Reserve Bank had concerns about South Canterbury Finance related party transactions in early 2009

By Gareth Vaughan

The Reserve Bank was worried that South Canterbury Finance (SCF) related party transactions potentially breached the Crown retail deposit guarantee scheme as long ago as April 1, 2009.

This is revealed among a series of documents released by the central bank covering its engagement with SCF.

The Serious Fraud Office (SFO) last month launched an investigation into SCF related party transactions. SFO CEO Adam Feeley says if fraud that enabled SCF to enter into the guarantee scheme is proven, the consequences would be "immense in financial terms" given the NZ$1.6 billion taxpayer funded payout to SCF investors' after the company’s August 31 receivership and subsequent Crown guarantee scheme payout.

In an email dated April 1 last year, the Reserve Bank’s senior risk analyst for domestic deposit taking oversight, Peter Williams, sent a file to colleague Douglas Widdowson. In it Williams commented on related party transactions from December 2008 and January 2009 noting they may breach the terms of the Crown Deed of Guarantee for non-bank deposit takers.

Williams noted in SCF’s January 2009 deposit guarantee scheme return, there were material changes including related party lending of NZ$70 million, an increase in fixed assets of NZ$53 million and an increase in listed equity investments of NZ$90 million.

Background information on this had been sought from SCF’s trustee, Trustees Executors. No specific information was provided on the January related party lending of NZ$70 million, although “general concerns” disclosed by the trustee, via the provision of a copy of a letter it sent to the company in November 2008, have been withheld from the information released by the Reserve Bank.

Nonetheless Williams says the possible Crown guarantee breach related to clause 6.2 covering arm’s length transactions.

 He notes that an un-named transaction, relating to the purchase of SCF loans by the parent – presumably Southbury Corporation – in December 2008 was a related party transaction and exceeded a 1% total assets limit, being NZ$89.6 million against the limit of NZ$21.36 million.

Furthermore, the deal didn’t have prior Crown consent, and didn’t have a written certificate provided by an approved expert that the transaction was arms length. Williams noted the latter two points had been confirmed by the Treasury.

Another transaction, relating to the purchase of listed equity investments in January 2009 from related parties, was also a related party transaction, based on Trustees Executors’ opinion. This also exceeded the 1% of total assets limit, at NZ$90 million against the NZ$21.36 million limit, didn’t have prior Crown consent nor the written certificate by approved expert.

Securities Commission also worried about related party transactions

The swathe of information also includes the revelation that the Securities Commission was concerned in November of last year that SCF's prospectus might include false or misleading statements and that it had raised the possibility of suspending or banning the prospectus if the concerns weren't resolved.

The Securities Commission was concerned about a number of related party transactions SCF had entered into earlier in 2009, the Reserve Bank's Andy Wood told Treasury's John Park in an email.

The array of information released by the Reserve Bank also includes a report suggesting SCF was not systemically important to the New Zealand economy or financial system, IE it wasn't viewed as being too big to fail.

'Glacial pace,'  'effective delaying game' & independent directors' ultimatum to Hubbard

There's also an email from Widdowson to Reserve Bank head of prudential supervision Toby Fiennes, governor Alan Bollard and deputy governor Grant Spencer dated May 28 this year.

It said: "John Park from Treasury has just let me know that events in Timaru are moving at a glacial pace."

"Their investigator informs them that (SCF director) Ed Sullivan has resigned, and Alan's (presumably SCF owner Allan Hubbard) resignation letter is on his desk. He is playing an effective delaying game holding up his signature, but time is running out."

Earlier, on May 18 and then May 19, Reserve Bank officials told Bollard, Spencer and Fiennes that SCF's independent directors - Bill Baylis, Stuart McLauchlan and Denham Shale - had asked Hubbard to stand down from the board due to governance issues. If he didn't, it was expected that the independent directors would issue him an ultimatum saying either he goes or they go. Ultimately Hubbard said he would resign, subject to a range of matters. He stepped down on May 31 and was appointed president for life.

Hubbard was subsequently placed in government enforced statutory management on June 20.

'Not all related party lending bad' & 'I will live in a tent before I see any of my depositors lose out'

A report, compiled after Fiennes and colleague Andy Wood visited SCF's leadership in Timaru in May 2009 notes that Hubbard stressed that not all related party lending was bad. In SCF's case all such deals were done on an arms length basis, Hubbard told the Reserve Bank officials.

"It was acknowledged that it is common practice for impaired assets to be removed from SCF's balance sheet and to be replaced with 'good' assets from (parent) Southbury Group, or from AH's private ventures at face value."

"In AH's view this approach protects depositors by insulating them from non-performing assets, demonstrates that the Southbury Group stands behind SCF and ensures that SCF never has to post a loss," the report, authored by Wood, says.

