountability matters. The
Beneficial Finance Board, knowing that the Audit Committee (which operated until August
1984) enhanced its awareness of the Company's operations, allowed itself to be persuaded
by the reasoning of Mr Clark to disband the Committee. The abolition of the Committee
deprived the Board of a forum which would have facilitated greater in-depth analysis of
Internal Audit reports, which clearly put the Board on notice that breakdowns in internal
control systems had been identified and that the assets of the Company were at risk.
(b) Findings and Conclusions
(i) Whilst the execution of the Internal Audit function
can, in general, be said to have been adequate, the procedures adopted by the Board in
response to important matters raised by the Internal Audit Reports were inadequate.
(ii) The disbandment of the Audit Committee placed the
Board in a position whereby, through its own act, it was handicapped in its ability to
manage the Company. The Board deprived itself of a specific forum that would have
facilitated in-depth analysis of Internal Audit Reports' findings and discussion
concerning the strengths and weaknesses of the Company's operation. In so doing, the Board
dispensed with an accountability arrangement important to its role of adequately and
properly supervising, directing, and controlling the operations, affairs and transactions
of Beneficial Finance.
Chapter 38: Equiticorp Receivables
(a) Overview and Summary
Between January and March 1988, Beneficial Finance acquired
five portfolios of receivables (ie loans), from various Equiticorp companies. Four, with a
book value of $165.8M, were acquired in Australia. One, with a book value of approximately
$100.0M, was acquired in New Zealand. In Chapter 26 of my First Report - "Dealings
Between the State Bank and Equiticorp" I reported on a series of transactions
between Equiticorp and the State Bank between late 1987 and 1988. This Chapter should be
read in the context of matters that I have already reported upon in Chapter 26.
Whilst the four Australian portfolios acquired through two
subsidiaries of Beneficial Finance's off-balance sheet company, Kabani Pty Ltd, have,
generally speaking, been profitable, certain features of these acquisitions were
inappropriate. Management used its delegated powers to approve individual transactions
which were within its delegated approval limits. The aggregate of the value of those
individual transactions, however, clearly exceeded management's delegated approval limits.
Management did not, but should have, obtained Board approval for each of the three
transactions as their aggregate exceeded the limit on Beneficial Finance's cumulative
exposure to a particular borrower.
The second, third and fourth Australian portfolios were
acquired in two transactions, in such haste that the review process was compromised.
Whilst no loss resulted, there was a serious risk of loss, and such risk ought not to have
The New Zealand portfolio was acquired in three tranches
(ie lots) through Ravlick Holdings Ltd, a New Zealand shelf company acquired through
Beneficial Finance's off-balance sheet structure. The portfolio suffered difficulties, in
that a number of the borrowers experienced financial problems. The first borrower had a
receiver appointed in June 1988. By 29 March 1989, twelve borrowers were either in
receivership, liquidation or some other form of statutory management. The principal cause
of this, was the collapse of three major New Zealand groups of companies. Six of the
borrowers in the New Zealand portfolio were directly related to these groups of companies.
Losses were incurred in relation to the New Zealand portfolio, both as a result of writing
off amounts and by way of forgone interest.
Mr Baker, Managing Director, had stated in the proposal to
the Board on 9 February 1988 for acquisition of the New Zealand portfolio, that Equiticorp
had not analysed the borrowers' cash flows in depth, and a downturn in the New Zealand
real estate market was anticipated. These two factors should have indicated to Beneficial
Finance the potential for higher than normal levels of default by the borrowers. Further,
Equiticorp had difficulty in providing loans of a quality acceptable to Beneficial
Finance, which was the reason for the first tranche of New Zealand receivables being of a
value less than that which had been anticipated. In my opinion, security values,
therefore, would be crucial to the review, particularly if the existing evaluations had
been performed when the property market had been more buoyant.
The available evidence includes reports on the New Zealand
receivables from Beneficial Finance's property consultant, which refer to individual
loans. The Beneficial Finance Board had told management at its meeting on 10 February 1988
to "obtain commercially realistic valuations." The reports from the
property consultant did not comprise valuations of the individual properties, but
consisted of general comments concerning the properties and, in some cases, comments on
valuations previously prepared by Equiticorp. These reports do not constitute "commercially
The lack of certain records relating to the New Zealand
acquisition is a matter of deep concern. The minimum records required to be maintained
should have recorded the reasons why each receivable was accepted. These should have noted
any representations made by the vendor, and would have provided the basis for any claim
against the vendor should this have been required. A report summarising the results of all
aspects of the inquiries should have been produced. There is no evidence that one was
made. Mr Baker cannot recall whether a written report was produced or not. The lack of
such a report casts doubt on the quality of decisions made by personnel who were not
familiar with detailed stages of the review and results of inquiries that had been carried
out by other personnel.
In the proposal to the Board dated 9 February 1988, Mr
Baker had sought approval from the Board to acquire the New Zealand portfolio. On 10
February 1988, the Board accepted a recommendation that management proceed to New Zealand
to conduct further negotiations to enable firm recommendations to be made to the Board.
There is no evidence that approval to acquire the portfolio was given at a subsequent
meeting of the Board on 26 February 1988. Mr Baker has acknowledged to my Investigation
that no approval was given by the Board before Beneficial Finance proceeded to acquire the
portfolio. At its next meeting on 25 March 1988, the Board was informed that the
acquisition of $100.0M New Zealand of receivables had taken place and was given assurances
by management. Management, and in particular Mr Baker, failed to comply with the Board's
direction to bring a firm recommendation to it after further investigation. Mr Baker's
conduct was in excess of his powers, and the Board ought to have censured him. Further,
the Board ought not to have been so easily reassured. The Board ought to have required a
detailed recommendation as it had originally directed.
The procedures followed in the acquisition of the second
New Zealand tranche particularly concern me. Although Beneficial Finance was not satisfied
with the quality of the receivables, Mr Baker wanted to proceed with settlement by 16 May
1988. Settlement of the second tranche of New Zealand receivables occurred on 15 March
1988 before the due diligence process was completed, and on the condition that Beneficial
Finance had fourteen days to reject any receivables it considered unsuitable.
In order for the second tranche to proceed, Beneficial
Finance provided $NZ 30.0M of additional security to the Bank of New Zealand. Whilst
the provision of a guarantee was referred to in Mr Baker's proposal to the Board, the
amount of the guarantee was not stated, and therefore the provision of this guarantee was
not approved by the Board on 10 February, and the Board was uninformed about an additional
exposure to Equiticorp.
(b) Findings and Conclusions
(i) The processes that led to Beneficial Finance engaging
in the acquisition of the Equiticorp Receivables were inappropriate.
(ii) The Managing Director, Mr Baker, did not exercise
proper care and diligence, in that he authorised the settlement of the second tranche of
the New Zealand Receivables prior to the completion of review of those receivables.
(iii) The operations, affairs and transactions of
Beneficial Finance, with reference to the acquisition of the portfolios of receivables
from the various Equiticorp companies, were not adequately or properly supervised,
directed or controlled by Mr Baker (Managing Director) and the Beneficial Finance Board.
(iv) The failure of Beneficial Finance Management to
maintain and safeguard proper records relating to the acquisition of the portfolio of New
Zealand Receivables may have constituted a breach of applicable companies or taxation
legislation, and this matter should be further investigated.
(v) Mr Baker acted improperly and was in breach of his
duty as a director in disregarding the direction of the Board by proceeding to acquire
receivables without presenting a firm recommendation to the Board for its approval, as he
had been directed to do.
Chapter 39: Mortgage Acceptance Nominees Limited
(a) Overview and Summary
Mortgage Acceptance Corporation was a mortgage broker. Its
business consisted of identifying businesses in need of finance, and then identifying a
financial institution that would be prepared to provide that finance. It earned its income
from bringing together businesses needing funds, with lenders prepared to provide those
funds. In some cases, Mortgage Acceptance Corporation would provide temporary loans,
called bridging finance, to the businesses until a lender could be found. It specialised
particularly in arranging finance for businesses in the real estate and bloodstock
industries. Mortgage Acceptance Corporation was controlled by an entrepreneur who, for
confidentiality reasons, I will call Mr Green.
Beneficial Finance was one of the financial institutions
invited by Mortgage Acceptance Corporation to provide loans to its clients, and Beneficial
Finance was appreciative of the opportunities. Before the proposal to establish a joint
venture in June 1988, Mortgage Acceptance Corporation introduced business totalling $15.0M
to Beneficial Finance's Parramatta branch, and made loans as the agent of Beneficial
Finance under a Principal and Agency Agreement. The Managing Director of Beneficial
Finance, Mr Baker, described Mortgage Acceptance Corporation as a "very strong new
business referee" at the Beneficial Finance Board of Directors' meeting on 27 May
1988. Indeed, so impressed were the Management of Beneficial Finance that, in May 1988, it
agreed to establish a joint venture with Mortgage Acceptance Corporation.
The joint venture was established, and commenced
operations, before a submission to establish the joint venture was presented to the
Beneficial Finance Board of Directors. When a submission seeking approval for the joint
venture was submitted to the Board at its meeting on 24 June 1988, it was rejected.
Nevertheless, the basic elements of the joint venture, particularly the management of loan
accounts by Mortgage Acceptance Corporation, were left in place, without the knowledge of
the Board of Directors.
A further submission to establish the joint venture was
presented to the Board at its meeting on 25 November 1988, and approved. The fact that the
joint venture had been established, and had commenced operations before the Board meeting
on 24 June, was not adequately disclosed to the Board in either June or November.
Such conduct by management, in settling transactions
prior to the Board meeting at which the proposal was to be considered, demonstrates an
attitude that the Board would "rubber stamp" management's recommendations. In
the event, management's expectation was wrong. The approval eventually given in November
1988 was given retrospective effect by management to include the business conducted from
The joint venture grew rapidly, and by 30 June 1989 had
total assets of $88.9M. By 30 June 1990 total assets were $97.3M, including $27.0M funded
by the State Bank under the Reverse Principal and Agency Agreement.
Beneficial Finance provided the great majority of the
funding for the joint venture, with the exception of the business written by the joint
venture as a sub-agent of Beneficial Finance under the State Bank of South Australia
Reverse Principal and Agency Agreement, and a $4.5M loan from the State Bank relating to a
I have examined the Reverse Principal and Agency Agreement
in detail in Chapter 33 - "Case Study in Credit Management: Pegasus Leasing".
Shortly stated, in legal form the Agreement appointed Beneficial Finance as the agent of
the Bank for the purpose of writing tax-effective finance leases, which are a form of
lending. The Agreement authorised Beneficial Finance to appoint sub-agents. Although the
legal form of the Agreement was that of a principal and agency arrangement, in substance,
however, the Agreement was a funding arrangement, and was used as such by Beneficial
Finance to fund some of the activities of its joint ventures, including Mortgage
By 30 June 1990, Beneficial Finance's loans to the joint
venture totalled $74.8M. When combined with the funding provided by the Bank pursuant to
the Reverse Principal and Agency Agreement, the total Bank Group exposure was at that time
$101.8M. There had effectively been no capital contributed to the joint venture by either
Despite the rapid growth of the joint venture and
Beneficial Finance's exposure to it, no joint venture agreement was executed by the
partners. Beneficial Finance did not impose any prudential limit on its exposure to the
joint venture, and did not exercise effective control over its operations. Although
Beneficial Finance had authority to approve all large loans made by Mortgage Acceptance
Nominees, the effective day-to-day control of the joint venture's activities was in the
hands of its joint venture partner.
The Mortgage Acceptance Nominees Joint Venture experienced
significant problems with respect to a major real estate loan to a borrower that, for
confidentiality reasons, I shall refer to as "Hotel Pty Ltd", and more recently
with its bloodstock loan portfolio. In July 1990, Beneficial Finance decided to wind down
its joint venture operations. Real estate lending by the Mortgage Acceptance Nominees
joint venture ceased in June 1990, and bloodstock financing ceased in October 1990. The
joint venture has not been profitable, and, in May 1991, a State Bank internal audit found
that 63.4 per cent of its portfolio was in arrears. As at 28 February 1991, the exposure
of Beneficial Finance, including its off-balance sheet companies, and of the State Bank,
to Mortgage Acceptance Nominees and related parties, was $109.0M, and a specific provision
of $10.2M was raised.
I have been informed by Beneficial Finance that a dispute
had arisen in respect of the termination of the joint venture. Accordingly, as required by
my Terms of Appointment, I have excluded from my Report any matters that may have a direct
bearing upon any possible litigation.
(b) Findings and Conclusions
The monitoring and control of Beneficial Finance's
participation in, and funding of, the Mortgage Acceptance Nominees joint venture was
highly unsatisfactory in a number of respects:
(i) No written joint venture agreement was ever entered
into between Beneficial Finance and Mortgage Acceptance Corporation. Nor was a sub-agency
agreement entered into in respect of the State Bank Reverse Principal and Agency
(ii) Mortgage Acceptance Corporation did not contribute any
capital to the joint venture, other than its share of profits totalling $0.245M.
Beneficial Finance effectively provided all of the funding for the joint venture.
Beneficial Finance was, as well, a lender to Mortgage Acceptance Corporation, and did not
obtain any guarantees from Mr Green in respect of its exposures until new loans were made
to Mortgage Acceptance Corporation in 1990. In those circumstances, Beneficial Finance
bore almost the entire risk associated with the joint venture's loan portfolio, which grew
to total $106.0M.
(iii) No prudential limit was placed on Beneficial
Finance's exposure to the Mortgage Acceptance Nominees joint venture, despite the fact
. in practical terms, it bore the risk of losses; and
. it was already heavily exposed to the real estate
industry and, through Pegasus Leasing, had an exposure to the bloodstock industry.
Chapter 40: Paper Meetings of Directors
(a) Overview and Summary
Throughout the period covered by my Investigation,
Beneficial Finance produced `minutes' of directors meetings that had not been held. The
minutes were drawn up by the Company Secretary of Beneficial Finance, and signed by the
Chairman of the Board of Directors, to document decisions that were required to be made by
the directors, but which in fact were not.
Pursuant to Beneficial Finance's Articles of Association,
the management and control of the business and affairs of the company are vested in the
directors. The directors were to exercise that power in meeting, at which a quorum was two
directors. Any director could convene a meeting of directors. The directors could delegate
powers and duties to the Managing Director, and to sub-committees of the Board.
The Board of Directors met on the last Friday of each month
(other than December) to deal with the business of the company. There was frequently,
however, a need for the directors to approve transactions at times other than the last
Friday of the month. The practice adopted by Beneficial Finance was not to convene a
meeting of directors to give the necessary approvals, but simply to produce minutes as
though such a meeting had been held. The minutes evidencing what Mr Baker was pleased
to call "paper meetings" were prepared by the company secretary at the request
of the senior manager who required the directors' approval, and would be signed by the
Chairman of the Board, Mr L Barrett. The minutes were sometimes included in the
Board Papers for the next Board meeting, but they were usually not discussed, and rarely
was the "decision" of the paper meeting referred to in the minutes of a
subsequent full Board meeting.
An analysis of the business recorded in these minutes as
having been conducted at the paper meetings reveals that it falls into one of the
following three broad categories:
(i) Borrowing by Beneficial Finance: eight of these minutes
record resolutions by the Beneficial Finance Board to accept, enter into or renew finance
facilities, and contain authorisations for various officers of the company, including at
times Mr Baker, to execute the relevant facility agreements;
(ii) Lending by Beneficial Finance: two of these minutes
contain resolutions by Beneficial Finance to lend amounts of $5.0M, $49.0M and $67.0M to
associated companies, together with resolutions to appoint Attorneys to execute the loan
agreements (the last two amounts relate to the acquisition of a portfolio of receivables
from the Equiticorp Group); and
(iii) Provision of Guarantees by Beneficial Finance for the
financial obligations of a third party: seven of these minutes record resolutions by the
Beneficial Finance Board to guarantee, underwrite or underpin financial obligations of
third parties, together with authorisations for certain officers to execute the required
documentation on behalf of the company.
Other minutes record various resolutions and
authorisations. For example, a minute dated 22 December 1988 documents a non-existent
meeting of the Chairman, Mr Barrett, and the Managing Director Mr Baker, resolving to
declare interim dividends, redeem preference shares, and issue ordinary shares to the
The practice of documenting non-existent approvals meant
that Beneficial Finance entered into transactions that were not reviewed or approved by
the directors. Even when the directors subsequently adopted the resolution at a full Board
meeting, that was sometimes after Beneficial Finance had already entered into the relevant
transaction. A $200.0M debenture program was falsely documented as having been
approved by Mr Barrett and Mr K D Williams on 5 September 1988. Although the minutes were
adopted by the Board of Directors at its meeting on 29 September 1988, that was after
$76.0M had already been raised by Beneficial Finance pursuant to the non-existent
It is not entirely clear whether all of Beneficial
Finance's directors were fully aware of this practice. Certainly the Managing Director Mr
Baker, and the Chairman Mr Barrett, were fully aware. They are the two directors most
commonly recorded as being present at non-existent meetings, and Mr Barrett signed the
Other directors recorded as being present at such paper
meetings were Mr Matthews, Mr Simmons and, on one occasion, Mr Williams. Those
directors should have been aware, from the copies of the minutes included in the Board
Papers, that they were shown as being present at a meeting that was not held. Directors
not recorded as having attended such meetings should at least have been aware that they
had not received any notice of the meetings. In April 1989, the Board requested that
proper notification of all meetings, including "Special" meetings, be provided
to all directors.
(b) Findings and Conclusions
(i) There was a practice within Beneficial Finance of
preparing minutes to record meetings of directors of the company which had not taken
place, either formally or informally.
(ii) The practice developed as a convenient alternative to
convening a Board meeting at short notice.
(iii) The practice was of long standing.
(iv) That accordingly the affairs of the company were not
always conducted in accordance with its Articles of Association, in that matters which
required approval by a properly convened meeting of directors were not put to such a
meeting, either for initial approval or for ratification.
The persons concerned in producing each set of minutes
made, or caused or procured to be made, a false document which purported to be an
important company record. It was false in that it purported to be a formal minute of a
meeting which did not take place. The directors who were aware of the practice,
particularly Mr Barrett and Mr Baker, condoned a practice that had the effect of allowing
Beneficial Finance to engage in transactions involving significant obligations without the
approval, or often even the knowledge of the directors.
In my opinion, the practice of documenting meetings of
directors that did not exist amounted to improper activity in the limited sense that it
enabled Beneficial Finance to enter into transactions that were not reviewed or authorised
by the Board of Directors.
There is nothing to suggest however that there was any
ulterior purpose in holding these "paper meetings", nor is there any evidence
before me to suggest that the Board of the Bank or of Beneficial Finance were misled as a
result of the practice.
Chapter 41: Management and Financial Information Reporting
(a) Overview and Summary
The debenture trust deeds under which Beneficial Finance
operated prior to 1985 were considered by both management and the Board to be restrictive
and even commercially unrealistic for sophisticated financing transactions prevalent
during the mid to late 1980's.
The restrictions imposed by the terms of these trust deeds
were designed to protect the interests of the debenture holders of Beneficial Finance.
In early 1985, following advice from its solicitors Thomson
Simmons & Co, Beneficial Finance established an off-balance sheet structure created
principally to avoid the restrictions imposed by these trust deeds.
The off-balance sheet structure thus created was intended
to provide Beneficial Finance with unofficial control over these entities whilst at the
same time avoiding the provisions of the Code as they applied to subsidiaries.
During the period under review the off-balance sheet
entities sustained substantial losses which contributed to the financial position into
which Beneficial Finance had fallen by early 1991.
The proposal to establish the off-balance sheet structure,
which became known as "Kabani", was approved subject to a condition, inter alia,
that the structure be submitted to Price Waterhouse to ensure they were satisfied from the
point of view of the auditors.
The Board was informed that the conditions had been met. In
this matter, the Board was misled because the auditors were not asked to give an opinion
on the proposed structure.
The off-balance sheet entities operated and controlled
through the Kabani type trust structures were not consolidated into the accounts of
Beneficial Finance. Beneficial Finance was advised that those entities did not fall within
the definitions of a subsidiary under the code. As a result, management of Beneficial
Finance, resisted attempts by the auditors to provide disclosure of the results and
affairs of these entities and insisted on disclosure being kept to a minimum.
Regardless of the legal efficacy of the proposed
structures, in my opinion, management should have known that the use of such structures
had given rise to some controversy with regard to proper accounting treatment and
From the outset, Thomson Simmons & Co had informed
management that the use of off-balance sheet structures could be perceived as a
contrivance to avoid the provisions of the Companies Code.
Management again, did not see fit to inform the Board of
this warning given by Thomson Simmons & Co.
Shortly stated, the affairs of the Kabani type companies
were in fact controlled by Beneficial Finance and conducted for its own benefit and at its
own risk pursuant to a variety of legal and practical commercial powers.
It follows, therefore, that the affairs and results of
these entities were relevant to the position of Beneficial Finance and, if material,
should have been disclosed in the accounts of Beneficial Finance in order to show a true
and fair view in accordance with Section 269 of the Companies Code.
Furthermore, the internal management accounts of the
Beneficial Finance Group did not consolidate the results and affairs of the off-balance
sheet entities. Accordingly, for most of the period under review, the Beneficial Finance
Board did not receive financial information clearly setting out the impact of these
entities on the overall Beneficial Finance position.
Given the extent of growth in the off-balance sheet
entities over the period of this investigation it would have been difficult, at any given
moment, to know the true financial position of the Group.
In response to these problems Beneficial Finance eventually
moved in January 1989 to introduce a system of "Aggregate Accounting" (a term
used to describe the notional consolidation of off-balance sheet entities into the
consolidated financial statements of Beneficial Finance.)
(b) Findings and Conclusions
(i) The affairs of the Kabani type companies were in fact
controlled by Beneficial Finance and were conducted for the benefit and, at the risk, of
Beneficial Finance, pursuant to a variety of legal and practical commercial powers created
under the off-balance sheet structure.
(ii) Consequently, at all relevant times, the results and
affairs of the off-balance sheet entities would, if material to the results and affairs of
Beneficial Finance, be required to be disclosed in order for the accounts of Beneficial
Finance, and the consolidated accounts of Beneficial Finance and its subsidiaries, to show
a true and fair view in accordance with Section 269 of the Companies Code.
(iii) The results and affairs of the off-balance sheet
entities of Beneficial Finance were such as to have a material effect on the financial
position of the Beneficial Finance Group reported, at balance dates, from 30 June 1988 to
30 June 1990 (inclusive).
(iv) Without accurate aggregate accounts, the Board and
Management of Beneficial Finance were not properly informed as to the extent of the assets
and operations under its control and responsibility. Accordingly, without such
information, the Board and Management of Beneficial Finance were unable to, and did not,
adequately or properly supervise, direct and control the operations, affairs and
transactions, of the Beneficial Finance Group.
(v) By April 1989, when it received the first aggregate
accounting figures, the Beneficial Finance Board was put on notice that the operations of
the off-balance sheet entities potentially had a material effect upon the financial
position of the Beneficial Finance Group.
(vi) The aggregate accounts produced in respect of each six
month trading period showed, as they became available, a deterioration in the financial
position of Beneficial Finance, as a result of the activities of the off-balance sheet
(vii) The aggregate accounts which were presented to the
Beneficial Finance Board on 29 June 1990, and which forecast aggregate accounting results
to 30 June 1990, contained forecasts which were substantially inaccurate. The Beneficial
Finance Board was not aware of the true financial position or performance of the
off-balance sheet entities under its control until August 1990 when further aggregate
accounts were prepared.
Chapter 42: Bank and Bank Group Provisioning
(a) Overview and Summary
This Chapter of my Report provides, in answer to my Term of
Appointment A(f), a description and evaluation of the procedures used by the Bank and
Beneficial Finance to identify bad and doubtful debts. Although some aspects of this
matter were dealt with in my First Report, I was not then in a position to answer that
Term of Appointment in respect of the Bank because the natural justice process was not
complete. Accordingly, this Chapter deals with both the Bank and Beneficial Finance.
The State Bank
From early 1986, the Bank's internal procedures required
Managers to complete a "Potential Bad Debt" report on a quarterly basis. It was
the manager's decision whether a Potential Bad Debt report was required or not, based on
their assessment of whether it was likely that a loss would accrue to the Bank. The Senior
Manager was to be advised immediately of defaults by borrowers, or where the Manager
suspected that the borrower was in financial trouble or intended to default. Where
necessary, the Senior Manager was required to refer the account to the Chief Manager, with
a recommendation regarding the action to be taken. In practice, the "suggested
criteria" for identifying potential bad debts were vague, and resulted in haphazard
reporting and treatment of problem loans. Without strict criteria for identification,
the procedure for recognition of problem loans was, at that time, inadequate.
Further, until March 1988, the Bank did not have a
policy of separately classifying potential problem loans as they were identified. Instead,
a review of the entire loan portfolio for potential bad debts was conducted on a quarterly
basis. In March 1988, the policy of classifying bad and doubtful accounts into three
categories - Irregular, Non-Performing and Non-Accrual - was introduced.
Upon an account being classified as non-accrual, the
Manager was to prepare a full report for the Chief Manager, Corporate Banking, detailing
the circumstances. The report was required to advise the amount of the potential loss, and
recommend whether a specific provision should be made. All non-accrual loans were also to
be listed in the Monthly Operating Review for reporting to the Board of Directors.
Non-performing loans were identified monthly, and separately identified on the Monthly
Excess Report. A Bad and Doubtful Debts report was to be prepared quarterly, and include
details of all non-performing loans with an excess of more than $25,000 outstanding for
more than one month.
Responsibility for identification of non-performing
loans remained solely with the line managers in the division which had originally
recommended or approved the facility. This was unsatisfactory. In situations where a
Manager has had a long association with a customer before the loan becomes non-performing,
there can be reluctance on the part of the Manager to acknowledge the severity of the
At its meeting on 23 March 1989, the Board of Directors
expressed concern that, given the growth of the Bank and the Bank Group, it would be
important "to continue to ensure that information in relation to the Group
exposure [to particular clients or client groups] was available for management
purposes". According to the minutes, the "directors were advised that the
Bank was giving a high priority in continuing to develop its Group Global Risk Management
techniques in order that it could accurately assess its group risk."
In April 1989, the first report of the Bank Group's
exposures to clients or client groups was presented to the Board. This included the
exposures of Beneficial Finance Corporation and various divisions of the Bank. The Board
was told that, in future, this information would be available quarterly. Although this
report to the Board made no mention of the problems encountered in its preparation, a
progress report to the Executive Committee in May 1989 commented:
"This exercise highlighted the difficulties in
obtaining accurate and timely information from current records and data bases. This
exercise also emphasised the urgent need for common terminology and systems to permit
electronic downloading of the required information."
After the report in April 1989, the Board regularly
received a variety of information concerning non-accrual loans, including a listing of
group non-accrual loans in the Monthly Operating Review. Before then, the Board received
information on non-accrual loans for the Corporate Banking division only.
The establishment of the Group Risk Management division on
1 July 1989 was directed at the development of an integrated and computerised commitment
register, to record and monitor risks on a Bank-wide, rather than a divisional, basis. Mr
J B Macky, General Manager Group Information Systems told the Jacobs' Royal Commission
"Well into 1989 we started work on the commitment
register, among many other projects, because there was a clear acknowledgment that we
didn't have enough analysis or reporting tools. We weren't getting things like bad and
doubtful debts quickly enough. We didn't have a group-wide exposure reporting system
that enabled us to look at an individual customer and say; Corporate Banking have got
some, International has got some, Treasury has got some, Beneficial has got some, etc. and
Z is the Group's total exposure. That capability emerged gradually over time, from early
1990 because we decided to take an evolutionary development approach to it. We did a broad
data base design, and we evolved programmes as we went along.
I am unsure when I initially formed the view that
there needed to be better reporting systems on a global basis for non-accruals and bad and
doubtful debts except to say for a long time I had been saying that there wasn't enough
management information. We didn't have enough executive information and we needed more
systems." [Emphasis added]
In July 1989, Group Credit Policy Statement No. 3 addressed
the remedial actions that the Bank should take when a customer was classified as
non-performing. This statement also introduced a policy concerning the need for a Group
perspective on the control of higher risk customers. The policy postulated the need for a
"controlling point" to ensure that the State Bank Group's overall best interests
were served where several entities within the State Bank Group were exposed to a single
customer group in financial difficulty.
The mechanism for setting specific provisions for doubtful
debts was first described comprehensively in Group Credit Policy Statement No 3 issued in
July 1989. It was stated in this document that:
"An appropriate provision is to be established
as soon as it is recognised that there is a likelihood of a loss of principal and
interest, fees, etc. resulting after realisation of any security and after exhaustion
of all possible courses of action for recovery.