"Rather than provisioning and recapitalising, SCF's idiosyncratic approach avoids crystallising losses in so doing avoiding the earnings volatility that 'confuses investors'. Supposedly it also enables non-performing assets to be better 'worked out' over time."

SCF director Bob White apparently noted this approach was only as effective as Hubbard's pockets were deep.

"AH reiterated the oft-quoted point that "I will live in a tent before I see any of my depositors lose out," Wood wrote.

He concluded his report by saying that the risk remained that SCF's impaired assets were greater than Hubbard's ability to absorb them and/or divest other assets to fund. "Ongoing engagement and close scrutiny" was warranted.

'Only thing not for sale was the VW'

Meanwhile, in a letter to Treasury's Park after the trip to Timaru, Fiennes said it was "all quite murky" and ultimately dependent on Hubbard making things good in the event of problems.

"In my view it really would be sensible to get someone in to properly kick the tyres."

Fiennes said in a meeting that lasted a couple of hours Hubbard stressed several times that he would never let any SCF investor lose a cent.

"The only thing he would not part with is his 40 year old VW Beetle," Fiennes wrote.

The Reserve Bank's head of prudential supervision also said: "Hubbard has in recent months swapped in some 'good assets' (NZ$80 million of farms) for loans that would have needed to be marked as impaired in the accounts. This was to 'keep the books clean' - from our point of view, it has muddied the waters and also worsened the company's capital adequacy ratio."

'Garbage' in Standard & Poor's report

The documents released by the Reserve Bank also include an email from Clive Thorp, an adviser in its statistics unit, dated June 15, 2009 and sent to Fiennes among others entitled: "Can we use the garbage in the S&P (Standard & Poor's) June 2008 SCF report re sector risk, via the Guarantee, to force consistent NBDT (non-bank deposit taker) sector disclosure in future?"

Thorp noted that S&P's June 24, 2008 report, which gave SCF a BBB- investment grade credit rating, said only 6% of the lender's loan book was rural at the end of 2007. In contrast, the Reserve Bank had it at 19%.

An email from Spencer to Bollard on July 30, 2009 notes topics covered in a discussion with SCF director Stuart Nattrass.

"They (SCF) are clearly on the edge. Crunch point is  NZ$100 million rollover from BNZ that comes up in two weeks," Spencer writes.

He notes that Nattrass was working on merger/capital raising options, with SCF seeking NZ$100 million of capital to start with, and ultimately NZ$700 million supporting a balance sheet of NZ$5 billion. A recapitalisation would necessitate a restructure with Hubbard moving aside, a new board and new CEO. Further potential sources of capital were private equity, "Adrian," and Pyne Gould Group, Spencer told Bollard.

"They have commissioned Rob Cameron (of Cameron Partners) to 'get the message through in Wellington' that the terms of the (Crown) guarantee extension will determine whether they get a book of assets in their lap."

Hubbard's cheque book 'removed'

After insolvency specialists KordaMentha's appointment by Treasury to to assess SCF, Spencer, Fiennes and other Reserve Bank staff in an August 5, 2009 email that: "AH has had his cheque book removed."

Furthermore, SCF's provisions on impaired assets should be NZ$120 million to NZ$130 million rather than the NZ$40 million estimated by management. And an email from the Reserve Bank's Andy Wood to Bollard, Spencer and Fiennes on August 10 last year, after he attended a KordaMentha presentation on SCF, notes the firm's findings were "rather worse" than expected.

KordaMentha's findings included an inappropriate level of direct involvement of Hubbard in loan decisions, Wood wrote.

There was also no systematic grading of loans making impairment assessment and provisioning of loans very difficult. KordaMentha believed SCF needed to make additional provisions of up to NZ$170 million. With debenture reinvestment rates below 40% there was insufficient liquidity and SCF's poor internal systems would make it hard for an unrelated investor to do sufficient due diligence to commit additional equity.

"So not at all promising," Wood concludes.

'Extend the guarantee to our US private placement'

There's also a letter sent to Minister of Finance Bill English on August 24 last year, signed by Nattrass. In it the SCF director asks for the Crown guarantee to be extended to cover SCF's US$100 million US private debt placement and for assurances on the future of the guarantee scheme. Furthermore there was a "positive role" the Crown could play by providing capital in some form to help consolidate the non-bank deposit taker sector, which could ultimately see SCF and some of its competitors merge with the aim of becoming a New Zealand owned business bank.

English replied on August 30 last year saying it was unlikely he would be able to offer assistance to cover the US private placement.

The Reserve Bank documents also include an email exchange from May 2009 covering what’s described as a “somewhat surprising claim” by ex-National Party cabinet minister and former Attorney General Paul East – now of law firm Bell Gully – on behalf of SCF that the industry had not been adequately consulted on proposed capital and related party prudential regulations for non-bank deposit takers.

(Updates add additional detail, including comments from Allan Hubbard to Reserve Bank officials and the Securities Commission's concerns about related party transactions).