The position of all higher risk customers is to be
reviewed periodically to establish whether a provision is necessary or whether a change is
required in the level of any existing provision (and whether there is any consequent
need for a change in the risk grading of a customer).
Officers are to ensure that they do not delay setting
a provision either until the end of the Group's financial year or half-year in the
unrealistic hope of an improvement in a particular customer's situation, but equally are
not to be over-zealous in setting a provision at too early a stage." [Emphasis
In January 1990, the Chief General Manager, Group Risk
Management, presented to the Board meeting an assessment of the accounts relating to the
Bank, and the current position relating to recovery. This was the first report to the
Board that presented comprehensively the Group's exposure, likely recovery position, and
current provisioning level, in a single document.
This report presented the views of Management in relation
to the matters noted and, on the basis of the information presented, the Board would have
been, in some instances, unable to form their own view as to the adequacy or otherwise of
the Bank's or the Bank Group's provisioning.
The arrangements utilised by Beneficial Finance for the
identification and classification of problem loans varied between the different areas of
the company. Different arrangements applied to the Branch operations which engaged in the
company's core businesses, from those used in respect of the operating joint ventures
undertaken by the company, and from those used in respect of the transactions undertaken
by the Structured Finance and Projects division.
Systems and procedures for the identification and
classification of problem loans in the branches which conducted Beneficial Finance's core
business were well developed. Computer systems identified and reported problem loans, and
provided support for the ongoing management of the problem loans and for the review of
that management. Organisational arrangements and review processes were implemented to
support the management and monitoring of problem loans.
The operating joint ventures in which Beneficial Finance
participated generally utilised the company's Finance Receivable System and collections
systems. The exception was the Pegasus Leasing joint venture, which between 1988 and 1990
used its own collection system. The use of the Beneficial Finance systems was intended to
provide the same system controls over the identification and classification of problem
loans as applied to the company's own receivables.
Management of the collections function, the classification
of loans, the determination of action with respect to specific problem accounts and
assessment of provisions was, however, the responsibility of joint venture personnel.
Provisioning for problem loans and management of specific problem loans was reported upon
to the Board of Management of each joint venture quarterly, when the Board received lists
of non-performing loans and details of proposed provisions and action plans for specific
loans. Beneficial Finance was represented on the Board of Management, and by a joint
venture manager who acted as Secretary to the Joint Venture Board. A representative from
Beneficial Finance was also assigned to each joint venture, with responsibility to manage
Beneficial Finance's exposure to the joint venture. The representative had access to the
joint venture's records held on Beneficial Finance's Receivable System and collections
The internal controls of the joint venture operations were
subject to periodic review by Beneficial Finance Internal Audit.
Each joint venture adopted a policy of establishing a
general provision equivalent to 1 per cent of receivables. This provision was proposed to
be established progressively.
Over time, Beneficial Finance entered into increasingly
large and complex transactions, specifically through the activities of the Structured
Finance and Projects division. While the loans and other assets arising from these
transactions were, with some exceptions, recorded on the Finance Receivable System, they
were not controlled by the Beneficial Finance's collections system. The nature of the
loans and assets meant it was not possible for the loans and assets to be subject to the
same problem loan identification criteria as were used in the company's core businesses.
Most of the assets of the Structured Finance and Projects division were property related
and identification of problems with property related loans often depended upon a
comparison of the total facility with an estimate of the valuation of the property at the
maturity of the facility. Further, many of the facilities provided for the capitalisation
of interest, so that no moneys were payable to Beneficial Finance until the maturity of
the facility. In neither of these two instances was the identification of arrears, which
was the basis of identifying problem loans in the company's collection system, possible.
The identification and classification of problem loans or
assets in these situations, and the subsequent assessment of provisions, required the
review of each loan or asset by Beneficial Finance officers. The effectiveness with which
these tasks were performed depended to a large extent upon the information available to
Beneficial Finance regarding the loan or asset, and the judgement of its officers.
Beneficial Finance developed a system to facilitate the
management of these loans or assets. The system provided for the recording of action taken
by officers responsible for the account, and allowed for the independent review of action
taken by those officers. A procedure was also implemented by Beneficial Finance that
required status reports to be prepared each month for each of these assets or loans. The
status reports were subject to review by a Senior Manager within the Structured Finance
and Project's division, and by the division's National Credit Manager, who assessed credit
processes and provisioning.
(b) Findings and Conclusions
(i) Before July 1989, the procedures adopted by the Bank
for the identification of non-performing assets, and assets in respect of which a
provision for loss should be made, were not adequate and proper.
(ii) The Bank's procedures after July 1989 were adequate.
(ii) I am not in a position to make any finding as to
whether the systems and procedures of the Bank with regard to the identification of bad
and doubtful debts satisfactorily led to the identification of all bad and doubtful debts
and the creation of adequate provisions for loss. However, as noted in Chapter 53 - "The
External Audits of the State Bank: Findings and Conclusions", I have concluded
. the Bank's exposures to National Safety Council and
Equiticorp were exposures in respect of which a further provision for loss should have
been, but was not, made in the accounts of the Bank at 30 June 1989; and
. the Bank's exposures on certain accounts including
Somerley and Equiticorp were exposures in respect of which a provision for loss or a
further provision for loss should have been made but was not made in the accounts of the
Bank at 30 June 1990.
The systems and procedures adopted by the Bank adequately
and properly brought these exposures to the attention of Management and the Board.
(i) The procedures adopted by Beneficial Finance in the
period under review were generally adequate and proper for the identification of
non-performing assets, and assets in respect of which a provision for loss should be made.
(ii) I am not in a position to make any finding as to
whether the systems and procedures of Beneficial Finance with regard to the identification
of bad and doubtful debts satisfactorily led to the identification of all bad and doubtful
debts and the creation of adequate provisions for loss. However, as noted in Chapter 60 - "The
External Audits of Beneficial Finance: Findings and Conclusions", I have
concluded that Beneficial Finance's exposure to Somerley was one in respect of which a
provision for loss should have been but was not made in the accounts of Beneficial Finance
at 30 June 1990. The systems and procedures adopted by Beneficial Finance adequately and
properly brought this exposure to the attention of Management and the Board.
188.8.131.52 Chapter 43: Other Matters Investigated within
the State Bank and Beneficial Finance
(a) Overview and Summary
This Chapter reports the result of my examination of a
variety of matters including the remuneration of officers of the Bank, and of Beneficial
Remuneration Arrangements in London and New York
The Chapter briefly describes the remuneration arrangements
that applied to the most senior executives of the Bank's United States and United Kingdom
operations. This report is supplementary to the observations made in my First Report
regarding the Bank's remuneration practices. Shortly stated, my conclusion is that,
similar to the remuneration of the Bank's officers in Australia, the remuneration
arrangements in respect of the senior executives in the Bank's New York and London
branches were excessive.
Principal features of Beneficial Finance's policies and
procedures regarding the provision of loans to its executives
This matter has been the subject of considerable public
comment, based in part at least on the contents of two reports prepared by the Bank's
Internal Audit department. My Investigation has examined this matter exhaustively, and it
is now clear that those reports were misleading and inaccurate. I have concluded that,
although there were some irregularities in the administration of the provision of loans to
executives of Beneficial Finance, the matter does not attract any adverse findings.
Section 43.4 of the Chapter reports a particular
remuneration arrangement, called "shadow" salaries, used by Beneficial Finance
until June 1986. Section 43.5 reports the evidence found by my Investigation regarding the
participation by certain executives of Beneficial Finance in a joint venture project
called the Jolen Court Project with a client of Beneficial Finance, in circumstances which
involved a conflict of interest on the part of some of those executives.
The "shadow salary" arrangements, which were used
until July 1986, involved the provision of benefits to senior executives in circumstances
apparently calculated to facilitate the non-disclosure of those benefits in the
executives' personal income tax returns.
Before the introduction of fringe benefits tax with effect
from 1 July 1986, Section 26(e) of the Income Tax Assessment Act required employees to
declare in their personal income tax return, as part of their taxable income, the value to
them of any benefit provided to them by their employers, other than reimbursements of
purely business expenses.
From about 1983 until the introduction of fringe benefits
tax in 1986, Beneficial Finance remunerated its senior executives, including the managing
director, with a combination of salary and "shadow" salary.
Under the "shadow" salary arrangements, an
executive would present accounts relating to expenditure incurred by the executive, which
would then be paid by Beneficial Finance and deducted from the executive's
"shadow" salary entitlement. The amounts deducted were debited to an expense
ledger account within Beneficial Finance, and not against its wages and salaries ledger
account. Records of the "shadow" salary proportion of the executives'
remuneration and of the application of the "shadow" salary were kept by
Mr G B Strutton, the Personnel Manager and later the Manager of the Human
Resources department of Beneficial Finance.
Pursuant to the arrangement, executives could elect to take
a proportion of their annual increase in remuneration as "shadow" salary. The
proportion of the total remuneration that could be taken as "shadow" salary
increased over time.
The salaries of executives were established in about March
of each year for the ensuing period 1 April - 31 March. In 1984, the proportion of total
remuneration that could be taken as "shadow" salary was 10 per cent. By the time
of the salary review of March 1986, for the year from 1 April 1986 to 31 March 1987, the
proportion of total salary that could be taken as "shadow" salary had increased
to about 20 per cent of an executive's total remuneration, and "shadow" salaries
totalling $365,322 were provided to forty-four executives.
The "shadow" salary arrangement was discontinued
in July 1986 when fringe benefits tax came into operation. Fringe benefits tax places on
employers the liability to pay tax in respect of benefits granted to employees as part of
Jolen Court Project
The Jolen Court Project involved the participation by
certain Beneficial Finance executives in proposed property development with a client of
In April 1989, these executives and a company called
Viaduct Services Pty Ltd (Viaduct Services), a member of the Tribe and Crisapulli Group of
Companies, entered into an arrangement to acquire and develop land located at 57-65
Springvale Road, Donvale, Victoria. The purchase price of the property was $2.5M, with
$0.5M payable as a deposit on 28 July 1989, and the balance of $2.0M payable in April
In August 1989, the executives borrowed a total of $475,000
from Beneficial Finance to fund their investment in the Jolen Court Project. That money
was used to pay the deposit to buy the land. The balance of the purchase price, payable in
April 1990, was to be raised by Viaduct Services. Viaduct Services was also to provide the
expertise to develop the project.
The ability of Viaduct Services to obtain the $2.0M to
purchase the land depended upon the continuing financial strength of the Tribe and
Crisapulli Group. Viaduct Services had given guarantees in respect of other companies in
the Tribe and Crisapulli Group with respect to borrowings by those other companies from
Beneficial Finance. Any failure of that Group would affect the ability of Viaduct Services
to obtain the $2.0M needed to complete the purchase of the land. That could, in turn,
result in the Beneficial Finance executives forfeiting the $0.5M they had contributed as
the deposit for the property, unless they could obtain $2.0M from other sources.
By September 1989, the Tribe and Crisapulli Group was
experiencing financial difficulties. Certainly, the Beneficial Finance Board of Directors
was concerned about Beneficial Finance's exposure to that Group. The Board imposed a limit
of $33.5M on the exposure to the Tribe and Crisapulli Group.
There was a potential for a conflict of interest on the
part of the executives involved in the Jolen Court project who were also involved in the
credit approval process in respect of applications by the Tribe and Crisapulli Group for
loans from Beneficial Finance. Without the continuing financial support of Beneficial
Finance to the Tribe and Crisapulli Group, Viaduct Services may not have been able to
perform its part in the Jolen Court Project, potentially resulting in the executives
losing their investment, itself funded by Beneficial Finance. The end result was that the
executives did lose their investment.
(b) Findings and Conclusions
(i) Both business and non-business expenses were paid by
Beneficial Finance on behalf of executives, and notionally deducted against the
executives' entitlements to "shadow" salary.
(ii) In the accounting records of Beneficial Finance, the
"shadow" payments were charged to various expense accounts in the Profit and
Loss Account, depending on the nature of the goods or services obtained by the employees
and paid for by Beneficial Finance.
The payments of those expenses relating to non-business or
part business expenditure should have been charged to the Wages and Salaries Ledger
Account in the Profit and Loss Account, and not to other expense accounts.
(iii) The accounting by Beneficial Finance of the
"shadow" salary payments was, to say the least, irregular. Whether for reasons
of convenience or otherwise, the reconciliation statements recording the utilisation of
"shadow" salary entitlements was performed by Mr Strutton at his private
residence, and the reconciliation records kept there. The records were then destroyed
within a matter of months following the annual reconciliation, and the only record which
then remained was the expense voucher and accompanying sundry cheque requisition, recorded
simply as part of Beneficial Finance's operating costs.
The accounting procedures in relation to
"shadow" salaries did not provide an adequate system for ensuring that
"shadow" payments were always included in Mr Strutton's listings and therefore
taken into account in the reconciliations. A situation was created in which Beneficial
Finance was not able to ensure that amounts were not paid on behalf of executives in
excess of their entitlements.
(iv) The application of "shadow" salary to
non-business expenditure by various executives was known to Mr Strutton, Manager of the
Human Resources department, and to Mr Baker, Managing Director, and was recognised by the
external auditors, Price Waterhouse, in their report dated 10 June 1986.
(v) In my opinion, the treatment of the
"shadow" salary benefits in Beneficial Finance's accounting records was
undertaken so that they could not be identified as having benefited the particular
executives. It provided the opportunity for executives to minimise their taxable income by
not including the "shadow" salary component in their income tax returns. It
must be stated, however, that I have not examined the personal income tax returns of the
executives of Beneficial Finance who received "shadow" salaries, and so no
inference can necessarily be drawn that the executives involved did not fully disclose the
benefit in their personal income tax returns. All that can be said is that the arrangement
provided them with the opportunity to not disclose the benefit. I have been advised that
the matter of the disclosure or non-disclosure of the "shadow" salary benefits
by executives is currently being investigated by the Federal Police.
(vi) In accordance with section 25(2) of the Act and Terms
of Appointment A(h) and E, I report that, on the basis of the evidence described in
this Chapter, I am of the opinion that the actions of Mr Baker and Mr Strutton may have
constituted offences against the Companies Code, and the Taxation Administration Act 1953.
Whether any further action should be taken is, in the first
instance, a matter for the Royal Commission to consider and recommend.
(i) Executives of Beneficial Finance entered into a
personal dealing in the form of participation in a venture with a client of Beneficial
Finance, Viaduct Services Pty Ltd, a member company of the Tribe and Crisapulli Group, to
which Beneficial Finance had a significant exposure. Viaduct Services had provided
guarantees in respect of the liabilities of other companies in the Tribe and Crisapulli
(ii) The success of the venture depended heavily upon the
Tribe and Crisapulli Group's capacity to arrange finance to complete the purchase of the
land that was the subject of the project.
Over the period of twelve months from the initial proposal
and payment of the $0.5M deposit, to the date for settlement of the contract, it became
apparent that the Tribe and Crisapulli Group was having difficulties in meeting its
commitment to obtain $2.0M to fund the settlement payment. Certainly, the exposure of
Beneficial Finance to the Tribe and Crisapulli Group was increasing.
(iii) In a situation where the Beneficial Finance
executives were at risk of losing their investment in the event that Tribe and Crisapulli
Group were not able to obtain ongoing funding from Beneficial Finance to meet commitments,
a conflict of interest arose whereby those executives involved in managing the exposure to
the Tribe and Crisapulli Group, and in recommending that facilities be extended to the
Tribe and Crisapulli Group, had a direct interest in ensuring that Beneficial Finance
continued to provide financial support to that Group.
(iv) In accordance with Section 25(2) of the Act and my
Terms of Appointment A(h) and E, I report that, on the basis of the evidence described in
this Chapter, I am of the opinion that the involvement of the Beneficial Finance
Executives Mr Baker, Mr Reichert and Mr Martin in a proposed venture with a company in the
Tribe and Crisapulli Group was, or amounted to, a conflict of interest or breach of
fiduciary duty, and therefore illegal or improper conduct. I recommend that the matter
should be further investigated.
184.108.40.206 Chapter 44: Reports from the State Bank's
External Auditors to the Reserve Bank of Australia
(a) Overview and Summary
A significant factor contributing to the Bank Group losses
was its excessive exposure to the commercial property industry. This imprudent exposure
was caused, in large part, by the Bank's failure to implement an effective system to
monitor its total exposure to the commercial property industry.
The Reserve Bank knew that an undue concentration of loans
in a particular industry, in a particular geographic region, or to any one client,
increases the risk of a bank incurring losses, and a diminution of capital. Accordingly,
the Reserve Bank's prudential supervision arrangements at all times sought to ensure that
banks had appropriate management systems to monitor, and thus limit, total loans to
In January 1985, the Reserve Bank described a new regime
for the "Prudential Supervision of Banks", stating that:
"The Reserve Bank's system of supervision is
directed towards satisfying itself that individual banks are following management
practices which limit risks to prudent levels and that banks' prudential standards are
being observed and kept under review to take account of changing circumstances."
The Reserve Bank required each licensed bank to describe,
among other things:
(i) its prudential policies for limiting credit risk
exposures to particular borrowers and particular industries; and
(ii) the systems used by the bank to ensure that those
policies were in fact observed in practice. Such systems would include information systems
to enable the bank to measure, at any point in time, its total credit exposure to a
particular borrower, or to a particular industry such as commercial property construction
Apart from introducing its own inspection arrangements
which the Reserve Bank determined that it would not do, the Reserve Bank's only source of
information as to whether a bank's systems were being effectively used in practice was to
ask the bank's management, which is hardly satisfactory. Management might be very
reluctant to admit to deficiencies in the operation of its systems, or might conceivably
be unaware of some deficiencies.
Accordingly, in April 1986, the Reserve Bank issued
Prudential Statement H1, titled "Relationship Between Banks, their External Auditors
and the Reserve Bank". The Prudential Statement noted that the Reserve Bank was
unable to determine whether banks in fact complied with the systems that they had
described to the Reserve Bank for monitoring and controlling risk. To remedy that
situation, the Prudential Statement stated that the Reserve Bank would:
"... seek the external auditor's opinion as to
whether a bank's internal management systems and controls are generally adequate, and
specifically ... whether management systems to control exposures and limit risks
outlined to the Reserve Bank are effective, and are being observed."
In summary, the key steps in the arrangements for the
reporting by the external auditors on the operation of a bank's risk management systems
(i) First, the bank would tell the Reserve Bank what its
prudential policies for limiting its credit risk exposures were. The Reserve Bank would
review those policies, and decide whether or not they were adequate.
(ii) Second, but ideally at the same time, the bank
would tell the Reserve Bank what systems it had in place to monitor and control those
risks. Again, the Reserve Bank would review those systems, and decide whether or not they
(iii) Third, upon receiving instructions from the bank
to do so, the external auditors would review the actual operation of those systems, and
express an opinion as to whether the systems were being observed, and were adequately
providing a means of monitoring and controlling exposures to within the limits set by the
The Reserve Bank made it clear in Prudential Statement H1
that its prudential supervision requirements would extend the scope of a bank auditor's
usual statutory audit role. The auditing profession were concerned to understand, and to
agree with the Reserve Bank, what that meant in practice. Accordingly, discussions were
held between the auditing profession and the Reserve Bank, and in December 1987, the
Australian Accounting Research Foundation released Auditing Guidance Release No 4, titled
'Audit Implications of Reserve Bank Prudential Reporting Requirements'. The important
clause in the Auditing Guidance Release was Paragraph 41, which said:
"Auditors will ... have the written description
of each system which client banks are to prepare and agree with the Reserve Bank.
These descriptions will detail the major controls in the respective areas, set by
management to control exposures and limit risks to the level determined by
To cut a long story short, the State Bank did not give the
Reserve Bank a description of its system of monitoring the Bank's total exposure to
particular clients or industries, for the simple reason that it did not have one to
describe. As I reported in detail in Chapter 5 of my First Report, the Bank was unable to
measure those exposures until December 1989, and then only by manually collating
information from its various divisions.
The absence of any description of the system was regarded
by the external auditors, consistent with the Reserve Bank's Prudential Statement H1 and
Auditing Guidance Release No 4, as precluding them from expressing any opinion to the
Reserve Bank in respect of the system, or lack of it. An essential first step was that the
system both be described by the State Bank, and be evaluated as adequate or inadequate by
the Reserve Bank. Indeed, the State Bank's external auditors went one step further. Their
view was that not only must the system be described and approved, but it must also be
included in the Audit Manual prepared by the Reserve Bank to assist the external auditors
in undertaking their review and report.
Even when the external auditors did eventually report to
the Reserve Bank on the State Bank's credit management systems, their opinions
(purportedly based on their specific examination of the relevant management systems, and
on appropriate tests and reviews of those systems) were that the State Bank was generally
observing those systems, and that the systems were adequate to limit risks to the prudent
levels set by management.
For the reasons identified in the Chapter, my conclusion
is that the auditors' opinions were not correct. On the evidence before the Investigation,
there were, at all material times, serious deficiencies with the Bank's credit management
systems for monitoring Bank-wide exposures. The auditors should have reported that:-
(i) The Bank was not capable of monitoring its Bank-wide
industry exposure in an effective or efficient way.
(ii) Even in the one division of the Bank which had at
least a rudimentary system to monitor its aggregated exposures (the Corporate Banking
division) it was not possible to be confident of the accuracy of relevant data. It
necessarily followed, therefore, that management could not be confident it had accurate
information on the Bank's loan portfolio.
(iii) There was inadequate control over determining, or
monitoring, the Bank's total exposure to any one client. Total exposure to any one debtor
was not easily and efficiently obtainable.
These are the very sort of inadequacies and weaknesses
which the Reserve Bank assumed and expected would be reported to it. Furthermore, there
are no grounds for the external auditors to misapprehend that expectation.
One of the best early indicators of significant weaknesses
in any bank, but particularly in a bank expanding quickly, is when management systems for
assessing and controlling credit risk become stretched and ineffective. The opportunity to
signal those very weaknesses at State Bank was lost. As it was, the absence of reports in
1987 and 1988, and the content of the 1989 and 1990 reports, seriously impeded the Reserve
Bank's ability to appreciate the true extent of management shortcomings at the State Bank.
The Investigation sought to understand how the external
auditors could have come to the opinions they reported to the Reserve Bank. My conclusion
is that the auditors arrived at their incorrect opinions because they failed to undertake
their task properly. Rather than perform specific tests and reviews of relevant Bank
systems, the external auditors seemed to have relied primarily on their general knowledge
of the Bank, which general knowledge arose out of the work they had done for the purpose
of their statutory audits.
(b) Findings and Conclusions
(i) Because of the general recalcitrance of the State
Bank's management to comply with the Reserve Bank's prudential supervision regime, it was
not until 1988 that the auditors were given instructions by the State Bank to prepare a
report in accordance with Prudential Statement H1.
Even then, the report prepared in 1988 amounted to no
report at all in respect of the risk exposure systems. The auditors expressly disavowed
providing an opinion, because they were waiting for the Reserve Bank to give its approval
to the State Bank's description of the system. As unsatisfactory as that situation was, in
my opinion the blame cannot be laid at the feet of the external auditors. Both Prudential
Statement H1, and Auditing Guidance Release No 4, said that the auditor's report would be
based on a written description of the system that had been provided to, and approved by,
the Reserve Bank.
(ii) The reports provided in 1989 and 1990 expressed
opinions regarding the adequacy of the Bank's systems that were, bluntly stated, wrong.
For example, in respect of the year ended 30 June 1989, the report stated that the State
Bank's credit management systems were generally observed during the year under review, and
adequately provided a means to control exposure and limit risk to the prudent levels
determined by management. That opinion was incorrect. It did not identify that one of the
Bank's most important credit policies, its industry exposure policy, could not be
effectively monitored, and that it was, therefore, not possible for the Bank to measure
its aggregate industry exposure.
The inadequacies of the systems were recognised in the bank
from late in 1988. A paper presented by Mr Matthews to the Executive Committee in February
1989 reported that the timely and accurate reporting of aggregate risk exposure in the
Bank was effectively impossible, because of the different classification systems in place
even within the Bank.
For the reasons set out in Chapter 15, the relevant State
Bank officers, particularly Mr Matthews, saw fit not to volunteer the true position
to the Reserve Bank. Even when the Reserve Bank raised the matter specifically, Mr
Matthews responded in a way which had the effect of suppressing the extent of the
inadequacies in the State Bank's credit management systems.
(iv) If the external auditors had reported in 1988, or
earlier, that the State Bank did not have management systems to enable it to comply with
its policies on industry exposure, the Reserve Bank would clearly have been put on notice
that there was a significant management inadequacy at the State Bank. It is the fault of
the Bank's management, not the auditors, that that did not happen.
As it was, the absence of any report in 1987 or 1988,
followed in 1989 and 1990 by the auditor's incorrect opinion on the Banks credit
management systems, seriously impeded the Reserve Bank's ability to appreciate the true
extent of management shortcomings at the State Bank. By the time of the 1989 report,
however, no action by the Reserve Bank could have reduced the losses that the State Bank
was to realise.
27.4 THE LAW APPLICABLE TO BENEFICIAL FINANCE
Although my Investigation is established by an Act of
Parliament and by an Instrument of Appointment from the Governor, my findings and
expressions of opinion do not affect anyone's legal rights. My Investigation is a purely
administrative inquiry, and not a court of law.
Nevertheless, my Investigation of Beneficial Finance could
not be undertaken without regard to the laws that applied to Beneficial Finance and its
directors, management and staff. Most obviously, Terms of Appointment A(h) and E, and
sub-section 25(2) of the Act, require me to investigate and report on such of the
following matters as, in my opinion, I should investigate and report:
(a) any possible conflict of interest or breach of
fiduciary duty or other unlawful, corrupt or improper activity on the part of a director
or officer of Beneficial Finance; and
(b) any possible failure to exercise proper care and
diligence on the part of a director or officer of Beneficial Finance.
Term of Appointment C requires me to investigate and report
whether the "operations, affairs and transactions" of Beneficial Finance were
"adequately or properly supervised, directed and controlled" by the directors,
officers and employees of Beneficial Finance. In order to answer my Terms of Appointment,
it was obviously necessary for me to use an objective standard of what is an
"adequate and proper" performance of their duties by the directors, managers and
employees. For the reasons stated in my First Report, I believe that the only acceptable
standard of what is "adequate and proper" is that established by the law. To
apply my own subjective standards would be unsound, and to apply a higher standard would
be unfair. Common sense dictates that a standard that is less than that demanded by the
law is not acceptable.
Accordingly, for example, in forming an opinion as to
whether the directors and employees of Beneficial Finance performed their respective
functions adequately and properly, I have applied the tests described, among others, by Mr
Justice Rogers in AWA v Daniels (1992 10 ACLC 933).
It is appropriate, therefore, that I describe in some
detail the tests laid down by the law as to what is expected of directors and employees in
performing their duties.
27.4.2 WHAT THE LAW REQUIRED OF DIRECTORS AND EMPLOYEES
OF BENEFICIAL FINANCE
220.127.116.11 The Important Features of the Standards
Required by the Law
The standard of performance required by the law is usually
described as being that of "reasonable care and diligence". The important
features of the standard of reasonable care and diligence required of directors and
officers can be stated, at least in broad terms, as follows:
(a) First, there is no objectively-determined standard of
skill which must be attained by non-executive directors in meeting their obligation of
reasonable care and diligence. It is for the shareholders - in Beneficial Finance's case,
the State Bank - to determine what skills they want on the Board, and to appoint
appropriately skilled and experienced directors accordingly. The law does not require
non-executive directors to display a level of skill and experience that they do not
possess. If, however, a non-executive director does have particular skills, he or she must
utilise them in the performance of their functions as a director.
In respect of executive directors and officers, however,
the law requires that a person must perform his or her functions with an objectively
determined level of skill. Full-time employees of a company who accept appointment to a
particular office for which recognised skills are required impliedly promise that they
have those skills that are reasonably necessary to perform the functions of the office. In
AWA v Daniels, Rogers J said:
"Generally a chief executive is a director to whom
the board of directors has delegated its powers of management of the Corporation's
business. Usually he is employed under a contract of service which will either include an
express term or, in the absence of an express term, an implied term, that the chief
executive will exercise the care and skill to be expected of a person in that position.
The degree of skill required of an executive director is measured objectively".
(b) Second, it is clear that the standard of reasonable
care and diligence that is required of directors - both non-executive and executive
directors - is higher now than it was when some of the earlier court decisions regarding
the obligations of directors were made.
In AWA v Daniels, Rogers J expressed the
changing content of the obligation of care and diligence in the following terms:
"Of necessity, as the complexities of commercial
life have intensified the community has come to expect more than formerly from directors
whose task is to govern the affairs of companies to which large sums of money are
committed by way of equity capital or loan. The affairs of a company with a large annual
turnover, large stake in assets and liabilities, the use of very substantial resources and
hundreds, if not thousands of employees demand an appreciable degree of diligent
application by its directors if they are to attempt to do their duty ... One of the most
striking features of the law concerning directors duties is the insistence that directors
accept more and more responsibility for oversight of a company's affairs at the same time
as the affairs of companies become more and more complex and diverse ... More recent
wisdom has suggested that it is of the essence of the responsibilities of directors that
they take reasonable steps to place themselves in a position to guide and monitor the
management of the company (cf Commonwealth Bank v Freidrich  5 ACSR 115,
187). A director is obliged to obtain at least a general understanding of the business of
the company and the effect that a changing economy may have on that business. Directors
should bring an informed and independent judgment to bear on the various matters that come
to the Board for decision. (cf Sir Douglas Menzies "Company Directors"
 33 ALJ 156, 164)."
In Commonwealth Bank v Friedrich (1991) 5
ACSR 115, Tadgell J said at page 126:
"As the complexity of commerce has gradually
intensified ... the community has of necessity come to expect more than formerly from
directors ... In response, the parliament and the courts have found it necessary in
legislation and litigation to refer to the demands made on directors in more exacting
In particular, the stage has been reached when a
director is expected to be capable of understanding his company's affairs to the extent of
actually reaching a reasonably informed opinion of its financial capacity."
In a subsequent judgment regarding the AWA case (AWA
v Daniels (No2) (1992) ACLC 1643, Rogers J said at page 1,658:
"It is essential for the purposes of corporate law
that the courts rigorously enforce the obligations of those who seek and obtain high
corporate office. Shareholders are entitled to look to the law and to the courts to ensure
that loss to the company, due to negligence in the administration of their company, is
compensated by the negligent actors, be they auditors, executives or senior management ...
honest bungling is no appropriate basis for relief from liability."
(c) Third, of particular importance in determining the
required standard of care and diligence is the division of responsibility within a
particular company between the non-executive directors and management. As stated by Rogers
J in the AWA Case, the "responsibility of the non-executive directors needs
to be examined in the light of the proper division of functions between directors,
management and auditors". In Friedrich's Case, Tadgell J said:
"What constitutes the proper performance of the
duties of a director of a particular company will be dictated by a host of circumstances,
including no doubt the type of company, the size and nature of its enterprise, the
provisions of its articles of association, the composition of its board and the
distribution of work between the board and other officers."
(d) Finally, the law recognises that conducting a
commercial enterprise involves some risk-taking, and will not hold a director or officer
to have breached his or her duty for mere errors of judgement. As stated in the
explanatory memorandum to the Corporate Law Reform Bill (at para 87):
"The courts have in the past recognised that
directors and officers are not liable for honest errors of judgement: Ford's Principles of
Company Law (6th ed, 1992) at p 528-9. They have also shown a reluctance to review
business judgements taken in good faith. Thus, in Harlowe's Nominees Pty. Limited v.
Woodside 121 CLR 483 at 493, the High Court said:
`Directors in whom is vested the right and duty of
deciding where the company's interests lie and how they are to be served may be concerned
with a wide range of practical considerations, and their judgment, if exercised in good
faith and not for irrelevant purposes, is not open to review in the courts.'"
18.104.22.168 The Allocation of Functions and Powers in
Any evaluation of the performance by directors, officers
and employees of their functions and powers naturally requires, as a first step, that
those functions and powers be identified and defined. As noted earlier, the particular
functions and powers of the directors and officers of a company will, to a considerable
extent, depend upon the allocation of functions and powers within the particular company.
There are some functions which, broadly stated, are
generally recognised as being properly the role of the Board of Directors. In the AWA
Case, Rogers J said:
"A Board's functions, apart from statutory ones,
are said to be usually four fold:
1. to set goals for the corporation
2. to appoint the corporation's chief executive
3. to oversee the plans of managers for the acquisition
and organisation of financial and human resources towards attainment of the corporation's
4. to review, at reasonable intervals, the corporation's
progress towards attaining its goals."
In performing these functions, the Board of Directors is
entitled to rely on Management:
"The directors rely on management to manage the
corporation. The Board does not expect to be informed of the details of how the
corporation is managed. They would expect to be informed of anything untoward or anything
appropriate for consideration by the Board.
The particular allocation of functions within Beneficial
Finance is set down first in its Articles of Association.
Article 25(1) provides that the management and control of
the business and affairs of Beneficial Finance are vested in the directors. Pursuant to
Article 27(1), the directors' powers under the Articles are exercisable in a duly convened
meeting of directors at which a quorum of at least two directors is present.
Article 26(1) provides for the directors to appoint one (or
more) of their number to be the Managing Director, who is subject to the control of the
Article 26(2) empowers the directors to delegate their
powers and duties under the Articles to the Managing Director. Such a delegation can be
for a limited time or indefinitely, upon such conditions as the directors think fit, and
can be to the exclusion of the directors' powers and duties under the Articles.
Apart from authorities regarding credit approvals, capital
expenditure approvals and the appointment of consultants, there were no formal delegations
to the Managing Director pursuant to Article 26(2).
Article 27(5) authorises the directors to delegate any of
their powers to a committee or committees consisting of one or more directors.
22.214.171.124 Reliance by Non-Executive Directors on the
Managing Director and Senior Managers
It is obvious that, in performing their functions in
governing a company, the directors must be able to entrust functions and powers to
Management, and rely on Management to perform those functions and exercise those powers
competently, diligently and honestly. As stated by Rogers J in the AWA case:
"The Board of a large public corporation cannot
manage the corporation's day to day business. That function must by business necessity be
left to the corporation's executives. If the director of a large public corporation were
to be immersed in the details of day to day operations the director would be incapable of
taking more abstract, important decisions at board level."
While directors are generally able to rely on Management,
the directors must carefully appoint the managing director, carefully delegate functions
and powers to the appointee, and monitor the managing director's performance of his
functions. The directors are not entitled to rely on management if there are reasons to
suspect that such reliance is misplaced.
Among the functions of a Board of Directors is the
selection and appointment of a Chief Executive Officer or Managing Director of the
company. As noted above, Article 26(1) of Beneficial Finance's Articles provided for the
directors to appoint one or more of the directors to be the Managing Director.
In exercising the power to appoint a managing director the
directors must act with reasonable care and diligence. The directors are entitled to the
benefit of the principle that matters of business judgment will not be reviewed by the
courts if the directors have acted as a reasonable board might have acted.
Similarly, in delegating functions and powers to the
managing director, the Board must act reasonably. The delegation of functions and powers
is also a matter of business judgment. In Re City Equitable Fire Insurance Company Ltd
(1925) Ch 407 v 426-7 Romer J said:
"The larger the business carried on by the company
the more numerous, and the more important, the matters that must of necessity be left to
the managers, the accountants and the rest of the staff. The manner in which the work of
the company is to be distributed between the board of directors and the staff is in truth
a business matter to be decided on business lines."
Having made the kind of appointment that could be made by a
reasonable board, and having made the delegations that could be made by a reasonable
board, the directors are then entitled to rely on the managing director to perform his
duties adequately, competently and honestly until such time as they were put on enquiry as
to his or her honesty or competence. In the AWA case, Rogers J said:
"A director is justified in trusting officers of
the corporation to perform all duties that, having regard to the exigencies of business,
the intelligent devolution of labour and the articles of association, may properly be left
to such officers (Dovey v Cory; in re Brazilian Rubber Plantations & Estates
Ltd; Huckerby v Elliot  1 AER 189, 193, 195). A director is entitled to
rely without verification on the judgment, information and advice of the officers so
entrusted. A director is also entitled to rely on management to go carefully through
relevant financial and other information of the corporation and draw to the board's
attention any matter requiring the board's consideration. The business of a corporation
could not go on if directors could not trust those who are put into a position of trust
for the express purpose of attending to details of management (American Law Institute
"Principles of Corporate Governments, Analysis and Recommendations" pp
175, 176). Reliance would only be unreasonable where the director was aware of
circumstances of such a character, so plain, so manifest and so simple of appreciation
that no person, with any degree of prudence, acting on his own behalf, would have relied
on the particular judgment information and advice of the officers (In Re City
Equiticable Fire Insurance Co). A non-executive director does not have to turn him or
herself into an auditor, managing director, chairman or other officer to find out whether
management are deceiving him or her (Graham v Allis-Chalmers Manufacturing Co 188 A
2nd 125, 130).
The managing director is obliged to keep the board informed
in relation to matters which need the board's attention. The board may, in the absence of
suspicion, rely on the managing director to do that. Reliance by a director following a
delegation by the board will not remain permissible once there are circumstances known to
the director which would put a reasonable director on enquiry.
What constitutes sufficient circumstances to put a
reasonable director on notice that he cannot rely on management must be judged in the
light of the increased standard of performance now required from directors. In particular,
as noted by both Tadgell J in Friedrich's case and Rogers J in the AWA case, directors are
now expected to take reasonable steps to enable them to understand the company's affairs
so that they can guide and monitor the management of the company. Although a non-executive
director need not turn himself into an auditor to review management's performance, he must
bring an informed and independent judgement to bear on the matters that come to the Board
Further, it is axiomatic that persons charged with
fiduciary administration of large amounts of money cannot simply make a delegation under
authority and then be unconcerned as to the results of the delegation. A Board which makes
delegations must establish a system of checks by which the use of the authority given by
the delegations can be monitored. The practice of setting up internal audit procedures is
an example. The practice of conducting reviews of management is another. The board has the
responsibility of satisfying itself that adequate checks exist. In the process of
approving a system of checks the Board is expected to deploy whatever relevant skills its
members possess. If they lack the necessary skills, the board is expected to obtain
professional assistance at a level and cost consistent with the scale of the company's
operations and resources.
In summary, provided the Board of Directors with
appropriate authority in the Articles makes a proper appointment of a managing director,
delegates within reasonable limits and institutes the necessary checks, the Board can rely
on the managing director to act properly within the scope of the powers delegated to him
or her. Whether the Board has so acted as to reach the point where it can so rely depends
on whether the Board has done what a reasonable Board could have done.
The Board's reliance on management cannot however be
passive. The directors must take reasonable steps to understand the company's business
operations, and must bring an informed and independent judgment to bear in performing
their functions. They must ensure too that adequate arrangements are made to monitor the
performance of management. It is against those obligations that the reasonableness of the
directors' reliance on management is to be judged.
126.96.36.199 The Obligations of the Board of the State Bank
for the Conduct of the Affairs of Beneficial Finance
The Bank as shareholder of Beneficial Finance had the power
to appoint the directors of Beneficial Finance. That power was exercised by the Bank's
Board of Directors. In doing so, the Board was under a duty at common law to exercise a
reasonable degree of care and diligence in making the appointments, and in ensuring that
the composition of Beneficial Finance's Board as a whole was appropriate taking into
account the qualifications and knowledge of all the directors appointed.
Once the directors of Beneficial Finance were appointed,
however, the Bank's Board of Directors was entitled to leave the direction of the
management of Beneficial Finance to its Board. If the directors of a parent company have
made proper appointments but the directors of the subsidiary do not perform their duty,
the directors of the parent corporation are, in general, not liable for that default.
However, directors of a parent corporation are under a duty to consider the results of the
subsidiary corporation's operations and to take action to try to improve the performance
of the subsidiary if it produces unsatisfactory results.
The relationship between the Bank and its subsidiary
companies was described in my First Report as one of co-operative independence.
The Bank exercised control over its subsidiary groups by
appointing its own representatives - directors of the Bank including the Chairman and the
Managing Director, and a Bank executive - to the Board of Directors of the subsidiary
companies. For example, at its meeting on 28 June 1984, the Bank's Board of Directors
appointed a Board of Directors for Beneficial Finance which comprised ten directors, five
of whom represented the Bank - Mr Barrett, Mr Clark, Mr Simmons, Mr R P Searcy and an
executive of the Bank, Mr Matthews. It expressly appointed Bank representatives to the
Beneficial Board "to ensure the new Bank control of the operations of Beneficial
Finance." It was the Bank's policy that its Chairman was also the Chairman of the
Board of Directors of subsidiary companies, including Beneficial Finance.
At its meeting on 22 June 1989, in considering alternatives
for the appointment of Directors to the Boards of subsidiary companies, the Bank Board "considered
that the Boards (of subsidiaries) should remain independent and have outside Directors
appointed, with the Bank continuing to maintain control mechanisms."
Although the subsidiaries of the Bank operated as
semi-autonomous businesses, there was one respect in which they had the potential to
profoundly affect the Bank - whatever the legal position, the Bank would act to meet a
subsidiary's liabilities and obligations should the subsidiary itself be unable to do so.
While the Bank did not provide any formal guarantee of
Beneficial Finance's obligations, it is beyond doubt that the Bank would not allow it to
fail. As noted in the Bank's 1990 Annual Report, the Bank was "totally committed
to maintaining full support for Beneficial." The Bank's advance of funds in
respect of the East End Market commitments of Beneficial Finance (described in Chapter 31
of this Report), and its purchase of non-performing assets from Beneficial Finance in the
1991 financial year, are particular manifestations of that commitment.
The Bank Group apparently adopted a guideline which limited
the size of Beneficial Finance relative to the Bank. The Bank's 1985 strategic plan
proposed the establishment of limits on the size of subsidiaries:
". Beneficial Finance; receivables no greater than
20% of total bank assets;
. Other subsidiary operations no greater than 10%
(total) of the total bank assets".
I have found no evidence that the Bank's Board of Directors
formally considered or imposed any such limits. However, the limit is expressly referred
to in the minutes of the Beneficial Finance Board of Directors' meeting held on 30 April
"Future plans to be produced on the basis of sales
which can be written even though this may increase Company assets above the guideline of
20% of SBSA assets. Any excess receivables can then be sold off to SBSA or other
The policy of the Bank in respect of its management of the
risk represented by the activities of Beneficial Finance was broadly in accordance with
the prudential guidelines of the Reserve Bank. Before August 1989, the Reserve Bank did
not require that the large exposures of non-banking subsidiaries of a bank be reported.
Instead, Reserve Bank Prudential Statement G1 required banks to ensure that a subsidiary
had "sound and prudent management which is aimed at achieving undoubted viability
within the capital resources of the (subsidiary) itself", and to ensure that the "size
of its subsidiaries does not become unduly large relative to the bank itself."
The Reserve Bank's guidelines was that the total assets of all subsidiaries should
together not exceed 50 per cent of a bank's own assets.
In summary, the directors of the Bank had an obligation to
exercise reasonable care and diligence in constituting the Board of Directors of
Beneficial Finance, and to monitor its results. Having appointed the directors however,
the directors of the Bank were under no duty to act as if they were directors of
Beneficial Finance and their legal obligations, in general, did not extend to giving
directions on matters of management to the Board of Beneficial Finance.
188.8.131.52 The Role and Duties of Common Directors on the
Boards of the Bank and Beneficial Finance
As noted, the Bank's Board of Directors ensured that it
appointed some of its own members to the Board of Directors of Beneficial Finance to
facilitate the Bank's monitoring of the performance of Beneficial Finance.
The law gives very little recognition to the practice of
common directorships in groups of companies. So far as their duties are concerned they do
not differ from other directors. The common director will owe a set of duties to each
corporation. He or she will be obliged to act in the interests of the parent corporation
when acting as a director of the parent, and to act in the interests of the subsidiary
when acting as a director of the subsidiary corporation. Where the subsidiary is
wholly-owned, the common director when acting in each corporation will be acting properly
if he or she has an honest belief that the interests of the parent and the subsidiary
RELEVANT PROVISIONS OF THE COMPANIES CODE
An important point of distinction between the State Bank
and Beneficial Finance is that Beneficial Finance was a company incorporated under the
Companies Code. While the Bank was a statutory corporation and an instrumentality of the
Crown, Beneficial Finance was a company like any other, and subject to the law
accordingly. As a statutory corporation representing the Crown, however, the Bank and its
directors, officers and employees were not subject to the Companies Code, or arguably to a
number of other relevant laws.
It is relevant to note here too that the statutory immunity
provided to the Bank's directors and officers by Section 29 of the State Bank Act does not
apply to the directors and officers of Beneficial Finance. Even those directors of
Beneficial Finance who were also directors and officers of the Bank are not entitled to
the immunity in respect of the performance of their duties as directors of Beneficial
The importance of the application of the Companies Code to
Beneficial Finance lies in the potential implications that might result from a breach of
those laws. The Companies Code and other statutes that may be relevant to Beneficial
Finance's activities commonly impose a liability to make restitution and pay damages, and
in some cases can result in a criminal liability, for their breach.
It must be clearly understood that, although the Companies
Code uses the term "reasonable care and diligence" in respect of the obligation
of directors and officers, and the standard applied under the Code is the same as that of
the general law described above, a simple failure to exercise reasonable care and
diligence is not by itself enough to constitute an offence against the Code. The Companies
Code applies only to a particular and specific act or omission, of such gravity as to
attract a criminal penalty.
Whether any criminal or civil legal action should be
initiated in respect of any of the matters addressed in my Report is not a question that I
am empowered to answer. That issue is reserved for consideration by the Royal Commission
following receipt of my Report.
Section 229(2): The Duty to Exercise Reasonable Care and Diligence
Section 229(2) of the Companies Code requires an
"officer" of a company to exercise "a reasonable degree of care and
diligence in the exercise of his powers and the discharge of his duties". Breach of
the section is a criminal offence carrying a maximum penalty of $5,000.
The meaning of "reasonable care and diligence"
was explained in my First Report, and its key features are summarised in Section 27.4.2 of
this Chapter. Where-ever I have formed the opinion that a person did not act with proper
care and diligence, I have provided my reasons for that opinion in the relevant Chapter of
this Report. There are however two important features of the obligation imposed by Section
229(2) which require some brief explanation.
First, the obligation applies to each company
"officer". An "officer" is defined to mean:
"... any person, by whatever name called and
whether or not he is a director of the corporation, who is concerned or takes part, in the
management of the corporation."
The meaning of that definition was explained by Ormiston J
in Commissioner of Corporate Affairs v Bracht  VR 821 as follows:
"It may be difficult to draw the line in particular
cases, but in my opinion the concept of "management" for present purposes
comprehends activities which involve policy and decision making, related to the business
affairs of a corporation, affecting the corporation as a whole or a substantial part of
that corporation, to the extent that the consequences of the formation of those policies
or the making of those decisions may have some significant bearing on the financial
standing of the corporation or the conduct of its affairs."
Although it is clear that all directors of Beneficial
Finance were "officers" of the company, it is not necessarily the case that
every employee of Beneficial Finance who was described as a "manager" was an
"officer" within the meaning of the Code. In order to be an officer, the
person's participation in decision-making must have occurred at a level and in areas of
the corporation's operations where significant discretions and judgment were exercised.
For ease of reference, I have throughout this Report
adopted the terminology of my Terms of Appointment in using the term "officer"
to refer to officers other than directors.
Second, it is important to recognise that, because section
229(2) creates a criminal offence, any prosecution for a breach of the section must relate
to a particular and specific act or omission, and not to some general failure over a
period of time to exercise reasonable care and diligence in the performance of the
person's functions and powers. In Bryne v Baker  VR 443 at 453, the
"The language used is appropriate and was designed,
we think, to introduce one aspect of the concept of negligence, as known and acted upon
for many years by the courts ... and this concept of negligence has reference to
identifiable acts or omissions, not to any general characterisation of the conduct of a
director over a selected period".
Section 229(1): The Duty to Act Honestly in the Best Interests of the Company
Section 229(1) requires an officer of a company to
"act honestly in the exercise of his powers and the discharge of the duties of his
office". The section sets a maximum penalty for its breach of $5,000 or, if there was
an intention to deceive or defraud the company, a maximum penalty of $20,000 or
imprisonment for five years, or both.
The term "act honestly" is not used in the sense
of requiring probity or truthfulness. Rather, it means "act bona fide in the best
interests of the company." As stated by King CJ in Australian Growth Resources
Corporation Pty Ltd v van Reesema  6 ACLC 529:
"The section ... embodies a concept analogous to
constructive fraud, a species of dishonesty which does not involve moral turpitude. I have
no doubt that a director who exercises his powers for a purpose which the law deems to be
improper, infringes this provision notwithstanding that according to his own lights he may
be acting honestly."
Note that, like section 229(2) requiring reasonable care
and diligence, section 229(1) applies only to directors and "officers" of a
company, and not to employees who are not "officers".
Section 229(3): The Duty Not to Make Improper Use of Company Information
Section 229(3) provides that the directors, officers and
employees of a company must not use company information for their own benefit. The section
"An officer or employee of a corporation, or a
former officer or employee of a corporation, shall not make improper use of information
acquired by virtue of his position as such an officer or employee to gain, directly or
indirectly, an advantage for himself or for any other person or to cause detriment to the
Penalty: $20,000 or imprisonment for 5 years, or
This section applies to all employees, not just directors
Section 229(4): The Duty Not to Make Improper Use of Position in the Company
Section 229(4) is closely related to Section 229(3). It
provides that a director, officer or employee must not make improper use of his or her
position to obtain a personal advantage or to benefit another person without the authority
of the corporation. The section states:
"An officer or employee of a corporation shall not
make improper use of his position as such an officer or employee, to gain, directly or
indirectly, an advantage for himself or for any other person or to cause detriment to the
Penalty: $20,000 or imprisonment for 5 years, or
In Chew v R  10 ACLR 816, the High
Court held that the actual obtaining of an advantage by the officer or employee or anyone
else, or the suffering of a detriment by the company, was not a necessary element of the
offence. A director, officer or employee who makes improper use of his or her office in an
attempt to gain an advantage is guilty of an offence, even if he or she is unsuccessful.
The majority of the High Court decided that is sufficient for section 229(4) that the
accused must have the purpose of gaining an advantage or causing a detriment, and must
believe that the intended result would be an advantage for himself or herself or for some
other person or a detriment to the corporation.
Potential Penalties and Liabilities Under Section 229
Section 229 creates criminal offences. The penalty for
breach of section 229(2) is monetary only, but breaches of other sections can result in
imprisonment for up to five years. Being a criminal offence, the standard of proof
required under section 229 is the criminal standard - proof beyond reasonable doubt. An
allegation of breach of duty made under the general law needs to be proved only on the
civil standard of proof on the balance of probability.
Section 229 also imposes a liability upon a person in
breach of its provisions to pay compensation to the company.
Section 229(6) empowers a Court which convicts a person of
an offence under section 229 to pay compensation to the company. The section states:
(a) a person is convicted of an offence under this
(b) the court is satisfied that the corporation has
suffered loss or damage as a result of the act or omission that constituted the offence,
the court by which he is convicted may, in addition to
imposing a penalty, order the convicted person to pay compensation to the corporation of
such amount as the court specifies, and any such order may be enforced as if it were a
judgment of that court."
Section 229(7) empowers the company to take court action to
recover compensation from a person who has contravened section 229, whether or not the
person has been convicted of an offence. The section states:
"Where a person contravenes or fails to comply with
a provision of this section in relation to a corporation, the corporation may, whether or
not the person has been convicted of an offence under this section in relation to that
contravention or failure to comply, recover from the person as a debt due to the
corporation by action in any court of competent jurisdiction -
(a) if that person or any other person made a profit as
a result of the contravention or failure - an amount equal to that profit; and
(b) if the corporation has suffered loss or damage as a
result of the contravention or failure - an amount equal to that loss or damage."
An action by the company under this section is a civil
action, in which a breach of section 229 need be proved only on the balance of
Section 542 of the Companies Code should also be noted.
That Section allows any person authorised by the Australian Securities Commission to make
an application to a Court that:
(a) a person is guilty of "fraud, negligence, default,
breach of trust or breach of duty in relation to a corporation"; and
(b) that as a result the corporation has or is likely to
If the Court is satisfied that the person is guilty as
alleged, the Court can make such orders as it thinks appropriate, including an order that
the person pay compensation or damages to the corporation. The test of liability under
this Section appears to be broadly the same as at general law and under Section 229. Note
however that Section 542 applies to any person, and not only company directors, officers
Finally, Section 535(1) of the Companies Code provides for
a court to excuse a person from civil liability where, although he or she has contravened
the law, they acted honestly and ought fairly to be excused:
"If, in any civil proceedings against a person to
whom this section applies for negligence, default, breach of trust or breach of duty in a
capacity by virtue of which he is such a person, it appears to the court before which the
proceedings are taken that the person is or may be liable in respect of the negligence,
default or breach but that he has acted honestly and that, having regard to all the
circumstances of the case, including those connected with his appointment, he ought fairly
to be excused for the negligence, default or breach, the court may relieve him either
wholly or partly from his liability on such terms as the court thinks fit."
Section 535 does not empower the court to grant relief from
criminal liability, and so does not allow relief from a criminal prosecution under section
27.4.4 MY POWER TO MAKE FINDINGS IN RESPECT OF MATTERS
184.108.40.206 The Issue
In their submissions to me in response to the draft
Chapters of my Report provided to them as part of the natural justice process, the
non-executive directors of the Bank and of Beneficial Finance argued that I could not draw
any conclusions or make any findings, in respect of any matter of law, or of mixed law and
The submission was that I had "no power under
Section 25(2) of the State Bank Act to make any finding on a matter of law or mixed fact
and law or which may declare or affect or attempt to declare or affect legal rights",
and that any finding I might make which involved me "reaching any finding based
upon the legal construction of a Board directors' duty - whether common law or statutory
... or a legal instrument, is ultra vires". The submission cited three
"factors" which, it was said, had this effect:
"(a) the proper construction of Section 25 of the
State Bank Act;
(b) the proper construction of the Auditor-General's
Terms of Appointment; and
(c) the decision of the full Court in Bakewell &
Others ... in which the Chief Justice makes it clear that the Auditor-General is acting in
his capacity as an investigator -he is not a judicial or quasi-judicial officer."
I do not accept this submission. It is my opinion,
supported by legal advice, that not only am I able to make findings and reach conclusions
in respect of matters of law, but that I am in fact expressly required to do so.
Nevertheless, this submission, which was made after section 25 of the State Bank Act was
amended on 3 December 1992, raises some issues regarding the nature of my Investigation
and the effect of my Report which should be understood by readers of my Report.
The Non-Judicial Nature of my Investigation
It is important to recognise that I am not a judge, and my
inquiry is not a court. This is an administrative investigation. My findings do not affect
any person's legal rights. I cannot convict anyone of any offence, or impose any penalty
for a breach of the law, or require anyone to make restitution or pay damages for a breach
of an obligation or duty imposed on them by the law.
This does not mean, however, that I cannot express an
opinion in respect of the application of the law. I can, and indeed I am required, to make
findings and reach conclusions regarding a variety of legal matters. The fact that my
inquiry is not judicial or quasi-judicial does not mean that I cannot form opinions
regarding matters of law, or make such findings or come to such conclusions. What it does
mean is that those opinions, findings and conclusions have no legal implications - they
affect no one's legal rights. They are, in the end, no more than an expression of my
opinion, based on the evidence available to me.
Of course, the opinions expressed in my Report can
potentially have serious implications for those persons who are subject to them, at least
in terms of damage to those persons' reputations. My Report could result in the
Attorney-General or the Australian Securities Commission deciding to institute legal
proceedings, based upon whatever recommendations may be made by the Royal Commission. In
any such legal proceedings however, the facts establishing liability under the law would
have to be proved to the Court. My findings and conclusions, whether of fact or law, will
not establish any liability.
Because of the serious implications which my Report could
have for a person's reputation, I have ensured that my findings and conclusions are
soundly based upon the established evidence, and fairly expressed, and are based upon
detailed legal advice. My investigation has been exhaustive and thorough, including the
taking of detailed and extensive advice, and the rigorous observance of the requirements
of natural justice and procedural fairness.
In the end though, whatever may be the implications of the
opinions expressed by me in my Report for people's lives, those implications do not
include any affect on their legal rights or status.
The Law Regarding Non-Judicial Investigations
It is clearly settled law in Australia that a non-judicial
investigation such as mine can reach conclusions regarding matters of law, including a
person's apparent commission of a crime, or breach of any obligation or duty imposed upon
them by the law. The Full High Court of Australia has ruled that a Royal Commission can be
appointed by the Governor in Council to determine whether crimes have been committed: McGuinness
v Attorney-General(Vic) (1940) 63 CLR 73; Clough v Leahy (1905) 2 CLR
139. The New South Wales Supreme Court held similarly in Ex parte Walker (1924) SR
(NSW) 604. In the authoritative "Royal Commissions and Boards of Inquiry" (LA
Hallett, The Law Book Company, 1982), the author states (at page 40-41):
"Whilst the power of the Governor General in
Council to appoint a Board of Inquiry has never been challenged in the same way as the
appointment of a Commission, it would appear that any challenge would be unsuccessful. The
basis of the decisions upholding the validity of Commissions is that there is nothing
contrary to law about an individual holding a voluntary inquiry. There is nothing in
either Clough v Leahy: Ex parte Walker or McGuinness v Attorney-General which put
Commissions in a special category, or attributed to them some special factor which would
not apply to a Board of Inquiry. However, it is suggested that it would be prudent to
provide a statutory power to appoint a Board of Inquiry, so that there would be absolutely
no doubt that such a power exists."
As described below, section 25 of the State Bank Act is
just such a statutory power.
At page 328-329 of "Royal Commissions and Boards of
Inquiry", the author continues:
"The executive government has power to establish
inquiries for the purpose of ascertaining whether there have been breaches of the criminal
law. It can also require that Commissions and Boards report the names of persons who are
found to have committed specific breaches of the law. Inquiries which have this function
invariably adopt an inquisitorial procedure; and it is inquiries of this nature which are
the most likely to cause injustice to or prejudice against individuals ... A strong
argument that Commissions and Boards should not be used to ascertain whether individuals
have committed crimes is the decision in Cock and Others v The Attorney-General and
Another ((1909) 28 NZLR 405). The Court of Appeal in New Zealand held that it was unlawful
for the Governor to appoint a Commission of Inquiry to investigate whether an offence had
been committed. It has already been seen that in Australia the High Court has taken the
The position in Australia is, then, that the Governor can
validly appoint me to inquire into, and report on, a possible breach of legal duties and
obligations by any person. As noted by the learned author quoted above, such an inquiry
does involve a risk of injustice and prejudice, which is precisely why my inquiry has been
so exhaustive, and why I have observed rigorously the principles of natural justice and
Since the Governor has the power to appoint me to
investigate and report in respect of legal matters, the issue of my power to conduct an
investigation of, and to make findings and reach conclusions in respect of legal rights
becomes one of the meaning of section 25 of the State Bank Act, and of my Terms of
Appointment. In particular:
(a) is there any limitation in section 25 of the State Bank
Act pursuant to which I was appointed which precludes the Governor from appointing me to
make such findings or reaching such conclusions? and
(b) do my Terms of Appointment contain such a limitation?
Section 25 of the State Bank Act
I am firmly of the view that there is nothing in section 25
which, expressly or by implication, precludes the Governor from appointing me to report in
respect of legal matters, including the legal rights, duties and possible breaches of
legal duties by any relevant persons. Nor does that section constrain me from acting as
the Governor directs.
Sub-section 25(1) provides that the Governor may appoint
the Auditor-General, or some other suitable person, "to make an investigation and
report under" the section. It is important to note that there are no limitations in
sub-section 25(1) on the matters in respect of which the Governor may require an
investigation and report. It is a grant of power, at large, to appoint an investigator. As
was described above, the common law in Australia does not preclude the Governor from
requiring an investigation of a person's compliance with the law.
Indeed, sub-section 25(2) (as amended on 3 December 1992)
which requires me to investigate and report on such matters as are determined by the
Governor, expressly provides that such matters may include questions of law. Sub-section
"...(2) An investigator so appointed -
(a) must investigate such matters relating to the
operations and financial position of the Bank or the Bank Group as are determined by the
Governor, which matters may include -
(i) any possible conflict of interest or breach of
fiduciary duty or other unlawful, corrupt or improper activity on the part of a director
or officer of the Bank or a subsidiary of the Bank; or
(ii) any possible failure to exercise proper care and
diligence on the part of a director or officer of the Bank or a subsidiary of the Bank,
(b) may investigate a matter of the kind referred to in
sub-paragraph (i) or (ii) that the investigator has not been required by the Governor to
investigate if, in his or her opinion, the matter should be investigated."
Thus, sub-section 25(2) is an express statutory requirement
that I form an opinion in respect of whether a person has breached the law, or failed to
exercise "proper care and diligence". Paragraph 25(2)(b) empowers me to do so in
respect of matters not required by the Governor.
It is significant too that sub-section 25(7) provides me
with the inquisitorial powers of the Public Finance and Audit Act 1987, powers of the kind
associated with an investigation of legal rights, as noted by the author of "Royal
Commissions and Boards of Inquiry" quoted above.
My Terms of Appointment
Since the Governor is not constrained either by common law
or by section 25 from requiring me to investigate and report on potential breaches of
legal duties or obligations, the issue becomes, simply, whether the Terms of Appointment
require me to do so.
In my opinion, my Terms of Appointment both authorise and
require me to report in respect of legal matters, including particularly the discharge by
directors and officers in respect of their legal obligations of reasonable care and
Term of Appointment A(h) is expressed in precisely the same
terms as sub-paragraphs 25(2)(a)(i) and (ii) of the Act, quoted above. The Governor has
therefore expressly directed me to investigate and report in respect of legal matters, and
is authorised by the State Bank Act to do so.
Further, Term of Appointment C requires me to investigate
and inquire into, and report on, whether the operations, affairs and transactions of the
Bank and the Bank Group were "adequately or properly" supervised, directed and
controlled by, among others, the Board of Directors of the Bank and the directors and
officers of Beneficial Finance.
This unavoidably raises the question of the standard of
"adequate" and "proper" that will be applied in evaluating the
performance of directors. The same question is raised by the use of the word
"proper" in sub-paragraph 25(2)(a)(ii) of the State Bank Act.
In my opinion, fairness and reasonableness both require
that the standard should be that established by the law. It would be unfair to the
directors to apply some higher standard - for example, the standard of adequacy based on
hindsight, or of some idealised expert banker - and it would be perverse and contrary to
common sense to apply a standard of "adequate" and "proper" that was
less than the law requires. The only reasonable standard of "adequate" and
"proper", in my opinion, is the standard established by the law.
Further, the necessary implication of the submission on
behalf of the non-executive directors in this respect is contrary to common sense.
According to the submission, I cannot apply the standard prescribed by the law in
evaluating whether the non-executive directors performed their functions adequately or
properly, since to do so would involve an ultra vires exercise of quasi judicial powers.
Accordingly, I can apply any standard of "adequate" and "proper",
except that required by the law. A result so contrary to common sense cannot be accepted
OVERVIEW OF MY REPORT ON THE EXTERNAL AUDITS
MY TERMS OF APPOINTMENT
The Terms of Appointment of my Investigation require me to
inquire into and report on the audits of the accounts of both the Bank and Beneficial
Finance. Term of Appointment B states:
"The Auditor-General is to investigate and inquire
into and report on whether the external audits of the accounts of the Bank and Beneficial
Finance Corporation Ltd ... were appropriate and adequate".
Answering Term of Appointment B required me to:
(a) investigate the procedures carried out by the external
auditors, and to determine whether those procedures were proper; and
(b) determine whether the information elicited by the
auditors provided a proper basis for the opinion which they expressed in each of the years
I consider that Term of Appointment B requires me to have
regard to the view which would be likely to prevail in the profession.
The Investigation was, conducted by way of a detailed
review of the working papers of the auditors, with the co-operation and assistance of the
auditors. I have approached the Investigation on the basis that I am not required to
conduct a fresh audit of the accounts of the Bank or Beneficial Finance. As a result of
matters arising out of the Investigation, however, I am able to make a finding that the
accounts did not give a true and fair view by reason of exceptions specifically noted.
I draw support for my conclusions from the pronouncement of
the Professional Accounting Bodies in Statement of Auditing Standards AUS1, which provides
"3. This statement of Auditing Standards describes
the basic principles which govern the auditor's professional responsibilities and which
must be complied with whenever an audit is carried out ...
4. An audit is the independent examination of financial
information of any entity ... when such examination is conducted with a view to expressing
an opinion thereon ...
6. The Standards set out in this Statement are mandatory
21. Auditors shall obtain sufficient appropriate audit
evidence through the performance of compliance and substantive procedures to enable them
to draw reasonable conclusions therefrom on which to base their opinion on the financial
Apart from the statutory duties relevant to the auditors of
Beneficial Finance, an external auditors' responsibilities concerning the audit process
are set out in the applicable pronouncements of the Professional Accounting Bodies, and in
the common law. The following is a summary of the salient points:
(a) In forming the audit opinion, the auditors must perform
sufficient tests to obtain reasonable assurance that the financial information is properly
stated in all material respects, that is, that transactions have been properly recorded in
the accounting records, and that transactions have not been omitted.
(b) Internal controls may contribute to the reasonable
assurance the auditor seeks, and audit procedures must include an evaluation of the
accounting systems and internal controls upon which the auditor chooses to place reliance
in determining the nature, timing and extent of substantive audit procedures.
(c) While it is not the purpose of the audit to determine
the adequacy of internal controls for management purposes, the auditors must inform
Management, or in certain cases the Board of Directors, of any material weaknesses in
internal control and accounting procedures of which the auditors become aware during the
course of the audit.
(d) The auditors must obtain appropriate and sufficient
audit evidence through the performance of compliance and substantive procedures from which
they could reasonably draw conclusions and base their opinion concerning the accounts and
financial position of the reporting entity.
(e) The auditors must bring to bear on the work they have
to perform that skill, care and caution which a reasonably competent, careful and cautious
auditor would use. What is reasonable skill, care and caution will be all determined by
I have assessed the appropriateness and adequacy of the
external audit by reference to what I consider to be the ordinary standard of skill, care
and caution which a reasonably competent auditor would bring to bear. In forming my views,
I have had regard to applicable professional standards and practices.
I have considered submissions from the Bank's external
auditors that Term of Appointment B should be interpreted to mean that an adverse finding
cannot be made unless I am able to conclude that no reasonably competent auditor could
have expressed the opinion which the auditors expressed, and that the incorrect opinion
was a contributing cause to the financial position of the Bank and Bank Group as reported
in February 1991. Such a finding would, in my view, correspond with a finding on the
principal elements of a cause of action against the auditors for negligence. In my
opinion, Term of Appointment B does not require this. A professional person may be wrong
without being negligent. In my opinion, Term of Appointment B requires me to assess the
appropriateness and adequacy of the external audit having regard to what a reasonably
competent auditor should have concluded to be proper in the circumstances. It is for
others to determine whether there has been negligence on the part of the auditors which
caused a loss.
A SYNOPSIS OF MY REPORT ON THE EXTERNAL AUDITS
Chapters 45 to 53: The External Audits of the State Bank
(a) Overview and Summary
There were a number of issues that were of particular
significance to my Investigation of the external audits of the Bank's accounts in the
years reviewed. They were:
Provision for Doubtful Debts
Financial institutions make provisions in their accounts
for losses incurred in respect of loans and advances. These provisions are commonly
divided into two types, specific and general. Specific provisions relate to identified
loans where there is a recognition that a loss has probably been incurred. Where it is
anticipated that the amount which is reasonably likely to be recovered will be less than
the book value of the loan, then a specific provision should be raised for the shortfall.
General provisions are established to provide for losses
within the loan portfolio which have not been specifically identified.
The provision for doubtful debts appearing in the State
Bank's accounts was comprised by:
(i) A specific provision relating to an assessment of
recoverability of individual loans; and
(ii) A general provision relating to the perceived credit
risk inherent in the Bank's corporate, treasury and retail operations, calculated by
applying risk percentages to outstanding balances and commitments for different categories
The 1987 accounts of the Bank recorded, at note 7, that the
Provision for Superannuation of $57.7M, and the Provision for Retiring Allowances of
$16.7M, were transferred to the State Bank of South Australia (Provisions) Trust as at 1
July 1987. Such a transfer never took place.
In March 1987, the Bank's Board had agreed to move the
Bank's superannuation provisions off the balance sheet by transferring corresponding
assets into a separate superannuation trust fund, and a draft trust deed to give effect to
this was approved. The accounting procedures to transfer the assets off the balance sheet
were implemented on 1 July 1987. The trust deed which had been prepared was not executed
at that time. The Board then decided, late in July 1988, to rescind their earlier decision
to approve a trust deed, and instead to operate the Fund as if it were a separate entity
within the Bank's financial statements.
The external auditors have submitted that assets comprising
land and buildings, investments in debentures, and deposits, were identified as being
superannuation fund assets which were sufficient to cover the superannuation liabilities
as determined by the public actuary. The external auditors also submitted that the income
from these assets has, since 1988, always been credited to the Provision for
Superannuation, and that the Provision for Superannuation has also borne the
expenses of the property assets. The external auditors submitted that:
"In the joint auditors' opinion, all actions taken
by the Board since 1988 have clearly demonstrated that the original intentions of the
proposal have been put into effect. All rights and interests in the assets designated to
meet the superannuation liabilities have been reserved, and all income and other benefits
arising from those assets has been credited to the Fund. The details of the assets held to
meet the superannuation liability are set out in the notes to the accounts. In summary,
the Superannuation (Provisions) Trust Fund has operated and been accounted for as if it
had been separately established outside the Bank, and the intention of the original
proposal has been preserved".
The external auditors submitted that a trust had been
created, which was effective to transfer beneficial title in the assets from the Bank for
the benefit of employees entitled to superannuation benefits, such that the relevant
assets would not have been available to creditors of the Bank, but that it was,
nevertheless, appropriate for the Bank to include such assets in its own balance sheet.
Having reviewed these submissions, I am not satisfied that
it was appropriate for the joint auditors to accept that the Provision for Superannuation,
and corresponding assets in the books of the Bank, constituted a separate fund. In my
opinion, it was inappropriate for the joint auditors to accept the Bank's treatment of
income of the relevant assets and revaluation increments as an accretion to the Provision
for Superannuation. The Provisions for Superannuation represented a liability of the Bank
to pay superannuation benefits to employees. It follows, in my opinion, that the external
auditors should have carried out appropriate procedures to ensure that the liability was
not materially misstated in the accounts.
To the extent that the Provision for Superannuation may
have been under-stated, it would have been appropriate to make an additional charge
against profits for the year, and a failure to do so would mean that profits for the year
would be over-stated.
State Government Taxation Charge
The Bank is required to pay, out of its profits, an amount
to the State Government in lieu of Federal income tax. This a is statutory obligation, and
is not a matter over which the Bank has a power to make recommendations, as is the case
with other payments to the State Government representing returns on investment.
It is a generally accepted accounting principle that an
entity's net profit for a reporting period should be presented after deduction of all
expenses, including taxation.
The Profit and Loss Statement of the Bank for the years
ended 30 June 1985 and 1986 disclosed the amount described as "State Government
Tax" as a deduction from operating profit before tax in arriving at the operating
profit after tax. The Bank calculated the future income tax benefit and the deferred tax
liability appearing in the accounts for those years in accordance with Australian
Accounting Standard "Accounting for Income Tax (Tax-effect Accounting)".
For the 1987, 1988 and 1989 years, however, the Bank
changed the presentation of State Government tax in its accounts. Although the amount was
calculated in the same manner as in 1985 and 1986, and the notes to the accounts stated
that the Bank adopted tax- effect accounting principles, the State Government tax for
those years was not shown as a deduction from the operating profit before tax, but rather
included in the amount disclosed as a distribution to the State Government. As there was
no State Government tax payable for 1990, there was no effect of this presentation on the
1990 accounts. The effect of this presentation for years 1987, 1988 and 1989 was to charge
the tax relating to those years' profit against accumulated profits, rather than being
taken into account when calculating the annual profit. This presentation is contrary to
generally accepted accounting principles, and to the requirements of Australian Accounting
For the year ended 30 June 1991, the Bank reverted to its
practice in 1985 and 1986, and disclosed the State Government tax as a deduction from the
operating profit before tax, separately from the distribution to the Government.
In my view, the substance of the State Government tax
payment is that of a charge in the nature of income tax and thus an expense, and that it
was, therefore, appropriate that its treatment in the Bank's accounts should reflect that
nature in the manner adopted by the Bank in its 1985, 1986 and 1991 accounts.
I have concluded the Bank's accounts for 1985, 1986 and
1991 were in accordance with the applicable accounting standards, while those of 1987,
1989 and 1990 did not follow the applicable standard.
The effect of treating the tax-equivalent payments as
distributions of income was to overstate the operating profit after tax by the amount of
the obligations so treated.
Concessional Housing Reserve
The Concessional Housing Reserve was raised in connection
with the concessional housing scheme, a service provided by the Bank as part of the State
Government's "House Ownership made Easy Program". The scheme provided low
interest mortgage loans to assist low income earners to buy a home. Annual movements in
the Reserve were meant to reflect the difference between the interest received by the Bank
from loans under the scheme, and the interest paid on funds provided by the State
Government, less administration and commission taken by the Bank.
The accounts of the Bank treated the surplus arising from
the scheme as forming part of the capital and reserves of the Bank, when in fact that
surplus should have been set aside in trust to be applied for housing purposes as directed
by the State Government.
The joint auditors submitted, and I accept, that a trustee
need not keep trust funds separate from its own assets if permitted by the terms of the
trust. Nevertheless, in my opinion, it is not appropriate for the trustee to account for
such funds as if the trustee were entitled to the whole of the benefit of the funds. In
the case of the Concessional Housing Reserve, it appears that the Bank was obliged to
apply the surplus for subsidies, remissions and further lending at concessional rates
under the concessional housing scheme as directed by the State Government.
In my opinion, the subsequent application of the reserve,
by way of transfer to the Bank's capital at the direction of the State Government,
supports the view that the Bank was not otherwise entitled to the funds.
(b) Findings and Conclusions
(i) For the reasons set out in Chapters 45 - "Review
of the 1985 External Audit of the State Bank" to Chapter 51 - "Review of
the 1990 External Audit of the State Bank", the audit opinions expressed by the
joint auditors, known on 30 June 1990 as KPMG Peat Marwick and Touche Ross & Co, on
the accounts of the Bank and the Bank Group for the years ended 30 June 1985 to 1990
inclusive were inappropriate, and the carrying out of the audit process leading to those
opinions was inadequate, in the specific respects set out in those Chapters.
(ii) For reasons set out in those chapters, the accounts of
the Bank and the Bank Group for the years ended 30 June 1985 to 1990 inclusive failed to
give a true and fair view of the results and affairs of the Bank and the Bank Group.
(iii) The more significant inadequacies were:
. Provision for Doubtful Debts - The provision was
materially understated in 1989 and 1990. I am not satisfied that the provision was
adequate in 1988.
. Superannuation Provision - The asset revaluation reserve
of the Bank was materially understated, and it was likely that the Superannuation
Provision was materially understated, with a consequent material overstatement in profits,
in the years 1988 - 1990 inclusive.
. State Government Charge in Lieu of Federal Income Tax -
The change in accounting treatment of this item resulted in a material overstatement of
net profit for the years 1987 to 1990.
. Concessional Housing Reserve - The reserves of the Bank
were materially overstated in the years 1985-1988 inclusive.
220.127.116.11 Chapters 54 to 60: The External Audits of
(a) Overview and Summary
The Investigation assessed the appropriateness and adequacy
of the external audits of the accounts of Beneficial Finance Corporation Limited and its
subsidiaries for the years ended 30 June 1985 to 30 June 1990.
It is important to emphasise that the year by year
assessment of the audits undertaken by my Investigation did not take the form of a
re-performance of the audits of the accounts. The investigation entailed the review and
evaluation of the audit process applied by the external auditor in each year in relation
to the accounting records and the accounts of Beneficial Finance, including the procedures
adopted by the auditors with regard to planning of the audit, execution of the audit, and
concluding and reporting on the audit.
It must also be borne in mind that the investigation of the
external audit process is not the same as an assessment of the accuracy of the accounts of
Beneficial Finance. For example, if the external auditor's conduct of the audit had been
inadequate, the only conclusion that could be drawn with confidence would be that there
was not a proper basis for the audit opinion expressed by the auditor. Whether the
accounts comply with the statutory requirements, and give a true and fair presentation of
the entity's results of operations and financial position, would depend upon other
matters. Conversely, it is conceivable that the conduct of the audit might have been
adequate, without the auditor detecting an error or irregularity in the accounts.
The review and evaluation of the annual audit process
included an analysis of the external auditor's audit methodology, review of external audit
evidence obtained and documented in the external auditor's working papers and
correspondence between Beneficial Finance and the external auditor, and direct inquiry of
external auditors engaged on the audits of Beneficial Finance. Conclusions drawn in
relation to the appropriateness and adequacy of the external audits were made having
regard to the Professional Accounting Bodies' Accounting and Auditing Standards and the
statutory requirements applying at the relevant times.
(b) Findings and Conclusions
(i) For the reasons set out in Chapters 57 - "Review
of the 1988 External Audit of Beneficial Finance" to Chapter 59 - "Review
of the 1990 External Audit of Beneficial Finance", the audit opinions expressed
by Price Waterhouse on the accounts of Beneficial Finance and of the Beneficial Finance
Group for the years ended 30 June 1988 to 1990 inclusive were inappropriate, and the
carrying out of the audit process leading to those opinions was inadequate, in the
specific respects set out in the those Chapters.
(ii) For the reasons set out in those Chapters, the
accounts of Beneficial Finance and the Beneficial Finance Group for the years ended 30
June 1988 to 1990 inclusive failed to give a true and fair view of the results and affairs
of Beneficial Finance and the Beneficial Finance Group.
(iii) In summary, the inadequacies were:
. The failure to disclose, by way of a note to the accounts
in each of the years ended 30 June 1988 to 1990 inclusive, the impact of the results and
affairs of Beneficial Finance's off-balance sheet entities on the results and affairs of
the Beneficial Finance Group, in particular the nature and extent of Beneficial Finance's
direct property exposures through the off-balance sheet entities, and their contribution
of a $7.7M loss to the Beneficial Finance Group result in 1990.
. The failure to disclose, in the accounts for the year
ended 30 June 1988, the $8.3M profit from Blossom Park as an abnormal item.
. The failure to make a doubtful debt provision in the
accounts for the year ended 30 June 1990 in respect of Beneficial Finance's $24.2M
exposure in respect of Somerley.
(iv) Other than in the specific respects referred to above,
the external audits of the accounts of Beneficial Finance and the Beneficial Finance Group
for the years ended 30 June 1985 to 1990 inclusive were appropriate and adequate. Planning
and execution of the audits, and preparation of working papers, was generally of a high
APPOINTMENT (AS AMENDED) OF AUDITOR-GENERAL
UNDER SECTION 25 OF
THE STATE BANK OF SOUTH AUSTRALIA ACT
(1) I am advised that the Bank has a significant amount of
non-performing assets for which there had been inadequate provision by way of specific or
(2) I am advised that by reason of the above, the Bank
faced substantial financial difficulties which have led to an indemnity being granted to
the Bank by the Government.
(3) I am advised that it is in the public interest that the
causes of the financial difficulties at the Bank should be identified.
(4) By Instrument dated the 9th day of February 1991 I
appointed the Auditor-General to investigate and report on certain matters relating to the
(5) I am advised that it is desirable that the matters
which the Auditor-General is to investigate and report on should be varied.
I, THE HONOURABLE DAME ROMA FLINDERS MITCHELL,
Companion of the Order of Australia, Dame Commander of the Most Excellent Order of the
British Empire, Governor in and over the State of South Australia acting pursuant to the
powers given me by Section 25 of the State Bank of South Australia Act, 1983 and all other
enabling powers and with the advice and consent of the Executive Council do hereby revoke
the said appointment and now hereby appoint the Auditor-General to investigate and report
on the following matters:
A. The Auditor-General is to investigate and inquire into
and report on:
(a) what matters and events caused the financial position
of the Bank and the Bank Group as reported by the Bank and the Treasurer in public
statements on 10th February 1991 and in a Ministerial Statement by the Treasurer on 12th
(b) what were the processes which led the Bank or a member
of the Bank Group to engage in operations which have resulted in material losses or in the
Bank or a member of the Bank Group holding significant assets which are non-performing;
(c) whether those processes were appropriate;
(d) what were the procedures, policies and practices
adopted by the Bank and the Bank Group in the management of significant assets which are
(e) were those procedures, policies and practices adequate;
(f) whether adequate or proper procedures existed for the
identification of non-performing assets and assets in respect of which a provision for
loss should be made;
(g) whether the internal audits of the accounts of the Bank
and Beneficial Finance Corporation Ltd (and of such other subsidiary of the Bank that the
Auditor-General considers should be subject to investigation, inquiry and report under
this subparagraph) were appropriate and adequate;
(h) such of the following matters that in his opinion he
should investigate, inquire into and report on;
(i) any possible conflict of interest or breach of
fiduciary duty or other unlawful, corrupt or improper activity on the part of a director
or officer of the Bank or a subsidiary of the Bank; or
(ii) any possible failure to exercise proper care and
diligence on the part of a director or officer of the Bank or a subsidiary of the Bank.
The Auditor-General is directed to report on the above
matters on or before 30 June 1993.
B. The Auditor-General is to investigate and inquire into
and report on whether the external audits of the accounts of the Bank and Beneficial
Finance Corporation Ltd (and of such other subsidiary of the Bank that he considers should
be subject to investigation, inquiry and report under this paragraph) were appropriate and
adequate. The Auditor-General is directed to report on this matter on or before 30 June
C. The Auditor-General is to investigate and inquire into
and report, with reference to the above matters, whether the operations, affairs and
transactions of the Bank and the Bank Group were adequately or properly supervised,
directed and controlled by:
(a) the Board of Directors of the Bank;
(b) the Chief Executive Officer of the Bank;
(c) other officers and employees of the Bank; and
(d) the Directors, officers and employees of the members of
the Bank Group.
The Auditor-General is directed to report on the above
matters on or before 30 June 1993.
D. The Auditor-General is to investigate and inquire into
and report, in relation to the matters set out in paragraphs A and B above, whether the
information and reports given by the Chief Executive Officer and other Bank officers to
the Board of the Bank:
(a) were under all the circumstances, timely, reliable and
(b) sufficient to enable the Board to discharge adequately
its functions under the Act.
The Auditor-General is directed to report on the above
matters at the same time as he reports in relation to paragraphs A and B above
E. Having regard to the material considered by him in
respect of the matters set out in paragraphs A to D above, the Auditor-General is in any
report on such matter, to report on any matters which in his opinion may disclose a
conflict of interest or breach of fiduciary duty or other unlawful, corrupt or improper
activity and the Auditor-General is to report whether in his opinion, such matters should
be further investigated.
F. The Auditor-General is authorised to seek and obtain
such advice or assistance on matters relating to banking, accounting and auditing practice
relevant to this appointment as he may consider necessary for the purpose of his inquiry.
G. The Auditor-General is directed to provide to the Royal
Commission appointed by me on the 4th day of March 1991;
(a) a copy of any report made by the Auditor-General as
directed in paragraphs A to D above;
(b) any interim report or any information including
relevant documents and records and including any document containing tentative conclusions
reached by the Auditor-General on any document containing any information or comment to
the Auditor-General by any person engaged to assist him in his report which interim report
or information the Royal Commission may seek relating to the matters falling within its
Terms of Reference.
H. The Auditor-General is directed in conducting his
inquiry and his report so far as practicable to avoid prejudicing pending or prospective
criminal or civil proceedings, and to report in part by way of confidential report if he
considers it appropriate.
I. The Auditor-General is directed so far as practicable:
(a) in any information provided or report made by him to
protect the confidentiality of information which could properly be regarded as
confidential information of the Bank or of a member of the Bank Group or of a customer or
person dealing with the Bank or a member of the Bank Group;
(b) in any report prepared by him when it is necessary in
his opinion to disclose or refer to such information, to present the report in a manner
which enables the findings and recommendations in the report to be considered separately
from the confidential information, the confidential information where practicable being
presented in a separate report or appendix.
J. The Auditor-General is directed to avoid as far as
practicable prejudicing or interfering with the ongoing operations of the Bank and the
K. The Auditor-General may perform his functions under
paragraphs A, B, C and D by preparing one or more separate reports.
In this Instrument:
"the Act" means the State Bank of South
Australia Act, 1983;
"the Bank" means the State Bank of South
Australia constituted by the Act;
"the Bank Group" has the same meaning as in
Section 25 of the Act as amended from time to time;
"operations" of the Bank or Bank Group has the
same meaning as in Section 25 of the Act as amended from time to time;
"the report" includes one or more separate
reports but unless the context otherwise requires does not include interim reports.
DATED the 28th day of March 1991.
THE HONOURABLE DAME ROMA FLINDERS MITCHELL